Qantas clawing its way back, but big challenges remain. Cautious outlook, shares plunge

Qantas' full year outlook suggests a very modest second half (albeit a significant improvement on the same period last year), reflecting “remaining uncertainty in the economic outlook, particularly in international markets, industry capacity, passenger and freight demand and high levels of volatility in fuel prices and exchange rates continue.

Total international capacity (all airlines) to/from Australia rose 4.8% year-on-year in 2009 to 34/2 million seats, according to OAG, including a 4.7% increase in Dec-2009 to 3.1 million seats. (Worldwide international capacity fell 3% last year, according to IATA, underscoring the resilience of the Australian market, and the preparedness of foreign airlines to put capacity into the Australian market as other markets struggled).

Australian international capacity (total seats): Annual seats 2001 to 2009

Source: OAG

The likelihood is for higher international capacity growth to/from Australia in 2010 than 2009, as foreign carriers, led by the expanding Middle East airlines, continue to add capacity into the relatively robust Australian market. This will place further pressure on Qantas’ yield recovery - even if economies improve - and justifies the airline’s cautious outlook.

Qantas also expects fuel costs to be approximately AUD200 million higher in the second half compared to the first half (at current prices). In addition, depreciation costs will be approximately AUD50 million higher in the second half due to a reassessment of aircraft residual values, reflecting the “reduction in secondary market demand”.

Margins are already slim, and rising input costs and the airline's cautious outlook (which fell short of analysts' projections), have spooked investors. Qantas’ shares fell up to 7.4% in early trade in Sydney today.

Qantas Group net profit margin: FY2005 to 1HFY2010

Source: Centre for Asia Pacific Aviation & Qantas

Fewer First Class seats; Premium Economy expands

Separately, Qantas today confirmed it would reconfigure its long-haul fleet to reflect lower premium travel demand. CEO, Alan Joyce, noted that Qantas’ assessment of longer term travel trends, which pre-dates the economic crisis, “shows that international premium travel demand is changing”.

Mr Joyce stated, “maintaining a First offering on flagship routes is essential for Qantas as a premium airline”, but added, “it is vital that we align this offering with forecast demand which is expected to be relatively slow, compared to Business, Premium Economy and Economy”.

12 A380 aircraft would continue to offer 15 First Class suites on daily services from Sydney and Melbourne to London via Singapore and Los Angeles only, while the eight remaining A380s (to be delivered from 2012) would offer a three-class configuration and with no First cabin.

Qantas stated that final A380 seat numbers are to be confirmed, subject to discussions with Airbus and suppliers, but noted, “they will also add the equivalent capacity of more than three B747-400s, ensuring we can support future growth while reducing the need to purchase additional aircraft”.

Nine Qantas B747-400s will be upgraded and fitted with Qantas’ A380 standard seats and inflight product under the programme, with First Class cabins removed and Business seats installed in their place. The new B747-400 three-class configuration will offer 359 seats (58 Business, 36 Premium Economy and 265 Economy) - an increase of 52 seats overall – or a 16.9% increase in capacity.

Meanwhile, Jetstar, which reported a record half-year while increasing capacity by 32.9% across its network will continue to aggressively expand its capacity supported by additional A330 capacity ahead of the arrival of the B787,

Qantas international still losing money; FFP, Jetstar and regionals generating the profit

While Qantas does not provide a breakdown, its domestic and regional operations are likely to be subsidising heavy losses on international operations, with mainline EBIT falling 38.8% to AUD60 million in the six months to Dec-2009. Jetstar and the Qantas Frequent Flyer programme are contributing strongly to the bottom line, helping the group report stronger pre-tax profits, despite sizeable reductions in Group revenue.

