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Outlook: Domestic Australia airline capacity truce; NZ prepares for new entry on regional routes

Reducing capacity in Australia is less a strategic decision than it is overdue common sense. Qantas and Virgin Australia appear finally to have settled into a more stable capacity approach, with growth largely a pivot of capacity away from Western Australia and back into the east coast as the commodities slowdown hits demand. A taste of profit for both carriers should head off the temptation for further scuffles.

With Australia more or less stable and international now back into expansion mode, the Qantas Group now looks set to take on Air New Zealand's domestic market with the expansion of Jetstar into regional services. While using idle assets to make a play at Air New Zealand’s monopoly, the move is likely to trigger an animated response – indeed, promotional fares have already been matched by the Kiwi incumbent and Air New Zealand is questioning the competition law implications.

Fiji Airways continues its quiet expansion in the South Pacific in the meantime while also looking to broaden its long haul markets into emerging inbound tourism markets such as China, Japan and Singapore. But the carrier is about to welcome its third CEO in three years and the shift back into expansion will require a steady hand to maintain the ruthless cost focus employed by previous CEO Stefan Pichler and prior, Dave Pflieger.

Cheap(er) oil remains a key part of the story – almost all airlines have benefitted

Fuel accounts for some 30% to 50% of airline costs, and the continuing fall in oil prices amid weak demand, strong US output and OPEC’s decision to maintain production rates should generate continued falls for the next six months. Although jet fuel has slightly lagged the fall, if the current oil price level is sustained throughout 2015 there will be significant material gains to carrier bottom lines.

The impact for Australia’s airlines is partially diluted by a strengthening USD - and the much lower AUD - but is still very substantial. Previous estimates suggested jet fuel prices would not fall bellow USD111/barrel, emphasising the unpredictable nature of jet fuel markets. There is no such thing as a good fuel price forecast.

Changes in fuel expenditure: Qantas and Virgin Australia FY2014 and FY2015

This present decline does however allow airlines an additional buffer by which to lower fares; notably if demand continues to wane, carriers have additional leeway to relax fares and stimulate demand. Qantas Airways reported a benefit of AUD461m from falling fuel prices alone, excluding AUD136m of transformation-related fuel benefits. The fall was manifested in a more than 11% fall in its fuel expenditure between FY2014 and FY2015 despite increases in long-haul flying.

Virgin Australia appears to have little exposure to falling oil prices – its fuel expenditure changed by less than 2%. CEO John Borghetti noted a benefit of approximately AUD60 million as a result of lower fuel prices in FY2015 but with the qualifier: “About half of that (AUD30m) disappeared because of currency exchange.” The benefit is projected to increase, on a net basis, to about AUD162m by FY2016 assuming Aug-2015 hedging and market rates, but even then: “This is expected to be offset by the approximately AUD99m adverse impact of a weaker Australian Dollar, resulting in a total expected net benefit of approximately AUD63m in the 2016 financial year.”

Air New Zealand – whose home dollar has fallen even more steeply than the AUD - expects greater gains in FY2016 than the previous period, noting that, based on a current Singapore jet fuel price of USD60 the benefit to its fuel costs in FY2016 compared to FY2015 is expected to be NZD293m. This price impact is improved by a decrease in hedge losses of NZD70m giving a net improvement of NZD363m.

This would be further affected by foreign exchange fluctuations to the extent that these are not hedged, as well as changes in the volume of fuel purchased due to capacity growth. CFO Rob McDonald noted currency hedging in FY2016 is 92% hedged USD/NZD exposure at 0.777 with a forecast benefit of NZD115m for FY2016.

Domestic capacity growth in Australia has subsided - but not before plenty of pain

Throughout the global financial crisis, Australia's domestic market defied global aviation trends. Although LCCs made inroads and grew the market, short-haul corporate travel – mostly in premium cabins – remained strong. A domestic market serving only about 23 million people produced profits in excess of AUD1 billion. More recently those profits were slashed during a capacity war between Virgin Australia, seeking a larger position in the market, and Qantas, which fought to defend its position.

Now the airlines are seeking a balance between growth/market share and profitability; Qantas Group (including Jetstar) is heading into 1HFY2016 (to 31-Dec-2015) with a domestic capacity forecast of between 0% and 1% - in other words, flat. According to schedules filed with OAG, between 01-Sep-2015 and 21-Feb-2016 Qantas Airways will increase its capacity by just under 1% while wholly-owned LCC subsidiary Jetstar will fall by 10.3% (although Jetstar aggressively mixes and matches to demand as shown in the chart below). Virgin Australia will decrease capacity by 0.7% while its subsidiary LCC Tigerair Australia will add almost 18%.

