20-Aug-2014 6:10 PM

Finnair's 2Q and expected 2014 losses highlight challenges for smaller full service airlines

Analysis

Finnair improved its load factor in 2Q2014 after a dip in 1Q and made further progress with its cost reduction programme. It has reached agreement with many employee groups over further cost efficiencies, but did not reach full agreement with flight attendants. Management's consequent decision to begin implementing plans to outsource part of its cabin services activities displays a commendable resolve to achieve the necessary savings.

Nevertheless, in the words of CEO Pekka Vauramo, "the second quarter of 2014 was difficult".

Weak market conditions meant that unit revenue declined more rapidly than unit costs and the airline fell into loss in 2Q2014. It now expects a significant operational loss for FY2014, which would mean a second year of falling results.

Finnair's 2Q result falls into loss as revenues drop by 7%

In 2Q2014, Finnair's net result slumped to a loss of EUR24 million from a profit of EUR18 million in the same period a year earlier. The operational result, which excludes non-recurring items, fair value changes and financial income and expenses, fell from a profit of EUR8 million to a loss of EUR20 million. Revenues declined by 7.2% to EUR 566 million.

Combined with losses already reported for 1Q, the net result for 1H2014 was a loss of EUR52 million versus a profit of EUR2 million in 1H2013, while the operational loss for 1H more than doubled to EUR54 million. IH revenues fell by 7.8%.

Finnair financial highlights: 2Q2014 and 1H2014

Cost reduction of 2.8% not enough to offset revenue decline

The operational loss in 2Q2014 came in spite of cost reduction efforts that successfully lowered expenses in almost every category. The problem for Finnair was that, while it cut costs by 2.8% in spite of a small capacity increase, this was not enough to offset the 7.2% fall in revenues.

Finnair operational result (EUR million): 2Q2014 versus 2Q2013

Cost performance was helped by a 3.2% reduction in fuel costs (mainly due to exchange rate movements). In addition, Finnair made particular progress in cutting labour costs, which fell by EUR14 million, or 14%, year on year, mainly due to staff reductions (average headcount was down 9% year on year in 1H2014).

Finnair year on year change in costs and cost breakdown by category: 2Q2014

Finnair is on track to reach annual savings target, although further labour cost reductions are needed

The company remains on track to achieve its target of a EUR200 million reduction in annual costs by the end of 2014, relative to its 2010 unit cost level. It had achieved savings of EUR176 million by the end of Jun-2014. It has also focused on moving costs from fixed to volume-variable, better preparing it for a revenue downturn.

A key part of the outstanding cost reduction target relates to labour cost efficiencies. Negotiations with unions over changes to wage structures and working hours have met with mixed results. Finnair signed an agreement in May-2014 with the IAU union in respect of Finnair Technical Services and Helsinki Airport employees. It also reached an agreement with its senior staff and engineers and "largely concluded" talks with admin and support staff.

Finnair says that it reached a "partial solution" with its pilots, with a decision on a new wage model that lowers unit costs and agreement on changes to new pilots' terms. Negotiations with pilots to finalise outstanding issues will continue until 7-Sep-2014.

However, talks with the Finnish Flight Attendants' Association did not conclude to Finnair's satisfaction. As a result, Finnair is proceeding with plans to outsource cabin services on around 20 routes, both long-haul and short-haul, over the next two years, with one to three routes outsourced in 2014. It is seeking a reduction in man-years of approximately 540 in connection with these outsourcing plans, but says that the exact cost reductions and their timetable are yet to be clarified.

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Group loss is due to the airline business segment

Following a reorganisation of the group's structure at the end of 2013, it now consists of only two business segments, airline business and travel services. In 1H2014, the group operational result largely reflected the result of the airline business segment. This division saw its loss widen from EUR12 million in 1H2013 to EUR55 million in 1H2014.

Travel services, which consists of a tour operator and business travel agencies, made a small operational profit of just over EUR1 million in 1H2014, versus more than EUR2 million a year earlier. However, its 2Q operational result improved from a loss of EUR1.0 million last year to a profit of EUR0.8 million in 2Q2014.

The segment's revenues fell by 17% in 2Q and 12% in 1H, reflecting lower demand for the tour operator Aurinkomatkat (Suntours). The turnaround in the 2Q operational result was due to the improved profitability of the business travel agencies.

Finnair results by business segment: 1H2014 and 1H2013

ASKs up 0.5%, load factor up 1.3 ppts, but RASK tumbles

Within the airline business segment, Finnair's passenger capacity in ASKs increased by 0.5% in 2Q2014 and its load factor gained 1.3 ppts to 79.5%, broadly in line with the average for members of the Association of European Airlines. This was an improvement on its performance in 1Q2014, when load factor dipped by 0.9 ppts to 78.7% in spite of a 2.9% cut in ASKs.

