Executive Summary
The current public debate over whether the Australian Government should give some form of assistance to Qantas is often uninformed and lacking in analytical structure. As is often the case with such debates over taxpayer assistance, different sides present counter arguments without ever mentioning the long term consequences on the wider economy of such assistance. This paper aims to inform the debate and provide thorough analysis, using a framework that is also applicable to other assistance requests. The framework asks two simple guiding questions of the Qantas situation; “Is the proposed assistance fair?” and “Is the proposed assistance necessary?” Answering these questions assists in judging whether intervention or assistance is justified and how substantial a response is appropriate.
On the questions of fairness, a change of the Qantas Sale Act would be a fair response. Qantas is currently at a disadvantage to Virgin in that it is restricted from having the same level of international share ownership as Virgin. In the interest of fairness, the current Australian government should therefore pursue legislative change to correct this imbalance on the basis that Qantas is no longer a special case and is entitled to a level playing field. In the opinion of the author, the level of public affinity for Qantas has declined since it was privatised with competitors proving that the same or better service can be offered at a lower price. Most of the remaining loyalty to Qantas is more likely due to the frequent flyer program rather than the historical perception of “national carrier” status.
On the question of necessity, no taxpayer assistance is currently required or justified. Qantas is not at risk of imminent failure and has sufficient cash reserves and assets it can sell to allow more than sufficient time to undertake necessary restructuring. Qantas is also primarily responsible for its current situation due to its 65% minimum market share target, its high operating costs and its insistence on running unprofitable business units. Qantas should be encouraged to solve these temporary problems on its own, without taxpayer assistance.
The paper encourages permanent solutions to be matched to permanent problems. Businesses and individuals can be expected to make preparations in advance for dealing with temporary problems, including using insurance and setting aside reserves. Governments are encouraged to remember that any taxpayer assistance is likely to “back a loser” with the costs of such assistance coming by “taxing winners”. In the long term, such behaviour is counter-productive with “winners” moving overseas to avoid the burden of paying for the recklessness of others. Based on historical experience of the airline industry, any taxpayer assistance to it is highly likely to be “backing a loser”.
After answering whether assistance to Qantas is fair and necessary, the paper then moves to an analysis of the cost of providing a government guarantee of Qantas debt. Two methodologies are needed for this, firstly the cost if Qantas was to become insolvent and secondly the annual cost/benefit of providing such a guarantee. Market data and the experience with the Ansett insolvency are used to provide estimated cost ranges.
If a government guarantee was to be provided, it should be restricted to financier obligations (loans and capital markets finance) which as at 30 June 2013 amounted to $6.48 billion. Qantas should pay an annual charge of approximately $125.7 million reflecting the market cost of such a guarantee. Any government that considers providing such a guarantee should be aware that a loss of $2.39 billion to $3.047 billion is estimated if Qantas was to become insolvent based on historical default averages and the Ansett experience.
Introduction and Framework
Before examining the different options available to the Australian Government for assisting Qantas, it is right to ask whether taxpayer assistance should be provided at all. In doing so, this paper attempts to take a dispassionate view of taxpayer assistance to companies and industries. To provide a balanced view the focus must include discussion of not just Qantas and the airline industry but also must include the impact on individual taxpayers, other companies and other industries that bear the cost of any assistance. If a dispassionate view is to be provided, then a framework must be developed to judge when assistance is justified.
Most analysis of taxpayer assistance fails to begin with an overall framework, and is instead simply a list of reasons (or in the minds of those who oppose the assistance a list of excuses) why that group merits assistance. This does not allow situations to be analysed consistently, with the lobbying skills of the proponents more important than the facts and analysis. If the right framework is adopted this issue can be easily rectified, with a consistent process bringing consistent and relatively predictable outcomes.
The framework used in this paper consists of two simple questions to judge whether government intervention is required; “Is the proposed assistance fair?” and “Is the proposed assistance necessary?” These are broken down into the following sub-questions:
Is the proposed assistance fair?
