Turbulent times

Certainly, there was the one-off $194 million cost of last year’s 11-month industrial action and the extra $444 million in fuel costs but these types of exceptions seem to visit Qantas — and the rest of the aviation industry — every year.

Once again, Qantas was rescued by low-cost subsidiary Jetstar and its frequent flyer program, whose combined profit was four times that made by the the parent airline before interest and tax.

Qantas has a raft of well-documented problems but now looming is the loss of critical mass in its international division.

In the past 12-months over 30 per cent has been wiped from its share price, prompting Moody’s to downgrade the airline’s credit rating to just above junk status and forcing to airline to retreat on its capital spending and look instead at capital raising. Moody’s noted high fuel prices and strong competition as the key factors for lowering the credit rating from Baa2 to Baa3.

Moody’s Senior Credit Officer Ian Lewis said: “The ratings downgrade reflects Moody’s expectation of ongoing pressure on Qantas’s credit profile from the combined effects of high fuel prices, strong competition and difficult operating environment. Qantas’s credit profile had been subject to ongoing pressure over several years and more particularly since March 2011, when the outlook was changed to negative.”

Moody’s noted the favourable outcome of the industrial relations issues, subject to final arbitration by Fair Work Australia but said Qantas’s operating challenges would continue to pressure its financial profile to the extent that financial leverage was expected to remain above the level consistent with the previous BAA2 rating.

Mr Lewis said: “We expect Qantas’s financial profile to remain outside the range required for the previous Baa2 rating, particularly over the next several years as it undergoes significant fleet re-investment. On a fully adjusted basis, we expect Qantas’s key financial metrics will continue to be elevated over at least the next two years, with Debt/EBITDA [earnings before interest, taxes, depreciation and amortization] staying above the 3.75x threshold set for the previous Baa2 rating.”

He also viewed the absence of adequate levels of free cash flow —defined as operating cash flow less capital expenditure (capex) and dividends — over an extended period to be another contributor to the ratings downgrade.

However, he did emphasise that Qantas remains one of only few investment grade-rated carriers in the Moody’s ratings universe: “The Baa3 investment grade rating continues to reflect the company’s very sound operating model, particularly its strong domestic franchise and strong liquidity.”

But Moody’s warned that the rating could face negative pressure if the company’s operations were further impacted by deterioration in the major economies that it services, including its domestic market. The rating also could be pressured if Qantas faced materially higher fuel prices and/or higher capex.

CBA Equities transport analyst Matt Crowe told the Sydney Morning Herald that Qantas probably would have to tap investors for fresh equity after the downgrade because the airline had ”little wriggle room” left to retain an investment-grade rating.

He said: ”They have got a lot of capex in the coming years to upgrade their fleet. That is a lot of debt that they will have to fund. It is possible some of that will have to be funded through equity. They have said in the past that their investment-grade credit rating is very important and they have shown that when it is under threat they will raise equity.”

In its half-year result Qantas announced reductions in capex of $200 million for the 2H12 and $500 million for FY2013 and said it was pursuing further reductions. Again, the international division was hardest hit with two more 747-400s to be grounded, bringing to six the number earmarked to be parked since August 2011.

The airline also announced the deferral of six A380s to 2018 and beyond in August last year. The first 15 787s — all -8s for Jetstar — have slipped in delivery due to Boeing’s ongoing production problems. According to Jetstar sources the first will be delivered in August 2013, about four months later than the most recent advice.

Joyce’s five-year international plans

At the half-year results announcement Qantas CEO Alan Joyce said its international arm remained a weakness and a key focus: “The reality is that even the strengths of the rest of our business will not be able to compensate for this issue over the long term.

“We face high competitor capacity growth into Australia. While we have a strong outbound travel market the inbound market is flat and in particular there is a softening of demand for travel out of the UK and Europe.” The challenges are structural and ongoing, which is why last year we developed our five-year plan for building a better and stronger Qantas.”

He told media that the five-year plan is now being implemented and in some areas accelerated: “Our Gateway Strategy continues with the popular services to Dallas increasing to daily from July. We have received Aanti trust immunity clearance for our Joint Business Agreement with American Airlines which will bring commercial benefits to both parties.”

Santiago would replace Buenos Aires in March, “opening many doors in a booming South America” — this move links Qantas into Lan Chile’s extensive network.

Also going in March will be the unprofitable Bangkok/Hong Kong and London, which will be and turned over to British Airways as a codeshare.

