Ailing Qantas needs a new battle strategy

Moody's downgrade of Qantas adds to the airline's woes amid an ongoing capacity war. Qantas' best defence is to convince Virgin that its tactics have no strategic value.

Moody’s announcement of its decision to downgrade Qantas’ credit rating to junk status is a pretty clear hint to the federal government of what it would need to do to revise ratings agencies’ perceptions of Qantas’ financial condition.

The downgrade (which was expected given that Moody’s rival, Standard & Poor’s, took similar action last month) was a response to Qantas’ December 5 market update, in which it foreshadowed an underlying loss of between $250 million and $300 million for the December half.

Moody’s noted that Treasurer Joe Hockey had recently commented on the need for a debate about whether Australia required a national carrier. He said the government would consider all options available to help Qantas should the public want it to continue in its role as the national carrier.

“While the issue is currently a matter of discussion  and the government has not yet detailed how it plans to proceed, a form of government support, depending on the form and structure, also potentially provides support for Qantas’ liquidity position and/or credit profile,” Moody’s said.

“Moody’s will observe any potential for positive credit impact when and if such counter-measures are announced,” it said.

There has been considerable discussion in Canberra about whether the government should take action to support Qantas, which has been engaged in a brutal and destabilising capacity war with Virgin Australia.

While much of the focus of the discussion has been on whether the restrictions on foreign ownership within the Qantas Sales Act should be lifted, that would offer little immediate support for Qantas’ credit profile. Indeed, in its current condition and with its current share price, it could make it vulnerable to asset strippers.

The federal opposition has suggested the government could take up a small equity position in the group as a demonstration of its commitment. However, Qantas’ own pleadings have been focused on the Abbott government providing a standby debt facility. Under this mechanism, Qantas would pay a fee similar to those paid by the banks for the wholesale funding guarantees extended by the Rudd government during the financial crisis.

A ‘lender-of-last-resort’ facility, accessible only in extreme circumstances, would demonstrate the government’s willingness to support the carrier. It could help Qantas regain its prized investment grade credit rating, thereby lowering its borrowing costs.

It might also send a signal to Virgin and its key strategic shareholders – Air New Zealand, Singapore Airlines and Etihad Airways – that Qantas would have the finances to withstand whatever capacity they threw at it. This might help temper the capacity war.

Qantas is also reviewing its own options for unlocking capital, which range from selling its terminals to selling equity in its frequent flyer and Jetstar operations. It needs to convince Virgin and its backers that it has the financial capacity to defend its 66 per cent domestic market share indefinitely, therefore suggesting that throwing more capacity at the market would be a pointless, profit-destroying exercise for both groups.

As discussed previously (Vulnerable Qantas flies a fine line, December 6), Qantas’s core operations have a cost base that is materially higher (estimated at between 10 per cent and 15 per cent) than Virgin’s.

That means it has to capture a disproportionate share of higher-yielding fares to be competitive and profitable, which in turn means that it has to have a frequency advantage to attract that higher share of business travel. This explains why it is so determined to maintain its 65 per cent market share by adding two seats for every one added by Virgin. Its historic dominance of business travel also creates a virtuous linkage with its frequent flyer program.

Until Virgin’s shareholders underwrote its $350 million capital raising last year, after Virgin plunged into the red in the second half and lost $100 million for the year, Qantas knew that its greater financial capacity meant it could defend its market share and draw a line-in-the-sand – and outlast Virgin.

The Virgin raising and the willingness of the three strategic shareholders to pump capital into Qantas’ rival – all of which are key Qantas international competitors with a strategic interest in getting better access to the Australian domestic market – set off the alarm bells at Qantas.

It meant Virgin could sustain loss-making capacity additions to the market for a very considerable period and inflict real financial stress on the Qantas group. If Qantas were forced to stop protecting its 65 per cent market share, its dominance and its entire business model could begin to unravel. Hence the plea for help to the federal government.

The profitability of its domestic franchise – the foreshadowed December half loss would be its first first-half loss since privatisation – has underpinned Qantas’ efforts to restructure its international business amid the emergence of low-cost carriers and the Middle Eastern hub carriers.

It has made considerable progress in reducing the losses in that international business. Domestic profits have also supported the group in its larger transformation program, which has taken billions of dollars out of its cost base and which Alan Joyce has accelerated in search of another $2 billion of cost reductions.

As Moody’s noted, the downturn in its domestic profitability caused by the Virgin onslaught (Moody’s referred to the ‘’aggressive competitive actions’’ of its key domestic competitor shifting the market dynamic against Qantas in a structural way) means the group is exposed to difficult execution challenges of two fronts simultaneously.

Qantas pointed out today that it retains strong liquidity, including cash and undrawn facilities, of about $3 billion. It had reduced its debt by $1 billion last financial year and it had no significant refinancings due until mid-2015. With reductions in previously planned capital expenditures, it believes can return to being cash-positive in 2014-15.

We’ll get a better handle on Qantas’ financial position when it formally reports for the December half in February.

But as capacity continues to grow in a relatively soft domestic market – and with Virgin maintaining its assault – there is little prospect of relief for Qantas.  Its only hope is to convince Virgin that there is no strategic gain in continuing to add capacity to the domestic market.