CAPA Aviation Outlook 2017: Australia & New Zealand - amid global uncertainty, China again the rock

Question 1: What has been the standout development of 2016 in the Southwest Pacific Region?

CAPA: In a word, China. But 2016 has been one of the more eventful years for this region. As a result, Australia and New Zealand enter 2017 on a very different level from 12 months previously.

Chinese airlines and inbound tourism have shifted the equilibrium

If any evidence were needed of the aviation future of both Australia and New Zealand, 2016 was the year when China's future impact on aviation and tourism really started to become apparent. China's tourism bloomed, largely on the back of Chinese airlines adding significant capacity and service into the South Pacific.

Much of the traffic between China and Australia/New Zealand has been carried on intermediate airlines like Singapore Airlines and its subsidiary Scoot, by AirAsia X and others.

But by Jan-2017, there will be seven Chinese airlines serving Australia and five to New Zealand - in each case also with two Hong Kong based airlines. And now both Qantas and Virgin Australia are embedded in solid partnerships with Chinese airlines. Air New Zealand meanwhile had moved away from its Chinese relationship in favour of a stronger Singapore Airlines partnership.

Qantas enjoying the fruits of its turnaround

Another vital development, not just compared to 2016 but since the global financial crisis, is that Qantas has been revelling in a very successful turnaround. After the lows of 2011 and a domestic competitive bloodbath, the Qantas Group has seemingly become a solid and sustainable story, now looking forward to a new future marked by 787s, due to arrive in the new year.

Historically, Qantas for too long had rested on laurels of a strong domestic market offsetting mounting international losses and overall inefficiency, and a bloated cost structure. With a sustainable commercial base, Qantas has turned to new cabin products, aircraft, routes and branding with a modified logo and livery to enter 2017 revitalized and ready to take advantage of the structural changes and consequent gains made over the last 24 months.

Qantas' biggest gains under its turnaround programme, fortunately (or unfortunately) coincided with the collapse in fuel price. The investment community has failed effectively to separate out the tailwind of fuel cost savings from ex-fuel cost savings - reflected in Qantas' share-price which has ended the year just short of AUD3.50, an improvement on the lows of early July at AUD2.60 but below the AUD4 plus level on which it started the year.

Question 2: How has Virgin Australia fared in comparison?

CAPA: Virgin's transformation under CEO John Borghetti has become more expensive than expected and produced a yield premium lower than budgeted. This alone is a dangerous combination and has been aggravated by Virgin's significantly larger competitor Qantas' successful restructuring.

This is of course not the first time in Virgin's history that the airline has had to confront Qantas' ability to adapt. Qantas' response to Virgin in the early 2000s was the establishment of its own LCC, Jetstar which confronted head on Virgin's then advantage in terms of cost structure.

The Virgin of 2016 is almost unrecognisable with that of 15 years ago, with the Virgin Australia brand continuing to take rival Qantas on head to head, particularly in terms of product, albeit it's come at a significant cost. Virgin's falling financial metrics were sufficiently destabilising throughout 2016 even before they spilled over into the boardroom and created a nearly six month long revolving shareholder registry.

Question 3: Looking to Virgin's revolving door of shareholders, who are the main players and how has ownership changed in 2016?

CAPA: From an ownership perspective, no airline in the world is like Virgin Australia. This is the result of creative company structuring and Australia allowing 100% foreign ownership of domestic-only airlines. Virgin was mostly owned by four airline groups. Sir Richard Branson's Virgin Group - the initial and long-standing investor which has gradually reduced its stake to near token status and then more recently Air New Zealand, Etihad Airways and Singapore Airlines have been the main investors.

Aside from Virgin Group, the other three airline owners are direct Qantas competitors, and have essentially seen Virgin Australia as relevant in its own right - for securing domestic traffic feed - but also leverage in their competition against Qantas.

Virgin Group's biggest benefit from Virgin Australia in recent times has been branding fees and a quality brand in the Virgin empire. Virgin Australia's presence with the Virgin branding has some trickle-down effect on Virgin Group's other business in Australia, notably Virgin Mobile and Virgin Active, although Virgin Australia itself has no direct financial interest in them. As such Virgin Australia's falling performance was not a crisis for Virgin Group as such.

Etihad and Singapore Airlines are large entities and, arguably, more able to tolerate falling performance at either investments or their own operations, provided the operational benefits followed - although Etihad may now adopt a tighter line as changes occur in Abu Dhabi.

Air New Zealand and Virgin's falling out continues a shaky ANZ aviation relationship

Air New Zealand was the spark to the Virgin ownership reshuffle. Before other investors had the opportunity to move in, the New Zealand flag carrier had a vision of a dominant role in Virgin, as they had 20 years earlier with Ansett. But, as new investors arrived and with little strategic alignment, along with its own relatively small status, it became too much to keep underwriting Virgin's weak performance. Air NZ CEO Christopher Luxon failed to persuade Virgin Australia's board to oust Mr Borghetti, so Mr Luxon excused himself from the board and announced Air NZ would sell its stake in Virgin.

