Virgin Blue

8/12/2019 Virgin Blue

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VIRGIN BLUE

FIGHTING WITH NATIONALCHAMPIONS

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This case was written by Professor Daniel Traca, Assistant Professor of Economics at INSEAD, with theassistance of Elisa Croti, Reseach Assistant. It is intended to be used as a basis for class discussion ratherthan to illustrate either effective or ineffective handling of an administrative situation.

Copyright 2004 INSEAD, Singapore.

N.B. PLEASE NOTE THAT DETAILS OF ORDERING INSEAD CASES ARE FOUND ON THE BACK COVER . COPIES MAY NOT BE MADE WITHOUTPERMISSION .


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Copyright 2004, INSEAD Singapore.

Introduction

In October 2002, Brett Godfrey, CEO of the domestic low-fare carrier Virgin Blue, was preparing to testify in a high level meeting aimed at discussing the future of the Australianairline industry. The meeting had been called by the Australian transport minister, JohnAnderson, and the chairman of the Australian Competition and Consumer Commission(ACCC), Allan Fels, and rival Qantas would also send a representative. Godfrey flashed backover the turmoil of the last couple of years in the Australian aviation market and thetremendous challenges surmounted by Virgin Blue.

Since the industry had been liberalized in 2000 a number of players had come and gone. Now, just two remained: Qantas, the so-called Flying Kangaroo, and Virgin Blue. Andwith Qantas claiming 80% of the domestic market and about to launch a new internationallow-cost carrier (reviving the historically significant name of Australian Airlines), Godfrey

foresaw more turbulence ahead. Given Qantas track record of aggressive behavior in themarketplace, it seemed unlikely that Virgin Blues plans to enlarge both its domesticoperations and to enter the South Pacific area would go unchallenged.

On a broader level, it was also unclear how Australian domestic aviation would evolve. Wasthe current state of competition due to mistakes made by the government in managingderegulation? Had Qantas played a role in driving the other contenders out of business?Indeed, would Qantas continue unchecked by regulators and policy makers, further growingits power in both domestic and international markets? And would this eventually threaten thesurvival of Virgin Blue?

Against this background, Godfrey wondered what role the ACCC would play in the future of

the industry. With public concern about Qantas dominant position rising, how should hemanage his relationship with the competition watchdog and the government?

Company Background

In 1999, with two airlines already in the Virgin Groups US$3.5 billion portfolio, Sir RichardBranson, Virgins energetic chairman, announced his intention to enter the Australiandomestic aviation market. Together with the launch of Impulse Airlines, another new low-fare carrier in June, Virgin Blues entry dramatically changed the industrys competitivelandscape, challenging the comfortable duopoly run by Qantas and Ansett since 1993.

On 31 August 2000, two months after the launch of Impulse, Virgin Blue started serviceoffering seven return flights a day between Brisbane and Sydney. A second route (Brisbane-Melbourne) was added in September and new cities such as Adelaide, Townsville and Cairnswere also served. Virgin Blues CEO strategically decided to avoid the most competitiveSydney-Melbourne route on which Qantas, Ansett and Impulse were already competing.

This decision and Virgin Blues keep-it-simple strategy led to some early successes. Thoughthe airline launched operations with A$40 million funding, only about A$11 million of thiswas used. Virgin Blues management had conservatively forecast at least three years of losses


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before turning a profit. However, with unit operating costs more than 30% below those ofQantas and about 50% below Ansetts (not controlling for differences in service), Virgin Bluewent into the black only three months after its entry.

The idea of being different was a crucial part of Virgin Blues strategy and Godfrey wasconvinced that the key to Virgin Blue's success would be innovation. He therefore sought to paint his airline as a streamlined low-cost carrier with a different attitude. Thus, as hedeclared a few months before the official launch, although Virgin Blue is a budget airline,its going to be a little up market. Offering food for sale (unlike Impulse) and new aircraft, itwould be a hybrid of the best of all the low cost airlineswith a few of our owninnovations. 1

Overview of the Airline Industry

The aviation industry was a tough industry in which to compete. In the 50-year span to 2002,

its profitability was about 0.5% compared to an average of all industries of about 6%.2 As

one observer put it:

To many, the airline industry appears exciting, dynamic and forward-looking,operating at the frontiers of technological innovation. Few realize that despite its

glamour, it is an industry whose long-term profitability is both marginal and verycyclicalThe airline industry is inherently unstable because it is an industry thatis constantly buffeted by new developments and constraints regulatory,operational and technological. 3

The degree of competition was strongly influenced by the industrys concentration, as well asheterogeneity in the cost structure and size of the competitors. Typically, rivalry soared when

a new airline entered the market as incumbents usually reacted fiercely. The initial performance of new carriers was strongly influenced by such barriers to entry as economies ofscale and scope, 4 capital requirements, access to terminals and takeoff and landing slots,strategic alliances and vertical/horizontal integration, frequent flier programs and institutionalrequirements. In addition, demand was highly influenced by season, day of the week andhour; in the leisure segment it was highly seasonal (with peaks at holiday and vacation

periods) and more price-sensitive, while in the business segment it varied according to dayand hour (with peaks from 7 AM to 9 AM and from 5 PM to 7 PM from Monday to Friday), andwas less price sensitive.

The international airline industry was regulated by a system of bilateral agreements set up bythe 1944 Chicago Convention. Negotiated between governments, these specified landing

rights, gateways and set out the rights of international carriers in foreign countries. Eachgovernment designated the carriers entitled to serve each route, which had to be at least 51%

1 Virgin Files Down Under, Corporate Finance , June 2000, Issue 187, p. viii.2 Reported in the speech of Qantas CEO Geoff Dixon to the Australia Israel Chamber of Commerce,

25 September 2002.3 Rigas Doganis, The Airline Business in the 21 st Century , Routledge, 2001.4 There are two kinds of economies of scale: the economies of density, which arise from the increase in the

number of passengers on the same route, and the economies of aircraft size.


