ANALYSIS: Under-valued airlines prompt alternative thinking

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It comes as no surprise at Qantas that an investor group would emerge such as the one including former senior executives Geoff Dixon and Peter Gregg.

Analysts have been warning since last June when the share price hit a record low, that this could attract opportunists keen to wrest control from Alan Joyce, current Qantas chief executive, and sell off assets. An aversion to the Emirates tie-up and Qantas's status as one of the world's few investment-grade airlines, may partly explain Dixon's group's interest. But a share price that capitalises Qantas at only A$3 billion ($3.1 billion) is bound to attract attention from those who see a potential profit, regardless of whether they are former company executives.

"Holding company discount" is the term economists use to describe a publicly-traded company's share price when it falls below the perceived value of the company's assets. Qantas shares are currently trading in the A$1.50 range, up from a record low of A$0.97. But even A$1.50 per share times the number of outstanding shares only equals the airline's cash reserves. It recognises no value for anything else.

Dixon is well aware that the Qantas frequent flyer program and a partial stake in Jetstar, the low-cost brand of the Qantas group, alone could fetch up to A$2 billion before even looking at cash reserves or other assets. As John Singleton, one of Dixon's investment partners, commented to local media after the Qantas share price plunged: "If you bought all its shares for a billion dollars tomorrow, you'd have $3 billion in cash in that company. Cash. It cost you $1 billion to buy $3 billion - is that a good deal or not?"

It is not quite as good a deal now, but still the spread between share price and asset value is enough to draw the kind of attention that Qantas managers would rather not have.

Peter-Jan Engelen, a professor of financial economics at Utrecht University, the Netherlands, has studied holding company discounts. His expertise and publications are on corporate finance, value creation and governance. He points to several studies that show discounts for US companies in the range of 11% to 21%, around 15% in the UK and 10% in Japan.

What level of holding company discount starts to attract the kind of attention Qantas is now receiving? It depends, says Engelen, on the investor appetite for corporate control, the level of free float on the shares, and how the acquirers assess the potential synergies and value of certain assets. "It is difficult to give a magic number," he says, "but anything above 20% seems like a natural candidate."

In other words, when the gap between share price and asset value exceeds 20%, watch out for a take-over bid. Or, as in the case of Air Canada six years ago, the company itself may decide to sell its own assets. Robert Milton was intent on "monetising" Air Canada's divisions, as he called it, partly to reduce the threat of a takeover and partly to reward investors who had helped the airline survive bankruptcy. Professor Engelen agrees that a corporate restructuring "can unlock and reveal the hidden value of certain business units".

In the case of Air Canada this happened. It sold its regional airline, Jazz, its frequent flyer programme, maintenance base and many other assets. Shareholders did very well, but others argue the sell-off permanently crippled the airline. Instead of fleet maintenance and repair at its own maintenance base, for instance, after the sell-off Air Canada had to negotiate with a third party for this work, and pay a commercial rate that included a profit margin for that third party.

Professor Engelen acknowledges that the value of spinoffs is lower when parent and subsidiary are in the same industry. "In same-industry holdings, synergies between different divisions can be important." Losing those synergies may be costly to the parent airline.

In such cases, says Engelen, a partial carve-out may be the best solution. "The parent company spins off a division (for instance, a frequent flyer programme) through an IPO, while retaining the majority of the shares." As he explains, "this combines the best of both worlds. On the one hand, the division becomes a stand-alone company so its value-creation is now transparent and all transactions between the parent and the new company occur at arm's length. On the other, the majority stake together with adequate agreements between both companies safeguard future business relationships."

Aeromexico completed just such an arrangement in December when it finished selling 49% of its Club Premier loyalty programme to Canadian partner Aimia (ironically this is the same the loyalty management company that grew out of Air Canada's divested frequent flyer programme Aeroplan).

Arm's length transactions instead of synergies are obviously a trade-off, but on balance they may help the parent airline if that is what it takes to keep corporate raiders at bay. Whether Qantas will resort to this as a defensive move remains to be seen. For now, Alan Joyce is touting the strategic value of keeping all of Qantas together, and promising: "we will never be wreckers of this amazing company."