Is Borghetti flying a white flag for Qantas?

There's no reason for Virgin or Qantas to throw away profits without a larger strategic purpose. Now happy with Virgin's footprint, John Borghetti may be ready to dial back the pair's fierce capacity war.

John Borghetti didn’t signal to Alan Joyce that it was time for a truce in the domestic airline capacity wars in his KGB interview (to be published on Monday), but his comments could be interpreted in that way.

Borghetti was asked how capacity wars end and how the particular war that was ignited by Virgin Australia’s push up-market into Qantas’ traditional full-fare stronghold – which has seen Qantas, but more particularly its Jetstar brand, throw a lot of capacity at the Brisbane, Sydney, Melbourne routes – might end.

"One of two ways," he said.

"Either the market catches up with the capacity or people slow down with their capacity growth, and from our perspective we’ve reached where we wanted to be. It wasn’t about market share. It was about having the footprint. We’ve done that now and we’re quite happy.

"Now, what other people do is up to them but, as far as we’re concerned, we’re happy where we are and we’ve said this is where we wanted to be and we’ll seen where the future goes," he said.

In the December half Virgin’s domestic earnings slumped about 43 per cent from $87 million (earnings before interest and tax) to $49.3 million while Qantas domestic profits were down from $328 million to $218 million (and Jetstar’s from $147 million to $128 million) as both groups stacked on capacity well ahead of the growth in the market.

Joyce has made it very clear that he will do whatever it takes to defend his "line in the sand" – a 65 per cent share of the domestic market.

By saying that Virgin will, with the introduction of an A330 service from Brisbane to Perth next month, have completed the reconfiguration of its domestic network, Borghetti is effectively saying to Joyce that his game plan has shifted from a strategic one to a more tactical and longer term battle, not for market share but higher-yield passengers. And therefore there’s no need to keep pouring capacity onto the east coast triangle routes.

Borghetti didn’t canvass the third option for ending a capacity war, one very familiar to this market (and with which, as a Qantas veteran of previous capacity wars, Borghetti has a lot of experience) which is the disappearance of the weakest player. It isn’t, however, in Qantas’ interest for that to happen. It would invite intense regulation, calls for a break-up and inevitably new entrants.

If Virgin gains Australian Competition and Consumer Commission approval for its proposed acquisition of 60 per cent of Tiger Australia and ramps up its capacity as aggressively as Borghetti has indicated it may do, then of course the war would erupt again, but on a different front as Jetstar would be forced to protect its position at the discount end of the market.

Borghetti admitted to being surprised by the timing and nature of Qantas’ response to Virgin's shift from a low-cost carrier positioning into Qantas’ premium territory, most notably on its services to Perth. He expected Qantas to respond much earlier and to protect its position on the Perth routes by shadowing Virgin with increased capacity.

Joyce, of course, was otherwise occupied when Borghetti made his move, caught up in a protracted, bitter and very costly battle with some of his unions that ended so controversially, and decisively, when he grounded his entire fleet. That explains why he didn’t respond to Borghetti earlier, even though Virgin was, before its recent placement to Singapore Airlines, far more vulnerable than it is today.

The Qantas decision not to confine the battle to the Perth route as Virgin’s team had expected was, perhaps, designed to send Borghetti a message about the seriousness of Joyce’s intent to defend his line in the sand.

He attacked, not a route, but Virgin’s core profitability by using Jetstar primarily to overload the Brisbane, Sydney and Melbourne routes with seats, forcing prices down and stripping profitability from Virgin.
The fact that in dollar terms it probably hurt the Qantas group more than Virgin is irrelevant. Qantas has a much bigger and stronger balance sheet than its rival and has more diversified revenue streams.

Its apparent over-reaction to Virgin’s initiatives was presumably designed to deter Borghetti from getting too ambitious in his efforts to shift higher-yield passengers on the core eastern seaboard routes. It has given Borghetti a taste of what might be unleashed if he pushes too hard.

Qantas will almost certainly back off from a continuation of a fully-fledged capacity war if it believes it has Virgin contained and its 65 per cent market share protected, with the battle ground then shifting to smaller and more tactical tussles to retain or win full-fare passengers.

There’s no good reason for either carrier to throw away profits without a larger strategic purpose and because Virgin has a much smaller market share, and a lower cost base than Qantas, Joyce will continue to give up bigger profits than Borghetti if he keeps adding capacity ahead of the market – although he might want to do what he can to weaken Virgin further.

The other interesting insight from Borghetti was the growing significance and value of the series of alliances Virgin has struck with international carriers, with interline and codeshare revenue growth of 56 per cent in the December half.

According to Borghetti, that’s just an early taste of what’s to come, with the impact of the new Sabre reservations system that came online in January only just starting to show up in a surge in bookings that has surprised even Borghetti. He expects Virgin to meet its target of $40 million in codeshare and interline revenue this year, lift it to about $100 million next year and have a run rate of about $150 million a year in 2014-15.

Borghetti’s ‘virtual’ carrier strategy for an international business that supports and leverages off his domestic operations is becoming very promising. That also points to the potential of Qantas’ alliance with Emirates and Joyce’s creation of his own virtual network on routes into and out of Europe.