ANA looks for international acquisition: talks with Philippines Airlines productive but not end game

All Nippon Airways is sitting on USD1.8 billion of cash

ANA is effectively in the relatively fortunate - and rare - position of being an airline with too much cash on its hands.

In Aug-2012 ANA raised JPY174.8 billion (USD1.8 billion) by issuing 991 million shares, bringing total shares to 3.5 billion. When ANA announced the capital raising in Jul-2012, it said it planned to offer 914 million shares in a public offering and 86 million shares in a secondary offering jointly worth as much as JPY211 billion (USD2.2 billion). The intent was that the proceeds would "be applied to capital expenditure, including the acquisition of aircraft, chiefly the fuel-efficient Boeing 787 aircraft (i.e. the 787-8 and 787-9 models), by the end of March 2015 for the main purpose of expanding the international route network."

With a backlog then of over 40 787s, the capital raising made some sense, although some also thought broader: rival Japan Airlines was preparing to re-list on the Tokyo Stock Exchange and ANA perhaps wanted to provide an alternative business for those looking to invest in the airline sector. But then ANA's intentions to purchase a foreign airline came into focus.

Intentions are to invest in growth outside of Japan - but then ANA raised its stake in StarFlyer

In addition to ANA's statement on using the raised funds to finance the purchase of 787s, was a brief and opaque statement that ANA was also seeking to establish "a financial base that is able to respond in a timely and flexible manner to future growth opportunities, aiming to establish a multi-brand strategy based in Asia". The statement received little attention - the first part about responding seemed generic while the second part, about a multi-brand strategy, did not seem new as ANA had two LCC brands AirAsia Japan and Peach (and from Oct-2013 will assume full control of AirAsia Japan).

As ANA clarified its intent to invest in foreign airlines in order to secure new channels of growth in population-declining Japan, the market became confused over what benefits ANA could bring, especially with foreign ownership control restrictions still pre-eminent in Asia.

The market was already concerned ANA's capital raising had diluted shareholder value. As CAPA previously wrote:

ANA can bring to an airline cash - but perhaps little else. ANA acknowledges its direct operation cannot be exported. Although it speaks of know-how and processes it has accumulated, their use internationally would have limits; Japan like much of North Asia has been a stagnating, not innovative, market. Costs are high, a reflection of fixed costs but also not seeking to cut them down.

The experience of ANA in establishing LCC Peach was that Peach's cost base became inflated as it inherited legacy ANA practices. AirAsiaJapan in comparison made a far greater effort to stay at arm's length from ANA, as did Jetstar Japan with partner JAL. Incidentally, the market favours Jetstar Japan because of how little involvement there is from JAL, which had billions in debt before filing for bankruptcy.

LCCs like AirAsia and Jetstar bring considerable intellectual property in terms of making airlines more efficient, but ANA has few such comparisons to bring to the table.

ANA has highlighted it is looking at airlines within Asia where there is "strong economic growth" and at where it can achieve least 8% ROA and 10% ROE. A stake in a full-service carrier should create "synergy" with the ANA brand while an investment in a LCC would provide for "early expansion". ANA would also seek to leverage its "resources and know-how" as well as the "value offered from the ANA brand".

ANA is making corporate changes to support possible acquisitions by moving to a holding company structure. Whereas previously various units (including ANA Wings and AirAsia Japan) were under ANA the airline, a new holding company will look after the individual operations. ANA Wings and AirAsia Japan, on paper, will report to the holding company and not ANA the airline.

ANA speaks of likely wanting to take a role in management of a carrier it invests in, but even with a minority non-controlling interest, its day-to-day benefits are not immediately clear.

See related reports:

• ANA's capital-raising and international acquisition strategy raise questions for investors
• All Nippon Airways would invest in airlines as part of strategy to counter Japan's declining economy

ANA's next move was to invest further in StarFlyer, a small and primarily domestic full-service Japanese airline. While the investment did not fit with ANA's aspirations to invest in foreign LCCs, StarFlyer has some successful niches and the additional stake was relatively inexpensive.

Foreign Asian carriers remain the target, and after very preliminary talks with Indian carriers (whose government was then on the brink of allowing foreign airline investment), ANA was quiet on the scene until San Miguel Corporation on 08-Jul-2013 made a statement to the Philippine Stock Exchange saying it had been in talks with ANA - but not Emirates, as reported - about a partnership with Philippine Airlines. San Miguel owns 49% of Philippine Airlines' parent company PAL Holdings.

The remaining 51% is owned by Lucio Tan's LT Group. LT Group is looking to sell its 51% stake and San Miguel has first right of refusal. The thinking seems to be San Miguel would welcome a stake from a high profile international carrier that could help manage PAL. If no domestic shareholder is brought in, San Miguel would need to raise its stake to satisfy local majority ownership requirements.

Although it is unusual to confirm ownership talks so explicitly, announcing the mighty ANA had interest (to whatever level) in PAL would have given a boost to San Miguel and LT's plans.

