L1 Capital has predicted the Virgin Australia-owned budget carrier Tiger Airways will continue to cut capacity and could eventually be forced to shut the airline completely, as
Virgin's new chief Paul Scurrah hunts for ways to lift profits.
But Virgin says it has no plans to shut the airline, and says
capacity reductions announced across the group last month, which included cuts at Tiger large enough to have two planes taken out of its fleet, will strengthen Virgin's financial position.
Mark Landau, managing director of L1 Capital, which is an investor in Virgin's rival Qantas, made the bold prediction on the future of Tiger at the Future Generation investor forum in Melbourne last week.
Capacity cuts are already under way at Tiger under Paul Scurrah.
He argued a restructuring at Tiger would be the catalyst for a surge in profitability at both Qantas and Virgin Australia, which acquired the 40 per cent of Tiger it didn’t already own in 2015.
“Tiger is losing money on many routes and it will be forced to significantly cut capacity or shut down altogether," Mr Landau told the forum. "That will be the step change that will see both airlines significantly increase their profitability.”Mr Scurrah has promised a renewed focus on earnings and cash flow at Virgin, and taken action to cut costs at Tiger in recent months, announcing a series of structural changes and pushing ahead with a plan to use only Boeing 737s in its fleet to manage costs.
On November 6, Virgin announced a plan to slash capacity across the group by 2 per cent by the end of the 2020 financial year.
As part of these cuts, Tiger will no longer fly the Brisbane-Darwin route or Proserpine-Sydney from February next year. Flights from Adelaide to Brisbane will cease at the end of March next year.
Virgin’s balance sheet has now become very highly geared, which will force them to be far more focused on route profitability.
— Mark Landau, managing director, L1 Capital
But Virgin says the subsidiary remains an important part of its future.
"Operating our low-cost carrier strengthens our offering and enables us to cater to a growing low-cost market segment in Australia," a spokesman said.
"A number of changes are under way to improve Tigerair's financial performance. In November, we announced network changes to reduce capacity, fleet and ensure Tigerair is flying on the routes it is best suited."
But Mr Landau says the announced cuts will not go far enough and Mr Scurrah will need to take more drastic action.
He said on Sunday that Tiger generated a negative 8 per cent margin on earnings before interest and tax in the 2019 financial year and "we believe that would only have deteriorated this year given the weakening domestic leisure market".
Mr Landau said L1's analysis suggested Tiger is "currently operating numerous routes at negative 15 per cent margins or worse, which is simply unsustainable".
"Virgin’s balance sheet has now become very highly geared, which will force them to be far more focused on route profitability and cash-flow generation, which we would expect will see both Qantas’ and Virgin’s earnings recover from this cyclical low point," he said.
Capacity cuts at Virgin would be a big win for Qantas. Despite L1 enjoying about a 150 per cent gain on Qantas over the past few years - and the stock soaring seven-fold in the past six years - Mr Landau said L1 was not ready to take profits just yet.
He said it was remarkable that Qantas still traded at an 11 times price-to-earnings multiple despite the significant reduction in volatility chief executive Alan Joyce had engineered. This is around half the average multiple of industrial companies on the ASX.
He said the multiple suggested earnings would stagnate or go backwards, with the end of irrational competition boosting profitability.
"Put simply, we think this is ridiculous," Mr Landau said.
"Qantas has dramatically improved the efficiency of its business over the past six years, which has made it a far more formidable competitor than ever before."
Virgin shares have fallen 19 per cent year to date, while Qantas shares are up 26 per cent.