The ‘Virginisation’ of Australian Aviation

  • Qantas still dominant with 80%+ corporate revenue share
  • Virgin has 31 “full switch” corporate account wins in FY14
  • Qantas Domestic FY15 Q1 capacity share 63.6% & pax. share 62.3%
  • Virgin FY15 Q1 RPK share 36.8% & pax. share 37.8%
  • Depreciating A$ helps close international cost gap by ~4%: estimate
  • 787-9 a Qantas International priority
  • Qantas Frequent Flyer 5-year EBIT reaches A$1.45 billion
  • A$1 Tigerair Australia acquisition to fast-track consolidation
  • All 13 Tigerair Australia A320s already leased
  • Tigerair Australia to start fuel hedging with Virgin
  • Network planning, revenue management could be consolidated
  • Tigerair Australia should switch to 737 MAX to enjoy fleet commonality
  • Single domestic 737 MAX fleet trims training, maintenance costs
  • Virgin Australia maintains a 24% CASK advantage versus QF Domestic
  • 50% of Virgin Domestic turnaround <30 minutes
  • QF Domestic CASK gap from 18% to 15% assumes stagnant Virgin performance
  • Qantas further cost savings questioned without full repeal of QSA

If there is anyone getting the last laugh from the acrimonious dogfight between Qantas and Virgin Australia apart from consumers, it would be Austrian political economist Josef Steindl. In his famous book “Maturity and Stagnation in American Capitalism”, he predicted the lower-cost player in an oligopoly will seek to increase its market share by engaging in a price war and once the shake-out process or “relative concentration” in Steindl’s words is complete, the remaining players will eventually realise their interdependence and cease engaging in price-war behaviours by focusing on other forms of competition.

This sounds an all too familiar tale for any stakeholder in the Australian aviation marketplace and the rest was history. But it is an increasingly “Virginised” marketplace in various aspects and not limited to Virgin Australia alone.

For Qantas, it will create a separate holding company for its international unit and add “optionality” in introducing a foreign shareholder as a result of the repeal of Part 3 of the 1992 Qantas Sale Act, which removed the 25% and 35% ownership caps on a single airline shareholding and the maximum shareholding by a group of airlines, although it still has to comply with Section 11A of the Air Navigation Act which stipulates the international arm to be majority Australian-owned.

The move to create a separate cash generating unit (CGU) for Qantas International and mimic Virgin’s shareholding structure was the primary culprit behind the A$2.65 billion write-down when its ageing Boeing 747 aircraft was purchased at an exchange rate of 57 US cents per Australian dollar. This one-off non-cash item led its statutory profit after tax of A$6 million in FY2012/13 slump to a historic A$2.84 billion statutory loss after tax in FY2013/14.

But its accelerated Qantas Transformation programme is delivering solid results, with a A$204 million cost saving being realised in the FY2013/14 second-half out of a total of A$440 million saved in the full financial year. Another A$300 million is to be realised in the FY15 first-half with Qantas reaffirming a return to the black in terms of underlying profit before tax (PBT).

Ironically, after the “Virginisation” of the Australian aviation marketplace, it is at Brisbane-based Virgin Australia where an earnings recovery is still elusive, even as it achieved its “Game Change” programme ahead of schedule. It is now acquiring the remaining 40% of Tigerair Australia it does not already own for a nominal A$1, in order to fast-track a return to profitability by reaping the benefits from further operational synergies. It also rolled out the “Virgin Vision 2017” and will bring the first 737 MAX delivery 1 year forward from 2019 to 2018.

Going forward, it is neither Qantas nor Virgin Australia that poses the biggest threat to each carrier’s financial fortunes. Rather, it is the weak Australian economy that is stirring the most concern, with the unemployment rate hitting 6.1% in September, the highest since mid-2003. Should the current trend persist, this will not only leave budget carriers Jetstar and Tigerair Australia disproportionately exposed to swings in the price-elastic leisure market, but also place Qantas in a relatively shielded competitive position due to its dominance in the domestic corporate market.

Image Courtesy of Reuters

Image Courtesy of Reuters

A silver lining at Qantas
If anything, Qantas’s FY2013/14 results marked the lowest point in its 94-year history and it is clearing the deck for its long-term future. In response, the stock market wasted no time in cheering Qantas’s stock, which has skyrocketed by 50.23% year-to-date and outperformed the ASX 200 index that only rose marginally by 2.32% this year. This included a staggering 18% increase in its share price since its October 24th annual general meeting (AGM) at which chief executive Alan Joyce confirmed that “preliminary figures indicate that the group has made an underlying profit before tax for the first quarter of financial year 2015”.

Admittedly, there are causes for optimism and arguably justifications for the carrier to claim its results are resilient in probably the most challenging year the Australian airline industry has ever faced, including a confluence of external factors and factors unique to the airline such as the A$428 million and A$394 million charges against the 2,530 full-time redundancies enacted so far and early retirement of ageing non-reconfigured Boeing 747-400 and 767-300ER aircraft, respectively.

