Southeast Asia: Turbulence in one of the world’s hottest emerging markets

Southeast Asia has established itself as one of the world's fastest growing aviation markets - and has huge potential for more rapid growth. Nearly all of the 10 countries that comprise ASEAN have robust economies and expanding middle classes, resulting in a favourable environment for airlines. Low-cost carriers, which already account for about 60% of capacity within Southeast Asia and have driven most of the region's passenger growth over the past decade, are particularly well positioned as demand continues to rise.

But Southeast Asia also has become one of the world's most challenging markets over the past year due to intense competition and overcapacity. Of the 17 airlines in Southeast Asia that report earnings, only four posted operating profits in 1H2014 compared to 12 in 1H2013. Most of Southeast Asia's markets have suffered from overcapacity since 2H2013, with the problems peaking in 1H2014 as new aircraft continued to be added at a rapid pace.

Market conditions have started to improve in 2H2014 as several groups have responded in recent months by adjusting capacity and slowing down fleet expansion. The region's two largest markets, Indonesia and Thailand, have also started to stabilise. But overcapacity, irrational competition and a lack of profitability remain a long-term concern.

Southeast Asia current fleet and orders by LCC group: as of end Sep-2014 Source: CAPA Fleet Database

Southeast Asia is the only region or sub-region in the world that has as many aircraft on order as active fleet. There are currently about 1600 active aircraft and 1600 orders from Southeast Asian airlines and airline groups, according to the CAPA Fleet Database. About three-quarters, or 1200, of the orders are from LCCs. While most of the approximately 400 full service airline orders are intended as replacements, almost all of the LCC orders are intended as growth aircraft. Southeast Asia's current LCC fleet consists of about 500 aircraft, including 36 widebodies.

The AirAsia and Lion groups have driven a large portion of Southeast Asia's passenger growth in recent years and have captured global attention by building up the largest order books in the airline industry. AirAsia and AirAsia X have more than 400 aircraft on order, while Lion has more than 500 on order. Some of these aircraft will end up outside Southeast Asia - as AirAsia has established new affiliates in India and Japan while Lion's leasing subsidiary has started placing aircraft with airlines from outside the group - but the majority will end up in the already intensely competitive Southeast Asian marketplace.

VietJet, which commenced operations in Vietnam only three years ago, has emerged as a new LCC group with ambitious plans for establishing affiliates in other Southeast Asian countries, starting with Thailand.

VietJet will take delivery in late 2014 of the first of at least 63 new A320s and is poised to become Southeast Asia's third largest LCC group in 2015, overtaking Jetstar and Tigerair. (Garuda Indonesia budget subsidiary Citilink and Philippine LCC Cebu Pacific are already larger than the Southeast Asian operations of Jetstar or Tigerair but are not considered groups as they are individual carriers with no ambitions to establish affiliates in other markets.)

Overcapacity has become a concern in the short-haul LCC sector as opportunities for further market share gains have started to dry up. LCCs accounted for about 59% of seat capacity within Southeast Asia through the first eight month of 2014, up only slightly compared to 2013.

After a decade of steady gains, the LCC penetration rates have started to flatten out in several Southeast Asian markets. Singapore has even experienced a slight drop in the LCC penetration rate this year. LCCs currently account for about 28% of seat capacity in Singapore, down from about 31% at the beginning of 2014.

LCC penetration rate (% of seats) within Southeast Asia: 2001 to 8M2014 Source: CAPA - Centre for Aviation & OAG Note: the jump from 2011 to 2012 was driven by the reclassification of Lion Air as an LCC. If Lion had always been classified as an LCC there would be a more steady increase in the LCC penetration rate from 2008 to 2012.

There will still be opportunities for LCCs to expand within Southeast Asia as overall demand continues to grow, particularly in markets with rising middle class populations and discretionary incomes. But with LCCs now accounting for a majority of capacity within Southeast Asia, the era of market share gains appears to be ending and therefore the growth rates across the short-haul sector will likely slow.

Slot constraints at several of the region's major airports are also a concern for LCCs that are still in expansion mode. Further liberalisation of the regional market through ASEAN opens skies is meaningless without available slots. Open skies also has little significance at this point as LCC groups have been able to get around the restrictions which are to be lifted under open skies by pursuing cross-border joint ventures.