- Is the proposed recipient currently being treated unfairly?
- Is the assistance proportional to the imbalance?
- What is the cost to the wider economy of providing assistance?
Is the proposed assistance necessary?
- Has the business or industry taken all reasonable steps to avoid and mitigate its current situation?
- Is there a realistic possibility of imminent failure without taxpayer assistance?
- Does the proposed assistance match a permanent problem and a permanent solution?
By answering the above questions the case for assistance can be decided in an impartial manner. If the assistance is deemed both fair and necessary, consideration of the different types of assistance available and their cost can be made using the following questions:
- What will the proposed assistance cost?
- How should the assistance be funded?
Before detailing what a government guarantee of Qantas debt might cost, it is important to recognise that assistance may be seen as unfair or unnecessary. The author acknowledges upfront that these are sensitive issues which each individual may have a different perception of. An individual’s view on free market versus interventionist philosophies, as well as the culpability of various parties for the current financial situation of Qantas will sway each person’s answer to these two questions.
Is the Proposed Assistance to Qantas Fair?
Is Qantas currently being treated unfairly?
The question of fairness begins with the view that the Qantas Sale Act places unfair restrictions on the proportion of shares that international shareholders can own. This argument can be summarised as:
“Qantas should have equal rights relative to Virgin to attract international shareholders that will support its strategy of maintaining market share of at least 65%, even at the cost of operational losses in the medium term.”
A more sceptical way to paraphrase the argument is:
“Qantas should have equal rights to attract international shareholders that will throw good money after bad.”
Either way, it is difficult to argue that this position is currently balanced. A change to Qantas Sale Act would be generally seen as creating a level playing field and is therefore a fair response.
However, it appears that the current Federal Parliament is unlikely to pass such legislation and therefore alternatives to the most logical response are being sought. The author understands that political motivations often overcome rational outcomes in such divisive situations. Noting that, if a change to the legislation was proposed and voted for by the Liberal/National Coalition and opposed by Labor and the Greens resulting in the defeat of the legislation, surely the blame for the continuing unfair position and events thereafter then resides with Labor and the Greens?
The counter argument to this is that Qantas is a special case as a “national carrier” and should therefore not be allowed to be foreign owned. The Australian public is now widely accepting of foreign companies taking ownership of Australian companies, with even Vegemite now foreign owned. With the introduction of low cost carriers showing how expensive the Qantas product is and the example provided by the disappearance of Ansett, any loyalty to Qantas is more likely to be generated by its frequent flyer program rather than its historical position as occupying “national carrier” status.
Is the assistance proportional to the imbalance?
In the case of a change to the Qantas sale Act, amending the legislation to match the legislation applicable to Virgin is clearly a correction to the imbalance. The question then turns to whether other potential forms of assistance will create a balanced situation. Qantas is asking for a government guarantee of its debts, though it is not clear which creditors would be covered by such a guarantee. The cost of a debt guarantee is discussed later in the paper with different scenarios modelled.
The impact of a government guarantee, even if limited to just bank and capital markets debt, would be to substantially lower the perceived risk of Qantas debt thus allowing Qantas to borrow much larger amounts of debt at much lower interest rates. Even with a material charge to Qantas for provision of such a guarantee, this would shift the competitive landscape so that Qantas is receiving an unfair advantage against both its domestic and international competitors. This provision of a debt guarantee would also create what is commonly referred to as a “moral hazard” situation, with Qantas encouraged to behave recklessly (by borrowing excessively) as taxpayers will suffer the loss if Qantas fails. Following the substantial bailouts of financial institutions since the global financial crisis, few taxpayers are likely to be supportive of such a “heads I win, tails you lose” scenario.
What is the cost to the wider economy of providing assistance?
