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Virgin’s $110 million problem

Virgin Australia (ASX: VAH) has announced it will post an annual loss of up to $110 million this year. The company provided a range of causes, including a weak economy, the carbon tax, price competition, and a new booking system. Even uncertainty around the upcoming election got a brief mention.

Virgin’s full year after-tax loss is now expected to be between $95 million and $110 million, compared with a $23 million profit for the previous year.

Super-investor and all round wise man Warren Buffett has often expressed his distaste for airlines as investments, saying, “If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright down. He would have saved his progeny money”.

Virgin has estimated that the carbon tax has cost the company between $45 and $50 million this year. Virgin’s CEO John Borghetti highlighted the carbon tax as a major contributor to the firm’s poor results and called for its removal “If it continues, it will obviously impact our results if the market remains soft”. Mr. Borghetti also noted that they have seen this problem coming “We have said all along, right from the beginning, that this carbon tax is not recoverable in a weak economic environment. It is purely a cost on the business”.

Virgin Australia is hardly alone in its struggle. There are numerous structural challenges inherent to the business model that all airlines face. As Buffett puts it, “You’ve got huge fixed costs, you’ve got strong labor unions, and you’ve got commodity pricing. That is not a great recipe for success.”

Regional Express (ASX: REX) is a regional carrier that has a monopoly position on many of its routes. But even without direct competition in much of its network the company has still struggled to pass on the costs incurred due to the carbon tax. In February, Regional Express Chairman Rex He announced that profits were expected to fall by 35-40%. At the time Mr. He painted a bleak picture of the industry’s future: “Many regional carriers are now struggling for survival. If the government does not reverse tack very soon, we will see irreversible damage being inflicted by the destructive policies that they have adopted. ”

In yesterday’s announcement, Virgin also touched on its long-running battle with Qantas Airways (ASX: QAN). For over 18 months the two have been battling it out in the domestic market resulting in sustained margin pressure. This pricing pressure has meant that airlines have not been able to pass the cost of the carbon tax on to customers. Despite the challenging environment, Mr. Borghetti did note that the recent months had shown some improvement: “We are seeing some green shoots there, or sunshine for the month of July.”

The company also announced that it would be following the lead of Qantas and raising fares across its network, with domestic flights to increase by 3%. Virgin will also be increasing its fuel surcharge for international flights to counteract rising fuel prices. It is very early days, but if the two companies can relax their intense price battle, then both could stand to gain.

Foolish takeaway

A large part of Virgin’s losses this year can be attributed to the burden of the carbon tax. But it is also a reflection of the structural challenges that the industry faces. Intense price-based competition coupled with high fixed costs are never a recipe for success. With Virgin now following Qantas’ lead and raising fares the two companies may be starting to realise that there will be no winners from a perpetual price war.

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Motley Fool contributor Matt Joass owns shares in Regional Express. You can follow him on Twitter @SoloThink.

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