Back in Black

The doomsayers have constantly been on his back. And little wonder.

Few airline chiefs would have survived the dramas that have

At least one analyst is forecasting Qantas is looking at a massive $1. 7 billion pre-tax profit.

plagued Qantas during his tenure.

Grounding the Airbus A380 fleet after the near disaster of QF32’s engine explosion near Singapore.

The unprecedented grounding of the entire fleet worldwide on the eve of the busy Christmas travel season in 2011 amid union threats to “slow bake” the carrier over a wage and conditions dispute. A long-haul international operation, mainstay of the carriers’ global reputation, turning into a financial disaster zone. A highly controversial “marriage” to long-time bitter foe, Dubai’s Emirates Airline.

Ongoing losses among its Asian Jetstar budget subsidiaries. A tough transformation program and, to top it all in August last year, its biggest net loss in history of $2. 8 billion.

While the media headlines made a meal of that dismal figure, in reality Qantas was actually a long way from the dire circumstances portrayed.

After write-downs and one-off costs, including an impairment charge of $2. 6 billion relating to a non-cash write-down of its international fleet, the real loss was a more manageable $646 million. Just a few months later, when Qantas releases its first half results for the 2014/15 year (due on February 29) it expected to report a record $300 to $350 million profit for the six months ended December 31.

Whatever way you look at it that represents a remarkable turnaround, particularly as Joyce disclosed all divisions of the airline, including its beleaguered international arm, were tracking back into the black.

It would be Qantas’s strongest first half performance since 2010 and an improvement of some $500 million on the underlying loss of $252 million in the same period a year earlier.

If that isn’t impressive enough, at least one analyst is forecasting Qantas is looking at a massive $1. 7 billion pre-tax profit for its current full year, ending June 30. Sydneybased UBS analyst Simon Mitchell says that with that potentially in its pockets, he expects the carrier to conduct capital management through share buybacks, as well as the revitalisation of its fleet upgrade

It is easier in retrospect to explain some of the strategies Joyce has employed.

that was put on hold last year. Qantas’s previous pre-tax earnings peaked at $1. 4 billion in 2008. That being said, UBS has been the most optimistic about Qantas’s outlook as it raised its 12-month price target on the airline’s stock to $4 from $2. 80. The consensus among other analysts is for a pre-tax profit of more than $600 million. That such a stunning turnaround could come in such a short period of time may surprise some but it was carefully planned by Qantas management. They knew there was going to be no gain without pain and in many ways the headline-grabbing deluge of red ink that grabbed everyone’s attention was, in essence, a way to dump all the bad news on the market in one go and get it out of the way. Joyce and his team knew that their vicious cost-cutting and efficiency program – launched at the beginning of last year to slash $2 billion from expenses and reduce staff by 5,000 by 2017 – was on the verge of showing genuine results. The cards were beginning to fall into place, and not only in terms of internal planning. The end of a crippling domestic capacity war with rival Virgin Australia brought immediate benefits last year. So did the dramatic and unexpected plunge in jet fuel prices, something that will have increasing benefits through the remainder of this year.

In its latest six monthly result, the transformation program alone was expected to deliver $350 million in cost savings and lower fuel prices by around $30 million. As Joyce put it: “This demonstrates that the strategy we have outlined to transform our business is working. Qantas is 12 months into a three-and-a-half-year program, but these strong early results give us the confidence that we will continue to meet all the targets we have set. We are committed to completing the full, $2 billion program to ensure a sustainable, competitive position for the long term. ” Joyce points to the more stable operating environment in most markets and says reduced capacity

For now, the low price of fuel has eased the pressure on airlines to rush into new aircraft.

levels and weaker competitive pressure are “allowing yield improvements”, despite the continuing patchiness of the Australian economy with the resources sector cutting back on flights and the leisure market not firing on all cylinders. The airline also has options, with asset sales, including its airport terminal leases, remaining on the cards. But for the full-year ending June 30, even Joyce isn’t taking anything for granted. He won’t give a profit forecast, citing oil price volatility.

