Qantas: should shareholders stay or go?

A report yesterday in The Age says that when APA’s $11 billion bid for Qantas closes next week investors must answer some tough questions.

It goes on to ask, who would be pleased if Airline Partners of Australia’s $11 billion takeover for Qantas fails?

And it answers – almost everybody, adding, this is one of the least popular takeover attempts in Australian corporate history and the Government would rather it had not happened on its watch.

Are there reasons to accept Airline Partners of Australia’s $5.45 a share takeover offer?

Yes. The bid offers every investor a profit from an investment in a business that is notoriously vulnerable to unpredictable external shocks.

Since the turn of the century, Qantas’ shares have averaged $3.67 and they were trading at about $3 in mid-2006, and at about $4.25 in October, before the takeover approach became public.

Qantas has upgraded its earnings outlook since then, but it has also warned that the good times could end as old and new competitors boost their presence on key routes. In a bull market that smells ripe, acceptance is a justifiable, conservative option.

Are there also reasons to reject the offer?

Yes. Profit upgrades and the market’s general strength have taken the gloss off APA’s offer, which for legal reasons cannot be increased.

Qantas’ revenue, profit and share price were climbing by the time APA appeared, and the airline said last month it expected to make $1.2 billion before tax in the year to June 2008.

Net profit will probably exceed $800 million, so APA is offering to buy Qantas for less than 13 times expected net profit in 2007-08, when the sharemarket as a whole is selling at more than 17 times, and when price-earnings ratios of 20-plus are not uncommon.

What this means is that the menu for people looking to reinvest their takeover cheques is more pricey than the one APA is using for its bid for Qantas, and that is one reason some institutional holders are declining to sell.

The bid is also cash, so shareholders who accept will pay capital gains tax.

A recent change in the way APA is attacking Qantas has also opened up some intriguing options.

What has changed?

APA wants to buy every share in Qantas, and will still compulsorily acquire the stragglers if it gets past 90% (it controls 27.8% and hedge funds that are expected to sell are believed to control about 40%).

But after realising that some institutions were holding out, APA rejigged its bid, so that if it holds between 70% and 90% of the airline’s shares at bid’s end it will keep the stake, and control Qantas with shareholders who did not accept on board as minorities.

And instead of using the cash flow of a 100% owned Qantas to service the debt it has raised for the acquisition, it will extract $4 billion from Qantas in the first year, through a $1.5 billion, 75c-a-share dividend out of retained earnings, and a $2.5 billion ($1.26) capital return.

Shareholders who reject an offer that nevertheless carries APA past 70% will participate pro-rata in both payments – unless APA has not bought them out by then with a second takeover offer.

Qantas’ debt will rise towards $8 billion, and shareholders’ funds after the capital return will be about a quarter of that.

This is very aggressive gearing, intended really for a private company structure, and it precludes the payment of ordinary dividends for the foreseeable future.

Those who stay in will be effectively punting that the special payouts they will participate in and either a clean-up offer or their participation in a refloat of Qantas a few years down the runway will give them more after payment of capital gains tax than they would get by accepting $5.45 now, paying capital gains tax, and quickly reinvesting the balance.

That is not guaranteed – airline profits are volatile, as previous downturns related to terrorism, pandemics, oil price spikes and new competition have demonstrated.

Any external shock, or even a more gradual deterioration in Qantas’ position from higher oil prices or increasing competition (which is clearly flagged), could result in a clean-up offer below $5.45, not above.

But there will almost certainly be a rump of investors willing to join the two institutional hold-outs, Balanced Equity and UBS Global Asset Management, for a ride as minority shareholders.

One risk is that there are so many refuseniks that APA falls short of the 70% mark, and the bid collapses.

Is saving Qantas from the jaws of a foreign-tainted private equity predator who might run an Aussie icon into the ground a good reason not to sell?

No, but that won’t stop some jingoistic shareholders from withholding acceptances for that reason.

It is trite but true that APA has not structured the deal to fail.

The balance sheet will be debt-laden, but not to the point where earnings are swamped, and APA has committed publicly to maintain the airline’s strategic and operational courses.

Even if the deal confounds the APA boffins and financially damages the airline, the Qantas brand is probably bulletproof and a new Qantas would almost certainly rise from the ashes.

When does the bid close?

Friday May 4, although it will be extended by two weeks if APA passes the 50% cent mark in the final week.

Report by The Mole and The Age