19-Mar-2013 9:00 AM

Cebu Pacific sees bright outlook for 2013 as rationality returns to Philippines market

Analysis

Cebu Pacific is planning more double-digit capacity expansion in 2013 as the Philippine LCC launches widebody services and expands its limited Japanese network. Cebu Pacific expects to expand seat capacity by 11% in 2013 and grow its fleet by 17% to 48 aircraft. The expansion, which includes the launch of its new long-haul operation, should allow the carrier to extend its already leading share of the Philippine market.

Cebu Pacific recorded 11% growth in passenger traffic in 2012 and a 7% operating profit margin despite intense competition, particularly in the domestic market. The carrier's load factor and net profit dropped slightly. But Cebu Pacific's outlook for 2013 is brighter given the recent rationalisation and consolidation in the Philippine domestic market and the new opportunities for international expansion created as a result of Philippine authorities passing an ICAO safety audit in Feb-2013.

Summary

Cebu Pacific plans to expand its seat capacity by 11% in 2013 and grow its fleet by 17% to 48 aircraft.
The carrier recorded 11% growth in passenger traffic in 2012 and a 7% operating profit margin despite intense competition.
Cebu Pacific's domestic load factor dropped to 83.6% and international load factor dropped to 79.4% in 2012.
The Philippine domestic market experienced over-capacity and irrational competition in 2012, leading to a consolidation and rationalization in the market.
Cebu Pacific is planning to expand its international operations, including launching long-haul services and expanding its presence in the Japanese market.
The carrier is seeking to regain Category 1 status from the US FAA, which would allow it to expand its operations in the US market.

Cebu Pacific reported on 15-Mar-2013 a 2% drop in net profit for 2012 to PHP3.57 billion (USD88 million) (see background information). Revenues were up 12% to PHP37.90 billion (USD923 million) but operating costs increased by 15% to PHP35.24 billion (USD867 million). As a result the carrier's operating profit (EBIT) margin dropped 2.8ppt to a still healthy 7%.

Cebu Pacific records higher domestic load factor than all competitors

Cebu's passenger traffic was up 11% to 13.3 million passengers, including an 11% increase in domestic traffic to 10.3 million and a 10% increase in international traffic to three million. But seat capacity was up 16%, resulting in a 3.7ppt drop in load factor to 82.6%.

The carrier's domestic load factor dropped 3.9ppt to 83.6% while its international load factor dropped 2.9ppt to 79.4%. But Cebu Pacific still maintained the highest load factor in the Philippine domestic industry by a wide margin.

2012 was a challenging year for all Philippine carriers as a result of rapid capacity expansion, which resulted in irrational competition and over-capacity in the domestic market. Total passenger traffic in the Philippine domestic market was up 10% to 20.6 million passengers, according to Philippine CAB data. But seat capacity was up 16% to 28.3 million seats. As a result, the average load factor in the Philippine domestic market slipped by over 4ppt to less than 73%.

All of the expansion was driven by LCCs as the only full-service carrier serving the Philippine domestic market in 2012, Philippine Airlines (PAL), recorded a 5% drop in domestic traffic to 4.1 million. LCCs accounted for 80% of passenger traffic in the Philippine domestic market in 2012, up from 76% in 2011.

Cebu Pacific led the market with a 46% share, up from 45% in 2011 despite the entrance of two new LCCs in the domestic market - AirAsia Philippines and new Tiger Airways affiliate SEAir - and rapid growth at PAL budget carrier affiliate AirPhil Express. A fourth LCC, Zest Airways, also serves the Philippine domestic market but recorded a 4% drop in domestic traffic in 2012 despite an 8% increase in seat capacity.

Philippine domestic market share (% of passengers transported) by carrier: 2012

The lower load factors combined with a reduction in yields that resulted from the intensifying LCC competition created conditions in the domestic market which were unsustainable. The situation peaked in 3Q2012, when new SEAir became the fourth LCC on domestic trunk routes, joining Cebu Pacific, AirPhil Express, Zest Airways and start-up Philippines AirAsia. (Prior to a change in ownership that included the sale of a minority stake to Singapore-based Tiger, SEAir operated domestically following a full-service regional carrier model. Philippines AirAsia launched services in Mar-2012.)

Domestic market conditions in the Philippines start to improve

But domestic market conditions improved in 4Q2012 and 1Q2013, leading to a brighter outlook for Cebu and other Philippine domestic carriers. Rationalisation has come to the market in the form of consolidation and a slowdown in capacity growth.

