Is a Qantas takeover still on the horizon for AQZ?

Alliance Aviation Services (ASX:AQZ) is an airline business with a very different business model to the other commercial carriers.

It owns and operates a fleet of aircraft, but only 3.4% of its revenue comes from operating regular public transport flights.

Its largest source of revenue is contract revenue. This is typically in the form of contracts with mining companies that fly mining staff from the major ports to remote mining locations. These are known as fly-in-fly-out (FIFO) workers. Its strategic goal is to be a wholesaler of aircraft capacity and therefore the business is continuing to reduce its regular public transport flights.

Its second largest source of revenue is through wet lease agreements. This is where Alliance own the aircraft but lease them to Qantas and Virgin. In addition to providing aircraft capacity, it also provides the staff, and take care of all aspects of servicing the aircraft. Revenue from this segment increased by 316% in the most recent half with six new aircraft being deployed.

In addition to regular public transport flights, it also derives a small amount of revenue from two other segments, but these are declining. It offers charter flights and aviation services.

Total revenue for Alliance has been rising strongly since 2017 with a compound annual growth rate of 13.1%. This accelerated rapidly in the first half of 2023 with growth of 40% largely driven by the expansion of the wet leasing component of the business.

Revenue for the whole of the 2023 financial year is forecasted to grow by 42% with further growth forecast for 2024. (Note: These forecasts are based on the average of the four market analysts who cover the stock.)

Profits have generally been rising but fell in 2022. Underlying profits fell due to the challenges associated with COVID. The statutory profit actually fell into a loss, driven down by a $12.1 million write-down of the older Fokker 50 fleet which are being retired. Profits are forecast to rebound strongly in 2023.

Over the medium term the return on equity and return on capital employed have been quite solid with levels in the low teens. Results were a bit lower in 2022 as mentioned above. A very similar pattern has been observed with operating margins. This adds up to a business that ranks highly in terms of quality.

Debt levels are a bit high but certainly not at alarming levels. Debt has been increasing due to the replacement and growth of its aircraft fleet. This has been driven by building a fleet of Embraer E190 jet aircraft.

An additional expansion of this fleet was announced in February. It is purchasing an additional 30 Embraer E190 aircraft that are currently operated by a US airline. The acquisition of the aircraft will take place gradually over two years starting in September.

This expanding fleet supports the extension of the wet leasing agreement with Qantas. In February the company announced the number of aircraft on wet lease for use within the Qantas network would increase from eight to 30.

It has also invested in building a hangar for a maintenance centre in Rockhampton.

When looking at the operations of the business on a stand-alone basis it appears to be solid. However, an analysis of Alliance is not complete without considering the actions of Qantas.

Over three years ago Qantas acquired a 19.9% stake in Alliance. Then in May 2022 it announced that it had reached an agreement to acquire the remaining 80% of the business. Naturally, this sparked the interest of competition watchdog the ACCC given the relatively small number of players in the Australian aviation industry and especially the FIFO charter segment. After 12 months of consideration the ACCC decided to oppose the takeover.

In an April 2023 statement, ACCC chair Gina Cass-Gottlieb said: "Combining such an important player with Australia's largest airline, Qantas, would be likely to substantially lessen competition and is something we oppose."

The ACCC considered the competition provided by airlines such as Virgin Australia and National Jet Express (which had been recently purchased by Rex), and other smaller market participants, and found it unlikely that a new or existing airline could expand quickly to a scale that would address the loss of competition resulting from the proposed acquisition.

"Qantas will face limited competition if allowed to acquire Alliance because most other airlines lack the right aircraft, fleet size, or capabilities needed to compete effectively," Ms Cass-Gottlieb said.

Qantas is now seeking further information and is yet to throw in the towel.

This development has caused the share price to fall 15%. If it is ultimately unsuccessful the 20% stake it currently holds may create an overhang on the stock price as people wait to see if Qantas decides to sell. There will be some uncertainty surrounding the stock until this issue is fully resolved. Qantas is also Alliance's largest customer, but that shouldn't be impacted by the takeover outcome.

Additional commentary from the ACCC reinforces the view that Alliance is a strong business in its own right which is reflected in its high Stockopedia Quality score of 89.

In the April 2023 media statement, the ACCC said it received considerable feedback that Alliance is valued by customers as an effective competitor.

"For many customers, Alliance is the preferred supplier due to its large fleet capacity, customer-centric approach and high-quality service offerings, including having the highest on-time-performance in the industry and demonstrated flexibility and willingness to meet customer needs," Ms Cass-Gottlieb said.

Any decision regarding an investment in Alliance Aviation Services should be made based on the assumption that it is a stand-alone company.

As has been illustrated, it is a well-run company with a firm foothold in its market. There are risks associated with its expansion plans, but if well executed they should lead to increased profitability. Whilst not a household name, given it does not sell seats to the general public, it is actually one of Australia's most significant airlines with a fleet approaching 100 aircraft.

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