14-Mar-2013 3:39 PM

Virgin Atlantic, the flying enigma – a great brand in need of greater financial discipline

Analysis

Virgin Atlantic is something of an enigma. Growing from nothing to become the UK's second largest airline by ASKs in the lifetime of a typical passenger jet and earning a reputation for innovation, attractive branding and a quality service, it is also loss-making, insufficiently cost-focused, under-capitalised and (until recently) strategically isolated.

Last month saw new CEO Craig Kreeger take control from his long-serving predecessor Steve Ridgeway; this month sees the start of new domestic services wet leased from Aer Lingus; later this year should see the implementation of the new joint venture with Delta and the entry of the latter into Virgin Atlantic's share register.

Mr Kreeger's challenge will be to unpick the enigma, bringing greater financial discipline to the airline, while maintaining its attractive qualities.

Summary

Virgin Atlantic is launching domestic UK services for the first time in its history, using wet leased aircraft from Aer Lingus.
The new domestic routes will provide feed to Virgin Atlantic's long-haul routes from London Heathrow and onward feed for its partner Delta Air Lines.
Virgin Atlantic reported an expected loss of GBP135 million for the year, prompting a cost-cutting plan and pay freeze.
The airline's revenue grew by 6% in the last reported financial year, but it made an operating loss of GBP92 million.
Costs increased by 11.5% in the same period, with fuel costs accounting for 38% of the total.
Virgin Atlantic's balance sheet is weak, with an adjusted net debt of GBP1.2 billion and a high adjusted gearing ratio of 1,170%.

Short-haul deal with Aer Lingus looks sensible

Starting from the end of Mar-2013, Virgin Atlantic will offer domestic UK services for the first time in its 29 year history. Using four Airbus A320-200 aircraft wet leased from Aer Lingus, operating under Virgin's new "Little Red" brand, the carrier will connect London Heathrow to Manchester, Edinburgh and Aberdeen. Virgin Atlantic had previously been interested in buying bmi to help secure feed to its long-haul network, but, when the latter was sold to IAG, VA decided to find an alternative solution.

The three domestic routes will provide feed to VA's 20 long-haul routes from Heathrow, in addition to onward feed for VA's new partner Delta Air Lines. They will not provide direct feed to VA's 15 long-haul routes from Gatwick, but perhaps this may be an option in the future, as may adding further short-haul routes from Heathrow. Adding such short routes to a long-haul network provides challenges, especially given VA's lack of previous short-haul experience. London-Manchester is just 243 km and London-Aberdeen only 649 km, while VA's shortest long-haul route from LHR is Lagos, at 5,008 km.

Comparison of the estimated size of Virgin Atlantic's new short-haul business with its existing long-haul business

Annual data	Frequencies	Seats	ASK 000	Average distance km
New short-haul business	9,464	1,703,520	802,358	471
Existing Virgin Atlantic*	20,547	6,958,261	49,189,727	7069
Total	30,011	8,661,781	49,992,085	5772
New short-haul as % of existing VA	32%	20%	2%	8%

The bmi/IAG deal led to a requirement for BA to give up some LHR slots to allow competition on these routes. Where bmi was previously the only competitor to BA, this position will now be taken by VA, who will offer roughly half of BA's capacity on these routes from this summer. On Manchester, VA will offer 5,040 weekly seats, compared with BA at around 10,000; on Aberdeen VA will offer 3,780 weekly seats against BA with around 7,600; and on Edinburgh VA will have 7,560 to BA's roughly 12,000. Of course, there is significant competition from LCCs between other London airports and the three cities, but that does not feed VA's Heathrow hub and it is important for VA that another competitor has not taken up these three routes.

The decision to outsource these three domestic routes to Aer Lingus appears to make sense. Aer Lingus has experience of operating short feeder routes to its Dublin hub and has a presence in all three UK airports to be linked to LHR. Moreover, Aer Lingus has a reasonably efficient cost base, with unit costs below those of other legacy flag carriers, especially on its short-haul network.

Virgin's profit record is patchy at best, another loss expected

As a privately-owned company, Virgin Atlantic does not directly publish detailed accounts, but it does report both its profit and loss account and balance sheet to the UK's Civil Aviation Authority (CAA), which publishes these financial statements and traffic data on its website. VA's financial year end is February and it will be some months before FY2012-13 accounts are available.