Its traditional profit powerhouses – Qantas Domestic and Qantas Loyalty, are still churning out profits.

Qantas Domestic reported an underlying earnings before interest and tax (EBIT) of A$30 million in FY14, 92% down on the prior year’s A$365 million on a 6% decline in revenue from A$6.22 billion in FY13 to A$5.85 billion in FY14. As Qantas Domestic reported a FY14 first-half EBIT of A$57 million, this implies a second-half loss of A$27 million, although this has to be put into context given it is not the first time Qantas Domestic recorded a second-half loss and Virgin’s domestic operation actually lost A$59.2 million in FY14.

Compounding the fall in revenue was a A$68 million unfavourable fuel cost as domestic yield fell to the lowest level since 1999, which was partially mitigated by a 3% reduction in comparable cost per available seat kilometre (CASK). It alongside QantasLink added 1.26% of capacity to 37.8 billion ASKs in FY14 from 37.4 billion ASKs in FY13 even as passenger traffic fell by 2.25% to 27.7 billion revenue passenger kilometres (RPKs) in FY14 from 28.4 billion RPKs in FY13, thereby contributing to a 2.63 percentage points decline in load factor to 73.3%.

It believes Qantas Domestic now has an underlying CASK gap with Virgin Australia at 15%, down from 18% from a year earlier. Combined with a unit margin premium of around 24% in terms of revenue per available seat kilometre (RASK), according to a June 25th analyst note at brokerage Shaw Stockbroking, as well as its dominance in the corporate market in which it won 48 new accounts, renewed 182 while losing 10 and winning back 8 to and from its arch-rival Virgin Australia in FY14, respectively, will lead to a unit profitability advantage against Virgin.

Qantas asserts that further measures will close the underlying CASK gap with Virgin to smaller than 5% by FY17. These include the retirement of the remaining 7 Boeing 767-300ERs by 27th December with its final flight QF452 from Melbourne to Sydney after having flown the last international sortie from Honolulu to Sydney on 13th September onboard VH-OGU; the simplification of domestic types to the Airbus A330-200s for use on transcontinental flights to Perth and peak-time ‘Triangle’ flights between Sydney, Melbourne and Brisbane and the Boeing 737-800s; the transfer of 3 Airbus A330-200s from Jetstar International; the decision not to renew leases on 2 Jetstar International A330-200s in FY16 first-half; the addition of 6 seats onto 38 Boeing 737-800s that will be refurbished with QStreaming in-flight connectivity beginning mid-2015 and be completed within 12 months; and the sale of 2 737-800s in FY15, including 1 example from the trans-Tasman fleet.

Though one also has to look at Jetstar Domestic’s performance in order to gain a full picture of Qantas’s dual-brand strategy domestically, which reported an around A$20 million EBIT earning in FY14, since it is the flexibility that a dual-brand strategy affords at play, with 180-seat Jetstar Airbus A320s serving Fortescue Metals Group’s Cloudbreak and Solomon sites from December onwards, replacing the 125-seat QantasLink Boeing 717s currently being used, according to The Australian.

Ideally, such a strategy allows an airline group to deploy capacity smartly in accordance to the underlying demand conditions: when an economy weakens, an airline group could expand its low-cost unit to stimulate price-elastic, primarily leisure demand, yet still maximise the group’s overall profits by providing supply at a considerably lower cost and expand the full-service brand in an economic boom as disposable income increases. This supposedly works in a similar way with regards to normal goods and inferior goods.

In practice, besides the airlines themselves, it is anyone’s guess as to whether yield has been cannibalised in giving incentives for consumers to trade-down which risks becoming a permanent behavioural change. This is especially true on domestic short-haul flights where product differentiations matter significantly less than on long-haul flights and are becoming increasingly commoditised. Such a loss in revenue would be difficult to estimate and model since consumers would then become indifferent to both price/service offerings on such short flights, even on the premium leisure segment.

Qantas and Jetstar are now fine-tuning dual-brand deployment on 129 routes with changes on around 20 of them to maximise profitability, with Jetstar Domestic aiming to slash controllable unit costs by 2% a year; but one should caution overplaying this could backfire, particularly when Jetstar Domestic is now half the size of Qantas Domestic and its growth seems to be unabated.

According to Aspire Aviation‘s calculations, Jetstar Domestic accounted for 33.3% of Qantas Group’s total domestic capacity in FY15 first-quarter, or 3.9 billion ASKs out of 11.05 billion ASKs, up from 32.1% in the prior corresponding period and FY14 full-year, and from 31.35% in FY13. In terms of the number of passengers, Jetstar Domestic transported 3.277 million out of 8.861 million total passengers at Qantas Group, or a 37.0% share, up from 35.2% share in the prior corresponding period and 34.42% in FY13.

