Qantas faces a turbulent future

The company delivered a strong result ahead of expectations with Earnings Before Interest and Tax increasing by almost 50% due to cost savings and a strong domestic performance. Domestic EBIT rose 48.6% and yields improved by 4%. International EBIT slipped 1% with no improvement in yields.

The domestic outlook remains reasonably strong and any slight softening in the economy over the next few years is manageable. But while the company's domestic operations provide some insulation, they only account for about one quarter of overall traffic.

Excess capacity

Unfortunately, the international outlook looks grim. A softer global economy, a likely increase in competition forcing down yields and load factors, and the Asian crisis will all play a part. The Asian economic turmoil has two major effects on Qantas. The first is on passenger numbers. Recent ABS statistics already show an adverse impact on passenger numbers on Asian routes, although it's too early to know the full effects.

However, the second major effect can be more serious - the issue of capacity. As more airlines suspend flights on Asian routes, the big question becomes the deployment of excess capacity. Aircraft are too capital intensive to have standing idle so it's usual to re-deploy them on other routes. That increases capacity on those routes and usually sees prices fall to attract more passengers.

If additional passenger traffic fails to materialise, the passengers are distributed across more aircraft - often unprofitably. The Asian routes had been expected to grow strongly over the next few years and many airlines had consequently ordered additional aircraft. We could easily see more capacity on Qantas' most profitable international routes and that could have serious implications for profitability.

Slip-ups come home to roost

In some ways, Qantas is now paying the price for past mistakes. After withdrawing from San Francisco, United Airlines increased their thrice-weekly service to daily, having accepted the Qantas passengers with thanks. The myopic belief that London Heathrow is the only port that really counts in Europe (Frankfurt and Rome are usually 'round-the-houses' flights) is shown to be folly.

Most Asian airlines fly to many secondary European cities very profitably, at least until recently. Finally, industry contacts report an increase in customer complaints, suggesting that the cost cutting may be having an effect on service delivery.

Oil price fall

The fall in the oil price could offset some of these factors, but the Asian situation has already had a negative impact on the share price as profit forecasts have been downgraded. But it is still too early to know how severe the impact will be and for how long it will last. The stock may look cheap at such a deep discount to the PER of the All Ordinaries, but the level of uncertainty is very high. We find it difficult to recommend this stock as a purchase when market sentiment could stay negative for some time. Current shareholders that are comfortable with the uncertainties can hold on.