Sat weekend "Australian Financial Review"
1. Why Qantas really needs to cut it
Jul 05
Jane Boyle
A confluence of events has placed massive stress on Qantas as it embarks on a potential $25 billion fleet overhaul and radical restructuring to meet aggressive competition.
Its ageing fleet was last renewed in the 1980s, allowing the company a holiday from aircraft replacement and a boost to shareholder returns following the company's 1995 sharemarket listing. Qantas chief financial officer Peter Gregg acknowledges: "It has fallen to Geoff [Dixon] and I to re-equip the business. But the ground's shifting underneath us."
The executive team is continually having to revise strategies in the light of what Merrill Lynch recently coined the "constant shock syndrome" afflicting global aviation.
Denis Adams, who led the start-up of Qantas' low-cost international subsidiary Australian Airlines last year, was recently seconded to accelerate the group's restructuring project, dubbed Sustainable Future.
Adams has been assigned to find ways to to strip $1 billion of costs out of the business in 18 to 24 months - ahead of a three-year target envisaged at the start of the year before severe acute respiratory syndrome and the Iraq war.
In the firing line is labour outlays, one of the few controllable variable costs, which totalled $2.7 billion, or a quarter of expenses from last year.
The latest retrenchment of 2000 staff - in addition to attritition, increased use of part-timers and forced leave - appears to be more about migrating staff into different areas and entities (with different labour structures) rather than downsizing the group.
To put it in context, Qantas has made significant provisions for redundancies and restructuring in the majority of years since it listed. Yet its full-time equivalent workforce grew a whopping 50 per cent to 34,770 since its listing and December last year.
"There is always restructuring going on in part of the company," says Gregg. "That doesn't stop us growing in other parts of the business."
Like its competitors around the world, Qantas is segmenting its operations into a suite of airlines with separate enterprise bargaining agreements and brands. If executed well, observers say this strategy should provide management with different vehicles it can move around to respond to changes in market demand and competition, and to overcome the constraints imposed by Qantas' traditional EBAs and regulatory hurdles.
Among the subsidiaries being expanded is Australian Airlines, a lower-cost, one-class Boeing 767 leisure carrier, which flies mid-range Asian routes but is also carrying feeder traffic on an increasing number of domestic routes. It is also growing Jet Connect, based in New Zealand, which will start flying the Tasman route in September. Industry insiders believe Jet Connect could be brought into the Australian domestic market as a low-cost vehicle taking advantage of NZ's lower labour costs.
And, if mutual recognition of safety regimens on either side of the Tasman is introduced, it offers a way around regulations that competitively disadvantage Australian carriers. While cost-cutting is the mantra in the global airline industry, it's not the only consideration.
The gap between Qantas' costs and those of Virgin Blue is estimated to be anywhere between 15 and 30 per cent. That gap, says Gregg, is narrowing quickly. The flipside is that Qantas commands a revenue or yield premium to Virgin Blue because it dominates the high-paying corporate market.
It's the difference between the revenue and cost premium that is key to Qantas' profitability.
Combined, Qantas and Virgin Blue made record profits out of the domestic market in the first half of the latest financial year. But Centre for Asia Pacific Aviation managing director Peter Harbison says that was not surprising given inefficiencies under the old Qantas-Ansett duopoly.
This year profits have been under greater pressure as international travel has slumped. And Harbison says average yields have certainly declined over the past 12 months. This intensifies the pressure to cut costs. Qantas is switching to an all-economy configuration on domestic leisure routes and speculation persists that it will introduce a lower cost vehicle like Jet Connect or a no-frills operation in the domestic market.
"The public is being reasonably well looked after," says Harbison. "But there is certainly room for cheaper prices."
Some analysts say competition will intensify if Virgin Blue uses the four new Boeing 737-800s earmarked for domestic use - out of 10 due next month - to lift capacity on Sydney routes.
Virgin Blue chief Brett Godfrey expects the domestic market to grow overall by 9 per cent in the 12 months to March next year. He says Virgin will aim to capture half of that growth, which is aggressive considering its market share was 28 per cent at March this year.
But Harbison observes that Virgin Blue needs to make good profits in the lead-up to a float. It is more likely to pursue that by sacrificing some load factor to chase higher yields rather than filling its planes with cheaper seats (which would worry potential investors), he says. As a result, Qantas is offering some fares cheaper than its "discount" rival.
At the same time international competition is intensifying. Gregg says Qantas' costs on long haul international routes are competitive. But that position is under threat as the Australian dollar strengthens and rivals slash costs.
Qantas is one of the strongest airlines, but that comparison is made against an industry that has destroyed value over its history, sending many operators broke.
Merrill Lynch analysis shows that even Qantas and two of its most profitable international rivals, Singapore Airlines and Cathay Pacific, have not been making returns on invested capital that cover their weighted-average cost of capital over the past seven years. And worse, those returns have been declining.
Qantas cannot afford to compromise on its fleet upgrade. While it has been forced to slash capital expenditure by $1 billion this financial year to $1.8 billion (compared with $3.4 billion in fiscal 2003), it is mainly non-flying investment like airport infrastructure that has been deferred.
The appreciating Australian dollar helps. As a rule of thumb, every US1¢ gain in the $A cuts its capex bill by $80 million and adds $14 million to profits.
The aircraft purchases provide for 5 per cent growth of the fleet. It has committed to spend up to $13 billion and has flagged potential further expenditure of as much as $11 billion to $12 billion, which would include replacement of its narrow-bodied fleet and part of its B767 fleet and more A380s. But those costs are falling in $A terms.
The fleet upgrade cannot be put off. It involves a rationalisation of aircraft types and the operating costs of the new jets are 15 to 25 per cent lower than its ageing planes.
At the same time, the investment in upgrading the cabins of its long-haul planes, including the installation of business class sleeper beds and improved inflight entertainment, is crucial to remain competitive with regional peers and maintain its yield premium.
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