Investors may not necessarily agree with the way budget carrier AirAsia Bhd takes fuel contracts and treats them as exceptional items in its books. But this does not mean it is wrong because fuel hedging and its accounting treatment are open to different interpretations.

Nevertheless, AirAsia group chief executive officer Datuk Seri Tony Fernandes told analysts at a briefing that there would be no more unwinding of costs. The airline will have a “clean” position this year as it is completely unhedged. This enables it to pay spot prices for fuel, which have come down significantly.

But for AirAsia’s sceptics, the picture will only get clearer when it posts its next quarterly results.

An investor with a significant interest in the budget carrier  is comfortable with the losses from the unwinding.

“By completely unwinding its hedge positions, it is able to remove fuel surcharge from its fares and offer competitive fares,” he says.

AirAsia posted its first full-year net loss of RM471.7 million for the year ended Dec 31, 2008, compared to a net profit of RM697.6 million the previous year despite turning in 36.6% revenue growth. The losses came about due to exceptional items incurred from the unwinding of its hedges and a steep rise in finance costs from the incease in its fleet size.

The airline’s second consecutive quarterly loss came mainly after unwinding its fuel and interest rate swap (IRS) derivative structures in FY2008, totalling RM640.9 million, which is being treated as an exceptional item in its books.

When AirAsia unwound its hedge position in the third quarter last year, Fernandes said swift action by management has saved a significant amount of money. He added that at US$50 per barrel, it would have to incur a total of US$481 million of fuel-hedging losses.

For the full year, AirAsia incurred a total of RM1.07 billion, which includes its collateral held by the now defunct Lehman Brothers. However, its associate companies — Thai AirAsia and Indonesia AirAsia — bore about 40% of the cost.

In AirAsia’s cash flow statements ended Dec 31, 2008, inter-company balances rose to RM487.07 million from RM16.12 million a year earlier. This, says a company official, mainly reflects the apportionment of the hedging losses to its associates.

Because of the inter-company balances, AirAsia’s operational cash flow, a key to determining the viability of its operations, went into the red with a deficit of RM72.7 million. Last year, its operational cash flow was RM711.8 million.

Besides fuel hedges, AirAsia partially unwound its IRS positions to take advantage of the low interest rate environment.

It says the group entered into IRS to hedge against fluctuations in US-Libor on its existing and future aircraft financing for deliveries between 2005 and 2009 at fixed interest rate of between 3.25% and 5.2% over 12 to 14 years.

Also adding to the net loss is the weakening of the ringgit against the US dollar, which resulted in a translation loss of RM192 million. However, AirAsia says it is comfortable with the current exposure, with 65% cover at attractive levels.

Stripping out these exceptional items, AirAsia’s core pre-tax profit of RM171.1 million is still above consensus’ estimates.

Despite AirAsia unwinding its hedges, analysts are still cautious about its prospects.

According to OSK Investment, it is not certain if the cost of unwinding the hedges should be treated as exceptional items.

“Although we see AirAsia returning to profitability, we are concerned about its associates’ longer-term prospects as these continue to bleed and AirAsia reaches saturation point in Malaysia. The share of unwinding costs from Thai AirAsia and Indonesia AirAsia recorded as amount due from associates have collectively raised a red flag,” the research house says in a note.

As at Dec 31, 2008, the amount due from associates increased to RM332.5 million from RM84.4 million a year ago while amount due from jointly controlled entities rose to RM313.3 million versus RM74.3 million.

Moving forward, OSK says AirAsia will be more competitive in pricing, but this year will be tough as passenger traffic slows although it may benefit from consumer down-trading.

“Tough competition and the delivery of its new planes should push load factors lower. Together with an airfare war, we expect yields to drop,” the research house adds.

However, it sees lower spot fuel prices and growing ancillary income as contributing positively to AirAsia’s bottom line.

Similarly, HLG Research reaffirms its “sell” call on AirAsia at 96.5 sen with a target price of 80 sen, on concerns over the airline’s debt repayment risks and demand growth.

It highlights the budget airline’s rising debt level to fund its new aircraft, estimating a FY2009 net gearing level of 4.1 times, low core Ebit (earnings before interest and tax) ratio (an estimated 1.4 times in FY2009) and negative free cash flow of 75 sen per share. AirAsia’s borrowings increased 81% to RM6.69 billion as at Dec 31, 2008, from RM3.7 billion a year ago.

HLG adds that AirAsia’s yields would be under pressure from aggressive seat sales to maintain its high load factor.

Additionally, the research house expects the gestation period for profitability of new aircraft and new routes to be under pressure on slowing passenger travel.

At the end of the day, AirAsia’s bold move to unwind paves the way for it to price its tickets at competitive rates and do away with a fuel surcharge, something which other airlines may not be able to do. This added advantage could prove to be useful for the budget carrier in riding out the storm.

This article appeared in the Corporate page, The Edge Malaysia, Issue 745, March 9-15, 2009