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Disconnecting flights

By Frances Martin

Sunday 1st June 2003

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"No retreat, no concessions." Those were Ralph Norris's staunch words back in April when he vowed to fight the Commerce Commission's draft decision to block Air New Zealand's proposed "strategic alliance" with Qantas. But if sanity prevails, "no retreat, no concessions" will be the message the commission sends back to the airline's managing director when it issues its final decision on the anticompetitive alliance in September.

Back then, Norris insisted the airlines wouldn't have to make big changes to the nature of the proposed alliance - which would substantially reduce competition between them - to get it past the commission and fellow competition watchdog the Australian Competition and Consumer Commission. Instead, he suggested the partners would stand by their original arguments for the alliance and knock over the commission's opposition. But given how strongly the New Zealand regulator rejected the proposal - the words "laughed out of court" spring to mind - it's hard to see how that plan could work. Indeed, by May the alliance was offering what it claimed were "substantial concessions" - aimed primarily at making it easier for new entrants like Virgin Blue to come into the New Zealand and transtasman market - to overcome the competition watchdogs' concerns.

Air NZ rests its argument for the proposed alliance on three key points. First, it admits the deal would reduce competition. (Under the arrangement, Qantas would take a 22.5% stake in Air NZ and the two would coordinate their pricing and schedules.) But it claims that if the alliance doesn't go ahead the two airlines will descend into a cut throat price war that will crush the financially vulnerable Air NZ.

The second point is that it needs an injection of cash in future to buy new aircraft, and that its current major shareholder - the New Zealand government, with 78% - isn't likely to stump up with the dough. Further, claims Air New Zealand, no other airline would want to buy in. Qantas is the only potential cornerstone shareholder on the horizon.

And the third point - the coup de grâce the airline hoped would see off all opposition to the alliance - is the claimed efficiencies that would be derived from blending the two operations. These, it asserts, would bring annual economic benefits of $226 million to the New Zealand economy.

How seriously can we take this triad of assertions? Let's start with the threatened "war of attrition". According to aviation industry players such as Virgin Blue and transport investor Infratil, this argument just isn't credible. For starters, Virgin Blue believes Qantas would lose millions of dollars fighting such a war. It would make sense if the victorious airline was going to end up with a monopoly on the transtasman and New Zealand domestic markets, enabling it to charge above-market prices and recoup the losses. But, by the two airlines' own accounts, that wouldn't happen. In fact, in their submissions justifying the proposed alliance, Air NZ and Qantas made a big deal of the potential competition they faced from Virgin Blue eventually entering those markets.

Infratil argues that Qantas shareholders would never accept the losses that would be incurred in a price war in New Zealand, especially as the airline is already under pressure from Virgin Blue back home. It also points out that the threatened war of attrition would very probably break competition laws, meaning Qantas could land itself in court if it did try to crush Air NZ so blatantly.

In reality, the logic behind the war of attrition argument is distorted. If the alliance is blocked, Qantas will allegedly crush Air NZ. But if it does go ahead, won't Air NZ be crushed anyway, at least as far as consumers are concerned? Air NZ might remain an independent company under the proposal, but the two airlines plan to coordinate pricing, schedules and capacity on all flights they operate within, to and from New Zealand, so that independence is unlikely to deliver many benefits to consumers. Certainly it's unlikely Air NZ will cause Qantas management sleepless nights by offering more competitive prices.

Also, if this doomsday scenario were credible, there'd be no point in Qantas and Air NZ modifying their alliance to encourage competition from the likes of Virgin Blue. If Qantas really has the power to crush an entrenched player like Air NZ, a newcomer like Virgin Blue would stand little chance in the long run even if, as promised, the alliance refrained from increasing capacity and shared the best airport facilities and take-off slots
History suggests that even if a price war did break out between Air NZ and Qantas, the Aussie carrier might not be the winner. Air NZ has a record of seeing off rivals in its home market - witness Ansett NZ and the ill-fated transtasman carrier Kiwi International. It's well equipped to defend itself against competition because of its brand strength, flag carrier loyalty, home ground advantage and comprehensive domestic service. The success of the Kiwi carrier's low cost "Express" service suggests Qantas has more to fear than Air NZ from the arrival of another budget airline like Virgin Blue into the New Zealand market. Air NZ has lower costs per seat-kilometre than Qantas, and its cut-price subsidiary Freedom is reputed to have a lower cost base than Virgin Blue.

