Philippines aviation Part 2: Renewed domestic capacity growth impacts Cebu Pacific, PAL & AirAsia

This is Part 2 in a series of reports on the Philippines aviation market. The first report focused on the expansion of Philippine Airlines (PAL) in the international market.

See related report: Philippine Airlines' international expansion continues with 5 new destinations, A350-900 HGW order

This report looks at the domestic market, including expansion by the PAL Group and LCC competitors Cebu Pacific and Philippines AirAsia. The next report will examine rapid growth for Mactan-Cebu International Airport, which is benefitting from the domestic expansion as well as some new international services as congestion in Manila forces Philippine carriers to grow in secondary hubs.

Philippines domestic market had zero growth in 2013 and 2014

The Philippines domestic market grew by only 0.1% in 2014 to 20.35 million passengers, according to Philippines Civil Aeronautics Board (CAB) data. In 2013 the Philippines domestic market contracted by 1.1%, ending a prolonged period of rapid growth.

The Philippine domestic market doubled in size from 2007 to 2012 - with annual growth ranging from 10% to 25% - driven by rapid LCC expansion. But this growth proved to be unsustainable as it came at the expense of yields and an irrational approach to capacity.

Total annual domestic passenger traffic in the Philippines (in millions): 2004 to 2014

Source: CAPA - Centre for Aviation & Philippine CAB

As CAPA previously highlighted, overdue consolidation came in early 2013 as Philippines AirAsia essentially merged with Zest Airways while the PAL Group transitioned AirPhil Express (now known as PAL Express) from a LCC to a full service regional subsidiary. There was further consolidation in early 2014 as Cebu Pacific acquired Tigerair Philippines (now known as Cebgo).

See related reports:

• Cebu Pacific domestic outlook brightens as Tigerair Philippines recovers & market share reaches 60%
• Cebu Pacific Air turns record profit in 2Q2014 as domestic market rationalises and yields improve
• Cebu Pacific poised for further Philippine domestic market share gains in 2014. Is 60% achievable?

Philippines AirAsia and Zest recently consolidated their operations into a single operating certificate and brand.

Cebgo recently took over operations of the Cebu Pacific Group turboprop fleet, leaving the parent airline to focus on regional trunk routes with a fleet of A320 family aircraft and a handful of long haul routes with A330-300s.

The PAL Group also still has two operating certificates but there is no overlap as there were during the AirPhil era. PAL Express now operates most of the group's domestic flights with the exception of a few trunk routes.

Domestic market expansion resumes in the Philippines in 2015

The PAL Group has resumed domestic expansion in 2015, driven by the relaunch of six point to point routes from Cebu at the end of Mar-2015 and additional capacity on some trunk routes from Manila. AirAsia also has resumed domestic expansion, reversing some earlier cuts, but on a much smaller base.

Meanwhile Cebu Pacific has continued to expand domestically in 2015. Its domestic expansion also continued in 2013 and 2014 although the total market did not grow as AirAsia and PAL contracted.

The Philippines domestic market grew again in 1H2015 but relatively modestly with year over year growth of about 5%. The Cebu Pacific Group accounted for 59.5% of the domestic Philippines market in 1H2015 while the PAL Group accounted for 28.7% and AirAsia 11.4%.

For the full year in 2014 Cebu Pacific captured 60.8% of the market followed by 29.1% for PAL and 9.7% for AirAsia.

Philippines domestic market share (% of passengers) by airline group: 1H2015

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Source: CAPA - Centre for Aviation and Philippines CAB

The Philippines CAB has not yet published any figures for 2H2015 but capacity growth has accelerated further in recent months. Cebu Pacific stated in its 3Q2015 analyst briefing that total domestic capacity was up 17% in 3Q2015.

Philippines domestic capacity grew rapidly in 3Q2015

Cebu Pacific domestic capacity was up by about 10% in 3Q2015 while its two competitors collectively expanded at a rate exceeding 25%. The rapid expansion by competitors pressured yields as Cebu Pacific's average domestic fares were down by more than 10%.

