16-May-2016 3:51 PM

Pegasus Airlines: 1Q loss grows; pricing comes under pressure from capacity growth and macro factors

Analysis

In 1Q2016 Pegasus suffered another fall in its operating margin, after being one of only a very small number of listed European airlines to experience margin contraction in FY2015.

The main cause of this slide in profitability for Pegasus is unit revenue weakness, which is partly due to external macroeconomic and geopolitical factors, and partly due to its own rapid capacity growth. Low fuel prices have not been a sufficient influence for Pegasus to lower its unit cost enough to offset falling unit revenue. Low fuel prices have actually even contributed to low unit revenue - by encouraging competitor capacity growth.

Pegasus' unit cost is around one third below that of its biggest competitor Turkish Airlines and one of the lowest in Europe. This gives its business model some robustness against weak pricing, but this environment also places greater pressure on its cost base.

Summary

Pegasus Airlines experienced a fall in operating margin in 1Q2016 due to weak unit revenue and rapid capacity growth.
The airline's operating loss widened by 80% in 1Q2016 compared to the same period in 2015.
Pegasus' operating margin was the lowest among listed European airline companies in 1Q2016.
The airline's load factor fell by 1.7 percentage points to 76.1% in 1Q2016.
Pegasus' total revenue increased by 18.5% in 1Q2016, but its revenue per available seat kilometer (RASK) decreased by 3.5%.
The airline's total operating costs increased by 26.9% in 1Q2016, with fuel costs falling by 11.1% and non-fuel costs rising by 46.2%.

Operating loss widens by 80% in 1Q2016

In 1Q2016 Pegasus more than doubled its net loss to TRY191 million (EUR59 million) from TRY81 million a year earlier. The 1Q2016 result was affected by a number of non-operating items, including foreign exchange movements, changes in net foreign exchange gains and losses related to financing activities, and by different tax charges.

Pegasus' operating result excludes these items and gives a better idea of the underlying performance of the business. The operating loss widened by 80% from TRY93 million in 1Q2015 to a loss of TRY167 million (EUR51 million) in 1Q2016.

Revenue grew by 18.5% to TRY691 million (EUR213 million), and the operating margin declined by 8.2ppts to -24.1%.

Pegasus Airlines financial and operating highlights 1Q2016 and 1Q2015

TRY million except where stated	1Q2015	1Q2016	Change
Total revenue	583.1	691.1	18.5%
Operating costs	676.0	858.0	26.9%
Operating profit*	-92.8	-166.9	79.7%
Operating margin %	-15.9	-24.1	-8.2
Net profit	-80.7	-190.6	136.3%
Total passengers million	4.52	5.36	18.6%
Passenger Load Factor %	77.8	76.1	-1.7
ASK million	5,645	6,933	22.8%
RASK kurus	10.33	9.97	-3.5%
CASK kurus	11.98	12.38	3.3%
Ex-fuel CASK kurus	7.95	9.46	19.0%

Pegasus' operating margin was the lowest among listed European airline companies to have reported calendar 1Q2016 results so far. As in previous years, the seasonality of Pegasus' business means that its 1Q result is not a good indicator of its FY result, but the deterioration in its 1Q margin bucks the trend of most of the larger European airlines that have reported for the period.

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The only airlines that report quarterly and have still to announce results for the quarter are fellow ultra-LCCs Ryanair and Wizz Air, which were the two most profitable European airlines by operating margin in 2015, and Aegean Airlines. Although calendar 1Q is seasonally weak, none of these is likely to announce a lower margin than Pegasus for this quarter.

EasyJet, Europe's second largest LCC behind Ryanair, did suffer a fall in profitability in the quarter but at a margin of approximately -5% - much higher than that of Pegasus.

ASK growth of 22.8%; load factor falls 1.7ppts

Pegasus increased its ASKs by 22.8% in 1Q2016, picking up the pace from its 1Q2015 growth rate of 17.4% and its FY2015 rate of 14.7%. This acceleration was a little difficult for Pegasus' markets to digest, and passenger load factor fell by 1.7ppts to 76.1%.

Pegasus has been unable to grow its FY load factor since it peaked at 80.2% in 2013 and, although 1Q is a seasonally weak quarter, this trend is troubling. Leading European LCCs such as Ryanair and easyJet are achieving load factors close to 90% in every quarter of the year.

Pegasus Airlines traffic statistics 1Q2016 and 1Q2015

Load factor weaker on international routes

ASK growth was higher on domestic routes, where it reached 26.0% in 1Q2016, but was still a strong 21.0% on international routes. This is in contrast with Turkish Airlines, which grew more rapidly on international routes than in domestic Turkey.

In spite of Pegasus' faster growth in the domestic market load factor in this part of the network held up better, staying almost flat at 81.2% (a reduction of 0.3ppts). Its international load factor shed 4.0ppts to 68.2%, a very mediocre level for a low cost airline. Uncertainty over geopolitical events is clearly weakening demand in international markets.

Revenue up 18.5%; RASK reduced by 3.5%

Pegasus 1Q2016 revenue increased by 18.5% year-on-year, but this did not keep pace with ASK growth. Scheduled flight revenue increased by 14.4%, with domestic flight revenue growing slightly faster at 15.8% and international revenue growing by 13.4%.

