Ten factors to consider in creating shareholder value - Qantas’ decision to operate direct flights between Perth and London

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Will Qantas create shareholder value with its exciting new city pair announced in December 2016? Operated by the new 236-seater 787-9 Dreamliner, and at a distance of almost 15,000 km the PER-LHR non-stop will be one of the longest sectors in the world flown by one of the most world’s most exciting aircraft. Let’s look at ten factors that will drive value creation or destruction for Qantas shareholders as a result of this new route decision. 

i. Demand estimates

Fundamental to the success of the route is whether underlying demand exists to support the business case. In total, the current demand for direct services between Perth and London is estimated to be around 400,000 passengers. To put this into perspective, a daily service on a Boeing 787-9 Dreamliner with 236 seats involves the carriage of around 170K seat movements per annum. Given these figures, if Qantas were a monopolist on the PER-LHR route, there would appear to be enough demand for a daily service on the Qantas 787-9.

According to Tourism Research Australia survey data, there were around 250,000 passenger movements involving residents of the UK arriving in the city of Perth over the 12 months to September 2016, and there were around 150,000 passenger movements involving travel by Australian residents between Perth and the UK. So as a rough guide, it would appear that the demand exists for this service - but more on this later.

ii. Competition

While Qantas will be the only carrier that offers a direct service on the route (assuming that Virgin Australia doesn’t begin services), there are a number of quality carriers that currently offer indirect services. These competitors include Singapore Airlines, Cathay Pacific, Malaysian, Emirates, Qatar, China Southern and Thai. These indirect services will compete with Qantas and as such will place a competitive ceiling on the fares that Qantas can charge. The point here is that Qantas will not have it its own way on this route, although the first mover advantage is a strong one and often coincides with value creation.

iii. Competitive advantage

The significant advantage that Qantas has over competing carriers is that a direct PER-LHR service has a significantly lower travel time than one-stop services. As indicated in Figure 1, Qatar offers the second lowest and Qantas’ partner, Emirates, the third lowest travel time, although both are still two and a half hours slower than Qantas. Reduction in travel time provides Qantas with a significant competitive advantage particularly in certain segments of the markets (see below) which signals that Qantas is making the kind of strategic decisions that maximise expected value – in the long term.

iv. Passenger demographic

The next question is then - is reduced total travel time an advantage to Qantas important? This will depend on the passenger demographic on the route. The stronger the business purpose and the higher the income demographic the greater the demand for the shortest travel time. This is because the opportunity cost of travel time, which is proxied by the wage rate of the passenger, is higher for business purposes and higher income per capita passengers.

Qantas is banking on a strong demand for the shortest travel time and thus a strong demand for premium travel and to that end, has structured its business model accordingly. The premium mix (the mix of business and premium economy seats) on the Qantas 787-9 is exceptionally high, with 30% of seats on the aircraft in premium cabins; contrast this with the next closest competitor time-wise, Qatar Airways’, which operates a Boeing 787-8 with a premium mix of just 8.7%.

Working against this choice however, is the current evidence on traveller demographics. Tourism Research Australia data indicates that just 5.9% of travellers from the UK to Perth make the journey for business reasons and 4.2% of WA residents travel to the UK for the same purpose over the 12 months to September 2016. While the business purpose proportion does not perfectly correlate with the proportion of passengers demanding travel in premium seats, it is a pretty good indicator. On balance, there is potential here for Qantas to create value on the basis of a strong premium configuration, but it is likely to rely on a strong premium demographic from before and beyond traffic as opposed to point-to-point Perth business travellers.

On the flipside there are also non-trivial considerations that relate to potentially value destroying cost and revenue inefficiencies on the route.

v. Fuel inefficiencies

For routes that are operated by aircraft that are at the edge of their maximum range, fuel productivity is typically low. The rationale here is simple. Fuel burn is a positive function of the fully-laden weight of the aircraft, amongst other things. When the plane flies long distances more fuel is loaded onto the aircraft, which adds to the weight of the aircraft and thus fuel consumption. The consumption of fuel to carry fuel therefore generates a cost inefficiency that is heightened on extremely long routes.

According to Qantas’ website the range of the Qantas 787-9 with a full payload of passengers and freight is 14,498 km. This happens to be 1km less than the great circle distance of the PER-LHR route, which implies the route is susceptible to inefficient fuel burn and over-exposure to higher oil prices. While the Boeing 787-9 is one of the most fuel-efficient aircraft in the sky, the very long distance that it flies results in fuel inefficiencies that adds to the cost of the route.

vi. Alternate Airports

All flights nominate an alternate airport. This is the airport at which the aircraft can feasibly land if it can’t land at the airport to which it is destined. I use the word ‘feasible’ because the tarmac must be long and strong enough for the aircraft to land, and the airport itself must be in a location that is unlikely to have the same poor weather events at the same time as Perth airport.

The nearest airports to Perth are Kalgoorlie (538 km), Learmonth (1,091 km), Port Hedland (1,308 km) and Adelaide (2,120 km). The Boeing 787-9 under its normal specifications requires a runway take-off distance of 2,900m. This means that the airline cannot elect Kalgoorlie as the closest airport as an alternate because its runway length is only 2,000m. It can however elect Learmonth which has a tarmac that appears to be feasible for the Boeing 787-9 and to that end, for the 14,498km LHR-PER flight, Qantas would be required to carry enough fuel to fly up to an additional 1,091km. This adds to fuel inefficiency on the route.

