Raising capital to burn in the skies

Qantas can’t afford to underestimate the possibility Virgin’s backers will fund losses indefinitely to destroy Qantas’ domestic dominance and undermine even a skeleton international network.

At a Senate committee hearing on Friday aviation consultant Ian Thomas found it hard to understand why Qantas would so abruptly announce its plans to cut 5000 jobs last month as part of a $2 billion cost-reduction program. The answer was actually in his own testimony.

‘’I’ve been looking at Qantas now for probably the best part of 20 years. During that time they have had various job cutbacks on various occasions but none of this substance,’’ Thomas said.

‘’You would have to think that to reach this stage there was something wrong in the way management was handling the situation. It could have been something that might have been phased down over a period or had adjustments along the way. To announce 5000 jobs going is fairly dramatic to say the least,’’ he said.

Leaving aside the fact the job cuts will be phased over three years, the key point he is making is reasonable.

Qantas has known for some years it has major cost disadvantages relative to its international competitors and to Virgin in the domestic market. Why would it announce something so dramatic now? Why hadn’t it done something significant about its declining competitiveness years ago?

There is, of course, the small matter of the $252m it lost in the first half but that is largely an outcome of a particular set of circumstances rather than a continuation of a trend. Of greater significance than a new blowout in the losses of its international business was a collapse in its domestic profitability.

That in turn relates to the domestic capacity war being waged by Virgin and Qantas. Given the capacity war was raging throughout last year, it again poses the question of why Qantas needed to respond so dramatically and structurally?

The answer lies in Thomas’ response to a question about Virgin’s $350m capital raising last year, more than $300m contributed by its three strategic shareholders – Air New Zealand, Singapore Airlines and Etihad Airways.

Thomas was asked what he thought the capital raising was for.

‘’That was essentially building a war chest, from what I could make out, for its competition in the marketplace and also to cover some of its immediate losses,’’ he said. Asked by Liberal senator Sean Edwards whether Virgin was raising capital to ‘’burn,’’ Thomas said that was essentially the case.

That is the nub of Qantas’ rather dramatic response to its losses and competitive position last month. Until Virgin raised that $350m last year, Qantas believed its domestic rival would have to stop adding capacity and attacking its corporate customer base because otherwise it would run out of cash. Once it pulled back, Qantas’ domestic profitability would return to its normal strong levels.

The Virgin raising galvanised Qantas -- it immediately sought Federal Government intervention and subsequently pleaded for help -- because it realised the infusion of capital would enable Virgin to fund further losses indefinitely.

Whether one believes Qantas’ view of a conspiracy between three of its international competitors and Virgin to destabilise it and destroy its profitability or not, there is certainly a belief within Qantas that the backing of its domestic competitor by the three state-owned airlines could lead to that outcome.

Alan Joyce told the committee that in the domestic market Qantas and Jetstar had been profitable until this year and even then ‘’our competitor’’ was losing more money proportionally. Tiger (60 per cent owned by Virgin) had lost money every year since it entered the market.

‘’If you have two competitors that have come in and are willing to lose money in the marketplace and are willing to be funded from three state-owned airlines, then it doesn’t matter what you do as a company, you are still going to take a hit to profitability. That is exactly what has happened to Qantas in the domestic market, because the competition is willing to lose money,’’ he said.

Qantas chief financial officer Gareth Evans spelt out Qantas’ fears quite directly.

‘’It would be naïve for anyone to think these sovereign airlines do not have an agenda in bankrolling our competitor. They do. It is a strategy directed at weakening Qantas and promoting the interests of Virgin’s foreign owners,’’ he said.

Whether or not Virgin and its shareholders do have that agenda -- and it actually looks as though Virgin miscalculated Qantas’ response to John Borghetti’s strategy of more directly competing with Qantas, nearly ran out of cash and had to be bailed out by its shareholders to prevent it from falling over -- Qantas’ board and management can’t afford to ignore or underestimate the possibility Virgin’s backers do have a longer-term goal of destroying Qantas’ dominance of the domestic market and undermining its ability to sustain even the skeleton of an international network.

Whatever the intentions Virgin’s shareholders might have, it is apparent Qantas believes the capital raising gave its competitor the capacity to pursue a loss-making strategy indefinitely.

Joyce also defended Qantas’ strategy of protecting its domestic market share by expanding its own capacity in response to Virgin despite the losses.

‘’We are going to continue to protect our domestic position. Some people would have us back off and some people will say that there is no need to protect that strong domestic position. That is waving a white flag and it sounds like an easy solution to a difficult problem.

‘’If Qantas loses its strong domestic premium position and Jetstar loses its strong leisure low-cost position, then this group will lose the core of its strategy, its profitability and its history -- and we are going to protect that,’’ he said.

Until the capacity war wiped out most of Qantas’ domestic profitability and losses from its international business suddenly accelerated again in the context of significant over-capacity on its international routes, Qantas could probably have continued to pursue evolutionary change.

The capacity war and its impact fuelled Qantas’ fears and provided an opportunity to pull forward some years of incremental cost-reductions into a more urgent agenda for structural change, as well as allowing it to plead for government assistance.

There may be a mix of both paranoia and opportunism at work but if Qantas is to survive long term it has to deal with the substantial cost and strategic disadvantages it faces in both its domestic and international markets.

The prospect of the capacity war continuing -- and Virgin’s capital raising was the catalyst for that expectation -- has belatedly galvanised Qantas and led it to that announcement of 5000 job losses as part of (about one-quarter of) a $2 billion assault on its cost base.

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