Australia Pacific - Competition is gearing up in the Australian domestic market, can everyone survive?

Transcript

George Woods:

Thank you and welcome everyone to the next panel on the Australian Aviation Market in 2021. My name is George Woods. I'm a partner from L.E.K. Consulting and Strategic Advisory Firm around the globe serving firms across the economy. I head our aviation practice in this region. I'm joined today by three great powers. I'm joined by Cameron McDonald, the head of research at E&P. Cameron brings many years experience in investment research across his span of E&P, and before that with Deutsche Bank covering the transport sector. Prior to joining that, Cameron was also at Hastings Funds Management as a director, and also at UTA where he served on the board at Perth Airport. Also joined today by Anna Wilson, who is from Frontier Economics, a specialist microeconomics from across the Pacific. Anna is an economist specializing in transport and regulatory issues. Currently heads up the transport practice and brings experience working with clients across the aviation sector in network, regulatory, and market forecasting issues.

George Woods:

Also joined today by Rod Sims, chair of the ACCC. He must be doing something right, he's the longest serving chair in the ACCC's history. Prior to that, Rod was chair of the National Competition Council, and before that had a very successful career as a strategy consultant sitting on multiple boards and also in Canberra as the secretary of PMNC. And today's conversation proves to be really interesting, I think. We've got very interesting times ahead of us. We are in normal times sitting on a domestic aviation market that is profitable, that contains the fourth busiest city pair in the world. But the industry has stopped, is in the process of rebuilding, both in terms of the industry where we see VA and Rex restarting or VA restarting and Rex starting their main line business. And where we also see the consumer restarting travelers. They've gone through multiple lockdowns.

George Woods:

International borders are shut, and I think most people agree that international travel is a long way away, but we're starting to see the green shoots in domestic. So in terms of today's conversation, I thought we might talk around a few things. We might talk around the market and how it's seeing, and then go into this domestic competitive environment. I might start by asking the panel where they think we are in the recovery. Maybe, Cameron, do you want to give us your thoughts of where you see the aviation market going in the next little while?

Cameron McDonald:

Sure. Thanks, George, and welcome everyone to the session this afternoon. In terms of where I see the market at the moment, and I cover both Qantas and Sydney Airport as a financial investment recommendations. We see the market as being very, very fragile. As you point out, international borders remained closed, international looks as though it's probably going to remain closed for an extended period of time. And it's not only just the willingness of airlines to operate or the ability to operate. It's also the underlying demand environment from passengers. So it won't just be them willing to get back on a plane, it will also then be things like travel insurance, healthcare, et cetera in the destination market that they're going to in our view. So we think that's going to push out the recovery in international markets for an extended period of time.

Cameron McDonald:

In the domestic market, there are some green shoots. Again, it's very, very volatile and we've seen state-based premiers very quick to lock down borders, in some cases within an hour of notification. So that makes planning of holidays and business travel very, very, very difficult. And you end up probably doing more of this and being on Zoom and virtual meetings from a business perspective. And I think you'll probably end up seeing a lot more intrastate holiday making than interstate in the short term before we start seeing the benefits of a vaccine being rolled out. So we certainly see some extended challenges for the international market, but some extended challenges and volatile conditions in the domestic market throughout the rest of this calendar year.

George Woods:

Anna, what about the nature of the recovery? We're sitting here on Zoom today, do you see this as being a consumer-led recovery?

Anna Wilson:

Look, I think in terms of forecasting or recovery in demand, I think that basically all forecast will be either lucky or wrong in some respects because the key drivers are mostly the pandemic and the government's response to it. Border closures are essentially the main thing that's affecting domestic travel, which is by and large the most important aspect of demand. And I think probably what we're seeing is that current levels of demand probably reflect this uncertainty as much as the explicit border closures themselves. We're quite loss averse humans, and we really do not like to lose, and much more than we'll like any equivalent size gains. So by and large, I would suggest people are responding to that and waiting to see which means they'll book light, but it also means they'll potentially avoid travel, which is what Cameron was pointing at in terms of seeing intrastate travel movement. But I think over time, passengers might start to become more comfortable with cancellation arrangements that airlines have in place. And when they feel more comfortable that they'll get their money back, that they'll be able to rebook.

