SIA bonds: a great way to earn stable income

Singapore's national airline

Singapore Airlines Limited (“SIA”) has commenced operations since 1972. The company is listed on the SGX Mainboard and is a constituent of the Straits Times Index, with a huge market cap of S$11.3 billion at yesterday’s market close. SIA’s biggest shareholder is Singapore’s sovereign wealth fund, Temasek Holdings, which controls around 56% of the company’s shares.

SIA is a well-established leader in Singapore’s aviation industry. Besides operating under its eponymous flagship carrier, SIA also fully owns the local aviation brands “SilkAir” and “Scoot”. In addition, SIA owns a 20.0% stake in Virgin Australia Holdings Ltd, and 49.0% of both TATA SIA Airlines Limited (operates the Indian domestic airline, Vistara) and NokScoot Airlines Co., Ltd (Thailand-based low-cost carrier).

SIA reports five main business segments by brands operating under the group, namely Singapore Airlines, SilkAir, Budget Aviation (under the Scoot brand), SIA Engineering Company (“SIAEC”), and SIA Cargo. The last two segments are mainly involved in aerospace maintenance and cargo transportation respectively.

Geographically, SIA serves 138 destinations globally (as at 31 Dec 18). As shown in Chart 1, most of SIA’s revenues are generated from the East Asia region, at about S$9.0 billion in its last financial year. Europe and South West Pacific contributed about S$2.0 billion respectively, while Americas, West Asia, and Africa contributed about S$1.0 billion individually in FY18/19.

Chart 1: Revenue by geography

Challenging market conditions in FY18/19

SIA registered a total revenue of S$16.3 billion in FY18/19 ended 31 Mar 19, up 3.3% from S$15.8 billion in FY17/18 thanks to growth in passenger volume. Revenue passenger-kilometres (a measure of demand) increased 7.0% year-on-year (“YoY”), which is higher than the 4.5% YoY increase in available seat-kilometres (a measure of passenger carrying capacity). Overall passenger load factor improved 2 percentage points to 83.1% in FY18/19. Singapore Airlines contributed around 80.0% of the total revenue, while Budget Aviation contributed 10.5% and the other segments accounted for the remaining 9.5%.

The aviation industry can be broadly characterised as one that faces tight competition as well as high operating expenses and capital expenditures. As such, tight profit margins are the norm in the industry. The group’s operating profit margin (operating profit/revenue) for FY18/19 decreased to 6.5% from 9.8% for the previous financial year, mainly due to larger increases in most categories of operating expenses such as fuel charges.

Singapore Airlines and SilkAir saw their segment operating margins drop to 7.6% and 1.5% respectively, from 12.7% and 4.4% in the previous financial year. Meanwhile, Budget Aviation (mainly Scoot) registered operating losses of S$15.4m, compared to an operating profit of S$77.7m in FY17/18. Slowdown in the rate of growth of Chinese travel, regional competition, an unusual level of operational disruptions, alongside rising fuel expenses sent Scoot to the red in FY18/19.

Despite facing challenging market conditions in the last financial year, SIA’s operating results have been growing healthily if we were to take a longer view. Operating profit and operating profit margin back in FY12/13 stood at S$229.2m and 1.5% respectively (see Chart 2). Since then, operating profits have grown almost five times to S$1.07 billion, and operating profit margin widened to 6.5%.

Chart 2: SIA's profitability from FY12/13 to FY18/19

Finance charges increased to S$116.1m in FY18/19 from S$89.8m in FY17/18 due to more borrowings raised for aircraft purchases. Other non-operating items took a loss of S$47.4m, compared to a gain of S$19.3m in the previous financial year, largely due to the incurrence of S$59.8m in re-fleeting and restructuring costs. These pertain to SilkAir’s re-fleeting costs for its transition from an Airbus fleet to a Boeing fleet, as well as reorganisation costs incurred in preparation for the carrier’s integration into Singapore Airlines.

The group also recognised share of losses of S$97.4m from associated companies in FY18/19, mainly due to the S$116m share of losses arising from Virgin Australia’s non-cash accounting adjustments2 in prior quarters. Overall, SIA ended the financial year with S$721.6m of net profit (FY17/18: S$1.35 billion).

