Winter 2012 x x x Aviation Primer A guide to navigating Asia’s increasingly busy skies Important disclosures, including any required research certifications, are provided on the last two pages of this report. Aviation Primer Winter 2012 Table of contents Introduction 1 I Getting off the ground 3 II Choosing the right places 15 III Assessing aircraft options 23 IV Money matters: buy or lease? 49 V Devising the right sales strategy 57 VI Plane spotting: future trends in Asia 69 VII Picking the winners 83 VIII How to score an upgrade 91 Appendix 95 Aviation Primer Winter 2012 Contributing Daiwa Analysts Summary The battle over Asia’s skies is intensifying. As GDP and disposable income rise in countries around the region, more people are getting the opportunity to fly. Tapping into the demand are the full-service airlines, low-cost carriers, and niche players. We look behind the ‘glamour’ of the industry to see what makes it tick. How important is it for an airline to be linked to a global distribution system, what Kelvin Lau (852) 2848 4467 strategies are working best in the various markets of Asia, and which aircraft [email protected] is right for a particular route? These are questions all airlines face, from established flag carriers to fledgling low-cost carriers. In the Aviation Primer, we look at the factors that airlines need to consider when operating their fleets and expanding their networks. It’s a constant balancing act, but we trust that the insights provided will put investors on the right flight path in terms of investing in the industry. I would like to thank Paul Sheridan of Ascend for his invaluable contribution on aviation-industry financing, and Daiwa’s Japan aviation analyst, Hitotsuyanagi Hajime Hitotsuyanagi Hajime, for his insights into the Japan airlines sector. (81) 3 5555 7025 [email protected] Kelvin Lau Senior Analyst, Aviation Paul Sheridan is the head of consultancy for Asia at Ascend. He joined the company in January 2010 after 10 years of working in the aviation industry. Guest Author Ascend, a Flightglobal advisory service, is a leading provider of expert advisory and valuations services to the global aviation industry. It provides specialist, independent services that inform and shape the strategies of aviation businesses worldwide, helping them to compete successfully in today’s global market. Companies large and small rely on Ascend to take their business to the next level. Ascend’s aviation expertise and experience is backed by unique access to robust industry data. Paul Sheridan, Head of Consultancy Asia, Ascend Ascend offers an unrivalled breadth and depth of aviation expertise and experience, backed by unique access to robust industry data. It provides an impartial yet informed perspective to help organisations direct and manage their investments to deliver the very best returns. As part of Flightglobal, Ascend can also offer a single point of access to the industry’s most trusted news, data and analytics services. Paul Sheridan is an independent contributor as part of Daiwa's guest author programme, which is separate from the firm's normal research coverage. The views expressed by the guest author herein represent the opinions of the author only, and do not necessarily reflect the opinions of Daiwa, the other authors of this report, or the author’s employer. - 1 - Aviation Primer Winter 2012 Introduction The aviation industry is a highly volatile one, with many airlines globally struggling to make a profit. In Asia, where the industry started later than in the US and Europe, the operating environment is better, resulting in the airlines there achieving a better net-profit margin over the past five years than many big players in the US and Europe. We believe airlines in Asia have learned some lessons from the US and Europe, and have also benefited from the fast-growing economies in the region. We consider Asian airlines, albeit with their smaller fleet sizes, to be much more attractive investments than their US and European peers. In the future, we expect the major divergences to persist within the industry, with the low-cost carriers (LCCs) focusing on the low-end market, and the premium carriers (full service carriers [FSCs]) that target business travellers focused on the high-end market. But, several new issues for the industry are set to emerge in Asia over the next decade, including ‘open skies’ in ASEAN, the Emission Trading Scheme (ETS) of the EU, the development of biofuels, all of which are likely to play a key role in changing the competitive landscape. As this traditionally capital-intensive industry is highly cyclical with low net-profit margins, every decision is crucial to profitability. In addition, there are numerous external factors, such as economic growth, government regulation, the industry cycle, and jet-fuel price movements that affect financial results. Airlines globally ranked in terms of net-profit margin (2011) Rank Country Company Bloomberg code Net profit margin (%) Net profit (US$m) ROE (%) 1 Japan Japan Airlines 9201 JP 15.5 2,360 63.6* 2 Ireland Ryanair Holdings RYA ID 12.8 780 17.9 3 Malaysia AirAsia AIRA MK 12.4 182 14.5 4 Philippines Cebu Air CEB PM 10.7 84 19.6 5 China Hainan Airlines 600221 CH 10.3 407 19.5 6 Russia Aeroflot Russian Airlines AFLT RM 9.8 525 40.1 7 Japan Skymark 9204 JP 9.6 97 25.6 8 China Air China 753 HK 6.7 1,096 16.2 9 UK Easyjet PLC EZJ LN 6.5 361 14.0 9 Chile Latam Airlines LAN CI 5.7 361 23.4 10 US Alaska Air Group ALK US 5.7 245 21.5 Source: Bloomberg. Note: Only listed companies included.