Virgin Australia marks rite of passage

  • Virgin’s domestic ASK share grew from 35.22% to 36.79% in 3 years
  • FY16’s A$162 million pricing benefit a 13.6% saving of fuel bill, versus 7.61% at Qantas
  • Qantas’s A$300 million pricing benefit, with 3-4% ASK growth, equates to ~10-11% pricing/efficiency benefit
  • Tigerair Australia needs A321LR to further lower unit cost in short-haul international market
  • Virgin posts 69.8% 2015 H1 L/F in Australia-Indonesia market; lags Jetstar 12.4 points
  • Virgin lags Jetstar in Australia-Thailand market by 21.9 points
  • Sydney-Shanghai Pudong ideal for Virgin to enter; possible Air China tie-up to address North Asia network gap
  • Virgin’s claimed 20% unit cost advantage derived from financial report, not assumptions, with pros & cons

In any dogfight, it is inevitable that parallels are constantly being drawn between the duopolists. In the Australian domestic aviation marketplace, a truce to the David versus Goliath face-off has produced a A$975 million FY2014/15 pre-tax profit for Qantas, whereas Brisbane-based Virgin Australia continued to post red inks with a A$49.0 million underlying pre-tax loss in the same period, albeit it represented a 76.85% improvement over FY13/14’s -A$211.7 million result.

Yet such a comparison is not entirely fair or meaningful, as its arch-rival tried everything it can to drive the upstart out of the marketplace – a battle which Virgin Australia chief executive John Borghetti eloquently said every challenger has lost in the past. What is also missing in the mainstream narrative is the fact that the upmarket move was driven by necessity as much as by choice; or simply put, how the airline would have fared had it remained a low-cost carrier (LCC) and being “boxed in” by Jetstar at the bottom and Qantas at the top.

If anything, FY15 marked a rite of passage for Virgin Australia, with a portfolio of business units being built: the launch of Virgin Australia Cargo on 1st July and charters; the accelerating growth of Velocity Frequent Flyer; Tigerair breaking even; initial investments on cost-saving projects starting to gain traction that will deliver a unit margin advantage for the carrier in the longer term.

Image Courtesy of AFP

Image Courtesy of AFP

Despite strong domestic turnaround, Tiger has to bite to keep Jetstar at bay
Underpinning a A$260 million reduction in statutory net loss to A$93.8 million in FY15 versus the -A$353.8 million recorded in FY14 was a turnaround in its domestic business, with Virgin Domestic staging a bounce back from the -A$99 million FY14 underlying loss to A$111 million earnings before interest and tax (EBIT). Operating margin improved from -3.1% in FY14 to +3.4% in FY15, implying a A$32.65 billion domestic revenue, or 68.7% of the A$47.49 billion total revenue, up from A$31.94 billion domestic revenue in FY14.

This was achieved on the back of a 5.2% increase in domestic yield and a 3.5% growth in “revenue efficiency”, or revenue per available seat kilometre (RASK). The question is whether Virgin Domestic’s turnaround has been equally thorough as Qantas Domestic, which recorded a A$480 million FY15 underlying EBIT from just A$30 million the financial year prior.

On the face of it, Qantas Domestic’s 8.24% operating margin, up from 0.5% in FY14, appears much more lucrative than Virgin’s. Yet this has to be looked at with their relative sizes. The A$450 million improvement in underlying earnings at Qantas Domestic, of which the net improvement was only A$350 million after factoring in the A$100 million reduced depreciation expense, yields a 62.5% share for Qantas of the gains produced for the two largest Australian carriers resulting from the truce and 37.5% for Virgin with its A$210 million improvement. This is pretty much in line with Qantas/Virgin’s 63.21%/36.79% FY15 capacity share using data compiled by Aspire Aviation, underlining the scale of Virgin’s domestic comeback was just as significant as Qantas’s.

