Malaysia Airlines restructuring: cost cuts must be deep to improve short-haul competitiveness

This is the third part in a series of analysis reports on MAS' current predicament and outlook. The first report looked at the carrier's 2Q2014 earnings, released on 28-Aug-2014, and its bleak outlook for 2H2014.

The second report focused on MAS' outlook in the long-haul market as it looks to reduce capacity and rely more on partnerships. This part looks more specifically at MAS' position regionally and at the job cuts announced by Malaysian government investment firm Khazanah on 29-Aug-2014, which are aimed at improving productivity and closing the gap with Asian competitors.

See related reports:

• Malaysia Airlines restructure will need partners - perhaps Etihad, BA, Finnair or Qatar Airways
• Malaysia Airlines 2Q loss widens. Restructuring is imminent but outlook remains bleak

MAS to focus on regional network

MAS would face huge challenges whichever direction it turns, but its best chance at recovery is to rely on the strength of its regional network.

That is driven not so much by a clear design - as Malaysia's regional markets are among the most competitve in the world - but more by the reality that it is not in a position to sustain a long-to-short-haul model. As a result the new recovery plan prepared by Khazanah envisions focusing on Asia-Pacific, or flights of under roughly eight hours from Kuala Lumpur.

As CAPA suggested in the previous part of this series of reports, capacity to Europe is expected to be cut through a combination of frequency reductions and in some cases route terminations. MAS will rely more on fellow oneworld members and other partners to serve long-haul markets. Partnerships should also contribute incremental regional traffic as partners leverage MAS' Asia-Pacific network, which includes over 40 international destinations.

But MAS is presently also ill equipped to compete in the regional market. Its cost structure, yields and labour productivity rates remain way too high - compared to both LCC and full-service competitors.

Khazanah plans to tackle the cost issue through several cost reduction initiatives. First and foremost are job cuts. MAS has attempted several restructurings in recent years but for political reasons jobs were always spared, making it impossible for executives to tackle the longstanding issue of a bloated workforce with employee productivity rates well below industry standards. The alternative, of increasing flying to seek to improve productivity in that way, has merely led to excess capacity and yield dilution.

MAS seeks to improve employee productivity

In its recovery plan, Khazanah pointed out MAS workforce productivity significantly lags full-service airline group peers Singapore Airlines (SIA) and Cathay Pacific. Khazanah stated that that MAS averages only 3.6 million ASKs per employee per year while Cathay averages 5.1 and SIA 6.1.

Annual ASKs (millions) per employee: Malaysia Airlines vs Cathay Pacific and Singapore Airlines

Source: Khazanah

These indicators can always be misleading, for example where one airline has a significantly shorter average stage length. But MAS does not fare well in any of the comparatives.

In terms of revenues per employee the gap is, not surprisingly, even larger given the higher yields and larger volumes of premium traffic that Cathay and SIA command.

Annual revenue (MYR thousands) per employee: Malaysia Airlines vs Cathay Pacific and Singapore Airlines

Source: Khazanah

Based on number of employees per aircraft, MAS is 33% less efficient than SIA and 46% less efficient than Cathay. Among the several airlines Khazanah compared only Thai Airways, which has its own considerable issues and also recently unveiled plans to cut jobs as part of a restructuring, is less efficient in this ranking.

Employees per aircraft: Malaysia Airlines vs select carriers

Source: Khazanah

In theory SIA and Cathay should have higher figures than MAS as they have a higher portion of widebody aircraft. MAS has over 50 narrowbody aircraft while the SIA and Cathay Pacific groups each have about 25 narrowbodies. (The MAS figures exclude the turboprops and employees at the group's regional subsidiaries.)

Khazanah concludes that a 30% reduction in employees would put MAS close to the global average in terms of employees per aircraft. This would assume no changes in the size of the fleet. Khazanah has unveiled plans to cut 30% of the MAS workforce, or 6,000 jobs, and has suggested there will be capacity cuts, particularly to the long-haul network. But it has not indicated if the fleet will also be cut.

