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Japan Airlines and the future of global aviation. Japanese Government holds the aces

28-Sep-2009
JAL Group President and CEO, Haruka  Nishimatsu
JAL Group President and CEO, Haruka Nishimatsu

Japanese aviation is in the midst of a confluence of events unparalleled in history. The future of Japan Airlines hangs in the balance, and with it the global airline alliance and investment structure, and the future direction of the North Asian aviation market.

Prime Minister Ichiro Hatoyama and his Transport Minister, Seiji Maehara, less than one month into the job, have an opportunity with JAL to establish the new centre left government’s credentials as a reformer. As such, it is a vital test case that could shape the country’s economic performance, potentially creating a powerful political legacy.

And much of the outcome will be decided over the coming few short weeks.

All the planets are in alignment

Mr Maehara is presented with a never to be repeated series of events.

  • Global economic crisis: Japan is suffering through its worst economic contraction since the 1940s;
  • New government: Japanese voters have installed a centre left government on a platform of reform and change. The previous Liberal Democratic Party had governed virtually continually since 1955;
  • US open skies: The US and Japan are in the final stages of negotiations for an open skies agreement to finally modernise a bilateral agreement signed in the early 1950s;
  • Giant leap in Tokyo airport capacity: Tokyo will gain its largest influx of airport capacity since the 1970s, when Narita Airport first opened;
  • Japan Airlines close to collapse: Japan Airlines is in its worst financial shape since its founding in 1951. Certainly, its valuation has never been cheaper since it started trading after its merger with Japan Air System in Oct-2002.

These elements provide an irresistible opportunity for change. If handled correctly, with the right mix of brinkmanship and pragmatism, the Hatoyama government can claim an early positive breakthrough. If it gets it wrong, the repercussions will be loud and long.

Mr Maehara’s objectives are clear:

1. Don’t let JAL collapse

This would be seen as a massive failure for the new government, and there is a real risk of systemic collapse in the Japanese aviation and tourism sector. JAL is the Fannie and Freddie of Japanese aviation – there are so many interdependencies that JAL’s failure would create a tsunami that could wipe out large parts of this key economic sector;

The corollary objective here for Mr Maehara is to buy enough breathing space for JAL to allow a deep restructuring programme to run its course over the remainder of the new government’s term. JAL can – and must – lower its cost of production by at least 30%, so it can lower its fares by a similar amount and stimulate massive growth in the market. Endless contraction is not the solution to JAL’s problems.

JAL’s key numbers & the current state of play

Aspect

Figures

Notes

Net loss forecast for 2009/10

JPY63 billion (USD693 million)

JAL reported a JPY99 billion (USD1 billion) loss in the first quarter to 30-Jun-2009

Current market capitalisation

JPY393 billion (USD4.3 billion)

JAL shares dropped 15.8% on 24-Sep-2009 to a record low (since listing in Oct-2002), wiping JPY62 billion (USD682 million) off JAL's market value

Total debt (as at 30-Jun-2009)

JPY1.5 trillion (USD16.5 billion)

Moody’s Investors Service stated on 24-Sep-2009 that it may downgrade JAL’s ‘Ba3’ long-term debt rating

Emergency loans (Jun-2009)

JPY100 billion (USD1.1 billion)

Emergency loan received from the state-backed Development Bank of Japan, as well as Mitsubishi UFJ Financial Group Inc, Mizuho Financial Group Inc and Sumitomo Mitsui Financial Group Inc

Draft restructure plan (Sep-2009)

6,800 job cuts, or 14% of JAL's overall workforce, by Mar-2012, to cut operational costs by 30%. Scrapping 21 international and 29 domestic routes.

Tie-up with foreign partner

Mr Nishimatsu stated on 15-Sep-2009 that JAL aims to complete talks on a tie-up with a foreign carrier by mid-Oct-2009

Banks’ position

Increasingly nervous about JAL’s outlook, suggested a breakup of the company, splitting off its more profitable parts and hiving off its loss-making operations, and seeking further government involvement before the banks will lend more to JAL. Creditors to the airline are concerned JAL will fall into negative net worth by the end of Mar-2010, if charges, including pension obligations, are booked, according to Nikkei English News

‘Good JAL’ and ‘Bad JAL’

Mr Nishimatsu stated a possible split of the company into two groups a ‘Good JAL’ and ‘Bad JAL’ "would not make business sense"

Funding requirement

JAL is seeking another JPY250 billion (USD2.75 billion) in fresh debt/equity to meet its financing needs through to the end of Mar-2010. Nikkei English News reported on 24-Sep-2009 that JAL needs to raise JPY150 billion yen (USD1.65 billion) by 30-Nov-2009 to continue operating, and a further JPY100 billion (USD1.1 billion) by 31-Mar-2010.