In fact, one has to be patient enough to see through the rite of passage, as once the pieces of the puzzle fall into place, such as the lounge investments, including the regional lounges in Alice Springs and Darwin; the new Brisbane terminal being opened by Sir Richard Branson; new Adelaide-Alice Springs-Darwin thrice-weekly flights since March 30th; 6 times weekly Sydney-Tamworth flight onboard the ATR 72-500 turboprop since late May; Virgin will have an enhanced capability to punch above its weight. It is forecasting a 6-9% EBIT margin for the domestic business by FY17, meaning it will become twice as profitable as it is today, although Qantas Domestic’s results are also expected to improve as well.

Nevertheless, Virgin’s biggest threats going forward will be a leaner and meaner Qantas Domestic with a narrowing cost gap, with the likes of analysts such as Citi’s Anthony Moulder warning “the risk for Virgin is that Qantas is closing the cost gap quicker than expected”; and Jetstar lurking behind its back.

On the cost front, it is paramount to understand the fundamentally and decidedly different methodologies adopted by Qantas and Virgin Australia when it comes to calculating unit costs. Qantas employs a methodology based on assumptions with adjustments such as foreign exchange, stage length changes, carbon tax and its repeal, the A$126 million Boeing 787-9 order cancellation refund and so on. Qantas’s “comparable” unit cost performance excluding fuel has improved by 3% in FY13, 3% in FY14 and 4% in FY15, the company reckons. Virgin, on the other hand, relies on its 4E preliminary annual report without using assumptions, then apportioning the operating cost to its domestic segment. Virgin does concede, however, that it has a unit margin gap with Qantas with a 46% RASK shortfall in FY13 and 31% in FY15 first-half, against a targeted 15% RASK gap. Based on the latest FY15 full-year results, the RASK gap has been further narrowed to 28% whereas the domestic cost per ASK is around 25% lower, Aspire Aviation understands. Another noteworthy point is, the total RASK growth at Qantas Domestic in FY15 was just 2.9%, instead of the purported 4.0% domestic passenger RASK growth that Qantas reported, should one use Virgin’s method of using total domestic revenue instead of just passenger revenue.

Although these differences look subtle, they will lead to vastly different results in the end, thus making any true comparison for outsiders very difficult. What is publicly known is that both carriers are slashing costs aggressively, and against this moving goalpost Virgin has raised its cumulative cost-saving target from A$1.0 billion to A$1.2 billion by end-FY17 as those investment projects such as insourcing line maintenance gather pace, with cumulative benefits now hitting A$514 million since FY13.

That said, Virgin needs a stronger Tigerair Australia to keep Jetstar at bay, with the chief executive of Qantas’s wholly-owned low-cost subsidiary Jayne Hyrdlicka saying Virgin has “disenfranchised” customers and “that has delivered very significant RASK growth for us in what has traditionally been very quiet periods of the year”. Tigerair Australia appears to be doing just that, in expanding domestically with a 14th A320ceo based in Sydney from December onwards. It doubled the frequency on Sydney-Gold Coast flights from 2 to 4 times a day, and will be launching the Melbourne-Gold Coast Friday and Sunday flights from 18th September onwards. Other new additions include Sydney-Whitsunday Coast flights on Sundays beginning 25th October, Melbourne-Coffs Harbour thrice-weekly flights beginning 9th December, and 10,000 extra monthly seats on the Sydney-Adelaide and Sydney-Cairns routes.

Similar to the -A$25.7 million underlying loss in FY15 at Tigerair from -A$46.1 million for Virgin’s 60% stake in FY14, which amounted to -A$76.8 million on a standalone basis, its customer experience has dramatically improved over the past year. From the customer relationship management (CRM) platform called “Infrequent Flyer Club”, “Express Fare” bundle that includes queue jump and seat selection at a 10% discount, to Cabin+ add-on that lets passengers carry 12kg of onboard baggage beyond the 7kg standard, to Melbourne Airport’s Terminal 4 with self-drop facilities and Max Airport iPad carried by Tigerair’s check-in agents, it is entering a new chapter.