At the half-year announcement Mr Joyce said that Singapore-Mumbai and Auckland-Los Angeles routes would go in May, while 747 services from Sydney to Bangkok would be downgraded to A330s.

In another downgrade, 737-800s will replace A330s on the Sydney-Auckland route. These cancellations and some tweaking of the Perth-Sydney route will allow the removal of two 747s from the fleet.

But it is not all bad news with three 747s upgraded to the A380 product standard and six more to be completed this calendar year.

Qantas also has placed A380s on the Hong Kong route and increased 747s services to the Japan market from six a week to seven.

And 747s will return to the LAX-JFK route.

Maintenance changes

As expected, the Qantas CEO had bad news for engineering staff, flagging the rationalisation of the sector — a move expected for some time.

He emphasised that the airline employs over 5,500 staff in the area and spends $1.4 billion on engineering and maintenance every year.

However, Qantas claims its engineering services are at least 30 per cent more expensive than those of its competitors.

Mr Joyce said that the combination of older fleet retirements, the advent of new-generation, high-tech fleet, the new technology maintenance system and a modernised regulatory regime meant the company could take significant steps to achieve greater efficiency.

And he stressed that the airline could not support three facilities at Avalon, Melbourne and Brisbane. Aside from this, Qantas also will consolidate the Qantas Airlines Aircraft Airworthiness Group to Sydney. The group translates regulatory requirements into the maintenance program as well as a variety of administrative, planning and fleet support functions. Qantas also will consolidate its Melbourne Maintenance Operations Centres, which look after 737s into the Sydney operation.

Moving on to the Engineering Supply Chain, Mr Joyce said it also could be made far more efficient, claiming that it was too fragmented and required a total operations restructure.

He’s also moving on restructuring daily line maintenance tasks to increase efficiency: “We don’t maintain cars the way we used to — nor should we maintain aircraft like we did even 10 years ago.”

The new system, which reflects new and revised CASA regulations, is being developed by Qantas Engineering and will be called Maintenance on Demand for new-generation aircraft.

Mr Joyce said: “Maintenance on Demand means that our well-qualified engineers will not be conducting aircraft checks that are not required. This will bring our practice into line with both the manufacturers’ guidelines and Civil Aviation Safety Authority regulations. It will allow our engineers to be assigned to aircraft that require attention.”

787 conundrum

In a blunt message to its long-haul pilots the airline stated that replacement capital would be restricted if not incremental to shareholder value and noted especially that the 35 787-9s it has on order for delivery from 2014 were still to be allocated. The airline warned in its investor presentation slides that the 787-9s would be delivered only if rigorous return metrics were met.

And those metrics will certainly be considered around the pay scale for the 787, with QF management wanting a pay rate more in line with the Jetstar 787’s, which is to be the same as the Jetstar A330 average of $237,000 for an 807-hour year. Qantas A330 captains get $340,000 for a 600-hour year. Qantas cautions also that there will be no growth capital to under-performing areas such as Qantas International.

However, while the plan numbers may look attractive there are inherent risks of losing critical mass in the international division while the 787 appears to attract passengers as no other aircraft has done in decades. That is the X factor and can’t be counted.

Over the decades there have been aircraft that have become passenger magnets. The Vickers Viscount, 707 and 747 proved exceptionally popular with passengers, forcing other airlines to follow.

In the 1950s and 60s the Viscount, with its huge windows and almost vibration-free turbine engines, enabled British European Airways to stay profitable for over 10 years in a row and made double the profit for the airline than all its other operations combined.

And so popular was the Viscount that Air France was forced to buy them. Similarly, the 707, 747 and their competitors dominated and airlines were forced to follow.

If the 787 lives up to half the hype it may well change the game dramatically for Qantas International. However, while its short-term gimmick value is strong, its long-term pulling power is untried.

One blog report in The Wall Street Journal casts some doubts about its attractiveness factor.

Scott McCartney reported on the first long-range operation of the 787, an 11½-hour flight from Tokyo to Frankfurt, in February: “Overall, cabin comfort was clearly better and big windows and voluminous overhead bins are definitely cool. But make no mistake—it’s still an airplane.”

In his review, Mr McCartney spoke to several passengers, among them senior executive at lens maker Zeiss Winfried Scherle: “If you put me in a blind test, I would say this is no different.”

But the blogger commented: “Others said they landed feeling more refreshed. They had an easier time sleeping, felt their eyes and nasal passages didn’t dry out as much as usual. Still, it was a modest improvement, not a dramatic difference.”

