Russia’s bear market
Russia, once a fast-growing engine of world economic growth enjoying robust growth in airline passenger numbers, has been hit hard by the effect of sanctions and reduced demand for international air travel to/from the country. Investors now are looking nervously at the prospects of what was until recently one of the phenomenal-growth BRICs.
- Russia's airline market has been hit hard by sanctions and reduced demand for international air travel, leading to a contraction in the market and a decrease in passenger numbers.
- Aeroflot, Russia's largest airline group, is taking advantage of the market contraction to increase its market share and is launching its low-cost carrier, Pobeda.
- Other Russian airlines, such as UTair, are contracting, and many foreign carriers are reducing capacity on international routes.
- Russia's airport sector requires investment, but the environment for foreign investors is not always ideal due to political impediments and the need for substantial infrastructure improvements.
- The Russian market is highly concentrated in Moscow, with the city's three main airports accounting for more than five times the number of seats of the next largest airport, St Petersburg.
- LCCs have yet to make a significant impact in the Russian market, with less than 5% of seats on international routes being operated by LCCs in 2014.
In this two part report Airline Leader and CAPA look at how Russia's airline market is evolving and the status of investment in its many airports.
Russia's largest airline group, Aeroflot, is taking advantage of market contraction to increase its market share, while launching its LCC, Pobeda. This consolidation process will accelerate with Aeroflot's acquisition of Transaero. Other Russian airlines, notably UTair, are contracting and many foreign carriers are reducing capacity on international routes.
Moreover, the current geopolitical and economic backdrop has implications for airport investment and construction in Russia. Russia's many airports do need investment and much of that must come from foreign investors, yet the environment for them is not always ideal.
Russia has shifted from a globally-isolated and centrally-planned economy in the Soviet Union days towards a more market-based and globally-integrated one, but with a high concentration of wealth in officials' hands.
Russia's reliance on commodity exports has made it vulnerable to boom and bust cycles that follow the volatile swings in global prices. The economy had averaged 7% growth during 1998-2008 as oil prices rose rapidly, but was one of the hardest hit by the 2008-2009 global economic crisis as oil prices plummeted and the foreign credits that Russian banks and firms relied on dried up.
The Russian economy recovered somewhat in 2010, but then its GDP growth slowed in successive years. In 2014, economic growth declined further when Russia forcibly violated Ukraine's sovereignty and territorial integrity, and interfered in Ukraine's internal affairs. In the second half of 2014, the Russian rouble lost about half of its value, contributing to increased capital outflows that reached USD151.5 billion for the year.
The rouble remains volatile. According to the International Monetary Fund (IMF), Russia's economic output, as measured by its GDP, slowed to an estimated 0.6% in 2014, from 1.3% in 2013 and 3.4% in 2012. Declining oil prices, lack of economic reforms, and the imposition of foreign sanctions have contributed to the downturn and created wide expectations that the economy will continue to slump. 2015's outlook is much worse than 2014.
In Jul-2015, the IMF forecast that Russia's 2015 GDP will contract by 3.4%, a severe recessionary rate, albeit better than the Apr-2015 forecast of -3.8%. Moreover, the IMF's forecast for Russia is in sharp contrast with its average emerging market forecast of 4.2% GDP growth in 2015. The IMF's Jul-2015 update also increased its forecast of Russia's 2016 GDP growth from -1.1% to +0.2%, but this remains a very weak figure and underlines the ongoing economic uncertainties.
Part 1: Russia's airline market
The nation's airlines carried 93 million passengers in 2014, according to data from Russia's Transport Clearing House (TCH) and Aeroflot. Including the 19 million passengers carried by foreign airlines, the total Russian airline market consisted of 112 million passengers. The largest market segment was international routes, accounting for almost 66 million passengers, while the domestic market consisted of 46 million.
As elsewhere, Russia's airline traffic was not immune to the effects of the global financial crisis. However, after a 4% fall in 2009, passenger numbers increased at a compound average growth rate of almost 14.6% p/a between 2009 and 2014. International numbers grew slightly faster, at 14.9% CAGR compared with 14.2% CAGR for the domestic market.
