05-Oct-2014 4:00 PM

Gulf Air ready to turn a corner after latest restructuring. Proposes aviation asset consolidation

Analysis

Gulf Air's latest round of restructuring continues to produce results ahead of its original targets. Without releasing figures, the airline reported a 30% year-on-year net reduction in losses for 1H2014, significantly bettering its target of 12%.

The airline is now 18 months into its latest round of restructuring, its fourth in a little more than a decade, but is finally emerging as a leaner and more appropriately structured carrier.

Improving operational and financial results show promise for the struggling airline. Operating costs declined 28% in the first half of the year and operational indicators have continued their sustained improvement.

Summary

Gulf Air reports a 30% YoY reduction in losses for 1H2014, exceeding its target of 12%.
The airline's restructuring efforts have resulted in a 28% decline in operating costs in the first half of the year.
Gulf Air's operational indicators have shown sustained improvement.
Despite the progress, the airline's break-even goal remains a long-term objective.
Gulf Air has focused on higher yielding point-to-point routes, particularly in the Middle East and Indian sub-continent.
The carrier has reduced its workforce by 27% and is now comprised of around 65% Bahraini nationals.

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Despite the gains, break-even remains a long-term goal rather than an immediate prospect. Gulf Air's management is reluctant to forecast when it expects to achieve a profit, but its turn-around performance so far at least gives it a reasonable hope of becoming a commercially sustainable airline, rather than a drain on Bahrain's national treasury.

Operating the carrier has cost Bahrain better than BHD1 billion (USD2.7 billion) over the past four years, but the airline is a national asset and so its losses are only a part of the country's wider development plans.

1H2014 development builds on the achievements of 2013

At the end of 2012, Gulf Air launched its latest effort to stem the run of heavy losses it had suffered over the prior decade. The carrier re-aligned its network and cut capacity in dramatic fashion, retiring a third of its fleet, ended a number of lease agreements and shuttered eight loss-making routes. At the same time it consolidated eight profit-making routes by adding more frequencies and then followed up by launching new routes to five destinations.

Simultaneously, it began a plan to simplify its business structures. It re-negotiated supplier contracts and launched a much-needed workforce reduction and productivity drive.

In the first 12 months of the restructuring, the carrier saw a 28% drop in costs, along with a 14% improvement in yields and a boost in load factors. Net losses for 2013 were still heavy, BHD93.3million (USD233.7 million), but progress was better than had been hoped for. The loss was better than half that experienced in 2012, when the country was still witnessing protests and other social unrest, and bettered Gulf Air's cost cutting target by BHD14.5 million (USD38.5 million).

Passenger load factors, revenue passenger numbers and passenger yields have all continued this upward trend during 1H2014. The airline has also reported improving connecting traffic through Bahrain, with the small Gulf hub now priming itself for renewed growth. Overall, Gulf Air revenue has grown by 10% year-on-year.

New routes point to Gulf Air's building confidence

At the end of 2012, Gulf Air's focus shifted to higher yielding point-to-point routes, connecting Bahrain to Middle East regional markets and the high demand Indian sub-continent routes. Regionally, Gulf Air operations are characterised by low-density aircraft operated at high frequency levels, to provide convenient timing for the high-yield business travel segment and better connectivity for transit passengers between the Asian and European markets.

Although it has increasingly concentrated its network in a four-hour flying time radius from Bahrain, Gulf Air has maintained some of its strategically important links to Southeast Asia, at Manila and Bangkok, and also to Europe (London Heathrow, Frankfurt, Paris and Larnaca). In terms of seat capacity and frequencies, regional business destinations such as Dubai, Doha, Kuwait, Dammam and Abu Dhabi remain the most important links for the carrier. Outside of the Middle East, India and Pakistan, followed by the UK are the most travelled markets.

Gulf Air network

During early 2014 Gulf Air incrementally began to rebuild its intercontinental network, a sign that it is now transitioning from a period of restructuring to one of consolidation and development. In Jan-2014, it resumed services to Iran, after a 15-month hiatus, with a route to Mashhad. It followed this with a return to Tehran in Mar-2014. Gulf Air faces no direct competition on either route and has increased capacity on the routes, increasing frequencies to Mashhad to now operate daily flights between Bahrain and the Iranian city.

Outside of the Middle East, Gulf Air has prioritised the European and South Asian markets for expansion. In Jan-2014, the carrier added service to Sialkot in Pakistan. It also added a new route to Athens in mid-Jun-2014. Like the Iranian routes, Gulf Air is the only operator between Bahrain and these two new destinations.

