Australian airline market enjoyed the sweetspot: now, how sour is the downside?

Qantas, Jetstar and Virgin Blue enjoyed the best ever conditions in the second half of calendar 2007. But 2008 promises a much more exciting array of challenges for Australian airlines - which now includes a hungry Tiger Airways.

Despite historically high fuel prices, strong load factors translated to profits: Qantas group profit up 73% on the previous corresponding period, Jetstar up fourfold as its capacity expanded by over 60% and Virgin Blue up 7.6% (excluding its investment in a range of new initiatives).

Much of this hot market was attributable to a strong domestic and Asia Pacific economy, with a relatively low interest-rate regime. For various reasons too, there was a general shortage of aircraft capacity, as earlier forecasts had not delivered sufficient seat build-up to meet the continued high level of demand.

But, while the outlook still looks reasonably good, each of those positive elements is about to change for the worse, some subtly, others more forcefully. In combination, their impact could create a very sour taste. New capacity is arriving this year, interest rates in Australia are climbing (which could dampen leisure demand), premium demand is softening and oil prices are today solidly above USD100 a barrel.

Two main factors will decide just how sour the next few months become: (1) the state of the Australian domestic economy; and (2) the level of new capacity introduced. This is where the bulk of profits have been generated.

The economy is an unknown, but the probability is for slowdown, perhaps gentle; demand will therefore soften, but it is too early to tell by how much. On the supply side, Virgin Blue yesterday flagged the likelihood of excess capacity in the domestic market, expecting it “to outstrip long term annual industry growth rates”. The result: a “challenging” yield environment. This affects profitability in different ways.

In the domestic feeding chain, Virgin Blue is hoping to bite into Qantas’ premium market while slowdown in premium demand is more likely than expansion. Meanwhile, Tiger, at the low end of the market, will eat into previously strong leisure yields – and contribute to the capacity expansion by bringing in more aircraft to its Australian operation. (Significantly, Tiger has not yet entered the “golden triangle” of Sydney-Melbourne-Brisbane, where the biggest profits have been delivered, and where Jetstar currently has only limited operations.)

Internationally, Japan and UK premium demand are already showing weakness according to Qantas (the US is not hurting so much as much of that traffic originates in Australia). This hurts Qantas financially, but it also increases the chance that Qantas will pull some capacity onshore – a strategy which would accentuate domestic strains, while helping restore Qantas/Jetstar’s market share to its desired 65% “line in the sand”.

Shareholders will be enjoying healthy dividends this year. But the flavour of the market is likely to be very different at this time next year.

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