• Raise FV post solid 1Q16 numbers; remain Buyers We up our FV 27% to AED2.10 (64% upside), as we raise our earnings estimates c30% on average post solid 1Q16 numbers (earnings +42% Y-o-Y despite higher hedging losses) that saw continued impressive passenger traffic growth and margin gains (+6.4pp Y-o-Y), driven by lower fuel costs. We reiterate our Buy rating, as valuation is compelling, with the stock trading at a 2016e P/E of c8x, which is at a c30% discount to LCC peers despite a strong recurring earnings growth outlook (2016-17e CAGR of c19%). Dividend yield is also attractive (c8%) on conservative dividend payout assumptions (60%+ vs. c80% in the past four years).
• Passenger traffic still strong; downside risk to top-line from yields Passenger traffic growth has averaged c17% Y-o-Y over the past three quarters, driven by fleet and route expansion. Air Arabia is set to increase its fleet by five planes (net) over 2016-17e, with additions thereafter (we assume one per annum), likely via leases capitalising on current cheap rates until an order book is placed. The main risk to revenue growth comes from fare prices that fell c9% Y-o-Y in 1Q16 (-11% in 2015), as competition offered aggressive prices, which is natural, given current low oil prices. Our numbers factor in yield compression over 2016-17e (flattish thereafter).
• Margin pick-up to sustain on lower effective fuel prices Fuel hedges have not worked in Air Arabia’s favour, preventing it from fully capturing the benefit of the oil price drop and increasing earnings volatility (ineffective portion of hedges are repriced on income statement). Accordingly, the airline has been restructuring its fuel hedges (now extended until 2020e), which, coupled with lower oil prices Y-o-Y, will drive a significant drop in Air Arabia’s effective price (-20% in 2016e, -14% in 2017e) that should drive continued margin improvement. We are also encouraged by a decline in cash costs/ASK (excluding fuel costs) in 1Q16 after rising over 2014-15.

Hatem Alaa, CFA
Nada Amin