Cebu Pacific expects domestic capacity in the Philippines will also be up 17% year over year for 4Q2015. A similar increase is likely in 1Q2016 followed by smaller increases the rest of 2016 due to a higher base.

The capacity increase is alarming as it has come so quickly and as the Philippines is a highly price sensitive market.

Eventually the demand should again catch up with the supply as the Philippine economy has been growing steadily at a healthy rate of 6% to 7% per annum.

Philippines annual GDP growth: 2012 to 2016

*2015 and 2016 figures are estimated
Source: International Monetary Fund, World Economic Outlook Database

But rapid capacity increases cannot be absorbed overnight - even when factoring in that the Philippines did not have any growth in 2013 and 2014 while most other Southeast Asian markets suffered from overcapacity. Ultimately how quickly supply-demand balance returns to the Philippine domestic market depends on the pace of further capacity growth in 2016.

While it is unlikely there will be another wave of high double digit expansion, the capacity reductions from prior years will almost certainly not be repeated.

Philippines AirAsia expansion hinges on turnaround attempt

Cebu Pacific expansion has traditionally been steady but relatively conservative compared to most Southeast Asian LCCs. Modest domestic capacity growth is planned for the next couple of years generated by up-gauging trunk routes from Manila to higher gauge aircraft and the launch of new point to point routes as the turboprop fleet expands.

Philippines AirAsia (PAA) domestic expansion is more uncertain as it hinges on its ability to complete a turnaround. PAA's business plan envisions three additional A320s per annum, which would be used to expand in both the domestic and international markets.

The AirAsia Group has not allocated PAA any of its 2016 deliveries but has said PAA could still potentially grow its fleet by sourcing aircraft through operating leases. In 2015 the airline has been able to add back capacity without growing its fleet by improving utilisation levels. There is limited opportunity to further improve utilisation and the decision to lease additional aircraft will likely only be made if PAA is able to improve its financial position.

See related report: AirAsia Part 3: Philippines AirAsia plans 2016 growth as it establishes new secondary hubs

PAA and Cebu Pacific were unprofitable in 3Q2015 while PAL was breakeven

PAA incurred an after tax loss of PHP1.357 billion (USD29 million) in 3Q2015, representing an improvement of 22% compared to 3Q2014. PAA reported a 10% reduction in average fares as domestic competition intensified. The AirAsia Group warned in its 3Q2015 results presentation that domestic demand on Manila to Cebu and Davao, the two largest routes within the Philippines, remains challenging.

Cebu Pacific was also in the red in 3Q2015 with a net loss of PHP1.645 billion (USD36 million) compared to a loss of PHP1.099 billion (USD25 million) in 3Q2014. PAL Holdings reported a small net profit of PHP244 million (USD5 million) compared to a slight loss of PHP126 million (3 million) in 3Q2014.

The third quarter is typically the weakest in the Philippines. The surge in domestic capacity created an even more challenging environment as yields declined, essentially offsetting the reduction in fuel prices. PAL and Cebu Pacific both had large improvements in profitability in 1H2015, an indication that market conditions were much more favourable in the first half than the third quarter.

PAL plans further domestic expansion

The PAL Group is planning further domestic capacity increases which could lead to a longer period of challenging market conditions. PAL is taking delivery of five A321s in 2016 while returning two A320s. A large portion of the capacity generated by the additional aircraft will be allocated to the domestic market - as was the case in 1H2015 as PAL added five A321s.

The PAL Group domestic strategy is to build up domestic capacity in phases. This is more manageable than the relatively sudden increases in capacity implemented in 2Q2015 and 3Q2015 but will still make it difficult for a return of more favourable domestic market conditions.

PAL is clearly keen to regain domestic market share after slipping from 42% in 2012 to 29% in 2014 despite the overall size of the market remaining flat.

There is particularly a risk for overcapacity in 2016 on the Manila-Caticlan route and in regional point to point markets. PAL is planning further expansion in 2016 on point to point routes from Cebu while Manila-Caticlan will see a large increase in capacity from all three Philippine domestic players after an extended runway opens in Mar-2016.

