01-Nov-2011 12:01 PM

Aeromexico plans further capacity expansion following profitable 3Q2011

Analysis

Aeromexico has recorded another strong quarter of profits and expects continuing favourable market conditions in Mexico despite the challenging global economic environment. As a result, Mexico's only remaining legacy airline is planning to increase capacity by another 12% to 13% in 2012, driven partially by the launch of several new routes within Mexico and to the US.

The expected expansion of Aeromexico's US network is made possible by its expanded partnership with Aeromexico, which will be formalised over the next few weeks and will result in Delta taking a 4% stake in its SkyTeam partner.

Summary

Aeromexico plans to increase capacity by 12% to 13% in 2012, driven by new routes within Mexico and to the US.
The airline recorded a 33% decrease in net profit in 3Q2011, but excluding certain impacts, net profit was up 5% compared to the previous year.
Revenues in 3Q2011 increased by 24% due to a surge in traffic.
Aeromexico achieved a record-high load factor of 80.8% in 3Q2011.
The airline is confident that the Mexican market can absorb the planned capacity increases, citing a relatively solid Mexican economy.
Aeromexico is expanding its partnership with Delta, which will result in Delta taking a 4% stake in the airline.

Grupo Aeromexico turned a 3Q2011 net profit of MXP886 million (USD68 million), a decrease of 33% from 3Q2010. But when excluding the impact of Groupe Aeroplan's 3Q2010 investment in Aeromexico's frequent flyer programme, net profit in 3Q2011 was up 5% compared to 3Q2010. Aeromexico also recorded a 1% improvement in operating profit for 3Q2011 to MXP1.141 billion (USD87 million).

Revenues in 3Q2011 surged by 24% to MXP9.594 billion (USD734 million) as traffic (RPKs) was up 24%. Domestic passenger revenues were up by 26% to MXP4.675 billion (USD358 million) while international passenger revenues were up by 19% to MXP3.782 billion (USD289 million).

Total operating expenses increased by 32% to MXP7.554 billion (USD578 million), driven by a 58% increase in fuel costs (see 'Background information' below for full breakdown). Aeromexico was unable to pass on the extra cost of fuel to its passengers as yields were flat compared to the prior year.

Aeromexico reports record-high load factor for 3Q2011

Capacity at Grupo Aeromexico was up 19% in 3Q2011 and 24% through the first nine months of 2011. Demand has so far been sufficient to absorb this capacity increase as the group's load factor was up 0.2 ppt in 3Q2011 to 80.8%, which Aeromexico says was a record high for any quarter in its history. Through the first three quarters of the year, Aeromexico's load factor was up 1.7 ppt to 78.6%.

Aeromexico CEO Andres Conesa told analysts during a conference call to discuss the group's 3Q2011 earnings that capacity is projected to be up 15% to 16% in 4Q2011 and another 12% to 13% in 2012. While this represents a slower rate of growth than the 20% plus capacity growth rate Aeromexico has been pursuing over the last 12 months, the future growth poses significantly more risk. Over the last 12 months, Aeromexico's additional capacity simply filled the void left in the market by Mexicana, which ceased operation in Aug-2010. As Aeromexico and the country's three low-cost carriers have already fully absorbed Mexicana's 27% share of the domestic market, additional capacity increases now need to be met by an overall increase in demand in the total market.

Aeromexico confident 12%-13% capacity increase for 2012 is not too bullish

Mr Conesa is confident the market can absorb the planned capacity increases, telling analysts the Mexican economy remains relatively strong despite the global economic challenges. "The economic perspective in Mexico remains relatively solid," he says, pointing out that Mexico's GDP is still expected to grow by 3.8% in 2011.

Capacity will increase over the next five quarters as Aeromexico receives several aircraft from the 20 aircraft it is purchasing using proceeds from its Apr-2011 initial public offering. Mr Conesa says the group plans to end 2012 with a fleet of 115 to 116 aircraft, compared to 102 aircraft at the end of 3Q2011 and an expected 106 aircraft at the end of 4Q2011. During 3Q2011, the group took delivery of two additional E190s and one additional B737NG.

