Virgin's year of living dangerously

It’s not a particularly good look when a company that has just posted a $150 million pre-tax loss has to call on its major shareholders for liquidity. But in Virgin Australia’s case, it is arguable that there are some extenuating circumstances.

With the announcement of its statutory after-tax loss of $98.1 million, Virgin Australia disclosed that its key shareholders – Air New Zealand, Etihad Airways and Singapore Airlines — would lend it $90 million for a year on commercial terms, with their contributions in proportion to their shareholders.

The year just ended was, as John Borghetti said today, a pivotal one in the carrier’s history. With hindsight, it probably bit off more than it could chew. It wasn’t helped by the weak external environment, but it also misjudged the response to its ambitions from its major domestic competitor.

As Borghetti said, there were some things that didn’t go according to plan that were within Virgin Australia’s control, and some that weren’t.

Since he arrived at the group about three years ago, Borghetti has presided over a quite radical change program and shift in strategy, which culminated in the year just ended.

Virgin Australia has been pushing into Qantas’ domestic business traveller heartland and trying to reduce its reliance on leisure markets by upgrading its product and infrastructure while also reducing its costs.

In the year just ended, it replaced its reservation systems, which didn’t go seamlessly, and also acquired 60 per cent of Tigerair Australia and Skywest Airlines to give it the ability to match Qantas’ Jetstar and regional offerings (Tiger pawns fall in place for Virgin's air battle, July 8).

Borghetti added capacity and provoked a Qantas determined to defend both its 65 per cent market share ‘line in the sand’ and its dominance of full-fare business travel.

Capacity growth in the domestic market was about 8 per cent (two years’ growth in a stable market)  as Qantas threw a lot of Jetstar capacity at Virgin Australia’s still-heavy reliance on leisure travel.

It was costly for both groups, but Qantas’ greater diversity enabled it to remain modestly in the black, whereas Virgin Australia’s profitability was hit hard: it had made a $28.2 million pre-tax profit in the first half so its second half was swamped by red ink.

It didn’t help that Virgin Australia’s new Sabre bookings system crashed a couple of times and it had to waive about $25 million of revenue to avoid alienating affected customers, nor that the intense competition meant that it couldn’t pass on the $48 million cost of the carbon tax. (Similarly, Qantas had to absorb $106 million in carbon taxes).

There were also $105 million of restructuring costs mainly associated with the new bookings system and new core IT systems, as well as some related to the Tiger and Skywest acquisitions and integration. It was a difficult and messy year.

If they can remain disciplined in terms of capacity and pricing, both Virgin Australia and Qantas should start this year with better outlooks than their experiences of the second half of last year.

Qantas is planning only marginal capacity growth this near – 1.5 per cent to 2.5 per cent. Borghetti says Virgin Australia is looking at growth of about 3 per cent to 4 per cent, excluding Tiger. (He won’t disclose his plans to ramp up Tiger’s presence.)

Both have kept good control of their cost bases. Virgin Australia says it had $60 million of productivity improvement in the year, and load factors and yields are improving off low bases. Borghetti said Virgin Australia’s yields, load factors and revenue per available seat kilometres improved in June and July.

There are still the headwinds of a weak economy, increased fuel costs and the carbon tax, but a more stable market and, in the medium term, the impact of a significantly lower dollar on domestic tourism, should under-pin an improvement in their underlying profitability. The wildcard is Qantas’ response to Borghetti’s plan to turn Tiger into a serious competitor to Jetstar.

Borghetti does have some insurance, evidenced by the willingness of his strategic shareholders to extend credit to his group after his unrestricted cash holdings fell from $480.1 million to $326 million.

Air New Zealand, which has a 23 per cent shareholding, has indicated it would support an equity raising if one were needed, and it is probable that Singapore Airlines (19.9 per cent) and Etihad (10.5 per cent but with ambitions of moving to 19.9 per cent) would too.

The backing of Virgin by some of Qantas’ major international competitors makes it less likely that Alan Joyce, unless provoked, would see Virgin Australia as vulnerable because of its losses and its need for liquidity support and mount a full-scale assault on his competitor to minimise any threat from the expansion of Tiger.

Borghetti regards his ‘network optimisation’ plan as complete and now appears to be prioritising profitability over simple expansion, with Virgin Australia emphasising yield over its previous discounting to raise load factors.

Neither of the airline chiefs have been prepared to provide guidance for this financial year, which isn’t surprising given the volatile and unpredictable nature of the industry and their experiences during the past financial year. The prospects of both groups would be improved if they behave rationally and avoid another destructive capacity war.