Anna Wilson:

I think then you'll see more demand emerging and maybe things heading back not to necessarily pre-COVID levels, but to something that's more keen to what we're used to as that uncertainty or the fear of the uncertainty declines. And I guess one more other observation I would make to build on Cameron's point, I think generally people are presuming there's been a massive change in demand from business travelers. I think time will tell how much that might have changed in the sense that we presume you can do meetings and conferences over Zoom like we are now, and you certainly can, but there's an aspect of business which doesn't do well in this kind of world. And that's winning new business, and their face-to-face interaction is actually critical. You don't remember people that you've met on a Zoom call, but you do when you've met them face-to-face.

Anna Wilson:

And I think at the moment, we're seeing that business demand might've been a little bit pent up. People are enjoying a change in pace working from home. As to whether, and to what extent, business demand will be dampened, I think we'll know more in about a year's time when you can start to see that more serious... I guess you would say that desire to start winning work for different businesses and expanding, and keeping their client bases and stuff like that. As that emerges, I think airline travel and face-to-face interactions will become more important again.

George Woods:

Thank you, Anna. So we're facing this uncertain environment with demand coming back slowly. It raises the question then as to how are we going to see the industry play out with three airlines for brands operating creating in the market, particularly on the main line network. And this has been tried before. There's been a lot of startups over the years that have tried to challenge the main line market. Maybe, Rod, you must've seen a lot of the various airlines that have come and gone over the last few years, big and small. What are the lessons from the past? Who got it right and who got it wrong?

Rod Sims:

Look, George, I'll just make one quick comment in response to Anna, I think it's going to depend very much with the travel on whether airlines particularly are making it very clear if the booking changes, you'll get a refund. Even if the government hasn't canceled something, you'll get a refund. I think that's going to be really important for the travel industry to underpin that consumer and business traveler confidence. Oh, look, there's a fantastic history in aviation in terms of companies that have come and gone, obviously Ansett is the one everybody remembers, but we've had other entrants to be the third player that didn't last. I guess the key point I'd make without getting too much into the history, George, is that Rex is an interesting player. It's been here a long time. I think it's mainly the buildup of Hazelton and Kendell, which had been around for a very long time. It's got its own base in terms of its regional network. I think it's still quite profitable.

Rod Sims:

It's obviously low cost given the nature of the airlines. So it's a slightly different beast than others that have tried to be the third or indeed second player in some ways. I think the key point I'd make is that it's really important we let the market play this out, and that means people shouldn't, I think, get... Look, it's quite fun to speculate what will happen with Rex and what will happen with Virgin for that matter. But at the end of the day, we must make sure that what government and perhaps others do it, doesn't try and preordain that outcome. And obviously the thing uppermost in my mind is slot management. If Rex is going to operate on the nine routes, Melbourne-Sydney, also Sydney-Brisbane, Melbourne-Brisbane, it needs slots, particularly, obviously in Sydney Airport.

Rod Sims:

And we've just got to make sure that we haven't grandfathered the slots in such a way that Rex can't get in there. Now I think in the short term, Rex is fine, but obviously we've got an 80% rule for other slots, but I've no doubt that Qantas and Virgin we've got someone sitting there making sure they use 80% of the slots, even if they have to cancel a flight over here and put one in over there. Obviously, that's what they're doing. So I just think the current review being done by the Department of Transport into slot management, particularly at Sydney Airport is just fundamental. We just cannot cement the current slots. So my strong message is, let the market play out. My subsidiary message is Rex is coming off a successful low-cost background. I don't know whether they'll succeed in what they're trying to do, but I would think that they're as well placed, or probably better placed than anyone else who's tried it to pull it off.

George Woods:

Excellent. Cameron, you've been following this sector for quite some time. You must have written about and had your views published about lots of these airlines and their tasks, and I think you've had to run through them.

Cameron McDonald:

Yeah, thanks. Yeah, it goes with the territory, I suppose. So look, we've done extensive historical analysis, if you like, over the journey about successful airlines and the history of aviation in Australia. And I agree with Rod's comments around Rex, albeit I don't cover Rex and I have no investment recommendation about them. They have an extensive history of operations here in Australia. But effectively the two things you are competing on in a domestic market is around product or price. There's very little differentiation other than those two elements. And both the two incumbents, being Qantas and Virgin, do have very, very large and successful loyalty programs, which people have, being very, very aligned with and loyal to and has driven consumer behavior.

