Calmer conditions help Alan Joyce beat Murphy’s Law

Qantas is on a much smoother flight path now, but only some of that comes down to the airline's CEO. Most it reflects reduced competition, oil and the dollar’s dip.

It is now apparent that the Qantas market update yesterday not only confounded Alan Joyce’s critics but completely blindsided the market. With the group’s share price surging 20 per cent since that announcement, the critical question is whether it can actually deliver on the soaring expectations.

The short answer is, maybe.

It is obvious that Joyce and his board are confident that, with only about three weeks to go before the end of the first half, they have left sufficient margin for error to be sure that Qantas will deliver a first-half underlying pre-tax profit of between $300 million and $350m, a remarkable turnaround from last year’s $252m loss.

Only a year ago, as Joyce’s army of befuddled critics were quick to point out, however, Qantas was begging for help in Canberra, seeking some form of government guarantee of a line of credit to protect the investment grade credit rating it subsequently lost.

That its fortunes and share price have now rebounded quite dramatically doesn’t, as some would suggest, point to cynical behaviour by the group last year. All it does is underscore how volatile and unpredictable the aviation industry is, and how much the sustainability of the rediscovered profitability is dependent on factors beyond Joyce’s control.

This time a year ago, when Qantas was petitioning Canberra for help, it was embroiled in a vicious capacity war with Virgin. Its international routes were also being battered by increasing competitor capacity, oil prices were above $US105 a barrel, and the Australian dollar was around US92c.

Each of those adverse influences has waned as 2014 has progressed. Virgin began winding back its capacity growth in the first half of the year, enabling Qantas to follow suit.

Not surprisingly, in the second half of the year (the first half of the 2015 financial year) the rate of growth in demand has outstripped the rate of capacity growth, leading to improved load factors and yields.

Happily for Qantas, the growth rate of international capacity on its routes, which had been running at double-digit rates early in the year, has tailed off to negligible levels as the year has progressed.

That, too, has had a positive impact on load factors and yields and has played a major role in the surprise return to profitability of the international business, which had been losing around $500 million a year.

Thus, one of the major influences on Qantas’ return to profitability has been the behaviour of its competitors.

With Virgin, having built out the domestic network to John Borghetti’s goals, now apparently focusing on profitability over growth -- and having to absorb 100 per cent of its Tiger brand’s losses -- continued discipline can be expected in the domestic market, which represents the core of Qantas’ profitability.

The declining capacity growth rate on international routes is probably attributable to the lower Australian dollar, which has fallen around 20 per cent in the past year. This was a much more attractive destination for foreign carriers when the dollar was above parity, the Australian economy was buoyant (relative to the rest of the developed world) and outbound volumes were strong.

The other external factor in the Qantas revival is the collapse in the oil price, which is now down to about $US66 a barrel. With a fuel bill of around $2 billion a year, jet fuel prices are a critical input to Qantas’ financial performance.

In the first half of this financial year the benefit of lower fuel costs to Qantas was only $30m. In the second half, however, its hedging strategies allow for much larger participation in the lower prices and the gains from the lower prices could amount to several hundred million dollars.

Qantas can have some influence over levels of capacity in the domestic market, but little over what its international rivals do. The dollar and oil prices are obviously beyond its influence or control, although it has always been a sophisticated hedger of fuel and currency.

Completely within its control, however, are its core costs, where the transformation program Joyce initiated has already stripped out $350m of costs and is on track to deliver at least $600 million of full-year benefits. That alone would offset almost all of last financial year’s operational losses.

The decision to write $2.6bn off the value of its fleet last financial year will also reduce its depreciation charges by about $200m to $250m this year, and the abolition of the carbon tax is probably worth another $100m or so.

If those things Qantas can’t control retain their current settings, and it continues to deliver on its transformation program, it isn’t difficult to see the group generating an underlying profit before tax of roughly the same magnitude as the $646 million underlying loss it incurred last financial year, which would be an astonishing $1.2bn-plus turnaround in the space of a year.

Those are, however, big “ifs”, and the group’s experience over the past 12 months illustrates how quickly and dramatically the industry settings can change. Relatively small movements in load factors and yields, or currencies and fuel prices, can have highly leveraged effects on the group’s performance.

A 1 per cent movement in domestic yields, for instance, could add or wipe nearly $80 million from its earnings; a $US1 a barrel movement in the oil price could shift earnings by around $40 million.

Last financial year just about everything that could go wrong for Qantas did go wrong. In the aviation industry, Murphy’s Law seems to be the norm. So far this financial year, most things are heading in the right direction. Joyce and his board will be hoping, even praying, that the novel conditions persist.