By Professor Jilnaught Wong*
Do Air New Zealand staff deserve the $1,800 bonus?
The team at Air New Zealand generated a return on net operating assets (RNOA) of 12.3% (12.7% in 2017). The RNOA is 50% above the company’s weighted average cost of capital (WACC) of 8%. What is WACC? Shareholders and debtholders provide capital to Air New Zealand. The capital is invested in operating assets, predominantly airframes, engines, and simulators.
The capital providers require a return on their investment in Air New Zealand; their expectation of a return is the WACC. Shareholders, one group of capital providers, require a higher return, known as the cost of equity because they carry the higher (residual) risk. Debtholders require a lower rate of return because they rank ahead of shareholders. Between these capital providers, PwC has estimated a WACC of 8%.
This means Air New Zealand is required to generate an 8% return on its net operating assets to give the shareholders and the debtholders a return. The WACC can be seen as a benchmark to judge management’s performance. Returns above this benchmark represent the value created from operating the business.
A big tick to the management and staff of Air New Zealand: RNOA of 12.3% versus WACC of 8%. Great stuff.
Let us now focus on the shareholders. The actual return on equity (to shareholders) (ROE) is 21.6% (19.4% in 2017), and it is higher than the RNOA indicated above. How did this come
First, Air New Zealand’s net operating assets generated a return over and above what it had to pay the debtholders. That excess return is known as the “spread”. In 2018, the spread was
14.9%, which is higher than the RNOA itself. This came about because, in spite of net interest costs of $33 million, its “other comprehensive income” comprised gains from financing items (predominantly cash flow hedges) of $58 million. Together, there was a net financing benefit.
Second, the spread of 14.9% was leveraged by 0.626, being the ratio of interest-bearing debt to equity, and the net result was a non-operating return to shareholders of 9.4% (14.9% * 0.626).
In summary, the ROE comprised:
The RNOA – an operating return – of 12.3%. That is, the return from the shareholders’ capital that was invested in the operating assets to generate the RNOA, and
the non-operating return of 9.4%. This is the gain to the shareholders from using debt to finance the operating assets. The shareholders are the beneficiary of this leverage effect, which is why it is called a non-operating return, being a return from financing (as opposed to operating).
Summing up the above yields an ROE of 21.7% (operating return of 12.3% plus non- operating return 9.4%, yielding an ROE of 21.7%).
Shareholders would be thrilled with the ROE of 21.7%. My assessment of Air New Zealand’s cost of equity is approximately 11.5%. The 21.7% actual return in 2018 is near twice the cost of equity, demonstrating the creation of a substantial amount of wealth for the shareholders. Air New Zealand’s market capitalization on 23 August 2018 was $3.67 billion; this yields a price-to-book (PB) ratio of 1.7. The market is prepared to pay a 70% premium over the book value of equity, which is an indication that investors are optimistic that future returns on equity will continue to exceed the cost of equity.
Congratulations, management and staff of Air New Zealand; go and enjoy your bonus.
*Jilnaught Wong is a Professor of Accounting and Finance at the University of Auckland Business School.