Australia domestic airline capacity growth: 19-Sep-2011 to 21-Feb-2016

While the market has tempered somewhat from the bloody battle of 2011/2012, there are still constant adjustments within the respective networks. Average figures may remain stable, but the airlines’ networks comprise some routes that are decreasing and others where sizeable growth is occurring. There is a reduction in capacity on some flights touching Western Australia – with Qantas the first to pull its A330s away from transcontinental services in favour of international deployment.

Western Australia in particular was home to excessive growth that small market could not sustain, despite the boom in demand as the state’s resources giants flourished. Once resources prices cooled – and they did very quickly – so did premium air travel demand. Meanwhile some east coast flights are being boosted; there the competition continues, although capacity the key Melbourne-Sydney-Brisbane triangle capacity is broadly down.

Domestic Australia capacity has flat lined following a period of growth (2012 to 2016)

Forward schedules show below or at trend capacity growth through to mid-financial year. It is also highly probable that continuing capacity and fleet consolidation will occur in line with a new focus on profitability. Virgin’s core business, domestic Australia, is the critical focus for Mr Borghetti.

It is also where major stakeholders Air New Zealand, Etihad and Singapore Airlines are pressuring for a solution, not wanting to keep reporting associate losses. Air New Zealand has been achieving record performances, but with the disclaimer that profit projections exclude its share of Virgin’s financial performance, which for now involve losses. Over at Qantas, there is now a recognition that muscling out Virgin is not an option as it was before the smaller airline gained some powerful big brothers.

Qantas Domestic vs Virgin Australia ASK Change Jul-2013 to Jul-2015

It can be predicted with some confidence that the current subdued market will last at least through the remainder of 2015, and likely stabilise into this equilibrium; network adjustments will continue as airlines shuffle their mainline, regional and discount arms to maximise profit.

Qantas’ move to a “dynamic scheduling” model in 2014 has seen a less restrained approach to underperforming routes and the group has become much more proactive in cutting frequency or service where needed and juggling mainline and Jetstar routes. Virgin Australia has acted similarly with Tigerair Australia.

Fares quietly tick upward while capacity winds back

According to data for 1H2015 from 4th Dimension Business Travel Consulting, Qantas restructured its domestic fare families in Feb-2015 – reducing the number from four to three (removing fully flexible economy) and increasing the number of price points in the discount Red eDeal family. Virgin Australia has been the primary instigator of fare increases however, which Qantas has followed, albeit not as aggressively, according to 4th Dimension.

Price increase leaders in Australia’s domestic market during 1H2015

 

Number of Fare Increases

Average Fare Increases

Qantas Airways

3

6.6%

Virgin Australia

4

9.3%

Source: 4th Dimension Business Travel Consulting

Across seven measured routes a consistent trend can be seen where Qantas is between AUD10 to AUD25 more expensive than Virgin Australia on the same fare class. On Melbourne-Sydney, the average difference between Qantas and Virgin Australia is 16.5% across all classes, with Qantas the more expensive carrier. During the review period of 1H2015, Sydney-Adelaide was identified as the route with the highest increases in fares YTD.

Qantas increased its fares by an average of 13.6% in economy, with the largest increases in Y and B class at 20.6% and 23.4% YTD respectively. Virgin Australia increased its fares by an average of 21.1% in economy, with the largest increase on Y and L class at 30.8% and 32.9% YTD.

The demand required to fill the glut of seats added through the capacity war was insufficient and yields suffered as a result, meanwhile providing great deals for customers. Business class fares bore the brunt of Virgin Australia’s rebranding in 2011, as it gained market share; but they have since recovered. Full economy has remained consistently strong through the period while, in real terms, discount economy fares have continued to trend downward.

This provides an important signal that despite a tightening of supply, good deals for consumers will remain.

New Zealand regional markets could be the next to feel the pinch as “Propstar” advances on Air New Zealand

Air New Zealand has long enjoyed a solid base in its home market, controlling most regional routes, and is outwardly confident that Jetstar Airways’ encroachment into regional routes will have little to no impact. CFO Rob McDonald observes: “I’d have to go back five years to say that’s something that would’ve been concerning for us.” The flag carrier is much better equipped to respond, having learned some lessons as Jetstar entered New Zealand trunk routes with its 737s.

