Virgin Australia's takeover of Tiger Australia hits a snag, CEO John Borghetti ready to compromise

Virgin Australia control of Tiger Australia would create a duopoly - sort of...

On the face of it at least, allowing Virgin Australia to take control of Tiger Australia reduces competition in the domestic market to two airline groups, each with a full service and LCC model. The ACCC is concerned that this arrangement could increase the likelihood of coordinated pricing and service conduct between the airline groups and that it will remove all competition between Virgin Australia and Tiger Australia, particularly in the off-peak periods favoured by more price sensitive leisure passengers.

Virgin Australia CEO John Borghetti has frequently reiterated that the deal will actually increase competition to the benefit of consumers. "By partnering with Tiger Airways, we can use our expertise to leverage Tiger Australia's low cost base and build a competitive and sustainable budget carrier."

Virgin Australia, which as LCC Virgin Blue was responsible for turning Australia's aviation market on its head, is keen to re-enter the LCC market that it has evolved away from in recent years as it sought to take a bigger slice of the lucrative corporate and government travel markets.

As the need for a response to Qantas Group's low-cost arm Jetstar became unavoidable, Virgin had two options: start up its own greenfield operation, or seek to combine with Tiger Australia, providing it with a ready-made LCC and allowing it to duplicate the Qantas-Jetstar domestic dual brand strategy. Without a low-cost arm able to compete for a growing proportion of Australian travellers, Virgin's days are numbered in this unusual market dynamic.

Virgin Australia could agree to reasonable capacity undertakings

The ACCC's delay is not unusual, but has prompted Mr Borghetti to signal that he is prepared to give some "reasonable" capacity undertakings to appease the regulator's concerns.

He maintains, however, that he will not cast in stone Tiger Australia's plans to more than triple its fleet to up to 35 A320s within five years as outlined in the application for authorisation. Mr Borghetti said at Virgin's first half financial results announcement in Feb-2013 that it would be "unrealistic" for the ACCC to ask for a capacity undertaking over five years, given a volatile aviation industry plagued by narrow margins and excess capacity. Virgin Australia would be forced to withdraw from the deal if this was a condition of approval.

In its application, Virgin Australia said that under its stewardship Tiger Australia could add significant capacity by increasing its fleet from the current 11 aircraft to up to 35 aircraft. But Mr Borghetti strongly qualified the statement in Feb-2013, saying that "up to" were key words.

Reading between the lines it would appear that this qualification was a bridge too far for the ACCC, already finding it hard to avoid the challenge of allowing an apparent reduction of competition in the domestic market. By the same token, if the Commission had been planning to make such a condition central to the approval, that would seem an extraordinary expectation in an airline world where next month has become the medium term. There would be no airline in the world prepared to make such a commitment - or able to meet it.

Capacity dogfight flooded the Australian domestic aviation market in 2012

Against fairly soft demand, capacity has flooded the Australian domestic market as Virgin Australia moved to challenge Qantas' dominance of the lucrative corporate and government sector market. Supply significantly outstripped demand at the expense of yields. While this is a part of the process of establishing acceptable footprints in the market as Virgin seeks to gain a bigger share, this only adds to the difficulty of projecting which way the players will go under different scenarios.

Virgin Australia increased capacity on domestic routes by 8.9% in the first half of FY2013, in line with guidance. Most of the increase was on transcontinental routes from Melbourne to Perth where widebody A330-200s replaced Boeing 737-800s, which were described as unsuitable and uncompetitive on the route. Capacity was also increased on the golden triangle routes of Sydney, Melbourne and Brisbane as well as on regional routes.

Mr Borghetti points the finger at the Qantas Group for capacity growth levels on domestic routes that were the highest since the launch of Jetstar in 2004, causing a 10.8% overall increase in the half year.

The resulting pressure on fares and yields meant Virgin Australia posted a sharply reduced tax-paid profit of AUD23 million (USD23.6 million) for the first half of FY2013, down 56% on the same period in 2012.

Virgin Australia has maintained its 20% share of corporate and government revenue achieved in FY2012 and says it is increasing, though it no longer provides a figure. The carrier expects its successful cut over to the Sabre GDS in Jan-2013 to accelerate the airline's growth in the corporate and government markets. Bookings through the GDS grew five-fold as corporate agencies and international travel agents gained easier access to the carrier's seating inventory.

This, together with more stable load factors and the typical 10% yield premium to average bookings on GDS bookings (despite their often controversial charges), is anticipated to improve RASK performance.

