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Air Do, product of Japan’s quixotic airline market, likely to remain independent pending reform

18-Sep-2013

Air Do, based in the Hokkaido region in Japan, is an unusual type of carrier and perhaps one that could only exist in Japan’s atypical domestic environment. It enjoys a strikingly synergistic relationship with All Nippon Airways and leverages a valuable position at slot-constrained Haneda.

Air Do has challenges: Its traffic is highly seasonal, relying on passengers to flee the scorching summer for Hokkaido’s cooler weather. Air Do’s fleet of 767s allows it to target Tokyo-Sapporo, the world’s largest air route, while 737 classics serve thinner points in Hokkaido. But this brings considerable inefficiency to a 13-aircraft fleet, Air Do CEO Sadao Saito told CAPA’s LCCs and New Age Airlines conference in Seoul. Air Do's CASK and yield are lower than at ANA, and Air Do creates efficiency with load factors typically 10ppts higher than at ANA or JAL on overlapping routes. Air Do generally posts profits but with large variance.

Air Do launched in 1998 but quickly entered bankruptcy, emerging with a strategic (but not equity) partnership with All Nippon Airways. Air Do allowed ANA to enlarge its position at constrained Tokyo Haneda Airport, especially after rival JAL merged with Japan Air System. More recently Air Do has taken over thinner routes ANA could not serve.

The partnership has kept Air Do afloat: ANA sells about one third of Air Do’s tickets, making Air Do something of a proxy for ANA. Air Do’s arrangement is found at other small Japanese carriers, and pride keeps them independent despite the synergies that could result from a takeover. Their small size means ANA and JAL concentrate on larger strategic issues.

Air Do is second largest of the ‘new entrants’ – but is being displaced by LCCs

Air Do started life as Hokkaido International Airlines in 1998. It was one of many airlines to enter the domestic Japanese market in the late 1990s and early 2000s. Collectively these carriers are referred to as the “new entrant” carriers.

Air Do had typically been the second largest of the new entrants, with Skymark being the largest. But the gulf between Skymark and Air Do was wide. In FY2012 Skymark reported 6.9 billion RPKs while Air Do reported only 1.7 billion RPKs. StarFlyer and Solaseed reported 1.0-1.5 billion RPKs. 

Although Air Do’s strategy is unique and it does not directly compete with LCCs, in sheer size it is being overtaken by the three LCCs that launched in 2012: Peach Aviation, Jetstar Japan and AirAsia Japan. These three carriers are excluded from the “new entrants” grouping. In the Jan-2013 to Mar-2013 quarter, when the three had started to amass size, Jetstar Japan had more RPKs (531 million) than Air Do (415 million).

Peach was not far behind with 404,000 RPKs. It seems likely that in FY2013 Jetstar Japan will be larger than Air Do. AirAsia Japan is unlikely to be larger as its network is being pulled down as it transitions to internationally focused Vanilla AirThis trend is evident in Sep-2013 ASK capacity.

Japan domestic ASK capacity by carrier: 16-Sep-2013 to 22-Sep-2013

Air Do’s network focuses exclusively on flights to and from Hokkaido

Air Do has two types of routes in its scheduled network. First are services from Tokyo Haneda, Japan’s largest airport, to points in Hokkaido. These include the capital and main destination of Sapporo, as well as secondary points including Asahikawa, Hakodate, Kushiro, Memanbetsu and Obihiro. 

Air Do routes from Tokyo Haneda: Sep-2013

Air Do’s second type of routes are those from Sapporo to other points in Japan. Air Do does not link secondary Hokkaido destinations with other parts of Japan. Besides Tokyo, Air Do also operates from Sapporo to Fukushima, Komatsu, Niigata, Okayama, Osaka, Sendai and Toyama.

Air Do routes from Sapporo: Sep-2013

Air Do sees competition on Haneda routes, but less from other Japanese points

Unless Air Do is the sole operator on a route (which it is on four routes), it typically has a minority share of capacity. Its largest competitor is JAL.

Air Do route competition summary: Sep-2013

Route Other operators
Tokyo Haneda-Asahikawa

JAL

Skymark

Tokyo Haneda-Hakodate

ANA

JAL

Tokyo Haneda-Kushiro

ANA

JAL

Tokyo Haneda-Memanbetsu JAL
Tokyo Haneda-Obihiro

JAL

Tokyo Haneda-Sapporo

ANA

JAL

Skymark 

Sapporo-Fukushima None 
Sapporo-Komatsu None
Sapporo-Niigata  ANA
Sapporo-Okayama  None 
Sapporo-Sendai 

ANA

JAL

Skymark 

Sapporo-Toyoma None 

Haneda slots keep Air Do afloat and away from LCC competition

The only notable asset of Air Do is its slots at Tokyo Haneda Airport, the convenient but slot-constrained airport. Air Do has acquired Haneda slots – and thus garnered success – under Japanese policy that disproportionately favours new and small entrants when additional slots are available.

