SIA battles perfect storm of LCCs and Superconnectors April 2014

With increasing competition from both full-service Asian and Superconnectors, as well as from LCCs, the SIA Group has seen yields fall steadily over the last two years. Can the Singaporean flag carrier’s attempts to diversify its portfolio stop this decline?

At first sight the SIA Group’s financial results look fine. In the first three-quarters of SIA’s 2013/14 financial year (the nine month period ending December 31st 2013), the Group recorded a 1.6% rise in revenue to S$11.6bn (US$9.2bn). Operating profit during the period increased by 16.9% to S$319.6m (US$253.4m), though profit before tax was S$402.7m (US$319.3m), some 4.3% down on the figure for April-September 2012.

The net profit figure was hit by an increase in exceptionals during the nine month period, including an impairment loss of S$293.4m on four surplus freighters that were removed from the operational fleet and put up for sale, as well as an offer of S$78.3m to plaintiffs to settle class legal action against its historical cargo business operation in the US. On the other hand these were partly offset by an exceptional gain of S$339.9m received from the sale of SIA’s stake in Virgin Atlantic to Delta Air Lines.

During Q1-Q3 2013/14 fuel accounted for 38.2% of Group costs, down slightly from the 40% it represented in the previous comparative period; SIA said that average jet fuel prices fell 5.6% in the October-December 2013 quarter compared with the same quarter in 2012.

Yet those results don’t tell the whole story, because underneath them the Group is facing steady erosion in some key fundamentals. Though not a problem in its own right, the vast majority of the Group’s revenue and profitability comes from the mainline operation. In the first nine months of 2013/14, of the group’s S$320m operating profit the mainline accounted for S$315.6m, SIA engineering Company for S$81.4m and SilkAir for S$27.5m — with SIA Cargo contributing an operating loss of S$70.5m to the overall net figure.

For decades that mainline has been known for its reputation for carrying high-margin first-class and business travellers around the globe (with premium traffic accounting for around 40% of total revenue) — but that reputation counts for much less in a world where global recession has slashed corporate travel budgets and where competitors care little about SIA’s reputation. That competition comes not just from traditional full-service airlines such as MAS, Cathay Pacific and British Airways, but increasingly from the “Big Three” Gulf carriers flying on east-west routes through their Middle Eastern hubs. To make matters worse for SIA, it’s also facing increasing competition from Asian LCCs, including Lion Air of Indonesia and AirAsia of Malaysia, which operate fleets of 150 and 169 aircraft in turn, but also have massive firm order books, of 571 and 337 aircraft respectively.

As can be seen on the chart to the left, mainline load factor trend line has remained stubbornly in the 70s for the last few years and — most worryingly — competitive pressure is manifesting itself in a squeeze on mainline yield, which has been falling relentlessly since the fourth quarter of 2011 (see chart, opposite). Mainline yield per RPK has fallen from S¢12.1 in October-December 2011 to S¢11.0 in July-September 2013, though it recovered to S¢11.2 in October-December 2013.

At the same time the mainline has been struggling to make further inroads into costs, with unit costs only falling from S¢9.2 in October-December 2011 to S¢8.9 in October-December 2013, and as a result the gap between unit revenue and unit cost that was so clear in the pre-2009 era has now all but disappeared. If that gap can’t be opened up again then the mainline could dip into the red, which will inevitably plunge the entire SIA Group into a loss.

SIA’s management has been trying to overcome these worrying trends for some time, most notably by surrounding the mainline airline with a constellation of lower cost carriers — SilkAir, the Tiger Group, Scoot, a new joint venture in India and a substantial investment in Virgin Australia.

The SIA mainline

The mainline operated A340-500s until they were taken out of service last year, as a result of SIA closing two non-stop routes operated from Singapore to Los Angeles and New York Newark. These were the two longest non-stop routes in the world, (the latter was a 19 hour trip), but clearly SIA couldn’t make them profitable with an A340.

On order at the mainline are 113 aircraft, including 70 A350-900s (plus options for another 20, though these can be converted to the larger 1000 model), which will start replacing the 777-200ERs from the second half of this year. Thirty 787-10s are also on order — for which SIA is the launch customer — and they will arrive from 2018 or 2019 onwards. SIA is currently deciding between the 777X and A350s for a new order for as many as 40 widebodies, it is believed, though a final decision is not imminent.

Providing feed for the mainline is the long established SilkAir, which operates a two-class service to more than 40 regional destinations in Asia. It operates 25 aircraft and has 53 737s on order, and has just received the first aircraft from an order for 23 737-800s, which will be configured with 12 business class and 150 economy seats. They will directly replace A319s and A320s. Also on order are 31 737 MAX 8s.

The SIA Group also has a standalone cargo business unit that operates 13 747Fs, but this is under severe pressure at the moment — after posting a significant loss for the first three-quarter of the year SIA says that air cargo demand is projected to be relatively flat through 2014, with “cargo yields likely to remain under pressure as the cargo business continues to face overcapacity”.

Diversification woes

The Tiger group wholly owns Tigerair (previously known as Tiger Airways Singapore until a rebranding in 2013), which operates 25 A320s out of Changi and which has with a further 10 A320s on firm order. The group also owns 40% of Tigerair Philippines, which has five A320 family aircraft, but this is currently being sold to Cebu Air (which operates the LCC Cebu Pacific) after accumulating significant losses since launching, it is believed. The Tiger holding company will receive just US$7m for its 40% stake in Tigerair Philippines.

