04-Oct-2014 1:56 PM

Monarch Airlines. Part 2: Why one of Europe's lowest cost airlines is right to seek cost reductions

Analysis

Monarch Airlines recorded a pre-tax profit in 2013, recovering from losses in 2012. This was driven by unit revenue gains outpacing a small rise in CASK. Nevertheless, its track record is one of losses and only occasional profitable years with thin margins. Traffic growth over a number of years, driven by a switch from charter to scheduled flying, has not typically led to profit growth.

Fleet expansion has contributed to falling aircraft utilisation rates and the airline's strong focus on leisure markets gives it one of the most seasonal demand patterns among European airlines.

In Part 1 of our Monarch analysis, we looked at most recent financial results of the airline's parent, the Monarch Group. We also reviewed developments initiated by the new management of the Group, in connection with strategy, ownership and labour conditions.

In this second part, we focus more closely on Monarch Airlines and suggest that management is right to be seeking cost reductions from what is already one of Europe's lowest cost operators. It will also need a longer term growth plan if it is to avoid becoming marginalised by its bigger LCC rivals.

Summary

Monarch Airlines recorded a pre-tax profit in 2013, recovering from losses in 2012.
Fleet expansion has contributed to falling aircraft utilization rates and the airline's strong focus on leisure markets gives it one of the most seasonal demand patterns among European airlines.
Monarch Airlines' growth has been driven by scheduled passengers, while charter traffic has been cut dramatically.
Monarch Airlines has the lowest unit cost (CASK) of any European airline outside the group of three ultra-LCCs (Pegasus, Wizz Air, and Ryanair).
Monarch Airlines' relatively long average trip length means that its fares are among the highest for LCCs.
Monarch Airlines needs a longer-term growth plan to avoid becoming marginalized by its bigger LCC rivals.

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All segments contributed to revenue growth in FY2013

In the year ended Oct-2013 (FY2013), the Monarch Group enjoyed a year of strong revenue growth and returned to profit.

All of the Group's segments enjoyed growth in revenues in FY2013, contributing to total revenue growth of 16%. The largest segment, Monarch Airlines, increased its external revenues by 15%, a similar rate to that experienced by number two segment, the tour operations division. The air charter broking business, First Aviation, more than doubled its external revenues and Monarch Aircraft Engineering grew its sales to third parties by more than 20%.

Monarch Group external revenues by division: FY2013 versus FY2012

GBP million	2012	2013	Change	% of 2013 total
Airline operations	504.3	580.0	15.0%	61%
Engineering services	24.3	29.7	22.2%	3%
Tour operations	291.4	336.5	15.5%	35%
First Aviation	5.0	10.7	114.0%	1%
Group	825.1	956.9	16.0%	100%

Monarch Airlines was the main driver of the Group's profit recovery

The airline accounted for more than half of the incremental revenue earned by the Monarch Group in FY2013 and was also the main driver behind its return to profit. Monarch Airlines turned around a pre-tax loss of GBP44 million in FY2012 to record a profit of GBP9 million in FY2013, compared with the Group's total pre-tax profit of GBP6 million.

If non-recurring items are excluded, the airline's result was a profit of GBP20 million out of a Group total of GBP17 million.

Monarch Group profit before tax by division: FY2013 versus FY2012

GBP million	2012	2013
Airline operations	-43.6	8.7
Engineering services	5.4	4.0
Tour operations	5.7	4.5
First Aviation	0.1	0.2
Group functions	-1	-11.5
Total	-33.4	5.9

Airline seat capacity was up 10.1% in FY2013

Monarch Airlines grew its seat capacity by 10.1% in FY2014, offering 8.1 million seats, while passenger numbers increased at the slightly slower rate of 9.5% to 7.0 million. Scheduled passengers accounted for 87% of this total, highlighting how far Monarch Airlines has already come from its background as a charter operator. Passenger load factor fell slightly, by 0.4 ppts, to a still strong 86.2%. This followed a number of years of a mainly rising trend in load factor.

The company did not report ASK data, but figures from the UK's Civil Aviation Authority (CAA) show that ASKs grew by 6.1%, slower than seat growth. This suggests a modest fall in average trip length.