The number of passengers in 2014 was 8% higher than in 2013. This growth rate was superior to global and European average growth, but represented a deceleration from the double digit rates of previous years. In particular, the international market slowed its passenger growth to 2% in 2014 after a number of years of outpacing the domestic market. By contrast, growth in the domestic market accelerated to 18% in 2014.
Sanctions and other uncertainties affecting demand following the Ukraine crisis have had a clear dampening impact on international traffic, but it seems that Russian leisure travellers substituted trips abroad with domestic travel in 2014.
Moving into 2015, the impact of the crisis has been more severe. Data from Rosaviatsia for the first six months of the year show that passenger numbers for all airlines in Russia fell by 3.9%.
Setting aside the current geopolitical environment, Russia's low penetration of air travel points to growth potential. According to data presented by Aeroflot, there was an average of just 0.7 airline passengers per head of population in Russia in 2013, compared with 2.6 in the US in 2012, 3.2 in the UK and 1.5 in the European Union in 2011. Aeroflot expects this figure in Russia to increase almost two-fold to 1.2 by 2025. Clearly, this potential will only be realised if international markets return to full strength.
Russia's air travel market is highly concentrated on the capital city Moscow. According to data from OAG for the week of 17-Aug-2015, Moscow's three main airports together account for more than five times the number of seats of the next largest airport, St Petersburg. The two leading Moscow airports, Domodedovo and Sheremetyevo, each account for more than twice the seats of St Petersburg. Outside Moscow and St Petersburg, airport size falls away rapidly, with the number five airport, Sochi, having only slightly more than one third of St Petersburg's seats.
Russia has one of the most significant domestic markets among European countries. Almost 49% of airline seat capacity that touches Russia is deployed within its borders (source: OAG, week of 17-Aug-2015). Internationally, the biggest region to/from Russia is Eastern/Central Europe, which accounts for 45% of international seat capacity, followed by Western Europe with 25%. Prior to the Ukraine crisis, the two halves of Europe had a more even share of seats to/from Russia. Asia has also fallen in importance as an international destination area, accounting for a low 20% share of international seats, compared with a high 20% share two years ago. The Middle East accounts for 4% of international seats and North America has only a 2% share (and this low share is reflected in Aeroflot's absence from the North Atlantic JV within SkyTeam).
Ukraine is by some distance Russia's most important country destination by seat capacity, followed by Germany, Turkey and China. Western Europe is also represented by Spain, Italy and Greece among the top 10 countries connected to Russia (source: OAG, week of 17-Aug-2015). The other countries in Russia's list of top destinations are former Soviet republics in Central Asia and Eastern Europe.
An important feature of Russian aviation in recent years has been consolidation among its airlines, prompted by the government's "national champion" policy towards Aeroflot. Moscow-based Aeroflot acquired Rossiya (St Petersburg), Orenair (Orenburg) and two carriers based in the Russian Far East, Vladivostok Air and SAT Airlines, in Nov-2011 from the Russian state. The latter two subsidiaries were merged in Nov-2013 to form a new carrier, Aurora. Donavia (based in Rostov) has been a 100% subsidiary of Aeroflot since 2007.
This has led to considerable concentration in the Russian market, with the share of passengers of the top five Russian groups increasing from 60% in 2010 to 78% in 2012 (note: this is the share of passengers carried by Russian airlines only). Aeroflot's subsidiaries account for around 13% of passenger numbers, and explain most of the increase in the market share of the top five Russian groups from 2010 to 2012. The top five share then remained stable until 2014, but data for the first six months of 2015 show that the top five share has increased to 83%, with the Aeroflot Group the main beneficiary.
In the first six months of 2014, the Aeroflot Group's share of passengers carried by Russian airlines was 38%, a figure that grew to 44% in the same period of 2015. By contrast with the 3.9% year on year market contraction in passenger numbers in 1H2015, the Aeroflot Group carried 14.0% more traffic than in the same period of 2014.
