20-Aug-2012 11:34 AM

Consolidation inevitable in the Philippines but Cebu Pacific's market leading position is assured

Analysis

Consolidation is emerging as an increasingly likely outcome in the crowded Philippines domestic market, where already fierce competition has further intensified with SEAir becoming the fifth LCC on trunk routes. SEAir over the last three weeks has launched several new domestic routes from Manila following the delivery of three A320 aircraft from its new part-owner, the Tiger Airways Group. The expansion at SEAir, which previously only operated small turboprops in the domestic market, is putting further pressure on yields which have already been on the decline as a result of rapid capacity expansion at LCCs Cebu Pacific Air, AirPhil Express, AirAsia Philippines and Zest Airways.

Domestic capacity in the Philippines surged by 20% in 1H2012, prior to the 31-Jul-2012 launch of SEAir's Manila-based narrowbody domestic operation. The new SEAir-Tiger domestic LCC operation now consists of 10 daily flights on seven trunk routes from Manila (the last of which is being launched on 20-Aug-2012). This results in over 21,000 additional weekly seats, equivalent to a 4% increase, to a domestic market which was already suffering from overcapacity.

Summary

Consolidation is likely in the crowded Philippines domestic market due to intense competition and overcapacity.
SEAir's expansion into the domestic market is putting further pressure on yields, which have already been declining due to rapid capacity expansion by other LCCs.
Cebu Pacific is currently the largest LCC in the Philippines, with a larger share of the domestic market than all its LCC competitors combined.
Cebu Pacific has a significant advantage over other LCCs in terms of slots at Manila airport, allowing for further expansion and better utilization of slots.
Cebu Pacific plans to maintain its leading position in the Philippines international LCC market, with rapid expansion expected in the future.
Domestic capacity expansion by Philippine LCCs is expected to continue throughout the second half of 2012, leading to further competition and potential consolidation in the market.

Total domestic passenger traffic in the Philippines increased by only 13% in 1H2012 compared to 1H2011 despite the 20% surge in capacity and a reduction in fares. At market leader Cebu Pacific, average fares were down by 4% in 1H2012 as the carrier recorded a 40% drop in net profit to PHP1.76 billion, or USD42 million (see Background information). For 2Q2012, average fares were down by 2% as Cebu Pacific saw its net profit drop by 38% to PHP773 million (USD17 million).

While overcapacity and intense competition has impacted Cebu Pacific's bottom line, the carrier claims it is currently the only profitable Filipino LCC and is confident it is best positioned to weather the inevitable shake-out that will result.

Cebu Pacific has first mover advantage, being the Philippines' first LCC. Cebu Pacific launched in 1996 and in many respects was Asia's first LCC as it predated AirAsia, Jetstar, Tiger and others (although for a few years after the turn of the century Cebu Pacific adopted more of a hybrid model before returning to its roots as a pure LCC). Zest only adopted the LCC model as part of a rebranding in 2008 while Philippine Airlines sister carrier AirPhil Express adopted the LCC model as part of a rebranding in early 2010.

SEAir and AirAsia Philippines are even newer players in the LCC sector with SEAir initially launching an international LCC operation at the end of 2010 and finally launching a domestic LCC operation in May-2012. SEAir's first narrowbody domestic route was launched on 05-May-2012 with four weekly flights from Clark to Kalibo while the much larger Manila domestic LCC operation began on 31-Jul-2012. AirAsia Philippines launched services in Mar-2012, initially operating domestically with international services being added in Jun-2012.

Cebu Pacific has larger share of domestic market than all its LCC competitors combined

Given its huge head start over the competition it is not surprising that Cebu Pacific is the largest LCC in the Philippines by a wide margin. Cebu Pacific accounted for approximately 45% of domestic passengers in the Philippines during 2Q2012, giving it a larger share than its four LCC competitors: AirPhil (22%), Zest (11%), AirAsia Philippines (1%) and SEAir (at the time less than 1%). Cebu Pacific also has a much larger share of the domestic market than the country's only full service network carrier, Philippine Airlines (PAL), which transported 21% of domestic passengers in 2Q2012.

Philippines domestic market share (% of passengers carried) by carrier: 3Q2010 to 2Q2012

The Philippines domestic market in 2Q2012 had an LCC penetration rate of 79%, which is practically unheard of in the global industry, and this figure will only get higher as SEAir has become the fifth LCC in the market. Rapid growth by LCCs over the last two years has led to steady quarter-over-quarter passenger growth in the Philippines domestic market from 3.9 million passengers in 3Q2010, when LCCs accounted for 68% of the total market, to 5.8 million passengers in 2Q2012.