*Japan Airlines was listed on 19 September 2012 World’s largest airlines in terms of fleet size (2011) Rank Country Airline Fleet size Orders Total 1 US United Continental Airlines 1,256 270 1526 2 US American Airlines 898 177 1075 3 US Delta Air Lines 775 127 902 4 US SkyWest 720 n.a n.a 5 US Southwest Airlines 698 342 1040 6 Germany Lufthansa 696 356 1052 7 France and Netherlands Air France-KLM 586 182 768 8 China China Southern Airlines 444 256 700 9 China Air China 432 219 651 10 China China Eastern Airlines 377 282 659 Source: Airbus, Boeing, companies World’s largest airlines by market capitalisation Rank Country Company Bloomberg code Market cap (US$m) 1 Chile LATAM Airlines Group LAN CI 11,690 2 Singapore Singapore Airlines SIA SP 10,024 3 China Air China 753 HK 9,807 4 Ireland Ryanair Holdings RYA ID 8,890 5 Japan Japan Airlines 9201 JP 8,722 06 US Delta Air Lines DAL US 8,309 7 Japan All Nippon Airways 9202 JP 7,336 8 Germany Deutsche Lufthansa LHA GR 7,160 9 Hong Kong Cathay Pacifc 293 HK 7,127 10 US United Continental Holdings UAL US 6,732 Source: Bloomberg. Note: Only listed companies included - 2 - Aviation Primer Winter 2012 - 3 - Aviation Primer Winter 2012 Preparing for take-off Overview The growth of an airline is highly dependent on numerous external factors, such as economic growth, population, income levels, and industry-specific factors, including competition and the regulatory environment. Even though many airlines’ founders prefer to set up their airline in their home country due to their greater familiarity with local market conditions, understanding these external factors enables them to assess future risks and opportunities. Economic growth According to our regression analysis, traffic growth (as represented by revenue passenger kilometres [RPKs]) is highly related to economic growth. We estimate that every 1% increase in GDP annually leads to a 1.5-2.0% YoY rise in traffic growth. For example, air-traffic growth rates in China and Japan are very different, reflecting the differing levels of economic growth. For 1992-2011, GDP increased at CAGRs of 10% in China and was flat in Japan. This could explain why the CAGR in RPK in China was 15% over the period, while in Japan it was only 1.2%. A new airline being set up in a market with mature economic growth is likely to find it hard to expand, especially as there will be competition from incumbent carriers. China: GDP growth vs. RPK growth Japan: GDP growth vs. RPK growth (YoY % ) (YoY % ) (YoY % ) (YoY % ) 16 50 10 15 14 8 40 10 6 12 30 10 4 5 20 2 8 0 10 0 6 (2) (5) 0 4 (4) (10) 2 (10) (6) 0 (20) (8) (15) 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 GDP (LHS) RPK (RHS) GDP (LHS) RPK (RHS) Source: CEIC, CAAC Source: CEIC Domestic competition Almost every country in Asia has a national carrier backed by the government. The national carrier often has a long history and sometimes receives preferential treatment from the government. As a result, the level of dominance of the national carrier in a country will determine whether or not there is room for competitors to survive. Some countries restrict traffic rights in order to avoid competition among domestic carriers on a particular route. When that is the case, new entrants may be forced to fly on secondary routes where traffic demand is weak. It is only when the aviation market is deregulated (ie, allows new entrants) and the incumbent carrier (mostly state-owned) is inefficient that there is more room for new players. - 4 - Aviation Primer Winter 2012 National carriers and their respective domestic market shares Country Airlines Market share (%) Australia Qantas 87 Canada Air Canada 30 China Air China 22 France Air France 56 Germany Lufthansa 53 Hong Kong Cathay Pacific 53 India Air India 23 Indonesia Garuda Indonesia 36 Italy Alitalia 20 Japan Japan Airlines 37 Malaysia Malaysia airlines 53 Netherlands KLM 47 New Zealand Air New Zealand 79 Philippines Philippine Airlines 48 Singapore Singapore Airlines 40 South Korea Korean Air 54 Taiwan China Airlines 29 Thailand Thai Airways 89 United Arab Emirates Emirates 65 UK British Airways 11 Vietnam Vietnam Airlines 66 Source: Government Statistics Bureaux, various media Population and income The size and distribution of the population of an airline’s base country naturally affects potential demand.