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Norwegian Air Shuttle: Brave innovator December 2014 Download PDF

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Norwegian Air Shuttle’s aggressive plan to become the first European LCC to build up a significant long-haul operation is starting to wobble, thanks to opposition to its Irish subsidiary and a plunge into the red over the past 12 months. Are these setbacks temporary, or are they indications that Norwegian’s ambitions are just too grand to pull off?

Norwegian relaunched itself as a LCC in 2002 (see Aviation Strategy, November 2013), and has been posting profits at both the operating and net level since 2008. However, the strategy has become much more ambitious over the last couple of years — with the placing of an order for 222 737s and A320s in 2012 followed by the launch of long-haul routes in 2013 — and the airline lurched into the red in 2014.

The airline’s growth has continued apace through the last 12 months: in the first three-quarters of 2014 passengers carried increased year-on-year by 19% to 18.3m, with RPKs in the January-September period rising by 45%, ahead of a 41% increase in ASKs, and with load factor increasing by three percentage points to reach 81.0%. This boosted revenue in 1Q-3Q 2014 by 27% year-on-year to NOK14.9bn (€1.8bn).

Revenue from international traffic accounted for 81% of all revenue in the third quarter (compared with 78% a year ago) and there was good news on the ancillary revenue front, where its share of total revenue rose to 13.4% in the third quarter of 2014 (equivalent to NOK124 — €15 — per scheduled passenger), compared with 10.9% in 3Q 2013 and not far short of the target proportion of 15%.

Into the red

However, whereas in the first nine months of 2013 the company achieved an operating profit of NOK1.2bn (€151m) and net income of NOK516m (€67m), in the same period of 2014 norwegian reported an EBIT loss of NOK328m (€40m) and a net loss of NOK91m (€11m).

The airline’s balance sheet also weakened over the last 12 months. Cash and equivalents fell by 38% in a year to NOK1.4bn (€169m) as at the end of September 2014 (less than 10% of annual revenues), and long-term debt increased by a hefty 82% over the year to September 30 2014, to reach NOK8.2bn (€1bn). Most of that was due to greater financing for fleet expansion: total capital expenditure in the nine months reached NOK3.7bn against NOK1.2bn in the prior period. In November Norwegian successfully placed a NOK225m (€29m) bond issue, but the balance sheet leverage — with net debt standing at 275% of shareholders’ funds — causes some concern.

Norwegian blames the recent results on a combination of “a weak Norwegian Krone, technical difficulties with our 787, the costs associated with the long overdue application before the US DoT for a foreign air carrier permit for Norwegian’s Irish subsidiary, and costs associated with flight delays, such as wet-leasing replacement aircraft and accommodation, food and drink for delayed passengers”.

Another fundamental reason for the weak results stems from the implicit aim of toppling SAS from its position as the de facto Scandinavian flag carrier. Both norwegian and SAS blame each other for putting too much capacity into the Nordic markets, but the fact is that they do seem to be into an internecine fight. Norwegian is in direct competition with SAS on  35% of its routes (and 70% of volume-weighted city-pairs), and the intensity of the fight seems to have been driving down yields.

A key issue is the delay in getting US regulatory approval for an application made in December last year for a foreign air carrier permit for Irish subsidiary Norwegian Air International (NAI). This subsidiary is facing fierce opposition from the major US airlines, US and European unions, and some major European airlines (notably Air France-KLM and Lufthansa, but not BA). The motivation on the part of  the airlines appears obvious — they do not really want any competition on the cosily-consolidated Atlantic, least of all from a low cost carrier. The opposition from the unions is less obvious (since norwegian would be hiring staff in the US and Europe) — but seem particularly aimed at closing down any possibility of the creation of aviation "flags of convenience".

Flag of convenience: false analogy

The arguments against the application are based on article 17bis of the 2010 protocol amendment to the 2007 US-EU Open Skies agreement. This states a recognition of the "importance of the social dimension ... and the benefits that arise when open markets are accompanied by high labour standards. The opportunities created by the Agreement are not intended to undermine labour standards or the labour-related rights and principles contained in the Parties’ respective laws."

ALPA (Air Line Pilots Association) avers that NAI was established “in order to avoid Norway’s employment laws and to be able to rent its pilots through a Singapore employment company. The pilots, who the company says are based in Thailand, work under individual employment contracts that contain compensation substantially below that of the Norway-based pilots who fly for NAI’s parent company".

