Domestic aviation is grounded by the capacity war

Virgin Australia's losses highlight how an intensifying capacity war has decimated Australia's once-profitable domestic aviation duopoly, with neither airline likely to change their tack.

Virgin Australia’s $118 million first half pre-tax loss closes the worst calendar for the domestic aviation industry’s profitability in more than two decades. There is no guarantee that 2014 won’t be worse.

With Virgin’s John Borghetti being cagey about his plans for capacity growth this year, there is no signal as to whether the destructive trend of capacity growth out-stripping demand growth -- the factor that decimated domestic profits in the December half -- will be reversed in the near term. Qantas said yesterday it expected its domestic capacity to rise by three or four per cent.

There is a lot of finger pointing and conflicting data being presented as to who’s to blame for the capacity increases. Borghetti points to Qantas’ capacity growth last financial year to argue that Qantas has added three times his capacity, while Qantas uses data over two years to show that Virgin has added more capacity, in absolute terms, over that period. However, the bottom line is that between them, they have turned a profitable duopoly into a loss-making sector.

Virgin itself incurred a pre-tax loss of $49.7 million in the half, with its 60 per cent-owned Tiger Australia contributing a further $18.4 million of losses and restructuring costs adding another $49.9m. The Virgin-branded domestic business had earnings before interest and tax of $25.7m, but its international business lost $29.5m at that EBIT level.

The other interesting aspect of a result was that as Virgin has pushed up-market to try to wrest a bigger share of the high-yield segments of the domestic market its costs have crept up too, with unit cost growth of 4.5 per cent.

Virgin’s significant cost advantage over Qantas-branded domestic product remains substantial. However, it is narrowing as it continues to shift up-market to attack the core of Qantas’ profitability and market share and Qantas continues to hack away at its legacy costs and shift volumes across to the lower-cost Jetstar.

Not surprisingly, given the intensity of Qantas’ attacks on Virgin’s tactics in the domestic market and its backing by three of Qantas’ major international competitors, Borghetti returned fire today. He urged the government not to provide Qantas with the guaranteed line of credit it has been seeking.

Tony Abbott appeared to have ruled out that option on Thursday, focusing on the removal of the Qantas Sale Act to get rid of the “ball and chain” that Qantas carries instead. He argued that if it provided a line of credit for Qantas, it would have to do so for the other players in the industry.

Given that Abbott has acknowledged the playing field is not level because of the restrictions imposed by the Act, there is no realistic prospect of it being amended. Labor, the Greens and even Clive Palmer have said they will oppose any amendments, which leaves the playing field tilted against it.

Qantas is, of course, the only company in the sector subject to its own Act of Parliament. The government’s previous inclination towards extending the line of credit only until the Act was amended reflected the view of senior members like Joe Hockey and Warren Truss. They believed that Qantas was in a unique position because of the government’s restrictions on its flexibility to manage its capital and operations.

Whatever the merits of the arguments for and against any form of assistance other than the unlikely removal of the Qantas-specific legislation, the Qantas and Virgin results underscore how damaging the capacity being thrown at the Australian market has been, both domestically and internationally.

It is conceivable that the hostilities and losses could continue. Qantas has vowed to do whatever it takes to maintain its market share (which it has allowed to slip to 63.4 per cent, below its ‘line-in-the-sand’ of a 65 per cent market share), while Borghetti has declined to signal his capacity plans.

The $350m capital raising Virgin made last year with the support of Air New Zealand, Singapore Airlines and Etihad Airways has given it a war chest. It has $896 million of cash, $665m of it unrestricted.

One of the interesting points Borghetti made today was that where Virgin’s capacity increases over the past year have been mainly on new routes. Qantas’ have been on existing routes.

Qantas responded, for instance, to Virgin’s increased and upgraded presence on the routes between the east coast and Perth by adding a lot of Jetstar capacity on the Melbourne-Sydney-Brisbane triangle.

The Qantas strategy was presumably to ramp up the pressure on Virgin where it thought it would hurt most and force it to back off its capacity increases and network expansion due to financial stresses.

If that were the strategy, the capital raising dramatically changed Virgin’s position. It meant it could sustain losses for a long period and, with continuing support from its strategic shareholders, potentially indefinitely. It probably explains why it triggered an immediate call from Qantas for Canberra to intervene and its subsequent pleas for direct assistance.

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