Issue no. 225 April 2017

Low cost subsidiaries – Repeating past errors? This issue includes Page of long-haul low cost, in the inial form of Norwe- gian Air Shule operang across the Atlanc and into Asia, po- Low cost subsidiaries – T tenally poses a serious challenge to established European, US Repeang past errors? 1 and Asian network carriers. Yet it is not at all clear that the incumbents see Norwegian — whose North Atlanc market share is less than 2% — Aeroflot: State resumes control 3 and other new entrants, like WOW and Westjet — as really viable, as a major threat in the long term. SIA: Reconciling Premium tradion with Budget Barriers to entry remain high, no- eventually abandoned. growth 8 tably the requirement for feed at high Vueling is admiedly a successful cost hub airports, the unit cost advan- short haul LCC within IAG, though Alaska Air absorbs Virgin tageachievedthroughhighulisaon this is largely because of its disnct America’s “great of widebody aircra and the ability brand as the de facto flag-carrier of emoonal energy” 13 to offer heavily discounted Economy Catalonia. Aer Lingus could conceiv- seats “cross-subsidised” by Premium ably play a role as a lower cost long traffic. haul carrier within IAG, but it appears Nevertheless, there is a growing that it is being integrated (mostly) suspicion that the Legacies could be into the antrust-immunised Atlanc repeang the mistakes they made in JV, which means that its pricing and the 90s and 00s — hugely underes- capacity has to be ghtly coordinated mang the impact of a new low cost with BA and American, with the business model on their established three carriers operang as a virtually business — when the expansion of merged enty. , easyJet, Wizz, etc in effect Instead IAG has opted to set of taking on unions with the aim of ul- undermined their network models, up Level as a long haul low cost mately reducing costs at the main- forcing them into painful cost cung subsidiary based at Barcelona line airline, through the introducon and route raonalisaon. and inially operang two A330s. ofA/Btypewagescales.Thisiswhypi- One of the unsuccessful strate- Luhansa’s low cost subsidiary Eu- lot unions can be so vociferously op- gies that is being re-enacted today is rowings has six A330s for long haul posed to low cost subsidiaries, with the establishment of lower cost sub- operaon, while Air France’s Boost Air France unions for instance. de- sidiaries, but this me for the long proposes A340s and later A350s manding that Boost’s pilots be on the haul sector. The short haul versions based at Paris CDG. same contracts as mainstream em- in Europe were unprofitable and gen- A fundamental problem with low ployees. The result, as all the Legacies erally could not be made to work as cost subsidiaries is strategic ambigu- know, is protracted strikes. v part of the parent airline group: BA ity: what exactly is their purpose? The subsidiary is an aempt to managed to sell off Go to 3i, the in- block off expansion of pure LCC en- vestment fund, and hence to easyJet, Conflicng aims trants or even put them out of busi- while KLM offloaded Buzz to Ryanair, Management at the parent company ness. This is never, of course, an purchases which were soon deeply have to resolve a number of conflict- explicit aim, and in today’s ligious regreed by the two LCCs. ing aims: world it is a dangerous strategy. In the US, Delta’s experiment v The subsidiary is designed as a with Song and United’s with Ted were v The low cost subsidiary is a means niche market operator. This strategy

Published by Aviation Strategy Ltd Aviation Strategy is meant to ensure that the sub- 777s will be reconfigured to 332 sidiary does not cannibalise the par- seats from 280, which will equalise, ISSN 2041-4021 (Online) ent. The problem is finding suitable BA claims, the operang cost per This newsleer is published ten mes a niches: pure leisure desnaons are Economy seat between itself and year by Aviaon Strategy Limited Jan/Feb the usual choice, but then the sub- Norwegian’s 787s). By contrast the and Jul/Aug usually appear as combined is- sues. Our editorial policy is to analyse and sidiary is operang in essence as a Premium classes are being upgraded cover contemporary aviaon issues and air- charter carrier, in a highly price sensi- with more seang capacity, gourmet line strategies in a clear, original and ob- ve market and one in which a Legacy food, refurbished lounges, etc). jecve manner. Aviaon Strategy does not airline has no real compeve advan- The outcome will be a sharper dif- shy away from crical analysis, and takes a global perspecve — with balanced cover- tage. ferenaon between long haul Econ- age of the European, American and Asian v Finally, there is the possibility of omy and Premium, which is vitally im- markets. using a low cost subsidiary to transi- portant to BA and the other European on the parent airline to a more effi- Legacies (see IATA’s bubble chart on Publisher: cient operaon, through allowing the this page). The problem is that the subsidiary and the parent to compete Legacy carrier ends up with an Econ- Keith McMullan for routes; the closest to this radical omy product that to passengers is in- James Halstead strategy is Qantas/ Jetstar. disnguishablefromthatofanewen- trant LCC, while total unit seat costs Editorial Team Meanwhile, BA appears to be remain way above those of a pure Keith McMullan coming up with a variaon on the LCC. kgm@aviaonstrategy.aero parent/subsidiary airline strategy — Then the Premium class is ex- creang two different airlines on the posed: most aenon so far has James Halstead same long haul aircra. The proposi- focused on long-haul LCCs winning jch@aviaonstrategy.aero on seems to be to duplicate its new Economy passengers but there is also short haul Economy product on long growing compeon for a segment Tel: +44(0)207-490-4453 haul — most visibly this means paying of the Business market — those Fax: +44(0)207-504-8298 for food and drinks (but not just air- travellers from SMEs, for example, line food but Marks & Spencer airline whose companies cannot nego- Subscriptions: food) and increasing seang density ate corporate discounts with the info@aviaonstrategy.aero (from 2018 BA’s Gatwick-based network carriers. Copyright: ©2017. All rights reserved PREMIUM TRAFFIC REVENUES 6% Aviaon Strategy Ltd South Atlanc Registered No: 8511732 (England) Registered Office: 4% Europe-S Africa 137-149 Goswell Rd Within Europe London EC1V 7ET 2% Europe-Middle East North VAT No: GB 162 7100 38 Atlanc Within Asia ISSN 2041-4021 (Online) 0% Europe-Asia Asia-SW Pacific The opinions expressed in this publicaon donotnecessarilyreflecttheopinionsofthe -2% editors, publisher or contributors. Every ef- Pacific fort is made to ensure that the informaon Premium fare growth minus economy -4% contained in this publicaon is accurate, but no legal reponsibility is accepted for any er- -15% -10% -5% 0% 5% 10% rors or omissions. The contents of this pub- Premium pax growth minus economy pax growth licaon, either in whole or in part, may not be copied, stored or reproduced in any for- Source: IATA. Note: the size of each bubble is proporonal to eachroute’s share of industry-wide premium revenues. mat, printed or electronic form, without the wrien consent of the publisher.