Full service airline groups are also fighting back and are not about to let LCCs take the entire short-haul market. Full service regional subsidiaries or brands are growing rapidly, including SilkAir, Thai Smile, Garuda Explore and PAL Express. Full service boutique carrier Bangkok Airways also maintains a strong and growing position in the Thai market.

Some consolidation in the regional and LCC sectors is likely, particularly among the smaller players. Indonesia and the Philippines have already seen significant consolidation over the past two years. For the rest of the region consolidation is overdue.

Adjustments to fleet and capacity plans - beyond what has already been recorded so far this year - are also likely. The short-haul market and narrowbody fleet are the most vulnerable. There are only about 300 widebodies on order in Southeast Asia, a sustainable figure given that more than half will be replacements.

The widebody growth is primary at LCCs, which have just started penetrating medium-haul markets. Unlike within the Southeast Asia market, there is still a lot of room to push up the LCC penetration rate between Southeast Asia and Northeast Asia. LCCs account for only about 18% of seat capacity between Southeast Asia and Northeast Asia.

There are some opportunities for Southeast Asian LCC narrowbody operators to expand in North Asia, particularly from Vietnam and the Philippines. But the growth driver will clearly be the emerging widebody LCC sector, led by the AirAsia X and Scoot groups. AirAsia X now has three hubs in two countries following the launch this year of Thai AirAsia X and Indonesia AirAsia X. Scoot has also established its first overseas joint venture, NokScoot, which plans to launch operations in Thailand in late 2014 or early 2015.

As they push into more medium-haul markets and adopt network models, with feed from short-haul partners, the medium/long-haul LCCs pose an increasing threat to the region's full service carriers. This is the segment of the Southeast Asian market that is poised to experience the fastest growth - and the biggest upheaval - over the next couple of years.

The impact of the emerging medium/long-haul LCC sector has already been felt in the Southeast Asia-Australia market. LCCs now account for about 32% of seat capacity between Southeast Asia and Australia, making it the world's most penetrated medium-haul market. This market has been suffering over the past year from overcapacity, leading to unsustainably low yields and load factors. But Southeast Asian LCCs plan to continue to expand in Australia, further pressuring full service carriers and intensifying competition among LCCs.

While LCCs have captured most of the growth and headlines, only about 20% of the more than 20 Southeast Asian LCCs were profitable in 1H2014. Several LCCs have been pursuing strategic growth in a bid to push up market share or fight off new competitors. Such a strategy is not sustainable over the long term. Fortunately some Southeast Asian markets have started to experience consolidation and more rational behaviour in the form of capacity cuts and slower expansion rates.

The Philippines represents the best example of how consolidation and more rational behaviour can improve the outlook of a market and profitability. The Philippine market experienced significant capacity adjustments and consolidation in 2013 and 1Q2014, putting it in a much better position in 2Q2014 compared to the other Southeast Asian markets.

2Q2014 marked a turning point, with market leader Cebu Pacific registering a record profit and flag carrier Philippine Airlines swinging back into the black. The two carriers are still fighting viciously and at times irrationally in medium/long-haul international markets such as Australia and the Middle East. But in the domestic market, rationality has finally returned and eventually the international market should see improvements as well.

Only Philippines AirAsia, which in 2013 merged with Zest Airways (now Zest AirAsia), remains unprofitable. But Philippines AirAsia has been able to narrow losses and is confident it can turn the corner and start to benefit from the country's favourable market conditions.

SOUTHEAST ASIA WEEKLY CAPACITY BY COUNTRY: as of end Sep-2014 Source: CAPA - Centre for Aviation, OAG, International Monetary Fund and World Economic Outlook Database Note: based on capacity data for early Sep-2014

Other Southeast Asian markets have also started experiencing some adjustments, including Indonesia, Malaysia and Singapore. As the adjustments took place earlier in the Philippines, the Philippine market bottomed out first. The bottom of the profit/loss cycle for some of Southeast Asia's other markets was likely reached in 2Q2014 or 3Q2014, paving the way for improvements in late 2014 or early 2015.

Thailand, for example, is now starting to recover from a prolonged period of instability. Civil unrest began in late 2013 and continued until the May-2014 military coup. The new military government has brought more stability, providing a better environment for the tourism sector. But the government has also taken over struggling flag carrier Thai Airways, leading to some uncertainty in Thailand's aviation sector as it has no experience at managing and restructuring an airline.