The next challenge for Tigerair Australia is how to expand and reap benefits from economies of scale beyond its fleet of 7 A320s, 5 and 2 examples based in Melbourne, Sydney and Brisbane, respectively; without undoing the gains in profitability made so far. Only when Tigerair starts to bite and narrows its passenger volume gap with Jetstar, at 3.639 million versus 12.859 million in FY15, can Virgin move further upmarket without worrying its back.

VAD ASK share game on

VAI 15 H1 performanceLooking beyond SE Asia restructuring: China calling
Internationally, a sweeping restructuring on its short-haul international network to Southeast Asia was launched following a 50% deepening in underlying loss to -A$69 million in FY15 from -A$46 million in FY14. Just how poor-performing its Southeast Asian operations in Thailand and Indonesia have become can now be revealed with Aspire Aviation‘s 2015 first-half international load factor data, using global distribution system (GDS) and the Bureau of Infrastructure, Transport and Regional Economics (BITRE) filings.

Virgin Australia has been flying from the four capital cities: Sydney, Melbourne, Brisbane and Perth, plus Adelaide to Bali, Indonesia and the Perth-Phuket route. The Indonesia and Thailand operations carried 253,901 and 28,176 passengers in 2015 January-June period, for a combined 22.6% of Virgin’s total of 1,248,262 passengers being carried on its branded international flying.

For its Bali flying, Virgin offered 363,928 seats onboard 2,075 both-way flights, carrying just 122.36 passengers on average on its 176-seat 737-800s at a load factor of 69.77%. Indonesia AirAsia X, which operates the Bali-Melbourne route, was fairing even worse, despite its chief executive Dendy Kurniawan asserting the carrier has 80% of its seats filled in June. Indonesia AirAsia X, or “Indonesia AirAsia Extra” (XT) in the filings, carried 29,117 passengers aboard 138 flights with 52,026 seats offered, yielding an average of just 211 passengers per flight onboard its 377-seat A330-300. At a 55.97% load factor, it was the 10th lowest-ranked among the 91 country/airline pairs tracked by Aspire Aviation. This compared to Garuda Indonesia’s 78.52% load factor and Jetstar International’s 82.2%. Jetstar’s Bali flying was performing particularly well, scoring 21st out of 91 country/airline pairs, having carried 438,410 passengers on 2,150 flights with an average of 203.9 seats filled per flight.

For Virgin’s Phuket flying, it carried 28,176 passengers on 247 two-way flights at a load factor of 65.87%, yielding an average of 114 seats filled per flight. Jetstar, which also flew to Bangkok, was able to fill 87.8% of its seats with 274 passengers per flight on average, a more than 20 percentage points lead on Virgin.

Therefore it is small wonder that Tigerair Australia will take over the Bali-Perth, Melbourne and Adelaide flights from 23rd March, 2016 onwards, with the Perth-Phuket route being suspended on 1st February and not being replaced. While Tigerair is better placed to serve such a price-sensitive market with 3 Tigerair-liveried 737-800s configured in a single-class, 180-seat layout with 18 seats in the first 3 rows and 12 seats in exit rows being extra legroom ones; whether the Bali-Sydney route remains viable will hinge on the entry of Indonesia AirAsia X’s 5 times weekly service beginning October 17. In countering a considerably better per-seat economics offered by an A330-300, provided that Indonesia AirAsia X can fill it, the 206-seat, 4,000nm 2-class A321LR equipped with 3 auxiliary fuel tanks may provide Tigerair Australia a good option. Not only will the single-class A321LR offer sufficient range to reach Bali from Melbourne, albeit shorter than the 4,000nm advertised owing to the single-class configuration, it can also be deployed on trunk East Coast route on the “intelligent misuse” between Bali flights while hiking capacity and alleviating the aforementioned “volume gap” with Jetstar.