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owned by citizens of the licensing country. In the case of Australia, state-owned Qantas wasthe only airline authorized to fly overseas until 1992.

Beginning in the 1980s, many countries created more liberal agreements, allowing for free-

entry and more flexible cabotage rules. Although Asia-Pacific aviation in 2003 was stillmostly regulated by bilateral agreements, it was likely to begin following international trendsand moving towards liberalization.

In contrast to international aviation, domestic air markets were wholly controlled by nationalgovernments. Beginning in the 1930s, governments introduced strict regulations aimed atsafeguarding their (at the time) infant airline industries. By the 1970s and 1980s, these

policies had become increasing unsatisfactory and many countries began liberalizing theindustry.

At the forefront of the trend was the US government, which deregulated domestic aviationwith the Airline Deregulation Act of 1978. A number of instant airlines rapidly sprang up,

principally on local routes in which their flexibility was an advantage. Although many ofthem failed to stay the course, the overall effects were positive for the US economy: since1982, airline load factor increased, fares fell, prices discrimination became less common androute structures shifted to an efficient hub and spoke system.

The Australian Domestic Airline Industry

With a population of just 19 million, Australias aviation market was disproportionately largedue to the countrys vast size and the lack of an alternative transport infrastructure. The localmarket was one of the fastest growing and the Sydney-Melbourne route was the third busiestin the world, with 5.7 million journeys a year. The airline industry also played a key role for

the tourism sector which, with over 4 million overseas tourists a year and an annual domesticturnover of over A$40 billion, accounted for 5% of national income and 12% of theAustralian workforce.

The Two-Airline Policy

The 1952 Civil Aviation Agreement Act (revised in 1957) launched the so-called two-airline policy in the domestic market. 5 The limited size of the market led the government to believethat there was only room for two airlines: the state-owned Australian Airlines and the

privately-owned Ansett Airlines of Australia (at that time, respectively called Trans-AustraliaAirlines and Australian National Airlines). The central government in Canberra restricted thecapacity of each operator to about 50% of determined capacity on trunk routes. In practice,the system was maintained by exclusively granting aircraft import licenses to the two players.

5 The domestic segment was legally defined by the 1981 Airline Agreement Act as the major interstate andintrastate scheduled routes linking 18 trunk towns within Australia. The remaining scheduled routes withinAustralia were part of the regional segment, which was regulated by the Australian states. Many of theregional airlines operated in conjunction with the domestic players. In 1981, Eastwest Airlines, a majorregional operator, started serving the Melbourne-Sydney route, finding its way around the governmentsairline policies. In 1987, Eastwest became part of the TNT/News Corp, the parent company of AnsettAirlines. By 1993, the Eastwest brand had disappeared.


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In addition, the government guaranteed all of the loans raised by Ansett and mandated thatAustralian Airlines set a target dividend each year. According to Prime Minister RobertMenzies, the purpose of the policy was to foster competition on the domestic network andavoid a monopoly.

The government has decided to attempt to secure the retention of the majorairlines in competitive service in the Australian community. It is no part of the

policy of the government to foster either a government monopoly or a privatemonopoly on the major air routes. Trans-Australia Airlines has been successfullyand efficiently established, and having secured substantial share of the public

goodwill, we consider it desirable that its competition should continue, as long asthat competition is fair. Quite frankly, the government would regard it asunfortunate if either Trans-Australian Airlines or Australian National Airways

Property Limited...disappeared from the airline business, since such an eventwould create either a straight-out government monopoly or a private monopoly, towhich each this government and, we believe, the public, are in principle opposed. 6

The two-airline policy guaranteed stability in domestic aviation, avoiding what thegovernment defined as unnecessary overlapping services and wasteful competition.Australian Airlines and Ansett operated with parallel schedules, the same types of aircraft andidentical fares. Unsurprisingly, their market shares were almost constant from 1984 to 1989(Exhibit 1). Against this situation, analysts argued that the strict regulation of both fares andcapacity resulted in high prices, inefficiency and reduced choices for domestic passengers. In1982, prior to the US deregulation, Australian airfares were on average 21% higher than in theUS.7 The two Australian airlines had higher operating expenses and lower labor productivitythan their US counterparts of comparable size (Exhibit 2). Overall, it was calculated thatregulation imposed a welfare cost of A$250 million on the community. 8

Deregulation of the Domestic Airline Industry

In the 1970s, Gough Whitlams Labor government introduced economic deregulation onto theAustralian political agenda. As a result and due to public outcry against high fares andinefficiency in the airline industry during the 1980s, the government decided to review itstwo-airline policy. The findings of this review that the strict regulatory regime had resultedin major losses of economic efficiency led the government to set a timeline for liberalizationof the industry.

On 30 October 1990 the deregulation of the domestic market took effect, permitting otherAustralian airlines to enter the market. This deregulation, however, was only partial: Qantasand the other foreign carriers were still restricted from carrying domestic passengers.According to the Bureau of Transport Economics (BTE), this deregulation was expected to: 9

6 As quoted in Sinha Dipendra (2000), Deregulation and Liberalisation of the Airline Industry, Asia, Europe, North America and Oceania , Ashgate, p.35.

