Aviation Strategy Issue No: 114 April 2007 Ryanair on the Atlantic ransatlantic open skies appears to have acted as a catalyst for CONTENTS Tstartling change in the long haul sector. Ryanair's announcement that it will enter the long haul business, in approximately four years time, with an upcoming order for 50 787s or maybe A350s, repre- sents potentially a big shake-up in the -US market. It is an Analysis indication that Ryanair had serious operational ambitions when it built up its stake in Aer Lingus, now frustrated by the EC's competi- tion concerns. It may also be a recognition of the limits to growth in Long-haul LCC? 1 the intra-European LCC market. For the European network carriers, Ryanair on the long haul hori- zon must be a worry despite their initial dismissive reactions. : and Air have been willing to absorb very heavy From bankruptcy to losses on their intra-European operations, as LCCs have captured industry-leading financials? point-to-point traffic and undermined yield, in order to assure feed to 2-10 their intercontinental hubs. Now they face the prospect of an LCC attacking their point-to-point long haul business, and not just econo- my passengers, as Ryanair also plans to offer a premium cabin. There are, however, a series of questions about how Ryanair will make its long haul work, how it will establish its cost advan- Briefing tage, and when it will be able to start up. The key may be the 787 price that will be able to provide Russian : to one of its most favoured customers. But Boeing isn't under any Dealing with the permeating particular pressure to discount, having a firm orderbook of about 550 Soviet legacy and its lasting units and delivery slots booked up until 2011/12. Maybe Ryanair, complications which is one of five airlines consulting with Boeing on the 737 11-20 replacement programme, has already started to negotiate (specula- tion surrounds a 30-unit order for an "undisclosed" purchaser revealed in mid April). The alternative is a deal with on the Spring Airlines: A350. Breaking the mould, the self- Ryanair will transfer its economies of simplicity to the long haul declared first Chinese LCC sector, selling only point to point tickets and only through the inter- survives its early trials net. Marketing will be high-profile but low cost; the €10 headline 20-23 fares have already generated great publicity. The carrier will contin- ue to eschew interlining and connecting services, though at its main bases, Stansted in particular, it should pick up a significant volume of self-connecting business passengers flying into STN from obscure points on the Ryanair network, flying out on the long-hauls (without, of course, any hope of compensation if they miss their connection). Presumably coordinated coach services will transport passengers to PUBLISHER city centres, a source of ancillary income to add to onboard sales, car hire agreements and hotel booking commissions. Ryanair could potentially launch transatlantic services from Aviation Economics Hahn, Marseilles and probably Bergamo, though Paris James House, 1st Floor Beauvais, Rome Ciampino and Girona are runway restricted. It will be interesting to observe customer reaction - fares are of course the 22/24 Corsham Street main selling point but long haul non-connecting travellers might also London N1 6DR be attracted to the lower stress levels offered by some relatively Tel: +44 (0) 20 7490 5215 uncongested, simple lay-out airports compared to the majors' hubs. Fax: +44 (0) 20 7490 5218 e-mail: [email protected] www.aviationeconomics.com Aviation Strategy

Analysis Delta: From bankruptcy to industry-leading financials?

aving fended off a hostile takeover bid The unsecured creditors, which will be Hfrom US Airways back in January, Delta major shareholders in the reorganised com- Aviation Strategy Air Lines is now on course to emerge from pany, merely wanted to make sure that is published 10 times a year Chapter 11 as a standalone entity at the end Delta's board and leadership would be open by Aviation Economics of April. The Atlanta-based carrier, which has to potential future mergers and acquisitions, Editor: been in bankruptcy since September 2005, should such opportunities arise. But those Keith McMullan has made a comprehensive effort to reshape moves certainly added an unusual twist to [email protected] itself. It looks to be a perfect example of the final months of Delta's Chapter 11 reor- Chapter 11 transformation, but are its busi- ganisation. Contributing Editor: ness plan forecasts realistic? In recent weeks, Delta and the creditors Heini Nuutinen Delta still needs final creditor and bank- have finalised the company's post-bankrupt- Contributing Editor: ruptcy court approvals for its Plan of cy compensation plans, corporate bylaws Nick Moreno Reorganization (POR), which was originally and the board of directors. The new board, filed on December 19 and amended in late announced on March 30, includes seven Sub-editor: January. The plan must be approved by at new appointees - all current or former exec- Julian Longin least 51% of the creditors and two-thirds of utives of large US companies. Ex- [email protected] the dollar amount of claims. The voting Continental chief Gordon Bethune, who Subscriptions: deadline is April 9, and the bankruptcy court acted as advisor to the creditors' committee [email protected] has scheduled a confirmation hearing for on the US Airways bid, is not included, but April 25. If all goes well, Delta hopes to ex-Northwest CEO Richard Anderson is. Ex- Tel: +44 (0)20 7490 5215 emerge from Chapter 11 on April 30 or short- Eastman Kodak CEO Daniel Carp will be Copyright: ly thereafter and re-list its stock on the NYSE chairman. The one director guaranteed a Aviation Economics (under its historic ticker symbol "DAL") in the board seat is Delta's CEO - currently Gerald All rights reserved first week of May. Grinstein, 74, who will retire after the post- Creditor approval is virtually certain. The bankruptcy board has named a successor. Aviation Economics official committee of unsecured creditors Delta has had Chapter 11 exit financing Registered No: 2967706 (England) and the two official retiree committees all commitments in place since late January. support the plan; after all, they have worked Unlike US Airways, but like UAL, it has Registered Office: very closely with Delta's management in the raised no new equity. It has lined up $2.5bn James House, 1st Floor past two months in finalising key aspects of in secured debt financing from a group of 22/24 Corsham St the POR. No major new objections have prestigious financial institutions, including JP London N1 6DR VAT No: 701780947 been raised. And, as of the end of March, Morgan, Goldman Sachs, Merrill Lynch, there appeared to be no competing plans in Lehman Brothers, UBS and Barclays ISSN 1463-9254 the works. Capital. The financing, which has competi- The opinions expressed in this publica- tion do not necessarily reflect the opin- Back in January, Delta made some tive terms and comprises a $1bn first-lien ions of the editors, publisher or contribu- important concessions and ceded authority revolving credit facility and $1.5bn in tors. Every effort is made to ensure that the information contained in this publica- in return for the creditors' committee not secured term loans, will replace Delta's tion is accurate, but no legal reponsibility is accepted for any errors or omissions. supporting US Airways' hostile bid, which $2.1bn DIP financing and boost its cash was withdrawn on January 31. Most impor- position. Since it is all secured financing The contents of this publication, either in whole or in part, may not be copied, tantly, the creditors' committee gained the backed by attractive collateral, risks to the stored or reproduced in any format, print- ed or electronic, without the written con- right to appoint 10 of the 11 post-bankruptcy lenders are obviously minimal. sent of the publisher. board directors (of which three had to be Finally, Delta has accomplished some- current directors). Delta also agreed to thing that bankrupt companies usually avoid exclude from its new charter and bylaws any until well after their emergence from Chapter poison-pill provisions that could be used to 11: it held a "2007 Investor Day" at its Atlanta block future merger deals. headquarters on March 27. This was despite

April 2007 2 Aviation Strategy

Analysis the fact that many shareholders got burned DELTA’S OPERATING MARGIN FORECAST in the lead-up to the Chapter 11 filing and % those still hanging on will receive nothing when the current stock is cancelled upon 15 Chapter 11 exit. But, based on what hap- 10 pened with US Airways and United, many analysts will be keen to quickly reintroduce 5 coverage of Delta. The many hours of man- agement presentations (also via the 0 Internet) were extremely helpful. -5 Delta's ability to hold an investor day at this stage may be another example of the -10 reduced stigma associated with bankruptcy. But another reason is that Delta has a great 2000 2001 2002 2003 2004 2005 2006 2007F 2008F 2009F 2010F story to sell. First, the airline has achieved Note: Excludes projected profit sharing payments in 2007-2010 an impressive financial turnaround in the Source: Forecasts from Delta Investor Presentation, 27 March 2007 past 18 months. Second, like United a year ago, Delta emerges from bankruptcy with a $bn DELTA’S PRE-TAX INCOME FORECAST formidable global network. 3

Financial turnaround 2

1 Ironically, Delta entered the post- September 2001 industry crisis in great 0 financial shape. It had earned double-digit operating margins and net profits in the -1 region of $1bn for five consecutive years up -2 to and including 2000. The famous (and much-maligned) 1994-96 "Leadership 7.5" -3 project had made it the lowest-cost major 2005 2006 2007F 2008F 2009F 2010F network carrier in the US. Delta retained that Note: Excludes projected profit sharing payments in 2007-2010 cost structure in the boom years of the late Source: Forecasts from Delta Investor Presentation, 27 March 2007 1990s, thanks to a favourable four-year pilot contract in April 2006, low-fare subsidiary became one of the highest-cost large net- Delta Express (October 2006) and tight cost work carriers. controls. As a result of a mid-1990s restruc- But, because Delta's balance sheet was turing, Delta also had a strong balance sheet still relatively strong in 2002 and 2003, it and investment-grade credit ratings. could do nothing but watch helplessly as But the strong balance sheet turned out United and American, in their Chapter 11 to be a mixed blessing: it enabled Delta to and near-Chapter 11 situations respectively, continue to tap the capital markets for funds extracted significant cost concessions from to a much greater extent than the other lega- their pilots in 2003. In other words, Delta cies, despite losing just as heavily post- happened to be financially strong at precise- 2000. Also, Delta was unlucky with the tim- ly the wrong point in the industry (pilot con- ing of its labour negotiations: it happened to tract) cycle. be the last major carrier to sign an expensive In the five years up to and including 2005, pilot deal before September 2001, making its Delta's net losses before special and pilots the highest-paid in the industry. restructuring items totalled $7.5bn, including Between 1999 and 2003, as its unit costs losses of $2.3bn and $2.2bn in 2004 and surged from 8.80 to 10.58 cents per ASM, 2005, respectively. Total lease-adjusted debt Delta not only lost its CASM advantage but surged by a similar amount, from $11.2bn in

