New Zealand Aviation NEWS: Air New Zealand's Tie With Virgin Challenges Qantas In Australia

Air New Zealand (Baa3 stable) announced it paid AUD145 million ($145 million) to acquire a 15% stake in Virgin Blue (unrated), the operator of Australia's second-largest airline. This credit positive investment will help Air New Zealand diversify its earnings from an overconcentration at home and provide exposure to Australia's larger market. For Qantas Airways Ltd. (Baa2 stable), operator of Australia's largest airline and parent of the country's third-biggest carrier, Jetstar (unrated), the investment serves as a further sign of Virgin's growing competitive challenge to Qantas in the airline's home turf.

The investment will weaken Air New Zealand's credit profile only slightly, as the carrier can use cash reserves to pay for it. However, Air New Zealand will probably not receive dividends in the near term as we expect Virgin to continue to invest in expanding its fleet as it steps up the competition with Qantas. Nevertheless, the purchase will give Air New Zealand a presence in Australia, one of the world's most profitable aviation markets, while sparing the carrier the cost of doing the actual flying.

Currently, Air New Zealand relies on its home market, where it has an 80% market share, for virtually all its earnings. As competition accelerates, we expect carriers to create more such "virtual networks" through multiple channels of cross-ownership, alliances, and code sharing. Air New Zealand, Virgin, and others will likely search for ways to acquire greater scale and network connectivity with leaner fleets.

In Australia, Virgin Blue has maintained a nearly 30% market share, positioning itself as a leisure line between Qantas's full-service offerings for business travelers and low-cost carriers (LCCs) such as Tiger Airways and Jetstar, the latter of which Qantas wholly owns. In 2010, Virgin Blue announced a shift to target the profitable business market, dominated by Qantas, while at the same time maintaining a leisure market offering. To do so, Virgin Blue is increasing the frequency of flights on key trunk routes and investing in additional, wide-bodied capacity to cater to transcontinental routes to Perth, a nexus for Australia's natural-resources industry.

Exhibit 1 (attached)shows market shares by carrier in 2010.

Virgin Blue previously announced new routes into Europe via Abu Dhabi's Etihad (unrated), into the US via Delta Air Lines (B2 stable), and across the Tasman Sea via Air New Zealand. These routes will not deliver direct incremental earnings to Virgin Blue, but the airline will benefit from channeling Etihad and Delta's customers into its domestic network. Previously, this type of international alliance and global reach was a competitive strength that differentiated Qantas.

Attached exhibit 2 shows the steep rise in the share of international arrivals carried by Virgin Blue and its partners, year to date.

This development increases competition for Qantas, as it brings Virgin Blue's range of offerings closer to that of Qantas for international travel and will require Qantas to reduce prices to keep load factors at acceptable levels. Virgin Blue has cheaper fares than Qantas, and is therefore well positioned to win market share. Qantas is already grappling with rising oil prices and subsidiary Jetstar's low yields, which bedevil the entire LCC segment. The additional threat from the Virgin Blue-Air New Zealand tie-up will add to pressure on Qantas's margins just as renewed passenger demand was helping it recover from the effects of the global recession. In 2000, Air New Zealand tried unsuccessfully to enter Australia by acquiring Ansett Airlines, which subsequently collapsed. By contrast, this latest move costs little but has a larger potential payoff. It may, however, be a tough fight. Qantas, with its dual-brand strategy and entrenched, leading position in Australia, has shown in the past that it knows how to counter competitive challenges.

NEHA JAIN

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