The big expenses: fuel and staff costs

Of total operating expenditures of S$15.3 billion in FY18/19 (FY17/18: S$14.3 billion), a substantial 30.1% incurred were fuel expenses after hedging, amounting to S$4.6 billion. Thanks to fuel hedging, SIA managed to save S$413.3m in fuel costs during the financial year. Without hedging, fuel costs would have increased by S$1.00 billion, mainly due to increased fuel prices observed over the financial year (see Chart 3).

Chart 3: Jet fuel prices in USD/barrel (July 2016 - July 2019)

In SIA’s financial results briefing for FY18/19, Mr Stephen Barnes (Senior Vice President, Finance) shared that the group has a program in place to continue hedging jet fuel for the next five years, such that the group will be in a hedge ratio range of 45-46%. For SIA’s 1QFY19/20 (ending June), 80% of the airline’s jet fuel requirements are already hedged at an average hedged price of USD75 per barrel. This would likely lead to a hedging gain for the quarter, as the average jet fuel price was USD80.8 per barrel over the three months ended June.

According to the breakdown of fuel costs as disclosed in SIA’s FY18/19 annual report, the increase in oil prices was the main reason for the overall increase in fuel expenses. Increase in volume consumed and depreciation of USD/SGD (fuel purchases are denominated in USD) had much smaller influences on the group’s fuel expenditures.

Meanwhile, fuel productivity as measured by load tonne-km per barrel (ltk/BBL), improved by 1.3% to 451ltk/BBL in FY18/19, mainly due to a higher load factor (the percentage of available seating or cargo capacity that is filled) and more fuel efficient aircrafts. Nonetheless, we think fuel hedging remains essential to reduce the exposure to volatility in fuel prices.

In its FY18/19 annual report, SIA said that an increase in price of one USD per barrel of jet fuel will increase the group’s annual fuel costs by S$56.7m, nearly 5.3% of its operating profit in the most recent financial year. Therefore, SIA’s profitability is highly sensitive to jet fuel price movements, and this situation is unlikely to go away as airlines tend to face difficulty in passing higher costs through to ticket prices.

Staff costs come after fuel costs as the next highest operating expenditure category, comprising 18.5% of total operating expenses in FY18/19 at S$2.8 billion (FY17/18: S$2.7 billion). There was about a 4.0% increase in staff costs over the financial year, largely due to an increase in staff strength and crew allowances from an expansion in operations, and introduction of ultra-long haul flights. Group-wide staff strength increased 4.2% YoY to 27,078 number of people at the end of March. Meanwhile, SIA also reclaimed the title of operating the world’s longest commercial flight with non-stop services on the Singapore-Newark route in October 2018.

While the increase in staff expenses is reasonable given the higher top line, more hires may not necessarily equate to additional value or wealth created. The group disclosed in its FY18/19 annual report that value added per employee decreased 7.6% YoY to S$200,283.

Other substantial components of operating expenses included handling charges, aircraft maintenance and overhaul costs, landing, parking, and overflying charges, which aggregated to S$3.1 billion, constituting 20.3% of total operating expenses, or 19.0% of total revenue. For the past three financial years, these expenses stood at an average of 19.3% of total revenue.

Fleet development entails heavy capex

As at 31 Mar 19, SIA has an operating fleet size of 202 aircrafts. 128 of the aircrafts are operated by Singapore Airlines, 27 by SilkAir, and 47 by Scoot. Moving forward, the group expects to add 28 planes and retire 23 to reach a fleet size of 207 by 31 Mar 2020.

The above fleet size excludes six Boeing 737 MAX 8 aircrafts (operated by SilkAir) due to global grounding of the aircraft series by regulators in March. The incident was triggered by two fatal crashes in just five months apart (Lion Air Flight 610 in October 2018 and Ethiopian Airlines Flight 302 in March 2019). SilkAir had originally planned to take delivery of nine 737 MAX 8s but that has now come to halt, for at least the current financial year. To accommodate the shortfall, SIA will extend current aircraft leases or look for replacement aircrafts.