Another passenger, Michael Grepo, said the 787 was more of a natural evolution than a revolution. He added that he didn’t feel as short of breath as on other aircraft and didn’t have to hold his nose and blow to clear his ears as often. He also commented favourably onthe LED lighting, saying the orange light before landing simulated sunrise and was calming: “It seemed to make a difference psychologically.”

Mr McCartney said his contact lens didn’t dry out as much

But didn’t sleep that well due to a wailing baby: “Still, I wasn’t dragging as much as I usually am after sleepless overnight trips.”

He lauded – as will many – the individual air vents over passengers, which come standard on the 787 and hugely impressed by the large 787 windows, which offer panoramic views.

On the 787’s improved humidity, he sought the views of Nobumi Matsuda, who runs an eye clinic in Tokyo and is studying the eye health of airline pilots in Japan. Mr Matsuda commented that the 787 humidity improvement just wasn’t enough: “I thought there would be more. It’s half-and-half. I half like it and I’m half disappointed.”

In response, Boeing argued that “the passenger comfort improvements are incremental, the combination of so many improvements in one airplane is revolutionary . . .”

All Nippon Airways says the 787 loads are higher than other types in its fleet and the aircraft is attracting passengers. Nonetheless, the pulling power for Qantas over the 767s — which unlike Air New Zealand’s have had no makeover in decades — will be significant.

And that pulling power would indeed be significant if the airline opened up new non-stop routes with the 787 such as Brisbane – Dallas Fort Worth, Sydney-Seattle or London-Perth.

The great appeal of the 787 is its flexibility and economy. No aircraft in the Qantas fleet has ever come close and it seems incomprehensible it will not see service in Qantas colours.

Result by the numbers

The Qantas premium brand was able to muster only EBIT of $66 million — all white kangaroo-branded units, including regional.

However these brands also were those greatest impacted by industrial action and fuel prices, although the effect on regional was minimal.

Despite the industrial dispute, revenue climbed 6 per cent and if the dispute were removed, EBIT would have been $260 million.

The airline no longer breaks out an individual EBIT for the white kangaroo but noted that improved international passenger revenue did not offset the impact of fuel, industrial action or the EU slowdown.

Importantly, Qantas was able to cut costs by 2 per cent. In its intensifying battle with Virgin Australia, the airline claimed it had only lost two accounts, had resigned 160 and had added 45 new ones.

Virgin has similar bullish numbers so it would seem the battle between the two is focussing customers on formally signing up with one of the two options.

However, Qantas is deeply concerned by the latest figures from the Department of Infrastructure, Transport and Regional Economics, which show the business class fare index has plummeted by more than 30 per cent in the past six months, with most of that fall since November.

Not surprisingly, the stellar performer was Jetstar with 11 per cent passenger growth and 15 per cent capacity growth, which brought the airline group EBIT of $147 million.

Jetstar has announced that it’s bringing forward its Japan adventure to a July 3 launch. It says its investment in Jetstar Japan over three years will be $64 million with the group having a 42 per cent interest. Jetstar Japan will have 24 A320s — initial cities are Tokyo Narita, Osaka, Sapporo, Fukuoka and Okinawa.

Over the past two years Jetstar Asia’s available seat kilometres (ASK) have lifted 47 per cent and the airline now serves 10 cities in China.

A big highlight of the result was the lift in ancillary revenue — jumping 35 per cent to $29.6 per passenger. At the same time unit cost declined 3 per cent to 4.1 cents per ASK excluding fuel and passenger service fees and taxes.

As before, the Frequent Flyer program was a standout with EBIT of $119 million — up 11 per cent on the year-ago period. Billings were up 16 per cent to $600 million while membership jumped 11 per cent to 8.3 million. Program membership has soared 69 per cent from 4.9 million in 2007.

Peace in my time

Interestingly, Mr Joyce reiterated that the airline can promise its customers industrial peace for the next four years: “The damaging industrial action we faced last year is over and industrial action on that scale is unlikely for the foreseeable future.”

However, the acrimony remains and while the grounding of the fleet brought the guillotine to the heated debate, the issues have not gone away. In fact, it could be argued that the unions are furious at the outcome.

If the same issues resurface in four years’ time Qantas will be in serious trouble, as Virgin’s foothold will be greater in the domestic business market and Qantas may face wholesale defections.

It is essential that Mr Joyce finds a permanent solution to the industrial malaise that is tearing at the heart of the airline. At the same time, the unions must accept the wider global dynamics that are at work and over which Qantas has no control.