In late 2012 Japan awarded additional domestic Haneda slot pairs. Air Do was awarded two additional slots while ANA received eight. This is despite Air Do’s extremely smaller position in the domestic market, having 1.7 billion RPKs in FY2012 to ANA’s 36.3 billion RPKs.

Air Do’s Haneda positioning will allow it to partially differentiate itself from the new LCCs. Only two – AirAsia Japan and Jetstar Japan – are based in the Tokyo region. But they are based at inconvenient Tokyo Narita Airport. While the LCCs are mainly stimulating new demand, they are also cannibalising existing traffic. The question for Japan in coming years is how much traffic can be shifted from Haneda to Narita by offering lower fares.

All six of Air Do's Haneda routes feature in its top 10 largest routes.

Air Do top 10 routes ranked on seat capacity: 16-Sep-2013 to 22-Sep-2013

Air Do is a player on Haneda-Sapporo route, the world’s largest air route

Air Do can also differentiate itself by linking Tokyo with smaller points in Sapporo, although the viability of this is another matter. Another differentiating factor is linking Sapporo with non-Tokyo destinations. But these are more likely to be eyed by LCCs; indeed, one LCC may consider a Sapporo base bearing in mind four of Japan’s 20 largest routes are to or from Sapporo (most are to/from Tokyo Haneda).

Top 10 Domestic Routes in Japan ranked on seat capacity: 16-Sep-2013 to 22-Sep-2013

Rank Origin Destination Total Seats
1 HND Tokyo Haneda Airport CTS Sapporo Chitose Airport 289,535
2 FUK Fukuoka Airport HND Tokyo Haneda Airport 211,284
3 HND Tokyo Haneda Airport OKA Okinawa Naha Airport 148,434
4 ITM Osaka Itami Airport HND Tokyo Haneda Airport 131,274
5 KOJ Kagoshima Airport HND Tokyo Haneda Airport 76,614
6 HND Tokyo Haneda Airport KMJ Kumamoto Airport 67,074
7 HND Tokyo Haneda Airport KKJ Kita Kyushu Kokura Airport 58,408
8 KMI Miyazaki Airport HND Tokyo Haneda Airport 57,638
9 HND Tokyo Haneda Airport NGS Nagasaki Airport 52,164
10 HND Tokyo Haneda Airport HIJ Hiroshima International Airport 50,906

For now, Air Do’s bread and butter is its services on Tokyo Haneda-Sapporo, the world’s single largest air route.

Top 10 global routes ranked on seat capacity: 16-Sep-2013 to 22-Sep-2013

Rank Origin Destination
1 HND Tokyo Haneda Airport CTS Sapporo Chitose Airport
2 CJU Jeju Airport GMP Seoul Gimpo International Airport
3 FUK Fukuoka Airport HND Tokyo Haneda Airport
4 SYD Sydney Kingsford Smith Airport MEL Melbourne Tullamarine Airport
5 HKG Hong Kong International Airport TPE Taipei Taoyuan International Airport
6 CGK Jakarta Soekarno-Hatta International Airport SUB Surabaya Juanda Airport
7 HND Tokyo Haneda Airport OKA Okinawa Naha Airport
8 SDU Rio de Janeiro Santos Dumont Airport CGH Sao Paulo Congonhas Airport
9 PEK Beijing Capital International Airport SHA Shanghai Hongqiao Airport
10 ITM Osaka Itami Airport HND Tokyo Haneda Airport

Air Do accounts for about 12% of capacity between Tokyo Haneda and Narita to Sapporo. Strategic partner ANA accounts for about 45% of capacity, giving the two majority control.

Tokyo Haneda and Tokyo Narita to Sapporo Chitose Airport (seats per week, one way): 19-Sep-2011 to 9-Mar-2014

The overall importance of Tokyo Haneda to Air Do is demonstrated by the carrier having more seats to or from Haneda than any other point in Japan.

