With two high yield USD bonds available, Virgin is now looking to issue another into the AUD high yield market. Research has initiated coverage on its current USD bonds, recent half year results and company outlook
Virgin Australia (VAH) is looking to issue AUD denominated senior unsecured notes that would rank equally with its existing notes due in 2019 and 2021. Research has initiated coverage on these existing USD notes with a recommendation and outlook. As at 31 December 2017, VAH had AUD2.4bn of debt, with 61% secured on aircraft or other assets.
The unsecured debt is comprised of two note issues as detailed below:
Virgin Australia unsecured debt
Source: Bloomberg
Given the high level of secured debt on VAH’s balance sheet, both rating agencies assume minimal recovery for the unsecured debt in the event of a default.
Credit strengths – Duopoly position and young fleet
Duopoly
VAH, together with the Qantas group, controls about 98% of the Australian domestic air travel market. This market benefits from the following supportive characteristics:
- No meaningful third carrier since 2001 when Ansett Aviation collapsed
- The size of our country, together with a lack of alternative modes of transport, means that air travel will remain the transport mode of choice for the movement of people in Australia
Typical of duopolistic markets, intense competition, if any, will usually be over a relatively short period. This duopolistic position also means that, absent a deliberate decision by one of the two players to intensify competition, earnings can prove more stable than in places where there are more market participants.
Fleet age
At 7.1 years, VAH’s average fleet age is relatively young and more than two years less than Qantas’. An older fleet accelerates the need for investment to replace assets so VAH is likely to lag Qantas by at least two or three years before it’s required to invest in fleet replacements. Newer aircrafts in a younger fleet also generally have better fuel efficiency and therefore lower running costs. The risk of a new price and capacity war over the near term is less likely, as Qantas would likely want to have the strongest balance sheet possible for that investment. VAH on the other hand has a longer timeframe before it needs to do the same.
Credit weaknesses – rising fuel prices
Fuel costs represent about 25% of the operating costs of an airline (excluding aircraft operating lease expenses) and are linked to the Singapore kerosene price, which is itself highly correlated to the Brent oil price. Large fluctuations in oil price could affect profitability in a material way. We estimate that a USD10 movement in the price of oil could have an impact of about AUD70m on earnings, absent the benefit of fuel hedging contracts.
VAH uses forward contracts to hedge the price of oil and would typically have its fuel cost hedged to 80% to 90% for the current year and about 70% for the following year. Hedging will significantly remove the volatility linked to oil price, however is only true in the short term as hedge books are short dated and new hedging instruments will be struck at higher prices as oil prices go up.
For more credit strengths and weaknesses, read the full coverage on the FIIG website.
Half year results
The company’s half year results (for the period ending 31 December 2017) reflected the ongoing efforts of the company to reduce costs and optimise its fleet, together with relative soft competition that did not put undue pressure on airfares. We believe the two key components that will influence VAH’s financial performance over the next twelve months are:
- Continued implementation of the cost-out program that is targeting AUD350m savings by the end of FY19. We understand that about AUD230m will flow to earnings and AUD120m will reduce capital expenditure
- Fleet rationalisation being broadly complete. In particular, VAH does not expect any new aircraft delivery until the last quarter of 2019, which should result in a reduction of capital expenditure in 2H18 and 1H19. Depending on market conditions, the 2019 deliveries could be delayed if necessary
With release of these results, VAH expect improvement in the second half of 2018 (2H18) against 2H17, reflecting the continued positive impact of the cost-out program, continued reduction in business restructuring cost and no likely pressure on fares.
Background
Virgin Australia (VAH), launched in 2000 (under the Virgin Blue brand), is the second largest airline in Australia and together with the Qantas group controls about 98% of the domestic market. VAH operates as a full service carrier under the Virgin Australia brand both domestically and internationally. The group also owns Tiger Australia, which operates as a low cost carrier. To complement its offering, VAH owns 65% of Velocity, the airline’s frequent flyer business.
VAH’s initial model reached a plateau around 2010, and since then the group has embarked on a number of measures to gradually compete in all segments of the market against the Qantas group. VAH is able to compete in all segments, ranging from the high-end business travel market (which had historically been dominated by Qantas) to the no-frill low cost carrier segment (through Tiger). VAH now controls about 37% of the Australian domestic market (by capacity) and has gained a meaningful foothold in the business travel segment. VAH’s international market share stands at about 24% (including the capacity of its alliance partners) against about 37% for Qantas and its own partners. 
VAH is listed on the Australian stock exchange but has five cornerstone investors controlling about 91% of the shares. The company has alliance partnership agreements with Etihad, Singapore Airlines and HNA Innovation that are the foundation of VAH’s strategy for international flights, relying primarily on a virtual network operated by its partners rather than operating its own aircrafts. As at 31 December 2017, VAH carried 24.5m revenue passengers (70% domestic, 11% international), operating 134 aircrafts (69 leased and 65 owned), including 84 Boeing 737-700/800.
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The Virgin USD and anticipated AUD bond are available to wholesale investors only.