The group's share of passengers in calendar 2014 was 37%, the same as in calendar 2012, immediately after its acquisitions. It now appears to be benefiting from a 39% drop in traffic in 1H2015 for number four ranked UTair, which is experiencing financial difficulties. Moreover, airlines outside the top five Russian carriers suffered a 24.3% fall in passenger numbers in 1H2015, when their share fell to 17% from 20% a year earlier. The Aeroflot Group's share of passengers so far in 2015 is now larger than the combined share of the other four in the top five. Aeroflot's acquisition of 75% of Transaero will take the group's share of passengers carried by Russian airlines to well over 50%.
The Russian market remains very much the preserve of Russian airlines. Local carriers operate 80% of all movements and 100% of domestic movements. This is a much less open market than other large countries in Europe. For example, local airlines account for 66% of seats in Germany and 68% in the UK. In Poland, local carriers have only 27% of movements (source: OAG, week of 17-Aug-2015).
Russia is the largest European country that is not part of the European Union's liberalised aviation market and this restricts access to foreign carriers. The impact of such restrictions is currently exacerbated by lower demand from international travellers and capacity reductions by foreign airlines.
Until recently, LCCs have not been a significant feature of the Russian market. On international routes, this has reflected the difficulty experienced by foreign LCCs in obtaining traffic rights. This is now changing slowly: for example, Vueling flies to the Moscow airports Domodedovo and Sheremetyevo, in addition to St Petersburg, Krasnodar, Samara, Kaliningrad and Kazan from airports in Spain. Turkish LCC Pegasus Airlines serves Domodedovo, Krasnodar and Mineralnye; flydubai operates to eight destinations in Russia; easyJet operates from London Gatwick and Manchester to Moscow Domodedovo (but has reduced frequencies on both routes); Wizz Air flies from Budapest to Moscow Vnukovo. Germanwings operates to Moscow Vnukovo from Cologne/Bonn and Berlin Tegel (the latter route taken over from parent Lufthansa). Ryanair has had permission to fly from Dublin to Moscow and St Petersburg since Mar-2014, but has not commenced operations.
Nevertheless, LCCs still had less than 5% of seats on international routes to/from Russia in 2014. Although this share was almost double the level it had been in the years 2007 to 2012, year to date figures for 2015 show it falling back to just below 4% (source: CAPA and OAG). The highest ranked foreign LCC by seats, Vueling, is still only at number 11 in the list of all airlines by international seats to/from Russia.
In the domestic Russian market, there is only one LCC, Pobeda. LCCs were not a feature at all after the collapse of Avianova and Sky Express in Oct-2011 until the establishment of Dobrolet in 2014. The Aeroflot subsidiary flew for two months before being grounded as a result of EU sanctions, which effectively annulled its leasing, maintenance and insurance contracts with European suppliers.
Aeroflot quickly established a second LCC, Pobeda, in Dec-2014. Pobeda is the only Russian LCC and currently operates only on domestic routes, although it plans to expand internationally also. It is the number six ranked airline in the Russian market by seats (source: OAG, week of 17-Aug-2015). According to Aeroflot, Pobeda's passenger numbers grew from 40,000 in Dec-2014 to 283,000 in Jun-2014 and load factors have been in the high 70s to low 80s since Jan-2015.
Part 2: Russia's Airport Sector and Privatisation
Economic reforms in the 1990s privatised most of Russia's industry, apart from energy and defence-related sectors. Slowly but surely, privatisation has spread to the airport service sector despite vacillation by respective Presidents Medvedev and Putin over the years.
In a CAPA report on Russian airport expansion in Nov-2011, the following observations were made:
Both the then Russian President Dmitry Medvedev and Prime Minister (soon to be President again) Vladimir Putin had spoken of plans to build a network of regional airports in Russia and of making "an infrastructure, transport breakthrough" by…boosting the capacity of airports. These were grand schemes, but could they realistically be completed without increasingly resorting to the private sector, at home or abroad?
The country needs to spend in total a whopping USD462 billion on transport, power and telecommunications over the next 20 years to spur economic growth, according to a joint study by the Royal Bank of Scotland Group Plc and Cambridge University released in Sep-2011, although that amount paled into insignificance compared to the requirement in the other 'BRICs,' which in the cases of China and India required trillions of dollars.
