Virgin more vulnerable to weak domestic market
Virgin Australia has an underlying loss of $72.8 million. Photo: Glenn Hunt
Both airlines are struggling but, by simple mathematics, the domestic weakness will hurt Virgin more than Qantas.
On Thursday Qantas announced an underlying profit of $192 million for the year that ended in June, which is up $97 million on 2012.
Part of this weak profit outcome was attributable to a 21.1 per cent decline in Qantass domestic profitability.
It is also the result of a 32.1 per cent decrease in Jetstar Group profitability, a large share of which is due to Jetstars domestic operation, which represents 39 per cent of Jetstar Group capacity. Advertisement
On a slightly brighter note for Qantas, the profitability of its mainline international operations improved, although still remaining in highly negative EBIT territory.
On Friday Virgin Australia announced an underlying loss of $72.8 million for 2013, which is down from the $82.5 million profit recorded in 2012. This result included a reduction in domestic and international EBIT of about $170 million and $32 million respectively.
In the case of Virgin the domestic business represents about 60% of its capacity and so is the key earnings driver.
The earnings weakness of both airlines may be the final nail in the coffin for shareholders, especially Qantas investors.
The Qantas share price fell by 9.1 per cent over 2013 at the same time as the Australian equities market rose by 9.1 per cent. In fact Qantas shares have been in trend decline since they peaked at $5.34 in 2007.
Conversely Virgin shares averaged growth of 23.3 per cent. The Virgin share price has not fared well over a long horizon, having peaked in 2007 at $1.94.
The general theme in the 2013 earnings results is weakness in the domestic market. We expect persistent earnings weakness in the international business so this is less of a surprise.
The domestic weakness will hurt Virgin more than Qantas by simple mathematics – Virgin domestics share of total Virgin capacity is higher than Qantas domestics share of total Qantas capacity which is about 39 per cent.
While this may benefit Qantas relative to Virgin this year, it is a big long-term structural problem for Qantas because it means it has a significantly greater exposure than Virgin to a persistently weak part of the aviation business.
Both airlines have alluded to excessive capacity growth in the domestic market as the dominant reason behind the poor results. This is partly true but not the full story.
While capacity in the domestic market grew strongly in 2013 by 7.2 per cent this is not materially higher than the long run average of 5 to 6 per cent.
In fact, domestic capacity in 2011 grew by 8.2 per cent. This certainly did not hurt the Qantas profit result of $552 million in 2011, but it appears to have had a deeper impact on Virgins domestic business, which ran at a loss of $40.8 million in that year.
Yield and excess supply
It seems clear that Virgin yields and thus earnings are more sensitive to excess capacity than Qantas yields. Qantass mainline domestic yields fell by just 0.5 per cent in 2013 while Virgin yields fell by five times this.
This observation is unusual because the demographics of the two would suggest that Qantas should have more capacity-sensitive yields.
Typically, one sees bigger yield declines in response to excess supply for airlines that have a more concentrated business demographic. This is because the business segment flies because they need to go to meetings rather than when airlines offer cheap fares.
When there is excess supply on routes that are intensively business the airfare needs to be pulled down a lot to stimulate travel.
As Qantas at the moment has a stronger business travel demographic than Virgin, one would have expected Qantas yields to fall further.
The answer to this apparent conundrum is that Qantas yields are more sensitive to Qantas capacity than they are to Virgin capacity and vice versa for Virgin. Qantas mainline domestic capacity rose only 2.9 per cent whereas Virgins more than doubled this.
The other important driver of the domestic earnings weakness is a lift in unit cost. Virgins rose by about 10 per cent while Qantas increased by 3.9 per cent.
The dramatic lift in Virgins unit cost is part of its strategy to invest in product to attract more of the corporate segment. It is for this reason that the airline can run at a loss without shareholders panicking.
The 32 per cent drop in Jetstar profitability during the year is a concern for Qantas. The group claims it reflects competition in the domestic market but with a weakened Tiger Air, and Virgin Australia re-focusing on the corporate market, there probably wasnt a better time for Jetstar domestic to make money.
The real trouble with Jetstar domestic is that it is no longer a truly low-cost carrier. In 2004 and 2005, it basically flew only in the off peak, from the east coast to tier 2 ports such as Cairns, Coolangatta and Maroochydore.
Now it has strong frequencies at the peak and off peak in all major tier-1 city pairs.
This shift in strategic direction has occurred because the airline is aggressively chasing revenue opportunities. It has had to do this because it is increasingly difficult to stimulate leisure air travel by offering low fares on tier 2 routes. In short, the domestic low-cost market on these routes is close to saturation.
The main reason for this revolves around the fact that the fare is just 16 per cent of total travel expenditure. What this means is that Jetstar can drop its fares by $30, $50 or even $100 but this will not stimulate travel because the passenger cant pay for the accommodation, food and beverages and land transport on arrival.
The interesting question over the period ahead is whether Tiger Air will also be affected by this saturation phenomenon.