April 2007 3 Aviation Strategy

Analysis

years in 2006 - a marginal $58m on rev- DELTA’S REVENUES $bn enues of $17.2bn. Significantly, the airline generated $1.2bn of free cash flow last year 18 - its first positive free cash flow since 1998. 16 The net loss before special and restructuring items was $406m, representing a $1.8bn 14 improvement over 2005. The reported 2006 net loss was $6.2bn, which included the 12 same amount ($6.2bn) of reorganisation 2000 2001 2002 2003 2004 2005 2006 charges, a $310m accounting-related DELTA’S OPERATING RESULTS charge and a $765m income tax benefit. $m (BEFORE RESTRUCTURING ITEMS) The full-year, second-half and fourth- 2,000 quarter 2006 operating margins were still measurably below those achieved by other 1,500 legacy carriers. However, Delta argued that 1,000 if the second-half results were adjusted for a 500 common fuel price of $2 per gallon and for 0 the now-terminated pilot pension plan, it was -500 already "in the middle of the pack" with a -1,000 5.5% operating margin. -1,500 2000 2001 2002 2003 2004 2005 2006 The Chapter 11 reorganisation

2000 to $18.9bn at the end of 2004. Delta's reorganisation plan estimates an Delta did manage to garner up $5bn of initial equity value of about $10bn and a annual cost reductions and revenue recovery to unsecured creditors of 62-78 enhancements before its bankruptcy, includ- cents on the dollar (76-100 cents in the case ing $1.1bn of pilot concessions and $1.8bn of regional subsidiary Comair). The unse- savings from other employee groups. But it cured creditors will receive primarily new was not enough and the company filed for Delta common stock to settle their claims. Chapter 11 on September 14, 2005 (coinci- Contrary to earlier expectations, Delta no dentally on the same day as Northwest). longer plans an equity rights offering, which Delta's financial turnaround in Chapter 11 would have allowed creditors to buy addi- has been swift and strong. The leadership tional shares. noted at the late-March investor event that The bulk of the new stock will go to the the company's economic performance had unsecured creditors, which hold $15bn in improved by $2.1bn in the past 16-17 claims ($14.2bn for Delta and $800m for months, despite a $1bn higher fuel bill. Comair). Most of the claims are from groups The airline attributed the past year's that are not traditional holders of equity (US improvements to revenue and cost mea- Bancorp, Bank of New York, etc.), so there is sures implemented in Chapter 11, revenue likely to be a large initial turnover. Delta's and network productivity improvements, in- pilots (current and retired) and the Pension court restructuring initiatives and labour cost Benefit Guaranty Corporation (PBGC) will reductions. However, 2006 was a good year also be major initial shareholders, due to for all legacy carriers - Delta's own compar- their $3.3bn and $2.2bn respective claims. isons show that while the two Chapter 11 Delta's non-union employees will be allocat- carriers (Delta and Northwest) saw their pre- ed a 3.5% ownership stake, while manage- tax income surge by about $1.6bn, ment employees will get about 2.4%. Continental's also rose by $1bn and AMR's After the Chapter 11 filing, Delta set a by $908m. goal of achieving $3bn in annual financial Delta earned its first operating profit in six improvements by the end of 2007. That tar-

April 2007 4 Aviation Strategy

Analysis get was reached a year ahead of schedule, and benefits, changes in work rules and the so additional cost cuts and revenue termination of their defined benefit pension enhancements are now expected in 2007. plan. In return, ALPA is receiving a $2.1bn Much of the financial improvement has unsecured claim and $650m in unsecured obviously been achieved through the usual 15-year notes. A similar deal was clinched in-court restructuring facilitated by Chapter with the flight dispatchers (the only other 11: debt, lease and facility restructurings, air- union at Delta), which are also receiving an craft lease renegotiations and rejections, unsecured pre-petition claim. vendor contract renegotiations and labour The pilot wage and work rule conces- cost reductions. sions are expected to result in $280m annu- However, Delta's reorganisation has al cost savings in the contract period. Other been notable for the wide-ranging efforts employee groups have contributed an made to re-engineer the company, rather aggregate $600m-plus in annual savings in than just cut costs, reduce debt and shore the form of pay and benefit reductions and up the balance sheet. Some of the $3bn staff cuts, and retiree healthcare benefit financial improvement has come from higher changes will result in a further $50m saving. revenue generation and network productivity The termination of the pilot defined bene- improvements. The key accomplishments fit pension plan, effective September 2006, have included simplifying the fleet by retiring reduced Delta's pension obligations by four aircraft types, right-sizing domestic $5.2bn to $7.6bn at the end of 2006. Other operations, undertaking significant interna- retiree benefit obligations were reduced by tional expansion, increasing point-to-point $859m to $1.2bn. The PBGC, which took flying and right-sizing and simplifying over the pilot pension plan at year-end, will domestic hubs. be issued $225m in senior unsecured 15- Delta has used the Chapter 11 process to year notes in addition to the $2.2bn unse- reject, return or sell a significant number of cured claim. aircraft - the tally at year-end was 188. It had Thanks to the Pension Protection Act of reviewed facility agreements at 55 locations August 2006, which allows US airlines to and rejected or restructured leases at air- significantly reduce their near-term pension ports such as Dallas, Orlando and Tampa. At funding obligations, Delta has been able to the end of March, negotiations still continued preserve its defined benefit pension plan in respect of various aircraft and facility covering ground employees and flight atten- agreements. dants. Funding requirements under that plan Recently amended contracts with several are expected to be only around $100m regional partners will facilitate cost savings annually in the next few years. this year. Two deals announced in March One of Delta's most impressive moves - incorporate lower fees and some reduction which just may help ensure continuation of in 50-seat RJ flying; partners Mesa and the surprisingly strong staff morale seen in Republic are receiving unsecured claims of recent months (partly because employees $35m and $91m, respectively. Delta also united to oppose the US Airways bid) - is an anticipates significant savings through unusually generous post-bankruptcy com- Comair's Chapter 11 restructuring. However, pensation programme. The company Delta has assumed its contract obligations announced in late March, first of all, that its with ASA and SkyWest. It has also granted 39,000 non-union employees (excluding offi- Mesa a new contract to operate 14 CRJ- cers and directors) will receive $350m worth 900s and signed up ExpressJet and of stock and $130m in cash lump sum pay- Mesaba's Big Sky unit as new regional part- ments upon the Chapter 11 exit. This is sep- ners. arate from the benefits secured by the two The key labour milestone was a compre- unions as part of their concessionary new hensive agreement with ALPA, effective contracts. Such a broad-based stock award June 2006 and amendable at the end of involving non-union workers is probably 2009. The pilots agreed to reduced pay rates unprecedented for a company emerging

April 2007 5 Aviation Strategy

Analysis

from Chapter 11. Second, the non-contract ance sheet that will allow reinvestment. employees will begin receiving pay increas- Closing the RASM gap: The focus of the es this summer. Delta has made a commit- business plan is very much on revenues, ment to move towards an industry-standard because Delta's former strong revenue posi- pay structure over time. tion (a decade or so ago) had by 2005 dete- Delta is also introducing a generous prof- riorated to such an extent that its RASM was it-sharing plan that will pay out at least 15% only 86% of the industry (ATA) average. The of the company's annual pre-tax profit, with airline estimated that the 14-point RASM no thresholds. There will be new incentive gap represented $2.5bn of lost revenues. performance awards and a new defined con- The airline believes that the RASM gap tribution retirement benefit, offered to was driven by three roughly equally impor- enhance existing pension plans. All the tant factors. First, Delta carried the highest employees (including the pilots and the flight percentage of (lower-yielding) connecting dispatchers) will participate in those pro- traffic among the network carriers - partly grammes. because it had a 22% larger average gauge These measures were reportedly explicit- in domestic operations and because it had ly designed to surpass what other airlines significant capacity at relatively small hubs have offered when emerging from Chapter such as Cincinnati. Second, in 2005 Delta 11, to prevent unionisation (currently only had a much lower percentage of internation- 17% of employees), to ensure that people al traffic than its peers (low 20s, compared to remain flexible to route and schedule an average of 35% for competitors). Third, changes and to maintain a happy frontline and most challengingly, Delta's non-stop workforce as Delta strives to raise unit rev- domestic yields are lower than the other net- enues. works' - reflecting factors such as a heavy Equally importantly, management and East Coast presence, competition with leadership pay and stock awards have been AirTran at Atlanta and a tertiary position at kept modest to avoid the sort of anger and New York (resulting in lower transcontinental criticism that UAL and other companies have yields than American's and United's). provoked with their big top executive pay- Consequently, while in Chapter 11 Delta outs upon Chapter 11 exit. While around has focused on fixing those problems. First, 1,200 Delta management employees will it has right-sized domestic operations, receive restricted stock, stock options and among other things, by utilising smaller air- performance stock representing about 2.4% craft; this led to a 16% reduction in domestic of Delta's value (vesting over periods of up capacity in 2006. Second, Delta has grown to three years), officers and directors will not internationally by shifting widebody aircraft receive pay increases until frontline employ- from domestic to international routes; inter- ees have reached industry standard pay. national capacity rose by 21% in 2006. CEO Grinstein has refused an exit bonus; Third, the airline has increased point-to-point instead, at his request, the company is set- flying and right-sized and simplified domes- ting up two charitable foundations to provide tic hubs to achieve a greater local traffic mix. scholarship and hardship assistance for As a result, Delta's length-of-haul adjust- Delta employees. ed PRASM surged by 17.8% in 2006, com- pared to an industry average increase of Delta's business plan 10.7% (in a relatively healthy overall rev- enue environment). The airline reduced the RASM gap by seven points, to 93% in 2006. Delta's business plan has three goals: The aim is to achieve industry parity by the closing the unit revenue gap with its peers, end of 2008. maintaining the lowest unit costs among the Having restructured its network and oper- large network carriers and achieving top-tier ations, Delta is now focusing on improving financial and operational results. A further the basic product in order to establish itself goal is to achieve an industry-leading bal- as "the airline of choice". In the first place,

