05-Nov-2012 12:00 PM

Philippine Airlines Group to step up competition against Cebu Pacific with new long-haul LCC

Analysis

The Philippine Airlines (PAL) Group is looking at launching a low-cost long-haul operation, potentially in 2013, as part of the Group's revised two-brand strategy. Allocating some of PAL's newly acquired A330-300s to its budget brand will help the Group stay competitive with archrival Cebu Pacific, which is planning to launch its own low-cost long-haul operation in mid 2013. A long-haul operation from AirPhil/PAL Express would also allow the Group to re-enter markets in the Middle East, which it has dropped in recent years and is the main target for Cebu Pacific's new A330 operation.

PAL Group sources say AirPhil Express, which is currently awaiting approval to be rebranded as PAL Express, is expected to receive several of the A330-300s PAL ordered in Aug-2012 for delivery from 2013. Sources say the aircraft will be operated in all-economy configuration and likely be used initially on routes between Manila and destinations in the Middle East.

PAL poised to become third Asian FSC group with low-cost long-haul operation

AirPhil/PAL Express would become the fifth low-cost long-haul operator in the Asia-Pacific region, joining Jetstar, AirAsia X, Scoot and Cebu Pacific. PAL would become the third full service airline group in the region to launch a low-cost long-haul operation, joining Qantas and Singapore Airlines (SIA).

PAL's entry in the nascent but fast-expanding low-cost long-haul sector could persuade other Asian carriers to launch long-haul low-cost subsidiaries or units. The Thai Airways Group is also considering entering the long-haul low-cost sector.

The A330s are part of a new strategy for AirPhil/PAL Express that is being implemented by the carrier's new owners, San Miguel, which took control of AirPhil and PAL in Apr-2012. San Miguel has already adjusted the domestic strategy at AirPhil which resulted, in late Oct-2012, in the LCC dropping service on several trunk routes while taking over from PAL several leisure-focused and secondary domestic routes. As a result the AirPhil and PAL brands now only overlap on a handful of domestic routes.

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AirPhil/PAL Express to focus on international routes not already served by PAL

The PAL Group's revised two-brand strategy also envisions minimizing overlap on international routes. AirPhil/PAL Express is expected to only use its anticipated fleet of new A330-300s on routes that PAL does not currently serve.

AirPhil/PAL Express will also focus on new markets to the PAL Group as it expands its narrowbody international operation, which currently only consists of five scheduled routes. For example, PAL Group sources tell CAPA that AirPhil is planning to launch services from Manila to Hanoi and resume services on the Singapore-Cebu route. Cebu Pacific is currently the only Philippine carrier on both routes (Singapore-based Tiger Airways and SilkAir also serve Singapore-Cebu).

PAL Group sources say there will be exceptions and AirPhil will be allowed to continue operating on PAL international routes that AirPhil holds international traffic rights on, such as Manila-Singapore and Cebu-Hong Kong. The PAL Group would not want to risk giving up traffic rights in these key markets to competitors and these routes are large enough to support both budget and full service brands. Manila-Singapore and Cebu-Hong Kong are now AirPhil's two largest international routes.

AirPhil's international routes by capacity (seats): 05-Nov-2012 to 11-Nov-2012

AirPhil, which was known as Air Philippines until 2010, has its own traffic rights as it was previously an independent carrier. The Lucio Tan Group acquired Air Philippines and PAL separately in the 1990s and kept the carriers separate for several years. Air Philippines became the group's budget brand in 2010 after adopting the LCC model and starting to work more closely with PAL. Lucio Tan continues to own large stakes in both carriers but has ceded management control to San Miguel.

The PAL Group's new focus on avoiding overlapping networks between its two brands contradicts the strategy used at other airline groups in Asia-Pacific, including Qantas and SIA. Jetstar serves a large number of domestic and international routes which are also operated by Qantas. SIA also allowed Scoot to make one of SIA's biggest routes, Singapore-Sydney, its launch route (albeit at very different scheduled times) while partially-owned Tiger overlaps extensively with SIA.

