16-May-2014 8:00 AM

Malaysia Airlines 1Q loss widens. Capacity growth to be adjusted, followed by restructuring

Analysis

Malaysia Airlines (MAS) is adjusting capacity growth rates for the remainder of 2014 and preparing another potential restructuring. The capacity adjustments, which will result in ASK growth of 10% to 12% for 2014 compared with an initial plan for 19% growth, follow the carrier's fifth consecutive quarter of losses.

The MH370 incident has impacted MAS, particularly bookings from China. But the upcoming changes were required regardless and are as much a response to challenging market conditions.

The outlook for the rest of 2014 and beyond is bleak, necessitating a thorough review. As is always the case with MAS restructurings, the outcome will largely hinge on how deep the MAS executive team is allowed by the government to restructure.

Summary

Malaysia Airlines (MAS) is adjusting capacity growth rates for 2014 due to challenging market conditions and the impact of the MH370 incident.
MAS reported a net loss of MYR443 million (USD134 million) for 1Q2014, marking the fifth consecutive quarter of losses.
MAS' goal of returning to profitability by the end of 2014 is now questionable, as the carrier was already on an unprofitable path before MH370.
MAS is reviewing its long-term fleet and network plan, and still plans to place a major order for new-generation aircraft later this year.
MAS expects most of its ASK gains for 2014 to be to and from Australia, but the Malaysia-Australia market is suffering from overcapacity.
MAS is preparing for another potential restructuring, which will require the government's support and approval to implement deep changes.

MAS loss widens by 59% in 1Q2014

MAS reported on 15-May-2014 a net loss of MYR443 million (USD134 million) for 1Q2014 compared with a net loss of MYR279 million (USD90 million) for 1Q2013. Revenues were up only 2% (including a 6% increase in passenger revenues) despite an 18% increase in RPKs as passenger yields dropped by 9%. ASKs were up 19% as load factor dropped 0.2ppts to 76.4%

Malaysia Airlines financial and operating highlights: 1Q2014 vs 1Q2013

MH370, a 777 flight from Kuala Lumpur to Beijing which disappeared on 8-Mar-2014 and has not yet been found, contributed to the poor 1Q2014 result. Insurance is covering the loss and all related charges, including hotel rooms for family members. But both existing and advanced bookings were impacted.

Out of respect for the families, MAS also immediately withdrew from marketing activities, including participation in a Malaysian travel fair which typically generates "significant and vital ticket sales". The carrier says it was only 4% short of its sales target for 1Q2014 prior to 8-Mar-2014 and was on track to make up the shortfall at the fair.

But the 1Q is typically a seasonally weak period for MAS and the carrier would have incurred a significant loss regardless of MH370 as its yields were already tracking down on a year-over-year basis amid intense competition. MH370 exacerbated an already tough situation and makes it even more challenging for MAS to turn around without major changes.

MAS was already on a highly unprofitable path before MH370

MAS says that due to MH370 its goal of returning to profitability by the end of 2014 is now questionable. But the reality is the carrier would have struggled to meet this goal. Market conditions were already challenging and MAS' losses were already mounting.

The 1Q2014 loss marked the fifth consecutive quarter in the red for MAS, which had been profitable in 3Q2012 and 4Q2012 in what was seen at the time as an indication that a restructuring plan initially implemented in late 2011 and early 2012 was bearing fruit. But 2013 proved to be a challenging year with net losses and declines in EBITDA every quarter. MAS ended 2013 with a net loss of MYR1.174 billion (USD372 million) as yields dropped 13% and passenger revenues were up only 9% despite a 27% spike in RPKs.

4Q2013 was particularly challenging with a MYR343 million (USD106 million) loss in a typically strong period and yields dropping 16%. Yields have been steadily on the decline since 2Q2013, when MAS started pursuing ambitious capacity expansion and implemented an aggressive pricing strategy in an attempt to boost load factors.

The initiative led to some of the fastest passenger growth rates and highest load factors in the Asian full-service airline sector, with MAS passenger numbers up 29% in 2013 and another 21% in 1Q2014. But well before MH370 it was becoming clear the carrier's strategy was not likely sustainable. As CAPA reported in Nov-2013:

Over the past year MAS has grown passenger traffic at record levels. … But MAS still has a long road ahead and challenges to overcome. Competition is intense and market conditions are not improving. Its pricing strategy is not sustainable and will only succeed if passengers are ultimately prepared to pay more to fly with MAS.

The carrier has shiny new aircraft, membership in a global alliance, an improved service, a bigger network and a more efficient hub. Now MAS has to execute the most difficult part of its strategy and turn all of those investments into higher yields and long-term profitability.

MAS reduces capacity projections for 2014

MAS is now closely reviewing its schedule and market conditions in order to better align capacity with demand. The carrier was initially projecting a 19% increase in ASKs for the full year 2014, matching the increase from 1Q2014. MAS management is still in the process of preparing an adjusted capacity plan for 2014, which it expects to complete within the next few weeks, but anticipates the carrier will now end the year with ASK growth of 10% to 12%.

