(This article refers to choices and strategies Virgin Australia was willing to uphold in regards to “Game-Theory” induced feedback of Air Asia Indonesia’s announcement and operational commencement of the notorious high-volume leisure route of MEL-DPS. This archive piece can also be contextualized to VA’s SYD-DPS route with XT’s (to be interim QZ upon required consolidation approval), and Virgin Australia’s overall strategy to South East Asia in regards to competition, operational constraints, and overall profitability. Currently, Virgin Australia proposed to marginally grow the route by capacity, and marginally reduce or keep hold on costs, with operational transfer to its LCC arm Tigerair Australia. TT is opting to operate the same aircraft in a 180-seater single class 737-800 (possibly pseudo-wet-leased), with TT cabin crew, and possible codeshare transfer by DL. GA is yet to announce their move on the already weak codeshare-programs with VA, and proposed in-house expansion of their LCC subsidiary Citilink (QG))
With the contextual inputs of financial performance of Virgin Australia Holdings, its operational statistics, capital management, asset utilization, returns and weighted costs of capital, margins, debt and equity standings and business plan, along with macroeconomic GDP growth, Virgin Australia’s logistical operations between low yield, high competition, unprofitable and low seat-factor segments of Melbourne Tullamarine and Denpasar Ngurah Rai, must be reviewed in order for VA Holdings to retain its motif of “re-positioning on a strengthened market to drive future earnings growth” (VA2013 Annual General Meeting, 2014). Re-positioning, as seen by Virgin Australia’s “Game Change” program, requires stronger pricing powers, yields, lower cost base and unit cost, inelastic demand growth and revenue (Aspire Aviation, 2014).
MEL-DPS is a 4376km direct segment (Gcmap.com, 2014), with 6h 20mins flight time, 2013 demand of 377676 passengers both ways (and assumed to grow at GDP rate), elasticity of -1.5, and currently holds 3 operators of Jetstar (with 9 788), Garuda Indonesia (with 7 A333) and Virgin Australia (with 10 738) weekly services (daily VA49/52 and 3 weekly VA51/48 on MEL-DPS segment on 737-800 aircraft in 168/8 configuration of economy business class mix). Information on ASKs, passenger growth, seat factors, market share, revenue, RPK and yield is portrayed by excel-depiction (Gcmap.com 2014)&(BITRE.com)&(Skyscanner.com + Stage length/average-fare simulation)
Context: Porter’s 5 Forces & Game theory
Accurate representation of the proximate, competitive and low-yielding segment operations can be identified by E.Porter’s 5 forces of industry competition (Business-fds.com, 2014) & (IATA Porter’s 5, 2014). The bargaining power of suppliers, demand and competition drives lower yields, revenues and margins in operations. This is specifically seen cost power of producers, services and labour, substitutes of government-financed substitutes, capacity/spillage inducement, lower pricing power, margin and revenues from competition entities through aviation-value-chain. Also, Game theory’s prisoner dilemma suggests activities and responses of competition in inducing profits/losses
And with the simulation of new entrants such as Air Asia X flooding the MEL-DPS market with hub capabilities, margin/cost minimization and subsidiary economies of scale, the impact on Virgin Australia would include less revenue customers, lower yields/revenues and high induced spillage.
OPTION 1: Do nothing (VA 10 x 738)
This option encapsulates the resumption of daily VA49/52 and 3 weekly VA51/48 on MEL-DPS segment on 737-800 aircraft in 168/8 configuration of economy business class mix. With retainment of total ASKs and reduced ASK market share, VA in this scenario will take 0-capital-sunk decision of ASK-service, supplier-services, market-capitalization, bargaining power, economies of scale, asset distribution, differentiation, supplier, cost and stakes retainment on MEL-DPS segment. With route elasticity held at -1.5, limited aircraft capability and cost retainment, pricing power for RPK growth is limited, hence squeezing margins (EBIT/costs) and profitability of services. Also given compact configuration and limited services on aircraft (tailored for Australian domestic services), market differentiation capability is also limited, reducing portfolio-induced prospect of premium-driven diversification and premium-segmented capabilities. This impacts embedded values of services due to reduced NPV of operational profitability, along with retained asset depreciation for service requirements and diminishing marginal utility (including infrastructure at destination port and aircraft “mid-life” aging). Operations also impacts unlevered net-incomes thanks to constant increase of variable costs (fuel, manpower, services, selling, admin costs and overheads), retained/grown risks thanks to new entrant, and working capital/budget management is retained to variable costs of operations. Slots, schedule, traffic rights, opportunity, ASK and asset utilizations costs are also kept constant to current operations. Costs of revenue passenger kilometres are impacted by spillage of market share to other carriers (especially to Air Asia X with hub capability and cheap operating costs) and break-even load factors constantly increase. This results in poor management capability within pro-cyclical purges in the air-transport-value chain (Profitability and the Air Transport Value Chain, 2014). Consumer demands within the elastic capacity-purge segment of MEL-DPS will weaken VA’s position in the market by customers. While frequency retained is high, timings held and capacity retained on smaller 737-800, causational pricing and yield power, fare-annuity power, risk capability, total load factors and forecasted cash flow will drop, impacting ROIC/WACC for equity holders and corporate valuation.
