a giant research on world top air transportation & aviation industry (baps publication)

8/3/2019 A Giant Research on World Top Air Transportation & Aviation Industry (BAPS Publication)

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RESEARCH ARTICLE

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Title Page

Chapter One: Introduction of The Company .. 1 - 4

1.1 Introduction .. 1

1.2 Brief Description of company .. 2

Chapter Two: Corporate Governance Analysis .. 5 - 12

2.1 Balance of Power Between Management & Shareholders ....... 5

2.2 Management Compensation . 6

2.3 Market Coverage .. 8

2.4 Social Responsibility .... 9

Chapter Three: Stockholder Analysis ..... 13 15

3.1 Analysis .... 13

Chapter Four: Risk Profile . 16 - 27

4.1 Market Risk & Return ...... 16

4.2 Bottom up Betas ... 20

4.3 Cost of Equity ... 22

4.4 Cost of Debt ..... 23

4.5 Cost of Capital .. 25

Chapter Five: Investment Return Analysis 28 - 32

5.1 Typical Project . 28

5.2 Measuring Returns ... 29

5.3 Future Outlook . 31

Chapter Six: Capital Structure Choices .. 33 - 36

6.1 Current Financing Mix ..... 33

6.2 Trade off on Debt & Equity . 34

Chapter Seven: Optimal Capital Structure ..... 37- 42

7.1 Current Cost of Capital/Financing Mix 37

7.2 Cost of Capital at Different Financing Mix .. 37

Table of Contents


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Title Page

Chapter Nine: Dividend Policy .. 48 50

9.1 Current Dividend Policy ... 48

Chapter Ten: Dividend Policy / A Framework .. 51 - 54

10.1 Affordable Dividends . 51

10.2 Management Trust & Changing Dividend Policy .. 51

Chapter Eleven: Valuation .... 55 - 58

11.1 Valuation Models ... 5511.2 Valuation Assumptions and Inputs 55

11.3 Valuation Results ... 57

Appendix I ...... 59 66

Appendix II 67

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Introduction and the companies

1.1 Introduction

The current report examines major trends in the Air transportation sector focusing on Top

four companies in particular Qantas (QT), Cathay Pacific (CX), Malaysia Airlines (MH)

and Emirates (EK). The companies reviewed operate in two different businesses, airlines

industry (QT, CX) and airport operators (MH, EK), utilize different business models and are

at different stage of their life cycle. The purpose of the report is to analyze different aspects

of their corporate finance policies and to assess the effect of these policies on the value the

managements of these firms create for their shareholders. Summary information for each

company is presented in Figure 1.

Figure 1 Summary company information

Company information QT CX MH EK

Country of incorporation Australia Hong Kong Malaysia UAE

Year of establishment 1926 1985 1965 1998

Year of stock exchange listing 1920 1946 1947 1985

Reporting currency Aus dollar HK dollar Ringgit Dirham

Revenues in 2009 (MM local currency) 18,645 1,074 1,970 1,976

Revenues in 2009 ($ equivalent1) 18,645 1,336 3,546 177

Book value of capital (MM 2009 local

currency2)13,749 2,939 8,960 12,326

Book value of capital (2004 $ equivalent) 13,749 2,158 16,128 1,106

C H A P T E R

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A list of commonly used terms and abbreviations is presented below:

Term Meaning

QT Qantas

EK Emirates

MH Malaysia Airlines

CX Cathay Pacific

BoD Board of Directors

BVE Book value of equityBVD Book value of debt

D Debt

E Equity

Load Factor Percentage of seats sold to total available seats

MVE Market value of Equity

MVD Market value of debt

n.a, N/A Information not available

n.m. Information not meaningful

RAPM or Revenue Yield Revenues per passenger per mile

T Tax rate

1.2 Brief description of the companies

Qantas

Qantas was founded in the Queensland outback in 1920. Registered

originally as the Queensland and Northern Territory Aerial Services

Limited (QANTAS), they have built a reputation for excellence in safety,

operational reliability, engineering and maintenance, and customer service. Today, Qantas is

widely regarded as the world's leading long distance airline and one of the strongest brands in

Australia. They also operate subsidiary businesses including other airlines, and businesses in


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Initially based in Shanghai, the two men eventually moved to Hong Kong and founded

Cathay Pacific Airways. Legend has it that Farrell and a group of foreign correspondents

thought up the airline's unique name in the bar at the Manila Hotel! The new company began

to operate passenger flights to Manila, Bangkok, Singapore and Shanghai. Expansion was

fast and, in 1948, one of Hong Kong's leading trading companies, Butterfield & Swire (today

known as the Swire Group) took a 45% share in the company. Under the leadership of John

Kidston Swire, Butterfield & Swire became wholly responsible for the management of the

airline.

Malaysia Airlines

Malaysia Airlines had its humble beginning in the golden age of

travel. A joint initiative of the Ocean Steamship Company of

Liverpool, the Straits Steamship of Singapore and Imperial Airways led to a proposal to the

government of the Colonial Straits Settlement to run an air service between Penang and

Singapore. The result was the incorporation of Malayan Airways Limited (MAL) on 12

October 1937. On 2 April 1947, MAL took to the skies with its first commercial flight as the

national airline. Fuelled by a young and dynamic team of visionaries, the domestic carrier

turned into an international airline in less than a decade. With the formation of Malaysia in

1963, the airline changed its name to Malaysian Airlines Limited and soon after, Borneo

Airways was incorporated into MAL. Within 20 years, MAL grew from a single aircraft

operator into a company with 2,400 employees and a fleet operator using the then latest

Comet IV jet aircraft, 6 F27s, 8 DCs and 2 Pioneers. In 1965, with the separation of

Singapore from Malaysia, MAL became a bi-national airline and was renamed Malaysia-

Singapore Airlines (MSA). A new logo was introduced and the airline grew exponentially

with new services to Perth, Taipei, Rome and London. However, in 1973, the partners went

separate ways; Malaysia introduced Malaysian Airline Limited, which was subsequently

renamed Malaysian Airline System, or simply known as Malaysia Airlines. Today, Malaysia

Airlines flies nearly 50,000 passengers daily to some 100 destinations worldwide. The airline


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Emirates

On 25th October 1985, Emirates flew its first routes out of Dubai with just

two aircrafta leased Boeing 737 and Airbus 300 B4. Then as now, their

goal was quality, not quantity, and in the years since taking those first

small steps onto the regional travel scene, Emirates has evolved into a globally influential

travel and tourism conglomerate known the world over for their commitment to the highest

standards of quality in every aspect of their business. Though wholly owned by the

Government of Dubai, Emirates has grown in scale and stature not through protectionism butthrough competitioncompetition with the ever-growing number of international carriers

that take advantage of Dubais open-skies policy. Not only do they support that policy, but

they see it as vital to maintaining their identity and their competitiveness. After making its

initial start-up investment, the Government of Dubai saw fit to treat Emirates as a wholly

independent business entity, and today they are thriving because of it. Their growth has never

been lower than 20 per cent annually, and the airline has recorded an annual profit in every

year since its third in operation.


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Corporate Governance Analysis

2.1 Balance of power between management and shareholders

We believe that the interests of shareholders are relatively well protected by the corporategovernance policies of the four companies analyzed, with the possible exception of Qantas.

As an example at QT, directors are nominated for life and more than half are CEOs of other

companies, two of them in related businesses. A shareholder is challenging the lifetime rule

at the next general shareholders meeting in May. Recently, some board members and the

CEO have raised their own salaries.

Insiders are generally not overrepresented in the companies boards, while the CEOs tend to

have a long history with their companies, once again with the notable exception of Qantas.

One interesting common feature is that all of the CEOs are relatively young with an average

age of only 48 years. These last two factors could suggest a dynamic leadership with intimate

knowledge of the challenges and opportunities facing their businesses. Although the balance

of power seems to tilt in favor of shareholders, it is interesting to note that 3 out of the 4

companies have board members who are CEOs of other companies. This could indicate a

lesser oversight due to the lack of time and possible conflicts of interest, although it should be

noted that only QT board members are CEOs of related companies. Nonetheless, the large

percentage of institutional shareholders in most firms, as well as the relative absence of

insiders in the boards of directors, leads us to believe that shareholders hold an adequate level

of power and oversight in their companies. An exception in terms of number of insiders is

MH, where company executives represent a majority of the board. We believe that

management discretion is counterbalanced in this case by the oversight of the regulatory

authority, the Civil Aviation Authority (CAA).

C H A P T E R

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2.2 Management compensation

Management compensation does not appear to be an issue at any of the companies analyzed.

Only the CEO of Cathay Pacific earns more than US$1 million in total compensation (half of

which is in stock options). All firms, with the exception of Emirates, use stock options as a

mean to align managements interest with those of shareholders, but with the exception of

Cathay Pacific, none of the CEOs own a significant stake in their companies. Details about

the CEOs, their compensations and the composition of the Board are presented in Figure 3

and Figure 4.


