A capacity truce in Australia’s domestic market - A return to profit for Qantas and Virgin Australia

Airline Leader

When Qantas and Virgin Australia recently ended their capacity war in the domestic market by tapering the high growth of past years, there was quiet jubilation in many quarters. But Qantas and Virgin now have many battle scars to address before they right themselves.

  • Qantas and Virgin Australia have recently ended their capacity war in the domestic market, but both airlines still face challenges.
  • Qantas has projected a first-half profit of AUD300-350 million, which would be its best since 2010, but the airline still has a long way to go to recover from the losses of the past four years.
  • Qantas has undergone a significant management shake-up, dividing the airline into separate domestic and international businesses, each with its own CEO.
  • Qantas is focusing on improving its international business by retiring aging aircraft, retrofitting existing planes, and expanding its partnership with Emirates.
  • Virgin Australia's international operations are facing challenges, particularly in the short-haul leisure market, where competition from Asian low-cost carriers is increasing.
  • Virgin Australia plans to take full ownership of Tigerair Australia and may consider deploying the airline internationally, potentially under a new brand.

The risk is Qantas' Dec-2014 projection of a first half profit of AUD300-350 million showing the carrier being back to normal. While this profit will be Qantas' best since 2010, the intervening four years have been poor when measured against Qantas' annual profit in better times in excess of a billion dollars.

To make very clear that complacency was still not on the agenda despite the good news, Qantas' profit projection was quickly followed by a significant management shake-up. The Dec-2014 announcement unwinds two significant changes made as recently as May-2012: the appointment of Simon Hickey and Lyell Strambi to respectively manage Qantas' international and domestic businesses.

In re-dividing the airline into its original domestic and international elements, Qantas in 2012 introduced separate CEOs for the domestic and international Qantas mainline business, with each reporting to Group CEO Alan Joyce. Those positions remain even though Qantas will not (yet) seek separate licences for its domestic and international businesses, which could allow Qantas to introduce unrestricted foreign capital into its domestic business, as Virgin did. The logic behind the separation is that domestic and international businesses are different and need separate oversight and accountability.

The Dec-2014 changes bring forward into leadership positions individuals with solid credentials; both are appointments from within. The immediate focus is righting Qantas, but the long-term implication could be formulating a successor pathway, something Qantas has not always excelled at.

When Geoff Dixon stood down in 2009, there were three pretenders, each feeling equally entitled; Alan Joyce's appointment generated considerable disappointment from the other two, both valuable longstanding employees and both of whom resigned.

One was John Borghetti, who went on to become CEO of Virgin Australia and an uncomfortable thorn in Qantas' side, knowing his new competitor inside and out.

Gareth Evans has been a familiar face as Group CFO but will move into a strategic position by becoming CEO of Qantas International and Freight. His counterpart at Qantas Domestic will be Andrew David, who has quickly risen at the Group. Mr David left Tigerair Australia for Jetstar, where amongst other things he helped mend Jetstar Japan, before moving to Qantas as Group COO.

Qantas' previously troubled international business is now coming into focus. Ageing 747s are being retired while those to remain have been refitted. A330s start a retrofit to make them more competitive in economy and business cabins on domestic and international routes. They will compete with Virgin's widebodies that will also be refitted. And, while there is a lull in the capacity war, the product confrontation will continue to ensure Australians enjoy among the plushest airline experiences in the world.

These investments raise questions but elsewhere Qantas is tightening the screws on efficiency. It has adjusted its Melbourne-London route timing - but for now resisted the logical temptation to axe it. This has helped free up aircraft capacity to bring the A380 to Dallas, introduce a second daily Tokyo service and permit ad hoc international services. Qantas International remains smaller than in the past, but is doing more with less. Its Emirates partnership on the whole has meant a boost to route coverage, with dozens of new destinations beyond Dubai now reachable on a Qantas code, albeit on Emirates' metal.

Virgin Australia's international worries meanwhile are not so much long-haul, but short-haul. Long-haul is mostly Los Angeles service in partnership with Delta and three weekly Abu Dhabi flights to contribute to its Etihad partnership. Virgin has spoken of one or two more long-haul destinations, but the obvious pick - Singapore - is not supported by Singapore Airlines, which has in the past been an uncomfortable partner by insisting on retaining services on its metal.

Virgin's short-haul leisure destinations such as Denpasar (Bali) and Phuket have experienced growing competition from Asian LCCs while Virgin's cost base steadily ticks upward. These are a small part of the network but have a disproportionate impact.

Also posing a dilemma for Virgin is Tigerair Australia, the LCC it initially took 60% of but will increase its stake to 100%, taking it off the hands of a frustrated, and embarrassed, Singapore Airlines. Virgin's share of Tigerair's losses in 1Q2015 amounted to a quarter (AUD11.6 million) of Virgin's own loss (AUD45 million) despite Tigerair having one tenth the ASKs of Virgin Australia. Nonetheless, Virgin still intends to bring Tigerair to profit by 2016, although it may reduce its fleet from 13 A320s. Singapore's Tiger Holdings said it would assume responsibility for an undisclosed number of aircraft that were to be delivered to Australia.

Virgin may decide to deploy Tigerair internationally now that it has secured rights; those Asian points and Pacific island destinations could be a good fit. But Tigerair may be flying under a new brand: it is all but a done deal that SIA's more successful (and wholly owned) LCC Scoot will take over Tigerair Singapore and drop the troubled brand that had managed to achieve a weak identity perception even before regulators grounded the Australian LCC.

