Risks never far away for Qantas investors

Contrition time. At the end of August when Qantas announced an underlying pre-tax loss of $31 million in the June half but an increase in pre-tax earnings for the year from $95 million to $192 million, I wrote that a 14 per cent jump in the airline's shares price to $1.40 on the day was justified.

The group had booked positive cash flow of $372 million, losses in its international division had halved to $246 million and were on track to be eliminated in 2014-15, the heaviest outlays on a fleet modernisation program were over and Qantas appeared to have fended off a market-share grab by its rival, Virgin Australia, I said, adding chief executive Alan Joyce had won "hard yards".

I would not say that is the worst call I have made in more than 30 years of writing about Australian markets and companies. When Eddy Groves' ABC Learning group was expanding into the United States in 2006, for example, I wrote that there was "some risk, but also considerable opportunity," in the move. I wish I had not pressed "send" on that one.

After Qantas's extraordinary earnings warning on Thursday, however, my piece on Qantas in August is right up there for waywardness. The group's shares fell by 11 per cent to $1.07 on Thursday and were down to $1.03 as trading drew to a close on Friday, after Standard & Poor's downgraded its debt to junk status, sacking it from an investment grade club that includes only two other big airlines, Germany's Lufthansa and America's Southwest Airlines.

There is not much solace in knowing I am not alone. The shares jumped on the day Qantas announced its June year profit because the underlying narrative was upbeat. Earnings downgrades by the big brokers were triggered by Joyce's declaration last month that Virgin Australia's $350 million share offer was a conduit for Virgin's three big airline shareholders, Air New Zealand, Etihad and Singapore Airlines, to finance a price war that could "terminally weaken Qantas and Jetstar".

This week's profit warning came as Qantas campaigned for the Abbott government to help the company. It was pinned to a November business downturn, but in hindsight there were earlier clues. Joyce had said in August that conditions remained "challenging and volatile", and Qantas gave no earnings guidance in August or at its annual meeting in mid-October. It had also been warning for some time the ownership structure that had cleared the way for the three foreign airlines to own a collective 63 per cent of Virgin Australia had created an uneven playing field.

The Air Navigation Act limits foreign ownership of Australian-based carriers to 49 per cent, but Virgin is deploying a government-approved ownership artifice that meets the foreign ownership limit for its international business while also opening the foreign ownership gate for its domestic business.

Qantas is using similar structures overseas for its discount brand, Jetstar, but in this market is separately held to 49 per cent foreign ownership by the Qantas Sale Act, the legislation that accompanied its privatisation 20 years ago.

It has been one of the most profitable airlines in the world since its debut as a privately owned company. Its dominance of the market in Australia has been its great strength, but is now also its main strategic challenge.

Capacity growth that surged last year has slowed, but its profit margins are down because it is discounting fares to defend its 65 per cent market share. It could charge more for flights, losing some market share in the process, but also boost its earnings. That is not ideal, but no scenario is.

Virgin Australia's ownership loophole is difficult to unpick now its share register has been transformed, and the Abbott government shows no sign of wanting to try.

The idea that the government should do what it did for banks during the financial crisis and guarantee Qantas's debt and charge for the service has also been overtaken by Friday's credit rating downgrade, and is problematic anyway: it would set an uncomfortable precedent for other companies to come begging, and would create moral hazard - the danger that a company classified as too big or too important to fail would consider it has a licence to take on excessive risk.

A government buy-in would be a policy volte-face, and the repeal or amendment of the Qantas Sale Act could take more time than Qantas appears to say it has to fix its problems.

A quicker fix is implementing cost cuts and asset sales, probably the part sale of high-value businesses including the frequent flyer program. They were foreshadowed on Thursday.

The longer-term issue for investors is, however, that airlines are always going to be a roller-coaster ride, to mangle a metaphor.

There is event risk in the very act of flying that is small, but potentially catastrophic if it eventuates. Event risk, too, exist in global shocks such as the September 11, 2001, attacks in the US and the global crisis, and price and currency risk in fuel bills and the financing of airline fleets.

Risk and volatility can be hedged by the airlines to an extent, but it is done at a cost, and earnings volatility remains, as industry profits worldwide reveal. Between 2004 and 2012 the industry earned as much as $US19.2 billion globally (in 2010) and lost as much as $US 26.1 billion (in 2008, when the global crisis was at its worst). The industry lost $US18 billion between 2001 and 2012.

mmaiden@fairfaxmedia.com.au