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Figure 3 Brief presentation of management

Chief Executive Officers QT CX MH EK

NameGerard

Arpey

Michael

O'LearyMike Clasper Kjeld Binger

Age 46 43 52 50

Years at the Company 23 17 4 6

Years as CEO 3 9 3 1

Education MBA n.a.

MA,Engeneering, St

John's College

Cambridge

BSc in Structural and

Civil

Engineering(Denmark)

CEO Compensation

Salary ('000) 518.8 505.0 553.0 N/A

Bonus ('000) - - 127.0 167.0 N/A

Other (000) 0.2 49.0 21.0 N/A

Stock Options (000.) 172.0 502.0 525.0 0

Total Compensation

(000).)691.0 1,183.0 741.0 1,317.0*

Stock Ownership (% of

Total)0.1% 5.44% 0.001% 0%

Market Value of Stock

Held (mm)1.14 237 0.1 0.0

* Compensation to all 5 executive officers including the CEO

Source: Annual reports, Statutory filings

Figure 4 Board of Directors

Board of Directors QT CX MH EK

Number of members 13 9 9 7


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2.3 Market Coverage

All firms, with the exception of Qantas, have shares listed in more than one stock exchange

and thus garner significant investors interest outside of their home markets. In the case of

Emirates, its shares are more heavily traded in the world market than in its home market of

UAE. The two airlines in our sample are leaders in their sectors, while MH is the largest

airport group in the world and Emirates is the largest public airport company in the UAE. As

such and despite the travails of the air transportation sector, all companies are relatively

widely followed by the financial community and command significant trading volumes.

Nevertheless, with the exception of Qantas, most of the information on the companies is

provided by the firms themselves, since some of the sub-sectors in which they operate,

discount airlines and airport operations, are relatively new and with few comparable

companies. With respect to the view of research analysts, this seems to be about evenly split

between buy and hold recommendations, despite their out-performance of the market, once

again with the notable exception of Qantas.

Figure 6 Listings

QT CX MH EK

Year of Listing 1939 1997 1987 2000


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Figure 7 Market coverage

Analyst coverage QT CX MH EK

Number of Analysts 10 19 12 5+

Analysts Recommendations (%)

Buy 50% 63.16% 50% 60.0%

Hold 40% 26.32% 50% 40.0%

Sell 10% 10.53% 0% 0.0%

Daily Average Trading Volume (mm)2002 2.14 1.54 4.98 1.01

2003 8.06 2.64 7.01 0.83

2004 5.13 2.26 6.43 1.37

2005YTD 4.06 3.41 6.93 3.27

Source: Annual reports, Statutory filings, Bloomberg, Zacks, Yahoo Finance and various

public sources

2.4 Social Responsibility

Due to the wide variability of business environments under which the four firms operate, we

have chosen to do a firm specific analysis of social issues.


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Qantas

The Qantas Foundation harnesses Qantas' people and resources - it

supports efforts to build a sustainable future for all Australians and helps

communities at times of urgent need. The Qantas Foundation harnesses

Qantas' people and resources - it supports efforts to build a sustainable future for all

Australians and helps communities at times of urgent need. The Qantas Foundation has

strengthened its commitment to investing in Australia's long-term future and supporting start-

up organizations by forming a partnership with the acclaimed sustainability organization, theCentre for Sustainability Leadership. The Melbourne-based not-for-profit is empowering

young people in Australia and beyond to make their communities more sustainable by

developing a network of environmentally and socially responsible future leaders. The Centre

for Sustainability Leadership, whose other partners includes the United Nations Environment

Program, aims to develop leaders that have the passion and the intelligence to understand

long-term global issues and the political, and community and business nous to tackle the

sustainability crisis. For the past five years, the Centre has run an annual program, the

Fellowship Program, which equips a select number of Australians with the skills, knowledge

and networks they need to be sustainability leaders. Now, with the help of the Qantas

Foundation, the Centre is developing the online Future Sustainability Leaders Program so

that many thousands of young people can access the Centers valuable training and support.The Qantas Foundation has donated $100,000 to support to the development of this Program,

which is set to launch in 2010.

Cathay Pacific

Cathay Pacific's impact on the environment and the communities in

which they operate, as well as the efforts they are making towards

managing those impacts (for example, their Supplier Code of Conduct). While they cannot

include all events and initiatives undertaken during the year, they have endeavored to

demonstrate a balanced review of the organizations most significant activities, together with


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Reference to the Global Reporting Initiative (GRI) 2006 reporting framework and theAA1000 Accountability standard.

The theme of the 2009 Report is Continuity and Change, outlining the initiatives undertaken

during the year despite the difficult economic times. It demonstrates their ongoing efforts not

only to manage their own practices in a responsible way but also to provide leadership within

their industry and to set global policy goals for the future. They are pleased to announce their

achievement of an A+ Global Reporting Initiative grade in this report and they have

revamped the environmental and social statistics table to demonstrate compliance with thisrating.

Malaysia Airlines

The perceived image of Malaysia Airlines as a low cost air carrier

and provider of value of its passengers is extremely important for the

company. This image is aligned with the operational model of the company, using modern

fleet of aircrafts with lower fuel consumption reducing the emissions and environmental

damage. In addition, its policy to operate from remote airports resulted in numerous benefits

for the communities in these regions, increasing economic activity. However, major focus of

the company is to be perceived as a value provider for its passengers.

Emirates

At the Emirates Group, they place great value on corporate citizenship and

social responsibility and believe their business ethics are integral to our

continued success.They firmly believe their employees are their greatest

asset and their contribution to the staggering pace at which they have

developed can not be underestimated. Without them it would not have been possible and they

acknowledge this with a range of excellent benefits, including a generous profit share

scheme, and programmes designed to help those employees fulfill their career goals. These

principles enable emirates to attract employees of the highest caliber and have helped them


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competition synonymous with their industry, emirates have posted profits in all but one year

of their history. While they are focused on maximizing profit margins, as a leader in aviation

innovation, they are devoted to growing their business while using fewer resources and

creating less waste and pollution. The billions of dollars emirates have invested in purchasing

the most advanced aircraft in production mean they operate one of the youngest and most

eco-efficient fleets in the world. Emirates commitment to the environment extends to their

interests on the ground. Emirates take great pride in their involvement with the Dubai Desert

Conservation Reserve, which is dedicated to preserving the natural and cultural heritage ofarea. The National Park, the largest protected area in the UAE and home to more than 30

species indigenous to the Arabian Peninsula, is considered the regional benchmark for

sustainable development and conservation. Emirates green projects do not stop at home and

plans are already well under way to create two of the worlds most eco-friendly conservation-

based destinations Wolgan Valley Resort & Spa in Australia and Cap Ternay Resort & Spa

in the Seychelles.


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Stockholder Analysis

3.1 AnalysisAll firms in our sample, with the exception of Malaysia Airlines which has a more

widespread investor base made up of small private investors, have a strong institutional

shareholder base which commands over 2/3 of the total outstanding shares of their

companies. This contrasts sharply with an industry average of only 33%, and gives credibility

to our argument that corporate governance is relatively strong and minority shareholder rights

are well protected. Moreover, the top 5 institutional shareholders in all companies are among

the largest and most diversified asset management companies in the world. On the other hand

and with the exception of Emirates, insider holdings are relatively small and in line with the

industry average of 6%. All these facts suggest that the marginal investor for all firms is a

well diversified global institutional investor and we can thus proceed to carry out CAPM

based risk and return analyses for the companies. In the case of MH, even though the

majority of the shares are held by private individuals, these tend to be buy-and-hold investors

with the majority of the trading is done by institutional funds, which are therefore the

marginal investor.

Most firms in our sample have only one type of share, common or ordinary. We take a look at

the exceptions below:

Qantas

Qantas has only common stock outstanding, but the board of directors has

already authorized the CEO to issue 20million shares of preferred stock,

probably to ease the deep financial stress of the company Book value of

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shares represent the remaining 15%. Each series B share and series BB share entitles the

holder to one vote at the general shareholders meeting. However, holders of series BB shares

are entitled to elect only two members of the board of directors, while holders of series B

shares are entitled to name the remaining directors. Under the companys bylaws, each

shareholder or group of shareholders owning at least 10% of Emirates capital stock in the

form of series B shares is entitled to elect one member to the board of directors for each 10%

interest that it owns. Directors and senior management do not own any shares of Emirates.

Pursuant to the companys bylaws, the holders of series BB shares are entitled to appoint andremove Emirates CEO And one half of the executive officers reporting directly to the CEO.

Currently, four executive officers report directly to the CEO, one of whom was appointed by

ITA as holder of the BB shares.

The shareholders distributions as well as details about institutional holdings in the companies

are presented in Figure 9, Figure 10. Insider holdings can not be shown as for secret measures

of all of these companies & unavailability source.


