COVID-19: Virgin Australia to survive, but in what form - and name?

Summary:

• Virgin's major shareholders could not provide enough aid, so will likely be sidelined.
• Government aid has spurred hot debate, but federal role is still appropriate.
• Strong market interest in recapitalisation should spur quick completion.
• Long haul operations, widebody fleet, and Tigerair may be most vulnerable.
• Ensuring part of the valuable corporate market is captured may be a necessary goal.
• The Australian government may be in the position of picking winners.
• Major decisions are looming on fleet composition and aircraft orders.
• The good news: Australia's domestic market could flourish next year.

Lack of adequate financing options left Virgin with no choice

Virgin's board made the decision to enter voluntary administration late on 20-Apr-2020 and announced the move on 21-Apr-2020. The airline was left with no other options after it could not secure the extra funding it needs to continue operating. A high debt load and a series of credit rating downgrades also made it difficult to attract new financing.

The company had attempted to tap its major shareholder groups - Etihad Airways, Singapore Airlines, the UK-based Virgin Group, and the China-based HNA and Nanshan Groups, who between them own 90% of the airline - but they were not able, or not willing, to front up more funding on the scale required. Many of these groups are suffering from the same market conditions as have hit Virgin Australia.

Virgin has also approached the federal government for financial assistance.

The airline asked for an AUD1.4 billion loan, as part of a proposal for a broader industry package. However, the government has declined to become involved in a Virgin bailout, at least for now.

Federal support for Virgin raises thorny questions

The question of federal government aid for Virgin has become a hot topic politically in recent weeks.

If Virgin did not recover and defaulted, the government could be left owning an airline, which it argues is not its role. There is also the tricky question about financial aid benefiting the overseas-based groups that were Virgin's major shareholders. And also the argument - as promoted by Qantas - that aid for just one airline would tilt the playing field.

On the other side of the argument is the need to protect thousands of Australian jobs, both in the airline and in the wider travel and tourism industry. There is also a general recognition that having two major airlines is beneficial to Australian consumers.

The possibility remains that the federal government will participate in Virgin's recapitalisation during the administration process. It appears the door is still open to a government role, even if it is as a last resort if a suitable outcome cannot be achieved from among the many would-be suitors. It is hard to argue that the government should not help, as the travel restrictions which hurt Virgin (justifiable as they may be) were imposed by the government.

Wage subsidies and fee relief are helpful, but more direct assistance is needed.

State governments may still play a role in relaunch

State aid has also been a large part of the debate. The Queensland government offered AUD200 million with the proviso that Virgin retain its corporate headquarters in Brisbane.

However, New South Wales muddied the waters somewhat by suggesting that it would also be willing to provide support to Virgin - if it moved its headquarters to Sydney and focussed its operations on the future second airport, due to open in 2026.

The Victorian government also said it almost weighed in with a potential AUD500 million underwrite, in its turn looking to support the operation of Melbourne's second airport.

While welcome, the state support would not have been enough to keep Virgin afloat absent more substantial federal aid. State support may yet be part of any eventual solution for Virgin and could influence such things as where its future headquarters are located.

Virgin and its administrator aim to prevent group break-up

A team from Deloitte has been named as administrator for Virgin Australia, led by Vaughan Strawbridge.

While there are many hurdles to overcome, both the airline and the administrator have made a point of stressing that Virgin has not collapsed and is not going away.

Virgin has said that it entered voluntary administration in order to "recapitalise the business and help ensure it emerges in a stronger financial position." Mr Strawbridge said the administrator's intention "is to undertake a process to restructure and refinance the business and bring it out of administration as soon as possible".

The task now is to find suitable new owners who can inject the capital needed.

Mr Strawbridge said that there had already been "extraordinary interest" from potential buyers. More than 10 entities have indicated "keen interest" in being part of the recapitalisation, and the administrator has begun canvassing for others.

Avoiding a break-up of the airline does not however necessarily mean that the airline that emerges from this process will be "Virgin Australia". If the UK-based Virgin Group is not successful in becoming a stakeholder in the new entity, the administrators will be faced with persuading - or not - the eventual owners to stump up the considerable cost of using the very valuable Virgin brand.

Strong interest in recapitalisation signals quick administration process

Those who have already contacted the administrator include "a wide cross-section" of entities, including some overseas groups, said Mr Strawbridge. He would not reveal any more details, but private equity groups are believed to be among the interested parties.

While some of the companies expressing interest are large enough to take over Virgin, Mr Strawbridge believes the government "still has an important role to play" in the process.

The intention of the administrator is to complete the recapitalisation process relatively quickly. Timetable details will be released soon, and formal expressions of interest will be sought over the next few weeks. A shortlist of potential candidates or consortiums will be formed, and Mr Strawbridge predicts that the likely outcome should be known within 2-3 months.

