09-May-2014 3:57 PM

Norwegian Air Shuttle's record 1Q loss: fighter pilot, lawyer, novelist needed?

Norwegian has had a challenging start to 2014. It has announced a record first quarter loss, as unit revenues plunged on the back of 48% ASK growth and unit cost cuts failed to keep pace. The loss was exacerbated by additional costs associated with the launch of long-haul operations and by currency movements.

It also faces strategic hurdles. Delays by the US Department of Transportation in granting a foreign carrier permit to its Irish subsidiary Norwegian Air International cast some uncertainty over its long-haul expansion. In addition, Norwegian faces possible strike action from Scandinavian cabin crew over new labour contracts, which it plans to transfer to new subsidiary companies.

Norwegian's low-cost model, and its long-haul application, demand innovative paths to grow without being tied to Norway's high labour cost environment. It has identified such paths, but innovation often provokes resistance. CEO Bjorn Kjos will need to draw on all his experience as a fighter pilot, lawyer and novelist to find the resilience, cunning and imagination needed to meet 2014's continuing challenges.

Norwegian Air Shuttle's highest ever 1Q loss

Norwegian's net loss widened to NOK595 million (EUR71 million) in 1Q2014, compared with a loss of NOK117 million (EUR16 million) in 1Q2013, while the reported operating result slumped to a loss of NOK777 million (EUR93 million) from a profit of NOK69 million a year earlier (EUR9 million).

Adjusting for the item 'other losses and gains', which do not reflect the underlying operating performance of the business, the adjusted operating result was a loss of NOK879 million (EUR105 million), versus a loss of NOK187 million (EUR25 million) in 1Q2013). Revenues grew 22% to NOK3,551 million (EUR425 million).

Net debt fell from NOK4.3 billion at the end of 2013 to NOK4.2 billion (EUR562 million) at the end of Mar-2014, although it was up from NOK3.0 billion a year earlier and is likely to increase further as the company acquires more aircraft. However, liquidity is reasonably healthy, with a gross cash balance at the end of Mar-2014 of NOK3.2 billion (EUR422 million), equivalent to 71 days of revenues (based on the 12 months to Mar-2014). This cash balance increased from NOK2.4 billion a year earlier and NOK2.2 billion at the end of 2013.

Norwegian Air Shuttle financial highlights: 1Q2014

The first quarter of the calendar year is seasonally the weakest quarter and typically loss-making, but this adjusted operating result was Norwegian's heaviest 1Q loss and represented 24.8% of revenues. Norwegian said that it suffered NOK78 million (EUR9 million) of additional costs in the quarter in connection with technical and operational problems with the nascent long-haul network.

In addition, it said that costs were inflated by more than NOK200 million by the depreciation of the NOK against the USD and EUR. Even after taking these points into account, the adjusted operating loss would still have been higher than any previous 1Q.

Norwegian Air Shuttle revenue and operating profit*: 1Q2009 to 1Q2014

ASK growth of 48%; average sector length up 15%

Norwegian's passenger numbers increased by 24% year on year in 1Q2014, but a 15% increase in average sector length drove growth of 50% in RPKs. With ASKs up 48%, load factor increased by 1.2 ppts to 77.3%.

The higher sector length reflects the development of the new long-haul network and also the growth of Norwegian's bases in Spain and London Gatwick, where its European routes are longer than from its Scandinavian bases.

Norwegian Air Shuttle traffic data: 1Q2014

Norwegian's load factor gain in the quarter was (just) higher than it has achieved in any previous 1Q and was in line with the average load factor recorded by members of the Association of European Airlines.

However, the AEA represents Europe's legacy carriers and LCCs typically manage load factors several ppts higher than this, leaving Norwegian with further scope for improvement.

Norwegian Air Shuttle ASKs and passenger load factor: 1Q2005 to 1Q2014

Norewgian's revenues were up 22%, total RASK down 17%

Norwegian's total revenues grew by 22% year on year in 1Q2014, well below the growth in ASKs and slightly below the growth in passenger numbers. Moreover, passenger revenues grew at the slower rate of 17%. Total revenue per ASK (RASK) fell by 17% and passenger revenue per ASK fell by 21%. While increased sector length is typically associated with lower RASK, this drop in unit revenues also reflects underlying pricing weakness.