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Figure 10 Institutional Holdings

Institutional holdings QT CX MH EK

Number of shares held

(million)158.0 n/a 124.2 20.8

% of Shares Outstanding 98.0% 70% + 11.6% 69.41%

Top 5 Holders Fidelity MGT.Fidelity

Investment

Legal &

General

First State

Investment

Management UK

Prime cap

Management

Capital Group

Company

Scottish

Widows

Columbia Wagner

Asset Management

Wellington

Management

Guilder

Gagnon

Holding

Newton Inv.

Mgmt

Oak mark

International Small

Cap Fund

Allianz

Global

Wellington

Management

Thread needle

Inv.

Schroder

Investment

Management

Group

Hall Phoenix JanusCauseway

Capital

American Express

Financial Corp

Number of shares held

by Top 5 (million)69.5 392.2 93.1 6.5

% of Shares Outstanding 43.1% 52.0% 8.7% 21.57%

Source: Bloomberg, Statutory filings


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Risk Profile

4.1 Market Risk and ReturnIn analyzing the risk characteristics of the four companies we first looked at their returns

over a five year period compared them to the returns of a broad based market index such as

the S&P 500.

Figure 11 below presents the rebased share prices of all four companies and the level of the

S&P 500.

In general, three out of the four firms (Cathay pacific, MH and EK) did better than the

market. These results were expected for Cathay pacific and Emirates since the two companies

are at the growth stage of their evolutionary cycle. Malaysia Airlines on the other hand, is

C H A P T E R

4

JAN-05

APR-05

JUL-05

OCT-05

JAN-06

APR-06

JUL-06

OCT-06

JAN-07

APR-07

JUL-07

OCT-07

JAN-08

APR-08

JUL-08

OCT-08

JAN-09

APR-09

JUL-09

OCT-09

JAN-10


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To analyze the market risk of the four firms we regressed their returns against broad based

market index and used the coefficient of the regression as a measure of market risk. We used

5 year monthly returns for the regression, with the exception of Emirates, which was listed in

late 2000. The choice of index reflected the marginal investor in each company, assuming

that each investor is exposed to the same market risks in their respective market. Although

based in Europe and Asia, CX and MH attracted a number of large institutional investors with

operations around the world and with the ability to diversify their holdings more broadly.

Therefore, the reference index used in the regression for these companies was the Morgan

Stanley Global Index. The reference index used for Emirates was the S&P 500, since it is

traded mostly in the US, Europe and its marginal investor is based in the Asia and US. Our

analysis focuses on the regression coefficient (beta), the regression constant (used for

computation of Jensens alpha) and the regression R squared. The results from the regressions

are summarized in Figure 12.

Figure 12 Risk return characteristics

Risk profile QT CX MH EK

Regression Beta 4.67 1.21 0.35 0.99

Reference index S&P 500 MS Global Index MS Global Index S&P 500

Industry average beta 1.34 1.80 0.95 0.95

Average Risk free rate 4.59% 4.58% 4.24%

Jensen's Alpha -5.92% 27.35% 4.43% 28.42%

R2 of Regression 35.0% 27.0% 7.0% 15.0%

Standard Error of Beta 0.56 0.48 0.17 0.32

Jansen's Alpha -

industry average -4.27% -4.27% n/a n/a

Source: Bloomberg analysis

Slope of the regression - Beta


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behind the different risk profiles of each firm will be examined in greater details further in the

report.

We also examined the excess returns of each firm as measured by its Treynor ratio. The

Treynor ratio measures the excess return of a stock given its level of risk (non-diversifiable)

and is computed with the formula below:

RfRstockTreynor =

Figure 13 below presents the Treynor ratios and the spread between stock Treynor ratio and

the market Treynor ratio over different investment horizons. The results suggest that over the

last 5 years CX had highest excess return compared to the market taking into consideration its

risk. None of the stocks outperformed the market over a 10 year period. Over the last couple

of years the best performing stock was Emirates. These two stocks were excluded from the 10

year horizon analysis, as data for them was not available.

Figure 13 Treynor ratios


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Intercept of the regression and Jensens alpha

We further used the intercept of the regression to compare the actual stock performance of

each company to the market expectation. For each stock we computed Jensens alpha equal to

Intercept Risk Free rate x (1 Beta), using the average monthly risk free over the period.

The results were annualized using the formula:

(1+Monthly excess return)12

1

The annualized returns indicated that on average all companies except for QT generated

returns that exceeded the markets expectations. In addition, comparing Cathay Pacifics high

excess return to the negative industry Jensens alpha suggests that the company performed

better than expected at a time when the sector as whole did not meet the markets

expectations.

R-squared

R-squared of the regression provides information as to what proportion of the variability in

returns could be explained by the regression, or in other words what part of the variability in

the returns (total risk) can be attributed to beta (market risk). The market non-diversifiable

risk represents 35%, 27%, 7% and 15% for QT, CX, MH and EK respectively. The remainder

is company specific, non-diversifiable risk. While the relatively low R-squared for CX and

EK could be explained by the fact that they were small, fast growing companies during the

observed period and were facing numerous company specific challenges in establishing their

business models, we were surprised to estimate that MH was characterized by a large

proportion of (93%) of company specific, diversifiable risk. One possible explanation could

be the fact that airport operators revenues are generally much more stable stream and have a

fixed nature they are based on long term contracts under which airport slots are sold to

airline companies. Even in the event of drop in passenger numbers the charge payable to

airports is generally steady.


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4.2 Bottom up betas

As an alternative approach to regressions betas we considered using bottom-up betas for our

analysis. This is mainly due to the following factors:

As growing companies CX and EK are likely to change over time, hence alter their risk

profile. In addition, their capital structure is likely to change;

MH is mature, steady company which risk profile is likely to remain similar.However, the standard error of the regression beta indicates that it might nor be a reliable

measure of risk;

QT as a company facing financial difficulties is likely to change in the long term if it is to

return to profitability. Making a going concern assumption about the business requires

change in the company and hence, its risk profile.

Therefore we believed that historical indicators might not be a reliable measure for the future.

Estimates of unlevered beta

We used market information about firms in the sector to estimate the risk profile of each of

the companies. While the main stream of cash flows for MH and EK come from their corebusiness (Airport Development and Maintenance), a significant part is generated from

general retail services, electronics and luxury goods retail and restaurants. Each of the

businesses is exposed to a different extend to market risks. In order to capture these

differences in the risk profile of each business we estimated the value of each business and

used these values as a weight to come up with an overall beta of the firms. The value of each

business unit was estimated by applying a market Enterprise Value / Sales ratio to the

respective revenue streams from each business. The average unlevered beta for each

respective sector was then used to compute the firm beta. Calculation of the unlevered beta of

MH and EK is presented in Figure 14 and Figure 15.


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Figure 14 Unlevered Bottom up Beta for MH

Business

line

Estimated

ValueComparable Firms

Unlevered

Beta

Division

Weight

Weight

* Beta

Airport 4,125 Airport 0.73 46% 0.34

Development/Maintenance

Retail 4,770Retail (Consumer

Electronics /1.05 54% 0.56

Luxury / Restaurants)

Firm total 8,895 0.90

Figure 15 Unlevered Bottom up Beta for EK

Business Line Estimated

Value

Comparable

Firms

Unlevered

Beta

Division

Weight

Weight

* Beta

Aeronautical services 684.2 Airports 0.88 75.0% 0.66

Non-aeronautical

services228.5

Commercial activities 76.3

Luxury38.2

Retail Perfume

& Cosmetics

1.08 4.2% 0.05

Restaurants38.2

Retail -

Restaurants0.82 4.2% 0.03

Real Estate

Access fees 152.2 Mgmt/Services 0.47 16.7% 0.08

Firm total 912.7 100.0% 0.82

Since CX and QT operate in a single business we used the respective unlevered sector

average betas to compute bottom-up betas.


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)/)(1(1( EDTmarket

unlevered++

=

))/()1(1( EDxTxunleveredlevered +=

Where:

T applicable tax rate;

D/E market value of debt / market value of equity

The market value of equity has been computed as current share price multiplied by the

number of shares outstanding.

Figure 16 Beta estimation -Summary

Beta measure QT CX MH EK

Top down Beta 4.67 1.21 0.35 0.99

Bottom up Beta (levered) 6.26 1.24 1.42 0.82

Industry avg. Beta (levered) 1.34 1.80 0.95 0.88

4.3 Cost of equity

The computed bottom up beta has been use to compute the cost of equity for the firms. This

is the return expected return by equity investors in the observed companies and an important

input for the calculation of the overall cost of capital. The cost of equity has been calculate

using the Capital Asset Pricing Model and includes the following inputs:

Risk free rate of return (Rf) in estimating the cost of equity we have used long term

government bond denominated in the respective currency to come up with the risk free. The

current 10 year Australia, Hong Kong and Malaysia bond yields were used in the analysis for

QT, CX and MH respectively. The 10 year maturity of the bond used reflects the long term

investment horizon of the likely projects. Other periods should be considered for shorter term

projects. The analysis for EK is done in US dollars.