In the historical tradition of trans-Tasman airline cooperation, Virgin sensed an opportunity to be enterprising and deliver a parting blow to Air NZ. With Air NZ drawing attention to Virgin as a prospective investment, Virgin quietly marketed itself and directly sold a stake to China's giant HNA Group. The effect was multiple: first, Virgin directly received a capital increase since new shares were issued, which diluted Air NZ's shareholding. Virgin's selling price was below Air NZ's, which caused Air NZ to have to discount its sale price, resulting in a loss once its stake was sold - to another Chinese group. The two are still partners, but

Virgin's new Chinese owners will reshape its strategies

Virgin Australia now has two main Chinese shareholders. Besides the direct sale to HNA, Air NZ sold its stake to the much lesser-known Nanshan Group. Nanshan has a small Chinese start-up, Qingdao Airlines, but it is more widely focused in its overseas investments, including several in Australia.

HNA brings an immediate strategy refocus to Virgin, and the larger Australia market. HNA owns multiple airlines in mainland China and Hong Kong. HNA is strategically disadvantaged: from mainland China it cannot obtain Australian traffic rights out of prime Chinese cities while from Hong Kong the Australia-Hong Kong bilateral agreement is saturated, leaving service to secondary Australian cities the only opportunities.

The investment in Virgin, to be accompanied by a proposed alliance, will allow HNA to benefit from the usual onward connections on Virgin. More specifically, Virgin will probably serve routes HNA units cannot because of the bilateral limits: to Hong Kong and Beijing from prime Australian gateways like Melbourne and Sydney.

Question 4: So what will likely be Virgin and Qantas' focus for 2017?

CAPA: The important issue for Virgin is not Asia but its domestic heartland. Virgin can now focus on a necessary restructuring, which may involve further change at the top. Most of Virgin's senior management has turned over, unsurprisingly raising questions - just as Air New Zealand CEO Christopher Luxon advocated - of how much longer Mr Borghetti will remain. He will stay, but eventually probably in a new role, to take account of the shifting nature of the Virgin Australia group.

Virgin has a few years of work ahead of it.

Qantas is sitting comfortably for now, but once Virgin can deliver on a turnaround, Qantas will again be under increased pressure to drive costs out of its business. Virgin's new ownership structure which has until now been more of a burden than a benefit, should start to deliver dividends in 2017.

Jetstar and Tiger roles are being reviewed

Both airlines will need to decide what to do with their LCC units. The cost gap between Qantas and Jetstar is not as big as it used to be, as Qantas' comes down. Jetstar's previously grand 787 ambitions are now apparently shelved in favour of Qantas' operations, although from a group perspective this is still healthy: for example Jetstar's Melbourne-Tokyo growth provides a pathway for Qantas to take over.

Tigerair Australia however is not growing as much as Virgin promised when it took the airline over, although it has replaced Virgin on short haul Southeast Asian flights. Virgin may need to address its LCC's branding now that the centralised Tigerair brand will be disposed of in Singapore, to be replaced by the Scoot branding as those two SIA subsidiaries are combined.

Question 5: How will Qantas' China Strategy evolve?

CAPA: Qantas is beginning to roll out its new China strategy by returning to Beijing in cooperation with Shanghai-based JV partner China Eastern, providing it access the Beijing-Australia market which the Chinese authorities will not allow China Eastern to fly in its own right.

Virgin will finally deploy to the international market on a regular basis the premium-equipped A330s it used on trunk domestic markets to Perth but which are now largely not needed following the collapse of the resource sector concentrated around Perth.

The emergence of an HNA-Virgin force around China competes with the Qantas-China Eastern tie-up and China Southern, which at the peak will operate four daily flights to Sydney, including one on the A380.

The competitive effects are also present on Cathay Pacific, a major mainland-Australia operator via Hong Kong - and, to a lesser extent, Singapore Airlines. In the absence of direct flights, there was good business to be had; this has changed too quickly to allow a gradual readjustment.

Question 6: Where does this leave Air New Zealand with its China strategy?

CAPA: Air New Zealand had been forward looking in establishing a Shanghai hub some years ago, but then forsook that for a closer relationship with Singapore Airlines to give it access to Asian markets.

For a relatively small airline in these large markets, options are limited and choices have to be made. SIA has proven reasonably successful, as Singapore also provides a useful staging point for Europe services, but it will become more pressing for Air New Zealand to partner with one or more of the Chinese direct operators if it wants to share more fully in the rewards to be gained from the burgeoning inbound tourism (and trade) that China promises. Meanwhile Air NZ is cool on its government's expansion of Chinese airlines' access rights.