The Tiger Group also has a 40% stake in Tigerair Mandala, based in Indonesia and which operates nine A320s, and a 40% stake in Tigerair Australia, also with 12 A320s (and with seven on order), which is 60% owned by Virgin Australia.

The Tiger group also has plans to launch an LCC in Taiwan late this year, in co-operation with China Airlines. The group still appears sub-scale however — excluding Tigerair Philippines it operates 46 aircraft, compared with 77 at Jetstar and 169 at AirAsia. The Tiger holding group made a net loss of S$127.5m (US$101m) in the nine months ending December 31st 2013, and in its third quarter 2013/14 figures the SIA Group took a one-off S$46m (US$36m) hit from an impairment charge in Tigerair Mandala and losses related to assets held for sale in Tigerair Philippines.

In the summer of 2012 the SIA Group also set up a medium- and long-haul LCC — the bizarrely-named Scoot. Scoot operates six 777-200s borrowed from its parent between Singapore and 12 destinations in China (five) and Australia (three), plus Tokyo, Seoul, Taipei and Bangkok — the latest additions being routes to Hong Kong and Perth, which were started in November and December 2013 respectively.

The Scoot fleet will grow to 14 aircraft by 2016, with the current ageing 777s being retired and replaced by an all 787 fleet, with 10 787-8 and 10 787-9s on order (initially placed by the SIA Group, but now allocated to Scoot) , the first of which will arrive in November this year.

However, the 777s are operated not with a single class but rather a two class configuration — 370 economy seats and a 32-seat “ScootBiz” class; this business product includes a 38 inch pitch and in-flight meals and entertainment.

In December last year Scoot also signed an MoU with Nok Air to establish an LCC in Thailand, to be based at Don Mueang international airport in Bangkok. Under the name NokScoot, the airline will operate widebodies on medium- and long-haul routes in the second half of 2014.

Altogether the SIA Group is believed to have invested an estimated S$300m in Scoot so far, but this operation is a long way behind AirAsia X, which operates 19 aircraft (with 49 on order) from its Kuala Lumpur base to destinations in China, Japan and Australia within a four to eight hour flying distance.

Indian adventure

Under a yet-to-be-announced new brand the carrier will operate a fleet of 20 leased A320s domestically in a two-class configuration, probably on routes between Delhi, Mumbai and other major Indian cities. One analyst believes that the new airline may receive the newer A320s currently used by SilkAir that will gradually be replaced by the new 737s on order.

The two partners will put S$100m into the joint venture, with SIA Group owning a 49% stake. It’s clear that SIA’s strategy with this move is to open up India as a major source market it can “own”, potentially with Delhi becoming a second hub for the SIA Group and generating a significant stream of Indian passengers travelling westbound to the Middle East and beyond, and eastbound into Asia. Currently the SIA mainline operates to six cities in India from Singapore and SilkAir operates to eight Indian cities.

Under current India regulations the start-up will be able to operate on domestic routes only until it has a five year track record, at which point it can launch international services. Apparently there are significant efforts being carried out at both the aviation and political levels to overturn this regulation, and it’s likely the stipulation will be abolished sooner rather than later.

But freedom to operate internationally will not guarantee success for the new SIA/Tata airline. The carrier will compete against full-service Air India and Jet Airways, as well as LCCs such as IndiGo, SpiceJet and GoAir, and the chances that the joint venture can successfully operate full a high quality, premium product in a very price sensitive market appears optimistic, with fare differences between Indian full-service and LCCs operations having narrowed dramatically recently (and which led to the closure of full-service Kingfisher Airlines in 2012).

Another problem may be that Tata has also agreed a deal for a joint venture LCC with AirAsia called AirAsia India, which will result in yet another competitor. A third partner in the AirAsia India airline — Arun Bhatia, a Delhi businessman, with a 21% stake in the venture — has already criticised the Tata-SIA venture, saying that it was unethical for Tata to go into two Indian aviation start-ups at the same time. Tata may well be hedging its aviation bets, but the SIA Group can’t afford to fail with its lone foray into the Indian market.

The other major attempt by the SIA Group to find new revenues in Asia is in Australia. After finally disposing of its troubled 49% stake in Virgin Atlantic for US$361m, in the summer of 2013 SIA Group spent US$125.8m to double its investment in Virgin Australia to 19.9%. SIA first bought a stake in Virgin Australia in late 2012, and in a direct challenge to Qantas Virgin Australia introduced business class seats to its aircraft.

A critical 24 months

Balance sheet aside, whether the SIA Group will weather the competitive storm and pressure on yield will become clear one way or another over the next two years. The market, however, may not want to wait that long. As can be seen in the graph on page 6, the SIA Group share price has been under huge pressure since late 2007. Since listing, the SIA Group has never reported a loss for a full year, but if it does slide into the red then free-float investors may lose patience altogether, even if support is assured from Singaporean state holding company Temasek Holdings, which owns 55.8% of the SIA Group.

In some ways SIA’s situation is not helped by the bright outlook for the Asian aviation market in general. In its latest forecast Boeing says that nearly half the world’s entire air-traffic growth over the next 20 years will come from the Asia/Pacific region, which will encourage airlines in the region to buy 36% of all commercial aircraft manufactured over the next 20 years. That’s 12,800 aircraft being bought by Asia/Pacific airlines through to 2034, and with only 25% of these being replacements for older models. Unfortunately for SIA much of that aircraft demand will come from LCCs — which already account for around 50% of all seat capacity in southeast Asia and for 25% in Asia as a whole — and whose challenge to SIA will only get stronger over the coming years.