06-Feb-2015 6:33 PM

Flybe SWOT Analysis: strengths as an airline do not necessarily convert to sustainable profits

Analysis

The late Jan-2015 profit warning from Flybe, the UK's largest regional airline, is a reminder that no restructuring programme ever follows a smooth path. Over the past couple of years, the airline has made good progress with cost reduction, repaired its balance sheet with fresh equity and a Gatwick slot sale, trimmed its network, exited a loss-making Finnish joint venture and rebalanced its fleet plan towards turboprops. In spite of its focus on the UK regions, it has also entered London City, London Southend and London Stansted.

However, the competitive response to its London City entry has been stronger than it anticipated and, although most of its network faces no airline competition, LCCs are its main competitors on routes where there are other airlines. This puts pressure on yields (although the impact on revenues is partially offset by Flybe's raised load factor). In addition, leasing costs associated with Embraer 195 jets that Flybe no longer wants are weighing on its results.

In this report, we consider these issues in the context of a review of Flybe's strengths, weaknesses, opportunities and threats.

Summary

Flybe is the leading operator in the UK domestic regional market, with a passenger share of 48%.
Flybe has a strong presence at several important UK regional airports, including Southampton, Exeter, Belfast City, Birmingham, and Manchester.
Most of Flybe's network has no airline competition, giving it a competitive advantage.
Flybe is Europe's largest independent regional airline, with the largest fleet among European operators of regional aircraft.
Flybe offers high frequencies on competitive routes, giving it an advantage over competitors.
Flybe has a high proportion of ancillary revenue and relatively low unit costs compared to other regional airlines.

STRENGTHS

1. Flybe is the leading operator in the UK domestic regional market

The UK regional domestic market (ie excluding London) is Flybe's most important segment. In the 12 months to Sep-2014, it had a passenger share of 48% in this market, ahead of second ranked easyJet with 31% (according to data presented by Flybe at its Capital Markets Day). Flybe's strength in this segment is further emphasised by the fact that no other carrier had more than 5% of passengers.

Airline share of passengers in UK domestic regional*sector: Oct-2013 to Sep-2014

2. Flybe has a strong UK regional airport presence

Flybe's strength in the UK regional domestic market is based on leading positions at a number of important UK airports outside the London region. In the 12 months to Sep-2014, it was the largest airline by passenger numbers at Southampton, Exeter, Belfast City, Birmingham and Manchester; and number two in Glasgow and Edinburgh.

According to data from OAG for the week of 2-Feb-2015, Flybe is present in 30 UK airports (out of a total of 60), compared with 16 for easyJet, 16 for Ryanair and 10 for British Airways. Although it all but exited London Gatwick in Mar-2014, after selling its slots to easyJet, it has re-entered the London market at London City, where it has become the third ranked airline, London Stansted and London Southend (a far smaller airport).

Flybe share of passengers at selected UK regional airports Oct-2013 to Sep-2014

3. Most of Flybe's network has no airline competition

According to CAPA analysis of OAG schedule data for the week of 1-Dec-2014, Flybe has no competitors on 93 routes out of 120 airport pair routes across its entire network, representing 78% of its routes covering 65% of its seat capacity.

This may vary seasonally, but highlights that it does not compete with low-cost carriers, flag carriers or mid-haul leisure airlines - at least on most of its network.

Flybe: proportion of Flybe's schedule with competitive overlap: 1-Dec-2014 to 7-Dec-2014

4. Flybe is Europe's largest independent regional airline

According to the CAPA Fleet Database for Dec-2014, Flybe's fleet is the largest among Europe's operators of regional aircraft (regional jets and turboprops), excluding the regional units of the major legacy groups. Flybe has a significant lead over Widerøe (the number two ranked independent regional airline). Even if the major legacy groups are included, Flybe is the third largest regional airline in Western Europe.

Western European airlines ranked by number of regional jets and turboprops in service at 5-Dec-2014

5. Flybe offers high frequencies on competitive routes

On routes where there is competition with other airlines, Flybe operates a greater number of frequencies than other competitors, except where it has a codeshare partner. Its policy on these routes is to fly the greater of a minimum of 2-3 times daily or 150% extra frequencies relative to competitors. On larger un-competed routes (more than 100,000 annual passengers), it aims to operate a minimum of 2-3 times daily. On smaller un-competed routes, it still aims for a minimum of twice daily if there is business demand.

Across its network, Flybe operates less than a daily frequency on only 36% of its routes, compared with 69% for easyJet and 74% for Ryanair (based CAPA analysis of OAG schedule data for the week of 2-Feb-2015).

