Mihin Lanka adds business class, re-fleets. Sri Lanka hardly needs two government-owned airlines

This is the third in a series of analysis reports on the Sri Lankan market. The first report analysed how SriLankan Airlines' market position and outlook is potentially improved by its ascension into the oneworld alliance. The second instalment looked at the flag carrier's turnaround plan, including its fleet modernisation initiative. This report looks at the market position and outlook of Sri Lanka's second carrier, Mihin Lanka.

See related reports:

• SriLankan Airlines raises global profile and expands oneworld presence in South Asia
• SriLankan Airlines turnaround hinges on fleet renewal, yield improvements and oneworld

Mihin Lanka initially was a SriLankan Airlines competitor

The government initially launched Mihin Lanka in Apr-2007 with two A320s following an LCC model. Mihin Lanka initially competed with SriLankan Airlines on some of SriLankan's largest routes with a network consisting of Bangkok, Dubai, Male and Singapore as well as three destinations in India. At the time SriLankan was managed and partially owned by Emirates.

The government took back control of SriLankan in early 2008 and Mihin Lanka suspended operations in Apr-2008. But Mihin Lanka resumed operations in Jan-2009 with Kapila Chandrasena as the carrier's new CEO.

Following its relaunch, Mihin Lanka resumed some of its initial routes and again competed against SriLankan in most markets. But the carrier's network strategy started transitioning at the end of 2010, after a codeshare partnership was forged with SriLankan.

Coordination between SriLankan and Mihin Lanka further increased after Mr Chandrasena became CEO of SriLankan in Jul-2011. Mr Chandrasena continued to serve as CEO of Mihin Lanka in parallel with his responsibilities at SriLankan until Mar-2014, when Nishantha Ranatunga took over as CEO of Mihin Lanka. (Mr Chandrasena is still the CEO of SriLankan.)

Mihin Lanka shifts focus to secondary routes

Over the past three years Mihin Lanka has focused on routes with limited premium demand that are not operated by SriLankan. Of the seven international destinations in its current network, none are regularly served by SriLankan. Only one of its current destinations, Gaya in India, was among its initial seven destinations from 2007.

Gaya and Varanasi, another popular pilgrimage destination in India which was initially added in 2008, are served seasonally. The carrier's other seven scheduled destinations are served on a regular year-round basis and were added over the last three and a half years - Bahrain (BAH), Dhaka (DAC), Madurai (IXM), Medan (MES), Jakarta (CGK), Seychelles (SEZ) and Sharjah (SHJ). Each destination is currently served with between two and five weekly frequencies, according to OAG data.

Mihin Lanka routes ranked by seat capacity: 12-May-2014 to 18-May-2014

Notes: Gaya and Varanasi are not displayed as they are not operated this week
One of Mihin Lanka's two weekly frequencies to Medan stops at Mattala in Sri Lanka but only on the return leg
Source: CAPA - Centre for Aviation & OAG

Dhaka and Jakarta were launched in Dec-2010, at the same time SriLankan and Mihin Lanka began codesharing. Sharjah was added in Oct-2011, followed by Bahrain in Sep-2012, Madurai in Dec-2013, Medan in May-2013 and, most recently, the Seychelles in Nov-2013.

Colombo-Bahrain was a route that had been operated by SriLankan for about 40 years and was handed over to Mihin Lanka after SriLankan determined it was a market more suited for a budget carrier as it mostly consisted of labour traffic with limited premium demand. The other routes were new markets for SriLankan/Mihin Lanka and most were also new links for Colombo overall.

Only two of Mihin Lanka's routes are currently served by other carriers - Madurai and Sharjah. The competition on both sectors is with budget carriers - SpiceJet on Colombo-Madurai and Air Arabia on Colombo-Sharjah. But the fact that most of Mihin Lanka's routes have no direct competition is an indication that the carrier is not generally being used in response to budget carrier competition, as is often the case with dual-brand models. Instead the perception was that Mihin Lanka's product was a better match for each route than SriLankan.

Mihin Lanka plays important role to SriLankan's network model

Mihin Lanka also has been used over the last few years to help support SriLankan's network model. Instead on focusing only on thick routes with sufficient point-to-point traffic, most of the markets Mihin Lanka has added in recent years need connections to be sustainable.

Mihin Lanka currently carries SriLankan's code on all its routes except Medan and Jakarta while Mihin Lanka codeshares to 18 of SriLankan's 32 international destinations. As Mihin Lanka is focused on the regional market, particularly the budget end, it does not sell on any of SriLankan's flights to Europe or North Asia.

