Australia and New Zealand hit highs in 2016, but 2017 will lose a little lustre

Published January 2017 in Airline Leader: Issue 38

Australia and New Zealand enter 2017 on a different level from 12 months previously. The biggest change, not just compared to 2016 but since the global financial crisis, is that Qantas is revelling in a successful turnaround.

After the lows of 2011 and a domestic competitive bloodbath, the Qantas Group has seemingly become a solid and sustainable story, now looking forward to a new future marked by Boeing 787s, arriving later in 2017.

Air New Zealand has continued along its thoroughly profitable path, while Virgin Australia and its Tigerair Australia subsidiary have struggled to achieve profitability in the new environment – now with a more settled share registry and emerging strategy.

After a mineral boom that carried Australia through the difficult years of 2008-2010, the country’s GDP growth has since slipped to 1.8% in 3Q2016 calendar year, with an outlook for 3.0% for the full FY2017. By contrast, New Zealand’s Treasury expects GDP growth of 3.6% for 2016 and has forecast a 3.5% increase in 2017.

The downside for Qantas is that investors seemingly have not fully recognised what a remarkable restructuring the airline has undergone. Qantas for too long had rested on laurels of a strong domestic market offsetting mounting international losses and overall inefficiency with a bloated cost structure. Qantas’ biggest gains under its turnaround programme (un)fortunately coincided with the collapse in fuel price, and the investment community has failed effectively to separate out the tailwind of fuel cost savings from ex-fuel cost savings.

With a sustaining commercial base, Qantas has turned to new cabin products, aircraft, routes and branding with a modified logo and livery. Qantas’ competitor Virgin Australia is making changes almost in the opposite direction: after a re-branding, new aircraft and greatly improved products, it is now having to contend with the financial wrath of the changes wrought on its cost base.

In short, Virgin’s transformation under CEO John Borghetti became more expensive than expected and produced a yield premium lower than budgeted. This alone is a dangerous combination, and the danger has been aggravated by Qantas’ successful restructuring. This is not the first time in Virgin’s history that it has had to confront Qantas’ ability to adapt: Qantas’ response to Virgin in the early 2000s was the establishment of its own LCC, Jetstar.

Virgin’s falling financial metrics were sufficiently destabilising even before they spilled over into the boardroom and created a nearly six month long revolving shareholder registry.

From an ownership perspective, no airline in the world is like Virgin Australia: this is the result of creative company structuring and Australia permitting 100% foreign ownership of domestic-only airlines. Virgin was mostly owned by four airline groups: Sir Richard Branson’s Virgin Group (the initial and long-standing investor but which had gradually reduced its stake to near token status) and then more recently Air New Zealand, Etihad Airways and Singapore Airlines. Aside from Virgin Group, the other three airline owners are direct Qantas competitors, and they essentially saw Virgin Australia relevant in its own right – for securing domestic traffic feed – but also leverage in their competition against Qantas.

Virgin Group’s biggest benefit from Virgin Australia in recent times has been branding fees and a quality brand in the Virgin empire. Virgin Australia’s presence with the Virgin branding has some trickle-down effect on Virgin Group’s other business in Australia, notably Virgin Mobile and Virgin Active, although Virgin Australia itself has no direct financial interest in them. As such Virgin Australia’s falling performance was not a crisis for Virgin Group.

Etihad and Singapore Airlines are large groups and, arguably, more able to tolerate falling performance at either investments or their own operations, provided the operational benefits followed.

Air New Zealand was the spark to the Virgin ownership reshuffle. Before other investors moved in, the New Zealand flag carrier had a vision of a dominant role in Virgin. But, as new investors arrived and with little strategic alignment, along with its own relatively small status, it became too much to keep underwriting Virgin’s weak performance. Air NZ CEO Christopher Luxon failed in a bid to persuade Virgin Australia’s board to oust Mr Borghetti. Following this Mr Luxon excused himself from the board and announced Air NZ would sell its stake in Virgin.