6. Flybe has a high proportion of ancillary revenue

Analysis of the ancillary revenues of 59 airlines globally by IdeaWorks Company for 2013 placed Flybe at number 16 for ancillary revenues as a percentage of total revenue and at number 13 for ancillary revenue per passenger.

7. Flybe's unit cost is relatively low for a regional airline

According to CAPA analysis of seven European regional airlines, Flybe's cost per available seat kilometre (CASK) is the median of the sample, with three airlines above it and three below it. Nevertheless, a plot of CASK versus average stage length shows that Flybe sits below the trend line, suggesting that its CASK is lower than expected for its average stage length. There are others that are further below the trend line, but our analysis reveals that Flybe is in the more cost efficient half of this peer group.

Cost per available seat kilometre (CASK, USc) versus average stage length for Flybe and selected other European regional airlines*

WEAKNESSES

1. Flybe suffers low profitability

In spite of its strong market position and its relatively efficient level of unit cost by regional airline standards, Flybe has struggled with profitability in recent years. It recorded a positive result in FY2014 for the first time since FY2010 (March year end), but its 1HFY2015 net result was a loss of GBP15 million compared with a GBP14 million profit in 1HFY2014.

This 1H result was weighed down by restructuring and other one-off items, as well as the Flybe Finland joint venture (from which it has now exited), although the Flybe UK underlying operating result improved by 17% to GBP13.7 million in 1HFY2015.

In a further sign that Flybe's FY2014 return to profit will not be easy to maintain, the company said in Jan-2015 that it expected a pre-tax breakeven result in FY2015. However, this does not take account of any USD loan revaluation or the ongoing GBP26 million annual costs of nine leased Embraer 195 aircraft that Flybe no longer requires.

It is seeking a solution regarding these surplus aircraft, including talking to other airlines about their possible use under white label contract flying or sub-lease arrangements, and has made a short term commercial decision to operate five E195s in the summer 2015 schedule. Meanwhile, these additional costs imply that Flybe's reported pre-tax result for FY2015 will be a loss. Its fuel hedging policy means that it will not see significant benefits from lower fuel prices until FY2017 (assuming prices stay low).

On a more positive note, a GBP150 million issue of new equity capital in Mar-2014 restored the health of Flybe's balance sheet, removing a growing threat to its survival and giving it time to pursue further restructuring.

Flybe revenues and profit before tax FY2009 to FY2014 (GBP million)

2. Flybe's unit cost is high compared with larger airlines

As noted above under 'Strengths', Flybe's level of CASK is relatively low for a regional airline. Nevertheless, in the very price sensitive short-haul market, this analysis also emphasises the need for further cost improvements.

Moreover, the challenge for Flybe remains that regional airlines have a fundamental CASK disadvantage compared with operators of larger narrow body jets in the short and medium-haul markets, even after taking account of regional airlines' shorter average trip length.

Cost per available seat kilometre (CASK, USc) trend curves for European regional airlines, full service carriers, low-cost carriers and ultra-low-cost carriers*

OPPORTUNITIES

1. Flybe has room for further cost restructuring

As noted above, Flybe still has scope for further reduction in unit costs. Indeed, the airline has an ongoing cost restructuring programme, aimed at achieving GBP71 million of savings by FY2015 relative to FY2012 and further savings into the future.

Savings in unit costs will come from lower fuel consumption as a result of a reduction in the proportion of jets versus turboprops in the fleet (the impact of lower fuel costs will be softened by Flybe's fuel hedging); lower aircraft ownership-related costs as Flybe increases the proportion of aircraft owned versus leased; and from control over fixed costs such as overheads and marketing.

2. Flybe is rebalancing its fleet towards turboprops

Flybe currently operates Embraer E175 and E195 regional jets and Bombardier Q400 turboprops. In 2013, it decided that the Q400 was its aircraft of choice for its regional UK network and that its E195 aircraft would exit the fleet at the earliest opportunity. It also took steps to terminate and defer E175 orders and secured 24 Bombardier Q400s on sub-lease from Republic Airways, with delivery starting in May 2015.

In addition to lowering fuel costs, the move towards a turboprop fleet will put Flybe more in line with other regional airlines operating at or below the 300 mile/500 km average sector length threshold. This should allow it to tailor supply more closely to demand in its chosen markets.