The reality is that however all these figures are skewed as MAS's count includes its maintenance and ground handling employees. MAS has large maintenance and ground handling units that also pursue some third-party business. Many airlines outsource these functions or have separate companies. For example, SIA employee figures do not include maintenance and grounding handling because SIA Engineering and SATS are separate companies with their own listings.

But even when accounting for these differences MAS is still relatively bloated. The airline should be able to cut a significant number of employees without adjusting capacity.

Capacity is also expected to be reduced, driven by cuts in long-haul ASKs. But capacity will likely not have to be reduced by a matching 30% figure.

MAS job cuts will likely include maintenance and ground handling units

Khazanah has not yet provided any breakdowns on the proposed job cuts. Until a breakdown is provided it is hard to determine with any accuracy what the productivity gains will be for the airline operation.

The maintenance and ground handling units could potentially be exposed to a larger portion of cuts than the airline itself. These would still help MAS in its overall cost cutting initiative as the airline would no longer have to pay as much for these - expensive - services.

MAS in particular has been paying higher than market rates for maintenance services as its maintenance unit is overstaffed. MAS Engineering has been able to win business from other airlines but the rates it has had offer to secure third party customers in the highly competitive MRO industry are generally well below cost, resulting in essentially a cross subsidy, with MAS indirectly underwriting the maintenance costs of other airlines.

MAS will need to get its maintenance costs in line as it restructures. MAS had been looking at spinning of and selling MAS Engineering as part of previous restructuring plans. Khazanah is no longer looking at this option, which is not realistic until the maintenance unit itself is restructured.

MAS will seek better deals from suppliers including leasing companies

Khazanah also has stated that as part of the recovery plan MAS will seek to "renegotiate contracts with suppliers, leasing companies and creditors to industry benchmarks".

While it has not been declared bankrupt, MAS seems to be seeking US style bankruptcy benefits as it transitions to a new corporate structure. As a new company is established over the next year, MAS suppliers will be given the option to migrate to the new company on new terms. (Bankruptcy was previously ruled out as an option for MAS, partly because bankruptcy laws in Malaysia do not provide the kind of protection received in the US and some other countries. Consequently the grounds for such adjustments may have their roots in another, specifically Malaysian, provision.)

MAS has been known to pay higher than industry norms for equipment and services. Its biggest competitor, AirAsia, has been highly successful at negotiating some of the most competitive rates for products and services, including aircraft. MAS must close the gap with AirAsia across all cost lines in order for the flag carrier to be sustainable.

MAS seeks to narrow the cost gap with short-haul LCCs: "Cost-competitiveness is the foundation..."

Khazanah estimates that the MAS short-haul operation has a cost disadvantage of 42% compared to LCC competitors.

The current unit cost for the MAS 737-800 operation is MYR21.1cents (USD6.7cents) per ASK while its LCC peer group has an average unit cost of MYR14.8 cents (USD4.7cents) per ASK - or over 40% higher.

Currently MAS does not enjoy nearly enough of a yield premium to offset the higher cost. It estimates its average yield or revenue per ASK on 737-800 routes is only 20% higher than its LCC peers.

Malaysia Airlines yield (RASK) and narrowbody unit costs (CASK) compared to LCC peers

Source: Khazanah

With the job cuts, renegotiated supplier contracts and other cost reduction initiatives, Khazanah is aiming to narrow this cost gap from 42% to within 15%. This would also give MAS' narrowbody operation lower unit costs than its regional full-service competitors.

MAS is not alone among Southeast Asian full-service airline groups in focusing on regional growth. SIA has been successfully focusing on these markets using SilkAir, which is a full-service subsidiary but has a lower cost structure than SIA mainline. Thai Airways has similarly recently established a regional lower-cost full-service subsidiary in Thai Smile. Garuda Indonesia has also been pursuing regional growth but like MAS has its own narrowbody operation rather than a separate subsidiary.