It has been reported that an internal memo from CEO Craig Kreeger refers to an expected loss that is "well behind where we expected", with a loss figure of GBP135 million quoted (source: The Sunday Times). Mr Kreeger is reported to have initiated a broad-based cost-cutting plan and a pay freeze. Further losses would be serious after a big loss in the last reported financial year (to end Feb-2012).

In FY2011-12, data from the CAA show that Virgin Atlantic Airways Ltd saw revenue growth of 6%, but made an operating loss of GBP92 million (profit of GBP26 million the previous year). The CAA data are only for Virgin Atlantic Airways Ltd, rather than for the whole group, which includes Virgin Holidays and differ slightly from those reported in Virgin Atlantic's press releases for group results. Nevertheless, the CAA data are much more detailed than any VA press release and show the performance of the core airline business of the group.

This report analyses the last reported accounts in some detail below.

Virgin Atlantic Airways Ltd revenue, operating profit and pre-tax profit (£000) 2011 and 2012 (financial year to end Feb)

GBP 000	2011	2012	change
Revenue	2,263,526	2,402,051	6%
Operating profit	26,415	-92,356	-450%
Pre-tax profit	17,354	-98,934	-670%

Virgin Atlantic Airways Ltd revenue, operating profit and pre-tax profit (£000) 2003* to 2012 (financial year to end Feb)

Revenue growth driven by capacity increase in FY2011-12

Virgin Atlantic Airways Ltd saw revenue growth of 6.1% in FY2011-12, bringing total revenues to GBP2.4 billion, just above the level seen in FY2008-09 before they collapsed in FY2009-10. Passenger revenues are the most important category and these grew by 4.9%, driven by a capacity increase of 5.8% and a fall in unit revenues of 0.8% (itself a result of a drop in load factor). Cargo revenues and, in particular 'other revenues' outpaced passenger revenue growth in FY2011-12.

Virgin Atlantic Airways Ltd revenues (£000) 2011 and 2012 (financial year to end Feb)

GBP 000	2011	2012	change	% of 2012 revenue
Passenger revenue	1,877,910	1,970,804	4.9%	82%
Cargo revenue	224,442	238,286	6.2%	10%
Other revenue	161,174	192,961	19.7%	8%
Total	2,263,526	2,402,051	6.1%	100%

Costs growing much faster than revenues

Costs increased by 11.5% in FY2011-12, much faster than the growth in revenues and capacity, leading to the operating loss. Fuel costs, which accounted for 38% of the total, grew by 15.5%, but excluding fuel costs also grew faster than revenues - by 9.1%.

Mr Kreeger's reported cost reduction initiative would seem long overdue.

Virgin Atlantic Airways Ltd costs (£000) 2011 and 2012 (financial year to end Feb)

GBP 000	2011	2012	change	% of 2012 costs
Fuel	828,954	957,598	15.5%	38%
Crew costs	206,960	222,881	7.7%	9%
Maintenance	196,644	213,612	8.6%	9%
Aircraft rental	186,663	203,279	8.9%	8%
Airport and navigation charges	172,879	188,023	8.8%	8%
Commercial costs	162,156	160,591	-1.0%	6%
General and admin	122,092	138,892	13.8%	6%
Handling & station costs	113,189	110,566	-2.3%	4%
Depreciation	57,853	50,272	-13.1%	2%
All other costs	189,721	248,693	31.1%	10%
Total	2,237,111	2,494,407	*11.5%*	*100%*

Virgin Atlantic's balance sheet is weak

At the end of its financial year to Feb-2012, Virgin Atlantic Airways Ltd had gross cash of GBP489 million. This was equivalent to 74 days of revenues, a reasonable cushion against unexpected events. Its balance sheet had only GBP100 million of debt (not including GBP110 million of liabilities to other group companies), meaning that the company was in a net cash position of GBP389 million.

However, VA makes significant use of operating leased aircraft and these are not shown on the balance sheet. Capitalising them at eight times annual rental payments would add GBP1.6 billion to VA's debt, bringing it to an adjusted net debt position of GBP1.2 billion.

