By David Knibb in Brisbane

God_freyVirgin Blue chief executive Brett Godfrey is trying to redefine the airline as the Australian market reaches saturation point.

Australian aviation has not been this stable for five years. The last calm spell was early in 2000 before two low-cost start-ups – Virgin Blue and Impulse – destroyed a cosy duopoly between Ansett and Qantas.

In the air wars that followed, Ansett and Impulse eventually succumbed. Qantas, trying to exploit the vacuum left by their defeat, ramped up as fast as it could. So did Virgin Blue, adding aircraft and then stimulating traffic with new low fares. As the battle turned to low-cost – Australia's fastest-growing sector – Qantas converted Impulse, which it had bought, into JetStar. Now, with the smoke clearing, the Qantas group – Qantas, JetStar and QantasLink – still controls two-thirds of the domestic market. Virgin Blue owns the rest, but the overall size of that market has ballooned from 29 million passengers a year following Ansett's collapse to 39 million today.

"We stimulated the bejesus out of this market," recalls Virgin Blue chief executive Brett Godfrey at his Brisbane office. Australia's annual growth averages 5%, but air traffic has expanded nearly 8% a year since Virgin Blue's August 2000 launch.

Having started with two Boeing Next Generation 737s, this May the airline took delivery of its 50th. Its network has expanded from its initial two cities, to 23 within Australia, New Zealand and three Pacific island nations through wholly owned subsidiary Pacific Blue. In the Melbourne-Sydney corridor, one of the world's busiest routes, it now operates 50 daily flights.

"We have filled Ansett's shoes," says Godfrey. "I'm not sure of any other airline that's taken one-third of its national domestic market in four years." Canada's WestJet reached a comparable share after nine.

But the days of unchecked growth are over. In fact they ended a bit earlier than Virgin Blue expected. Anticipating the launch of low-cost rival JetStar, Virgin Blue accelerated its own growth last year, boosting capacity in 12 months by an aggressive 45%. It was more than the market could absorb and Virgin Blue has been paying the price ever since. Lower loads and yields will lead to an announcement of a year-end profit of around A$135 million ($104 million), down as much as 15% from last year.

Part of the reason is that Virgin's crystal ball was cloudy. As Merrill Lynch analyst Simon Gresham notes: "We are in the early stages of a slowing economy, further compounded by extraordinarily high global fuel costs and the hangover impact of aggressive capacity growth."

Never known for dwelling too long on what is behind him, Godfrey defends the decision to grow. "We took some short-term risks for the long term. To write us off is a bit premature. With fuel at A$77 a barrel, very few airlines will make any money this year, but we will be one of them."

A step too far
Kalgoorlie, a remote gold mining town in Western Australia, illustrates a new reality, however. Looking for new markets, Virgin Blue planned to launch to Kalgoorlie in April. Entry into other remote towns had already worked. But days before the first flight Virgin Blue shelved Kalgoorlie. Citing inadequate bookings, it had hit the outer margin of potential growth.

"We've saturated a lot of the market," Godfrey concedes. "In the next 12 months our capacity growth will be much more abated. We'll only take one or two more aircraft this year. It would be irresponsible – arrogant – of us to suggest that we'll just keep taking market share without regard to profitability."

In contrast, rival JetStar plans considerably more growth; its route map still shows big blank spaces. Yet, if it follows its current pattern, most of JetStar's growth will come from a conscious reallocation of low-cost traffic from parent Qantas – not from Virgin Blue. In similar fashion, Virgin Blue's rapid growth has come at no one's particular expense. It was a mix of former Ansett passengers, some Qantas traffic and a lot of new "guests", as Virgin likes to call them, attracted by low fares. When the pie keeps growing, everyone can enjoy a bigger slice.

But this bloodless growth is about to end. With the domestic market maturing, the only way for Virgin Blue to make more money with less growth is to take traffic away from its rivals, and there is no doubt what Godfrey has in mind: "Qantas is going to come and try to eat our lunch with JetStar; we're going to go eat their dinner with Virgin Blue." More precisely, but in equally pointed terms, Godfrey adds: "I aspire to take a bigger percentage of the corporate and government market from Qantas."

