Qantas challenge may become a bumpy ride
It is a high-stakes game. In the past six months a decision by Qantas to release 10 per cent excess capacity into the market wiped more than $100 million in profit from its domestic airline business.
Put simply, if Qantas hadn't retaliated, or only half retaliated by pumping 5 per cent extra capacity into the market in the past six months, its group profit would have looked between $50 million and $100 million better than it did.
The Qantas domestic business is a jewel in the airline's shrinking crown. To put it into perspective, in the past six months Qantas domestic profit fell to $218 million from $328 million in the previous corresponding half.
Intricately wrapped in the success of the domestic business is the group's loyalty program business, which has nine million customers and generates profits of $137 million.
It explains why Joyce is fighting tooth and nail to protect what he calls his 65 per line in the market share sand. Indeed, on Thursday he told investors that the airline was prepared to put between 5 and 7 per cent extra capacity in the domestic market - or even more if required - depending on Virgin and Tiger.
It is based on a belief that the airline industry works on the "S-Curve" phenomenon, which measures capacity share against revenue share.
The theory is there is a certain profit optimisation point where if you add more capacity you get little in the way of increased revenue, but if you lose capacity, revenue falls off a cliff.
According to a paper published by McKinsey & Company in 2006, the S-Curve is based on the premise that airlines which provide a high frequency of flights attain disproportionately high market shares. The high margin corporate market flies with carriers that offer the most flights, lounges and a loyalty program.
"With the S-Curve in mind, network managers around the world have been building dominant positions at airports and on routes, to capture the revenue premium that goes with such dominance. Additionally, managers have tried to limit the damage in those markets in which they are disadvantaged. They do this either by matching competitors' frequencies (often triggering unnecessary overcapacity), and/or by focusing on connecting traffic or by withdrawing altogether," the paper argues.
The problem with the "S-Curve" is it breaks down when there is low cost carrier competition and works best when there is a level playing field of two legacy carriers. In the 2006 McKinsey report, it argues that management needs to move on from the S-Curve model. "The S-Curve principle has been 'hard-wired' in the heads of many network planners for decades. Nevertheless, times are changing and airlines need to take stock of what does and doesn't work," the report says.
Given Joyce is a fan of the "S-Curve," he will be praying that if he pours enough excess capacity into the market it will force Virgin and Tiger to retreat. On Thursday he confirmed more capacity in the second half and said the airline would reconfigure the interior of 20 A330-200 aircraft for domestic use and buy five additional Boeing 737-800 aircraft.
It is not the first time airlines have dumped extra capacity in the market and it won't be the last. But the dynamics have changed. Qantas has a low-cost carrier and is competing against Virgin, which was a low-cost carrier but has moved up the value chain to take on Qantas, and if the ACCC gives it the green light to buy 60 per cent of Tiger Australia, it will move down the value chain to take on Jetstar.
The disadvantage for Qantas is Virgin has a relatively lower cost base than Qantas, and Tiger has a lower operating model than Jetstar.
Combine this with Virgin's decision to buy West Australian airline Skywest to take on Qantas' regional airline QantasLink and the competition is starting to look stiff.
It looks even stiffer when Singapore Airlines is thrown in the mix. Singapore Airlines recently bought a 10 per cent stake in Virgin and the expectation is that it will increasingly move its traffic to Virgin.
If seems the end game for Virgin is to turn the tables on Qantas from a situation where it had Virgin in a pincer move, to one where Virgin has Qantas in a pincer move, with Virgin hovering above Qantas, Tiger hovering above Jetstar and Skywest hovering over QantasLink with the three lowest operating cost models.
For Qantas' part, it won't give up easily. It is pinning a lot of hope on its deal with Emirates, which officially kicks off at the end of March, subject to regulatory approvals.
It is also trying to develop a strategy in Asia, with the launch of Jetstar Japan and Jetstar Hong Kong as part of a plan to beef up its footprint in an important region for Australia.
Then there is its lucrative loyalty program business, which it continues to expand, along with a dramatic program to overhaul its international business. But aviation isn't for the faint hearted.
Frequently Asked Questions about this Article…
The article says a savage domestic airfare war is being driven by Qantas and Virgin Australia competing aggressively on price and capacity. Qantas has responded by pouring excess capacity into the market to protect its roughly 65% domestic market share, prompting sharp competition from lower‑cost rivals such as Virgin and Tiger.
Qantas released about 10% excess capacity into the market in the past six months. That move wiped more than $100 million from its domestic airline profits and left domestic profit at $218 million, down from $328 million in the previous corresponding half. The article notes that if Qantas had only partially retaliated it could have been $50–$100 million better off.
The domestic business is a core profit driver for Qantas and supports its loyalty program. The article highlights Qantas’ loyalty business has nine million customers and generates $137 million in profits, so maintaining a dominant domestic position helps protect high‑value corporate and frequent flyers who drive revenue.
The S‑Curve links capacity share to revenue share: carriers offering high flight frequency, lounges and loyalty programs can capture a disproportionate revenue premium. Qantas’ CEO Alan Joyce appears to be using the S‑Curve logic to justify adding capacity to deter rivals and preserve market share, even at the cost of short‑term profits.
Virgin has moved up the value chain from a low‑cost model and bought West Australian carrier Skywest to challenge Qantas’ regional operations. Tiger operates with a lower cost model than Jetstar. The article also notes Singapore Airlines has taken a 10% stake in Virgin, potentially directing traffic to Virgin, which increases competition for Qantas.
Qantas said it is prepared to add between 5% and 7% extra domestic capacity (or more if needed). It plans to reconfigure the interiors of 20 A330‑200 aircraft for domestic use and to buy five additional Boeing 737‑800 aircraft to increase capacity.
The article warns that if the ACCC allows Virgin to buy a 60% stake in Tiger Australia, Virgin could move down the value chain to compete more directly with Jetstar. Regulatory approvals therefore have the potential to shift competitive dynamics among legacy and low‑cost carriers.
Qantas is pinning hope on its partnership with Emirates, which is due to start at the end of March subject to approvals. It is also expanding in Asia through Jetstar Japan and Jetstar Hong Kong, overhauling its international business, and continuing to expand its lucrative loyalty program.
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