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The Sydney Morning Herald

Virgin wants regional growth for public listing

Author: Brian Robins
Date: 16/03/2002
Words: 1282
          Publication: Sydney Morning Herald
Section: Business
Page: 45
Different commercial imperatives are driving the airline's new partner. Brian Robins reports.

Virgin Blue is poised to enter the regional aviation sector as it revs up its growth options ahead of a public listing in the middle of next year.

That comes as it is also to start code-sharing talks with Air New Zealand, again to lift passenger numbers on its domestic services.

The no-frills air carrier has targeted snaring 30 per cent of the domestic aviation market by the end of 2003, which will involve ramping up the number of aircraft on major trunk routes and also the variety of aircraft, as it looks to enter the international sector needing larger aircraft and the regional aircraft sector, demanding smaller aircraft.

Both of these moves carry extreme risks to the Virgin Blue business model, which is built around a single class of aircraft the Boeing 737, which is the aircraft of choice for budget air carriers worldwide. Any domestic airport that can accommodate this class of aircraft is a candidate for a Virgin Blue service.

The key centres that can handle this class of aircraft and that it does not service are Hobart and Alice Springs. Mount Isa, which it entered for a time after Ansett's collapse, is too small a market.

Virgin Blue plans to have 23 aircraft in the air by year end, up from 16 now, rising to 30 next year basically one aircraft for each percentage point of the market.

Last November, Patrick Corp agreed to pump $300 million into Virgin Blue for a big slice of equity and to help fund the purchase of Ansett assets. This week, it signed off on that deal, taking half of Virgin Blue for $260 million, with part of that to bolster the aviation company's balance sheet ahead of the purchase of Ansett assets its terminals and maintenance facilities.

Even though the exact amount paid for the equity hasn't been clarified, it has put a multi-million value on Virgin Blue's chief executive, Brett Godfrey, and some staff, who are believed to have options over as much as an estimated 8 per cent of the capital, which are likely to be triggered once the company goes public.

Patrick's buy into Virgin Blue, plus last month's co-purchase of NRC/FreightCorp from the Federal Government for $1.1 billion, has boosted Patrick's sharemarket value by well over 50 per cent, to over $3 billion.

In two steep share price rallies first last month's deal into railfreight and this week's Virgin Blue purchase investors have priced in the next three years of profit growth in one fell swoop.

Patrick owns its profitable waterfront business outright, but has only a half interest in the railfreight operations and Virgin Blue, which cost $815 million between them half of $1.11 billion for the railway businesses and $260 million for Virgin Blue. In a matter of months Patrick has spent an amount equal to its entire net worth when it ruled off its books last October.

But the only return from this huge investment will be dividend income, which is likely to be modest at best. NRC/FreightCorp is expected to take time to hit its straps and while Virgin Blue will be throwing off cash, it, too, will need a large chunk of that to strengthen its balance sheet.

For Chris Corrigan, perhaps the most realistic way to generate a return on his play in Virgin Blue over the next few years will be to sell down its stake, putting a more opportunistic spin on the move into aviation. If, for example, Patrick raised its Virgin Blue stake to a controlling 51 per cent, this would dampen the price Virgin Blue would fetch when it goes public, and perhaps stretch his balance sheet.

Patrick will include in its own accounts its share of the profits or losses of these two big associates, but they will simply inflate the bottom line without actually strengthening its balance sheet. It will not be able to access the cash generated by either business, for example unless it takes control.

Corrigan is targeting a healthy 16 per cent return on funds from the railfreight business within three to four years, as restructuring benefits come through. As for Virgin Blue, when it rules off its accounts at the end of the month, it has foreshadowed a pre-tax profit of $33 million after reporting an $8.2 million profit in the September half.

In other words, from little better than break-even, Ansett's demise flowed straight through to the Virgin Blue bottom line.

By 2005, analysts reckon Virgin Blue could be generating a pretax profit of $150-$160 million, if it delivers on its growth ambitions.

Virgin Blue's load factor surged from the ``high 70s ...well into the 80s" following Ansett's failure. In other words, its flights are now all but full, with only a little over 10 per cent of the seats empty.

In the year to March 2001, Virgin Blue posted a pre-tax profit of just $0.5 million on revenue of $75 million, before bringing $10 million of start-up costs to account. Within three years, Virgin Blue will be ``ex-growth" and as a result, should trade at a discount to the broader sharemarket, at 12 to 14 times earnings compared with the average of around 16 times, according to some analysts.

Discount airline operators have seen massive growth over the past few years in Europe and the US, typically taking advantage of lower-cost, second tier airports an option that is not available in Australia.

And, profits can be patchy.

Sir Richard Branson was one of the first into the sector, paying 1.8 million Belgian francs ($73.5 million in dollars of the day) in 1996 to take control of Euro Belgian Airlines, changing its name to Virgin Express. Based in Brussels, Virgin Express is valued in the sharemarket at only around $50 million.

Stiff competition from mainstream airlines such as Belgium's Sabena, which has since collapsed, pushed Virgin Express into the red, and it is yet to fully recover. Virgin Blue chief executive Brett Godfrey was the chief financial officer at Virgin Express for a year before spending another year planning the launch of Virgin Blue.

As Virgin Express has suffered, rivals such as Ireland's Ryannair, Go, easyJet and Buzz have all seemingly prospered. In January alone, Ryannair placed orders for up to 150 Boeing 737 aircraft, the aircraft of choice for discount shuttle operators such as Virgin Blue.

Two-thirds of its seats are sold on-line, which includes on-line sales via travel agents. The high on-line portion of its sales, which maximises revenues retained and limits the amount split with resellers (that is, travel agents) ranks among the highest in the industry globally, surpassed perhaps only by Easy Jet of the UK.

For the existing east state regionals primarily Hazelton and Kendell if Virgin Blue were to enter their sector, this would slam their potential valuation at a time when negotiations are under way for their sale.

To win a third of the domestic market, Virgin Blue needs to bulk up its feeder services. Hence the decision to look at entering this sector directly. Analysts reckon Qantas generates 5 per cent of its domestic traffic from its regional services, with another 15 per cent coming from international operations.

Virgin Blue is looking to cherry pick on both these sectors, and both could account for as much as a third of its domestic traffic as its operations mature.

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