Looking back, while some of Qantas’s actions have come under a sustained barrage of criticism, from an airline point of view, operating in a complex and volatile environment, it is easier in retrospect to explain some of the strategies Joyce has employed. Grounding the A380 fleet after the QF32 incident was a nobrainer.

It was based on safety and the decision enhanced, rather than damaged, the airline’s unparalleled image for safety.

Grounding the entire fleet in late 2011 may have brought down the wrath of unions, politicians and a great deal of the public but viewed from an airline management perspective it was a different story.

Two or three days of non-operations and disruption along with the cost of dealing with stranded passengers across the globe and catching up once flights resumed was far preferable to the prospect of a year or more of unpredictable industrial action and the untold disruption that would have caused on an ongoing basis, not only to customers and the bottom line but to the Qantas brand.

The tie-up with Emirates and abandonment of Singapore as a hub to Europe was also widely criticised, with many accusing Qantas of “selling the farm”. Yet, as it has been bedded in, that partnership is bringing increasing financial benefits and passengers, particularly the high end corporate travelers, simply love being able to fly to more than 30 European destinations onestop through Dubai rather than twostop through Singapore and either London, Paris or Frankfurt.

As for Joyce’s tough “transformation” program, analysts agree it may be hard but it is also necessary. Like all legacy airlines it has been burdened for years with inbuilt inefficiencies, high staff numbers and productivity levels that needed improving. Previous cost-cutting programs – and there have been several – have not been enough. Reducing overall operating costs in the face of intense competition, particularly on international flying, is critical to achieving profit-generating yields.

The rationalisation of maintenance operations, whatever slant unions put on it, was also crucial. With 747s and 767s departing the fleet and new aircraft arriving that require less maintenance at more infrequent intervals, operating engineering facilities at previous levels was simply not economically viable.

Speaking to journalists in Seattle in November, Qantas chief financial officer (and soon to be head of Qantas International) Gareth Evans said the transformation program was going well, though it was still in its early days. “So far, so good,” he declared. Like Joyce, Evans pointed out that the domestic market is in a more stable situation than it has been for some time, albeit that it’s quite weak on the demand front. “But there’s also very little capacity growth so demand/supply is matched better than it has been. ” He said lower fuel prices were having only a relatively small impact on the July-December numbers owing to the timing of fuel purchases and Qantas’s hedging program but that if the fuel price stayed low there would be a bigger benefit in thesecond half (ending June 30). Indeed, Qantas is expected to be one of the big winners from current pricing levels because it has relatively low levels of hedging and is buying much of its fuel at low spot prices.

Improved fuel costs aren’t the only contributors to better finances.

Evans disclosed Qantas will recoup over $100 million a year just from smarter scheduling of its Airbus A380s. “When we re-timed the Melbourne-Dubai-London flight, that freed up a whole A380, and changing the way we plan and do our A380 maintenance freed up another A380. We’ve taken those two A380s and deployed them on Dallas and retired two older 747s.

The A380 can make Dallas a direct flight in both directions where the 747 had to drop into Brisbane. That all adds up to over $100 million a year in terms of the cost benefit. ” Another small example: not filling up the water tanks of its Airbus A330s on their Sydney-Melbourne legs. A330s have large water tanks which are normally topped up. On the short flight between Sydney and Melbourne less than a quarter will be used. Now, the tanks are only being 25 per cent filled. It may only represent a few hundred dollars saved on each sector but over a year it adds up to a saving of $1 million to $1. 5 million.

“You’ve got to do the big things and you’ve got to do the little things, but they all add up,” said Evans. With international operations, other transformation steps include the exiting of unprofitable routes, rationalisation of catering and engineering operations, more efficient capital allocation, reconfiguring the fleet to enhance profitability and building better alliances, including the continued strengthening of the Qantas-Emirates partnership.

