Is the market tiring of Virgin's kamikaze strategy?
The Virgin Australia share price developed a severe case of the wobbles today. That could be due to the increased focus the group is getting as its first-half results draw closer.
At one point today the group’s share price had fallen more than 15 per cent to a two-year low before it recovered a little more than half that ground to trade around the 31 cents a share level.
There is no obvious explanation as to why the stock should have been so volatile and have fallen by far more than the broader market and its arch-rival Qantas, other than a series of recent analysts’ reports suggesting its first-half result – and indeed its full-year result – might be worse than anticipated.
There had been some analysts hopeful, until recently, of either a small first-half profit or, at worst, a modest loss when Virgin reports at the end of the month. Virgin itself has provided no guidance but there has been a flurry of analyst downgrades in recent days, which now point to losses of more than $50 million for the first half and at least double that for the full year.
Bank of America Merrill Lynch, for instance, issued a report this week forecasting a first-half pre-tax loss of $49 million and a full-year loss of $120 million. There are other estimates of an interim loss of as much as $80 million and a full-year loss of up to $150 million.
Qantas, of course, has warned the market that it expects losses of between $250 million and $300 million in the first half, guidance that saw it losing its prized investment grade credit rating. It is conducting a ‘’no options ruled out’’ strategic review to try to generate enough cash and capital to buy time as it accelerates an already substantial and long-running cost-cutting program.
The market had been more optimistic about Virgin’s outlook than that of Qantas, perhaps because Virgin has been reporting improving yields while Qantas’ have been declining. Yields, of course, are only one input into the equations driving airline profitability. And there are costs associated with Virgin’s dramatic transformation under John Borghetti, the big increases in capacity it injected into the market last year and its attack on Qantas’ dominance of premium fares.
If the analysts are correct and Virgin does report a first-half loss of around $50 million it would mean that Australia’s domestic airline duopoly would, between them, have lost $300 million to $350 million in the space of six months.
Last year, Virgin lost $100 million and Qantas, which had made a profit of $111 million in the first half ($223 million on its preferred underlying and pre-tax basis) lost just over $100 million in the final half ($31 million on its preferred basis).
The torrents of red ink that began pouring through the airlines in the June half and which now appear to have swollen further in the December half pose an obvious question: Is this a sensible way to manage a duopoly?
Until the past few days there appears to have been an assumption by many in the market that Qantas’ losses reflect Virgin’s gains – that the industry is something of a zero sum game. If the revised expectations are borne out, however, the competition between the two would appear more akin to a suicide pact. (Or should that be murder/suicide?)
Virgin raised $350 million of new capital after its losses last year, mainly from its three big strategic shareholders – Singapore Airlines, Air New Zealand and Etihad Airways – so it has the financial capacity to sustain more losses.
Qantas, because of its far greater size and 65 per cent market share – and its significant cost disadvantage as a legacy airline -- is losing far more than Virgin in dollar terms and also has its loss-making international business to support. It does have about $2.8 billion of cash and has the option of selling and leasing back terminals, spinning-out its frequent flyer program and selling interests in its Jetstar businesses if it is forced to.
Ultimately, however, while Qantas is committed to and has the capacity to continue to defend its 65 per cent market share ‘’line in the sand’’ and Virgin continues to try to challenge that defence, both are probably going to continue to bleed heavily.
The outcome of the Qantas strategic review, to be released with its interim results later this month, could be pivotal if Virgin and its airline sponsors are convinced that Qantas can sustain heavy losses, if not indefinitely, then for another couple of years.
Continuing to rack up big losses of their own for no strategic gain – other than, perhaps, weakening a key regional competitor – would not be appealing.
Air New Zealand (having lived, barely and only with the help of the New Zealand taxpayer) through the Ansett collapse, Etihad (which has a very commercial mindset) and Singapore Airlines (long regarded as one of the better-managed airlines) won’t want to have to inject another big lump of capital into Virgin to try to protect their already sizeable exposures. Those shareholders will soon have board representation.
At some point, if both Qantas and Virgin are convinced that both their medium term futures, perhaps even their long term futures, are awash with red ink if nothing changes, one would expect more rational competition – and some profits -- to emerge.
If both groups deliver on the market’s current dismal expectations for this year, the pressure for change to the competitive settings will rise considerably.
With Virgin unlikely to voluntarily abandon its strategy of pushing up-market into Qantas’ stronghold while using Tiger Australia to attack Jetstar, and no prospect of Qantas voluntarily walking away from its commitment to a 65 per cent market share, however, there is no obvious way for rational commercial behaviour to emerge unless the scale and duration of the losses forces one or both to choose between a radical shift in strategy and ambition -- or potential oblivion.