April 2007 6 Aviation Strategy

Analysis this has meant improving on-time perfor- up with a different set of figures. mance and customer service, increasing the Furthermore, what matters the most is what frequency of aircraft cleaning and upgrading your main competitors' cost levels are. in-flight entertainment. Delta has also invest- AirTran has claimed that it has actually ed in new technology, products, equipment increased its cost advantage over Delta and facilities in Atlanta to improve all aspects despite the latter's bankruptcy. of the customer experience. Delta's aim is to sustain a low average Unlike United, Delta has not introduced unit cost and it recognises that the process any type of "premium economy" service, and is a "never-ending battle". The airline enjoys it does not really have a brand - things that some inherent cost advantages: a flexible would help attract business traffic and make workforce (due to its minimal unionisation) a mark in markets such as New York and and a main hub (Atlanta) at a low-cost loca- Los Angeles. In other words, Delta is not tion. doing anything exciting or extraordinary - Industry-leading profits? Delta's busi- just positioning itself as a good network car- ness plan projects an amazingly swift finan- rier. But Delta's top executives indicated at cial recovery this year and continuation of the investor event that "revitalising" the strong results in 2008-2010. After only brand would follow after Chapter 11. The pri- breaking even operationally in 2006, the air- ority is to "absolutely nail down and execute line is forecasting a 9% operating margin in our two-product strategy" before considering 2007, subsequently increasing to the 11- premium economy maybe in a couple of 13% range. On a pre-tax basis, Delta antici- years. pates a turnaround from a $452m loss in Best-in-class CASM? Following the 2006 to an $816m profit in 2007, to be fol- $5bn pre-bankruptcy cost cuts, Delta elimi- lowed by profits of $1.5bn, $1.6bn and nated $2bn from its cost structure while in $1.9bn in 2008, 2009 and 2010. Chapter 11 - through improved productivity, Those forecasts assume 2-4% capacity fleet simplification and renegotiated con- growth in 2007 (domestic down 1-3% and tracts. As a result, the airline has reduced its international up 14-16%), to be followed by mainline non-fuel CASM by 20% in the past 3% annual growth from 2008 onwards. three years, from 8.99 cents in 2003 to 7.20 RASM growth is expected to be 4% this year cents in 2006, despite a 6.6% capacity (compared to 1.5% growth for the industry) reduction in that period. Significantly, Delta and 2% in later years. Fuel is assumed to be projects a further non-fuel CASM decline in $2.06 per gallon in 2007 (including taxes), 2007, to 6.60 cents. That would mean a 27% subsequently increasing by 5% annually. unit cost reduction in four years. Mainline CASM is expected to decline by 7% Delta is claiming that it is emerging from in 2007, with further reductions in later Chapter 11 with the lowest unit costs of any years. network carrier and that it is closing the gap Many Wall St. analysts have considered with LCCs. According to Delta, its mainline Delta's projections "aggressive" or overly stage-length adjusted non-fuel CASM of optimistic and have questioned them basi- 6.93 cents in the second half of 2006 was cally on three grounds. First, as one analyst 12-13% below American's and Continental's asked, "how can Delta catapult itself from and 15% below United's though still above industry laggard to leader profitability-wise in Northwest's 6.78 cents. However, when 6-12 months?" Second, can Delta realistical- adjusted for the elimination of the pilot pen- ly expect to fully close the RASM gap given sion plan, Delta's 2H06 CASM of 6.71 was its heavy exposure to the East Coast and below Northwest's. The full-year projected LCCs and in light of the continuing RASM CASM of 6.60 cents would even bring Delta improvements at competitors? Third, would close to US Airways' LCC-type CASM of it not be unprecedented to have such strong 6.54 cents. profits for four consecutive years? What are These comparisons have to be taken with the GDP growth assumptions? a pinch of salt, because each airline comes The 2007 profits are probably achievable

April 2007 7 Aviation Strategy

Analysis

because they are largely based on the cost craft order commitments, of which $523m cuts accomplished in Chapter 11 but that are for 2007, $823m for 2008, $960m for came too late to help the 2006 results. 2009 and $712m for 2010. Those cost cuts (the pilot pension plan ter- Delta anticipates free cash flow in excess mination and other Chapter 11 deals) will of $1.5bn per year in the four-year plan peri- contribute $739m and lower fuel prices could od, which will allow reinvestment in the busi- add $107m to this year's bottom line, while a ness as well as continued debt reduction $171m profit sharing will represent a new and hopefully credit rating improvement. expense. The $593m revenue contribution Investing in baggage handling and ground (from improved RASM and capacity growth) facilities at various locations will be early pri- needed to achieve the projected $816m pre- orities. tax profit is also likely to materialise, given The airline calls its Net Operating Losses that recent domestic fare increases have (NOLs) a "significant asset"; they amount to stuck and international routes are apparent- $7.8bn and can be used to offset regular tax- ly performing better than expected. able income in full until depleted. But the longer-term revenue trends are Delta has said that it will continue to seek less encouraging. AirTran will continue to be opportunities to unlock shareholder value, an aggressive competitor at Atlanta. Delta's including further monetisation of assets. This new focus on New York will bring it into clos- may include spinning off wholly-owned sub- er contact with Continental and JetBlue, sidiary Comair. Delta sold its other former which are currently really fighting it out in the regional unit, ASA, to regional carrier New York area, and potential new transcon- SkyWest for $425m in August 2005. tinental entrants such as Virgin America. The North Atlantic market, which is a primary Network strategy and plans focus for Delta, is likely to see increased price competition as a result of the new EU/US agreement. Delta's argument that it Delta's network restructuring has fea- can return, on a sustainable basis, to the tured a sharp domestic to international shift. 12% operating margins seen in the late In the fourth quarter of 2006, the airline's 1990s seems a little idealistic. North American ASMs were down by 11.8% Industry-leading balance sheet: Delta year-over-year, while North Atlantic capacity will emerge from Chapter 11 with one of the was up by 27.6% and Latin American capac- strongest balance sheets in the industry. Its ity by 18.5% (Pacific ASMs were total lease-adjusted debt has been reduced unchanged). The strategy was possible from $18.6bn in June 2005 to $10.9bn in because Delta had a large inventory of wide- 2007. Lease-adjusted net debt (after the body aircraft suitable for international opera- deduction of cash reserves) has fallen by tions that were causing revenue dilution in 55% in the same period, from $16.9bn to the domestic market. $7.6bn, with a further reduction to $6.2bn Since filing for Chapter 11, Delta has expected in 2008. Cash reserves at the end added 60-plus new international routes, with of 2006 amounted to $3.5bn, of which many more planned for 2007 and 2008. The $2.6bn was unrestricted - an adequate 20% airline is moving from a domestic/interna- and 15% of last year's revenues. tional capacity split of 80/20 in 2004 to a According to Delta's annual report, debt 60/40 split over the next couple of years; the maturities (excluding amounts subject to long-term goal is 50/50. compromise) amount to $1.5bn in 2007, In addition to becoming more internation- $2.2bn in 2008, $392m in 2009, $1.3bn in al, Delta is looking to get a more globally bal- 2010 and $2.4bn thereafter. Operating lease anced network. This means focusing near- payments amount to $1.3bn in 2007, $1.2bn term growth on - one of the few large in 2008, $977m in 2009 and $915m in 2010. gaps in its network - at the expense of Capital lease obligations are running at Europe, which saw significant expansion in about $100m annually. Delta has $3bn of air- 2006. Delta's business plan calls for increas-

April 2007 8 Aviation Strategy

Analysis ing the Asia// regions’ ple, Delta would like to operate Atlanta-India share of international capacity to 22% by - and there will also be expansion through 2009 (from just 3% in 2005), while Europe's codeshares. Delta is seeking Atlanta- share would fall from 70% to 50% and Latin Shanghai route authority from March 2008; it America/Caribbean's share would remain is the only large US international carrier unchanged at 27-28%. That would be similar without service to . The airline is to Continental's nicely balanced internation- proposing daily non-stop 777 flights, with al network. codeshares beyond Shanghai with its part- The new strategies have strengthened ner and future SkyTeam member China Delta's two principal international gateways, Southern. Atlanta and New York, while the smaller Europe: Since September 2005 Delta hubs have contracted. In October 2006, has added nine new European destinations, Delta's capacity was 30%, 16% and 5% many of them in Eastern Europe: Budapest, down year-over-year at Cincinnati, Salt Lake Bucharest, Copenhagen, Dusseldorf, City and Los Angeles, respectively. Edinburgh, Kiev, Pisa/Florence, Prague and However, RASM was up at all of the hubs - Vienna. The profitable expansion has been either due to profitable international growth facilitated by the domestic widebodies. Delta or reduced capacity - and Delta will resume is the largest US carrier on the transatlantic, growing also at Los Angeles and Salt Lake serving 31 destinations. City. The airline is looking to develop Los Delta has supported a liberalised US/EU Angeles as a gateway to Latin America. agreement from its inception, believing that Domestic plans: Delta's top priorities in a good cost structure and strong balance the next two years will be to boost its pres- sheet will enable it to compete. The top pri- ence in New York and improve Delta ority is to gain access to London Heathrow, Connection's seriously lagging operational in the first place from Atlanta but also from performance. JFK - routes that the carrier describes as Delta is the largest carrier in terms of "huge opportunities". In October 2006 Delta departures at JFK and LaGuardia combined bought United's New York-London route but is not getting its share of premium traffic. authority for $21m; however, under the cur- The airline is determined to rectify that and rent ASA it cannot serve Heathrow and has attain sustained profitability in New York to operate to Gatwick. Having paid United through measures such as increasing $13m when the deal closed, Delta will not domestic connectivity, upgrading the have to make the four subsequent annual transcontinental product, implementing an payments of $2m due in 2007-2010 if the lib- international flight bank split at JFK (this eralised US/EU agreement becomes effec- spring) and improving facilities at JFK. tive. However, JFK poses a tough challenge, Delta executives indicated on March 27 because key competitors there have spent that the airline would immediately start years strengthening their positions and investigating how to secure Heathrow slots. building new facilities. Delta will not be able One obvious source is SkyTeam partner Air to match American's $1.1bn spending on a France, which is unlikely to want to operate new terminal - its current JFK plans feature London-New York but would probably be only $50m spending. Although Delta appar- happy to include its code on Delta-operated ently has got its long-term strategy at JFK flights on that route. Delta, , sorted out, its facility plans are still up in the , CSA and Korean have benefited air. According to CFO Ed Bastian, the airline from antitrust immunity in the US since "needs to be looking at alternatives" to its 2002. current facilities, as competition heats up. Latin America & Caribbean: Delta had Asia: This year's growth will focus main- added or announced more than 40 new ly on Asia, spearheaded by new JFK- routes to Latin America and the Caribbean Mumbai and Atlanta- flights. The 777- since the autumn of 2005. There was a 200LR opens many new markets - for exam- major growth spurt in November/December