Norwegian argues that NAI would boost competition into the US and that it is just a means to obtain better traffic rights (as Norway is not an EU member) and more attractive aircraft financing rates — and not a means to get cheap labour. One of the reasons it chose Ireland, against the UK or Sweden, it states, was that Ireland has fully adopted the Cape Town agreement, and establishment in the country would not affect export guarantees.

It insists that, as NAI fulfils all necessary criteria and regulations, the refusal to grant a permit is in breach of the 2007 transatlantic Open Skies agreement, with Bjørn Kjos, the CEO of Norwegian (and a former Norwegian air force pilot), saying that “the time is well-past due for the DoT to fulfil its legal responsibility and approve NAI’s application”.

Long-haul impact

The delay has slowed norwegian’s long-haul growth timetable,  halting US expansion and — in the airline’s words — “reducing our ability to optimize our fleet of aircraft”.

Norwegian now operates 417 routes to 126 destinations in 39 countries, with the long-haul network comprising Los Angeles (Oakland), New York, Orlando, Fort Lauderdale and Bangkok. The carrier is pursuing a three-phase plan for long-haul; the first is the establishment of Scandinavia to North America services (initiated in 2013, and subsequently to be expanded into a much larger network); the second is the launch of routes out of London Gatwick (in 2013), and the third is expansion of Europe to Asia routes (currently it operates only to Bangkok), most likely to India, China and Japan initially.

This is why it really needs to establish an EU AOC (whether in Ireland or elsewhere). Based in Norway it has access to long haul routes out of Scandinavia, and routes to the US from European points thanks to the EU-US Open Skies Agreement. However, Norway is not party to the European horizontal traffic agreements, and the company will need an EU certificate to access other long haul routes from the EU, in order to achieve the utilisation necessary on the 787s to make its low cost model work.

The US DoT approval delay is forcing adjustment of this overall plan, and the key knock-on effect is  on anticipated improvements to unit cost and revenue. While Norwegian’s average sector length continues to rise — in the first three-quarters of 2014 it rose 15% to 1,337km — the inability to optimize the long-haul fleet becomes more acute as further long-haul aircraft are delivered.

Norwegian began operating 787s (configured with 32 seats in Premium Economy and 259 in Economy) in May 2013, and there are currently seven 787s in operation, with another 10 coming by 2018, nine of which will be the 787-9 model, which has a longer range that the 787-8. The 787s were supposed to transform the economics of the long-haul network, where Norwegian previously wet-leased A340s. The A340s were a major factor in making the routes loss-making, with Kjos stating: “before the 787, we could not add up the figures to get a low enough cost and sufficient margin against legacy carriers”.

The 787s improve fuel consumption per seat by approximately a third compared with the A340s, but this will have a reduced impact on the bottom line because of the sharp decline in oil prices. Combined with an inability to optimise schedules thanks to the US DoT issue, the introduction of the model has not been enough to turn the current long-haul routes into profitability.

The 189-seat 737 MAXs 8s start arriving from mid-2017, and this month norwegian revealed a plan to use these on long-haul routes between smaller European cities (such as Edinburgh, Aberdeen, and Bergen) and the US and Caribbean. The MAX extends the range of the 737 to more than 6,667 kilometres, and Kjos observes: “There are a lot of routes that are served via a hub-and-spoke system today that we will serve with direct flights in the future.” The carrier already employs 300 cabin crew in Fort Lauderdale and New York, and is starting to recruit American pilots, but clearly much depends on that US DoT approval.

As well as long-haul, norwegian is also counting on substantial short-haul expansion with another 50 737-800s are on order, plus 100 A320neos from 2016. Norwegian’s core strength is in its home base, at Oslo, where it had a 39% share of the market in the third quarter of 2014 (in terms of all passengers carried), backed up by significant market shares at Stockholm (24%), Copenhagen (17%) and Helsinki (12%).

Growth has come elsewhere over the last year: from a 2% to 3% combined market share at all the Spanish airports it operates to (Malaga, Alicante, Las Palmas, Tenerife, Madrid Barajas and Barcelona), and — much more importantly — a leap from 5% to an 8% share at London Gatwick. Gatwick is much larger than any of Norwegian’s Scandinavian airports, and Norwegian only launched a base there as recently as the spring of 2013.

The 100 Airbus A320neos on order are likely to be based at norwegian’s six Spanish bases, although there is no clarity yet as to just where the significant route expansion necessary to take all these aircraft will occur.

