Singapore Airlines Shares and Rights Issue – Safe Distancing Required

The economic fallout from COVID19 has been brutal and extensive.

The aviation industry is one of the hardest hit. With many borders still shut, demand for air travel has fallen off a cliff. The International Air Transport Association (IATA) estimates that up till June alone, we will see more than 4.5million flight cancellations and up to US$314 billion in lost revenues for 2020.

In the midst of this swirling storm, national carrier Singapore Airlines has taken centre stage. Together with subsidiary Silkair and Scoot, the SIA group forms an integral part of our national transportation ecosystem, providing air links to 138 destinations all over the world. Including subsidiary SIA Engineering, the group hires in excess of 27,000 staff. The airlines facilitate travel and trade, and their economic contribution to the country is a healthy multiple of their revenue and profits. 

COVID19 has hit SIA hard. The airline has announced capacity cuts of up to 96%. This will be in force until the end of June and in all likelihood be further extended. The situation is dire. 

SIA is burning cash and it had to react quickly. In late March, even before the implementation of the Circuit Breaker, SIA has come out to announce two rights issue. It is to raise S$5.3B via the issuance of new equity and up to S$3.5B via mandatory convertible bonds. A provision was also made for an additional S$6.2B of MCBs as and when the directors deem necessary.  When fully subscribed, SIA can expect a S$15B capital injection in total. 

The airline business attracts a lot of attention from retail investors worldwide. Airlines are very visible and some would even say, sexy businesses. Coupled with the sheer size of the injection, SIA has dominated the news cycle for the past few weeks. The issues at stake are highly complex and have left many investors scratching their heads. In fact, very few investors have a good grasp of what is at stake. 

Here are 3 things you need to know about Singapore Airlines and its Rights Issue. 

#1 Airlines are bad businesses. 

The economics of the airline business is shaky at best and downright disgusting at worst. Sir Richard Branson, owner of the UK based airline Virgin Atlantic famously remarked that ‘The quickest way to become a millionaire in the airline business is to start out as a billionaire’. Airlines are capital intensive, they operate on wafer thin margins and are highly susceptible to asymmetrical downside risk. 

Capital Intensive Business – Using Billions to earn Millions 

In the year 2000, Singapore Airlines announced that it has entered an agreement with Airbus to purchase 25 A380s for US$8.5B, making it the launch customer for the largest commercial airliner to take to the skies. Based on those numbers, each aircraft is estimated to cost in excess of US$340 million. 

In more recent years, SIA has completed a series of sale and leaseback deals on their A380s, one of which has a reported monthly rental of US$ 1.7m.  

Either way you see it, the business requires huge amounts of upfront capital investment. Other businesses requiring such heavy investment in hardware include utilities, rail networks and telcos. They tend to be highly regulated, monopolistic in nature or even fully state owned in nature. This allows the incumbent to provide a quasi-public good at an affordable rate to everyone who needs its services. 

Singapore’s Open Skies Policy

Aviation is a rather unique creature. On one hand, the government regulates not only Airlines based in Singapore (other than the SIA group, only one other – Qantas backed low cost carrier Jetstar Asia, holds a Singapore Air Operator’s Charter) but also has oversight on any operator that wants to fly into Singapore. 

On the other, Singapore has one of the most open skies aviation policy in the world. Airlines all over the world are often granted carte blanche access to Changi Airport, many of them not only carrying passengers to and from their own country, but also exercising the precious fifth freedom right to carry passengers from Singapore onwards to a third country. On the extremely lucrative Kangaroo route, SIA’s biggest competitors Emirates and Qantas fly their own super jumbos daily from Europe and Dubai to Singapore and then on to Australian cities. 

It has been stated on many occasions that our status as an aviation hub precedes SIA’s survival. Unfortunately this has also taken a toll on SIA’s profit margins. 

Wafer Thin Margins. 

SIA has stopped reporting their breakeven load factor since two years ago. This figure has typically hovered around the high 70s and low 80s and the last reported number was 82.4% for FY17/18.

The actual passenger load factor for Q3 FY19/20 was 85.6%. For the lack of a better comparison, if we were to mesh the two numbers together we would get a margin of 3.2%.

At the risk of oversimplifying things, what this means is that the SIA derives its profits from only 3.2% of the passengers it carries. For an A380 carrying 471 passengers across all classes, it is the final 15 passengers that make or break the profitability of the flight.

To understand how difficult the business is and how thin the margins are, imagine a cab driver who makes 85 trips a day. He makes nothing from the first 82 trips, they go towards the rental and fuel for his vehicle. Only his 83^rd, 84^th and 85^th trips will bring in income for him.

Should it rain and or if he gets caught in a jam, he is almost certain to declare a loss for the day. Such is the nature of the business.

Asymmetrical Downside Risk. 

The word asymmetric means radically different things in both aviation and financial modelling, so it a highly befitting term for the potential downside perils Airlines have to contend with. 

