SriLankan Airlines & Mihin Lanka outlook improves following strategic adjustments by new government

Sri Lanka's longstanding president, Mahinda Rajapaksa, was defeated by Maithripala Sirisena in a surprise 8-Jan-2015 election result. Mr Rajapaksa had led Sri Lanka for 10 years and was heavily involved in steering the country's aviation industry. He established Mihin Lanka in 2007 and played a pivotal role in taking back control of SriLankan in 2008, which had been managed and partially owned by Emirates since 1998.

New government quickly moves to end flights at Mattala

Mr Rajapaksa also drove the decision to build a second international airport in the southern Sri Lankan town of Mattala, which is located in his home constituency of Hambantota. The Rajapaksa International Airport opened in 2013 and features a 12,000m² terminal building along with a runway long enough to accommodate A380s. SriLankan and Mihin Lanka were subsequently required to launch several flights at Mattala as part of an ill-advised dual-hub strategy.

Less than two weeks after the elections, SriLankan announced the immediate suspension of services to Mattala. SriLankan had been stopping some of its Beijing, Chennai, Jeddah, Male and Shanghai flights at Mattala as part of triangular routings combining the new airport with Colombo Bandaranaike International Airport.

Previously SriLankan also had Mattala stops on some of its Bangkok, Riyadh and Tiruchirappalli flights. Mihin Lanka operated similar triangular routings with Mattala stops on some of its flights to or from Medan, Madurai, Gaya and Varanasi.

Virtually all the traffic at Mattala was transit. Some passengers transferred between flights, in particular traffic heading from China to the Maldives and from Indonesia to Saudi Arabia. But this traffic is more easily served via Colombo, where SriLankan has the scale to offer more connections and has a much larger local market.

The local market at Mattala was practically non-existent. The three weekly A320 domestic flights that SriLankan operated between Colombo and Mattala on a turnaround basis had an average load factor of less than 20%. As CAPA wrote in May-2014:

Developing a second hub is far from ideal as SriLankan is a relatively small carrier, operating only 21 aircraft and carrying about 4 million passengers per year. SriLankan has always relied heavily on transit passengers, which currently accounts for slightly over half of its total traffic, but the volumes simply do not justify a two-hub strategy.

The current Mattala schedule, with a focus on Maldives-China and soon Indonesia-Saudi Arabia connections, offers a better alternative than the original schedule which relied too much on a local market that does not exist. But by promoting Mattala connections such as Maldives-China, SriLankan simply takes away from existing connections via Colombo. China-Maldives and Indonesia-Saudi Arabia are good markets for SriLankan but it may be more sensible to focus on building up the volumes in Colombo.

…The 2013 opening of the airport at Mattala came with significant fanfare as its construction was an important project for President Rajapaksa, who initially took office in 2006. The airport was again in the spotlight at the end of Apr-2014 as it hosted SriLankan's oneworld joining ceremony. But the reality is Mattala Rajapaksa International is not needed and is a distraction in SriLankan's efforts to turn itself around. The flag carrier continues to be highly unprofitable and having to meet the political requirement of developing and operating a second hub will make it even harder to meet its targets for financial improvement.

See related report: SriLankan Airlines develops a hub at Mattala. Two international airports may be one too many

SriLankan has been highly unprofitable in recent years

SriLankan and Mihin Lanka should achieve a significant reduction in costs without a tangible impact on revenues or traffic following the recent withdrawal of flights at Mattala. But both airlines were already highly unprofitable before flights to Mattala began in 2013 and have long been in need of significant overhaul.

SriLankan has accumulated losses of nearly USD1 billion since the government took back control in 2008. In its most recent financial year ending 31-Mar-2014, the flag carrier incurred a loss of about USD220 million on revenues of about USD840 million. Much smaller Mihin Lanka incurred a loss of about USD10 million in FY2014.

SriLankan has said it expects to incur a loss of about USD100 million in the current fiscal year ending 31-Mar-2015 (FY2015). This marks a significant improvement over FY2014 but still would represent an unsustainable double-digit negative profit margin.