Although Jetstar Domestic has sold 5 new A320ceos to ease capacity growth, its capacity still rose by 3.5% in FY15 first-quarter to 4.727 billion from 4.57 billion in the year-earlier period, albeit traffic rose by 5% to 3.903 billion revenue passenger kilometres (RPKs) from 3.72 billion RPKs a year ago, thereby leading to a load factor of 82.6% versus the 81.35% recorded in the year-ago quarter. Jetstar’s growth more than offsets the declines at Qantas Domestic in FY15 first-quarter, which witnessed a 0.56% fall in passenger traffic to 7.145 billion RPKs from 7.185 billion RPKs a year earlier. This was outpaced by a 2.23% reduction in capacity to 9.46 billion ASKs from 9.67 billion ASKs a year ago, hence yielding a load factor of 75.56%, up from 74.29% in FY14 first-quarter. On a combined basis, group domestic capacity was marginally or 0.41% lower year-over-year.

While this is where Qantas Frequent Flyer might make a difference in offering more benefits to the top-tier members, such as the new 1,500mQantas Club in Darwin that could accommodate more than 350 guests, the construction of the new Perth business lounge that will open in 2015 and is connected to Qantas’s dedicated terminals T3 and T4, a swathe of benefits for Platinum One members including complimentary Platinum membership for a spouse or de facto domestic partner, complimentary Qantas Golf Club Platinum membership, waived fees for changing to an earlier flight when travelling on a flexible fare, a new 75,000 bonus Qantas points for reaching 5,000 status credits in a year and 100,000 bonus points for reaching 7,000 status credits; offering the same 10 and 20 status credits on Jetstar Domestic’s Starter Plus and Starter Max bundle and same points as on Qantas Domestic’s economy and flexible economy fare classes, respectively, unnecessarily muddles the segmentation between the two businesses for the most price-elastic passengers at Qantas Domestic.

Meanwhile, Qantas Loyalty will continue to be Qantas Group’s main earnings driver in the foreseeable future, with its FY14 underlying earnings before interest and tax (EBIT) increasing by 10% to A$286 million from A$250 million a year earlier. It has now reached 10.3 million members in September 2014, with an 8.4% increase in billings to A$353 million in FY15 first-quarter from A$325 million recorded a year earlier. As Qantas Frequent Flyer still carries significant earning potentials such as more than 35,000 small and medium-sized enterprises (SMEs) are registered with Acquire, the launch of qantaspoints.com and it smooths over the volatility inherent in the airline business, it makes perfect sense for Qantas to retain a unit which has consistently produced A$1.447 billion in underlying pre-tax earnings over the past 5 years (“Qantas faces defining moment“, 7th Aug, 14).

Screen Shot 2014-10-31 at 16.52.09

787-9 still crucial to Qantas International turnaround
Even at Qantas International, which has been plagued by excess competitor capacity growth of 44% between FY2008/09 and FY14, and 9.5% in FY14, things are improving at long last as a falling Australia dollar discourages airlines from adding capacity in the market, which is also aided by a 22% drop in jet fuel prices so far this year, the first annual decline since 2008.

“We believe this business is turning the corner. It is making growth opportunities where they exist and we are growing into markets where we see big potential for us in the future. It narrows the gap in terms of our competitive cost base with other international carriers. [The] sweet spot for us [is] in the low 80s,” Qantas chief executive Alan Joyce was quoted as saying.

Improvements include an increasing yield at Qantas International for 6 consecutive months, with a 12% higher aircraft utilisation in 2014 versus 2013. The higher aircraft utilisation was the result of working existing assets harder following the retime of the Melbourne-Dubai-London flights, which subsequently saw Qantas deploying the Airbus A380 superjumbo on the world’s longest flight from Sydney to Dallas/Fort Worth and upping the weekly frequency of Sydney-Santiago flights from 3 times to 4 times, as well as adding the new 3 times weekly QF95/96 Melbourne-Los Angeles flights on Wednesday, Friday and Sunday and retiming the QF17 Sydney-Los Angeles flight to an evening departure.

The launch of A380 flights on the 13,805km Sydney-Dallas/Fort Worth route follows the carrier having transported 300,000 passengers on it. The Dallas/Fort Worth service provides great convenience for passengers with 45 American Airlines codeshare connecting destinations and all major US cities lie within 4 hours of Dallas with the top 3 connection destinations being Orlando, Boston and Houston.

Given the success of the Dallas/Fort Worth route which saw a capacity increase of 10% and the introduction of the First Class product following the deployment of the A380, thus making half of around 40 return services to the US being flown by the people-mover, this leaves some wonder whether Qantas should route its New York John F. Kennedy service via Dallas/Fort Worth instead.

Yet doing so would not make sense from an operational perspective. Currently Qantas groups its Los Angeles operations from Melbourne, Brisbane and Sydney onto the QF15/16 Los Angeles-New York John F. Kennedy flights. The 1345 arrival in Dallas/Fort Worth and the 2010 departure time during Northern winter will leave insufficient time for the 4-hour one-way sector between Dallas/Fort Worth and New York John F. Kennedy. Qantas is also barred from selling its connecting US flights owing to the existing open skies treaty with the US. Since Los Angeles has a very strong point-to-point traffic from the Australian East Coast, and very likely more than Dallas/Fort Worth, such an operational shift does not make business sense.

