07-Oct-2014 3:06 PM

Virgin Atlantic SWOT. Little Red's demise further re-emphasises the Atlantic and the Delta ownership

Analysis

The decision by Virgin Atlantic Airways (VA) to close its fledgling UK domestic operation Little Red in 2015 came as no surprise. Its load factor in the 12 months to Jun-2014 was less than 42% and, although the trend was improving, this was clearly not sustainable. In spite of the likely losses at Little Red, VA said last month that it was on target to deliver an annual profit by the end of 2014, which would be its first in four years.

Historically an exclusively long-haul point to point carrier, it seems that it does not need to try to generate its own feed through loss-making short-haul activity.

This development comes as VA is set to take delivery of its first Boeing 787 Dreamliner. It also follows recently announced changes to the airline's long-haul network that will see it increase its already sharp focus on the part of the world that is included in its name - the Atlantic - and the US where its 49% owner, Delta resides. In this report, we consider Virgin Atlantic's main strengths, weaknesses, opportunities and threats.

Summary

Key Points:
Virgin Atlantic's North Atlantic network remains at the core of its business, responsible for two-thirds of its scheduled revenues in 2013.
The joint venture with Delta Air Lines has helped drive Virgin Atlantic's revenues up and provides opportunities for cost synergies.
Virgin Atlantic's profitability record is poor, with losses in four out of the past five years.
The closure of Virgin Atlantic's UK domestic operation, Little Red, demonstrates its focus on long-haul routes and its reliance on accidental feed from other airlines.
The Boeing 787 deliveries will help lower costs and increase new route options for Virgin Atlantic.
Threats to Virgin Atlantic include North Atlantic overcapacity, the EU investigation into Delta's part ownership, competition from Gulf airlines, geopolitical events, and the cyclical nature of the airline industry.

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Virgin Atlantic Strengths

1. The Virgin brand sets it apart

Virgin Atlantic enjoys the positive perception afforded to the Virgin brand, benefiting from an image that extends well beyond the world of aviation. One of the relatively few Virgin branded companies that is more than 50% owned by Sir Richard Branson, it remains at the heart of his business empire.

Representing values such as value for money, quality, fun and individuality, Virgin Atlantic has won many awards over the years for its brand and its advertising campaigns.

2. It has a strong North Atlantic network

Thirty years on from its launch in 1984, the airline's North Atlantic network remains at the core of the business. Including the Caribbean, the North Atlantic was responsible for two thirds of its scheduled revenues in 2013. According to OAG data, Virgin Atlantic is the second largest competitor between the UK and the US, with 18.6% of seats (behind British Airways on 37.5%).

Virgin Atlantic Airways split of scheduled revenues by destination region (%) year to Feb-2013 and 10 month period to Dec-2013

This focus looks set to increase further as network changes in 2015 will see Virgin withdraw from London to Tokyo, Mumbai and Cape Town. It will also cut one North Atlantic route, Vancouver.

However, it will add London to Detroit (taking one daily frequency from Delta) and Manchester to Atlanta (replacing Delta), while Delta will take one of Virgin's daily frequencies on London to Newark. It will launch a new summer only route from to Orlando from Belfast and increase frequencies on its summer service to Orlando from Glasgow. VA will also increase frequencies on London to Atlanta, New York, Los Angeles, Miami and San Francisco.

3. Virgin's joint venture with Delta should boost revenues

Since Jan-2014, Virgin Atlantic's North Atlantic routes are now part of a joint venture with 49% shareholder Delta Air Lines, whose 8.3% share of seats between the UK and the United States brings the total share on the JV to 26.9%. With antitrust immunity, the ability to coordinate schedules and pricing should be positive for revenues.

Indeed, on its 2Q2014 conference call, Delta said that the Virgin joint venture helped drive its Heathrow unit revenues up 5% on 18% higher capacity. For its part, every 1 ppt improvement in VA's revenues on the North Atlantic network is a 0.5 ppt gain to its operating margin.

According to VA's CEO Craig Kreeger, the relationship with Delta "makes the transatlantic more attractive than it used to be", (Reuters, 03-Sep-2014). Mr Kreeger said: "We do see it as intensely competitive, but I don't think I would say that I see it as fundamentally changing in that regard."

The relationship with Delta also provides opportunities for cost synergies (see below).

Virgin Atlantic Weaknesses

1. Its profitability record is poor

Virgin Atlantic Airways reported a pre-exceptional pre-tax loss of GBP74 million for the year ended 31-Dec-2013, according to its 2013 annual report filed at the UK's Companies House. This pre-tax loss compared with a pro forma loss of GBP105 million in 2012.

Although the 2013 results show that the company is moving in the right direction, it has made losses in four out of the past five years. Even in profitable years, its operating margins have typically been only around 1% of revenues or less.

