15-Dec-2014 1:05 PM

Malaysia Airlines 1H2015 outlook: more losses as capacity levels are maintained prior to transition

Analysis

Malaysia Airlines (MAS) continues to incur large losses as the flag carrier tries to rebuild confidence in the aftermath of the MH370 and MH17 incidences. Yields remain at unsustainable levels due to the combination of challenging market conditions and the lingering impact of MH370 and MH17.

MAS has not yet cut capacity and is instead focusing on trying to woo passengers through promotional fares. While the flag carrier has completed several initial milestones from the recovery plan initially outlined in late Aug-2014 it will take several more months for the main components of the plan to be implemented.

Bigger changes are inevitable starting in 2H2015. But adjustments to capacity levels and the carrier's fleet could be smaller than anticipated.

Malaysia Airlines reports after-tax loss of about USD180 million for 3Q2014

MAS reported at the end of Nov-2014 an after tax loss of MYR576 million (USD181 million) for the three months ending 30-Sep-2014 compared to a loss of MRY373 million (USD115 million) for 3Q2013. The group incurred an operating loss (EBITA) of MYR170 million (USD53 million) in 3Q2014 compared to an operating profit of MYR62 million (USD19 million) in 3Q2013.

The MH17 incident, which occurred on 17-Jul-2014, impacted bookings and set back the airline just as it was starting to recover from the MH370 incident, which occurred on 8-Mar-2014. MAS incurred a smaller (although still very large) loss in 2Q2014 of MYR307 million (USD95 million).

Through the first nine months of the year MAS racked up MYR1.324 billion in after tax losses (USD409 million) compared to losses of MYR827 million (USD265 million) in 9M2013. A slight improvement is expected in 4Q2014, driven partially by lower fuel prices. But MAS is likely to end 2014 with losses exceeding USD500 million. MAS has incurred annual losses every year since 2011, including a loss of about USD370 million in 2013.

Malaysia Airlines financial highlights: 3Q2014 vs 3Q2013 and 9M2014 vs 9M2013

Malaysia Airlines begins new chapter as private company on 15-Dec-2014

The 3Q2014 earnings statement was the last results announcement for MAS as a publicly traded entity. MAS is being delisted from Malaysia's stock exchange on 15-Dec-2014, completing a process which began in Aug-2014 when Malaysian government investment firm Khazanah proposed taking over minority shareholders and privatising the airline group.

Minority shareholders approved the privatisation proposal on 6-Nov-2014, enabling Khazanah to increase its stake in MAS from 69% to 100% and resulting in the formal delisting on 15-Dec-2014. With the delisting Khazanah completes one of several milestones from the recovery plan for MAS it unveiled at the end of Aug-2014.

Khazanah aims to eventually relist the airline group but not until a turnaround is completed and profitability is restored. Khazanah hopes MAS will be back in the black by the end of 2017. However, this could prove difficult to achieve.

The delisting is significant as it allows for the release of the first tranche of funds the government has committed to the restructuring. MYR2 billion (USD570 million) will be released by the end of Dec-2014 and will be used to pay off the minority shareholders and help cover the continuing losses. Another MYR4 billion (USD1.14 billion) in funds is to be made available pending the completion of additional milestones.

MAS transition begins as NewCo is established

The Khazanah recovery plan also outlined the creation of a new company known as NewCo, which was formally established on 7-Nov-2014. NewCo is expected to assume control of the airline group from the current company on 1-Jul-2015. In the meantime preparations are now underway for the transition, including negotiations with suppliers and determining which employees will be retained.

The turnaround plan calls for 6,000 job cuts as NewCo will have a staffing level of about 14,000 compared to about 20,000 at the existing company. NewCo will be based at Kuala Lumpur International Airport (KLIA); the existing company is based at Kuala Lumpur Subang Airport, which is now only served by its turboprop subsidiary Firefly and houses the MAS maintenance base.

The movement of staff from Subang to KLIA was initially expected to begin by the end of 2014 but has been delayed to 2Q2015 in order to avoid the inconvenience of moving employees who will not be retained.

CAPA previously analysed the planned job cuts, which are aimed at improving productivity and closing the gap with the group's Asian competitors, as part of a two-part series of reports on the recovery plan that was published at the beginning of Sep-2014. In this series CAPA also examined the expected reduction of long-haul capacity as the recovery plan outlines a focus on regional operations within Asia-Pacific while relying on partnerships to cover other markets.

See related reports:

Khazanah appoints Christoph Mueller CEO to lead the new MAS

Khazanah completed another milestone indentified in its recovery plan with the 5-Dec-2014 appointment of Christoph Mueller as CEO-designate. Mr Mueller has been the CEO of Aer Lingus since 2009 and has previously held senior positions at several other European airlines including Delta Air Transport, DHL, Lufthansa, Sabena and TUI.

