Philippine Airlines looks to slow fleet expansion by subleasing A330s and reducing A321 commitments

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This is the first in a series of reports on the outlook for Philippine Airlines (PAL) and the Philippine market. This report looks specifically at the challenges PAL faces with its fleet as the group's new management and ownership group prepare a new business plan.

Lucio Tan retakes control of Philippine Airlines and PAL Express

Philippine conglomerate LT Group took back control of the flag carrier in late Oct-2014, completing a deal to buy back the 49% stakes in PAL and PAL Express which LT initially sold to Philippine conglomerate San Miguel in Apr-2012. LT had all along retained a majority stake but agreed to cede management control to San Miguel, resulting in the appointment of San Miguel president Ramon Ang as PAL president.

The original intent was for LT to later sell its remaining stakes in PAL and PAL Express to San Miguel and/or a new strategic investor which San Miguel was aiming to secure. But LT and San Miguel could never agree on a deal for the remaining stake while attempts to find a new strategic investor failed to bear fruit after talks with several foreign airline groups including All Nippon Airways. (There is still a possibility of a strategic stake sale materialising later.)

In Sep-2014 LT offered to buy back San Miguel's share of PAL and PAL Express, which was previously known as AirPhil Express. The deal was completed in late Oct-2014 and Jaimie Bautista was appointed PAL's new president, replacing Mr Ang.

LT now again owns 100% of PAL Express and about 89% of PAL Holdings. Individual shareholders account for the remaining 11% in PAL Holdings, which is listed on the Philippine Stock Exchange and is the parent of Philippine Airlines but not PAL Express.

Mr Bautista had been the president of PAL for several years prior to exiting in 2012 when LT ceded management control to San Miguel. He advised LT on the deal to regain control and initially returned to PAL in Sep-2014 as general manager.

PAL also appointed on 23-Oct-2014 several new board directors to take the seats that had been controlled by San Miguel. Several new executives including a new CFO were also appointed, replacing executives that had been seconded by San Miguel to PAL.

Other executives that were brought in under San Miguel's tenure but were contracted directly by PAL (rather than on secondments from San Miguel) have stayed. This includes former SpiceJet CEO Neil Mills, who joined PAL in 2013 as CEO advisor.

PAL to slow the pace of international expansion

The new executive team and board are now closely reviewing the previous business plan, which envisioned rapid growth of the fleet and international network. This review effectively began in Sep-2014 under Mr Bautista after San Miguel first agreed to sell back the stake to LT. Now that the deal is done and a new board is in place a new business plan can be prepared and implemented.

Under Mr Ang's tenure, PAL added several medium/long-haul destinations and was planning to further expand the network in Europe and North America. PAL Holdings reported a 51% increase in passenger revenues in 2Q2014, driven mainly by the expansion of the international network. Monthly international passenger numbers were up between 15% and 39% the first seven months of 2014.

Philippine Airlines monthly international passenger numbers: Jan-2012 to Jul-2014

Source: CAPA - Centre for Aviation and company reports

See related reports:

• Philippine Airlines seeks a strategic investor as its international expansion continues
• Philippine Airlines needs more and stronger partnerships. All Nippon Airways tie-up is a small step

Most of the new medium/long-haul destinations that have already been launched are expected to be maintained including London, Toronto, Abu Dhabi, Dubai, Dammam and Riyadh. But PAL is expected to suspend plans for launching more new international destinations with the exception of New York and potentially Jeddah. PAL has already begun selling New York, which will be launched in Mar-2015 with four weekly flights via Vancouver.

San Miguel's business plan envisioned multiple new destinations in both the US and continental Europe. None of the new destinations in the US after New York are expected to be pursued at least for the short to medium term.

In Europe the focus will be on improving the performance on the Manila-London Heathrow route, which is still unprofitable although load factor and yields have been on the rise after a dismal start. (The performance of London should also improve as PAL finally secured Russia overfly routes in late Oct-2014, enabling the carrier to significantly reduce the flight time to London. PAL however is still trying to secure betters slots from Heathrow which it needs to offer a full range of connections on the Manila end of the outbound leg.)

Philippine Airlines drops plan for 757s and Brisbane and Perth non-stops

Mr Bautista said in a recent meeting with CAPA that he expects PAL will also no longer pursue plans for further expansion in Australia. San Miguel had been planning to upgrade Brisbane to non-stop and re-launch Perth as a non-stop using a planned new fleet of 757s. San Miguel was also looking to upgrade Melbourne to daily. Sydney has already been upgraded to daily.

