Aeroflot acts to relaunch its LCC project with Pobeda after Group profits fell again in 3Q2014

Aeroflot Group falls into loss in 3Q2014

In 3Q2014, Aeroflot Group posted a net loss of RUB1,658 million (EUR35 million), compared with a profit of RUB17,192 million in the same period a year earlier. This result was significantly affected by one-off costs, including foreign exchange losses related to finance lease revaluation. Operating profit fell by 31% to RUB15,046 million (EUR314 million) in 3Q2014 from a profit of RUB21,688 million in 3Q2013. Revenues increased by 2.4% to EUR96,417 million (EUR2,010 million).

For 9M2014, revenues grew by 6.5% to RUB236,698 million (EUR4,936 million), operating profit almost halved to RUB13,662 million (EUR285 million) and the net result fell to a loss of RUB3,563 million (EUR74 million) from a profit of RUB17,237 million a year earlier. Adjusted for foreign exchange fluctuations related to finance lease revaluation and non-recurring provisions, the operating result was still 43% down year on year and the net result, while positive at a profit of RUB12,907 million, was still 36% below last year's adjusted result.

The parent company, JSC Aeroflot, reported a 3Q2014 net loss of RUB1,988 million, down from a profit of RUB14,490 million last year, and an operating profit of RUB12,805 million, down 31% year on year.

See related report: Aeroflot Group suffers first 1H net loss in many years as geopolitical backdrop starts to show

Aeroflot Group financial highlights 3Q and 9M 2014 versus 2013

Source: Aeroflot

Group ASKs rose 6.9% in 3Q, driven by strong domestic growth

The Group grew its capacity, measured in ASKs, by 6.9% in 3Q2014, an acceleration from the 5.0% growth in 1H2014. The Group's RPKs grew faster, by 8.0%, and load factor gained 0.9ppts to 84.8% in 3Q2014, reversing the slight fall in load factor in 1H. Growth in capacity, traffic and load factor was driven by expansion in the domestic market (ASK +14.8%).

On international routes, the Group's capacity growth was muted (+2.4%) and its load factor fell (see table below), reflecting the geopolitical environment.

The growth was also driven by the parent company, JSC Aeroflot, whose ASKs were up by 10.5% in 3Q, much faster than the Group's 6.9% increase.

Aeroflot Group and JSC Aeroflot traffic statistics 3Q and 9M 2014 versus 2013

Source: Aeroflot

For 9M2014, the Group increased both ASKs and RPKs by 5.7% and load factor was stable at 79.2%. Again, the domestic market enjoyed the strongest growth, with ASKs up 14.1% and RPKs up 18.6%. By contrast, the Group's capacity in CIS countries fell by 8.7% and RPKs fell by 8.6% here, as a result of the Ukraine crisis.

Capacity growth in Europe, Middle East and Asia was relatively high, but was not matched by traffic growth and so load factor fell in all three regions (see chart below). The international region where the Group's capacity growth was slowest, and where load factor was almost stable, was North and Central America.

Aeroflot Group growth in passengers, ASK and RPK by region 9M2014 vs 9M2013

Source: Aeroflot

Aeroflot's 3Q revenue rose 2.4%

Group revenue increased by 2.4% in 3Q2014, less than the 6.9% increase in ASKs. This deterioration in revenue growth from the 9.4% increase reported in 1H2014, in spite of higher capacity growth, owed much to the fall in the value of RUB versus international currencies, but also to weaker demand.

Aeroflot Group revenues 3Q and 9M 2014 versus 2013

RUB million	3Q2013	3Q2014	Change	9M2013	9M2014	Change	% of 9M2014 total
Scheduled passenger flights	77,082	78,011	1.2%	177,534	188,834	6.4%	80%
Charter	5,011	6,186	23.4%	13,087	13,340	1.9%	6%
Cargo	2,130	2,149	0.9%	7,269	5,968	-17.9%	3%
Traffic revenue	84,223	86,346	2.5%	197,890	208,142	5.2%	88%
Other revenue	9,950	10,071	1.2%	24,463	28,556	16.7%	12%
Total revenue	94,173	96,417	2.4%	222,353	236,698	6.5%	100%

Source: CAPA - Centre for Aviation, Aeroflot

Passenger revenue (scheduled plus charter) per ASK fell by 6.7% year on year in 3Q, reversing the 3.3% increase reported in 1H and taking the 9M passenger RASK development to a drop of 2.5%. This reflected the weakness of passenger yield in 3Q, particularly on international routes, only partly offset by the load factor gain noted above.

Aeroflot Group yield (passenger revenue per RPK) and passenger RASK 3Q and 9M 2014 versus 2013

Source: Aeroflot

But costs increased 12.3%, led by staff costs

The Group's operating costs increased by 12.3% year on year in 3Q2014, faster than ASKs and revenue. Excluding foreign exchange movements and non-recurring items, the growth in costs was 10.3%, but this still outpaced ASKs and revenue. Fuel costs increased by 9.3% and non-fuel costs grew at the faster rate of 13.6%.