Gulf Air now operates to 11 destinations in the Indian sub-continent, five in Pakistan and six in India. The region accounts for around 18% of its capacity by seats and just under 30% of capacity by ASKs. Gulf Air is likely to continue its expansion into Pakistan, with more capacity available following bilateral air service agreement talks between the civil aviation authorities of Bahrain and Pakistan, concluded earlier this year.

Gulf Air Indian sub-continent destinations by seats

The carrier is following up its 1H2014 expansion with a new route to Moscow, due to be launched on 28-Oct-2014. The carrier will operate four times weekly to Moscow Domodedovo, using A320 equipment with 110 seats. This is Gulf Air's first ever route to Russia. Like many regional carriers, Gulf Air views Russia and the CIS as a major untapped market, both for business and tourism traffic. The airline is also hopeful of capturing some connecting traffic from the Indian subcontinent and Asia into the region.

The carrier also launched a new Kuwait-Istanbul Ataturk service with effect from 02-Oct-2014, also with A320s. The twice-weekly service will be the only route not operated from the carrier's Bahrain hub. Both Istanbul and Kuwait are key markets for Gulf Air, with the airline operating six times weekly between Bahrain and Kuwait and five times weekly between Bahrain and Istanbul.

Gulf Air winds up labour force reductions

Along with the 'right-sizing' of its fleet and network, the restructuring has also seen Gulf Air undertake the troublesome task of reducing its workforce to levels more appropriate to its size and structure. Employment at the state-owned carrier is a politically sensitive area. During 2012 and 2013, Gulf Air's management faced rounds of negotiations with the carrier's three unions, as well as with concerned Bahraini politicians, before it could implement its downsizing plans.

During 2013, more than 1000 employees left the airline, almost 50% of them via an attractive voluntary redundancy packages and early retirement scheme. Compulsory redundancies were initiated in May-2013, although they were temporarily halted by the Bahraini parliament. The result was an overall workforce reduction of 27%.

Expatriates made up the majority of the departures, accounting for better than 60% of the downsizing. BHD25 million (USD66 million) was spent in 2013 on the early retirement/voluntary redundancy packages and other staff cost cuts during 2013.

Workforce reductions continued through early 2014, with the carrier shedding around 300 more staff through its voluntary redundancy programme. However, not all workers went quietly. In Feb-2014, the General Federation of Bahrain Trade Unions launched a protest about some staff redundancies. The carrier has held a number of meetings involving its unions, board, Ministry of Labour and other members of the Bahraini government, to keep its unions abreast of its restructuring efforts and attempt to reduce labour issues to a minimum.

Gulf Air's workforce has been reduced to around 2400 workers, less than half the size it was four years ago. The workforce is now comprised of around 65% Bahraini nationals, the highest level in Gulf Air's history, although still below the targeted 75%. Efforts to increase employment of nationals are ongoing, with the carrier emphasising hiring young Bahrainis across the enterprise, especially in technical roles such as engineering and cockpit crew.

According to Bahraini Deputy Prime Minister and Gulf Air chairman Sheikh Khalid bin Abdulla Al Khalifa, the success enjoyed by the restructuring to date means that no more staff reductions are planned at the carrier. Instead, work will continue on process and productivity improvements, as well as training more Bahraini nationals for roles at the carrier.

Restructuring funds go to debt and fleet plans

The launch of Gulf Air's restructuring plan was accompanied by BHD185 million (USD491 million) in Bahrain Government funds. The financing was provided by a Royal Decree in late 2012, but local politics have been such that the financing was not formally backed by the country's parliament until Jun-2014, well after the money had been spent.

The state funds were primarily devoted to reducing the carrier's heavy debt load: BHD59.7 million (USD158 million) was used for repayments on ongoing loans and another BHD23 million (USD61 million) was used to cover late payments. Outstanding loan debt stood at approximately BHD82.7 million (USD214.9 million) at the end of 1H2014.

The fleet restructuring has also consumed the financing. BHD27.2 million (USD70.7 million) was invested in two A321 aircraft, which have been deployed on Middle East/North African and Indian sub-continent routes. A further BHD26.1 million (USD67.8 million) was invested on settling agreements with aircraft providers, including manufacturers and leasing companies. This was substantially lower than the BHD59 million (USD153.3 million) the carrier initially projected for the fleet restructuring.

Money has also been invested on improving aircraft interiors. Gulf Air took delivery of the first of its refurbished A330-200s in Jul-2014 and a second in Aug-2014.

The aircraft are part of the carrier's brand and service overhaul, featuring its new 'Falcon Gold' premium product with fully flat seats, an upgraded economy class seat and new IFE system. The improvement will go a long way in addressing the service deficit that Gulf Air suffers in comparison to its larger GCC competitors. The retrofit programme, covering all six of the carrier's A330-200s, is due to be completed during 4Q2014.