The financial cost of a government guarantee is covered later in the paper, but at this stage it is worth highlighting other costs to the wider economy. In providing taxpayer assistance, governments are in effecting taxing more heavily well-performing industries to support poorly performing industries. Government can be seen as penalising those who are prudent and don’t require assistance, to reward those who are reckless and have performed poorly. If this pattern is repeated businesses and individuals learn that the way to be better off is by lobbying the government, rather than focussing on research and development, efficiency and customer service. If the cycle continues for long enough, well performing companies move overseas to avoid the burden of supporting poorly performing companies. Governments effectively end up backing “losers” and taxing “winners” on a large scale.
Economists will largely deride such activity, noting that markets have a superior record in picking “winners” compared to governments. In the case of airlines national governments overseas have regularly picked “losers” by providing support to their national carriers. This is not just a case of governments making bad decisions in individual cases, but rather symptomatic of an industry that is plagued by losses and poor returns to investors1. There is rarely a year that goes by without a “one-off” events impacting airlines with oil prices, terrorism, SARS, ash clouds, currency movements and economic downturns all blamed in the last decade. Many investors are familiar with the euphemism (or a paraphrase of it) often attributed to both Warren Buffet and Richard Branson:
“The easiest way to become a millionaire is start out as a billionaire and to buy an airline.”
Not only would support for Qantas come at a price of taxing “winners”, historical experience points to government support for airlines as backing a “loser” 1. Any use of the term “co-investment” should be read as a “handout” unless it is accompanied by a realistic prospect of the government receiving a disproportionate share of future profits.
Before moving to the question of necessity, it needs to be noted that if government intervention is limited to a legislative change that is balancing the playing field then the question of fairness is the only concern. Companies and industries should have a right to expect fairness of competition within the economy and in return governments that create such a position should see additional investment by existing and new businesses.
Is the Proposed Assistance to Qantas Necessary?
Has Qantas taken all reasonable steps to avoid and mitigate its current situation?
If taxpayer assistance is being requested, the question must be asked whether Qantas is somewhat responsible for its current loss making position and could have avoided or lessened its current position. Any business that has failed to take adequate steps to prepare for and manage difficult conditions, including reducing costs wherever possible, should not be given taxpayer assistance. On several fronts Qantas fails this test including:
- Qantas has engaged in a volume war with Virgin, sacrificing profit to maintain market share of at least 65%
- Qantas has not paid a dividend to shareholders since April 20092, an outcome indicative of long standing financial underperformance however;
- senior management each continue to receive multi-million dollar remuneration packages including performance based bonuses2
- The eleven non-executive directors received a combined $2.71 million in cash and benefits for the 2013 financial year2
- The mainline Qantas business continues to have well above industry average cost levels3, in part due to a less flexible and more expensive workforce and poor relationships with unions
- The Qantas international business continues to remain unprofitable with the Emirates partnership only a partial solution2
Based on the above Qantas has many areas it can and should have rectified before taxpayer assistance was requested. Other businesses and industries would no doubt feel unfairly treated if Qantas received taxpayer assistance without undertaking meaningful cost cutting and restructuring. The Qantas situation parallels with the GM, Ford and Chrysler CEOs flying into Washington in 2008 on private jets to request taxpayer assistance without having made meaningful change to their businesses.
The framework used overseas for dealing with banks requiring bailouts is an appropriate back drop to the steps any business should take before it asks for taxpayer assistance. Such steps should include:
- Senior management remuneration capped at $250,000 per year
- Director remuneration capped at $50,000 per year
- General staff salaries reduced to at most the industry average
- Removal of benefits such as business class travel, expensive hotels, conferences, excessive leave and downtime provisions
- A clear plan on when and how the business will return to profitability
- A realistic proposal on how any “co-investment” funding will see taxpayers repaid before shareholders and then receive a share of the future profits
Governments should keep in mind that if the businesses owners and capital markets are not willing to provide the assistance that is claimed to be necessary, then governments have a right to expect that substantial sacrifices will be made by the business owners, managers and employees. Businesses should not expect different treatment relative to individuals, who are subject to means testing when they receive assistance in times of hardship.
