29-Dec-2011 10:30 AM

Croatia Airlines eyes return to profitability following fleet and network adjustments

Analysis

Croatia Airlines is confident it can return to profitability in 2012 after significantly narrowing its losses this year despite high fuel prices. The Croatian flag carrier is banking that its future fleet plan, which focusses on replacing three A320s with four A319s, will result in further improvements in profitability as it will be able to better match capacity with demand. New routes to the east are also planned - including Moscow, St Petersburg and Sofia - to balance a network that is now primarily focussed on Western Europe.

Croatia Airlines, which launched services in 1991 just as Croatia declared independence from the former Yugoslavia, has incurred losses every year since posting a breakeven result in 2007. Croatia Airlines CEO Srećko Šimunović expects the carrier to end 2011 with a loss of EUR9 million (USD12 million).

This loss represents a significant improvement over the EUR21 million (USD27 million) loss incurred in 2010. He says the government-owned carrier was initially aiming to breakeven this year, a goal it would have met if it were not for the rise in fuel costs.

The higher than anticipated fuel prices has forced Croatia Airlines to push back its target for a breakeven or better result to 2012. "Next year the target is for the first profit after four years," Mr Šimunović told CAPA during an interview at the Star Alliance meeting in Ethiopia earlier this month.

While still in the red, Croatia Airlines has been able to significantly improve its financial position this year following adjustments to its schedule and network, which have driven a 16% growth in revenues and 11% growth in passenger traffic. Mr Šimunović expects Croatia Airlines to end 2011 with EUR195 million (USD255 million) in revenues and 1.95 million passengers carried, compared to EUR168 million (USD219 million) in revenues and 1.76 million passengers in 2010.

The increase in revenues comes after a period of five years in which revenues in local currency terms were relatively flat. Revenues decreased slightly in 2010 as Croatia's economy slipped into a recession. The country recorded negative GDP growth in both 2009 and 2010 but a small increase in GDP is projected for 2011, leading to a better demand environment.

In response to improved demand, Croatia Airlines launched this year year-round service from Zagreb to Istanbul along with several new seasonal routes including Dubrovnik-Belgrade, Rijeka-London Heathrow, Zadar-Munich and Zagreb-Belgrade. It also increased capacity on several year-round routes from its main Zagreb hub. The carrier currently operates most of its international routes from Zagreb but has a secondary hub at Dubrovnik as well as a few point-to-point primarily seasonal international routes from Rijeka, Split and Zadar.

Croatia Airlines adds capacity by improving utilisation of turboprop fleet

Mr Šimunović says the increase in the carrier's capacity this year was achieved primarily by increasing utilisation of its Bombardier Dash 8-Q400 fleet. He calls the turboprop "a workhorse" and says the carrier now uses its six Dash 8s on average 8.6 hours per day.

The 76-seat Q400s were added in 2008, replacing smaller, slower and older ATR 42s. Last year Croatia Airlines recorded an average daily utilisation of 7.9 hours for its Q400 fleet.

The Q400 will remain a backbone of the carrier's domestic and regional international operation through at least 2018, when leases on the fleet expire. In addition to replacing ATR 42s, Croatia Airlines has used the Q400 to replace jets on select frequencies in international markets such as Brussels, Istanbul, Munich, Paris and Zurich, particularly during the slower winter months.

Unusually, Croatia Airlines now gets higher utilisation out of its turboprop fleet than its jet fleet, which currently consists of four 132-seat A319s and three 162-seat A320s. Mr Šimunović says the carrier's average utilisation rate on its A320 family fleet is currently only 7.8 hours per day.

He says the carrier is unable to get higher utilisation on its Airbus fleet because during winter months there is not enough demand in the Croatian market to keep all seven of its A319/A320s flying. The market in Croatia is extremely seasonal with monthly traffic figures at Croatia Airlines during the peak summer months typically double the winter figures.

Croatia Airlines monthly passenger traffic: Jan-2009 to Nov-2011

Croatia Airlines slashes capacity by about 50% every winter in response to lower demand. But even with such big adjustments the carrier's load factor typically dips below 60% during the off-peak months.

Croatia Airlines monthly passenger load factor: Jan-2009 to Nov-2011

Such seasonal fluctuations make it very difficult for any carrier to be profitable on a year-round basis. Even during the peak summer months, market conditions are challenging in Croatia because low-cost carriers and charter carriers from throughout Europe add large amounts of capacity.