Melbourne is now served with three weekly widebody flights while Brisbane is currently served with three weekly A320 flights via Darwin. Manila-Darwin-Brisbane was launched in Jun-2013 along with Manila-Darwin-Perth, which was operated four times per week with A320s. Perth was quickly cut and Darwin and Brisbane could also now be suspended as the route has been unprofitable.

San Miguel planned to acquire 757s, which are able to operate non-stop from Manila to Perth - routes which were seen as too thin for A330s. Mr Bautista said San Miguel had put a down payment with Boeing for five ex-Shanghai Airlines 757s using its leasing subsidiary. (San Miguel set up a leasing company which now owns several of the Airbus aircraft that were added over the past two years. The leasing company had been 60% owned by San Miguel and 40% owned by PAL but the 60% stake has now been transferred to LT.)

Mr Bautista has been able to cancel the 757 deal with Boeing and get back the deposit. This was a sensible move as acquiring a new aircraft type for two likely marginal routes was extremely ambitious and risky.

Competition in the Philippines-Australia market has already intensified significantly as a result of Cebu Pacific's Sep-2014 launch of flights to Sydney. Cebu Pacific is currently serving the route with four weekly flights, is adding a fifth frequency in Dec-2014 and is interested in securing more traffic rights to potentially increase Sydney to daily and launch Melbourne.

See related reports:

• Cebu Pacific long-haul LCC hybridises by pursuing transit traffic, starting with Sydney-North Asia
• Cebu Pacific long-haul low-cost part 2: new period of growth begins as five destinations are added

San Miguel long-haul expansion was more strategic than rational

San Miguel's plan for rapid expansion in Australia was seen as an aggressive response to Cebu Pacific entering the market. Under San Miguel, PAL also quickly launched services to several cities in the Middle East which were being targeted by Cebu's new long-haul operation.

Dubai, which was launched by PAL in Nov-2013 using A330s in single-class 414-seat configuration operated by PAL Express, has been highly unprofitable. Yields and load factors have been under pressure from the beginning as Cebu Pacific also launched Dubai in Oct-2013.

Cebu Pacific's long-haul unit in Oct-2014 added services to Dammam and Riyadh, routes that PAL launched in late 2013 using A330s in all-economy configuration. For these routes, PAL mainline operates the aircraft.

The intensifying competition between the Philippines and the Middle East and PAL's options for this market, including an enhanced partnership with Etihad (both PAL and Etihad now operate the Abu Dhabi-Manila route) will be examined in a later instalment in this series of reports.

PAL ordered too many A330s

PAL's fleet currently consist of 11 A330-300s while PAL Express has two A330-300s. All 13 aircraft have been delivered since Sep-2013 - a remarkably quick spool up period for a widebody fleet - and are part of the 64 aircraft deal that was forged with Airbus in 2012.

Philippine Airlines fleet summary: as of 5-Nov-2014

Source: CAPA Fleet Database

PAL Express fleet summary: as of 5-Nov-2014

Source: CAPA Fleet Database

Both PAL Express aircraft and six of the PAL A330-300s are in 414-seat configuration. The other five PAL aircraft are in two-class 368-seat configuration. PAL is slated to take two more 368-seat A330-300s by the end of Nov-2014, marking an end to the A330 portion of the 2012 order.

(Both A330 configurations have the same economy class product including extra legroom seats at the front three rows, which are sold as premium economy. The dual-cabin aircraft include 18 lie flat business class seats. Wireless IFE is provided, requiring economy passengers to bring their own tablets, instead of seatback monitors.)

The new A330-300s have been used partially to replace six older generation A330s, which were phased out earlier this year. But most of the aircraft were ordered for growth, with San Miguel opting to take eight aircraft in single class configuration in response to Cebu's decision to launch a long-haul operation. The San Miguel aircraft order was clearly overambitious.

PAL initially ordered a more realistic 10 A330s but only a month later ordered another 10 A330s, lifting the total commitment to 20 aircraft. The San Miguel management team recognised in early 2014 that 20 A330s were too many and converted the last five of the A330-300 orders, slated to be delivered in 2015, to eight additional A321neo orders. (This lifted PAL's A321neo commitment from 10 to 18 aircraft.)

But it was too late to potentially get out of any of the other 15 A330-300 commitments. Mr Bautista told CAPA that the best he could do upon rejoining PAL was to defer the Sep-2014 delivery to Oct-2014 and the two Oct-2014 deliveries to Nov-2014.