“Operating a B747 to Dallas Fort/Worth is not commercial viable due to associated costs including aircraft. Additionally the schedule would not work due to curfews. Also operating Melbourne to Dallas Fort/Worth is not within range of current generation aircraft,” a Qantas spokeswoman told Aspire Aviation.

With A$400 million of costs being taken out at Qantas International over 2 years, an international capacity growth of 2.4% in FY15 first-half, and a falling Australian dollar which Aspire Aviation estimates closes its underlying unit cost gap with its competitors by around 4%, firming up its 50 Boeing 787-9 Dreamliner options would be pivotal in further improving its cost competitiveness.

Make no mistake, while it is questionable whether the aforementioned consecutive 6 months of positive yield growth will reverse the profitability trend fast enough where Qantas International posted a A$497 million loss before interest and tax, doubling FY13’s A$246 million loss, and whether further costs can be taken out without the full repeal of the 1992 Qantas Sale Act which still stipulates the operational base must be located in Australia, the 787-9 will nevertheless aid its cost competitiveness, with a still significant underlying unit cost gap of 22.2%, 22.7% and 24.5% with Air China, Singapore Airlines (SIA) and Cathay Pacific, respectively.

In particular, Aspire Aviation does not share Qantas’s conservatism towards new aircraft for the international unit, with its 50 options – the first of which was deferred from 2016 to 2017, only to be exercised after Qantas International returns to the black. This virtually amounts to a reversal of the causal link as the major undeniable cause for Qantas International’s woes is the fact of it being saddled with an ageing, fuel-guzzling fleet.

“We’ve got to get through the transformation of the business first and drive the international business into profitability, and we’re well on track to do that. Then we will be making the future investment decisions and what we’ve got is a lot of flexibility and some great opportunities to bring some new generation very efficient aircraft into the Qantas fleet,” Qantas chief financial officer (CFO) Gareth Evans said.

Most importantly, the 8,300nm 280-seat 787-9 Dreamliner will not only provide a 20% block fuel burn reduction, but also enable Qantas International to capture lucrative growth opportunities in Asia such as launching new routes to Tokyo Haneda, Seoul, Beijing, Taipei, New Delhi as a first step to complete its “Sydney Connect” network strategy.

Qantas holds significant strategic advantage in any potential East Asia and Southeast Asia-Latin America one-stop flights once the Civil Aviation Safety Authority (CASA) of Australia grants approval beyond the 180-minute extended twin engine operations (ETOPS) rule. Examples include Shanghai-Sydney-Rio de Janeiro and Singapore-Sydney-Rio de Janeiro routings. At present, passengers have to fly United Airlines’ Shanghai-San Francisco-Houston-Rio de Janeiro service that takes 32 hours and 10 minutes, including lay-over times and American Airlines’ offering of a Singapore-Tokyo Narita-Miami-Rio de Janeiro flight that takes 36 hours and 20 minutes with 3 stops or United’s Singapore-Hong Kong-Chicago-Houston-Rio de Janeiro flights that takes 38 hours and 20 minutes.

Should Qantas launch the 7,269nm route to Rio de Janeiro or 7,173nm route to Sau Paulo using 330-minute ETOPS, the journey time on the Shanghai-Sydney-Rio de Janeiro/Sao Paulo and Singapore-Sydney-Rio de Janeiro/Sao Paulo services can be reduced to 23-hour 41-minute and roughly 25 hours, respectively.

The 787-9 is important as Qantas International’s 10 A330-300s, which will be retrofitted with the Thompson Aero Seating Vantage XL business class flatbed with direct aisle access in a 1-2-1 configuration and featuring a 7-inch and 5-inch recline during take-offs and landings on international and domestic sectors, subject to CASA approval, does not have the range required to complete the “Sydney Connect” strategy, nor can Qantas Domestic’s 16 A330-200s. Neither is there a sufficient number of A330-300s even for its expansion in Asia, now that Qantas International has switched to the A330-300s on Sydney-Singapore and Brisbane-Singapore flights.

“We believe this product will deliver the best travel experience between Australia and Asia, and probably the best domestic travel experience anywhere in the world. We can’t wait for our customers to experience it for themselves. A key point of difference from all other carriers is that the seat can be in recline and fitted with the mattress from take-off right through to landing. With many Business passengers enjoying a meal in the lounge prior to travelling, this means more time to rest and sleep,” Qantas chief executive Alan Joyce commented.

By the time the retrofit is complete in end-2016, which also features a “Do Not Disturb” function and a 16-inch personal television screen while seeing the seat count of business class seats being reduced from 30 to 28, in addition to new Recaro economy class seats, the 787-9 will be a highly sought-after differentiator.

All in all, while Qantas International has become much nimbler with some seasonal cancellation of A380 flights between Dubai and London and seasonal Sydney-Vancouver 747-400 flights between January 3 and 22 and seasonal Perth-Auckland flights, it is the 787-9 that will speed Qantas International’s turnaround.