Virgin Atlantic Airways Ltd revenue, operating profit and pre-tax profit (GBP000) 2005* to 2013

2. Its balance sheet is under-capitalised

At the end of Dec-2013, VA had an adjusted net debt position of GBP1.6 billion, if off balance sheet operating leases are included at eight times annual lease rental. With book equity of just GBP39 million, VA looks under capitalised. In 2013, its average 12 month gross cash balance was GBP360 million, down from an average of GBP445 million for the 12 months to Feb-2013 and GBP529 million for the 12 months to Feb-2012.

This is a fairly rapid rate of cash burn, although this should stabilise if the company can achieve its aim to return to profit in 2014. VA's private ownership structure may also ease its access to funds when needed (its balance sheet typically includes around GBP100 million of loans owed to group companies).

Nevertheless, with its first Boeing 787-9 joining the fleet in Oct-2014 and 15 more due to be delivered in the next four years, a capital injection cannot be ruled out if its return to profit in 2014 is not achieved.

3. Little Red has not been a success

VA launched its first ever domestic UK routes, between London Heathrow and Manchester, Edinburgh and Aberdeen, in Apr-2013 using aircraft wet leased from Aer Lingus under the 'Little Red' brand. Data from the UK Civil Aviation Authority show that Little Red's load factor has been weak.

For the rolling 12 month period to Jun-2014 (the most recent month for which data are available), its load factor was just 41.7%, although trend has been rising and it achieved the 50% mark for the first time in the month of Jun-2014.

Passenger load factor for Virgin Atlantic's 'Little Red' domestic operation and for the overall UK domestic market (%) by month Apr-2013 to Jun-2014

International Airlines Group (IAG) CEO Willie Walsh has not been slow to highlight VA's struggle with Little Red. "I have said from the very beginning Little Red would be Big Red, the performance must be dreadful," he said. "They are struggling to get load factors above 50pc. You cannot make money flying aircraft that are less than half full. I don't know why they did it. I said at the time I thought it would be a mistake, I am delighted to have been proven correct" (The Telegraph, 02-Oct-2014).

VA's recent decision to pull the plug on its UK domestic operation demonstrates that it shares Mr Walsh's opinion. The Heathrow-Manchester service is to cease operations in Mar-2015, while the Heathrow to Aberdeen and Edinburgh routes will be discontinued in Sep-2015.

It seems that Little Red attracted too few passengers, in particular those transferring onto long-haul flights and the losses that it made were not justified strategically. If VA's overall profitability is improving, this suggests that its long-haul network may be quietly picking up "accidental" feed from other airlines (British Airways in particular - see "Opportunities" below).

Little Red was not helped by the fact that the number of slots made available to it by the European competition authorities after BA's takeover of bmi was not enough for it to build a short-haul network with critical mass. Putting an end to Little Red's losses should have a positive impact on VA's profitability.

Virgin Atlantic Opportunities

1. The Delta relationship should drive cost synergies

If VA can build on its equity relationship with Delta to drive cost synergies, this should prove to be beneficial over time. The importance of North America to VA's revenues and costs means that a 1 ppt reduction in costs on this network is roughly a 0.5 ppt gain to its operating margin.

2. The alliance question

Virgin Atlantic is not a member of one of the three branded global alliances. CAPA has previously argued that joining one need not be a priority, particularly given its North Atlantic joint venture with Delta and a series of tactical bilateral partnerships with other airlines in other regions. Nevertheless, the subject continues to be one worthy of consideration and could provide VA with opportunities for growth in the future.

The European Commission's approval of the IAG acquisition of bmi requires IAG to offer favourable interline rates to competing airlines at Heathrow, provided that those airlines do not join an alliance. This allows Virgin's long-haul network to benefit from feed at Heathrow from British Airways' short-haul operations, despite the new ownership relationship with SkyTeam leader, Delta. The demise of Little Red will make such "accidental" feed more important to VA and so may further reduce the likelihood of its joining a global alliance.

3. Boeing 787 deliveries should help to lower costs and increase new route options

VA's first Boeing 787-9 delivery in Oct-2014 is the first of a total of 16 due to join the fleet by 2018. With its lighter fuselage and more efficient engines, the aircraft will contribute to lower operating costs and should help to bring down VA's cost per available seat kilometre.

These aircraft will mainly be used for replacement of older, less efficient equipment as VA retires two A340-300s and two A340-600s by the end of 2015 and withdraws its Heathrow-based 747-400 fleet by Jul-2016. The new deliveries will also help to lower the average age of the fleet, which currently stands at 9.9 years (source: CAPA Fleet Database).