However, unit revenue (RASK) fell by 5.8% in 2Q, an acceleration on the 4.0% decline in 1Q. In difficult market conditions, the trade-off between load factor and yield resulted in load factor gains at the expense of weak yield, although 2 ppts of the RASK decline was due to exchange rate movements. The airline business segment's revenues fell by 7.2% in 2Q, in spite of the 0.5% growth in ASKs. The 5.8% reduction in RASK compared with a 2.4% cut in CASK.

Finnair traffic data, unit cost and unit revenue: 2Q2014 and 1H2014

Traffic revenue growth is less than ASK growth in all regions except the North Atlantic

Finnair's markets were characterised by a weak economic backdrop in Finland and strong competition in international markets and passenger traffic revenues fell by 6.0% year on year in 2Q2014. Revenues were also adversely affected by the strengthening of the EUR against Finnair's other primary revenue currencies, particularly in Asia.

In every region, passenger traffic revenue growth was below ASK growth, apart from the North Atlantic. The contribution of the Atlantic joint venture with British Airways, Iberia and American Airlines helped Finnair to limit its revenue reduction in this region to 8.4% in spite of a cut in ASKs of 11.3%.

The region where traffic revenue underperformed against ASK growth most was Europe, were revenue grew only 0.4% in spite of ASK growth of 11.6%. Revenue underperformed ASK growth by 7-8 ppts in both the domestic and Asian markets.

The joint venture with Japan Airlines and BA on routes between Europe and Japan commenced on 1-Apr-2014. Although Finnair says that it is performing in line with expectations, it does not yet appear to be having a noticeable impact on Finnair's traffic revenue in Asia.

Charter traffic revenue fall 34% on a capacity cut of 31% as demand from external tour operators fell. Finnair continues to convert its most popular charter routes to scheduled services.

Only in the cargo business was there a more positive revenue outcome in 2Q2014. Cargo revenues grew by 1.2%, in line with ATK growth of 1.1%. Finnair said that overcapacity in the cargo market continues to depress yields and that foreign exchange movements also had a negative impact, but that it is seeing early signs of a recovery in demand.

Finnair traffic and revenue by region: 2Q2014

Finnair expects a "significant" operational loss for 2014

At the start of 2014, Finnair expected that revenue this year would be close to 2013's level. In Jun-2014, it said that 2014 revenue would be "significantly lower" than last year, since unit revenues were weaker than previously expected. It did not give any guidance on profit at that time, saying that it would at the conclusion of employee negotiations over further savings.

Finnair still expects 2014 revenue to be significantly lower, in spite of a small traffic increase. It now also says that delays in the personnel cost reduction talks and the continued decline in unit revenues mean that it expects a "significant" operational loss in 2014. In 2013, the operational result was a small loss of EUR5 million. This followed a profit of EUR45 million in 2012, which had been the first positive result since 2008.

It can be assumed that the 2014 result will be worse than in 2013, marking a second successive year of deteriorating results. As CAPA has suggested previously, this makes Finnair's long term target of an operating profit margin of 6% look further distant.

Finnair's deteriorating profits buck the global airline cycle

Moreover, Finnair's operating profit performance is going in the opposite direction to that of the global airline sector. According to IATA, the world's airlines saw improved results in 2013 over 2012 and another improvement is forecast for 2014. Finnair's underperformance against the global airline profit cycle highlights the challenges faced by smaller network carriers.

Strategically, its membership of oneworld and, in particular, Finnair's participation in the joint ventures on the Atlantic and on routes to Japan appear to be advantages. Moreover, it has successfully carved out a niche in developing connecting traffic on routes between Europe and Asia via its Helsinki hub.

However, its small domestic market and relative lack of scale perhaps leave it too dependent on this niche at a time when Gulf carriers (and, to some extent Asian airlines) with lower unit costs and high service quality are rapidly coming to dominate these markets. In addition, competition from European low-cost carriers is eating into the crucial European feeder traffic that it needs to sustain its niche.

Finnair has taken steps to invest in product upgrades and this may partially help to offset some downward pressure on unit revenues, but unit cost reduction rightly remains the priority. The arrival in 2H2015 of Finnair's first A350, with its greater fuel efficiency and superior cabin, may even help both unit costs and unit revenues.

It will be vital for Mr Vauramo to achieve all the necessary labour cost reductions so that Finnair can derive the maximum benefit from its new long-haul aircraft. That is a tough call.