The Worst Is Over?

As Borghetti announced a move to slash $1 billion from the carrier’s costs in the next three years, and Joyce presses ahead with a massive restructure slicing 5,000 jobs (half of these have already gone) and $2 billion in costs from his balance sheet, the stage still remains littered with questions. Is Joyce right in declaring the worst is over? Will he himself survive in the face of a rising crescendo of calls for his head? Will Virgin’s romance with powerful owners Singapore Airlines, Etihad Airways and Air New Zealand and the arrival of their heads onairline’s board finally begin to pay off? Can the two airlines really restrain themselves from re-igniting a damaging domestic capacity war? Ever the pragmatist, for a chief executive who has overseen some $2. 5 billion in net losses during his tenure, Joyce is nonplussed by suggestions his days may be numbered. “Well, there’s always people that are after my head,” he says. “I don’t think that changes. It hasn’t changed for a long time. ” Despite the dismal results, he appears to have the full backing of his board, if not all of his shareholders. As for Borghetti, his zest for the fight shows no sign of abating either. “Is the fire still burning bright for me? Look at me. I might be 59 but I feel 29. I’ll leave it at that,” he quips. In Joyce’s case, it would be sheer madness to replace a leader at such a critical time in the airline’s history.

Behind the bravado, is their confidence well-founded? Back toRESULTSthe matter of perspective. Firstly, it should be pointed out that while the amount of red ink splattered over Qantas’s books is probably as bad as it gets for any airline, short of total bankruptcy, Australian carriers are hardly alone in their suffering. With a few notable exceptions, Asia Pacific operators have seen their income plummet over the past 12 months in the face of steep fuel costs, exchange rate losses, unprecedented and mounting competition from low-cost carriers and capacity expansion that is sending load factors and yields on a downward slide. Right now, the landscape looks bleak in a number of Asian markets.

All of Thailand’s listed carriers have been racking up losses, badly hit by the country’s political turmoil. For obvious reasons, Malaysia Airlines is mired in debt and struggling to survive. China’s big three – Air China, China Southern and China Eastern – have dipped into loss, ornear loss. Even Singapore Airlines has reported a 52 per cent fall in its first-quarter operating profit as intense competition for passengers and cargo squeezed yields at Asia’s second-biggest airline.

In India too, there is little sign of healthy income and even low-cost carriers, which until now have bucked the deficit trend, are reporting diminished returns as competition increases and more and more capacity flies into the region’s skies. Several other full-service airlines are undergoing massive restructure programes to try and stem the tide.

Joyce rightly points out that Qantas is undergoing its biggest and fastest transition since privatisation in 1995. These things don’t produce results overnight. “Our transformation is about working our assets harder, making ourbusiness smarter, giving even more to our customers and reshaping our operations for long-term sustainable success. We are only six months into the program but we frontloaded many of the more difficult employment and restructuring measures, so we are well ahead in terms of the execution of our major plans,” he says.

Qantas’s frontline financials paint a misleading picture. Most of that massive headline loss came from a $2. 6 billion write-down of the value of its international fleet – A380s, 747s and A330s – bringing them into line with true market value.

The 747s in particular were bought when the exchange rate was A$0. 57 to the US$. Now it’s around A$0. 93.

Fuel costs were up year-on-year by $253 million. Capacity levels, both internationally and domestically have been outstripping demand. A 9. 5 per cent growth in international capacity alone resulted in an over three per cent yield revenue hit on international business, costing some $560 million. The underlying loss was a still-significant but far more modest $646 million, below the $750 million market expectation because Qantas is actually cutting costs faster than expected.

Both Qantas and Virgin caused themselves damage through the capacity tussle. Now, it appears commonsense has prevailed and an uneasy truce should see yield improvement on the home front.

Virgin’s underlying pre-tax loss of $211. 7 million was in line with market expectations, but the tough environment was described by chief executive John Borghetti as one of most difficult in aviation history.

“While the Virgin Group performed well in attracting high-yielding passengers and containing cost growth over the full year, underlying revenue performance was impacted by the challenging operating environment,’’ Borghetti said. Joyce, who refuses to show any dismay at all of those leaking dollars, insists the worst is over. He is even forecasting an operating profit in the first half of the current year, ending December 31. Is it wishful thinking or confidence based on a sound business plan? Indeed, the Qantas Transformation Program is delivering accelerated benefits, some $440 million during the past year with another $900 million in initiatives underway and $600 million to be delivered in the current financial year.

Certainly, the Qantas Group still looks like a business suffering from schizophrenia, with some parts cheerfully churning out profits and others in the depths of depression.