PAL has seven to eight excess A330s as utilisation rates are extremely low

PAL at this point has no use for the last two A330s but has to take the aircraft to meet its contractual commitment with Airbus. As it is the 13 current aircraft are being under-utilised, particularly the eight aircraft in single-class 414-seat configuration. Mr Bautista said these aircraft are only being used on the Dubai (daily), Dammam (three times per week) and Riyadh (four times per week) routes as well as on some Bangkok flights.

As a result the eight single class A330-300s are only being used about 330 hours per week, resulting in an average individual utilisation rate of less than six hours per day. This is a dismal figure for a fleet which has an average age of less than one year, particularly given that these aircraft are designed to compete against LCCs.

The utilisation rate of the five 368-seat A330s is slightly higher as these aircraft are currently being used to Abu Dhabi, Osaka and some flights to Hong Kong, Seoul and Tokyo Narita. But the rate will dip as the final two aircraft are added to the fleet.

The average utilisation rate for the 414-seat A330s will also likely dip further as PAL is planning to switch to the 368-seat two-class A330s on Manila-Bangkok as there is demand for a premium product on this route. PAL currently serves Manila-Bangkok with one daily A321 flight and one daily A330 flight.

Mr Bautista acknowledges the current PAL schedule only requires seven or eight A330s. PAL has been looking to sell or sublease the surplus aircraft. It prefers to offload the single-class aircraft as it sees a potential need for using most or all of the dual-class A330s. But the pool of potential buyers for the single-class aircraft is very limited as few airlines operate A330s in single-class configuration.

These aircraft are also now used, making it more difficult to place. Ironically one of the few operators of single-class A330s is Cebu Pacific, which is seeking to lease two additional A330-300s. But Cebu Pacific has rejected offers from PAL as it does not like the product that PAL uses and prefers to take new aircraft which it can configure with its own product.

A partial reconfiguration by adding business seats while keeping the economy cabin is one of several options being considered. Mr Bautista said that PAL could potentially use more than seven two-class A330s if the airline starts to use the type to Melbourne, Sydney and Honolulu. These routes are currently operated with A340-300s and require two to three aircraft, potentially reducing PAL's requirement for offloading A330-300s to about five aircraft.

PAL struggles with newly acquired A340-300 fleet

PAL currently operates six A340-300s. These are ex-Iberia aircraft that were acquired under San Miguel's tenure, with four being added in 2013 and two earlier this year.

San Miguel purchased the A340s to support accelerated expansion of the long-haul network as the A330 does not have the range to operate to Europe or North America non-stop. In addition to the three medium-haul routes (Melbourne, Sydney and Honolulu) the A340s are now used on PAL's five weekly flights to London and two of its nine weekly flights to Los Angeles. The A340 is also scheduled to be used on the new route to New York via Vancouver when it is launched in Mar-2015. (In addition, the A340 will be used for three weekly additional seasonal frequencies to San Francisco from mid-Dec-2014 to mid-Jan-2015.)

Using the new A330-300 fleet on Sydney, Melbourne and Honolulu is sensible as they are significantly more efficient than the A340. But it would require PAL to under-utilise or cut its newly acquired A340-300 fleet.

The new management team would be keen to phase out the A340-300s as soon as possible and acquire additional 777-300ERs to support the long-haul network while using the A330s to take over medium-haul missions. But PAL would have to take a big hit to phase out A340-300s. PAL only acquired the aircraft over the last 18 months and is now investing further in the A340 fleet by installing the OnAir system. (There is no seatback IFE in the economy cabin.)

Another complication is a lack of availability for near-term 777-300ER delivery slots. Mr Bautista said so far PAL has been told the earliest slot is 2016.

PAL needs more 777-300ERs

PAL's six 777-300ERs are now being used to operate daily flights to Los Angeles, San Francisco and Vancouver (with three of the Vancouver flights continuing on to Toronto). The 777-300ER fleet is not big enough to support the entire long-haul operation.

One intriguing option on the table is to swap with a leasing company its excess A330s for 777-300ERs. But this would be a difficult deal to complete as 777-300ERs are in high demand and leasing companies may not be interested in PAL's A330s as they are no longer new and perhaps in a difficult configuration to remarket.

A widebody fleet consisting of just two types, A330s and 777-300ERs, is the ideal scenario for the LT Group and would allow PAL to complete the renewal of its fleet. PAL already phased out earlier this year its 747-400s fleet as well as older model A340s. These aircraft had been used on the US routes until the US FAA upgraded the Philippines to Category 1.

Under Category 2, PAL was unable to change aircraft gauge or expand in the US market, forcing it to retain ageing aircraft types. The decision to acquire 777-300ERs was initially made by Mr Bautista back in 2006, with the aircraft envisioned for US routes. The Philippines was subsequently downgraded to Category 2 in 2008, forcing PAL to find alternative routes for the 777-300ERs as they were delivered. Category 1 was finally restored in Apr-2014.