Cebu Pacific also has a huge advantage over its LCC competitors because it has the largest number of slots at Manila and has a fleet plan that will squeeze out more utilisation of its slots by gradually transitioning over the next decade to larger aircraft. Cebu Pacific has 30 A321neos on order that will replace smaller A319s and A320s, resulting in seat growth of 26% to 54% on dense routes without having to increase frequencies or secure additional slots. Cebu Pacific recently agreed to sell its 10 A319s to US low-cost carrier Allegiant Air, which will be handed over to Allegiant in 2013 and 2014.

Cebu Pacific also has committed to acquiring at least eight A330s, which will be equipped with over 400 seats in a single-class configuration. In announcing plans to launch a new medium/long-haul, low-cost operation early this year, Cebu Pacific executives originally said the A330s would only be used on new routes to the Middle East and Australia. But Cebu Pacific CEO advisor Garry Kingshott now says Cebu Pacific also expects the A330s to be used to replace A320s on regional international routes to destinations such as Beijing, Singapore and Seoul, which would provide seat growth of over 100% without increasing frequencies and leading to better utilisation of slots at Manila along with other slot-controlled Asian airports.

In the meantime, Cebu Pacific will improve utilisation over the next few months of its existing Manila slots by upgauging some of its domestic flights from ATR 72s to A319s or A320s. Cebu Pacific's decision to shift some turboprop flying out of Manila comes as all domestic carriers serving Manila are cutting back on peak hour flights as part of an initiative to ease congestion.

Cebu Pacific and other Philippine carriers agree to cut peak hour flights at Manila

Mr Kingshott said during a 16-Aug-2012 conference call to discuss Cebu Pacific's 2Q2012 results that peak movements at Manila are being reduced to 42 per hour, down from as many as 55 per hour. Cebu Pacific will cut seven or eight daily flights, starting with its upcoming Northern Hemisphere winter schedule, as its contribution to easing the congestion. But Mr Kingshott expects the cuts to be temporary as projects are underway, including the realignment of Manila's secondary runway so that it no longer intersects with the primary runway, to expand the airport's capacity. Cebu Pacific believes movements at Manila will eventually be increased by 15 to 20 per hour to approximately 60, without causing the congestion and delays that have been seen in recent months.

Manila Ninoy Aquino International Airport movements per hour: 20-Aug-2012

Cebu Pacific's on-time performance slipped to only 70% in 2Q2012 although it improved to 83% in Jul-2012 as Manila International Airport implemented other congestion-easing measures, including new air traffic controller training and shifting some general aviation traffic to other airports. The upcoming decrease in peak hour flights along with a further reduction in general aviation movements and the construction of new high-speed taxiways is expected to lead to a further significant improvement in on-time performance. Cebu Pacific stands to benefit from the continuing operational improvements at Manila International Airport as its model depends on quick aircraft turnarounds.

Cebu Pacific will also benefit more than other LCCs when the airport is able to increase peak hour movements. Those carriers reducing flights this year will get the first right to take back their slots after the runway realignment project is completed. Carriers will also be able to apply for additional peak hour slots as Manila is expected to operate above previous maximums once the secondary runway is realigned although competition for such slots will be intense.

SEAir in particular has a limited number of slots, which were previously used for its currently suspended turboprop operation, while AirAsia Philippines does not have any slots at Manila and is currently only now able to operate out of Manila alternative airport Clark. AirPhil Express, which has been directing a large portion of its expansion this year to Clark, also faces limitations at Manila unless sister carrier PAL is willing to cede some of its slots.

Strong slot portfolio guarantees Cebu Pacific can maintain leading positing in Manila

Cebu Pacific currently accounts for 35% of peak-hour movements and 36% of off-peak movements at Manila, according to Innovata data. PAL accounts for 21% of peak movements while AirPhil accounts for another 18%, giving the PAL-AirPhil group only slightly more slots than Cebu Pacific. PAL is unlikely to hand a significant number of its slots to AirPhil Express given that PAL's premium positioning needs the carrier to remain Manila-focussed.

The new partial owners of PAL and AirPhil, the Filipino conglomerate San Miguel, plan to invest significantly in improving PAL's product and renewing the network carrier's fleet. While PAL is not likely to grow as fast as the LCCs, it may pursue modest growth in Manila, which if anything could force AirPhil to focus more at Clark or secondary cities, leaving Cebu with an even more dominant position among LCCs in the key Manila market.