Year-over-year domestic seat growth was 9% in 4Q2012 compared to 18% through the first three quarters of 2012. Capacity at the PAL Group in particular decreased as AirPhil Express exited seven domestic routes as part of a revision to the group's two-brand strategy. PAL Group's domestic seat capacity was down 11% in 4Q2012 compared to 4Q2011.

AirPhil Express has since been used primarily on thinner regional routes that are not served by PAL mainline, leaving PAL without a budget brand on trunk routes. As CAPA reported in Oct-2012, Cebu Pacific and the country's other LCCs benefitted from AirPhil's exit from domestic trunk routes as it left a more sustainable three LCCs rather than four competing on the main routes. In discussing Cebu's 4Q2012 earnings on 18-Mar-2013, Cebu Pacific CEO advisor Garry Kingshott said the carrier has already noticed a positive impact on yields in the markets that AirPhil exited.

AirPhil has since moved further away from LCC competition, adopting more of a hybrid model as part of its rebranding as PAL Express. Under the new PAL Express brand, which was implemented on 15-Mar-2013, the carrier has again begun to offer frills such as drinks and snacks, becoming more like a regional full-service subsidiary than a budget subsidiary.

Cebu Pacific to benefit from changes at AirPhil and other Philippine LCCs

AirPhil, which is the second largest domestic carrier in the Philippines after Cebu Pacific, had been following the LCC model since 2010. Cebu Pacific and smaller Philippine LCCs clearly benefit as AirPhil/PAL Express hybridises and becomes more like a full-service carrier under the revised strategy of new PAL Group owner the San Miguel Group.

In Feb-2013, AirPhil also dropped its operation at Manila alternative airport Clark, where it had operated three domestic and two international routes. AirAsia Philippines also has dropped in recent months one domestic and two international routes from Clark. Cebu is based at Manila but also operates four international routes and one domestic route from Clark.

AirAsia Philippines is based at Clark and currently has a leading 30% share of capacity at the airport. But the new AirAsia affiliate has struggled in its first year of operation, dropping several routes and postponing fleet growth beyond two aircraft. On 11-Mar-2013 the carrier announced a tie-up with Zest, which also has struggled financially over the last year. AirAsia Philippines is acquiring a 49% stake in Zest, which has a valuable portfolio of slots at Manila International, while Zest is receiving a 15% stake in AirAsia Philippines.

The two LCCs plan to pursue a strategic alliance. Few details have so far been provided but the alliance could see the AirAsia brand enter the Manila market, taking over some slots and flights from Zest. Cebu Pacific believes the resulting consolidation is a positive development for the overall industry given the excess capacity and irrational competition that plagued the domestic market in 2012. "While the details are a little hazy we generally welcome this development as the Philippine aviation industry is ripe for consolidation," Mr Kingshott said.

Cebu Pacific well positioned to exploit opportunities in Philippine international market

Cebu Pacific executives are also bullish on the international market. The carrier captured 16% of the Philippine international market based on Philippine CAB data from the first three quarters of the year. (Full year data is not yet available for the international market.)

Philippine international market share (% of passengers transported) by carrier: 9M2012

But Cebu Pacific is only scrapping the surface when it comes to the international market as it currently only operates regional international services and has an all-narrowbody fleet. The carrier is taking the first of at least eight A330s in mid-2013, opening up new opportunities in the long-haul market. Cebu also plans to use its A320 fleet to pursue significant expansion in the Japanese market in 2013.

Cebu Pacific has been blocked in recent years from expanding in Japan beyond its current three weekly flights to Osaka due to a JCAB restriction that prevents all Philippine carriers from adding capacity because Philippine authorities have not been in compliance with ICAO standards. Japan is now analysing the recent ICAO determination that concluded that the Philippines is in compliance again and is expected to lift restrictions on Philippine carriers within the next few weeks.

Cebu Pacific plans Nagoya service and more capacity to Osaka

Cebu Pacific has already applied to add frequencies to its thrice weekly Manila-Osaka service and launch service from Manila to Nagoya. The carrier already has traffic rights for more Osaka services and for Nagoya but has until now been unable to use them due to the JCAB restriction. Cebu Pacific is also interested in serving Tokyo and has requested the Philippine Government to open bilateral talks with Japanese authorities in the hope that a second Philippine carrier will be authorised for the Manila-Tokyo route.