"In the summer season in Croatian skies we have 86 competitors - all the main low-cost carriers, all the main legacy carriers and all main charter carriers," Mr Šimunović explains. "They are supported by local authorities - the airports, etc. They are given a lot of money [in incentives]."

As a result, foreign carriers are able to capture a majority of Croatia's tourism market. Mr Šimunović estimates that Croatia Airlines now only captures 30% of the tourist market. As it is on the Adriatic coast, Croatia is a popular beach destination for Europeans. Mr Šimunović says the country attracts about one million tourists per year, with the majority coming during the summer season.

The local Croatian market is relatively small as the country's population is only about 4.5 million. While foreign carriers account for the majority of the inbound tourist market, Croatia Airlines is positioned well for the local market given its domestic operation, its year-round presence at all of Croatia's main airports and its presence on all the major short-haul business routes.

Croatia Airlines market share fluctuates wildly depending on the season

Based on current capacity figures from Innovata, Croatia Airlines has a 100% share of the country's domestic market and 59% of the international market (see Background information). Low-cost carriers currently account for 18% of international capacity to and from Croatia, including a 10.6% share by Germanwings and a 7.7% share by easyJet. Three of Croatia Airlines' Star Alliance partners are among the top eight carriers in the country, leading to a dominating 77% share of the Croatian market for Star.

In the capital Zagreb, Croatia Airlines now accounts for 56% of all capacity compared to 15% for LCCs (see Background information). In Dubrovnik, Croatia Airlines currently accounts for 70% of international capacity but the airport at this time of year is only served by one foreign carrier, British Airways.

Croatia Airlines' market share decreases significantly in the summer months across the country and especially at airports along the Adriatic coast, which is a popular spot for beach holidays as well as a frequent stop for Mediterranean cruise ships. On an annual basis, Croatia Airlines only carries about one out of every three passengers that flies in and out of the country's airports.

In its 2010 Annual Report, Croatia Airlines says it accounted for 32% of total traffic across Croatian airports. These figures include charter and scheduled passengers. Croatia is a huge charter market, attracting 51 foreign charter carriers in 2010, which in peak weeks during the summer season operated 116 weekly flights to 35 destinations throughout Europe. In 2010, 35 foreign scheduled carriers served Croatia including 16 LCCs, offering 409 weekly flights to 56 destinations during the peak season.

Dubrovnik, Rijeka, Split and Zadar particularly see a huge influx of LCCs, leisure and charter carriers during the summer season because all four airports, unlike Zagreb, are located on the Adriatic coast. In the 2011 summer season Dubrovnik was served by several LCCs including Air Berlin, bmibaby, easyJet, flybe, Germanwings, Jetairfly, Jet2, Norwegian and Vueling. Air Berlin and Norwegian also serve Rijeka during the summer along with Ryanair. Germanwings and Ryanair serve Zadar seasonally while LCCs serving Split include Germanwings, easyjet, and Wizz Air (Germanwings also maintains four weekly flights to Split during the winter season).

Switching to smaller aircraft will help Croatia Airlines deal with seasonal fluctuations

Over the last several years, Croatia Airlines has tried to reduce its reliance on seasonal flights by focussing more on business routes and reducing its own charter operation. The carrier also had tried to position itself as the leading carrier in Southeast Europe by marketing Zagreb as a hub for the region.

But even with a relatively small portion of its traffic now coming from the inbound tourist sector, it is difficult to be completely immune from the sharp seasonal fluctuations of the Croatian market. The carrier continues to find it difficult to keep its A320s filled during most of the year and in response has adopted a revised fleet plan which calls for the type to be replaced with smaller A319s.

Transitioning the Airbus fleet to all A319s should result in higher utilisation as the aircraft is a better fit for the carrier's predominately thin route structure than the A320. The carrier's A320s are also on average 14 years old while the A319s will be brand new, allowing for higher utilisation rates with minimum downtime for maintenance. Last year, Croatia Airlines only averaged 6.5 hours of utilisation per day for its A320s while its existing A319s, which are only slightly younger, averaged 8.1 hours per day.

Mr Šimunović says Croatia Airlines plans to return two of its three A320s when they come out of lease at the end 2012 and phase out its final A320 in late 2013. The carrier initially placed an order with Airbus in 2008 for four additional A319s. Mr Šimunović says two of the new A319s will be delivered in late 2012 with the other two coming in late 2013. As a result, the carrier's fleet will transition from a total of 13 to 14 aircraft by the beginning of 2014.

Croatia Airlines plans new destinations in Russia and Bulgaria

As the 14th aircraft will not be placed into service until the end of 2013, Croatia Airlines expects relatively flat capacity for 2012 and 2013. But Mr Šimunović says the carrier plans to add one new destination in 2012, Moscow, which will be served from Zagreb by better utilising its current fleet.