7 P. Forsyth, R. Hilland C. Trengove (1986), Measuring Airline Efficiency Fiscal Studies 7(1).8 M.G. Kirby (1979) An Economic Assessment of Australias Two Airline Policy Australian Journal of

Management 5.9 Bureau of Transport Economics (1991), Deregulation of Domestic Aviation: The First Year , Report 73,


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Increase the responsiveness of airlines to consumer needs; Provide a wide range of airfares and types of services to enhance travel opportunities; Increase competition and pricing flexibility, leading to greater economic efficiency in the

industry; and Continue Australias world-renowned aviation safety record.Within a month a no-frills start-up based in Brisbane, Compass Airlines entered the market,offering a single-class service and serving four airports (two more were added in 1991). 10 Because the Australian market was highly concentrated, these six key airports gave Compassaccess to a large portion of the market (the top five routes, all served by Compass, counted forabout 50% of the market). Its cost advantage over the incumbents (total operating cost perAvailable Seat Kilometers (ASKs) of about A$0.08 vs. A$0.14 for incumbents) allowedCompass to offer fares that were 20% lower than the full economy fare set by AustralianAirlines and Ansett. 11 Though Compass had gained a 12% market share by September 1991(Exhibit 1), this was not sufficient to keep it in the air. The airline registered a loss ofA$16.5 million in November 1991 and ceased operation on 20 December 1991. Compasscollapse resulted in the Civil Aviation Authority holding a debt of around A$12 million,A$60 million of invested capital being written off, and about 125,000 people left with aworthless ticket just before Christmas. A second attempt to launch a discount carrier with theCompass banner was made on 31 August 1992 but it too failed after less than seven months.

Compass bankruptcy raised the attention of the Australian Trade Practices Commission, andit started investigating the possibility of anticompetitive behavior by the incumbents. Its 1992study however, found no evidence of either predatory pricing or other breaches of theAustralian competition law (Trade Practices Act). It concluded that the failure of Compasswas mainly due to the shortcomings in its entry strategy, with the economic slowdown and

problems in accessing terminal facilities also playing a role. 12

Still, a few years later, some observers remained convinced that the powerful position of theestablished airlines had in fact placed Compass at a relative disadvantage. Lacking evidencethat Qantas behavior had been anti-competitive, some observers wondered whether thecompetition regulations themselves were strong enough.

Consequences of Deregulation 13

By 1995, the deregulation process had already had a significant positive impact. Averagefares dropped by 22% in real terms between 1990 and 1995, particularly during the life ofCompass (Exhibit 3). 14 The number of domestic passengers almost doubled from about

AGPS Service, Canberra.10 The six airports served by Compass were: Adelaide, Brisbane, Cairns, Melbourne, Sydney and Perth.11 Bureau of Transport Economics (1991), op. cit. The Available Seat Kilometers are obtained by aggregating

the product of the number of seats made available for sale on each flight and the flight distance.12 In particular, it found that Compass had not calculated that to gain market share at the high end of the

market (business travelers), it would have to offer high frequency, which was extremely expensive.13 All the data in this section are reported in Bureau of Transport Economics (1991), op. cit and Bureau of

Transport Economics (1996), Deregulation of Domestic Aviation in Australia 1990-1995 , InformationSheet 6.

14 The average fares decreased by about 35% between September 1990 and December 1991. During the first


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3 million in June 1990 to 5.6 million in June 1995. The compounded annual growth rate inRevenue Passenger Kilometers (RPKs) between 1990 and 1995 was about 13.6%, with a peakof 35% during the first year (Exhibit 5). 15 The quality of the service was also higher:

The flight frequency on the top 50 domestic routes climbed by 58% betweenSeptember 1990 and September 1994, with almost half of the rise (29%) occurring duringthe first year (Exhibit 6);

The number of scheduled non-stop flights per week increased by 20% between mid-1990and mid-1991;

In all three major airports (Sydney, Melbourne and Brisbane), the punctuality ofdepartures and arrivals improved after deregulation;

The terminal facilities were upgraded and the quality of in-cabin and on-ground serviceswere enhanced, including more space per passenger, an on-board movie, and a valet

parking service; and Both Ansett and Australian Airlines introduced frequent flyer programs.For the carriers, deregulation had a more ambiguous effect. On the one hand, AustralianAirlines became more efficient, benefiting from economies of scale and scope and fromaggressive cost cutting. On the other hand, the savage fare-discounting war and the increasein capacity negatively affected its profitability. Compass was unable to last more than a yearin this aggressive market and Ansett itself barely survived. Its chief executive admitted thatAnsett was, just a few weeks away from going bankruptwhen Compass fell over.

The Australian International Airline Industry

Liberalization took a further step forward in February 1992, when a policy of multiple

designations for international services was introduced. National carriers would also beallowed to fly internationally and Qantas would be permitted to service the domestic sector.Thus, in June 1992, Qantas monopoly on international flights ended and the governmentnegotiated additional capacity on Asia Pacific routes enabling Ansett to enter profitablemarkets such as Kuala Lumpur, Seoul and Indonesia.

It was because competition between international carriers was so tough that Qantas needed toexpand into the domestic market. Certain routes had become prohibitively competitive.Qantas general manager John Kerr recalled: The routes to Kuala Lumpur are a good exampleof the tough international rivalry that Qantas was facing in those days. In March 1995,Malaysian Airlines began adding capacity and improving its service (new aircraft, more non-stop flights, etc.). Though this may have been aimed at preventing Ansetts entry, Qantas also

felt the effect. Competition from Malaysian Airlines was so tough that Qantas withdrew itsKuala Lumpur service. Qantas restriction from serving its own national market had also

two quarters of 1992, just after Compasss first collapse, they increased by more than 51%. Flying was notcheaper for all passengers: in December 1992, the full economy, business and first class fares were about14%, 12% and 6% respectively, more expensive than before the deregulation. Between 1993 and 1995, theeconomy fare was almost stable in nominal terms with a decline of 3% in real terms, while business andfirst class fares increased by 9% and 8% respectively.

15 The Revenue Passenger Kilometers (RPKs) are obtained by aggregating the products of the number ofrevenue passengers carried over each flight and the flight distance.