ACCC forced to navigate the complexities of the real marketplace - and partnership dynamics

The complexity for the ACCC's calculations relates to a simple one-two-three - and whether a Virgin-Tiger combination would lead to two airlines or four. The enigma is in the nature of the dual brand Qantas-Jetstar operation. Is it one airline or two? Certainly Jetstar operates largely independently of its big brother, aside from regular - and often contentious - route coordination meetings.

And pricing in the marketplace is far less than obviously a coordinated matter of Qantas pricing high and Jetstar low. It is no longer rare to find a lower price on the kangaroo tail on some routes, although of necessity Jetstar is the low-cost leader of the pair. This has become a competitive conundrum for a competition law analysis. There are no clear precedents for a situation, where, as Virgin argues, adding Tiger to its team could actually enhance competition by enabling it more squarely to face up to Qantas Group's products, with Tiger and Virgin also operating together across the market spectrum.

Apart, they are each relatively weak, confronted by a Qantas Group that holds 65% of the domestic market; together they are arguably more likely to provide a durable fighting combination.

The situation is made even more intriguing because Tiger Australia's parent is one third owned by Singapore Airlines, which also has a minority equity stake in Virgin Australia (and a partnership with much larger aspirations). Virgin Australia promises SIA access to the extremely valuable domestic market, permitting the Singapore flag carrier to put its code on Virgin's services to a large number of domestic destinations. Australia drives about a fifth of Singapore Airlines' revenue, on some 35,000 seats a week, with another 5,000 from wholly owned LCC Scoot.

Together they occupy some 60% of all capacity on Australia-Singapore routes (although Qantas is planning to ramp up its share, having recently reallocated its Europe services over the Gulf, effective late Mar-2013).

So, being able to accumulate beyond gateway feed on Virgin is immensely valuable for Singapore Airlines - and for Virgin alike - as it also offers a better platform for competition for corporate contracts. Singapore Airlines therefore has a serious vested interest in the success of Virgin Australia. Meanwhile, Tiger Australia is losing money as it seeks to reinstate its position.

There are many other forces at work, but it is scarcely presumptuous to assume that SIA would not wish to continue support for a loss-making LCC which is also acting against SIA's own best interests by undermining its key partner - Virgin Australia. In other words, it is a big call to assume that Tiger Australia will remain in the market if the ACCC rejects the current application.

SIA, which necessarily has an interest in containing its great competitor Qantas, would be much better advised to withdraw its support from Tiger and set up a joint venture domestic LCC with Virgin - a much more roundabout and costly way of achieving what is currently being sought!

Tiger Australia acquisition would potentially ignite an LCC capacity battle with Jetstar

In this current environment, if the ACCC approves the Tiger Australia acquisition it will in reality almost certainly re-ignite a capacity war between it and LCC rival Jetstar. Tiger Australia has had a progressively more competitive impact since relaunching following its six-week grounding in 2011 due to safety concerns. This is clearly demonstrated in capacity and market share changes on the golden triangle routes of Sydney, Melbourne and Brisbane.

Capacity on the Sydney-Melbourne route has increased 7% in the year to Mar-2013 to 98,500 one-way seats. This increase is almost entirely due to a dogfight between Jetstar and Tiger Australia which have each increased their seats by about 35% and 60% respectively, according to Innovata. This compares to a 2% decline by market leader Qantas, while Virgin Australia cut its capacity on the route by more than 4%.

As a result Tiger Australia and Jetstar both increased their market share of seats by 3ppts to about 10ppts for Tiger Australia and 15% for Jetstar. Qantas slipped 2ppts to about 45% while Virgin Australia has lost about 3ppts to a 31% share of the market.

Sydney to Melbourne (seats per week, one way): 19-Sep-2011 to 01-Sep-2013

Source: CAPA - Centre for Aviation & Innovata

The Tiger Australia effect is even more pronounced on Sydney-Brisbane, where route capacity has increased 6.5% to about 55,000 one-way seats per week in the Mar-2013 year.

Tiger Australia re-entered the route in Aug-2012, immediately carving out a 6% market share. Jetstar added 5% capacity just to maintain its 8% share. Qantas added 1% capacity, but its market share dropped about 2.5ppts to 46.5% and Virgin Australia reduced capacity by nearly 2%, costing it about 3.5ppts of market share to 39.5%.

Sydney to Brisbane (seats per week, one way): 19-Sep-2011 to 01-Sep-2013

Source: CAPA - Centre for Aviation & Innovata

Melbourne to Perth has been the main battleground between Virgin Australia and Qantas

The capacity battle between Virgin Australia and Qantas has been largely fought on the Melbourne-Perth Australian transcontinental route during the Mar-2013 year, where Boeing 737-800s have been replaced with widebody A330 featuring lie-flat business class.

As a result, capacity on the route has ballooned 22%, or about 5,000 seats, to nearly 28,000 one-way seats, according to Innovata.