Staff costs grew by 34.1% year on year in 3Q2014 and by 20.4% for 9M2014, compared with a 5.9% year on year increase in headcount at the end of the period. The growth in headcount was less than the increase in passenger numbers, but was broadly similar to the increase in ASKs and RPKs. Moreover, the sharp increase in staff costs compared with the increase in headcount and in revenue is a source of concern, although it partly reflects the grant of share options.

For 9M214, CASK grew by 8.0%, while RASK fell. After stripping out the impact of foreign exchange and non-recurring items, 9M CASK still increased by 4.7%.

Aeroflot Group operating costs 3Q and 9M 2014 versus 2013

1 Includes sales and marketing expenses and administration and general expenses.
2 Non-recurring expenses include provision on accounts receivable in relation to doubtful debtors (Ideal-tur and PGS), provision for pre-term return of MD-11, gain on pre-term return of TU-204 and increase of aircraft return reserves
Source: Aeroflot

Pobeda replaces Dobrolet in Russia's nascent LCC segment

On 04-Aug-2014 Aeroflot suspended the operation of its low cost airline subsidiary Dobrolet as a result of economic sanctions imposed by the European Union. The EU objected to the Russian annexation of the Crimea region of Ukraine and to Dobrolet's operation on the route Moscow to the Crimean city of Simferopol. Leasing, repair and maintenance services and airplane insurance agreements were annulled, as well as the provision of aeronautical information, effectively grounding Dobrolet.

Dobrolet had originally planned to launch with Moscow-St Petersburg, but delayed the planned start of this route until late 2014, reportedly due to a disagreement over airport fees. Its original plans also did not anticipate operating any international routes until 2016, but Dobrolet launched with the Simferopol route on 11-Jun-2014. It seems that the influence of the Russian government, majority shareholder in Aeroflot, was felt on Dobrolet's route decision making.

At the time that its operations were suspended in early Aug-2014, Dobrolet had also started to sell tickets for a number of domestic Russian routes that had not yet commenced operation. These were Moscow Sheremetyevo to Volgograd, Samara, Perm, Ufa, Surgut and Ekaterinburg, which were due to commence operating in Aug-2014, and Moscow Sheremetyevo to Kazan, due for Oct-2014.

Aeroflot's new LC subsidiary, Pobeda, began operations on 2-Dec-2014 with a daily service from Moscow Vnukovo to Volgograd. It plans to start daily flights from Moscow to Yekaterinburg, Samara, Perm, Belgorod, Tyumen and Surgut in December, with one-way fares starting at RUB999 (not including taxes and fees).

Pobeda's 2014 network plan

Source: Aeroflot

The concept behind Pobeda is essentially the same as for Dobrolet: a low cost carrier with fares at a 20% to 40% discount to "traditional" airlines in Russia, aimed at price sensitive customers.

It is differentiated from Aeroflot's core product not only through lower fares, but also through an unbundled approach to pricing, the use of direct/on-line sales channels and operating from Vnukovo, rather than Aeroflot's Sheremetyevo hub. Dobrolet had operated from Sheremetyevo, but this had never been intended to be its permanent base.

See related report: Dobrolet nears take-off, but can Aeroflot's LCC subsidiary achieve the required cost structure?

Like Dobrolet before it, Pobeda operates Boeing 737-800 aircraft with 189 seats. It expects its fleet to consist of four aircraft, operating seven routes by the end of 2014. Dobrolet had planned eight aircraft and 11 routes by the end of this year, so Aeroflot's LCC plans have slipped a little, but it has acted quickly in relaunching them. Looking further ahead, Pobeda is aiming for 10 million annual passengers, 37 aircraft and 47 routes (including international) by 2018.

The challenge to Aeroflot's LCC operation that arose from the EU sanctions was a strong test of its commitment to the concept in addition to its sense of national pride. Group CEO Vitaly Saveliev, who is also Chairman of the LCC, said in a press release: "The name Pobeda (Victory) is directly related to the upcoming anniversary of the Great Victory and symbolizes our common victory inevitable over those difficulties and external challenges faced by our country and our people this year."

The opportunity afforded by regulatory change permitting the LCC concept to thrive in the Russian domestic market is one that Aeroflot could not afford to miss. With no other LCCs yet operating in this market, it was important for it to retain its first mover advantage.

The ups and downs of being Russia's national champion

As Russia's airline sector national champion, still 51% controlled by the Russian government, Aeroflot has experienced some ups and downs.

It was given the chance to lead consolidation of the domestic airline industry in 2011 and now to lead the development of the LCC model in Russia. The flipside to this is that the state's desire to provide air links to the newly annexed Crimea inadvertently led to a significant setback in Aeroflot's ability to take its chance in the low cost sector. Moreover, the weakening of demand on the Group's international network owes much to the Russian government's geopolitical influence.

While treading a careful line on political matters, Aeroflot must not lose sight of the fundamentals. This means reversing this year's trend of RASK growth lagging CASK growth. Political temperatures fluctuate; costs are immutable.