Mihin Lanka network map: as of May-2014

Source: Mihin Lanka

SriLankan says it aims to add its code on Mihin Lanka-operated flights to Medan and Jakarta and that it has only been a regulatory issue that has so far held up the carriers' codeshare partnership from covering Indonesia. SriLankan, which relies on transit passengers for slightly over half of its total traffic, expects strong demand for connecting services from Indonesia to Saudi Arabia.

The current network strategy is certainly more sensible than what transpired between 2008 and 2010, when the two carriers competed head to head on several routes from Colombo. While in other markets budget and full-service brands successfully operate the same routes, in Sri Lanka there are few if any routes which are large enough to sustain two local carriers, even with separate full-service and budget propositions.

While avoiding network overlap was a sensible move a more sustainable long-term scenario given the relatively small size of the Sri Lankan market and the consistent unprofitability of both carriers would be a merger. Without sufficient scale the benefits of having a separate airline for the bottom end of the market is significantly diluted. Mihin Lanka currently only operates two A321s and one A320.

Mihin Lanka has also been gradually taking on more of a full-service carrier model. While a hybrid model is necessary, particularly as Sri Lanka's two carriers need to be aligned, the amount of differentiation between the two could be reduced to the point that it no longer makes sense to have two separate carriers/brands.

Mihin Lanka will introduce business class from 25-May-2014

The latest strategic change at Mihin Lanka is the decision to introduce business class. The carrier recently announced it will offer a business class product from 25-May-2014 on all routes except Gaya and Varanasi.

The carrier's A320s/A321s will be outfitted with a separate business class cabin featuring 12 convertible seats. Hot meals, full choice of beverages including liquor, in-flight entertainment tablets, amenity kits and blankets and pillows will be offered. At the airport separate check-in counters and lounge access will be available.

Despite its LCC origins Mihin Lanka already has a hybrid product with complimentary check-in baggage (business class will have a higher allowance) and snacks while all types of beverages and hot meals are sold. The new business class will provide a product more in line with SriLankan's business class although with more of a premium economy style seat as the business class seat pitch on Mihin Lanka will be limited to 32in to 34in with 6in recline. (While there will be a cabin divider, Mihin Lanka seems to be following the European short-haul model with a flexible business class at front as it will continue offering an all-economy configuration on Gaya and Varanasi, religious pilgrimage routes where there is essentially zero business demand.)

The new business class option on Mihin Lanka is a positive move for SriLankan as SriLankan's premium passengers connecting onto Mihin Lanka-operated flights will now have a more seamless experience. As four of Mihin Lanka's routes are over four hours (Bahrain, Jakarta, Seychelles and Sharjah), the business class product should help SriLankan sell Mihin-operated flights to premium passengers.

Mihin Lanka average stage length by number of weekly seats: 12-May-2014 to 18-May-2014

|Source: CAPA - Centre for Aviation & OAG

While Mihin Lanka's routes are primarily labour and leisure markets, there is some business and upmarket leisure demand. Much of this demand does not come from point-to-point traffic but on connections from SriLankan-operated business destinations such as London and Tokyo.

The addition of a business class cabin at Mihin Lanka also makes it easier for SriLankan when the flag carrier wet-leases aircraft from its smaller sister carrier. For example SriLankan is currently wet-leasing a Mihin Lanka A321 for one of its two daily flights to Bangkok. SriLankan provides its full service with hot meals and complimentary beverages on flights using wet-leased Mihin Lanka aircraft but its inability to offer business class on such flights creates confusion and is an issue, particularly because the service operated by the Mihin Lanka A321 is an overnight flight.

But while offering some frills in economy and a business class option results in a more aligned product, Mihin Lanka's move upmarket makes it even harder to see the justification of the Sri Lankan government maintaining two separate carriers. Sri Lanka is already the smallest market in Asia with both a budget and full-service local carrier.

Is Mihin Lanka an example of a two-brand strategy?

SriLankan itself is a relatively small carrier, operating a fleet of 21 aircraft and carrying about 4 million passengers per annum. Among the world's growing list of full-service airlines with second budget brands, SriLankan would be the smallest.

SriLankan does not actually consider itself to have a dual-brand strategy because Mihin Lanka is separate and not part of the same group. SriLankan does not have any ownership or control of Mihin Lanka and the two carriers no longer share any executives. But SriLankan does consider Mihin Lanka as a sister carrier and recognises the importance of network coordination. SriLankan also handles Mihin Lanka and provides engineering services.

As Mihin Lanka and SriLankan are separate, any decision to integrate the two carriers would have to be made by the Sri Lankan government. Consolidating ownership and converting Mihin Lanka into a 100% subsidiary of SriLankan would be one potential option. Under such a scenario, Mihin Lanka would undoubtedly become a budget brand under SriLankan, enabling the flag carrier to follow the multi-brand strategy that has become common across Asia. But a merger would be a more sensible option given Mihin Lanka's tiny size.