Is there a realistic possibility of imminent failure without taxpayer assistance?
Qantas often seeks to reassure its customers, suppliers and investors by stating that it has approximately $3 billion in cash. As well as cash currently held, analysts have noted that Qantas could generate hundreds of millions or billions of dollars of additional cash in the near term by taking any of the following actions:
- a sale of its airport terminal leases;
- a partial sale of the frequent flyer business; or
- a sale and lease back of planes that it owns.
The current credit ratings from Standard and Poor’s and Moody’s of BB+ and Ba1 also do not indicate a company that has imminent cashflow issues. The recent downgrades by both agencies indicate that Qantas has an increasing risk profile but has substantial time to make changes before the risk of default is imminent. At this stage of the debate, there does not appear to be any concern that Qantas is close to insolvency.
Does the proposed assistance match a permanent problem and a permanent solution?
In the provision of taxpayer assistance temporary solutions to temporary problems should be strongly discouraged for two reasons. Firstly, businesses and individuals should be encouraged to set aside reserves to cover unexpected circumstances as well as using available mechanisms, such as insurance, to cover against temporary setbacks. Secondly, given the timeframes involved with consideration, approval and implementation of taxpayer assistance, temporary solutions may only reach the intended recipients after the problem has been resolved.
The loss that Qantas is expected to announce in its coming half year results is based on temporary problems including the market share target, high cost levels and continuing to run unprofitable business units. As such, Qantas requires no solution for these issues and instead should be encouraged to finds its own solutions.
What is the Cost of a Government Guarantee of Qantas Debt?
As part of the public discussion of a potential government guarantee, it has been said by the Qantas CEO and numerous market commentators that a government guarantee of Qantas debt is not a handout per se as there is no direct cost to the government. Whilst there is not expected to be any actual funds passing hands unless a default occurred, the provision of a debt guarantee is essentially the same as providing an insurance policy. If there is no charge for this provision of insurance, Qantas will directly and indirectly benefit relative to its competitors who don’t receive such a guarantee. Qantas’s cost of debt will become far cheaper and its suppliers will be much more comfortable providing services to it without upfront payment or security for payment. These benefits clearly have material financial value to Qantas.
To provide a cost estimate of a guarantee of Qantas’s debts, two different methodologies need to be considered. Firstly, the cost of a guarantee can be estimated under an insolvency scenario, when the government would be required to make payments to creditors to cover losses incurred following a Qantas insolvency. Secondly, the benefit can be estimated on a per annum basis, using either the market cost of credit insurance or a risk based approach that uses the probability of default and the loss given default. Each of these two methodologies is detailed below.
Methodology 1 – Cost of a Qantas Guarantee in Insolvency
If Qantas becomes insolvent, any debt guarantor would be required to make good the losses suffered by creditors. There are many variations on the potential form of a debt guarantee, so for this analysis a basic guarantee of different debt classes is shown with a total cost then provided. Two scenarios are shown to illustrate the different outcomes for various classes of debt under different default scenarios. These are an “average” large industrial company default where unsecured creditors recover 30% of debts (70% loss), and the “Ansett” scenario modelled on the actual recoveries received by employee and unsecured creditors of Ansett. All liability numbers are sourced from the most recent Qantas annual report dated 30 June 2013.
To assist with understanding the table an explanation of each creditor group is provided:
Secured Creditors: These creditors will include financiers that have lent to Qantas and its subsidiaries with their claims secured by the assets of the company. These are predominantly aircraft leases secured by the aircraft themselves, but also include lending directly to Qantas that ranks ahead of unsecured creditors. In both scenarios, secured creditors are assumed to have an 80% recovery (20% loss) on their debts reflecting their ability to take possession of aircraft, engines and commercial property and sell those assets to repay their debts.