Manila Ninoy Aquino International Airport share (%) of peak hour aircraft movements by carrier: 20-Aug-2012 to 27-Aug-2012

While Clark is being positioned as the airport to accommodate future growth in the Manila area, Cebu Pacific is confident it can continue to expand at least for the next several years at Manila International, allowing it to maintain its advantage over LCCs which will need to rely on less convenient Clark. In addition to increasing its slot portfolio at Manila after the second runway is realigned and squeezing more from its existing slots by gradually transitioning to larger aircraft, Cebu Pacific believes it can also pursue further expansion at Manila by utilising available off-peak slots.

Significant international expansion in particular is feasible during night and early morning hours, although such timings can be undesirable from passengers. Such timings also allow Cebu Pacific to further improve average aircraft utilisation (currently its A320 fleet is utilised an average of about 13.5 hours per day), a key component of the carrier's model.

Cebu Pacific movements per hour at Manila Ninoy Aquino International Airport: 20-Aug-2012

Cebu Pacific plans to grow leading position in Philippines international LCC market

Cebu Pacific has rapidly expanded its regional international operation in recent years, resulting in international passenger traffic nearly tripling from 2007 to 2011. The carrier reported further international RPK growth of 16% in 1H2012, slightly surpassing its domestic RPK growth of 15%. International flying now accounts for 19% of Cebu Pacific's sectors and 51% of its ASKs, based on 1H2012 data (see Background information). Cebu currently serves almost 20 international destinations.

Unlike Cebu Pacific, other Filipino LCCs have very small international operations. AirPhil and AirAsia Philippines currently each only serve three international destinations while SEAir serves four and Zest Airways serves five.

Only in the Kuala Lumpur, Hong Kong and Singapore markets does Cebu Pacific compete against more than one Filipino LCC. AirPhil, AirAsia Philippines and SEAir all serve Hong Kong while SEAir and AirPhil both currently serve Singapore and AirAsia Philippines and AirPhil both currently serve Kuala Lumpur. (SEAir and AirAsia Philippines both only operate international flights from Clark, leaving Cebu Pacific and AirPhil as the only airlines serving the Kuala Lumpur, Hong Kong and Singapore markets from Manila.)

Based on current Innovata data, Zest, the Tiger Airways Group (includes Tiger Singapore and SEAir) and the AirAsia Group (includes AirAsia Philippines and AirAsia Malayia) each now only account for 3% of international capacity in the Philippines while AirPhil accounts for less than 2%. Cebu Pacific currently accounts for 16% of international capacity in the Philippines, giving it bigger chunk of the market than all other LCCs combined. PAL currently accounts for a leading 26% share of international capacity. Based on 1Q2012 Philippine CAB data, Cebu Pacific captured 16% of the international market compared to 26% for PAL.

Philippines international capacity by carrier (seats per week): 20-Aug-2012 to 26-Aug-2012

Cebu Pacific particularly has an advantage over other LCCs in the South Korea market, which is the largest international destination for the Philippines. Cebu Pacific currently accounts for 14% of capacity between the Philippines and South Korea, making it smaller than PAL, Asiana or Korean Air but significantly larger than any of the four other LCCs serving the market: Zest and Korean LCCs Air Busan, Jeju Air and Jin Air.

Mr Kingshott points out that AirPhil, AirAsia Philippines and SEAir/Tiger are currently barred from launching services to South Korea because of South Korean restrictions that block any new Philippine carrier from entering the South Korean market until the Philippines passes an ICAO safety audit. He says a new ICAO audit of the Philippines is scheduled for later this year and if Philippine regulators are able to meet ICAO standards current restrictions could be lifted in 2013.

There is also now a moratorium by Japanese regulators on any additional flying from any Philippine carrier including Cebu Pacific, which is currently the only Philippine LCC in the Philippines-Japan market but has just three weekly flights to one destination (Osaka). This restriction would also be lifted in 2013 if the Philippines passes the upcoming ICAO audit, allowing Cebu Pacific to pursue rapid expansion in the Philippines-Japanese market potentially along with other LCCs. But there is no guarantee the Philippines will pass the audit given prior failures and postponements of previous audits. (Japanese LCCs do not face any restrictions but have not yet applied for traffic rights to the Philippine CAB, which could potentially block such applications if lodged out of retaliation for the restrictions placed on Filipino carriers by Japanese authorities.)

Mr Kingshott explains Japan is currently blocking any expansion by any Philippine carrier until the Philippines passes an ICAO audit while South Korean authorities have a different interpretation of the current situation, which has been in place for several years due to ICAO concerns over the Philippines' ability to regulate safety standards, and allows carriers already in the market to expand while banning new entrants. The US over the last four years has had the same restrictions on Philippine carriers as Japan, banning any Philippine carrier from expanding, changing equipment or entering the market until the country receives a Category 1 rating from the FAA.