Thai Airways plans to eliminate 1500 jobs by the end of 2014 and downsize its workforce by 25% by 2018. Cuts to its long-haul network are expected as the airline increases focus on the relatively stronger regional market within Asia Pacific. The restructuring is long overdue but may not go deep enough to right the ship. Thai Airways faces huge challenges as LCCs start to compete between Thailand and North Asia, which accounts for 40% of its international seat capacity and has traditionally been its most profitable market.

Thailand's international market shrunk through the first three quarters of 2014 as tourists, particularly from China and other parts of Asia, avoided Thailand because of the civil unrest. The domestic market has continued to grow rapidly but has been suffering from overcapacity, driven by the launch of Thai Lion and an increased focus on domestic expansion at Thailand's existing LCCs due to the challenging conditions in the international short-haul market.

Indonesia, Southeast Asia's largest market, has also been stabilising in recent months following a period of political and economic uncertainty. Demand in Indonesia slowed significantly in late 2013 and 1H2014 due to weaker economic conditions and the rapid devaluation of the rupiah. Airlines were impacted as most airline costs are fixed in US dollars and Indonesian carriers have not been able to sufficiently raise fares given the intense competition and price sensitiveness of Indonesian consumers. Demand was also impacted in the lead-up to the Jul-2014 presidential election.

Meanwhile, Indonesia's international market has been suffering from overcapacity due to rapid expansion at Garuda and foreign carriers. Garuda's international load factor in 1H2014 was a dismal 63% as RPKs dropped 3% despite 15% ASK growth. Garuda responded in 3Q2014 by cutting international capacity, joining Indonesia AirAsia in making adjustments. Indonesia AirAsia has decided to suspend fleet expansion until at least 2016. AirAsia is the largest airline group in Indonesia's international market while Garuda is second largest. Lion is by far the largest domestic carrier but has a very small international operation.

As is the case in Thailand, the outlook in Indonesia is starting to improve. Capacity is more in line with demand, political stability has returned following the inauguration of a new president and the rupiah has stabilised.

Indonesia's economy continues to expand rapidly, with GDP growth of more than 5% projected for 2014 and 2015. But infrastructure constraints and irrational competition remain long-term challenges.

Vietnam is also expected to record GDP growth of above 5% in 2014 and 2015. The Vietnamese aviation market is smaller - it is the smallest of the six major markets in Southeast Asia - but has huge potential and a more rational number of players.

Vietnam Airlines, which also has a 70% stake in Jetstar Pacific, and fast-expanding VietJet enjoy a virtual duopoly. There should be room for both groups to continue expanding and to complete planned public offerings.

Singapore is now a relatively mature market and has had a slowdown in passenger growth to less than 2% in 2014. But recent adjustments in the country's short-haul market, which has been suffering from overcapacity for the past year, should lead to improved profitability in 2015. Tigerair Singapore does not plan to take any new aircraft until 2018, while Jetstar Asia has suspended expansion until market conditions have fully recovered.

AirAsia, which is the third largest LCC in Singapore with about a 7% share of capacity, has also cut capacity in Singapore by reducing flights from Indonesia and Malaysia (Singapore's two largest international markets).

Singapore Airlines regional subsidiary SilkAir has slowed expansion by accelerating A320 deliveries. SilkAir has been the growth vehicle for the SIA Group, expanding capacity at double digit rates over the past four years, while SIA mainline growth has been in the low single digits. But SIA has dropped initial plans to grow ASKs at SilkAir by a further 12% in the fiscal year ending Mar-2015. SIA mainline is growing ASKs by only 1% as the group looks to other segments - such as long-haul low-cost through Scoot - or other markets (such as India through its new joint venture with Tata) for growth.

Double digit passenger growth, which Singapore enjoyed in 2010, 2011 and 2012, is unlikely to resume in the foreseeable future. But there are opportunities to unlock new growth by pursuing LCC transit traffic, particularly as Scoot resumes expansion in 2H2015 after an 18-month moratorium. SIA and Changi may also benefit as other flag carriers in the region cut back and restructure.

Malaysia is another Southeast Asian market which has been suffering from overcapacity over the past year. Malaysia had the fastest capacity and traffic growth in Southeast Asia in 2013, driven by ambitious expansion at Malaysia Airlines (MAS) and AirAsia X as well as the entry of Lion Group affiliate Malindo Air. But the Malaysian growth came at the expense of yield and was clearly not sustainable, particularly the rapid expansion at MAS.