Cameron McDonald:

So that a hurdle that I think any new entrant is going to have to try and overcome. In terms of the market, we haven't really seen the market grow that much in terms of the profit pool. The prior four years, prior to COVID, the profit pool in Australia was roughly a billion dollars per annum. We've seen it dip to 900 million at the EBITDA level, at $900 million in one year up to 1.3 in others. But it's been a billion dollars or 1.1, either side of that. So in average, it's about a billion dollars worth of profit that you're trying to compete over. That's the size of the price.

George Woods:

Anna, and I think you're done on the market structure. There are a billion dollars, we've got a very fat roof in Sydney, Melbourne, one of the busiest routes in the world. You're probably a large part of that profit pool over many years. Number of competitors that a market like that can sustain?

Anna Wilson:

I think there's an assumption that the Sydney to Melbourne route defines whether there's enough profit pool there for competitors. But I think we overlook the fact that there is some economies of scale in airline services. And I think we can't discount that. I guess there's just the sheer size factor, it helps to lower your marginal costs and incremental costs, I should say. I think there's also the fundamental underlying principle here, which is that passengers and customers do benefit from having airlines that service multiple locations with greater frequency. And so that's another contributing factor as to why you end up with large carriers.

Anna Wilson:

So, there can be a profit pool on a single route, but that doesn't drive whether you're likely to have, I don't think three serious network carriers in Australia. And so that, I think only time will tell. And essentially, I probably echo what Rod said, it's possible. I would say Rex is in as good a position as any to take advantage of that. They've got a low cost of borrowing at the moment. Some of their inputs to the actual expansion would be low cost pilots. Potentially they can access some more slots, I guess that will tell. But ultimately they're facing two competitors who will have a lot of excess capacity at the moment. And the only sensible thing for them to do is to look to feel that. And so it's a real challenge I think Rex will face. Yep.

George Woods:

Lots of them are talking about how they're not chasing down the bottom. Virgin has been talking that they're aiming at the middle market, and similarly Rex has been talking about more value added to innovate the basic service, and everyone had to the same spot. What do you think they're going to need to diverge a little bit more than the PR departments have them maybe doing at the moment?

Anna Wilson:

If you look internationally about how you see airline competition, there does tend to be a lot of competition on the nature of the product. Not necessarily on a route-by-route basis, but on pegging yourself as a low-cost airline, servicing business travelers. It's that differentiation in product, which is how people tend to compete. So I don't know that it's silly firms pegging themselves at different segments of the market.

Rod Sims:

Just one bit of history though, of course, Anna. I remember when we had Ansett and Qantas, and I actually left at the same time. Their schedules were identical. That they all want to leave at 12 rather than five past 12. And they were just so much the same. So I think with Virgin coming along, we did get differentiation. And if Rex is going to survive, they'll need to differentiate as well. I take Cameron's point about the frequent flies that they do have the regional linkages. I'm not suggesting that drives the Melbourne-Sydney market, but I think they're going to have to differentiate rather than copy. And I'm sure they will. That's clearly what they're aiming to do.

Anna Wilson:

I think they've also got that added advantage, which is at the moment, everything's up in the air, if you like. All the cards have been thrown into the air, and you have an opportunity to think about how you might restructure a network, what might be most efficient, and obviously Qantas and Virgin are a little bit behind in that sense. They have a highly optimized network, which suddenly, in this current scenario, isn't highly optimized or efficient. So you've got a bit of an opportunity to take advantage of that if you're a expanding entrant, but obviously this is all potentially a little bit temporary and short term. So I think that will sort of play into this as well.

George Woods:

And I haven't warned you about this Cameron so this is a question on notice, but there's been announcements recently about regional plans of Qantas doing deals and things changing on the regional front. What do you see happening in that landscape?

