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Flight Risk

Airline results

The biggest change to the airline industry over the last three decades has perhaps been the introduction of the low-cost carriers (think Southwest Airlines, Ryanair, easyJet etc) and the demise of the formerly government-owned behemoths (think British Airways, Lufthansa, JAL etc).

The trend to the low-cost carrier (LCC) model has undergone its own transformation with the advent of the ‘second brand’ approach by the major airlines to combat the incursion of the new competitors.

In Australia, Qantas launched the JetStar brand to achieve two things: provide competition against LCCs (Ansett, Virgin, Tiger) and to create its own LCC to profitably substitute its own capacity where the Qantas brand was uncompetitive. This concept has extended into its international capacity.

The JetStar brand has done an exceptional job to fortify the Qantas Group. Domestically, it now represents 20% of capacity with Qantas (including Qantas Link) at 47% and Virgin at 32% (using the 3 carriers only for simplicity).

Using the same groupings, JetStar represents about 22% of domestic passengers with Qantas at 44% and Virgin at 34%.

Both Qantas and Virgin have been adding a lot of domestic capacity in recent years in a mad scramble for market share.

Airfares have been on a one-way trip downwards just as fuel prices have tucked into an increasing share of the cost pie. According to IATA data (International Air Transport Association), fuel has increased from 13% of total operating costs to 30% over the last decade. Qantas’s fuel expense is about 29% of total costs and has averaged over $2bn per half-year for the last 18 months. That’s more than the average $1.89bn spent on staff over the same period.

The latest issue in the Australian industry has been the re-shaping of the alliances that Qantas and Virgin have formed. For Qantas, the Emirates deal looks like a long term winner with substantial benefits across the board. It should go a long way to enhancing its problematic international airline division and the company was brave enough to reveal the financial metrics of this division for the first time.

In the six months to 31 December 2012, the international division at Qantas generated revenue of $2.8bn and operating earnings (EBIT) of -$91m. The equivalent figures for the domestic airline were revenue of $3.2bn and EBIT of $218m.

Qantas CEO Alan Joyce has conducted a brave strategy to ensure the survival of the group by re-shaping the international airline, establishing the Emirates alliance and attempting to extend the Jetstar brand throughout Asia.

To ensure the company’s financial sustainability, the balance sheet and capital expenditure commitments have undergone frequent adjustments. The capital intensity of the industry is unavoidable and has often been the source of pain for failing airlines, so it is encouraging to see Qantas staying on top of this factor.

Nipping at their heels, Virgin seems intent on gaining a greater share of the corporate domestic travel market and so they should. It will be a long hard battle but one it must sustain or the JetStar/Qantas combination will strangle it.

Virgin’s equivalent steps to extend alliances and create LCCs are sensible but there is substantial execution risk. Virgin is far more reliant on domestic earnings than Qantas so it must win a profitable share of all parts of the Australian domestic market to survive.

Regional airline Rex Group reported a sombre result this week, laced with dire predictions about the future of regional airlines due to detrimental government policies (carbon tax and other unspecified factors). Along with higher fuel bills and dwindling passenger numbers, Rex forewarned of a 35-40% drop in its annual profit for this year given the current environment.

Related to the airline industry, Flight Centre is coping very nicely with the boom in air travel helped along by the high Australian dollar. FLT’s profits are improving as its corporate travel volume and reach keeps growing, its online strategy is working and its market leadership gives it a strong negotiating position with its key suppliers, the airlines themselves.

FLT’s half-year result continued a good run of results yet the share price doesn’t look totally overcooked.

Nicely ensconced in the midst of the airline wars is the infrastructure/retailer Sydney Airport (SYD). Its full year result for 2012 released this week showed operating earnings growth (EBITDA) of 7.4% on passenger growth of 3.6%.

Consistent with the industry trends, international passenger growth at SYD of 5.6% as more capacity came on stream and the long term rise in Asian travel persisted.

Most of the attention on SYD is focused on the airside activities, with the perennial debates about landing, slot and movement capacity foremost among the issues. SYD maintains that the Badgery’s Creek option is the best outcome for Sydney but there is no real solution in place yet.

In the meantime, SYD has forged ahead with its landside operations adding all manner of new initiatives to its retail, car-parking and commercial services.

The next chart shows the price performance of these stocks against the ASX200 over the last year and for the year-to-date.

The airline industry is a tough industry and categorically not one that we would recommend. We are reminded of Warren Buffet’s quip on how to become a millionaire – start with a billion dollars, then buy an airline – roughly paraphrased.

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