Question 7: Will the Australia-China market continued to boom?

CAPA: The Australia-China market will continue to boom now that 2017 has been named the 'China Australia Year of Tourism' by China's tourism bureau. Australia has sealed its position as a natural and good lifestyle destination for the Chinese. As a mostly leisure market, it is an ideal first market for increasingly maturing Chinese airlines as they can partner with tour agencies to sell the service before developing independent sales and strategies on how to sell premium cabins.

Australian and New Zealand's benefit is that they are perceived by the Chinese as 'safe' markets. Geopolitical instability and terrorism around Europe has seen Asian visitors put off not just towards directly impacted countries but often to an entire continent. There has consequently been some reorientation in their visit profile, to intra-Asia and North America. From an airline perspective, Asia-North America has been growing too rapidly for sound commercial outcomes in the short term. Combined with depleted Canadian and American traffic rights, Chinese airlines now need to put aircraft elsewhere.

Australia and New Zealand are at least temporarily the answer as the Chinese airlines receive more and more long-haul premium aircraft in the form of the latest variant 777s instead of A330s. It is not just mainland China: a stuttering Cathay is also sending more 777s, while Korean Air is bringing in the A380. Southeast Asia, once the main driver of growth (and over-capacity) is now relatively modest, while Northeast Asia accelerates growth.

The risk is that some of this capacity diverts elsewhere as more compelling opportunities become available. Although Australia and New Zealand are generally proactive with traffic rights, the objective is steady growth and not the peaks and troughs that have characterised the market in the past.

Capacity is at historically high levels and China - in Dec-2016 - agreed to Australia's previous request to remove capacity constraints on passenger services. To have seven Chinese airlines serving Australia, and five in New Zealand, is remarkable considering the respective sizes of these long haul destinations. Also, Qantas is preparing to return to Beijing using its own aircraft and Virgin Australia planning its Chinese debut within the coming year. The China market has a long way to go before it peaks - if it ever does.

Growth does not equate to profitability though. Virgin's planned services to Hong Kong and Beijing may not be profitable in the short term, but there are long term benefits and they come with the trade- off of stabilising the shareholder registry.

One problem with such an unusual and eclectic share registry is the inevitable conflicts that arise: despite some coordination, Etihad and Singapore Airlines already compete for Australia-Europe traffic, and with time HNA's presence will be felt on SIA's Australia-China transfer market, and even later HNA's sixth-freedom Australia- Europe traffic will impact Etihad and SIA.

Question 8: Air New Zealand - is the focus now Asia, North America or consolidating its domestic position?

CAPA: Air New Zealand has not reacted favourably to its government's addition of traffic rights to China. A remarkably and consistently profitable airline, Air New Zealand once saw itself having a larger China role in coming years, partly assisted by a stronger relationship with fellow Star Alliance member Singapore Airlines. An influx of Chinese airlines will make this expansion more difficult however.

New Zealand, with a population of only 4.5 million, is meanwhile adjusting its tourism strategy to take account of the potential size of the Chinese market, seeking to focus on the high end tourist (along with many others).

Domestic will remain central to Air New Zealand's profitability

But China strategy is still a tertiary concern. Air New Zealand, like Qantas and Virgin, is most profitable domestically. Jetstar has for some time gradually pressured Air NZ on domestic trunk New Zealand services and, using written-down turboprop equipment, is now challenging on select regional flights.

Jetstar will not come close to matching Air NZ in size or scope, but it is delivering a disproportionately large pricing impact - and flow-on revenue cost, although there will inevitably be some market stimulation. From a Jetstar perspective, its new regional turboprop network is less a profit driver and more designed to cause annoyance and pain to Air NZ, while not being a drag on Jetstar Group. Importantly too, in an increasingly integrated tourism and travel product, it allows Qantas to fill in some gaps in its business travel and frequent flyer network.

The US market is becoming more of a challenge

Air New Zealand, like Qantas and Virgin, has North America as its main long haul market, both in terms of size and profitability. Air New Zealand's New Zealand-US direct services were a valuable monopoly until the entry of American Airlines and United, the latter now a JV partner with Air New Zealand. Yet the capacity growth and pricing discipline imposed by American Airlines' entry weakens performance. Even Fiji Airways is an annoyance with its one-stop service, allowing a business class experience to Wellington residents.

Air New Zealand's North America network also had a tidy business as a sixth freedom operation to Australia. This is now under pressure from growing Australia-North America capacity. After United and Qantas grew and American entered Australia, Virgin Australia is also growing to Los Angeles. Although Virgin's growth may seem the latest punch, it has added impact since Virgin and Air New Zealand had effectively ceded certain North American markets to each other.

