Virgin Australia’s $653.3 million loss, studded as it was with big non-cash writedowns, is a fairly clear signal of the imminent appointment of John Borghetti’s successor. The board has cleared the decks.
Those writedowns disfigured what would otherwise have been a creditable result by Virgin’s standards.
Virgin Australia has booked big writedowns as it clears the decks for John Borghetti's successor.Credit: Dallas Kilponen
The underlying pre-tax profit of $109.6 million is only the second underlying profit generated during Borghetti’s eight-year tenure. The other, a $27.2 million surplus, was in 2011/12 after the grounding of the Qantas fleet gifted Virgin a windfall.
By taking a broom to the balance sheet, sweeping out $452 million of deferred tax assets, writing down the value of Virgin International assets by $120.8 million, treating $45.6 million of restructuring costs as significant items and incurring more than $100 million of other writedowns, the Virgin board will give the next CEO a cleaner base to work with.
Borghetti said earlier this year that January 1, 2020 was the latest date to which he’d extend his contract. It was always probable the board would act well before that and the respectable result, at an operating level, makes a handover easier.
Best of Borghetti's era
While the result is the best of Borghetti’s era, that’s not to say the incoming CEO won’t face some challenges. Virgin generated record operating cash flows of $570.4 million and had positive free cash flow of $73 million, but the $109.6 million of underlying pre-tax earnings isn’t particularly impressive for a group that generated $5.4 billion of revenue.
More particularly, Virgin’s core domestic business generated earnings before interest and tax (EBIT) of $246.1 million, but the group overall had EBIT of only $259.5 million. And while it did make an underlying pre-tax profit in the second half -- for the first time in Borghetti’s period as CEO -- that amounted to only $7 million.
With Tiger losing $36 million at the EBIT level ($24.3 million previously), Virgin International losing $12.8 million (after a $500,000 profit the previous year) and the Velocity loyalty program’s earnings falling 23 per cent to $110.1 million, the slate for an incoming CEO isn’t entirely clean.
Virgin has raised $1.5 billion of new equity and roughly doubled the amount of capital invested in its business while losing more than $2 billion during the Borghetti era. The fact that it has made an underlying profit and is flagging a profitable first half does, however, represent a major milestone in its recent troubled history.
It is worth noting that on a much smaller equity base Virgin Blue, as it was then, had pre-tax earnings of $309 million in 2007-08, ahead of the financial crisis. Even including the $226 million loss incurred during the GFC, under Brett Godfrey Virgin it generated more than $1 billion of earnings.
Qantas remains dominant
That tends to underscore the upside. If the domestic premium brands – Virgin Domestic and Qantas Domestic – were isolated, Virgin’s core has about 37 per cent of the revenue pool but only about 25 per cent of the profit pool.
Despite the massive amounts of capital Virgin has thrown at it over the past eight years and the big investment in business class product and glitzy lounges, Qantas has retained its disproportionate share of the premium market, while Jetstar has eaten into the leisure market Virgin was built on.
If the big wave of investment has ended, as Virgin says, it might be more focused on extracting a share of the profit pool that better reflects its market share.
Both Virgin and Qantas are reporting very strong forward bookings for the first quarter of the 2019 financial year. Virgin expects to be profitable at both an underlying and statutory level in the first half despite a net $85 million increase in fuel costs.
The 2018 result was, however, achieved in highly favourable conditions. There was little capacity growth in the domestic market, demand was strong and fares increased. Conditions have been unusually benign by industry standards, where volatility is normal.
Indulgent fleet upgrade
With the result Virgin announced that it had converted 10 of the orders it has for 48 Boeing 737-MAX aircraft into orders for the more expensive MAX 10s. With an average fleet age of only 7.5 years – Qantas Domestic’s is 10.5 years – the replacement of its 737-800s with the MAX aircraft, which have the same interior fit-outs, appears an indulgence.
Virgin says it won’t be paying the standard $US500,000 monthly lease costs per plane – against about $US325,000 a month for a relatively young 737-800 or $US200,000 a month for a 10-year-plus aircraft – and it will phase the new planes in gradually, from November next year, to replace the oldest aircraft in its current fleet.
Older planes are more expensive to maintain and less fuel-efficient but any incoming CEO would, given the youthfulness of the current fleet, want to test an eventual $US250 million-plus annual commitment for the new aircraft against the alternative of "milking"’ the profitability of the existing 737-800s for a few more years.
It was reportedly a difference of views on that MAX order that saw John Thomas, then in charge of both Virgin’s domestic and international operations and the clear heir apparent for the CEO role, departing the group last year.
That kind of debate – new planes versus profitability – is the one that frames judgements on the Borghetti era.
He has unquestionably created a better airline, if the assessment is based primarily on product – the planes and lounges.
The gold plating of what was a very profitable low-cost carrier, however, hasn’t yet produced a better business. That’s been left to the next CEO.