Qantas is no easy target

When Alan Joyce decided to reform a defence team he would have asked himself whether a bid for Qantas while its share price is languishing at historically low levels was probable. The answer was almost certainly no, but it is possible, hence the precautionary measures.

With John Singleton fanning takeover talk from the sidelines, and Qantas knowing that a group, which includes former chief executive Geoff Dixon and former chief financial officer Peter Gregg, had at least pondered the possibility of acquiring a strategic shareholding last year, it makes sense for Qantas to at least be prepared. It has brought Macquarie, which spearheaded the pre-crisis private equity tilt at Qantas that so narrowly failed, and Citi on board just in case.

Despite the dive in its share price, momentarily below $1 a share, following the disclosure last week that Qantas International is set to lose about $450 million this year, almost wiping out the group's profitability in the process, Qantas is no easy target.

The Qantas Sales Act is a major obstacle to another private equity assault and while the Airline Partners Australia bid in 2006 demonstrated that it is possible to bring together a consortium with majority Australian equity that was for a highly leveraged bid in a very different environment for raising both debt and equity and, indeed, for operating an airline. Covenant-light loans and payment-in-kind notes aren't as much in vogue today as they were then.

Qantas, despite its share price, is a big target. It has a market capitalisation of about $2.6 billion and an enterprise value of more than $6 billion. It does have $3 billion of cash but, as the APA bid structure showed, airlines need to retain a pile of cash to support the financing requirements for their fleets. APA planned to leave a minimum of $2 billion of cash within the Qantas balance sheet.

The other deterrent to a bid is that the problems being experienced by Qantas International, while there is an element of cyclicality to them – soaring jet fuel prices and the recessed global economic environment – look like being prolonged cycles.

Of even greater consequence are the structural elements – persistent industry over-capacity, particularly on Qantas' core routes, the emergence of new Middle Eastern and Asian carriers with more efficient and far newer and high-quality product, the virtual international network John Borghetti has created for Virgin Australia, the growth of the low-cost-carrier model and the legacy cost structures Qantas is burdened with within skies that have been progressively deregulated.

No Australian government would readily sanction a bid for Qantas that involved its break-up to extract the value in the Qantas domestic business, the Jetstar franchises and Qantas Frequent Flyer that didn't involve the maintenance of the full-service national flag carrier.

The prospect of having to do what the New Zealand Government was forced to do for Air New Zealand and re-nationalise and recapitalise an airline losing hundreds of millions of dollars a year would be unpalatable in Canberra, regardless of the party in power.

Qantas, despite some of the criticisms of its management, isn't unique. Almost all the legacy carriers have experienced and are experiencing similar plights. Indeed, Qantas is universally regarded as one the best and best managed aviation groups in the world. The industry as a whole, including the new carriers and low-cost-carriers, will be fortunate if it breaks even this year.

Qantas' domestic strength, the success of its Jetstar brand and the profitability of its frequent flyer business is enabling it to support the international operations while it attempts to restructure them, which inevitably involves sizeable cost-reduction programs and a re-drawing of Qantas' international footprint.

Joyce remains confident that Qantas International can be returned to profitability by 2014 and be in a position, when combined with Qantas Domestic, to return their cost of capital by 2016.

Qantas International doesn't actually have to be profitable to be viable. It plays a significant role in providing feeds of traffic into the Qantas Domestic network, is a key component of Qantas' dominance of premium travel and business travel in particular and is important to its frequent flyer program. The group can't sustain losses from that business approaching $500 million a year but if it can get closer to break-even it would still be able to justify a place within the portfolio.

There isn't a lot government can do to help Qantas in its attempt to manage the international business towards a more stable position. It is improbable that the federal government will suddenly undo the open skies policy that has brought the continuing influx of capacity from foreign carriers into this market that has decimated Qantas' market share.

Given the relations between Joyce and the government, it is also unlikely the government will lift the ceiling on foreign ownership of Qantas, or allow it to emulate Virgin Australia and quarantine its international business within a separate structure.

Qantas argues that the foreign ownership limit of 49 per cent increases its cost of capital. It also precludes a strategic investment by a foreign carrier that would enable Qantas to create a fully fledged alliance with a hub carrier, although the structure British Airways used for its merger with Spain's Iberia suggests there are creative ways to deal with the issues generated by national flag carrier status.

After the APA bid failed, Qantas looked at whether it should emulate the private equity game-plan and spin-out the frequent flyer business and perhaps Jetstar and sell off its non-strategic express freight and travel agency interests and decided against it. The core aviation and frequent flyer businesses do create substantial synergies.

Joyce has made it clear that he is prepared to sell non-core assets to generate extra cash, and continue to defer the much-needed deliveries of new aircraft for the same reason.

In an ideal world Qantas would be accelerating the replacement of its fleet to lower its fuel costs and provide a more attractive and competitive product. But with a capital raising unpalatable at the current share price, that's not a realistic or financeable strategy and, with about $5 billion of capital already tied up in the loss-making international business, not one that could be easily justified to shareholders.

The possibility that it could again be in the sights of a raider won't alter the course that Joyce is already pursuing with some urgency because Qantas is already doing just about everything it can think of to reduce the haemorrhaging from the international division.