25-Oct-2012 5:04 PM

AirAsia faces uphill battle in Indonesian domestic market after dropping plans to acquire Batavia

Analysis

AirAsia’s decision to drop plans to acquire Indonesian carrier Batavia Air leaves the group with the daunting task of having to rely on organic growth to increase its share of Indonesia’s booming but crowded domestic market. Southeast Asia’s leading LCC group is now the sixth largest player in the region’s biggest domestic market, a glaring weakness in an otherwise strong portfolio that it was aiming to overcome by acquiring Batavia.

The Batavia acquisition, while against the grain of normal AirAsia strategy, would have given the group a respectable third place position in Indonesia’s domestic market. Batavia would have also given AirAsia slots at Jakarta’s congested airport and access to a valuable local distribution network. Perhaps most significantly the Batavia deal would have allowed AirAsia to compete more effectively against fast-expanding Indonesian LCC group Lion Air, which has emerged as a bigger rival to AirAsia than the more well known Jetstar or Tiger groups.

The AirAsia Group initially unveiled plans to buy a 49% stake in Batavia for USD40 million at a high profile signing ceremony in Jakarta in Jul-2012. The group initially said it expected in 2Q2013 to conclude the transaction, which also involved its Indonesian partner Fersindo acquiring the remaining 51% from Batavia’s existing private owners. But AirAsia announced on 15-Oct-2012 it had decided not to move forward with the proposed deal, saying there were too many risks.

Potential integration challenges derailed AirAsia-Batavia transaction

Batavia would have become AirAsia’s second affiliate in Indonesia after Indonesia AirAsia, which is also 49% owned by the Malaysian-listed AirAsia Group and 51% owned by Fersindo. But the AirAsia Group never divulged details on how it would handle coordinating two operating certificates and two brands, or sub-brands, in one market. Batavia, which is considered a full-service carrier as it offers some frills (such as drinks and snacks) as part of its all-economy product, was expected to continue operating independently although a partial re-branding (perhaps to Batavia AirAsia) and the adoption of the LCC model was likely.

Acquiring an existing airline, particularly an airline that is not a LCC, is against the norm for AirAsia. The Group has traditionally launched new affiliates by establishing new joint venture companies or by taking over defunct carriers (such as the case with Indonesia AirAsia, which was formerly known as AWAIR), allowing it to inherit an existing operator’s certificate while still having the opportunity to create something from scratch with low-cost DNA. Batavia has its own corporate culture and legacy type of inefficiencies which would have been difficult to erase, particularly given Indonesia’s labour laws.

Batavia also presented AirAsia with potentially costly fleet integration issues as Batavia operates a mixed fleet consisting of over 30 A320s, 737-300/400/500s and A330s. Indonesia AirAsia only completed its transition to an all-A320 fleet in late 2011.

Under AirAsia, Batavia would have looked to phase out its 737s but accelerating fleet renewals is often a costly exercise as Indonesia AirAsia found out in 2011, when early aircraft returns had an impact on the carrier’s financials. Indonesia AirAsia turned an operating profit margin of only 4% in 2011, compared to 27% at AirAsia Malaysia and 12% at Thai AirAsia. Indonesia AirAsia did not perform much better in 1H2012, reporting an operating profit of IDR93.1 billion (USD10 million) and a 5% operating profit margin, which was once again well below the margin of its sister carriers in Malaysia (19%) and Thailand (9%).

AirAsia Group CEO Tony Fernandes had refused to say whether Batavia would continue operating its small widebody fleet of two A330s, which the carrier uses on its service to Jeddah in Saudi Arabia and some trunk domestic routes such as Jakarta-Medan, or if transferring the aircraft to Malaysia-based low-cost long-haul carrier and A330 operator AirAsia X was an option. The decision to formally call off the acquisition hardly came as a surprise because over the last two months it became increasingly clear that integration challenges had been underestimated and the deal would not be completed.

Indonesia AirAsia to proceed with IPO despite weak position domestically

With the Batavia deal formally called off, the AirAsia Group is now able to move forward with a planned initial public offering at Indonesia AirAsia, which is likely to take place in early 2013. The IPO was originally planned for 3Q2012, shortly after the IPO at Thai AirAsia and before the upcoming AirAsia X IPO, but was postponed after the Batavia deal was announced. While investors now have a clearer picture of Indonesia AirAsia’s position in the market, the Group’s overall position in Indonesia has been weakened as without the Batavia deal AirAsia will likely struggle to meet its goal of becoming a significant player in the domestic market.

AirAsia established its original Indonesian affiliate in 2004 but the carrier has been slow to expand (it currently only operates a fleet of 19 A320s) and had to abandon its original strategy of competing across domestic trunk routes after losing a fierce battle against much larger Lion. In recent years Indonesia AirAsia has been focusing almost entirely on the much smaller international market, where it is now Indonesia’s largest carrier and has successfully been able to leverage the powerful international brand of AirAsia.