If anyone thinks this is all painting too rosy a picture of where Qantas currently stands nobody should be in any doubt that not everything in the garden is blooming. There are plenty of challenges ahead. Fleet composition is one area that raises serious questions. The flagship A380 is probably a must-have for Qantas but it lacks flexibility in terms of route planning. Essentially it is an aircraft that can only be used on high-density major hub to major hub routes and these are relatively few in number.

Some analysts criticise the airline’s decision not to order Boeing 777s, which has become the

Despite the recent negative result, Qantas remains an asset rich business.

gold standard for long-haul flying and is far more flexible in terms of route diversity. For some time, only two front-line international carriers had not ordered the 777, Qantas and Lufthansa. The German operator is now a launch customer for the 777Xs (with 59 on order), leaving Qantas as the odd man out.

It is also puzzling that while Qantas ordered the 787 Dreamliner, it has handed all of them over to low-cost Jetstar. Again, it is a plane which would fit well into Qantas’s mainline fleet, bring huge cost savings and give it numerous network options. Qantas does have purchase and option rights on 50 787s and 20 of them have guaranteed delivery slots, from 2017. But it hasn’t made a decision yet on when to take delivery.

As the airline removes the 747-400 from its fleet it has been suggested the 787-9 will act as its replacement.

That doesn’t add up. Qantas operates the 747 in three configurations, from 353 to 371 seats. The 787-9 is a 300 seat aircraft (Air New Zealand‘s has 302 seats), close to the 297-seat Airbus A330 Qantas also operates.

A more suitable replacement would be Airbus’s A350-1000 (370 seats) or the new 777X (around 400 seats).

Once the 747s are gone Qantas, assuming it does take the 787-9, will have a fleet with a big gap between the Dreamliner’s 300 seats and the A380s 474 seats. And as its competitors stampede to lock in orders and delivery slots for the next generation of wide-bodies – the 777X and the Airbus A350 – there is no doubt Joyce and his team will need to take a long hard look at the carrier’s next fleet step, or risk being left years behind rivals in term of heavy metal.

For now, the low price of fuel has eased the pressure on airlines to rush into new aircraft, prolonging the life of older models. That, surely, will be a temporary reprieve.

Also a major challenge going forward will be increased levels of competition, particularly internationally. Qantas may have dampened the Emirates threat but its Gulf neighbours Etihad Airways and Qatar Airways are no slouches in terms of increasing capacity and penetrating markets.

Chinese carriers too are fast becoming major players. The new China-Australia bilateral agreement signed in January will deliver an immediate 136 per cent increase in seat capacity and triple seat capacity by October next year. China is already Sydney’s largest and fastest growing market, increasing 16. 4 per cent in 2014 and accounting for half of all foreign nationality growth.

Based on current growth rates, China is on track to overtake New Zealand as Sydney Airport’s largest inbound market by next year. Qantas already has codeshare agreements with all three of China’s big three – Air China, China Eastern and China Southern – but that won’t ease the competitive pressure of other Chinese carriers taking advantage of the new deal to enter the market.

Qantas will also face greater competition in the Japan market this year when All Nippon Airlines resumes flights to Australia, its first since withdrawing from the route in 1999. The Australian carrier has, however, won a valuable slot at Tokyo’s Haneda airport, which is far closer to the city than the main facility at Narita.

All in all, it will likely add up to further dilution of Qantas’s international marketshare out of Australia. Interestingly, while Asia obviously remains important, Joyce recently said he believed growth in the short term will come from the US and the UK rather than Asia.

“While the Chinese market has huge opportunities, in the short term it’s still a market that is very low yield, very high volume. The greatestgrowth for Qantas over the next three to five years – we still believe – is in the traditional markets (the US and UK). The United States is a huge market for Qantas. We’ve added extra capacity: about 100 frequencies over the peak period, because we see good strength coming out of the US market… (and) we still have a big operation into London and we see the UK market also as an area of potential growth going forward. ” Another problem Qantas will have to sort out is the performance of its budget Jetstar brand in Asia. The Jetstar group overall lost $116 million last year compared to a $138 million profit a year earlier and the Asian arms are bleeding cash.

