Qantas earnings guidance suggests an update of expert’s report

A report by Brian Frith in The Australian says that the release by Qantas Airways last week of earnings guidance for 2008 raises the issue of whether the airline should also require Grant Samuel to revisit its independent expert’s report.

In particular, the question arises whether the earnings guidance would cause Samuel to revise upwards the valuation of Qantas and, most importantly, whether it sticks by its conclusion that Qantas shareholders are “likely to be better off” accepting the offer now rather than waiting for the sharemarket price to “possibly” rise to the bid price or higher “over time”, and whether it considers the Qantas share price would still be likely to fall back to the pre-bid level if the $11 billion APA consortium bid fails.

This is a live issue because at least two institutional shareholders, UBS Global Asset Management and Balanced Equity Management, have expressed reservations as to whether the offer price of $5.45 a share is adequate. If they hold out, the bid would be at risk of failing. Grant Samuel has valued Qantas in the range of $5.03 to $5.83 a share.

Bidder’s statements and target’s statements have long been required to include all information known to them, and material for shareholders deciding whether to accept the offer.

Until the 2000 CLERP law reform, bidders and targets were not required to update those documents, but the law was amended to require the issue of supplementary statements if material issues arose that may affect target holders’ decision on a bid.

There is no requirement that experts’ reports be updated should a material issue arise after the report has been published, even though it may affect the expert’s valuation and conclusion were it to be taken into account. If the aim is to ensure that target shareholders are properly informed, there can be little argument that the supplementary regime should extend to experts’ reports.

Qantas has twice updated its 2007 profit forecasts since the bid was launched. On December 1 it forecast that 2007 pre-tax earnings would be 25 per cent to 30 per cent higher than the previous year. On February 8 that was upgraded to 30-40 per cent.

Last week, Qantas capitulated to institutional shareholder pressure and indicated it expected the pre-tax earnings rise to be near the 40 per cent top of the range, which would equate to $940 million, and pre-tax earnings would rise a further 30 per cent in 2008 to $1.23 billion in line with the average consensus of analysts. That equates to a price to earnings ratio of 14 times the 2007 result, and 12.7 times the expected 2008 result.

If anything, that has increased the feeling in some quarters that APA is not offering enough, despite the consortium’s insistence that it is unable to increase the bid price of $5.45 a share (ex-dividend). Whether it would change Grant Samuel’s view is another matter, but that would be useful for the market to know.

Grant Samuel said in its reports that its source of information included publicly available material such as the bidder’s and target’s statements, annual reports for the past five years, public announcements and media reports, and sharemarket data on Australian and international airline companies and acquisitions in the industry, and broker reports.

It also had access to non-public information, including board business reports (including management accounts) for the four months to October and six months to December, the latter including the latest management forecast for the 2007 years.

It was also provided with management’s three-year plan to 2009, prepared in May last year, and the five-year outlook to 2011, which was prepared last June. The expert was also provided with other confidential documents, board papers, presentations and working papers, and held discussions with, and obtained information from, senior management and the airline’s advisers. Management’s three-and five-year plans would also certainly include an earnings forecast for 2008.

It may well be that 2008 earnings guidance now given by Qantas is in line with that information. In fact, that’s probable because the guidance is in line with analysts’ expectations.  It would nevertheless be helpful for the market if Qantas was to ask Grant Samuel was to clarify the matter, one way or the other.

That’s what Flight Centre’s independent expert, Ernst and Young, did on its privatisation proposal after the company posted a 10 per cent increase in its half-yearly profits.  The analyst considered the results and confirmed that it was still of the opinion that the proposed scheme of arrangement was in the best interests of the non-associated shareholders.

Of course, that recommended proposal was killed off by one institutional shareholder, Lazard Asset Management, which did not consider the offer was high enough.  That had unsettled the market, which is concerned that UBS and Balanced Equity may do the same.

Hedge funds, which have piled into Qantas and are now estimated to hold close to 40 per cent, are particularly worried because they stand to incur heavy losses if the bid fails.  It’s difficult, though, to have much sympathy for hedge funds.  They are professional investors and they take a calculated risk when buying into stocks subject to a takeover bid.

What is behind much of the simmering institutional discontent, and which led to the pressure for a 2008 profit forecast, is the suspicion that, in deciding on a bid for Qantas, the APA consortium was privy to more vital information than has been given to shareholders to enable them to decide whether to accept the offer.  Both Qantas and APA deny that is the case.

What’s driving this view is knowledge of how private equity groups normally work.  Before bidding for a company they demand the ability to undertake detailed due diligence to be able to convince their investors and bankers to back the transaction.

Typically, the investment committees and financiers require an information memorandum, which includes financial models and a detailed five-year profit forecast and where management is to be retained, as is the case with Qantas.

Often the incentives for senior management are built around those assumptions.

Those critical of the amount of information provided to target shareholders may have a point on Qantas domestic and international operations.

It’s suggested that the domestic operations are performing strongly since the introduction by Qantas of its low-cost offshoot, Jetstar.  That’s because it has enabled Qantas to quit routes on which it was not making money and to use Jetstar to service those routes profitably from its lower cost base.  Qantas international operations are more patchy because it is still flying some unprofitable routes.  If the bid succeeds, APA would no doubt use the same formula – have Qantas quit those routes in favour of Jetstar.

It’s possible to get some indication of this trend from the Grant Samuel report, which separated the earnings of Qantas and Jetstar, but didn’t break them down into domestic and international.

The tables show that the Qantas EBITDAR margin fell from 20.6 per cent in 2004 to 18.2 per cent in 2006, but recovered to 20.9 per cent in the December half year, which may partly reflect quitting unprofitable domestic routes.

Jeststar’s EBITDAR margin, by contrast, has shown consistently strong growth. In 2005, the first full year of operations, it was 18.2 per cent.  It rose to 19.7 per cent in 2006 and bounded to 25.2 per cent in the December half year.

It wouldn’t surprise if Qantas came under pressure to release further guidance, in particular on the split between the earnings of the domestic and international operations, and the outlook for those divisions.

Report by The Mole from The Australian