A330 Business Suite 01

Image Courtesy of Qantas

‘Virgin Vision 2017’
At the same time, Brisbane-based Virgin Australia is at a markedly different stage after completing its 5-year “Game Change” programme a full year ahead of schedule. The game is unquestionably changed in the domestic aviation marketplace and that a viable alternative to Qantas has been created in the business travel segment and Qantas no longer enjoys a monopoly similar to the way it used to since the collapse of Ansett Australia in 2001. Going forward, the “Virgin Vision 2017” envisages the creation of a “VA Loyalist” base from the point of indifference today, which is confirmed in Roy Morgan Customer Satisfaction Awards of August 2014 showing Qantas and Virgin Australia both scoring 82% satisfactions.

For Virgin Australia and its proponents, the picture presented by its nemesis Qantas contains several points of contention, both from a market share and cost perspectives, in addition to the magnitude of change.

First of all, viewing market share figures as a group masks changes in the underlying trends in different market segments. Aspire Aviation‘s Australian market tracker shows Virgin Australia and Qantas in a virtual duopoly in the full-service segment, with Virgin having a 42.6% passenger traffic share and Qantas 57.4% in FY15 first-quarter, little changed from the prior year period. The split is maintained as Virgin witnessed a similar fall in passenger traffic to Qantas’s at 0.64% to 5.302 billion RPKs from 5.336 billion RPKs a year ago.

In terms of passenger numbers, Qantas grew its share by 0.5 percentage points to 55.5% with Virgin accounting for the remaining 44.5%, as Virgin transported 1.91% fewer passengers at 4.47 million compared to 4.56 million in the year-earlier period, although Virgin grew its capacity share to 41.2% from 40.38% as it supplied 0.63% more capacity to 6.87 billion available seat kilometres (ASKs) from 6.827 billion ASKs a year ago.

But it is at the budget segment where changes are quietly taking place as Tigerair Australia expanded with its 13th Airbus A320 and launched the Brisbane base.

This saw Jetstar’s low-cost shares fell in the FY15 first-quarter, with RPK share slipping from 78.4% to 77.6%, ASK share from 78% to 77.1%, in spite of an increase in the share of passenger numbers from 78% to 78.4% in the period. This means Tigerair Australia now has a RPK share of 22.4%, up from 21.6% a year ago, an ASK share of 20.9% versus 20% a year ago and a passenger share of 21.6%.

Overall, Virgin Australia has broken Qantas’s notorious 65% “line in the sand”, with Qantas Group and Virgin Australia Group’s total passenger traffic share little changed in FY15 first-quarter at 63.2% and 36.8%, respectively. From a capacity perspective, Virgin Group grew its ASK share from 35.9% in FY14 first-quarter to 36.4%, although the traffic measure is considered to be more meaningful as well as the yield at which its planes are filled. Virgin Group’s passenger share dropped to 37.75% from 38.66% during the period, however.

Moreover, the notion of Qantas Domestic narrowing its underlying cost per available seat kilometre (CASK) gap from 18% to 15% in FY14 and eventually to 5% by FY17 has a very strong, if not unrealistic, assumption underpinning it. This assumes a stagnant cost performance by Virgin Australia, which ignores the effect of the A$1 billion cumulative cost reduction programme on the underlying unit cost by FY17. So far A$191 million has been achieved by end-FY14 and will grow to A$400 million by end-FY15, implying a A$209 million cost reduction in the current financial year alone.

Measures being implemented include a new fuel management system that targets a 2% fuel saving by end-FY15, integrating its trans-Tasman management team into its main Brisbane base, bringing forward the first Boeing 737 MAX 8 delivery from 2019 to 2018 and boosting its 737-800 utilisation even though around 50% of its domestic flights already have a turnaround time of under 30 minutes, according to the July/August 2014 issue of the Airline Business magazine.

These initiatives are bearing fruit with the underlying CASK growth, inclusive of fuel and foreign exchange, slowing from 3.4% in FY14 to 2% in the FY14 second-half and to just under 1% in FY15 first-quarter.

Aspire Aviation estimates Virgin Australia managed to retain a 24% “all-in” underlying CASK advantage against Qantas in FY14 and predicts it to continue doing so owing to the cost reduction programme, as the “comparable unit cost” measure adopted by Qantas which showed a 3% comparable unit cost reduction in FY14 includes carrier-specific factors that make comparison across carriers anything but “comparable”.

In fact, Qantas Group’s underlying CASK grew by 3.8% from 4.99 Australian cents/ASK in FY13 to 5.18 c/ASK in FY14 even including the 5 and 11 Australian cents tailwind from group associate losses and foreign exchange movements, respectively. Intriguingly, excluding the one-off headwind recorded in FY13 such as the 9 and 10 Australian cents impact from the Boeing 787-9 settlement and change in accounting method for passenger revenue, respectively, Qantas’s “comparable unit cost” actually increased by 0.8% from 4.96 c/ASK in FY13 to 5.00 c/ASK in FY14 by its own definition.