While PAL should reconsider this strategy and allow its budget brand to operate alongside the main PAL brand on major domestic and international short-haul routes, on long-haul routes the separation will not be as big of a factor in limiting the success of AirPhil/PAL Express. There are several long-haul routes PAL is now unable to viably serve, giving AirPhil/PAL Express plenty of opportunities to build up a long-haul network without overlapping with PAL's relatively limited long-haul network.

PAL looks to use budget brand to re-enter Middle East market

AirPhil/PAL Express in particular could be used to re-establish PAL's presence in the Middle East. PAL has pulled out of all Middle East markets in recent years due in part to intense competition from Gulf carriers, which have the advantage of offering the Philippine market connecting flights throughout the Middle East as well as to Africa and Europe.

Once Emirates launches it third daily flight to Manila in Jan-2013, Middle Eastern carriers will have almost 50,000 weekly seats to and from Manila. PAL's long-haul network, in comparison, has less than 14,000 weekly seats, all of which are deployed on routes to North America (see Background Information).

Philippines to Middle East capacity by carrier (seats per week, one way): 19-Sep-2011 to 21-Apr-2013

PAL now relies on codeshare partnerships with four Gulf carriers - Emirates, Etihad, Gulf Air and Qatar Airways - to cover the Middle East. While PAL will likely extend its existing codeshare with AirPhil to include any routes to the Middle East that AirPhil/PAL Express launches, PAL will be able to continue covering the premium end of the Philippines-Middle East market through existing codeshare agreements with Middle Eastern carriers.

While the local Philippine-Middle East market is large enough by itself to sustain carriers without having to rely on onward connections, this market is extremely price sensitive as it primarily consists of migrant worker traffic and visiting friends and relatives (VFR) traffic. The market is generally considered too low yielding to support full service carriers and could be better served by low-cost carriers. The Gulf carriers serving the Philippines carry some point-to-point traffic but rely more on higher yielding connecting traffic.

When deciding in early 2012 to launch a long-haul operation, Cebu Pacific said a majority of migrant worker traffic between the Philippines and the Middle East were travelling on cheaper one-stop flights rather than the non-stop flights on the Gulf carriers. Cebu Pacific believes it can offer lower prices than these one-stop offerings and take advantage of the fact that most Filipinos prefer to fly Philippine carriers when given the choice.

Cebu is also now considering using its new fleet of A330s to take over some of its A320 flights to north Asia, particularly slot congested airports such as Beijing. Flights to Australia and the US are also a possibility. But the bulk of capacity from Cebu Pacific's new low-cost long-haul network is expected to be allocated to Middle East routes. There are about 2.3 million Filipinos working in the Middle East, including over one million in Saudi Arabia and over 600,000 in the UAE.

In Oct-2012 Cebu Pacific and PAL both requested from Philippine authorities traffic rights to Saudi Arabia, made possible by a new bilateral between the two countries. The UAE and the Philippines also recently expanded their bilateral, which could lead to flights from both Cebu Pacific and the PAL Group. Currently PAL holds the only rights to both Saudi Arabia and the UAE but dropped Saudi Arabia flights in 2011 and only serves the UAE on a codeshare basis.

AirPhil/PAL Express and Cebu Pacific both opt for A330s in single-class configuration

Cebu Pacific has committed to acquiring at least 12 A330s in single-class configuration with about 400 seats, for delivery starting mid-2013. PAL Group sources say AirPhil also plans to outfit its A330s with all-economy seating. While Jetstar, AirAsia X and Scoot are all operating aircraft in two-class configuration, AirPhil and Cebu Pacific believe the long-haul budget market in the Philippines would struggle to support a two-class product if migrant worker routes are the main target.

PAL in Aug-2012 placed orders for 10 A330-300s for delivery starting in 2013 and has said it is seeking to purchase another of 10 of the type. The Group at the same time also ordered 44 A321s/A321neos which are expected to be used to renew the narrowbody fleet initially at PAL and eventually AirPhil/PAL Express. Both PAL and AirPhil now operate A320s but PAL's aircraft are older.

PAL already operates eight A330-300s on regional international routes within Asia as well as on some domestic trunk routes. The 20 additional A330s-300s are intended for growth and will be delivered in the new High Gross Weight (HGW) variant. AirPhil/PAL Express could be allocated some of the eight existing A330-300s if the Group decides to have PAL operate the new aircraft.

