Chart of the Week: Virgin pre-IPO analysis
Why is finding success as an airline so difficult?
Virgin’s recently announced IPO has piqued the interest of many Australian investors. A weak IPO market means this is the first high profile listing in the recent past. Ahead of Virgin’s IPO on the ASX on June 24, Morningstar analyst Angus Hewitt, CFA has conducted an in depth market, industry and company analysis.
As part of this, he looks at Australia’s deregulated airline industry, currently more profitable than most markets. However, durable long-term excess returns on invested capital are still elusive.
The rise and collapse Tigerair, Bonza, and Rex’s voluntary administration highlight the industry’s fragility. Barriers to entry are low, as new entrants can lease aircraft and acquire slots relatively easily. However, barriers to exit are higher because of long-term lease obligations and gate commitments, often lasting over a decade, which leads to excess capacity, weak pricing discipline, and persistent value destruction.
Durable differentiation is near impossible. Most airlines offer similar booking systems, aircraft, and service models. With little to distinguish one carrier from another, consumers book based on price and schedule, not loyalty. Virgin’s midmarket positioning doesn’t change this. It competes directly with Qantas and Jetstar on core domestic routes and cost-based advantages are fleeting. While a low-cost model may have greater efficiency, it is easily replicable by competitors and offers little lasting protection.
Airlines also face constant margin pressure from volatile inputs. Around 75% of Virgin’s revenue is consumed by operating costs, such as staff, fuel, and maintenance. Fuel typically accounts for 20%-30% of Virgin’s revenue and is the most volatile input. Virgin hedges its exposure and uses fuel optimisation strategies to manage oil price volatility, but these efforts are common across the industry. While movements in oil prices often lead to short-term swings in ROICs (Return On Invested Capital), we believe carriers’ long-term profitability has little to do with fuel given all players wear the cost almost equally. Reductions in fuel, and other input costs, are typically competed away, and savings are passed through to customers, reflecting the intense competition in the airline sector. Likewise, investment in more efficient aircraft will eventually be taken on by the entire industry, eroding any cost advantages.
Angus’ full analysis is available to Morningstar Investor subscribers. It outlines Virgin’s competitive positioning in Australia and our Fair Value Estimate for the IPO.
You’re able to find previous editions of Chart of the Week here.
