Air Arabia announced that it will launch a third hub in Egypt succeeding Sharjah and Morocco. ‘Air Arabia Egypt’ is a joint venture between Air Arabia, which will manage the airline, and Egypt-based Travco Group, the Middle East’s largest travel and hospitality group. Further details on the joint venture will be announced at a later date. Some news wires reported additional details about the joint venture, including that Air Arabia’s stake will be 40% and that it is expected to begin service by the end of 2009 or early 2010. We are generally positive about Air Arabia’s third hub of choice given Egypt’s favorable demographics and the near-absence of an LCC model in the country. It also provides a more efficient deployment of Air Arabia’s order of 44 aircrafts from Airbus with deliveries starting 2010f until 2016f.
Our valuation assumes that all 44 aircraft orders will be financed and utilized by the Sharjah base, which is currently unlikely given Air Air Arabia’s multiple hub operation. Therefore, in an attempt to assess the impact of Air Arabia’s multiple hubs on valuation, we conducted a rough exercise valuing each operation separately. Key assumptions include: (i) that each hub would operate a maximum of 25 aircrafts, (ii) a sustainable load factor of 80%, and (iii) a long-term EBITDAR margin of 25%. We look at three possible scenarios regarding the financing of the 44 A320 aircraft orders: (i) each base will be responsible for financing payments for the aircrafts it uses (Price Target: AED 1.88; Upside: 70%), (ii) Air Arabia will use its cash balance and investments to purchase 10 aircrafts (Price Target AED 1.51; Upside 36%), and (iii) the Sharjah base will finance the entire CAPEX itself and lease the aircrafts to the other hubs (Price Target: AED 1.11; Upside: 0%). We favor the second scenario and find it the most reasonable.
Given limited guidance and disclosures regarding Air Arabia’s hubs excluding Sharjah, we maintain our price’s recent rally, we maintain our ‘Buy’ recommendation as we strongly believe that there is upside to our valuation that is not factored in our current base case scenario. Despite relatively strong financial performance, Air Arabia has underperformed the DFMGI by 21% since the index hit its low last February. It also underperformed its LCC peers on average by 25% YTD and by a more significant 54% over the past six months as global markets rallied.
In all scenarios, we have included to our valuation Air Arabia’s cash balance (AED 1.7 billion at 2009e and half of its AED 1.5 billion investment portfolio contributing AED 0.53 per share.
Scenario 1
This scenario assumes that each hub would pay for and finance its share of the upcoming 44 planes. This would imply that Air Arabia would not need to raise debt at the holding company level (the Sharjah base). This scenario yielded a value of AED 1.88 per share, which offers an upside of 71 percent to the current market price and is higher than our price target by 50 percent. This is the most attractive scenario as it entails that Air Arabia will not solely finance its growing fleet and that the CAPEX would be shared by its partners in Morocco and Egypt. However, we view this scenario as somewhat unlikely as it would require committing Air Arabia’s partners at its other bases to huge capital investments. Also, this scenario would be very value-eroding for the Moroccan and Egyptian operations as it burdens them with a large CAPEX bill in their early years of operations. Accordingly, around 92 percent of our valuation under this scenario (excluding cash and investments) is driven from Sharjah.
Scenario 2
This scenario assumes that Air Arabia (the Sharjah base) would finance 10 aircrafts from its cash and investments and will lease them to the Moroccan and Egyptian bases. For the remaining 34 aircrafts, the carrier will engage in sale-and-leaseback agreements whereby it will effectively book no CAPEX on these aircrafts. Again, this scenario assumes that Air Arabia will remain debt-free. This scenario yielded a value of AED 1.51 per share, which offers an upside of 36 percent to the market price and is higher than our price target by 20 percent.
Scenario 3
This scenario assumes that the Sharjah base would fully finance the 44 A320 aircrafts and would lease those that it will not utilize to the other two bases generating rental income at the holding company level. This scenario assumes that Air Arabia will finance around 40 percent of its fleet costs through debt starting 2013f.
Accordingly, we applied multiple WACCs for our Sharjah base valuation to reflect the changing capital structure as aircraft deliveries come through. This scenario yielded a value of AED 1.11 per share, which offers an upside of 0 percent, implying that Air Arabia is fairly priced at the current price level. The value is lower than our price target by 12 percent as Air Arabia will not get to enjoy the full return potential of the aircrafts that it fully funds, since it doesn’t fully own its Egyptian and Moroccan bases. This scenario is unlikely and unfavorable as Air Arabia would yield a non-lucrative return on a huge investment.
Air Arabia has underperformed other Dubai stocks, lagging the DFMGI by 21 percent since the index hit its low last February. Until recently, it has also underperformed LCC peers despite stronger financial performance. The stock has lagged its LCC peers on averaged by 25 percent YTD and by a more significant 54 percent over the past six months as markets rallied. It is trading at a P/E of 12.32 x (09e) and 11.00x (10e), compared to peers’ average of 14.57x (09e) and 10.9x (10f). Air Arabia is more attractive on EV/EBITDA given its large cash balance and investments trading at 8.93x (09e), below peers’ average of 11.02x (09e). The stock is also attractive on P/BV (08) trading at 1.05x below peers’ average of 1.90x.