Virgin bares the scars of a capacity campaign

John Borghetti’s strategies are having a positive impact on Virgin at the operational level but the raid on Qantas' market share won't be without its dark days.

The Virgin Australia result confirms the obvious. No one wins from a capacity war.

Last week’s Qantas result showed that the underlying earnings of its domestic mainline business fell 34 per cent in the December half from a prior-year base that was severely affected by industrial disputes. Its Jetstar brand’s earnings were down 13 per cent.

Today Virgin, which ignited the capacity war in the domestic market by moving upmarket to attack Qantas’ stranglehold on business travel, announced a 36 per cent fall in underlying profit before tax, from $96.1 million to $61 million and a decline in statutory earnings from $51.8 million to $23 million. Its domestic earnings before interest and tax fell 43 per cent, from $87 million to $49.3 million.

Virgin grew its domestic capacity 8.9 per cent in the half and expects to add another 5 to 7 per cent in the second half. Not surprisingly, its yield and revenue load factors slipped. Qantas added even more capacity to its twin domestic brands, particularly on the key Melbourne-Sydney routes, reflecting its absolute determination to defend its market share ‘’line in the sand’’ of 65 per cent.

There is no doubt that John Borghetti’s strategies are having a positive impact on Virgin at the operational level. He is lowering the group’s cost base, he is growing passenger volumes, there is very strong growth in the membership of the Velocity loyalty program, his international business is growing its interline and codeshare revenues and there is strong growth in Virgin’s still fledgling business class offering.

If the Australian Competition and Consumer Commission allows him to add control and 60 per cent ownership of Tiger Australia to his acquisition of Skywest he will be able to exert pressure from low cost bases across the full range of Qantas’ domestic operations.

Qantas’ aggressive defence of its dominance, however, means that Virgin’s progress is coming at a cost, even if the latest half-yearly earnings decline might be a little overstated because Virgin was the beneficiary of Qantas’ industrial woes in the previous corresponding period.

Virgin’s cash flow from operations was down heavily, from $233.3 million to $158 million, with the group citing reduced schedules and loads due to the migration to the Sabre reservations system and shorter term bookings because of the competitive environment and changes in its business model as the reason for a $93.3 million working capital deficiency.

The group’s cash holdings fell from $802.6 million to $685 million, with its unfettered cash balance falling from $480 million to $430 million.

Virgin does, of course, now have some powerful allies on its register, with Singapore Airlines, Etihad Airways, Air New Zealand and Richard Branson all major shareholders. Singapore, of course, injected $105 million of equity into Virgin to help it fund the Skywest and Tiger deals.

Those alliances are helping Virgin to grow its international revenues and earnings, with international revenue up from $551.7 million to $595.4 million and earnings before interest and tax rising from $32.2 million to $35.4 million. Virgin said interline and codeshare revenue was 56.1 per cent higher in the half. Those alliances are also helping to build the Velocity business, which added 500,000 members in the half (relative to the December half of 2011). Velocity now has 3.5 million members.

Borghetti has transformed Virgin but the financial consequences of his strategies remain a work-in-progress and, to a degree, are dictated by the larger Qantas group and its continued willingness to throw more capacity at the key domestic routes to protect its share.

It was, however, a necessary transformation given Virgin’s previous over-reliance on discount leisure routes and the overexposure that gave it to Queensland and its spate of natural disasters.

It is not clear how the capacity war will end, or at least abate, given Qantas’ determination to protect its position and Virgin’s strategic imperative of shifting up the passenger value curve to validate the investment it has made in its transformation from discount carrier to a direct challenger to Qantas’ core business.

The substantial reduction in the losses from Qantas’ own international business (from $262 million to $91 million), the imminent start of its own powerful alliance with Emirates, which should also strengthen its domestic franchise, its greater diversity of earnings and its $3 billion of cash means Qantas has the capacity to absorb the impacts on its domestic profitability flowing from a continuation of the fight with Virgin.

Borghetti is, of course, a Qantas veteran and understands his competitor intimately. He has executed the shift in Virgin’s market positioning near-seamlessly, at breakneck pace and with more than a few surprises.

Teaming up with Qantas’ most powerful international competitors other than Emirates added a dimension to the contest, as did the Skywest and (ACCC permitting) Tiger acquisitions, and may provide Virgin with the financial backing to withstand any prolonged increase in the competitive intensity of the domestic market.

There generally aren’t, however, winners from capacity wars and this particular outbreak of hostilities is negatively, and materially, impacting both the major domestic carriers while showing no signs of abating.

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