From a government perspective the driver could be financial. Both carriers have been consistently unprofitable for several years. A merger should provide better scale and lower costs for both carriers.

oneworld would benefit from accessing Mihin Lanka's network

A merger under SriLankan would also allow SriLankan to more fully leverage the potential benefits of oneworld membership. Mihin Lanka-operated flights currently do not fall under the oneworld network and Mihin Lanka has no intentions of joining oneworld as an affiliate.

Mihin Lanka's network may be small but would add value to oneworld as it has more destinations than SriLankan that are not served by any other oneworld carrier. SriLankan added just two new destinations to the oneworld network - Mattala in Sri Lanka and Tiruchirapalli in India. Mihin Lanka would add another three destinations in India and the Seychelles to the oneworld network. Three of the carrier's other international destinations are also only served by one oneworld carrier.

Folding Mihin Lanka into SriLankan would also bolster Colombo's position as a oneworld hub. Mihin Lanka currently accounts for about 6% of international seat capacity at Colombo, while SriLankan accounts for 54% and other oneworld members account for about 11%.

Colombo international capacity share (% of seats) by carrier: 12-May-2014 to 18-May-2014

Source: CAPA - Centre for Aviation & OAG

Mihin and SriLankan also are jointly developing a second hub at Mattala, which became Sri Lanka's second international airport in 2013. (The outlook for Mattala and the Mihin Lanka and SriLankan strategy for the new airport will be analysed in the fourth and final instalment in this series of analysis reports on the Sri Lankan market.)

Mihin Lanka will acquire 737-800s

But for now Mihin Lanka seems to be trying to assert its independence, making a merger with SriLankan potentially more difficult to pursue. In addition to again having its own CEO, the carrier is planning to transition its fleet from A320 family aircraft to 737-800s.

Mihin Lanka has already committed to acquiring two 737-800s which are slated to be delivered in 2015, and is expected to eventually acquire a third 737-800 allowing it to replace its two A321s and one A320 on a one for one basis. The carrier has no ambitions - at least for now - of growing its fleet beyond three units.

While SriLankan has been looking to acquire additional A321s, it is not interested in taking on Mihin Lanka's aircraft, which are expected to be returned to their lessors. Mihin Lanka's A320 is an eight-year old aircraft leased from ILFC while its two A321s include an 11-year old aircraft from ILFC and a seven-year old aircraft from Air Lease, according to the CAPA Fleet Database.

The decision to transition to 737-800s at Mihin Lanka was driven partially by a government desire to diversify the operating fleet in Sri Lanka and not rely entirely on Airbus (as SriLankan operates an all-Airbus fleet). But for a country with only 24 jets, having multiple types of narrowbody aircraft makes little sense, particularly given the emphasis the government has put on SriLankan's growing maintenance operation.

SriLankan Engineering currently has the capability to overhaul A320s and A330/A340 widebodies. In addition to working on all of SriLankan's aircraft it has a growing third-party business with Mihin Lanka and Indian A320 operator IndiGo as its largest customers. It will be hard for SriLankan Engineering to justify adding a 737 maintenance capability given its investment in A320 tooling and the fact Mihin Lanka plans to operate only three 737-800s.

The government's decision to transition to 737s could force Mihin Lanka to use maintenance providers in other countries, a rather illogical outcome given Sri Lanka's significant investment in building up its aircraft maintenance capability. Mihin Lanka also now benefits from joint purchasing and training with its larger sister carrier - some of which would be lost as the carrier transitions to the 737-800.

A merger before the re-fleeting plan is implemented would be logical

Mihin Lanka's transition to 737s would also make it harder to potentially merge with SriLankan as a merger would result in a mixed narrowbody fleet. As a result it would be smart for the government to relook at the current two-carrier strategy and make a decision before the fleet transition at Mihin Lanka begins.

Mihin Lanka has evolved over the years and is now operating a network that adds value to its sister carrier and the overall Sri Lankan market. The current situation is certainly a much better outcome compared to the earlier years of Sri Lanka's two carriers competing head to head.

But the reality is Mihin Lanka has not grown in recent years, giving it insufficient scale to be profitable. Two-brand strategies can be effective but Mihin Lanka-SriLankan is not a typical example of a two-brand strategy and, regardless, Mihin Lanka is too small to be an effective budget brand.

As it further hybridises with the introduction of business class, Mihin Lanka is trying to improve its position. But ultimately the outlook of both Mihin Lanka and SriLankan would be improved if the two carriers were merged.