Indonesia AirAsia currently allocates 64% of its seat capacity and 76% of its ASKs to the international market, according to Innovata data for the week of 22-Oct-2012 to 28-Oct-2012. Most of Indonesia's other carriers are more domestic focused as the domestic market is more than seven times the size of the international market. In 2011 Indonesian carriers transported 60.2 million domestic passengers but only 8.2 million international passengers, according to Indonesian DGAC data.

Indonesia AirAsia carried only about 1.3 million domestic passengers in 2011, giving it only a 2% share of Indonesia’s domestic market. It is currently the eighth largest domestic airline in Indonesia, after Lion, Garuda, Sriwijaya, Batavia, Merpati, Wings and Citilink. As a group AirAsia is the sixth largest player, behind Lion, Garuda, Sriwijaya, Batavia and Merpati (as Wings is the regional subsidiary of Lion, and Citilink is the low-cost subsidiary of Garuda).

Indonesia domestic market share (% of passengers carried) by airline group: 2011

Indonesia AirAsia only serves eight domestic destinations, giving it a network that is much smaller than its competitors and surprisingly small given the vast size of the country and the fact that Indonesia in 2011 had 20 airports with at least one million domestic passengers. Batavia, in comparison, serves 41 domestic destinations. Indonesia AirAsia has eight international destinations while Batavia has seven.

As an ASEAN-branded carrier and ASEAN's largest LCC group, AirAsia has been keen to have a larger presence in ASEAN’s largest domestic market. Indonesia’s domestic market grew by 16% in 2011 and is projected to continue expanding at an annual clip approaching 20%, reaching an estimated 100 million passengers in 2015 and 180 million passengers in 2021. With about 70 million passengers projected for 2012, Indonesia is poised to overtake India as the fifth largest domestic market in the world after the US, China, Brazil and Japan. (India had only a half million more domestic passengers than Indonesia in 2011.)

AirAsia earlier this year moved its regional headquarters to downtown Jakarta, reflecting its pan-ASEAN branding (as the ASEAN secretariat is in Jakarta) but also how important the Indonesia market has become to the group. Indonesia accounts for nearly half of the ASEAN’s total population and has the characteristics LCCs dream about: archipelago geography that means airlines typically compete against boats rather than trains or buses on short-haul routes, a growing middle class and a booming economy. AirAsia cannot afford to continue to ignore Indonesia’s domestic market.

Indonesia AirAsia plans to pursue rapid fleet growth but from a small base

Indonesia AirAsia will now pursue domestic growth organically and said immediately after the Batavia deal was dropped that it plans to triple the size of its fleet over the next five years. The approximately 40 additional aircraft are envisioned to support annual growth in both the domestic and international market exceeding 20%. Indonesia AirAsia says the growth will include additional bases and a focus on eastern Indonesia, where the carrier currently does not have a presence. Its easternmost destination is Bali, which is in the middle of the very wide country, some 3,000 miles from east to west.

While the fleet expansion should ensure Indonesia AirAsia maintains its position as market leader in the international market, Indonesia AirAsia's market share domestically is likely to remain in the single digits. Even if equal domestic and international growth is pursued over the next five years (about 20 aircraft for each market), AirAsia domestically would still be smaller than the present day size of Batavia and Sriwijaya. Lion, Wings, Garuda and Citilink meanwhile have the aircraft orders in place that will result in each of these carriers adding more aircraft than Indonesia AirAsia, albeit from a higher base.

All seven of the airlines that are currently larger in the domestic market than Indonesia AirAsia have the ambitions, and in most cases the fleet plans, in place to maintain their market share as the market continues to grow at high double-digit clips. This leaves little room for smaller carriers or start-ups unless there is consolidation.

Indonesia AirAsia told CAPA in Sep-2012 that the carrier planned to add two A320s in 4Q2012 and five A320s in 2013, which would give the carrier a fleet of 26 aircraft at the end of 2013. Now that the Batavia deal has been dropped, it is possible the AirAsia Group will allocate Indonesia AirAsia more than the five A320s initially planned for 2013.

Indonesia AirAsia said the two aircraft to be added in 4Q2012 will be used to increase capacity on international routes including Jakarta-Bangkok. The plan for 2013 is to pursue a combination of domestic and international growth.

Batavia has strength in distribution – and AirAsia may tap into that with enticing but difficult alliance proposal

The AirAsia Group has also said that it now plans to pursue an alliance with Batavia that could cover ground handling, pilot training and distribution (there has been no mention of codesharing). Access to Batavia’s local distribution network would be particularly enticing to AirAsia. Batavia has a network of 5,000 authorised travel agents, which had been cited by AirAsia as a key benefit of the proposed acquisition.

