(Part 2) AirAsia Group: Highly-levered Malaysian airline sweetheart. Gambling, or justified high-risk bet? 

Star troopers?

In my last post, I talked about what I think AirAsia Group’s direction is headed, and I used a traditional DCF valuation based on that story. It might seem surprising to see that the valuation output is surprisingly low, even with pretty decent assumptions.

Before we give up on the company. I think traditional DCF models are unable to capture the true value of companies, especially those highly distressed. This is because, in a discounted cash flow approach, the primary assumption we make is that the company will be around in perpetuity, meaning, forever. It does not account for the fact that some companies, especially highly distressed, have a high probability of not surviving in the next few years. If traditional DCF models don’t work, let’s try some other approaches to valuation.

Relative valuation: the pricing game

Relative valuation is highly popular among analysts, especially in an uncertain market condition. People who prefer using multiples, such as price-to-earnings, argues that in an unpredictable market, it is safer to just compare and price a company to its peers. But what if that entire peer group is collectively overpriced? Like the glove manufacturing industry. On the other end of the spectrum, what if the whole sector is underpriced? Like, say, maybe the airline industry? Well, let’s find out. Let’s compare AirAsia Group to its peers.

I gathered a list of all the publicly traded airline companies in the world, a total of 84 companies. From Southwest Airlines to El Al Israel Airlines, even the little sister, AirAsia X. Except for Air Koryo. Then, I need to decide on a multiple that will give me the most data. In this case, the popular price-to-earnings didn’t work because less than half of the list have positive earnings. I settled on enterprise value-to-invested capital (EV/IC), basically, the value of the entire operating company against its operating assets. Then I would need to find a factor to compare it against the multiple. In this case, I settled with the companies’ cost of capital (WACC), which is a measure of the riskiness of each company. So a company with higher risk should have a lower multiple, or priced cheaper, and vice versa. In a perfect world, I would need to run a regression of the EV/ICs to WACCs, but we’re not living in one. With such a small sample size, I doubt the regression would be meaningful, but I tried it regardless.

Just by looking at this, a regression would definitely NOT work!

This is the regression result, and... it looks terrible...

With a tiny R-square and insignificant t-statistics, I might as well just fall back to the unsophisticated approach, using the “eyeballing” method. 

AirAsia Group is in the 10th decile in terms of WACC (risk).

I estimated AirAsia Group to have WACC of around 13% and that puts them in the lowest decile group. Again, WACC is a proxy for risk, and companies with higher risk should be priced cheaper. So because of that, I will assign them with EV/IC from the lowest decile group, which is 0.74. With that multiple, I get an Enterprise value of USD2.1 billion and also a Firm value of USD2.5 billion, which is not far from the estimate that I got from my previous DCF model.

Both regression and "eyeballing" way of pricing, with commentary.

So what gives? If both a cash flow and pricing model doesn’t explain the current market price, what would? 

Cue the option pricing model.

Viewing highly levered, distressed companies as options

Options are a sort of financial derivatives, contractual agreements based on underlying assets. A call option gives the option holder the right but not the obligation to buy the underlying asset at an agreed-upon price at a future date. Let’s say your own a call option, to profit, the agreed-upon price or the strike price has to be lower than the market price. So that you can buy the asset for less than the market price, provided that the payoff is higher than your initial investment. Now, for highly levered, distressed companies, they can be viewed as deep out-of-the-money options. With market value as the company value, the strike price as debt, and initial investment as the liquidation value of the company.

Treating AirAsiaGroup as an option.

In options, very deep-in-the-money options, which also means the chances of profiting is very low, will still have value regardless. This is why people buy the lotto, right? The most that one can lose is the money that they’ve invested, this is true for the company and also for the investors. With even the slimmest possibility of actually making money, when they do, the payout is massive.

Snapshot of the Black Scholes model with commentary.

The only new input that we need for the Black Scholes’ option pricing model is really just variance, meaning how uncertain the valuation is in the industry. Risk or uncertainty becomes our ally when it comes to options because, for the deep-out-of-the-money option to pay off, we would need big swings in value. 

Looking from an option’s point of view, the value of AirAsia Group actually comes close to its market price, at USD456 million market capitalization. Note that the implied debt value is lower than the book debt, from USD3 billion down to USD2.3 billion. This is because while shareholders gamble their investments, hoping for a miracle payoff, debtors are left holding the bag, not able to profit from the upside. Also, the model implies that the option has only a 15% chance to exercise, suggesting an 85% chance that the company will go bust.

 

Closing thoughts

I think that traditional cash flow models and pricing models do, in fact, capture the total value of the firm. They just fail to properly account for the individual claims of the firm. When the shareholders of AirAsia Group has a low probability of surviving, they resort to all sort of risk-taking in high-stake investments. Why worry? Since there is nothing much left to lose, go big or go home, at the expense of the debtholders. What can the debtholders do? Unless there are already covenants in place before the fact, shareholders have free-reign to take all sorts of risky bets until the debt matures, which is roughly 6 years. Or if the company fails to pay its interest.

Model: AirAsiaGroup 2020aug

Data: airline comps 2020aug

Disclaimer: I own shares in AirAsia Group. This writing is for informational purposes only, is not intended to serve as a recommendation to buy or sell any security, is not a research report, and is not intended to serve as the basis for any investment decision.