Virgin Australia Outlook Becomes More Uncertain

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-Reduces FY16 profit guidance
-Aggregate 2.0% industry supply cut
-Demand weakness likely short term

By Eva Brocklehurst

Virgin Australia ((VAH)) will reduce its carrying capacity in the June quarter, making a similar response to competitor Qantas ((QAN)) in the face of weaker consumer demand.

The company's pre-tax loss in the March quarter of $18.6m was greater than brokers expected and guidance for FY16 pre-tax profit of $30-60m is also materially lower than forecasts. UBS lowers its forecasts to $45m by reducing aircraft utilisation and unit revenue as well as updating FX and fuel assumptions. The broker's FY17 estimates drop by 40%.

The broker observes the business remains highly leveraged to the uncertain outlook in demand, with every 1.0% change in unit revenue driving a $40m change in pre-tax profit.

The company's remarks on the state of consumer demand echo recent commentary from Qantas. Both carriers are making reductions in capacity in the domestic market, which UBS estimates will amount to a 2.0% cut to industry capacity in the June quarter. This should help correct the supply/demand imbalance.

A capital structure review is still underway at the airline, following a weak performance in the December half year. This, together with Air New Zealand ((AIZ)) signalling an intention to divest its 26% stake, suggests to UBS a range of scenarios will be contemplated as to future management control and the current 16% free float. Pressure also continues on management to improve profitability and reduce gearing.

The capacity cuts are a rational response to weak short-term demand, Macquarie maintains. Demand is also hampered by pre-election uncertainty and the resources downturn. The broker is encouraged by the decision, as it reflect the airline's intention to preserve profitability rather than scramble for market share gains.

Virgin Australia will cut final quarter average seat kilometres (ASKs) by 5.1%. Traffic statistics were solid enough in the March quarter although yields were low and the broker highlights the performance was affected by the comparable revenue benefits from the Cricket World Cup in 2015, and Easter occurring at a separate time to the school holidays this year.

Macquarie expects domestic capacity control will stabilise load factors and stimulate a recovery in yields. The broker also notes this is a positive development for Qantas as it signals that the current weakness is not carrier specific.

Deutsche Bank believes the update implies the fourth quarter will also be loss making and, while reducing its target by 19c to 44c, maintains a Buy rating, given the upside from the current share price. Still, the broker accepts that risks are increasing as oil prices continue to rally and consumer demand falls.

There are one Buy and five Hold ratings on FNArena's database. The consensus target is 41c, suggesting 30.2% upside to the last share price. This compares with 51c ahead of the update. Targets range from 31c to 50c.

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