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become an anomaly. As a Qantas executive pointed out: Qantas expansion into the domesticmarket was a necessary step to allow the carrier to compete against the big national flagcarriers in the aggressive international market. As the airlines executive responsible for

pricing strategy Ian Douglas, pointed out: otherwise Qantas would have been the only

international airline that could not fly in its home domestic market.

The Privatization of Qantas

In 1992, the government took the controversial decision to privatize Australian Airlines,selling it to Qantas for A$400 million. The original privatization plan for the two state-ownedairlines was to sell them separately. However, since both carriers were financially strappedand needed large capital injections, two separate sales would have resulted in a much smallerfinancial return to the government. Thus, it was decided to sell Australian Airlines to Qantas.The acquisition of Australian Airlines was completed in September 1992 and the two airlineswere merged under the Qantas banner in April 1993. In this way, the Kangaroo carrieracquired a fully developed domestic network, emerging as the principal Australian airline andone of the most powerful airlines in the Asia Pacific region. Qantas management estimatedthe cost savings arising from the merger with Australian Airlines at least A$100 million ayear.

The two carriers together were huge: 128 aircraft, 27,500 employees and A$4.5 billionrevenues. In February 1993, while Ansett had not yet recovered from the substantial lossesregistered in 1991, Qantas received a A$1.35 billion capital injection from the government.Shortly thereafter, the government announced its intention to privatize Qantas by selling ashare of the airline to a large international partner and by launching an IPO.

It hoped that privatization would increase efficiency and create a strong international anddomestic Australian airline. Moreover, by privatizing Qantas, the government sought torenew its commitment to microeconomic reform and deregulation and eliminate the conflict

between maximizing competition in the aviation industry and maximizing the value of a state-owned enterprise. The government also planned to gain as much as possible from this

privatization. 16

From the airlines perspective, privatization was a great opportunity to improve Qantasfinancial position and to form a strong strategic relationship with a major international airlinethat would allow it to compete more effectively. At the same time, the IPO promised togenerate broad community support and customer loyalty among the numerous new Australianshareholders.

In March 1993 British Airways acquired a 25% stake in Qantas for A$665 million (whichimplied a valuation of the entire entity of A$2.66 billion). Having moved towards

privatization, in July 1993 the process stalled as the government announced it would postponeselling the residual 75%. This deferral was made to provide more time for the benefits of themerger with Australian Airlines and the commercial arrangement with British Airways to take

16 In order to avoid a negative effect on the valuation of the airline, the government reneged on an open skiesagreement with New Zealand (only 11 hours before the agreement was supposed to have taken effect). Arevised open skies agreement was finally signed in November 1996.


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effect.

The newly appointed CEO James Strong launched a major restructuring program of Qantas inadvance of the IPO:

Top-level management was reshuffled; The fleet was realigned and the number of aircraft was reduced from 128 (fleet of the two

companies before the merger) to 91 (at 30 June 1995); Almost all the major domestic and international operations were integrated (such as the

marketing division, sales operations, flight operation dispatch group); Jobs were cut by over 3,500 between 1992 and 1995; Aircraft utilization was improved (the average daily use increased by 1-1.25 hours per

aircraft) by focusing attention on scheduling and rearranging how maintenance was performed; and

A program of service improvement was also launched: Qantas moved toward a two-classservice on all of its longest routes.

In the meantime, Qantas negotiated a commercial agreement with British Airways underwhich mutual benefits were derived for them and their customers. 17 When this wasimplemented in 1995, the two airlines started integrating operations in a number of Asianairports, establishing joint or co-located airport and sales offices in other airports all aroundthe world, sharing airport lounges and cooperating in fuel purchasing, ground handling,aircraft maintenance and catering. Because of their complementary services (British Airwayshad strong European and North Atlantic networks and Qantas had a comprehensive AsiaPacific network), customers would benefit from more itinerary options, ticket exchangeabilityand reciprocity of frequent flyer programs, lounge access and check-in facilities.

After a difficult year in 1993 Qantas recovered quickly, especially in the domestic market. In1994 it sharply increased its capacity on trunk routes, meeting growing demand and gainingalmost 5% market share on its rival Ansett (Qantas market share increased from 45% in 1994to 50% in 1995). A record A$301.8 million profit was reported for Qantas in 1994. Its CEOargued that this turnaround would show the financial markets we are treading in the rightdirection. The Public Share Offer of Qantas was launched on 22 June 1995 and privatizationwas completed on 31 July 1995. 18 The IPO raised A$1.45 billion for the government.

Following its privatization, there was a marked improvement in the level of commercial focusand discipline within Qantas. In the period between 1995 and 2002, financial resultsimproved significantly. Financial leverage improved by 22 percentage points, operating profitincreased by 97% and the Available Seat Kilometers per employee increased by 18%.

Returns to shareholders also improved: earnings per share increased by 62%, dividends pershare increased by 386% and the share price increased by 114%. (For the evolution ofQantas stock price, see Exhibit 7)

17 Though it was only in June 1995 that official approval for the joint service agreement was granted by theAustralian antitrust authority, which had blocked the integration for nearly two years.

18 The government imposed a cap of 49% for total foreign equity and of 25% for any single overseas airline(Air Navigation Act).


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The New Wave of Competition and Consolidation

Ansetts Takeover and the Entry of Impulse and Virgin Blue

In 1996, Air New Zealand (ANZ) entered the Australian domestic air market by buying 50%of Ansett Holdings, coinciding with the creation of the Australia-New Zealand SingleAviation Market. In June 2000, the takeover of Ansett was completed, as Air New Zealand

bought the residual 50% stake, making it one of the top 20 airlines in the world.

