The capacity war has Virgin caught in a tailspin

The bill for last year’s airline capacity war is now in and, depending on how you look at it, amounts to either $3.2 billion or a bit over $1bn. Either way, it illustrates how senseless and destructive the war between the two domestic duopolists has been.

Within 24 hours of Qantas’ headline loss of $2.8bn ($646m on an underlying basis), Virgin Australia has now checked in with a $484m headline pre-tax loss, or about $427m if non-cash impairments are stripped out.

It was over-capacity in both the domestic and international markets that smashed the profitability of both carriers and, in a relative sense, damaged Virgin at least as much as Qantas, which at least had a (very) modestly profitable domestic business.

Virgin’s main domestic business lost $59.2m and at earnings before interest and tax level, its international business lost $66.8m and its 60 per cent interest in Tigerair Australia cost it $46.1m, implying Tiger lost $77m in Australia.

The cessation of hostilities in the domestic market earlier this year, a sharp slowdown in the rate of growth in capacity on international routes, the abolition of the carbon tax and, if sustained, lower oil and therefore jet fuel prices ought to mean that the 2014 financial year is the nadir of the sector’s near-term fortunes. Neither carrier can afford another year like last year.

Virgin’s John Borghetti, like Alan Joyce yesterday, tried to find positives in what was a disastrous year. He talked about the conclusion of the group’s "game change" program, which has seen revenue from the corporate and government sectors grow to more than 25 per cent of its domestic revenue base, ahead of the original target of 20 per cent. It is now targeting a 30 per cent share of those segments, which would bring it close to its overall capacity share of the domestic market.

That program also involved the creation of a largely virtual international network via alliances and code shares but really centred on shifting the Virgin domestic brand upmarket to try to siphon off some of Qantas’ higher-yielding customers.

One aspect of the program has been the growth in Virgin’s Velocity loyalty program, which now has about 4.5 million members. Borghetti announced the sale of a 35 per cent interest in that program to Affinity Equity Partners today, a transaction that will release $336m of cash but will have no impact on earnings.

While Borghetti said the sale would enable Virgin to grow the program faster, the most obvious impact is to increase the group’s liquidity and reduce its gearing by 8 per cent.

With last year’s $350m equity raising backed by its three big foreign airline shareholders (without which Virgin would have been in serious trouble), the transaction will shore up Virgin’s balance sheet. Interestingly Qantas considered (and rejected) the concept of selling a minority interest in its far larger program.

Borghetti was uncharacteristically defensive when discussing the result today, describing the financial outcomes of the past couple of years as a necessary investment in future growth.

There is no doubt that he has transformed Virgin into a viable alternative to Qantas. However, the cost to both carriers -- even if, as Borghetti said, it was a "war that had to happen" if Virgin was to challenge Qantas -- has been considerable.

The losses in its international business were disconcerting given its relatively small scale, but support the Qantas argument that capacity growth of 9.5 per cent on its international routes was the core reason for its near-$500m of losses in its international arm. That rate of growth has abated, Qantas says, to about 2.4 per cent, which should help this year.

Like Qantas, Borghetti is driving a cost-reduction program to try to offset the inevitable increase in costs that comes with the shift of the brand up-market. Costs per available seat kilometre rose 3.4 per cent, although they moderated in the second half.

He needs to do that because Qantas is generating significant reductions in its cost base to narrow a cost advantage Virgin held in the domestic market that started at about 18 per cent. Qantas is targeting a 5 per cent differential and said it has closed the gap to about 13 per cent so far.

Borghetti said his program had produced benefits of $191m so far, would deliver cumulative productivity gains of more than $400m over the three years to June 2015 and $1bn by 2017.

Having largely completed his repositioning of the Virgin brand, Borghetti now wants to turn the improved offer and acceptance of the brand into more entrenched customer loyalty, saying the vision is to become the country’s favourite airline.

In the meantime, however, he needs to stop the haemorrhaging within the international business and Tiger, which Virgin hopes will be profitable by 2017.  The sale of equity in the loyalty program might shore up Virgin’s balance sheet but, relative to its size, the current scale of the losses from international and Tiger are unsustainable.

Unlike Qantas, which said it would be profitable in the first half of this financial year in the absence of unforeseen external circumstances, Virgin hasn’t provided guidance for this year, citing the uncertain economic outlook.

There is no doubt that Borghetti has transformed Virgin from a low-cost carrier to something far closer to a full-service airline in the domestic market, but that the transformation and the competitor response to it has come at a very heavy cost.

Now he needs to demonstrate, not so much to the market but to the strategic shareholders now within his boardroom – Air New Zealand, Etihad and Singapore Airlines -- that there is a prospect of a reasonable return on their investments that will justify the heavy losses, totalling more than $630 million, experienced over the past two years.