The new government, which came to power with an anti-corruption agenda and reform pledge, is keen for SriLankan to become a viable commercial entity. It quickly appointed a new chairman for the airline and engaged the management team, which has been tasked to try to turn around SriLankan and achieve profitability. The government has promised not to interfere in management or commercial matters but clearly expects results.

The government also unveiled plans in late Jan-2015 to merge Mihin Lanka with SriLankan. For now Mihin Lanka continues to be managed separately pending a formal merger, which the government said would improve productivity and profitability.

Mihin Lanka-SriLankan merger makes sense

A merger is sensible as Mihin Lanka lacks the scale to be profitable on its own right. Mihin Lanka, which was established when SriLankan was still under Emirates control, has always been a separate entity rather than a budget airline subsidiary. But the two carriers have been working more closely in recent years, particularly since a codeshare arrangement began at the end of 2010.

Mihin Lanka has since been focusing on leisure routes, including routes that SriLankan was previously unable to sustain. None of the nine destinations Mihin Lanka currently serves from its Colombo hub are also served by SriLankan. Only one of these destinations was among Mihin Lanka's initial seven destinations in 2007, when the carrier was pursuing a very different network strategy and competed with SriLankan on most routes.

(At the time SriLankan was managed by Emirates although the Sri Lanka government still had a 56% share in SriLankan. The government reacquired a 100% stake in SriLankan in 2010 and has always owned a 100% stake in Mihin Lanka.)

Mihin Lanka further adjusted its strategy in 2014 by reconfiguring its fleet of A320 family aircraft to include a new business class cabin. The new product brought Mihin Lanka more in line with partner SriLankan, providing a business class option for premium passengers connecting from SriLankan flights. Mihin Lanka was already following a hybrid rather than a pure LCC model with check-in baggage, snacks and drinks provided to all passengers.

While several Asian airline groups have successful dual-brand strategies, a single brand is probably a better strategy for a small market like Sri Lanka. As CAPA wrote in May-2015:

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.

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

Mihin Lanka-SriLankan merger will also benefit oneworld

Merging Mihin Lanka into SriLankan will also open up additional destinations to SriLankan partners and the oneworld alliance. SriLankan entered oneworld in May-2014 but Mihin Lanka did not join under oneworld's associate programme. As a result the Mihin Lanka network, which includes several destinations not served by any oneworld members or by only one oneworld member, is not part of the alliance.

The merger with Mihin Lanka will instantly expand SriLankan's network from 31 to 40 destinations (including Colombo). It will also generate efficiencies as operations are combined, resulting in much needed cost reductions.

Mihin Lanka network summary: as of 12-Feb-2015

Total non-stop passenger destinations	10
Domestic	1
Africa	1
Asia Pacific	6
Europe	0
Latin America	0
Middle East	2
North America	0

Source: CAPA - Centre for Aviation & OAG

SriLankan network summary: as of 12-Feb-2015

Total non-stop passenger destinations	31
Domestic	1
Africa	0
Asia Pacific	18
Schengen Europe	3
Other Europe	1
Latin America	0
Middle East	8
North America	0

Source: CAPA - Centre for Aviation & OAG

The newly merged airline however will need to quickly relook at Mihin Lanka's fleet plan. While Mihin Lanka and SriLankan both currently operate A320 family aircraft Mihin Lanka decided in 2014 to transition to 737s, a move which was never sensible given its relationship with SriLankan and the fact SriLankan's maintenance division only has A320 capabilities.

A deal forged in May-2014 with Air Lease for two 737-800s could potentially be renegotiated before the aircraft are delivered later this year. Air Lease could potentially instead supply Mihin Lanka/SriLankan with A320s.

