Alliance Airline (AQZ) is a diamond in an unfashionable, capital intensive industry where competition and uncertain macro-economic events puts pressure on pricing and revenue, whilst fuel, staffing costs and necessary maintenance puts significant pressure on profits.

The perfect airline would have the ability to pass on costs and locked in contacts to protect revenue. And that’s exactly AQZ, indeed, it has a strong moat around it, which airlines like REX and QAN would love and ‘would be’ airlines like BONZA and all those cheapies before it would have killed to have.

So, why is AQZ different and why is it worth more than a glance? Afterall, it made a loss in FY22, but has returned to profitability in FY23.

Different, YES. It derives 57% of its revenue from locked in Fly-In-Fly-Out (FIFO) contacts with the cream of Australian mining. It is the largest FIFO supplier in Australia and has been for many years. This has to be a very strong moat. I cannot recall it losing a client and this year it added two more major clients. Plus, these contracts have clauses in place to accommodate rising costs, so margins are protected.  

So, let me tell you about the loss in FY22 – not significant, given this was a year to reflect the damages of Covid, as the results of QAN & REX will attest. The major reason for the loss was an abnormal cost of $28m to reflect the infrastructure& administrative costs of recruiting and training staff to man their 33 Embraer E190 jets which they acquired at a bargain price of $5m each when the real market value was around $50m apiece. Such was the depression in the airline industry during Covid.

AQZ had more infrastructure costs in FY23 but chose not to capitalize them in the accounts. Long story short, 30 of those 33 jets are now under wet or dry leases and the revenues and profits will be streaming in during FY24 and beyond.

Such is the expected future demand, AQZ in May this year announced yet another major capital purchase of an additional 30 E190’s and some 16 of these will be made ready for service by June 2024 – that said, the costs of establishing staff and infrastructure will be done at a much more economical cost. Besides up to 16 of this acquisition might well be cannibalized for parts and replacements which will lower their operating costs plus provide also commercial opportunity in selling to others as well. At this stage it should also be noted that AQZ – with the assistance of Government funding – has established a substantial hangar at Rockhampton in Queensland to service its growing fleet. This will automatically save on maintenance costs as previously this was done overseas. The hangar is open for business in early September 2023.   

Now, you probably know that QAN (20% ownership of AQZ) has lobbed a $4.75 takeover bid which has been kyboshed by ACCC. It’s not dead, as QAN are boxing on, though I’d be sure the $4.75 price tag will have to be upped to well over $5, given the impressive runway now pretty well laid out and ready for take-off.

Why their interest? Well, they have an agreement to take up to 30 of the initial E190’s under a wet lease and have so far executed some 22 of them – with more to follow.

AQZ are positioning themselves to become wet and dry lease wholesalers as well as FIFO specialists; all of these have protection against cost increases. So, a dry lease is one where they simply lease out the plane and the lessee pays all costs. With a wet lease, AQZ supply the plane plus staff at an hourly rate, but the lessee in this instance pays airport charges, fuel, sells the tickets etc.

Why consider AQZ and what are the catalysts?

One line summary: Infrastructure in place for more planes travelling more hours at reduced operational maintenance costs with fuel costs covered by customers; mosy of whom are largely ASX200 entrants.

The company has a very experienced board & management team with a very strong shareholding interest.  

 Moat like status in both core areas of the industry (a) FIFO (b) Wet leasing

 Very great majority of infrastructure and start-up costs of the E190 fleet now met from past years results. The E190 fleet plus parts will number around 63 by FY25.

 AQZ sell plane hours and for that you need planes. At FY23 they have 68 planes (Fokkers and E190’s) in the fleet. This grows to 84 in FY24 and 94 in FY25.

 The new Rockhampton hangar will provide cost reductions on annual maintenance. Expect better margins going forward.

 Substantially more flying hours in FY24, FY25 and beyond.

 Dividends likely to be reintroduced at 1HFY24 – analysts see 3c to interim FY24 and 16c in FY25.

 The value of the planes has been recorded at cost though the market value is likely to be substantially higher given the brilliant acquisition price, particularly of the first 33 E190’s at a low point in the cycle. 

 Analysts Considerations on Value

 Analysts have FY24 revenue improving by 20% and 15% in FY25. EPS expected to be 37c in FY24 (v 22.7c in FY22) and 42c in FY25.

 3 analysts value AQZ at $4.55 – 1 Strong Buy and 2 Buy

 Potential Headwinds

 Failure to place E190’s under wet or dry leases - unlikely in short to medium term given the pent-up demand for travelling presently – acknowledged by the company.

 Debt Levels are high as they digest the two E190 acquisitions. Net debt to equity at 61% FY23. That said, my estimate of interest cover at end of FY24 is 3.6 – so comfortable.  