Virgin Australia makes up more than half of that increase, adding about 2,700 seats or 44%, while Tiger Australia added 1,600 seats, more than doubling its capacity on the route (from its much lower base).

Qantas added just 3% capacity and Jetstar about 11% for a combined group increase of about 680 one way seats per week.

The end result is Qantas' market share dropped nearly 9ppts to 46% while Virgin Australia gained 5ppts to lift its market share to 32%.

Perth to Melbourne (seats per week, one way): 19-Sep-2011 to 01-Sep-2013

Source: CAPA - Centre for Aviation & Innovata

Some of the heat has gone out of the Perth-Sydney route with both Qantas and Virgin Australia recently reducing capacity, Qantas by 5% and Virgin Australia nearly 14%. Qantas holds a commanding 59% market share on the route, up slightly on Mar-2012, while Virgin Australia lost nearly 3ppts to about 32%.

The airline has a seventh A330 arriving later this year, which it has indicated could be used to make its Sydney-Perth route exclusively A330.

Perth to Sydney (seats per week, one way): 19-Sep-2011 to 01-Sep-2013

Source: CAPA - Centre for Aviation & Innovata

Virgin Australia will also ramp up capacity on the Brisbane-Perth route when its moves to a double weekday A330 service in May-2013.

Virgin Australia has substantial domestic fleet expansion plans

Virgin Australia has 65 Boeing 737-8 and 737-800s on order and has also ordered an additional three ATR72 to expand its regional network and will have 19 of the type in service by the end of FY2015.

The ATRs are operated by Skywest in Virgin Australia livery.

Virgin Australia fleet summary

Aircraft	In Service	In Storage	On Order
Airbus A330-200	5	0	3
Boeing 737-700	4	0	0
Boeing 737-8	0	0	23
Boeing 737-800	68	0	42
Boeing 777-300ER	5	0	0
Embraer ERJ190-100IGW(AR)	18	0	0
ATR72	8	0	11
Total:	108	0	79

Source: CAPA - Centre for Aviation

Skywest takeover approved by Singapore owners

Virgin Australia has also moved another step closer to take the domestic fight to the regions with the acquisition of Perth-based Skywest gaining the approval of Skywest's Singaporean shareholders. Approval is still needed from the Foreign Investment Review Board, as well as the sanction of the High Court of Singapore.

The acquisition of Skywest and a controlling stake in Tiger Australia will, according to Mr Borghetti, give Virgin Australia the lowest cost base across the full service, LCC and regional markets.

Skywest will give Virgin Australia greater exposure to the high-growth regional market as well as the important resources sector "fly-in-fly-out" traffic.

Virgin Australia is already stepping up the pressure on Qantas' supremacy in regional markets, announcing it will break the monopoly on the Brisbane-Moranbah and Brisbane-Bundaberg routes in Apr-2013 and May-2013 and lower year-round fares by between 15% and 20%.

Qantas is not standing still in this dynamic marketplace, pre-empting the threat on some of its other monopoly routes by adding capacity.

Alliances anchor Virgin Australia's long-haul network

Virgin Australia is reaping the benefits of its global network of alliances which is driving strong growth in interline and codeshare revenues.

Virgin Australia has built a formidable virtual long-haul network with alliance partners Air New Zealand on the trans-Tasman routes, Delta Air Lines between Australia and the United States, Singapore Airlines between Australia and Singapore and onwards to Asia and Europe, and Etihad for connections to Europe and the Middle East.

A total of 73 new codeshare destinations were added in the six month reporting period, mostly with these partners, and at least another 24 are planned in the second half of the financial year.

The airline's virtual long-haul strategy is beginning to deliver ahead of target. Interline and codeshare revenues from these relationships are on track to top AUD40 million (USD41.2 million) in FY2013 and to exceed the previous target of AUD150 million (USD154.5 million).

Virgin Australia expects to achieve AUD60 million (USD61.8 million) in FY2013 and AUD200 (USD206 million) by FY2015 as part of its three-year "Game Change" programme launched at the beginning of FY2012.

The carrier has moved to the next phase of its development programme, focusing on realising the benefits of the complete overhaul of the business in the previous two years by driving growth through product and service improvements.

Virgin Australia will now need to focus on adding a Northern Asia partner

Virgin Australia has built a strong international network covering Southern Asia, the Middle East, Europe and North America. But like Qantas, Virgin Australia will now need to turn its attention to finding a partner in Northern Asia which is able to connect the increasingly important Australia-China routes.

While SIA and its hub at Singapore are ideal for Southeast Asia, India and Europe, they are less efficient for North Asian one-stop connections, where non-stop services are increasingly available.