2 www.aviationstrategy.aero April 2017 Aeroflot: State resumes control

face of it 2016 was a su- 2015 failed to materialise, and me the carrier collapsed. perb year for Aeroflot, with Transaero ceased operaon in late While that was the short term O significant increases in rev- October of the same year, instantly price to pay, the longer term result enue and profits. But it was also the taking out a carrier that accounted for Aeroflot is a lot beer than if year that Aeroflot reverted to being for around 11% of the total domesc it had been forced to swallow the close to a state monopoly, with all and internaonal market in Russia. whole of Transaero, as the govern- that implies for corporate strategy Aeroflot was obliged to step in ment wanted back in 2015. Instead, In calendar 2016, under IFRS anyway, financing the carrying of Aeroflot has been able to cherry- standards, Aeroflot group saw rev- 1.8m passengers on “Transaero” pick the best of the former Transaero enue increase by 19.9% to ₽495.9bn flights through the rest of the year, routes; it has taken over (or plans (US$7.4bn), thanks to a combinaon while transferring another 0.2m to take over) 56 of the 141 inter- of traffic growth (passengers carried passengers onto its own equipment naonal routes previously operated rose 10.3% to 43.4m), efforts to and fully refunding all others that by Transaero — although of course increase yield and the connuing de- couldn’t be accommodated on the ability to take over Transaero valuaon of the rouble. With further those flights. In total, support to slots at internaonal airports is not cost control efforts, Aeroflot’s oper- Transaero passengers cost Aeroflot as easy as it is in Russia, where the ang profit rose 43.4% to ₽63.3bn some ₽16.8bn (US$277m), and there government rubber stamps anything ($949m) and a net loss of ₽6.5bn have been other adverse impacts of Aeroflot wants. Indeed, rights for 13 in 2015 turned into a net profit of the bailout, such as provisions for Transaero routes were returned by ₽38.8bn ($583m) in 2014. Aeroflot group loans to Transaero. Aeroflot to the Russian aviaon au- The Aeroflot group’s debt po- In addion, the Aeroflot group hired thories voluntarily, while seven des- sion has improved significantly more than 4,250 ex-Transaero em- naons were not extended aer in the last 12 months — total debt ployees and took over 30 aircra one year of operaon. fell by 38.4% in 2016 to stand at from the former Transaero fleet, The Aeroflot group currently ₽143.9bn ($2.2bn) at as December including 10 737s and six A321s that operates to more than 150 des- 31st 2016, while cash and short-term were on outstanding order at the naons in 51 countries. It follows investments rose 3.2% to ₽37.8bn ($567m). However, this was due partly to the connuing devaluaon AEROFLOT: FINANCIAL RESULTS ($m) of the rouble, the sale of nine aircra 1,200 10,000 and a revaluaon of finance lease Operang profit 1,000 obligaons; and net debt sll stood 8,000 800 Revenue at a not inconsiderable ₽106.1bn 6,000 ($1.6bn) at the end of 2016. 600 4,000 Transaero effect 400 200 2,000 The airline’s 2016 results were boosted by the demise of Transaero 0 Airlines, the second largest airline in -200 Net profit Russia. The government-mandated -400 merger (see Aviaon Strategy, -600 September 2015) between Aeroflot 2000 2001 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 and Moscow-based Transaero in

April 2017 www.aviationstrategy.aero 3 onal desnaons out of the remote PASSENGERS CARRIED IN RUSSIAN MARKET 2016 airports of Vladivostok, Khabarovsk and Yuzhno-Sakhalinsk. It carried 50 1.4m passengers last year, compared +4.0% with 1.1m in 2015. Aeroflot owns 40 51% of Aurora, but it makes lile sense not to incorporate it into the 30 Rossiya operaon; indeed there is a strong argument that Rossiya itself 20 +0.7% is a brand too many for the Aeroflot Pax (millions) group, where operaons, manage- -0.9% +2.5% ment and markeng would probably 10 -0.6% +1.0% be much simpler were it to consist of solely the Aeroflot brand 0 and an LCC operaon. Aeroflot All other Foreign S7 Group UTair Ural Airlines Group Russian airlines airlines Group That LCC operaon is Podeba (which means ’victory’ in Russian), the group’s latest aempt at the low a confusing mul-brand strategy, Rossiya, which is based in Pulkova cost segment and which operates 12 largely as a result of the variety (Saint Petersburg) and operates 737-800s (all leased) out of Moscow government-mandated domesc on domesc, regional flights and a Vnukovo on 36 routes — mostly mergers and acquisions it has had handful of internaonal routes out domesc, although it does operate to swallow. The mainline Aeroflot is of Pulkova and Vnukovo airport in to eight internaonal desnaons. the country’s flag carrier and oper- Moscow. Last year Rossiya absorbed It carried 4.3m passengers in 2016, ates a hub-and-spoke operaon out the group’s Donavia and Orenair a 39% increase on the year before, of Moscow Sheremetyevo, which airlines, and today it operates 67 and follows a standard LCC business accounts for around two-thirds of aircra, carrying 8.8m passengers in model with paid-for meals, fees for all passengers carried by the group 2016 (2.8% down on 2015). carry-on luggage and ckets sold (29m passengers in 2016, 11% up Not part of Rossiya (as yet) is Au- primarily through direct channels. year-on-year). rora, a regional airline in the far east The total Aeroflot group fleet Somewhat obsnately, Aeroflot of Russia that operates 23 aircra comprises 291 aircra, 44 more than is sll aempng to develop Moscow domescally and to some interna- 12 months ago (see chart below), as a transit point for passenger flows between the Asia/Pacific region and Europe/North America, though AEROFLOT: MAINLINE TRAFFIC STATISTICS — frankly — this is a tough sell to 85 passengers, many of whom would 100,000 prefer to transit anywhere other Load Factor 80 than Russia. Indeed internaonal- 80,000 internaonal transit passengers for RPK 75 the group fell from 9.1% in 2015 to 60,000 ASK 8.5% in 2016, and at Sheremetyevo 70 airport the proporon of Aeroflot 40,000 traffic that was transit fell from

44.2% in 2015 to 42.1% in 2016 (with 20,000 65 internaonal-internaonal transit traffic falling from 14.0% to 13.1%). 0 60 Next in the group porolio is — 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 in its own words — “middle-price”

4 www.aviationstrategy.aero April 2017 as the airline connues to expand and modernise its fleet from the AEROFLOT GROUP FLEET assorted rag-bag of types it used 350 12 to have into a young, western-built Group fleet average age 291 fleet — the last six An-148s have now 300 10 been phased out through a sublease. 251 247 250 Other group airlines 232 The total group fleet has an average 222 102 8 209 age of 6.5 years — slightly higher 200 101 82 92 than at the end of 2015 — but that 97 6 100 is sll impressive, and the mainline’s 150 average of 4.2 years is beer than 4 100 189 almost any other full-service rival. 150 165 125 140 On outstanding order for the 50 Mainline 109 2 group are 35 aircra, comprising 14 0 0 A350s and one 777. At the end of 2011 2012 2013 2014 2015 2016 last year it cancelled 8 of its original order for 22 A350s, and transferred its order with Boeing for 22 787s to GDP growth fell steadily from 2010 to divert aenon domescally from Avia Capital Service — the leasing to 2014, plunging to a 3.7% GDP increasing economic woes. The most subsidiary of state-owned conglom- contracon in 2015 and followed significant effect on Aeroflot (and all erate Rostec from which Aeroflot has by another 0.7% GDP shrinkage in Russian airlines) is that the value of a contract to lease 50 737NGs. Its 2016. There are many reasons for the Rouble fell by almost 60% in just medium term fleet plan (see table this deep recession but falling oil two years, from a rate of 33 Roubles below) show it acquiring a net 68 new prices have been exacerbated by US to the US Dollar at the start of 2014 aircra over the next two years in- and EU sancons over Russia’s illegal to 84 Roubles exactly two years cluding two 747-400s for long-haul, interference in the Ukraine/Crimea, later. Of course that significantly and 37 737s, 21 A320s and 13 A321s. carried out partly by President Pun increases costs incurred abroad in In addion, Aeroflot has another 20 SSJ-100s due to be delivered this year and next (and yet another example of AEROFLOT GROUP FLEET PLAN state interference). State control 2016 2017 2018 2019 2020 Aeroflot Subsidiaries Orders The state agency Rosimushchestvo A319 36 33 26 18 15 owns 51.17% and Rostec, a state A320 70 5 79 80 69 59 conglomerate, has a further 3.3%. A321 32 39 43 41 41 There is a free float of about 41% of A330 22 22 22 19 15 the shareholding, but the reality is A350 (14) 5 8 10 737-800 20 29 68 80 79 79 that strategic decisions are made by 747-400 7 9 9 9 9 the state, and this effecvely means 777-2/300 15 6 (1) 21 26 26 26 that Aeroflot has lile — if any — SJ100 30 (20) 42 50 50 50 chance of transforming itself into a An-148 6 DHC-8 11 10 10 7 6 truly modern airline that is flexible DHC-6 2 2 2 2 2 enough to instantly take advantage 189 102 of new market opportunies as they crop up. Total 291 (35) 325 353 328 312 Not that there are many of Source: Company reports, Boeing, . Notes: plan in according with exisng contracts. Ex- these at the moment, as the Russian cludes one An-24. economy is sll in deep trouble.

