Vulnerable Qantas flies a fine line

Qantas cannot afford to cede any market share to arch rival Virgin because the eventual loss of volume and yield advantage could create a one-way route to oblivion.

There appears to be a perception that Qantas’ crisis is self-inflicted because of its obdurate refusal to budge from its 65 per cent ‘’line-in-the-land’’ market share in the domestic industry. The consequences of abandoning that objective, however, could worsen the plight, which has just been underscored by the loss of its precious investment-grade credit rating..

Qantas has always rationalised its defence of its 65 per cent market share by reference to the aviation ‘’S-curve,’’ or the industry experience that airlines that have a frequency-share advantage garner a disproportionate market and revenue share. In Alan Joyce’s terms, Qantas’ market share enables it to ‘’optimise’’ its profitability.

With Qantas having foreshadowed losses of $250 million to $300 million in the first half of this financial year – its first interim loss since its privatisation – it could be argued that with no profits to optimise, he should stop matching Virgin Australia’s capacity increases on a 2:1 basis, relinquish share and focus on restoring profitability, or at least minimising the losses.

There are those who argue that Qantas should accept that in a two-carrier market the natural order is for a profitable duopoly, surrender its disproportionate share and allow the market to reach its natural level.

The problem for Joyce is that surrendering share to Virgin, even if he and his board were prepared to contemplate relinquishing the dominance and disproportionate share of the industry profit pool Qantas gained when Ansett collapsed, might simply create a one-way route to oblivion.

Airlines are very high fixed-cost businesses and relatively small shifts in volume and yield result in exaggerated effects on their profitability – they can either make big profits or large losses.

Qantas, in an era of new low-cost airlines that are often state-backed and some of which operate out of natural hubs that generate significant network benefits, carries a lot of fixed cost legacy baggage into the contest that exacerbates its cost disadvantages.

In the domestic market, Virgin has a significantly lower cost base than Qantas, as does its newly-acquired Tiger Australia brand over Jetstar. On international routes Qantas is trying to compete with the newer Middle Eastern airlines and others whose state sponsorship lowers their cost of capital, among other benefits.

Until now Qantas’ domestic profitability had supported its loss-making international business and bought Joyce time to restructure to reduce those losses. Virgin’s John Borghetti, who as a longtime senior Qantas executive would understand its vulnerabilities better than most, started shifting Virgin up-market and stacking on domestic market capacity.

Without the backing of his three big foreign allies and shareholders – Singapore Airlines, Etihad Airways and Air New Zealand – that would have been corporate suicide.

Virgin’s $100 million loss last year would have suggested the strategy was unsustainable given that Qantas was adding two seats for every new one Virgin put into the skies.

The game changed radically, however, when those shareholders – all fierce Qantas competitors – committed to underwriting Virgin’s $350 million equity raising.

Borghetti now has a war chest to continue to adding capacity, even if it loses his group money, in the knowledge that in dollar terms it will hurt a now very vulnerable Qantas far more.

Given how severely the capacity war has destabilised Qantas, Virgin’s strategic shareholders would presumably write more cheques if called upon to crack open a potentially highly profitable Australian domestic market while undermining a key competitor in the process.

Qantas, restricted by foreign ownership limitations within the Qantas Sales Act that Virgin isn’t subject to, is now desperately searching for unconventional mechanisms for getting access to new capital to fund its defence of its market share, with no option ruled out. Selling equity in Jetstar Asia, or the larger Jetstar group, or in its lucrative Frequent Flyer program, are among the options on the table.

At face value it would seem less painful to cede market share to Virgin than relinquish equity in its most valuable business, the loyalty program, but the risk in that option would be that it would transform the S-curve into an S-bend.

Because its cost base is significantly higher than Virgin’s, Qantas needs to capture a disproportionate share of higher-yielding fares. To do that – to dominate business travel – it has to have a frequency advantage, which means it has to more than match Virgin’s capacity increases. Its dominance of the high-yield end of the market feeds into its frequent flyer program in a self-reinforcing fashion and that combination also provides volume and yield for its international business.

In other words, the entire Qantas business model is built on that domestic market dominance and that dominance has, until now, enabled its domestic business to remain consistently and highly profitable despite its otherwise uncompetitive cost base.

If that delicate Qantas eco-system starts to unwind – if it were to cede share to Virgin – it could create a destructive cycle where the losses of volume and yield advantage compound and undermine the entire business model, exposing the cost disadvantage.

Borghetti could strip share off Qantas continuously and, if he wished, destroy it. There is no rational reason why he would stop exploiting his cost advantage at the point where the groups had matching market shares.

A profitable ‘’natural duopoly’’ would only be achieved if both groups had very similar cost bases and were continuously operating commercially.

Virgin could, as Qantas has argued, be accused of acting uncommercially by adding capacity while losing money so heavily, except that there is a longer-term strategic logic for both Virgin and its key shareholders in attacking Qantas’ strength.

The only rational response for Qantas, without the government aid or intervention it has been pleading for, is to try to defend that line in the sand by raising sufficient capital by whatever means necessary. That would send a signal that it can survive a prolonged and loss-generating capacity war indefinitely and that Virgin and its allies are wasting large slabs of their own capital by maintaining the assault.