Level heads may not prevail in airline wars

There were two mildly surprising aspects of Qantas’ otherwise unpalatable first-half performance that provide a context for the result that Virgin Australia will reveal tomorrow.

One is that the Qantas-branded domestic business was profitable in the half, although the $57 million it earned was a fraction of the $218 million it contributed in the previous corresponding period. The other was that Alan Joyce said Jetstar’s domestic business, too, was profitable in the half.

Virgin has said that its first-half result will be ‘’materially in line’’ with the median forecast of the broking analysts that cover the group. That median forecast is for a pre-tax loss of about $49 million. That excludes Virgin’s share of losses from its 60 per cent-owned discount brand, Tiger Australia and ‘’one-off’’ restructuring costs.

Virgin hasn’t yet provided an indication of where the losses were generated but the relatively modest size of its international business and what we know about the capacity war in the domestic market would suggest the bulk of them stem from within the domestic business.

What’s curious about the contrast between the profitability, albeit modest, of Qantas’ domestic airline franchises and the lack of profitability of the Virgin brand is that logic would have suggested that either the roles should have been reversed -- or Virgin should also be profitable.

Virgin has a cost advantage over Qantas’ domestic business estimated at about 18 per cent. It should be relatively more profitable than Qantas.

Part of the explanation for why that isn’t so probably relates to Qantas’ continuing dominance of full-fare passengers, where it has about 80 per cent of that market segment. Qantas’ much-touted 65 per cent market share ‘’line in the sand’’ is largely about defending that dominance via a frequency advantage and the feedback loop created by its loyalty program.

Virgin’s strategy since John Borghetti took its helm has been to try to grab what he would regard as Virgin’s natural share of that segment. Virgin has about a third of the market overall but only something around 20 per cent, maybe a little more, of the higher yielding fares.

To try to increase that share Virgin has been adding capacity and frequency, as well as upgrading the front of its planes and its lounges.

Within the Qantas presentation today there was a slide that showed Virgin had added 18 per cent to its capacity since July 2011, whereas the Qantas group had lifted its domestic capacity by 8 per cent – Virgin had added 4.5 billion available seat kilometres against Qantas’ 4.3 billion.

Given Qantas has said it would add two seats for every one Virgin put into the market to defend its line-in-the-sand (for which it has been criticised) it is somewhat surprising to see that it has been Virgin adding more capacity in absolute terms than Qantas.

Qantas’ domestic market share was 65.2 per cent in 2012. But in the first five months of this financial year it has slipped to 63.4 per cent – the line isn’t as immovable as had been thought.

If Qantas is still making money in the domestic market and Virgin is losing quite heavily relative to its size it would tend to support Qantas’ view that Virgin is running a strategy of losing money and dumping capacity to try to grow its market share and wrest business travellers away from Qantas – and trying to destabilise Qantas in the process.

As a long-term strategy losing money to grab share might be defensible, although it could only be pursued if (a) Virgin believed Qantas would eventually be unable to maintain its defence of its market share, particularly in the premium fare end of the market and (b) its own shareholders were prepared to fund substantial losses for a sustained period.

Virgin, of course, raised $350 million of equity last year, predominantly from its three strategic shareholders – Air New Zealand, Singapore Airlines and Etihad Airways. Like most of Qantas’ competitors, all three are either government-owned or backed, which has fuelled a certain level of paranoia within Qantas.

As Joyce said today, the competition with Virgin and Virgin’s willingness to add capacity despite its losses has reduced the domestic profit pool from $700 million in 2011-12 to less than $100 million in the first half.

Depending on what the combined losses of Virgin and Tiger are, that pool – which used to be about $1 billion in a decent year -- might have been completely emptied. As discussed previously, that’s not a rational outcome for a duopoly.

But then an outcome, in a duopoly, where the low-cost operator loses money heavily while the legacy carrier remains profitable isn’t particularly logical either.

There will be a focus tomorrow on what Borghetti says about Virgin’s capacity plans for the remainder of the year and therefore for an indication of whether the intensity of the hostilities might fade slightly to something closer to more rational and profitable competition for both players.

Given the increasingly bitter and acrimonious nature of the relationship between the two carriers – and the conflict between their strategies and ambitions --  there is no certainty that rationality will prevail.