CEO Bjorn Kjos and head of investor relations Karl Peter Gombrii told analysts on a conference call to discuss the 1Q results that price weakness was most apparent in the Nordic markets, Norway in particular. The fact that passenger revenues (and total revenues) grew at a slower rate than passenger numbers when average sector length grew highlights this price weakness.

Total revenue per passenger fell by 1% and passenger revenue per passenger fell by 5% in spite of a 15% increase in average sector length.

Norwegian Air Shuttle revenue by activity: 1Q2014

NOK million	1Q2013	1Q2014	Change	% of 1Q2014 total
Passenger	2,473	2,900	17.2%	82%
Ancillary	338	523	54.9%	15%
Other	93	128	37.6%	4%
Total	2,904	3,551	22.3%	100%

By region, revenue growth on international routes was 35%, while domestic revenues fell by 1%. This year on year drop in 1Q domestic revenues is, as far as we know, unprecedented. While international revenues have been the main driver of growth for some years, a fall in domestic revenues is a disturbing sign.

Norwegian does not break down its traffic figures by region, but its statement does refer to 'minor increases' in domestic capacity. This fall in domestic revenue suggests a substantial weakening of demand, leading to the need for price stimulation, in its own back yard.

Norwegian Air Shuttle revenue by region: 1Q2014

NOK million	1Q2013	1Q2014	Change	% of 1Q2014 total
Domestic	1,043	1,032	-1.0%	29%
International	1,861	2,519	35.3%	71%
Total	2,904	3,551	22.3%	100%

Moreover, growth in international revenues of 35% was much slower than growth in international capacity. According to data from OAG, international routes account for around 85% of ASKs. If we assume only low single digit ASK growth on domestic routes, we can estimate that international routes probably saw ASK growth in the region of 60% and a total RASK decline of 15% year on year in 1Q2014.

We cannot estimate a further breakdown between European international traffic and intercontinental traffic, but it seems likely that both the longer average sector length and price declines contributed to this estimated RASK weakness on international routes.

New routes typically require price stimulation and this seems very much to be the case for Norwegian on its new European and long-haul routes.

Norwegian Air Shuttle unit revenue development (NOK): 1Q2014 versus 1Q2013

NOK	1Q2013	1Q2014	Change
PRASK*	0.39	0.31	-21%
RASK**	0.46	0.38	-17%

Operating costs were up 43%, CASK down 3%

Norwegian's operating costs, at the level of reported EBIT, grew by 53% year on year, but this included a lower offsetting positive figure from the line 'other gains and losses'. This item includes gains/losses from foreign currency contracts and on working capital in foreign currency. Excluding this non-operating line, costs grew by 43%, still much faster than revenue growth, but slower than ASK growth.

Fuel costs increased by 48%, in line with ASK growth, while non-fuel costs (excluding other losses/gains) grew by 41%. Within non-fuel costs, labour costs grew by 22%, well below ASK growth and also slightly below passenger growth. Labour cost growth was also lower than the increase in the average number of man-labour years, which was up by 31% year on year.

The key to success for Norwegian's expansion, particularly on long-haul, will lie largely with labour costs and the control over staff cost growth shown in the 1Q2014 results is encouraging. However, it has recently been unable to reach agreement with cabin crew over the reorganisation of employment contracts.

The cost categories that grew fastest were maintenance (up 67%) and leasing (up 60%), both growing much faster than ASKs. Maintenance cost growth was due to expenses related to Norwegian's new Boeing 787 fleet and also NOK weakness against USD. Leasing cost growth related to the use of wet lease aircraft on international routes and 787 lease costs, in addition to NOK weakness.

Norwegian Air Shuttle operating costs (NOK million): 1Q2014

	1Q2013	1Q2014	Change
Personnel	624	760	21.8%
Sales/distribution	83	121	46.4%
Fuel	860	1,275	48.3%
Airport & ATC	401	577	43.9%
Handling	253	376	48.9%
Maintenance	163	272	66.9%
Other expenses	338	487	44.1%
Other losses/(gains)	-256	-103	-59.9%
Leasing	250	400	60.2%
Depreciation	120	162	35.1%
Total operating costs	2,835	4,327	52.6%
Total costs excl other losses/gains	3,091	4,430	*43.3%*
Total costs excl other losses/gains ex fuel	2,231	3,155	41.4%

In spite of a 15% sector length increase in 1Q2014, Norwegian's cost per available seat kilometre (CASK) fell by only 3% (note that we calculate CASK using costs at the EBIT level and excluding other gains/losses, while Norwegian's published figures use costs at the EBITDA level). As noted earlier, costs were inflated by currency impacts and one-off costs in connection with the launch of long-haul routes.