In addition, SilkAir’s plan to transfer 10-14 Boeing 737-800s to Scoot is now suspended while it awaits clarity on the Boeing 737 MAX 8 grounding situation. SIA expects the incident to result in a 3% contraction in SilkAir’s passenger capacity for FY19/20.

Singapore Airlines also faced some operational challenges from the Rolls-Royce Trent 1000 TEN engines that power its Boeing 787-10 aircrafts, of which the carrier owns nine. That said, the group projects a 7% increase in capacity for both Singapore Airlines and Scoot in FY18/19.

In monetary terms, SIA’s fleet development plans translate to heavy capital expenditure (“capex”) needs (for aircraft) of S$5.7 billion in FY19/20, S$5.4 billion in FY20/21, and S$5.0 billion in FY21/22. In the longer term, aircraft spending is expected to reduce to S$3.9 billion and S$3.3 billion in FY22/23 and FY23/24 respectively. The group have off-balance sheet capital commitments relating primarily to aircraft acquisitions and related equipment that totalled a huge amount of S$24.1 billion (as at 31 Mar 19), including S$1.7 billion attributable to its share of associated companies’ and joint ventures’ commitments for capex.

Credit highlights

Net gearing (net debt/equity) as at 31 Mar 19 stood higher at 27.1% compared to 4.2% a year ago. The higher net gearing was largely a reflection of an increased debt load of S$6.7 billion, up from S$3.1 billion over the same period.

The bulk of the increase in debt came from note issuance, including the S$600m SIASP 3.160% 25Oct2023 Corp (SGD) and S$750m SIASP 3.030% 28Mar2024 Corp (SGD) - Retail. According to exchange filings, a total of S$448.3m of gross proceeds raised from the SIASP 3.03% ‘24s have been utilised for aircraft acquisitions. We are unsurprised by the considerable increase in debt (+112.8% YoY), as it was in line with the group’s planned fleet renewal and capacity growth plans. Looking forward, we think SIA’s leverage would continue to rise given its capex requirements.

SIA’s refinancing risk is low in our view, with just S$231.1m of short-term debt (S$223.0m of secured borrowings and S$8.1m unsecured) against cash and bank balances of S$2.9 billion. The group exhibits a decent debt maturity profile (see Chart 4), with a yearly average of around S$600m maturing coming due in the next five calendar years, based on Bloomberg data.

S$2.3 billion of secured borrowings are pledged against aircraft-related assets, such as aircraft purchase agreements, assignment of engine warranty, and plane mortgages. We estimate SIA’s fixed asset coverage (property, plant, and equipment divided by total debt) stood at 3.3x at the end of March (4QFY17/18: 5.8x).

Chart 4: SIA's debt distribution profile (as at July 2019)

Healthy interest coverage

Interest expense totalled S$116.1m in FY18/19, up by a substantial 29.3% from S$89.8m in FY17/18. The increase in interest expenses was due to more debt taken during the period for aircraft purchases.

Meanwhile, EBITDA decreased to S$2.6 billion from S$2.8 billion over the same period. Movements in the finance charges and EBITDA led to an interest coverage (EBITDA/interest) of 22.2x in FY18/19, a healthy level in our view, despite weakening from 31.5x in the previous financial year. At the current level of interest expense, we estimate that SIA’s EBITDA would have to fall by close to 96% for its interest coverage to reach 1.0x. Hence, the current level of interest coverage denotes a comfortable margin of safety in our view.

Nonetheless, we acknowledge that the group’s interest servicing capability has deteriorated over the years, along with rising debt levels. Interest coverage and total debt stood at 49.7x and S$1.0 billion respectively in FY12/13 (see Chart 5).

Chart 5: SIA's interest coverage (FY12/13 to FY18/19)

SIA will adopt new accounting policies pursuant to IFRS 16 (Leases) from 1 Apr 19 (1QFY19/20) onwards, which require SIA to recognise most of its operating leases related to aircrafts and company accommodation and leases on its balance sheet. This means that the group will classify these formerly off-balance sheet operating leases as “right-of-use” assets with corresponding lease liabilities. As a result of the adoption of IFRS 16, the group expects an increase in “right-of-use” assets (almost entirely pertaining to aircraft leases) of S$1.7 billion and an increase in lease liabilities of S$2.2 billion.