The Golden Fleece remains its frequent flyer scheme, delivering $286 million in profits and its fifth straight year of double-digit earnings growth. Wisely, the carrier has decided not to put it up for sale.

Qantas Domestic still managed to stay in the black, though its return was down to $30 million from $365 million a year earlier thanks to the capacity squeeze. Even Qantas Freight managed to eke out a profit of $24 million, down from $36 million the year before. Jetstar lost $116 million, compared to a $138 million profit a year earlier. Its Asian operations lost $70 million, including start-up costs involving Jetstar Japan.

Yet, again, this was hardly surprising because there have been significant capacity increases in the market and other operators in Asia, such as Tigerair and AirAsia X, are also losing money.

But the capacity situation in the region is beginning to ease and the coming year should bring better operating conditions.

One troublesome spot is the ongoing impasse over the proposed Jetstar Hong Kong which has cost many millions of dollars, is yet to fly and looks less and less likely to get into the air anytime soon.

Well, there’s always people that are after my head. ALAN JOYCE

But the biggest black hole remains Qantas International which suffered an underlying pre-tax loss of $497 million, up from $246 million in FY13. That might have been worse but for a strong year of cost reduction which realised more than $400 million in benefits, though these were partially offset by competitor capacity growth of 9. 5 per cent, well above demand. Fuel and foreign exchange movements hit Qantas International hardest of any of the Group’s businesses, with an impact of $142 million. Between FY09 and FY14, competitor capacity growth in the Australian international market was 44 per cent, compared with global growth of 29 per cent.

Importantly for the future, capacity expansion is now slowing, with expectations for competitor growth of only 2. 4 per cent in the first half of this financial year.

Going forward, fleet and network adjustments hold promise of significant gains. The retirement of older 747s will cut unit costs and tweeking of the network promises to bring improved asset utilisation. Joyce also insists that the controversial Emirates alliance is working. “We’ve seen significant traffic levels going over Dubai… we’re getting a lot of people availing of the greater network out of Dubai, into Europe and to North Africa, and we are seeing the benefits coming through, through areas like our exit from loss-making routes on continental Europe… so the benefits that we saw and believe are coming through this partnership are really good for us and this partnership is adding to the desirability and the approach that we have on the Qantas international business. ” Still, he won’t offer any predictions on profitability for long-haul operations. “The whole focus of the transformation program… over the next few years (is) to give rapid improvement to all of our business. We expect to see a significant improvement of the economics of Qantas International, Qantas Domestic and Jetstar in the coming year, but there’ll be significant benefits coming through for the international business. We are not going to be giving an expectation of when it’ll get back to breakeven.

Needless to say, the target around the whole Qantas Transformation Program is to improve all of our businesses. ” Another potential gain for Qantas’s future is its fleet plans, although some questions remain as to where specific aircraft should be utilised. It took 20 aircraft in the past year and another 10 will arrive this year. New 737s and 787s are continuing to join the fleet, which is now at its youngest for 20 years. It still has options and purchase rights on 50 787 Dreamliners with delivery of the first couple pushed back to 2016 and 2017.

To date, all the 787s have gone to Jetstar, which bring it obvious gains in operating costs. Qantas chief financial officer Gareth Evans says the airline is “very much looking forward to exercising those options and purchase rights and bringing those aircraft into the Qantas fleet”.

There are many who suggest that the bulk of them should actually be going to Qantas International, which could in future make good use of them against rivals who are already operating the aircraft on long-haul services around the world with significant economic savings.

All in all, the carrier’s fleet strategy is focused on maximising the advantages of a young, competitive fleet, and completing the retirement of older aircraft types, increasing fleet utilisation in international and domestic markets and putting the right aircraft on the right route.

Qantas has targeted $561. 5 million in cost reductions from fleet and network initiatives. Key fleet and network changes completed or announced include a more than five per cent increase in asset utilisation by Qantas International, gradual replacement of Boeing 747s with A330s on routes to Asia and early retirement of four 747‑400s. In the past year it took delivery of 23 new aircraft, retired 19 older aircraft and returned eight leases. In the current year it will get 10 new aircraft, retire 18 aircraft and return two leases. The mainline fleet will be reduced from 11 different types to seven different types by 2016.

Another significant development is the decision to set up a separate holding company for Qantas International, following the government’s decision earlier this year to amend the Qantas Sales Act.

This cleared the way for foreign airlines, previously limited to a combined 35 per cent holding, to take up to 49 per cent of the carrier.