2. Retain as much value in JAL as possible

Japan Airlines has some good aspects and lots of really bad ones. Its greatest attraction is its portfolio of slots at Tokyo’s Narita and Haneda airports. This must be maintained and maximised.

The JAL brand is also valuable, from a premium business perspective, but has been compromised by the various lower cost “splinter” brands JAL has developed under previous partial restructuring exercises.

Mr Maehara’s agenda could involve the following.

1. Vest as many new Haneda and Narita slots with JAL and ANA as possible, eliminate restrictions on pricing and slot transfers

Limiting the supply of near term slots for foreign airlines (which presently enjoy lower costs of production than both ANA and JAL), particularly fifth freedom rights beyond Tokyo to key Asian points, will maximise Japan Airlines’ value. Any foreign carrier slot deal should be back loaded, offering more slots after perhaps three years, when the local carriers are in a better position to fight.

Balancing this, an offer by Japan to eliminate restrictions on pricing and introduce some limited freedoms to transfer slots among airlines at Narita and Haneda could help broker a deal with the US.

Unfettered freedom to exchange slots would reduce the value of Delta buying into JAL. But the creation of a limited secondary slot market would provide the securitisation any potential investor would demand in exchange for fresh equity. It would also provide JAL with a balance sheet boost (that would grow over time as the economic recovery gathers pace), providing a future source of income.

In Mar-2008, Continental Airlines paid what was thought to be a record USD105 million (then USD209 million) for four sets of prime slots at Heathrow, or GBP26.25 million per pair. bmi, which has some 500 pairs of slots, valued its slot portfolio in 2008 at GBP770 million – or GBP1.54 million per pair. But given the recent Lufthansa deal to takeover bmi valued the UK carrier at just over GBP600 million, the value of those slots has plummeted as a result of the global economic downturn.

The same would be true of slot-constrained airports around the world, including Narita – one of the highest cost airports to operate to globally.

Haneda expansion – Oct-2010

In its recent annual report, JAL claims to have 43% of Haneda Airport’s slots, followed by ANA on 38% and other carriers with the remaining 19%.

The expansion of downtown Haneda Airport from the end of October 2010 involves a new fourth runway which will add capacity for another 110,000 daytime slots (06:00-23:00). In addition, apart from the daytime slots, 30,000 early morning/late night slots will be allocated for international services.

The allocation is as follows:

  • International: Not all the new slots will be released at once. The current plan is for 30,000 international slots to be released immediately, which equates to around 41 day flights (arrival and departure). The Japanese Government has reportedly proposed splitting these evenly between Japanese and foreign airlines. (US carriers were earmarked to receive just four slots, which was probably one cause for Delta Air Lines to raise the stakes and discuss the possibility of investing in JAL).
  • Domestic: A further 27,000 domestic slots will be released over a six-month period.
  • Remainder: Distribution of the remaining slots will be decided by the Japanese Government over the coming months. This remains the single biggest bargaining chip for the government.

In total, Haneda’s total slot pool (currently 303,000 slots for day time flights) will eventually rise by 144,000, or a massive 47.5%. In addition, under certain conditions (such as the number of flights per hour and flight routes), more slots in the early morning and late night are available, but they are currently not fully utilised.

Narita expansion – Mar-2010

Narita is adding 10% (or 20,000) more slots next April following the extension of its second runway, for a total of 200,000.

Summary of slot expansion at Tokyo Narita & Haneda airports: 2010

 

Haneda

Narita

Current slots p/a

303,000 (Daytime)

200,000

Expansion Details

Construction of new 2,500 m Runway D

Runway B expansion from 2,180 m to 2,500 m

Effective date

Oct-2010

Late Mar-2010

New slots p/a

104,000 (Daytime)

+ 40,000 (Night/early morning)

20,000

  - Domestic

27,000 (Daytime)

-

  - Int'l

30,000 (Daytime)

+30,000 (Night/early morning)

20,000

   - Non
      scheduled
      int'l/dom
+10,000 (Night/early morning)  

    - Not
    determined

65,000 (Daytime)

-

Total slots p/a

447,000

220,000

Increase

+47.5%

+10.0%

Extra potential slots

Under certain conditions more slots in early morning/late night are currently available, but they are not fully utilised.

