AirAsia X's press statement

In a press statement released last week, AirAsia X (AAX) asserted that our reports were "untrue, misleading and inaccurate" with regards to profit shifting between itself and AirAsia. Management claims that an apparent failure on our part to check our facts apparently necessitates an investigation by Malaysia’s Securities Commission.

We regard these comments as an attempt to undermine our credibility and distract from the real issues that matter: AirAsia’s opaque recognition of profits from selling goods and services to financially distressed associates and our belief that it needs to raise capital. AAX’s comments refer to 280 words in a 14,000 word long document written on AirAsia (not AAX). The information presented therein was sourced from AirAsia’s annual reports which we assume are factually correct. We have made it quite clear what we believe is fact and what are our suppositions. We are well within our rights to draw our own conclusions.

We did not discuss the conclusions of our AirAsia report with AAX or anyone else as this is prohibited under our regulatory framework. However, we held a dialogue with AirAsia management during the course of our research in which we felt they were less than forthcoming. We have provided a copy of our report to the Securities Commission and will co-operate with them to the fullest. We welcome any investigation around the related party transactions between AirAsia, its affiliates and associates, especially if conclusions are made available to stakeholders.

AirAsia needs to recapitalise

Given that AirAsia management refuses to disclose how much profit it's generating from selling goods and services to its associates, we've had to come up with our own numbers. We think that profits have been inflated by 39% since 2009, but it could be higher. It's well known that Philippine and Indonesia associates are loss-making, have no shareholders equity and are past due on significant amounts. They clearly need to raise a substantial amount of new capital and there have been tentative steps by management in this direction. However, we think it's actually the parent company, AirAsia, that needs the most new capital, about US$1.9bn by our rather generous estimates. This assumes that there is a significant recovery in profitability because, of course, if profitability stays at current levels, AirAsia is unlikely to be a going concern for much longer. Watch our video (minute 6:55) to get more details on how we come up with these numbers.

Generates no operating cash flow

The problem is that AirAsia hardly generates any operating cash flow, about MYR307m in 2014 by its own numbers, which is an OPCF/Sales margin of just 5%. Worryingly, MYR293m of this cash inflow came from maintenance expense accruals. These accruals are an expense which will materialise at some future date and so we should not consider them to be recurring operating cash flow. As such, we should adjust operating cash flows to strip out accruals which leaves it with just MYR14m in 2014 operating cash flow – basically break-even.

Underlying cash flow situation could be far worse

Unfortunately, real operating cash flows could be even lower. In 2014, AirAsia made MYR431m of loans to associates which might have come back to it in the form of operating cash flow (associates paid for some of their charges but not all). That means that without accruing for maintenance expenses and possible loans to associates, AirAsia would have been haemorrhaging operating cash outflows in the region of MYR400m. In other words, its underlying financial position could be far worse than what is already being disclosed.

Can’t service its debt without selling assets

Operating cash flow drives a company’s financial statements; it pays for capex, debt repayments and dividends. They are what we consider to be true profit, not the accruals adjusted income statement which accountants would have us believe is profit. If AirAsia is unable to generate operating cash inflows, it is unable to service its debt. If it can’t service its debt repayments from operating cash flows, then it must drain its cash balances or sell assets.

Sell the family silver

At the end of 2014, AirAsia had MYR2.3bn in short term debt of which MYR1.4bn were term loans falling due in 2015 (the balance is its credit revolver). The company had MYR768m in cash but MYR569m was actually restricted cash held on deposit, supposedly for its credit revolver. That means it only had MYR199m to meet its working capital commitments and debt service obligations. Unrestricted cash equates to just 3.7% of sales, below the 5% comfort zone we regard as being the minimum cash required. Clearly, AirAsia needs to sell the family silver.

Liquidating assets as fast as possible

And selling the family silver seems to be the main game plan. AirAsia sold half of its stake in AA Expedia in 1Q15 for MYR320m, is looking to either sell additional stakes in its Philippine and Indonesian associates (good luck with that!) and has plans to sell a stake in its Aircraft leasing subsidiary. It’s also engaged in sale-and-lease-back agreements for as many planes as possible, even making a MYR39m provision for aircraft sales in 1Q15 (apparently, it’s not so easy to generate a gain on aircraft sales when to a genuine third party, as opposed to a tame associate). Still, all these asset sales smack of a company in financial distress. It is also another form of capital raising which will result in dilution for AirAsia shareholders.

About those associate profits

A few of our peers have claimed that there is nothing wrong with AirAsia recognising a profit from the likes of aircraft leasing. After all, shouldn’t it get compensated for lending out its balance sheet to associates? We think they’re in cuckoo land. First, we have no idea what profit AirAsia is generating and management refuses to clear up the uncertainty. This is very suspicious. Secondly, leasing aircraft from one part of the business to another creates an internal conflict of interest….which is why almost no-one else gets away with doing it.

A structure set up to milk associates?

In our opinion, AirAsia set up this structure so that it could milk profits from its associates and not recognise the bottom-line losses. A more transparent structure would have seen AirAsia’s associates lease the planes directly from third parties under guarantees from AirAsia. This would have made them far more competitive and/or profitable. The likely reason this structure was not adopted is that AirAsia would miss out on a slice of the aircraft leasing profits and the loan guarantees would mean that it would have to continue recognising its share of losses from associates in the event that they ran out of shareholders’ equity.

Should not be recognising profit from sales to associates

We believe there is a strong argument that AirAsia should not be recognising profits from the sales of services to its associates and we would like to thank John Besant-Jones for his thoughts on this. John is an Asian special situations equity research analyst and owner of Red Flags Consulting LLC. He points out that in AirAsia’s rebuttal to our report, management claimed that it could not consolidate associates: "power in practice is however not legal control. Whilst in practice there is control in substance…”. This would seem to confirm that it has effective control of associates, even though it does not have legal or equity control. As such, under IAS18, there is a strong argument to suggest that AirAsia should not recognise the sales of goods and services to associates.

At best, should only be recognising a portion of profits

Furthermore,  under IFRS, AirAsia is only supposed to book profits in proportion to the amount of equity that it does not own, not the full 100%. The company filings suggest that it makes an adjustment, but nowhere does it make it clear what that adjusted amount is. We’re not sure if Malaysian accounting standards currently adopt this rule, but it will adopt a modified version of it next year. Further clarity from the company is needed.

Why the smoke and mirrors?

We don’t understand why AirAsia won’t disclose what profits are derived from sales to its associates. After all it’s a very simple number. Besides, AirAsia’s shareholders have a right to know whether their company makes money from flying people around Asia or from selling stuff to insolvent associates.

In amongst the hate mail

On a related subject, we've been receiving quite a bit of hate mail lately....well, you can't make an omelette without breaking a few eggs. There's been the fairly standard disgusting emails (which we won't detail here), one illegal attempt (that we know of) to steal our phone records, the investigation into our backgrounds sponsored by a firm we've written on, etc... However, we received this particularly fascinating anonymous letter from Malaysia. Within, it questions the revenue and cost recognition at AirAsia. There’s no way for us to verify its contents but we find it extraordinary that someone would actually spend the time to pen this. Anyway, its contents are worth considering at the very least.

To conclude

Whether or not you agree with AirAsia's accounting, its difficult to deny that the company's capital structure is unsustainable. There's unlikely to be a sudden turnaround in the profitability of Southeast Asia's airline sector. As such, AirAsia is likely to remain unprofitable and haemorrhage operating cash outflows. It's time for management to improve disclosure and raise capital.