The Philippines has a large but low yielding and congested LCC scene

What might ANA see in PAL - other than availability? The Philippines has one of the world's largest LCC markets.

LCC capacity share (%) of total domestic seats in the Philippines: 2001 - 2013*

Source: CAPA - Centre for Aviation with data provided by OAG
Note: * Year to Month indicated. PAL Express, formerly known as AirPhil Express, is included in LCC capacity share for 2013 although it is no longer considered an LCC.

LCC capacity share (%) of total international seats in the Philippines: 2001 - 2013*

Source: CAPA - Centre for Aviation with data provided by OAG
Note: * Year to Month indicated. PAL Express, formerly known as AirPhil Express, is included in LCC capacity share for 2013 although it is no longer considered an LCC.

But this is an intensely competitive and low-yielding market. In recent times the largest, Cebu Pacific, has been the only profitable carrier.

Philippines domestic seat capacity by carrier: 22-Jul-2013 to 28-Jul-2013

Source: CAPA - Centre for Aviation and Innovata

The market should improve now that some competition has been taken out: AirAsia Philippines has partnered with Zest Air while PAL Express, previously known as AirPhil Express, has adopted a full-service model (although not necessarily the right move for that business).

As CAPA previously wrote:

AirAsia Philippines, Zest and SEAir all struggled in 2012 as the Philippine domestic market was plagued by over-capacity and intense competition. The Philippine domestic market grew by nearly 10% to 20.6 million passengers but capacity was up by 16% to 28.3 million seats.

As a result the average seat load factor fell to about 73%, a very low figure for a price sensitive market that is primarily penetrated by low-cost carriers. (LCCs accounted for 80% of domestic passenger traffic in the Philippines during 2012, giving the Philippines the highest domestic penetration rate in the world.)

Zest saw its domestic seat load factor slip to 65.6% in 2012 as its passenger traffic dropped by 4%, despite an 8% increase in seat capacity. Smaller and newer AirAsia Philippines and SEAir suffered even more, recording domestic seat load factors of only 44.5% and 58.8% respectively. This highlights the challenges the carriers were faced with as they entered domestic trunk routes although the figures are not surprising given their very small market share and the unfavourable market conditions, which made it particularly tough for new entrants.

See related reports:

• AirAsia Philippines and Zest Air outlook improves following tie-up, but challenges remain
• Cebu Pacific sees bright outlook for 2013 as rationality returns to Philippines market
• Philippine Airlines group faces challenging future after exiting budget carrier sector
• Philippine Airlines banks recovery on international expansion but faces uphill battle

There are growth opportunities in the Philippines, but in the medium term it is difficult to see another carrier entering the short-haul LCC market given the existing conditions. Rather, it is likely the current players will grow. To capture some of this market, ANA could theoretically look to use Philippine Airlines.

Philippine Airlines no longer has a LCC strategy

Practically, if ANA were interested in PAL to access the low-cost market in the Philippines, PAL would be a complicated choice as the carrier contentiously abandoned its LCC strategy to focus on the full-service segment. In the Philippines' highly price sensitive market this segment is considerably smaller than in, for example, Hong Kong where Cathay Pacific is firmly focused on the full-service segment with apparently no intentions of entering the low-cost market with a separate entity.

Singapore Airlines and its SilkAir unit are focused on the full-service market, but SIA also has part ownership in short-haul LCC Tiger Airways and full ownership of long-haul LCC Scoot.

As CAPA previously wrote:

The outlook for Philippine Airlines (PAL) remains relatively bleak following a strategy shift which has resulted in the group exiting the budget end of the market. Transitioning low-cost sister carrier AirPhil Express into full-service regional carrier PAL Express may succeed at improving the group's short-term financials but at the expense of growth and market share. The PAL Group will likely see its share of the Philippines domestic passenger market slip to less than 35% in 2013, compared to 42% in 2012.

The shift in strategy, which leaves PAL focusing entirely on the much smaller but less competitive top end of the Philippine market, follows the Apr-2012 ownership change at PAL and AirPhil. The new majority owner of both carriers, the San Miguel Group, has brought new life into the group, providing a badly needed recapitalisation which is being used to pursue fleet renewal and growth of its long-haul network.

But in the domestic and short-haul international markets PAL is suffering and the prospects are not bright given some of the decisions made by San Miguel during its first year running the PAL Group.

ANA is still learning how to operate a dual brand strategy of a full-service carrier and low-cost carrier operating alongside each other. ANA has its mainline division as well as a minority stake in Peach and majority control in AirAsia Japan. And, from late Oct-2013, ANA will have full control of AirAsia Japan following the AirAsia Group's exit. The trauma to AirAsia Japan, less than a year old, is sourced from ANA's legacy/high cost inclinations but also the AirAsia Group's unwillingness to adapt to the local market the way Peach and Jetstar Japan have, in areas like distribution outlets and check-in times.

ANA will gain a lot more experience - and not necessarily all positive - once it takes complete control of AirAsia Japan and has no other investors to make decisions with.