Market risk premium (Rp) this measure reflects the excess return to which an investor is


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added an additional country risk premium of 1.8%, to account for the increased risk to equity

investors of investing in a UAE based company. The country risk premium is based on the

UAE sovereign debt rating of Baa (spread of 1.2%) and relative volatility of equity compared

to bonds (assumed to be 1.5 times). The country risk premium applied to EK was 1.8%

Beta as computed above.

The cost of equity, for all companies except EK, is defined as:Ke = Rf + x Rp

The cost of equity for EK, is defined as:

Ke = Rf + x (Rp+Country Risk)

We did not add any country risk premium for QT, CX or MH, since the Australia, Hong

Kong and the Malaysia are all AAA rated countries.

The cost of equity computation is summarized in Figure 17.

Figure 17 Calculation of cost of equity

Cost of Equity QT CX MH EKRisk Free Rate 4.27% 3.47% 4.5% 4.24%

Beta 6.26 1.24 1.42 0.82

Risk Premium 4.82% 4.82% 4.82% 4.82%

Country Risk - - - 1.80%

Cost of Equity 34.54% 9.45% 11.30% 9.65%

4.4 Cost of Debt

The other important component of the cost of capital is the cost of debt. It reflects the

i d i k f th i b l d d d bt i t it dit i k Th t

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The cost of debt for each company has two components a risk free rate of return and

compensation for the credit risk associated with the company. In estimating the credit risk for

each company we took 2 approaches:

For QT and MH we looked at the current credit rating of the company. The companieshad recently issued traded bonds which represent a good indicator of the risk of their

debt and hence we used the implied default read on long term publicly traded debt.

Since CX has not issued any publicly traded debt, we computed synthetic credit ratingfor the firm based on its interest rate cover ratio.

EK currently has no debt.

After obtaining the respective credit ratings we looked at the credit default spreads

corresponding to each rating, which is a measure of the risk premium required. For QT and

MH we used the credit default spread embedded in current yields of publicly traded debt. We

computed the cost of debt for each by adding the default spread to the risk free rate for the

respective company. The results are presented in Figure 18.

Figure 18 Calculation of cost of debt

Cost of debt QT CX MH EK

Credit Rating CCC A- A+ n.a.

Spread vs. Treasury (a) 9.66% 1.00% 0.70% 0.00%

Risk Free Rate (b) 4.27% 3.47% 4.47% 0.00%

Pre-tax Cost of Debt (c) = (a) + (b) 13.93% 4.47% 5.17% 0.00%

Marginal Tax Rate 35.00% 12.50% 30.00% 33.00%

After Tax Cost of Debt (c) * (1-tax rate) 13.93% 3.91% 3.62% 0.00%

After computing the cost of debt for each firm we computed the after tax cost of debt. The

after tax cost of debt reflects the fact that interest payable on debt is deductible from the

operating income for tax purposes and results in tax savings for the firms.

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4.5 Cost of Capital

Market value of equity

The market value of equity for each firm has been estimated by multiplying the number of

shares outstanding for each company by the current share price. The market values of equity

are presented in Figure 19.

Figure 19 Market values of equity

Market Value of Equity (million) QT CX MH EKMarket Value of Equity (million) 1,862.2 4,352.4 6,153.3 912.7

Source: Bloomberg

Market value of debt

In estimating the market value of debt we again took two approaches:

Use the current value for debt that is publicly traded and information is obtainable; Project interest and principal payments and discount them back at the current cost of

debt as estimated above.

In projecting the interest payments we have used the current interest payments to book value

of debt ratio as a proxy for the average interest rate payable on the debt; and the average

maturity of the outstanding debt.

In addition, QT, CX and MH have significant operating lease commitments, which are not

recorded in their books. Such commitments require that the firms make regular payments to

the lessors in exchange for the use of assets (aircrafts, real estate). Such transactions are

treated as rent for accounting purposes and lease payments are recorded as operating expense.

The essence of the transaction, however, is financing the use of the assets and lease payments

could be viewed as interest and principal repayment of a loan provided for the acquisition of

the assets. Moreover, the companies are committed to making these payments for a long

period of time

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subtracting the estimated depreciation charge associated with recording the leased assets in

the companies books.

Summary of the market value of debt calculation is presented in Figure 20.

Figure 20 Estimation of market value of debtMarket value of debt (million) QT CX MH EKBook Value of Debt 14,254.0 1,178.7 4,578.7 -Current cost of debt 13.93% 4.47% 5.17% 0.00%Average maturity 7.3 6.4 11.1 -Interest Expense 894.0 53.3 143.0 -

Market Value of Debt (a) 6,261.3 1,179.6 4,618.2 -PV of Operating Leases (b) 5,822.57 181.64 388.82 -

Total Market Value of Debt (a) + (b) 12,083.9 1,361.3 5,007.1 -

Debt and Equity ratios

The market values of debt and equity have been used as weights in calculating the weighted

average cost of capital.

Figure 21 Capital weights

QT CXIndustry

Avg.*MH EK

IndustryAvg.*

Market Value of Equity (a) 1,862.2 4,352.4 6,153.3 912.7Market Value of Debt (b) 12,083.8 1,361.3 5,007.1 -

Firm Value (a) + (b) 13,946.0 5,713.7 11,160.4 912.7D/(D+E) 86.65% 23.82% 33% -49% 44.86% 0% 9% -35%

E/(D+E) 13.4% 76.2% 67% -51% 55.1% 100% 91% -65%

Source: Bloomberg, own analysis, www.damodaran.com

*Airline Transportation industry, **Airport maintenance and operation industry

Comparing the debt ratios for the analyzed companies to the industry average we observe that

QTs financial leverage is significantly higher than that of the average for the sector. On theother hand, EK is rather unusual in its industry since it does not have any debt.

These inputs are used in computing the cost of capital for each firm. The weighted average

cost of capital is computed as follows:

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Figure 22 Calculation of cost of capitalCost of capital QT CX MH EKBeta 6.26 1.24 1.42 0.82

Cost of Equity 34.54% 9.45% 11.30% 9.65%E/(D+E) 13.35% 76.18% 55.14% 100.00%After-tax Cost of Debt 13.93% 3.91% 3.62% 0.00%D/(D+E) 86.65% 23.82% 44.86% 0.00%

WACC 16.69% 8.13% 7.85% 9.65%

Not surprisingly the company with highest cost of capital is QT, reflecting its high

risk. The high cost of capital is driven by two factors high beta (volatile earnings and highdebt to equity ratio) and high cost of debt (low credit rating because of high debt and huge

interest payments). The lowest cost of capital that of MH reflects the fact that the company is

relatively mature and stable, with predictable earnings and cash flows and is less subjective to

market fluctuations.

The estimated cost of capital of and cost equity are the hurdle rates that should be

used in capital allocation decisions in each company. These are the minimum acceptable rates

against performance of each new project considered should be measured return on equity

against the cost of equity and return on capital against cost of capital. In addition, the cost of

equity and cost of capital rates are the rates at which projects cash flows should be

discounted to estimate their net present value.

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Investment Return Analysis

The ability of each firm to grow and create value for its stockholders ultimately depends on

its management capability to identify and undertake projects that generate returns exceeding

the cost of capital employed. In this section we will analyze the quality of the projects that the

four companies undertake ad review the past performance of the companies as measured by

indicators such as Return on Capital (ROC) and Return on Equity (ROE).

5.1 Typical Project

The companies, subject to our analysis are involved primarily in 3 types of businesses air

transportation, aeronautical services and retail services. Aeronautical services include

operation and maintenance of airport and all related facilities that are used by passengers and

airlines. Some of the characteristics of a typical project for each business are presented in

Figure 23.

Figure 23 Typical projectsBusiness Typical Project / Flow Characteristics

Airlines Fleet Acquisition: Long term payment, Long life of the asset

New Route Opening: local offices and labor force. Long term anddifferent currenciesSet up of new bases long term, may have option value to expandin new routes at a later stage.New Terminal buildings and maintenance. Long term, singlecurrency Cash flows are volatile and sensitive to macroeconomicrisk factors.

Aeronautical Services Medium to long termCash outflows that are primarily in local currency,but there could be a significant dollar componentCash inflows that are almost exclusively in local currencyPart of cash flows related to passengers can be volatile andsensitive to global risk factors

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In general, the time horizon of the core businesses of companies is long term with the

exception of the retail business which has shorter duration of its projects. Airline and retail

businesses cash flows are sensitive to macro risk factors and certain cyclicality (following the

economic cycles) might exist. Aeronautical services business, however, is less exposed to

such cyclicality as the bulk of its revenues are generated from long term contracts with

airlines for the use of their facilities. Even in the case of an airline to meet its payments, big

international hubs such as Kualalampur operated by MH have a solid backlog of airlines,

which are ready to purchase potentially available landing slots.