Expansion of Jetstar Asia in Singapore is currently frozen. The Jetstar brand is now the largest no-frills operation in Asia but the expansion freeze risks rivals such as AirAsia, Lion Air and the like leaping ahead. It also needs to resolve the long-running saga of the proposed Jetstar Hong Kong, still grounded and awaiting permission to fly, creating an ongoing drain on cash. That circumstance may not be of Qantas’s making because the issue comes down to the Hong Kong government’s indecision, fuelled by local airline protests, on the “principal place of business” issue, whether a local Jetstar will be run in Hong Kong, or from Australia. Nevertheless, the standoff can’t go on indefinitely.

In a recent research report from Australian investment adviser FIIG, Alen Golubevic, director infrastructure and fixed income research, says Qantas’s strengths include its dominant domestic position with a 65 per cent marketshare and its dual-brand strategy, using Qantas and Jetstar to drive growth both domestically and internationally in both the business and low-cost ends of the marketsimultaneously. With $3 billion in cash and a further $630 million in available facilities, the airline also maintains a very strong liquidity position. “Despite the recent negative result, Qantas remains an asset rich business, with a number of significant entities and opportunities to reduce debt levels through asset sales available to management. ” Qantas’s decision not to sell its loyalty program was a good one, Golubevic adds, saying that “overall, while a sale of the frequent flyer business could generate significant cash which could be used to pay down debt, retaining this business within the group is a positive given it provides a stable, quality earnings stream to supplement the underlying airline business. ” But the FIIG analyst doesn’t ignore the risks. Among them is the transformation program itself. “Qantas is in the midst of restructuring its business. As such, Qantas is exposed to the execution risks of implementing change on a number of fronts and transitioning its business to profitability. ” The research report also draws attention to what everyone knows: the airline industry remains highly competitive and competition is increasing both on domestic and international routes. In particular Qantas’s international business faces strong challenges from government backed, or significantly government owned rivals.

“The nature of the airline industry presents a risk to investors because it is cyclical, capital intensive, being exposed to ‘force majeure’ events (eg: terrorism) as well as the cost of jet fuel which fluctuates with movements in the underlying commodity,” says Golubevic. He concludes that despite its weak result last year, with the general media attention focusing on the large headline losses, there were still a number of positives for Qantas’s bondholders to take away.

“Of particular note were the better than expected underlying earnings, an increase in group liquidity of $600 million to $3. 6 billion, positive management comments on market conditions, progress on the cost reduction initiatives and confirmation that Qantas Loyalty (Frequent Flyer) will not be sold. Qantas remains one of the strongest brands in Australia and one of the best known internationally. Notwithstanding the recent poor result the company retains a significant asset base and a market capitalisation (at time of writing) of over $3. 3 billion which provides comfort for investors in the company’s ability to meet its commitments. ” People can throw dismal financial result figures around all they like but the fact is that half of the airline’s debt won’t come due until after 2019, leaving it free to focus on its operational overhaul, reversing recent losses and a declining marketshare. Qantas was actually able to generate positive operating cash flows of $1. 1 billion in its last financial year despite very challenging conditions and being engaged in that domestic price war with Virgin.

Has it turned the corner? All the indicators point to the answer being “Yes”. But Joyce knows, as does everyone in the airline business, that success hangs on a knife edge of circumstance, much of it outside his control. That includes global or regional economic developments, the possibility of the recent spate of terrorism incidents reaching into the airline sector, the fuel price surging upwards again, or some shock no-one has even yet considered.

All in all, Qantas’s ongoing return to fiscal and operational health currently looks good… but it is far from assured.