Having restructured 22.6% of its international network, Virgin Australia can leverage on one of its newest product innovations – “The Business”, to kindle the next stage of international growth. This is primarily because of the superb quality of “The Business”, with its strong back support from a 3-layered seat cushion with memory foam mattress toppers in a Tangerine London and Hulsbosch-inspired sports car design style. At 80 inches long and 28 inches wide, “The Business” on the A330-200 was actually far superior to some of the international long-haul business class seats that Aspire Aviation has experienced. This November’s debut of “The Business” on its 5 Boeing 777-300ERs will make the seat even roomier. Building on the strength of such a great seat design, the airline has what it takes to succeed internationally while lowering its procurement cost via the purchase of a bigger volume from the seat maker B/E Aerospace.

Virgin Australia does not need to look too far beyond its shore. Being Australia’s second-largest inbound tourism market with a potential worth of A$13 billion by 2020, China offers promising growth despite its stock market’s recent volatility and the rebalancing away from manufacturing sector to internal consumption. According to The Economist magazine, even a 5% GDP growth rate today will add more to the world economy in absolute terms than a 14% growth would have in 2007 and the service industry’s size has already surpassed that of manufacturing.

Image Courtesy of Virgin Australia

Image Courtesy of Virgin Australia

The Sydney-Shanghai route is particularly ideal for Virgin Australia to enter, complete with a possible immunised alliance with Air China, the only other operator on the route besides Qantas/China Eastern. There are several benefits on why such an alliance with Air China would be in the best interest of not just Virgin Australia, but also its shareholders Air New Zealand (ANZ) and Singapore Airlines (SIA).

First and foremost, the Sydney-Shanghai route is a high-yield route with a large amount of business traffic. It alone accounts for 23% of all travel and number of seats on the direct Australia-China market, according to data in the Australian Competition and Consumer Commission (ACCC) submissions made by Qantas and China Eastern. Even though Virgin Australia chief executive John Borghetti maintained on a media tour onboard its A330-200 featuring “The Business” that its alliance with Singapore Airlines (SIA) is working well and can serve the China market, the ACCC disclosed that indirect travel only accounts for 12-15% of traffic on this route. The Amadeus MIDT MAT data seems to support the ACCC’s position, with Singapore Airlines (SIA) only accounting for a 1.86% passenger share on the broader China-Australia market, after China Eastern’s 39.54%, Qantas’s 34.38%, Air China’s 14.88% and Cathay Pacific’s 6.95%.

Most importantly, neither Virgin Australia nor Air China is likely to succeed on the Sydney-Shanghai route without each other. Between March 2011 and March 2015, Qantas/China Eastern’s combined market share rose to 84.5% from 78.5%, whereas Air China’s fell from 21.1% to 15.5%. For Air China, a tie-up with Virgin in exchange for local Australian feed traffic alongside Virgin’s launch of new Sydney-Shanghai flights will consolidate and reinforce its competitive position, which would otherwise be considerably diluted as Qantas/China Eastern guaranteed the ACCC a 21.67% capacity growth between Shanghai and Australia over the next 5 years at a compounded annual growth rate (CAGR) of 4%. In January-June 2015, Air China filled 77.89% of its Australia-China seats, against Qantas’s Shanghai route of 84.79%, which makes the flying kangaroo’s China foray 11th best-performing route out of 91 pairs Aspire Aviation tracked.

For Virgin Australia, an alliance with Air China not only helps it obtain slots at Shanghai Pudong International Airport, with the capacity cap between Beijing, Shanghai and Guangzhou and the 4 capital cities in Australia being relaxed to 30,500 weekly seats each way from October 2015 onwards and further to 33,500 weekly seats each way from October 2016; a codeshare on services from Air China’s Shanghai Pudong hub will help Virgin Australia penetrate deeper into China in a capital-light manner, with cities not served by SIA/SilkAir – Xi’an, Lanzhou, Dalian, Changchun, Harbin, Wenzhou, plus more.

In this instance, a Virgin/Air China tie-up would not be necessarily anathema to Singapore Airlines (SIA), as it itself is reportedly exploring a codeshare with Air China designed to address the very same network gap. Virgin would also pose much less a threat to Air China’s 18.71% cornerstone shareholder, Cathay Pacific, than Singapore Airlines does, thus making a deal more palatable. Air New Zealand (ANZ), Virgin’s largest and 25.99% shareholder, is already a strategic partner of Air China in the Australia-New Zealand market and stands to gain as more traffic from China is routed through the trans-Tasman market (“Partnership is Air New Zealand’s answer to litmus test“, 10th Sep, 15).

