The ‘Healthy’ Balance Sheet of MAS

While studying a company, many people will focus on examining the financial statements of the company, and tends to ignore the lengthy, multipages notes in its annual reports.

In this article, I just like to show an example, to demonstrate the importance of going through all those notes in order to get a correct picture on a company.

Recently, there are analysts keep calling that “it’s time to accumulate good quality stocks, their prices are so cheap and are undervalued.” Last week for example, I saw a buy list on news paper that recommended investors to buy companies with healthy balance sheet.

What surprised me is, Malaysia Airlines was listed top on the list.

Well, since the “professionals” suggested that MAS had a healthy balance sheet, I guess we should at lease have a glance on its financial statements.

According to its latest annual reports, the balance sheet item of MAS is as follow:

• Non-current Assets: RM 2.63 billion.
• Current Assets: RM 7.42 billion
• Current Liabilities RM 5.25 billion.
• Non-current Liabilities: RM 0.86 billion.
• Equity to shareholders: RM 3.93 billion.

See any attractiveness in these figures?

Let’s go into more details. On its balance sheet, we’ll see that the current liabilities of MAS are mainly trade-payables and sales-in-advance, which are non-interest-bearing liabilities. The total debt (borrowing) of MAS is just about RM 0.9 billion, while it is holding about RM 5.3 billion of cash. In other words, MAS is having a net cash position of RM 4.4 billion!

Wow, this is really good, as the saying, a great balance sheet.

What’s the pitfall that lies behind this “healthy balance sheet”?

If you had gone through the footnotes in its annual reports, you’ll get some clue. MAS is actually having a huge amount of debt that is not reflected on its balance sheets -- what we called “off balance sheet items”. The most significant figures come from "operating lease arragement".

As we know, most of the aircrafts operated by MAS are not owned by itself. Instead, it leased the aircrafts from other parties and MAS had to pay rental fee on the aircrafts. The fact is, aircraft-leasing contracts are normally long-term arrangements, which are unlikely to be terminated earlier without penalty. Though they are not categorized as debt on the balance sheets, these contracts actually have the same effect as a real debt does on MAS’ cash flow -- MAS is obligated to make periodical payments on these contracts.

According to its FY2007 annual report (note 35, page-217), the amount of Operating Lease Arrangements of MAS at the balance sheet date are as follow:

• due within one year: RM 1.92 billion
• due between one and two years RM 1.91 billion
• due between two and five years: RM 3.23 billion
• due after five years: RM 1.72 billion

The total amount is RM 8.78 billion!

Taking these items into consideration, the financial position of MAS is nowhere near to ‘healthy’.

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Let's end this article with some great definitions for financial jargons: (copied and pasted from Dali's blog.)

• EBITDA - Earnings Before I Tricked the Dumb Auditor.
• Off Balance Sheet Items - More important than items in the balance sheet, and represent things that really should be in the balance sheet.
• Economist - Someone who tells you why their predictions went wrong after every quarter, and proceeds to give a confident prediction for the next 3 quarters.
• Short Term Investor - Someone who is in-and-out within 3 days or less.
• Long Term Investor - A short term investor who cannot get out profitably after 3 days.
• Momentum Investing - The fine art of buying high and selling low with the crowd.
• Value Investing - The art of buying low and selling lower.

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Get a 9% Compound Return with Minimal Risk

Few weeks ago, Burren Buffett investment in Goldman Sachs had got the attentions of Wall Street. Despite the bad economic outlook, the purchase of $5 billion preferred stocks with a juicy 10% dividend is said to be a great investment. It's said that only Warren Buffett can have the power to secure such a good deal.

But here, in KLSE, I had found a similar opportunity which can generate a 9% compound return in the next few years. And the best part is, the risk of this investment is very low.

What we had to do is just buying the Redeemable Convertible Preference Shares (RCPS) of Malaysia Airlines System at its current market prices. This RCPS is a product of MAS' debt-restructuring processes during year 2007.