The airline added seven new destinations in the year, bringing the total to 38 and increased the total number of routes from 88 in 2012 to 122 in 2013. Only two of the new destinations (Malta and Split) were in the relatively distant Mediterranean, while the other five (Bordeaux, Grenoble, Munich, Friedrichshafen and Innsbruck) were in nearer markets.

Monarch Airlines revenues grew 14% in FY2013, with RASK up 7%

The airline's total revenues (including intra-Group sales to the tour operations division) grew by 13.9% in FY2013 to reach almost GBP768 million. This outpaced the growth in seats and passengers. Revenue per seat was up by 3.0% according to figures reported by the company (up by 3.5% according to figures calculated from reported revenue and seat data), in spite of the fall in average trip length.

We calculate that total revenue per ASK (RASK) increased by 7.4% in FY2013, based on Monarch's revenue figures for the airline and CAA data on ASKs.

Monarch Airlines operating highlights: FY2013 versus FY2012

	2012	2013	Change
Total pax 000	6,398	7,008	9.5%
Total seat capacity 000	7,382	8,126	10.1%
Total load factor %	86.7	86.2	-0.4 ppts
Total revenue GBP million	673.7	767.5	13.9%
Total revenue per seat GBP (calc'd)	91.26	94.45	3.5%
Revenue per seat GBP (reported)	90.07	92.78	3.0%
Core Revenue per seat GBP	75.58	73.84	-2.3%
Retail revenue per seat GBP	14.50	18.94	30.6%
Cost per seat GBP*	93.55	91.10	-2.6%

Revenue per seat growth was driven by a 30.6% improvement in retail revenue per seat. Core revenue per seat fell by 2.6%, but this was not surprising in view of the shorter average trip length.

The increase in total revenue per seat, and the still high load factor, demonstrates a degree of pricing power as Monarch targeted its growth on markets where demand was strong.

CASK was up 1% in FY2013

CAPA estimates that Monarch Airlines' operating cost per seat fell by almost 3%, although the fall in average trip length means that CASK grew by an estimated 1%.

Management reported that it had reduced the cost base of the airline by GBP22 million during the year (this roughly corresponds to our estimate of its operating costs in FY2012 and the costs that it would have incurred in FY2013 if its cost per seat had remained the same as our estimate for FY2012 cost per seat).

The Group's annual report does not give a detailed cost breakdown and so we cannot analyse the source of cost savings, but the company said that the airline's cost savings programme had removed GBP52 million of annualised costs over the previous two years.

Headcount: Group was up 12% and airline was down 5% in FY2013; redundancies are expected

The Monarch Group's annual report shows that staff costs increased by 17% in FY2013. This was faster than the 12% growth in average headcount, partly due to increased pension contributions, but also reflecting wage increases.

Staff numbers in the airline division fell by 5% to 1,520, out of a Group total of 3,191, but its staff costs are not separately reported. Headcount in the engineering and administrative functions increased by more than 40% in FY2013.

According to media reports, the Group is seeking a headcount reduction of 900, of which around 300 may be compulsory redundancies.

Monarch Airlines track record of profitability is weak

FY2013 was a relatively rare year of profitability for Monarch Airlines. Although the privately owned Monarch Group has only published an annual report in the past two years, filings with the UK's Civil Aviation Authority (CAA) show the financial results of Monarch Airlines over a number of years. FY2013 was the airline's first profitable year post the global financial crisis, but, even in the good years leading up to the crisis, it rarely achieved better than breakeven results.

From FY2005 to FY2013, Monarch Airlines' revenues increased by 71%, or GBP320 million, but this was offset by an almost identical rise in costs. The airline's pre-tax profit increased by only GBP6 million from FY2005 to FY2013 and its pre-tax margin rose from 0.5% to 1.1%.

Monarch Airlines revenue and profit before tax (PBT), GBP million: FY2005 to FY2013

Monarch Airlines' growth has been driven by scheduled passengers

The growth in the airline has been driven by a strong increase in scheduled passenger numbers, while charter traffic has been cut dramatically.

