Tiger will test Virgin's flight path to stability

Improved dynamics in the domestic aviation market will be welcomed by Virgin, but question marks remain over its profitability and balance sheet stability.

The cessation of the suicidal capacity war in the domestic aviation market earlier this year is generating a sense of cautious optimism that the two big domestic airline groups are regaining some stability.

Last month, Qantas’ Alan Joyce told his shareholders at their annual meeting that the group was on track to return to underlying profitability in the first half of this financial year, which would be a major turnaround relative to the $646 million underlying loss last financial year.

Today John Borghetti told his shareholders that, after losing $211.7m at an underlying level last financial year (excluding $77m of losses within the partly-owned Tiger Airways Australia) Virgin Australia, having lost $45m in the first quarter (again excluding Tiger, which lost $11.6m) expected to achieve an underlying profit in the second quarter.

He also said that Tiger was expected to more than halve its underlying loss in the second quarter relative to the previous corresponding period.

Virgin is moving to acquire the 40 per cent of Tiger held by the Singapore Airlines-controlled Tiger Airways Holdings for a token $1. While previously it had avoided consolidating Tiger because of its governance arrangements, in future it will have to include the entirety of Tiger’s results.

Borghetti told the meeting he expected the struggling discount carrier to break even by the end of the 2016 financial year, or about six months ahead of schedule.

In the meantime, however, Tiger’s losses will be a drag on Virgin’s profitability. Virgin also sold 35 per cent of its Velocity loyalty program to Affinity Equity Partners earlier this year for $336m, so there will be leakage of earnings from that program to Affinity.

It isn’t surprising that the significant slowing of capacity growth in the domestic market that has occurred since that growth rate began tapering earlier this year is having a positive impact on the industry’s dynamics.

The domestic aviation market has a profit pool of somewhere between about $700m to $1bn a year, so adding capacity at a rate well ahead of the growth in demand -- in an effective duopoly -- was irrational and profit-destroying.

The two groups still have to work their way through the legacy of that capacity growth, but the losses it generated have helped Qantas to accelerate its dramatic transformation program, which is expected to reduce costs by $600m this year. The strength of the dollar also enabled it to write $2.6bn off the value of its fleet, reducing depreciation charges by $200m a year.

With those cost reductions flowing through and the lower oil price reducing fuel charges, Qantas will be able to add a dimension to the improving fundamentals of the domestic market. Virgin too will benefit from lower fuel costs and its own cost-reduction program.

There are two question marks over Virgin’s performance that only time will resolve.

There is no doubt that over the past four years Borghetti has managed, very effectively, a remarkable transformation of Virgin from a discount, leisure-focused brand into a full-service, diversified group with a big virtual international network and alliances with three big international airlines.

What Virgin hasn’t yet achieved is profitability and balance sheet stability. The $350m equity raising last year, mainly from its key allies -- Air New Zealand, Singapore Airlines and Etihad Airways -- was executed while Virgin was haemorrhaging.

Only last week Virgin raised $US300m through an unsecured note issue with a costly 8.5 per cent coupon in what might be regarded as insurance against future losses and financial stress.

Without or without the consolidation of Tiger’s losses, Virgin is almost certainly going to report a loss for the first half of this year, despite the changes to its business that have occurred since Borghetti became CEO. He’s improved its strategic position and cracked Qantas’ former complete dominance of higher-yielding market segments but needs to demonstrate that can translate to profitability and, eventually, reasonable returns for shareholders.

He also needs to show that he didn’t over-pay when he handed over that $1 to acquire the remaining 40 per cent of Tiger; that the discredited brand can be salvaged and the losses it has generated since its launch seven years ago staunched, as he has now foreshadowed.

With his key shareholders -- all big airline operators -- now within the Virgin boardroom and all having quite substantial financial exposure to its fortunes, there is going to increased pressure on the group to start showing a positive return on the big investment made in the transformation.

The sharemarket’s treatment of the two groups is instructive. Qantas share have risen about 58 per cent in just over a month to $1.83; Virgin’s has risen 11 per cent to 40 cents.

With the impact of the capacity war receding, investors (including, one suspects, the strategic shareholders within the boardroom) are waiting to see whether completion of Borghetti’s 'game change' program this year leads to the structural improvement in its financial position that the program targeted.