Here's a short summary about this RCPS:

• Issued at RM1.00.
• preferred dividend: 3.0 sen per RCPS.
• convertible to common share of MAS at RM4.05 by surrendering the RCPS. (period of conversion: four years starting from 1-Nov-2008)
• at maturity date (31-Oct-2012), all un-converted RCPS will be redeemed at RM1.00.

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The Potential Return

the RCPS is currently trading at around 70 sen. Assume that we bought it now and hold it until maturity, the average compound return will be at least 9% p.a. in the next four years.

If MAS decided to declare any dividend during the coming years, the holder of RCPS is entitled to received a preferred dividend of 3.0 sen per share. Then the return on investment will become higher, (up to 13%, if the preferred dividend is received in each the four years).

Furthermore, the RCPS is convertible to MAS common shares. As a result, while enjoying the above benefits, the holders of RCPS will not miss the opportunity to ride on the share market performance. If, by whatever reasons, the share price of MAS shoot up during the next four years, the price of RCPS should enjoy the same increase as well.

(the converible feature of RCPS may be the main reason why it's trading at such an attractive price now. People simply tie up its price to the share price of MAS. So, when the share price of MAS drop, the price of RCPS simply follow. By right, a preferred stock should be traded at a premium to its common shares).

For anybody who is interested to buy the stocks of MAS (and the share-holders of MAS), I strongly recommend buying RCPS (or replacing their common stocks of MAS with RCPS). Because the RCPS is currently traded without premium to the common share price of MAS. That means we are paying nothing for the above benefits of preferred shares if we buy the RCPS instead of MAS common shares.

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Risk Analysis

If we are ready to hold the RCPS to maturity, there's only one risk risk that will cause us earning a return less than 9% p.a. -- MAS may be unable to redeem the RCPS at the maturity date. We have to examine the probability of this event.

According to its latest financial report, MAS is currently holding more than RM 5-billion of cash. The total number of RCPS issued was 417.7 million. Thus, MAS will have to pay out RM 417.7 million to redeem the RCPS if all of them are being held to maturity. That means, the cash currently held by MAS is actually more than 10 times higher than the amount needed to redeem the RCPS.

However, the huge amount of cash in MAS may reduce significantly in the coming years if the operating performance of MAS is very bad. But I have little worry about that.

One of the reasons is our government's policy that always protect the GLC's. Thus, despite the economic downturn and the increasing competitive environment, I think that the chance of MAS going into bankruptcy is very low. The second reasons is merely my confidence on the management team leaded by Idris Jala. I believe that with his Business Transformation Plan, Idris will turn MAS into a continuous profitable company.

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Conclusion:

With a purchase price around 70 sen, the compound return rate on RCPS of MAS will be:

• minimum 9% in the next four years,
• between 9% ~ 13%, if MAS declare dividend,
• even higher return if the share price of MAS go up.

While there's a risk that MAS may not be able to redeem the RCPS at maturity, I believe that the probability is very low.

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Profit of AirAsia (Part 2)

The main purpose of this article is to discuss why we should examine the economic performance of AirAsia from the perspective of the whole AirAsia Group, i.e. we should consolidate the statements of AirAsia with 100% revenues and profit/losses from TAA & IAA.

First, let’s have a look at the revenues and profit/losses of the three entities in AirAsia Group, presented separately in the following table (all figures are RM illion):

• (the Jan-Jun 2008 revenues for IAA & TAA are not announced yet.)
• * Adjusted PBT of AirAsia shown excludes non-operating items, but not including the profit/losses from IAA & TAA.

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If we include the share of losses (48.9%) from TAA & IAA into AirAsia’s income, then AirAsia’s profit will be as shown in the following table (as discussed in my previous post):

After these adjustments, the earnings of AirAsia will be about 8.9 sen per share (twelve months ended Jun-2008). If we accept this figure, then the current PE ratio of AirAsia is just around 12x, which is a very attractive level for me due to the high potential of AirAsia's earning growth in the coming years.

However, I still think the above adjusted figure is not reflecting the real economic performance of AirAsia. In my opinion, these figures may have been distorted by two factors – the asset allocation in AirAsia Group, and the transactions between the entities in the Group.

Let’s discuss them one by one.