Cebu Pacific believes the Japan-Philippines market is under-served as a result of ICAO-related and bilateral restrictions. There are currently about 43,000 weekly return seats between the two countries. PAL, which serves four Japanese cities, currently has a leading 43% share of capacity in the market, according to Innovata data. "We believe a lot of those services are overpriced and we can stimulate that market," Mr Kingshott said. He added that Cebu Pacific expects to allocate the equivalent of at least two A320s to the Japanese market.

But the opening up of the Japanese market will also likely lead to services from other Philippine LCCs. The Philippines is also a potential destination for the new trio of Japanese LCCs which launched in 2012. As a result there is a risk that the now under-served market could quickly swing to an over-capacity situation.

Philippines-South Korea market could see over-capacity

Over-capacity is a more likely possibility in the larger Philippines-South Korea market. South Korean authorities have blocked new Philippine carriers from launching services to South Korea during the period that the Philippines was not in compliance with ICAO standards. But unlike Japanese authorities, South Korean authorities still allowed Philippine carriers that were already serving South Korea to add capacity. This provided an advantage to the three carriers already in the market - Cebu Pacific, Zest and PAL.

With the Philippines passing the recent ICAO audit, the playing field in the Philippines-South Korea market will be levelled, allowing for other carriers including PAL Express and AirAsia Philippines to enter. Over-capacity could result. The South Korea-Philippines market is already suffering from too much capacity, particularly during certain times of the year. The average load factor in the market for 2012 was only 68%, according to Philippine CAB data.

Korean Air is the largest carrier in the Philippines-South Korea market, carrying a 23% share of passengers between the two countries in 2012. PAL and Asiana each captured a 21% share, followed by Cebu Pacific with a 17% share and Zest with a 10% share. Three South Korean LCCs also serve Philippines - Air Busan, Jeju Air and Jin Air - but have a limited number of flights in the market.

Opening up the Japanese market is key as Cebu Pacific has already expanded significantly in recent years to South Korea, greater China and all major markets within Southeast Asia. The carrier recorded 32% growth in passenger traffic in 2012 to Brunei, 30% growth to Vietnam, 29% growth to China, 22% growth to Taiwan and 21% growth to Malaysia.

It already had a large operation in the bigger markets of Singapore and Hong Kong. Cebu Pacific captured a 25% share of passenger traffic between the Philippines and Singapore through the first three quarters of 2012, making it the second largest carrier in the market after Singapore Airlines. In the Philippines-Hong Kong market, Cebu Pacific captured a 21% share of the market through the first nine months of 2012.

Passing the ICAO audit should also open up opportunities for Philippine carriers to expand in the Europe and the US. Cebu Pacific plans to join a delegation consisting of Philippine authorities and PAL in Brussels in Apr-2013, where they will meet with EU authorities to discuss removing the Philippines from the EU black list. Cebu Pacific believes this should occur by the end of 2013 although there will be no short or medium term benefits to the carrier as it currently has no ambitions of flying to Europe.

US FAA Category 1 status could open up Guam for Cebu Pacific

Philippine authorities have also requested a new audit from the US FAA, which in theory they should pass on the basis of the recent determination by ICAO auditors. But the process of being audited by the FAA and waiting for a determination will likely take at least several months. Philippine authorities need to pass a US FAA audit and regain its Category 1 status for Philippine carriers to add capacity in the US market.

The current Category 2 status has mainly impacted PAL, which has been unable to use its new fleet of 777-300ERs to expand in the US market. But Cebu Pacific also has been unable to launch services to Guam, which it has been considering for several years. Recently it looked at launching Guam using wet-leased aircraft because Category 2 means it cannot launch services into the US with its own aircraft. As wet leases are expensive Cebu Pacific would prefer to serve Guam with its own A320s, something that would become feasible if the Philippines regains Category 1 status.

Hawaii could also be an option with Cebu's new fleet of A330-300s, which do not have the range to operate to the mainland US. But Cebu is focused at least for now on using its initial fleet of A330s on medium-haul flights to the Middle East and Australia rather than the US or Europe.

Cebu Pacific expects extension of Philippines-Australia bilateral

The carrier's first batch of two A330s will be used to launch in Oct-2013 daily service to Dubai and up-gauge starting in mid-2013 some existing A320 flights to Singapore and Seoul. Dubai ticket sales are ahead of plan with about 7% of tickets already sold for flights in 4Q2013.