April 2007 9 Aviation Strategy

Analysis

2006, when 16 new routes were added in 22 is to reduce the 22% domestic gauge gap days. Currently 58 destinations are served in with the industry to 6%. the region, mainly from Atlanta and to a less- Delta is in much less of a hurry than er extent from New York. This year will see American to retire its MD-80s, because its some further growth to Latin America, also aircraft are 5-10 years younger, have full from new gateways; most recently, Delta has electronic cockpits (keeping training costs announced plans to add Los Angeles-Belize lower) and have market-rate financings. City and Fort Lauderdale-Santo Domingo When ownership costs are taken into flights in June. account, the MD-88's unit costs are lower than the 737-800's. But Delta has quite a Fleet plans gap between the 144-seat MD-88s and the 70-seat RJs - in the future it will be address- ing the issue of whether to get a smaller- Delta had a mainline fleet of 440 aircraft gauge aircraft into mainline. at the end of 2006, down from 480 a year Delta has about 30 internationally capa- earlier. The mainline fleet consisted of eight ble mainline aircraft coming in the next three 777-200ERs, 21 767-400ERs, 59 767- years. The 777-200LRs open up a whole 300ERs, 24 767-300s, 121 757-200s, 71 series of markets that the airline was not 737-800s, 16 MD-90s and 120 MD-88s. Firm previously able to serve. However, Delta still orders included five 777-200LRs (plus six regards the 767-300s, especially with options) and ten 737-700s, all for delivery in winglets, as competitive aircraft and well- 2008-2009. Delta has also signed a letter of suited to the North Atlantic. intent with a third party to lease ten 757- Nevertheless, re-fleeting is going to be 200ERs from July-November for seven one of Delta's top priorities after it emerges years and three 757-200ERs from early from Chapter 11. The key question will be 2008 for five years. where the airline stands regarding the 787. Delta also has 50 737-800s on firm order, Would the 787 be mainly for growth in but it has agreed to sell 48 of those aircraft longer-haul markets or would it replace the to third parties immediately after they are 767s? delivered in 2007-2010. These sales will But the Delta board's first task will be to reduce the aggregate mainline aircraft order select a new CEO. Grinstein, who is (unfor- commitments from $3bn to $1bn over the tunately) retiring, has made it clear that he next four years. However, in January the would like an internal candidate to succeed bankruptcy court allowed Delta to place a him because "Delta is an unusual entity and $1.1bn order for 30 76-seat CRJ-900s (plus understanding the social network is critical". 30 options), which will be operated by The two internal front-runners are CFO Ed regional partners. Bastian and COO Jim Whitehurst - both very The domestic down-gauging is achieved impressive candidates, except that they both by transferring 767-400ERs to international sounded just a little too bullish on industry By Heini Nuutinen markets and adding 737-700s - and in the mergers when grilled about that subject at future 100-seaters - domestically. The goal the March investor event.

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April 2007 10 Aviation Strategy

Briefing

Aeroflot battles through chaotic times in

eroflot is starting to post significant prof- domestic market in 2004, and Aeroflot cur- Aits, but the airline is battling against a rently serves 25 Russian destinations, but shambolic Russian aviation industry and a the aim is to grow domestic traffic by more government owner whose indecision contin- than 20% in 2007 through both new routes ues to hold back Russia's flag carrier. Can and greater frequencies, with a target of a Aeroflot overcome these external chal- 30% market share domestically by 2010. lenges, or is the airline destined to fall back Though Aeroflot's yield lags behind all its into the ranks of Europe's niche carriers? major western competitors, it is improving Aeroflot was established in 1923, not long (see chart, page 12), and according to after the end of the Russian civil war, but in Deutsche Bank analysis "the growth in 1992 the state airline was divided up into domestic routes will not lead to a deteriora- hundreds of regional airlines, with interna- tion in the quality of its revenues, as domes- tional routes remaining together as Aeroflot tic yields are only marginally lower than inter- Russian International Airlines (ARIA). Later national yields." that decade 49% of ARIA was sold to In 2006 Aeroflot carried 7.29m passen- employees, and Aeroflot started building up a gers - 8.5% up on 2005, but somewhat short domestic network again. of the targeted 8.3m for the year. Load factor At the start of the current decade its name reached 70.1% in 2006 (see chart, page 13), was modified yet again, to Aeroflot Russian one percentage point up on 2005. Excluding Airlines, and today the airline serves almost its wholly-owned regional subsidiary Aeroflot- 100 destinations in 53 counties around the Don, mainline Aeroflot carried 6.7m passen- globe, including 36 in Europe, five in North gers in 2006, which is identical to the 2005 and Central America, two in Africa, five in the figure. Aeroflot is aiming for 8.3m passengers Middle East, nine in Asia and eight in the in 2007 (including its subsidiaries), repre- CIS. senting a 14.6% rise, and believes this will be Aeroflot has a 21% share of international achieved through better fleet utilisation, high- traffic to/from Russia and 17% of the domes- er frequencies and better connection with tic market, but international passengers SkyTeam partners. Overall capacity will rise accounted for 62% of Aeroflot's revenue in by 11% this year, although this varies greatly 2005, and most of Aeroflot's profits come by segment, and particularly internationally. from scheduled routes into Europe. Though There are capacity growth targets of 19.5% more profitable, the reliance of Aeroflot on on routes to CIS destinations, 16% on international traffic means "the company is European routes and 8.2% to Asian destina- more vulnerable to external shocks", accord- tions excluding . Traffic to North ing to one Russian analyst, and a key part of America (Aeroflot operates 15 flights a week the company's strategy is to win a much to four US destinations - New York, Los greater share of the domestic market, both in Angeles, Seattle and Washington DC), the trunk routes and those routes that feed into Middle East and Japan is forecast to rise by international services. But perhaps a more less than 2% this year. important rationale for the domestic push is European capacity will increase despite that Aeroflot wants to build up its position the refusal of the Russian aviation authorities prior to Russia joining the WTO (expected last year to allow Aeroflot to extend its oper- sometime this year), which will oblige the ations in St Petersburg from the current government to open up domestic routes to domestic network to up to 30 European des- foreign airlines. tinations. Instead the authorities reserved a Aggressive expansion began in the European route monopoly at the airport for

April 2007 11 Aviation Strategy

Briefing

the airline created by the merger of St, as a higher proportion of the fleet will be Petersburg-based and owned going forward, this will also lead to a Pulkovo Airlines in October 2006 (now oper- reduction in aircraft leasing costs (which ating under the name Rossiya, and owned totalled approximately $180m in 2006). 100% by the government). Other cost-saving initiatives include the Nevertheless, Aeroflot's domestic expan- construction of a new $100m headquarters sion in the rest of Russia will mean a further for Aeroflot in (not far from increase in staff numbers. At the end of 2005 Sheremetyevo), which will be completed in the Aeroflot group (including regional sub- 2010. Once finished, this will save the airline sidiaries) employed around 18,500 staff, of the $10m a year that it currently pays for rent- which 17,064 were in airline operations. ing various offices throughout Moscow. Though Aeroflot has a relatively bloated Aeroflot is also tackling distribution costs employee base that makes productivity poor through a encouraging a higher proportion of (see graph, page 14), staff costs are relative- telephone and online bookings; the airline is ly low in Russia compared with western still too dependent on selling tickets via the Europe, and employees accounted for 14.9% Russian travel agent network, which of costs in 2005 - a percentage considerably accounted for 30% of all sales in 2005. lower that at any of its major European rivals. Aeroflot has, of course, been trying to Good prospects? reduce costs for several years, but the prime motivation for this has been fuel prices, which doubled in Russia over the 2003 to Results for full 2006 are likely to be 2005 period. Fuel costs of $741m in 2005 encouraging. In the first nine months of 2006 were 49% up on 2004 and accounted for net profits rose 46.2% to $186.3m (under 32.3% of total costs (25.3% in 2004). As a IFRS standards), with operating profit rising reaction to the rising fuel bill, Aeroflot 36.8% to $246m and revenue up 15.7% to increased fares by around 15% in 2005, and $2.1bn. Full year results are expected to while international passengers carried come in at $2.66n in revenue, with net profits remained flat, domestic passengers carried reaching $218m, more than 14% up on the rose by 17.6% in 2005. But Aeroflot hedged 2005 figure (see graphs, page 15). only 6% of its fuel needs in 2005, and though In 2007 Aeroflot's revenue is forecast to fuel costs rose by "just" 26.3% in the first nine grow by 21%, although net profit will remain months of 2006, to $691.1m, the airline says just above the $200m level, according to it is now considering hedging up to 30% of its Aeroflot CEO Valery Okulov. The latter is due fuel needs every year. And although the cur- primarily to the need to devote increasing rent reduction in fuel prices comes as a relief amount of capex to upgrading Russian to Aeroflot, the fact that Russian aircraft are equipment (which in 2006 included installa- much less fuel efficient than western aircraft tion of wing enhancements and lighter inter- has led to an overhaul of the entire fleet. And nal fittings on Tu154s in order to reduce fuel consumption); to the requirement to invest in USc/RPK AEROFLOT’S YIELDS domestic expansion eastwards; and to the 10.0 fact that the change to IFRS from Russian accounting standards will reduce net profit by 9.0 an estimated $100m in 2007, according to International Aeroflot. 8.0 The good news is that Aeroflot is relative- ly strong financially. Its debts have been cut 7.0 substantially, and as at the end of September Domestic 2006 Aeroflot's long-term debt was just 6.0 $106m, while cash and cash equivalents 2003 2004 2005 2006F 2007F 2008F stood at $63m. Source: Rye, Man & Gor Securities. Crucially, this year Aeroflot is being boost-