Whatever the new ownership structure is, it will undoubtedly be less complex than the current arrangement.

The existing shareholding groups are expected to see their holdings virtually wiped out unless they change their minds about injecting more capital and participating in recapitalisation. Richard Branson has indicated the Virgin Group may do so.

Operations (such as they are) will continue through administration

Mr Scurrah and his management team will remain in operational control of Virgin Australia Group through the administration period.

Mr Scurrah has been at the helm of Virgin for just over a year, having focused on improving the balance sheet and the airline's financial health. The airline was showing signs of this improvement although, as Mr Scurrah notes, that progress was cut off by the arrival of COVID-19, the partial closure of most states' borders and the nationwide self-isolation strategy, which quickly starved the business of revenue.

Mr Strawbridge has stressed that no redundancies are planned in the administration process and all employees will retain their entitlements. Approximately 80% of Virgin's 10,000 workers have already been temporarily stood down, and they will still receive government wage subsidies.

The airline will also continue to operate its very limited flying schedule, partially subsidised by the federal government in order to provide basic connections, although 96% of its flights have been suspended.

For the week of 9-Mar-2020 - before large scale domestic reductions began - the Virgin Australia Group (including its Tigerair subsidiary) accounted for approximately 37% of domestic seats, according to data from CAPA and OAG. Qantas and Jetstar accounted for a combined 57%.

Their market shares were largely in that range over the past eight months, until all traffic fell off a cliff in late March 2020.

Australian domestic market seats through May-2020

Source: CAPA - Cente for Aviation and OAG.

Administrator aims to retain as many jobs as possible

Regarding how Virgin's fleet, network and operations will be affected by the restructuring, Mr Strawbridge said that all options were on the table for review. The final shape of the airline post-administration (and presumably post-COVID) will obviously also depend on the intentions of prospective buyers.

The administrator said the preferred - and intended - outcome is for Virgin to be sold as a whole entity, rather than assets being sold separately. There is no intention to sell off the Velocity loyalty program, which is operated as a separate business, under a trust structure, as part of the Virgin Australia Group. Velocity has been excluded from voluntary administration.

The intention is also to retain as many jobs as possible, Mr Scurrah and Mr Strawbridge have stressed. The administrator will consider the interests of all stakeholders - including employees - in analysing the restructuring offers.

Virgin Australia management believes its strategy would still work

Mr Scurrah has proposed to the administrator that Virgin's relaunched operation should be based on the group's pre-COVID strategy. This would include a role for international operations, the CEO said. Mr Scurrah said the airline has already analysed its pre-crisis strategy and determined that it represents the best path forward.

Whether this plan is acceptable to the administrator and the potential new ownership is not so certain. Question marks particularly surround the international network, and how much (if any) will eventually be retained.

Long haul international operation could be most at risk

Virgin's most important short haul international market is New Zealand, although intense competitive pressure was hurting profitability on these routes before the pandemic struck. Virgin could conceivably make money in this market by focusing on trunk routes and cutting some of the thinner routes.

The airline also has short haul international routes to the Pacific Islands and Bali. Mr Scurrah has indicated that international leisure routes will remain part of the plan.

Virgin's limited long haul operation is mainly focused on routes to Los Angeles with its fleet of five Boeing 777s. This is generally regarded as a valuable market, although it is unclear how long it will take long haul international to recover.

Virgin had already decided to pull out of its only Asian long haul flights to Hong Kong, which were not performing well. A service to Tokyo's Haneda Airport was due to begin in Mar-2020, but COVID-19 has put this on hold.

Any decision to reduce or remove international operations would be made easier by the strong likelihood that travel across national borders will be extremely difficult until multilateral standards are in place to govern the way passenger and community health is protected.

Major fleet decisions loom, particularly for widebodies

Any network changes will obviously be closely tied to fleet decisions. It is widely believed that the complexity of different aircraft types had imposed a costly burden on the airline, something Mr Scurrah had already begun to address.

Boeing 737-800s represent the core of Virgin's domestic and short haul international fleet, and its widebody fleet comprises Airbus A330s and the 777s. Most of its aircraft are parked now.

Virgin Australia fleet summary: as at 20-Apr-2020

Source: CAPA Fleet Database

Orders include those placed directly by the operator and by lessors assigned to the operator, from 20-Apr-2020 onwards.

Virgin also has 48 Boeing 737 MAX aircraft on order. The delivery target for these aircraft has been delayed more than once, most recently in 2019 in one of Mr Scurrah's initial moves. The revised first delivery date was in July 2021, although it is not clear how that is affected by the well-publicised MAX program disruption.

Mr Scurrah said the MAX order - and the fleet strategy - will be a hot topic during the administration process and restructuring. Virgin has told Boeing it wants to have discussions about the future of its MAX orders.

