ANALYSIS: Qantas sticks to line in the sand over domestic capacity

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Conventional wisdom says airlines should pursue yield instead of market share, but as an ongoing battle between Qantas and Virgin Australia reveals, the issue is rather more complicated.

For years, Qantas has declared it will defend its domestic capacity share of at least 65% as a "line in the sand" against any and all rivals. Former Qantas chief executive Geoff Dixon first announced this policy, his successor Alan Joyce reasserted it, and now Lyell Strambi, chief executive of Qantas Domestic, stresses that for every aircraft added by his rivals, Qantas as a group will add two.

Two for one equals 66%, but no-one is quibbling because everyone understands the warning. "We're very clear, we're not making any apologies for it," says Strambi. "That's the game and people need to understand the game."

How Qantas determined this figure and why it applies to Qantas Domestic, the full service airline, low-cost affiliate Jetstar, and regional carrier QantasLink as a total for the three of them rather than for each airline individually remains opaque.

However, there is no doubt Qantas has concluded that at least 65% of the domestic capacity represents what it regards as the group's optimum market share - and it is prepared to defend this at considerable short-term cost.

The first half of this financial year proved especially bloody, costing Qantas an estimated A$100 million ($104 million) in lost revenue following a fare war it sparked by adding two-to-one capacity in response to its rivals' growth. As Alan Joyce, Qantas Group chief executive, says: "The short-term pain is worth it because of the long-term strategic position of the airline."

The collapse of Ansett in 2001 almost gave Qantas a monopoly. Start-up Virgin Blue was its only domestic rival, claiming less than 10% of the market. But Virgin introduced Australians to low-cost air travel, and they liked it.

As Virgin Blue's market share rose to 30% during the next two years, with no signs of slowing down, Qantas knew it needed a response. It came in 2004 in the form of Jetstar, a low-cost subsidiary to match low-cost Virgin Blue. Geoff Dixon, Qantas chief executive at the time, reasoned that Jetstar would block Virgin from growing beyond its market share, then almost 33%.

Dixon was careful not to say Jetstar was aimed at Virgin Blue - the latter had already complained to competition officials several times about Qantas - so he explained instead that Qantas "must defend" a market share of 65-70%. In February 2004, just before Jetstar's launch, Dixon explained: "From what we know of the capacity plans of Virgin Blue and the other domestic carriers over the next two years, and our own plans for capacity increases, the three-product offering of Qantas, Jetstar and QantasLink will have around 65% of the domestic market. This is our line in the sand and we will provide the capacity and infrastructure to defend it against Virgin Blue and the other carriers."

Dixon offered no explanation as to why 65% was so important. Coincidentally or not, the Qantas group at the time held 66%. Nor did he explain the significance of 65% as an aggregate share for the "three-product offering" of Qantas airlines.

It soon became apparent Qantas regarded 65% as a figure for the group as a whole. It has never disclosed target market shares for each airline, and such targets are inconsistent with Qantas's practice of turning routes which mostly carry leisure traffic or are otherwise marginal over to Jetstar.

These route transfers, plus Jetstar's own phenomenal growth, boosted its capacity and shrank the capacity share of Qantas Domestic. But this has not changed the "line in the sand" mantra.

What has changed in recent years are the market dynamics. Qantas discovered its two-brand strategy - Qantas Domestic and Jetstar - allowed Qantas Domestic to focus more on the business end of the market. Even though Jetstar's share of total capacity kept growing, so did Qantas Domestic's share of total revenue. This diversification also brought more resilience when the group faced challenges such as swine flu, soaring fuel costs, and a global financial crisis. "With two flying brands and a diversified portfolio of businesses, the group has the scale and scope to respond rapidly to market developments," says Joyce.

Virgin Blue was also discovering the disadvantage that comes with too much dependency on low-cost traffic. It evolved into a hybrid airline and, since John Borghetti took the controls in 2010, has turned full attention to the high-yield business market where Qantas enjoys a virtual monopoly.

Borghetti's goal as part of a major makeover is for Virgin Australia - as it is now called - to earn at least 20% of its revenue from this high end of the market.

In this new contest, Jetstar is less relevant in blocking Virgin's expansion because the two airlines are competing less for the same passengers. Virgin's target is the high-yield traffic Qantas Domestic carries, and the contest is more about yield than capacity. As Virgin says: "Our plan is to focus on yield and RASK [revenue per available seat kilometre] improvements, not market share."

Yet Qantas still insists its three domestic airlines - Qantas, Jetstar, and QantasLink - will maintain their aggregate 65% of domestic capacity. The only rationale Qantas offers, in Joyce's words, is that "this is the market share that enables us to maximise profit".

Joyce attributes this to the widely-recognised economic theory "S-Curve". Generally, it means size matters - up to a point. An IBM white paper describes the S-Curve in terms of slow initial growth followed by accelerated growth as a product or business takes off.

