Plane Crash

Array
(
    [0] => Array
        (
            [0] => ((VBA))
            [1] => ((QAN))
        )

    [1] => Array
        (
            [0] => VBA
            [1] => QAN
        )

)

This story features QANTAS AIRWAYS LIMITED.
For more info SHARE ANALYSIS: QAN
The company is included in ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

The events of 2001 were understandably bleak for US airlines. Already passenger numbers had been affected by the tech-wreck, and not only did 9/11 result in a long period of grounding, the subsequent fear factor and unavoidable recession sent the US airline industry – which has always been fragile – close to the brink.

But the ensuing period saw economic boom and good times returned. Both Boeing and Airbus were busy building a new generation of airliners, and orders were healthy. Despite a consistently rising oil price, as little as two months ago Continental and United had come close to organising a merger which would have created a new number one airline in the US, above incumbent American Airlines. But the sudden sharp jump in the oil price over those months has since forced Continental to walk away from the deal.

Suddenly US airlines are fighting for their lives. They now face their worst crisis since 2001. The doubling of the oil price over the period of a year has seen airlines respond with fuel surcharge increases, but as the US economy slows it is becoming less viable to pass those increased costs on to passengers who are now cancelling travel plans in droves.

As a result, Continental became the latest airline to announce cutbacks, suggesting last night it would be shedding 3000 jobs (more than 6% of its workforce) and reducing capacity by 11% this autumn, the post summer holiday period. In a show of solidarity, the two most senior executives would forgo any further pay in 2008.

In an explanation to employees, management noted that fuel had now exceeded labour as the greatest cost to the airline. Several ticket price hikes have not covered the fuel cost increase and the airline was losing money on a large number of flights. As fares rise, fewer people will fly, and that means less staff are needed to look after them.

As grim as this outlook is, most US airline analysts consider Continental to be in the healthiest position of all the airlines. This does not bode well. Continental has now followed both United and American in cost cutting. The former is cutting 1100 jobs, grounding 70 planes, and withdrawing its discount carrier service called “Ted”. The latter will cut an as yet unconfirmed number of jobs, and cut capacity by 11-12% after summer. Back in March, Delta Air Lines had already flagged 10% capacity cuts in the second half of 2008.

There are also other little tricks the airlines can pull to save money. Post-summer is always a time airlines discount their fares to encourage off-peak travel. They will still have to do this in order to attract anyone to fly, but by enforcing minimum stay-over limits on the discounts the airlines can still pick up full fares on the no-choice travelling business community. This will upset business travellers, but we are now talking survival.

And survival has been very much in focus in Australia as well, as yesterday JP Morgan published a report questioning Virgin Blue’s ((VBA)) ability to do just that given the current environment.

Virgin has already announced 5% fare increases, but if the price of oil remains at elevated levels for the longer term JP Morgan suggests this price rise will not cover increased costs. Under this scenario raising more equity would be futile, says JPM, as even $1 billion would not prevent insolvency. Earlier in the week UBS analysts reversed their forecast $60m profit for Virgin in FY09 into a $40m loss. If jet fuel prices remain at current levels, UBS suggests Virgin will be trying to raise more capital by 2010.

JP Morgan believes an equity raising would simply help buy time in the hope oil prices can eventually fall. But what Virgin really needs to do is increase fares not by 5%, but by 10%. Even then it would simply be a case of preventing insolvency. On flat longer term oil prices JPM suggests Virgin would still earn less in FY15 on a 10% fare increase than it did in FY07.

Virgin management has come out and denied any insolvency issues, suggesting the airline can respond by cutting costs. But as to exactly how Virgin will cut costs is problematic.

The national carrier Qantas ((QAN)) last week announced a 5% cut to its domestic capacity, and yesterday announced the same cut to its international capacity. Deutsche Bank analysts noted this morning that a 5% international cut means Qantas risks losing global market share, but only provided no other competing international carrier makes similar cuts. As we have seen from United for one – a rival on the SYD-LAX route -  other global airlines are announcing even more severe cuts domestically than Qantas, so there’s little doubt cuts will follow on international routes.

At the risk of using poor English, let’s just say that Qantas has a lot of capacity to make capacity cuts. Passenger numbers are going to fall anyway, so the opportunity presents to scrap less popular routes and to reduce flights on well-serviced and competitive routes. To do this Qantas can decommission or ground older planes in its fleet – planes that are the equivalent of seventies gas-guzzler automobiles when it comes to jet fuel consumption. And it can also defer more routes to its discount Jetstar service, cutting back on the costs involved in the higher cabin service level “Qantas” brand flights.

What Qantas can do domestically, it can also do internationally, and while airline analysts concede that the ongoing fate of the Qantas share price is inexorably tied to the price of crude, the airline has a substantial ability to ride out this storm and, provided it also makes more fare increases, is doing all the right things at present.

For Virgin, however, it’s a different story. As the newer carrier it does not have any old gas-guzzlers it can retire. As a discount airline it does not have an even more discounted airline to which it can defer routes. Qantas has the ability to reduce capacity and thus costs without meaningfully reducing the net number of tickets sold. If Virgin cuts capacity it must surely simply lose business.

Shares in Virgin Blue have fallen 75% in a year, from $2.56 to around 64c today. Over the same period Qantas shares have fallen from $6 to $3.50 – a fall of only 24%. It is no surprise that Virgin’s CEO would be quick to come out and quash the insolvency rumours, and even question the UBS forecast loss, given the resultant fear-factor among potential passengers could act just like a run on a bank. Those planning their flights ahead may decide Qantas/Jetstar is a safer option, lest tickets paid up front are lost when Virgin goes into receivership. This could be self-feeding.

Not that Virgin is about to go into receivership tomorrow, and one wonders what Mr Branson’s thoughts are at this point, but as we know from the long history of the Australian airline industry, only one – Qantas – ever survives over time.

Click to view our Glossary of Financial Terms