DEUTSCHE: Here's Why The Qantas Capacity Pull Back Could Be Good For The Aviation Industry

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Qantas’ decision to cut capacity could be good for the aviation industry in Australia.

Deutsche Bank analyst Cameron McDonald has said it could mean Australia mimics the US market, which has “shrunk itself to greatness”.

According to the AFR, McDonald pointed to earlier analysis which shows that when the US market pulled back on capacity, profitability increased sharply.

Yesterday Qantas said it would freeze capacity in the first three months of the next financial year after it failed to achieve year-on-year growth for April 2014. This was despite demand increasing over the period.

It was described as an admission of defeat, with Virgin Australia and Qantas locked in a bitter fight for the domestic market.

Whether or not Qantas decides to pull back on capacity will depend on Virgin Australia, McDonald explained. Qantas has been desperately trying to maintain its domestic market share, and Virgin Has been trying to win it by undercutting the national carrier on domestic routes.

Qantas’ reaction was to flood the market with capacity, and analysts have always pointed out that both airlines’ strategies were only ever short-term plays. Virgin relied on a war chest of capital partly provided by its overseas airline shareholders.

If Virgin doesn’t pull back in line with Qantas, allowing the industry to take stock and consolidate, nothing much will come of Qantas’ decision. But if it does, the situation could potentially mirror that of the United States market, which DB has outlined in previous research.

From DB:

What is evident from these graphs is the sharp increase in profitability for the total markets when capacity growth is constrained.

It can be seen that the US domestic carriers’ combined profitability is at record levels compared to Australia which is at record losses.

We continue to believe that cutting costs (such as Qantas has announced) is only part of the strategy to return to profitability and capacity rationalization also needs to be considered.

Here’s the graph showing how the periods of huge capacity growth in the 1980s US domestic aviation market was a time of comparatively low profits, while the more constrained capacity growth of recent years has laid the foundations for record industry results.

The pattern is similar in Australia, with the years that see a slowdown in capacity growth being quickly followed by periods of increased net income. The implication here is that the likely impending period of more restrained capacity addition should quite quickly lead to better results for the sector.

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