Cebu Pacific aims to add service to Kuwait, Saudi Arabia and Australia after it takes delivery of two additional A330s in early 2014. Cebu Pacific already has received traffic rights to operate seven weekly flights to Australia, seven weekly flights to Saudi Arabia and four weekly flights to Kuwait. The carrier is now in the process of securing operating permits from Saudi Arabian authorities and could use its Saudi Arabian rights to serve Jeddah and/or Riyadh. Dammam is also being considered but would not count against its traffic rights as Dammam is an open skies airport.

As CAPA previously reported in Jan-2013, for Australia Cebu Pacific currently only has the traffic rights to support seven weekly A320 flights. But Philippine and Australian authorities plan to meet in Apr-2013 to discuss extending their bilateral agreement. Mr Kingshott is confident "a substantial amount of traffic rights will become available" and Cebu Pacific will secure enough to support daily A330 services to Australia. The carrier has been considering both Melbourne and Sydney.

While Cebu Pacific is seeking to expand its A330 fleet to at least eight aircraft by 2016 so far it has only secured four aircraft. The carrier currently operates 43 aircraft, including 25 A320s, 10 A319s and eight ATR 72s.

Cebu Pacific fleet: as of 18-Mar-2013

Cebu Pacific defers A320 deliveries as A319 sale falls through

Cebu Pacific has already taken delivery of two A320s this year and plans to take delivery of three additional A320s in 2013 along with its first two A330s. Mr Kingshott said the carrier recently deferred delivery of two A320s from 4Q2013 to 2H2017. But its capacity plan for 2013 was actually adjusted upwards slightly as the earlier version of its 2013 fleet plan included the exit of seven A319s.

The A319s are now staying in the Cebu Pacific fleet after a deal to sell the entire 10-aircraft A319 fleet to US low-cost carrier Allegiant Air fell through. Under the proposed sale, which had been forged in Jul-2012 but was dropped in Dec-2012, Cebu Pacific would have removed seven A319s from service in 2013.

Mr Kingshott said Cebu Pacific still plans to phase out its A319s by 2017, when it takes the first of 30 A321neo aircraft that it has ordered as the carrier does not want to operate three different gauges of A320 family aircraft at once. But he said the carrier is happy to continue operating its A319s, which have fallen out of favour at most LCCs as they come with higher per seat costs than A320s, for the next few years and had adjusted its fleet plan accordingly. The proposed deal with Allegiant was dropped as the two carriers could not agree on conditions that could make the transaction work financially and operationally.

The revised fleet plan for Cebu Pacific has the carrier's fleet growing to 48 aircraft at the end of 2013, 51 aircraft by the end of 2014, 57 aircraft by the end of 2016 and 60 aircraft by the end of 2017. Cebu Pacific is slated to receive its first three A321neos in late 2017 with the other 27 aircraft to be delivered in 2018 to 2021.

Cebu Pacific fleet plan: 2012 to 2017

The growth of the narrowbody fleet in 2014 for now is only one aircraft as Cebu Pacific has five A320 deliveries but four lease returns. But this could be adjusted depending on market conditions. The current fleet plan also only lists four A330s as the carrier has not yet secured leases on the other four aircraft it plans to acquire.

Cebu Pacific outlook is bright as opportunities for expansion beckon

The A330s are a key component of Cebu's medium to long-term strategy as they open up new international markets which are relatively under-served given the size of the Philippine Diaspora. But the carrier is also well positioned to benefit from continued growth in the domestic and regional international markets. Local demand remains strong and the recent rationalisation in the domestic market has led to an easing of the over-capacity situation from 2012.

The Philippines also has emerged as a popular tourist destination, a status the government is working to further exploit. This should lead to increasing inbound demand in the international market as well as additional domestic demand as tourists fly around the Philippines to visit the country's various islands.

As the Philippines largest carrier by passengers carried, Cebu Pacific is well positioned to cash in on the anticipated growth in the Philippine market. Competition remains intense but Cebu Pacific has successfully ridden out the eye of the storm and should enjoy improved profitability along with continued double-digit growth over the medium to long-term.

This is the first part of a series of articles looking at the outlook of the main carriers serving the Philippine market.

Background information

Cebu Pacific financial highlights: 4Q2012 vs 4Q2011 and FY2012 vs FY2011

Cebu Pacific operating highlights: Dec-2012 vs Dec-2011 and FY2012 vs FY2011