It will be a separate corporate entity although Qantas isn’t yet talking in detail about precisely how it will work. Joyce says it will “create options” into the future. “Those options could be mixed and varied and we’re not going to speculate on how they could occur, but this is aimed at allowing us to seek further investment – future investment around the international business. ” Right now, Qantas isn’t actively looking for an airline partner but is giving itself the option of becoming involved in partnerships, alliances or consolidations in the international business over the long-term.

Importantly, Joyce also appeared to take a subtle step back from his previously declared 65 per cent domestic “line in the sand”, admitting that he had perhaps “simplified” things in the past.

“It’s been more complex than that, making sure that we have a network of frequency advantage for Qantas across the board as a product advantage. That product advantage, we believe, is reallycritical,” he said. Of course there will always be competition between the two airlines, particularly for the high value corporate customer. That won’t change. Qantas still has 80 per cent of the corporate market. It lost 10 accounts to the competition during the last year and got eight back, which amounts to a gain of two for Borghetti.

It is also unfair to compare Qantas’s performance with that of Air New Zealand, which posted a NZ$262 million profit in its latest year. As Joyce put it, its apples and oranges. Air NZ is seeing the benefits of a major transformation it went through in the early 2000s, something which Qantas is only doing now. And unlike Qantas, the Auckland-based operator actually saw its fuel costs go downRESULTSover the past 12 months. This was because the Australian dollar moved 11 per cent against the US dollar while the New Zealand dollar didn’t. Additionally, Air NZ didn’t have to face a domestic capacity war.

On his part, former Qantas employee Borghetti isn’t gloating over his rival’s perceived misfortunes. “Whether it’s an airline or Alan or anybody else, you know I don’t like to see any company or any CEO or any business go through hard times because that reflects on the economy and consumer confidence and everything else… we went through bad times too but I think what is slightly different in our position is that our bad times ended when we launched the Game Change Program because we know that from that moment on we had a vision and a strategy that was long term. And if you look at what we’ve done over the last three or four years we have absolutely stayed true to every single point we have and now today we outlined what we want to achieve in the next three years and we are going to stay focused on that. ” Virgin has undergone remarkable change, transforming into a high quality, full-service airline. Borghetti says the landscape of Australian aviation has been altered and he is right. Unlike Qantas, he has decided to sell part of the airline’s Velocity frequent flyer program. Leading Asia Pacific investment firm Affinity Equity Partners will take a 35 per cent stake in the program. Virgin will retain majority ownership. Thetransaction values the business at an enterprise value of almost $1 billion and the deal will increase Virgin Australia’s cash position by $336 million and reduce its gearing.

Borghetti said the airline had now finished its “game change” restructuring program, which saw it introduce new aircraft and premium cabins, as well as acquiring Perth-based charter company Skywest and the 60 per cent stake in Tigerair (which lost $46. 1 million in the latest year). He said it would now work on maximising the group’s potential in a program called Virgin Vision 2017. Over the next three years, the Virgin Australia Group will focus on six key areas: capitalising on growth business opportunities, driving yield, implementing a new cost program, optimising the balance sheet, customer experience and developing its people.

“These last few years have been about rebuilding the business, and that required a solid plan, investment and the buy-in and hard work of our team. The next period for us is aboutRESULTSmaximising the Group’s potential, by extracting value from the business and generating sustainable profitability. ” Virgin is seeing growth in a number of areas. Its charter business delivered revenue growth of 30 per cent in the latest financial year and it is soon to launch a freight business, expecting cargo revenue to treble to between $150 million and $200 million over the next three years. Tigerair is expected to achieve profitability by 2017, the same year as Virgin itself is projected to get into the profit column.

As is the story at Qantas, yield improvement is a key focus for Borghetti. He has increased the target of corporate and government domestic revenue mix to around 30 per cent by the end of FY17. Over the five years to June 30 2017, a business efficiency program will generate $1 billion in cumulative productivity gains. That will centre on enhancing its procurement capability and working in conjunction with alliance partners, improving productivity and streamlining operations, including the integration of Virgin Australia’s New Zealand operations into the rest of its international business and the consolidation of its long-haul international bases from three into two.

Two 12-year-old Airbus A330s will be retired and deliveries of Boeing 737 MAX aircraft are being brought forward from 2019 to 2018. At some stage (Borghetti says there’s no rush) the airline will also be considering whether to buy 787s or Airbus A350s. Asked if he might do this with partners (such as Etihad Airways) he said: “Would we talk to the other three partners as to how we could do this together. Yes, within legal boundaries, absolutely. ” All things considered, both airlines now look as if they have cleared the hump and are on an upward path towards recovery. Their plans look good. The real danger is the possibility of events outside their control impacting on performance. As Borghetti put it: “There’s a lot of volatility out there. Aviation can be affected by anything. ”