With Air New Zealand no longer a Virgin shareholder, Virgin is pursuing growth in its own right. A saving grace for Air New Zealand may be that the US has rejected the American-Qantas JV, although if the JV had restricted competition as the US authorities suggested, this could in turn have equated to more opportunity for Air New Zealand.

Cost reduction and refocussing become necessary as conditions get tougher

The cumulative effect was Air New Zealand, after years of growing and - much admired - performance, delivered the airline's record profit in its 76 year history in FY2016. CEO Christopher Luxon was forced, however, to issue a warning that the peak had been reached and subsequent profits would not be as strong. There is competition for Air NZ to contend with, but, like Qantas a few years ago, Air New Zealand now also needs to address its cost base.

Although Air New Zealand has achieved a lower cost base than Qantas, the national carrier has lost some of its momentum on containing costs and maintaining efficiency. This was inevitable as new equipment arrived and as strategies evolved. A deep restructuring like Qantas is not needed, but there is much internal work for Air New Zealand to do.

Question 9: So, what is the overall 2017 outlook for the Southwest Pacific region?

CAPA: China will inevitably feature largely in aviation and tourism planning for both Australia and new Zealand.

But 2017 will also be a year of new technology as Qantas finally introduces the 787-9 on it mainline services.

It will be a year of local consolidation as bedding down domestic markets remains the core task for the region's airlines. Qantas is also looking to grow in Asia, clawing back gains from Singapore Airlines and Cathay now that Qantas has reduced its costs to levels it believes are comparable with the Asian heavyweights.

But the attention-getting developments in 2017 centre around Europe. New Zealand will have two ultra-long-haul flights, with Qatar Airways planning a Doha-Auckland nonstop, the mere mention of which had provoked Emirates into launching, on a month's notice, Dubai-Auckland nonstop. These services will have an unwelcome and potentially extensive impact on a number of New Zealand long haul routes, but will serve the New Zealand inbound and outbound markets well.

Qantas' recently announced Perth-London service has already been a multi-million dollar marketing coup- even though it is not planned to start before early 2018. A non-stop 787-9 flight, the service would link Australia and Europe together for the first time. But despite being a long flight, it will not be the world's longest - that distinction will go to SIA's New York service when it resumes. Yet a nonstop service between two continents at the antipodes will provide a level of enchantment. 787 profitability, however, will come from Qantas using the type to North America, ideally launching Dallas flights from Melbourne and Brisbane, supplementing existing A380 Sydney-Dallas.

Perth Airport and Qantas, with a little financial support from the West Australian government, agreed in Dec-2016 to the terms to modify Qantas' domestic terminal to support international-domestic connectivity. A same-terminal domestic transfer in an intimate environment Qantas can control and brand appropriately has considerable upside for Qantas financially and for marketing compared to competitors' offerings in the likes of Singapore, Hong Kong and Abu Dhabi. It also offers Qantas another alternative in an international market that is always in flux.

Qantas' 787 use also reflects a wider shift in the global market

Successive generations of Qantas were defined by increasingly bigger aircraft, from variants of the 747 to the A380. Qantas' next era is the more compact 787. It has taken time for Qantas to adjust to end-of-line geography and the realities of stopover hubs growing and new ones emerging.

Airlines elsewhere in the world still struggle to define - and redefine - themselves to create a market that is sustainable. Even the relatively healthy groups are not satisfied: IAG finds itself again needing to churn British Airways to reduce costs and improve product, while US airlines balance their view of international growth with demanding investors.

Loyalty programmes will continue to be moneyspinners

Loyalty will also remain an important commercial focus given each of the three major ANZ airlines has a powerful frequent flyer programme. In FY2016, to 30-Jun-2016, Qantas reported AUD1.45 billion in loyalty revenues, a tenth of the group's revenue, allocating it an underlying EBIT of AUD346 million. Virgin's Velocity programme, part of which it sold down during the year, accounted for a healthy AUD140 million EBIT, almost as much as its domestic flying operations generated. Air New Zealand meanwhile naturally dominates its domestic market, for frequent flyers and for corporate travel.

The business and corporate traveller is an integral part of this loyalty system and 2016 was marked by the greatly added activity of LCCs in the SME and corporate markets. Jetstar's targeted Aquire programme is about to be relaunched and its New Zealand activity relies on GDS access - where travel management companies still dominate the corporate interface - for its corporate access viability.

Back to basics in an uncertain and competitive world

Australia and New Zealand's airline success will continue to be defined by restructuring, partnerships, and loyalty strength.

That forms a solid base for what new challenges will inevitably emerge in 2017.

But in a tepid global economy, shaped by political uncertainty, with intensifying competition internationally, there will be reduced profitability for each of the main airlines in 2017. The tailwind of low oil prices is moderating, although unlikely to return to previous heights, but again emphasises the need to contain costs. Where all else is uncertain, owning the lowest costs is always a key feature of sustainability.