Manila-Caticlan route will likely experience overcapacity in 2016

Manila-Caticlan is currently served with 10 daily Dash 8 frequencies from PAL Express and eight daily ATR 72 frequencies from Cebgo, according to OAG data. The PAL Group and Cebu Pacific are planning to transition most of these flights in phases to A320s while PAA is planning to enter the market. As CAPA wrote in a Jul-2015 report:

Manila-Caticlan could easily see at least a doubling in capacity as AirAsia enters the market and the two incumbents up-gauge. Manila-Caticlan has the potential of becoming the third largest domestic route in the Philippines after Manila-Cebu and Manila-Davao.

Most of the additional capacity could be absorbed, particularly if Manila-Kalibo sees a large decrease. But Kalibo is unlikely to see a decrease that matches the increase at Caticlan. This will inevitably pressure yields at both Caticlan and Kalibo.

Yields at Caticlan are now among the highest in the Philippine domestic market. The airlines serving Caticlan can afford some reduction in yields as large gauge aircraft come with lower unit costs. But there is a risk that stiff competition will lead to a much larger reduction in yields compared to the expected reduction in costs, particularly when taking into account the cost of operating at the newly privatised airport.

See related report: Cebu Pacific, PAL, AirAsia plan Boracay expansion. Will new runway at Caticlan lead to overcapacity?

Caticlan is the closest airport to the popular resort island of Boracay but currently can only handle turboprops. Kalibo is also a gateway to Boracay but is about 70km away and it takes about two hours to travel to Boracay from Kalibo Airport compared to a short ferry ride from Caticlan Airport.

Competition to further intensify on secondary routes from Cebu

PAL Express plans to move some its Manila-based turboprops to Cebu as flights to Caticlan are up-gauged. In 2016 Cebgo also plans to move one or two of its four Manila-based ATR 72s - most likely to Cebu. Cebgo currently has four of its eight aircraft based at Cebu and is also planning to allocate to the Cebu base the ninth and tenth aircraft which are being added to the fleet in 2016.

The planned regional expansion at Cebu will likely lead to further yield declines in the Cebu market, impacting profitability of the overall domestic sector. Cebu Pacific has already noticed larger yield declines on point to point routes from Cebu as PAL re-entered these markets compared to trunk routes from Manila.

While these markets had been relatively under-served, the markets are small and extremely price sensitive. The capacity added by PAL Express, which has been serving the new point to point routes with single class A320s, was significant as in some markets it resulted in an over 50% increase in total capacity.

Long term outlook is relatively bright for Philippines domestic market

Secondary point to point routes will likely continue to see significant increases in capacity over the next couple of years as Cebu Pacific has committed to increasing its turboprop fleet from eight ATR 72-500s to 16 ATR 72-600s. The first two ATR 72-600s that were ordered in Jun-2015 are slated to be delivered in 2H2016 and will be growth aircraft.

As Cebgo doubles its turboprop fleet new bases will be opened, resulting in the launch of several new point to point routes that are currently not served by any carriers. But there will inevitably be some overlap with PAL - from Cebu and potentially other secondary cities, as PAL moves its turboprop fleet from Manila. PAL Express also has been looking at replacing and potentially growing its turboprop fleet - which currently consists of five Dash 8 Q400s and four smaller Dash 8 Q300s - with new 86-seat Dash 8 Q400s, which would result in further capacity growth on point to routes.

Overall the long term outlook for the Philippines domestic market is relatively bright. There are huge opportunities to open new point to point routes.

Demand for such routes is growing as the economy expands and a larger portion of the population is able to opt for short flights instead of ferries - particularly as low fares stimulate demand. Such routes also enable Philippine carriers to fly fewer domestic passengers via Manila, where slots are at a premium and should be used where possible to cater to the local Manila market.

The consolidation from recent years also has whittled down the playing field to only three groups, with one of the competitors relatively insignificant and only competing on trunk routes. This has created a relatively rational environment in the Philippines compared to most other major Southeast Asian domestic markets.

There is always the prospect of the remaining competitors waging irrational market share battles but such battles are likely to be short lived as the incumbents stabilise the market, producing a healthy supply/demand balance.