Indonesia AirAsia’s lack of a local distribution network is viewed as the main reason why the carrier has struggled to gain a foothold domestically. All of Indonesia’s major domestic carriers rely heavily on its network of travel agents, including market leader Lion, as web booking penetration levels remain low in the country – and, critically, the portion of the population that have credit cards also remains low.

But cooperation with Batavia on distribution could be difficult to pull off especially if Indonesia AirAsia makes a new push into the domestic market, intensifying competition between the two carriers. AirAsia’s plans for alliances or cooperation with other carriers also have a track record of never materialising – for example with Jetstar and most recently with Malaysia Airlines. (The Jetstar one was questionable from the start while the MAS deal encountered government and MAS union troubles.)

The lack of a local distribution network has led Indonesia AirAsia to focus more in recent years on markets with a higher portion of non-Indonesian passengers. Foreigners travelling to or within Indonesia have been a relatively easy target market for Indonesia AirAsia because non-Indonesians are more likely to book tickets online, have credit cards and because the AirAsia brand, while relatively weak compared to competitors in Indonesia, is stronger compared to competitors outside Indonesia.

The popular resort destination of Denpasar (Bali), which features a larger portion of non-Indonesian passengers than Jakarta, has particularly been a successful market for Indonesia AirAsia and the AirAsia Group overall. The Group accounts for about 20% of international capacity, including flights from Indonesia AirAsia and AirAsia Malaysia, at Bali. The island’s Ngurah Rai Airport in Denpasar is Indonesia’s third largest airport and second largest international airport.

Bali international capacity (seats) by carrier: 22-Oct-2012 to 28-Oct-2012

Indonesia AirAsia currently offers 290 weekly frequencies at Bali to seven destinations: three international and four domestic. The carrier offers about 52,000 weekly seats and bases four of its A320s at Bali. On both counts this makes Bali the carrier’s second largest base, only slightly behind Jakarta.

Indonesia AirAsia's eight domestic destinations by capacity (seats) and size of base: 22-Oct-2012 to 29-Oct-2012

Destination/base	Weekly Seats	Number of A320s at base
Jakarta	63,360	8
Denpasar Bali	52,200	4
Bandung	30,240	3
Surabaya	27,720	3
Medan	17,640	1
Yogyakarta	12,600	0
Semarang	5,040	0
Pekanbaru	2,520	0

While Jakarta has slightly more overall capacity, Bali is Indonesia AirAsia’s largest domestic base in terms of domestic seats. While Bali represents a bigger inbound market than other Indonesian destinations when it comes to the international market, domestic routes at Bali also attract a larger share of foreigners than other Indonesian domestic trunk routes. The construction of a new terminal, which began earlier this year, should provide AirAsia the space to further grow its Bali operation in both domestic and international markets.

An AirAsia widebody base is also under consideration for Bali as long-haul low-cost sister carrier AirAsia X looks to establish a second base after Kuala Lumpur, possibly in 2013. Tokyo and Bangkok are also possibilities, part of rapid growth in coming years at AirAsia X. While Indonesia AirAsia has become Indonesia’s largest international carrier, it currently only serves other countries in Southeast Asia and Australia's Perth (AirAsia X's other Australian destinations of Gold Coast, Melbourne and Sydney are out of narrowbody range for AirAsia).

A widebody base in Indonesia from AirAsia X or Indonesia AirAsia would help ensure the AirAsia Group maintains its leading position in Indonesia’s international market. Bali would be the most logical base given AirAsia’s strong international brand and the current congestion issues at Jakarta.

Indonesia AirAsia looks to expand further at Bandung

Indonesia AirAsia has also built up a successful niche at much smaller Bandung, where it is currently the second largest carrier and is only slightly behind Lion. Bandung is the third largest city in Indonesia but its airport in 2011 only handled 938,000 passengers, making it the 21st largest in Indonesia. Indonesia AirAsia currently operates 168 weekly frequencies at Bandung to six destinations: four domestic and two international.

A runway extension that was completed in 2011 has unlocked new growth opportunities for Bandung and led to expansion over the last year for AirAsia as well as the launch of flights by Singapore Airlines' regional subsidiary and A320 operator SilkAir. Previously the airport could be served with some variants of the 737 but not A320s and it is no coincidence Indonesia AirAsia waited to phase out its final batch of 737s until after the runway extension opened.

Bandung is well positioned for rapid growth as it is located only about 150km from Jakarta and is more convenient than Jakarta’s Soekarno Hatta International Airport to some portions of Jakarta’s booming and expansive metropolitan area. Congestion at Jakarta and the fact that Soekarno Hatta is located to the west of Jakarta while Bandung is to the southeast make it an attractive alternative.

Indonesia AirAsia says Bandung’s catchment area is about 45 million people. The carrier is now pressing the government airport operator Angkasa Pura II to build a second terminal to accommodate its expected growth. According to Angkasa Pura II, the current Bandung terminal was designed to handle only 350,000 passengers per year.