5.2 Measuring Returns

ROE and ROC

For each of the company we computed the Return on Equity (ROE) and Return on Capital

(ROC) as follows:

2/)( 1+=

tt BVEBVE

NetIncomeROE

2/)(

)1(

11 +++

=

tttt BVEBVDBVDBVE

TOpIncomeROC

Where:

BVE - book value of equity

BVD - book value of debt

T - Tax rate

t - Time period

The historical returns are presented in figure 24and Figure 25.

Figure 24 ROE, ROC and industry averages

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Figure 25 Investment returns AmericanQT CX MH EK

ROE n.m.3 14.69% 8.50% 5.15%

ROC 8.54% 16.94% 5.59% 4.76%

Economic Value Added

We further compared the obtained returns to the cost of equity and cost of capital. The results

are presented in Figure 26 and Figure 27.

Figure 26 Equity Economic Value Added QT CX MH EKROE (a)4 nm 14.69% 8.50% 5.15%Cost of Equity (b) 34.54% 9.45% 11.30% 9.65%Equity Return Spread (a)-(b) nm 5.24% -2.80% -3.23%Average book value of equity (268.0) 1,574.7 4,797.0 1,057.7

Equity EVA n.a 82.5 (134.5) (47.6)

From the companies included in the analysis only CX created excess returns on equity(Return in Equity Cost of Equity). It created a positive equity economic value added (EVA)of $82.5 million based on the last 12 months results. At the same time the airline industrydestroyed on average value of $ 4, 95765.7 in 2004. Both MH and EK had return on equitylower than their cost of equity. Comparing these results with the positive Jensens alphavalues, we can conclude that although both firms performed better that the market expected,they still have not generated equity returns in excess of their equity costs.

Multiplying the spread between the return on capital and cost of capital for each company bythe average book value of total capital (equity + debt) we estimated the economic valueadded for each firm.

Figure 27 Economic Value AddedQT CX MH EK

ROC 8.54% 10.14% 5.59% 4.76%Cost of Capital (b) 16.69% 8.13% 7.85% 9.65%Capital Return Spread (a)-(b) -8.15% 2.01% -2.27% -4.89%

Average book value of capital 13,862.5 2,652.8 8,427.0 1,057.7EVA (million) (1,129.5) 53.3 (191.0) (51.7)

Again the only company that created value during the observed period was CX. The average$

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g

5.3 Future OutlookThe ability of any of the companies to generate positive excess returns depends on itscompetitive advantages and their sustainability in the medium and long term. In this section

we look at some key indicators for the air transportation sector, which could help us tounderstand how the companies are positioned for the future.

Figure 28 Comparison of key figures airline transportationTraditional and low cost air carriers at a glance QT CX Asian Industry EU Industry

Revenue Yield per Passenger Mile (RAPM) ($ cents) 11.5 n.a. 12.3 15.8

Load Factor 72.8% 84.0% 73.4% 64.8%

Number of Planes 1,013 79 213 80.9

Revenue per Employee ('000 $) 202.4 489.3 174.6 n.a.

Average Age of planes 12.5 n.a. 11.2 n.a.

Source: QT annual Report, ATA (Air Transport Association),

and Elfaa (association of low fares airlines) Economic reports

The analysis suggests that while CX is relatively small airline in terms of number of aircraftsit has more efficient operations which is evident from higher load factor (seats capacityutilization) and higher revenues per employee ($635K compared to $202K for QT). Furtheranalysis supports the fact that CX relies on operational efficiencies to maintain its cost

advantages:

Figure 29 Key Performance IndicatorsKPI

CX Low cost carriersIndustryAverage

Passenger per employee 10,050 6,000 1,069

Average fare (Euros) 40.0 86.3 206.6Lost bags per 1000 passengers 0.5 n.a. 11.3Employees per aircraft 35 n.a. n.a.Schedule on time 93.0% 85.0% 81.2%

Source: QT annual Report, ATA (Air Transport

Association), and Elfaa (association of low fares airlines)

Economic reports

On average CX benefits from much higher passenger to employee ratio and much loweremployees to aircraft ratio, this helps the company to maintain cost efficiency. Indicators

such as lost bags per 1,000 and schedule on time suggest operational efficiencies andcustomer satisfaction. One of the reasons for this is the structure of the aircraft fleet that CXuses as compared to its peers CX currently employees predominantly two types of aircrafts Boeing 737-200 and Boeing 737-800 and a program whereby all aircrafts will be replacedwith 737-800 machines is in place. Qantas, on the other hand, has a large fleet comprising of11 different types of aircrafts, which have different technical and maintenance requirements,

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Conclusions

In conclusion, we believe that in the medium term CX can sustain competitive advantageswhich will allow the company to earn return on capital in excess of its cost of capital. Thecompany has an investment program aimed at increasing its capacity from the current 15million passengers per year to 50 million by 2010. This would enhance CXs growth,however at the expense of huge capital spending.

Qantas, on the other hand is facing fierce competition in a market where it clearly lackssignificant competitive advantages. Excess domestic capacity, fragmented market andincreasing competition from low cost carriers such as JetBlue and SouthWest Airlines are allfactors that have negative impact on the company. We believe that the renewal of the fleet is

crucial for Qantas: the current aged and too diverse fleet generates, by itself, an inefficientcost structure (more maintenance costs, different training for pilots and mechanics, differentscheduling of engines check up). Moreover the average age of Qantas fleet is over 10 yearsand this represent a huge cost in term fuel (old airplanes are less efficient) landing fees at theairports (old airplanes are heavier) and customer satisfaction (old airplane are lesscomfortable and therefore less attractive). Finally the company is targeting expansion ininternational markets, where it believes it can enjoy higher growth and margins, but new longhaul planes are needed to successfully compete in that arena. Qantas average age of long haul

planes is close to 13 years. Overall we believe that Qantas as a traditional renowned carriershould focus on the international long haul segment (not threatened by low cost carriers, aspassenger need to be comfortable in a long trip) by renewing its fleet on offering a vastnetwork of routes thanks to international alliances. Returns on capital and operating marginlong term are going to be positive again, but below the peaks of the mid nineties.

In the case of MH what project it takes and the associated returns depend on negotiationswith the CAA, the regulatory authority. Negotiations take place every place 5-years with the

next one scheduled to be in March 2008. Tariffs are currently set below their market pricesand the consequence of this is that MH shareholders are subsidizing the airlines landing at itsairports. We think that this situation is very unlikely to change in the short term, at least untilthe new review in March 2008. Similarly for EK, the company faces mandatory capitalinvestments which are negotiated with the Dubai Ministry of Communications andTransportation every five years. In the coming years, EKs main investment project will bethe construction of another runway at the Dubai airport, to handle the higher than expectedgrowth in passenger volumes. This project has already been moved forward five years fromits original start date, signaling the companys strong confidence in its growth prospects forthe coming years.

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Capital Structure Choices

6.1 Current Financing Mix

Figure 31 below summarizes the current debt structure of Qantas, MH and CX (EK has nodebt). As can be observed, the three companies employ very different kinds of debt:

Qantas(QT)QT has outstanding a wide variety of notes, from bank debt, plain vanillabonds to more structured debt instruments. On one hand this is driven bythe necessity to tailor the debt to match the companys cash flow profileand risk, which is very specific. On the other hand this is a symptom ofthe financial difficulties the company has been going through and the

need to raise capital in any form it was available. With this respect, it is worth noticing that

the BoD has even authorized (but not yet issued) the emission of 20million preferred shares.

Cathay Pacific(CX)CX has only bank debt outstanding and this is a reflection of both theearly stage of the life cycle is in and its ability to generate cash flows,thus funding growth largely with internal funds. We expect the

financing mix to change as the company continues to expand and it will need to access thepublic bond markets to fund its future projects.

Malaysia Airlines(MH)MHs debt is almost all made up by straight bonds (82% of the total),with the rest coming from bank debt and two outstanding convertible

bonds issues. This is due to the high stability and predictability of its cash flows, which hasgiven MH easy access to the public the bond markets. The company has issued substantialdebt over the last years (Gross Debt went from approx. R1.0 bn in 1995 to over R4 bn todaywith D/E climbing from 20% to 81%) as a result of the expected capex expendituresconnected with the other terminals at Kualalumpur and other projects.

Emirates (EK)EK has no debt outstanding as it has been able to fund all its capexrequirements through internal cash-flows.