Air Do top 10 hubs/bases/stations by seat capacity: 16-Sep-2013 to 22-Sep-2013

Summer months are critical to Air Do

Critical to Air Do are the three months from July to September, coinciding with the Japanese summer season. This is when there are school and national holidays, and also when temperatures in most parts of Japan soar to 30-40C, making the cooler weather of Hokkaido appealing. It is typically the single largest quarter for the carrier.

Air Do direct revenue by fiscal quarter (JPY million): 2004-2012

From FY2004 to FY2012 Air Do’s summer quarter revenue was the highest of the year, except in FY2004 when Jan-Mar revenue was higher. About one third of Air Do’s direct revenue (excluding codeshare and ancillary revenueis generated during these three months, with an even higher proportion of profit generated during the summer months when planes are fuller and the operation more efficient.

Air Do direct revenue share by fiscal quarter: 2004-2012

Air Do’s yields are high with large seasonal variation

Air Do's yields are the highest after ANA, JAL and StarFlyer.

But this comes with large seasonal variation. Whereas ANA and JAL saw a 6-8% dip in yields from 2Q2012 to 3Q2012, Air Do had a 17% fall. Skymark likewise had a 16% dip while Japan Transocean Air, the leisure unit of JAL, shed 26%. The new LCCs also had significant dips. This is reflective of the new entrants and LCCs discounting off-season fares to stimulate demand, whereas ANA and JAL ride their incumbent position - but also have weak load factors in the off-season.

Japanese quarterly domestic yields by carrier: 2012

While Air Do may have a yield premium, that is necessary to make up for its high operating cost: about USD14 cents per km. This is less than ANA's CASK (USD14.5 cents, but this includes ANA's efficient long-haul operation) but considerably more than Skymark (USD7.8 cents).

Air Do has load factors higher than ANA or JAL on overlapping routes

While Air Do may have a bloated cost base, it gains some efficiency by higher than average load factors. On all of its services from Tokyo Haneda in FY2012, Air Do typically had a load factor at least 10ppts higher than ANA or JAL and above the system average. On its one overlapping route with Skymark, Air Do has a lower load factor than Skymark but still higher than ANA or JAL.

Airline and system load factors for Air Do flights from Tokyo Haneda: FY2012

Air Do's services from Sapporo to non-Tokyo points likewise saw strong performance over peers. An exception is Sapporo-Komatsu. While this may seem odd as Air Do is the only operator on the route, Air Do reports the load factor for only the seats it sells and not the block seats it sells to ANA. (ANA does not report the load factor of codeshare seats it buys.)

That means on Sapporo-Komatsu ANA was more efficient than Air Do at selling seats. But on three other routes where Air Do was the only operator, its load factor was above average, indicating it sold seats more efficiently than ANA.

Airline and system load factors for Air Do flights from Sapporo to Japanese destinations excluding Haneda: FY2012

It will be interesting to watch the performance on Sapporo-Sendai, which Skymark commenced serving in Apr-2013. In the fiscal year to Aug-2013, Skymark has an average load factor of 56%, although this is weighed down by 40% load factors in the route's first two months of operation. Skymark withdrew in 2010 from the Haneda-Asahikawa route after a year of service. Its final FY2010 load factor was 89%. 

ANA codeshares account for one third of Air Do’s revenue

If Tokyo Haneda slots are critical to Air Do, than All Nippon Airways is the lifeline. Air Do's post-bankruptcy existence has relied on partnering with All Nippon Airways. 

This went against the grain of airlines in other markets favouring the exit of smaller carriers. But ANA saw an opportunity. In 2001 rival Japan Airlines announced a merger with Japan Air System. Predominantly international JAL, which had about half the domestic market share of ANA, wanted to become a more formidable force to ANA, the largest. Japan Air System brought JAL a number of Haneda slots to its network. While Air Do was tiny compared to Japan Air System, it provided pushback, enabling ANA to enlarge its presence at Tokyo Haneda and provide a slightly lower cost vehicle to take over Hokkaido routes.

Under the partnership ANA helped in areas including maintenance, ground handling, IT, fleet and commercial. It is the latter that is most significant. A block-space codeshare sees ANA effectively guarantee about one third of Air Do’s revenue.

Exact figures of ANA’s sales to Air Do are unavailable. But Air Do in its annual report states total revenue while the carrier reports to regulator MLIT the revenue of its own seat sales. The difference in the two figures does include miscellaneous revenue (on board drinks etc.) but is primarily comprised of ANA codeshare revenue.