An important part of Russia's plan was to invite into the Federation European firms seeking a growing market, including those in transportation. This strategy would require the Kremlin to spend billions of dollars in support, but this would be factored in to the overall cost of forming ties with strategic European firms. The goal appeared to be to convince large European firms - which, for whatever reason, do not have ways to expand in Europe - that gaining access to the Russian market should be their preferred way forward.
Intriguingly, another part of the scheme was to do the reverse, i.e. to purchase assets in Europe while they were cheap. Russia already had begun to buy up firms throughout Europe that had been suffering during the crisis. It was focussed mainly on banks and energy firms, followed by strategic assets like ports and airports. Russian investors were rumoured to be interested in acquiring shares in Athens Airport, which, coincidentally, will shortly be back on the market.
The Kremlin was thinking in the long term about these assets' uses. It also was not looking at assets that would give Russia the greatest financial return; rather it was considering those that would give Russia important leverage in Europe, particularly in Central Europe.
But that did not eventuate. Russian investors have not been as evident in Europe as they might have been, though there are several banks with representation and involved in transactions that are based in major European financial cities. But they cannot be compared for example with the Chinese, who are very active in this sector, or the Japanese, who are becoming more involved, especially so since concession-based privatisation was announced in Japan itself.
They are certainly active in their own country, and with a full range of airports from the major hubs such as Moscow and St Petersburg, through to much smaller regional ones.
There is little evidence of Russia making a direct financing and operating impression in European or other markets and most of the investment into Russian airport infrastructure is from Russian companies, even though the country still seeks to attract foreign institutional investors.
But Russia's many airports do need foreign investment and there are companies such as Fraport and Incheon Airport that are active there and sticking it out. Fraport is notable for its contribution to the Northern Capital Gateway Consortium that has a 30-year PPP deal at St Petersburg Pulkovo Airport.
Other foreign investors such as Meinl Airports attempted to invest in smaller regional airports such as Ulan Ube in Siberia a decade ago but was not successful though that was attributed to legal and other factors concerning Meinl Airports rather than the performance of that particular airport.
There has been some privatisation also at Moscow, where Domodedovo Airport, Russia's busiest, is operated by the Russian East Line Group (but the terminal infrastructure only, not the runways, which remain with the state). In the case of Sheremetyevo (technically Joint Stock Company [JSC] Sheremetyevo International Airport), still regarded as the primary Moscow gateway airport, it will be merged with Vnukovo Airport at the conclusion of a lengthy process in 2016, at which stage the joint entity - and possibly Aeroflot, which is an existing shareholder in it) - will be partly privatised via disposal of some of the equity held by the state (currently 83.04%).
Deutsche Bank was appointed agent for the sale in Jul-2014. Other shareholders now are: JSC Aeroflot Russian Airlines (8.96%), State Corporation Vnesheconombank (4.24%), and VTB Bank (JSC) (3.76%).
There are several issues that negatively influence foreign investors into Russian airports. Firstly, and as mentioned earlier, apart from at Moscow and St Petersburg, passenger traffic remains relatively low, with only a handful of airports handling more than a few million passengers per year. In 2014, the third and fourth largest cities, Novosibirsk and Ekaterinburg, managed just 3.9 and 4.4 million passengers respectively through their airports.
Until recently there had not been a working budget (low-cost) airline in Russia for several years, though that gap has now been filled by Pobeda. Even so, LCC penetration is stuck on just 5% of seats. Moreover, alliance penetration is low. 46% of seat capacity is unaligned, and only SkyTeam - of which Aeroflot is a member - (37%) has an appreciable presence. Star Alliance is virtually invisible.
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Secondly, much of the nation's airport facilities are in need of substantial investment and changes to operational management. It is really only those big city airports in Moscow and St Petersburg that look at all attractive to foreign investors. There are similarities with Spain's AENA, where there are two dominant airports at Madrid and Barcelona, but there is no Palma de Mallorca, Malaga or Alicante in Russia. (Not that there is any intention to privatise Russian airports wholesale as there was in Spain.)