With shareholder's equity of only GBP106 million at the end of Feb-2012, this means an adjusted gearing ratio (adjusted net debt to equity) of 1,170%, a very high level indeed. An expected loss in the year to Feb-2013 will further erode the equity base, making the balance sheet look even more fragile. As a privately owned company, this may not be as important as it would be for a company with publicly traded shares (there may be shareholder guarantees in place, for example), but it does suggest that a significant capital injection may be necessary unless Delta is prepared to stand as guarantor in respect of aircraft financing (VA has a major delivery programme from 2014-15 - see below).

Before the Delta deal was announced, controlling shareholder Sir Richard Branson was prepared to consider the sale of a controlling stake in the airline, but the weak balance sheet may have deterred potential buyers.

Delta complements VA's Atlantic focus, but does not give it cash

CAPA has covered in some detail Delta's planned purchase of the 49% share in Virgin Atlantic previously owned by Singapore Airlines

Prompted by its growing strategic isolation as one of the world's very few long-haul point-to-point carriers and as a high profile airline not part of one of the global alliances, the situation had become more critical when BA gained antitrust immunity for its Atlantic JV with American Airlines. VA had been seeking a new partner, one with whom it could more actively engage and which reflected the importance of the Atlantic in its network (see below). It got this, not so much through the transfer of the shareholding, but through an agreed metal neutral joint venture across the Atlantic and 31 joint services between the US and London, with nine of those between London Heathrow and New York's JFK and Newark airports. According to Delta, the deal will create a USD3 billion revenue JV.

Moreover, it also has the prospect of joining SkyTeam and the Air France-KLM/Delta JV. Chief commercial officer Julie Southern said joining the SkyTeam will "probably make sense", although no decision on alliance membership has been made (source: The Financial Times, 17-Feb-2013). If Virgin joins SkyTeam, it will move from ploughing a lone furrow with 5% of seat capacity on Europe-North America to being part of a team with a 30% share. On UK-US, it will move from a 21% share of seats to being in a JV with 28% (source: Innovata database 29-Jul-2013 to 04-Aug-2013). The share purchase and the JV are expected to be implemented by the end of 2013, subject to competition authority approvals.

What Virgin does not get from Delta is a new injection of capital, which might well be needed in the not too distant future (see below), since Delta's USD360 million investment all goes to Singapore Airlines.

However, the presence of Delta on its share register is likely to assist VA with financing (depending on the details of the shareholders agreement and governance processes) and the JV is likely to improve VA's profitability. It is also possible that Delta has made some contingency for investing more cash directly into Virgin when necessary, although this cannot be taken for granted. Delta is likely to want evidence that VA is doing all it can to make itself more sustainably profitable and would expect other shareholders (ie Sir Richard Branson) to invest alongside it in any capital raising exercise.

All long-haul route structure dominated by North America

Excluding the new domestic services, 58% of Virgin Atlantic's seat capacity is to North America and 13% to the Caribbean. Only one of its top 10 routes (Hong Kong-Sydney) does not involve the Atlantic Ocean: eight are UK-US and one is UK-Caribbean (Gatwick-Bridgetown). Out of its top 10 bases, only Hong Kong is not in the UK, US or Caribbean. It is not a coincidence that the word 'Atlantic' has remained part of the airline's name for 29 years.

Virgin Atlantic Airways capacity by region (% of seats) 13-May-2013 to 19-May-2013

Virgin Atlantic Airways top 10 routes by seats 13-May-2013 to 19-May-2013

Virgin Atlantic Airways top 10 hubs/bases/stations by seats 13-May-2013 to 19-May-2013

Passenger traffic is below its pre-recession peak and load factor has been volatile

The chart below shows VA's annual traffic and capacity development for its financial years since FY2003. Its last reported financial year ended in Feb-2012, but the most recently reported CAA traffic data are for Nov-2012 and so the chart also shows the 12 month period to Nov-2012. Capacity and traffic volume peaked in FY2007-08, before falling for three years. FY2011-12 saw ASKs grow by 5.8% and the 12 month period to Nov-12 saw growth of 3.8%.

A striking feature of the chart is the volatility in VA's load factor over the past 10 years. Load factor has been inversely correlated with ASK growth in recent years, falling sharply in FY2011-12 when VA resumed capacity growth after three years of cuts. The most recent data show that load factor has stabilised, but remains short of previous peaks.