Many factors can cause the business of an airline to plummet drastically in a very short period of time. Airlines have to contend with acts of nature on an ongoing basis. Typhoons and snowstorms cause minor disruptions and inconveniences to passengers and airlines. On a larger scale, earthquakes and volcanic activity wreak havoc and cause extended disruption. Exactly ten years ago this month, a volcano in Iceland erupted, spewing ash cloud all over continental Europe. Aviation was bought to a standstill for weeks. 

Geopolitical instability such as wars and acts of terrorism are an even greater cause of concern for the aviation industry. 9/11 bought about a radical rethink of aviation security. In the aftermath, jittery travellers were slow to take to the skies and the industry had to deal with an extended period of weak numbers. 

Other devastating events include having to contend with technical issues within the fleet. After two fatal incidents in 2019, the FAA grounded the entire Boeing 737-800 Max fleet to correct a design flaw. Silkair used to operate a fleet of 6 737-800 MAX, with another 31 on order. Overnight, 20% of its fleet is grounded indefinitely and a spanner throw into its expansion plans, no doubt causing a significant impact to its bottom-line. 

And of course – Pandemics. It is not the first pandemic airlines had to contend with in recent years and the industry emerged stronger after SARS and H1N1. It will also not be the last. At this moment however, it is looking to be the most deadly event. 

Any one of the above scenarios can cause an airline to lose many of its passengers. Demand can halve overnight, or in this case – become practically non-existent. 

Yet, not one single event can cause demand to increase by 50% over a short period of time. Even if there is, airlines will not be able to cope because they are limited by capacity in terms of aircraft and crew. Therein lies the asymmetrical nature of the airline business. Capacity growth is usually slow and planned, while many unexpected events can cause a sudden and acute dip in traffic and business.

Lack of a Domestic Market

To add on to our aviation woes, Singapore does not have a domestic market. Unlike the US, China or even our closer neighbours Indonesia, Vietnam and Malaysia, we depend entirely on international traffic. Every regular scheduled flight into Changi Airport is an international flight. 

Airlines within these countries are able to start flying and to rely on domestic demand without being subjected to border controls. Unfortunately SIA does not have that luxury. 

#2 SIA will survive – Shareholders may not. 

Imagine a pie cut into three slices. Employees, Customers and Shareholders each staking their claim on one third of the pie.

There are two ways for each set of stakeholders to have a bigger share of the pie – either the pie expands and everyone benefits or somehow one party is able to slice a bigger cut away from the others. 

For every dollar of revenue, the company can choose to pay its employees more with the view that more pay would eventually equate to higher quality workers and a better output. 

It can also determine that the employees are already adequately compensated and the revenue should be kept within the company, either as retained earnings or distributed as dividend – both options benefiting the shareholders.  

A company can also spend money to enhance its product offering. SIA flies the most modern and one of the youngest fleet of aircraft amongst airlines around the world. Its cabin crew have won awards and accolades worldwide. Both would not have been possible without constant capital investment in fleet renewal and an unrelenting obsession with crew training. Companies may also decide to reduce the pricing of its products, with SIA offering discounted fares and one off deals. This could potentially reduce revenue. On both occasions, customers would stand to gain. 

Every company would have to contend with this allocation. 

SIA has been historically profitable, and the healthy profits have enabled them to strike this delicate balance between shareholders, employees and customers over the years. For companies that are not profitable, instead of sharing profits, they now have to decide who is to bear the blunt of the loss most.

The Pie has Shrunk

With the onset of COVID19 and the swift implementation of border controls, passengers disappeared overnight. At this moment the airline is only flying 4% of its capacity. There is no longer any customer to bring in revenue and they are no longer part of the consideration. The pie has shrunk and whatever that is left has to be split between shareholders and employees. 

Airlines worldwide have woken to this new reality very quickly and major airlines have reacted. Almost every major carrier around the world has announced layoffs, early retirement schemes and no pay leave for staff. Virgin has cut 3000 staff, Etihad 720, China Southern 220 pilots while Qatar states that the number will be ‘substantial’. British Airways and Emirates are now requiring crew to retire before the mandatory retirement age. 

Fortunately for SIA employees, they work not just for any airline.

Leaving no one behind

The Unity, Resilience and Solitary Budget rolled out in the early stages of the COVID outbreak is highly protective of companies in the aviation sector, with the government offering to co-pay up to 75% of salaries for workers. From the get go, it is a clear indication that no one will be left behind. 

To tie in with the national narrative, SIA has instituted a rather cursory round of no pay leave for staff. Depending on their job scope, staff are required to take between 2 to 7 days of no pay leave a month. This translates into a pay cut of between 7% to 25%. For a company operating at 4% of its capacity, it does sound rather generous. One may say it is almost civil service like.

Bonanza!

On top of that, SIA has also promised to pay out a one month bonus to all staff for financial results achieved in FY19/20. The criteria for determining bonus payable are predetermined and mandated by collective agreements with the unions. Truth be told, the airline has made an operational profit for the FY and COVID19 related cancellations have not had a material impact on the bottom line for the period. What pushed the airline into the red were losses incurred for fuel hedging.

