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Is Qantas and Australia’s aviation system in meltdown? No, but challenges are all around

5-Dec-2013

Qantas' 5-Dec-2013 pre-tax loss projection of up to AUD300 million for the six months to 31-Dec-2013 is accompanied by plans for an accelerated cost reduction programme involving an additional 1,000 head count reduction.

Since Qantas started getting its international network into order last year with a ground-breaking Emirates alliance, at least one major issue seemed to be solved. A new codeshare alliance announced with China Southern on 3-Dec-2013 complements its existing one with China Eastern, offering a good platform for future growth in the massive China market. Meanwhile Jetstar, with joint-venture alliances, is developing new markets across the region from various country platforms.

Many of the main ingredients are in place for a viable longer term international operation. It is the short term that is proving hard to digest. Virgin Australia is being annoyingly aggressive, at home with its expanded product and capacity including a Tigerair dual-brand to match Qantas’, and internationally through its equity partnerships with Etihad, Singapore Airlines and Air New Zealand. There is also a host of very aggressive foreign airlines feeding off the still relatively strong Australian outbound market.

The Qantas mainline brand remains overweight and proving increasingly vulnerable as competition persists. Hence the emergency measures.

See related report: Virgin Australia and Tigerair Australia move to implement the group's dual airline brand strategy

It is not only competition that is hurting. Australian demand is also softening fast. As the announcement noted, “Trading conditions saw a marked deterioration in November in particular, with both passenger loads and yields below the already negative trends for the year to date.” And there is little prospect of a marked improvement.

It’s time to remove the nonsense restrictions on Qantas ownership

Australia’s domestic aviation market has been a model of futurism over recent years, adopting very liberal principles which have served the consumer extremely effectively and transformed a previously high cost/high priced and marginal industry to a profitable and consumer friendly one.

But it has created some new pressures, especially as there is an overhang of political residue that continues to see Qantas, “the national flag carrier”, as being a government entity. The image is supported by strong legacy unions pursuing elusive job security.

The inertial position is enforced by elderly legislation, the Qantas Sale Act, which places limits on ownership levels by other airlines. The Act restricts foreign airline ownership of Qantas (only) to 25% for a single airline and 35% for airlines in aggregate. Meanwhile, as CEO Alan Joyce is at pains to point out, Virgin Australia has established a holding structure that permits up to 100% foreign ownership; 80% of that (listed) company is now held by four groups: Etihad, Singapore Airlines, Air New Zealand and Virgin Group. Virgin’s international ownership and control integrity is protected by ring-fencing the international operation from the domestic operation. Australia is one of a few countries that permits majority foreign ownership of a domestic airline.

A recent equity raising by Virgin, made easier thanks to these shareholdings, has provoked indignation from Qantas that it is being forced to fight on unequal terms with Virgin Australia.

Of that there can be no dispute.

But when it comes to making aviation decisions, successive Australian governments have shown all the imagination and courage of a wombat. 40 years of dithering over a second Sydney airport is still unresolved and there sadly seems to be little more enthusiasm for amendment of an Act whose original purpose has long been redundant and today serves no purpose other than to place Qantas at an artificial market disadvantage.

Faced with continued indecision from government – which leaves the default position in place – Mr Joyce has sought a government guarantee for Qantas’ debts, a remarkable request in a deregulated market, but one which is presumably intended only to highlight the need for a compensatory mechanism to offset the legislated disadvantage.

The subsequent extraordinary series of exchanges involved highlights both the issues now emerging around foreign ownership rules and the intense nature of the confrontation between the two major Australian airlines as they seek a new status quo in the market.

Virgin’s mission to metamorphose into a full service airline has accelerated the evolutionary process

In the second half of the last decade, the former LCC Virgin Blue began its mission to evolve away from its roots and convert to a full service airline, competitive across all market segments with Qantas. The fundamental nature of the Australian market has as a result changed significantly and, when former Qantas executive John Borghetti took the reins and changed the airline’s name to Virgin Australia, the intensity of that battle increased dramatically. Qantas had enjoyed a near monopoly of corporate travel and was easily the dominant international operator.

Air New Zealand had already made an unsolicited invasion of Virgin’s share register, seeking to secure its place in the valuable Australian domestic market, but then in early 2012 the Virgin team established a new financial structure, opening up the entire registry of a new entity to foreign ownership.

This was possible because Australia has an open policy that permits up to 100% foreign ownership of its domestic airlines, as long as management control resides in the country. Virgin Australia needed a two-tier structure though to ensure it would continue to be able to operate internationally under the 70 year old regulatory regime that requires substantial ownership and effective control to remain with nationals of the home country for international operations.

With this in place, Virgin Australia has moved ahead to become a near-virtual international airline, relying heavily on the services of its main shareholders to provide a wide range of overseas destinations that allow it to compete effectively with Qantas in the valuable business and corporate markets.

