Mixed results

On the other hand, across the Tasman in the Kiwi half of Australasia, there was a starkly contrasting picture as Air New Zealand came home with an impressive 156 per cent profit lift to $142 million. Not bad considering it was on the verge of bankruptcy and had to be bailed out by the New Zealand government in 2002, then struggled again through the 2008 global downturn.

For Qantas and Virgin, however, the truth is somewhat different. Times are tough and there are very good reasons why Australia’s two carriers came in with the results they did. They are, in effect, suffering short-term pain for the sake, hopefully, of long-term gain. Qantas Group chief executive Alan Joyce and his Virgin counterpart’s John Borghetti might well say: “We are works in progress”.

In reality, they are still in the midst of the most significant re-balancing of the country’s airline market since the collapse of Ansett just a few days after the terror attacks on the US on 9/11. As Joyce puts it: “**********We’ve been going through the biggest restructure in Australian aviation history”*********. And Borghetti: “There isn’t another airline in the world that I know of that has undergone the transformation that we have undergone”.

The pair are shuffling the cards like a couple of bears with bees in their bonnets, tussling with the usual high fuel costs, a vicious competitive landscape at home and abroad, not to mention potential jokers in the pack such as volatile economic conditions and mounting unrest in the Middle East which could send consumer confidence and travel markets across the globe into a spin at any time.

Yet despite all of this, both airlines have been making what can only be described as remarkable progress in restructuring their businesses and redefining the way they operate.

“We’ve been going through the biggest restructure in Australian aviation history.”
Alan Joyce

Take Qantas. Without the substantial profits generated by its loyalty scheme, up 13 per cent to a record $260 million in the latest year, as well as black ink on domestic flying and from low-cost subsidiary Jetstar, the carrier would certainly have been in serious financial strife.

It did, after all, lose $244 million a year ago, mainly due to the fiscal black hole of international flying. The good news from the latest results is that long-haul is finally beginning to show turnaround. Underlying operating losses on its international arm have been cut in half in the last 12 months to $246 million and Joyce remains confident profitability can be achieved by 2015.

He has good reason to be optimistic. The dramatic, unexpected and unprecedented tie up with Emirates Airline and the hub shift from Singapore to Dubai earlier this year is showing every sign of being a masterstroke… and the marriage is only six months young. While Joyce won’t cite gains in dollar terms he says the reaction from customers has been “phenomenal”. Qantas’s level of bookings into Europe is already running at twice what it was with previous codeshare partners such as British Airways, Air France and Cathay Pacific.

This talk is supported by the latest figures from Dubai airport. In July its passenger traffic to and from Australasia (Australia and New Zealand) was up 49.4 per cent on the same month last year, a surge it largely attributes to the Qantas-Emirates partnership. On a country level, traffic from Australia rose 53.6 per cent. Clearly, travelers are grasping the opportunity to take advantage of one-stop flying through Dubai to 65 destinations in the Middle East and Europe. The financial gains from the arrangement will almost certainly accumulate over the next few years.

Qantas’s meagre return must also be seen in the light of a number of positives and negatives that impacted its earnings. Domestic income fell 21 per cent to $365 million thanks to a capacity war that saw seat numbers rise eight per cent, double what was expected. The carbon tax cost it $100 million. The hub move to Dubai cost $56 million. Start-up losses for Jetstar Hong Kong (yet to fly) and Jetstar Japan were $31 million and another $26 million had to be paid out to pilots in back-pay. A $125 million compensation payment from Boeing over the delayed arrival of its 787 Dreamliners (the first to arrive for Jetstar this month) didn’t exactly balance the ledger. Given all of this, and other factors, it is a small miracle Qantas managed to stay in the black.

For Virgin too, it has been a pivotal year. The carbon tax cost it $47.9 million and there were serious glitches in its cutover to the SabreSonic booking system, including about $25 million in losses from the waiving of ancillary fees in order to protect the customer experience and forgone revenue due to the scheduled cutover of the booking system. Strong competition in the market made it impossible to recover that money.

