Virgin Bleeds As Qantas Holds Firm

This story features QANTAS AIRWAYS LIMITED. For more info SHARE ANALYSIS: QAN

By Greg Peel

I have never been a fan of longer term investment in airlines. Traders can find shorter term price fluctuations to exploit, but historically airlines are struggling businesses unless they can sufficiently lever off route protection.

If the global economy is solid, holiday-makers and business executives take to the sky, bringing more planes out of hangers and even more airlines into being, thus increasing competition. Just look at the difference in a ticket price now per average wage than two decades ago. And if the economy is strong, so is the oil price, leading airlines to either lose margins or pass on costs to passengers and thus lose market share.

If the global economy is weak, oil prices fall but passenger demand drops off anyway, and planes have to be mothballed again. Small airlines go out of business. It's all a bit damned if you do and damned if you don't, and that's before one considers the rapid development of more and more sophisticated teleconferencing systems exploiting faster broadband speeds. I mean, who actually wants to fly if they don't have to?

It was only three weeks ago that Virgin Blue ((VBA)) effectively downgraded its FY10 profit guidance from a range of $80-120m to the “low end” of the range, so let's just say $80m. Not a major downgrade, but a downgrade nevertheless. Virgin cited falling demand in the leisure market as the reason for weaker profit expectations.

Then only three weeks later, Virgin absolutely slashes its guidance again, down to a range of $20-40m citing exactly the same reason. Now that's a downgrade. It was all about “rapid deterioration and increased volatility in operating conditions”, management noted.

In simple terms, Australians have suddenly stopped booking holidays to Virgin's destinations. Virgin's no frills service, competitive pricing and cutesy “fun” persona provides the airline with a heavy weighting to the leisure passenger and a light weighting to “premium” passenger, which is basically someone flying on business. Business passengers tend to prefer the higher service/higher cost Qantas ((QAN)) on domestic routes or if not the cheaper Qantas joint-ventured Jetstar. Many businesses run longstanding accounts with Qantas meaning executives simply fly on Jetstar without being given the option of Virgin anyway.

But then Jetstar competes with Virgin in the leisure market, and more recently Tiger Airways has joined the fray to take on both. In Australian airline history, no “third airline” has ever lasted very long, but then which one is third?

The fresh and significant profit downgrade from Virgin has forced brokers to slash their earnings forecasts, in some cases over 50%. Six out of eight brokers in the FNArena database previously rated Virgin a Buy, largely citing a share price shattered by the GFC and prospects for recovery. But today both RBS and UBS have downgraded to Hold, leaving Virgin with a 4/4/0 Buy/Hold/Sell ratio. For the remaining Buy-raters, the fall in Virgin's stock price from over 75c in March to 31c yesterday is enough to consider value is still apparent at knock-down prices.

But on the same day that Virgin slashed its FY10 profit guidance, Qantas reaffirmed its own ($300-400m). Qantas, too, has suffered from a drop-off in demand in the lower-cost leisure sector, but as solid April traffic numbers show, Qantas has seen an off-set from recovering demand in the “premium” sector. Qantas boasts an 8/2/0 ratio in the FNArena database.

With consumer demand in general now taking a hit from rising local interest rates and a run of general bad news, led by the European debt crisis, holidays have taken a back seat again. Nervous falls in the stock market also mirror nervousness in discretionary spending. The outlook for Virgin is unlikely to improve in the short-term and the average target price in the FNArena database has today been cut from 73c to 47c. The Qantas target remains steady at $3.27.

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