Tuesday 12 July 2016 by Company updates

Is the ‘sweet spot’ for the domestic airlines over?

Domestic airlines may face less favourable operating conditions going forward

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With the end of the damaging ‘capacity war’ between Qantas and Virgin, falling fuel prices, strong inbound tourism particularly from China and aided by a weaker Australian dollar, the domestic airlines have been the beneficiaries of two years of favourable operating conditions.

However, the airline sector is historically one of the most cyclical and exposed to a number of external factors, including volatile fuel prices, foreign exchange movements, geopolitical events (eg: terrorism), global health issues (avian flu, Zika) and variable passenger demand. Recent announcements from both Qantas and Virgin indicate that the buoyant domestic operating conditions experienced in recent years may be turning:

  • Qantas – recent commentsExternal link - opens in a new window from the airline suggested demand for domestic flights has been softening in recent months, partly driven by reduced activity in the resources markets of WA and Queensland. Revenue yields (ie: the proportion of revenue generating capacity to total available capacity) had softened, until the airline announced in April that it would be cutting capacity to arrest the fall in yields. In its most recent monthly releaseExternal link - opens in a new window for May 2016, Qantas cut its domestic capacity by 5.1% while Jetstar cut capacity by 2.3% relative to May 2015.
  • Virgin – in a recent presentationExternal link - opens in a new window, Virgin reaffirmed FY16 guidance for an underlying profit before tax of A$30m to A$60m. However, after allowing for cash restructuring costs (A$200m to A$250m) and non cash impairments (A$150m to A$200m), Virgin is expected to deliver a statutory loss in the order of A$400m for FY16. We note performance for the three quarters to March 2016 was A$63m suggesting an underlying loss in 4Q16. However, while FY16 performance is expected to be relatively weak, the company has flagged cumulative operational cost savings of A$1.2bn by FY17 which could drive an improvement in cash flow generation going forward.

Holders of Qantas and Virgin have had a favourable run in recent times and bondholders in these lines have enjoyed good returns. Virgin is currently trading in a USD103.50 to 105.50 range (which equates to 6.60%-7.30% on a yield to worst* basis). All Qantas lines are trading below yields to worst* of 4.50%. If you think that the airline industry is positioned for a weaker period of operating performance, now may present a good opportunity to take profit and reduce airline sector exposure.

Please contact your FIIG representative for further details on the Qantas and Virgin bonds. Available to retail (Qantas only) and wholesale investors only with a minimum face value of AUD10,000 (Qantas) and USD10,000 (Virgin).

*In the case of both Qantas and Virgin, the yield to worst equates to the yield to maturity.