Pent-up demand has largely been exhausted as many of us resumed travel post pandemic. This led to Qantas (ASX: QAN) having an exceptional fiscal 2023, but profit is now normalising. We’ve seen pricing competition increasing in the airline industry as the capacity bottlenecks ease as the surge of demand ends.

Qantas and airlines globally are burdened by high fixed costs, low barriers to entry and low switching costs. These issues plagued airlines before the golden period post pandemic and are now set to return. A slew of bad press due to poor service and conditions has forced the carrier to shift their focus, with criticism that the balance between cost and service has tipped too far.

Relatively newly installed CEO Vanessa Hudson has flagged increased investment into customer service in fiscal 2024. Approximately $230 million will flow into call centre improvements, catering review and increased Frequent Flyer redemption opportunities. This amount will also cover removing the expiry date on COVID-19 flight credits and fleet renewal.

All in all, this is a substantial cost to Qantas to buoy their image and reputation. Adding to this, Qantas’ fleet of more than 300 planes were sitting on a tarmac for most of the pandemic. The delays and cancellations during that period aged Qantas’ already old fleet. They will need a substantial capital investment. Our analysts forecast capital expenditure of about $17 billion over the next five years, compared with about $8 billion in the past five.

Although these costs are substantial, our analysts see this as a near-term impact to profitability. The impact to valuation is immaterial and the longer-term forecasts stand. We maintain our $6.10 fair value estimate for Qantas. This has Qantas at 12% undervalued (at 31 January 2023) and fairly valued.

The airline industry is highly competitive and Qantas lacks a moat

We do not believe Qantas has carved an economic moat. On average, we forecast returns on invested capital ("ROIC") failing to keep up with the firm's 11% weighted average cost of capital. While Qantas' returns on invested capital, or ROICs, may exceed its weighted average cost of capital ("WACC") as it has done in the past on occasion, we do not think this will be consistent over the next decade.

Airlines globally lack economic moats for the following reasons: a long history of value destruction, a business model not conducive to rational pricing, a lack of barriers to entry, the commoditization of air travel, and the presence of low switching costs coupled with growing price transparency. We believe these conditions which have plagued the airline industry will persist through the cycle. Airlines are extremely capital-intensive, and management has limited control over key external earnings drivers, such as fuel costs and exchange-rate movements.

Qantas sells commodity goods in highly competitive markets. Air travel is perceived as a standardized product which, coupled with price transparency, leads to low switching costs. The domestic market is effectively a duopoly between Qantas (including Jetstar) and Virgin Australia, and despite the voluntary administration and subsequent re-emergence of Virgin under private equity firm Bain Capital, we do not expect this to change. In light of industry disruption, the Australian Competition and Consumer Commission has been tasked with keeping a close eye on the domestic competitive environment as demand returns.

The international segment is fiercely competitive, with many carriers aggressively adding capacity to and from Australia during recent years, weighing on Qantas' returns. This is creating downward pressure on ticket prices, evident in Qantas International's falling yields. This elevated competition on international routes is reflected in the division's 15% earnings before interest, taxes, depreciation and amortisation ("EBITDA") margin, which is lower than the 26% generated in the Qantas domestic division. Although movements in oil prices often lead to short-term swings in ROICs, we believe carriers' long-term profitability has little to do with fuel given the cost affects all players almost equally. Reductions in fuel (or other input costs) are typically competed away, and savings are passed through to customers, reflecting the extremely high level of competitiveness in the airline sector.

To garner customer loyalty, airlines utilize frequent-flyer programs. Frequent-flyer programs incentivize customers to fly with the same airline--consumers want to earn loyalty points when they fly, and status benefits are important for corporate passengers. The program generates earnings from the sale of points to hundreds of partners, including banks, supermarkets, telephone companies, and department stores. While the capital-light Qantas Frequent Flyer business has somewhat cushioned flying earnings volatility, we do not think it has carved switching costs. The business is also intrinsically linked to the capital-intensive, highly competitive airline business.

Airlines remain highly sensitive to unpredictable events that can quickly destroy value. Demand disruptions are common within air travel--including terrorism, war, natural disasters, and epidemics. The COVID-19 pandemic had wreaked havoc on the global airline industry, effectively grinding Qantas' air travel business to a halt.

Further, airlines are highly capital-intensive and extremely cyclical, and heavily exposed to volatile fuel prices, which makes them prone to value destruction. During the 10 years ended fiscal 2020, Qantas incurred almost $7 billion, cumulatively, in write-downs, impairments, and restructuring charges. The most noteworthy was the almost AUD 3 billion fleet write-down in fiscal 2014, and more recently the $1.4 billion impairment (mainly to the A380 fleet) in fiscal 2020.