12-Nov-2015 12:12 PM

Malaysia Airlines' restructuring enters new phase with fleet & possible regional capacity reductions

Analysis

Malaysia Airlines (MAS) has begun a new phase of its long restructuring process, as it starts to reject aircraft leases. MAS transitioned to a new company on 1-Sep-2015, but the restructuring in many respects is far from complete, and will take another year to implement.

MAS still has the flexibility to reject aircraft leases, giving it a benefit similar to US airlines that are restructuring through bankruptcy protection. While MAS cut capacity and head count prior to the transition to the new company, the flag carrier has only begun the process of reviewing its fleet.

A large portion of the fleet is expected to be returned over the next several months. More capacity cuts are possible, particularly in the domestic and short haul sectors, as MAS has already cut back its network outside Asia to a minimum level.

Pace of MAS restructuring has been very slow

MAS began a massive restructuring exercise in late Aug-2014, when the Malaysian government investment firm Khazanah unveiled a recovery plan and announced a buyout of private investors, which led to a delisting in late 2014.

The recovery plan called for job and capacity cuts, particularly on long haul routes, under a new strategy that outlined an increased focus regionally and partnerships to cover the rest of the world. A transition period began in Sep-2014 and was initially slated to conclude with the launch of a new company in Jul-2015.

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From the beginning the restructuring proceeded much more slowly than initially expected. It was not until Aug-2015 that MAS finally implemented significant capacity cuts.

At about the same time MAS cut its head count by about 7,000, resulting in a new, leaner company with about 13,000 employees. The company, Malaysia Airlines Berhad, began operations in 1-Sep-2015, two months later than initially planned.

As CAPA has previously outlined, MAS international seat capacity was down by about 18% in the first month of the new company, Sep-2015, compared with Sep-2014 levels, while international ASKs were down by about 23%. About three quarters of these cuts were implemented in Aug-2015, driven partially by a 40% capacity cut to Australia, and the rest was implemented during an initial, more modest, pruning of the network in 2Q2015.

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MAS has another year to terminate aircraft leases

Despite the capacity cuts, MAS has so far continued to operate broadly the same number of aircraft. Since the restructuring initiative began almost 15 months ago, MAS has reduced its fleet by only four aircraft, according to the CAPA Fleet Database.

This includes one 737-800 and three 777-200ERs, which were returned in recent months following cuts to the European network.

Malaysia Airlines active fleet: Sep-2014 vs Nov-2015

Aircraft	Sep-2014	Nov-2015
Total:	97	93
Airbus A330-200F	4	4
Airbus A330-300E	15	15
Airbus A380-800	6	6
Boeing 737-800	57	56
Boeing 747-400F	2	2
Boeing 777-200ER	13	10

MAS' operation is clearly inefficient, given the size of the fleet and current capacity levels. The fact that MAS has not cut its fleet more significantly is somewhat surprising, as in late 2014 the Malaysian parliament passed the MAS Act, giving the airline the freedom to cancel aircraft leases and other contracts. However, as it focused on other aspects of its restructuring, MAS did not move rapidly to use this benefit, a benefit similar to that provided to US airlines a under Chapter 11 bankruptcy protection.

Technically it is the old company that gained the right under the Act to cancel leases, but when MAS realised in Aug-2015 that it needed more time to implement fleet cuts, it asked its leasing companies to agree to a one year sublease, from the old company to the new company.

Since the leases are legally still with the old company, the airline's new management team essentially gained an extra year to use the MAS Act to cancel aircraft leases. Leasing companies technically did not have to agree to the one year sublease, but had little choice if they wanted to continue doing business with the company.

The leasing companies all decided against a legal challenge to the controversial MAS Act, a practical and sensible decision, as they are keen to continue supplying the flag carrier over the long term.

The new MAS management team, which took over about four months prior to the formal transition to the new company, may not need the entire extra year to implement fleet cuts, but the return of most of the aircraft may not be achieved until the middle portion of 2016. While MAS is expected to start to make lease rejection decisions by the end of 2015, it will take time for the aircraft to be prepared for return, and to exit the fleet formally.