Finally, and this is the most significant factor, there are political impediments to privatisation. Foreign investment in all airports is subject to prior approval by the government investment committee. Some particular airports have privatisation restrictions under which the state's share may not fall below a threshold outlined in a Presidential Decree. Airport fees are subject to certain limitations by the Federal Tariffs Service. Usually tariffs are based on airport operation costs, increased by a limited margin.
When conducting a due diligence review for a particular airport, among other areas that are standard for other businesses, a number of specific issues need to be addressed. These include expansion possibilities, ownership of refuelling depots, ground handling, municipal social obligations connected with the airport, the condition of the aerodrome, infrastructure and equipment, as well as various types of aviation and non-aviation operations. Russian airports in most cases do not own their runways, taxiways and ramps.
When choosing a partner the state may also attempt to limit certain types of potential investor. It may expect to see not only a financially sound partner, but also a company with a particular experience qualification (e.g. successful management of an international airport, expressed in years). Certain types of applicants may be even banned, such as competing airports (within a certain range) or airlines, etc.
The privatisation process and scope for investor involvement largely depends on the level of control and potential responsibility the state is looking to transfer and the investor ready to accept. Depending on the airport, the approach may range from a consulting agreement to concession or complete purchase.
Under Russian law, a concession means an arrangement where an investor is required to construct or renovate a certain object (usually buildings, infrastructure, etc.), operate it for a specified time, and then transfer to the state: the classic build, operate, transfer (BOT) model.
The concession model may be viewed by the government as a compromise between attracting a private investor and retaining the control over the strategic infrastructure. It provides an investor with enough operational independence effectively to run an airport, and influence policies, development and potential profits, while providing the state scope for regaining control over important infrastructure in the future. A state or regional government owner may also include specific management restrictions and obligations for an investor in the contract, e.g. a requirement to gain owner approval for construction or certain other major actions.
Concessions are regulated by a special Federal Law on Concession Agreements, which is fairly flexible in allowing the state and a private investor to allocate risks between them and agree on the financing structure.
Depending on an airport's condition and the concession project's principal objectives, the parties may choose between different types and combinations of payments to the owner, e.g. a single fixed payment, fixed periodic payments (as with lease payments in the LDO - "lease, develop, operate" - model) or a portion of the airport's profit or proceeds. The project may, alternatively, demand the owner's co-financing together with the investor, which is also legally acceptable, subject to budget legislation.
Concession models are typically more appropriate for larger projects, such as construction of new terminals. The most noted Russian example of a concession contract involves the aforementioned St Petersburg Pulkovo Airport, having been executed between the city of St Petersburg and the Northern Capital Gateway, an international consortium including Fraport, VTB Capital and the Greek Copelouzos Group. The consortium was put in charge of aerodrome infrastructure development, reconstruction of the existing Terminal 1, construction of a new terminal, as well as a new hotel, business centre and parking.
So there are many regulations that foreign investors and operators could fall foul of. And if the pitfalls mentioned earlier were not enough, all documents must be in Russian (only) and negotiations must take place in Russian.
In the case of the forthcoming opportunities at Moscow the risk could be judged worth taking. But in the case of the hundreds of other Russian airports, even while the Transport Minister is keen to stress that Russia's national transport industry is experiencing interest from investors, the most likely investors for the foreseeable future will be indigenous companies that can benefit specifically from a local investment. Because Russia is one of the world's leading producers of oil and natural gas for example, and is also a top exporter of metals such as steel and primary aluminium, quite frequently these producers are turning up as operators of airports, even if their primary objective is merely to cater for the operational demands of their own business.
Forthcoming small airport opportunities include Omsk-Fedorovka Airport (49% equity availability, determination to be made on 09-Sep-2015), and Yuzhno-Sakhalinsk Khomutovo Airport, which will be sold if the right offer is presented.
There are currently 75 airport construction projects at existing airports in the Russian Federation, with a total value of USD22 billion according to the CAPA Global Airport Construction Database. This compares with total investment in Europe of USD103 billion over 246 projects.