In light of the current market conditions a deeper cut would be ideal. But this is very difficult to achieve because virtually all the ASKs being added in 2014 are driven by capacity (and aircraft) that were added in late 2013. On a month by month basis, MAS ASKs are not likely to go above the 5.4 to 5.5 billion mark, which is the level the carrier was at in Dec-2013 and again in Jan-2014 and Mar-2014 (February was lower as it is a shorter month). In fact it will likely come down slightly from this level as some frequencies are cut.

Malaysia Airlines monthly ASKs: Jan-2012 to Mar-2014

MAS is taking delivery of 20 aircraft in 2014, including 12 at the main airline and eight at regional subsidiaries Firefly and MASWings. But on a net basis its fleet will remain flat when taking into account retirements. (Five of the 12 mainline aircraft, four 737-800s and one A330, were delivered in 1Q2014 with seven 737-800s to be delivered over the remaining three quarters.)

Malaysia Airlines Group aircraft deliveries: 2014 and 2015

MAS will not defer any deliveries, still hopes to place new orders this year

MAS executives say there is no consideration of deferring or cancelling any of its upcoming deliveries or sub-leasing aircraft. It points out it still has a need for all seven of the 737-800s as short-haul demand remains relatively strong. (Some of the 737-800s will also be replacements for MAS' last batch of remaining 737-400s, which the carrier says will be phased out by the end of Jun-2014.)

The long-haul market is where MAS sees weaker demand, dictating fewer frequencies and down-gauging some flights from larger to smaller widebody aircraft. MAS' widebody passenger fleet currently consists of 15 A330-300s, 14 777-200s and six A380s.

MAS currently does not have any additional widebody aircraft on order, giving it the opportunity to potentially adjust its widebody fleet and long-haul capacity plan by accelerating retirements. While the carrier is not easily able to reduce ASK growth for 2014 into the single digits, which would be the ideal scenario given current market conditions, there is an opportunity to significantly slow down growth in 2015 and beyond as it only has nine outstanding mainline orders beyond 2014 (all 737-800s, only two of which are slated for delivery in 2015).

The carrier is now reviewing its long-term fleet and network plan (which goes through 2020) in parallel with an overall review of its strategy. MAS had been planning prior to MH370 to place in 2014 a major order for new-generation aircraft covering both replacements and growth. The carrier still plans to resume negotiations later this year with manufacturers, which had replied to a request for proposals.

A large order is still necessary as it will enable MAS to improve efficiency levels and catch up with competitors as MAS is the only major carrier in Asia-Pacific that has not yet committed to new generation narrowbodies (A320neo or 737 MAX) or widebodies (A350, 787 or 777X). But the carrier could adjust the total figures to reflect adjustments in its long-term strategy and business plan.

MAS continues to expand in domestic market

MAS executives say about a quarter of the 10% to 12% growth in ASKs for 2014 will come in the domestic market. This is a relatively high figure given that the domestic market accounts for only 11% of the carrier's total ASKs (but 35% of passengers, based on 1Q2014 figures).

But MAS has seen less impact in the domestic market from MH370. Long-haul international traffic has been particularly impacted as some passengers do not seem to have the confidence to travel with MAS on long flights and are instead travelling domestically or on short-haul regional international flights within Southeast Asia.

MAS also has been expanding rapidly in the domestic market over the last year in response to increased competition, driven by the Mar-2013 launch of new hybrid carrier Malindo Air from the Lion Air Group. MAS domestic ASKs were up 20% in 2013 and 16% in 1Q2014. Total domestic passenger growth in Malaysia was about 18% in 2013.

While MAS has not had too much trouble filling up its domestic flights, with its domestic load factor increasing 6.9ppts in 1Q2014 to 75.4%, fares have been unsustainably low as a result of the intense competition. MAS says its yield declines over the past year have been significantly bigger in the domestic than international market (Malaysia AirAsia has previously made similar revelations.) As MAS and its two local competitors continue to add domestic capacity in 2014, albeit at reduced levels compared to 2013, yields will remain under pressure.

Australia drives international ASK growth for MAS

In the international market, MAS expects most of the ASK gains for 2014 to be to and from Australia. This is driven by significant capacity expansion on Australian routes from late 2013, when MAS added a third daily flight to both Melbourne and Sydney while launching Darwin as its sixth Australian destination. (MAS also serves Adelaide, Brisbane and Perth; capacity has been relatively flat over the last year to Adelaide and Brisbane while Perth has seen a few additional weekly frequencies.)

The Malaysia-Australia and broader Southeast Asia-Australia market has been suffering from overcapacity as MAS was not the only Southeast Asian carrier to significantly add capacity to Australia in 2013. Yields and load factors between Southeast Asia and Australia are expected to remain under pressure in 2014, impacting the revenue contribution from one of MAS' most important markets. Australia currently accounts for about 14% of MAS' international seat capacity and 22% of ASKs, making it the carrier's largest single market.

