Executive Summary - NECG Report On Air NZ/Qantas

Executive Summary - NECG Report On Air NZ/Qantas

Report on the Competitive Effects and Public Benefits Arising from the Proposed Alliance between Qantas and Air New Zealand

EXECUTIVE SUMMARY

Link To Full Report (1.7MB PDF)
http://breakingnews.webairnz.co.nz/necg_report.pdf

The Application

This is an Application by Air New Zealand Limited and Qantas Airways Limited seeking authorisation to implement the terms of a Strategic Alliance arrangement. A separate Application seeking authorisation for Qantas to subscribe for up to 22.5% of Air New Zealand’s voting equity is filed simultaneously with this Application. The documents underlying each application are inter-conditional.

Associated with the transactions is the right for Qantas to have up to two directors on the board of directors of Air New Zealand. In turn, Air New Zealand will be entitled to have one director on the board of Qantas, notwithstanding that it is not subscribing for shares in that company. This recognises that the Strategic Alliance will require clear and open communication between the parties. It also indicates the willingness of both airlines to take all steps to achieve the best outcome from their shared vision for the future.

The Strategic Alliance

The Strategic Alliance creates a Joint Airline Operation network (the JAO Networks) which, once fully implemented, will be commercially managed by Air New Zealand. However, the day to day flying operations will remain the responsibility of each airline. All Air New Zealand flights will be part of the JAO Networks, together with all Qantas flights into, within and departing from New Zealand. There are also extensive reciprocal rights for codesharing on each other’s services. By way of example, this will enable Air New Zealand to obtain feeder traffic from codesharing on connecting flights on Qantas’ Australian domestic and international networks.

In respect of the JAO Networks, the parties will co-ordinate pricing, capacity and all other aspects of the normal business operations of an airline. The two airlines also agree, as part of the Strategic Alliance, that where it is effective and efficient for them to do so they will also coordinate on their non-JAO networks.

Air New Zealand’s management of the JAO Networks will be supported by a Strategic Alliance Advisory Group that comprises three representatives appointed by each airline. The decisions of that group are required to be unanimous. In simple terms, a recommendation of the Strategic Alliance Advisory Group will only result in a change in management direction when both Air New Zealand and Qantas agree that such a change should take place.

AL023430124 041202 1458 2 After taking into account the capacity of Air New Zealand and Qantas, each airline’s net financial performance for the JAO Networks is compared to allow for the equitable allocation of benefits.

The Aviation Environment

The arrangements between Air New Zealand and Qantas are proposed at a time of unprecedented turmoil and mounting pressure for restructuring and consolidation in the international aviation industry.

Losses

2001 was only the second year in the modern history of civil aviation in which international air traffic declined. In 2001, member airlines of the International Air Transport Association (IATA) recorded a collective loss of some US$18 billion. The prospect for 2002 is for significant losses to continue. The events of 11 September 2001, which resulted in the US Government providing $US billions in loans and grants to the US industry only exacerbated already material pressures on the long-term profitability of the aviation industry. The European industry has experienced similar pressures. Together those two markets have already seen the bankruptcy of Sabena, Swissair and US Airways. There is still substantial fallout to follow, with United Airlines expected to file imminently for Chapter 11 bankruptcy protection. Other countries also have been forced to provide substantial financial support in order to maintain the viability of their flag carriers, including New Zealand (NZ$885 million to date). Air New Zealand’s recapitalisation was a direct result of these global pressures and the failure of Ansett, but was not directly related to the events of September 11. In this global environment, Air New Zealand and Qantas are individually small players; even together they represent less than 4% of the global aviation market.

Value Based Airlines (VBAs)

The ultimate failure of Ansett Australia is an example of the pressure full service airlines (FSAs) are facing from the dramatic growth of low cost, “no frills”, point to point airlines such as Southwest, easyJet, Ryanair and Virgin Blue, operating on short haul routes.

Airlines such as Air New Zealand and Qantas operate a network business, in which impacts on individual routes have flow-on effects throughout the entire network. The network generally comprises a profitable “core” with less profitable fringes that are tolerated because of the contribution they make to the core. These “network effects” make traditional network airlines particularly susceptible to VBA entry, because the VBA enters as a “greenfield” operation with no legacy costs, “cherry picks” the most profitable and busiest routes and, with costs already very low, commences competition with the incumbent FSA.

Despite best efforts by FSAs to reduce costs in order to compete with the VBA model, they have generally been unsuccessful; many costs are entrenched and others are essential to compete on long haul routes and to maintain a full network. The FSA finds itself losing market share on the very routes that are integral to the viability of its overall network.