Business travel as a percentage of each airline's total traffic shows the reason for this battle. Less than 10% of JetStar's traffic is business travellers, according to Godfrey. The comparable shares at Virgin Blue and Qantas are 35% and 50%, respectively. "We're somewhere between the two," he notes. Merrill Lynch estimates that 60% of Qantas revenues come from business travel, so "Qantas enjoys a 30% plus average yield premium versus Virgin Blue, which compensates for its higher cost structure".

Virgin Blue wants more of that higher-yield traffic and it has an impressive array of offerings to attract it, including high frequency on business routes, corporate lounges, valet parking, preferential seating and more leg room in the "Blue Zone" of its single-class 737s. It is now working on several more offerings, including a frequent flyer plan that Godfrey calls "one of the last pieces of the puzzle".

He insists Virgin Blue can compete with Qantas for most of the corporate market. "The only people we don't have a right to go after are those business travellers who want two-abreast seating because we're not going to play in that game. Anyway, that's only about 3-4% of the Australian market." The remaining customers are fair game, especially business travellers because "they are less seasonal, higher yield and they travel more frequently", says Godfrey.

The typical dilemma for a low-cost carrier that tries to improve yield is that in the process it also raises costs, so it finds itself trapped between two markets, unable to serve either very well. Virgin Blue's solution is to offer all its service upgrades as options on a user-pay basis. "If you want more, you buy it" is Godfrey's slogan. So people pay an extra A$10 to use a corporate lounge, for example, and the airline treats its lounges as a separate profit centre.

By keeping unit costs low for non-upgraded service, the airline will not, Godfrey insists, "do anything to move my foot, which is firmly planted in the low-cost end of the market".

Virgin Blue is not the first low-cost carrier to offer more services on a user-pays basis, but so far its array is unmatched and the list of possibilities seems endless. "If we can buy your groceries and have them waiting for you there on the tarmac when you get off, we'll do that as well," Godfrey laughs, "as long as we can make some money off it."

Network connections
Another feature distinguishes Virgin Blue even more from the typical low-cost carrier. It started as a point-to-point airline for leisure traffic, but after Ansett's demise it became a network carrier because there was no other to rival Qantas within Australia. With so many flights on the country's busy triangle – Sydney-Melbourne-Brisbane – schedules not only attracted business travellers, but allowed more connecting traffic through those hubs to other domestic or New Zealand points.

Two years ago, in another move to improve connections, it began checking through baggage for Virgin Blue and Pacific Blue passengers connecting anywhere on their combined networks. "I don't know any other low-cost carrier that does this," says Godfrey.

Given his own low-cost carrier roots at Europe's Virgin Express, and Virgin Blue's early growth, it is surprising Godfrey agrees so readily with analysts who claim his airline is becoming something more than a low-cost carrier.

"We have to continue to evolve to remain relevant," he admits. "We're not a low-cost carrier point-to-point any more. We have a great position in which to be relevant to a much bigger market.

"We're actually a hybrid – a network low-cost carrier. We're trying to engineer a user-pays model that differentiates us from low-cost carriers. We've evolved to a point where we're almost leaning to the right side of the spectrum, but with an enviable cost base that allows us to compete right across that spectrum. I honestly believe we're in a class of our own."

Two other domestic market sectors are still largely the domain of Qantas and Godfrey hopes to make inroads into both. One is high-yield air travel by federal employees and the other is the behind- and beyond-gateway feed of overseas passengers. Virgin Blue's share of both sectors is minuscule.

Godfrey is especially annoyed that Virgin Blue carries only 0.43% of all federal government travel. According to an investigative newspaper report in Melbourne's The Age, Qantas last year gained A$140 million from domestic government travel and A$84 million from government travel overseas. By contrast, Virgin Blue earned a paltry A$717,875.

"This is a disgrace," Godfrey complains, pinning much of the blame on the Qantas travel centre in Canberra that books most government air travel. Not surprisingly, he calls it "the fox guarding the hen house".

Publicly he rails against Canberra for not supporting more competition, but his private strategy is to work with individual government departments to induce them to fly Virgin Blue. He can cite statistics on how much various state governments have saved by switching more travel to Virgin Blue.