Grupo Aeromexico fleet as of end of 3Q2011

Grupo Aeromexico is slated to receive in 4Q2011 two additional B737NG, one additional E190 and one additional B767, giving it 44 B737s, 11 E190s and eight B767s. Mr Conesa says six more E190s and three more B737NGs are slated for delivery in 2012.

Mr Conesa says while the group is now planning "an important increase for capacity", it has the flexibility to quickly adjust its 2012 fleet plan in the event of an economic downturn. He explains that eight aircraft leases are expiring in 2012. For now the group plans to extend all of them but Mr Conesa says they can still be returned if necessary as part of its "well managed policy of risk with our lessors".

New Aeromexico pilots to be hired at lower wage scale

Aeromexico executives also point out that the upcoming fleet expansion will come with lower unit costs as new pilots being hired to support the growth are coming in at a lower wage rate. As part of a deal forged with Aeromexico's pilots union at the end of last year, the union agreed that any new mainline pilots would be hired under a newly established second tier. Aeromexico has not yet hired any new mainline pilots since Mexicana's collapse, despite increasing the size of its mainline fleet by nine aircraft, as the union, as part of the same deal, agreed to productivity improvements. Mr Conesa says pilots are now working 70 hours per month, compared to 55 hours per month previously, but as there is no room for further productivity improvements Aeromexico plans to start hiring additional mainline pilots next year.

Mr Conesa says a new deal with the carrier's flight attendants union will also be negotiated over the next few months with the aim of forging a similar contract to the pilots, maintaining the current level of benefits for existing crew but providing a second lower level for new hires. The group is also now hiring crews at regional subsidiary Aeromexico Connect, which operates the expanding fleet of E190s. Aeromexico in Jul-2011 forged a new contract with Aeromexico Connect pilots, allowing for increased efficiencies. Unit costs at Aeromexico Connect are being further reduced as the E190 is significantly larger than the subsidiary's ERJ145s.

Under the planned 12% to 13% capacity increase for 2012, Aeromexico is planning a relatively equal increase in both domestic and international flying. Mr Conesa says over the last year the carrier has directed about 70% of its additional capacity to the international market to the fill the void left by Mexicana on international routes, but "we expect a more balanced proposition next year".

Aeromexico plans to add four to five new domestic destinations in 1Q2012

Mr Conesa explains the additional E190s will mainly be used domestically, replacing ERJ145s on routes where the 50-seat aircraft is now too small. This will free up some of Aeromexico Connect's 39 ERJ145s to open new routes. Mr Conesa says there are still four to five destinations in Mexico such as Saltillo and Mazanillo the group does not serve. He says Aeromexico plans to start serving these destinations in 1Q2012, giving Aeromexico complete coverage of the domestic market.

Group Aeromexico currently has a 41% share of Mexico's domestic market, including a 21% share by Aeromexico Connect and 20% by Aeromexico mainline. Mexico's three LCCs, which have all expanded rapidly since Mexicana's suspension, now account for 54% of the domestic market. This includes a 25% share by Interjet, 18% by Volaris and 11% by VivaAerobus, based on data from Mexico's DGAC for the first eight months of 2011.

Mexico domestic market share by carrier: Jan-2011 to Aug-2011

Aeromexico plans up to four new US destinations in 2012

Most of the additional B737 capacity will be directed at the Mexico-US transborder market. Aeromexico has already added significant capacity to the US in recent months, launching since July service from Monterrey to Chicago and Brownsville; Guadalajara to San Francisco and Las Vegas; and Cancun to Miami.