April 2017 www.aviationstrategy.aero 5 AEROFLOT: ROUTE MAP

Los Angeles

Havana Miami Petropavlovsk−Kamchatsky Washington

New York Magadan Iturup Island Yuzhno−Kurilsk Nogliki Yuzhno−Sakhalinsk OkhaShakhtersk Bogorodskoye Sapporo Tokyo Komsomolsk Na Amure Yakutsk Khabarovsk Plastun Kavalerovo Vladivostok Neryungri Blagoveschensk Harbin Tynda Busan Seoul Moscow Dalian St Petersburg Beijing Novyj Urengoj Irkutsk Shanghai Ulaanbaatar Murmansk Salekhard Krasnojarsk SurgutNizhnevartovsk Abakan TomskKemerovo London Heathrow Arkhangelsk Khanty−Mansiysk Novokuznetsk Tainan London Gatwick Helsinki Oslo Syktyvkar Novosibirsk Barnaul Stockholm TyumenOmsk Tallinn PermEkaterinburg Manila Copenhagen Riga Kirov Chelyabinsk Hamburg Hong Kong Kaliningrad NizhniyKazanNaberevnye NovgorodUfa ChelnyAstana AmsterdamBrussels Hanover Cheboksary Paris CDG Düsseldorf BerlinKaunasVilniusVnukovo Magnitogorsk Karaganda Paris Orly Köln Minsk Samara Frankfurt Dresden Warsaw Madrid Stuttgart Prague Orenburg Barcelona GenevaMemmingen Munich VoronezhSaratov Aktyubinsk Lyon BratislavaZürich Vienna Belgorod Almaty Milan Milan (Orio)Budapest Volgograd Bishkek Hanoi Girona NicePisaVenice Rostov Atyrau Valencia Zagreb Chisinau Shimkent Malaga Alicante Belgrade SimferopolStavropol Astrakhan Tashkent Tenerife Rome Split Bucharest Mineralnye Vody BolognaRiminiTivat Varna Nalchik Magas Aktau Samarkand SofiaBourgas Anapa Sochi Makhachkala Ho Chi Minh City Thessaloniki IstanbulGelendzikKrasnodar Tbilisi Baku Yerevan Vladikavkaz Bangkok Athens Gyoumri AntalyaGazipasa Delhi Heraklion Tehran Larnaca Beirut Aeroflot Tel Aviv Phuket Pobeda Aurora Dubai

Malé

Rouble terms. The good news is Long term goals 30m domesc passengers carried that the currency has recovered a year by 2025. The group carried The Aeroflot group has four strategic parally since that huge devaluaon, 18.2m internaonal and 25.2m do- goals for 2025, a date that is such a to approximately 59 Roubles to the mesc passengers in 2016, so from long way away (maybe on purpose) Dollar as at mid-March 2017, and that it needs just an average annual it is very difficult to pass considered there is hope of returning to GDP growth of 2% domescally from now judgment on how well the airline is growth this year — though Pun unl 2025 — but for internaonal doing in geng there. would be unwise to assume that a it needs a CAGR of 9.2% for nine “Russian-friendly” President Trump v To become a top five European consecuve years, which could prove will substanally reduce sancons and top 20 global airline in terms of difficult to achieve. anyme soon, especially aer events passengers carried, with more than Overall the group has 44.7% share in Syria. 40m internaonal passengers and of the domesc market and a 39.4%

6 www.aviationstrategy.aero April 2017 profitability and cash generaon — AEROFLOT: SHARE PRICE PERFORMANCE (₽) measures that are noceably absent from Aeroflot’s grand strategic vision. 200 175 v Development of the hub-and- 150 spoke model, with an explicit goal 125 by 2025 to have a 32% share of transit passengers among total group 100 passengers carried. The problem is 80 that, given very strong growth for LCC 70 Podeba, the percentage of transit 60 passengers in the group is actually 50 falling, not rising — the proporon of 40 transit passengers fell from 28.7% in 2015 to 27.5% in 2016. It would be 30 2012 2013 2014 2015 2016 2017 madness for the group to restrict the growth of its LCC, and so the only way it will be able to increase its transit share of the internaonal market to- precarious domesc economy as well proporon to 32% by 2025 is to sig- from Russia last year. That compares as internaonal sancons to punish nificantly increase transit passengers very well with the respecve market Pun for his imperial ambions in at the mainline at Moscow, which is a shares of 20.6% domescally and Ukraine. In fact the total number of very tough ask indeed. 18.9% internaonally it had back in internaonal passengers to/from v Increasing presence in various 2009, and Aeroflot’s domesc share Russia has fallen from 65.5m in 2014 geographical and price segments. has risen consistently over the last to 46.4m — a calamitous drop of This is a vague, general statement few years thanks to government- almost 30%. This means it will be and is the only one of its four strategic mandated domesc consolidaon, extremely difficult for Aeroflot to hit goals without any specific KPI target. development of the LCC market and its 2025 internaonal target unless a decline in “long-haul” domesc rail either the market grows very fast passengers as train fares have risen. (unlikely) or the Russian flag carrier However, yield is clearly higher on can effecvely double its market Despite the negaves, Aeroflot’s internaonal routes (by around 20%), share (extremely unlikely). share price has quadrupled since and the crical problem that Aeroflot v To become a top five European 2015 giving it a market capitalisaon faces is that the internaonal market and top 20 global airline in terms of of $3.5bn and a historic PER of 5x. connues to shrink — which the revenue. As of 2015 Aeroflot claims Investors appear to have taken the airline says is due to “connuing to be the seventh highest revenue view that the benefits of consolida- pressure on consumer confidence” airline in Europe and 23rd in the on of the Russian airline industry — another way of saying interna- world, but most analysts would say outweigh polical interference and onal travel has been hit hard by this goal is irrelevant; what counts is internaonal sancons.