With the fourth additional A319 allocated as a growth aircraft, Croatia Airlines expects to again pursue capacity growth in 2014. Mr Šimunović says the carrier is already planning to launch two new routes in 2014 - St Petersburg in Russia and Sofia in Bulgaria. Additional frequencies to several existing routes are also expected in 2014.

Mr Šimunović says the carrier is now primarily focussed on serving the main cities of Western Europe from Zagreb, including London, Paris, Frankfurt, Amsterdam, Brussels, Copenhagen, Munich, Rome and Vienna. Frankfurt, Paris and Rome are also currently served from the Dubrovnik mini-hub, according to scheduled data from Innovata.

To the east, Croatia Airlines now only connects Zagreb on a year-round basis with Istanbul, Skopje in Macedonia and Sarajevo in Bosnia-Herzegovina. But Russia represents an important growth market with services to both Moscow and St Petersburg envisioned. Service to Bulgaria and other Eastern Europe countries also would help Zagreb develop into the regional international hub envisioned by the Croatian Government. Zagreb is already the main hub for domestic services, which currently accounts for 28% of Croatia Airlines' total capacity (seats).

Star Alliance membership is important component to Croatia Airlines strategy

Mr Šimunović says Istanbul, which was only launched in May-2011, has already become an important transit hub for passengers heading further east as well as a big leisure destination for Croatians, particularly in the summer. Croatia Airlines codeshares with Star Alliance partner Turkish Airlines on the Zagreb-Istanbul route with the two carriers combined offering a daily frequency.

Croatia Airlines also has codeshare partnerships with fellow Star members Austrian, BMI, Brussels Airlines, Lufthansa, SAS, Swiss, TAP Portugal and Spanair. These partnerships virtually expand Croatia Airlines' network to about 30 additional destinations beyond the 20 it serves with its own aircraft.

Germany is Croatia Airlines' biggest online destination and now accounts for the carrier's three biggest routes - Zagreb-Frankfurt, Split-Frankfurt and Zagreb-Munich.

Croatia Airlines top 10 international routes by capacity (seats per week): 26-Dec-2011 to 01-Jan-2012

Conclusion: Croatia Airlines looks to carve out profitable niche in challenging market

Croatia Airlines' ability to even approach breakeven is a noteworthy accomplishment given the current challenges of the European market. Small flag carriers in the region are finding it increasingly difficult to survive as they lack the muscle to compete with big network carriers and fast-growing low-cost carriers.

The Balkans and the broader Eastern Europe region have several ailing flag carriers, many of which are currently in crisis or restructuring mode. Most of these flag carriers remain government owned with aspirations for privatisation that will be difficult to achieve given current market conditions and their relatively weak positioning. Croatia Airlines is 95% government owned with the remaining 5% in the hands of private equity.

Croatia Airlines is in relatively good shape, being stronger both financially and from a network perspective than most of the region's carriers. But it is no easy task to carve out a profitable and sustainable niche.

Mr Šimunović says the constant focus at Croatia Airlines is cost cutting. He acknowledges this is difficult to achieve given the high seasonality of the Croatian market and its very low utilisation of its aircraft during winter months, which makes it hard to keep unit costs low. "You need to be a magician, believe me," he jokes.

In attempt to survive as a small network carrier, Croatia Airlines has adopted "not a low-cost but a low fare" model. Such a proposition is always a tough one to sustain as inevitably fares must be high enough to cover costs. But the carrier has a solid position in its home market and could develop a profitable niche if it succeeds in its aim of becoming the leading carrier for Southeast Europe. Star Alliance, of which Croatia Airlines has been a member since 2004, allows the carrier to build the offline network needed to provide global reach while focussing its own operation on short-haul markets.

Croatia Airlines is providing the year-round services the country requires and is on the brink of profitability despite the challenging market conditions. As Croatia becomes more of a year-round destination for both business and leisure, Croatia Airlines should be able to avoid the downward spiral facing a large portion of small European flag carriers and be able to pursue modest growth while finding a sustainable niche.

Background information

Croatia international capacity share by carrier (seats per week in international market only):
26-Dec-2011 to 01-Jan-2012

Croatia capacity share by alliance (seats per week in domestic and international markets combined):
26-Dec-2011 to 01-Jan-2012

Zagreb Airport international capacity share by carrier (seats per week in international market only):
26-Dec-2011 to 01-Jan-2012