Reborn Virgin’s international conundrum
Simply lopping off Virgin's international arm and focusing on the most profitable domestic routes isn't as easy as it seems. The optimistic spin put on Virgin Australia’s collapse by the government, the administrator and the company’s chief executive, Paul Scurrah, is understandable.
With so many jobs on the line, and the national interest to be protected, it’s in everyone’s interest that a reborn airline emerges with a relatively clean slate, restructured operations and a hell of a lot less debt.
The dominant narrative suggests Virgin could prosper
with a "less is more" mindset. By ditching its loss-making international operations and carefully selecting the domestic routes it flies, the new Virgin would be a more focused, profitable entity.
Refocusing Virgin isn't as easy as many might think. But in the airline game, nothing is quite as simple as it seems. Chanticleer’s discussions with former airline executives and insiders suggest the seemingly simple, slim-down strategy isn’t so simple at all.
What makes airlines so difficult to turn a dollar from is that the sector must balance extraordinarily high fixed costs – basically 30 per cent aircraft, 30 per cent people and 30 per cent fuel – with revenue that is particularly volatile to price movements (raise your prices and people stop flying very quickly) and economic conditions.
And that’s the steady-state business model. On top of that airlines need to deal from time to time with the fallout from freak accidents, terrorist attacks,
volcanic ash clouds, international incidents and, of course, the odd pandemic.
While Virgin’s poor profitability over the past decade has been well documented, its divisional results do tend to fit the narrative that the best solution is to refocus the airline on the domestic market.
While group earnings before interest and tax (EBIT) for Virgin in financial 2019 totalled $89.5 million, domestic EBIT was $133.4 million, and EBIT from the Velocity loyalty program was $122.2 million. By comparison, Virgin’s international business lost $75.6 million, and its low-cost offshoot, Tiger Airways, lost $45 million.
The surgery necessary looks pretty obvious.
But some observes suggest simply killing the international arm would make Virgin far less attractive to Australia’s corporate travellers, who offer much better margins than leisure travellers.
Virgin doesn’t necessarily have to fly international routes itself to provide corporate customers with an international offering; agreements with foreign airlines via international alliances and code-sharing deals (including access to good quality lounges in overseas airports) would do the job, with lower costs and less risk.
But insiders say these agreements can be tricky. International travel is notoriously competitive, and foreign airlines will often pressure domestic carriers to push travellers towards their home countries.
As one former executive says, if Virgin wants to keep any international exposure, it will likely need to deal with one or more of the 600-pound gorillas that dominate international aviation – which, of course, has long been one of its problems, given it has previously had as many as five foreign airlines on its share registry.
The suggestion that Virgin will be able to pick and choose what domestic routes it flies doesn’t necessarily stand up to scrutiny either.
Observers suggest the rational competitive response to that strategy is to take what the airline industry calls a matrix pricing approach. That is, Qantas would be likely to drop prices on the routes where it is competing fiercely with Virgin, and raise prices on the routes where there is no competition.
Virgin may have little choice then but to match Qantas on all significant routes, which would, of course, limit its ability to bring its fixed cost base down.
Prime Minister Scott Morrison said on Tuesday that it was important that the new Virgin
is "not crushed by any anti-competitive actions that may be put in place by another player in the market" but exactly what regulatory framework the government would be prepared to put in place isn't clear. Price caps or profit caps on specific routes seem pretty unlikely.
No doubt the interested parties that have apparently flooded administrator Vaughan Strawbridge in recent days are working through the combinations and permutations that might work for a reborn Virgin.
But the central conundrum investors will need to get to grips with is around the question of an international arm. Would a domestic-only airline have the scale to be sustainably profitable if it doesn’t have an international offering, and so can’t attract as many high-margin corporate passengers?
Finding the middle road – something between the unprofitable Virgin Australia and its far more profitable forerunner, Virgin Blue – looks the best bet.
But it’s won’t be an easy task, and its why potential owners will want government support.