April 2007 12 Aviation Strategy

Briefing

ed by two key strategic developments. 2007 AEROFLOT’S TRAFFIC STATISTICS will be the first full year in which Aeroflot KMm PLF reaps the benefits of being in the SkyTeam 35,000 ASK RPK PLF 75% global alliance (which it joined in April 2006). Aeroflot already codeshares with Delta and 30,000 has asked for permission to codeshare with 25,000 fellow SkyTeam members Continental and 20,000 Northwest. Aeroflot estimates the revenue 70% impact of joining SkyTeam at around $20m a 15,000 year, but perhaps the more valuable benefit 10,000 is the raising of some of Aeroflot's operational and commercial practices to the standards 5,000 requited by SkyTeam. This has included a 0 65% new reservations system (supplied by 2000 2001 2002 2003 2004 2005 2006 Sabre), a proper internet booking facility and the installation of self-service check-in kiosks ble that Sheremetyevo airport itself may buy at Sheremetyevo - all standard practice at another 25% of Aeroflot's share. international airlines, but not at Aeroflot prior The bad news is that at some point over to 2006. The new infrastructure boosted rev- the next few years Aeroflot is going to take a enues by around $15m in 2006, Aeroflot huge hit on its bottom line from the loss of a believes, although the capital cost of the peculiar hangover from the Soviet era - fees upgrades is considerable. paid by international airlines overflying The second key development is the Siberia. These are collected on the govern- imminent provision of an efficient, modern ment's behalf by Aeroflot, but the in Russia (which Aeroflot has never had), retains a staggering 70% of the fees for doing when a long-awaited new Terminal Three so. It's difficult to calculate the precise opens at Moscow's Sheremetyevo airport, amount that this benefits Aeroflot, as the air- the airline's base, at the end of the year. line does not separate out the overflight rev- Sheremetyevo has experienced severe over- enue/profit. In Aeroflot's 2005 accounts, with- crowding for several years, but Aeroflot and in "other revenue" there is an "airline revenue its partners will transfer all their flights at the agreements" category, which includes over- airport into the new $430m terminal, which flight revenue as well as revenue from code- will have a capacity of 10m passengers a sharing and pooling; this totalled $357m in year. The terminal will enable easy transfer 2005. One analyst estimates that overflights between domestic and international were worth $277m in 2004 alone (represent- SkyTeam flights, and also allows Aeroflot to ing 13% of total revenue in that year). This connect passengers arriving on European goes straight to the profit line, with the only flights through to connections into Asia and deduction being tax. To be fair, other analysts east Russia, with Okulov talking of develop- say the figure is lower, at around $100m- ing a "bridge between Europe and Asia". $150m per year, although this is still a sub- The terminal will boost Aeroflot's profit line stantial sum. Following talks with the by around $20m per year, it is estimated, and European Commission, Russia has agreed Aeroflot is financing the project by selling to abolish these charges by 2012, but the 45% of the development to two state-owned Commission is now putting pressure on Russian banks in exchange for $130m in Russia to speed up the timetable for aboli- cash as well as a 13-year, $475m loan. In the tion, and pressure will intensify once Russia first part of that deal Vnesheconombank joins the WTO. (VEB) bought 20% of the terminal in January, A slightly more intangible challenge for while Vneshtorgbank (VTB) will buy another Aeroflot is improving passenger service over 25% later this year. After these deals the the next couple of years, although in-flight "net" cost to Aeroflot of the terminal is catering and entertainment has improved believed to be around $150m. It's also possi- substantially recently. However, Aeroflot has

April 2007 13 Aviation Strategy

Briefing

destination), Rostov-on-Don (home of 000s AEROFLOT’S ASKS PER EMPLOYEE Aeroflot-Don) and Murmansk. The airline 2,000 was launched by the owners of KrasAir, two Russian investments funds and a number of 1,800 private investors, although the European Bank for Reconstruction and Development 1,600 bought a 20% stake in December 2006 for an 1,400 investment in the region of $10m-$20m. SkyExpress tickets are sold online and, 1,200 most importantly, via the network of 40,000 post offices in Russia, as well as a mobile 1,000 phone retailer. Flights are being offered for as 2000 2001 2002 2003 2004 2005 little as $19 and the airline hopes to tap into to balance improved services with the need the large proportion of the population that to cut costs - last year the airline introduced cannot currently afford to fly (the average a paid-for service for alcoholic drinks in econ- salary in Russia is $4,800 per annum). omy class as part of the drive to compensate Ironically, despite the plethora of airlines after for higher fuel prices. the break up of Aeroflot, the number of domestic passengers has fallen from 130m Domestic chaos to less than 20m a year in the last 15 years, thanks largely to the increase in fares. SkyExpress will add another six leased Aeroflot is facing the same problems as 737s through the year, with a planned net- the rest of the Russian aviation sector - work of eight domestic routes by the summer increasing penetration by foreign carriers and a target of 1.2m passengers carried in combined with rising fuel prices and an over 2007. The longer-term target is to build a reliance on ageing, fuel-inefficient Russian fleet of 44 aircraft, and if these plans come aircraft. into fruition this will be a major challenge to In 2005 (the latest year for which data is Aeroflot, not least because it will encourage available) foreign airlines accounted for just other LCCs in the domestic market. over 31% (7.3m passengers) of the interna- However, the challenge that Aeroflot tional market to/from Russia, with Aeroflot faces from foreign and domestic competitors carrying 21% and five other airlines/groups are being exacerbated by the chaotic state (Vim-Avia group, Sibir, Pulkovo, AirUnion of the Russian aviation sector, which - while group and ) accounting for 32%. not as bad as in the immediate period after The domestic market is more fragmented, the break-up of the USSR in the 1990s - is with Aeroflot, Sibir, the AirUnion group still in a state of flux. The core problem is that (KrasAir, , , the industry is still fragmented, even though and ), and over the 2000s the number of Russian air- Pulkovo accounting for 57% of domestic pas- lines has halved, from around 400 to less sengers - although the rest is divided than 200. That's still way too many, even for between more than 150 much smaller small a country as huge as Russia, particularly as airlines. the vast the majority of these operate a hand- So far foreign LCCs have not had a major ful of obsolete aircraft and - crucially - cannot impact in the Russian market. Air and afford to upgrade to western aircraft. germanwings operate a handful of routes, These so-called "babyflots" continue to but as yet neither easyJet nor Ryanair fly to survive only because they were handed air- Russia - although easyJet is believed to be craft and other assets for free in the 1990s, looking at the potential for the market. but as Oleg Sudakov, analyst with Rye, Man However, in January the first Russian-based & Gor Securities in Moscow, says, "these LCC was launched - SkyExpress, which smaller airlines will go out of business when operates a couple of 737s on routes from their aircraft are fully depreciated, or else Moscow's Vnukovo airport to (a leisure they will be acquired by larger companies".

April 2007 14 Aviation Strategy

Briefing

The problem is, this consolidation is hap- AEROFLOT’S REVENUES.. pening at a sluggish pace, and so the $m Russian government - mindful of the concern 3,000 about the growing presence of foreign air- 2,500 lines in the country - is now frantically trying to reduce the sector into to a handful of car- 2,000 riers that are more robust financially, which 1,500 can replace ageing aircraft with modern western equipment and that are strong 1,000 enough to establish hubs throughout Russia 2000 2001 2002 2003 2004 2005 2006 (and so lessen the dependence of the avia- $m ..AND FINANCIAL RESULTS tion industry on Moscow). It's difficult to keep count, but at present 250 the Russian government completely owns 200 more than 55 airlines and holds stakes in 150 around 60 others, and - unsurprisingly per- Op. haps - within parts of the government there 100 profit has been a growing lobby to reconsolidate Net the aviation industry around Aeroflot. Many 50 profit regional governments in Russian also see 0 Aeroflot as a white knight that can rescue 2000 2001 2002 2003 2004 2005 2006 debt-burdened and/or loss making local air- lines. In 2006 the state property fund there- the process of consolidation, and some were fore proposed consolidating up to 100 state- fiercely opposed, particularly KrasAir, which controlled regional airlines back into Aeroflot, heads up the AirUnion alliance of five the effect of which would be to increase the Russian airlines. KrasAir is based in government stake in Aeroflot to more than and operates a mixed fleet of 40 75%. Some managers within Aeroflot are aircraft, and instead proposed that the mem- believed to favour this option, but most oth- bers of the AirUnion merge to form a decent- ers, including CEO Valery Okulov, as well as sized competitor to Aeroflot. It's also uncer- important allies in the government, are fierce- tain as to whether Rossiya (into which ly opposed, and prefer Aeroflot to cherry pick Pulkovo was merged late last year) wants to the best regional airlines as needed. be part of Aeroflot, while will def- The latter alliance of interests appears to initely not be part of Aeroflot's plans due to have won the argument, and Aeroflot is like- (depending on the source) either a willing- ly to be helped in its more "selective" region- ness of the government to maintain competi- al acquisition policy by the transfer of its for- tion in the region, a reluctance of Aeroflot to mer CFO, Yevgeny Bachurin, to the Russian become involved with the airline, or a wish of civil aviation authority in May last year, where the airline itself to remain independent. Sibir he is now responsible for the reconsolidation - which rebranded as last year - is of the Russian airline industry. Last year now due to be auctioned off by the Russian Aeroflot therefore proposed taking over six government early in 2007. airlines based in the east of Russia - Pulkovo However, one of the airlines among those (in which the state owns 100%), GTK "chosen" by Aeroflot was receptive to the Rossiya (100%), (100%), idea, and so in early 2007 the Aeroflot board Vladivostok Avia (51%), KrasAir (51%) and gave formal approval for "Aeroflot-East" to Sibir Airlines (25%). Combined with existing launch via the takeover of Dalavia and anoth- Aeroflot subsidiaries, this would result in a er airline, Sakhalin Aviatrassy (SAT), which domestic market share of more than 50% for will be combined with Aeroflot's existing oper- the group, and an international share of ations in the region. Dalavia is based in approximately 60%. and operates 25 Russian aircraft However, many of the airlines named by to around 30 destinations, with international Aeroflot insisted they wanted to have a say in routes to Japan, China and . It