In order to explore this growth opportunity, though, Virgin Australia will need to lease incremental units of Airbus A330-200s, with 2 additional examples needed to maintain a daily flight. A Boeing 787 or Airbus A350 order seems too far into the future to make it to be realistically considered, particularly its 777-300ER fleet is being refurbished with “The Business” and a new Premium Economy cabin. With a monthly lease rate of US$775,000 per all-new A330-200 as of September, according to Collateral Verifications data, Virgin Australia’s depreciation policy of 7 times of annual operating lease cost and a 10% weighted average cost of capital (WACC) hurdle rate, the capital budgeting process would be fascinating to look at and an internal rate of return (IRR) could be obtained fairly easily. On the demand side, using PaxIS airfare data and the MIDT market share data despite the underreporting issue on separate itineraries, Virgin Australia could discern the airfare or premium it can charge with what would be the best Business Class seat offering on the direct Sydney-Shanghai route.

It needs to, however, consider the adverse effect of suboptimal aircraft utilisation given the notorious air traffic delay in China, which may hinder its ability to redeploy the A330-200 onto short East Coast domestic routes during downtime between Shanghai flights, an issue not plaguing Qantas International as it uses the A330-300 on the route.

Source: ACCC

Source: ACCC

Outlook
In the end, Virgin Australia’s goal of reaching “Destination: Greatness” is about outsized profitability with its relative size in mind and growth in the long-run. This needs to be supported by a strong balance sheet and a business that generates cash for a capital deployment strategy featuring dividends for its shareholders, all of which deserve rewards for their patience and commitment over the past few years.

Despite a weakening Australian dollar that pushed its interest-bearing liability 41.6% higher to A$2.76 billion as at 30 June, 2015 from A$1.96 billion a year ago, its US$300 million bond sale and a much improved operating cashflow (OCF), which swung from -A$7.7 million in FY14 to A$218.1 million to FY15, meant its leverage improved to 5.9 times from 7.4 times in the same period, with a target of 4.0-4.5 times by FY17.

In FY16, fuel is anticipated to become a bigger contributor to improved profitability with a A$162 million pricing benefit, versus just A$60 million in FY15. Whilst one may question the size of the incremental benefit is going to be dwarfed by Qantas’s A$300 million benefit, whose fuel bill at current forward price stands at A$3.64 billion in FY16 compared to A$3.94 billion in FY15, it has to be put in perspective by the same token as the benefits delivered to Australia’s two biggest carriers from the truce in capacity war at the beginning of this analysis. Qantas’s 7.61% reduction in fuel bill, coupled with a 3-4% overall group capacity increase comprising an only 0-1% domestic capacity growth in FY16 first-half, amounts to an 11.61% total fuel pricing and efficiency gain. At Virgin, the A$162 million reduction already amounts to a 13.60% pricing gain, exclusive of any efficiency gain resulting from capacity growth, as Virgin does not provide any guidance in this regard.

Domestically, capacity discipline looks set to grow tighter at Virgin with 3 737-800 lease returns and another 2 being freed up for sale as a result of higher aircraft utilisation. 17 -800 deliveries are also deferred and converted into 737 MAX 8 orders, taking the total to 40 on backlog. With only 4 -800 deliveries slated for FY16, the net total will marginally decline to 76 Boeing 737 Next-Generation aircraft. There has been intense speculation on whether Tigerair Australia would follow the footsteps of Virgin and become an all-737 operator following the leasing of 3 -800s to start the Bali flights. Given Virgin’s rationale of having a split fleet and the prohibitive switching cost involved, the Tigerair-liveried 737-800s are likely to be an interim solution rather than a strategic shift. The leasing of Airbus A321LRs could re-establish commonality at Tigerair’s fleet, thus freeing up another 3 737-800s for disposal that would simplify its operation. The A321LR, based on the A321neo, is only available from 2019 onwards, however.