Under usual circumstances the amount of extra fuel that is carried will be determined by the captain, which will depend on, amongst other things, Perth weather reports at the time of departure from London. However, since the flight time to Perth is 17 hours, and Perth weather reports could change over 17 hours, then the amount of discretion flexed by the captain is likely to be reduced and Qantas will have rules in place that relate to alternate fuel carriage on the route.

Given Qantas’ impeccable safety record and the fact that it has the best pilots in the world, it is unlikely to take any risks with alternate fuel. Other airlines that stop between London and Perth need to carry the same extra fuel but not over the same distance as Qantas and as such this will add to Qantas fuel costs relative to other carriers.

vii. Forgone revenue

For some proportion of the flights, the airline may have to forgo the carriage of some revenue-earning belly freight if it is to arrive safely in Perth or in London because the PER-LHR route could be payload restricted. This is the case for journeys involving strong headwinds, given that the route is very close to the maximum range of the aircraft. To compensate for this, the airline may have to increase passenger fares that could potentially lead to switch to competitors. Either way, these payload restrictions add to revenue risk on the PER-LHR route.

viii. Cost reduction from reduced aircraft movements

Two of the biggest volume drivers of airline cost are flying hours and the number of aircraft movements. By flying non-stop, the PER-LHR doesn’t need a technical stop. Costs such as fuel, tech and cabin crew costs, either implicitly or explicitly, positively depend on the number of flying hours. While costs such as ground handling, re-fuelling, catering, terminal navigation, airport charges, aircraft depreciation depend on the number of aircraft movements. The PER-LHR route has both a lower travel time, and fewer aircraft movements (two movements – one take-off and one-landing) compared to airlines flying indirect services (which will have four aircraft movements – two take-offs and two landings), which will contribute to lower Qantas costs compared to competitors.

ix. Competitive Disruption

From a strategic perspective, it appears that Qantas management aims to disrupt the current state of play in the market with routes to and from the Australian mainland. In doing so, they will open up a new gateway for travellers from the eastern seaboard to travel to Perth and fly on from there to Europe or the Middle East (as opposed to going through Asia); and they will also open up new gateways for UK residents, and potentially residents of continental Europe, for travel to Australia.

The market for flying between PER and LHR does not only include people who only want to travel between Perth and London but also people who will travel on ‘before’ and ‘beyond’ passenger legs. Both the Australian and UK residents (and to a lesser extent residents of continental Europe) can travel via Perth – in the case of east coast Australians travelling to London, Perth would involve a ‘before’ leg, and for UK residents, and other Europeans, travelling to the east coast of Australia, Perth to the east coast represents a ‘beyond’ leg.

Table 1: Potential Perth Hub – Before and Beyond Traveller Numbers

Tourism Australia Data
12 months to Sep 2016
                                          # Residents
From the UK travelling to
SYD, MEL, BNE or ADL                            1M


Australians travelling from
SYD, MEL, BNE and ADL travelling to the UK    900k


 

As Tourism Australia data shows, the market for setting Perth up as a ‘before and beyond’ hub for east coast Australians and UK travellers is just under 2M passenger movements.

Given it is highly conceivable that Qantas services from the east coast to London via Perth will involve shorter total travel time than most of its competitors, who fly via hubs in Asia and the Middle East, you begin to understand that Qantas has set itself up very nicely indeed.

Assuming that the transit time in Perth is two hours, Qantas has a shorter total travel time than other competitors, with the exception of Singapore Airlines on the Sydney route (although if Qantas can reduce its transit time to less than one hour - the same transit time as Singapore Airlines) then Qantas may be quicker as a route than Singapore overall. See Figures 2 and 3. [1]

Concluding remarks

Qantas should be congratulated for taking on this risky, complex new city pairing. The fundamentals appear to be in Qantas’ favour at present – demand, cost advantage and the competitive landscape – to allow management to deliver on the promise of a value creating strategy in 2018. Whether they can bring it home as we enter a period of higher demand for oil, slower GDP growth domestically and above average ASK is the subject of another discussion altogether and is not to take away from the strategy.

Dr Tony Webber is the CEO and founder of Airline Intelligence and Research and has over 30 years’ of complex macroeconomic modelling experience for significant business decision including serving as a Chief Economist of one of Australia’s flagship carriers. See more of our Aviation Analytics work by visiting the website.

[1] The total travel time is based on the Qantas implied assumption, as calculated from figures presented in the QF media release, of an average speed of 853km on PER-LHR, which is considerably faster than the implied average speed of most of its competitors (although this may be because the cruise distance is a higher proportion of the total distance travelled). The results of the graphs below will be sensitive to this assumption.

Disclaimer

The information in this article is provided for general information only and should not be taken as constituting professional advice or financial product advice or investment advice from Airline Intelligence and Research or Dr Tony Webber.

Neither Airline Intelligence and Research or Dr Tony Webber are financial advisers. You should consider seeking independent financial, investment or other advice to check how the information relates to your unique circumstances.

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