Then, in June and August 2000 two low-fare airlines entered the market. The arrival ofImpulse Airlines and Virgin Blue doubled the number of players and dramatically challengedthe stable duopoly of Qantas (after its merger with Australian Airlines) and Ansett, setting offa vicious price war. Both newcomers were prepared to fight, especially Impulse, whichadopted an aggressive fare strategy and had the security of A$120 million capital behind it(vs. Virgin Blues A$40 million). Qantas and Ansett reacted immediately deciding to matchImpulses fares, even if this meant operating below their costs.

The Price War

The fare war took place mainly on the two major Sydney-Melbourne and Sydney-Brisbaneroutes, with similar dynamics: a newcomer (either Impulse or Virgin Blue) would beginoffering service at vastly reduced fares and the two incumbents (Qantas and Ansett) wouldmatch these prices immediately. Qantas executive responsible for pricing strategy, IanDouglas argued that the incumbents had little choice but to react: although Impulses fareswere far below our operating costs, Qantas had no choice but match them, otherwise it wouldhave had empty aircraft flying anyway. Virgin Blue often launched special discounted offersfor a very limited period of time (such as one-way Sydney-Brisbane tickets for A$48 on

condition that they be purchased within a 48 hour period). This drew weaker retaliation fromthe incumbents.

Beyond the major routes, another opportunity for the newcomers to increase market share wasto offer service on secondary routes. These were often underserved by the incumbents eitherdue to high fares or inconvenient departure times. In December 2000, Virgin Blue beganoffering two daily direct flights between Brisbane and Adelaide, leading to a substantialincrease in demand (air traffic increased by 120-130%, see Exhibit 8). Qantas responded byadding one return flight per day (to a total of three) and matching Virgin Blues fares.

This aggressive behavior led Virgin Blue to complain to the Australian Competition andConsumer Commission (ACCC) and it decided to launch legal action against Qantas for

unfair competition in May 2002. The competition regulator found that Qantas hadengaged in capacity dumping, significantly increasing capacity beyond expected demand,to eliminate or substantially damage Virgin Blue, or to deter or prevent Virgin Blue fromengaging in competitive conduct in the marker including the expansion of its network, therebyseeking to lessen competition. 19

This fierce competition led to a decrease of about 22% in the price for discounted tickets in

19 Virgin Blue CEO-ACCC Decision Vindicates Companys Complaints, 5 July 2002, AFX News.


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the year ending in March 2001. Meanwhile, both full economy and business fares went up by5%. In the same year, the number of passengers rose by 8.5% and the flight frequency on thetop 50 domestic routes soared by 35% (Exhibit 6).

The intensification of discounting and the reduction of loading yield, together with theeconomic slowdown and the weakness of the Australian dollar, made things difficult for allfour carriers. Though it was three times the size of Ansett, the Flying Kangaroo was ailing.Its CEO, Geoff Dixon admitted that at the height of the fare war, Qantas was not makingmoney. 20 Impulse was forced to change its forecast for the 2001 financial year from aA$3 million profit to a loss. 21 The financial situation of Ansett worsened: the airline reporteda A$378 million loss between July 2000 and June 2001, while its market share plunged from50% to 41.5%. Moreover, it needed an urgent cash injection to update its ageing fleet of 767sas Australian regulators had already grounded its planes for safety concerns at Christmas 2000and Easter 2001, jeopardizing the holidays of many Australians. Virgin Blue was theexception in the industry reporting an operating profit before abnormal items of aboutA$519,000 in the seven months to 31 March 2001.

According to David Huttner, Virgin Blues head of commercial operations, the positioningand fares strategies of the two Australian low-fare airlines crucially determined their

performance. By creating a different image, using a strong yield management and offeringlow but sustainable fares with strong but very short promotions to avoid retaliation by theincumbents, Virgin Blue appeared to adopt a sustainable strategy. On the contrary, Impulsesstrategy appeared weaker. It fought head to head with the incumbents, offering substantiallythe same service at a lower price, lacking any significant yield management (all seats weresold at the same price), and with very aggressive promotions that lasted long enough to permitincumbents to react and match their prices.

The Collapse of Impulse and Ansett

By spring 2001, Impulse was in trouble, losing almost A$1 million a week. The prospect of bankruptcy loomed and Qantas stepped forward as a rescuer in April 2001. Seekingregulatory approval for the takeover, Qantas argued that the move would protect theAustralian economy from the damage Impulses failure threatened to inflict upon it. 22 Furthermore, it argued that industry consolidation was necessary. Impulses discount fareswere unsustainable and the industry structure prevented each of the four players from

producing reasonable and consistent profits. If the market could not sustain more than one ortwo players, then competition risked translating into value destruction. To support itsargument, Qantas pointed out that every player in the industry was losing money.

20 Speech to the Australia Israel Chamber of Commerce, 25 September 2002.21 Malcolm Meyrick in One Airline Should Prepare to Land-Permanently, Australias BRW , 6 April 2001.22 Among these potential costs were: A$20 million debt unpaid, more than A$50 million of invested capital

bust, thousands of people with worthless tickets, the suppression of some regional services, the negativeeffect on the tourism industry, and the loss of 1,200 jobs.


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Both Ansett and Virgin Blue opposed the deal claiming that it was anti-competitive and thatQantas would gain a competition-eroding 55% market share by acquiring Impulse. Othersfurther argued that Impulse was not a failing firm. David Huttner remarked:

Impulse was not out of cash but it still had A$40-50 million left in capital. Itbecame a failing firm when Gerry McGowan [ Impulses executive chairman ] declared his company was failing (since customers stopped buying its tickets).Gerry (who was also the owner) declared it on purpose to close the deal withQantas. Qantas matched Impulses prices intentionally, to drive it out of business

first and to attack Virgin Blue later. And the reason why Qantas first went after Impulse was that it believed that Virgin Blue had much deeper pockets, thoughthis was not true. Our biggest concern was that the deal gave Qantas the

possibility to buy a lower-cost operating vehicle that they couldnt createotherwise by themselves. Through Impulse, Qantas could launch a savage attackagainst us.