Virgin Atlantic Airways development of passenger capacity (ASKs), traffic (RPKs) and load factor (%) 2003* to 2012 (financial year to end Feb)

Virgin has a relatively young fleet

VA's fleet contains 12 Boeing 747-400s, whose average age is almost 14 years and 15 Airbus A340s averaging 9.5 years. Nevertheless, its 10 A330s only came into the fleet from early 2011, first to replace ageing A340s and then to provide growth. The overall average age of its fleet is less than nine years, younger than most major European network carriers.

Note the fleet details in the table below do not include four Airbus A320-200 aircraft to be wet leased from Aer Lingus for services connecting London Heathrow to Manchester, Edinburgh and Aberdeen under Virgin's new "Little Red" brand from the end of Mar-2013.

Virgin Atlantic Airways Fleet Summary: as at 13-Mar-2013

Aircraft	In service	Average age (years)	On order
A330-300E	10	1.4
A340-300	1
A340-300X	3
A340-600	14
A340-600 (HGW)	1	(all A340 fleet) 9.5
Boeing 747-400	12	13.8
Total in service	41
of which:
Leased	36
Owned	5
On order
A380-800	0		6
Boeing 787-9	0		16
Total on order			22

Virgin Atlantic told CAPA that it does not yet have an exact delivery schedule, but 787 deliveries are due from summer 2014 and A380s from 2015. Given possible delays in all 787 deliveries by Boeing, it would not be a surprise if these dates slipped and we suggest a possible delivery schedule in the chart below.

Virgin Atlantic Airways projected delivery dates as at 11-Mar-2013

RASK vs CASK trends show weak cost control

As the chart below demonstrates, using data on Virgin Atlantic Airways reported to the CAA, VA's unit revenue (RASK) was on a broadly upward path over the 10 years to Feb-2012. It fell in FY2009-10, as it did for many airlines, but recovered sharply in FY2010-11 as VA cut capacity for the third successive year.

In FY2011-12, RASK fell once more as VA added 5.8% more ASKs (this was all seat growth as there was no increase in average stage length). This fall in RASK was due to lower load factors, as passenger yield (revenue per RPK) actually increased in FY2011-12, and was contrary to global trends.

Unit costs (CASK) have also been on a 10 year upward path, broadly following the RASK trend until FY2001-08. This rise in RASK was mainly due to increasing fuel costs, particularly until the financial crisis, but more recently ex fuel RASK has increased quite sharply. The rise in ex fuel CASK in FY2009-10 and FY2010-11 coincided with significant capacity cuts, demonstrating that VA was not cutting its costs in line with its capacity.

The increase in CASK ex fuel in FY2011-12, when capacity once more returned to growth, is perhaps more worrying, especially as it was accompanied by a fall in RASK. These trends suggest that VA has not had a strong cost control culture and that, in spite of its strong branding, it has been unable to fill its aircraft sufficiently to cover its costs.

Virgin Atlantic Airways - index of operating cost per ASK and passenger revenues per ASK financial years ended Feb 2003* to 2012 (each indexed to 100 in 2010)

Unit costs look efficient vs other European airlines, but is that good enough? Aer Lingus looks to be a sound move

The chart below, which compares unit costs and average sector length for a number of European legacy carriers and LCCs, suggests that Virgin Atlantic has a fairly efficient cost base for a carrier with such a long-haul route structure. However, it is the only European airline with a pure long-haul business model and so there are no direct European comparable carriers.

Moreover, many of its competitors - those in Asia and the Gulf, but also in the US - typically have lower unit costs than European network carriers. So it may be the case that merely looking cost competitive against European flag carriers is not enough.

The chart also highlights Aer Lingus - both its overall unit cost position and estimated long-haul and short-haul unit costs (based on Aer Lingus' overall unit cost and its reported revenue split between long-haul and short-haul). This shows that Aer Lingus is competitive on short-haul against the flag carriers that form the main competition at VA's Heathrow hub.

Assuming that it can broadly replicate its cost base when carrying out its wet leased services for Virgin, the latter appears to have chosen a fairly efficient partner for its new domestic services (depending also on the exact terms of the commercial arrangements between Aer Lingus and Virgin).

Unit costs (cost per available seat kilometre) and average sector length for selected European legacy and low-cost carriers 2011, 2012*

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