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Figure 31 Current debt characteristics

Company Type of Financing Amount (mm)Interest Rate on

BooksMaturity

Secured Variable and Fixedrate indebtness

6,340.0 2.03%-9.16%

Enhanced Equipment trust 3,707.0 2.14%-9.09% 2011certificatesSpecial facility revenue bond 946.0 6.00%-8.50% 2036

Qantas Credit Facility Agreement 850.0 9.150% 2010

Senior Convertibles Notes 619.0 4.25%-4.50% 2023-2024Debentures 330.0 9.00%-10.20% 2021Notes 303.0 7.88%-10.55% 2039Other 1,159.0

Straight Bond 200.0 7.875% 2007Straight Bond 400.0 5.750% 2013Straight Bond 300.0 11.750% 2016Straight Bond 250.0 8.500% 2021

MalaysiaAirlines Straight Bond 200.0 6.375% 2028

Straight Bond 900.0 5.750% 2031Straight Bond 750.0 4.500% 2014Convertible Bond 424.0 2.940% 2008Convertible Bond 425.0 2.625% 2009

Secured bank debt 80.3 n.a. 2005Secured bank debt 84.2 n.a. 2006

CathayPacific Secured bank debt 88.1 n.a. 2007

Secured bank debt 92.1 n.a. 2008Secured bank debt 608.2 n.a. 2009 -2016

In addition to the balance sheet debt 3 of the 4 companies analyzed have relevant off-balancesheet items related to operating leases that we summarize below.

Figure 32 Debt embedded in operating lease commitments

Off Balance Sheet Debt QT CX MH EKPV of Operating Leases 5,822.57 181.64 388.82 -As a % of total market value ofdebt 48% 13% 8%

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Optimal Capital Structure

7.1 Current Cost of Capital / Financing Mix

In the table below we computed the current cost of capital for each of our companies, withthe cost of equity based on a levered bottom-up beta and using market values to compute the

debt/equity weights. As expected given their operating and financial profiles, Qantas has thehighest cost of capital and MH the lowest. EKs cost of capital is equal to its cost of equitygiven that it is only equity financed.

Figure 34 Current cost of capital and inputs for calculation of optimal cost of capitalCost of capital -summary QT CX MH EKCost of Equity 34.54% 9.45% 11.30% 9.65%After-tax Cost of Debt 14% 4% 4% 0%

D/(D+E) 87% 24% 45% 0%E/(D+E) 13% 76% 55% 100%Rating CCC A- A+ Not RatedStock Price 10.2 5.77 5.8 30.45Cost of Capital 16.69% 8.13% 7.85% 9.65%

Firm Value (million) 13,946.0 5,713.7 11,160.4 912.7

7.2 Cost of Capital at Different Financing Mixes

As the next step in our analysis to estimate the optimal capital structure we used the cost ofcapital approach to compute a different WACC at each debt ratio for our companies. Thetable below summarizes our results.

Figure 35 Cost of CapitalDebt Ratio QT CX MH EK

0.0% 10.07% 8.16% 8.82% 9.65%10.0% 9.76% 8.09% 8.58% 9.48%20.0% 9.63% 8.13% 8.39% 9.39%30.0% 10.96% 8.71% 8.24% 9.56%

40.0% 11.78% 11.30% 8.18% 9.93%50 0% 13 86% 13 33% 8 90% 12 01%

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Based on the objective of minimizing the cost of capital, the table above yields the followingresults:

Qantas: assuming a normalized EBIT of $ 2600million (which results in a ROC of8.54%, Qantas should reduce its debt/capital ratio from the current 87% to 20%.

Cathay Pacific: contrary to the result of our qualitative analysis, this analysis showsthat CX is currently over levered and should decrease its debt/capital ratio from itscurrent 24% to 10%.

Malaysia Airlines: MH is currently at its optimal capital ratio (the actual optimum isat the current debt ratio of around 45%). The higher optimum can be explained by thelow variability and uncertainty of its operating profitability due to the regulatoryenvironment in which MH operates. This enables the management to design thecompanys debt profile with a low level of error.

Emirates: The Company is clearly under levered and should move to a 20%debt/capital ratio in order to maximize firm value.

7.3 Firm Value at Optimal

The following tables present the computed expected Firm Value and Stock Price (bothassuming positive growth and no growth) if our companies were to move to their optimalcapital ratios.

Figure 36 Effect of moving to the optimal capital structure

Optimal Ratios

QT CX MH EKCost of Equity 8.62% 11.01% 8.62% 11.30% 10.56%

After-tax Cost of Debt 4.07% 3.34% 3.62% 4.72%D/(D+E) 20.00% 10.00% 44.86% 20.00%E/(D+E) 80.00% 90.00% 55.14% 80.00%Rating BB+ AAA A+ A (probably capped at BBB)Current stock price 10.20 5.77% 5.8 30.45Cost of Capital 9.63% 8.09% 7.85% 9.39%Firm Value (1) (million) 24,173.0 5,742.7 11,160.4 938.1Firm Value (2) (million) 33,107.3 5,763.7 * 951.2Stock Price at optimum (1) $74.99 $5.80 * 31.30

Stock Price at optimum(2) $130.41 $5.83 * 31.74

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Figure 37 Firm values at the optimum capital structureFirm value at

optimal capital

structure

QT CX MH EK

Debt Ratio Current 86.65% 23.87% 44.86% 0%Optimal 20.00% 10.00% - 20%

RatingCurrent CCC A- A+ Not Rated

Optimal BB+ AAA -A- (probably capped at

BBB)

Cost of Capital Current 16.69% 8.13% 7.85% 10.13%Optimal 9.63% 8.09% 7.85% 9.59%

Firm Value (1) Current 13,946.0 5,716.8% 11,160.4 912.7Optimal 24,173.0 5,742.7 11,160.4 963.5

Change in firm value 10,227.0 25.9 0.0 50.8

(1) assuming no growth

As the table shows QT is the company that would benefit the most from the transition,whereas the effect on CX and EKs value would be more limited. More in detail:

Qantas: a strong deleveraging (from 86.65% to 20% debt/capital) will be difficult toexecute in the short term, which in any event would significantly impact the equityvalue as well. The crucial aspect is that we believe that QT cannot but maintaincurrent Capex. We therefore believe that even though necessary, moving to theoptimal capital structure is going to be a very long process. More specifically, thecompany needs to reinvest in the fleet (particularly the long haul fleet: the only onethat cannot be threatened by low cost carriers, and the one that is operating where thecompany believes the higher growth and margins are) in order to be able to compete

in the market and get back to profitability.

Cathay Pacific: the company should focus on reducing its debt/capital ratio byraising more equity capital to fund its future projects, instead of using debt as it hasdone in the last years.

Emirates: raising its debt ratio by issuing debt would benefit the company not onlyfrom an increase in firm value, but also from opening a new capital source, therefore

facilitating access to it in the future. We estimate, that although EKs interestcoverage ratio at its optimum 20% debt ratio would warrant an A- rating, this wouldprobably be capped at BBB, which is the sovereign debt ratio for Dubai.

7.4 Optimal capital structure APV approach

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Tax rate is assumed at 35% stable Unlevered firm value is calculated as Current Firm Value tax benefits on debt +

Expected Bankruptcy cost.

Figure 38 APV optimal capital structure - assumptionsQantas Basic AssumptionsCurrent Debt Ratio 86.8%Unlevered Firm Value $12,615.13Current Firm Market Value $13,923.99Tax Rate 35%

Debt Market Value $12,083.85Tax Benefits on Debt $4,229.35Expected Bankruptcy Costs 45%Bankruptcy Probability 47%Cost of Bankruptcy $2,920.49

We have undergone an iterative process that yielded us the capital structure that maximize thefirm value.

Figure 39 AA optimum debt levels - APC approach

DebtRatio

$ DebtTaxRate

UnleveredFirmValue

TaxBenefit

RatingProb ofDefault

ExpectedBankruptcy

Costs

Value ofFirm

0% $0.00 35% $12,615.13 $0.00 AAA 0.01% $0.57 $12,614.5710% $1,307.21 35% $12,615.13 $457.52 AAA 0.01% $0.59 $13,072.0720% $2,707.69 35% $12,615.13 $947.69 A+ 0.40% $24.37 $13,538.46

30% $4,198.77 35% $12,615.13 $1,469.57 A- 1.41% $88.80 $13,995.90

40% $5,515.42 35% $12,615.13 $1,930.40 BB 12.20% $756.99 $13,788.5450% $6,687.62 35% $12,615.13 $2,340.67 B 26.26% $1,580.55 $13,375.2560% $7,457.22 35% $12,615.13 $2,610.03 CCC 50.00% $2,796.46 $12,428.7070% $9,010.81 35% $12,615.13 $3,153.78 CCC 50.00% $2,896.33 $12,872.5980% $10,679.48 35% $12,615.13 $3,737.82 CCC 50.00% $3,003.60 $13,349.3587% $11,072.48 35% $12,615.13 $3,875.37 0 65.00% $3,731.89 $12,758.6190% $11,614.96 35% $12,615.13 $4,065.24 CC 65.00% $3,774.86 $12,905.51

Source QT Annual Report, our estimates

The analysis yields us an optimal debt ratio of 30%, not far from the results obtained with theoptimal capital structure model.