Qantas first half segment earnings: 1HFY2008/09 vs 1HFY2009/10

	Qantas	Jetstar	Freight	Frequent Flyer	Consolidated
Revenue
- 2008/09	6,662	958	628	482	8,068
- 2009/10	5,295	1,131	494	547	6,909
- % change	-20.5%	18.1%	-21.3%	13.5%	-14.4%
EBITDAR
- 2008/09	772	168	59	73	906
- 2009/10	710	282	26	157	1,135
- % change	-8.0%	67.9%	-55.9%	115.1%	25.3%
EBIT
- 2008/09	98	43	49	73	275
- 2009/10	60	121	17	157	307
- % change	-38.8%	181.4%	-65.3%	115.1%	11.6%

Source: Centre for Asia Pacific Aviation & company reports

Revenue slumps 13.4% - billion dollar hole in passenger revenue

Qantas’ revenue slumped 13.4% in the fiscal first half (six months to 31-Dec-2009), reflecting a 13% drop in passenger revenues (over AUD1 billion was carved off the top line), as yield (excluding exchange) plunged 15%, “driven by price discounting in competitive markets and lower demand in premium segments”, as well as lower fuel surcharge revenues.

Qantas domestic and international yield growth (% change year-on-year): Nov-2008 to Dec-2009

Source: Qantas

The outlook is for a slow recovery in international yields, coming off a low base. Mr Joyce stated, “while international yields are improving, they are expected to continue to lag behind the recovery of the domestic market in the short to medium term. This is driven by current economic performance in international markets, the softer demand for premium travel, continuing competitive pressures and the cyclical nature of the international business”. See related report: Airlines lose six years of premium travel growth – IATA. Will it ever come back?

But costs drop even further, by 16.2%

On the cost side, Qantas reduced operating expenditure ahead of the fall in revenue. Costs fell 16.2%, including a 7.8% reduction in staff costs (a creditable result, but still well short of Singapore Airlines’ 26% reduction in its fiscal third quarter), a 9.7% reduction in aircraft operating costs (reflecting lower utilisation and a 2.2% reduction in ASKs) and a 32.5% reduction in fuel costs. Overall costs fell 13.2% (including finance expenses).

Load factors are rising, reflecting the airline's capacity discipline.

Qantas Group pax numbers and PLF

Source: Centre for Asia Pacific Aviation & Qantas Group

Qantas mainline loses quarter of a billion dollars in calendar 2009, slow trajectory from here

Overall, Qantas mainline had a horrible 2009, losing quarter of a billion dollars in calendar 2009, but it restored some respectability in the second half, while Jetstar went from strength to strength and Qantas Freight turned its business around. The Frequent Flyer unit had a better first six months of 2009 than the second half, but is still by far the strongest contributor in the Group.

Qantas segment profit before tax: 2009 Calendar Year

	Qantas	Jetstar	Freight	Frequent Flyer	Total
Six months to 30-Jun-2009	-276	54	-56	191	-85
Six months to 31-Dec-2009	12	121	17	157	143
12 months to 31-Dec-2009	-264	175	-39	348	58

Source: Centre for Asia Pacific Aviation & company reports

Sombre outlook, with threat of added capacity

2010 should be better, but investors hoping for a rapid recovery have clearly been upset by the airline’s expectations of a slower climb out of last year’s heavy turbulence. FY2008's record AUD1.4 billion profit looks a long way off.

Qantas Group profit before tax: FY1999 to 1HFY2010

Source: Centre for Asia Pacific Aviation & Qantas

Mr Joyce offered a very restrained outlook, obviously remaining concerned about international services. Domestically, despite retaining around 65% market share, Qantas is hurt by

1. Continuing low yields in a competitive market; and
2. Increasing attacks on its corporate business, even if it wins the current bid for Federal government business, valued at around AUD500 million, the carrier is likely to have made substantial margin reductions to retain the contract.

Although not broken out separately, the "profitable growth of Qantaslink" probably means strong profits on the carrier's near-monopoly routes.

Faced with a weak economic recovery at best, the biggest risk for Qantas in the domestic market is rapid expansion of capacity. 2009's result was aided by reducing Qantas capacity, but the mainline carrier "will be restoring domestic capacity, adding 340,000 seats over the next 12 months".

This is only part of the story, because both Virgin Blue and Tiger (as well as Jetstar) will be throwing additional seats into domestic routes as well. The result: continuing pressure on domestic yields. This will be unwelcome, coming together with much greater competition for corporate accounts.

Qantas' overall strategy is however coming to the rescue; the magnificent frequent flyer programme is the real cash cow. Meanwhile, the two brand strategy, growing Jetstar aggressively, gives Qantas Group a very valuable option that few others can match.