All of the full service airline groups in Southeast Asia have the advantage of attracting some premium traffic on regional routes as well as higher yielding connecting traffic. But these groups must keep their narrowbody costs to a minimum as a large portion of their short-haul traffic is point to point and price sensitive. As the Malaysian short-haul market is particularly competitive and price sensitive MAS has to lower its short-haul cost structure significantly if it is to survive.

Khazanah recognises this need by stating in the MAS recovery plan: "Cost-competitiveness is the foundation upon which the rest of the business will be built. Resetting the cost structure is particularly important given the Malaysian market context, especially for short-haul travel. The importance of the price-sensitive leisure travellers is growing (they make up the majority of MAS' current customer base), there is increasing emphasis on the short-haul business traveller's preference for efficiency and convenience versus a premium product, and MAS' premium advantages are eroding as LCCs move upmarket (e.g., LCCs moving to the state-of-the-art new terminal at klia2 and bringing new aircraft on line).

"MAS can draw on a range of initiatives to help it achieve its target cost structure, including, but not limited to: increasing seat capacity, raising utilisation of short-haul aircraft, redesigning the short-haul product and service model, reducing fuel costs, improving labour productivity, and increasing direct sales."

MAS will also seek to improve yields

Tackling costs cannot be the only solution. Khazanah is also targeting a 10% to 15% improvement in unit revenues, driven partially by improved revenue management measures. This would widen the relatively small revenue advantage MAS has with LCC competitors and narrow the revenue gap with its full-service competitors

Khazanah estimates MAS has on average a 14% lower yield or RASK than its Asian full service peers while its CASK compared to its Asian peers is only 4% lower.

Malaysia Airlines yield (RASK) and unit costs (CASK) compared to LCC peers

Source: Khazanah

Improving unit revenues however will not come easily. MAS has tried previously to increase yields without success. It is hard to imagine a sufficient improvement in market conditions that would allow MAS to raise yields. As CAPA outlined in the previous instalment in this series, the Malaysian market is likely to remain intensely competitive and MAS hardly has much upside pricing power these days.

Capacity reductions could help as they would enable MAS to focus more on higher yielding traffic and sell fewer seats at lower fare buckets. But it is unclear how much if any short-haul capacity will be taken out as part of the upcoming restructuring. As MAS will be increasing its focus on its regional network most of the capacity cuts are likely to come from the long-haul network.

MAS may consider smaller aircraft for short-haul operation

MAS also has just completed the renewal of its narrowbody fleet, which could make it difficult to cut short-haul capacity, particularly as Khazanah has cited the possibility of increasing narrowbody utilisation rates and adjusting configurations to increase seat density. MAS' fleet of 57 737-800s has an average age of less than three years and approximately half are leased, according the CAPA Fleet Database. Negotiating early returns for the leased aircraft or selling the owned aircraft could be challenging and expensive (although a 2017 profitability horizon does perhaps allow for the absorption of considerable expenses meanwhile). Deferring or cancelling the remaining 11 737-800 orders could also be difficult.

Khazanah has raised the possibility of reducing average aircraft size as part of the restructuring. This could be a sensible move and reduce short-haul capacity without compromising utilisation rates. But smaller narrowbody aircraft would have to be acquired and a portion of its new 737-800 fleet would need to be phased out.

Embraer and Bombardier have already been proposing 100-seat regional jets believing smaller aircraft should be part of the solution at MAS and other struggling airlines in Southeast Asia. Regional jets could allow MAS to increase frequencies on regional routes, providing a better product for business and connecting passengers. Small jets could also be used to add thinner regional routes which would not be viable options for LCCs. As a result smaller jets in theory would support initiatives to improve yields and differentiate the product from LCCs.

Acquiring regional jets would be a bold move. MAS and other airline groups in Southeast Asia have repeatedly resisted going the regional jet route. But bold moves - provided they are the right ones - will be needed to secure MAS' future. Smaller jets should generate a yield benefit, but there would have to be very careful management of unit costs if MAS is to meet its target for narrowing the cost gap with LCCs.