Virgin sensed an opportunity to be enterprising and deliver a parting blow to Air NZ. With Air NZ drawing attention to Virgin as a prospective investment, Virgin quietly marketed itself and directly sold a stake to China’s giant HNA Group. The effect was multiple: first, Virgin directly received a capital increase since new shares were issued, which diluted Air NZ’s shareholding. Virgin’s selling price was below Air NZ’s, which caused Air NZ to have to discount its asking price, resulting in a loss once its stake was sold – to another Chinese group.

So Virgin Australia now has two Chinese shareholders. Besides the direct sale to HNA, Air NZ sold its stake to the much lesser-known Nanshan Group. Nanshan has a small Chinese start-up, Qingdao Airlines, but it is more widely focussed in its overseas investments, including several in Australia.

HNA brings an immediate strategy refocus to Virgin, and the larger Australia market. HNA owns multiple airlines in mainland China and Hong Kong. HNA is strategically disadvantaged: from mainland China it cannot obtain Australian traffic rights out of prime Chinese cities, while from Hong Kong the Australia-Hong Kong bilateral agreement is saturated, leaving service to secondary Australian cities the only opportunities.

The investment in Virgin, to be accompanied by a proposed alliance, will allow HNA to benefit from the usual onward connections on Virgin. More uniquely, Virgin will serve routes HNA units cannot because of bilateral limits: to Hong Kong and Beijing from prime Australian gateways like Melbourne and Sydney.

Qantas is beginning to roll out its new China strategy by returning to Beijing in cooperation with Shanghai-based JV partner China Eastern Airlines, providing access to the Beijing-Australia market which the Chinese authorities will not allow China Eastern to fly in its own right. Virgin will finally deploy to the international market on a regular basis the premium-equipped A330s it used on trunk domestic markets to Perth, but which are now largely not needed following the collapse of the resource sector concentrated around Perth.

The emergence of a HNA-Virgin force around China competes with the Qantas-China Eastern tie-up and China Southern Airlines, which at the peak will operate four daily flights to Sydney, including one on the A380. The competitive effects also spill over onto Cathay Pacific, a major mainland-Australia operator via Hong Kong – and, to a lesser extent, Singapore Airlines.

The Australia-China market continues to boom. Australia has sealed its position as a nature and lifestyle destination. As a mostly leisure-oriented market, it is an ideal first market for increasingly maturing Chinese airlines, as they can partner with tour agencies to sell the service before developing independent sales and figure out how to sell premium cabins. China in Dec-2016 agreed to Australia’s previous request to remove capacity constraints on passenger services. As of Jan-2017, there are no less than seven Chinese airlines serving Australia.

Growth does not equate to profitability. Virgin’s planned services to Hong Kong and Beijing may not be profitable, but there are long term benefits and come with the trade-off of stabilising the shareholder registry. One problem with such an unusual and eclectic share registry is the inevitable conflicts that arise: despite some coordination, Etihad and Singapore Airlines already compete for Australia-Europe traffic, and with time HNA’s presence will be felt on SIA’s Australia-China transfer market, and even later HNA’s sixth freedom Australia-Europe traffic will impact Etihad and SIA.

The important issue for Virgin is not Asia but its domestic heartland. Virgin can now focus on a necessary restructuring. In the process, most of senior management has turned over, unsurprisingly raising questions – just as Mr Luxon advocated – of how much longer Mr Borghetti will remain. Virgin has a few years of work ahead of it. Qantas sits comfortably, but once Virgin can deliver on a turnaround, Qantas will again be under increased pressure to drive costs out of its business. Virgin’s ownership structure, which has until now been more of a burden than a benefit, should start to deliver dividends in 2017.

