Pain before gain?

With extraordinary items, it is almost certain the Flying Kangaroo is headed for a net loss for the full year.

In a confluence of circumstances, the company blamed its highest-ever fuel bill, the deterioration in the international market due to the affects of the Eurozone economic crisis and declining domestic yield as a result of capacity growth.

Group yield was growing but at a slower rate of 0. 5-1. 0 per cent compared with pre-vious forecasts of 1. 5-2. 5 per cent. Qantas previously had said it expected yield during the six months to June 30 to be stronger than over the same time last year.

Fuel costs also are expected to blow out by $700 million more on last year, tak-ing total Group fuel spend to $4. 4 billion. The industrial action and grounding of the airline also will wipe $100 million from its bottom line.

Qantas has warned that there also will be a $370-$380 million charge on its transformation program, mostly non-cash items. Another $50 million non-cash charge will come from declining bond yields since this March.

The biggest impact is being felt by Qantas International, which is expecting to produce an earnings before interest and tax (EBIT) loss of $450 million, more than double the $218 million loss of 2010-11.

CEO Alan Joyce has said the airline is tackling a number of problems from the international business: “We have taken decisive action to mitigate losses in Qantas International by withdrawing from loss-making routes, reducing capital investment, and transforming Qantas engineering. ” He claimed the recent increase in capacity on the Dallas-Fort Worth route, moving its South American services to Santiago and the reconfiguration of its remaining Boeing 747-400s would have a positive impact on Qantas International in the year ahead.

“We remain focused on returning Qantas International to profitability in 2014 and for Qantas International and Domestic combined to exceed their cost of capital on a sustainable basis within five years of August 2011,” he said.

Nevertheless, the Group is counting on a $600 million EBIT contribution from Qantas Domestic and Jetstar to help coun-teract the international losses. It did not provide any further detail on how much is expected to be delivered from each business but said they would each produce higher EBITs than 2010-11.

Interestingly, Qantas did not reveal a forecast EBIT for the highly success-ful Frequent Flyer business, which from July 1 will come under the leadership of Lesley Grant. During the first half of the financial year Frequent Flyer increased its EBIT to $119 million, boosted by higher billings to banks and other purchasers of loyalty points.

Mr Joyce also has tried to reassure the market that the company is responding prudently to the challenges facing the Qantas Group as a whole: “We are also attacking costs and allocating aircraft and capital efficiently. Over $300 million in annual benefits have been identified from the changes we are making and we will continue to seek improvements in all parts of the business. ” Earlier, Qantas had announced it would defer delivery of two Airbus A380s due to arrive next year until 2016-17 as part of its efforts to cut capital expenditure.

Mr Joyce denied the company would have to launch a new share issue to top up its cash reserves to meet its current capital expenditure plans, saying: “The Group has funding in place for the majority of its 2012-13 aircraft deliveries and intends to fund the remainder of its future capital commitments from operating cashflow, cash reserves and available debt. ” But chairman Leigh Clifford has been reported as saying there could be some asset sales ahead for the company as it rides out the current global market uncertainty.

The June 5 announcement shocked capi-tal markets, resulting in hundreds of mil-lions of shares being dumped on the ASX. By the close of trade on June 8, the airline’s share price had sunk to an all-time low of 97 cents, valuing it on the market at $2. 2 billion, nearly $1 billion lower than before the announcement. This was a far cry from the failed 2007 bid by private equity con-sortium Airline Partners Australia which offered Qantas shareholders $5. 47 a share.

More bad news came soon after with Standard & Poors announcing Qantas had been placed on watch for a downgrade to a BBB credit rating. If such a downgrade is made, it probably will increase Qantas’s cost of debt, which may in turn further impact on its capital management plans.

Despite the selloff, Mr Joyce said at the sidelines of the IATA annual general meet-ing in Beijing in June that most sharehold-ers still had confidence in Qantas and his plans for restructuring its businesses.

Some commentators have noted that with the airline’s share price in the doldrums the timing could be ripe for a takeover offer on the airline. The markets seem to be waiting for an imminent bid with hedge fund The Capital Group rush-ing to take up shares being offloaded at the low prices and lifting its stake in Qantas to over 10 per cent.

By June 12 there were some indications Qantas was preparing to challenge any takeover bids. The Australian Financial Review reported that Mr Joyce had begun assembling a team within the company to defend itself from a possible hostile takeover bid and has appointed Macquarie Group to advise it.

It is understood a similar team was formed last year after former CEO Geoff Dixon, advertising guru John Singleton and other investors apparently formed a plan to take a cornerstone stake in Qantas. With the share price now at its lowest point ever, there is strong speculation the consortium may be moving to again build a stake.

Another possible suitor for Qantas may be British Airways and Iberia parent com-pany International Airlines Group, headed by another Aer Lingus alumni Willie Walsh. In recent months he has made com-ments that IAG is looking at other invest-ment opportunities but with the European financial situation still dire, funding to buy a stake in Qantas may be hard to come by in the short term.

BA and Qantas previously held merger talks in 2008 that could have seen the car-riers pursue a dual-listed company structure but these were abandoned after the two airlines could not agree on a price.

News of the profit downgrade came only one week before IATA’s AGM, where the industry association forecast Asia Pacific airlines would collectively produce a profit this year of US$2 billion, down $300 million on its previous forecasts due to generally weak results in the first quarter of the year.

Tellingly, Qantas’s major international competitor Singapore Airlines recorded a loss of S$38. 2m (A$29. 9m) for the January-March quarter this year as compe-tition dragged down yields, particularly on long-haul services to Europe and the US.

TROUBLE ON THE HOME FRONT Despite the carrier expecting its do-mestic businesses to make a tidy profit for the year ending June 30, the outlook is more muted as a price war in the domestic market looms.

Qantas already has signalled it will fight to the death against the rejuvenated Virgin Australia to preserve its line in the sand of 65 per cent share of the domestic market, with plans for Qantas and Jetstar to add a number of frequencies to key destinations on the east coast from July. Qantas will also once again utilise 747-400s on some Sydney-Perth flights and add more A330 services on the Melbourne-Perth route.

Those moves seem to be aimed squarely at containing Virgin Australia, which has been gaining momentum in the busi-ness travel market with the addition of business class across its fleet of jet aircraft this year.

Short term, the moves by Qantas and Jetstar are expected to cause an overall decline in fares and yield across the impor-tant Sydney-Melbourne-Brisbane triangle, as well as on the transcontinental routes where Virgin has employed most of its Airbus A330-200 capacity.

Virgin may also be emboldened to mount its own capacity increases by the recent move by partner Etihad Airways, which has taken a 4. 99 per cent stake in the demerged domestic airline and has set its sights on taking its stake up to at least 10 per cent.

Jetstar may also have its hands full, Tiger Airways signalling it will take a more aggres-sive stance in the domestic market. In June the carrier launched a half-price sale that saw a number of its seats sold for between $29 and $69 across its domestic network.

It’s widely expected that more aircraft will be added to Tiger’s Australian opera-tion over the year, possibly further com-pounding the inevitable price war in the leisure market.

While domestic operations are expected to see yields come under pressure, one area expected to yield positive results for Qantas is the burgeoning resource charter market.

The company began a new contract recently to fly charter services between Perth and Fortescue up to five times a day for Fortescue Metals Group. These are be-ing operated by Network Aviation Fokker 100s and QantasLink Boeing 717s and are expected to transition to larger Boeing 737-800s later in the year.