However, the relative growth rates of domestic and international revenue did not fully reflect the different capacity growth rates. It can be calculated that total flight revenue per ASK fell by 6.9%, split by domestic revenue per ASK falling by 8.0% and international revenue per ASK falling by 6.3%.

Ancillary revenue was strong, increasing by 38.1%, with ancillary revenue per passenger up 16.5% to TRY32.8 (EUR10.1). This is consistent with its target for ancillary revenue per passenger of EUR10-EUR11 for FY2016. Ancillaries partly offset the passenger yield decline and total revenue per ASK (RASK) fell by 3.5%.

Pegasus Airlines revenues 1Q2016 and 1Q2015

TRY million	1Q2015	1Q2016	Change	% of 1Q2016 total
Int'l scheduled flights	259.4	294.1	13.4%	43%
Domestic scheduled flights	177.6	205.7	15.8%	30%
Total scheduled flight revenue	437.0	499.8	14.4%	72%
Ancillary revenue	127.3	175.8	38.1%	25%
Charter revenue	5.4	2.0	-63.0%	0%
Other revenue	13.5	13.5	0.0%	2%
Total revenue	583.2	691.1	18.5%	100%

Costs up 26.9%; CASK up 3.3%

Total operating costs increased by 26.9%, faster than the growth in ASKs and revenues. Fuel costs fell by 11.1%, but non-fuel costs jumped by 46.2%. Labour costs rose by 57.8%.

According to CAPA calculations, total CASK increased by 3.3% and non-fuel CASK grew by 19.0%.

Pegasus Airlines operating costs 1Q2016 and 1Q2015

TRY million	1Q2015	1Q2016	Change	% of 1Q2016 total
Fuel costs	227.3	202.1	-11.1%	24%
Labour costs	97.6	154.0	57.8%	18%
All other costs	351.10	501.90	43.0%	58%
Total costs	676.00	858.00	26.9%	100%

Adjusted for currency, both RASK and CASK fell heavily (but RASK fell faster)

However, as is typically the case for Pegasus (and as with RASK), this CASK performance was sharply affected by movements in foreign exchange rates. Although TRY is its reporting currency, only 26% of Pegasus' 1Q2016 operating costs were TRY-denominated. Moreover, Pegasus uses EUR as its functional currency.

The value of TRY versus EUR fell by 14.6% year-on-year in 1Q2016 and this helps to explain much of the movement in its TRY-denominated CASK figure. Converting into EUR at the average exchange rates for 1Q2016 and 1Q2015, CASK fell by 11.9% and non-fuel CASK was up 1.6%.

Currency movements also had an impact on total RASK. In EUR terms, RASK fell by 17.6%, rather than the 3.5% fall based on TRY numbers. This heavy EUR-denominated RASK fall reflects the softness of demand in Pegasus' markets, particularly on international routes.

Although Turkish Airlines has a much wider global network, Pegasus' EUR-denominated RASK decline was consistent with its FSC rival's USD-denominated RASK fall of 17.2%. Geopolitical events have soften demand in many markets, but Turkey has felt this impact more than some.

Pegasus' EUR RASK has fallen in each of the past four quarters and increased in only two of the past 11 quarters.

RASK has underperformed against CASK too often

Profit margins are driven by the difference between RASK growth and CASK growth (typically, this difference is not much affected by currency movements, which tend to have a broadly similar impact on both RASK growth and CASK growth).

Since the beginning of 2013 RASK growth has underperformed against CASK growth in eight out of 13 quarters, including three out of the past four.

Pegasus Airlines year-on-year change in EUR-denominated RASK and CASK 1Q2013 to 1Q2016

2016 outlook unchanged, but a lower operating margin seems possible

Pegasus has not changed its 2016 guidance. This includes an ASK increase of 18% to 20% and passenger growth of 13% to 15%, with load factor flat at its 2015 level. It expects domestic yield to be flat in TRY terms, but international yield (and load factor) to fall in EUR terms.

Pegasus anticipates a decrease in total CASK of 2% to 3%, mostly due to lower fuel prices, which suggests that ex fuel CASK may continue to rise. There is no change to its target EBITDAR margin range of 19% to 21%, which compares reasonably with its 2015 outcome of 19.5%.

However, in 1Q2016 its depreciation and operating lease expenses increased sharply and, if this continues through the year, it can be expected that the airline's operating margin will be lower, even if EBITDAR margin is flat or higher than in 2015.

Weak unit revenue is partly due to market factors, but exacerbated by Pegasus' market share battle with Turkish

Pegasus suffered a fall in its operating margin in 2015, when almost every other listed European airline increased their margins. This was, at least partly, due to downward RASK pressure, which was partly the result of very rapid capacity growth.

In a low fuel price environment its leading local competitor, Turkish Airlines, is accelerating its growth, and Pegasus is anxious to maintain its market share. Both are experiencing heavy declines in unit revenue, partly due to external market factors affecting demand, but partly also due to their own growth ambitions.

Pegasus already has one of the lowest unit costs in Europe, but in this environment it must continue to work hard at lowering ex fuel unit costs even further.