Both airlines will need to decide what to do with their LCC units. The cost gap between Qantas and Jetstar is not as big as it used to be. Jetstar’s previously grand 787 ambitions are now apparently shelved, although from a group perspective this is still healthy: Jetstar’s Melbourne-Tokyo growth has already provided a pathway for Qantas to take over and other routes could follow. Tigerair Australia however is not growing as much as Virgin promised when it took the airline over, although it has replaced Virgin on some short-haul Southeast Asian flights. Virgin may need to address its LCC’s branding now that the centralised Tigerair brand will be disposed of in Singapore, to be replaced by the Scoot branding as those two SIA subsidiaries are combined.

Internationally, another Australian and New Zealand benefit is that they are ‘safe’ markets. Terrorism around Europe has seen Asian visitors put off not just to directly impacted countries but to the entire continent. There has consequently been some reorientation in their visit profile, to intra-Asia and North America. From an airline perspective, Asia-North America has been growing too rapidly for sound commercial outcomes in the short term. Combined with depleted Canadian and American traffic rights, Chinese airlines now need to put aircraft elsewhere.

Australia and New Zealand are at least temporarily the answer as they receive more and more long-haul premium aircraft 777s replacing A330s. It is not just mainland China: a stuttering Cathay is also sending more 777s, while Korean Air is bringing in the A380. Southeast Asia, once the main driver of growth (and over-capacity) is now relatively modest, while Northeast Asia accelerates growth.

The risk is that some of this capacity diverts elsewhere as more compelling opportunities become available. Although Australia is generally proactive with traffic rights, the objective is steady growth and not ups and downs.

Air New Zealand has not reacted favourably to its government’s addition of traffic rights to China. A remarkably and consistently profitable airline, Air New Zealand saw itself having a larger China role in coming years, partly assisted by a stronger relationship with fellow Star Alliance member Singapore Airlines; but an influx of Chinese airlines will make this expansion more difficult.  New Zealand, with a population of only 4.5 million, is meanwhile adjusting its tourism strategy to take account of the potential size of the Chinese market, seeking to focus on the high end travellers.

This is now a tertiary concern. Air New Zealand, like Qantas and Virgin, is most profitable domestically. Jetstar has for some time gradually pressured Air NZ on domestic trunk New Zealand services and, using written-down turboprop equipment, is now challenging on select regional flights.

Jetstar will not come close to matching Air NZ in size or scope, but it is delivering a disproportionately large pricing impact. From a Jetstar perspective, its new regional turboprop network is less a profit driver and more designed to cause annoyance and pain to Air NZ, while not being a drag on Jetstar Group. Importantly too, in an increasingly integrated tourism and travel product, it allows Qantas to fill in some gaps in its business and frequent flyer network.

Air NZ, like Qantas and Virgin, has North America as its main long-haul market, both in terms of size and profitability. Air NZ’s New Zealand-US direct services were a valuable monopoly until the entry of American Airlines and United, the latter now a JV partner with Air NZ. Yet the capacity growth and pricing discipline imposed by American Airlines’ entry weakens performance. Even Fiji Airways is an annoyance with its one-stop service, offering a business class experience
to Wellington residents.

Air NZ’s North America network also had a tidy business as a Sixth Freedom operation to Australia. This is now under pressure from growing Australia-North America capacity. After United and Qantas grew and American entered Australia, Virgin Australia is also growing to Los Angeles. Although Virgin’s growth may seem the latest punch, it has added impact since Virgin and Air NZ had effectively ceded certain North American markets to each other.

With Air NZ no longer a Virgin shareholder, Virgin is pursuing growth in its own right. A saving grace for Air NZ may be that the US has rejected the American-Qantas JV (although if the JV had restricted competition as the US authorities suggested, this could have equated to more opportunity for Air NZ).

The cumulative effect is Air NZ, after years of growing and – much admired – performance, delivered a record profit for 76 year history in FY2016; but CEO Christopher Luxon was forced to issue a warning that the peak had been reached and subsequent profits would not be as strong. There is competition for Air NZ to contend with, but, like Qantas a few years ago, Air NZ now also needs to address its cost base.

