Last month Virgin Australia tapped strategic shareholders for $425 million prompting a review of its capital structure to enhance cashflow and profitability. The last time Virgin went to these shareholders was in late 2013 ($90 million) when the aviation industry was facing poor consumer sentiment and high oil prices. Qantas was in an even worse position which resulted in management asking the Federal Government for financial assistance. Since then, Qantas has been able to recover strongly while Virgin’s financial health has been shaky and required an additional $336 million cash injection from the sale of 35% of its Velocity frequent flyer program in 2014. So what has changed? Over the past few years, Virgin has re-positioned itself from a budget airline to a more diversified service. Although this strategy seems logical (positioning Virgin with Qantas), poor implementation has seen costs spiral out of control weighing heavily on cashflow. They have spent millions on upgrading their fleet and the group’s close relationship with unions has resulted in higher salaries and increased fringe benefits. In financial terms, the group’s margins were higher with the low-cost model (Virgin Blue) and similar profits were generated with a third of today’s balance sheet. Even though Virgin is offering a higher quality product (in a stronger strategic position) it is producing the same profits as it did 5 years ago which includes the help of two substantial rounds of funding. With fuel prices remaining low and capacity growth in the local domestic market subdued, Virgin is failing to take advantage of this favourable environment while Qantas is capitalising on the opportunity. These conditions could easily deteriorate and debt investors should be concerned of current vulnerability of the Virgin balance sheet. Going forward, the question will be whether the group should review its product strategy or continue on the path now chosen. Over the last 6 months, Virgin’s operating cashflows fell $65 million to $10 million resulting in a negative free cash flow of $253 million. In comparison, Qantas increased its free cash flow from $194 million to $770 million. At present, Virgin is substantially under-capitalised for the scale of management’s ambitions and this could restrain the group’s progress. Virgin is funded by 25% equity and 75% debt and the focus is now on finding a more appropriate and stable capital structure. Although management have given no indication on how this will pan out, large shareholdings will most likely need to inject further capital if the group wishes to achieve a more balanced funding mix. Another option would be an asset sale such as the spin-off of the group’s remaining stake (65%) in its Velocity frequent flyer program. With free-float down to just 16%, the debate over whether the airline should be privatised by major shareholders is becoming a hot topic. The recent decision from Air New Zealand to review its 26% stake in the group has left the door wide open for a potential takeover by two of the other major shareholders, Etihad Airways and Singapore Airlines. Speculation is growing that the buyer will be Singapore Airlines after it gained approval from the Foreign Investment Review Board to own up to 25.9% of Virgin (current stake sitting at 23.1%). Many believe that Singapore Airlines’ position will be used to counter any offers that come to the table from Chinese carriers. What does this mean for Bond Holders? Virgin’s capital structure consists of 62% secured debt, 14% unsecured debt and 24% equity. Included as part of their unsecured debt is the group’s 8.50% USD bond due to mature in 2019. This security was initially had an issuance of $US300 million in 2014 but was tapped recently for an additional $US100 million and offers a yield-to-maturity of 8.64% p.a. Due to the group’s poor outlook and deterioration in its credit profile, bond holders have experienced a 5% loss since June 2015 with more uncertainty moving forward. Consequently, Virgin now offers a risk premium of 4.21% over comparable Qantas’s 2020 bonds. Some other considerations would be:
- Differing Capital Structures: Qantas is funded by almost double the amount of equity compared to Virgin. As a result, Virgin offers substantially less equity buffer if they were to deteriorate further. This increases the vulnerability to bond holders.
- Free Cash Flow: With the transition from a budget airline into a more diversified service, rising costs have had a damaging effect on Virgin’s free cash flow. While funding has been used to relieve the financial pressure this will be only short term. This increases pressure on the group to make timely interest payments.
- Corporate Activity: The Virgin USD bonds contain an embedded change of control clause. This effectively means that if Virgin were to be taken over by one of its majority shareholders, bond holders would have the right to request redemption at par value. Considering Virgin’s current situation, this is outcome is a growing possibility.
- The Airline Industry: This industry has always been known for its volatility driven by external factors. These factors include (but are not limited to) fuel prices, consumer sentiment, exchange rates, national disasters and government policy. Therefore, as with most debt investments, investors should seek to have a view on the industry as well as the underlying issuer.
- Strategy: Virgin have been unable to capitalise on their transitional strategy. To put this in perspective, every dollar of debt employed by Qantas produces 30 cents of EBITDA. On the other hand, Virgin have only returned 7 cents on each dollar of debt. This reflects the inefficiency of Virgin’s strategy and investors should question if it can improve.
- Secured debt dilution: Virgin’s fresh round of funding has added an additional 17% of secured debt to its already unsustainable capital structure. Although Virgin have begun a strategic review into this issue, the outcome is still uncertain and bond holders could experience substantial losses as the equity buffer is currently low in relative terms.
- Reliance on Shareholders: Virgin’s reliance on major shareholder funding could be a potential issue moving forward as management put their interests ahead of debt holders.