April 2007 15 Aviation Strategy

Briefing

open market, thus improving Aeroflot's liquid- AEROFLOT GROUP FLEETS ity. Fleet Orders Options Aeroflot Russian Airlines Once established, Aeroflot-East will join A319 8 the two existing major subsidiaries - Aeroflot- A320 10 2 Don and Aeroflot-Nord. A321 7 3 Aeroflot Don is based in Rostov-on-Don 767-300 11 in the south of Russia, and operates a fleet of DC-10-40F 4 IL-86 7 13 aircraft - all but two of which are Tu-134s IL-96 6 6 or Tu-154s - on 17 domestic and regional Tu-134 13 routes, with the most important routes includ- Tu-154 25 ing Rostov to Moscow and St. Petersburg SuperJet-100 0 30 20 and handful of international destinations, Total 91 41 20 Aeroflot-Nord including Frankfurt, , Istanbul and 737-500 4 Dubai. The airline carried 0.59m passengers An-24/26 7 in 2006 (1.9% down on 2005), but the first Tu-134 10 western aircraft - a pair of 737-500s on six- Tu-154 4 year operating leases from Pegasus - arrived Total 25 0 0 Aeroflot-Don in August last year, and another four will be 737-500 2 added to the fleet during 2007 as it seeks to Tu-134 2 introduce more modern equipment to its key Tu-154 9 domestic and European routes. Aeroflot-Don Total 13 0 0 had previously planned to introduce Fokker Aeroflot total 129 41 20 100s into its fleet, but faced regulatory prob- carried 0.58m passengers in 2006. SAT car- lems due to non-certification of the Fokker ried 0.12m passengers in 2006 and operates 100 in Russia, with the relevant authority (the 10 aircraft out of the island of Sakhalin on 14 Interstate Aviation Committee) reluctant to mostly domestic routes, although there are grant certification to a model that is no longer services to Japan, China and South Korea. in production. Aeroflot-East will be based at The airline dates back to the 1920s, and Khabarovsk (30km from the Chinese border), was previously known as Airlines where a hub operation is to be built up, until Aeroflot acquired a 51% stake 2000, although Aeroflot says it will take two years to after which it became Aeroflot-Don. The rest bring the acquired airlines up to "Aeroflot of the shares were held by Opt Invest, a standards". It's probable that other airlines Russian investment company, but at the start will be rolled into Aeroflot-East at a later of 2007 Aeroflot bought all of the shares in a stage, and among the possibilities is Yamal deal in which few details have been revealed. Airlines, based in Siberia with a fleet of 22 Aeroflot-Nord carried 0.8m passengers Russian aircraft. Potentially also part of the in 2005 and is based at Arkhangelsk Airport new regional grouping will be former employ- in the north of the country, It was launched in ees and aircraft of Mavial Magaden Airlines, 1961 as Arkhangelsk Airlines, before Aeroflot a Siberian-based airline that operated six air- acquired a 51% stake in 2004 (with the rest craft to local destinations as well as Moscow, being held by Aviainvest, although again St Petersburg and , but which sus- Aeroflot plans to acquire a 100% stake as pended operations last year (leading to a soon as possible). The airline operates a hunger strike by employees in an attempt to fleet of 25 aircraft (with the only non-Russian get their outstanding wages paid). types being four leased 737-500s, introduced Whichever regional airlines do become last year) on more than 30 domestic and part of Aeroflot's eastern empire, the most international routes, including services to likely mechanism will be that airlines are Norway, Sweden and Finland. The 737s had acquired in exchange for newly-issued initially been considered an a temporary shares in Aeroflot being given to the govern- measure, with the airline's management ment, who will subsequently sell them in the reportedly favouring an order for new An-

April 2007 16 Aviation Strategy

Briefing

148s, but the influence of its parent is likely to ing civilian ( and ) and military result in further 737 leases. (Sukhoi, MiG, Yak and Irkut) aircraft produc- Elsewhere, Aeroflot pulled out of a deal to ers into one company - the United Aircraft buy a majority stake in Moscow-based char- Building Corporation - with the civilian aircraft ter airline in 2005 after makers under the control of the Russian concern about tax reimbursements owed to defence minister Sergei Ivanov, it is too late the airline by the Russian government, as to make existing models competitive with well as about ambiguity over who the actual Airbus or Boeing. owner of some of the Continental shares Today Aeroflot's mainline fleet comprises was. Instead, in 2006 Aeroflot set up Aeroflot 91 aircraft (see table, opposite), of which 40 Plus, its own VIP charter operation that uses are western models. On medium haul, the last IL-86s in the Aeroflot fleet and three Aeroflot's 25-strong fleet of Tu-154s will grad- older Tu-154s. In contrast to elsewhere in ually be phased out by the end of 2010, with Europe, the Russian charter sector has been its replacement being the A320 family, of growing strongly in the last couple of years, which the airline currently has 25 aircraft. based on increasing traffic flows to popular Five A320s and A321s are on outstanding Russian holiday destinations. order, most of which are arriving on 12-year Another carrier being linked with Aeroflot finance leases over the next year, but by is , a 26-aircraft carrier with a 2010 Aeroflot will place an order for 45 network that overlaps considerably with A320s, according to Valery Okulov, which Aeroflot's regional routes, but which is attrac- would be worth around €2.4bn at today's list tive to Aeroflot as the airline's management prices. owns 73% of its shares, with just 27% held by On short-haul Aeroflot operates a fleet of the state. 13 Tu-134s, a model that Aeroflot admits is both old-fashioned and uneconomical. The Fleet farce 76-seat Tu-134s are being phased out this year, either being sold or passed on to its regional or charter subsidiaries, and they will In the late 1990s Aeroflot operated 120 be replaced ultimately by 30 Sukhoi Russian aircraft - of which just 20 or so were western Regional Jets (RRJs), for delivery in 2008 types (Aeroflot aircraft went through spate of onward (with 20 more on option). accidents in the early 1990s) - with the fleet However, the order process for the RRJs consisting of 12 different types. This variety went on for more than a year, largely due to of types and the large amount of unreliable the fact that as the Russian government and fuel-hungry Russian models was simply owns a majority stake in both Aeroflot and not viable for Aeroflot in the long-term. As fuel Sukhoi, this triggered the necessity for a prices have risen through the 2000s so long-winded "related party" approval proce- Aeroflot has tried to rationalise the fleet, but dure. Whether the 95-seat RRJ has been pressure to increase the pace of modernisa- purchased purely from a commercial view- tion has also come from the SkyTeam point is doubtful. The Russian government is alliance. The goal is to reduce aircraft types believed to have put pressure on Aeroflot to to four, but although the situation has become the launch airline for the new model, improved, Aeroflot is still some way off and the order has been approved despite achieving that. reported reservations by some airline execu- With one major exception (see below), tives on everything from the model's techni- Aeroflot's fleet will be based on western air- cal specifications and price to the feasibility craft from now on. New Russian aircraft of the delivery timetable. There was also a development has been beset by many prob- preference among some Aeroflot managers lems, not least of which has been an inability for the An-148 aircraft instead, complicated to define an accurate price per unit in by the fact that the National Reserve advance. Although the Russian government Corporation (known as NRC, and a 30% recently decided to consolidate the remain- shareholder in Aeroflot) has an interest in

