Rational behaviour puts Virgin back on a stable flight path

There is extreme operating leverage in airlines. A year ago, when Qantas and Virgin Australia seemed to have embraced a mindset of mutual destruction, it worked savagely against them. Now, however, with the ending of the capacity war, it is working for them.

While it was obvious that the ending of that destructive battle for market share would lead to an improvement in the performance of the two main domestic carriers – it needed to, given that between they declared underlying losses of nearly $900 million last year – the rate at which their performance is rebounding is remarkable.

Late last year Qantas forecast it would earn an underlying pre-tax profit of between $300m and $350m for the December half, a stunning turnaround from the $252m in lost in the same half of the previous year.

Today Virgin Australia revealed that it too is recovering rapidly. It has posted a $55.3m underlying pre-tax profit for the second quarter, a $47.6m improvement on the same period of 2013-14 and one that will leave it $10.3m in the black for the first half.

Given that it incurred a $45m loss in the first quarter, John Borghetti and his team have managed a $100m turnaround in the space of three months.

Importantly, given that it handed over a $1 gold coin to Singapore Airlines today to acquire the remaining 40 per cent of Tigerair Australia and will now have to consolidate its results, it also reported that Tigerair was actually marginally profitable in the second quarter, with an underlying profit of $500,000 compared with a loss of $15.5m in the corresponding prior period.

There is seasonality within the industry, and the December quarter is the strongest period for the two carriers. But the outbreak of rational behaviour last year has transformed its economics. The plunge in oil prices and therefore lower jet fuel costs will progressively add to their earnings momentum.

The benefit to Virgin in the quarter was only $7m but there ought to be a materially larger impact in the second half. Qantas has said it expects to benefit to the tune of about $30m in the first half from the halving of oil prices that has occurred.

The two major drivers of the J-curve in earnings being experienced by both the carriers have been capacity discipline and an intense focus on costs.

Compared to the same quarter a year earlier, Virgin added only 1.4 per cent to the capacity of the core brand. Qantas' capacity growth has been minimal. Naturally, yields have improved.

Qantas seized last year's moment of crisis to attack its cost base and is on track to take out at least $600m of costs this year. Virgin, while not having the same swollen legacy costs of Qantas, appears to have made progress of its own.

It said underlying costs per available seat kilometre (CASK), excluding fuel and Tigerair, had actually fallen relative to the previous corresponding period.

Given the big investments Virgin has made in shifting its brand and product positioning, that's a major achievement. Its CASKs had previously been rising even as Qantas' were reducing. It also says there have been both cost and revenue gains within Tiger, which is in the early phase of being properly integrated into the Virgin group.

The return to profit of both the major domestic carriers has occurred against the backdrop of relatively soft demand growth within a deteriorating economy and therefore, other than the windfall from falling jet fuel prices that will become more meaningful as the year progresses, it has been driven by their own actions on capacity and costs.

Virgin said it was seeing some improvement in domestic trading conditions but international yield recovery had been constrained by continued pressure in the South-East Asian and Europe/UK markets. Virgin has a relatively modest international network, relying on alliances rather than its own metal.

Qantas has said its international business, which was losing roughly $500m a year, will be profitable in the first half. While the carriers' international operations will be adversely affected by the lower Australia dollar (it was about US90c this time last year) there is a corresponding and, for Qantas, very material benefit in terms of the decline in the appeal of this market to international competitors. Competitor capacity growth has slowed dramatically.

With both carriers having been pushed to the brink by the capacity war last financial year --- Qantas sought help, unsuccessfully, from the Federal government and Virgin was forced to raise $350m in capital from its shareholders – it would seem reasonable to assume that commonsense will prevail in the near term and, hopefully, beyond.

Rational and sustainable competition is a good thing for consumers and the economy. What Qantas and Virgin engaged in last year was neither rational nor sustainable.