In recent years the gap between Air Do’s total revenue and revenue from its own sales has been about one third of the total revenue. That indicates Air Do has been relying on ANA for about one third of its revenue, making Air Do something of a proxy airline for ANA.

Large variance in profits and operating margins

FY2011 was Air Do's best performance ever, both in terms of operating profit and margin: Air Do posted a JPY3,541 million profit (USD35.7 million) with an operating margin of 8.2%. But this was a large change from the previous year's 4.6% operating margin.

In FY2012 the margin fell back to 3.9%. The FY2012 decline was a result of 4.8% revenue growth being outpaced by a 9.6% increase in costs. Air Do attributed the cost growth to higher fuel prices and larger aircraft depreciation costs. The system load factor also dropped 2ppt to 73.5%.

Air Do operating profit (JPY millions) and operating margin: FY2003-FY2012

Air Do has been in the red only twice in the past decade, albeit by small amounts.

Air Do and ANA could see further gains if codeshare rules are relaxed

Further liberalisation in Japan will help Air Do. Press reports have suggested the MLIT will lift the maximum percentage of Tokyo Haneda seats an airline can sell via codeshare. This rule is one of a number of bureaucratic policies that have almost no public benefit but hurt the industry. (Other anachronistic examples include the requirement for Japanese carriers to file every domestic fare offered, and rules limiting the number of sales a domestic carrier can have.)

Press reports suggest the MLIT will increase the percentage of seats that can be sold via codeshare from 25% to 50%. (There is already a relaxation on regional routes.) With ANA accounting for about one third of Air Do’s passengers, this likely means ANA is selling at the cap for Haneda flights and selling a higher percentage on regional routes. It stands to reason that if the MLIT relaxes codeshare volumes, ANA will be able to sell even more of Air Do’s seats from Haneda.

This will provide significant lift to Air Do and allow ANA to virtually enlarge its Haneda base. But the consequence is Air Do becoming even more of a proxy to ANA, raising the question if ANA is better off absorbing Air Do.

ANA has handed over routes to Air Do

Air Do’s growth in recent years has largely come from ANA handing over routes to it. ANA had been seeking a strategy to improve finances on regional Hokkaido routes. Air Do proved the answer, especially as it down-gauged from 150-seat 737-400s to 126-seat 737-500s, providing helpful right-sizing on the thinner nature of secondary Hokkaido routes.

ANA in 2009 announced it would codeshare on Air Do’s Sapporo-Niigata route, allowing ANA to reduce its own capacity from 21 to 14 weekly services. Later ANA announced it would transfer Sapporo-Fukushima, Sapporo-Komatsu and Sapporo-Toyama routes to Air Do. This strategy was partially changed as ANA in recent years has built up capacity to Sapporo. In 2011 ANA commenced codesharing on Air Do’s Tokyo Haneda-Obihiro route.

Air Do would gain from merger synergies as it balances demand and fleet

Air Do being acquired by ANA is a scenario that has never seriously been mentioned but one that offers benefits. Air Do’s traffic is highly seasonal, with off-peak months seeing about 75% of the passengers during peak months.

This has been underscored by the previous mention of Air Do’s revenue strength in summer months.

Air Do monthly passengers: 2011-2013

Air Do is able to reduce the impact of seasonal variation by cutting capacity in off-peak months, a tactic used in the extreme at easyJet and Ryanair, which effectively ground dozens of aircraft during their winter. But this does nothing for aircraft cost efficiency. And even then load factors are still considerably lower during winter than summer.

Air Do monthly available seats: 2011-2013

Air Do monthly load factor: 2011-2013

If Air Do’s fleet was integrated with the larger ANA, in winter months the fleet could be re-deployed to warmer destinations or even used more efficiently across the network.

Air Do would also gain the benefit of being part of ANA’s hundred-plus aircraft fleet rather than its own dozen or so. And within Air Do’s fleet there is fragmentation, such as having classic 737s, next generation 737s as well as two 767s. This further challenges scale.

Air Do’s 767s primarily operate the Tokyo Haneda-Sapporo sector but have limited deployment capability elsewhere. Being part of a larger fleet would help the 767s see better utilisation.

A new owner would also likely make efficiency upgrades. Air Do intends to replace its classic 737s with next-gen 737s but Air Do has no replacement plan for the 767s. Further, the next-gen 737 replacement plan may be driven less by ideal efficiency than what it can secure with its limited resources. On thinner routes regional jets may be more practical in terms of size and efficiency, and could be introduced with the help of a new owner.