Aviaon Strategy has produced in recent years special analyses for our clients on a wide range of subjects. Examples include:

v Implicaons of Virtual Mergers on the North At- v Intra-European Supply and Demand Scenarios lanc v Super-Connectors: Financial and Strategic Analysis v The Future of Airline Ownership v Key Trends in Operang Leasing v Air Cargo in the Internet Era v Business Jet Operang Leasing Prospects v LCC and ULCC Models For further informaon please contact: info@aviaonstrategy.aero

April 2017 www.aviationstrategy.aero 7 SIA: Reconciling Premium tradition with Budget growth

the financial crisis a decade of 2016/17 (the nine months ending regional full service carrier — by 25% ago Airlines has December 2016), the Group saw to S$74m; Tigerair and — the S been stuck in a rut of low revenue fall by 3.2% year-on-year low cost brand offering — reversed growth, weak financial results (while to S$11.1bn (US$8bn). However, minor operang losses to operang remaining profitable as a group) operang profit during the period profits of S$20m and S$26m respec- and a mire of external compeve increased by 13% to S$595.2m vely; while SIA Engineering saw forces — beset by the pincer devel- (US$425m) as fuel costs fell by 23% profits decline by a third to S$48m, opment of the growth of SE Asian to S$2.78bn, while net profits fell but SIA Cargo registered a modest LCCs on short- and medium-haul, the by 14% to S$499m. Operang profit S$8m profit for the period — and this seemingly inexorable growth of the improvements offset by losses from is following Cargo losses of S$458m in super-connectors undermining its associates, losses on disposal of air- total over the previous five financial 6th freedom hub in Singapore. In the cra and a writedown of the Tigerair years. background has been the relavely brand and trademark. At the end of December 2016 weak local economic performance. This was on the back of a 3.4% in- the Group had total debt of S$1.6bn, SIA has been trying to establish a crease in the total number of passen- some S$245m higher than the debt mul-brand group of airlines offering gers carried by group airlines, a 2% figure at the end of the last finan- products in the low cost sphere as a growth in demand in terms of rev- cial year. On the other hand, cash complement to its tradional full ser- enue passenger kilometres and a 3% and cash balances fell from S$4.6bn vice high-quality offering, while it an- increase in capacity in ASKs. The load at end March 2016 to S$3.7bn at the cipates a resumpon of growth in factor dipped by 1.5 points to 78.5%. end of the period. This compares with the parent company airline as its new On a divisional breakdown, the a total net asset value of S$13.8bn. generaon ultra-long haul A350s and parent company Parent company pressure 787-10s are delivered. itself increased operang profits by SIA’s financial year runs to end 10% to S$427m up from S$387m in The parent company Singapore Air- March, and in the first three-quarters the prior year period; Silkair — its lines remains the crical driver of the group’s performance, accounng for 85% of group revenues and profits. SIA GROUP FINANCIAL DATA (S$m) However, the airline is under signif- 2,500 20,000 icant pressure and has deliberately Operang Profit Revenue reined in growth plans in the past five years. As we show in the chart below, 2,000 15,000 since the last cyclical peak in 2008 and the collapse in demand following Net Profit 1,500 thefinancialcrisis,SingaporeAirlines’ 10,000 passenger numbers have stagnated. 1,000 In the past four years growth in pas- senger demand has been lacklustre 5,000 500 — and on a twelve month rolling basis annualised carryings of 18.9m to the end of February 2017 were sll some- 0 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017† what below the peak 19.4m achieved in the twelve months ending August Note: Financial years ending March. † rolling twelve months to Dec 2016. 2008.

8 www.aviationstrategy.aero April 2017 dipped by 1.6 percentage points to SINGAPORE AIRLINES PASSENGER TRAFFIC 78.4%.Yieldsintheperiodfellby4.5% but unit revenues fell by 6.6% and 20 10 unit costs dropped by 7%. The pas- 5 senger breakeven load factor came 19 down to 78.4% from 80.4%, match-

0 change pct Yr-yr ing that achieved. Disturbingly, ex- 18 fuel unit costs increased by 3.7%. -5 Pct change Conundrum 17 Pax (millions) -10 Singapore Airlines was one of the industry disruptors when it devel- 16 -15 oped 6th freedom services through Passengers the hub through the 70s and 15 -20 80s — aracng the same type of op- 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 probrium currently being directed at Source: Company reports. Notes: twelve month rolling total passengers carried parent airline the Superconnectors in the Gulf. With only. a populaon of less than 6m, the is- land state could not naturally support Further,uptotheendof2008,the gest that this lower rate of growth will an airline of SIA’s size purely on O&D Singapore economy had been motor- connue. demand. SIA itself doesn’t give the figures, but has indi- ing along with GDP growth averaging In the nine-month period to the cated 30% of passengers are in trans- 7% a year. In the last ten years, un- end of 2016 Singapore Airlines it- fer through the Singapore hub, and der the “new normal” economic envi- self saw revenues fall by 6% year on withSIAandSilkairholding34%ofthe ronment it has only managed a mod- year to S$8.4bn as fuel costs fell by slots at the airport it is reasonable to est4.5%growthayear—withthelast a quarter (it effecvely passed on assume that 60% of the airline’s traf- two years generang a relavely in- all the fuel savings to the benefit of fic is 6th freedom transfer. sipid 2% growth reflecng the impact the passengers). It cut ASKs by 0.5% perhaps of the slower rate of growth year-on-year, but with RPKs falling It now itself is suffering from the in China. The latest IMF forecasts sug- by 2.6%, the passenger load factor compeon on its mainstay Europe- Asia routes from the aggressive growth represented by the new com- SIA GROUP DIVISIONAL OPERATING PROFITS peng models, as well as an aack on the Pacific from the development of 700 SIA Engineering Singapore Airlines Chinese internaonal services. 600 The management is well aware Scoot 500 of the changing fundamentals of the Silkair 400 market, and recognises that these 300 changes are structural and probably permanent.Takingthedecisionnotto S$m 200 grow however puts pressure on unit 100 costs that other expanding carriers 0 avoid at the margin. -100 SIA has tradionally provided Tigerair SIA Cargo a quality product and, has been -200 2012 2013 2014 2015 2016 2017 recently reducing the density of seang, adding premium economy Note: Year end March. Data for 2016/17 four quarters to end December 2016. to the new fleet acquisions (and retrofing exisng aircra in the

April 2017 www.aviationstrategy.aero 9 SIA GROUP FLEET

SIA SilkAir Scoot/Tigerair NokScoot Vistara In service On order In service On order In service On order In service In Service On Order 747F 9 777-200/300 53 3 787-8/9 12 (8) 787-10 (30) A330 24 A350 12 (55) A380 19 (5) 737-800 17 737MAX-8 (37) A319 3 2 A320ceo 10 21 13 A320neo (39) (7) Total 117 (90) 30 (37) 12 (8) 3 13 (7)

Source: Company Reports

fleet), presumably to try to reduce SIA prides itself on operang a via Canberra to Wellington. And the number of seats available for young fleet (currently 7.5 years). It tagged routes are rarely very prof- the deepest discount buckets in the has started taking delivery of A350s. itable, but may be a precursor of revenue management system. It currently has 12 of the type with a future direct intenons. At the same me it has been try- further 55 on order. It also has orders Meanwhile there may be ques- ing to bolster access to markets at the for 30 787-10s due for delivery from ons of the long term future of the other end of its long haul routes and 2018. These will be used to replace company’s A380 fleet. The first of has been developing a plethora of the aging 777s in the fleet (see table). these is approaching the end of its code share agreements — currently CEO de- ten-year lease in the current year and on some 10,000 frequencies up from scribes the new equipment as a SIA has stated that it does not intend 2,000 six years ago. “game-changer”.The extended range to renew the lease. It has 19 A380s in Last year it signed a Joint Venture and lower seat density allows it to operaon and nominally has another agreement with fellow schedule services on some very five of the type on order. The airline partner Luhansa Group (including long haul routes that conveniently currently operates the aircra to 14 SWISS, Austrian, Brussels and Silkair) overfly intervening sixth freedom desnaons with double daily flights to coordinate on pricing and capac- hubs — seven of the aircra on to slot-constrained Heathrow and to ity — cleared by the Singapore au- order are for the ultra long range Sydney aside from Aukland, Bombay, thories subject to certain condions version and will be delivered from Paris, Frankfurt (tagged on to New in December 2016 — covering routes 2018. It recently iniated a direct York),HongKong,Kansai,Melbourne, between Germany, Austria, Switzer- Singapore-San Francisco service (see Beijing, Shanghai, Sydney and Zürich. landandBelgium(the“LHHomeMar- map) and ancipates being able to The LCC future hope kets”) and certain Asia/Asia Pacific return to operang direct services countries (specifically Singapore, In- from Singapore to New York and Los In 2016 Singapore Airlines Group donesia, Malaysia and Australia — Angeles — (which it used to operate took full control of its associate short- the “SQ Home Markets”). with the less opmal four-engined medium haul low cost operator, Things don’t always go to plan, A340). Tigerair Singapore, with the aim of and Indonesia has rejected the JV Other recent route openings merging it fully with its long haul agreement and blocked SIA’s pro- meanwhile appear less than opmal: low cost operator Scoot. It has put posal to operate a fih freedom tagged routes via Manchester to them into a new holding subsidiary service between Jakarta and Sydney. Houston; via Moscow to Stockholm; under the dynamic sobriquet of