See related report: Cebu Pacific and Philippine Airlines are poised to expand in US following Category 1 upgrade

PAL faces excess narrowbody issue as well

Unfortunately the fleet challenges PAL currently is grappling with are not limited to widebody aircraft. Mr Bautista said PAL is committed to taking in 2015 10 A321ceos from its narrowbody order. These are all growth aircraft as PAL does not have any A320 leases expiring until 2016.

PAL has so far taken delivery of 12 of the 34 A321ceos it ordered in 2012. The final 10 aircraft from this order are slated to be delivered in 2016.

The 2016 aircraft do not pose as much of a problem as 2015 aircraft because about half of the 2016 aircraft are earmarked as replacements. In 2017 PAL will start taking delivery of the 18 A321neos it now has on order but this also does not pose a challenge as these are intended mainly as replacement for current generation A320 family aircraft.

PAL is now looking at alternatives for deferring, cancelling or subleasing several of the A320s slated for delivery in 2015. The commitment for 10 growth aircraft in a single year is another example of overambitious expansion under the business plan that was prepared by San Miguel. PAL at this point only has a need for two or three of these aircraft.

The group currently has 34 A320 family aircraft in its active fleet. The 12 A321s, which have all been delivered since mid-2013, are all operated by PAL mainline. PAL earlier this year phased out its remaining A319s.

Of the 22 A320s, 12 are currently flown by PAL Express and 10 at PAL mainline. All the PAL Express aircraft are in the domestic market while virtually all PAL narrowbody flights are in the regional international market. All of the PAL A320s are in two-class configuration while some of the A320s at PAL Express are in single class configuration. These are the aircraft originally operated by AirPhil, which followed the budget carrier model before rebranding as PAL Express in early 2012 and transitioning to the full-service regional model.

PAL Express may pursue domestic expansion in 2015

LT at least at this point does not see the need to return to its old multi-brand strategy with AirPhil operating alongside PAL and focusing on the bottom end of the market. But Mr Bautista says the preferred configuration for the domestic market is all-economy aircraft with extra legroom seats at the front. PAL Express - which offers frills including snacks, drinks and checked bags - now sells a premium economy product, which provides extra legroom seats on the all-economy A320s while on the dual-class A320s an actual business class seat is provided for the same price.

If PAL is unable to find new homes for the A321s it is committed to taking in 2015, the fallback plan is to add capacity, primarily in the domestic market. PAL Express, which has taken over almost all of the group's domestic flights, would likely be the operator of the additional aircraft.

The prospect of the PAL group adding capacity in the domestic market is a concern as the domestic market has returned to profitability in 2014. The domestic market previously suffered from overcapacity and irrational competition. Consolidation and capacity reductions have ushered in much more favourable market conditions.

See related reports:

• Cebu Pacific Air turns record profit in 2Q2014 as domestic market rationalises and yields improve
• Cebu Pacific Air profits drop; PAL, Philippines AirAsia remain in the red. But outlook is improving

Cebu Pacific reported record profits in 2Q2014 driven primarily by the improvement in the domestic market. Mr Bautista said PAL Express also has been profitable in the domestic market. (PAL Express' overall profitability was dragged down by its only international route, Dubai.)

Aircraft challenges will make it difficult for PAL to be profitable in short to medium term

PAL Holdings, which includes PAL mainline but not PAL Express, also returned to the black in 1H2014. But PAL Holdings is again expected to end 2014 in the red. More losses are likely in 2015, particularly if PAL is not able to resolve the huge aircraft issues it now faces.

San Miguel deserves credit for several improvements under its watch and investing significantly in PAL's product. But San Miguel made some big mistakes with the fleet.

The overambitious order with Airbus has put PAL in a dificult position. The decision to acquire used four engined A340s, an aircraft type avoided by virtually every other airline group, was also rash. Thankfully at least the even more shortsighted decision to acquire 757s has been undone.

The aircraft challenges that have been inherited by PAL's new management team will likely impact the carrier's profitability for at least the short term. The group is already saddled with the cost of carrying excess aircraft, which is impacting utilisation rates. It may have to take substantial one-time hits if it subleases excess A330s and A320s and if it reduces or phases out its newly acquired A340-300 fleet.

PAL's outlook is not all gloom as the Philippine market is now relatively strong, boosted by a reduction in the number of domestic competitors, the restoration of Category 1 and a relatively strong economy. But PAL first needs to adjust its fleet plan to a more rational level and get the right mix. This will not be an easy task.