Should the airline adhere to the agreements made with the unions and make good its promise to all staff? Or should it invoke the emergency act and declare a halt on all unnecessary payments to conserve cash? The decision is a dicey one. The fact that a bonus is declared does seem to imply that the board and management are not overly concerned with survival at this stage. Would the decision have gone this way if Temasek had not entered the fray with money guns blazing – this is something we would never find out.

With customers no longer in the picture, it is now a tussle between shareholders and staff. From the way things are progressing, it seems like the SIA management and staff are doing swimmingly well in keeping their share of the pie intact.

For staff to get more, shareholders will inevitably end up with less. Majority shareholder Temasek Holdings seems more than happy to indulge in their love child and to pick up the tab. The rest of the shareholders have little say but to tag along for the ride. 

SIA will never die. 

Over the past month I have heard many proclamations by family and friends that the government will never allow SIA to die. More than one has put his money where his mouth is and has picked up SIA shares. As SIA shares drop below $4 today, there is renewed bravado from retail investors. Many are salivating at the prospect of picking up a bargain. They have conflated SIA’s success with shareholder’s success. I wish them well. 

SIA may never die, but it is now on life support and plugged into a ventilator. 

And shareholders have been sent the $15B bill. 

#3 The deal is complex – and rightly so. 

There are two issues (pun intended) at stake here – a renounceable rights issue for shares and also a callable zero-coupon renounceable rights issue for Mandatory Convertible Bonds (MCB). 

Both issues are fully underwritten by Temasek and any amount that is not taken up by retail investors would be mopped up by Temasek. 

First, some background. When companies need to raise cash they can either sell off part of the company (issue shares) or borrow money from shareholders (issue bonds). Each option has its pros and cons, and SIA is leaving no stones unturned by utilising both options to the fullest.

By issuing shares, current shareholders will own a smaller percentage of the company, a process known as dilution. It may not sit well with every shareholder. From an operational perspective however, there is no cost to the company in the issuance of more shares. 

Bonds however, comes with a cost. The cost of borrowing is a drag on the profits. This interest or coupon rate can either be distributed on a regular basis or in the case of SIA’s zero coupon bonds, paid out in one lump sum at the end of the tenure. SIA has managed to up the complexity level of this exercise by declaring the issues to be renounceable (shares and bonds) and also callable and mandatory convertible (bonds). 

Renounceable implies that the rights that you are entitled to can be traded in the open market. Both sets of Rights have started trading on 13th May and will continue to be traded until 5pm on 21st May. They are respectively named SIA R (symbol LRDR) and SIA MCB R (GANR) for the shares and MCB respectively. If you are an SIA shareholder before the ex-right date on 5th May, you will be credited with both counters in your CDP account. 

Mandatory convertible implies that while SIA is obliged to return bond holders their capital, the repayment will be in the form of SIA shares. Every bond unit is scheduled to be worth $1.80611 at maturity. This will be converted to SIA shares at an already predetermined price of $4.84 per share. 

Finally, if your head is not spinning yet and you can take on even more pain, the MCBs are callable on a semi-annual basis. SIA can choose to make partial repayment of their bond every six months. For that, you will be paid in cash and your net return will be less than the value at maturity.

Typically corporate bond issues are pretty straightforward affairs. Investors zoom in to the headline coupon rate and make a decision whether to subscribe based on that. The MCB is so convoluted that there is no simple way to express it. 

The Elephant in the Room – Why is it so complicated? 

There are many things SIA is trying to achieve with the raise. First and foremost is the need for a cash injection to keep the company going. It must do so in a palatable manner for existing shareholders, hence the bond issue to prevent excessive dilution. It must also keep its gearing and borrowing cost manageable, hence the coupling of bonds with issuance of more shares. 

With MCBs, they have kicked the can for further dilution a decade down the road. During this period, should conditions improve, SIA has the flexibility to pare down its borrowing by calling on the MCBs. On the flip side, they have also kept the door open for another bond issue of up to $6.5B. 

Finally, after this exercise Temasek should emerge with an even greater ownership of the company. Should it be necessary to delist and nationalise the airline, they will be able to do so with greater ease. 

What should I do now? 

Singapore Airlines is our National Pride and Joy. I am made to feel at home and amongst my people every time I step onto one of our planes. The feeling of doing so after an extended sojourn in a foreign land is indescribable. 

However, COVID19 has clearly exposed the vulnerabilities of the airline business. The margins, the economics and the uncertainties make airlines a real dodgy investment proposition. COVID19 has also highlighted the dynamics between SIA and majority shareholder Temasek – the massive bailout undertaking is in itself an unprecedented show of force by the otherwise subdued sovereign wealth fund. 

Equity holders should be rewarded for the risk they take on. The risk however should not include having to put up with downside incurred with a minor pay cut for staff and a decision to continue paying out bonuses in these trying times. 

Retail investors should do well to practise some form of social distancing with Singapore Airlines shares.