On the other hand, Virgin has also shed light on how lucrative its Velocity Frequent Flyer loyalty business is, following the sale of a 35% stake to Affinity Equity Partners. On A$238.4 million of revenue, Velocity produced an A$81.2 million earnings before interest and tax (EBIT) in FY14, at a margin of 34.06%, or 10 times more profitable than its domestic flying business from a margin perspective. Velocity is also shifting to a higher gear of growth after striking the BP deal with 2 points earned for every litre of fuel purchased and 2 points for every dollar spent in-store, as the daily join rate increased from 1,900 in FY14 to 2,400 in FY15, of which the figure skyrocketed to 4,300 a day during FY15 fourth-quarter after the BP partnership commenced in late-April. At the current growth pace, combined with the acquisition of the Torque data analytics business, a 15% EBIT growth in FY16 and FY17 appears attainable.

In conclusion, much has changed since the “Game On” phase in 2013, let alone since the Game Change programme in May 2011. While its transformation over the last financial year has been as swift as its arch-rival Qantas’s was, as this analysis demonstrated, much less credit was given to Virgin Australia for its rite of passage, and the fact that had it not been there exerting competitive pressure, the steady stream of product innovations benefitting the Australian flying public today would otherwise have been much slower.

Image Courtesy of Virgin Australia

Image Courtesy of Virgin Australia

For more information on Aspire Aviation‘s data research cited in this analysis, Enquire now

Trackbacks and pingbacks

No trackback or pingback available for this article.

1 comment

  1. 2016 is going to be the watershed year for Virgin Australia. With its transformation, complete with new business class seats, new lounges and fine dinning all rolled out the end game (market share / profits) is what we should be looking for.

    The rubber now hits hits the road. The questions are, are there flaws in the strategy, are the numbers that support their market assumptions correct, how will the competitive pressures of a revitalised QANTAS affect its business plan and can the substantial amounts of investment support a reasonable return for shareholders?

    The BITRE statistics do raise some interesting questions.

    Out of all of the players, Jetstar is the winner. It had strong yield growth, very high load factors and grew in size by about 4%. I'd suggest an effective return on capital invested far greater than 10%.

    QANTAS Domestic came in second. Having yields to die for and load factors within a more than acceptable operating range, the slight decrease in size (about a percent) is neither here nor there when we consider the results from the year previously.

    Virgin Australia comes in a distant third. With (underlying) yields in the okay range (nothing special), its load factors were on a downward projectory and like QANTAS was a little smaller than what it was a year previously. Where it won some of QANTAS premium customers, some of their loyal long standing traditional budget passengers migrated over to Jetstar. When we consider we are talking a percent here and a maybe a couple of percent there, at this stage these numbers really don't support the considerable amount of investment that has occurred over the last five years.

    I have a sneaking suspicion Virgin Australia is starting to loose market share. Where Virgin Australia's war to date has focussed on the big end of town (business class), its services to secondary and regional airports could well be hit by a re-vitalised QANTAS. With QANTAS further rolling out its dual brand strategy and re-deploying its now substantial 717 aircraft to east coast flying the competitive pressures in these markets is where the game will be won or lost.

    There is evidence to suggest where the QANTAS group deploys both the QANTAS and Jetstar brand it is able to grow market share at the cost of Virgin Australia. Cairns, Townsville and Newcastle are all examples of where this has rang true.

    With Virgin Australia now all grown up, Richard Branson has taken more of a back seat. This game is no longer about personalities, hollow promises, cheap gimmicks and social media campaigns, but hard numbers, investment in product and long term strategy.

    For Virgin, this was a big corner to turn. With JB at the wheel, they now have someone with considerable substance to help them reach their end game.

    In saying this, if the Virgin Australia numbers are not good this year, there will need to be a whole lot of soul searching to turn this now highly leveraged beast around!

    Travel

    Reply

Leave a reply