SIA will also replace expenses related to these operating leases with interest expense on lease liabilities and depreciation expense on the right-of-use assets. This is likely to lower the group’s interest coverage. SIA reported no outstanding finance leases at the end of March.

Investment income helped to offset rising finance expenses

As at 31 Mar 19, the group has S$343.9m of long-term investments, of which S$63.9m of them are quoted non-equity investments (such as corporate bonds and investment funds) that carry interest rates at the range of between 3.01% and 4.30%. Some S$229.9m are unquoted non-equity investments that generate interest of 1% per annum.

SIA also has S$116.8m of quoted non-equity investments accounted under current investments to manage its liquidity needs, comprising of government securities, corporate bonds, certificates of deposits, and money market funds. These investments carry interest rates between 0.78% and 5.60% per annum.

Finally, the S$2.9 billion of cash as at 31 Mar 19 also generates interest income for the group. Short-term deposits of S$1.6 billion carry a weighted average effective interest rate of 2.28% per annum, while cash at banks earns floating interests based on daily bank deposit rates ranging from 1.96% to 3.05% per annum.

These investments and cash generated a decent interest income of S$41.9m in FY18/19, which was slightly more than one-third of SIA’s financial charges. Factoring in interest income, we find adjusted interest coverage (EBITDA/net interest expense) at 34.7x in FY18/19.

Healthy operating cash flow

Thanks to the aviation industry’s operating model of collecting cash from advanced bookings (before the plane takes off), the group has been exhibiting a stable trend of operating cash flows, generating an average of S$2.7 billion in cash flow from operating activities over the past five financial years. In FY18/19, it generated S$2.8 billion of cash flow from operations (“CFO”).

SIA’s ratio of total debt to CFO stood at 2.4x in FY18/19. This implies that the group would require less than two and a half years to generate enough operating cash flow to extinguish its debt in full. That said, we are mindful of SIA’s heavy capex needs, which are likely to weigh on free cash flow moving forward.

Bright outlook for aviation

According to the International Air Transport Association (“IATA”), Asia Pacific will be the greatest driver of air travel demand from 2015 to 2035. IATA also forecasted for China to replace the United States as the world’s largest aviation market by around 2024. Besides China, other fastest-growing markets over IATA’s forecast period include South East Asia countries like Indonesia and Vietnam. We like the burgeoning passenger demand in Asia, which should translate to healthy volume growth for SIA.

Known for its greenery and the impressive Marina Bay skyline, the bustling and culturally diverse Singapore has been an attractive tourism spot. A quarterly report from Singapore Tourism Board’s showed that the city-state’s international visitor arrivals reached a record high of 18.5m in 2018, representing a 6.2% YoY increase (see Chart 6).

Chart 6: Singapore's monthly international visitor arrivals

With the recent opening of the iconic Jewel Changi Airport, as well as other tourism developments such as the integrated tourism development in the Jurong Lake District, we expect growth in international visitor arrivals to continue, which should support aviation demand.

We observe that SIA’s revenue typically peaked during the third financial quarter (September-December), as shown in Chart 7. The peak season was supported by popular events such as the annual Formula 1 Singapore Grand Prix in September and the Christmas season.

Chart 7: SIA's quarterly revenue (FY13/14 - FY18/19)

Furthermore, increasing domestic disposable income is likely to bode well for outbound demand. According to Singapore‘s Department of Statistics, the median monthly household income from work rose steadily from S$7,872 in 2013 to S$9,293 in 2018, indicating that Singaporeans are having more disposable income, which is an important growth driver for overseas travels.

Business repositioning

SIA has continued to work on its three-year transformation programme, currently in its second year. Key developments include the launch of Singapore Airlines’ digital innovation lab, KrisLab, which launched the world’s first blockchain-based airline loyalty digital wallet.

Another significant development is the announcement of SilkAir’s merger into Singapore Airlines to operate the regional wing under one brand. As part of the multi-year plan, SilkAir will undergo product upgrades commencing in May 2020, which will feature new lie-flat seats in business class and installation of in-flight entertainment systems in both business and economy classes. The merger also encompasses the full rebranding of SilkAir as Singapore Airlines, with the repainting of aircrafts and adoption of Singapore Airlines’ service delivery.