It would be extremely challenging for ANA, which has little LCC experience in a still-nascent Japanese LCC market, to try to implement a dual brand strategy in a more developed and competitive LCC market like the Philippines. Additional factors like culture clash would further make for a trying experience that is perhaps best left uninitiated. ANA would be no stranger to the complexities of the Philippines market.

Does ANA see potential in the Philippines as a low-cost pan-Asian hub?

ANA is seeking LCC growth across Asia. But the Philippines is a relatively niche market heavy on travel due to larger numbers of foreign Filipino workers. There is tourism, but nowhere on the scale of Thailand. There is a market for greater LCC travel from Northeast Asia to Southeast Asia. While the latter region is congested and the former still emerging, LCC traffic between the regions remains light.

AirAsia X, Jetstar and Scoot currently have the main offerings. One of the strategy planks behind Jetstar Hong Kong - and now Hong Kong Express - is to use Hong Kong's geography to link Northeast Asia with Southeast Asia via Hong Kong. Narrowbody flights would be possible in both directions from Hong Kong, and broadly from the Philippines too. Cebu already serves northern points in China, Korea and Japan and as far south as Jakarta and Denpasar.

Could ANA use the Philippines as a pan-Asian hub? The Philippines' geography, well east of continental Asia, provides some efficient routings from Southeast Asia to Japan but not from Southeast Asia to more inland points like China and Korea, which have greater growth prospects than Japan. Even Cebu Pacific has not focused on connecting traffic, which is fairly volatile and competitive. There would also need to be infrastructure changes to better support connections. This is also an unlikely avenue for ANA to explore.

Using the Philippines as a full-service hub would be challenging too

That leaves the last theoretical major offering: to use a stake in PAL to benefit from long-haul traffic. This is not without challenges. As CAPA recently wrote:

Philippine Airlines (PAL) is preparing an ambitious expansion to Europe made possible after the carrier was recently removed from the EU's list of banned airlines. PAL plans to launch non-stop services to Europe within the next few months and serve up to five Western European destinations in the near to medium term.

But PAL faces huge challenges in trying to carve out a sustainable niche in the Southeast Asia-Europe market. PAL and another Southeast Asian flag carrier, Garuda Indonesia, are both entering the market just as competition intensifies and while the European economy remains relatively weak.

...

But PAL faces numerous challenges in re-establishing itself globally and competing with the other six main flag carriers of Southeast Asia.

PAL will be the only carrier among the six that is not part of a global alliance once Garuda formally enters SkyTeam in early 2014, which could put PAL at a competitive disadvantage. While the Philippines has one of Asia's fastest growing economies, the market has a relatively high portion of low-yielding leisure and migrant worker traffic compared to higher-yielding business passengers.

See related report: Philippine Airlines banks recovery on international expansion but faces uphill battle

Manila also is not positioned well geographically or from an infrastructure standpoint to attract a significant amount of transit traffic. All of the leading flag carriers from Asia and the Middle East now serve Manila and will make it difficult for PAL as the carrier tries to establish a presence in the Philippines-Western Europe market.

Thai and SIA have typically been the leaders in the Southeast Asia-Western Europe market although their positions have been under pressure in recent years from Gulf carriers, which offer attractive one-stop products to a wider range of European destinations at an often cheap price. The Gulf carriers have also significantly impacted MAS, which remains the third largest carrier in the Southeast Asia-Western Europe non-stop market although as a group Air France-KLM is marginally bigger.

See related report: Philippine Airlines joins Garuda in plotting ambitious European expansion despite stiff competition

There will also be considerable long-haul expansion to the United States once the Philippines receives category 1 rating from the US FAA, which is likely to occur in the short term. In that market PAL will be limited to destinations substantial enough for it to serve with the large capacity aircraft that also have the necessary range. While there are some theoretical connecting opportunities to Southeast Asia, the market is heavily competitive and often light on substantial and consistent premium traffic.

As noted earlier, the Philippines is not set up for large amounts of connecting traffic the way Seoul Incheon, Tokyo Narita or Hong Kong are. PAL's absence from a global alliance or having substantial partners will also limit traction. This would be another unappealing possibility for ANA.

Outlook: talks are good, but ANA still searching for a suitor worthy of its cash

A foreign acquisition by ANA will take a lot of exploratory efforts with prospective airlines that do not come to fruition. This is natural and should be the context to view talks between ANA and San Miguel.

PAL's low-cost and long-haul strategies are not yet the right fit, and ANA is a long way from being an effective trainer to bring matters into shape.

Unlike Europe, there are few airlines in the market; Asian airlines are not a buyer's market. ANA will likely have to keep looking for its bride, even perhaps venturing beyond the region. After all, a dowry of USD1.8 billion in cash must be spent carefully.

NB: CAPA's second annual LCCs and New Age Airlines in North Asia Summit will be held in Seoul, 4/5 September. Proudly hosted by Incheon International Airport Corporation and supported by Travelport, SITA, Sabre and Bombardier. Click here for full details.