The war of attrition theory certainly doesn't hold water with several experienced aviators. The commission asked six former Air NZ directors and senior managers if they believed it. Only two did.

But just how financially vulnerable is the Kiwi airline? Is its claim that it needs Qantas as a stakeholder a credible one? Sure, it did nearly go bust a while back and, yes, times are tough in the aviation industry. But even the commission thought Air NZ's money woes were being dramatised to support the alliance argument. The national carrier has undergone a dramatic financial improvement in the last year and expects to post a $200 million net profit in the June year - one of the hardest periods aviators have experienced. This quick recovery supports arguments that the airline's recent troubles were almost entirely a result of it buying into Ansett (Australia), and that its core business is profitable.

Financial modelling done by investment firm Cameron and Co for Air NZ suggests increasing profitability - whether the alliance goes ahead or not - for at least the next four years.

In their pleadings to the commission, Air NZ and Qantas made much of the harsh conditions airlines face, and both airlines have since reduced flights as a result of the Sars epidemic. But as the commission pointed out, Air NZ is probably less vulnerable than most international airlines, including Qantas, because of the strength of its domestic operations and New Zealand's reputation as a relatively safe destination.

Air NZ has been through tough times before and survived, says former chief executive Norman Geary. The airline suffered a massive loss in 1983, then went on to experience strong growth in passenger numbers internationally and domestically throughout the 80s - even though in the early part of that decade the aviation industry was in considerable difficulty, he says. Air NZ's international operations might not be profitable now, but they have been in the past and who's to say they won't be again?

But what about the argument that Air NZ needs a capital injection to pay for new planes and Qantas is the only likely source? Air NZ has said it needs $1.4 billion to fund new investment in aircraft and infrastructure over the next five years, and even the commission accepted that its majority shareholder, the government, mightn't be willing to front up with that much money. But there's no guarantee Qantas will, either. And the Aussie airline isn't Air NZ's only hope for raising money, says Infratil. Improving profitability means Air NZ could eventually go to the domestic capital markets to raise the cash. In fact, broker Andrew McDoull says there have already been a few occasions this year when Air NZ's share price has been strong enough to support a capital raising through a rights issue (where shareholders get to buy shares at a slight discount to the market price). And when conditions improve in the aviation industry, there is potential for the likes of former suitor Singapore Airlines - which lobbied hard in 2001 to be allowed to up its stake in Air NZ - to reappear as a major shareholder.

Either way, it seems unlikely that having saved Air NZ once, the government would let it collapse a few years down the track because of a lack of money for new planes.

And the multimillion-dollar gains the alliance would supposedly bring to the New Zealand economy? Air NZ's and Qantas's bean counters worked out there would be benefits of $226 million a year. But when the commission did the sums, it worked out the loss of competition would damage the economy to the tune of $155.7 million to $401.8 million. While these numbers might be affected by the concessions offered by the airlines in May, in reality the changes are little more than window dressing and don't alter the fact that the proposed alliance would virtually do away with competition in the New Zealand and transtasman markets. Sure, the airlines have promised to go easy on any new competitor for up to three years but what happens after that?

The airlines have also promised not to raise fares on some transtasman flights, but there are no promises to drop them either. That's more likely to happen if the partners were competitors rather than allies.

Norris has accused the commission of not understanding commercial realities, and says it has underestimated the incentives that exist for Qantas to muscle in on Air NZ's core market.

But the commission's first take on the proposed alliance shows it has a very good grasp of commercial reality - namely, that the only people who'd benefit from this proposed anticompetitive alliance would be shareholders in the two airlines.

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