Air Do fleet summary: as at 16-Sep-2013

Aircraft In Service In Storage On Order*
Total: 13 0 0
Boeing 737-500 6 0 0
Boeing 737-700 3 0 0
Boeing 767-300 2 0 0
Boeing 767-300ER 2 0 0

But Air Do’s risks being part of ANA’s inefficient cost culture

The biggest risk to being part of ANA is that ANA has the highest operating cost in Asia amongst major airlines. While Air Do is no Emirates or Ryanair in terms of discipline, it does offer some advantages over ANA. Bringing Air Do fully under ANA risks a scenario of costs inflating and routes becoming unprofitable. After all, Air Do partially owes its existence to ANA pulling off routes that were too expensive for it to operate.

Short of serious market reform, Air Do’s future has limited domestic growth

Any growth from Air Do will be tied to ANA handing over more routes or Air Do gaining more Tokyo Haneda slots. Neither are overwhelming prospects in the medium term. Even in the last Haneda slot expansion programme, Air Do secured only two pairs.

Air Do’s business plan calls for it to increase revenue from JPY51,000 million (USD653.8 million) in FY2013 to JPY53,500 million (USD685.9 million) in FY2015, representing an optimistic 4.9% growth. The increase in operating margin from 2.9% to 4.9% is even bolder.

Air Do hopes to grow where it can at Haneda but also further develop its Sapporo network, although the thinner nature of this market (outside of Tokyo) will be challenging for Air Do.

International flights: new growth market for Air Do?

Unlike the new LCCs, Air Do does not have the cost base to stimulate new domestic demand. International could be a possibility, with local reports in early 2013 suggesting Air Do would turn to international charters and then scheduled services. Most likely to be launched, according to media reports, were services to Seoul and Taipei.

This international option is consistent across the Japanese sector, with previously domestic-only carriers Skymark and StarFlyer dipping their toes into international operations with limited charter or scheduled flights. The major carriers, ANA and JAL, are expanding their own international operations. 

Air Do will face multiple challenges if it enters international markets. With Hokkaido being an inbound leisure destination, Air Do will have to heavily market to foreign markets. This puts it at a disadvantage as few have heard of Air Do outside of Japan. Carriers in Korea and Taiwan have a strong local base. Korean carriers are yet to make notable inroads in the Hokkaido region, but Taiwan’s TransAsia has, following the Japan-Taiwan open skies agreement. 

Air Do’s cost base puts it at a disadvantage, not only in stimulating new demand but competing with foreign carriers that have set their eyes on Hokkaido. There has been inertia in North Asia that has resulted in a lack of cost discipline but this is slowly changing as the Korean LCCs and TransAsia acknowledge they must cut their cost base.

Air Do: stuck between a rock and a hard place

The radical scenario is deep reform in Japan’s aviation sector. A number of critical areas need improvement: low load factors and high cost bases are the norm. These could potentially make Air Do redundant. Efficiency gains at ANA could make its historical Hokkaido operation more efficient than anything Air Do could offer.

Tokyo Haneda slots are a sensitive matter. Some carriers already argue ANA’s deep partnership with airlines means those partner airlines should see their Haneda slots decreased and given to truly new and independent carriers. But with the exception of Skymark, the "new entrants" have not yet delivered on their purpose to shakeup Japanese aviation, especially as Air Do and IBEX are operating as proxies for ANA. So perhaps a re-thinking is in order anyway. But until the industry can look past the sensitivity of Haneda slots, ANA will find greater value in an independent Air Do than a wholly-owned Air Do that has to divest slots.

At the same time, ANA might find it a distraction to work on a closer relationship with – or even acquisition of – Air Do. Air Do’s growth prospects are small and ANA has already extracted considerable benefit. A closer relationship would require the bandwidth of management, which is intent on making big picture and long-lasting changes to ANA by acquiring foreign companies. This is part of ANA’s strategy to have a business base outside Japan to combat Japan’s local declining economy.

Air Do has few options. Mr Saito sees Air Do being a “reasonable cost carrier”, somewhere between full-service and LCC. A low-cost model could support growth in international markets, but Air Do seems unlikely to be able to execute this successfully, let alone have the interest in doing so. One of Japan’s LCCs is likely to take up the task, leaving Air Do to the domestic market.

The limited nature of Haneda slots and ANA’s desire to gain ground against JAL have kept Air Do in existence. But now that Haneda slots have limited growth and there is little additional ANA can do with Air Do as far as competition with JAL is concerned, the unique Japanese factors that have sustained Air Do are now the factors that limit it.


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