Cameron McDonald:

Look, the regional aspect's really interesting, and I was going to pick up on one of Anna's comments before about how the market is changing. And you've only got to look at property prices in regional areas outside of the major capital cities, where people have decided that they will go and live there and then telecommute or travel more into the city on an ad hoc basis and work from home more often, et cetera. So I think some of the regional routes might actually get a benefit out of that as people decide, "Well, I'll work from home two days a week or three days a week. I can effectively work remotely from the office and we've proven that we can do that over the last 12 months." I think some of that probably actually favors a player like Rex with their history in that regional market.

Cameron McDonald:

And Rod might find this interesting, but we did do a research report, which we published back in 2019, where we stuck 250 routes into a statistical program and analyzed whether or not there was a pricing differential between routes that had competition on the route versus ones that were operated solely. And obviously given that I only covered the Qantas group, I didn't cover Virgin. We focused on Qantas, so I don't want to just solely pick on them, but that was the topic of the report. So of the 250 routes, there was about 50% were routes that Virgin competed with the Qantas group, being Qantas and/or Jetstar, and 50% where there was a sole operator.

Cameron McDonald:

And what we found was that when Qantas was the sole operator, the price per kilometer flying, including the starting airfare was about 70% higher than where they had competition. While it's not perfect analysis, by putting it through a statistical program, we had used enough roots to be statistically significant, and it was a pretty interesting point to highlight. To the point where you get more competition on some of these routes, the consumer does seem to do better. The other comment I would just also [crosstalk 00:21:18].

Rod Sims:

I may now just mention great analysis, thank you.

Cameron McDonald:

It's a public piece of research, Rod.

Rod Sims:

[crosstalk 00:21:25] Absolutely.

Cameron McDonald:

So the other thing I would say is that the airfares themselves are very small part of the overall decision-making point to travel, and travel particularly for leisure. To Rod and Anna's points earlier, it's not only that the airlines need to make it clear that you can cancel your plans at the last minute because of government intervention or that you don't feel safe to go. And this is one of the reasons that we see people travel overseas. It's cheaper to go skiing in New Zealand or Japan than it is to ski here in Australia. Similarly, accommodation and tourism here in Australia is expensive compared to pre-COVID, at least, international. And that's where, we say it's not just the airline's responsibility here to take... They maybe have to lead that conversation, but there are other parts of the value chain that are going to have to come to the party here as well.

George Woods:

Thank you, Cameron. Thank you. I'm conscious of time. We're racing through this. I did want to build out on something that Rod said a little bit earlier about the slots at Sydney. We face an environment where we've got one very large competitor and two just smaller competitors. Anna, what are some of the issues that you see from a competition and the challenges that you would throw to Rod with a regulatory and competition hat on?

Anna Wilson:

I think Rod is going to have a bit of a challenge on his hands actually, because I think if you look at the HPLC's first report on airline competition, which is something that they'll be doing more regularly, I can't quite remember the frequency Rod. Is it quarterly, maybe?

Rod Sims:

I think it's quarterly. Yes, it is quarterly.

Anna Wilson:

The interesting part about that is that they're actually focused on concerns about airline behavior, which look a little bit predatory. So things to do with lower prices rather than high prices, which is about ensuring that new entrants and expanding entrants can compete fairly. And that there is a possibility of increased competition. I think the challenge is actually assessing that in a COVID context, particularly, because there are very rational reasons why the existing players would lower their prices. They've got massive amounts of excess capacity and they're going to have to fill it in order to keep operating. They've got planes sitting on tarmacs that they'll put on to other routes because otherwise they just sit there. And so I think the real challenge will be trying to separate that out from some predatory or anti-competitive conduct. At the moment, it's easy to say, but it's very hard to show that any of the actions that you see currently are in any way intended to be anti-competitive. So I think it is more of a challenge for Rod and his team to figure out how are you going to balance that in the reports, I guess.

George Woods:

Rod, I'm sure you'll solve this.

Rod Sims:

All gaze in [inaudible 00:24:56] is quite large That is the challenge. We understand with excess capacity, you want that capacity utilized. We'll obviously be looking, for example, to see whether people are covering their cash costs. Obviously, if they're not doing that, that's something we'd be interested in. We've got a range of metrics we can look at to see how the market's going, but overall, this is a health of the market check. And also to make sure there's no barriers. So clearly I've already signaled we'll be looking very closely at the slots issue to make sure that you don't get a market outcome determined by government determined by slots. That would be a dreadful anti competitive outcome, but the government understandably has a great interest in a competitive airline industry. Australia is the classic city state, huge continent, 70% of the population living in what is it, five cities give or take a bit.