MAS' upcoming fleet cuts to focus on 737

Most of the upcoming fleet cuts are expected to focus on the 737 fleet, which accounts for over half of the total mainline fleet and generates about 80% of total weekly seats. The airline's 737 lessors have been asked to provide best and final offers for new leases with the new company, Malaysia Airlines Berhad, by mid-Nov-2015. The new company will then choose which offers to accept while those aircraft that are rejected will be returned as the subleases with the old company expire, or potentially sooner.

MAS has reportedly stated that it plans to reduce the 737 fleet to only 35 aircraft, which represents a steep 38% reduction compared to the 56 aircraft currently in the active fleet. Some leasing companies view these statements as a threat, or bargaining tactic, and do not believe that MAS will cut its 737 fleet by 21 aircraft, necessarily.

The new management team initially indicated that the 737 fleet would be kept intact, since the new strategy incorporated an increased focus on the regional network. It is conceivable that MAS now realises that the regional operation - both domestic and short haul international - could use some pruning, given market conditions, and the fact that less feed is needed for the much smaller long haul network.

But MAS competitors are particularly keen to know how deep the regional cuts are. The question remains unanswered.

Ultimately MAS will almost certainly cut its 737 fleet, as it has already reduced regional capacity to a degree, and has been seeking to second over 100 of its 737 pilots to other airlines. Nevertheless, the cuts may not be as large as threatened.

MAS could cut domestic capacity, until now only modestly affected

So far MAS has cut international capacity within Southeast Asia capacity by about 10%. MAS also uses the 737 fleet to North Asia and South Asia, where there have been bigger cuts, but these have mainly been offset by down-gauging some flights from widebodies to narrowbodies. MAS' only non-Asian route with the 737 is Darwin, but this is the only Australian destination not impacted by the Aug-2015 40% overall capacity reduction to Australia.

Similarly, MAS has only so far pursued modest cuts to its domestic network. Based on Nov-2015 schedules, MAS domestic seat capacity is down by about 8% compared to Nov-2014, and 4% compared to Nov-2013. (These figures include MASwings but exclude its other regional subsidiary Firefly).

Malaysia Airlines domestic seat capacity (seats per week): Sep-2011 to Apr-2016

Roughly half of the MAS 737 fleet is allocated to the domestic market: currently domestic flights account for about 55% of seats and 38% of ASKs that are flown with the MAS 737 fleet, according to CAPA and OAG data.

MAS has suffered a sharp drop in domestic traffic at its Kuala Lumpur International Airport (KLIA) hub in 2015, including an 18% drop in Sep-2015 to 381,000 for the month.

Its two domestic competitors, AirAsia and Lion Group Malaysian affiliate Malindo Air, have meanwhile managed a domestic traffic surge at KLIA, including a 22% increase in Sep-2015 to 788,000. (Note: Separate figures for AirAsia and Malindo are not available as Malaysia Airports provides data by terminal but not by airline. MAS is the only domestic carrier at the main terminal, while both AirAsia and Malindo operate from KLIA2.)

The drop in MAS domestic passenger traffic could be a precursor to MAS cutting capacity once it starts to reduce its 737 fleet. So far much of the traffic decline has been driven not by capacity cuts but by lower load factors: domestic movements have not been declining nearly as fast as passenger traffic.

This could be an indication of a new pricing strategy, which has resulted in lower load factors. MAS could potentially improve these in 2016 not by pricing changes, but by cutting frequencies.

MAS maintains a 45% share of domestic seat capacity - for now

Almost all of MAS' domestic jet capacity is at KLIA. MAS currently has almost 160,000 weekly domestic seats at KLIA, a small reduction of 3% compared with Nov-2014.

MAS currently has a 41% share of domestic seat capacity at KLIA compared to 52% for AirAsia and 6% for Malindo, according to CAPA and OAG data. Yet in Sep-2015 MAS carried only 33% of domestic passengers at KLIA, according to Malaysia Airports data.

In the overall Malaysian domestic market the MAS Group (including Firefly and MASwings) currently has about a 45% share of seat capacity compared to 46% for AirAsia and 9% for Malindo.

The MAS Group has so far been able to maintain its share of domestic capacity at 45% since the start of the restructuring process 15 months ago, but the group's share of domestic traffic has dropped in recent months, visible in lower load factors, and a drop in its domestic capacity is likely in 2016.

