Qantas rides the atmospheric pressure

The sharp break in the value of the Australian dollar in April, while perhaps not as significant as many businesses had hoped for, has eased some of the pressures on trade-exposed industries and helped blunt the impact of lower commodity prices on miners. It isn’t, however, doing Qantas any favours.

In Alan Joyce’s KGB Interview the Qantas chief executive made the point that, while there might be some longer-term benefits for his group from a somewhat lower dollar, in the near term it was inflating already inflated fuel costs. Last year, he said, Qantas paid $600 million more for its fuel than it did before the financial crisis and in the first half of this year alone it faces a further $160 million increase.

The problem for Qantas is that an historically close correlation between the value of the dollar and jet fuel prices has broken down. The dollar has fallen close to 15 per cent against the US dollar since April but jet fuel prices have climbed from about $US110 a barrel to more than $US120 a barrel. In Australian dollar terms they have moved from about $110 a barrel to more than $135 a barrel.

Joyce said it was the first time since the first Gulf War that the correlation has broken down, pointing to the anarchy in Syria as the main cause.

Qantas, as the numbers above indicate, is highly sensitive to both oil prices and currency relativities – Goldman Sachs analysts have estimated (based on their own assumptions about currency values and oil prices) that a $US1 a barrel rise in the oil price strips $12 million of earnings from the group while a one cent movement in the Australian dollar/US dollar relationship has a $16 million impact on earnings. Clearly, if both move significantly against Qantas, it gets hammered.

In the longer term, a lower dollar clearly benefits Qantas and probably by more than the higher fuel costs generated by the current relativities of currency and oil prices.

As Joyce said, during that period post-crisis when the Australian economy was strong and attractive relative to the US and Europe and the dollar was at historic highs, there was a big shift of international capacity into this market, which has had a significant impact on yields. With the Australian dollar at those highs, Qantas’ Australian dollar cost base left it at a significant competitive disadvantage.

The fall in the dollar, the modest recovery underway in the US economy and, for the moment at least, a more stable Europe is shifting the economic framework for the industry.

Joyce said Qantas has calculated that the fall in the dollar against their local currencies has taken about $700 million of revenue off its international competitors, compressing what had been from their perspective very attractive yields and reducing the incentive for all the carriers to continue to increase capacity.

United Airlines has already reduced capacity on Qantas’ most important and profitable international route, the trans-Pacific, effectively taking about 6 per cent out of the overall capacity on that route.

The lower dollar increases the value to Qantas of the international revenues it generates while also making it less attractive for Australians to travel overseas, which should help Qantas’ dominant domestic business.

The Goldman Sachs analysis suggests a 1 per cent increase in Qantas’ international yield could be worth about $73 million of extra pre-tax earnings relative to its base assumptions for this financial year.

If the strife in the Middle East were to moderate, Joyce’s five-year plan to get his international business to break-even in 2015 (it reduced its losses from $450 million to $260 million last year) would be given a significant boost, although Joyce appears increasingly confident that the business will get there even with the headwinds it currently faces.

Having culled the loss-making international routes in the Qantas portfolio, carved into its cost base with a 5 per cent reduction in unit costs and with the benefits of the alliance/joint venture with Emirates on routes into Europe yet to come, the outlook for its international business is more positive than it has been for years.

Now all he needs is for jet fuel prices to fall back and, provided Virgin Australia doesn’t ignite another domestic capacity and price war, Qantas will be in a stronger position strategically, operationally and financially than it has been for years.

The other interesting comments Joyce made were in relation to the Jetstar joint ventures in Asia – Japan, Singapore, Vietnam and, potentially, Hong Kong – which he described as “investments”. Qantas is now focusing on building its existing Asian joint ventures and focusing on profitability rather than further expansion.

He differentiated those positions from the wholly-owned Jetstar operations, saying shareholders would see returns from them in “a number of different ways” and that in the long term Qantas believed it could release value for its shareholders “through a number of dimensions.”

With those businesses targeting 2016 to move through their establishment and development phases to generating positive returns and Qantas’ international business now tracking towards the same outcome at the same time, if Joyce’s strategies do deliver the outcomes he is pursuing Qantas will be in a much better place in the second half of this decade than it has been in the first half.

It would, of course, be helpful if the headwinds that have buffeted the group in recent years were replaced by tailwinds, but volatility and the unexpected have, as Qantas shareholders and management know all too well, always been constants in the sector.