PAL brand to focus on long-haul expansion in North America and Europe

PAL is also committed to renewing its long-haul fleet, having ordered six Boeing 777-300ERs in 2008. More 777-300ER orders or lease commitments are expected as PAL, under San Miguel, seeks to replace its fleet of 747-400s and A340s as well as accelerate expansion of its long-haul network.

San Miguel has said it aims to have PAL re-enter the European market and expand in North America. It is unlikely PAL will resume services to the Middle East as it is more logical to have its budget brand operate these services.

The carrier in Sep-2012 unveiled plans to launch three weekly flights from Manila to Toronto on 30-Nov-2012, following delivery of its fourth 777-300ER. Manila-Toronto will be its longest route and its first to the eastern portion of North America. The flight will be operated as a non-stop eastbound but will stop in Vancouver on the return westbound sector.

PAL now serves Vancouver in Canada as well as Los Angeles, Las Vegas and San Francisco in the US. But service to Las Vegas, which is now served four times per week as a tag with Vancouver, is being dropped in Jan-2013. PAL will continue to serve Vancouver with four weekly 777-300ER flights, excluding the three weekly flights which will stop in Vancouver on the return leg from Toronto.

PAL is still aiming to expand significantly in the US once the Philippines regains Category 1 status under the FAA's safety assessment programme. New destinations on the east and west coasts are being evaluated, including New York.

PAL initially ordered the six 777-300ERs primarily for the US market but has been forced to use the aircraft in other markets because under Category 2, Philippine carriers are unable to add new flights or change the gauge of existing flights. PAL has had to continue using its 747-400s and A340s on all its US services.

As Las Vegas was served via Vancouver, PAL also has been forced to operate four of its seven existing weekly frequencies to Vancouver with A340s. Terminating Las Vegas, while not ideal, allows the carrier to transition to an all-777 service to Vancouver, giving premium passengers a more uniform product as only the 777-300ERs feature new generation lie-flat business class seats.

Philippine carriers need authorities to pass audits from US, Europe and Japan

PAL is hopeful the Philippines will finally regain Category 1 status in 2013. If this occurs, PAL will be able to place the two remaining 777-300ERs from its current order, which are to be delivered in 2013, on US routes. It would also likely quickly finalise plans to acquire additional 777-300ERs and potentially redeploy 777-300ERs from Australia and Japanese routes to US routes.

But the carrier has been saying for some time that it is hopeful of a near term upgrade for the Philippines to Category 1. In 2011 PAL even took the unusual step of hiring a consultant to help Philippine authorities meet Category 1 standards, thinking at the time that an upgrade could be secured by the time the carrier received its third and fourth 777-300ER in 2012.

PAL instead reintroduced 777-300ER service on medium-haul routes to Melbourne and Sydney in Australia in Jun-2012 after taking delivery of its third 777-300ER. PAL was initially unsuccessful at using the 777-300ER on its Australia routes in 2010, after taking delivery of its first batch of two aircraft, discovering the 777-300ER was too big for the market. PAL's decision to put the 777-300ER back into Australia reflects its limited options as it doubles its 777-300ER fleet to four aircraft without having the flexibility to use the type to the US or Europe.

Cebu Pacific would also benefit from Category 1 status as the carrier recently applied for traffic rights to the US. The carrier intends to initially operate using more expensive wet-leased aircraft until Category 1 can be achieved.

While Cebu Pacific is seeking rights for several US destinations, including in the mainland, Guam and Hawaii are the most logical destinations. Guam can be served from Manila with A320s and Hawaii with A330s but A330-300s do not have the range to serve the US mainland non-stop.

As Cebu Pacific had already stated that the US was not a focus for its new long-haul low-cost operation, it is unclear if the carrier would use its US traffic rights, if awarded, for any market other than Guam. AirPhil is also not likely to use its A330s to fly to the US given the US is now one of PAL's largest markets and the PAL Group prefers to use AirPhil in markets PAL is not already serving.

PAL's international expansion plan under San Miguel also hinges on Philippine authorities passing audits from the EU and Japan. Philippine carriers are currently on the EU black list although San Miguel has flagged Paris as a potential destination with the two 777-300ERs to be delivered in 2013.

