Slow learners at the flying roo

After listening to the Qantas annual results announcement today one couldn't help but feel a sense of déjà vu.

The airline's profit result for the 12 months to 30 June 2012,  a statutory loss after tax of $244 million, was the lowest profit result for the group since 1953 when records were available.

In response, the two big chiefs at Qantas, Allan Joyce and Gareth Evans, trotted out the same, seemingly uncontrollable driver of that poor performance – fuel prices.

This excuse, however, has a use-by date. The great thinkers and strategists at the company by now should have developed a deeper understanding of how this force affects the company and developed the optimal response to it.

A share price that sits around $1.18, where it once peaked at over $6 back in October 2007, reflects the managerial inability to develop and implement such a response. Management, and indeed the board, must now begin to be held more accountable because it should become increasingly, although not completely, within their control.

Fuel gauge

To start with, it's true that the spot price of Singapore jet kerosene, the product that Qantas uses to benchmark its fuel costs, has risen on financial year average terms by just under $US17 per barrel, or in percentage terms 15.54, between 2011 and 2012.

At fuel consumption of about 30 million barrels per year, this increase means an additional fuel cost of about $US500 million per year. As a stand-alone adverse exposure, this hit is massive.

The company's fuel exposure, however, is not a stand-alone exposure. Over the same period as the jet fuel price increased by 17 per cent the Australian dollar rose by 4.4 per cent. The Australian dollar, therefore, offered the company around 30 per cent protection from higher fuel prices. It doesn't appear that the airline has accepted this offer.

There are very few airlines in the world with that type of fuel-cost shield from the exchange rate. If Qantas had taken advantage of this protection, the net fuel exposure would have declined to somewhere in the order of the $US350 million mark – a saving of $US150 million.

But the exchange rate protection doesn't just stop at fuel. The company has a number of other costs in US dollars that it would have paid less for because of the stronger Australian dollar. The biggest are the cost of aircraft purchases, spare parts (including engines), operating leases and capacity hire.

One can imagine the unfavourable cost impact if Qantas were paying for their A380 and B787 aircraft purchases today at the 2001 exchange rate, which is around half the current value.

If Qantas were better able to use these non-fuel costs benefits from a stronger Australian dollar then the adverse fuel costs would almost be completely offset by the reduction in non-fuel costs.

Hedgers clipped

I can't help but think that the exit over the past few years from Qantas of some of the best fuel hedgers and thinkers in the world, namely the former CFOs Peter Gregg and Colin Storrie, the former treasurer Steve Fouracre, and the former deputy treasurer Craig Hughes, has had an impact on the risk-management function.

Treasury risk management at Qantas is a very small, talented young team but it is hard to give up this old-hand nous without having an impact.

In my view Qantas can go unhedged on fuel and deploy operational foreign exchange hedging. Hedging is incredibly risky - diametrically opposite to its intention, which is to mitigate risk. It is also extremely expensive, often costing the group hundreds of millions of dollars over the space of a year.

When the oil price is trending upward all that hedging will do is delay the onset of higher fuel prices, buying the company time to operationally respond to higher costs. Unfortunately the operational response has not benefited the company's financials.

Economic strength

The state of the economy is no excuse for the Qantas Group.

Qantas is based in one of the fastest-growing developed economies in the world. It has a strong exposure to the fastest-expanding group of countries in the developing world. And it has a strong exposure to the fastest growing segment of the multi-speed Australian economy, which is the mining and resources segment.

Seat supply or capacity in the international and domestic markets are also forces that Qantas cannot rely on for an excuse. When airline capacity is elevated at the market level, this outcome leads to downward pressure on yield, or ticket prices, which prevents the company from clawing back higher unit costs.

International capacity over the 12 months to May 2012 has grown by 3.2 per cent and domestic capacity by just 2 per cent, although it has ramped up very quickly over the past few months. On average, international and domestic capacity grows at around 5 per cent a year. The past 12 months has therefore seen very moderate capacity growth, which has helped, not hindered Qantas.

Turning it around

What can Qantas do to turn this around? The first thing they should do is abandon the 65 per cent market share target. It's not profit-maximising despite the rhetoric. This strategic focus on capacity is a distraction for the real objective, which is profit and returns to shareholders.

Imagine a strategy that takes away the most important operationally important weapon that a company is possessed with – its aggregated output. This is what a market-share strategy does.

Every time Virgin Australia raises domestic capacity Qantas must follow it to preserve its market share. This means Qantas's capacity depends entirely on Virgin Australia capacity (and Qantas must guess what Virgin capacity will be to stay ahead of the capacity game).

Taking away this strategic lever means that its operational response to fuel and the economy is severely constrained. About the only thing it can do is change the mix of Qantas and Jetstar that it flies.

Qantas must hook up with a strong carrier like Emirates. This is a no-brainer. If Qantas cannot make it work with Emirates, then there are no other decent carriers out there to form a relationship with – they are all tied up with the super-smart decisions of Virgin Australia (think Etihad, Singapore Airlines and Air New Zealand).

The most profitable segment for the Qantas business is its Frequent Flyer Program, having made $230 million over the past 12 months, followed closely by Jetstar at $203 million.

An airline has a problem when its non-flying segments are more profitable than its flying segments because the flying segments are at the core of its business, and the non-flying segment performance depends heavily over a long term on the strong performance of the flying segments.

It is unlikely that the Qantas frequent flyer program can hold the ship upright for a long period if the flying segment of the business continues to perform poorly.

Tony Webber was Qantas Group chief economist between 2004 and 2011. He is now managing director of Webber Quantitative Consulting and Associate Professor at the University of Sydney Business School, and contributed this article to BusinessDay

The story Slow learners at the flying roo first appeared on The Sydney Morning Herald.

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