The new venture is a departure from Jetstar’s previous jet-only fleet. The LCC plans to operate some of the plum regional markets, Nelson-Auckland and Napier-Auckland from 01-Dec-2015, followed by New Plymouth-Auckland, Palmerston North-Auckland and Nelson-Wellington from 01-Feb-2016. It will at first use a fleet of five Bombardier Dash 8-Q300s. The aircraft come from Qantas Group subsidiary Eastern Australia Airlines, which operates QantasLink services in Australia and will also do so for Jetstar in New Zealand. Having previously been stored, the Q300s provide a very low-risk endeavour for the group using otherwise idle aircraft.

Since Jetstar’s announcement in Jun-2015, Air New Zealand’s share price has fallen 15% and it reduced fares on 32 regional routes by between 11% and 40% over the same period. Air New Zealand chief sales and commercial officer Cam Wallace said the reductions were however to towns not on Jetstar's list of planned destinations: "We have delivered reduced lead-in fares to every domestic port we operate over the past six months or so. The biggest reductions have been on routes that are being up-gauged from the 19-seat Beech aircraft to the larger 50-seat Q300s." Mr Wallace said the carrier had been able to offer a greater number of lower fares due to the equipment upgauge.

This follows a protracted period of public and media scrutiny of the airline in late 2014 over the perceived high prices of its regional airfares – although similar complaints afflict regional airlines around the world, where a low passenger count and high fixed cost base often result in disproportionately high fares relative to sector length. Although Jetstar is likely to be just an irritant in the short term, it has significant potential to disrupt an otherwise lucrative domestic market.

According to the CAPA Fleet Database, Eastern Australia Airlines currently operates 16 Dash 8-300s (including the five already earmarked for Jetstar). Qantas Group is moving toward an all-Dash 8-Q400 fleet for regional services in Australia, raising the possibility of further Q-300s entering the domestic New Zealand market. Air New Zealand’s subsidiary Air Nelson, by comparison, operates 23 Dash 8-Q300s while another subsidiary, Mount Cook Airline, operates 17 ATR 72s.

Air New Zealand is also planning an 8% domestic capacity increase in FY2016 – although largely due to the retirement of the Boeing 737-300, being replaced with the larger A320, and the addition of further ATR 72s. Domestic New Zealand has been performing very strongly for the carrier, with demand outstripping capacity during FY2015.

At the CAPA Australia Pacific Aviation Summit on 05-Aug-2015, Jetstar Group CEO Jayne Hrdlicka noted the expansion into regional New Zealand is a reaction to local demand for choice and alternatives: “The New Zealand people don’t want an opportunity where they can’t travel to and from the regions… 15 years ago, before low fares really penetrated Australia, travel to the outreaches was a luxury item and unfortunately that’s still the case in New Zealand.”

Jetstar Airways CEO David Hall has expressed his desire to expand the regional operation further: "We'll keep talking with stakeholders in Hamilton, Rotorua, Invercargill and Tauranga because they’ve all expressed a desire for airline competition and they support Jetstar’s model of stimulating market growth through lower fares."

The Q300s have very low capital costs, but exactly how low Jetstar will be able to price its fares on a turboprop with considerably fewer seats to split the same fixed costs is unclear, especially given that it plans to offer regular lead-in fares of less than NZD50. However, with all of the initial routes linking to a major port, a proportion of traffic will progressively be connecting beyond. Network pricing can often allow different parts of a system to cross-subsidise others. Air New Zealand is unconvinced however.

Fiji Airways continues its gentle expansion but…

Fiji Airways is planning modest growth over the next five years as it focuses on further improving its profitability. The flag carrier has been profitable for five consecutive years and recorded a record half-year profit in 1H2015. Fiji Airways will take its first A330-300 and the fourth A330 for the group in Dec-2015, to be used for expansion into two Asian destinations (the first being Singapore, the other believed to be Beijing). The larger -300 will also allow for up-gauging across the network to mix and match with the seasonal nature of Fiji’s tourism traffic.