Examining Qantas proposal, the ACCC took into account the only two available alternatives:a merger between Qantas and Impulse (with its impact on the long-term competitiveness indomestic aviation) or the demise of the discount carrier (with the consequent loss of 1,200

jobs). Unfortunately, no other buyer for the airline stepped forward despite Ansetts CEOinitially entertaining making an offer. Virgin Blue declined the ACCCs suggestion that it

buy Impulse on the grounds that the big differences between the two carriers would makeintegration difficult. On 18 May, after less than three weeks of investigation, the competitionregulator decided not to oppose the Qantas purchase. Its sole request was that Qantas giveconcessions to preserve the competitive position of both incumbents allowing them to expandor new carriers to enter. Hence Virgin Blue gained two-thirds of Impulses takeoff andlanding slots at Sydney airport.

The end of Impulse as an independent carrier had a significant impact on industry economics.Discount fares started to increase and flight frequency diminished by 3% from March to June.Passenger activity over Impulses former routes began to decrease as well. In particular,traffic on Australias main Melbourne-Sydney route fell by 5% from June 2000. On the otherhand, the routes served by Virgin Blue continued to register strong increases in passengernumbers. Its activity on the Brisbane-Melbourne and Brisbane-Sydney routes, for example,rose by 48% and 33% respectively (Exhibit 8).

A few months after the demise of Impulse, the Australian domestic industry witnessedanother big collapse. Instead of recovering in the smoother market situation, Ansetts

performance continued to plunge, causing a considerable drag on its owner Air New Zealand.The carrier was losing US$9 million a week and needed an urgent capital injection to upgradeits fleet. 23 Without a rescuer, ANZ was forced to put Ansett into voluntary administration on12 September, only three months after the bailout of Impulse by Qantas. 24

Already affected by Impulses bankruptcy, Ansetts collapse caused significant damage to the

23 Geoffrey Thomas, Recipe for the Disaster, Air Transport World , November 2001, Vol.38, Issue 11.24 The New Zealand government bailed-out ANZ with a NZ$885 million (about US$415 million)

recapitalization, which corresponded to an 82% stake. ANZs previous major shareholders, BrieleyInvestments and SIA, ended up with a stake of 5% and 4% respectively.


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economies of both New Zealand and Australia. Over 15,000 people (most of whom wereAustralian) were put out of work. Moreover, Ansett owed its workers about A$780 million inentitlements such as wages and holidays and had a cumulated debt of A$3.5 billion. 25

Challenges to Australias Airline Industry in 2002

Twelve years after deregulation, only two companies survived the fare war of 2000-2001. Ofthese, Qantas was doing well: it gained an 80% domestic market share, capitalizing on thecessation of Impulse and Ansett, and the number of its international passengers declined byonly 11% after 11 September, compared with an average decline of about 25% in globalaviation. The launch of its new discount medium-haul airline, Australian Airlines, was acontinuation of its expansionist strategy. The new venture would serve Cairns and six Asianairports (Osaka, Fukuoka, Nagoya, Taipei, Hong Kong and Singapore).

The other survivor of the fare war, Virgin Blue emerged as the second Australian domestic

carrier, with about 20% of the domestic market. It also succeeded in penetrating the businesssegment, capturing more than 100 corporate clients, among which were such big names asMicrosoft, Shell and Siemens. Thanks to its low operating costs and soaring market share, itrecorded a pre-tax profit of A$8.2 million in the six months ending in September 2001, whichgrew to A$16 million in the fourth quarter of 2001. In March 2002, Sir Richard Branson sold50% of the airline to Patrick Corporation, the premier port cargo handler. The deal made theVirgin Blue chief executive Godfrey confident about expansion: We have a million thingswe could do, including enlarging the domestic operation and entering into the internationalmarket with service to the South Pacific (e.g., New Zealand, Fiji and Indonesia). WithAnsetts collapse and the Australianization of Virgin Blue through Patricks stake,regulatory approval should be easier to obtain.

The duopoly structure returned the commercial sustainability of the players. FollowingAnsetts cessation, Qantas gained some stability in its domestic business, freeing up resourcesto fight in the competitive international market. Observers, such as Peter Harbison, of theCentre for Asia Pacific Aviation, believed that the platform now exist[ed] for theestablishment of sustainable long-term competition. He argued that Qantas could not affordto be too complacent, as Australian regulators were among the few in the world that wouldallow a 100% foreign-owned carrier to enter the domestic market. Qantas CEO Geoff Dixonagreed that, though consolidation had been necessary, there was constant pressure to remaincompetitive:

Let us have no doubt about what happened in Australia last year. We had fourairlines operating in the domestic market dancing to the tune of those calling forever-greater price competition, with ridiculous and unsustainable fares such as

A$33 between Sydney and Melbourne. Qantas was not making money, Ansett waslosing hundreds of millions of dollars on an annual basis, while Impulse collapsedand Virgin Blue was struggling and probably ultimately saved by Ansett goingunder. The Ansett collapse cost 15,000 direct jobs, ten of thousands of jobs inassociated businesses and industries, great human suffering and considerable

25 As reported in Ansett Sydney Terminal Sold, The Age (Melbourne), 3 May 2002 p. 7.


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INSEAD 5179 13


damage to the economy.Domestically we are competing robustly with a low-cost, no-frills operator and there is absolutely nothing to stop a new playerentering the market at any time. Cherry-picking the most lucrative routes is anobvious starting point for any entrant. This places constant pressure on

incumbents .