The VBA has become an extremely successful business model in Europe and North America, and also in Australia where Virgin Blue’s entry precipitated the failure of the incumbent, long established and well-branded Ansett Australia.

In summary, the lesson to be taken from the global experience is that the VBA model will inevitably find its way onto the New Zealand domestic and trans-Tasman routes. The low barriers facing VBA entry into or expansion in Australasia, particularly in the context of the Single Aviation Market, undoubtedly support this message. Further, absent the Strategic Alliance, in a battle between two FSAs and a VBA, the Ansett Australia experience graphically demonstrates that in Australasia, the weaker FSA will quickly surrender its position in the market - it is impossible to fight the battle on both fronts.

Australasia

In September 1996, the Australian and New Zealand Governments entered into an “open skies” Memorandum of Understanding creating a Single Aviation Market for Australasia. As a result, the airlines that operate within Australasia see their home market as encompassing Australia, New Zealand and the trans-Tasman. However, this market is relatively small and neither of the local geographic regions can sustain two FSAs. Despite Air New Zealand recently restructuring its domestic operations in New Zealand as “NZ Express”, Air New Zealand still remains overall a full service airline and NZ Express is still in many respects a full service operation, but with some costs taken out. Any attempt to remove the remaining costs, i.e. to downsize “NZ Express” to a full VBA model, would be totally incompatible with the remainder of Air New Zealand’s international network, rendering that remainder unsustainable.

From a business perspective, the international network is reliant on the domestic network. In that circumstance, and despite its New Zealand cost base being relatively efficient by international standards, Air New Zealand would cease to be the flag carrier promoting and supporting New Zealand’s tourism (6.6% of GDP) and export industries - both crucial to New Zealand’s economy.

Why the transaction?

Qantas and Air New Zealand, absent the Strategic Alliance, face a lengthy war of attrition for supremacy of the New Zealand based networks (i.e. domestic and key international routes from New Zealand). Air New Zealand is of the view that it cannot afford to surrender its domestic network without facing ultimate failure. Its domestic base is the core of its profitability, with most of its international routes feeding traffic to that domestic network.

However, the international routes are inadequately profitable other than as part of the overall network. Absent the Strategic Alliance, the war of attrition would be unavoidable. While Air New Zealand’s domestic New Zealand routes are profitable (assisted by international feed), those of Qantas presently are not (on a standalone basis). In order to reverse that position, Qantas must increase its capacity in domestic New Zealand in order to provide frequency for the higher yield passengers - expansion by Qantas is commercially rational.

The increase in capacity and resulting battle for customers will ultimately result in one of the two FSAs leaving the New Zealand market. There is an insufficient customer base to allow two FSAs to survive. Air New Zealand is not well placed to win that battle nor does it have the financial resources to signal to Qantas that it can successfully engage in a long-term fight for market share.

The Strategic Alliance, while undoubtedly having competitive impacts in domestic New Zealand and on the trans-Tasman, will avoid the need for, and the consequences of, a war of attrition. The Strategic Alliance will enable Air New Zealand to maintain its operations both domestically and internationally. It will place both carriers on a more secure foundation from which to manage external “shocks”, ranging from international conflicts to fuel price increases or foreign exchange fluctuations.

A one-off equity injection, absent a robust strategy that resolves the industry problems for Air New Zealand, does not provide an answer. Nor does an alliance with another airline, which simply expands Air New Zealand’s international network outside of Australasia. The problem lies much closer to home. The Strategic Alliance provides the only solution. The Strategic Alliance avoids a wasteful duplication of resources and achieves material benefits for New Zealand. In contrast, the war of attrition and its consequences deny New Zealand the major benefits that flow from the Strategic Alliance. Those benefits include the retention of a viable New Zealand majority owned and controlled flag carrier.

The Benefits

There is anti-competitive detriment associated with the Strategic Alliance. It is for that very reason that the two airlines now seek authorisation from the Commission. However, the Strategic Alliance will create substantial and demonstrable net benefits overall. The benefits to New Zealand from the Strategic Alliance, assuming VBA entry, exceed the detriment by over NZ$1.4 billion over five years. Even assuming no VBA entry, the net benefits to New Zealand over the same period are in excess of NZ$1.2 billion. Those benefits, tested against the future world without the transaction (and not the world as it now is), flow from:

- increased tourism;

- increased engineering services;

- increased freight capacity;

- cost savings;

- new direct flights; and

- enhanced connectivity.

The benefits and detriments have been modelled and extensively tested in a report prepared by Network Economics Consulting Group Pty Limited, an expert Canberra-based economic consulting group with considerable experience in network industries. The benefits disclosed in that report clearly overwhelm the modelled detriment. On that basis, the Applicants request the Commission to grant authorisation as sought.

ENDS

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