Yet at the same time Virgin completed its major restructuring and transformation program, including the acquisition of regional Skywest and taking a 60 per cent controlling stake in Tigerair Australia. The complex, time-consuming and costly task of turning the low-cost Virgin Blue into the all-encompassing airline group it is today should not be underestimated. Virgin is now a high quality, full-service airline, which for the first time is in a position to begin competing with Qantas across the sectoral board, from full-service to regional, low-cost and fly-in-fly-out charters.

More significant, through its partnerships with big international players Singapore Airlines, Etihad, Air New Zealand (all of which have equity stakes), and the non-equity deal with Delta Airlines, Virgin can also offer an imposing international network. Indeed, despite the latest disappointing result, the three stakeholders – Air NZ, SIA and Etihad – have given conditional commitment to a new term-loan facility for an aggregate amount of $90 million as part of a focus on supplementing and diversifying Virgin’s liquidity position. It’s a sign of the confidence they have in the airlines’ future. Borghetti doesn’t foresee using the loan but the fact it is there is comforting.

Virgin remains the minor player in Australia’s domestic and international markets, but what it has done is lay a solid foundation on which to build. Domestically, Qantas is maintaining its 65 per cent market share and its entrenched position gives it 85 per cent of the corporate market revenue share. But as the Virgin group continues to grow, particularly if its attempts to revive Tigerair and build its budget fleet are successful, it is not difficult to see these numbers change. The partnership with Air New Zealand, where new chief Christopher Luxon is clearly continuing the good work of his predecessor Rob Fyfe, is also critical because it allows them jointly to compete effectively in both countries domestically and across the Tasman with Qantas-Emirates. For Qantas, it is likely that maintaining the “line in the sand” will become more difficult. Indeed, ********if there is a flaw in Qantas plans, it may be its stubborn insistence on a market share level*********. After all, when it comes to the bottom line, it isn’t the market share that counts, it’s how profitable the share you have is.

Air New Zealand’s relationship with Virgin – it has a 19.99 per cent stake in the Australian carrier, soon to rise to 22.99 per cent – is a crucial link in the Brisbane-based airline’s chain. “The key reason we have bought a significant chunk of Virgin is to gain exposure to the Australian domestic aviation market. This market is large and growing and complements our New Zealand domestic, Tasman and international market exposures,” says Luxon, who isn’t phased by the recent Virgin loss. It may not be the news shareholders wanted to hear, but he remains confident Virgin has the right strategy and Borghetti is driving his team hard to deliver the financial, operational and customer experience results that all shareholders expect.

“The fact that Virgin has a cornerstone collective of significant shareholders in Air New Zealand, Singapore Airlines (19.9 per cent), Etihad (10.5 per cent) and Virgin Group (13 per cent) is testament to the belief the aviation industry has in its future.”

Borghetti says the relationships with its international airline partners and the interline and codeshare revenue they bring continues to grow strongly, some 45 per cent increase over the past year.

“Domestic business class passengers continue to increase, with passenger traffic in the business class cabin more than doubling compared to the 2012 financial year.” Matching Qantas’s powerful hold on corporate Australia won’t be easy but there are certainly signs that Virgin is making inroads. For instance, a Roy Morgan Research survey showed Virgin finished the 2013 financial year with 81.0 per cent of domestic business travellers “very or fairly satisfied” with its offering compared to Qantas at 78.8 per cent.

Overall, in a volatile market, both airlines are also showing good progress in reducing costs, a key to future stable profitability. Qantas has cut its costs by 19 per cent over the last four years, some five per cent in the latest 12 months, the highest it has ever achieved. Virgin’s business efficiency program, in place for just a year, has also exceeded targets, delivering sustainable gains of more than $60 million. It is on track to deliver cumulative productivity gains of about $400 million over the next three years. Qantas, which had $3.5 billion in capital committed in firm aircraft orders, has managed to get that down, working with flexibility with the manufacturers, to $1.5 billion.

There are other drivers of profitability that will begin to come through. The imminent arrival of 787s into the Jetstar fleet will bring serious cost benefits in terms of fuel, maintenance and economics to its operations. And Qantas still has the option to take 50 more 787s if, as and when it feels the time is right.