10 www.aviationstrategy.aero April 2017 roughly half that of parent company SIA LONG HAUL ROUTE NETWORK SIA. And, as we menon above, it is now profitable. New York One of the more interesng new routes starng this year is that to Houston Athens (see map) — SIA itself used to operate the route with 777s unl 2015 — seemingly a strange choice of a first desnaon in Europe. How- San FranciscoLos Angeles ever, this does seem to signal the strategy to target a sixth freedom low Manchester cost operaon through Changi, in this London Amsterdam Stockholm Paris Copenhagen Düsseldorf case perhaps focusing on low yield- Zürich Frankfurt Milan Munich ing VFR traffic of the Greek diaspora: Moscow Rome Australia has one of the largest Greek

Istanbul communies in the world. Athens

Sapporo Tigerair operates 23 A319s and Shenyang Beijing Dalian Seoul Narita Tianjin Qingdao Haneda A320s out of Changi to almost 40 des- Osaka Nagoya Amritsar Fukuoka Nanking Shanghai naons in Asia (within a five-hour Dubai Delhi Chongqing Hangzhou Jeddah Jaipur Taipei Ahmedabad Dhaka Kolkata Guangzhou Kaohsiung flying me), with a single class. It also Mumbai Hanoi Hong Kong Yangon has 39 A320neos on order. Its perfor- Manila Chennai Bangkok Ho Chi Minh City mance recently has been somewhat Colombo Malé Bandar Seri Begawan SIA less than dynamic. In the past twelve Kuala Lumpur Scoot/NokScoot Singapore months it carried 5.1m passengers Jakarta Surabaya Denpasar Bali with an average growth rate of 0.2%. Aer a couple of loss-making years it returned to profitability at the oper-

Brisbane ang level in the financial year ended Perth Bilinga Johannesburg March 2016 and generated a modest Adelaide Canberra Sydney Melbourne S$20m profit in the nine months to Auckland Dec 2016. It encounters intense com- Wellington Christchurch peon at its Changi base, not least from Jetstar Asia and AirAsia (which “Budget Aviaon Holdings” with the In the last twelve months it increased are aer SIA, Silkair and Tigerair the idea of combining the two under a the number of passengers carried by fourth and fih largest operators at single AOC, single management and 45% year on year and achieved a to- the airport). operaonal control. This is expected tal number of passengers booked of From SIA’s point of view, the ra- to take effect in the second half of 3.5m with an 81% load factor. It only onale for the full Tiger acquision 2017. started in 2012 but has become prof- was to “harness full synergies to ben- Scootwaslaunchedin2012toop- itable relavely quickly — it regis- efit the SIA Group and the Singapore erate medium- and long-haul routes tered a S$20m operang profit for hub”, although it also argued that as from its base at Changi. It has fleet the first me in the financial year an independent airline Tiger lacked of 12 787s (with another 8 on or- endedMarch2016.Thepublishedfig- the scale and network necessary to der) and flies to 22 desnaons. It has ures we have are sketchy, but it ap- compete in the LCC market. By bring- an average stage length of 3,600km pears that it is operang on a unit cost ing the two under a single brand, the (the longest routes being Singapore- base of around US¢3.5/ASK — not far management is clearly signalling that Athens and Singapore-Gold Coast). from that achieved by AirAsia X albeit a long haul low cost operaon needs Scoot has been growing strongly. on a slightly shorter stage length — feed.

April 2017 www.aviationstrategy.aero 11 so-called 5-20 rule, where new car- SIA REGIONAL ROUTE NETWORK riers had to operate domescally for five years and have a fleet of at least Shenyang 20 aircra before being allowed to fly Beijing Tianjin Dalian Seoul Narita internaonally. The new 0/20 rule an- Jinan Qingdao Nagoya Haneda Srinagar Leh Osaka Xi’an Zhengzhou Fukuoka nounced last June specifies that an in- Jammu Amritsar Nanking Wuxi Shanghai dian airline has to have the lesser of Chandigarh Wuhan Chengdu Hangzhou Delhi Chongqing Ningbo Jaipur Kathmandu Changsha 20 aircra or 20% of its fleet dedi- Lucknow Bagdogra Fuzhou Guwahati Taipei Varanasi Kunming Xiamen cated to domesc indian routes. Ahmedabad Dhaka Jinjiang Guangzhou Kolkata Nanning Kaohsiung Mandalay We would expect that SIA will Hanoi Macau Hong Kong Mumbai Bhubaneswar Luang Prabang Haikou SIA Chiang Mai Silkair move quickly to expand Vistara fur- Pune Hyderabad Vishakhapatnam Yangon Scoot Goa Luzon Island NokScoot ther, enabling India to become a ma- Tigerair Bangkok Bangalore Chennai Bangkok Manila Vistara Siem Reap jor source market for the SIA Group Coimbatore Kalibo Tiruchirappalli Port Blair Phnom Penh Ho Chi Minh City Kochi Koh Samui forpassengerstravellingwestintothe Thiruvananthapuram Phuket Krabi Colombo Hat Yai Cebu Davao Middle East and Europe, and east into Langkawi Kota Kinabalu Malé Penang Ipoh Kuala Namu Bandar Seri Begawan Asia. Kuala Lumpur Kuching Manado The final airline in the group sta- Pekanbaru Balikpapan

Palembang ble is NokScoot — a joint venturewith Singapore Ujung Pandang Jakarta Thai Air’s Nok subsidiary. Based in Semarang Bandung Surabaya Yogyakarta Lombok Dili Bangkok’s older Dom Mueang airport Denpasar Bali it started operaons in 2015 and flies Darwin 3 777s in a two-class configuraon to six cies in China as well as Taipei Cairns — directly targeng inbound leisure Mul-hub? The airline has been a success (it travel. The SIA management appears carried 2.5m passengers in 2016, its to believe that this also fits in with a The SIA Group also has other air- second year of operaon, on a 76% mul-hub strategy. line investments; in January 2015 it load factor) even though it may not launched Vistara, a full-service Indian yet be profitable. The longer term airline (in which it owns 49%) in asso- strategyhasbeengivenaboostbythe ciaon with Tata Sons, part of the Tata recent changes to the Indian state’s Group — the giant Indian conglom- erate. Though two previous aempts by SIA and Tata to start an airline in India had come to nothing, this effort SIA GROUP SHARE PRICE PERFORMANCE appears to be more successful. 12 Based at Delhi’s Indira Gandhi airport, Vistara operates 13 A320s 11 domescally in a three-class con- figuraon (with 8 , 24 premium economy seats — becom- S$ 10 ing the first airline to introduce the class domescally — and 126 in econ- omy) to 20 domesc desnaons (see map). The medium-term plan is 9 to increase the fleet to 20 aircra by 2018 with the seven A320neos it has 2012 2013 2014 2015 2016 2017 on order due for delivery from late 2017.

