Is loving Qantas to death in Australia’s national interest? Airline ownership dogma defeats logic


Australian flag carrier Qantas will on 27-Feb-2014 report a loss of around AUD300 million for the first half of the 2013/14 financial year; it will also announce a 2-3,000 reduction in staff numbers. There is an atmosphere of crisis at the airline - which is (at least partly) justified. Its smaller homegrown competitor Virgin Australia will the next day also announce a loss in what has become a fiercely competitive domestic market.

Qantas faces two main challenges to its future: (1) its classic legacy model is extinct, notably internationally; and (2) domestically it is overweight and ill-equipped to deal with the competition that Virgin Australia has generated since its metamorphosis from LCC to full service airline.

The first is a long term problem that requires major surgery; the second is a pressing one that has to be addressed immediately, including perhaps even a change of strategy. Staff reductions and a level of restructuring at Qantas may help reshape the short term; more complex solutions are required to resolve its dinosaur dilemma.

  • Qantas is expected to report a loss of AUD300 million for the first half of the 2013/14 financial year and announce a reduction in staff numbers.
  • Qantas' classic legacy model is no longer sustainable, especially internationally, and it is ill-equipped to compete with Virgin Australia domestically.
  • Virgin Australia has evolved from a low-cost carrier to a full-service operator, challenging Qantas in the business and corporate markets.
  • Virgin Australia's ownership structure, with majority ownership by foreign airlines, allows for better adaptation to modern conditions and access to international markets.
  • Australia's liberal aviation policies have benefited Virgin Australia, while Qantas is encircled by ownership restrictions that hinder its competitiveness.
  • Qantas needs to undergo major transformation and regulatory adaptation to survive in the international aviation industry.

Qantas' legacy model is 20th century, Virgin Australia's is of the 21st

Perhaps the best way to look at the Qantas model - and its future sustainability - is to contrast it with its main competitor at home, Virgin Australia.

The most important differences are (1) Qantas' ownership structure and (2) its still mostly conventional international operations.

Virgin Australia, established as LCC Virgin Blue in 2001, has evolved through a hybrid into a still fairly low-cost full service operator. The transformation was to allow it to challenge Qantas for the business and corporate markets over which Qantas held a near-monopoly for most of this century. Virgin has lost much of its cost advantage in making the transition, but recently acquired a controlling interest in Tigerair Australia, arguably the nation's lowest cost airline, to allow it to contest the leisure markets more effectively.

Virgin remains a predominantly domestic airline; nearly nine out of 10 seats it flies are internal. And internationally 60% of its seats are on narrowbody aircraft to neighbouring New Zealand and Indonesia. On long-haul - it has five 777-300ERs - the bulk of service is to the US and Abu Dhabi. Most of its international operations are virtual; that is, they use codeshares on other high quality airlines to deliver their leisure and corporate products.

Ownership freedom permits an airline profile much better adapted to modern conditions

At a regulatory level the contrast between the two airlines is even starker.

The airline is owned by listed Virgin Australia Holdings, (VAH, which includes Virgin Australia; Virgin Australia (NZ) and Virgin Australia Regional Airlines, each 100% owned; and Virgin Samoa (49% JV) and Tigerair Australia (60%; Singapore Airlines is a partner).

In turn, the holding company is owned by:

The structure is made possible thanks to Australia's foreign ownership rules.

The benefits are mutual: for the foreign carriers, Virgin is a proxy for access to the valuable Australian market, with beyond-gateway codesharing and on-carriage; Virgin meanwhile adds a host of virtual international connections to enhance its international product without the capital investment needed to operate with its own metal. For Virgin Australia's international services using its own aircraft, a majority local ownership corporate profile is retained, so as to conform with bilateral restrictions.

The equity ownerships are still the exception in the airline business, much more used to mere operating or commercial partnerships. Here the logic presumably is that the investment ensures a better position at the table when it comes to getting what the investing airline needs - and, in a new world, that this could not be achieved otherwise. It seems to be working.

Virgin has another significant partnership, anti-trust immunised, with Delta on its US routes. But Delta has no equity, although the strategy is no stranger to the world's largest airline since it acquired 49% of Virgin Atlantic in 2013.

In short, under CEO John Borghetti, Virgin Australia has been able to evolve very much in keeping with the new environment. The new ownership structure is very much of the 21st century, forward looking and innovative. The airline has remained relatively low cost. It has refocused to delivering a comprehensive product in the domestic market, while internationally, to ensure its attraction for leisure and corporate travellers, it has become almost a virtual airline, with limited consequential need for capital investment or operating costs.

