Domestic Dogfight: Qantas Vergin’ On Desparation

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

-Capacity oversupply to persist
-Virgin's cashed up and ready
-Qantas market share a casualty
 

By Eva Brocklehurst

There's a battle looming in the skies above Australia and it's about grabbing market share. Virgin Australia ((VAH)) and Tigerair are adding capacity while Qantas ((QAN)), as yet, has shown restraint. Something has to give. Either Qantas relinquishes domestic market share – which the airline aims to maintain at 65% – or makes a response to the other carriers.

Macquarie thinks the softness in the domestic economy is taking a toll on Qantas. The economy is just not growing enough to absorb the excess airline capacity. There are not enough top paying passengers. Regional yields are being affected by increased competition from Virgin, while sluggish demand and corporate pricing pressure is squeezing yield at the top end in Qantas' international operations. Macquarie notes Virgin is looking to add 7% capacity growth to the market and Qantas is probably going to have to step up capacity to meet this. JP Morgan has analysed the current domestic airline seat capacity as well as demand. Market oversupply is calculated at around 2% of capacity. The broker has a negative view on the sector and thinks Qantas is not out of the woods yet, in terms of resuming profit growth.

In FY13 domestic airline market seat capacity is estimated to have increased 8.2% at the same time demand growth increased 5.4% – that's the comparison. JP Morgan estimates, if no additional capacity is added to this position as at September 2013 and demand increases 1.8-2.5% per annum, it would take a year to absorb the excess supply. Hence, the broker's forecasts for the airlines assumes the difficult conditions will persist. In the case of Qantas' 65% long-term market share aim, JP Morgan suspects that, on all metrics for the year ending September 2013, it has already slipped below that figure. The domestic share of seat capacity was 64.1%, the share of revenue per seat kilometres was 64.4% and the airline took 62.7% of passengers.

September load factors fell 2% across the Qantas group, according to Macquarie, and the trend has continued into October and November. The broker does not expect conditions to reverse any time soon. Importantly for investors, this deterioration was occurring prior to Virgin's equity raising earlier this month. Macquarie observes there's been negative yield growth at Qantas since July. Qantas has guided for a group-wide yield decline of 2-3% for the first half, more than what the broker expected.

Macquarie considers Qantas is yet to see benefits from cost improvements, efficiency gains, or the ongoing agreement with Emirates and has decided to downgrade the stock to Neutral. Deutsche Bank maintains that, as the second half is traditionally weaker, there's little likely that Qantas earnings will recover by enough to turn the business around any time soon.

The question brokers are asking is: how can Qantas respond to the competition? Macquarie notes Qantas has complained about the ongoing investment in Virgin by international airlines and, while a repealing of the Qantas Sale Act is unlikely, the solution may lie with a deepening of the partnership with Emirates.

Virgin Australia's recent capital raising provided the means to push for equality with Qantas in the domestic market. Macquarie does not think the company is trying to flood the market with capacity but is looking to add density on specific regional or under-serviced routes. It's just that passenger demand is simply not available to fill all seats in the market at current prices. The $350m rights issue boosted cash reserves and the four strategic shareholders took up their entitlements, which indicates ongoing corporate interest in UBS' opinion. Hence, Virgin's share price is likely to be underpinned by the major shareholders and the potential for privatisation.

Qantas, on the other hand, is expected to be a casualty of all this. Credit Suisse believes the coming 12 months will enable better judgment of the shape of the domestic market but, as Virgin is now competing in all market segments, the extent of any bleeding from Qantas will depend on Virgin's final cost advantage. CIMB responds thus: more funds for Virgin means more competitive pressure for Qantas. A situation that's here to stay and perhaps intensify.

Qantas has a range of recommendations. On the FNArena database there are three Buy, two Hold and two Sell. The consensus target price is $1.52, suggesting 32.2% upside to the last share price. Virgin Australia has one Buy, four Hold and three Sell. The consensus target price is 40c, suggesting 2.9% upside to the last share price.
 

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