A better business

Those investments have unquestionably led to a better on-board product, a larger domestic and (with the addition of key alliance partners) international network and swelled Virgin’s Velocity Frequent Flyer program to beyond eight million members.

What it has not done (yet) is build a profitable business, with Virgin in the red to the tune of $1 billion after posting losses over the past five financial years.

In fact, Virgin’s last full year statutory profit was in 2011/12, which covers the time Qantas grounded its entire fleet as part of a dispute with unions.
The most recent result, handed down on August 10, was a statutory after tax loss of $220.3 million for the 12 months to June 30 2017, an improvement from a loss of $260.9 million in the prior corresponding period.

Revenue rose half a per cent to $5.05 billion.

As a consequence, the jury is still out on whether the changes on the ground and in the air, the remodelled international network and the transformation into a diversified airline group competing in all segments of the market represented the right strategy for generating positive returns.
And in the period ahead, Virgin is banking on its restructuring program (dubbed “Better Business”) will yield the necessary cost reductions and operating efficiencies to boost the bottom line and return the airline into the black.

On that front at least, the airline had made significant progress during the first 12 months of the three-year Better Business program, according to Virgin chief executive John Borghetti.

Borghetti said the company was now targeting a $350 million improvement in net free cash flow by the end of 2018/19, up from a goal of $300 million previously. (Free cash flow is the money a company has after accounting for operating expenses and capital spending.)

“I am pleased to say that we are ahead of schedule in our implementation of this program and indeed today we are reporting that we expect to remain ahead,” Borghetti told reporters during Virgin’s full year results conference call on August 10.

“While there are costs associated with implementing the program, including for example fleet restructuring and organisational rightsizing, these costs will subside and will ultimately be far outweighed by the signifiant ongoing savings that the program will deliver.”

But the 2016/17 financial report also shows Virgin has a long way to go.

FROM GAME CHANGE TO GAME ON AND NOW BETTER BUSINESS

The significant capital investment under Borghetti’s “Game Change” program launched shortly after he took over as chief executive was succeeded by “Game On” that sought productivity gains while still growing the business. And Better Business is the latest phase of Virgin’s development.
Borghetti puts the current focus on sustainable free cash flow, lowering costs, managing capacity in response to demand and continuing to strengthen the balance sheet in the context of what has come previously.

“The first few years of the transformation was about investing in building and obviously when you are building you’re investing and you’re putting dollars in,” Borghetti said.

“The second part is getting your financial metrics right – reducing your debt, improving your leverage, all those sorts of things – which we are well and truly on the path of.

“The third element then obviously becomes sustainable profits going forward. So at a macro level that journey is pretty obvious and we are tracking on it.”

Neil Hansford, the chairman of aviation consultancy Strategic Aviation Solutions, is unconvinced there is the necessary direction and sense of purpose among the senior executive team for Virgin to be a sustainable and profitable airline group.

“They have been saying that for five years,” Hansford told Australian Aviation in an interview. “Borghetti always has got an excuse.”

“Australia’s domestic market is probably one of the best, most profitable in the world. On the golden triangle of Brisbane, Sydney, Melbourne, it’s hard not to make money.

“Qantas, competing in the same markets, managed to make a record profit at a time that Virgin continues to lose money and every year Virgin has got reorganisation or special items in its financial results.”

They have been saying that for five years.
Neil Handford

SHAREHOLDERS’ MONEY HAS PROVED CRITICAL

The years of product upgrades, acquisitions of Skywest (now Virgin Australia Regional Airlines) and Tigerair, alongside a fierce battle with rival Qantas in 2012/13 that left both carriers badly bruised, had taken a toll on Virgin’s balance sheet.

However, Virgin was able to count on its stable of key shareholders for support in its time of need.

It banked $351.5 million and $852 million from two capital raisings held in November 2013 and July 2016, respectively. There was also $248 million from welcoming HNA Group onto its share register.

And Virgin sold off 35 per cent of its Velocity frequent flyer program to Affinity Equity Partners for $336 million in October 2014.

That all adds up to some $1.7 billion or so in equity raised in a period just shy of four years. The figure is roughly equivalent to Virgin’s current market capitalisation (as of August 11).

There have also been two shareholder loans offering support.

In March 2016, Air New Zealand (which has since sold out), Etihad Airways, Singapore Airlines and Virgin Group loaned Virgin $425 million for 12 months to provide “additional flexibility in the short-term”. There was also a $90 million loan in August 2013.