MAS could also reduce its ATR 72 fleet

While the 737s are used to compete against AirAsia and Malindo on domestic trunk routes MAS also has a turboprop fleet of 33 ATR 72s, which are almost entirely flown in the domestic market. This includes 19 ATR 72s at regional subsidiary Firefly, based at Kuala Lumpur's old airport Subang, and 14 ATR 72 at regional subsidiary MASwings, which operates within east Malaysia.

The group has nine more ATR 72-600s on order, and also has a fleet of seven De Havilland Twin Otters, which are operated by MASwings to serve smaller communities in east Malaysia.

MAS initially indicated the turboprop operation would continue to grow as it restructures, but MAS is now reviewing its ATR 72 leases, and has the ability to reject these aircraft - as it does with the 737s.

MAS is obviously keen to reduce the rates on its ATR 72s and could potentially use the MAS Act to pursue earlier returns of older model dash-500s, enabling it to accelerate the transition to an all-ATR 72-600 fleet. The group currently has 22 ATR 72-500s and 11 ATR 72-600s, according to the CAPA Fleet Database.

Any capacity reductions at Firefly would impact the overall Malaysian domestic market as passengers flying between Kuala Lumpur and domestic cities within peninsular Malaysia have the choice of using the near-city of Subang, or more remote KLIA.

Subang airport has experienced a huge increase in passenger traffic, including a remarkable 49% in 2014 to 2.8 million, driven by rapid turboprop expansion from Malindo and continued expansion at Firefly. The Subang market has become oversupplied, pressuring load factors and yields, and on some routes is now more oversupplied than similar routes from KLIA.

Malindo is watching closely as MAS potentially cuts its turboprop and 737 fleets.

AirAsia will also have the opportunity to accelerate expansion if MAS makes any new domestic or regional international capacity cuts, but will not be significantly impacted by any cuts at Subang.

The outlook for Malindo and AirAsia as MAS continues to restructure will be examined in upcoming analysis reports. CAPA will also look at how some foreign airlines, particularly Gulf carriers, are benefitting from the changes at MAS.

MAS cuts its long haul network

MAS competitors were initially hoping for quicker capacity cuts after Khazanah initially unveiled the recovery plan in late Aug-2014. During the transitional year conditions in the Malaysian market continued to be challenging due to overcapacity and intense competition, including aggressive pricing from MAS.

As CAPA has previously highlighted, the capacity cuts so far implemented by MAS have not had a significant impact on Malaysia's largest carrier, short haul AirAsia. Medium- and long haul LCC AirAsia X has benefitted more, particularly from MAS cuts in Australia, but has not benefitted from MAS long haul cuts because AirAsia X currently does not serve Europe.

MAS seat capacity to Europe is currently down about 27% compared with Nov-2014 levels. The suspension of Frankfurt and Istanbul leaves MAS with only three long haul routes - daily flights to Amsterdam and Paris, and double daily flights to London Heathrow.

Malaysia Airlines capacity to Europe (one-way seats per week): Sep-2011 to Apr-2016

Four other long haul destinations were cut as part of a 2012 restructuring - Buenos Aires, Cape Town, Johannesburg and Rome - while Los Angeles was cut from the network in 1H2014.

MAS has been looking at also suspending Amsterdam in 2016, which would reduce it to only two long haul routes. At one point the new MAS management team was also looking at axing Paris in 2016, but Paris seems to have won a reprieve through Air France's recent suspension of Kuala Lumpur-Paris.

Most widebody fleet decisions have already been made

MAS has, for the most part, already decided on its widebody fleet, while it started only recently to look closely at its much larger single-aisle fleet.

MAS' new management team decided in 2Q2015 to reduce its A380 fleet from six to four aircraft, although it has not yet found a new home for the two aircraft being remarketed. MAS still has all six A380s in its active fleet, but is only currently deploying the type on its two London flights.

In the medium to long term MAS plans to transition its European operation to the A350-900. MAS signed a deal with Air Lease covering four A350-900s in Sep-2015, plus two options for delivery in late 2017 and 1H2018.

MAS has already started to return some of its ageing 777s, which are expected to be phased out entirely over the next few years. For example, Aircastle announced on 2-Nov-2015 that MAS had informed the leasing company (in Sep-2015) that it was rejecting the lease on a 17-year old 777-200ER. The aircraft was subsequently repossessed in Oct-2015.