During this phase, IBM explains, "relatively small increments of effort and resources will result in large performance gains". Finally, growth or size reaches a point of diminishing returns. Plotted on a graph, this curve follows the shape of an "S".

Deutsche Bank Australia research analyst Cameron McDonald recently tested this theory and concluded Joyce is right. McDonald compared the market shares of Australia's domestic airlines, measured in available seat kilometres, with their shares of total earnings, measured as earnings before interest and taxes (EBIT), for the half year ending in December 2012.

He concludes in a research note: "The S-Curve theory employed by Qantas appears to be true." With a 65% market share, Qantas "captures a substantially high percentage share of the domestic market profits" - specifically, 89% of the total EBIT generated by all airlines. "Our analysis confirms Qantas management's strategy of defending its market share position."

Based on this, McDonald predicts: "Qantas will continue to add capacity into the domestic market in response to its competitors - particularly given it generates a greater share of the domestic industry profits and Qantas enjoys a stronger financial position from which to defend its position."

Not all economists agree. Peter-Jan Engelen, a financial economics professor at Utrecht University in the Netherlands, has studied market shares and Deutsche Bank's research note. His expertise and publications are on corporate finance, value creation and governance.

"I do not see any causal connection between capacity market share and earnings," he says. "What they should show is that EBIT would be lower at other market shares. Just showing that [the Qantas Group] generates the highest EBIT in the sector does not say anything on the impact of market share.

"I would like to see an analysis showing different market share scenarios and showing that for the 65% market share, Qantas has the highest level of EBIT," Engelen explains. "It might very well be the case that their profits will be even higher at a different capacity market share."

Engelen also questions how meaningful it is to draw conclusions from a market share that lumps Qantas Domestic and Jetstar together: "Maybe Jetstar realises some synergies from being part of the Qantas group, but one can also argue that adding Jetstar and Qantas together is misleading, as both are in different markets. The profits of Qantas, operating in the higher market segment, might be even higher at a different capacity market share." The study, he concludes, simply does not address this.

In short, Engelen questions whether the apparent link between market share and a higher EBIT share is driven by higher market share, as Deutsche Bank suggests, or if it is equally likely that the higher EBIT is due to higher yield traffic.

McDonald responds: "All other things being equal, yes, higher EBIT could come from higher yielding traffic - but the question is somewhat circular."

Business travellers prefer airlines that offer more routes, more frequency and more route diversity, he explains. More capacity and diversity also make the Qantas frequent-flyer programme more attractive to business travellers. It may seem circular, he concedes, but greater capacity and diversity intrinsically attracts higher-yield traffic.

Aside from who is right on this point, other economists argue that the whole focus on market share is misplaced. Tony Webber, who was with Qantas for seven years, first as general manager microeconomics and then chief economist, is now managing director of Sydney-based Webber Quantitative Consulting. He cites at least three problems with the emphasis by Qantas on market share.

First, it means Qantas loses control of a strategic variable - aggregate group capacity. Locking itself into a capacity target that is a multiple of its rivals' capacity means Qantas is turning capacity planning over to its rivals. They effectively decide what level of capacity Qantas should have.

Secondly, it means "Qantas must guess what its competitors' capacity will be in the years ahead to determine what its capacity should be," Webber explains. "This guess will drive fleet decisions." And if it is wrong, "which it invariably is", he adds, "then fleet decisions will be wrong".

Finally, Webber says: "Market share preservation is problematic for all participants in the market because it often creates yield and capacity instability - precisely what we are seeing at the moment."

When a rival such as Virgin Australia adds capacity and Qantas responds by adding capacity to preserve market share, Webber says: "This generates significant yield decline.

The decline in yield then forces carriers to reduce capacity, which then forces yield up and the volatility in the capacity and yield cycle continues."

Looking at market data from recent years, Webber explains: "You will find a two-to-three-year oscillation. This means that growth increases for two to three years then falls for two to three years, and increases for two to three years." Statistics show this as a rise and fall in revenue passenger kilometres per available seat kilometres.

Australia may be about to start another "down" cycle. After Qantas lost A$100 million in 2012's brutal battle, analysts detect a capacity slowdown that started in February. In a research note, CIMB analyst Mark Williams declares: "The capacity battle of 2012 is waning.''

No-one suggests Qantas is unaware of the drawbacks in its emphasis on market share. Indeed, the airline seems willing to stick with this policy despite its drawbacks. This, in turn, prompts questions about whether its underlying strategy is maximum profit or something else.

"Qantas has never presented quantifiable evidence to support their thesis that a 65% share is consistently profit maximising," says Webber. "They focus on market share, I think, because it sends a signal to incumbent and prospective competitors."

He says a 100 million-dollar message puts "the fear of god" into rivals because they know any capacity boost they make will trigger an even bigger response from Qantas. Then, everyone will suffer, and Qantas has the deepest pockets.

Equally skeptical of the 65% target, Engelen draws a similar conclusion: "I am still afraid that the market share story is a cover-up for the market power story."

Whatever its rationale, the line in the sand continues to prompt much debate.