Disclosure: a long-term fan and held IRL

Qantas has lobbed a 100% takeover bid for AQZ (that is, acquire the remaining 80% which they don't already own) by offering $4.75 per AQZ share as then converted to a QAN share based upon a volume weighted average price (VWAP) of Qantas shares over the 20 business day period ending on (and including) the record date for the Scheme, subject to certain adjustments. So for example if the value of a QAN shares as determined as above is $5.50 then AQZ shareholders will get $4.75/$5.50 of QAN shares or 0.8636 QAN shares ofr each 1 AQZ share

The intrinsic value of the offer is about right, so no issues there, but there are many hoops to be jumped through to make this happen which may take time and then one needs to decide whether they want to hold QAN shares. But, the catalyst has been set for an AQZ share appreciation and so it has happened.

I am a big fan of AQZ, it's strategy and execution by a good management team – but the poor 1HFY22 results are a reminder of two things.

 (1)  Business “gobbledy-gook” can cloud reality. The company guidance of $45m to $50m in ‘underlying’ NPBT for FY22 translates into a breakeven (at best) ‘statutory’ NPAT and likely no final dividend either.

 (2) the difference between “underlying” and “statutory” results can be put down to two events; one predictable and the other an abnormality.

 The predictable extra expense was the massive one-off cost in preparing to take on a much larger flying fleet; hiring and training of extra crew, maintenance on the additional E190’s, ground infrastructure etc.

 The unpredictable event was of course Covid and its impact on flying. It put back their E190 fleet deployment by at least three months, perhaps more.

 So FY22 is an absolute ‘dot-ball’ and the focus must be on FY23 where we will possibly reap 75% of the benefits of the very much enlarged flying fleet and FY24 should really reflect the full value of the bargain based purchase of the 32 E190 planes.

 Of mild concern is management’s failure to advise the market of the loan covenant breach and the huge expenditure impact of onboarding the E190’s. As investors, we probably should have taken the latter into consideration, but the extent of the impact was what stunned me.

 Still, onwards and upwards and I can see FY23 eps of around 33c with a 18c ff dividend which isn’t too shabby at current $3.75 SP. That said, I do think there are better opportunities atm and I will just sit and watch how effectively they complete the roll-out.  

The Pandemic has made an absolute mess of the airlines and tourism, yet there is one exception. It Alliance Airlines (AQZ) where FY21 revenue was up 3%, underlying NPBT was up 25% and underlying cash ops up a massive 73%!

And wait for it, FY22 will trump this like Donald, because anticipated annual flight hours could be as much as 3 times higher than FY21.

Apart from good and astute management, the secret sauce here is the brave, even audacious, decision to buy 32 Embraer E-190’s at the bottom of the cycle and now these ridiculously cheap E90’s at approx. $5.5m each will generate around $2m EBITDA annually according to Credit Suisse analysts. By the way, not that many months before the FY20 collapse these E190’s were valued as much as $50m each!

So QAN now have them flying and likely there will be 18 of them wet leased in QAN colours before FY22 is concluded. Indeed all 32 of the E190’s are likely to be in service come end of FY22 where annual flying hours at that point will be around 80,000 from the E190’s alone. Plus there is the usual workload of the Fokkers where around 37,000 hours pa can be expected.

Demand is strong and management are very confident in their E190 fleet.

So FY22 will be a transformative year as they roll out their E190’s progressively and whilst they didn’t give an outlook in figures, this very conservative management team did state  - quote – “Alliance retains a positive outlook for the FY22 year with organic opportunities geographically and across contract, charter and wet lease revenue streams.”

Analyst coverage of (1 strong buy 2 buy and 1 hold) suggests FY22 eps of 26.5c (FY21 20.9c) and a huge 35.7c in FY23. Personally, I don’t believe they have fully factored in the progressive rev/profit from the E190 roll out and I believe it could be close to 30c in FY22.  

Net debt to equity is a manageable 37.5% with interest cover of 12.72x. Plus management are not declaring a final dividend and I suspect this will be the same for 1HFY22 as they digest the debt of the E190 purchase.

AQZ made a massively cheap purchase of E190's in 2020 and the recent Qantas agreement suggests they are going to get them out very quickly on wet or dry leases. This will give them a brilliant ROI and don't forget its not just the Aussie marketplace. These E190's will be deployed throughout Asia in due course. A great company which will grow NPAT yoy. But likely no divvy in 2020 as they crunch the debt burden.

AQZ dropped today as has REX and QAN - no doubt on fears of higher oil prices due to Middle East problems. But, I would contend that AQZ is better equipped to deal with such cost blow outs because its operating margin (13%) is close to double that of the commercial airlines (QAN, REX, Air NZ and basketcase VAH).

It also beats the commercial airlines in the all important metric of ROC @ 14.7% v the average of the commercials at just 11%.

I topped up today at $2.38 because of its strong Balance Sheet and a likely grossed up yield of just over 9%, but it does have both headwinds and tailwinds as follows:

Tailwinds:

Expected expansion in contracts and wet leases - plus onboarding of extra aircraft

Headwinds:

Oil prices and a likely lower AUD

The company is expecting growth in FY20 and I see FY20 eps @ 18.4c with a FF divvy of around 15.5c.