Virgin Atlantic Airways Fleet Summary as at 7-Oct-2014

Aircraft	In Service	In Storage	On Order*
Total:	37	2	22
Airbus A330-300E	10	0	0
Airbus A340-300	1	0	0
Airbus A340-300X	1	2	0
Airbus A340-600	12	0	0
Airbus A340-600(HGW)	1	0	0
Airbus A380-800	0	0	6
Boeing 747-400	12	0	0
Boeing 787-9	0	0	16

Moreover, as VA's network planning manager Rob Bissett has said, the Boeing 787-9 will increase its options when considering new route opportunities. "Having a smaller and more efficient aircraft certainly gives us more confidence when looking at new routes. The range capability also means that 11+ hour sectors which may have looked unattractive on other types in the past are now right back in the mix," said Mr Bissett (RoutesOnline.com, 21-Sep-2014).

In addition to the firm orders, the airline has options over a further eight 787s and is reported to be considering exercising five of these.

Virgin Atlantic Threats

1. North Atlantic overcapacity

The concentration of VA's network on the North Atlantic makes it less diversified than airlines with broader global operations. In particular, it is more exposed to the overcapacity identified by a number of operators in that market.

The effect of this supply-demand imbalance should be mitigated by the positive impact of the nascent joint venture with Delta, but VA's profitability will continue to be susceptible to the health, or otherwise, of the North Atlantic aviation market.

2. The EU is investigating Delta's part ownership

In Apr-2014, the European Commission began an investigation into "certain non-EU investments in European airlines" to consider whether or not they might contravene restrictions on non-EU ownership and control. Although inspired by reactions against Gulf airline investments, necessarily included in these inquiries is Delta's 49% stake in Virgin Atlantic.

The ownership and corporate governance structure of VA does not overtly contravene these restrictions, but the Commission is likely to be concerned about whether or not Delta has de facto control. This has been dismissed by Virgin's Mr Kreeger, but IAG's Mr Walsh has a different view.

Mr Walsh said: "Virgin is controlled by Delta. Decisions are taken in Atlanta by the Delta management team who are one of the best in the business. They are much more rational in terms of their behaviour." Mr Walsh added: "Virgin has almost disappeared... Delta controls Virgin, without any doubt, without any question. We just call it Delta now." (The Guardian, 02-Oct-2014).

In theory, the investigation could lead to question marks hanging over the future of the relationship between VA and Delta. It can be dangerous to second guess regulators, but it does not seem likely that this will happen in this case.

3. Gulf airline competition

As for all European airlines operating on Europe-Asia routes (and, to a lesser extent on Europe-Africa), VA is exposed to competition from the Big Three Gulf carriers (Emirates, Qatar Airlines, Etihad) and Turkish Airlines. All of these airlines attract global traffic flows through connecting flights via their hubs in the Middle East or Turkey, in competition with direct services offered by the likes of VA from Europe. These operators combine lower unit costs with high service quality and have made a significant impact on Europe's long-haul carriers.

Virgin is less exposed than some of its bigger European rivals: in 2013 only 13% of its revenue was in the Far East and 10% in Africa, and its recently announced network changes should further reduce this exposure. Moreover, codeshare partnerships with Asia Pacific airlines such as Singapore Airlines, Air China, ANA, Jet Airways, Virgin Australia and Air New Zealand help to strengthen VA's position on Europe to Asia.

3. Geopolitical events are a risk to all airlines

As for all airlines, VA and the aviation industry's demand cycle its exposed to demand shocks that can arise from geopolitical events such as war, terrorism, epidemics and natural disasters.

4. Virgin could do without a downturn in the aviation cycle

Again a generic airline industry threat, the airline industry remains highly cyclical, but VA is perhaps more exposed than some to a possible downswing in the cycle. Globally, airline profitability has broadly been on an upswing for the past five years, whereas VA has been mired in losses.

Virgin is attempting to make progress with structural profit improvements, but needs help from the demand cycle to keep this on track. If the next global downturn comes too soon, this could pose a threat to VA's profit recovery.

"Record levels of sustained profitability" targeted

After joining the airline in Feb-2013, CEO Craig Kreeger committed to restoring profits in 2014 as part of a two year recovery plan. Building on this, in Sep-2014, VA announced plans to "grow to record levels of sustained profitability" by 2018.

This target for 2018 has not been publicly defined, but suggests that VA hopes to generate a return on capital sufficient to cover its cost of capital. This will require it to add several ppts of operating margin, a very challenging hurdle even with the benefits of the Delta JV and cost synergies.

VA's 49% shareholder Delta Air Lines' CEO Richard Anderson has been a consistent advocate of the need for airlines to exceed their cost of capital. If the relationship between the two is to endure in the long run, he is unlikely to be happy with anything less.