Why Qantas' prognosis may not be terminal

The losses announced by Qantas are the worst in its corporate history, but they could also mark a turning point in the company's fortunes as it stabilises its balance sheet and undergoes its structural transformation.

Alan Joyce hasn’t wasted a good crisis. The gut-wrenching scale of the losses Qantas announced today reflects the worst year in Qantas’ history and one of the biggest clearing of the decks in corporate history.

The headline loss of $2.8 billion, however, could also mark a fundamental turning point in Qantas’ fortunes. It was clear from the surprisingly upbeat tone of Joyce’s commentary that he believes the group has passed its nadir.

In fact, the nature of the loss, which included $2.6bn of non-cash writedowns of the value of its international fleet, will boost Qantas’ performance going forward.

Lower depreciation charges for the written-down international fleet alone will add $200 million a year to its underlying earnings while $428m of restructuring and redundancy costs flowing from its transformation program will lower its cost base.

The 2014 financial year was the worst since Qantas’ privatisation in 1995, with its domestic operations barely profitable at an underlying level and its international losses (which had been reducing) blowing out from $246m to $497m.

Given the 9.5 per cent growth in competitor capacity on its international routes (Qantas says competitors have increased capacity by 44 per cent since 2008-09) and the much-discussed capacity war in the domestic market, it perhaps isn’t surprising that the group’s revenue base shrank $550m. Additionally, at an underlying pre-tax level before significant items, Qantas incurred a $646m loss compared to a $186m profit previously.

Qantas, however, isn’t the only airline feeling the pressure and its international competitors and Virgin Australia in the domestic market are cutting back on capacity growth.

Qantas is forecasting capacity growth on its international routes of 2.4 per cent and, with both Qantas and Virgin signalling a truce, flat capacity growth in the first half of the current financial year.

Joyce’s somewhat upbeat commentary -- he expects the group to return to profit in the first half of this year and says it has "come through the worst" -- may also relate to the progress of the transformation program.

That $2bn cost-reduction program has already seen 2500 of the eventual 5000 redundancies occur and lowered costs by $204m in the year just ended and enabled Qantas to reduce its group unit costs by 3 per cent. The program is expected to realise a further $600m-plus of benefits this financial year.

The crisis -- and last year did create crisis-style conditions for Qantas -- has enabled Joyce to make very difficult and (for Qantas employees) quite traumatic structural changes to the group that might otherwise have been far more difficult to implement.

The impairment charges against the value of the international fleet point to another potential structural change.

Earlier this year, the federal government amended the Qantas Sale Act to remove some of the restrictions on foreign ownership. Qantas has decided to create a new holding company structure with its international operations held within a separate entity, creating the option of emulating Virgin and introducing foreign investors/partners into the structure.

That forced the group to review the carrying value of its international fleet, which had aircraft that were acquired when the Australian dollar was around $US0.68. Inputting the current exchange rate obviously had a major impact on the carrying value of the fleet, which Qantas doesn’t intend to sell.

Part of the explanation for Joyce’s confidence -- apart from the reduced rates of capacity growth, the $200m a year impact of the lower depreciation charges and the accelerating cost reductions flowing from the transformation program -- is that Qantas’ balance sheet is stable. Net debt fell $96m and it has extended the maturity of its unsecured debt, its cash flows are stable and it has $3.6bn of liquidity, including $3bn of cash.

That underlying stability means that the "strategic review" hasn’t thrown up any fundamental changes to Qantas’ portfolio, with a partial sale of its frequent flyer loyalty business considered and rejected. Neither will it sell any equity in the Jetstar group or its associates, although Joyce has ruled out any new Jetstar ventures offshore until the transformation program has been completed. It is still looking at selling its remaining terminal assets.

Jetstar, as a group, had an underlying loss at the earnings before interest and tax level of $116m, with a (presumably modestly) profitable domestic business swamped by losses in its Asian operations and investments.

Qantas domestic was profitable, but earned only $30m at the EBIT level as a consequence of the capacity war with Virgin compared with $365 million in the 2013 financial year. With both domestic carriers behaving more rationally, there is considerable potential for both groups to generate substantial profits this year in a market where the profit pool in the past has ranged from about $700m to $1bn.

Qantas Loyalty, the frequent flyer program, had a record $286m of EBIT ($260m previously), which probably explains why Qantas is loath to sell even a minority interest in it.

If Qantas does return to profitability in the first half of the 2015 financial year, competition in the domestic market is rational and the cost reductions continue to flow it may be that, with hindsight, the 2014 financial year will be seen as the moment in which Joyce seized the opportunity to finally address and attack the legacy issues and costs that have bedevilled the group since privatisation.

If it doesn’t….

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