Mihin Lanka fleet summary: as of 12-Feb-2015

Aircraft	In Service	In Storage	On Order*
Total:	3	0	2
Airbus A320-200	1	0	0
Airbus A321-200	2	0	0
Boeing 737-800	0	0	2

Note: *Firm orders include those placed directly by the operator and by lessors assigned to the operator
Source: CAPA Fleet Database

SriLankan fleet summary: as of 12-Feb-2015

Aircraft	In Service	In Storage	On Order*
Total:	24	0	11
Airbus A320-200	7	0	0
Airbus A321-200	2	0	0
Airbus A330-200	7	0	0
Airbus A330-300E	2	0	4
Airbus A340-300	3	0	0
Airbus A340-300X	3	0	0
Airbus A350-900XWB	0	0	7

Note: *Firm orders include those placed directly by the operator and by lessors assigned to the operator
Source: CAPA Fleet Database

SriLankan fleet renewal should continue as planned

SriLankan has also been negotiating potential leases of A320neo family aircraft as part of the next phase of its fleet renewal programme. The renewal of SriLankan's widebody fleet began in 4Q2014 with the delivery of its first two A330-300s.

SriLankan initially committed in 2013 to acquiring six A330-300s and seven A350-900s. The remaining four A330-300s are slated to be delivered in 2015 while the A350s are slated to be delivered from 2016, according to the CAPA Fleet Database.

SriLankan has not been planning any growth of its long-haul network as the six A330-300s were acquired as replacements for its six A340-300s (although SriLankan has net yet phased out any of its A340s) while its five A350-900s were acquired as replacement for its five A330-200s. There should be no need for the new government to make major adjustments to SriLankan's fleet plan or commitments, as they are not overly ambitious.

While the merger with Mihin Lanka and suspension of services at Mattala are sensible strategic adjustments, other components of the former SriLankan's strategy should remain including fleet renewal. As CAPA wrote in May-2015 the renewal of the widebody fleet "reduces costs, improves efficiencies while also raising product standards.

SriLankan's current fleet is a hodgepodge of configurations and in-flight products, making it confusing for passengers. Offering a more standard product should aid efforts to improve yields and better leverage its membership of oneworld."

See related report: SriLankan Airlines turnaround hinges on fleet renewal, yield improvements and oneworld

SriLankan already has the right partnership strategy

Joining oneworld is also a major component of the previous strategy that should start to bear fruit over the next few years. SriLankan has been pursuing partnerships with oneworld members since it entered the alliance nine months ago. SriLankan should continue expanding its portfolio of partners - both within and outside oneworld - as well as further enhance some of the tie-ups it has forged in recent months.

SriLankan only codeshared with two oneworld members when it entered the alliance on 1-May-2014 - Malaysia Airlines (MAS) and Royal Jordanian. It has since added codeshares with Asiana, Finnair, S7 Airlines, Qantas and Japan Airlines.

Talks with British Airways, Cathay Pacific and Qatar Airways continue. BA, Cathay and Qatar along with MAS are the only oneworld carriers serving Colombo.

See related report: SriLankan Airlines raises global profile and expands oneworld presence in South Asia

oneworld currently accounts for about a 59% share of seat capacity at Colombo, according to CAPA and OAG data. This includes a 49% share from SriLankan. The planned merger with Mihin Lanka would increase SriLankan's share to about 55% and oneworld's share to about 65%.

Colombo capacity share (% of seats) by alliance: 9-Feb-2015 to 15-Feb-2015

Source: CAPA - Centre for Aviation & OAG

Partnerships could become even more important for SriLankan as the airline will likely restructure its network as part of its new turnaround efforts. Since the change in government, SriLankan has already decided to suspend services to Moscow effective 8-Feb-2015.

Cutting Moscow was a sensible decision given the economic situation in Russia. Other unprofitable routes could also potentially be axed over the coming months.

SriLankan should continue focus on China

SriLankan should focus primarily on major source markets for its tourism sector as markets which rely heavily on transit traffic are typically lower yielding. Mr Rajapaksa had big hub ambitions for SriLankan but these are not realistic under the new profit-focused model.

China will likely continue to be the focus of growth as China is by far the fastest growing source market for Sri Lanka's tourism sector. Visitor arrivals from China more than doubled in 2014 to 128,000 as total arrivals increased by 20% to 1.5 million, according to Sri Lanka Tourism Development Authority data.

