Virgin insures itself against Tiger turbulence

John Borghetti has demonstrated in the past that he has an acute sense of timing when it comes to balance sheet management, so Virgin Australia's preparations for a proposed $US300 million debt raising may have a more than routine significance.

Borghetti has been very actively managing the carrier's balance sheet in the past couple of years, starting with the injection of $106m of equity from Singapore Airlines in 2012 that he used partly to buy an initial 60 per cent of Tiger Airways' Australian business as well as SkyWest.

Last year he borrowed $770m against the security of his fleet and then promptly raised $350m, largely from his strategic shareholders, which triggered howls of complaint from Qantas and pleas for government intervention that fell on deaf ears.

This year he has raised another $336m by selling a 35 per cent stake in Virgin's Velocity rewards program to Affinity Equity Partners.

Given that Virgin had nearly $800m of cash at the end of last financial year, the decision to seek ratings from the major credit agencies in order to tap the US unsecured note market is more interesting that it might otherwise be.

Part of the explanation might be that it is pre-emptive. When Virgin issued its first quarter trading update last month, it said it had incurred a $45m underlying loss before tax. It also announced the acquisition of the residual 40 per cent of Tiger for $1.

Virgin paid $35m to acquire its 60 per cent interest in Tiger, which valued that business at about $58m in 2012. Today, having lost $77m last financial year, it is apparently worth a couple of dollars.

The governance arrangements around the Tiger joint venture somehow enabled Virgin to avoid consolidating it despite its majority ownership. Now, of course, it will have to consolidate its losses in their entirety.

Until now Virgin's key shareholders -- Air New Zealand, Singapore Airlines and Etihad Airways -- have been highly supportive. The equity raising last year was critical to the group maintaining stability despite its $212m loss (excluding Tiger's losses) in 2013-14.

The sale of the Velocity rewards program and the interest in tapping debt markets might signal that Borghetti doesn't want to test their forbearance, given the likelihood that Tiger, whose losses swelled in the first quarter, will propel Virgin to another sizable loss this financial year.

The backdrop for the domestic industry has been improving, mainly due to the cessation of the capacity war with Qantas earlier this year, but also to the big fall in crude oil prices, which have slumped about 25 per cent since the start of the financial year.

While capacity growth has almost stopped, domestic demand remains quite soft. That may explain why Virgin's share price has barely moved.

Without stronger demand, Borghetti would be conscious that reducing Tiger's losses is going to be a lengthy and tough process. It makes sense to take out some insurance in the form of extra and more diverse funding, even if the industry settings are better than they were a year ago.

Qantas is, it appears, on a slightly different path. Alan Joyce told its annual meeting that it was profitable in the first quarter. Its share price has leapt more than 33 per cent in the past month.

Qantas will also get a boost from the lower oil price despite the lower Australian dollar because its fuel cost and foreign exchange exposures are largely hedged, with Qantas retaining some participation rights that enable it to benefit from favourable movements.

More fundamentally, the lower dollar has almost halted capacity growth on its international routes while boosting its own revenue from them. That ought to help reduce the losses from its international business that were the major factor in last financial year's $646 million underlying loss.

It is also expected to benefit from its transformation program, which is expected to reduce costs by $600m this year, and from the impact of the $2.6bn of impairments it took on the value of its fleet. They will reduce its depreciation charges by about $200m.

Joyce has good reason to be confident of a greatly improved result and the market expects him to deliver one, with the Qantas share price, at $1.72, reflecting the market's confidence that he will.