At Aer Lingus Mr Mueller has led a remarkable turnaround of a flag carrier in a medium-sized market which like Malaysia has seen an LCC become the largest player, leading some to question if there is still room for a full-service flag carrier. Ryanair currently accounts for about 44% of Ireland's seat capacity compared to 39% for Aer Lingus, according to CAPA and OAG data.

In Malaysia, the AirAsia brand also currently accounts for a 44% share of seat capacity while the MAS group, including regional subsidiaries Firefly and MASWings, accounts for about 34%. AirAsia is Asia's largest LCC group, with Malaysia its original home market, while Ryanair is the largest LCC in Europe, with Ireland its original home market.

Malaysia capacity share (% of seats) by carrier: 8-Dec-2014 to 14-Dec-2014

The challenges confronting MAS however are not directly comparable to the situation that confronted Aer Lingus last decade. MAS is based in a fast-growing emerging market and has been impacted by two unprecedented incidents. A flag carrier has never faced twin tragedies to the extent of the two major crashes MAS had to endure within a span of only four months.

The political situation in Malaysia is also somewhat different. The Malaysian government has a track record of meddling in MAS and blocking change. MAS for years has faced a pressing need to reduce costs to enable it to compete better with LCCs. But cuts to the bloated workforce and a renegotiation of contracts with local suppliers could not be pursued for political reasons.

The government has promised to let the new company, including the new CEO, pursue the deep restructuring it has needed for years. But it will be a couple of years before an assessment can be made on whether the government will keep to its promise and give Mr Mueller the freedom needed to fully restructure the airline. Already, sadly predictable criticisms have been aired by the country's controversial former prime minister, stirring hostility towards the appointment of "a foreigner".

MAS keen to renegotiate supplier contracts

Another milestone outlined in the Khazanah recover plan was completed in recent weeks with Malaysia's parliament tabling and passing a bill which provides the legal framework required for MAS to cancel supplier contracts as it transitions to the new company. Savings from renegotiated contracts are an important component of the restructuring plan.

MAS executives have complained for years about being tied to contracts which force the carrier to pay for certain products and services at a much higher rate than other airlines including AirAsia. The bill that has been passed gives MAS an opportunity to renegotiate all its contracts similar to the opportunities that have been available to US airlines under Chapter 11 bankruptcy protection.

While there will be opportunities to reduce what MAS pays foreign companies, the largest savings are expected to be generated from the renegotiation of contracts with other Malaysian companies. This includes PMB, an aircraft leasing company which is also owned by Khazanah.

Khazanah has stated that 5,000 supplier contracts are currently being reviewed. While it will be several months before the new company is running and the new executive team is on board, a restructuring management office consisting of almost 50 personnel has started work over the last three months on implementing some components of the recovery plan.

Capacity cuts prove elusive during interim period

During the current interim period the airline continues to be led by the outgoing management team, which will remain in place until NewCo formally takes over in Jul-2015. Competitors were initially anticipating (or hoping) that MAS would start cutting capacity in 2H2014. But the outgoing management team has determined that MAS is better off maintaining capacity and focusing on restoring consumer confidence.

Fares, which were initially cut in 2013, have remained low. MAS began an aggressive pricing strategy in 2H2013 - long before MH370 and MH17. As MAS grew ASKs by 17% in 2013 it determined its best option was to fill up the extra seats by discounting. This enabled MAS to increase market share despite the entrance of new competitor Malindo Air and rapid growth at AirAsia X. MAS RPKs were up a staggering 27% in 2013, resulting in a 6.3ppts improvement in load factor for the year to a record 81%.

MAS has maintained its aggressive pricing strategy throughout 2014 and in some cases has engaged in even deeper discounting in attempt to win back passengers after the MH370 and MH17 incidents. AirAsia also has adjusted its pricing and revenue management strategies, a move MAS management believes has been a bigger driver than its own actions.

It is hardly a surprise that losses at MAS have ballooned in recent quarters given the competitive dynamics and the impact of MH370 and MH17, which have resulted in a steep drop in load factors while yields (and fares) have dropped from already low levels. But MAS management believes the losses would have been even stiffer if MAS had elected to raise fares and/or cut capacity.

Capacity reductions would have reduced aircraft utilisation levels, driving up unit costs, as there have been no changes to the fleet. Productivity would have also been reduced as the job cuts which were outlined in Khazanah's recover plan have not yet been implemented. (A team supported by an independent human resources advisory firm is now in the process of identifying which employees will be retained by NewCo.)

Maintaining capacity and offering promotional fares has given MAS an opportunity to attract more passengers with the idea that these passengers will regain confidence in the carrier. This is a logical strategy and is probably the best option for getting through a very difficult and unique situation. But it understandably has frustrated competitors, which would have preferred to see immediate capacity adjustments.

Malaysian market suffers due to overcapacity and aggressive pricing

The result has been an extremely challenging environment for all airlines competing in the Malaysian market.

As CAPA previously outlined, Malaysian long-haul low-cost carrier AirAsia X has also faced huge challenges in 2014. AirAsia X's results for 3Q2014 were by some measures even more dismal than the results for MAS. For example, AirAsia X reported a net margin in 3Q2014 of -25.2% while MAS' net margin was -17.3%.