Employee Liabilities: Certain employee liabilities have priority over other creditors in the event of insolvency. In the case of Ansett, employees have so far received 95.4% of their priority claims with almost all of the proceeds from Ansett asset sales going to employee creditors. In the “average” scenario employees are deemed to have full recovery of their claims through sale of company assets.
Unsecured Creditors: Remaining creditors are grouped together as unsecured or non-priority creditors. These creditors ranks behind secured creditors and the employee liabilities for payment, and as such are expected to receive a much lower recovery rate. The frequent flyer scheme, tickets paid for in advance, trade creditors and unsecured loans are grouped together here. In the “average” scenario unsecured creditors recover 30% of their debts (70% loss) in line with historical recovery rate averages for unsecured debt4. The Ansett scenario reflects the 100% loss that its unsecured creditors suffered.
| Creditor Category | Liabilities ($m) | Average Scenario ($m) | Ansett Scenario ($m) |
|---|---|---|---|
| Employee | 789 | 0 | 36 |
| Secured | 4,291 | 858 | 858 |
| Unsecured | 8,493 | 5,945 | 8,493 |
| Total | 13,573 | 6,803 | 9,387 |
In the event of an insolvency of Qantas, the two scenarios provide a range of $6.803 billion to $9.387 billion of losses if a full guarantee of Qantas creditors is provided. This could be lessened substantially if the guarantee was limited. For instance, the guarantee could be restricted to loans and debt capital markets finance (e.g. bonds and aircraft leases) with the frequent flyer scheme, trade creditors and employee liabilities excluded. The table below removes the frequent flyer scheme, trade creditors and employee liabilities leaving just the loans and capital markets finance.
| Creditor Category | Liabilities ($m) | Average Scenario ($m) | Ansett Scenario ($m) |
|---|---|---|---|
| Employee | 0 | 0 | 0 |
| Secured | 4,291 | 858 | 858 |
| Unsecured | 2,189 | 1,532 | 2,189 |
| Total | 6,480 | 2,390 | 3,047 |
By restricting the guarantee to financiers, the total amount of liabilities covered falls by 52%. However, the total amount of estimated losses falls by roughly two-thirds to $2.39 billion to $3.047 billion. The much lower weighting of unsecured creditors in the restricted guarantee explains the disproportionate movement in estimated cost.
Methodology 2 – Cost on a per annum basis
The second methodology for costing a Qantas guarantee takes a per annum cost (like an insurance policy) approach. The two scenarios here aim to reflect the two different ways the actual cost of an insurance policy can be viewed. Firstly, the “market” cost of insurance reflects what the market would charge (in this case the credit default swap market) to provide cover against losses. As there is an active credit default swap for Qantas unsecured debt, this is a straight forward process, although assumptions need to be made for secured and employee creditor protection costs as there is not a credit default swap market for the priority creditors. This “market cost” scenario should be thought of as the annual benefit received by Qantas from a government guarantee.
The second scenario is the “theoretical” cost of providing the insurance. This scenario should be thought of as the risk weighted annual cost to the government of providing a guarantee. All insurance providers seek to make a margin above the actual risk cost to cover operating expenses, capital/regulatory requirements and shareholder returns. It logically follows that the market cost should be materially higher than the theoretical cost of the risk.
A full guarantee of Qantas liabilities is shown below. In the market cost scenario, the five year Qantas credit default swap cost of 2.90% per annum (after the recent credit downgrades but before announcements that the government may provide assistance) is used for unsecured creditors. For secured and employee creditors, a 50% deduction to the unsecured credit default swap is applied. In the theoretical cost, the probability of default is assumed to be at a BB rating, reflecting the BB+/negative outlook and Ba1/negative outlook from Standard and Poor’s and Moody’s respectively. The loss given default percentages use the actual recovery rates from Ansett.