Mr Conesa says Aeromexico will resume service to Delta's Atlanta hub in 1Q2012 with service from Mexico City and Monterrey. He says Aeromexico, which dropped Mexico City-Atlanta service in early 2009, is also now looking at another three new destinations in the US east coast for summer 2012, which could become viable under the new joint sales programme with Delta.

He did not elaborate which cities are being looked at but Aeromexico previously looked at Washington Dulles, which was served by Mexicana before it ceased operations. Aeromexico currently serves only one destination in the northeast US, New York JFK, which would leave open the opportunity for service to Boston, Philadelphia and Washington under the expanded Delta partnership.

Delta's planned investment in Aeromexico to be completed in Nov-2011

Aeromexico and Delta unveiled in Aug-2011 an expanded partnership which includes joint sales efforts, an expanded MRO tie-up and Delta investing in Aeromexico in exchange for a small equity stake. Mr Conesa says the transaction with Delta will be completed "within the next two to three weeks". Upon completion of the deal, Delta will receive an estimated 4% stake in Aeromexico, although the exact amount received will depend on the Mexican Peso-US Dollar exchange rate on the date the transaction closes.

While Aeromexico and Delta will jointly sell Mexico-US flights, revenue sharing and anti-trust immunity will not be pursued as the two countries do not yet have an open skies agreement. The expanded MRO partnership will result in Aeromexico's Guadalajara MRO facility expanding from four to seven lines in 2013. Mr Conesa says the MRO facility expansion is designed to support higher volumes of narrowbody heavy maintenance from the group fleets of Aeromexico and Delta, including E190s which previously were overhauled in the US. He says Aeromexico is also now looking at adding widebody capabilities at Guadalajara as the group is now incurring significant cost to ferry its B767s and B777s to overseas facilities when heavy maintenance is required.

Mr Conesa says Aeromexico may also look at taking over Mexicana's former MRO facility in Mexico City should it become available. The Mexican court overseeing Group Mexicana's bankruptcy is still trying to sell the company, including the MRO facility, with a few bidders now under consideration. Mr Conesa says if Mexicana isn't sold to new owners by 18-Nov-2011, the court is expected to start a liquidation process at which point the MRO facility could be purchased separately. "In that case the MRO is a valuable asset they have," Mr Conesa says. "We would certainly be interested in taking a look at doing something and expanding our MRO capacity. It's too soon to say."

Re-launch of Mexicana could pose new competitive threat to Aeromexico and LCCs

If Mexicana is sold as a group and the carrier is successfully re-launched, Aeromexico and Mexico's three LCCs would suddenly face the prospect of having to compete against a second legacy carrier. But Mr Conesa is not too concerned about the potential impact of a re-launched Mexicana. He points out Mexico's LCCs would be more impacted if Mexicana resumes services to the US as some of Mexicana's traffic rights under the existing US-Mexico bilateral were temporarily awarded to the LCCs. These temporary rights could be revoked if Mexicana re-launches while all of Aeromexico's US rights are permanent.

Volaris, which has a partnership with Southwest Airlines, has been directing most of its additional capacity this year at the US market. Volaris currently accounts for 7% of total capacity in the Mexico-US market, compared to 17% for Aeromexico and only 1% for VivaAerobus, which is starting to pursue modest expansion of its very small international operation. Interjet, which currently does not serve the US, last week unveiled plans to launch its first US route, Mexico City-San Antonio, with two daily flights commencing at the beginning of Dec-2011.

If it resumes operations, Mexicana will likely focus on the US market. Mexicana was the largest Mexican carrier in the US market and - despite the capacity increases by Aeromexico, Mexico's LCCs and US carriers - Mexicana's previous capacity in the US-Mexico market still hasn't been completely absorbed by other carriers. Mexicana's share of the domestic market, however, has already been fully absorbed by other carriers, making a re-launch of domestic services less appealing.

Mexican carriers accounted for only 17% of total traffic in Mexico's international market over the first eight months of 2011, indicating there is potentially room for a re-launched Mexicana in the international market. But competition with foreign carriers is already fierce and a re-launched Mexicana will also have to overcome a stronger Grupo Aeromexico, which now accounts for 91% of total international capacity provided by Mexican carriers.