We think the absorption of SilkAir into Singapore Airlines is the right direction for a brand that has been reporting declining operating income for the past three financial years. We are think that the merger is unlikely to weigh on SIA’s credit profile, as additional costs relating to the initiative may be mitigated by synergies such as better route optimization.

A couple of case studies on failed airlines

Like companies in other industries, an airline could land in insolvency due to excessive debt. One such example is Air Berlin, which ceased operations in late 2017 after its major shareholder Etihad Airways declined to provide any further financial aid. The airline had been mired in losses for years before its eventual collapse. A combination of operational difficulties, cost mismatching, intense competition, and the series of delays to Berlin’s new Brandenburg Airport were among the reasons behind Air Berlin’s financial struggles. After the company folded, Lufthansa took over a big part of its assets and employed most of its staff.

Japan Airlines (“JAL”) is another textbook example of how an airline business could go wrong. Once the symbol of Japan’s fast-growing economy back in the 1980s, JAL was one of the world’s top-performing airlines before it became financially ill due to overspending and  diversification into businesses outside its core competency.

JAL was further hit by global turbulences like the Severe Acute Respiratory Syndrome outbreak and global financial crisis in the 2000s. The airline tried to borrow its way out but eventually filed for bankruptcy in 2010.

Fortunately, JAL managed to stay afloat after making major corporate turnarounds including cutting nearly a third of its payroll, grounding more than 100 jets, and trimming almost 50 unprofitable routes. These decisions were made under the leadership of Buddhist monk turned CEO Kazuo Inamori, who focused on returning the airline’s focus to customer service and safety, while keeping costs under a tight rein.

JAL also received financial support from the Japanese government totalling JPY900 billion in the form of JPY600 billion in credit lines and a JPY600 capital injection. The airline slowly recovered and is back in the green again, registering operating income of JPY176.2 billion in its FY18/19 ended March.

Compared to the examples described above, SIA’s financials are in much healthier shape. The flagship carrier and emblem of impeccable service has not had a year of operating loss for the past two decades. SIA record positive operating income even in the year of 2000, when it unfortunately had its first fatal crash that killed 81 of 179 occupants on a Boeing 747-412.

SIA’s status as Singapore’s flag carrier and its ~56% direct interest held by Temasek suggest a good likelihood of financial support from its parent in times of need. The link to Temasek also benefits SIA by providing it easier access to capital markets, allowing the airline to ride through the peaks and troughs of the aviation industry.

Note: We took reference from various media reports and sources in summarising the case studies above. Please refer to the end of this article for the list of references.

The SIASP bonds

SIA’s bonds carry yields to maturity (“YTM”) ranging between 2.24% and 3.04% for tenors between 1.0 to 8.1 years (see Table 1). We think the bond yields have largely priced in the likelihood of parental support from Temasek and SIA’s leading market position in the aviation sector.

We expressed our credit opinion on SIA’s bonds in Table 1. Among the SIASP notes, we like the S$200m SIASP 3.145% 08Apr2021 Corp (SGD) and S$600m SIASP 3.160% 25Oct2023 Corp (SGD). They carry ask YTMs of 2.41% and 2.71% respectively, representing 79bps and 109bps above SGD swaps. Between the two, we think the SIASP 3.16% ‘23s look more attractive given its decent yield pick-up of 30bps for the 2.5-year longer tenor.

Moving down the curve, we are neutral on the SIASP 3.03% ’24s, SIASP 3.75% ’24s, and SIASP 3.035% ’25s. They are currently priced to yield between 2.71% to 2.88%, for approximately 4.7-5.8 years to maturity, which in our view represents fair returns given SIA’s credit metrics. We think the longer-dated SIASP 3.13% ’26s and SIASP 3.13% ’27s seem pricey at their YTMs of 3.01% and 3.04% respectively, providing insufficient compensation for SIA’s longer term business and operational uncertainties.