Bahrain Airport poised to start growing

The demise of Bahrain Air and Gulf Air's downsizing took significant capacity out of the Bahrain market in 2013. Traffic at Bahrain International Airport declined 13.1% last year, with Gulf Air's capacity realignment accountable for declines in traffic between the airport and several major destinations, including Riyadh and Dubai.

Bahrain International Airport traffic: 2008 to 2013

Despite the capacity reductions, the competitive climate in the Bahrain market has not been appreciably altered since the departure of Bahrain Air. Gulf Air still accounts for about 60% of seat capacity and 74% of ASKs at its home hub, which is not substantially different to the situation prior to the beginning of its restructuring.

Bahrain International Airport capacity (seats)

Major regional competitors have not strongly capitalised on the collapse of Bahrain Air and the capacity reduction by Gulf Air. Qatar Airways upped its operations to 49 times weekly in Sep-2013, but other major GCC hub carriers and LCCs have kept capacity at Bahrain airport fairly static. Etihad Airways has not raised capacity to Bahrain since 2012, and neither has Air Arabia or flydubai. Emirates has announced plans to increase frequency to Bahrain from three to four times daily in Dec-2014.

Bahrain International Airport expects traffic to recover as Gulf Air continues to add destinations and increase frequencies. Traffic at the airport is still around 1.5 million passengers below its 2009 peak, but indicators for the future are positive. 2014 traffic to the end of Aug-2014 was up 8.9% year-on-year, and the airport is projecting total traffic of around 7.9 to 8 million for the full year.

The airport is due to complete the design of its new, USD1 billion terminal and associated airside upgrade by the end of 2014. Construction is projected to be completed by 2018 or 2019, lifting capacity to around 14 million passengers p/a. The airport is also launching a number of initiatives aimed at improving passenger satisfaction and boosting service quality, as part of its efforts to improve the overall attractiveness of Bahrain as an alternative Gulf hub.

Gulf Air is ready to resume growth, but not willing to relinquish government subsidy

All the major elements for a long term Gulf Air turn-around are now in place. The airline is searching for growth opportunities, while still continuing to improve operational performance. Challenges remain in the Bahrain market, including lingering overcapacity, growing airspace congestion and the Gulf region full-service and LCC competitors, but there are plenty of opportunities for growth.

To follow its Moscow service and new Kuwait-Istanbul connection, at least one more route launch is under consideration for before the end of the year. African markets remain under-served from the Gulf, as does Eastern Europe and Central Asia, although low-cost carriers are rapidly entering these markets.

The airline has also recognised "additional capacity opportunities regionally", initiating talks with various civil aviation authorities to request additional frequencies across its network. Kuwait and Cairo frequencies have been expanded in the past few months, and other routes are under discussion. Schedule enhancements to key routes will be a major growth strategy for the airline.

Even with the streamlining and better performance, Gulf Air has shown it is unwilling to separate itself from government support. In Jul-2014, acting CEO Maher Salman Al Musallam said the airline had issued a proposal for a 30% fuel subsidy to the Bahrain Government. With fuel at around 35% of costs, Mr Al Musallam said the subsidy would allow the airline to achieve an operating profit and reach its goal for the year to "operate with no losses and leave the losses in the overheads only".

The carrier has also proposed a consolidation of Bahrain's state-controlled aviation assets, including itself, Bahrain Airport Company and Gulf Aviation Academy, into a single holding company. All three assets are already owned by the Bahrain Mumtalakat Holding Company sovereign wealth fund, so combining them under the one umbrella would not prove particularly difficult. Bahrain Aviation Fuelling Company, Bahrain Airport Services and Bahrain Duty Free Shop Complex could also join them under a unified, state-directed aviation entity.

The benefit of such a consolidation for Gulf Air would be cross promotion and synergies across a number of business areas, as well as possible discounts on landing and other airport fees and charges. Similar structures are already successfully at work in several Gulf States.

Regional governments view airlines, airports and related organisations as collective instruments of national policy and development, rather than separate entities. Bahrain is no different in this regard, but has not seized on the opportunities the same way some as its near neighbours have.

Regardless of future subsidies or aviation system collectivisation, Gulf Air's immediate objective must be to continue the positive progress of the past 18 months. The growing economies of the Middle East and the burgeoning regional passenger traffic provide ample opportunity.

Even though its competitive position has improved and Gulf Air anticipates further positive developments during the second half of the year, 2014 will inevitably be another year of red ink. Gulf Air will need to continue to adapt to its operating environment and evolve its structure, in order to maintain its trajectory towards long-term commercial sustainability.