gram grows as a proportion of earnings,
the quality of the business improves. But
let’s not get ahead of ourselves. It’s how
Buffettmadehisbetthat’sarguably
moretelling.Hedidn’ttrytopickasin-
gle winner; he spread his money evenly
acrossthebigfourairlines.Perhaps
he thought they were all undervalued,
although it may also suggests there is
very little to differentiate one airline
from another.
So what is Qantas’s loyalty division
worth? It earned $1.5 billion in revenue in
2016and$346millioninpre-taxprofit,a
figure that has grown at around 10% a
year over the past decade. The program’s
pervasiveness–withfewmajorcompeti-
tors–givesitareasonablecompetitive
advantage that looks sustainable, at least
in the short to medium term.
In 2014, Virgin Australia sold a 35%
stakeinitsVelocityloyaltyprogramto
theprivateequitygroupAffinityPart-
ners for $336 million, suggesting a total
valueofaround$960million.Atthe
time it had around 4.5 million members,
with $205 million in revenue and
$76 million in earnings before interest
andtax.Onasimilarvaluation,ifitwere
sold,Qantas’sloyaltydivisioncouldbe
worth around $4.3 billion, although its
lowermarginsandslowergrowthmean
somethinginthe$3billionto$3.5billion
range seems more reasonable.
AtQantas’scurrentmarketcapitalisa-
tion of $9.66 billion, the loyalty division
accounts for roughly a third of the stock’s
value–butit’sthatothertwo-thirdswe
worry about. There is a diamond here
butit’ssurroundedbyabigpileofrough.
Hugefixedcosts,volatilefuelprices,
unionisedlabour,acapital-intensive
business model, competition from gov-
ernment-subsidised Middle Eastern and
Asianairlines,andafleetofotherrisks
could still leave investors in deep, deep
fertiliser if the airline hits turbulence.
ThesameargumentgoesforVirgin
where, if anything, even more risks exist.
Qantas’s loyalty division offers a floor
toourvaluation,butwiththeshareprice
up 87% over the past year and currently
trading far above that floor... avoid.M
GrahamWitcombisananalystatIntelligent
Investor, owned by InvestSMART Group. This
article contains general investment advice only
(under AFSL 282288). To unlock Intelligent
Investor stock research and buy recommenda-
tions, take out a 15-day free membership.
tailwind for Qantas. It earns a couple of
centsorsoperpointawarded–andits
partnersareclockinguppointsinthe
tens of billions. All those points being
issued translated into more than $1.5 bil-
lion in revenue for the company in 2016.
HIGH MARGINS
The old laws of the airline industry
are being rewritten. As mentioned, when
selling flights directly to travellers,
airlinesfighttoothandnailtooffer
thelowestprice,which–giventheir
largefixedcostbase–tendstomean
wafer-thin margins. Increasingly, how-
ever,Qantasisn’tsellingflightstotrav-
ellers, it’s selling points to banks, hotels
and businesses.
Thosebusinessesknowthatifthey
aren’t associated with the Frequent Flyer
program, they’re going to lose custom-
erstoacompetitorthatis,andthat
makes them more willing to pay up for
points.Qantas’sloyaltyprogramistwice
as profitable as any of its other divisions,
with a pre-tax profit margin of 24%.
What’s more, the loyalty division is
improving Qantas’s balance sheet. Oper-
atinganairlinerequiresmountainsof
capitalfortheupfrontpurchaseofplanes
and maintenance. Despite the occasional
year of decent returns – this past one be-
ingacaseinpoint–Qantasearnsterrible
returns on capital “through the cycle”.
Over the past decade, the airline has pro-
ducedanaveragenetprofitofjust
$61millionyetrequiredmorethan$3bil-
lion of shareholder equity to do so.
The loyalty division, on the other
hand,hasbeenaconsistentearnerand
requires very little capital to operate. It
also has more favourable cash flow, be-
cause revenue from the merchants ar-
riveswhenthepointsareissuedbut
Qantas only pays for a product or ser-
vicewhenthepointsareredeemed.That
maybeagood18monthslaterandQan-
tasgetstoinvestthecashinthemean-
time.
ThiscouldbeonereasonBuffettmade
his airlines bet – their loyalty divisions
resemble the Blue Chip Stamps loyalty
program that got Berkshire started and
the “float” generated at its insurers.
DIAMOND IN THE ROUGH
Buffett’s airline purchase suggests
thatmaybeairlinesaren’tasbadasthey
oncewere.WithregardstoQantas,we
would have to agree. As the loyalty pro-
QANTAS:
FACT
FILE
- Loyalty division
consistently profitable
- Improving balance
sheet and margins
- Major risks remain
- Avoid