Furthermore, the comparison in labour cost per ASK measure also appears skewed. Virgin Australia’s labour expense soared by 6.7% from A$976.1 million in FY13 to A$1.0414 billion in FY14 whereas Qantas’s decreased by 3.4% from A$3.846 billion in FY13 to A$3.717 billion in FY14. This yields a respective labour cost per ASK of 2.47 c/ASK and 2.337 c/ASK for Virgin in FY14 and FY13, respectively; and 2.62 c/ASK and 2.75 c/ASK for Qantas in FY14 and FY13, respectively. At first glance, one would assume that Qantas’s labour cost per ASK gap significantly narrowed from 17.63% to just 6.33% in a year. But the denominator used in the comparison is utterly different since Virgin Australia’s ASK figures exclude charter operation of which Skywest was only acquired in May 2013 and Virgin Australia Regional Airlines (VARA) subsequently launched its first charter flights in the East Coast utilising the mainline 737-800 aircraft and reaped a 30% gain in charter revenue in FY14.

As Virgin Australia chief executive John Borghetti puts it, running an airline is not about “slash and burn”.

Significant operational investments include a new Pros revenue management system (RMS) to which Qantas will also migrate in mid-2015, that will maximise revenue generation through setting different price points according to the forward booking curve more accurately and be complemented by the UpgradeMe Premium Bid system on the Plusgrade platform; a new online check-in system that enables the sale of extra legroom and baggage during the streamlined process, thereby maximising ancillary revenue.

With the Pros revenue management system (RMS) in place, Virgin Australia could also co-ordinate its pricing more efficiently and effectively alongside its partners Singapore Airlines (SIA), Etihad Airways, Air New Zealand and Delta Air Lines, all of which use the same RMS platform. Any effect similar to the “significant revenue boost” observed by Air New Zealand following the deployment of Pros’ hybrid solution in 2006 would positively aid Virgin Australia’s earnings recovery.

Image Courtesy of Virgin Australia

Image Courtesy of Virgin Australia

For passengers and frequent fliers, though, the most visible investment would be the Business Class suite design based on the B/E Aerospace “Super Diamond” seats, which will have an 80-inch pitch and 28-inch width and a 16-18 inch touchscreen for the Panasonic eX2 in-flight entertainment (IFE) system.

The first Airbus A330-200 featuring the Business Class suite will enter into service in March 2015 and the retrofit will be complete by August, whereas the retrofit on its 5 Boeing 777-300ERs will commence in November 2015 and be complete in early 2016. This means there will be product consistency on its 6 Airbus A330-200s in the transcontinental market much sooner than Qantas, although one must take into account the scale of Qantas’s upgrades on 16 A330-200s and 10 -300s is significantly larger than Virgin’s.

Virgin Australia chief executive John Borghetti is confident its “Super Diamond” seat will knock the competition “out of the park” and that Qantas’s Vantage XL seat has a pitch of 79 inches and a width of up to 26 inches, both inferior to Virgin’s specifications. Qantas chief executive Alan Joyce refuted by saying it will have 5 aircraft already featuring its new product by the time Virgin Australia has its first A330 equipped with the Business Class suite, and that “these are bespoke seats, not just off-the-shelf seats that are bought straight away. What is also great about this is it has forced our competitor to take a new aircraft with new seats on it, rip those seats off and put new seats in”. Joyce also said Virgin’s “Super Diamond” seat was “third on our list”.

Virgin Australia vehemently denied that its Business Class Suite is an “off the shelf” seat, saying the seat has been highly customised through months of work.

Following the introduction of the Business Class suite, the seat count on Virgin’s 777 will drop from 361 to 339, with 37 business class seats, 24 premium economy seats and 279 economy seats, against the existing configuration of 33 business seats, 40 premium economy seats and 278 economy seats, as a result of increasing the seat pitch of its premium economy product to 41 inches from 38 inches. On its A330-200s, the seat count will decline from 279 to 270, with 20 business class seats and 250 economy seats, against the 24 and 255 business and economy seats on today’s aircraft.

“Our strategy has been very simple. We’re trying to pitch the business class seat as a halfway house between business and first and premium economy as more of halfway house between economy and business. It’s a question of yield mix, it’s not a question of absolute seat numbers and I think that’s where a lot of people make the mistake of thinking more seats means more revenue. Not necessarily because the bigger the aircraft, the more seats, the harder it is to yield manage and the more desperate you are to fill every seat. So yield management comes into this very importantly and we wouldn’t do this if we didn’t think that we’d get better yield,” Virgin Australia chief executive John Borghetti was quoted as saying.

Along with the introduction of the business class on its trans-Tasman and Pacific Islands services from March 2015 onwards, the launch of a freight division which will have a A$150-200 million revenue and grow its charter revenue to over A$200 million by FY17, these will help Virgin Australia derive 30% of its domestic revenue from the corporate and government sectors, up from 25% today and reduce its susceptibility to the leisure sector.

Virgin Australia has also made 31 “full switch” corporate account wins in FY14, with high-profile defections during the year such as the Seven Network, AFL and ABC.