The airline has previously said that it was weighing a widebody replacement order, although it has to be assumed that such a move will at least be put on the back burner. Again, the necessity for a widebody replacement order is tied up with decisions about Virgin's long haul strategy.

If international flying is reduced or dropped, access to overseas networks will be needed to help attract corporate buyers

One option for Virgin is to cut its widebodies to simplify its fleet, but this would also mean giving up all long haul routes. Ideally, Virgin could cherry-pick desirable long haul routes, but the trade-off would mean having a subscale widebody fleet.

Virgin has also pursued a strategy of operating a "virtual" international network, using other airlines' metal to make up for its own limited international footprint. Renewing and possibly extending these arrangements will be important, particularly if Virgin's international routes are reduced. Such an approach involves much less capital investment, but also diffuses the value of its brand and relies on its ability to negotiate effective deals with foreign airlines. Some of its most important partnerships are with its (former) major stakeholders.

If the airline does return in the form of a full service operation as the government has hinted it feels is necessary, capturing part of the highly valuable corporate market will be essential. Over the past decade the airline has invested heavily in new business-focused facilities at most major Australian airports, as well as its inflight products.

In doing so it stimulated a marked improvement in service levels, as well as offering corporate buyers an effective alternative to the very powerful Qantas product, at the same time as provoking reduced business costs. Large buyers will be keen to see a competitive tendering market as something like normality returns.

Tigerair was already on the ropes, and may not appeal to buyers

The outlook for Virgin's Tigerair LCC subsidiary is also very much in question. The underperforming Tigerair unit was a problem for the group even before COVID-19, and Virgin had trimmed back the subsidiary's network. Largely by virtue of its small scale and perhaps over-ambitious goals, Tigerair had not found it possible to achieve a cost base that would make it fully competitive with Jetstar.Tigerair was completely grounded on 25-Mar-2020.

Mr Scurrah has said that the proposed Virgin strategy still has a role for an LCC - although it is perhaps unlikely that a prospective buyer would want a dual-model approach.

That does of course raise the possibility of a sale of the LCC as a separate entity. Rumoured interest in the administration process from groups like Indigo Partners, which has successfully launched a stable of LCCs across the world, could perhaps even focus on a Tigerair solution, as part of a wider outcome. Whether the government would favour such a situation is not clear.

The government's unwillingness to invest in the airline could still leave it in the position of having to pick winners

By placing its own financial specialist in the data room, the government apparently intends to seek to steer the negotiations in a direction that will produce the most acceptable outcome in the national interest. Nicholas More, the government appointee, has a highly distinguished financial career, heading Macquarie Bank through a long period of profitable expansion.

It is obvious that multiple sets of options may emerge - including substantial involvement of private equity investors, previous airline shareholders (including, but not limited to the Virgin Group) and a variety of other interested parties.

Typically it is then the role of the administrators to achieve an outcome they consider the optimum - covering such factors as the interests of the staff and creditors as well as, vitally, establishing an outcome considered to be viable in the long term.

If, as seems probable (and arguably highly desirable), the government seeks to overlay this decision-making with national interest criteria, this will add an interesting ingredient into the mix.

And the current unique circumstances may even add a further layer of innovation. The government has also indicated that it may seek to introduce competition guidelines designed to protect the emerging new airline from overly enthusiastic market behaviour by the powerful Qantas group. Remarkable times.

Virgin may have been on the right track, but strategy changes are likely

Virgin's future shape and strategy are very much in flux in the current extraordinary environment. The management's plans and opinions will carry some weight, but the views of the administrator, creditors, government and future owners will be much more important. Virgin essentially ceded the right to determine its fate when it was forced to enter voluntary administration.

Mr Scurrah can make a strong argument that his changes would have turned around Virgin's performance and improved its financial health, as was beginning to occur when external forces closed off the market.

However, the long term balance sheet weakness gave the airline little leeway, and made its restructuring vulnerable even to the more moderate kind of external forces that are almost inevitable in the airline industry.

Signals from the administrator - and the apparent market interest - show that there is a good chance Virgin, under whatever brand, will be relaunched rather than liquidated, and quickly. If so, it could be re-established as domestic flying conditions loosen. This is undoubtedly good news for the workforce - although the airline may not be the same size as before.

Virgin's value is based largely on its position in Australia's domestic market, and certain short haul international narrowbody markets would probably still fit in well. The long haul widebody routes could be a tougher sell to potential buyers.

And the good news...

The good news is that the very valuable Australian domestic market could well experience a uniquely positive year in 2021.

If the coronavirus is effectively contained, so that domestic (and even Australia-New Zealand) flying becomes widely possible, the likely absence of other international options would mean a mini-bonanza for domestic tourism. A well positioned Phoenix Airlines would be a prime beneficiary of that.

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