Description

A simple idea 

1.       Enterprise value is significantly above the start of the year, meaning that even if the business fully returns to pre-covid levels, it will trade at a very high multiple for an airline

2.       Business travel is unlikely to return at any kind of significant level, impairing airline economics. There is likely to be a high amount of overcapacity

3.       Many European airlines have received significant amount of state aid, whereas Finnair has received limited government support. Finnair was required to borrow against their pension to receive a state-backed loan, even though the government is the majority shareholder

4.       There are a large number of non-economic actors in the airline industry so there is unlikely to be a major economic improvement or capacity rationalisation.

5.       Finnair is highly reliant on transit traffic from Asia (50% of revenue), which is likely to be a worse industry short term as Asian travelers are unlikely to leave their countries until covid is fully resolved

6.       The other key transit routes from Asia to Europe go through places like Russia, Turkey and Dubai, where the main airlines are heavily state supported, so there is likely to be no abatement in competition for such travelers on an ongoing basis

7.       Finnair is burning a considerable amount of cash

8.       Airlines are bad businesses in the best of times and are hated by investors

9.       Finnair’s share price has jumped around 70% after the vaccine announcement, giving a compelling fundamental and tactical entry point

10.   There is no exposure to the typical common factors of widow-making shorts this year e.g. EVs, high growth, promotional management teams

11.   The Finnish government pushed them to raise a lot of equity capital early in the crisis which raises the likelihood they will do so again

A non-TMT idea from me. I am no airline expert but I have looked across a wide range of airlines post-vaccine as I know in many cases they trade at valuations considerably above pre-covid despite me seeing a wide range of expert opinions/anecdotes that travel at a corporate level at least is likely to be materially lower than pre-covid, so in cases where airlines had significant non-leisure volumes they were likely worth less than pre-covid. I had previously done some work on Finnair for a different reason and it strikes me as particularly attractive relative to the group. It is fairly small cap so is likely only actionable in size for fairly small funds.

The crux of the thesis is really that even when we get back to the normal world, Finnair’s share count has expanded a lot and they have burnt a considerable amount of cash, and are burning more and more cash over time. Additionally, they have 5 scheduled A350s over 2020-2022 that they will need to pay around EUR5-600mln if they take delivery. They have around EUR200mln in 10% perpetual debt which will also need to be called when normal business resumes. They have also deferred around EUR150mln in lease payments, rising around EUR45mln per quarter, that will need to be paid at some point (or will be subject to a negotiation which they may well succeed in). They are currently burning EUR50mln per month – which excludes lease payments and capex that will have to be turned on again in the normal course of business - and already have net debt of around 7x EBIT based on normal pre-covid times. The cash burn is adding 1 turn to this every quarter, and if they are to take on the A350s as they seemingly plan to do (most likely deferred some), this will create an additional 3-4 turns on debt vs EBIT. Moreover, it is highly likely that the business’ profitability is structurally impaired vs pre-covid as they will have lower Asian volumes for some time and business travel is likely to be much lower short-term (and long-term from what I hear). This is a highly unsustainable capital structure that will violate normal covenants and they will need to raise equity.

The worst-case scenario is that they raise a lot of equity well above the current price after some kind of sentiment/technical squeeze. If they were to raise EUR1bln at EUR1 per share, burn just EUR400mln on an operating basis as they were to recover from covid, fully recover to an EBIT level above pre-covid levels, and trade at 12x EV/EBIT or a very full multiple for an airline, the equity would be worth 0.76 per share or 25% upside fundamentally. Their CMD presentation from late 2019 implies around this level of EBIT under their long-term strategic targets  (7.5% margin on around EUR3.1bln in revenue), and they have only once achieved anywhere close to this level of EBIT (in 2018).

More likely, they will have to raise EUR600mln in additional equity, assumed at the current share price, and trade at 10x EBIT, while burning EUR400mln again as they recover to breakeven, and achieve an EBIT of EUR150mln or the same level as 2019 (2018 was the peak year). This implies a share price of 0.12 EUR, or 80% downside, while still probably having an over-levered capital structure and lacking capital to take on their aircraft commitments.

In reality they probably don’t even get to this level of EBIT, burn more cash to get to breakeven, and are forced to do multiple highly dilutive capital raises. So it could be considerably worse for the company.

There are of course risks such as short squeeze in a company will a majority government shareholder and only 15% foreign ownership, sentiment squeeze on a reopening, but I don’t think investors want to buy airlines and the whole sector is going to need a lot of capital in the next year so I doubt we see a big technical move but size accordingly of course. I think the vaccine efficacy data clearer out a lot of the technical problems and I was waiting for that.

Other risk is I know basically nothing about the airline business, and I could be missing some big things – I think this is a simple idea with a lot of margin for error. My estimates are not that precise as I don’t think it matters that much and it is tough to precisely forecast an airline business for next year even if you know the industry super well.

Catalyst

Airlines being bad

Cap raise