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AirAsia Under Pressure As Accounting Questioned; Stock slumps 20% as accounting practices come under fire, adding to concerns about a weak ringgit.

ROBERT GUY

June 16, 2015

It’s been a tough six months for AirAsia chief executive Tony Fernandes as he’s grappled with the tragic aftermath of the crash of flight 8501, which plunged into the Java Sea off Indonesia just after Christmas. Having worked hard to contain the damage to the reputation of the Malaysian airline which over the past decade forged a reputation as a pioneer of low cost airline travel across Asia, Fernandes now confronts a new challenge threatening the company’s reputation – questions about its accounting practices.Shares in AirAsia (AIRASIA.MY) have fallen 20% over the past six days, the stock’s longest losing streak since mid-March, after Hong Kong-based accounting research group GMT Research said it had penned a report that “questions its accounting, profit generation, cash flow issues, leverage and group structure.” While the report is embargoed from the media until June 24, GMT said it was “in discussions with the company about our concerns.”

The punishment meted out by investors over recent days has pushed AirAsia shares to their lowest point since September 2010, with the stock down 36% so far this year compared to a 50% advance in the Bloomberg Asia Pacific Airlines Index. The stock was trading around MYR1.71 a share on Tuesday afternoon. Not surprisingly, the stock’s slump and its relative underperformance compared to its airline rivals has sparked debate among analysts about whether AirAsia represents a good buying opportunity, while some have used the claims to take a closer look at the airline’s earnings quality.

Deutsche Bank analysts Joe Liew and Joshua Lee told clients on Monday that the selloff was “unwarranted”, although they acknowledged investors concerns about the company’s exposure to the weak Malaysian ringgit and the significant growth in loans to associates over the past couple of years. The ringgit has weakened by about 7% against the U.S. dollar this year, a not insignificant headwind for an airline that pays for its aircraft and about half its operating expenses in greenbacks. Deutsche calculates that every 1% depreciation in the ringgit against the U.S. dollar hurt core earnings by 1.7%.

However, it is the sizeable increase in the size of loans to AirAsia’s associates, or the regional AirAsia carriers, that has monopolized analyst attention in recent days. Deutsche says the loans have increased to around MYR2.8 billion from MYR800 million over the past two years, with the Indonesian and Philippine operations owing AirAsia the most. The amounts owed by the associates to AirAsia are not trivial, amounting to around 59% of AirAsia’s equity. However, the analysts note the company’s latest quarterly results reveal AirAsia’s plans to deal with the issue by swapping debt for equity and finding external investors to inject new equity into the indebted businesses. The challenge, of course, is finding investors that want a slice of an indebted airline.

Despite AirAsia’s challenges, Deutsche reckons that the pullback in the share price offers a good opportunity to buy, noting that the airline is trading at one times its projected 2015 price-to-book value, the lowest level since August 2010. The broker has a 12 month price target of MYR2.88 a share.

An upbeat view of the stock was echoed by Maybank analyst Mohshin Aziz, who noted that “none of the issues raised in the report are new and the analysts community have deliberated it meticulously.” Running through a worst case scenario where AirAsia writes off the associates, equal to about MYR1.03 a share or 61% of shareholders equity, this would cut shareholders equity to MYR1.8 billion or a book value of MYR0.65 a share.

While deeming such as scenario as “improbable”, the analyst notes that such a massive write down would raise gearing to 6.1 times from 2.5 times currently, which would surpass the previous peak of 4.4 times in 2008 during the global financial crisis. The analyst cautions that “at such stretched levels, it may potentially trigger debt covenants and become an impediment to future borrowings.”

Aziz rates AirAsia a buy with a price target of MYR2.45 a share, a target based on a price-earnings ratio of nine times projected 2015 earnings. “We are confident that the Malaysian operations will perform better, buoyed by a better supply-demand balance and the restructuring at Malaysian Airlines will provide significant benefits.”

A more circumspect view on the stock was offered by AllianceDBS analyst Tan Kee Hoong, who called out the airline’s depreciation policies as “aggressive” compared to its regional peers in a note on Tuesday morning. AirAsia’s price target was cut to MYR1.80 a share from MYR2.30 a share after the broker raised the discount on its sum-of-the-parts valuation to 50% from 35%. The problem with AirAsia’s depreciation policies is they imply an annual depreciation rate of 3.6% compared to between 4.5% and 6.3% among its rivals. Normalizing the depreciation rates to 4.5% – which is in line with Cathay Pacific and Thai Airways – could deliver a decrease of between 22% and 24% in the broker’s core net profit forecasts for the 2015 to 2017 financial years.

AirAsia’s performance vs. Bloomberg Asia Pacific Airlines Index in 2015

Source: Bloomberg

AllianceDBS also zeroed in on the role played by AirAsia’s associates in the company’s recognition of aircraft lease income and interest income. The broker notes that “over the past few years, IAA [Indonesia AirAsia] and PAA [Philippines AirAsia] were unable to make good on the lease expense payable due to their deteriorating cash flows in the face of tough operating environments in the two countries.” The analyst also says the recognition of interest income from the loans to associates distorts earnings quality and there are unlikely to be any cash inflows in the near term.

AllianceDBS argues that adjusting for the distortions it has identified could mean between 30% and 35% downside to its core earnings forecasts for the 2015 to 2017 financial years. The broker rates the stock as a hold, arguing that at 10 times its projected 2015 earnings the airline‘s valuation seems fair relative to its peers. “As such, we think the recent sell-down has yet to offer significant value and margins of safety for investors, especially in light of negative sentiment surrounding GMT’s Research’s report.”

It appears investors in AirAsia should be bracing for more turbulence over the coming week before GMT’s research is revealed on June 24, but more importantly, as they await the airline’s response to the claims.