Philippine carriers are also now prohibited by Japan's JCAB from adding capacity or launching services on any Japanese route until Philippine authorities can demonstrate they are in compliance with ICAO requirements. South Korea also now prohibits any new Philippine carrier from launching services to South Korea although existing carriers in the Philippines-Korea market are able to add capacity.

AirPhil currently does not serve South Korea or Japan but is interested in launching flights to both countries from secondary destinations in the Philippines such as Cebu and Kalibo, where there is large inbound demand. This could occur once Philippine authorities prove they are in compliance with ICAO requirements.

China and more flights to Southeast Asia also likely as PAL Group expands budget brand

AirPhil/PAL Express is also keen to launch services to China. The carrier would likely launch scheduled flights to secondary destinations in China as PAL now serves the country's two largest destinations - Shanghai and Beijing - as well as Xiamen.

Unlike South Korea or Japan, AirPhil is not prohibited from launching scheduled flights to China. However, the carrier is waiting for tensions over the Scarborough Shoal, which has led to plummeting demand on China-Philippines flights in recent months, to ease.

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Over the last year AirPhil had been aiming to increase its international operation in an attempt to lower its cost base through higher utilisation of its A320 fleet. Most of the carrier's international flights are operated in the middle of the night, using its fleet of 12 A320s which during the day operate domestic flights. Cebu Pacific has a much higher utilisation rate for its A320 fleet, due to its much larger international network with frequent night flights, giving it a lower cost base and a competitive advantage over AirPhil and other Philippine LCCs.

In Southeast Asia, the PAL Group plans to use AirPhil/PAL Express mainly to compete against LCCs in markets that PAL does not serve. For example, AirPhil earlier this year launched three weekly flights on the Manila-Kuala Lumpur route and the carrier is now planning to increase this service to daily. Manila-Kuala Lumpur is a natural AirPhil route as it is no longer served by PAL but is served by Cebu Pacific and Zest Air. AirAsia also serves Kuala Lumpur from Manila alternative airport Clark.

AirPhil could also be used by the PAL Group to enter international routes where Cebu Pacific is now the only carrier such as Manila-Siem Reap, Manila-Bali and Manila-Kota Kinabalu. These are all primarily leisure routes which PAL would struggle to viably serve. Extending the AirPhil-PAL codeshare to such international routes in Southeast Asia could also provide feed for PAL's expanded operation to North America.

AirPhil currently only has a 2% share of international capacity in the Philippines, compared to about 17% for Cebu Pacific. PAL has an approximately 24% share.

But on international routes between the Philippines and other Southeast Asia countries, Cebu Pacific currently has a leading 31% share of capacity, according to Innovata data. LCCs account for about 61% of capacity in this market. The PAL Group only has about a 23% share of this market - including only a 4% share with AirPhil. The PAL Group needs to accelerate expansion at AirPhil to ensure it does not cede more market share to rival Cebu Pacific and other LCCs.

Philippines international capacity share (% of seats) by carrier: 05-Nov-2012 to 11-Nov-2012

Philippines-Southeast Asia international capacity by carrier: 05-Nov-2012 to 11-Nov-2012

Philippines can support higher LCC penetration rate in international market

Having a budget carrier for both the short-haul and long-haul international markets is logical given the strategy at PAL's Asian peers and the fact the Philippines is predominately a budget market. While there will be some growth in the premium market as the Philippines economy expands, most of the growth in the country is at the lower end of the market. To capture this growth, the PAL Group needs a strong budget brand for the domestic, international short-haul and international medium/long-haul markets.

The Philippines already has one of the highest LCC penetration rates in the world, about 60% according to Innovata data. While the domestic LCC penetration is unlikely to grow significantly as it is already above 80%, the approximately 32% international LCC penetration rate will continue to increase as regional markets such as Japan open up and as Philippine LCCs expand into the long-haul market.

The PAL Group needs to make sure it has the budget market fully covered to keep up with larger Cebu Pacific. An A330 operation at AirPhil/PAL Express is logical and would allow the PAL Group to join the long-haul low-cost party at a relatively early stage.

This is the second in a two-part series on the new PAL Group strategy. The first part looked at the group's two-brand strategy for the domestic market.

Background information

Philippine Airlines international capacity by region: 05-Nov-2012 to 11-Nov-2012