Meanwhile Qantas remains victim of a tired mentality that still sees it as a tool of government

The origins of the limit in the so-called Qantas Sale Act, are obscure and not originally aviation-related anyway, but with inertial pressures from unions and the support of a small handful of political primitives who still see The National Icon in 1950s terms, successive governments have failed at the gate when asked to update the archaism.

For some years it did not really matter that much that Qantas was hamstrung in this way. The airline was dominant in a highly profitable domestic market and had little home competition on international routes; it also possesses the world’s most valuable airline frequent flyer programme that serves to deliver considerable loyalty and enormous revenue streams.

But even though much of its equity ownership is disguised behind investment fund managers, the restriction does limit the airline’s ability to raise capital on global markets. This is a foolish inhibitor that serves only to ensure that Qantas operates at a handicap, while doing nothing to ensure that this publicly listed entity, with no government ownership, remains in Australian hands – whatever that is worth.

More to the point, in a newly equity-investment driven world, Qantas is unable to match its up-front competitor, Virgin Australia in seeking out airline partners for growth.

As Virgin Australia creatively adapts to a new world with its forward looking corporate and operating structures, Qantas is clearly placed at a disadvantage. Mr Joyce has attacked the other carrier’s two-tier approach somewhat indiscriminately, arguing that Virgin’s investors are intent on undermining Qantas’ market presence.

The argument gains some poignancy as Qantas stares down the barrel of a very substantial loss in the current financial year to 30-Jun-2014, which some analysts are projecting could be as high as AUD400-500 million. Merely the prospect of that could be sufficient to see Qantas’ credit rating downgraded from its present elevated investment grade, a position it occupies along with only a couple of other airlines worldwide.

The result of such a fall would be to add over AUD100 million to the airline’s borrowing costs; a government guarantee would secure the investment grade ranking. But this would be a highly controversial move, compatible only with quasi-government ownership.

As Virgin’s Mr Borghetti relevantly points out, that scarcely fits in a deregulated market environment. If Qantas were to receive such a guarantee, then so, arguably, should Virgin Australia, he quite reasonably maintains.

See related report: Qantas and Virgin Australia reach an uneasy truce on domestic capacity expansion

Legislative change is needed – but Qantas still needs to get its house in order too

Mr Joyce’s recent attacks on Virgin Australia’s structure should be read not so as seeking to force a reversal of his competitor’s corporate format, but to awaken legislators to the fact that the Qantas ownership cap creates a real and unnecessary disadvantage for his airline. Sadly, as noted earlier, the latest attempt seems only to have generated a combination of the usual spectrum of government indecisiveness through to the populist rabble of political voices calling for the airline to be re-nationalised.

The 5-Dec-2013 cost reduction announcement is against this background. Projecting a heavy loss in what is typically the better half-year for Qantas has prompted a dramatic acceleration of Qantas’ cost reduction programme. In summary this involves:

  • A head count reduction of at least 1,000 positions within 12 months, with an ongoing review; 
  • CEO and Board pay cuts:
 
  • A pay freeze and no FY14 bonus for executives;
 
  • A review of spending with Qantas’ top 100 suppliers; 
  • Network optimisation and improved fleet utilisation; and 
  • “Further overhead reductions”

There is also talk of unspecified non-core asset sales – in which context Mr Joyce has not ruled out selling the highly profitable Qantas FFP. (In a sane world of course, the sale would be of the “core asset”, while keeping the FFP!)

And partners for Qantas look as if they'll have to wait, for now

Mr Joyce has remained coy about potential investors in the airline were the legislated limit to be removed. There may well have been no explicit approaches. But if the goods are not on the shelf there is less likelihood of a buyer coming knocking. Qantas, despite its short term woes, is a highly attractive proposition as a partner; it is relatively well cashed up, with the best airline frequent flyer programme in the world, has two thirds of what is one of the most lucrative domestic markets, in a country whose population is highly peripatetic. That is what attracted Emirates and there are numerous other airlines that would see value in anchoring a stake in the airline.

It is a clear and apparent trend that many airlines are now looking to evolve away from the historic positions in aviation and cross border equity investments are quickly becoming part of that portfolio.

The constraints of the Qantas Sale Act militate against any change and, rather than serving any useful purpose – either in the ubiquitous national interest, or more to the point in Qantas' interests – they provide a major obstacle which threatens to derail what is after all a listed company that must make profits. Unless the extreme – and in today's world, no less than foolish – step is considered of re-nationalising the airline, there can be no lingering logical reason why the Qantas Sale Act limits should not be removed.

As is increasingly evident from the innovative and highly intelligent Virgin Australia model, partner airlines can go a long way to supporting future viability. There is little that would ensure Qantas' survival into the future better than enlisting the solid support of one or two powerful international players. Returning to some sort of 1960s nationalised icon would not go near achieving that.

The days of wombat policy should be for yesterday.

See related report: Qantas reports AUD192 million profit as the Emirates deal helps long-haul losses halve


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