Domestic strength the appeal in Virgin Blue's $231m plan

IT WAS coincidental that Virgin Blue announced its deeply-discounted capital raising at the same time news reports surfaced that a nose-wheel had fallen off one of the airline's planes as it taxied out to take off at Tullamarine airport, but as metaphors go, it'll do. Virgin Blue the airline is damaged, but still flying. Virgin Blue the investment has never taken off.

Margins on high-volume domestic routes in Australia are being squeezed as competition increases. For example, Singapore Airlines-sponsored discount carrier Tiger Airways is now attacking the Sydney-Melbourne route. Airline earnings everywhere are under pressure in the global downturn.

Yesterday's announcement that Virgin Blue was seeking to raise about $231 million through a $21 million institutional placement and a $210 million across-the-board renounceable retail entitlement offer pitched at 20?, a 31 per cent discount to Virgin Blue's share price, confirmed that the group is far from immune, as does its decision to free up another $215 million through sale and leaseback deals.

Still, the group says it will be back on profits overall in the year to June 2010 after losing between $160 million and $165 million in the year to June 30 just completed. By international standards, that's outperformance.

The International Air Transport Association last month scrapped a March estimate that the industry would lose $US4.7 billion world-wide this year and replaced it with a $US9 billion loss forecast, on top of losses of $US10 billion in 2008.

Virgin's rival, Qantas, is pound-for-pound one of the most profitable airlines on the planet, and its pre-tax earnings in the year to June just past will plunge from $1408 million to between $100 million and $200 million.

With the benefit of 20-20 hindsight, Virgin Blue would have set less ambitious international expansion plans ahead of the market crisis and the economic downturn it spawned. But it has taken steps now to cut costs at its international start-up VAustralia by announcing a Pacific route joint-venture with Delta, and it is still profitable in its core business, the domestic franchise it created at the end of 2001 when it moved in to fill the vacuum left by the collapse of Ansett Airlines.

Preliminary June 30 figures released yesterday have the group producing a positive operating cash flow of $76 million in the year to June, with all and more of it accounted for by the domestic short-haul division, which is set to generate operating cash flow of $147 million.

The short haul business is expected to earn between $25 million and $30 million after tax in the 2008-09 year, down from $95 million in 2007-08, but still in the black at least.

The flip from last year's bottom line profit of $98 million to a loss of between $160 million and $165 million comes after financing and hedging costs and start-up costs and trading losses of between $90 million and $100 million at VAustralia. The stress of its launch is also evident in Virgin Blue's unaudited cash-flow chart, which shows a net outflow of $128 million, cutting cash on hand from $603 million to $475 million.

The share offer looks good enough to maintain Virgin Blue's current operational flight path, however, and it has been weighted to keep the group's founding shareholder, Virgin, happy and engaged.

There were questions about Virgin's willingness to fully subscribe to a larger raising, but Sir Richard Branson's group is paying more than its share of the amount Virgin Blue has finally gone for.

Virgin will take up all of its 25.5 per cent entitlements in the one-for-one share issue, subscribe for 35 per cent of the smaller institutional placement to boost its stake to 25.9 per cent and will sub-underwrite 20 per cent of the entitlements offer. Its final stake in the Australian airline will rise to as much as 30.2 per cent, depending on how many shares are not taken up by shareholders.

How many other shareholders will cough up? The answer to that depends on whether the 20?-a-share offer price is enticing enough to overcome the heavy turbulence Virgin Blue investors have experienced since the airline took off on the ASX at a float price of $2.25 a share in December 2003.

Virgin Blue's shares have been above their initial offer price for only about two weeks, between February 19 and March 5 in 2007, and their all-time high of $2.37 on February 21 of that year was only 5 per cent above what investors paid to get in.

Their average price since the float is $1.36, a level they breached in January last year during a steep descent from just under $2 to less than 50? a share.

I have mentioned before that in my opinion airlines are adults-only investments. They are capital-intensive, exposed to currency risks, subject to the unpredictable price of fuel, open to price competition (as Tiger has shown yet again), are at the leading edge of wars and pandemics and, of course, are crucially dependent on their safety record.

It isn't surprising then that their shares tend to be volatile, and they are therefore loved by sophisticated short-term traders.

As a long-term investment, they have been less successful over the decades, however, and in that respect, the experience of Virgin's shareholders is not unusual: losses including sharemarket losses are the norm in the airline industry, which in aggregate has not made money since its invention.

The flip side this time is that at 20? a share, this offer price discounts an awful lot of pain, and Tiger, the global downturn and swine flu notwithstanding, Virgin Blue is still sitting on a profitable local franchise. The domestic airline operation underpins the prediction that the airline will be back in the black in 2009-2010.

Some of Virgin Blue's shareholders will see the offer price as a way to build exposure to the recovery predicted by outgoing chief executive Brett Godfrey.