From 2005 to 2013, Monarch Airlines' scheduled passengers increased by 136%, its charter passengers decreased by 72% and total numbers grew by 27% (using CAA data for calendar years). Scheduled passengers were less than half of Monarch's total traffic in 2005, but represented 88% in calendar 2013.

The more rapid rise in revenues compared with total passenger numbers probably reflects the higher yield generated by scheduled traffic and the development of ancillary revenues, in addition to inflation.

Monarch Airlines passenger numbers (million) and passenger load factor: 2005 to 2013

Monarch has outpaced market growth since the global financial crisis

Since the trough that followed the global financial crisis, Monarch Airlines' growth has been particularly strong, mimicking that of the boom years just before the crisis. From 2010 to 2013, its total passenger numbers increased by 18%, outpacing the 11% increase experienced by all UK airlines in that time frame.

Monarch's scheduled passenger numbers rose by 63% over this period, exactly mirroring the decline in its charter passenger numbers. (Source for all passenger data: UK CAA).

The growth in scheduled traffic has been impressive and may have contributed to the increase in revenues since 2010. However, as noted above, this growth does not appear to have driven a sustained increase in profit. Moreover, such growth rates, if maintained, will lead to greater competition with bigger LCCs that have wider pan-European networks, placing more pressure on Monarch's cost base.

Monarch Airlines and all UK airlines: change in passenger numbers: 2010 to 2013

Aircraft utilisation is falling

As noted in the first part of our analysis of Monarch, the Group CEO Andrew Swaffield has said that the airline has too many aircraft. At first sight, his reasoning may not be obvious. After all, load factors are at industry high levels and revenues have risen faster than passenger numbers. However, what these figures do not show is that aircraft utilisation has dipped in recent years, mirroring the growth in the fleet.

Monarch Airlines number of aircraft at year end and average daily aircraft utilisation (hours): 2005 to 2013

Again using CAA data, Monarch's aircraft flew an average of 9.1 hours per day in 2013, down from 10.0 hours in 2009. Over the same period, the year end fleet increased to 39 from 31 aircraft (it now stands at 42, according to the CAPA Fleet Database).

Load factor gains are welcome, but, in terms of overall asset utilisation, they have been more than offset by the fall in the amount of flying each aircraft is doing each day.

Monarch is one of Europe's most seasonal airlines

Lower aircraft utilisation may be linked to seasonality. Monarch's focus on leisure destinations means that it has much higher demand in the summer months than in the winter.

It is difficult to establish historic data series showing whether the degree of seasonality in its business is increasing, but the 1HFY2013 results press release, which contained comparative data for the previous year, suggests that this might be so (at least in terms of traffic numbers). The Group did not publish 1H data for FY2014, a clue that perhaps overall trends were deteriorating.

Whether or not the trend is increasing, Monarch Airlines already has one of the most seasonal businesses of any European airline. Monarch's Feb-2014 seat capacity was just 36% of its Aug-2013 seat capacity. Among European airlines that fly year round, only TUIFly has a lower ratio of trough to peak season capacity, with 31%.

Other leisure airlines such as Condor and Jet2.com have a figure above 40%, while charter carriers Thomas Cook Airlines and Thomson Airways are above 50% on this measure. LCCs Vueling, Ryanair and Transavia are also more than 50% and easyJet's figure is more than 70%. A figure of 100% would mean that low season capacity is equal to the peak season, so Monarch's level of 36% represents a very high degree of seasonality.

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Quite simply, it means that its fleet will inevitably be under-utilised. This might be acceptable for an airline with a fully depreciated (and so 'costless') fleet, but not for Monarch. Its fleet is predominantly operating leased and lease payments must be met all year round, whether or not the aircraft are being flown.

As noted in Part 1 of our analysis, it seems likely that Monarch's fleet will reduce over time from the current 42 aircraft (of which 37 are narrowbodies) to the 30 aircraft envisaged in the planned Boeing 737 MAX order (although the order will also include 15 further options). This should help to improve utilisation.

Measuring seasonality: Feb-2014 seat capacity as a percentage of Aug-2013 seat capacity for selected European airlines

Monarch has established a leisure niche

Monarch Airlines has carved a niche in serving leisure markets from the UK to destinations focused mainly in the Mediterranean, North Africa and the Canary Islands. It also serves winter ski resorts, a market segment that it has developed in an attempt to reduce the seasonal fluctuations of the business.