OPTION 2: Increase capacity (VA 10 x A332)
This option consists of increasing aircraft size for daily VA49/52 and 3 weekly VA51/48 on MEL-DPS segment, to A330-200 aircraft with 255/25 economy business mix. Thus sums to increase in ASKs, revenues and market share on the market segment. With this scenario, VA will undertake a capital-rich venture of altering operations from 738 equipment to A332, inducing supplier-services expediture, greater economies of scale and traffic density, altered asset ditribution/concentration, product-differentiation capability, greater comfort for passengers, overall unit cost reduction and advantage, corporate-value addition, greater firm presence/volumes at DPS and incentives. With firm-capacity driven ASK growth catalyzing demand/elasticity alterations resulting in lower reservation prices and elasticity<-1.5, along with greater capital -induced fixed, varibale and overhead costs obtained from leasing and/or opportunity costs on operating other more-profitable services, VA would need to undertake game-theory induced requirements of further narrowing margins and yields for volumes and induced RPKs and seat factor. While having greater opportunity to compete in the high-yield business market, lack of hub operability at DPS, limited Australain economies of scale and diversified government aided capital-structure of sole premium competitor of Garuda will further constrict VA’s price-power capability on all market fronts, reducing portfolio-induced prospect of premium-driven diversification and premium-segmented capabilities. Operations also impacts unlevered net-incomes thanks to high sunk costs, high opportunity costs, increase of variable costs (fuel, manpower, services, selling, admin costs and overheads), growth of revenue and profitability risks and working capital/budget management is altered to higher variable costs of operations. Slots, schedule, traffic rights, opportunity, and asset utilizations costs are also increased constant to current operations, while ASK is reduced. Spillage is minimized and break-even load factors altered thanks to product flexibility and cargo capability. Causational pricing and yield power, fare-annuity power will drop, while risk-management capability, total load factors and forecasted cash flow will increase, impacting ROIC/WACC for equity holders and corporate valuation upon profitability of route.
OPTION 3: Halt operations
This results in the axing of services on the MEL-DPS segment, hence allowing complete slippage of capacity while minimizing operational running costs, working capital, and opportunity revenues. With ASK and market share being 0, VA will undertake miniscule capital investment for operational re-structure, tertiary/management sunk costs and potential capital requirement for lease-returns/backs. Market capitalization is eliminated, significantly reduce overall economies of scale power, brand identity, costs and capital requirements, cost advantage capability, corporate growth, revenues and market share, operational anti-dilution, opportunity costs (due to over-capacity of segment), customer volumes, product quality for O/D customers and incentives. In turn, sales from slots may provide returns to VA. Route elasticity and customer reservation prices will increase upon reduced supply (despite fierce competition and capacity). Game-theory suggests higher yields and revenues from VA-spilled customers for other operators, especially business-customer-facilitative Garuda Indonesia thanks to hub, cost-base and product capability. Variable costs are over-turned to 0, while fixed costs such as capital-intensive assets and infrastructure costs must facilitate greater capital/expenditure/budget management and utilization post-pull-out from the MEL-DPS segment. Opportunity costs of services predominantly seen in performance of segments where 738 aircraft will be re-allocated/re-distributed to, including domestic, trans-Tasman and other Asian/Pacific destinations with high yields, operational flexibility, high revenues/seat-factors and plenty of RPKS. This consolidation process provides greater risk share capability, portfolio-risk reduction, pro-cyclical binge-purge management, elimination and offset of incompatible cargo-carrying capability/service, while alternating cash-flow forecasts for revenues in diversified and higher-yielding markets.