However, given the high subjectivity of the bankruptcy cost, we have run a sensitivityanalysis that, taking into account also the tax rate, provide a measure of the debt ratio that


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Market debt ratios

We additionally looked at a regression based on the overall market. The regression applied is:

Market Debt to Capital = 4.881 + 0.81 Eff Tax Rate - 0.304 Insider holding +0.841EBITDA/AV Capex/Total assets

The results are summarized below:

Figure 42 Optimal capital structures market regressionVariable Coefficient QT CX MH EKConstant 4.881Insider Holdings -0.304 2.00 12.47 0.03 30.59

Effective Tax Rate 0.81 - 9.9 29.0 33.5EBITDA/EV 0.841 7.92 9.03 9.46 13.75Capex/Total Assets -2.987 2.85 10.44 12.56 3.25

Predicted Debt Ratio 2.44% -14.47% -1.20% 24.61%

The market debt ratio regression clearly provided some controversial results for QT, CX andMH, suggesting a negative market debt ratio, which is contrary to our previous analysis basedon cost of capital or APV (for Qantas Airlines)

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Mechanism of Optimal

8.1 A Path to the Optimal

In the table below we have listed the main cash flow characteristics of the three businessesour companies are in: Airlines (Qantas & Cathay Pacific), Aeronautical service and Retail

(Malaysia Airlines and Emirates). We have then listed what would be the optimal features ofthe debt for each business.

Figure 43 Typical projects and cash flow characteristicsBusiness Typical Project Cash Flow Characteristics Type of Financing Debt should be

Airlines

Fleet Acquisition: Long term payment,Long life of the assetNew Route Opening: local offices and laborforce.

Long term and different currenciesNew Terminal buildings and maintenance

Long term

Multiple currencies

AeronauticalServices

Medium to long termCash outflows that are primarily in localcurrency, (there could be a significant dollarcomponent for EK)Cash inflows that are almost exclusively inlocal currency

MH: very stable cash flowsEK: volatile due to exposure to tourismtravel

Medium/Long term

Single currency (dollar portionfor EK)

EK: if possible tied to influxof tourism

Retail

Medium termCash outflows that are almost exclusively inlocal currencyCash inflows that are primarily in localcurrency although influenced by relative

strength of Ringgit/DirhamCan be very volatile, especially sensitive toglobal risk factors

Medium Term

Mix of currencies

EK: if possible tied to influxof tourism

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revenues), while the operating income is negatively related. One possibleinterpretation of this is that higher GDP growth boasts companys long term growthprospects. On the other hand, fundamentally the low cost airline model attracts more

passengers during economic slowdown when travelers are generally more pricesensitive, hence negative correlation with the operating earnings.

Dollar: - Although the value of the firm does not appear to be influenced by theDollar exchange rate, stronger currency has significant negative impact on operatingincome. Therefore we would recommend use of mix of currencies in the capitalstructure

Inflation: - Cathay Pacifics firm value seems to be significantly related to theinflation rate and our recommendation would be to use floating rate financing.

Price of Oil: - in addition, we looked at the price of oil as a factor that might impactthe firms value and profitability. It appeared that changes in the oil prices have littleimpact on the firm, which is the result of the airlines hedging strategy. In addition,during the analyzed period CX was less exposed to the increasing oil prices comparedto some its Others counterparties as the price increases were partially offset by theloss of value of the US dollar, which is the referent currency for the price of oil.

The results from the regressions are presented in the tables below.

Figure 45 Regression of Firm value against macroeconomic variablesCathay Pacific Constant Coefficient T-statistic R2Firm value (dependent variable)Change in Long Term rate 30.2 -5.3 -0.2 0.70%GDP growth 6.03 3.24 2.63 36.60%

Change in Dollar 32.4 0.68 -0.27 1.20%Change in Inflation 18.8 6.56 1.56 16.80%Change in price of oil 38.5 -0.532 -1.08 16.3%

Malaysia Airlines (MH) Long Term Interest Rates: Both regressions have a

negative coefficient which points to a longer duration of

debt, approx. 2 years. It should be noted that the T-statistic and the R

2

of bothregressions are very weak.

GDP Growth: MH is positively correlated to GDP growth but shows a low degree ofcyclicality as evidenced by the coefficients.


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8 3 S f d i bl d bt h t i ti


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8.3 Summary of desirable debt characteristics

The profile of the ideal debt that the companies should use is presented in Figure 48 below:

Figure 48 Summary of desired debt featuresCompany Maturity Currency Interest rate Comments Other features

QantasMedium to longterm, despitethe regression

Dollar Fixed Rate

Analysisdistorted by thedistressed stateof the firm

None, provided thatthe company ishedged againstsharp movement inprice of oil

CathayPacific

medium term (5years)

Dollar Floating rate

Analysis isdistortedby the growthstage of thefirm

None, provided thatthe company ishedged againstSharp movement inprice of oil

MalaysiaAirlines

short term (2years)

Ringgit Fixed Rate n.a. n.a.

Emiratesshort to mediumterm Dirham Floating rate n.a. n.a.

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Dividend Policy

9.1 Current Dividend Policy

Of the four companies that we are analyzing, only two of them pay dividends: MH and EK.

This is consistent with their different characteristics in terms of cash flow profile, expectedgrowth and profitability. The main factors behind Qantas Airlines and CX not issuingdividends are the following:

Qantas Airlines: The constraint is clearly the financial and operational distress thecompany is going through

Cathay Pacific: although the company is profitable it chooses not to pay dividendgiven the stage of the life cycle and the consequent growth it has to fund. Investorshave been rewarded by the high stock price appreciation over the last years. Inaddition, the management of CX stated on a number of occasions that it does notintend to pay out dividends in the foreseeable future as it intends to fund a large scalecapacity expansion program. The management put up the issue for a large purchase of50 new Boeing 737-800 aircrafts for vote at the forthcoming general annual meeting.

Malaysia Airlines (MH)

MH has kept a stable dividend policy over the past 5 years, with an average dividend yield of

3.3%. The companys policy of keeping a stable dividend yield was evidenced in 2002 whenit paid a dividend although it recorded a much lower net income (this resulted in a dividendpayout ratio of 114%). The only year in which MH bought back stock has been in 2001 toreturn cash to its shareholders after it had sold some non-core assets.

Figure 49 Dividend policy Malaysia Airlines (MH)Historical Dividends MH 2000 2001 2002 2003 2004Dividend Paid (mm) 150 178 188 196 205

Stock Buyback 0 141 0 0 0Total Cash to shareholders 150 319 188 196 205Average Market Cap 4,071 6,604 6,787 5,027 6,106Dividend Yield (%) 3.7% 2.7% 2.8% 3.9% 3.4%Dividend Payout (%) 58% 46% 114% 52% 54%

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Figure 51 Trade Offs on Dividend Policy

Different table


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Emirates EK has been retaining a significant portion of their available free cash


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flow to equity and on the other hand has not been able to deliver excess returns over its cost of capital. We believe that it should return more cash to its stockholders in theform of dividends. In addition, it is not constrained by high debt ratio as its debtcapacity is still unused.


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Figure 62 Cathay Pacific DCF valuation assumptionsCathay Pacific High Growth Phase Stable Growth


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Cathay Pacific High Growth Phase Stable GrowthLength of Period 4 years and 4 years transitional

periodForever

Operating income growth 22.53% 3%Tax Rate 12.50% 20.00%Return on Capital 15.48% 7.78%Cost of capital 8.13% 7.78%Non-Cash Working Capital starting at 8.45% and declining to 2% 2.00%Reinvestment Rate (Net Cap Ex + WorkingCapital Investments/EBIT 146% 39%Debt Capital Ratio 23.87% 10.00%

Beta 1.24 1.00Cost of Equity 9.5% 8.3%Cost of Debt 4.5% 4.0%

Source: Company reports, analysis

Figure 63 MH DCF valuation assumptionsMalaysia Airlines High Growth Phase Stable GrowthLength of Period 4 Years Forever

Starting at $1,970 and growing with 4.8%

Revenues CAGR Growing at 2.00%

Tax Rate 30% 30%

Return on Capital 5.23% 6.93%Reinvestment Rate (Net Cap Ex + Working

Capital Investments/EBIT Starting at 161.65% and declining to 28.85% 28.85%Expected growth Rate in EBIT starting at 8.45% and declining to 2% 2.00%Debt Capital Ratio 45% 45%

Beta 1.42 0.90Cost of Equity 11.30% 8.81%Cost of Debt 5.17% 5.17%

Source: Company reports, analysis

Figure 64 EK DCF valuation assumptionsEmirates High Growth Phase Stable GrowthLength of Period 5.0 Forever