| Creditor Category | Liabilities ($m) | Average Scenario ($m) | Ansett Scenario ($m) |
|---|---|---|---|
| Employee | 789 | 11.4 | 0.6 |
| Secured | 4,291 | 62.2 | 13.8 |
| Unsecured | 8,493 | 246.3 | 136.7 |
| Total | 13,573 | 319.9 | 151.1 |
For a government guarantee of all creditors, the market cost (benefit to Qantas) is estimated to be $319.9 million. The theoretical cost (actual cost to the government) is estimated to be $151.1 million. The table below shows the same scenarios, but adjusted for the removal of the frequent flyer scheme, trade creditors and employee liabilities.
| Creditor Category | Liabilities ($m) | Average Scenario ($m) | Ansett Scenario ($m) |
|---|---|---|---|
| Employee | 0 | 0 | 0 |
| Secured | 4,291 | 62.2 | 13.8 |
| Unsecured | 2,189 | 63.5 | 35.2 |
| Total | 6,480 | 125.7 | 49.0 |
By limiting the guarantee to financiers the cost estimate range falls to $49.0 million to $125.7 million.
How Should the Cost of a Government Guarantee of Qantas Debt be Funded?
Putting aside the arguments that a government guarantee of Qantas debt is neither fair nor necessary, it is worth making brief comments on how such a guarantee would be funded. The most logical mechanism for funding a debt guarantee would be for Qantas to pay the government the estimated market cost of the benefit it receives each year. At $125.7 million per annum for the financier only guarantee, it is unlikely that Qantas will want to proceed with such assistance. If the $49.0 million theoretical cost per annum was to be charged, it is far more likely that Qantas would take up the taxpayer assistance as it would receive direct financial benefits that far outweigh the cost.
Another potential mechanism is an industry wide passenger charge, as was the case with Ansett levy. On one hand, this seems reasonable as passengers have been benefitting from the additional volume and lower prices as Qantas and Virgin have fought a volume battle in recent years. On the other hand, passengers of all airlines would be paying a charge which is arguably due to the poor decisions of the Qantas management and board. Whilst this option appears somewhat clumsy, it at least places the cost of the assistance onto the industry that benefits from it.
Conclusion
A change of the Qantas Sale Act would be a fair response to the current imbalance that restricts Qantas from having the same level of international share ownership as Virgin. The current Australian government should pursue legislative change to correct this imbalance on the basis that Qantas is no longer a special case and is entitled to a level playing field. The level of public affection has declined since Qantas was privatised with remaining loyalty to Qantas more likely due to the frequent flyer program rather than any perceived “national carrier” status.
The provision of a government guarantee of Qantas debt is neither fair nor necessary. Qantas is responsible for its current situation due to its market share target, high operating costs and by continuing to run unprofitable business units. Qantas should be encouraged to solve these temporary problems on its own, without taxpayer assistance. Qantas is not at risk of imminent failure and has sufficient cash reserves to allow for it to undertake necessary restructuring.
If a government guarantee was to be provided, it should be restricted to financier obligations which as at 30 June 2013 amounted to $6.48 billion. Qantas should pay an annual charge of approximately $125.7 million reflecting the market cost of such a guarantee. Any government considering providing such a guarantee should be aware that a loss of $2.39 billion to $3.047 billion is estimated if Qantas was to become insolvent based on historical averages and the Ansett experience.
References
- Note the operating profit margins and return on invested capital on p4 http://www.iata.org/whatwedo/ Documents/economics/IATA-Economic-Briefing-Financial-Forecast-December-2013.pdf
- Qantas annual reports
- https://theconversation.com/cost-heavy-qantas-must-look-beyond-government-bailout-21206
- Long term average recovery rates for senior unsecured bonds range from 30-40% depending on which data set is used and whether the mean or median is used, with credit professionals often using 30% as a conservative rule of thumb. For example see the table on p4 of the following link.
https://www.moodys.com/sites/products/DefaultResearch/2006600000428092.pdf