Also on the budget front, Virgin’s plans to increase the Tigerair fleet to 23 and possibly to 35 will bring economies of scale and deliver a further cost advantage. Tigerair has a way to go before it makes heaps of cash but performance indicators have been positive, with load factors for July at 92 per cent, an increase of 8.2 points on the same time last year.

Air New Zealand is also planning to invest NZ$1.8 billion in new planes over the next three years, including six 787-9s, the first of which will arrive next June. It will also buy two A320s, two 777-300ERs and four ATR72-600s. Luxon says the latest result makes Air New Zealand “one of the strongest-performing airlines” in the world and it is benefiting from a shift in global power from the Atlantic to the Pacific and a corresponding increase in demand for Asian and Pacific routes. The airline’s business in China alone rose 55 per cent in the past year.

One critical element on the domestic battlefield will be how capacity growth stacks up over the next 12 months. Qantas hopes it will be a modest 1.5 – two per cent. Virgin thinks it will be more like four per cent. Certainly, any more than that will cause damage to both.

Internationally, Qantas’s move to Dubai hasn’t hurt its presence in key Asian markets. Most of its Jetstar subsidiaries are now making money and Japan has started off far better than expected with the promise of strong growth in an emerging budget market. In Singapore, Jetstar has broken ground with a swag of interline and codeshare deals with full-service carriers flying in from Europe and elsewhere, gaining passenger feed from the likes of British Airways, Air France, KLM, Lufthansa, Turkish Airlines, American and Emirates. This sort of partnership between legacy and budget operators was unheard of a few years ago.

Qantas mainline into Asia is also strengthening, laying to rest any thoughts its hub move to the Gulf would damage its presence in key Asian markets. As Joyce explains, the airline has been restructuring the Asian network as a consequence of de-linking it from Europe.

“A great example is now Hong Kong and Singapore. Previously the timing of those services were all set up to meet European connections. They’re being re-timed and extra capacity’s been added for local market demand. So we now have double dailies from Sydney to Singapore. Time to connect in Asia. Time to meet the local market demand. The numbers are pretty impressive on how it’s going. We’ve added 54 per cent capacity as an example to Singapore. We said at the time it’s going to take us a little bit of time to fill it. I think it was reported that in May we had a 56 per cent load factor on Singapore, and we did. But in June we had a 75 per cent load factor. In July we had an 80 per cent load factor. In June we overtook Singapore Airlines in terms of seat factor. So we’re growing into this capacity at a more rapid rate than I thought we would, which is great for our presence in these key markets. When you look at the key markets where the business travel wants to fly to, Qantas flies where 70 per cent of the business market wants to fly to, Qantas has direct services or partner services and that’s key to us,” Joyce explained.

The real story behind the latest financial results is that *********both Qantas and Virgin have been doing the essential groundwork to prepare for the future********. The report card on how they are going is pretty good. But like all well laid plans there are elephants in the room. These include fuel prices, subject to volatile world events such as the impact on markets of the current Syria crisis. Potential regional flashpoints, like North and South Korea, can also hit air travel. Economic conditions on the other side of the world can dent consumer confidence and cause sudden dips in air traffic. As Joyce puts it, there is always potential for headwinds and always potential for tailwinds.

“You can always have the economies reversing from where they are today, going back into recession. We could always have a geopolitical situation in the Middle East that means oil prices don’t come back from the high levels that they’re in at the moment. We could have other things that we don’t know of, unidentified risks that could come in. Equally there could be tailwinds, stuff that helps us get there faster. The economy’s recovering a lot faster, fuel prices dramatically dropping.”

“Both Qantas and Virgin have been doing the essential groundwork to prepare for the future.”

He is absolutely right. Surprise events and unexpected crises are part and parcel of the airline game. Yet, whatever the bottom line fiscal results today, there is plenty of evidence that Qantas and Virgin are making significant progress towards long-term stability. Anyone who thinks otherwise is ignoring the unprecedented changes that are being pushed through by Joyce and Borghetti and their management teams and the solid foundations that are being laid for future profitability.