Revenues 177.2Pre-tax Operating MarginTax Rate 33.0% 33.0%Return on Capital 7.5% 11.0%Non-Cash Working Capital 5.93 5.93


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Appendix IQT Income

2001 2002 2003 2004 1Q04 1Q05 2004TTM


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QT IncomeStatement

2001 2002 2003 2004 1Q04 1Q05 2004TTM

Passenger Revenues 17,208 15,871 15,851 16,897 4,098 4,292 17,091of which Qantas Airlines 15,780 14,440 14,332 15,021 3,678 3,841 15,184

of which Regional 1,428 1,431 1,519 1,876 420 451 1,907

Cargo 662 561 558 625 148 151 628Other 1,099 988 1,031 1,123 266 307 1,164Total Revenues 18,969 17,420 17,440 18,645 4,512 4,750 18,883

Labor Costs -8,032 -8,392 -7,264 -6,719 -1,640 -1,644 -6,723Fuel -2,888 -2,562 -2,772 -3,969 -808 -1,097 -4,258Commission andBookings

-1,540 -1,163 -1,063 -1,107 -288 -271 -1,090

Maintenance -1,165 -1,108 -860 -971 -231 -235 -975Other rentals and airportfees

-1,197 -1,198 -1,173 -1,187 -305 -300 -1,182

Food Service -778 -698 -611 -558 -137 -125 -546Other Operating -2,996 -2,715 -2,428 -2,366 -582 -617 -2,401Special Charges -1,466 -718 -407 -11 0 0 -11Australian GovernmentGrant

856 10 358 0 0 0 0

Ebitdar -237 -1,124 1,220 1,757 521 461 1,697Aircraft Rentals -829 -840 -687 -609 -153 -148 -604

Ebitda -1,066 -1,964 533 1,148 368 313 1,093Depreciation and

Amortization

-1,404 -1,366 -1,377 -1,292 -326 -290 -1,256

Ebit -2,470 -3,330 -844 -144 42 23 -163Interest Income 110 71 55 66 14 36 88Interest Charges -538 -685 -703 -871 -212 -235 -894Capitalized Interest 144 86 71 80 18 23 85Other -2 -2 113 108 -28 -9 127

Financial Income /

(Charges) -286 -530 -464 -617 -208 -185 -594EBT -2,756 -3,860 -1,308 -761 -166 -162 -757Tax Benefits 994 1337 80 0 0Income (Loss) -1,762 -2,523 -1,228 -761 -757Accounting ChangeI t

0 -988 0

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QTBalance Sheet 2001 2002 2003 2004 1Q05Current Assets Current 6,469 -6,740 4,833 - 4,562 - 4,851 - 5,272 -


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Liabilities Inventory, ,

0,

6,372 0,

5,755 0,

6,212 0,

6,852 0

Net Working Capital -271 -1,539 -1,193 -1,361 -1,580

Tangible AssetsIntangible AssetsFinancial Assets (cash)

19,6556,615

102

19,6945,636

104

19,4605,188

120

19,1374,665

120

19,1164,631

148

Total Assets26,372 25,434 24,768 23,922 23,895

Termination Indemnityreserves

-10,122 -9,760 -9,599 -8,812 -8,758

Net Capital Employed 15,979 14,135 13,976 13,749 13,557

Total DebtTotal Equity

-10,6065,373

-13,178957

-13,93046

-14,330 -581

-14,254-697

Net Capital Employed

15,979 14,135 13,976 13,749 13,557

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CX income Statement


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CX- Balance sheet


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MH IncomeStatement

2002 2003 9M 2003 2004 9M 2004 2004LTM

il i l ld 866 755 802


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Retail (incl. World Duty Free) 866 755 802Airport/traffic charges 677 690 734

Property/op. facilities 260 266 282Other 60 49 59Total Airports 1,863 1,760 1,452 1,877 1,589 2,014

Rail 58 64 50 67 51 68Other 51 58 18 26 15 23Total Revenues 1,972 1,882 1,520 1,970 1,655 2,105

Labor Costs (443) (420) (475)

Retail Expenditure (276) (167) (176)Operating LeasesExpenses

(45) (43) (44)

Other Operating Costs (401) (407) (401)Total Costs (1,165) (1,037) (829) (1,096) (882) (1,149)Share of operating profitin Joint Venture

6 11 5 9 15 19

Ebitda 813 856 696 883 788 975

Depreciation andAmortization

(257) (258) (191) (258) (213) (280)

Ebit 556 598 505 625 575 695

Interest Income 34 60 52Interest Charges (134) (176) (143)

Net Interest (100) (116) (66) (91) (63) (88)

Other Financial Income 49 42 2 2 9 9Financial Income /(Charges)

(51) (74) (64) (89) (54) (79)

EBT 505 524 441 536 521 616Taxes (152) (161) (137) (162) (153) (178)Minority Interests (2) (2) (1) (1) (1) (1)

Income (Loss) 351 361 303 373 367 437

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MH -Balance Sheet 2002 2003 2004 Dec-04

Trade Receivables 183 218 270 314


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Trade Receivables 183 218 270 314Trade Payables (125) (143) (152) (150)

Inventory 34 27 23 53 Net Working Capital 92 102 141 217

Other Current Assets / (Liabilities) (576) (669) (792) (810)

Total Net Current Assets (484) (567) (651) (593)

Tangible Assets 6,975 7,802 9,074 9,997Intangible Assets 10 10 10 10

Share of Gross Assets 51 75 60 62

Share of Gross Liabilities (39) (72) (46) (48)Loans 39 30 17 18

Investments in JVs 51 33 31 32

Investments in associates 6 7 49 42Other investments 80 142 122 80

Total Fixed Assets 7,122 7,994 9,286 10,161

Other Liabilities (267) (971) (901) (941)

Net Capital Employed 6,371 6,456 7,734 8,627

Gross Financial Debt 2,567 3,029 3,598 4,169of which Convertible Debt 311 730 838 838

of which Bonds 1,842 1,873 2,266

of which Bank Loans 350 378 447

other financial debt 34 48 47

Cash & Marketable Securities (939) (1,156) (890) (849) Net Debt 1,628 1,873 2,708 3,320

Minority Interest 6 8 8 9Total Equity 4,737 4,575 5,018 5,298

Net Capital Employed 6,371 6,456 7,734 8,627


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EK- Balance Sheet


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CX I t t t L t 12 th D 04 D 03 2004 2003 2002 2001 2000

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CX -Income statement Last 12 months Dec-04 Dec-03 2004 2003 2002 2001 2000

000 $ 000 $ 000 $ 000 $ '000 $ '000 $ 000 $ '000 $Operating revenues 1,238,387 1,015,536 851,373 1,074,224 842,508 624,050 487,405 370,137

Operating expensesDepreciation and amortization (100,623) (70,960) (71,728) (101,391) (76,865) (59,010) (59,175) (44,052)Lease payments (42,018) (23,636) (6,450) (24,832) - (4,021) (7,286) (2,097)Staff, fuel, route charges and others (811,193) (636,753) (509,771) (684,211) (502,169) 398,086) (306,933) (239,933)Total operating expenses (953,834) (731,349) (587,949) (810,434) (579,034) (461,117) (373,394) (286,082)

Operating profit beforeexceptional costs

284,553 284,187 263,424 263,790 263,474 162,933 114,011 84,055

Reorganization costs - - (3,012) (3,012)Other exceptional costs - - (9,491) (9,491)Amortization of goodwill (2,287) (1,702) (1,757) (2,342)Total exceptional costs (2,287) (1,702) (14,260) (14,845) - - - -EBIT

282,266 282,485 249,164 248,945 263,474 162,933 114,011 84,055

383 350 340 222 173 128Financial charges -Interest expenses (53,254) (40,992) (35,302) (47,564) (30,886) (19,609) (11,962) (3,781)Other financial income/(charge) 25,981 17,368 18,486 27,099 31,962 29,050 21,339 9,820Total (27,273) (23,624) (16,816) (20,465) 1,076 9,441 9,377 6,039

Profit before tax 254,993 258,861 232,348 228,480 264,550 172,374 123,388 90,094

Taxes (23,680) (24,257) (22,446) (21,869) (25,152) (21,999) (18,905) (17,576)-

Net income 231,313 34,604 209,902 206,611 239,398 150,375 104,483 72,518

CX B l h t L t 12 th D 04 D 03 2004 2003 2002 2001

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CX - Balance sheet Last 12 months Dec-04 Dec-03 2004 2003 2002 2001

'000 $ '000 $ '000 $ '000 $ '000 $ '000 $ '000 $Fixed assetsIntangible 30,872 30,872 45,085 44,499 - 36Tangible 1,845,452 1,845,452 1,611,127 1,576,526 1,352,361 951,806 613,591Total fixed assets 1,876,324 1,876,324 1,656,21

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