"There was no major revelation in today’s Qantas presentations for its investor day. That’s both unusual and a good thing in a sector where volatility and uncertainty are the norm.
What was, perhaps, somewhat surprising was the disclosure that all of the group’s core brands and business units -- including its international operations -- are on track to deliver returns on invested capital greater than 10 per cent and greater than Qantas’ weighted average cost of capital this financial year. It also expects to be sustainably free cash flow positive by the end of this financial year.
Airlines, and Qantas is no exception, generally destroy shareholder value, not create it and Qantas has rarely delivered returns above its cost of capital throughout its history.
There are, are however, a number of factors coinciding to create, not the perfect storms that regularly mar its financial performance, but a massive improvement in its financial condition.
The biggest relates to Qantas’ leveraged position to the domestic market, where it enjoys a profit share materially larger than its capacity share because of its dominant share of higher-yielding customers and therefore its yield advantage over its rival, Virgin Australia.
Qantas says that its capacity share of 63 per cent in the first half gave the group a domestic profit share (earnings before interest and tax) of 79 per cent. Its target is to own at least 80 per cent of the domestic profit pool and it claims it is winning back a lot more (25) corporate accounts than it is losing (5) to Virgin.
The end of the domestic capacity war last year has transformed the financial performance of both the carriers, but particularly Qantas.
That dramatic fall in oil prices, which is flowing through to jet fuel costs, is also helping. Qantas has always had very sophisticated fuel hedging programs that enable it to benefit when fuel costs fall. It said today it would get at least a $550m benefit from lower fuel costs this financial year, with a best-case outcome of $580m.
In 2015-16 its worst-case are fuel costs in line with the lower level this financial year and its best case a further $80m reduction.
The piece of the Qantas financial puzzle that is directly within Alan Joyce’s control is his underlying cost platform, where the group is in the midst of an aggressive and painful $2bn transformation program.
This financial year Qantas says it will exceed its target of $875m of benefits from the program, having reduced its workforce by the equivalent of 4,000 people. Next year the final 1,000 will go.
Qantas says there is 'high visibility' of the remaining $1.1bn of savings, with about $600m of them in the 'implementation' phase and the remaining $500m still in the 'development' phase.
By 2017, Qantas hopes/expects to have closed the cost gap between Qantas Domestic and Virgin to less than 5 per cent while retaining a revenue premium of more than 15 per cent.
In the international business the impact of the transformation program, the lower fuel costs and a lower Australian dollar are helping Qantas. Competitor capacity growth, which ran at a compound annual average rate of 7 per cent between 2009 and 2014 -- it reached 9 per cent in 2014 -- has dropped back to only 1 per cent this financial year as the combination of excess capacity and the lower dollar impacted their yields.
Qantas estimates that a US75c dollar would wipe around $1.5bn off competitor revenues relative to where they were when the dollar was around parity.
There has been a massive overhaul of Qantas’ international route network, including its exit from unprofitable routes and the entry into a partnership with Emirates and code shares with China Eastern and China Southern.
The international business’ non-fuel unit costs have been cut by 15 per cent since 2012 and aircraft utilisation has increased by 16 per cent. It will contribute more than $800m of the $2bn benefits targeted by the transformation program.
The large-scale restructuring of Qantas’ international presence, which includes significant investment in lounges and on-board product, has impacted customer attitudes negatively, with the group’s net promoter scores steadily and significantly improving in recent years and a forecast increase in revenue per available seat kilometre of more than 5 per cent this financial year indicating stronger high-yield passenger volumes.
Qantas is also quite upbeat about the position and prospects of its Jetstar-branded businesses, saying Jetstar International is experiencing strong underlying EBIT growth this financial year and generating a return above its cost of capital, as is the domestic core, where costs continue to edge down. Qantas says Jetstar is a beneficiary of Virgin’s shift to a full-service model.
Its controversial investments in Asian ventures are described as a portfolio of growth opportunities with the potential for higher risk-adjusted returns over time. The jury is out on those, and will probably remain so for some years.
A year ago, with the effects of the capacity war still flowing through its numbers, Qantas was heading towards its announcement of a $2.8bn loss, with an underlying pre-tax loss of $646m.
The transformation in the numbers, sentiment and confidence within the group is quite dramatic, as indeed it has been within Virgin.
Qantas took advantage of its crisis to lock in really substantial gains in its cost base and, with the cessation of the fiercest of the hostilities with Virgin and some reduction in competitive intensity on its international routes, is opening up the capacity to invest more heavily in its product and even in some new routes.
It is also, perhaps, getting closer to the point where it might be able to reclaim its investment-grade credit rating and even contemplate reinstating cash returns to shareholders."
QAN Price at posting:
$3.63 Sentiment: Buy Disclosure: Held
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