The carrier has yet to announce frequency to Singapore but plans to commence operations "hopefully before" Apr-2016. The service will be guaranteed by the Fijian Government for at least the first 12 months, and negotiations are underway for potential codeshare agreements ex-Singapore. Fiji's Acting Prime Minister and Minister for Finance Aiyaz Sayed-Khaiyum said: "Singapore is very important. It is another major hub and there is very good connectivity into the Middle East, Africa and of course into markets like India." Mr Sayed-Khaiyum said the carrier is also considering Beijing Capital International Airport but noted challenges negotiating an Air Services Agreement (ASA) to support the service. Tokyo is another possible destination, having last been served in Apr-2009, should negotiations stall.

Fiji Airways Group fleet: as of 01-Sep-2015

Aircraft

In Service

In Storage

On Order

Airbus A330-200

3

0

0

Airbus A330-300E

0

0

1

ATR 42-600

1

0

0

ATR 72-600

2

0

0

Boeing 737-700

1

0

0

Boeing 737-800

4

0

0

de Havilland of Canada DHC-6-300

3

0

0

Total

14

0

1

Fiji Airways acting CEO David Bowden attributed the carrier's strong 1H2015 financial result to excellent performance of the group’s international network: "The growth of our Hong Kong service to China clearly shows the diversity and resilience within the Group to deliver strong results despite economic and market pressures within our core Australian market."

The group completed a restructuring and turnaround in FY2011 under former CEO David Pflieger, ending several years of large losses. Fiji Airways has since been consistently profitable, although on a relatively flat revenue base.

Encouragingly the carrier is reducing its reliance on Australia, although that remains the largest market by a significant margin. Australia has fallen from 45.5% to 40.2% of Fiji Airways’ market over the same period in 2014, while New Zealand is up from 18.3% to 20.2% and the US is down from 17.7% to 14.9%. Growth has come from adding a fourth Boeing 737-800 in May-2015, and the addition of new routes such as Nadi-Wellington, Nadi-Vava'u, Nadi-Honiara and seasonal frequency increases on others, such as Nadi-Hong Kong.

The Nadi-Wellington route offers an attractive onward connection to the US for the Wellington region, providing further diversity. This expansion came however with a corresponding CASK increase of 4.4% in 1H2015.

Fiji Airways capacity share (% of seats) by country: 31-Aug-2015 to 06-Sep-2015

The airline's business plan calls for only modest growth of about 3.5% and the carrier, at least under the previous CEO Stefan Pichler, has prioritised cost management and sustainable profitability over growth. One additional A330 would almost certainly result in a faster growth rate than the 3.5% indicated.

But Mr Pichler departed the carrier on 28-Feb-2015 to head for the CEO role at airberlin, and his replacement was not made until the appointment of David Bowden on an interim basis on 03-Jul-2015. Mr Bowden will step down on 01-Oct-2015 to make way for new CEO Andre Viljoen, previously of Air Mauritius.

Fiji Airways is in a relatively strong position, but as a boutique flag carrier it is always vulnerable to sudden changes in market conditions. As it heads through a period of minor transition, adding its ninth aircraft and inducting a new CEO, Fiji Airways will need to maintain its focus and not be distracted by operating in competitive transit markets or placing too much capacity in a highly competitive market such as Australia-Fiji.

South Pacific Outlook: Domestic Australia has cooled, New Zealand may have more to come

Australia has undergone its transformation and adjusted to the new equilibrium of two full service carriers, each with a low cost subsidiary – although Virgin Australia has yet to reap the rewards. Capacity is flat and fares are trending gently upward, although it perhaps would only take a spark to set off round two – especially if Virgin feels its hard-won gains are at threat. For Qantas, the impressive EBIT booked by its domestic arm in FY2015 may be enough of a carrot to cool any retaliatory thoughts.

Jetstar keeps its cards close to its chest and, while Air New Zealand appears relaxed, there is certainly a level of apprehension about the new threat. Air New Zealand has taken down competitors before, but a newly invigorated Qantas is clearly making a play for New Zealand, with free Qantas Frequent Flyer membership for residents and points on all Jetstar fares. There is certainly significant scope for the small beginnings to grow.

Fiji Airways is the quiet star – under Mr Pichler it has built an efficient operation and positioned itself well to capitalise on greater interest from North Asia. Having operated its first charters to mainland China in the past year, Fiji Airways is shifting its capacity focus from Australia and the US into growth markets of mainland China, Japan and Southeast Asia. The challenge will be making this adjustment while retaining a strong cost focus, all while initiating its third CEO in three years.

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