Rod Sims:

Airline travel is absolutely fundamental. We can't do what Europe can do and jump on a train. You could, but not a good use of your time. We need travel, and as Cameron's kindly pointed out and reminded there's competition matters. So the government has this interest in the competition. So I guess in response to Anna, we'll have to rise ourselves up and just try and make judgment calls about how the competition's going, what needs to be done about it. If we find a breach of the act and we'll take someone to court, but I think the bigger role we've got here is just advising government on how the competitiveness of the market is shaping up. And that certainly what we'll be doing and what government has a great interest in. I should just add, finally, of course, we often find ourselves perhaps in the opposite position to where Cameron might look at things in the sense that, remember when Virgin was challenging Qantas and trying to grow its share, and Qantas was pushing back and you had great competition and you had low fares, and the airlines weren't making much money.

Rod Sims:

We were, of course, saying, "Well, this is fantastic. This is terrific competition." And then you had some form of signaling, which got pretty close to the line, I have to say, where, "Okay, we'll stop doing that now." And so you saw prices go back up and you saw a more stable market. Often shareholder returns don't benefit from competition. We're here for competition for exactly the same reason that Cameron so eloquently illustrated earlier. So the complex task, but a fundamental one for Australia.

George Woods:

Thank you, Rod. That's a good point to finish. We've got a couple of minutes to go. I might just each ask you to, and there's no skin on this one, but just maybe to get your crystal balls out. What's your prediction between 12, 18 months time, where we'll be? Cameron.

Cameron McDonald:

Thanks, George. First of all, let me also just clarify my earlier comments about competition. That was competition. Yeah, that pricing benefit was if there was lack of competition on either front, so it wasn't specific to one airline or another, but clearly competition does benefit the consumer. So, where are we going to be in 12 or 18 months?

George Woods:

One sentence, give us a quick version.

Cameron McDonald:

Look, I'd say, whatever you think it is right now, it will be different. The aviation industry just moved so quickly. This time last year we were overseas in Hawaii. We'd never even heard of a pandemic. And then all of a sudden we got back and we probably only just missed being locked out. Things could be really much better if the vaccines are highly effective. But on the flip side as well, we could quite quickly go into another lockdown scenario as we go through the winter period here in the Southern hemisphere and the virus gets out of control again. So I think, whatever you think it is right now, I think you need to think what is the opposite and what are your plans for that in case that is the actual eventuality.

George Woods:

Thank you, Cameron. Rod or Ann, is there anything else you'd like to add? I think Cameron has covered everything. Should we add on to that?

Anna Wilson:

I agree with him, who knows. But I guess consumers or passengers will have been benefiting or starting to take up some of the benefit of low fares. I think that might happen, or starting to get confidence in travel again. And I think from an airline perspective, I think the thing that they'll be doing in 12 to 18 months is trying to figure out all the operational challenges that are building up behind the scenes. How do we get enough pilots that haven't been through the simulator and have de-registered essentially, or moved into other professions. How do we restructure our routes again? I think that those operational challenges will be fun to find.

George Woods:

Thanks Ann. Rod, any last words from you?

Rod Sims:

Look, clearly the next 12 months are going to be highly uncertain, and as Cameron and Anna, and I'll say anyone who tries to predict that, no, can't do it. But I think beyond that, the airline industry will recover. The vaccine will have an effect. So I think if you look beyond 12 months, we'll get a very strong domesticated aviation industry again. That's what Australia depends on. How much virtual meetings replace business meetings, I don't know. But I think I'm a little bit on Anna's side that it might be down a bit, but I think we'll be surprised at how quickly things do get back to normal. After all, this is a pandemic, and what level we've got the pandemic, we're in chaos. Once the pandemic is under control, and I think that'll take a hell of a long time internationally, but once it's under control in Australia, I think things will get back to normal faster than people think. And we'll have a strong domestic aviation industry, hopefully, potentially with three players.

George Woods:

Thank you. Thank you all the three of you for joining that conversation. It's been a lot of fun. And to everyone at [inaudible 00:31:37], hope you enjoy the rest of the seminar.

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