Short-haul LCC Malaysia AirAsia also has seen its operating profits slide in 2014 despite maintaining relatively flat capacity. The fourth main carrier in Malaysia, privately owned Lion Group affiliate Malindo Air, does not report financial results but certainly has been in the red since launching services in Mar-2013.

Overcapacity has been an issue in Malaysia since 2H2013 due to the rapid expansion of MAS, AirAsia X and Malindo. The MH370 and MH17 incidents exacerbated an already challenging situation, further pressuring yields and load factors.

MAS stated in its 3Q2014 results announcement that it is starting to see an improvement with bookings in some markets. But conditions in Malaysia and the broader Southeast Asia region generally remain challenging.

MAS reported an 11.5ppts drop in system-wide load factor for 3Q2014 to 73.3%. For the first nine months of the year the group's load factor was down 6.3ppts to 74.5%, reversing the gains from 2013.

Malaysia Airlines operating highlights: 9M2014 and 3Q2014 vs 9M2013 and 3Q2013

Yields have been on the decline since 2H2013, when MAS began its aggressive pricing strategy. In 3Q2014 yields were down 2% year over year compared to an already low level.

MAS ASK levels remain relatively high

MAS has pursued some ad hoc flight cancellations since Mar-2014, when the MH370 incident started to impact demand. But the cuts have been small and relatively insignificant.

Overall ASK levels remain at relatively high levels. International ASKs have been up on a year over year basis every month so far this year. In 3Q2014 international ASKs were up 3% while international RPKs were down 11%.

Malaysia Airlines monthly international ASKs: Jan-2012 to Sep-2014

Domestic ASKs were up on a year over year basis seven of the first nine months. The only exceptions were Jul-2014, when capacity was reduced for Ramadan, and Aug-2014. MAS again reported an increase in domestic ASKs in Sep-2014.

Malaysia Airlines monthly domestic ASKs: Jan-2012 to Sep-2014

As discussed above, the current MAS management team is planning to stay the course for the remainder of the interim period. As a result current capacity levels will likely be maintained for the next several months.

MAS could implement short-term international route cuts at Kota Kinabalu

The only major exception could be the cut of international routes at the secondary hub of Kota Kinabalu. The current management team is seeking approval to cut by Jan-2015 several international routes at Kota Kinbalu which have been highly unprofitable and are not strategic.

According to OAG data, MAS currently operates five international routes at Kota Kinabalu - Hong Kong, Perth, Shanghai, Taipei and Tokyo - all using 737-800s. MAS initially cut services from Kota Kinabalu to Perth and Tokyo in early 2012 as part of a network restructuring exercise. But Perth was resumed at the end of 2012 and Tokyo in 2013. Shanghai was also launched in late 2012.

The expansion at Kota Kinbalu was mainly driven by political pressure. The Kota Kinbalu hub does not have any strategic significance as MAS has been focusing in recent years on building up its main hub Kuala Lumpur hub - a focus that was reiterated in the Khazanah recover plan.

International routes at Kota Kinabalu are better served by LCCs as East Malaysia is primarily a leisure market and the routes are all within the range of narrowbody aircraft. (Kota Kinabalu is the largest city in East Malaysia, which is part of the island of Borneo.)

Market conditions in Malaysia are likely to remain challenging in 2015

Cuts at Kuala Lumpur, which accounts for over 95% of MAS' international seat capacity, are not likely during the current interim period. There could be cuts at Kuala Lumpur after NewCo takes over in Jul-2015. But reductions in regional international capacity within Asia-Pacific, which accounts for almost 90% of MAS' international seat capacity, are not expected. As CAPA has previously outlined, the recovery plan envisions a network that is primarily regionally focused.

Cuts to the long-haul network are more likely as MAS looks to rely mainly on oneworld members and other codeshare partners to cover other regions. But there are relatively limited opportunities for long-haul cuts as the MAS network outside Asia-Pacific has already been whittled down to seven destinations - five in Europe and two in the Middle East.

How (and if) to cut the long-haul operation will ultimately be decisions by the new management team. The new management team will also be tasked with implementing most of the main components of the recovery plan including the resetting of the business model.

MAS changes to business model

The new company and new management team will face a long and challenging road to recovery. For now the outlook is relatively bleak.

Over the next year more stiff losses are inevitable. MAS will benefit from lower fuel prices but the airline group will be impacted by the recent depreciation of the Malaysian Ringgit. Meanwhile market conditions in Malaysia and throughout Southeast Asia will remain challenging. Overcapacity is likely to persist despite adjustments by some carriers including AirAsia X.

A more meaningful improvement is possible in the medium-term. But there is still a lot of uncertainty as Malaysia waits for the new MAS to emerge. And, while a necessary part of that is likely to involve some hard decisions about capacity reduction, the fact that those actions are being left for later will make the incoming management's job that bit harder.