Aviation's Indian Summer

Yesterday's profit upgrades from Qantas and Flight Centre highlight just how good conditions are in the aviation sector.

Qantas and Flight Centre have both announced profit upgrades, with Qantas forecasting a 40 per cent increase in full-year pre-tax earnings and Flight Centre a 25 per cent rise. Aviation is in the sweetest of spots.

Qantas has consistently underestimated the steepening curve of its profitability over the past year. Like Flight Centre, that almost led it to sell itself short to private equity. But even those who believed the failed Airline Partners Australia bid for Qantas severely under-valued the airline will have been taken aback by the strength of the surge in its fortunes.

The sector is, despite the impact of oil prices on what is today about a third of its cost base, experiencing a remarkable confluence of favourable conditions. For Qantas and Flight Centre, the strength of the economies of Australia and its region, the strong Australian dollar and, most particularly, capacity constraints created by the very significant delays in the delivery of Airbus A380s, has created remarkably favourable conditions. The success of Qantas’ twin-brand strategy and the continuing shift of capacity and volume, both domestic and increasingly international, to its lower-cost offshoot is also having an impact on Qantas’ ability to leverage the conditions into its performance.

Qantas’ October traffic and capacity statistics tell the story. For the year-to-date, Qantas Domestic’s passenger volumes were growing at about twice the rate of its capacity – 8.3 per cent to 4.2 per cent – which, not surprisingly, translates to an increase on load factors, which were up 3.1 per cent to 83.3 per cent. In October, passenger volumes were up 8.2 per cent, capacity up 2.5 per cent and load factors up 4 per cent to 85.7 per cent.

With demand surging but only limited capacity being added, Qantas is flying planes that are virtually full, which creates super-profitability for an airline. The Flight Centre upgrade suggests the buoyancy reflected in Qantas’ numbers is sector-wide.

In Qantas’ case it is increasingly able to amplify the impact of volume growth on its profitability by finessing the relationship between the Qantas-branded product and Jetstar.

Jetstar’s passenger volume growth for the year-to-October was 17.9 per cent (the rate is accelerating rapidly) but its capacity rose 68 per cent. The numbers are opaque because Jetstar is adding international capacity and routes almost on a daily basis – an apparent 3 per cent drop in load factors inevitably disguises a very strong domestic performance and the flip side of Jetstar’s apparent loss of productivity was a significant improvement in Qantas International’s load factors as it shifted volume to the lower-cost Jetstar.

That fundamental rearrangement of its domestic and international capacity and traffic will see Jetstar developed as the low-cost, high-volume, mass-market brand, with Qantas focused on smaller premium segments of its domestic and international markets. It will give Qantas a unique flexibility to finesse the economics of its overall business.

That could become important in the not-too-distant future. The A380s start arriving in this market in the middle of next year, with hundreds of additional planes on order from Airbus and Boeing over the next few years. Virgin has similarly ordered a raft of new planes. Tiger has launched, albeit with a very small fleet, but will inevitably bring in a lot more planes if it can establish a beachhead – it probably needs closer to 20 planes to have a meaningful impact.

Thus, the market will shift quite rapidly from one where there was a global tightening of supply during a period of surging demand and global economic growth to one where a lot of capacity will be added and where the sub-prime crisis will, at best, shave economic growth.

The International Air Transport Association has already downgraded its estimates of the industry’s profitability in 2008 from almost $US8 billion to $US5 billion on the back of the increase in fuel costs and the credit crunch.

The twin brand strategy, the mix of owned and leased planes, and the reality that a significant component of the existing and ageing fleet could be retired, means Qantas as a group has some flexibility to respond to a change in conditions. It helps that it is in a region where aviation is booming.

The looming surge in both global and domestic industry capacity, the ripples from the sub-prime meltdown and the increasing impact of climate change on the industry’s economics, however, means that this financial year could be the sector’s Indian Summer.

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