This niche is relatively defendable in some ways and Monarch says that it is number one or number two by market share at each of its bases on the routes that it operates. However, as we have seen, this market niche also locks it into a very seasonal demand pattern, with negative consequences for asset utilisation. This requires trimming the network to reduce the proportion of summer only routes and those that are not profitable.

Costs tend to be less seasonal, remaining broadly constant all year, while revenues fluctuate significantly according to the time of year. For Monarch, this revenue variation is more exaggerated than for almost any other airline in Europe and so its presence in the leisure niche also requires a lower and more flexible cost base so that it can be more profitable (or less loss-making) in the low season.

Group CEO says "We will stay in our heartland"

Group CEO Andrew Swaffield's strategic review appears to have taken account of much of Monarch Airlines' challenges. He has said that the change of ownership will not change Monarch's market focus. "We will stay in our heartland, that leisure, sunny belt," he has said, before adding that he wanted "a more efficient and sustainable cost base" (The Guardian, 25-Sep-2014).

Nevertheless, although it is not fundamentally changing its markets, Monarch is expected to reduce its network, cutting annual passenger numbers from eight to six million at the conclusion of its restructuring. This is broadly consistent with the expected reduction in the fleet size and in Group headcount.

All this points to a more focused network, presumably with fewer loss-making and marginal routes and higher frequencies. Indeed, it has already announced the closure of its East Midlands Airport base.

Monarch Airlines' CASK is the lowest in Europe, apart from the ultra-LCCs

According to our analysis, Monarch Airlines has the lowest unit cost (cost per available seat km, CASK) of any European airline outside the group of three ultra-LCCs (Pegasus, Wizz Air and Ryanair). This does not reduce the need to lower its cost base.

To some extent, its low CASK is due to its higher average trip length (all other things being equal, unit cost falls as the length of the flight increases). Monarch Airlines has an average trip length of more than 2,200km, the longest among European LCCs, but Monarch is still a little below the trend line for LCCs, if the ultra-LCCs are excluded (see chart below).

Nevertheless, the airline's CASK rose in FY2013, albeit only slightly, and the ultra-LCCs cannot be ignored. In addition, Monarch Airlines' FY2013 operating margin (which we estimate at 3.5%) is around half the European LCC average and insufficient to sustain reasonable returns to investors in the long run. This suggests that its costs are too high for the revenues that it is able to generate (especially in the low season).

Moreover, Monarch's relatively long average trip length means that its fares are among the highest for LCCs. Its prices are reasonable on a distance-adjusted basis, but the price sensitive consumer may look to spend less by taking a shorter flight. "People won't pay more to fly on us than they will on easyJet or Ryanair", said Mr Swaffield (The Guardian, 25-Sep-2014).

FY2013's profit recovery was driven by a RASK increase, but Monarch cannot rely on this for future profit improvement. Indeed Mr Swaffield has said that 2014 is proving "difficult" because of overcapacity. We take this as code for a falling profit trend.

Cost per available seat kilometre (CASK, USc) versus average trip length (km) for European airlines 2013

2014 looks to be a pivotal year for Monarch

Nevertheless, 2014 also looks like being a hugely important year in Monarch Airlines' development. If the proposed sale of the Monarch Group to Greybull Capital completes, as expected, by the end of Oct-2014, this should assure investment in the company's future.

The Greybull deal should allow Monarch to confirm the 737 MAX order, which in turn will help it to achieve CASK reductions from 2018 (although there will be a tricky phase of operating a mixed Airbus/Boeing fleet). Planned headcount reductions and changes to pay and conditions that have already been agreed with unions should further contribute to a lower and more flexible cost base.

As CAPA said in Part 1 of our analysis of Monarch, the new senior management has already had a significant impact on the company. What it cannot control is the response of competitors.

Monarch's lower cost rivals are currently expanding and will take every opportunity to absorb any demand that it sheds. Monarch may have little option at the moment other than to contract in size and lower its cost base, but it must also have a longer term growth plan if it is to avoid becoming marginalised by these bigger rivals.