SriLankan launched services in Dec-2014 to Kunming, its fourth destination in China after Beijing, Guangzhou and Shanghai. SriLankan still serves Guangzhou as well as Hong Kong via Bangkok but has been looking at upgrading Hong Kong and Guangzhou to non-stop - as it did with Beijing and Shanghai in early 2014.

Hong Kong however could be a more viable market if SriLankan is able to forge a partnership with Cathay Pacific. Cathay Pacific and regional subsidiary Dragonair could provide offline access to secondary cities in mainland China as well as other points in North Asia.

SriLankan also has been operating charters to other secondary Chinese cities including Chengdu and Chongqing.

The airline is keen to launch scheduled non-stop flights to more secondary Chinese destinations but increasing competition from Chinese carriers and the lack of a Chinese partner are challenges. Air China became the second Chinese carrier after China Eastern to serve Colombo on 10-Feb-2015, when it launched four weekly flights from Chengdu.

Non-stop capacity in the Sri Lanka-China market has increased nine-fold over the last year, from about 500 to about 4,500 weekly one-way seats. SriLankan, which began non-stop flights to China at the end of Mar-2014, accounts for about 2,800 of these seats.

Sri Lanka to China non-stop capacity (one-way weekly seats): Sep-2011 to Jul-2015

Source: CAPA - Centre for Aviation & OAG

Network adjustments are likely

SriLankan continues to serve four destinations in Europe - Frankfurt, London, Paris and Rome - but faces stiff competition from Gulf carriers in the Sri Lanka-Europe market. Europe remains Sri Lanka's largest source market but growth is relatively modest.

Emirates and Qatar Airways are the two largest foreign airlines in Sri Lanka and are currently the only foreign carriers with more than two daily services to Colombo. Emirates and Qatar each have three daily services on the Dubai-Colombo and Doha-Colombo routes respectively while Etihad has two daily services from Abu Dhabi to Colombo.

Emirates also operates one daily service from Colombo to Singapore, which SriLankan serves with 19 weekly services and is the carrier's fourth largest destination based on seat capacity.

Colombo-Male is SriLankan's largest route, with up to 10 daily services. The Maldives is an important destination for transit traffic but could see reductions as SriLankan focuses more on inbound traffic.

SriLankan top 10 routes based on weekly seat capacity: 9-Feb-2015 to 15-Feb-2015

Source: CAPA - Centre for Aviation & OAG

SriLankan will need to relook at its long-haul network including ambitions for serving Australia. Its codeshare with Qantas to Brisbane, Melbourne and Sydney via Singapore, which was implemented in Oct-2015, should be sufficient for the Australian market. SriLankan could also potentially work with Qantas subsidiary Jetstar Asia in Singapore for providing offline access to destinations throughout Southeast Asia.

SriLankan could also use a partner in India, its largest single market with seven destinations accounting for 24% of its international seat capacity. SriLankan has a particularly strong presence in nearby southern India but as is the case with the Maldives this operation relies heavily on relatively low yielding transit traffic with limited premium demand.

Membership in oneworld should help boost yields and attract more premium passengers as other oneworld carriers start to use Colombo for accessing South Asia. SriLankan is the only South Asian member of oneworld. But as SriLankan becomes more profit-minded some regional destinations and frequencies may need to be cut as they are unlikely to provide a positive contribution.

SriLankan's outlook brightens as adjustments are implemented

SriLankan has a tough road ahead as it tries to achieve profitability. But the upcoming merger with Mihin Lanka and exit from Mattala are steps in the right direction - as are the previously implemented fleet renewal and partnership strategies.

The merger, the more efficient fleet, new codeshares and the recent reduction in oil prices should mean there will be a significant reduction in losses starting in FY2016.

Additional changes will be necessary, including to the network, for the airline to turn around completely. But adjustments and tweaks rather than wholesale strategy changes should be sufficient.