Nevertheless, many observers remained concerned about Qantas market power and wonderedwhat degree of competition could exist between an 82-year-old veteran carrier and a smalldomestic low-fare airline targeting the price-sensitive end of the market. The transportminister, John Anderson was among these, insisting that Qantas cannot be allowed todominate the market and 60% or 65% of the market in, say, 12 months time is about all itshould reasonably be allowed to have. 26

Qantas General Manager for government and regulatory affairs, John Kerr fired back: Thenumber of carriers in a market is not the only consideration in determining whether there iscompetition. Many regional markets have only one player because any more would make

them unprofitable or because no one else is interested. Qantas serves some of these routesspontaneously even when it loses money on them.

One of the major problems appeared to be the difficulty of attracting either investors to theairline sector or a viable third airline to compete with Qantas and Virgin Blue in serving thecapital cities, especially after the deal with Patrick Corp. One observer argued that Qantasneeds a rational duopoly competitor to provide an effective lockout to any aspiring entrants inthe industryand Chris Corrigan, Patrick Corp.s managing director, is known for hisrational, competitive behavior in a duopolistic markethe will be a more predictable playerthan the volcanic Branson. Indeed, although the announced launch of Australian Airlinescould be perceived as a move to challenge Virgin Blues international expansion, Qantasappeared well disposed towards its smaller competitor. It declared that it was ready to reduce

its domestic market share to 65%, as suggested by Minister Anderson.

Conclusion

Given the state of Australias domestic aviation industry, Brett Godfrey knew that thegovernment faced serious challenges regarding its deregulation policies, and wondered howhe could play this to the advantage of Virgin Blue. Among the questions he expected thetransport minister to raise were the following:

First, with a duopoly and the failure of four airlines (the two Compass ventures, ImpulseAirlines and Ansett) did the structural features of the industry support competition? Or,given the huge losses linked to these collapses, was it preferable to aim at a more stableair market?

Second, the government needed to question whether mistakes in the deregulation processhad led to the duopolistic situation. Were the newcomers sufficiently helped and

26 The ACCC chairman was also perplexed by the tremendously powerful position of Qantas and sought tostrengthen the competition regulation to prohibit, not only intentionally anti-competitive behavior, but alsoconduct with anticompetitive effects.


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INSEAD 5179 14


protected by the government? In particular, the major issue concerned the merger andthen privatization of Qantas and Australian Airlines. Was Qantas-Australian Airlines too

big when it was privatized and, therefore, so large that Ansett could not compete? Werecompetition regulations sufficient to prevent Qantas from becoming too aggressive or

engaging in anti-competitive practices and creating its own strategic barriers to entry? Third, if the situation did pose a threat of excess market power, what were the possible

solutions? Strengthening Australian competition regulations, imposing fare caps orimplementing level-playing-field actions (e.g., move assets from Qantas to Virgin Blue, or

breaking up Qantas)? How could the government and regulators help new airlines enterthe market?


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INSEAD 5179 15


Exhibit 1Domestic Market Shares (1984 to 1996)

Notes:Ansett Group includes Ansett Australia, Ansett Express, Ansett NT (which ceased operations in May 1991),Ansett WA and Airlines of South Australia (which ceased operations on 28 June 1986) and Eastwest Airlines(EW) after 31 December 1993. However, Ansett Group already bought EW in 1987 and slowly dismissed its

brand.Australian Airlines Group (Qantas Group after 1993) includes Australian Airlines, Australian Airlink (whichstarted operations on 3 August 1991) and Air Queensland Ltd (from the takeover by Australian Airlines on6 February 1985 to its cessation in April 1988).

Source: Bureau of Transport Economics (2000).

Exhibit 2Performance Indicators of Selected Airlines in Australia and the US

(1983-84)

Source: Bureau of Transport Economics (1985), pp. 70-71.

0 %

1 0 %

2 0 %

3 0 %

4 0 %

5 0 %

6 0 %

7 0 %

8 0 %

9 0 %

1 0 0 %

1 9 8 4

1 9 8 5

1 9 8 6

1 9 8 7

1 9 8 8

1 9 8 9

1 9 9 0

M a r c

h 9 1

J u n e

9 1

S e p

t . 9 1

D e c

9 1

M a r c

h 9 2

J u n e

9 2

S e p

t . 9 2

D e c

9 2

M a r c

h 9 3

J u n e

9 3

S e p

t . 9 3

D e c

9 3

1 9 9 4

1 9 9 5

1 9 9 6

A n s e tt G r o u p A u s tr a li a n A . G r o u p E a s tw e s t C o m p a s s A ir li n e s

Airlines

Expenses per Available Tonne- KM (A cents)

Expenses perRevenuePassenger-KM(A cents)

Passenger-KM per employee(Thousand KM)

Australian Airlines 89.8 13.6 545 Ansett 74.6 11.8 582 Air California 53.6 11.8 1,251Frontier 50.1 10.2 1,233Ozark 49.7 11.6 1,066People Express 36.1 5.1 3,040Southwest 30.1 6.8 2,074


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INSEAD 5179 16


Exhibit 3Index of Real Average Airfares on Top 21 Interstate Routes

Source : Bureau of Transport Economics 1995, Deregulation of Domestic Aviation in Australia 1990-1995,Information Sheet 6, p.2.

Exhibit 4First, Business, Economy and Best Discount Real Domestic Airfare Indexes

(4 th Quarter 1992 1 st Quarter 2002)

60

80

100

120

140

Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01

R e a

l D o m e s

t i c

A i r f a r e

I n d e x

Best Discount Economy Business Firs t Class



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INSEAD 5179 18


Exhibit 6

Flight Frequency Index on Top 50 Domestic Air Routes from September1993 to March 2002 (1989/90=100)


Exhibit 7Daily Performance of Qantas Stock Price over the Australian Stock

Exchange All Ordinaries Index (31 July 1995 24 September 2002)

Source: Datastream and press releases (1996-2002).