It is unclear whether Borghetti and his management team would be able to call on the likes of Etihad Airways, Singapore Airlines, HNA Group, Nanshan and UK-based Virgin Group – who together account for a tick over 90

per cent of all shares on issue – for more money should there be further balance sheet worries in the period ahead.

To that end, Virgin has spent the past 12 months working hard to bring its balance sheet back to some semblance of heath.

It posted positive free cash flow of $37 million at June 30 2017, the first positive result for that metric since 2011/12. Meanwhile, it used the roughly $1 billion raised in the past year to pay down debt and improve its financial leverage.

Virgin chief financial officer Geoff Smith said the Better Business program, as well as a a pickup in earnings, would support ongoing efforts in this area during the year ahead.

“Driving earnings improvement and driving free cash performance will enable us to continue on that trajectory of improvement,” Smith told reporters during the conference call.

“That is actually delivered, or underpinned, by a better business performance. That will drive both. That’s the clear focus for us going forward.”
Smith said the company would also continue to work on restructuring the maturity profile on our debt book.

We’ve moved the near term debt, we continue to accelerate our debt repayments where possible and we will continue to do that and where we’ve taken out new debt we’ve packaged that out to a longer tenor so that’s all positive things from our perspective,” Smith said.

In October 2016, Virgin issued US$350 million worth of five-year bonds in the US that mature in October 2021 at a fixed interest rate of 7.875 per cent per annul, with interest payments due semi-annually.

The challenge to maintain that work without the shareholders dipping into their pockets was reflected in a recent analysis from S&P Global Ratings, which said Virgin’s major shareholders had a “variety of interests that may extend beyond the airline’s stand-alone profitability”.

“There are no guarantees that Virgin’s owners will continue to underwrite future operating losses,” S&P Global Ratings analyst Graeme Ferguson wrote in a research note dated June 27.

“For example, Etihad Airways recently supported airberlin but allowed Alitalia to file for special administration. Also, the operating environment for Etihad and Singapore has become more difficult, which might affect their willingness or ability to provide timely support to Virgin.
“Government stakes in Virgin’s owners might also complicate these decisions. We believe Chinese government capital controls could hinder HNA and Nanshan’s outward investment.”

Hansford believed there were “too many conflicting interests” on the board, with SIA, Etihad, HNA, Nanshan and Virgin Group all having a seat at the table.

“To me, the biggest crisis I believe that Virgin has got at the moment is the composition of its shareholding and the uncertainty of its shareholders,” Hansford said.

“You’ve got HNA under focus, Etihad seriously under focus so if they have to make a call for more shareholder funds, are the shareholders going to step up and put the money in?”

Borghetti refused to comment when asked about the company’s key shareholders, except to say they were “great shareholders”.
“I’m not going to speculate on what is or isn’t happening,” Borghetti said.

“All of them are very supportive of the company, all of them are just a great source of assistance in terms of around the board table bouncing around ideas and I couldn’t be happier with them.”

Virgin has protocols in place which it says manage potential issues relating to conflicts of interest and confidential information while ensure its board served the interests of all shareholders

I’m not going to speculate on what is or isn’t happening.
John Borghetti

For example, board members do not get details on Virgin’s alliances with other carriers, or its international operations. Further, directors receive aggregated financial data.

RESTRUCTURING CHARGES AGAIN A BIG FACTOR

The statutory loss was weighed down by “business and capital restructure and transaction costs” that totalled $141.9 million in 2016/17, Virgin’s financial accounts showed.

Taking out these one-off costs – which as Hansford noted earlier have been a significant feature of Virgin’s results in the past five financial years (see separate graphic 2) – the underlying loss before tax was for the year $3.7 million, a deterioration from the underlying profit before tax of $41 million in the prior corresponding period.

Smith said the bulk of the 2016/17 restructuring charges related to the fleet changes currently underway. Virgin expected to have all Embraer E190 regional jets out of the fleet by the end of calendar 2017, while up to eight if its 14 ATR 72-500/600 turboprops are also heading for the exits, although no timeframe was given for their withdrawal.

“We are active in our negotiations with the market and indeed lessors around the most optimal solution,” Smith said in reference to the ATRs.
The three-year transition of Tigerair from Airbus A320s to Boeing 737s over a three-year period will also be covered in future financial years, with the LCC yet to dispose of a single Airbus narrowbody since announcing the move more than 12 months ago.

