ANALYSIS: Capacity increases hit Qantas and Virgin domestic earnings

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A major increase in capacity, intense competition and the imposition of the carbon tax led Qantas and Virgin Australia's domestic earnings to stall during the first half of the fiscal year.

Virgin's domestic earnings before interest and tax (EBIT) declined by 43% over the six months ended 31 December 2012 to Australian dollars (A$) 49.3 million ($50.5 million), while Qantas's domestic EBIT was down by 33% to A$218 million.

Both airlines pointed to a highly competitive six-month period where domestic capacity increased by close to 11%.

Virgin chief executive John Borghetti placed that in context, noting that it is the largest increase since Qantas introduced its budget arm, Jetstar Airways, into the market in 2004.

On its part, Virgin's domestic ASKs increased by 8.9% as it upgraded a number of transcontinental services to Airbus A330-200s, added frequencies on certain routes and continued its expansion into regional markets. That resulted in its seat factor falling to 77.9%.

The Qantas group was also a major contributor, with mainline Qantas capacity up by 5% and Jetstar adding 16% more capacity. This brought seat factors down to 78.3% and 81.8% respectively.

"If you look at the load factors, clearly profitability has come under pressure and competition has been impacting on the yield as well," says David Fraser, an analyst from Nomura Securities in Sydney.

Virgin reported that its group yield declined by 1%, while Qantas would only say that there was "yield pressure" as a result of excess capacity that affected both the Qantas and Jetstar earnings.

Virgin says that competition on the business-heavy Sydney-Melbourne route was particularly aggressive. It adds that government figures show that Jetstar increased its capacity on the route by 57%, Qantas by 11% and Virgin only by 3% as the market grew by 2.8%.

Nevertheless, both airlines have pointed to their respective positions in the higher-yielding corporate market as a sign of their strength.

"We have continued to grow our corporate and government revenue and maintained the new norm in which more than 20% of our domestic revenue comes from this higher yielding market," says Borghetti.

Qantas chief executive Alan Joyce adds that the Oneworld carrier holds an 84% share of the corporate market and won a number of new accounts over the six months, including four that had previously gone to its competitors.

But the advantage of having a strong corporate customer base appears to be falling, with the Bureau of Infrastructure, Transport and Regional Economics' Domestic Air Fare Index showing that business class fares have been on a sharp downward trend since August 2011.

source: bitre

In comparison, the best discount and restricted discount fare indexes remain depressed, indicating the level of price competition in the market, which has also been influenced by the presence of Tiger Airways Australia in the low-cost market.

source: bitre

source: bitre

source: bitre

That competition made it difficult for both airlines to pass on the impact of Australia's carbon tax. The tax, applicable only to domestic flights, came into effect on 1 July 2012, and cost Virgin A$24.4 million and Qantas A$55 million over the six months.

"The carbon tax is impacting the airlines as well, and they have not been able to pass that on in their pricing," says Fraser.

Despite the impact of the excess capacity and competition on yields, neither carrier is planning to pull capacity from the market.

Virgin and Qantas have stated that they each expect to add 5-7% capacity to the market over the second half of the financial year, which will likely ensure that fares and yields remain subdued.

"The fact that they are looking at 5-7% capacity growth in the second half indicates that it will continue to be very competitive," says Fraser.

Virgin has stressed that its moves to add capacity are not an attempt to gain market share against the more dominant Qantas. In an investor presentation, it said that its future plan is to "focus on yield and RASK [revenue per available-seat-kilometre] improvements, not market share".

In contrast, Qantas is maintaining that it intends to hold its "line in the sand" of 65% market share.

"Maintaining our profit-optimised 65% position is the best long-term outcome for our shareholders, and we are very convinced that it is the right strategy to continue to go with," says Joyce.

Nevertheless, Fraser says that with both carriers unable to gain any major decreases in unit costs, there must be some action to rein in the capacity increases to try and boost yields over the longer term.

"I suspect they are going to become economically rational because they are just cutting each other's face off at the moment," he says.

"Once we get back to economically rational behaviour, then one would assume that yields will slowly begin to move back again."