120

150

180

210

240

Sep 1993 Sep 1994 Sep 1995 Sep 1996 Sep 1997 Sep 1998 Sep 1999 Sep 2000 Sep 2001

F l i g h t F r e q u e n c y I n d e x

Qantas's daily stock price over ASX all ordinaries index

0,0

0,2

0,4

0,6

0,8

1,0

1,2

1,4

1,6

1,8

2,0

3 1 / 0 7 / 1 9 9 5

3 1 / 1 0 / 1 9 9 5

3 1 / 0 1 / 1 9 9 6

3 0 / 0 4 / 1 9 9 6

3 1 / 0 7 / 1 9 9 6

3 1 / 1 0 / 1 9 9 6

3 1 / 0 1 / 1 9 9 7

3 0 / 0 4 / 1 9 9 7

3 1 / 0 7 / 1 9 9 7

3 1 / 1 0 / 1 9 9 7

3 1 / 0 1 / 1 9 9 8

3 0 / 0 4 / 1 9 9 8

3 1 / 0 7 / 1 9 9 8

3 1 / 1 0 / 1 9 9 8

3 1 / 0 1 / 1 9 9 9

3 0 / 0 4 / 1 9 9 9

3 1 / 0 7 / 1 9 9 9

3 1 / 1 0 / 1 9 9 9

3 1 / 0 1 / 2 0 0 0

3 0 / 0 4 / 2 0 0 0

3 1 / 0 7 / 2 0 0 0

3 1 / 1 0 / 2 0 0 0

3 1 / 0 1 / 2 0 0 1

3 0 / 0 4 / 2 0 0 1

3 1 / 0 7 / 2 0 0 1

3 1 / 1 0 / 2 0 0 1

3 1 / 0 1 / 2 0 0 2

3 0 / 0 4 / 2 0 0 2

3 1 / 0 7 / 2 0 0 2

( A $ / t h o u s a n

d s

A $ )

An no un cem en tof Virgin Blueslaunch Ac qu isit ion of

50% Virgin Blueby Patrick Corp.

Impulsestakeover byQantas

Stockissues

Voluntaryadministrationfor Ansett

Failure of Ansett 'sre-launch

Failure of Qantassoffer to buy ANZand Qantass firstslump in earnings

VirginBlueslaunch

Qantass reductionin profit

Qantass positiveperformanceCost cutting

programme

As ian cri se s

Qantas's daily stock price over ASX all ordinaries index

0,0

0,2

0,4

0,6

0,8

1,0

1,2

1,4

1,6

1,8

2,0

3 1 / 0 7 / 1 9 9 5

3 1 / 1 0 / 1 9 9 5

3 1 / 0 1 / 1 9 9 6

3 0 / 0 4 / 1 9 9 6

3 1 / 0 7 / 1 9 9 6

3 1 / 1 0 / 1 9 9 6

3 1 / 0 1 / 1 9 9 7

3 0 / 0 4 / 1 9 9 7

3 1 / 0 7 / 1 9 9 7

3 1 / 1 0 / 1 9 9 7

3 1 / 0 1 / 1 9 9 8

3 0 / 0 4 / 1 9 9 8

3 1 / 0 7 / 1 9 9 8

3 1 / 1 0 / 1 9 9 8

3 1 / 0 1 / 1 9 9 9

3 0 / 0 4 / 1 9 9 9

3 1 / 0 7 / 1 9 9 9

3 1 / 1 0 / 1 9 9 9

3 1 / 0 1 / 2 0 0 0

3 0 / 0 4 / 2 0 0 0

3 1 / 0 7 / 2 0 0 0

3 1 / 1 0 / 2 0 0 0

3 1 / 0 1 / 2 0 0 1

3 0 / 0 4 / 2 0 0 1

3 1 / 0 7 / 2 0 0 1

3 1 / 1 0 / 2 0 0 1

3 1 / 0 1 / 2 0 0 2

3 0 / 0 4 / 2 0 0 2

3 1 / 0 7 / 2 0 0 2

( A $ / t h o u s a n

d s

A $ )

An no un cem en tof Virgin Blueslaunch Ac qu isit ion of

50% Virgin Blueby Patrick Corp.

Impulsestakeover byQantas

Stockissues

Voluntaryadministrationfor Ansett

Failure of Ansett 'sre-launch

Failure of Qantassoffer to buy ANZand Qantass firstslump in earnings

VirginBlueslaunch

Qantass reductionin profit

Qantass positiveperformanceCost cutting

programme

As ian cri se s


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INSEAD 5179 19

Exhibit 8Increase in the Air Traffic of Melbourne-Sydney, Brisbane-Sydney and

Adelaide-Brisbane Routes (January 1999-June 2001)

City 1-City2 Melbourne-SydneyBrisbane-

SydneyAdelaide-Brisbane

Newcomer(s) Impulse Virgin &Impulse Virgin

Year-Month % Increase in ASKs 27 year-to-year2000- 1 3,9% 0,4% 3,0%

2 5,1% 1,1% 3,1%3 6,1% 1,1% 2,7%4 6,4% 1,5% 3,1%5 6,9% 2,1% 3,6%6 8,1% 2,6% 3,5%7 9,1% 3,6% 3,5%8 10,1% 4,0% 3,8%

9 11,5% 6,2% 3,8%10 12,5% 8,9% 3,8%11 13,4% 12,7% 4,2%12 14,1% 16,5% 9,5%

20001- 1 15,0% 20,9% 18,2%2 15,4% 23,7% 28,1%3 16,6% 27,9% 39,3%4 18,3% 31,7% 50,3%5 18,7% 34,5% 61,5%6 16,6% 36,7% 72,1%


27 ASK: Available Seat Kilometers. See footnote 11.

Virgin Blue

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