Qantas is an undervalued stock

In a Halloween commentary in its Lex column, the Financial Times points out that the Australian airline Qantas is unusually cheap compared with regional rivals.  By the newspaper’s reckoning, Qantas trades at .7x book value and 9x earnings per share, vs. its competitors’ average of 2.5x book and 12x eps.

labor problems

The FT attributes this substantial discount to the labor problems that plague many Australian firms, and Qantas in particular.  I’m sure that this is part of the issue, but I don’t think it’s the entire explanation.  The other factor that the FT is overlooking is the type of foreign ownership restriction Australia has imposed on the airline.

foreign ownership restrictions

It’s not just the fact of a limit on the percentage (49%) of the outstanding shares of Qantas that can be held by foreigners, although that is really a relic of a past that’s long gone.  The way in which the restriction is enforced is considerably more important, in my opinion.

When I first became involved in global investing in the mid-1980s, limitations on foreign ownership of companies a country thought had strategic, national security value–like telecom, media or transportation–were commonplace.  Some still exist.  In addition, however, many smaller countries restricted the ability of a foreigner to own more than a specified percentage of many other–or even all–companies, for another reason.  They feared that wealthy outsiders would snatch up a nation’s birthright for a song.

The Switzerland of post-WWII Europe did so to protect its industry against acquisition by US companies.  In the Pacific, when I began investing there in 1984, dual share systems were already in place in markets like Singapore and Thailand.

This distinction is a relic of a bygone era in most wealthy countries and has been eliminated as an impediment to equity capital raising and to generally having the stock price go up.  I think Australia should follow suit in the Qantas case.  More about this below.

how you implement ownership limits matters

The most widely used method of implementing foreign ownership controls in the Pacific was to allow foreigners to buy ordinary shares in the market.  On settlement day, these shares would be recorded and designated (in the old days, share certificates were physically stamped) as foreign-owned.  Once the ownership limit was reached, the company would no longer register the new ownership of ordinary shares bought by foreigners.

But the “foreignness” of the shares already purchased by non-citizens remained an enduring characteristic of those shares.  This gave new foreigners a legal way of buying stock in a given company.  They could purchase shares already designated as foreign from another foreign holder; the place on the foreign register would transfer to the new owner.  Typically, the stock exchange would make this easy to do by setting up a separate quote for foreign shares.

I remember buying foreign shares of Singapore Airlines, for example, in the mid-1980s for either no premium to the local shares or maybe 0.5% extra. The premium of foreign to local eventually breached 100%.

This was partly due to the indifference of local citizens to equities in general and to airline stocks in particular.  Global investors saw a different picture–stunning growth prospects for Asian airlines, which were trading at far cheaper prices than their much less attractive home-town alternatives.

Australia’s choice

Australia deliberately chose not to take the conventional route with Qantas.  The “foreignness” of foreign shares in Qantas doesn’t stay with the shares.  When the company sees that foreign ownership has reached the 49% level, it stops allowing foreigners to register share ownership (which is legally required, and in any event is necessary to collect dividends).  All foreigners can do at this point is wait for enough other foreigners to sell, making room for them to buy.  But since Australian investors show limited interest in stocks in general and in airlines in particular, once the foreign ownership nears the 49% level the Qantas stock price stops dead in its tracks.

This system makes life more difficult for Qantas.  A relatively low valuation makes it more expensive for the company to raise equity capital or to use stock as a method for compensating employees.  To my mind, this puts the airline at a substantial disadvantage to international rivals.

why?

Why would Australia do this?  And, how would I know?  It turns out that at the time Qantas was being prepared for its IPO I was managing a large portfolio of Australian equities (the Kuwaiti Investment Office held the only larger foreign portfolio I was aware of).  I remember discussing at length with a fact-finding commission the defects I saw in the Australian approach to foreign shares–basically predicting what has occurred.  I also said that although I admired Qantas as a company I wouldn’t participate in the offering.

The officials I spoke with said they didn’t care.  New Zealand Air had listed shortly before, using the conventional structure.  The foreign ownership limit there was quickly reached.  Foreign shares began trading at a substantial premium to local.  New Zealand investors were outraged and complained bitterly to their politicians.   Canberra’s highest priority was to avoid the same outcome.

Yes, a higher foreign-share price is a problem.  In most cases where this has occurred, like in Singapore, the authorities eventually end the foreign-local structure.  The unified share price typically settles at a level much closer to the foreign price once the limits are lifted.

My guess is that ending the two-share structure for Qantas would easily add 10% to the stock price.  I think +20% is more likely.