Option 4: Re-scheduled service consolidation
This decision encapsulates the requirement of reducing capacity on the MEL-DPS segment to retained optimal volumes after undertaken sensitivity analysis and cases encapsulating service resumption, capacity increase and halt operations. This decision involves the consolidation of ASK and market share to DPS appropriately, where VA will undertake capital-sunk-decision with immediate returns, of:
- cut services from 10 weekly to daily 737-800
- Services axed will be the service that run similar timings to Garuda’s DPS-MEL services.
- The proposition involves axing VA 49 and VA 52 (which runs daily, reciprocal to timings of Garuda services) (-7), hence returns in slots.
- The proposition then makes 3 weekly VA 51 and VA 48 run daily (+4), where capital investment is required
- Potentially sharing capacity and inducing flexibility with Garuda’s daily service in codeshare/interline opportunity (increase business and economy weekly capacity if demand is there, while axe services in response to week demands)
This scenario in Poter’s 5 force context is amended through VA’s consolidation of ASK, supplier-services, market-capitalization, economies of scale power, asset distribution, fixation to lower asset requirements (1 fixed 738 operations on service rather than 2), higher utilization, differentiation, yield, pricing and revenue power, supplier costs and risk/stakes on the MEL-DPS segment. With elasticity of -1.5, and limitations conceived from aircraft capabilities/performance, improvement of portfolio-induced prospect of premium-driven diversification (from commercial growth and economic activity of both Melbourne and Denpasar/Bali precincts) and market segmentation are thanks to economies of traffic density and firm size, cost reduction, pricing power, RPK reduction with higher margins and yields, loyalty incentives, price insensitivity, frequency and schedule convenience and high service provisions. This impacts embedded values, WACC and ROIC of the carrier, with greater margins and NPV of operational profitability/unlevered-net-incomes and forecasted earnings, diversification, fare-annuity power, asset utilization and capital/risk management. With reduction of variable costs (fuel, manpower, services, selling, admin costs and overheads) and retained/reduced risks thanks to new entrant, it’s evident that working capital/budget management is improved variable costs of operations. Slots, schedule, traffic rights, opportunity, ASK and asset utilizations costs are also optimized to consolidated operations.
Hence it is evident, that a sustained reaction from the VA board room is required to the stimulus of capacity addition of new lower cost-base carriers entering the MEL-DPS market segment. The reaction requires (as proven from logistical scenario/sensitivity analysis):
- recognition from inputs, and contextualization from Porter’s 5 forces, and Game Theory’s prisoner dilemma
- market diversification/capitalization, capacity reduction/consolidation, yield/revenue/profit retainment capability and service/spillage retainment
- Market capitalization and competition entrance: route elasticity, pricing power, competitive market analysis, diversification requirement, resultant embedded values (npv of profitability and asset value), market segmentation/ GDP indicator/time value of money analysis.
- Variable costs/working capital management, budget, slots, traffic rights (freedoms of the air), interline agreements, asset utilization, scheduling, indirect costs, opportunity costs, pro-cyclical risks management. CASK, CRPK, break-even load factor analysis.
- Consumer demand, elasticity utilization, frequency, capacity, timings, pricing/yield power (growing annuities), risk share capability, pricing on capital, spillage, ASK, RPK, FS, yield, total load factor (including freight, mention VA not interested; offset) cash flow forecasts.
2013 Annual General Meeting, (2014). Virgin Australia Holdings. [online] Available at: http://www.virginaustralia.com/cs/groups/internetcontent/@wc/documents/webcontent/~edisp/agm_presentation_2013.pdf.
Aspire Aviation, (2014). Virgin Australia holds invaluable lessons for Qantas. [online] Available at: http://www.aspireaviation.com/2014/03/10/virgin-australia-lessons-for-qantas/ [Accessed 24 Oct. 2014].
Gcmap.com, (2014). Great Circle Mapper. [online] Available at: http://www.gcmap.com/mapui?P=mel-dps&MS=wls&DU=km [Accessed 24 Oct. 2014].
Business-fundas.com, (2014). [online] Available at: http://business-fundas.com/wp-content/uploads/2011/03/Porter-5-forces-model.jpg [Accessed 24 Oct. 2014].
IATA Porter’s 5, (2014). IATA. [online] Available at: http://www.iata.org/whatwedo/Documents/economics/Aviation-Advocacy-Economics-2013-December.pdf [Accessed 24 Oct. 2014].
BITRE International Aviation Activity 2013, (2014). BITRE Aviation. [online] Available at: https://www.bitre.gov.au/publications/ongoing/files/International_airline_activity_FY2014.pdf [Accessed 24 Oct. 2014].
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