MAS international capacity share (% of ASKs): 12-May-2014 to 18-May-2014

MAS is planning to cut capacity in several international markets as it reduces total ASK growth for 2014 from 19% to 10% to 12%. But entire routes are not expected to be axed as the focus will be on down-gauging certain flights and suspending select frequencies where there is relatively low demand, particularly flights during non-peak hours and or non-peak days (such as Tuesdays and Wednesdays).

MAS has already been cancelling and consolidating such flights over the last couple of months and is now combing through its network to identify flights to be cut or suspended on a less ad hoc and more regular basis. MAS expects to complete this effort and implement the schedule cuts within the next few weeks.

MAS to reduce aircraft utilisation rates

The cuts will result in slightly lower aircraft utilisation rates - something MAS has worked hard to increase over the past two years as part of its turnaround efforts. Higher utilisation was also the driver of the ASK growth in 2013 and 1Q2014 as the total size of the fleet increased only slightly. But a utilisation reduction is now sensible as a large number of MAS flights are simply not covering variable costs.

Reducing aircraft utilisation and even parking aircraft during certain periods is a common practice by some carriers in Europe and North America. While it is almost unheard of in Asia, the current over-capacity situation in Southeast Asia calls for new measures. Other carriers will likely join MAS in cutting capacity and reducing aircraft utilisation levels - although for MAS the cuts will likely wrongly be labelled as responses to MH370 rather than to the overall challenging market conditions.

Demand has indeed been impacted by MH370, particularly in China where the carrier saw sales drop by about 60% soon after the aircraft disappeared, but the bigger and more long-term issue is over-capacity and intense competition in the overall market place.

MAS has dropped plans to add a third daily frequency to Guangzhou, which was to be implemented in Sep-2014, but is not likely to scale back significantly in China as it cannot risk losing its slots at Chinese airports. MAS also has seen a sharp drop in demand for long-haul flights, which is expected to significantly impact its year-over-year RPK and load factor figures in 2Q2014.

Mar-2014 represented the first time in 14 months that MAS' load factor dropped year-over-year, starting what will likely turn out to be a new trend of year-over-year declines.

Malaysia Airlines monthly load factor: Jan-2012 to Mar-2014

MAS prepares new brand campaign and works on restructuring plan

MAS has resumed promotional activities within the last couple of weeks and is planning to roll out a brand campaign next week which will focus on restoring trust and confidence in the carrier. The campaign, which will end an over two-month hiatus on media advertisements, will be aimed particularly at loyal passengers in Malaysia.

But while passengers that have been avoiding MAS in the aftermath of the MH370 incident may gradually return there are broader structural issues that will still need to be addressed. The carrier's management team recognises that another restructuring will be necessary to ensure long-term viability. "The reality of our situation following the MH370 incident and the challenging business environment has made it even more imperative and urgent that the Group re-look at its business model and plans going forward to ensure sustainability of the business," MAS stated in its 1Q2014 results announcement.

MAS executives declined to provide analysts with any details on the potential changes to its business model and possible new restructuring initiatives, saying they are looking at all options. Clearly a major review is underway aimed at improving the carrier's long-term position.

The biggest question is how deep a restructuring MAS executives will be allowed to undertake by the Malaysian government, which remains the carrier's main shareholder.

MAS has restructured multiple times over the past several years but each and every time the carrier has been back in the red after a year or two as the restructuring did not go deep enough to fix the main fundamental problems.

MAS is now again looking at implementing several initiatives that have been part of prior turnaround plans but have not been implemented, including selling its maintenance and ground handling units. While MAS is again eager to sell these units, with the hopes of reducing its cost structure, ultimately the government needs to agree. Finding a buyer may also prove tricky without first restructuring the units - a costly and potentially politically unacceptable exercise.

MAS executives need to be given the opportunity to implement a deep restructuring

As MAS has already restructured its network in recent years, eliminating most of the longstanding unprofitable long-haul routes (Los Angeles was the last to get the axe with the final flight operating at the end of Apr-2014), the focus needs to be on the company's staffing levels and overall productivity. Politics and unions have always made this a no-go subject.

But the scenario now facing MAS is different and could potentially be the trigger to allow the carrier to finally actually pursue the kind of restructuring it has needed for years.

In the short-term the outlook is very bleak. Losses for the 2Q2014 will almost certainly be higher than 2Q2013 and 1Q2014 levels due to the full quarter impact on demand from MH370 and the continuing challenging market conditions.

There could be a slight improvement in 2H2014 as capacity adjustments are made (both by MAS and some competitors) and as MAS efforts to restore its brand start to bear fruit. But MAS will not be able to fully recover and return to profitability without a major overhaul.

The challenges facing Malaysia's flag carrier are its biggest yet but there could be a silver lining in the current predicament if the government finally gives the MAS management team an opportunity to fully right the ship.

Courage will be needed; it is politically easier to tinker at the edges and slip through another big subsidy. But that simply digs the eventual hole a lot deeper.