Australia's liberal ownership policies have delivered major benefits for consumers

The repositioning has been helped by Australia's aviation policies. For some two decades Australia has pursued a very liberal domestic aviation strategy. It was deregulated in 1987, then later, unlike most other countries, 100% foreign ownership of domestic airlines was permitted - provided management is locally based (a principal place of business requirement). Internationally, liberal access has been granted to Asian sixth freedom carriers and the Gulf airlines (almost one in 10 international seats from Australia are to the Gulf); Australia has an in principle open skies reciprocity policy, with unilateral open skies for all major cities except the main state capitals. Open skies bilateral agreements with the EU, the US, Japan and New Zealand, along with very liberal provisions with most other countries; and while there is formally a complex balance of interests in applying the access strategy, priority is based on enhancing tourism and consumer benefits.

With this regulatory freedom, against the background of its supporting ownership and with losses threatening, Virgin in late 2013 first established new lines of credit then made an equity raising, each supported by its owners to contribute to a fighting fund (to "supplement and diversify the company's liquidity position") for the airline in its battle with Qantas.

Qantas CEO Alan Joyce was not impressed. It didn't help that the timing coincided with Qantas' credit rating downgrade to near junk bond status, thus increasing Qantas' own cost of borrowing.

The Virgin Australia airline ownership is by airlines which are in turn each majority owned by their governments (although both Singapore Airlines and Air New Zealand are listed - and visibly profitable - companies). Qantas charged that: "If wholly privatised, Virgin Australia's ability to receive potentially unlimited capital from its government-backed owners would seriously distort the domestic aviation market for the benefit of foreign interests".

As far as it went, and from Qantas' position, this may have been true. But the benefit was not just to foreign interests. From a consumer and taxpayer viewpoint, what better arrangement could there be than having foreign governments underwrite the losses of an Australian airline?

For Qantas, there is an obvious answer: simply adopt the same corporate structure and gain access to a wide range of options.

Qantas is encircled by ownership restrictions that apply only to it

But here is where the silly stuff begins. Qantas is at the centre of a bizarre debate over preserving anachronistic ownership provisions in the 22 year-old legislation that provided for the airline's privatisation.

Thanks to the Qantas Sale Act 1992, the formerly government owned airline has been singled out for "preferred" treatment. It may not have more than 25% ownership by any one foreign airline and a maximum of 35% among foreign airlines overall; the maximum foreign holding permitted by investors overall is 49%. Importantly too the Act contains provisions which effectively prevent an ownership structure similar to Virgin Australia's. These may not sound seriously restrictive, but in the local ecology they represent an unnecessary and very significant handicap.

The Australian government is willing to amend the Act, but the opposition parties, which control the country's upper house are, for diverse reasons, opposed.

Their dogmatic response to proposals to bring the legislation into the 21st century is that Qantas as a national icon "needs to be kept in Australian hands" and "should not be sold off to foreign interests".

If the legislation is not changed, one proposal on the table is that the government underwrite future Qantas debt - tantamount to partial renationalisation of the airline - in order to recreate "a level playing field" with Virgin. Hardly an advance in open market thinking, this is part political ploy to awaken the dogmatists to the facts, part realpolitik to achieve a form of capital-raising parity.

Dogma defeats logic every time - and facts are just collateral damage

It is genuinely difficult to discern the logic in arguments supporting the status quo concerning the Act. Although inertia is a most powerful force, denial of world aviation changes - well beyond the power of the Australian government or Qantas to influence - can only lead to very uncomfortable collisions with reality.

If truth is the first casualty in war, there is certainly no shortage of misrepresentation from those who want to cling on to the archaic 70-year old "ownership and control" rules of the airline industry. And, in this case to the fast-ageing Qantas Sale Act legislation.

For example, one "strong" supporting argument for the nationalists in retaining the conditions of the Qantas Sale Act is that keeping Qantas nationally pure will keep jobs in Australia.

There is little evidence to support any such claim. In fact the evidence points in precisely the opposite direction. Virgin Australia, propped up by foreign governments (so it is argued), has actually expanded its Australian workforce by over 30% between 2010 and 2013; not so Qantas.

The Qantas Group in the meantime, carefully safeguarded by the Sale Act, remained static in full time employee head-count over the equivalent period - now with several thousand promised redundancies ahead. This is despite carrying 20% more passengers - a notable improvement in productivity, but still low on global benchmarks.

Qantas mainline - the "red tail" - is a 90-year old company whose fundamentals have scarcely changed in half a century. Meanwhile, low-cost airlines have come to dominate short-haul, sixth freedom airlines have robbed the full service carrier of competitive access to any routes where one stop is necessary, and its legacy background ensures that its cost profile is higher than almost all of its main competitors.