3. Flybe should make further load factor gains

The regional airline business model, with a focus on high frequencies, tends to lead to load factors that are lower than the average for the airline industry as a whole. After several years of load factor in the low to mid 60% region, Flybe UK increased it from 64.1% in FY2013 to 69.5% in FY2014 (year to March). In FY2015, Flybe UK's seasonally stronger 1H load factor increased by 8.6ppts to 77.2%, while its first winter quarter, 3Q, saw load factor up 5.5 ppts to 74.3%.

For the 12 month period ended Sep-2014, Flybe UK's load factor was around 73%, still below the industry average of close to 80% for all airlines, but very high for a regional airline. This load factor gain has been achieved through cutting average fares, thereby stimulating demand, while also boosting revenue per seat. Further load factor gains, coupled with enhanced revenue management systems, provide the opportunity for further increase in revenue per seat.

Passenger load factor for regional airlines: 2013-2014

4. Flybe is revising its route selection process

CEO Saad Hammad introduced a new, more rigorous, route assessment and selection process after he arrived at Flybe in Aug-2013. This aims to ensure than all routes and aircraft make a contribution, based on a core strategy Flybe describes as "connecting the regions". From summer 2014 to winter 2014/2105, Flybe cut 46 routes including 37 year-round) and started 29 new routes (including 11 year-round). It plans 20 new routes for summer 2015, including nine from its new Bournemouth base and three from London Stansted, but will cut 13.

On each route, the selection process is designed to ensure that Flybe offers an advantage over its competition, whether through frequency, timings or prices. This process provides an opportunity for the further optimisation of Flybe's network.

5. Flybe has room for growth

The route selection process outlined above, together with a cost reduction focus, have led to capacity and network cuts in FY2014 and FY2015. However, the fleet plan allows for seat growth from FY2016, with the arrival of the Q400s from Republic Airways. Provided that the initiatives around restructuring of cost and network lead to profitability, Flybe could then have an opportunity for profitable growth.

6. Flybe's 'white label' operation can be lucrative

In addition to its Flybe UK operation, the group operates a 'white label' contract flying business on behalf of other airlines. This is aimed at utilising Flybe's operational expertise in flying smaller aircraft and taking advantage of economies of scale, while reducing its commercial risk.

It also hopes to take advantage of demand by a number of legacy airlines for a more cost efficient regional feeder operation than they are capable of operating in-house. Flybe signed a contract with SAS in late 2014 and is in active discussions with a number of other airlines in this area.

THREATS

1. Flybe's LCC competition is tough where it competes

Although, as noted above, Flybe is the only airline on the majority of its routes, it faces LCC competition on 16% of its city pairs, which account for 22% of its seat capacity. LCCs are Flybe's biggest competitors and their lower average unit cost across their networks allows them to under-price Flybe when they do compete on the same city pairs. Even without direct competition, LCCs have a downward impact on pricing in many markets as they compete for discretionary travel spend. This could become a major threat to Flybe, especially if the level of overlap with LCCs grows.

Flybe: competitive overlap by airline type as a proportion of Flybe's schedule: 1-Dec-2014 to 7-Dec-2014

2. High cost LCY may not deliver sufficient yield for Flybe

Flybe launched new routes from London City Airport (LCY) at the start of the winter 2014/2015 season. As CAPA has noted in previous analysis, LCY is a high cost airport, generating aeronautical revenue per passenger equal to that of Heathrow.

See related reports:

LCY's position near the financial district and its appeal to business travellers should also allow a higher yield, but the competitive nature of most of Flybe's routes may limit the airline's ability to maximise its yields at the airport. Indeed, the competitive response, in particular by BA, at LCY has slowed the maturity of Flybe's new routes.

Flybe and LCY signed a five year deal, the terms of which were not disclosed. Flybe's ambitious passenger target (to carry 500,000 annually on its LCY routes) suggests that it received pricing incentives from the airport. However, it is likely that Flybe will need to grow its yields from its starting fares, particularly when the price incentives start to unwind.

3. Flybe's operations are sensitive to road and rail improvements

The main competition to Flybe on domestic routes where there is no other airline comes from road and rail. Flybe's clear advantage lies in shorter journey times, but this may erode if there are land transport infrastructure improvements such as high speed rail and road upgrades.

Outlook: management of change presents huge challenges

There is a transformation taking place in all aspects of Flybe's business, including its culture and branding. The successful management of change on this scale, especially in a highly competitive and fast paced sector such as aviation, presents huge challenges.

The largely new executive team under Mr Hammad appears to be moving Flybe in the right direction, but it is not yet certain that its considerable strengths can be converted into sustainable profitability.