Grounded: What is going on with Virgin Australia?
By Dominic Holden and Anton Mifsud
As the COVID-19 situation and corresponding restrictions continue, airline Virgin Australia entered voluntary administration on April 20th. Virgin was already struggling before COVID-19, with nearly $7 billion in debts, and net losses of $349m and $681m in the previous two financial years. Creditors are lining up to ensure they are paid outstanding balances, with Perth Airport taking possession of a number of Virgin aircraft over failure to pay its bills on Friday (24/04).
What is voluntary administration?
Voluntary administration is like “hitting the pause button” for the company. In short, it means a business is in a dire financial position and in order to take control of the situation, the board of directors at the company get help from an external administrator to investigate finances, review operations and develop a plan for the business to become profitable. Vaughan Strawbridge of Deloitte, the administrator of Virgin, has said in an ASX announcement “our intention is to undertake a process to restructure and refinance the business and bring it out of administration as soon as possible”.
Even if a buyer is found, it is not even guaranteed a deal will eventuate. When Australian airline Ansett collapsed in the early 2000s, a deal led by Melbourne businessmen Solomen Lew and Lindsay Fox was in the final stages before the buyer backed out of the deal due to a lack of government support. Thus, there is no guarantee that anyone will purchase Virgin, and even if they did, no certainty as to whether the airline will return with the same service and route offerings to consumers.
What does the domestic airline industry look like?
The Aviation industry underpins business and tourism across the nation with an estimated annual revenue of $45.98 billion, adding $18.42 billion to the Australian economy in 2018. There were 4.60 million passengers carried on Australian domestic commercial aviation (including charter operations) in February 2020, a decrease of 2.2 per cent in February 2019.
Airline profit margins fluctuate heavily alongside world oil prices. Although given no one is flying, the decrease in oil prices is irrelevant. Other factors which influenced the profitability of airlines include the price of the Australian dollar, strong overseas economies demanding travel and the level of discretionary income. All of which have been hit by COVID19.
Should the government bailout Virgin?
With the airline industry contributing significantly to jobs and national income, there have been calls for the federal government bailout Virgin.
A bailout would undoubtedly be expensive, with Deloitte revealing Virgin Australia owes close to $7bn to creditors, including almost $2bn to bondholders, and $450m to employees.
Deloitte also revealed the cost of voluntary administration would be in the vicinity of $20m to $30m with further costs to be incurred should the matter proceed to liquidation.
The Liberal government refused to provide a lifeline to Virgin, maintaining a position that the government would not get in the way of a merger or acquisition. From an ideological perspective, the government is refusing to bail out Virgin because of the party’s belief that doing so would essentially nationalise an airline which does not follow the “free-market” line the Liberal party tows.
However, the more practical reason is simply because Virgin is not really Australian owned. Virgin Australia is majority foreign-owned by Etihad Airways (20.94 per cent stake), Singapore Airlines (20.09 per cent), Nanshan Group (19.98 per cent), HNA Group (19.82 per cent) and Richard Branson’s Virgin Group (10.42 per cent). Given this, it is likely the view of the government that their responsibility is to the average Australian taxpayer, not foreign multinationals.
As for the employees, they will be entitled to receive the Job Keeper package, which is already the largest government spending scheme.
On a final note, it would be a dangerous precedent for the government to bail out business as it creates a corporate culture of greed, risky investments and no diligence because of the expectation of a government bailout. Investors need to be aware of the risk- it is why they are paid high rates of return on their investment. When an investment turns sour, it should not be the responsibility of the taxpayer to compensate for the risk of the investor.
Who will buy Virgin?
Administrators Deloitte have launched a 7-point pitch to potential Virgin buyers, highlighting the strength and profitability of the domestic market and key synergies with the Velocity Frequent Flyer program, which posted a $68.9m gain last year. The buying process seeks non-binding offers by mid-June, and to execute a binding deal by June 30th. Up to 20 private equity firms, such as Bain Capital, Oaktree and Blackstone have been reported to be interested, but only TPG Capital and BGH Capital are reportedly interested in taking the business on in its current state.
Private Equity firms typically operate by purchasing poor performing business, typically financed by debt, and enacting a turnaround, by cutting unprofitable business areas, altering management teams and redefining strategic direction, before exiting the business with substantial profit if all goes to plan. But private equity is known for being ruthless in cutting jobs and altering services, and not every buyout succeeds, with some major brand names controlled by private equity such as Toys-R-Us and the Fairway Grocery chain failing to turn around.
So, what does the airline industry look like on the other side?
Virgin failing to return to the skies could cause serious financial pain for Australian consumers. Having Virgin competing with similar services on the same routes forced Qantas to remain competitive on price, with Virgin claiming that its own arrival after the collapse of Ansett reduced Australian airfares by 37%.
While other small specialist and regional players remain, an exit of Virgin leaves Qantas as the only premium domestic and international provider in the Australian market. Business and high-end travellers will only have one choice for services such as business class, airport lounges, and premium service, creating a monopoly in a lucrative segment of a $45.98 billion industry.
Basic economics tells that in monopoly, the lack of competition enables the sole provider to act as a price maker, increasing the price charged above the so-called “fair” market price. With no other options for consumers in this segment, it would be reasonable to expect Qantas to start pushing prices upwards to boost their profits.
Even aside from the impacts of an effective monopoly, the aviation industry faces a steep challenge in a COVID world. In an effort to reduce the spread of the virus, Indian airlines have enforced social distancing on planes, with occupancy rates capped at one-third. Restricting a 180 seat plane to just 60 seats will undeniably drive up ticket costs, as airlines seek to recoup their fairly similar costs from far fewer passengers. It is likely this level of control will continue beyond the current period of “lockdown”, as some countries flatten the curve quicker than others.
Additionally, expect to see highly reduced passengers relative to pre-COVID. Businesses shifted to working from home and suffering a tough financial outlook will reconsider the need for frequent flights, and consumers under duress will have a reduced ability to undertake leisure flights.
What happens now?
The combination of a poor financial position and COVID-19 lockdown measures has forced Virgin to “hit pause” on their operations. With the government steadfast in their beliefs on not bailing out private foreign shareholders, administrators are fielding interested private buyers to enact a turnaround. But even if a deal is met, it is difficult to imagine Virgin returning to the skies with the same services and routes. A resultant effective monopoly of the Australian airline industry and extra travel restrictions create challenging times for consumers hoping to fly for business and leisure in a post-COVID world.
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off this article.