MAS is expected to roll back the capacity added in 2013, when it grew ASKs by 17% and RPKs by 27%, as part of a new recovery plan from parent Khazanah. MAS is also slashing 6000 jobs by mid-2015, representing about 30% of its workforce, as part of a bid to narrow the cost gap with LCCs from 42% to about 15%. Like Thai, MAS has been long overdue for a deep restructuring. The MH17 and MH370 tragedies have exacerbated an already challenging situation.

MAS is planning to cut long-haul capacity and increase its reliance on partners and the oneworld alliance to cover markets outside Asia Pacific. AirAsia, AirAsia X and Malindo stand to benefit from any capacity cuts. But as MAS plans to increase its focus on the regional market within Asia Pacific, competition will likely remain intense. Malindo, AirAsia and AirAsia X only operate within Asia Pacific.

AirAsia has already significantly slowed expansion in the Malaysian market with seat capacity up only 1% in 1H2014 (ASKs were up by 3%). After nearly doubling its Malaysian operation over the past year, AirAsia X is now turning its focus to expansion at its two new joint ventures in Thailand and Indonesia.

Southeast Asia capacity share (% of seats) by group: Oct-2014 Source: CAPA - Centre for Aviation & OAG Note: group figures include subsidiaries and affiliates (for example Tigerair under SIA and Nok under Thai)

The AirAsia and Tigerair groups combined have deferred or cancelled 31 new aircraft deliveries (23 A320s at AirAsia and nine A320s at Tigerair), which were initially slated for 2014 or 2015. In addition, each group grounded 12 A320s in 2Q2014, which they have been trying to sell or sublease. SilkAir, Garuda and Citilink have also slowed fleet expansion.

Even the extremely ambitious Lion Group has slowed down expansion by starting to use its leasing subsidiary to place aircraft with airlines outside the group. However Lion is still adding aircraft into the Southeast Asian market at an alarming rate. The group is adding almost 20 aircraft in 4Q2014 alone and is projected to end the year with 179 aircraft.

This includes 148 in the Indonesian market, 21 in Malaysia and 10 in Thailand. AirAsia and AirAsia X plan to end 2014 with a combined fleet in Southeast Asia of 183 aircraft, including 99 aircraft in Malaysia, 42 in Thailand, 31 in Indonesia and 11 in the Philippines.

AirAsia is now only planning to add 13 aircraft in 2015, seven of which have been allocated to affiliates in Southeast Asia. AirAsia X also plans to expand its Southeast Asian fleet by seven aircraft in 2015. Lion, however, has approximately 60 deliveries slated for 2015, a staggering figure that will allow it to overtake AirAsia/AirAsia X as the largest group in Southeast Asia based on fleet size even if a large portion of these aircraft are leased out. Lion will also likely overtake AirAsia and AirAsia X based on seat capacity; currently the two are neck and neck with each accounting for about a 15% share of total seat capacity to, from and within Southeast Asia.

Tigerair has decided to halt deliveries until 2018 while Jetstar Asia has suspended growth. All the adjustments should give the Southeast Asian market an opportunity to start catching up with the overzealous capacity influx of the past year.

The demand environment is also starting to show some signs of improvement. Meanwhile the impending restructurings of MAS and Thai Airways should provide some relief to several competitors.

But more adjustments will likely be needed for a full recovery. Deferrals and aircraft sales have so far only been pursued by a few of the players. Consolidation has to date only taken place in the Philippines - with the AirAsia-Zest and Cebu Pacific-Tigerair Philippines deals - and in Indonesia, where there have been three smallish airline casualties this year (Tigerair Mandala, Merpati and Sky Aviation).

Myanmar still has nine airlines, with two more to launch in the coming months, a clearly unsustainable figure for a small albeit promising market. It is inevitable consolidation will come to Myanmar and other Southeast Asian markets as airlines struggle to cope with the recent losses.

But at the same time there is a threat that the launch of more start-ups and the possible strategic response by some incumbents to re-accelerate expansion could jeopardise a prolonged return to rational capacity levels.

Southeast Asia remains fundamentally a favourable market for airlines, with healthy economic growth and a fast expanding middle class. But competition is extremely intense. The market is not currently profitable and needs bigger and more permanent adjustments to enable airlines to cash in on the growth.