Borghetti's bold boardroom trade-off

It has been evident ever since Virgin Australia Holdings’ share register became dominated by three strategic players that they represented a source of contingent capital if John Borghetti needed it. Today he called in that capital.

From the moment that Borghetti became chief executive of Virgin and embarked on his radical re-making of the airline and its strategies to try to break Qantas’ dominance of the domestic market, it was obvious that he had two vulnerabilities.

One was an over-reliance on leisure routes – and the Queensland market in particular – which he has progressively addressed as he has shifted Virgin’s positioning up-market. The other was a stretched balance sheet.

Against a formidable competitor like Qantas – with its twin-brand offering, its dominance of high-yielding business travel, a diverse portfolio and a robust and liquid balance sheet – the Borghetti strategy was ambitious and potentially hazardous, particularly as Qantas made it very clear that it would fight any increase in Virgin’s capacity with even more of its own.

The Virgin strategy has been making progress, but at a cost. Last year the group, after igniting a capacity war in a weak market, posted a $150 million pre-tax loss. In conventional circumstances, given his balance sheet, that could have been disastrous.

On the Virgin register, however, Air New Zealand (22.9 per cent), Etihad Airways (19.9 per cent) and Singapore Airlines (19.8 per cent) have built up big strategic shareholdings. In August, with Virgin under some pressure, they provided $90 million of funding in a clear demonstration of their support for Borghetti’s strategy and his assault on a key competitor for all three of the international airlines.

Today’s announcement of a $350 million equity raising, sub-underwritten by those three key shareholders, underscores the extent of their commitment and their view of the strategic significance of their Virgin positions. The other major shareholder, Richard Branson, isn’t sub-underwriting the issue but will take up his entitlement to maintain his 10 per cent shareholding.

With the five-for-14, non-renounceable issue pitched at 38 cents a share – marginally below Virgin’s share price of 40.5 cents yesterday – it is probable there will be a significant shortfall, tightening the strategic shareholders’ hold on the group.

Between them today, the three airlines control 62.6 per cent of Virgin and have been taking every opportunity to edge their interests higher. They could conceivably increase their combined interests to as much as 69.8 per cent (79.8 per cent including Branson) if other shareholders forego their entitlements.

The issue will shore up the Virgin balance sheet and allow Borghetti to maintain what is now, with the addition of Tiger and Skywest, a three-pronged attack on Qantas and its 65 per cent domestic market share ‘line-in-the-sand’ in a market that remains difficult.

Yields are under continuing pressure, fuel costs remain high and the market is struggling to absorb the over-capacity generated by Virgin’s aggression and Qantas’ response last financial year.

The capital raising, however, also changes some of the dynamics within Virgin itself.

The three airline shareholders have similar reasons for being on the Virgin register. They want an exposure to the big Australian domestic market and they want to protect their own regional interests against a key competitor. The tit-for-tat share purchases indicate, however, that while they might have some strategic interests in common, they aren’t working together and, indeed, are suspicious of each other.

There are some particular tensions between Etihad – Borghetti’s initial international ally – and Singapore, his most recent. The two airlines and their hubs are direct competitors: Singapore is worried about the dramatic growth of the Dubai and Abu Dhabi hubs on the routes it flies. Both, however, would see common cause in trying to weaken Qantas, particularly after it struck its partnership with their arch rival, Emirates. Air New Zealand, which has some shared history with Singapore Airlines, has a more localised interest in getting an exposure to the Australian market.

Borghetti has previously kept his key shareholders and regional aviation politics out of his boardroom, with only Branson among the large shareholders having representation. However Virgin’s chairman, Neil Chatfield, said today the Virgin board intended to work with the sub-underwriting shareholders to agree to future board representation “with appropriate protocols”.

There have been mutterings for some time about how the manoeuvrings on the Virgin register might ultimately play out, and the likelihood that the free float in the market for Virgin shares will end up at less than 20 per cent (Air New Zealand has approval to lift its interest to 25.9 per cent) will intensify the pressure on the current structure.

The obvious option would be for the strategic shareholders to take the group private – probably buying out Branson in the process – but the element of conflict in their strategies and aspirations complicates that option.

Etihad’s James Hogan would be concerned that he might be frozen out if Singapore and Air New Zealand, whose interests aren’t in direct competition, formed an alliance. The Branson stake could be pivotal to the future ownership structure of Virgin and Etihad’s role in its affairs.

In the meantime, assuming the three carriers are given board representation, the tensions between them will be imported into Virgin’s boardroom. Borghetti has shown, by maintaining relatively good relationships with all three, that he has some diplomatic skills. Those, and Chatfield's, may be tested.

The proceeds of the capital raising will be used to repay the $90 million of shareholder funding, pay down debt and restore liquidity levels that were significantly diminished by last year’s losses, providing a balance sheet buffer against continuing difficult conditions. Virgin remains unable to provide profit guidance for the current financial year.

Fiscal 2014 is supposed to be the start of the real growth phase – or “Game On”, as Borghetti refers to it – in Virgin’s five-year plan, with the three-year restructuring of the group to enable it pursue his strategic vision essentially completed.

Qantas will be watching very closely to see how Borghetti intends to deploy his about-to-be-gained improvement in financial stability and liquidity, as well as monitoring the politics of his register. The one certainty is that, regardless of any movements in their relative financial positions, if he dials up Virgin’s competitive intensity it will provoke an aggressive response.