That said, most analysts think profits at Virgin will nevertheless be elusive until FY17, especially after it reported a large A$355.6 million statutory after-tax loss in FY14, worsened by 262.5% from FY13’s A$98.1 million net loss despite a 7.1% higher revenue to A$4.31 billion in FY14 from A$4.02 billion a year ago. While it is true that the net loss included a myriad of special items during the year, such as a A$56.9 million impairment charge against the early retirement of 2 12-year old A330-200s, an 11.6% higher restructuring expense at A$117.3 million, a A$46.1 million loss for its 60% stake in Tigerair Australia in addition to another A$46.9 million losses resulting from time value movement and ineffectiveness on cash flow hedges and interest rate swaps; the A$211.7 million underlying pre-tax loss, which was 125.7% larger than FY13’s A$93.8 million pre-tax loss, was disappointing.

Its domestic operation, in particular, saw its underlying earnings before interest and tax (EBIT) before special items plummet by 71.1% from -A$34.6 million to -A$59.2 million in spite of an 8.41% surge in domestic revenue to a historic A$3.2 billion in FY14 from A$2.95 billion in FY13, whilst its international division saw its underlying pre-tax loss excluding special items deteriorated by 685.9% to -A$66.8 million in FY14 from -A$8.5 million in FY13 on a 2.56% higher revenue at A$1.15 billion.

Worryingly, Virgin Australia is still burning cash at a staggering pace, with the net cash flow in operating activities reversed from a A$123.3 million surplus in FY13 to a -A$7.7 million deficit in FY14, before the A$380.3 million obtained via capital raising activities that pushed its unrestricted cash balance 65.7% higher from A$326.5 million as at June 2013 to A$541 million a year later. The total debt-to-equity ratio worsened further to 185.7% at June 2014 from 172% a year earlier as interest-bearing liabilities increased by 3.21% to A$1.95 billion from A$1.89 billion even as it paid down A$200 million in gross debt in FY14 second-half. Though this included unearned revenue and the net debt-to-equity figure actually decreased from 54.3% in FY13 to 52.7% in FY14.

Hence the prevalent view that the 35% stake sale of the A$960 million Velocity Frequent Flyer programme to Hong Kong-based Affinity Equity Partners was as much about replenishing its war chest with a A$336 cash intake as fast-tracking its growth from 4.5 million members in FY14 to 7 million members in FY17 and reducing its lease-adjusted gearing by 8%. Though Virgin Australia heavily contests such a notion as Velocity Frequent Flyer is at a high growth stage versus the Qantas Frequent Flyer programme which has reached maturity, including the launch of the world-first loyalty programme conversion with Singapore Airlines’ KrisFlyer and a perennially expanding network reach with new codeshares on South African Airways’ Perth-Johannesburg route from 21st October onwards and Delta Air Lines’ services from Los Angeles to Nashville, Kansas City and Raleigh/Durham.

Nonetheless, the Velocity transaction which was approved by the Foreign Investment Review Board (FIRB) on 2nd October and completed on 22nd October, would be a welcome news to investors, coinciding an 18.3% improvement in underlying loss before tax of A$45.0 million in FY15 first-quarter on a 1.3% higher quarterly revenue and a positive domestic yield growth. Forward revenue as at September 30th is 3% higher and another tailwind will materialise from the abolition of the carbon tax which cost Virgin Australia A$51.6 million in FY14, although it still reported a A$59.1 million statutory loss after tax, including a A$8.2 million restructuring charge and a hedging ineffectiveness cost of A$14.3 million during the June-September period.

Image Courtesy of James Morgan

Image Courtesy of James Morgan

Low-cost business, high cost pain
The last part of the “Virginisation” of the Australian marketplace entails the A$1 acquisition of the remaining 40% stake in Tigerair Australia which Virgin Australia does not already own, in order to speed up the recovery at a beleaguered low-cost carrier (LCC) that has never turned in a single dime of profits since commencing operations in 2007 and saw its FY15 first-quarter loss widening by 19.6% year-over-year to A$11.6 million from A$9.7 million for Virgin’s 60% stake, implying a A$19.3 million FY15 first-quarter loss against a A$16.2 million loss in the prior year period.

Obtaining full control of Tigerair Australia, upon completion of the deal by the end of 2014, will bode well for further revenue and cost synergies, Virgin Australia says, after implementing a new revenue management system (RMS), onboard catering menu tigerbite, a more stringent clampdown on oversized and overweight baggage with a A$70-85 charge on the former and A$20-25 per kilogramme on the latter, and the joint procurement of fuel with Virgin, which will return it to profitability by the end of 2016, a year earlier than initially envisioned.

“I would be surprised if it’s not profitable by the end of calendar year 16, if not sooner. Typically when we give a target we always undershoot it so if I’m saying end of calendar 16 it probably means earlier,” Virgin Australia chief executive John Borghetti commented.

Confirmed areas of cost savings include relocating Tigerair Australia’s Melbourne headquarters to Virgin’s office and starting fuel hedging with Virgin to minimise costs. According to Aspire Aviation‘s sources at the Brisbane-based carrier, network planning, revenue management and accountancy roles could be consolidated across the companies.