12 www.aviationstrategy.aero April 2017 Alaska Air absorbs Virgin America’s “great emotional energy”

AirGroup’s$4bnacquisi- deal faces fleet dis-synergies, size- current thinking? on of Virgin America, which able labour cost hikes, potenal loss Another queson in the minds of A closed in mid-December, has of premium market share, and risks investors: Will Alaska be successful in been generally well-received by US associated with expansion in some re-deleveraging its balance sheet af- analysts and investors. The combina- of the naon’s most compeve ter borrowing $2bn to finance the ac- on has moved quickly to take advan- markets. quision? tage of new growth opportunies. One of the toughest decisions Alaska held its first post-merger The merger synergy target has been was what to do with the two strong investor day on March 29, which gave raised from $225m to $300m. Every- brands. Alaska announced on March the management an opportunity to one agrees that the new Alaska will 22 that it would eliminate the Vir- tackle some of those issues and ex- connue to report industry-leading gin America name, probably in 2019. plain the strategy and plans in more 20%-plus pretax margins. Will Virgin America’s cult-like follow- detail.Highlightsincludedapresenta- The merger combined two ers take their business to other air- on on a thorough 10-month brand award-winning, low fare airlines into lines? analysis. “West Coast’s premier carrier” and Another potenal problem is Bigger plaorm for growth the fih largest US airline, which will that the combinaon is going down- benefit from the West Coast’s strong market with the product offering. Alaska has grown at a relavely brisk economy and a focus on the growing Will that result in a loss of premium 7.7% average annual rate since the “bleisure” segment. market share on the transcon? mid-1990s. 2015 and 2016 both The management team, led by Investors are eagerly awaing saw a 10.6% capacity growth. As a CEO Brad Tilden, has an impressive Alaska’s big decision on whether or result, the network has broadened track record. Alaska has been an not to retain two fleet types in the from the original north-south/West industry leader on many financial longer term — expected by year-end Coast/Alaska niche to include size- fronts, be it cost reducon, profit 2017. What is the management’s able transcon, midcon and Hawaii margins, debt reducon, manag- ing to ROIC or returning capital to shareholders. ALASKA AIR: FINANCIAL DATA In a recent report, JP Morgan an- 2,000 10,000 alysts reiterated their “higher-than- Revenue 1,750 usual confidence in Alaska’s ability Proforma 8,000 1,500 to profitably integrate”. Two-thirds of Including VA the analysts who cover Alaska cur- 1,250 6,000 Net Income rently have a posive recommenda- 1,000 on on the stock. 750 4,000 However, this merger also faces Operang Income 500 many potenal challenges that have 2,000 prompted some analysts to adopt a 250 wait-and-see approach (and neutral 0 0 rangs). -250 In addion to the usual inte- 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 graon risks associated with airline Note: The 2016 figures include Virgin America’s results for the 18 days from December 14th to mergers (especially with systems and 31st. Sources: Alaska Air Group, J.P.MorganNorth American Equity Research (March 30, 2017) labour), the Alaska-Virgin America

April 2017 www.aviationstrategy.aero 13 much larger popula- ALASKA AIR ROUTE NETWORK on.

Barrow Alaska has moved

Prudhoe Bay/Deadhorse Kotzebue quickly to take ad- Nome vantage of the new

Fairbanks Bethel growth plaorm,

Adak Island Dillingham Anchorage launching reciprocal King Salmon Cordova FFP accruals and Kodiak Yakutat Gustavus Juneau codesharing just five Sitka Petersburg Wrangell days aer the merger Ketchikan Boston Edmonton closed. Calgary JFK Newark La Guardia Kelowna Philadelphia As of mid-April, Vancouver Detroit Baltimore Bellingham Kalispell Minneapolis Milwaukee Victoria Great Falls National Seattle Spokane Chicago Washington in the four months Wenatchee PullmanMissoulaHelena YakimaPascoLewiston BozemanBillings Walla Walla Indianapolis Portland Raleigh/Durham since the merger Eugene Redmond Omaha BoiseSun Valley Saint Louis Kansas City Medford Nashville closed, Alaska had Charleston Salt Lake CityHaydenDenver Atlanta Colorado Springs Wichita Reno Gunnison announced an un- Santa Rosa Sacramento Oklahoma City San Francisco OaklandMammoth Lakes San Jose Orlando precedented 37 new MontereyFresno Las Vegas Albuquerque DallasDallas Tampa San Luis Obispo New Orleans Fort Lauderdale BurbankOntario routes from the West Los Angeles SantaPalm Ana SpringsPhoenix Houston Santa Barbara Austin San Diego Tucson San Antonio Havana Coast that “connect

Kauai the dots”.The services Honolulu Cancun Kahului Loreto will be operated on Kona Mazatlan San Jose Cabo a codeshare basis Puerto Vallarta Guadalajara Manzanillo unl the airlines are Ixtapa/Zihuatanejo San Jose

Liberia able to combine their operaons. operaons; and desnaons in naonally. The deal also brought The routes announced so far in- Mexico, Canada, Costa Rica and Cuba more access to slot-constrained clude at least 13 new desnaons (since January). But the network is airports on the East Coast. from San Francisco, seven from San sll heavily focused on the states of Alaska paid a big premium for Diego, five from the LA Basin, three Washington, Oregon and Alaska. what it considered “scarce real es- from San Jose, and two from Port- A couple of years ago, in the face tate” and a one-me opportunity. land. Alaska has also announced a of the consolidaon of the US air- But it would have taken it a long 40% increase in Dallas Love Field fly- line industry, Alaska’s management me to achieve the same through or- ing—anaggressivemovethattargets became convinced that “scale is rele- ganic growth because of airport in- business traffic at Southwest’s home vant” and that Alaska Air, too, should frastructure constraints alone. There base. be bigger. was also a defensive element to the Such routes were not viable (or a The Virgin America acquision deal: JetBlue was also bidding for Vir- priority) for Virgin America, but they represented a unique opportunity gin America (see Aviaon Strategy, now look aracve, first, because to get a solid foothold in California, April 2016). of the crical mass achieved when which has more than three mes the At the investor day, Alaska’s the networks are combined. Second, populaon of Alaska, Washington management found a novel way of much of the new growth is to cies and Oregon combined (39.1m, com- communicang the West Coast’s Alaska already serves, which helps re- pared to 11.9m). California is also the economic dynamism: the “crane duce start-up and operang costs. naon’s largest economy. index”, or the number of cranes that Another reason why some routes The deal gave Alaska an “en- are currently up in each city. That are now more viable is that there is hanced plaorm for growth” so that number was roughly 2.5 mes higher more fleet flexibility. Virgin America it could become more relevant to on the West Coast than on the East lacked a regional aircra type to take customers on the West Coast and Coast, even though the laer has a advantage of mid-sized markets.