The airline's remaining 10 777-200ERs have an average age of more than 15 years, while the other passenger aircraft types in the MAS fleet all have an average age of less than five years. Four of the 777s are owned by foreign leasing companies, according to the CAPA Fleet Database.

Malaysia Airlines fleet average age: as of 12-Nov-2015

MAS currently operates the 777 to Amsterdam, Paris and Guangzhou (served with one flight daily). MAS reportedly has been looking to second at least 50 of its 777 pilots to other airlines.

The 777 and A380 each only account for about 3% of MAS' total seat capacity. The A330-300, which is used regionally within Asia-Pacific, accounts for about 14%, while the 737-800 accounts for 80%.

Malaysia Airlines seat capacity by aircraft type: 9-Nov-2015 to 15-Nov-2015

MAS retrofits its A330 fleet

MAS has also asked its A330 leasing companies to provide best and final offers. The airline is obviously keen to reduce rental payments across all types, as in the past it has typically paid above industry averages. It is unlikely that MAS will cut any of its A330s, as it has committed to retrofitting the entire fleet.

In early Nov-2015 MAS announced plans to retrofit its 15 A330-300s with new lie-flat business seats. The first retrofitted aircraft is slated to enter service in Apr-2016, and the last aircraft by Sep-2016. (This gives it potentially enough time to cancel an existing lease and lease a replacement aircraft with the new configuration, if such a swap results in lower rental costs).

While the new business class seats will not feature aisle access for all seats, the new product is a significant improvement over the current angled business class seats on the A330s. The new seat still falls short of the current long haul standard for Asian carriers but it should be adequate, as MAS only uses the A330 on regional routes within Asia Pacific. Only the A380 currently features lie-flat business seats and a first class cabin; the 777 only has angled business seats, despite operating long haul routes.

MAS is also looking at introducing a premium economy cabin, which could enable it to compete better for premium traffic in the Australian and UK markets.

MAS turnaround plan to gain momentum in 2016

The retrofit of the A330s and other upcoming product enhancements - such as in-flight entertainment, onboard Wi-Fi, lounges and upgraded catering - are a key part of the MAS turnaround plan. While MAS is just now starting to implement several components of the plan, the minimum target has always been to reach break-even by the end of 2017.

Symbolically MAS turned over a new leaf in Sep-2015 with the formation of Malaysia Airlines Berhad, but in reality 2016 will be a more important transitional year. In addition to the product upgrades planned for 2016, most of the anticipated fleet cuts will finally be implemented, leading to some additional capacity reductions.

MAS continues to renegotiate contracts with other suppliers, a long and tedious process which will not be completed until well into 2016.

Meanwhile a new commercial strategy is in the pipeline for 2016, as MAS transitions to a new unbundled pricing platform that could involve short haul passengers on lower fare buckets paying extra for meals and bags, and even result in lower-fare business class passengers not being offered lounge access.

And last, but not least, 2016 is expected to see a refresh of the brand.

MAS starts to make headway but challenges remain

It will take a few years to determine whether MAS has finally gone deep enough to fix the longstanding issues that several prior restructurings failed to resolve. Unlike the previous restructuring attempts, the restructure plan by the new management has been able to press the restart button to make hard but sensible decisions, which clearly puts MAS on a brighter path.

Nevertheless, MAS still faces huge challenges, including intense competition and a resistance to change in some areas.

For example, in the past cutting the entire A380 fleet was an option that was not open, for political reasons, as all six A380 are owned by the Malaysian government's Khazanah arm PMB. As a result, the MAS Act essentially only applies to foreign leasing companies and banks. MAS ultimately could be stuck with all six A380s for at least a few years, although the ideal scenario would be to phase out the type entirely as soon as possible.

MAS is not out of the woods yet. The airline is only one year into a two to three year turnaround effort. It is critical that the new management team continue to implement difficult decisions and for the government to provide unwavering support without any meddling. The second scenario is a big ask, based on previous performance. The result of any backsliding will be to return MAS to the downward cycle that got it into this situation in the first place. The short term pain should mean that in the medium term a more efficient MAS can begin to grow again.