There is literally no place in the international aviation future for an end of the line legacy carrier like Qantas - in its current form. So, anchoring the airline to the bottom of the ocean to show how much it is loved may warm some hearts, but it is neither going to help it survive, nor ensure that jobs will be created. Unless it undergoes a major transformation, with substantial regulatory adaptation, Qantas will soon be relegated to a fond memory.

The otherwise parochial political issue is important in global terms because it is yet another battlefront in the war to redefine the relevance of airline ownership rules in international aviation. These provisions are the main stumbling block to allowing rationalisation and consolidation in an industry that is probably the financially worst performer of any. They remain in place largely because of outdated nationalist emotions and misguided beliefs about ensuring job stability - very similar to the current debate in Australia.

While all this local navel gazing is occupying the front page, there is little correlation applied to the astonishing developments that are unfolding just to Australia's north. They are important because they will, over the next five years, further transform the Australian market.

Already AirAsia X, a low-cost airline, became the fourth largest international airline to fly to Australia in 2013. Then there is Lion Air, now the biggest airline in Indonesia - the fastest growing market in the world - with a fleet of nearly 100 aircraft and 540 (sic) more on order. Lion has already established joint venture airlines in Malaysia and Thailand. It is hardly a big leap to suggest it will enter the Australian market before the end of this decade. There are several more LCCs in Indonesia which are making noises about Australian operations.

Then there are the Chinese airlines, growing rapidly and improving by the day; they will be major players in Australia's market by 2020. They will also dictate to the region the sort of regulatory norms that will prevail.

In short, as protectionist barriers are removed around the world, there is no place for rear-view mirror strategies. Adaptation is possible still in 2014, but soon the limited range of options will disappear entirely.

Amending the Qantas Sale Act will alone by no means save Qantas. There is much more to be done. But not amending it will do a lot to ensure its demise, ironically without even protecting the privileged minority which seeks to maintain the status quo.

Burning the furniture to keep warm doesn't do much for sustainability

Then there is the short term.

In a labour intensive industry with substantial input costs outside management control (fuel alone accounts for over a third of costs), there are few levers for management to pull when looking to slim down. The obvious one is labour costs - and improved productivity. Hence Qantas will be making even deeper staff cuts than its long running cost reduction programme has required.

Cutting routes is another, and there will be some announcements surely on 27-Feb-2014 - but there is always the danger in this case of reducing costs while undermining revenues. Looking further, if the short term fix is to be anything more than that, some form of restructuring is going to be necessary too.

Qantas does have advantages: In operating terms, it has made a big step to being able to access new international markets "virtually" over Dubai with its major partner, Emirates. Its low-cost subsidiary Jetstar has been a saving grace, protecting it from a ravaging Virgin Blue in the domestic market in the early part of the last decade and then later in the international forum, as Qantas' high cost base ruled it out of most Asian long-haul routes. It also has one of the best and most profitable Frequent Flyer Programmes in the world. The domestic regional operations too are still profitable, despite Virgin's inroads.

Jetstar and the FFP each have a value which far exceeds the paltry capitalisation of the Qantas Group to which they belong. As a rough indicator of this disparity, when private equity was planning to buy the group and presumably liquidate the various parts, the share price leapt to around AUD6; today it trades at around AUD1.25. Presumably the sum of the parts is of much greater value than the whole. The weight of the legacy airline drags it down.

Consequently, some analysts are promoting a sell-down of the profitable entities, a move that might please some short term traders in the stock and generate advisory fees, but would do little to improve the group's position. Unless synergies can be created by any sell-down, these would simply generate one off capital injections - that would do nothing to solve the fundamental problems.

Qantas is far from broke, with a very decent AUD3 billion or so in cash and equivalents. Despite all the smoke and noise, Qantas is not about to go under - but it is bleeding heavily.

The domestic arm wrestle on capacity is good for consumers, but not a sustainable medium term scenario

There is nothing of equilibrium - dynamic or otherwise - about the current domestic market. That doesn't make it unique; a quick look at what is happening in Southeast Asia can verify that. Massive changes are afoot, even if most domestic commentators are blissfully unaware of them.

To make matters worse, domestic demand is softening, so that even current levels of capacity are generating insufficient yields.

But this is a market where a (relatively) new entrant is seeking to establish a foothold, while the incumbent is fairly naturally resisting. The flavour is added by suggestions that in the airline business a 65% market share generates higher than proportionate returns. That is where Qantas stands now and Virgin understandably would like to alter the balance.

In the circumstances, and given the torrid nature of the industry, it is therefore not unusual to see heavy losses. There is not yet a crisis in the Australian industry, but it is certainly time for a reassessment of where the key players stand. And the fewer obstacles in their way, the better they will be able to prepare for an increasingly onerous future. It's not going to get any easier.

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