Macquarie Securities analyst Sam Dobson said the underlying profit before tax result result was “in line with expectations”.

Dobson said in a research note dated August 10 the deterioration compared with the prior year was driven by the loss of share in the domestic market to Qantas.

Virgin Australia said its domestic operations suffered a 69 per cent decline in underlying earnings before interest and tax (EBIT) in 2016/17 to $92.9 million, compared with $162 million in the prior year, with subdued trading conditions and reduced demand for corporate and regional travel impacting the overall performance.

There was a slight dip in demand, with revenue per available seat kilometre (RASK) down 0.2 per cent while the airline flew 5.9 per cent fewer sectors in 2016/17 compared with a year earlier as part of efforts to better match capacity with demand. However, capacity, measured by available seat kilometre (ASK) was only 0.1 per cent lower and load factors rose one percentage point to 77.6 per cent.

IBISWorld senior industry analyst Nick Tarrant cautioned that the drop in domestic underlying EBIT was not as great as it first appeared, with the 2015/16 figure a bit of an outlier due to changes in fuel costs.

“The 2015/16 year might be overstated slightly because of the oil price shock that happened a couple of years ago,” Tarrant told Australian Aviation in an interview.

“You can see with Qantas last year posted a record underlying EBIT because of oil prices falling so sharply. I think a similar thing happened with Virgin and the margin is coming back to where it probably should be.”

While the third quarter of 2016/17 was particularly weak, Borghetti said an improvement in the three months to June 30 2017 which has continued into July and August were reasons for optimism.

“We expect the positive momentum seen in the fourth quarter to continue,” Borghetti said.

“Business travel seems to have picked up more than leisure travel and that of course always translates to better yields.”

Macquarie Securities’ Dobson said the weakness in domestic RASK was mainly on east-west and regional Western Australia routes, noting Virgin’s fares on the Sydney-Perth route were down in both economy and business.

“Corporate bookings have been the major contributor to this decline on East-West, which we expect has impacted VAH materially more than QAN,” Dobson said.

There was positive news on the international front, as Virgin’s overseas flying eked out an underlying EBIT of $500,000 for the year, up from a $48.8 million underlying EBIT loss in the prior year.

Encouragingly, RASK was up 1.4 per cent and yields rose 2.1 per cent amid network changes such as cutting Sydney-Abu Dhabi and restarting Melbourne-Los Angeles, as well as the introduction of new business class on its 777-300ER.

Load factors fell half a percentage point to 81.3 per cent, while ASKs were 5.4 per cent lower.

And Virgin is confident its new five times weekly service between Melbourne and Hong Kong in partnership with HNA Group’s Hong Kong Airlines that began in July will support further improvement in its international operations. The alliance received the final approval from Australia’s competition regulator in early August.

“We started the route and we automatically had distribution at the other end and sales capability which clearly showed in the southbound bookings so I am quite happy with the way it is going and quite optimistic,” Borghetti said.

Tigerair suffered a $24.3 million underlying EBIT loss in 2016/17, compared with $2.2 million positive underlying EBIT a year earlier. The company said the result was impacted by Indonesia’s cancellation of Tigerair’s authorisation to operate flights to Bali, with the budget carrier’s domestic operations profitable.

Despite the Bali debacle, Tigerair carried 10.7 per cent more passengers in 2016/17 compared with the prior year, while load factors were up three percentage points at 88.8 per cent.

And Virgin’s Velocity frequent flyer program generated the bulk of the company’s earnings, with underlying EBIT up 3.1 per cent at $142.8 million.

MARKET FORECASTING A RETURN TO PROFITABILITY IN 2017/18

In terms of the outlook, Virgin Australia guided the market to expecting an improved first quarter 2017/18 result. It did not provide full year earnings guidance.

However, Borghetti noted market estimates had put the airline group back in the black, without offering any opinion on that.

“Obviously I can’t go and give more guidance but what I can though say to you is that I think consensus has us at somewhere around positive $80 million on the underlying level and I will just leave that there,” Borghetti said.

“I’m pleased that we’ve been able to do the work that we’ve done in the restructuring and the balance sheet improvements in frankly a very short time. Really, it’s been 12 months’ work.

“And when you look at the seismic shift almost in terms of our cash flows and in terms of our leverage and in terms of our debt repayment, I am very comfortable with that.”

Those key strategic shareholders may soon be able to begin receiving some returns on their millions of dollars in investments. But it is unlikely anyone will be counting their money just yet.