14 www.aviationstrategy.aero April 2017 quickly, increasing from $26m in NET SYNERGIES IN RECENT US AIRLINE MERGERS 2017 to $300m in 2021. The integraon metable is ro- 8 bust: a single operang cerficate in 7 $680m $2bn early 2018, joint labour deals by mid- 6 2018,singlepassengerservicesystem

5 cutover in late 2018 and the remain- Average 4.4% ing integraon in 2019-2020. $300m $1.0-1.2bn 4 Alaska has idenfied revenue 6.5% 3 6.3% $400m+ $1bn+ synergies from seven categories:

Pct of annual revenues network presence, network growth, 2 4.0% 3.9% 2.8% 2.7% fleet deployment, alliance porolio, 1 aircra retrofits, cargo and loyalty. 0 The network synergies will come US Airways Delta Alaska United Southwest American America West Northwest Virgin America Connental Airtran US Airways from two sources: an increase in the number of inerary/connecng op- Source: Alaska Air Group presentaon (April 2017) ons for passengers created when the exisng networks are combined, Now, for example, Alaska is bringing In California, Alaska currently has and from new routes and frequen- its regional partner SkyWest’s E175s 2m loyalty programme members in a cies facilitated by the larger customer to Dallas Love Field this summer populaon of 39.1m. The strategy is base. to replace Virgin’s A320s on the La to “build Pacific Northwest-like rele- The fleet synergies will come Guardia and Washington Naonal vance to develop Pacific Northwest- from the availability of two mainline routes. The A320s will be freed up for like loyalty in the significantly larger aircra types (at least for a few years) new transconnental services. California market”. to beer match capacity to demand Importantly, California presents Alaska says that the merger in different markets. Essenally, a sizeable opportunity for Alaska to has already increased its customer Alaska plans to allocate the 178-seat grow its loyalty and credit card pro- relevance in California to 38% (120 737-900ERs to the highest-density grammes, which currently bring in nonstop markets). Its relevance in transcon markets and the smaller $900m in cash flow annually. San Francisco has increased from (146/149-seat) A320s to north-south Alaska operates an unusually 9% (Alaska only) to 70% (Alaska flying. generous FFP by industry standards. + Virgin, including the Q1 route Alaska says that the opportunity It also connues to make the pro- announcements). to boost revenues from alliances gramme more aracve, which “increases exponenally” with the Synergies and dysergies contrasts with the trend of other expanded Los Angeles and San Fran- US airlines reducing the basic value The combinaon is expected to gen- cisco presence. The two airlines have proposion to regular FFP members erate $300m in annual net synergies currently 15 internaonal alliance as they focus more on revenue at the when fully integrated — $240m rev- partners. top. enue benefits and $60m cost syner- The aircra retrofit synergies will That helps explain why Alaska’s gies. One-me integraon costs are come from a reconfiguraon of Virgin FFP has aracted 3m members in the esmated at $400m. The synergies America’s Airbus fleet, which entails Pacific Northwest, or one in every are in line with other recent mergers adding more premium seats, elimi- four residents. But the airline also at- in the US airline industry (see chart on nang some economy seats and re- tributes the high parcipaon to its the current page). ducing the premium seat pitch to 41 69% customer “relevance” in the re- Because of the focus on debt inches (Alaska’s standard). The net gion (meaning that 69% of the resi- funding, the transacon is likely to effect is to increase the total num- dents are able to take nonstop flights be accreve to earnings in year one ber of seats. The move will facilitate onAlaskaAirtowheretheywanttogo (excluding integraon costs). The Alaska’s generous complimentary up- in North America). synergies are expected to ramp up grades policy for FFP members, in-

April 2017 www.aviationstrategy.aero 15 it is typically because the cultures did ALASKA AIR GROUP’S DELEVERAGING PLAN not work together. 90 Consequently, and even though the cultures are not that different, 80 Alaska has spent an “extraordinary amount of me” with people from 70 both airlines (using surveys, focus 60 groups, programmes and events) to “define what we want the new cul- 50 Target ture to look like” and to educate Vir- gin’s workers about Alaska Air’s his- 40 tory, values, etc. 30 Alaska is also determined to avoid the problems some past airline merg- 20 2008 2010 2012 2015 2016 2020 ers experienced with the cutover to a single passenger reservaons sys- Source: AAG presentaon (March 2017) tem. Being able to do a Sabre-to- Sabre migraon will help. Otherwise, crease revenues and lower unit costs. mid-2018. The management expects Alaska is following American’s exam- Alaska esmates the revenue bene- to get the other labour deals in place ple of doing it gradually over a num- fits at $40m. in an expedious fashion. ber of weeks or months, minimising Loyalty and credit card pro- JP Morgan analysts in their lat- data migraon and using codeshares grammes are the single largest est report envision a worst-case total to bridge to the new Alaska. component of the ancipated rev- labour cost dysergy of $100m for the enue synergies. Alaska did not give combined group. The brand decision a figure, but the presentaon slides Alaska expects to benefit from The decision to rere the Virgin suggested that it could be around the experience of past mergers at America name was based on a 40% of the $240m total. other airlines and in other industries. comprehensive brand analysis that The $60m cost synergies will One of the key findings of its research involved hiring an expert brand con- come from reduced overheads, im- is that if a merger does not work, or if sulng firm, performing extensive proved purchasing power and higher the full synergy value is not extracted, qualitave research (focus groups) in efficiency/asset ulisaon. This merger will see labour cost dis-synergies as Virgin employees are ALASKA AIR GROUP’S EX-FUEL CASM brought to Alaska’s higher pay scales 9.2 and an A320 rate is incorporated into the Alaska pilot contract. However, 9.0 pilot costs are on the rise for the in- dustry generally, so not all of the cost 8.8 escalaon at Alaska will be merger- related. 8.6 On the posive side, Alaska Air, Virgin America and their ALPA- 8.4 represented pilot groups have agreed to a meline and binding arbitraon, 8.2 if necessary, to get to a new joint 8.0 agreement by early 2018. Aer that 2009 2010 2011 2012 2013 2014 2015 2016 2017F there will be a defined process to agree on seniority list integraon by Source: AAG investor day presentaon (March 2017)

16 www.aviationstrategy.aero April 2017 that it believes that the two brands ALASKA AIR GROUP’S CURRENT FLEXIBLE FLEET PLAN can be combined into a winner. Alaska plans to retain key elements

497‡ of the Virgin brand such as mood 500 Opons 485 493 460 Rerements lighng, music and enhanced in-flight Commied fleet† 427 109 entertainment. The management 400 385 346 talked of building more “emoonal 323 91 energy” into the Alaska brand. 300 285 The new brand will be “warm and welcoming, with a modern, West 200 Coast-inspired vibe”. The planned en- 297 hancements, to be rolled out mostly 100 in 2018-2019, include new seats and amenies, new uniforms, satellite 0 2016 2017 2018 2019 2020 2021 2022 2023 2024 WIFI, free movies and chat, more premium class seang and airport Notes: † Commied aircra, including exisng firm deliveries. ‡ Fleet if all opons exercised and no rerements or lease returns. Source: AAG presentaon (March 2017) lounge expansion. Alaska’s Mileage Plan will become the sole loyalty programme in 2018 and will offer California and Washington, conduct- scribed Alaska as “service-oriented, the most generous complimentary ing a naonal survey and compleng authenc and professional” and Vir- upgrades in the industry. a financial and operaonal analysis. gin America as “feel-good, hip, bold This is obviously the most cost- The challenge was that both and modern” with “great emoonal effecve soluon. Maintaining two Alaska and Virgin America have energy”. brands would be expensive, ineffi- strong but very different brands. The management menoned two cient and potenally confusing to Alaska focuses more on the airport factors that influenced their decision. passengers. experience and has a highly ac- First, Alaska appeals to a broader set The new brand could work, but claimed FFP, while Virgin focuses on of customers, while Virgin America the problem is that the combinaon the in-flight experience. has strong peaks at the top end but is gravitang towards Alaska’s more Either brand is a good fit for is less relevant for “value-oriented” basic in-flight experience. First, the “premium-product, low fare” travellers (the boom category that Alaska will offer a lower premium segment (also known as “bleisure” ULCCs typically focus on). Second, seat pitch than competors (41 or “leisure enthusiasts”, Alaska’s new preference for Alaska increases at a inches in first class, which is a step- term) that Alaska, Virgin America, greater rate when flyers, especially down from Virgin’s 55-inches though JetBlue and Hawaiian all focus on. Elite FFP members, become more fa- in line with Alaska’s recent upgrade That segment makes up $25bn or a miliar with the brand. from 35 inches). Second, Alaska has quarter of the $100bn US domesc However, those differences decided not to offer lie-flat seats, air travel market. would seem to have lile to do with which are now the industry norm on Alaska’s management had kept the brand. Virgin America gets fewer the transcon. an open mind about using two brands “value-oriented” travellers simply The decision not to offer lie-flat because Virgin America has won a because it does not always need seats reflected Alaska’s determina- cult-like following in the California to offer the lowest fare types or on to keep costs low. Instead, the markets, especially among the Bay discount heavily. And the “geng airline will sck to the strategy that area business travellers. Seven out of to know” impact is less because the has worked well in the past, which in- its top-ten corporate customers are Virgin brand is much beer known cludes easy upgrades to first class and Silicon Valley-based tech companies. globally and in the US than the Alaska a premium class that “fits the target The Virgin brand is driving a big rev- brand. market we’re going aer”. enue premium at Virgin America. The real reason why Alaska is Many analysts disagree with the The investor day presentaon de- dropping the Virgin America brand is strategy of using the first class more