Without these items, the fall in CASK would have been around 10%, a better performance but still well short of the 17% drop in RASK.

Norwegian Air Shuttle unit cost development (NOK): 1Q2014 versus 1Q2013

NOK	1Q2013	1Q2014	Change
CASK*	0.48	0.47	-3%
ex fuel CASK	0.35	0.33	-4%

Fleet growth supplemented with three additional 787 orders

Norwegian has announced that it will lease three new Boeing 787-9 Dreamliners for its growing long-haul network, bringing the total number of firm orders for the variant to nine. Four of these will be delivered in 2016, three in 2017 and two in 2018. It also has five 787-8 aircraft in operation and three of this variant on order (one for delivery in 2014 and two for 2015).

Norwegian Air Shuttle committed fleet plan to 2016*

Norwegian has established an Ireland-based financing subsidiary, Arctic Aviation, into which it has reportedly invested USD349 million (Irish Independent, 19-Apr-2014). This leasing vehicle will be able to lease out to third parties any spare aircraft, should Norwegian not need the capacity it has ordered.

Further CASK reduction is targeted

Norwegian remains focused on achieving unit cost reductions (it targets a FY CASK ex fuel of NOK0.25 versus NOK0.29 reported in 2013, using costs at the EBITDA level, without specifying the year for this target).

There is scope for unit cost efficiencies from a number of sources, including the phase out of the 737-300 in favour of the 737-800, the phase-in of the fuel-efficient 787, increased automation, higher short-haul utilisation and the outsourcing and off-shoring of employees. A major thrust of Norwegian's drive towards lower CASK is the ongoing increase in average sector length.

The chart below shows how Norwegian's annual RASK and CASK followed declining trend lines as average trip length increased over the period 2005 to 2013. As the chart shows, the small, but growing proportion of long-haul capacity in Norwegian’s total ASKs will lower CASK regardless of any underlying cost efficiency measures.

Norwegian Air Shuttle annual unit cost (operating cost per available seat km) and unit revenue (total revenue per available seat km) versus average trip length: 2005 to 2013

The following chart plots Norwegian's 1Q RASK and CASK over recent years and also shows the annual trend lines from the previous chart. It demonstrates the seasonal weakness of the first quarter, when RASK is below its annual trend line and CASK is above its trend line. RASK weakness in 1Q reflects seasonally weaker demand than in the rest of the year.

The higher CASK of 1Q reflects lower levels of capacity, while fixed costs are not very different from peak season. The chart also illustrates that it is normal for CASK to be higher than RASK in 1Q.

What is not so normal on the chart, however, is the sharp divergence between RASK and CASK that is apparent in 1Q2014. RASK slumped by 17% year on year, falling well below the trend line and more than should be expected from the increase in average trip length. At the same time, CASK fell only 3%, less than should be expected from the increased distances.

Norwegian Air Shuttle 1Q unit cost (operating cost per available seat km) and unit revenue (total revenue per available seat km) versus average trip length: 1Q2009 to 1Q2014

Lower profits look likely in FY2014 compared with FY2013

As Norwegian continues to build its new network, with both long-haul expansion and the development of new routes and bases in Europe, it may continue to suffer from weak RASK and higher than hoped-for CASK.

Pricing weakness comes with the territory when capacity expansion is rapid and new routes are launched, particularly when price is the main dimension of competition. In addition, new operations using new aircraft types often experience 'one-off' start up costs that were not fully anticipated.

For FY2014, Norwegian is aiming to increase ASKs by 40%, slower than the 48% growth in 1Q2014, but still a rapid rate of growth that is likely to lead to further significant downward movement in unit revenue. Its unit cost target for FY2014 is around 5% lower than in FY2013, implying better progress on unit costs in the rest of the year than the 3% cut in 1Q, but not enough to match the likely fall in unit revenues.

RASK fell faster than CASK in FY2013 and again, more dramatically, in 1Q2014.

Norwegian cannot afford to relax its focus if it is to manage its way successfully through this period and move into a new phase where the relative growth of RASK and CASK becomes favourable once more. This does not look likely in 2014, which seems set to produce lower profits for Norwegian compared with last year.

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