Space is limited at Bandung given the airport’s location near the city, making the construction of second runway impossible. But Indonesia AirAsia believes a second terminal can be added and is advocating that the second terminal follow a basic design and potentially be only used for low-cost carriers. Indonesia until now has not constructed a LCC terminal.

Indonesia slow to embrace pure LCC model

In many ways Indonesia has not fully embraced the concept of LCCs although the market is a natural high growth LCC market. As AirAsia has discovered, Indonesia is a unique market that presents challenges to the pure low-cost model.

The importance of partnerships with local travel agents, which are connected to most Indonesian carriers through a relatively low-cost distribution network rather than GDSs, cannot be underestimated in Indonesia. A network model with connectivity is also important given Indonesia’s geography requires multiple hubs. Indonesia AirAsia is a point-to-point operator while all the other main players, including Lion, rely significantly on connections. The AirAsia Group in recent years has built up a connecting flight network with its "Fly-Thru" service, but this is not available for domestic transfers in Indonesia.

Lion also has a regional subsidiary which operates turboprop aircraft and provides feed from smaller markets. Garuda is now looking to replicate this model by acquiring turboprops for its LCC unit Citilink. AirAsia earlier this year looked at adding smaller aircraft, which could help Indonesia AirAsia compete in smaller domestic markets, but for now have decided against the idea.

Over the years even Lion has been reluctant to define itself as a LCC. Lion is now considered by most as a LCC as it charges for frills including drinks and snacks and nearly its entire fleet is in all-economy configuration, although it continues to have a business class on a small portion of its fleet and offers a 20kg luggage allowance. While selling drinks and snacks, Citilink also now offers complimentary checked luggage, which it says it would like to charge for but has to wait until the market becomes more educated with the concept. That leaves Indonesia AirAsia and new Tiger Airways affiliate Mandala as the only pure LCCs competing in the domestic market but with market shares in the very low single digits.

Positioning of Indonesia’s major airline brands: 2013

In the international market the pure LCC model is more common as Indonesia AirAsia is the largest Indonesian international carrier, accounting for 42% of all international passengers carried by Indonesian carriers in 2011. Based on current capacity figures, Indonesia AirAsia accounts for about 17% of the total market (includes foreign carriers). AirAsia Malaysia accounts for another 8% of total international capacity and Thai AirAsia less than 1%, giving the AirAsia Group about a quarter of total international capacity to/from Indonesia.

Indonesia international market share* (% of passengers carried) by carrier: 2011

Indonesia international capacity share (% of seats) by carrier: 22-Oct-2012 to 28-Oct-2012

Overall, LCCs currently account for about 42% of international seat capacity in Indonesia. In addition to the 25% share for the AirAsia Group, the 42% figure includes an 8% share for Lion, a 5% share for the Jetstar Group and just over 2% for the Tiger Airways Group (including Tiger Singapore and Mandala).

As a group, AirAsia now links Kuala Lumpur with 15 destinations in Indonesia. Seven of these destinations (Balikipapan, Banda Aceh, Padang, Palembang, Solo, Makassar and Lombok) are now only served by AirAsia Malaysia and do not yet have any service from Indonesia AirAsia. This illustrates how far behind AirAsia is in exploiting opportunities in Indonesia’s domestic market. The carrier currently only links Jakarta with three domestic destinations: Bali, Semarang and Yogyakarta.

AirAsia needs to move fast in Indonesia as rival Lion is racing ahead

Despite its very small presence in Southeast Asia’s largest domestic market, AirAsia is still ASEAN's largest LCC group. But Lion is already bigger in ASEAN than the Jetstar or Tiger groups and has also overtaken AirAsia as the largest airline group in the intra ASEAN-market based on current capacity figures on routes within Southeast Asia.

While Lion is primarily a domestic operator, it is expanding its international network in Indonesia and plans to launch in 2013 a new joint venture carrier in AirAsia’s original home market of Malaysia. Clearly AirAsia is watching Lion closely as Lion determines where to place the 300-plus aircraft it has on order.

The proposed Batavia acquisition was seen as an attempt by AirAsia to close some of the gap with Lion in the Indonesian domestic market and therefore in the overall ASEAN market. Lion in many respects has emerged as AirAsia’s biggest competitor and Mr Fernandes will not let Lion get in the way of his goal of maintaining AirAsia's leading position in the ASEAN market.

An acquisition of another Indonesian carrier should not be ruled out and if any Indonesian carrier should fail in the intensely competitive market AirAsia will almost certainly swoop in with rapid organic growth. AirAsia simply cannot afford to be a minor player in what has emerged as the fastest growing country in Asia.

This is the first in a series of articles on Indonesian carriers and the Indonesian domestic market