Our view on the S$750m SIASP 3.030% 28Mar2024 Corp (SGD) - Retail remains unchanged since its issuance in March (see “SIA launches new SGD 5Y bonds with retail tranche at 3.10% IPG”). At its indicative price of 101.42, the retail bond carries an ask YTM of 2.71% (Z-spread: 108bps).

We are neutral on the SIASP 3.03% ‘24s, as they provide a reasonable return for SIA’s credit risk, but look relatively expensive against the SIASP 3.160% 25Oct2023 Corp (SGD). Having said that, we note the scarcity of retail corporate bonds in the market, and the SIASP 3.03% ‘24s remain a good alternative for retail investors.

Finally, we note that China Eastern Airlines Corporation Limited’s CHIEAS 2.8% ’20s at their ask YTM of 2.61% (Z-spread: 96bps) offer a higher return than the short-term SIASP notes. However, we note that China Eastern Airlines (“CEA”) has much higher leverage than SIA and operates in more competitive markets than SIA (see “8 Things You Should Know About China Eastern Airlines and Its 2020 SGD Bond”). As at 31 Dec 18, CEA’s net gearing ratio excluding RMB77.4 billion of finance leases stood at 0.89x.

Table 1: SIA's outstanding bonds

Conclusion

We are mindful SIA’s trend of rising leverage in light of its heavy aircraft spending. Other risks include the disruptions to its capacity growth from the Boeing 737 MAX groundings, and external threats imposed by oil price volatility and, to a lesser degree, international competition.

On the other hand, we think that SIA is likely to sustain decent profitability going forward, which should enable it to generate consistent cash flows, given the positive outlook on Asia’s aviation sector. Furthermore, SIA should continue to enjoy good access to capital markets given the substantial shareholding by Temasek.

To conclude, we are cautiously neutral on SIA’s credit profile. Positive developments such as resolution of the challenges from the grounding of Boeing 737 MAX 8 aircraft and Rolls-Royce Trent 1000 TEN engine issues, substantial progress in the group’s transformation programme, and stabilization of leverage would lead us to upgrade our credit outlook on the airline.

References

• Cynthia Drescher, CNN Travel, 15 airlines that no longer exist, updated 1 Apr 19. https://edition.cnn.com/travel/article/former-airlines/index.html
• Derrick A Paulo, CNA, How a Buddhist monk turned CEO revived Japan Airlines from bankruptcy, published 15 Dec 18. https://www.channelnewsasia.com/news/cnainsider/buddhist-monk-ceo-kazuo-inamori-save-japan-airlines-jal-bankrupt-11033866
• Hiroko Tabuchi, NYTimes, Japan Says JAL Can Be Saved, With State Bailout, published 29 Oct 09. https://www.nytimes.com/2009/10/30/business/global/30jal.html
• Harry Garner of Arnold & Porter LLP, Bloomberg Law Reports, The Economic Downfall of Japan Airlines and its Prospects for Reorganization, 2010. https://files.arnoldporter.com/arnold&porterllp_bloombergbankruptcylawreport_082310.pdf
• Justin McCurry, The Guardian, Japan Airlines files for bankruptcy, published 19 Jan 10. https://www.theguardian.com/business/2010/jan/19/japan-airlines-files-bankruptcy
• Lauren McMah, News AU, Everything must go as Air Berlin leaves behind mountain of debt, published 19 Jan 18. https://www.news.com.au/travel/travel-advice/flights/everything-must-go-as-air-berlin-leaves-behind-mountain-of-debt/news-story/6b2a84ba1c5709369fdb589e053037b6
• Nathan Layne, Reuters, After bankruptcy and makeover, Japan Airlines returns, published 19 Sep 12. https://www.reuters.com/article/us-japanairlines-ipo/after-bankruptcy-and-makeover-japan-airlines-returns-idUSBRE88H1AP20120918
• Patrick Whyte and Brian Sumers, Skift, Air Berlin’s Slow Collapse Into Bankruptcy Explained, published 16 Aug 17. https://skift.com/2017/08/16/air-berlins-slow-collapse-into-bankruptcy-explained/
• Tobias Buck, Financial Times, Air Berlin administrator sues Etihad for up to €2bn, published 14 Dec 18. https://www.ft.com/content/05c68878-ff9e-11e8-aebf-99e208d3e52

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.