Key decisions loom as Malaysia invests another USD1.9 billion in MAS

Ultimately several key decisions will need to be made over the next year as MAS embarks on the restructuring process. MAS will have the capital to make major adjustments. But the investments made need to clearly have a high chance of improving flag carrier's overall position and long-term profitability. Khazanah has stressed that the MYR6 billion (USD1.9 billion) the Malaysian government has pledged for the MAS recovery programme will not be made available unless certain criteria are met.

Half of the capital will be spent not on long-term improvements but to get MAS out of the current hole.

For example MYR1.6 billion (USD510 million) will be spent on severance packages and retraining workers for other jobs. Another MYR1.4billion (USD440 million) will be spent on delisting the current company, including buying out the private shareholders. The remaining MYR3 billion (USD950 million) is being set aside for the "new MAS" with funds available on a staggered and milestone basis over the next three years.

A significant portion of this investment will be spent on new headquarters at Kuala Lumpur International Airport. MAS currently still has its headquarters and maintenance facilities at capital's old airport, Subang, but all flight operations except turboprop subsidiary Firefly are at KLIA.

MAS will transition to a new corporate structure and executive team in "NewCo"

A new corporate structure will also be introduced from mid-2015 along with a new executive team. Current CEO Ahmad Jauhari Yahya will continue to manage the current business or the old company until Jun-2015 as work begins on establishing the new company.

The new company is expected to begin operations in Jul-2015 with about 14,000 employees compared to the current 20,000 employees with the existing company. "The migration to NewCo, with its strong funding conditionality imposed, is envisaged to result in a lower cost structure based on industry benchmarks and work practices, with savings principally coming from improved supply contracts and labour practices," Khazanah stated.

Khazanah is now recruiting for a CEO to lead the new company with the goal of selecting a candidate by the end of 2014. Khazanah has been hunting both in Malaysia and internationally for a new CEO. It also has pledged to upgrade the top 500 positions with global aviation specialists from around the world in an attempt to prepare MAS for a better future. This represents a serious commitment from the Malaysian government - with considerable political implications - and will not come cheaply.

MAS has one last chance to chance to right the ship

The Malaysian government clearly wants to give MAS another opportunity to right the ship. But the government will not continue funding the airline if does not find a sustainable path over the next four years. "The Government cannot continue to financially support the airline without a clear path to sustainable profitability and financial self-sufficiency, despite MAS' importance to the broader economy," Khazanah stated in the MAS recovery plan.

MAS has incurred MYR8.4 billion (USD2.7 billion based on the current exchange rate) in losses since 2001 and has required MYR17.4 billion (USD5.5 billion) in expenditure from the government during that period. Khazanah pointed out that with the same amount of funds the government could have linked over 200,000 rural households to running water and electricity.

Malaysia Airlines annual profit/loss (MYR billion) and share of Malaysian market (% of ASKs): 2001 to 2013

Source: Khazanah

The government and its investment firm Khazanah is taking one last roll of the dice with the most dramatic restructuring to date. As the long-haul network will be reduced to a very small size ultimately the success of the restructuring will hinge on the ability to improve the fortunes of MAS' regional operation.

Competing as a full-service carrier in any short-haul market is tough. Southeast Asia, where the short-haul LCC penetration rate is already over 50% and most competing full-service airline groups have successful regional subsidiaries, is particularly challenging.

MAS must be able to reduce its costs. But reducing its cost structure sufficiently to compete effectively while simultaneously increasing unit revenues will be challenges that few have ever achieved, especially among "flag carriers".

The seemingly inevitable link with nationalism and politics does not travel well with consistent rational debate over national airlines. Khazanah's reference to alternative funding uses for social improvement will echo widely around the region, as some other heavily subsidised airlines - notably in India - undergo reassessment. The big task in fact for Khazanah and MAS will be to convince successive Malaysian governments to stay the course.