USD9.8 billion of this figure is accounted for by unspecified/unnamed projects that are to be completed by 2021 according to government statements.
The largest individual projects are, as one might expect, in Moscow (the two main airports). Elsewhere there are close to USD1 billion value projects at St Petersburg and Rostov-on-Don.
Six of the projects are or include new runways (including Moscow Domodedovo and Sheremetyevo), six are or include runway extensions, new terminals account for 28 projects (again including Moscow Domodedovo and Sheremetyevo, also St Petersburg), and three are terminal expansions.
Typical of smaller airport construction projects are Perm Bolshoye Savino Airport which received 11 bids for its 29,000sqm terminal construction tender, ranging from RUB4.6 billion (EUR65.5 million) to RUB7.1 billion (EUR101.1 million), and Khabarovsk Novy Airport's new 54,000sqm terminal, which is to be constructed by 2018 at a cost of EUR93.6 million. In the latter case foreign investors from Pacific Rim countries will be invited to invest.
It is difficult to obtain detailed financial data from large Russian airports and their operating companies, by which to assess profitability levels. The most recent data to which we have access are for Moscow Vnukovo Airport, for the six months ended Jun-2015 (1H2015). In that period revenue grew by 20% to EUR46.5 million. EBITDA was EUR211,000 (+107%) and net profit EUR1.1 million (+117.7%).
Sheremetyevo Airport has not yet published financials for 1H2015, but in the year ending Dec-2014 it grew its revenues to EUR317.6 million (+7.5%), EBITDA (just, by 0.37%) to EUR95.9 million but net loss increased by 1430% to EUR264.3 million.
The most recent figures we have for Domodedovo is for the year ended Dec-2013, which is somewhat before the present crisis took hold. In that year revenue gained 9.7% to EUR0.57 billion and EBITDA by 15.8% to EUR0.22 billion.
Saint Petersburg Pulkovo's most recent available financials go back even further, to the full year 2012, when an operating profit of EUR28.1 million was made on revenues of EUR189.9 million (+18.4%).
The economic crisis and sanctions are hurting Russian airports now and it is interesting that Vnukovo that appears to be riding the storm quite well, based on the available data. Vnukovo is home base to the only LCC, Pobeda, and has a high-speed rail link between its terminals and downtown, pitching it into direct competition with Sheremetyevo and Domodedovo, both of which offer the same facility.
So the picture is of a Russian Federation that is in economic turmoil; an unusual situation for a BRIC country in recent years although neither China nor Brazil could be described as an economic hot-spot right now.
International travel has been adversely influenced by the Ukraine crisis and its economic impacts, but domestically travel has increased. The growth potential is certainly there, with only 0.7 airline passengers per head of population last year, but that potential cannot be reached as things stand. And an excessive focus on the capital has to be addressed.
Airline consolidation is as evident as it is elsewhere in the world. Aeroflot is set to benefit from financial difficulties at some other airlines.
While Russia remains outside the reach of the EU's liberalised aviation market, local carriers will continue to dominate both domestic and international operations.
LCCs have yet to make their mark for a whole host of reasons that require a separate report in its own right, and their capacity shares rate amongst the lowest in the world.
In the airport segment Russian investors are far more active in their own country than abroad, partly because of intermittent and recurring reluctance by the government to welcome foreign ones in, which is probably tied to the same paranoia over security issues that was evident in the United States a few years ago and which helped set back the privatisation programme there.
Moreover, the pursuance of any investment and management deal can be extremely difficult both technically and administratively.
And many Russian airports hold little interest for foreign investors anyway, excepting the 'big city' ones where passenger and cargo volumes are guaranteed - and those are few. Those investors that do take the plunge face not only political impediments but also sustained investment in infrastructure facilities and human capital.
The main airport construction projects are in Moscow and St Petersburg but much needed infrastructure investment is, at last, beginning to find its way to other cities as private sector involvement, often by Russian companies with self-centred industrial and commercial interests, becomes more evident.