For the US ban to be lifted the Philippines needs to pass an audit from the FAA. The US ban is impacting PAL as the carrier is unable to pursue plans to expand capacity and use its new fleet of Boeing 777-300ERs in the US market but is not impacting Filipino LCCs as Cebu Pacific has no intentions of using its new A330 fleet to serve North America.

Domestic capacity expansion by Philippine LCCs to continue throughout 2H2012

The restrictions in North Asia placed on Philippine carriers could partially explain the large amounts of capacity being directed by the country's LCCs to the already crowded domestic market. According to Innovata data, over the next three months Zest plans to increase domestic capacity by a further 19% over current levels while AirPhil plans a 7% increase and Cebu Pacific plans a 10% increase. AirAsia Philippines has not yet loaded any new flights but domestic and international capacity increases are likely by year-end as the carrier plans to take delivery of two additional A320s in 4Q2012, giving it a fleet of four A320s.

Zest is expected to increase its A320 fleet from 10 to 13 aircraft in 2H2012 while Cebu Pacific plans to increase its A320 family fleet from 30 to 33 aircraft. AirPhil is expected to slow down fleet expansion in 2H2012 after adding six A320s in 1H2012 for a total of 15 aircraft.

SEAir, which expanded its A320 family fleet from two to five aircraft in Jul-2012, has not yet unveiled plans for further capacity increases beyond its recent launch of seven domestic routes. But the carrier will likely continue to expand over the next year as the Tiger Airways Groups looks for homes for the several additional A320s it is committed to acquiring in fiscal 2013. Tiger completed its purchase of a 40% stake in SEAir on 13-Aug-2012 for only USD2.5 million while a group of Filipino investors acquired the remaining 60%.

The acquisition excluded SEAir's previous turboprop business, which has been retained by the carrier's previous ownership group. SEAir grounded its fleet of Dornier 328 turboprops in Jul-2012 in anticipation of the sale of its Air Operator's Certificate (AOC) to Tiger but the turboprop fleet is expected to resume operations over the next few months on small regional routes once a new AOC is secured.

While Tiger was not interested in retaining the turboprop operation or serving regional destinations, LCC competitors Cebu Pacific, AirPhil and Zest all operate turboprops alongside their A320s. Small aircraft are the only way to access several of the Philippines' popular destinations, such as Caticlan, the gateway to the resort island of Boracay and the eighth largest domestic route from Manila.

SEAir/Tiger brings intense competition to seven domestic trunk routes

Tiger handed SEAir three A320s during Jul-2012 in anticipation of the deal closing, which has been in the works since SEAir leased two A319s from Tiger for international LCC operations in late 2010. SEAir has since moved its two A319s from Clark, where SEAir operates all its international flights, to Manila while two of the three newly delivered A320s are based at Clark, where they have replaced the A319s on international flights. The third A320 is based in Manila and was used to launch on 18-Aug-2012 two daily flights to Davao and on 20-Aug-2012 one daily flight to Bacalod. According to Innovata, the two Manila-based A319s are used for three daily flights to Cebu and one daily flight each to Tacloban, Iloilo, Puerto Princesa, Kalibo (all these routes were launched between 31-Jul-2012 and 04-Aug-2012).

All seven new SEAir routes are among Manila's eight largest domestic routes based on total capacity. Manila-Cebu is the largest domestic route in the Philippines, followed by Manila-Davao. SEAir now has an 8% share of capacity on Manila-Cebu and 10% share on Manila-Davao, according to Innovata data.

Capacity share (% of seats) by carrier on top eight domestic routes from Manila: 20-Aug-2012 to 26-Aug-2012

Route	Total weekly one-way seats	PAL capacity share	Cebu Pacific capacity share	AirPhil capacity share	Zest capacity share	SEAir capacity share
Manila-Cebu	40,529	35%	33%	15%	9%	8%
Manila-Davao	24,716	30%	41%	11%	8%	10%
Manila-Iloilo	18,459	23%	41%	20%	11%	5%
Manila-Puerto Princesa	16,655	17%	32%	22%	23%	6%
Manila-Cagayan de Oro	15,637	34%	47%	19%	N/A*	N/A
Manila-Kalibo	15,176	26%	22%	16%	29%	7%
Manila-Bacolod	15,011	29%	38%	25%	N/A*	8%
Manila-Tacloban	12,829	25%	30%	19%	18%	8%

Manila International top 10 domestic routes based on capacity (seats per week): 20-Aug-2012 to 26-Aug-2012

On five of the seven new SEAir domestic routes, there is now direct competition between four LCCs: SEAir, Cebu Pacific, AirPhil and Zest. On the other two new SEAir routes, three LCCs now compete head to head: SEAir, Cebu Pacific, AirPhil. Cebu is the largest carrier on five of these routes but does not have capacity share exceeding 50% on any, illustrating the fragmentation of the Philippine market.

