Everyone’s hurting

Breaking down the headline figures, Qantas suffered a fall in earnings from its core domestic business by a dramatic 34 per cent, reflecting intensifying competition from Virgin Australia, particularly in the normally higher-yielding corporate sector.

However, it was not necessarily Virgin Australia’s gain, with aggressive positioning by both carriers hurting its overall performance.

Virgin Australia’s profitability in the first half of the current financial year slipped by more than half to a statutory profit after tax of $23 million and an underlying profit before tax of $61 million. Significantly higher borrowing and capital costs further eroded performance, which the airline put down its successful move to the Sabre reservations system.

It is in the domestic financial figures that the true state of the competitive environment is expressed. Virgin’s domestic revenues in fact increased from $1.45 billion in the first half of 2011 to 1.51 billion in the corresponding period of the current financial year. However, its earnings before interest and tax (EBIT) fell considerably – from $87 million to $49.3 million this year. And for carrying only 100,000 more passengers. The fact the airline operated some two billion more available seat kilometres during the period accounts for its poor performance domestically.

Internationally, the picture was considerably brighter for Qantas’s mainline business, reporting an underlying loss of $91 million – a vast improvement on the $171 million it lost a year earlier. The 65 per cent improvement was not attributable to revenue, which decreased by three per cent to $2.82 billion but what the airline called the “result of transformational benefits”.

Jetstar’s international performance was marred by stiffening competition and start-up impairments as it launched Jetstar Hong Kong. Jetstar’s overall earnings dropped 13 per cent to $128 million.

Performance of Virgin Australia’s international operation showed consistent, measured growth, with capacity and demand keeping pace and creating an improved EBIT of $35.4 million, up from $32.3 million in the corresponding period last year.

Market share or strategic growth?

Both airlines’ CEOs were, naturally, keen to assuage investor concerns by talking-up their strategies in the face of what is becoming a blood-bath in the domestic market and continuing efforts to solidify their international businesses.

Keen to demonstrate that Qantas is headed firmly in the right direction, Qantas CEO Alan Joyce said: “Qantas International is well advanced in its turnaround plan,” adding that the 65 per cent improvement in its bottom line was “testament to the steps taken to remove costs from the businesses, from closing down loss-making routs to retiring aircraft and consolidating operations.”

In all, Qantas claimed to have realised $172 million in ‘transformation benefits’ during the first six months. “The operating environment remains complex and volatile, but we are beginning to realise the benefits of the tough decisions that we have made over the past 18 months,” Joyce said.

Though he expects domestic capacity to normalise in the medium term, domestic capacity across the Qantas group is expected to rise by five to seven per cent during the second half of the financial year compared with a year earlier.

Borghetti defended the results, saying: “Considering the aggressive competition and challenging economic environment, Virgin Australia has delivered a solid financial performance for the first half of the 2013 Financial Year, illustrating the success and resilience of our new operating model.”

Virgin explained the result could in part be attributed to the $24.4 million in carbon tax costs, and noted the same half in the 2011-12 financial year included a direct $6 million “impact” from the Qantas grounding in October 2011.

Said Borghetti: “The Game Change Program strategy has driven improved revenue performance, with revenue growth of 5.4 per cent on the first half of financial year 2012, building on the strong growth of 18.0 per cent that we achieved on the first half of financial year 2011. This revenue growth was also achieved in the context of the highest domestic market capacity increase since the launch of Jetstar in 2004.”

Neither Virgin nor Qantas provided profit guidance for the second half, uncertainty in economic conditions and the competitive environment.

Economic conditions are outside both airlines’ control, as are fuel prices. The competitive environment, though, is firmly within the hands of the respective CEOs. As it stands, both need to determine how much more shareholder blood needs to be spilled before domestic equilibrium is reached.

Dangerous games

However, domestic capacity remains the key issue affecting both airlines, with both guilty of ramping up services to protect market share. Virgin Australia CEO John Borghetti has repeatedly stated his strategy is not about market share, though within the airline’s half-yearly results announcement it euphemistically referred to the same concept as “capacity growth… based on strategic objective”.

Those strategic objectives are clearly targeted at ensuring the Qantas monopoly is broken in as many former strongholds as possible.

Borghetti – while not focusing on market share – is going after Qantas by “expanding the domestic footprint and entering monopoly markets”. This so far has seen the introduction of weekday double-daily A330 services between Brisbane and Perth and more regional services in Queensland (Moranbah and Bundaberg from Brisbane).

And that does not include the recently-approved acquisition of Skywest or the potential for Virgin to take a majority stake in Tiger Airways. With those additional competitive assets, Virgin Australia will force Qantas into a corner it will find it hard to fight from.

Internationally, the tension between the airlines is less and their strategies continue to evolve divergently. Virgin Australia continues to pursue a virtual global network through leveraging the strengths of its strategic and equity partners, which during the first half saw it increase interline and codeshare revenue by more than 56 per cent.

Qantas, meanwhile, is ready to consummate its marriage to Emirates, itself becoming a potent asset to the Qantas international business and in Europe, at least, will become as equally virtual as Virgin’s is globally.

Capacity growth in the domestic market during the first six months of the financial year was 10 per cent – double that of the same period last year. Both airlines blame the other for the capacity surge domestically.

It is perhaps best evidenced on the Sydney-Melbourne route where Virgin claims it added a modest three per cent in capacity during the first half of the financial year, while Qantas mainline added 11 per cent and Jetstar a massive 57 per cent.

Ironically, in its results announcement Qantas said its mainline and Jetstar domestic operations generated “solid earnings despite excess capacity in (the) domestic market”.

The assault by Qantas on this route to protect its high-yield business is understandable, but the dumping of capacity to retain market share is a dangerous strategy.

Borghetti described his opponents’ strategy as: “Increased competitor capacity to maintain market share” and “aggressive competitive pricing due to capacity growth above passenger demand growth”.

“The dumping of capacity to retain market share is a dangerous strategy.”

And herein lies the danger for both airlines. It is an unsustainable policy to fly empty seats.

Qantas cannot afford to diminish returns from its domestic business – it has been the Group’s only sustained profit salvation. Virgin Australia has so far not sought to match capacity – and wisely – but if it cannot offer the frequency of its opponent to key corporates, it will fail to continue to lure customers away from Qantas.

Part of Virgin Australia’s future success may lie in the Qantas Group’s continuing transition on key trunk routes from Qantas mainline domestic to Jetstar. If full-service schedules are replaced with Jetstar, the Qantas Group will intrinsically relinquish corporate customers to Virgin.