April 2017 www.aviationstrategy.aero 17 the A320/A321s as they come off VIRGIN AMERICA’S AIRBUS lease. But they also noted that the LEASE COMMITMENTS A321neos could be more interesng 80 as they are aracve aircra for the 73 72 70 Leased Hawaii and transcon markets. 70 68 63 61 According to regulatory filings, 60 Virgin is due to take 10 A321neos 50 47 from GECAS in 2017-2018. It also has an order for 30 A320neos from Air- 40 58 63 62 60 Owned 53 51 bus for 2020-2022 delivery that can 29 30 37 23 be cancelled for just $15m. 20 20 19 Alaska’s management expects 13 10 10 to decide by the end of this year 10 10 10 10 10 10 10 10 10 10 whether to remain a mixed-fleet 0 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 operator or go back to an all-Boeing fleet over me. Source: AAG presentaon (March 2017) Financial consideraons as free upgrades for highly valued Upcoming fleet decision Alaska has been the industry’s finan- FFP members, rather than mones- cial leader in many respects in the Alaska will be a mixed-fleet opera- ing it like the rest of the industry does. past decade and that is not expected tor for many years to come because But the management insists that the to change post-merger. The only although the vast majority of Vir- strategyworksfortheAlaskabusiness quesons are whether the profit gin’s Airbus aircra are leased, those model, where “geng a chance to margin lead will narrow and whether leases will not start expiring unl upgrade is part of loyalty, and loyalty Alaska will succeed in reducing the 2020. The lease commitments will is part of successful growth”. debt on its balance sheet. then dwindle from 60 aircra in 2020 It is not clear if the royalty pay- According to the investor day pre- to just 10 in 2025 (see chart on this ment that Virgin America pays to the sentaon, last year Alaska had an page). Virgin Group (0.7% of annual rev- eight-point lead over the legacy car- enues) had any impact on the brand The management noted that it rier group in terms of pretax margin decision. But now that Alaska is elim- would be “extraordinarily expensive” (22%, compared to 14%) and a three- inang the Virgin America brand, it to terminate the Airbus leases early. point lead over the US LCCs (19%). definitely does not want to connue In any case, Alaska needs the li and Alaska says that the $300m run-rate paying the license fee unl the con- having two mainline types offers use- merger synergies will make it a 25% tract expires in 2040. ful flexibility when developing the pretax margin business. Virgin Group founder Richard network to become more relevant in Most US airlines’ pretax margins Branson is reportedly very unhappy California. are expected to temporarily decline about the brand decision and said The management esmated the by a couple of percentage points in at Virgin Atlanc’s London-Seale currentdysergyofoperangtwofleet 2017,butAlaskaissllexpectedtore- launch event in late March that types at just $20-25m annually. They main in the lead. Alaska would be required to pay speculated that the “added lever- The acquision increased royales unl 2040. However, Alaska age you’d get from having two differ- Alaska’s capital base from $4bn to has a different interpretaon of the ent manufacturers” might even offset $7.4bn, as a result of which aer-tax contract. When asked about it at the that dysergy (an interesng but not ROIC declined from 21.3% to around investor day, the execuves said that very convincing argument). 15% (pro-forma 2016). But that is sll there were “lots of ways out of the Cowen and Company analysts almost double the weighted average contract” and that in their opinion said in a recent research note that cost of capital. they would not need to keep paying they connued to believe that Alaska Low costs are crical to Alaska’s for a brand they are not using. would move to a 737 fleet and return business model and it has a strong

18 www.aviationstrategy.aero April 2017 United’s recently-reconstuted ALASKA AIR GROUP SHARE PRICE PERFORMANCE board and management offer hope. But the analysts were less op- 180 160 misc about Alaska’s prospects on 140 Relave to Arca Airline Index the transcon. Referring to the deci- 120 sions to eschew lie-flat seats and re- 100 duce the first class seat pitch, they said that they were “surprised by the 80 70 decision to go with an uncompe- 60 ve premium product in the lucrave transcon market”. Then again, Virgin 50 has only a 7% share of the premium Alaska Air Group 40 seats on the New York to San Fran- cisco/Los Angeles routes. 30 JPMorgan sees JetBlue as the 2014 2015 2016 biggest beneficiary of Alaska’s decision to “all-but-abandon the track record on that front: ex-fuel cated that they would do some mod- premium transcon market”. The unit costs fell from 9.16¢ in 2009 to est share buybacks this year but oth- analysts wrote: “If you liked the 8.24¢ in 2016. The management erwise the priority in 2017-2020 is to edginess of Virgin’s offering, JetBlue’s projects flat unit cost development implement integraon, pay dividends Mint is the next best thing out there”. for 2017 and hopes to connue a and pay down debt. Since being outbid for Virgin a year slight downward trend over me, ago, JetBlue has expanded the Mint Compeve concerns though a new pilot contract may premium product aggressively on the temporarily cause CASM to rise. Alaska has coexisted profitably with transconnental routes. Aer slashing its debt-to-capital Delta in Seale in recent years even A year ago Richard Branson said rao from 81% in 2008 to 27% in as the legacy has aggressively built that he would consider launching a 2015,Alaskasawtheraosoarto59% hub operaons in that city. The man- new Virgin brand airline in the US if in 2016 because it raised $1.8bn of agement sees no reason why Alaska Alaska chooses not to use the brand. debt to finance the Virgin acquision could not deploy the same strategies There could now be an opening for (at very aracve rates thanks to its successfully in San Francisco and Los an edgy new entrant to shake things investment grade credit rangs). Angeles. upintheincreasinglyconsolidatedUS A 59% leverage rao puts Alaska But investors fear that compe- domesc market. squarely in the middle of the indus- on against United in San Francisco try, but the management plans to “re- might be a different ballgame. United deleverage” and has set a target of dominates San Francisco with a 47% 45% by 2020. domesc market share and is less Alaska strives for “balanced capi- ROIC-oriented than Delta. talallocaon”.Fleetgrowthandmany JP Morgan analysts suggested By Heini Nuunen non-aircra investments will result in that the outcome was actually likely heini@theaviaoneconomist.com higher near-term capex ($1.2-$1.3bn to be “similarly benign” in San Fran- in both 2017 and 2018), but Alaska cisco, because Virgin as a pricing is also commied to delivering free agitator is taken out, because the cash flow and connuing to increase new Alaska represents a significantly the dividend. The management indi- lesser threat to United, and because

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