Share of Mexico's scheduled international traffic by carrier nationality: Jan-2011 to Aug-2011

Mexico's international traffic (millions of passengers), first eight months of 2011 vs first eight months of 2010

A re-launched Mexicana may also focus on the charter market. Grupo Aeromexico now has its own charter operation but Mr Conesa expects minimal impact if Mexicana re-launches as a charter carrier given the small size of Aeromexico's charter business. It is also hardly a certainty that Mexicana will be able to re-launch. Over the last 14 months, several potential bidders have emerged for Mexicana but until now all have walked away when it came time to put money on the table. The prospects for sustaining a second legacy carrier in Mexico are bleak given the size of the market and the strong penetration of LCCs.

Over the 15 months Aeromexico also has been rapidly expanding its Latin American network, adding six destinations in the region including Caracas in Venezuela in Oct-2011. No further expansion of Aeomexico's Latin American network is planned as Mr Conesa believes with the recent addition of Caracas the carrier now serves all the important points in Latin America.

While Aeromexico is taking delivery of an additional B767 in 4Q2011, the carrier is also not planning to add any capacity to Asia or Europe. The additional B767 will instead be used to improve the reliability of its existing long-haul operation, which has seen significantly higher widebody utilisation rates as a result of expansion after Mexicana's collapse. Aeromexico now uses its relatively small widebody fleet of 11 aircraft to serve Spain, France, China, Japan as well as the southern part of South America.

Aeromexico increases B787 commitment from five to seven aircraft

After the eighth B767 arrives later this year, Aeomexico is not planning any further increase in its widebody fleet until Aug-2013, when the first of the carrier's B787-8s is slated for delivery. Mr Conesa revealed during the analyst call that Aeromexico recently secured two more delivery slots for B787s, lifting its commitment from five to seven of the type. He says all seven B787s will be delivered within three years, allowing for a rapid phase out of the carrier's entire B767 fleet.

For at least the medium term, Aeromexico will continue to operate its four B777-200s, which are now primarily used on its Asian routes to Shanghai and Tokyo. Mr Conesa says Aeromexico has been trying to secure additional B777-200ERs but as it was unable to find any suitable high gross weight aircraft, a requirement for operating long-haul routes from the high altitude of its Mexico City hub, it had to settle on additional B767s. Aeromexico quickly added two B767s after Mexicana's collapse, using the aircraft primarily to increase capacity on routes to southern South America.

Conclusion: Mexican market risks returning to overcapacity scenario

Aeromexico's outlook remains relatively positive. After several consecutive years of losses the group has now been profitable since early 2010. But there are uncertainties. The Mexican market historically has been oversaturated, making it difficult for sustainable profits, and there is a risk that once again there will be too much capacity in Mexico.

Now that the void left by Mexicana has been filled by other carriers, from here on in any additional capacity will need to be supported with a corresponding increase in demand. The double-digit capacity increase planned for Aeromexico next year plus the even higher double-digit capacity increases planned by all three of Mexico's LCC as well as the potential re-launch of Mexicana could be too much for the market to bear - even under good economic conditions.

If Mexico's economy slows down, the situation could quickly become ugly. Mexico's economy for now remains relatively solid but economic conditions in the past have rapidly deteriorated in Mexico. The country is far more reliant on the US than other Latin American countries, making economic growth unlikely during any period of downturn for North America and Europe. Mexico's aviation market has been unusually healthy since Mexicana's collapse, as capacity levels have finally been in tune with actual demand. Aeromexico is clearly hoping the good times will continue to roll but that could require more conservative capacity plans from all of Mexico's carriers.

Conversion rate used: USD1 = MXP13.07

Background information

Aeromexico financial highlights: 3Q2011 vs 3Q2010