Qantas the Global Financial Crisis

Qantas

The global financial crisis began in 2008 in the United States and quickly spread. Most major world economies -- and many minor ones as well -- have suffered over the past few years from suppressed demand, exacerbated by government cutbacks that have increased unemployment while doing nothing to restore shattered consumer confidence. The impact on the global airline industry was significant. The 2000s were already a difficult decade for many firms in the industry, the result of the September 11th, 2001 terrorist attacks and then the economic crisis (Ghosh, 2010). The Air Transport Association reported that the industry lost $4.7 billion (USD) in 2009 (de Bruyn, 2009). While 2010 saw the industry recover somewhat (Ghosh, 2010), the decade was on the whole a challenge for many carriers.

For its part, Qantas weathered the financial crisis well, posting a profit in 2008/2009 (Qantas 2010 Annual Report). The company continued to be profitable in fiscal 2010, posting a profit before tax of $377 million. The company attributes this success due to its "decisive response" (Ibid). This response included deferring aircraft deliveries, capacity reductions and job cuts in order to lower the airline's cost structure (Govindasamy, 2009). While the Australian economy held up better than most during the crisis (Eslake, 2009), Qantas saw reduced revenue on its lucrative international routes (2010 Qantas Annual Report). This paper will further analyze the financial condition of Qantas, including analysis on the impacts of the global economic crisis.

Capital Structure

The capital structure of an organization refers to the balance of debt and equity capital that is used to finance the firm's operations (Loth, 2006). The optimal capital structure for a firm is based on the nature of the business and the point of the business life cycle in which the company can be categorized. Debt costs less than equity, but leverage is also a source of risk for firms because it represents a demand on free cash flow. When cash flow is low, the demand still exists. Equity financing need not represent any drag on free cash flow, but it costs more. Most firms have a target range for their capital structure that they prefer to work within, but they can deviate from this range during times of financial distress.

At the end of the 2010 fiscal year (June 30, 2010), the capital structure for Qantas was 70% debt and 30% equity. The largest component of the liabilities was interest-bearing liabilities (bonds and debentures) and this accounted for 25.6% of the entire capital structure. These included secured bank loans (53.2%), unsecured bank loans (14.5%), other unsecured loans (20.3%) and lease/hire purchase liabilities (8.6%). In comparison, the pre-economic crisis capital structure at the end of fiscal 2007 (June 30, 2007) was 68.4% debt and 31.5% equity. Not only is this almost identical to the capital structure in 2010, but the company's total size is almost identical between these two time periods as well. In 2007, total assets were $19.6 billion, and in 2010 it was $19.91 billion, only 1.5% larger (2007 Qantas Annual Report).

Economic Crisis

For most parts of the world, the global economic crisis resulting in a shift in capital market conditions. Global equity markets tanked and credit markets dried up. The situation in Australia was somewhat different. Eslake (2009) notes that the ASX suffered sharp declines as there were fears about exports declining, with many of Australia's major customers suffering the impacts of the recession. There was also a lack of business confidence in Australia at the time. However, Qantas was unlikely to be interested in going to the equity markets to raise funds and as a result the book value of its issued capital has only increased $300 million over the course of the crisis (it recorded $514 million in proceeds from the issue of shares in 2009). The company's retained earnings declined $437 million during that time, a decline of 27.4%. This can be attributed to disbursements for plant, property and equipment, which were strong net cash outflows over the course of the crisis. Despite deferring some deliveries, Qantas increased its fleet size by 5.8%, or 14 aircraft, from 2009 to 2010 (2010 Qantas Annual Report).

Eslake (2009) notes that Australian banks remained solvent throughout the crisis. Due to tight financial controls, Australian banks were not heavily invested in the mortgage-backed securities that brought down many banks in many other Western nations. As a result, Australian banks remained profitable throughout the crisis, and they did not need capital injections from governments. Their lending terms were "more demanding" but they continued to lend throughout the course of the crisis. This is evident at Qantas, which was able to borrow throughout the crisis. The company borrowed $1.448 billion in fiscal 2009 and $1.352 billion in fiscal 2010 (2010 Qantas Annual Report).

What this shows is that Qantas did not need to change its strategy with respect to its capital structure as a result of the global economic crisis. Australian banks remained healthy, and Qantas being a well-established firm was able to continue borrowing throughout the crisis. Because Qantas was also able to continue with profitability during the crisis, the firm had no reason to take on extra debt in order to finance its operations. It was able to finance operations through retained earnings, which decreased, and through the issue of stock. The company's stock issue came in 2009, when market conditions were difficult and Australian stocks had experienced strong declines in value. This did not deter Qantas, the company was able to raise fund successfully (Smith, 2009). The issue was conducted during the depths of the crisis in order to "bolster its balance sheet" (Ibid). The company saw a need to maintain its capital structure, and knew that with retained earnings set to decline in lockstep with profits, an equity issue would be needed in order to maintain the 70/30 capital structure that it covets. The company executed the issue with UBS and Macquarie as underwriters, showing that the market for share issues of major firms remained robust even during the depths of the financial crisis. The move was proactive, occurring in February 2009. This was strategic -- Qantas knew that its financial position at the time was strong. It had plenty of cash on its balance sheet - $2.5 billion (Smith, 2009). With a strong financial position, it would be able to raise capital. If it waited and the economic downturn hurt its balance sheet, Qantas may not have been able to raise capital so easily.

Optimal Capital Structure

It is important to understand the nature of Qantas' business in order to determine whether or not it has the optimal capital structure. Clearly, management sees the 70/30 split as optimal since it has maintained that capital structure and did so by actively taking steps to ensure that the economic crisis did not disrupt the structure. The 70/30 split is a structure suited for well-established firms with stable cash flows. These firms benefit from the lower cost of capital that a high degree of leverage has, but they have the free cash flow to meet the obligations represented by debt service.

Qantas fits the description of a company that would benefit from a highly-leveraged capital structure. The airline industry has intense capital requirements that sometimes find their way to the balance sheet -- lease commitments for aircraft, for example -- so the company needs to have a fair amount of debt on the balance sheet. More importantly, Qantas is a well-established company. Some of its revenue streams are protected, in particular the vital international routes. There is competition on routes to Asia, but less competition on routes to Europe and the Americas. This gives Qantas stable cash flow -- even during the economic downturn when revenues on these routes declined they were still profitable. With diversification, Qantas has been able to generate strong free cash flow from its Jetstar subsidiary, and this helped the company tremendously during the economic crisis (no author, 2009).

With stable cash flows, Qantas is able to meet the interest obligations that arise from its debt. The company also has stable access to capital due to its strong relationships within the Australian banking system and the overall stability of that system. While Qantas is willing to turn to equity markets when it feels the need to, it derives a lower cost of capital from its leverage. Operationally, Qantas has shown the flexibility to be able to control its capital structure. While other airlines struggled mightily during the economic downturn (de Bruyn, 2009), Qantas was able to restructure its operations in order to limit the growth of debt. It slowed its rate of expansion, protected key businesses and raised equity capital before that became too costly. In demonstrating that it is able to manage economic stress easily, Qantas further made its case that it is able to handle a high level of debt.