April 2007 17 Aviation Strategy

Briefing

Antonov, but that deal didn't happen after Russia's entry to the WTO. concerns that the unit price of the An-148 But - as the year progressed - a firm order was too high. was still not forthcoming. Aeroflot's managers Whatever the decision-making process, used the delay to make it clear that they pre- the RRJ order is worth around $630m ferred the 787 (and specifically the 787-8 and (approximately 15%-20% less than list 787-9 stretch version), largely because it prices), and the aircraft will arrive on a mix of would be available earlier than the A350 finance and operating leases. To fill the gap (2010 rather than 2012). Yet another compli- between the last of the Tu-134s and the cating factor became the Russian govern- arrival of the RRJs, some 737s will be leased ment's keenness to increase its influence in on a short-term basis. Airbus after Vneshtorgbank (VTB), a state It's on long-haul, however, that Aeroflot bank, acquired 5% of EADS in the summer of has managed to make itself look something 2006 for $1bn, and drew the Airbus group close to incompetent, via a long-running into supporting the struggling Russian aero- saga over a new order that has still not been space industry. resolved. Aeroflot completed an evaluation A final decision between Airbus and of its long-haul fleet options back in 2005, Boeing was going to be made at Aeroflot's identifying a need for up to 22 aircraft for board meeting in September last year, but in delivery in 2009-2015. The A350 and the 787 the end the board decided not to make a firm were (and are) the favoured types for the order after the Russian government failed to order, but the decision has been complicated make clear which manufacturer it wanted the by the fact that Russian airlines have to pay airline to choose. Bizarrely, a few days later a 20% import duty as well as 18% VAT on all the privately-held NRC signed a preliminary imported aircraft. Previously Aeroflot has agreement with Boeing to purchase 22 787s negotiated exemptions with the government at prices fixed as of 18 months previously on these import taxes and tariffs, usually by (roughly equivalent to a discount of $15m- promising to buy a certain number of $20m per aircraft on current list prices, and Russian-built aircraft at the same time, but thus making the whole order worth around this time around the government insists that $3bn). In signing the deal, NRC paid Boeing it can no longer make an exception for around $40m to secure a month's option on Aeroflot (even though the airline is committed production slots for the 787 in 2010 onwards, to buying six IL-96-300s). That's partly a in the clear expectation that final approval negotiating tactic in order to pressure the air- from the board the government was just a line into buying further Russian types, but a matter of days away. looming external factor in the situation has Inevitably perhaps, Aeroflot missed the been talks over Russia's imminent entry to November 1 deadline to confirm the NRC the WTO, in which aircraft import tariffs are a "order", and so Boeing awarded the produc- key discussion point. (since when Russia tion slots for the 22 aircraft to other cus- joins the WTO, taxes on western aircraft will tomers. NRC was furious about the delay have to be reduced substantially). and persuaded Boeing to backtrack and So while in early 2006 Aeroflot provision- extend the deadline to December 1, but - to ally chose the 787 as its preferred model, a no-one's surprise - Aeroflot/the government firm decision was delayed time and time still could not make a confirmation by that again as Aeroflot negotiated with the govern- date, and so the delivery slots were lost for ment over a tariff exemption, and the govern- good. ment negotiated with the EU and the US over One senior Aeroflot executive describes entry into the WTO. In April, Aeroflot was the situation as "farcical", while another says then "persuaded" to switch its preference the airline is "hamstrung" by the situation. over to the A350, a move that some analysts The owner of NRC - - a saw as a non-too-subtle Russian govern- billionaire businessman who is a deputy of ment response to perceived aggressive pres- the Duma and a former KGB employee, did- sure exerted by the US over the terms of n't hold back in his reaction, saying that: "The

April 2007 18 Aviation Strategy

Briefing bureaucracy of the government is very inept. grounding of the existing IL-96s in Aeroflot's The state has practically left the national air- fleet in August that year (for 43 days), which line with no modern long-haul planes, and took out just under half of the airline's long- losses from that decision will run into hun- haul capacity at the time and cost the airline dreds of millions of dollars." The NRC is a great deal of money. Hopefully the long- threatening to sue the Russian government haul crisis will not persuade Aeroflot to hang over its "dithering" in choosing between on to its remaining IL-86s, which were sup- Airbus and Boeing, but that will not help the posed to be taken out of the fleet in airline solve its fleet problem. November last year, although Aeroflot has Further developments in the saga appear apparently struggled to find suitable buyers to occur every week, but the latest news is or lessees. that Aeroflot has "changed" its analysis of its On cargo, last December Aeroflot sepa- long-haul needs, and now needs a fleet of up rated out its operations (it is currently the to 45 long-haul aircraft, with differing capaci- largest cargo operator in Russia) into a sepa- ties. This should have allowed the compro- rate subsidiary called Aeroflot Cargo, though mise of splitting requirements between still fully owned by the mainline. Aeroflot cur- Airbus and Boeing - even though that will not rently operates four DC-10-40Fs from its be optimal from an operating viewpoint - with cargo hub at Frankfurt Hahn, but they should orders for 22 A350XWBs worth $3bn, as well be replaced on international routes by up to as 22 787s. The likelihood of this, however, six MD-11Fs leased from Boeing Capital depended on whom you spoke to, and other Corporation, and scheduled to be delivered sources within Aeroflot indicated another, this year and in 2008 (although they were final twist in the story, with the growing cool- originally supposed to be delivered from 2006 ness between the US and Russian govern- onwards, and there is no confirmation of this ments potentially leading to a placement of order yet). The DCs would then be reas- the total (expanded) long-haul requirement signed to purely domestic Russian routes. with Airbus. If this occurs it will likely set off a Longer term, the cargo unit will look to order storm of complaints from both Boeing and new aircraft, most likely to be 777s. Cargo the US government, but as Aviation Strategy generates around 10% of Aeroflot's revenues, went to press, Aeroflot said it had indeed and the group is looking to increase cargo signed an MoU to buy 22 A350s, as well as a volumes by 9% in 2007. deal to lease up to 10 A330-200s, the latter of which will cover the minimum seven-year A bright future? period until the A350s arrive. If this deal is confirmed, the unavailability of the A350 XWB until 2014 at the earliest It's clear that Aeroflot is facing severe chal- (and even this is subject to confirmation of lenges at the moment, many of which stem the A350 production schedule) means that from the government's inability to make sen- Aeroflot still has to find interim (and costly) sible, timely decisions, whether on which air- solutions to its long-haul fleet needs - over craft to buy for Aeroflot or on the way forward and above the leased A330s. That has to clear up the mess in the Russian aviation already resulted in extending leases on the industry in general. eleven 767-300s Aeroflot currently operates, From Aeroflot's point of view it mattered and extending the life of its six owned IL-96- relatively little which manufacturer the gov- 300s, even though the model has relatively ernment chose for long-haul aircraft - just as high operating costs. Aeroflot also has anoth- long as the government did make a choice er six IL-96-300s on order, which will come and that the airline received new western air- on 15-year leases from the manufacturer - craft as soon as possible. But the chance of even though back in 2005 there were con- receiving new aircraft in the next few years cerns from the Russian authorities over tech- has gone, and the cost to Aeroflot will run into nical reliability of the model, particularly on tens of millions of dollars, if not hundreds of the braking system. Those concerns led to a millions.

April 2007 19 Aviation Strategy

Briefing

As for restructuring the Russian aviation Sheremetyevo, Aeroflot can have a success- industry, it's vital that the government does ful future, but it's vital that the state divests its not bend to pressure to force regional airlines remaining stake as a matter of urgency. upon Aeroflot. There's no doubt that many of Currently, the Russian government owns the smaller regional airlines will be loss-mak- 51.2% of Aeroflot, with employees having ing for ever, and should either be allowed to 14% and NRC 30%, with a negligible free go bankrupt or (more likely) receive continu- float of around 3%. ing state help in order to survive,. This may Although an ambitious (and unrealistic) necessitate wrapping up these airlines into a plan by the state to privatise the airline by new state aviation concern - but one com- 2005 inevitably came to nothing, Russian pletely separate to Aeroflot. government sources say that it wants to dis- On the positive side, the management pose of its stake in Aeroflot at some point, but team at Aeroflot is much improved (in there are no plans as yet for an IPO, either in November last year the airline successfully the short- or long-term, (and anyway, this sued three former senior executives - includ- can't happen until Aeroflot is formally struck ing Nikolai Glushkov, a former deputy director off the list of Russian "strategic enterprises" - for embezzling millions of dollars from the by the Russian president). Until that situation company in the late 1990s). With (at some changes (and NRC is believed to be lobbying point) a new fleet, a continuing strategy of hard for an IPO), analysts will be sceptical picking off the strongest regional airlines in about the long-term future of Russia's flag By Nick Moreno order to secure feed, and the benefits of both carrier. SkyTeam and the new terminal at Spring Airlines: China’s self-styled “first LCC” hree Chinese start-up airlines launched in Chinese start-ups is struggling to survive. The T2004 but only Shanghai-based Spring second group of start-ups, of which Spring Airlines seems to have survived. Spring Airlines is the most prominent, are motivated reported a profit of RMB30.6m (US$3.9m) on by and implementing a simple strategy: a ver- revenues of RMB539.03m (US$69m) in 2006 tical integration of the tourism and airline busi- with a fleet of five A320s. How does China's nesses. self-styled "first LCC" work? Spring Airlines is a subsidiary of Spring Tourism Group, the largest tour operator in Spring's distinction China. Following China's airfare deregulation in 1997, Spring Tourism began to purchase Prior to 2004, when the Chinese govern- flights from the Chinese majors to carry ment first allowed private investment in start- tourists and quickly dominated the most pop- up companies, an Air Operator Certificate ular tourism routes originating from Shanghai. (AOC) was regarded as a valuable scarcity. Publicly, it was announced that Spring The first few airline founders seemed to be Tourism had launched an airline because it investing for a fast buck, through obtaining was constrained by the established airlines' AOCs and then selling shares to foreign air- routes, schedules and capacity, and had to lines or via the IPO process. The emphasis have its own carrier to meet surging demand. on quick returns meant a lack of care in Spring's real reason however, was that the choosing management teams, operational relationship between China's airlines and tour bases, fleet planning and any route network operators was becoming trickier: as the air- development. The glory of owning a licence, lines' finances came under pressure they however, faded quickly after 2004 and the attempted to recover their losses by increas- start-up airlines' lack of efficiency has dis- ing ticket prices to tour operators. suaded further investment. This first group of Spring Airlines was set-up in 2004 by two