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1. the asset (aircraft) allocation of AirAsia.

As we know, currently there are two types of aircrafts in AirAsia Group – the old Boeing-737, and the brand new Airbus-320. And we know that the later is the more profitable one due to its oil-efficiency and low maintenance cost. So, the routes served by Airbuses are more profitable than those by Boeing, especially in recent periods of high oil price.

What happening in AirAsia Group is, the allocation of Aircrafts is not even among the entities in the Group. AirAsia Malaysia is operating almost all the Airbuses, while the old Boeings are being pushed to TAA and IAA.

For example, according to the figures announced for the quarter ended Jun-2008, out of the 39 airbuses in the Group:

• 35 of them are allocated to AirAsia Malaysia,
• only five are in TAA,
• and none in IAA.

few weeks ago, AirAsia announced that all its routes in Malaysia are now operated by new Airbuses.

In other words, AirAsia pushed the non-profitable assets to its associates, and retained the most profitable assets within Malaysia. This might be one of the reasons why TAA and IAA are suffering continuous losses while AirAsia is making great profit.

So, if we adjust AirAsia’s income statement using only 48.9% share of losses from TAA and IAA, we are giving more weight on the Airbuses, and have a lower weights on the poor-performing Boeings. As a result, we will get an upward-biased figure about the Group’s performance.

Some people may argue that AirAsia Group is replacing all the Boeings with Airbuses. Thus TAA and IAA might become as profitable as AirAsia (Malaysia) after the replacement. So, the upward biased figures of AirAsia’s statements is a more accurate measure of Group’s future performance (After all, the future performance should be most concern to the shareholders, right?)

I will not agree to this argument. Though AirAsia is accelerating the retirement plan of the Boeings, it will take several years to complete the plan. By then, the new Airbuses today may become aged, and their maintenance will become higher, and who knows, they may just become like the old Boeings today. So, to be consecutives, I think we’d better use today combination of assets (a mix of new and old) even when we are estimating the Group’s future performance.

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2. The transaction between TAA, IAA and AirAsia. (the Aircraft Rentals)

As we know, all the aircrafts of the Group are owned by AirAsia. So, to operate those aircrafts, TAA and IAA have to pay rental fees to AirAsia. This is another part that may distort the reported performance of AirAsia.

When AirAsia receive rentals from TAA & IAA, it’s recorded as an income, which is off course 100% reflect on AirAsia’s earnings. So, the higher the rental, the more it benefits AirAsia. But from the view of TAA or IAA, these rentals are expenses. That means a higher rental fees will reduce their profit (or increase their losses), i.e. a higher fee will have a negative impact on them and thus AirAsia.

Again, because AirAsia owns 48.9% stake in TAA and IAA, only half of the rental expenses in TAA and IAA would be consolidated into AirAsia’s statement, while 100% of AirAsia’s rental income will be reflected on the same statement. So, by simply charging a higher rental fee, AirAsia could increase its reported earnings without improving its operating performance.

From the perspective of the whole AirAsia Group, the rental fee among entities shouldn’t have any effect on the overall performance. So, we should consolidate 100% of the revenues and profit/losses of TAA & IAA into AirAsia’s statement, to get a clear picture on the Group’s operating performance.

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Conclusion:

By treating three entities as a group, we can eliminate the potential distortion of AirAsia’s economic performance from both its asset allocation policy and the aircraft rental fees.

The following table shows the 100% consolidated revenue and profit/losses for AirAsia Group. Profit margins of AirAsia (Malaysia only) are included in the table for comparison purpose. (Revenues and PBT are in RM million, Margins are in %).

• The 3rd column (AirAsia Margin) is calculated using PBT reported in AirAsia’s statement.
• The 4th column, Adjusted AirAsia Margin, are reported figures excluding non-operating items (the foreign exchange gain and selling of interest rate swap contracts), and not including profit/losses from TAA and IAA.
• the Group’s PBT and Margin are also excluding non-operating items.

From the table, we can see that the overall profitability of AirAsia Group is much lower than the figures reported in AirAsia’s statement (which only reflect the non-consolidated profit of AirAsia in Malaysia).

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