Bleeding Qantas dives into dire straits

The capacity war between Qantas and Virgin has the national carrier haemorrhaging at a furious pace. Without a truce or a much-needed government intervention, Qantas’ future is bleak.

Qantas’ market update today provides the context for Alan Joyce’s desperate pleas for federal government assistance. Qantas is bleeding at an unsustainable rate in the face of continuing increases in capacity in both its domestic and international markets despite soft demand.

The foreshadowed $250 million to $350 million first-half loss – its first, first-half loss since privatisation – has prompted an urgent response from a group already undergoing significant and painful restructuring. Qantas has announced another big bout of job losses (1000 over the next 12 months), pay cuts for Joyce and his board, pay freezes for executives and a likely further reduction in capital expenditures.

After a “marked deterioration” in trading conditions in November, Qantas now expects it will be in negative free cash flow this year. The “substantial” reduction in capital expenditures is aimed at returning it to a cash flow positive position in 2014-15.

Qantas sees its plight as so dire that it plans an urgent review to identify “structural changes” to unlock sources of capital, with no options excluded. That presumably means that, apart from Qantas’ declared interest in selling its terminals, a sale of some equity or a spin-out of its frequent flyer business or some of its Jetstar operations is possible. Selling minority interests in some or all of its non-core assets and operations would not just raise capital, but create market values for those assets. This might help its share price and its conversations with credit ratings agencies.

At the heart of the predicament confronting Qantas, which expects yields to be about 3.5 per cent lower in the first half (nearly back to the immediate post-financial crisis levels) and load factors to be 1.6 percentage points lower, is a continuing mismatch between demand and industry capacity.

Last year, about 8 or 9 per cent was added to the industry’s domestic capacity and a similar figure on the international routes into and out of Australia. Today Qantas said total domestic market capacity was expected to increase by about 2.7 per cent, with Virgin Australia expected to add about 3.9 per cent to its capacity.

Virgin, which lost $100 million last year, provoked the capacity war last year and doesn’t appear to have any plans to end it. The $350 million capital raising it has underway, underwritten by its three foreign airline shareholders, sparked Qantas’ calls for the federal government to act. Joyce and his board are fearful that it will be used to fund a continuation of the war.

Without that capital, Virgin would have faced significant financial constraints in continuing to push more capacity into the market. Before the raising it had to borrow $90 million from those shareholders: Air New Zealand, Singapore Airlines and Etihad Airways.

Qantas, which could be paranoid but which could equally be facing an alliance of its main competitors who are truly out to get it, sees this as a sinister attempt to undermine its stability. Competitors have been pouring capacity into Qantas’ domestic and international markets, which threatens the airline’s 65 per cent domestic market share and dominance of higher-yielding fares.

Virgin Australia’s John Borghetti would say that the strategic upmarket shift of the Virgin brand necessitates more frequency and therefore capacity, while the addition of Tiger Australia to his group will inevitably have to involve a more extensive schedule and therefore capacity.

He would be well aware that in a prolonged capacity war, no one wins – but the group with the strongest financial position will inevitably emerge in better shape.

Until the Virgin equity raising Qantas, despite losing more in dollar terms than Virgin, was in a much stronger financial position than Virgin. The $350 million of new equity, however – as Qantas immediately recognised – is a game-changer.

With both the domestic carriers losing money – in Qantas’ case, at an accelerating rate – continuing to pour more seats into the market isn’t conventionally rational commercial behaviour. But with Virgin and its allies smelling blood and a generational opportunity to crack Qantas’ dominance of the domestic market – a position that has supported its loss-making international business – it could make long-term strategic sense.

While making considerable progress in reducing the losses within its international business, Qantas has also experienced real pressure in that business because of the massive increase in capacity on the routes into this market since the crisis. A relatively healthy economy and Australian dollar earnings while the dollar was at historically high levels have made it an attractive destination for foreign airlines, although the more recent weakening in the dollar might also weaken that appeal.

The three big Virgin shareholders, however, would see their domestic carrier as a conduit into and out of the Australian domestic market and a way of shifting former Qantas volume onto their networks. They are unlikely to scale back their presence.

It is that fear that Virgin’s strategic shareholders will continue to finance its assault that caused Qantas to run to the federal government for assistance. It cited an uneven playing field because Virgin is designated as an Australian carrier, even though it is now about 73 per cent foreign-owned. This level might rise as a result of the capital raising.

Relaxing the restrictions on Qantas’ foreign ownership by amending the Qantas Sale Act would provide Qantas no near-term relief unless its key ally, Emirates, were prepared to inject capital in circumstances where there is no obvious rationale for doing so.

Qantas has raised the possibility that the government guarantee some of its debt in exchange for a fee akin to that paid by the banks for their government guarantee post-crisis. This idea has been mooted in recognition that it is the national carrier, which means it carries obligations that other carriers don’t have.

The government appears sympathetic but has yet to disclose what, if anything, it is prepared to do. One thing it could do is commission a quick review of recent developments in the industry to come to terms with what is happening. This might help inform any action it might (or might not) decide to take. If Qantas (and Virgin for that matter) continue to haemorrhage, the government might well be confronted with a far worse and far more expensive problem.

If capacity wars don’t end in a truce, they tend to result in the disappearance of the weakest player. Until recently, that would certainly have been Virgin. Today, if Air New Zealand, Singapore and Etihad are prepared to continue writing cheques that may not necessarily be the case.

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