April 2007 20 Aviation Strategy

Briefing major shareholders: Spring International a bespoke in-house Tourism Company which owns 60% and the system. Spring's IT SPRING’S COST AND REVENUE Spring Charter Flight Tourism Company department is plan- BREAKDOWN 2006 which owns 40%, whose registered working ning to set itself up as Passengers 97.7% Cargo capital is RMB80m (US$10m). Spring Airlines' a stand-alone, serving 1.8% Other sales 0.5% Chairman, Wang Zhenghua, is also Chairman Spring and other cus- Total revenue 100% of the Spring Tourism Company and he owns tomers. Crew 6% 39% of the airline's shares. About 40% of Overall, Spring's Fuel 43% Spring Airlines’ traffic was provided by the goal is to achieve Airport charges 12% Spring Tourism Group in 2006. operating costs of Avation Construction Fund 4% Maintenance 11% about 30-50% lower Insurance 1% Low-cost rationale than China's estab- Aircraft leases 15% lishment airlines. In Other 2% Spring Airlines has styled itself as a low- 2003 the Civil Salaries 5% cost carrier; its strategy is to adapt the LCC Aviation Total Costs 100% model to the Chinese market, which is char- Administration of acterised by a huge, low income per capita China (CAAC) issued a price directory for population. Importantly, Spring wants to avoid every domestic route, stipulating that fares the mistakes of the established Chinese car- could not be higher than 120% of the list price riers. China's airlines have moved from an era in the peak season or lower than 40% in the of high growth and high profitability and off-peak season. Spring's 2006 average fare entered a new stage of expansion with little or was about 38% of the list prices set by the no profitability. From 1998 to 2003 the whole CAAC and now Spring and others are pricing industry reported a total financial loss of more tickets lower than 40% (see page 23). than US$1bn, although the period saw an The airline encourages website ticket dis- average passenger growth rate of about 13% tribution, while still selling greatly discounted with more than 200 aircraft delivered to the group tickets to travel agents. Spring uses the airlines. Pricing deregulation, deflation from established LCC yield management system 1998 to 2002 and excessive competition were but faces the problem that credit cards are not blamed for the financial loss, but the main widely used in China, which limits the scale of reason was the inablility to lower operating online transactions. Even so, passengers pur- costs. chasing e-tickets have continued to grow and Like other LCCs, Spring has used relative- accounted for 67% of total passengers in ly high aircraft utilisation in order to lower 2006. operating costs. China's established airlines Spring provides a no-frills flight service average around nine hours per day with the and charges for food and refreshments. This A320. Spring Airlines achieved 11 hours per simplified service results in a cost saving of day in 2006, reducing rental per flight hour by about US$2.5 per passenger. Revenue of about 20%. The established airline employee about US$35,000 was raised from ancillary to aircraft ratio is more than 200:1, a legacy of services last year, a relatively modest the past planned economy and ineffective amount. mergers. Spring has a ratio of 100:1, reducing labour costs by more than 50%. New base, new route Normally, start-up airlines purchase rev- enue management systems or adopt a pay- Currently Spring operates five A320s and as-you-use model provided by RM providers. a point-to-point model based at Shanghai The majority of China's airlines use reserva- Hong Qiao Airport. The bulk of its original pas- tion/distribution systems provided by sengers were tourists collected by Spring Skytravel, a Chinese company owned by Air Tourism. Business passengers, however, China, China Eastern and other smaller generate about 20% more revenue than Chinese airlines. Skytravel charges about $3 tourists and they are the airline's priority tar- for distributing one ticket. Spring Airlines uses get. In December 2006, business passengers

April 2007 21 Aviation Strategy

Briefing

accounted for 62.5% of total passengers. with a Chinese rather than international salary Recognising the importance of the revenue level. advantage gained from business passengers The carrier's DOCS, administration costs, and constrained by a lack of slots in Hongqiao capital costs and sales cost in CASK terms Airport, the airline plans to set up another were 24.5%, 68%, 75% and 55% lower than base in Sanya, a popular resort by the South the average of China's airlines, respectively. China Sea. Once this base is established, Profit after tax in 2006 was RMB30.6m Spring plans to carry tourists to/from Sanya (US$4m, 655% higher than the average for on morning and evening flights and transport Chinese airlines in RPK terms. business passengers on Shanghai routes Although the airline is making efforts to during the day, maximising tourist and busi- secure and consolidate its Sanya base, sup- ness traffic revenue streams. With two bases ported by the Hainan Province Government, established, the airline could establish a hub- its prospects still heavily rely on Shanghai and-spoke model. and its lucrative business traffic. Besides the Spring will stick to a point-to-point opera- shortage of slots at Hongqiao Airport, the tion, which suits the Chinese internal markets. change in market focus avoids head-to-head Only 8% of Chinese airline routes exceed competition with Shanghai-based China 2,400km, while 61% fall between 930km and Eastern and . Hopefully, 2,400km and 24% between 465km and once the airline solidifies its presence in 930km. These stage lengths make a China's tourism market and grows its fleet Western-style hub-and-spoke operation with and route network from its Sanya base, it will several banks per day unfeasible in China. return to the Shanghai market with greater competitive power. At the moment there are Financial performance no other bases planned. In 2006, Spring Airlines announced earn- In 2006 Spring Airlines transported 1.13m ings of RMB0.22 ($0.03) per passenger on passengers on 6,713 flights, producing rev- ancillary revenues. Most passengers were enues of RMB539.03m (US$69m). 97.7% of tourists, who traditionally spend little inflight. the total revenue was attributable to passen- Once business passenger numbers rise, ger service and 1.8% came from cargo. inflight services revenue should increase as Unlike its European counterparts, Spring only should hotel reservations and car hire ser- recorded 0.5% of total revenue from ancillary vices, which still remain underdeveloped in and merchandising services. The carrier China. obtained a load factor of 94.4%, the highest load factor among all Chinese passenger car- Growth potential riers. Passenger numbers are expected to Another potential area of growth comes reach 2.6 million in 2007, a 232% increase with the reform of China's Airport Charge and from 2006. Another significance of the two- Aviation Construction Fund. The former base operation is that aircraft utilisation could accounted for 12% (around RMB56m) of the increase to 12 hours per day, further lowering airline's DOC and the latter 4% (nearly Spring's operating costs. RMB19m). Airport fee regulations aimed at Total direct operating costs (DOCS) lowering airport charges are to be announced reached RMB465m (US$60m). Fuel costs by the CAAC, but a much more significant accounted for 43% of operating costs with air- improvement will come from the elimination of craft lease rental accounted for 15% of the the Aviation Construction Fund, a de facto total direct costs. The third largest operating corporate tax for Chinese carriers. The legiti- cost was for airport charges, which accounted macy of the fund has been long been chal- for 12% of the total DOCS. Crew costs only lenged by the airlines, it is unsure when the accounted for 6% of the DOCS, as pilots and fund will be eliminated, but once ended all cabin crews serving China's airlines, except Chinese carriers will benefit. those recruited from outside China, are paid Spring Airlines needs more capacity. The

April 2007 22 Aviation Strategy

Briefing carrier currently has five A320s leased from Airlines and protect the -based airline's GECAS and is approaching lessors for further interest. Although the out-dated regulations aircraft. However, due to a dearth of A320s on will be abandoned eventually, Spring will have the market, at the moment the lessors are dic- to develop under these constraints in the fore- tating terms - high lease rates or a minimum seeable future. lease of ten years. As the airline's financial position is improving, outright purchase Towards a Chinese Southwest? seems attractive and is also possible. The air- line has submitted a request to China's Spring Airlines has not yet significantly Reform and Development Committee to pur- impacted the market or created anything like a chase 20 A320s. There are two problems, "Southwest Effect" in China. At the same time, one political, the other fiscal: first, how many China's established airlines still have paid little aircraft can the government be seen to allo- attention to the start-ups. By gradually enter- cate to the airline and then how can the carri- ing China's key markets, such as er raise the finance for the aircraft. To raise and, in future, , and some overpriced funds, the airline needs to tap into the capital routes, Spring Airlines will eventually engage markets. Spring has two options: First, to sell in fierce price wars with the incumbents. equity to private or strategic investors or sec- Spring's disadvantage is its comparably weak ond to conduct an IPO. Introducing strategic financial position, but the question is how investors to the airline is not on the airline's determined and how capable the incumbents agenda and institutional investors might well are to wage a broad price war against a start- require a high return in a few years. Hence up and how low the prices can go, given the the two options are not ideal for the airline. incumbents' high and inflexible cost structure. The IPO process has more appeal to Spring Air safety remains Chinese public's con- as it provides equity while leaving the current cern. China's airlines have achieved a record management to run the company. Spring of no accidents for five years. Given Chinese intends to conduct an IPO in the next two air transport industry's explosive growth, its years, but before this the airline needs to weak air traffic control system and many for- deliver financially. When and where to con- eign and fledgling pilots' joining the airlines in duct the IPO and who to underwrite it remain recent years, the air safety risk is expected to undecided, but the airline will need to obtain grow. To address this issue, Spring Airlines China's Securities Supervision Committee's has adopted a stringent safety procedure and approval to have the IPO in an overseas employs experienced domestic as well as for- stock market. eign pilots. The second constraint is out-dated regula- There is a risk derived from the two-base tions and vested benefit groups behind the operation model. The success of the model regulations. In 2006 the airline was almost relies on the smoothness of the whole opera- fined by the Jinan Pricing Agency for selling tion and dispatch reliability. Given the low effi- tickets at a price of RMB1 (12 US cents). A ciency of airport handling and air traffic control regulation issued in 2003 justified the in China, the airline is taking a risk that might agency's decision that a domestic airline is for- be beyond its control. bidden to sell a ticket at a price of below 40% Another potential risk comes from the pos- of the list price. Although Spring Airlines set- sible conflict between Spring Tourism and the tled the argument by applying a special airline business within the group. The airline's approval regarding pricing from CAAC and rapid expansion relies on the stable existing through negotiating with the agency, this event market provided by Spring Tourism. On the reflected a dilemma facing China's start-up air- other hand, the airline provides sufficiently low lines. Urged on by a state-owned and Jinan- airfares to the tourism company to ensure based airline, which was seeing its market tourism's success. With the airline's ownership share dramatically shrink since Spring's entry getting complicated, how the two businesses into the market, the Jinan Pricing Agency used ensure a harmonious working relationship will the pricing regulation to challenge Spring prove challenging.

April 2007 23 Aviation Economics

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