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Virgin ups the pressure on Qantas

Virgin Australia (ASX: VAH) is once again taking the fight for domestic market share to Australia’s dominant airline, Qantas (ASX: QAN).

Virgin has tapped its three majority stakeholders on the shoulder for $350 million to pay down debt and allow the company to better compete with Qantas in both the full fare market and the discount market with recent acquisition TigerAir. The capital raising offers five shares for every 14 owned at 38 cents per share, a 6% discount to the current share price of 40.5 cents.

Virgin’s three largest shareholders — Air New Zealand (ASX: AIZ), Etihad, and Singapore Airlines — will take up their full entitlement and pick up the slack of any other shareholders who fail to take up the entitlement. This will allow them to increase their interest in Virgin from their current levels of 23%, 20% and 20% respectively. As part of the deal, they’ll also get a seat each on the Virgin board, giving them a more power in the future direction of the company.

Analysts were broadly in agreement that the capital raising was necessary for a continued assault on Qantas’s domestic dominance. Virgin’s gearing ratio increased to 76% at June 30 following a full year loss of $98 million, well above Qantas’ 55% gearing.

Virgin’s future has been increasingly clouded as recent efforts to improve market share resulting in a hemorrhaging of cash. This raising represents the third time in a year that Virgin has sought extra capital, with a $100 million unsecured loan provided by the three major shareholders in August, and $750 million in debt raised in the US with some of the fleet provided as security.

Qantas has ruled a line under the 65% of the domestic market it currently controls, matching Virgin with increased capacity and lower fares. In 2012-13, aggressive discounting by Virgin saw the airline burn through $240 million in free cash flow and report a huge loss, while Qantas was able to maintain profitability, albeit at lower margins from the previous years.

Foolish takeaway

Over the years Qantas has overseen the failure of Ansett, Compass and Impulse through its market-leading margins and significant cash hoard. While this has changed somewhat, with margins edging lower as increased capacity and lower fares have not been matched by increased demand, Qantas still holds the lion share of the domestic market and is in a dominant position.

For Virgin’s three biggest shareholders, it’s a case of my enemy’s enemy is my friend. They view supporting Virgin as a way of damaging Qantas’s domestic and international interests by lowering margins and pushing Qantas’s profit margins to uncomfortable levels. The next 12 months will likely see Qantas downgraded by analysts as downside earnings risks are present, however, if Virgin struggles to regain profitability or significantly improve market share it’s difficult to see shareholders continuing to bankroll a loss-making airline forever.

A lower risk bet for your portfolio

Airlines have unperformed the market over the short and long term, and don't pay any dividends. The potential for medium term gains is there, especially for Qantas if it can withstand the sustained pressure from Virgin, however if you're more interested in a stock paying a big, reliable dividend, you should discover The Motley Fool's favourite income idea for 2013-2014 in our brand-new, FREE research report, including a full investment analysis! Simply click here for your FREE copy of "The Motley Fool's Top Dividend Stock for 2013-2014."

Motley Fool contributor Andrew Mudie does not own shares in any of the companies mentioned.

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