If freed from various operating and environmental restrictions, total annual slots could be expanded up to 300,000. A study and works on this have commenced

2. Position ANA and JAL for immunised global alliances

Another offset to US concerns over access could be mitigated by ensuring the US-Japan open skies deal gifts ANA and JAL antitrust immunity with their respective US alliance partners – whoever they shake out to be.

The problem here though is the tougher antitrust scrutiny of alliances in the US. It remains to be seen if the US House of Representatives' move to toughen rules on alliances gains Senate approval. Chairman of the US Committee on Transportation and Infrastructure, Rep Oberstar, and the US Justice Department have certainly taken a strong line on curbing the influence of alliances.

The Japanese side however is in a position to demonstrate consumer benefits would flow from a thoroughly restructured JAL (see below) and the promise of more access for US airlines at Tokyo area airports into the future.

The Japan-US talks will resume on 26-Oct-2009 in Tokyo, with hopes a deal can be reached before the end of 2009. The urgency of JAL’s situation should help ensure an agreement is reached. JAL is to decide between the respective purchase offers before the bilateral talks begin.

3. Raise as much funding as possible for JAL, through a radical restructuring

a) From the public purse. The Japanese government will need to lead JAL’s restructure, to keep the wheels turning (JAL reportedly needs USD1.65 billion in fresh capital by 30-Nov-2009 to keep operating). It also needs to demonstrate its commitment to the banks, potential airline investors, and US open skies negotiators. The electorate would probably digest the application of public funds under the industrial revitalisation laws, as it has given the government a clear mandate to reform the Japanese economy, particularly if more private capital is involved in the process.

After meeting on 24-Sep-2009 with Transport Minister, Seiji Maehara, Japan Airlines President and Chief Executive, Haruka Nishimatsu, stated, “considering debt repayments planned ahead, we thought asking for the public fund injection would make the most sense”.

Minister Maehara responded he was “sceptical” about the feasibility of JAL's rehabilitation plan, adding, “at this stage, I have yet to say whether the government will inject public funds to JAL”. He noted a Cabinet decision would be made “as soon as possible after debating this matter with [Prime Minister] Hatoyama”.

b) From the bankers. Clearly, more work needs to be done on JAL’s restructuring. The bankers’ proposal to create a ‘Good JAL’, with the profitable bits of the business, and a ‘Bad JAL’ with all the messy parts (including the massive pension problem) has merit.

What the ‘Good JAL’ could look like

The ‘Good JAL’ could probably raise at least USD3 billion in fresh debt, to go with the USD1 billion or so in equity from the airlines, if it involves:

  • A new two-brand business model, with totally re-written employment and pension dea:
    • Premium (JAL) vehicle, covering a streamlined network of key business routes, retaining the profitable frequent flyer business and enjoying Immunised alliance relationships, such as fare and route coordination with a foreign partner(s);
    • Leisure (JAL-lite – with non-JAL branding) vehicle, for short/medium haul international routes (possibly based offshore under a JV arrangement) to tap into Haneda’s expansion;

With the fresh funding, and with the support of its alliance partners and favourable aircraft pricing amid the downturn, ‘JAL-lite’ must be allowed to quickly grow its fleet to utilise the Tokyo slot boom and a dramatically lowered cost base to revitalise its competitive position.

c) From the airlines (and their bankers). The prospect of immunity could create so much competitive tension within Star, oneworld and SkyTeam that a bidding war would deliver a sizeable chunk of the USD3 billion or so that JAL needs to make an effective turnaround - perhaps even as much as USD1 billion. If Delta/SkyTeam is successful in acquiring JAL, a secondary war would erupt over ANA (whose position in Star is by no means guaranteed).

Much to do and little time to do it

But it must be done soon. US carriers in particular have just about exhausted the capital raising opportunities afforded by the unexpectedly generous run on equity markets lately. It will be a cold winter and any spare finance will be guarded preciously.

For Mr Maehara and Mr Hatoyama this is a remarkable early test. They stand on the brink of something special – a unique moment in time. They can make or break JAL, the alliance/ownership structure and the North Asian aviation opportunity all in around three weeks.

For JAL, the very survival of the airline is at stake. At a time when US-Japan relations are being recalculated, this is also a major issue for the US. Too tough a position on their side and they may unwillingly be cast as the villains, should JAL not survive or be emasculated.

This story will continue to roll out over coming weeks – and there is barely a section of the airline industry that will be unaffected by its outcome.

____________

See related article: Japan Airlines dances with SkyTeam and oneworld. Three weeks that will reshape North Asian aviation

See CNBC interview with CAPA Consulting CEO, Andrew Miller


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