AirAsia Philippines also competes indirectly on three of the seven new SEAir domestic routes - Cebu, Puerto Princesa and Kalibo - as the new AirAsia Group affiliate now serves these three domestic destinations from its base at Clark. AirAsia Philippines serves Kalibo with two daily flights while Cebu and Puerto Princesa is served with one daily flight, giving AirAsia Philippines a total domestic operation which is less than half the size of SEAir's new domestic operation. AirPhil also operates from Clark to Cebu, Pueto Princesa, Kalibo and Davao (in addition to serving all four of these destinations much more frequently from Manila) while SEAir operates four weekly flights from Clark to Kalibo that supplement its newer Manila-Kalibo route.

Zest does not have any scheduled flights at Clark. Cebu Pacific has a very small base at Clark with one domestic destination, Cebu, served with only three weekly flights, and four international routes: Bangkok, Hong Kong, Macau and Singapore (which are served with one daily frequency or less). Cebu Pacific's very small base at Clark is seen mainly as a defensive measure as it allows the carrier to compete against rivals on its competitors' largest Clark routes without having to allocate significant capacity to what Cebu Pacific claims is a much lower yielding market than Manila.

Cebu Pacific to expand in secondary Philippine cities, where competition is less intense

Rather than add capacity at Clark, Cebu Pacific is now focussing on adding capacity to secondary cities throughout the Philippines such as Iloilo, where it is launching later this year new domestic routes and flights to Singapore and Hong Kong. Iloilo will be a new base for Cebu Pacific, allowing the carrier to open new point-to-point routes that bypass congested Manila.

Cebu Pacific also is planning new domestic routes from Kalibo (where it recently added scheduled international flights to Hong Kong and charter flights to Taipei) and Puerto Princesa. Like Iloilo, Kalibo and Puerto Princesa have previously primarily only been served from the main hubs of Manila, Cebu and Davao. New point-to-point domestic routes enable Cebu Pacific to get into markets with no or limited completion and redeploy some of the smaller aircraft that it can no longer base in Manila due to the upcoming reduction in peak hour movements. Mr Kingshott says it was always part of Cebu Pacific's medium- to long-term plan to build up operations at secondary cities but this plan has been accelerated.

The situation in the main domestic markets is clearly unsustainable as five LCCs are now competing in three key markets: greater Manila to Cebu, Puerto Princesa and Kalibo (includes operations from both Clark and Manila International). "The Philippines can't support five players," Cebu Pacific CEO Lance Gokongwei acknowledged during the conference call to discuss the carrier's 2Q2012 results.

While Mr Gokongwei says it is impossible to predict when the inevitable consolidation will occur, Cebu Pacific seems content to wait out the storm rather than force the action by buying one of its smaller LCC rivals although Mr Gokongwei says "everything depends on price," when asked if Cebu Pacific would consider an acquisition.

In discussing its most recent quarterly results, Tiger Airways Group outgoing CEO Chin Yau Seng also dismissed the idea that Tiger may acquire a second Filipino LCC, saying there have been "absolutely no" talks with Zest as reported by some local media. Tiger/SEAir and Zest are in the most precarious positions in the overly crowded Philippine LCC market given Cebu Pacific's strong market leading position and AirPhil's ties with PAL. (AirPhil is the second largest LCC in the Philippines and is an important component of the new PAL group dual-brand business plan being implemented by San Miguel, which has the funds to cover continued AirPhil and PAL losses while the new business plan is implemented.) AirAsia Philippines faces challenges given its entire operation is based at less convenient Clark but the carrier has the backing from Asia's leading LCC group and can leverage the powerful AirAsia brand as it enters new markets.

The Philippines is an important growth market in Asia as economic growth continues to drive more demand for air travel. But the demand cannot support the recent capacity increases and any domestic market the size of the Philippines (about 22 million annual passengers) cannot support five LCCs. Something will have to give. The question is not if but when.

Background information

Cebu Pacific operational highlights: 2Q2012 vs 2Q2011 and 1H2012 vs 1H2011

Cebu Pacific financial highlights: 2Q2012 vs 2Q2011 and 1H2012 vs 1H2011