Foreign passengers on domestic sectors are equally elusive, for different reasons. Those flying in or out on Qantas are naturally inclined to stay on it within Australia. But Virgin Blue's limited interlining, lack of frequent flyer partners and baggage allowance policies turn other foreign passengers away.

Godfrey estimates only 5-8% of domestic passengers are connecting to or from overseas flights and most of those passengers fly economy. The yield from these passengers is therefore lower than from business or government travellers. Still he sees them as an untapped opportunity.

One-way codeshares
"We've had just about every Star Alliance carrier knock on our door," Godfrey says. He would be happy to see more "one-way" codeshares – inbound passengers from foreign carriers who interline with Virgin Blue for domestic sectors. Already the airline transports passengers for Star's United Airlines this way and expects to launch a similar deal soon with Virgin Atlantic part of the Virgin Group that launched but no longer controls Virgin Blue. Virgin Blue is also starting a trial upgrade of its Open Skies computer reservation system to make its flights more accessible to overseas passengers.

"Once we have this improved computer compatibility, we should be able to get a disproportionate share of the international market," Godfrey predicts. "Our target is A$60-75 million more in incremental revenue."

But his willingness to codeshare or interline only one way could make this difficult. Godfrey will not allow Virgin Blue to assume any risks for outbound connections. "If a passenger heading to Wichita misconnects in Melbourne, we have to pay A$5,000 to put them on Qantas." He may be overstating the fare to emphasise his point, but it is still loud and clear: "We want to keep out of that game. For a A$70 prorate we're not going to pay A$5,000."

Business, government and foreign feed traffic are the only ways Virgin Blue can grow faster than the domestic market. But Godfrey sees another potential way to grow – overseas. And he has the opportunity to do it through 40 options that Virgin Blue still holds at Boeing for 737s at post-11 September prices.

"They are more than a third off today's prices," Godfrey gloats. With Boeing's narrowbody production booked through all of next year and into 2007, he sees these options opening up "a whole bunch of opportunities".

"Not that we're going to get into aeroplane leasing, mind you, but it gives us the flexibility to do a number of things. We could farm one out and make some money on it. Another option is to be risk-takers and buy for the future."

Offshore options
Admitting he is a gambler, Godfrey seems to lean towards the latter. For some time, Pacific Blue has been threatening to expand within New Zealand. He mentions this in passing, but seems more excited about other offshore options. The one with the most risk and potential has fizzled. In early May Virgin Blue called off talks with Air Macau on a joint venture from there into China. Among other things, the two sides failed to agree on how to allocate routes. Godfrey knew all along that Macau would be, in his words, "speculative", but he is still disappointed

The consolation prize is a much smaller venture in Western Samoa, where Pacific Blue is the preferred tenderer to joint venture with Polynesian Airlines. Pacific Blue will probably start with only one jet. But Godfrey sees it as a template for other island carriers. "The problem for a lot of Pacific island airlines", he says "is that they have good revenue streams but the cost base because of operating only one airplane is horrendous. Polynesian's revenue stream and Pacific Blue's cost base will produce a phenomenal result."

Yet, even if he can convince other Pacific island carriers to follow Samoa's lead, these are not markets that will absorb many aircraft. Virgin Blue still faces the dilemma of how to exploit the cheap 737 options it holds. Given Godfrey's propensity to gamble and Australia's maturing market, he is almost certain to look for other offshore ventures.

Following the recent takeover of Virgin Blue by Patrick Corporation, the Australian transport conglomerate that was already its largest shareholder, questions inevitably arise about the airline's abiding appetite for such adventures. Godfrey foresees no problem: "It comes back to my whole reason to stick around. I've had a lot of discussions with our chairman [Chris Corrigan, Patrick Corporation's president] over the past couple of months. I wanted to make sure that we had a shared vision.

"Shareholders run the agenda; they don't run the airline. That's my responsibility. I am principled and I have a way that I want the airline run, but to date my chairman and my major shareholder have the same view. We've agreed publicly that we share that view.

"This business still has a way to go. But there is no suggestion that Patrick has a different agenda. Our shared agenda is to make Virgin Blue more profitable, more sustainable, more relevant to the market." Don't count on that market staying stable for very long.

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