Although Air NZ has been lower cost than Qantas, the airline has lost some of its momentum on containing costs and maintaining efficiency. This was inevitable as new equipment arrived and as strategies evolved. A deep restructuring like Qantas is not needed, but there is much internal work for Air NZ to do.

Bedding down domestic markets remains the core task for the region’s airlines. Qantas is also looking to grow in Asia, clawing back gains from Singapore Airlines and Cathay now costs have been reduced to levels it believes are comparable with the Asian heavyweights.

But the attention-getting developments in 2017 centre around Europe. New Zealand will have two ultra long-haul flights: Qatar Airways is planning a Doha-Auckland nonstop, the mere mention of which had provoked Emirates into launching, on a month’s notice, Dubai-Auckland nonstop. These services will have an unwelcome and potentially extensive impact on a number of New Zealand long-haul routes.

Qantas will attract global interest if its recently announced Perth-London service goes ahead in 1Q2018. It has already been a marketing coup. A non-stop 787-9 flight, the service would link Australia and Europe together for the first time. Although a long flight, it will not be the world’s longest (that distinction will go to SIA’s New York service when it resumes). Yet a nonstop service between two continents so far away will provide a level of enchantment. 787 profitability, however, will come from Qantas using the type to North America, ideally launching Dallas flights from Melbourne and Brisbane, supplementing existing A380 Sydney-Dallas service.

Perth Airport and Qantas, with a little financial support from the West Australian government, agreed in Dec-2016 to the terms to modify Qantas’ domestic terminal to support international-domestic connectivity. A same terminal domestic transfer in an intimate environment that Qantas can control and brand appropriately has considerable upside financially and for marketing compared to competitors’ offerings in the likes of Singapore, Hong Kong and Abu Dhabi. It also offers Qantas another alternative in an international market that is always in flux.

The 787 for Qantas also reflects a shift in the overall market. Successive generations of Qantas were defined by increasingly bigger aircraft, from variants of the 747 to the A380. Qantas’ next era is the more compact 787. It has taken time for Qantas to adjust to end-of-line geography and the realities of stopover hubs growing and new ones emerging.

Airlines elsewhere in the world still struggle to define – and redefine – themselves to create a market that is sustainable. Even the relatively healthy groups are not satisfied: IAG finds itself again needing to churn British Airways to reduce costs and improve product, while US airlines balance their view of international growth with demanding investors.

Each of the three major airlines has a powerful frequent flyer programme. In FY2016, to 30-Jun-2016, Qantas reported AUD1.45 billion (USD1.1 billion) in loyalty revenues, a tenth of the group’s revenue, allocating it an underlying EBIT of AUD346 million (USD102 million). Virgin’s Velocity programme, part of which it sold down during the year, accounted for a healthy AUD140 million EBIT, almost as much as its domestic flying operations generated. Air New Zealand meanwhile dominates its domestic market.

Sydney-China market by passenger type: 2012-2016

North America to Southwest Pacific seats per week, one way, 16-Dec-2013 to 22-May-2017

Middle East to Southwest Pacific seats per week, one way, 16-Dec-2013 to 22-May-2017

Development of O&D versus transfer traffic for Sydney airport’s China flights: 2012-2016

The business and corporate traveller is an integral part of this loyalty system and 2016 was marked by the greatly added activity of LCCs in the SME and corporate markets. Jetstar’s targeted Aquire programme is about to be relaunched and its New Zealand activity relies on GDS access – where travel management companies still dominate the corporate interface – for its corporate access viability.

Australia and New Zealand’s airline success will continue to be defined by restructuring, partnerships, and loyalty strength.

That forms a solid base for what new will inevitably emerge in 2017. But in a tepid global economy, with intensifying competition internationally, there will be reduced profitability for each of the main airlines in 2017. The tailwind of low oil prices is moderating, although unlikely to reach previous heights, again emphasising the need to contain costs.

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