The elimination of these duplicative resources makes sense as Tigerair Australia has to further optimise its collaboration with Virgin in network planning and revenue management from a group standpoint in order to boost revenues. One of the most rampant rumours surrounding Tigerair Australia is that it will take over the Virgin East Coast-Bali flights, although Tigerair Australia currently does not have the traffic rights to do so and that there will continue to be demand for premium leisure travel to Bali. Getting the Tigerair Australia/Virgin mix right is important as Tigerair only accounts for 15.4% of Virgin Group’s domestic capacity in FY15 first-quarter.

Looking ahead, Aspire Aviation believes further cost savings could be reaped by transitioning the Tigerair Australia fleet to the Boeing 737 MAX and operating a single, common domestic fleet despite Virgin Australia chief executive John Borghetti shrugging off the idea: “The benefit of it is you have two manufacturers that will compete with each other for sales. We have no plans – I mean zero, zilch of getting rid of all the A320s and moving to 737s in the Tiger fleet. Or vice versa”.

Indeed, one should not underestimate the benefits provided by steep discounts as a result of a competitive tendering process. But Tigerair Australia’s fleet is very unlikely to expand to the necessary size to make the additional training and maintenance costs worthwhile, now that it has effectively slowed its growth plan and did not take the 14th Airbus A320 from its lessor after which it subsequently leased the aircraft to Jetstar Pacific, let alone the original vision of having a fleet of 35 A320s by 2018. In contrast, Jetstar operates a domestic fleet of 54 A320s and 6 A321s.

Instead, all 13 Tigerair Australia A320s are leased and have line maintenance operations (LMOs) and base maintenance done by BAE Systems in a 5-year contract till October 2018 and inventory technical management (ITM) by AJW Aviation whereas Virgin Australia conducts 75% of its maintenance in Australia, according to filings to the Australian Senate in 2014, including LMO and base maintenance in-house at major capital cities such as the maintenance hangars in Melbourne, Brisbane and Perth.

While leasing its aircraft is the right strategy that improves its balance sheet and provides flexibility, such as returning ageing aircraft to the lessors to avoid depreciation and maintenance costs, operating and maintaining such a small sub-fleet does not appear to be the best practice. Additionally, Tigerair Australia has 6 out of 13 aircraft whose age exceeds 6 years, according to airfleets.net, with the oldest example having an age of 8.1 years, although their 12-year lease term takes full advantage of the 12-year heavy maintenance check and engine overhaul cycle.

Likewise, Tigerair Australia could leverage on Virgin Australia’s order book for 23 737 MAX 8s and most likely follow-on MAX orders to arrange SLB deals to pocket similar gains. This would be the earliest available opportunity for Tigerair Australia to consolidate its fleet as Virgin’s existing order backlog of 21 737-800s appears off-limit for Tigerair Australia, as those aircraft appear to be slated for the replacement of 30 737-800s in Virgin’s fleet that exceed 7 years of age.

Last but not least, the tale of two tails ends with Jetstar’s foray into Asia, whose underlying earnings before interest and tax (EBIT) reversed from A$138 million in FY13 to -A$116 million in FY14 on a 2% lower revenue at A$3.2 billion from A$3.29 billion a year earlier. As Qantas makes notable progress in its accelerated Transformation programme, Jetstar’s investments in Asia will continue to be a drag and it remains to be seen whether the promising growth potential will translate to profits, if at all. Its Jetstar Japan joint venture (JV) has lost A$55 million in FY14, Jetstar Pacific and Jetstar Hong Kong a combined A$15 million with a public hearing yet to be scheduled for the latter’s Air Transport Licence application (“Cathay Pacific’s prospect poised to take flight“, 1st Oct, 14), while Singapore-based Jetstar Asia bled another A$40 million in red ink during the period.

And Qantas’s transformation programme is by no means without uncertainties. While the Australian Licensed Aircraft Engineers Association (ALAEA) agreed to an 18-month pay freeze in exchange for the return of 50 engineers, Qantas’s short-haul pilots have rejected a similar 18-month wage freeze in an overwhelming majority of 79% and a similar in-principal agreement with Jetstar pilots is now being voted on until December 4.

Qantas’s recovery is still fragile and the progress achieved so far could be easily undone by yet another bitter industrial dispute, which is the last thing the flying kangaroo can afford right now.

For Virgin Australia, on the other hand, its first and foremost priority is to bed down the significant structural changes being made to its business and start generating cash to improve its balance sheet. Profits will eventually flow once customer loyalty has been built and when it continuously increases its share of the business travel segment – changes that do not happen overnight and need time for them to take root.

By then, players will find themselves in a decidedly different operating environment – a ‘Virginised’ Australian aviation marketplace.

Tail-on-Tarmac

Image Courtesy of Virgin Australia

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  1. […] contrast to only 30% of all Qantas Domestic flights having a 45-minute turn in March 2015 (“The ‘Virginisation’ of Australian aviation“, 3rd Nov, 14). With Qantas initiating the 35-minute turn in FY16 which yields a total of […] Reply

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