Virgin may look to introduce a new brand, but CEO John Borghetti maintains he will keep the two apart, unlike the overlap between Qantas and Jetstar. "You walk into a supermarket and look at the toothpaste…there's probably 20-30 brands. They're probably owned by one or two manufacturers but you'd never know it. I think that's the way you run a multi brand strategy and that's the way we intend to run it," Mr Borghetti said in a video interview with CAPA TV. Codeshares and reciprocal lounge access are off the cards.

Mr Borghetti also holds firm views on the company's Asian strategy. While Qantas has formed a codeshare with China Southern and proposed a JV with China Eastern, Mr Borghetti is not looking for a new solution. "We can feed the China traffic over Singapore with Singapore Airlines and that's as good as it gets," Mr Borghetti says. "There is no better partner than Singapore Airlines."

Virgin's core business - domestic Australia - is the critical focus for Mr Borghetti. It is also where stakeholders Air New Zealand, Etihad and Singapore Airlines are pressuring for a solution, not wanting to keep reporting associate losses. Air New Zealand is achieving record performances, but has a disclaimer that profit projections exclude its share of Virgin's financial performance, which for now involve losses.

Success for Qantas and Virgin will depend largely on their performance in the domestic market. The apparent truce on capacity may be a little uneasy. Qantas and Jetstar are pulling back capacity while Virgin and Tigerair Australia grow, according to schedules they have filed with OAG.

To suggest there is low or no domestic capacity growth is to mislead. While average figures may remain stable, their respective networks comprise some routes which are decreasing and others where sizeable growth is occurring. For example there is a pull-down of capacity on some flights touching Western Australia, which was home to excessive growth the small market could not sustain; the end of the mining boom has exacerbated any excess. Meanwhile some east coast flights are being boosted; there the competition continues, although the key Melbourne-Sydney-Brisbane triangle capacity is broadly down.

Air New Zealand has a much better run in its domestic market, although its lack of competition and strong yields invite consumer criticism. Air New Zealand will pull out of some domestic markets too small for its regional fleet. On long-haul, Air New Zealand continues to benefit from more limited competition than the Australian carriers have to confront.

Chinese airlines are growing, and will continue to, following the New Zealand government expanding the bilateral with China, to the frustration of Air New Zealand, arguing that Chinese carriers gain disproportionately from the expansion.

A proposed joint venture between Air New Zealand and Air China will see Air New Zealand's Asian network defined by partnerships, with JVs in all markets - SIA in Singapore, Cathay in Hong Kong, Air China in mainland China - except Japan where there is a close partnership with All Nippon Airways.

North America is growing in importance for Air New Zealand and accounts for about 35% of ASKs. Despite some moves from the New Zealand government to welcome fifth freedom competition (eg by Emirates, possible under the respective open skies agreements), Air New Zealand has the non-stop New Zealand-North America market to itself, although forced to compete with large transfer volumes going through Australia first.

Air New Zealand will realise its Latin American aspirations when it launches Auckland-Buenos Aires service in late 2015. A codeshare with Aerolineas is planned, but the airline has shown itself to be fickle in the past - as can be Argentina's economy, one of many reasons Qantas exited Buenos Aires in favour of Santiago, where its oneworld partner LAN can support it. There are significant Argentine cultural and expatriate links with Australia and New Zealand, but the low yielding nature of the market has made the ultra-long service marginal in the past.

A bigger long-haul international challenge is to Jetstar, which has cut the Auckland-Singapore route and services to Beijing. Scoot's entry on the Melbourne-Singapore route will further pressure Jetstar, which has to contend with Emirates' low fifth freedom fares on the route. In another sign of a more conservative strategy, Jetstar will defer delivery of its final three 787s.

Jetstar's long-haul low-cost aspirations have been overtaken by Scoot and AirAsia X, although there have been some hiccups. Scoot had to consolidate its presence over the slow season but is now bullish, with 787s beginning to take over from the oversized 777s it received from its parent; meanwhile AirAsia X will cancel its Adelaide-Kuala Lumpur service.

The quiet success story has been Fiji Airways' transformation. A new CEO, replacing Stefan Pichler who moves to airberlin, will oversee modest 3.5% growth under a new strategic plan put in place by Mr Pichler, which also includes one new A330 in 2016.

The new CEO also takes up the position of Tourism Fiji CEO, a slightly contradictory role, as Fiji Airways will want to secure growth for itself. As 2014 came to a close, Fiji and the Solomon Islands were in their fifth month of a bilateral spat. Qantas remains in an even longer impasse over its ownership stake in the Fijian flag carrier, although the country's return to a form of democracy is providing some hope for conciliation.

Australia and New Zealand's aviation markets are among the most open in the world, with massive sixth freedom foreign airline operations, notably from the Gulf carriers. The fact that they are mostly profitable, have their costs relatively well under control and are innovative in their strategies speaks volumes both for the quality of management and the value of an openly competitive marketplace. Now that the inflated local currencies are falling back to earth following the collapse of the mining boom, tourism will be the major beneficiary. And fuel price reductions will be very welcome additions to the airlines' bottom line.

The South Pacific markets were the first in the region to exploit leisure markets fully. This has ensured a broader travel market and a heavily entrenched expectation of low fares. In this environment, cost management is a vital element of a successful operation. Air New Zealand, with the lowest costs of the full service airlines, has been able to exploit this virtue, along with applying some sound strategy and on the back of its domestic market domination.

There is, however, a strong sense that both Qantas and, not far behind it, Virgin Australia groups are getting to a level where they can ensure a long-term sustainable model - whether through direct operations or via a range of partnerships.

Overall, the consumer and associated travel industries have been beneficiaries of this market profile; for 2015, they look set to continue to benefit, on the back of some relatively healthy and increasingly smart airlines.