Interestingly, the fleet plan has become less aggressive compared with the plan as of just 12 months ago, with the planned fleet at the end of 2015 being 99 aircraft, compared with a year-end 2015 target of 102 aircraft that was in plan a year ago. The fleet will then increase significantly in 2016 as new deliveries start arriving, to reach 117 by that year-end and comprising 101 737-800s (of which 68 will be owned, 13 sold and leased-back, and 20 leased); four A320neos and 12 787-8/9s (with three owned and nine leased).

Kjos has also indicated that some of the outstanding orders could be leased out to other carriers, depending on how the market looks in 2016 onwards as the deliveries start piling up. Norwegian has set up an Irish-based leasing subsidiary (Arctic Aviation Assets) that will give the airline fleet flexibility in the future. In this it is following a trend of other low cost carriers that have large numbers of aircraft on order — notably in Asia with airlines such as AirAsia, Lion Air and Spring.

The in-house leasing operation may provide a buffer to long term risk (but at the moment, as CFO Frode Fosse recently claimed, norwegian needs all the aircraft it can get its hands on for its own route network expansion). The downside may be that the carrier may well be left with a large overhang of aircraft that — without the experience or contacts of the established lessors — are difficult to place in the market (and could end up at competitors).

In addition, airlines rarely obtain the same low cost of funding as lessors, and have less clout than established lessors in being able to go back to manufacturers and switch models around in response to changing market demand. At the heart of the argument is whether norwegian (or indeed any airline) can operate successfully at the margins of the ultra-competitive leasing industry.

A cost battle

Unit costs have been gradually edging down, due to a combination of cost-cutting and the scale effects of increasing the long-haul network. In the third quarter of 2014, CASK excluding fuel fell 4% year-on-year to NOK 0.26, with overall CASK remaining at NOK 0.40, the same level at Q3 2013.

The problem is that this cost reduction has not been enough to close the gap with unit revenue, although the latter has risen substantially over the last two quarters, from NOK0.31 in Q1 2014 to NOK0.38 in July-September.

The question is whether the narrowing of the unit cost/revenue gap will continue through the next few quarters, enabling the carrier to get back into the black? The airline is targeting full 2014 CASK excluding fuel of NOK 0.25 (and including fuel of NOK 0.41).

Norwegian does not hedge its jet fuel requirements, and it is possible that it could be the airline to benefit most from the decline in fuel prices in the short run: a 1% fall in the cost of jet fuel would have a NOK56m positive impact on operating income. However, the savings are being offset by the near 20% depreciation of the Norwegian Krone against the dollar (and for a 1% decline in the NOK-USD exchange rate the company estimates a negative effect on operating profits of some NOK 80m).

Norwegian’s major cost reduction efforts are:

  • Fleet adjustments. The current fleet comprises 83 737-800s, eight 737-300s and seven 787-8s, and the 300s will be replaced completely by 800s in 2015, which provide better economics, essentially giving 38 “free seats” according to Norwegian.

  • Scale economies. As the long-haul network grows (which is why the US DoT approval issue is so important), overhead will be spread thinner, improving the underlying unit cost base. And frequency based costs will also be spread over greater ASKs as the average sector length increases.

  • Continued off-shoring of costs. The Irish subsidiary is only the latest example of this; key parts of the back office infrastructure are already based in east European; the IT department, for example, is based in the Ukraine.

  • Other costs measures include increased automation (such as automated charter and group bookings), and more streamlined operational systems and processes.

Using norwegian’s own figures, its unit costs are 75% higher than those of Ryanair, though much better than local rivals SAS and Finnair, which are 76% and 38% higher on a unit cost basis respectively. Remarkably, given its base in Norway and substantial operations in Scandinavia (with high costs, taxes and strong unions), its unit costs are not too dissimilar from those of easyJet or Vueling.

The future

Long-haul low-cost expansion is full of risk. The traditional wisdom is that there is not the same potential to create the cost advantages against incumbent legacy carriers as there has been in short haul. It is not just that long haul operations encounter the complexity of airport curfews and crew hotac expenses. It is also that incumbent carriers on long haul routes have a bucket of discount fares at the back of  Economy that they can switch on to undermine incipient competition.

 After receiving 14 737-800s and four 787-8s in 2014, 2015 will be a time for relative consolidation, with just a 5% growth in overall ASKs anticipated (with short-haul up by 2% and long-haul by 25%). 

Investors appear uncertain as to whether the current dip into the red is a short-term blip. After a bumpy ride from the 2003 IPO until the end of 2011, the share price soared until the second quarter of 2013, after which it fell back (and coinciding with the launch of long-haul routes), becoming very volatile through 2014.

This industry needs innovators — and norwegian with Bjørn Kjos at its helm is an innovator. The real dilemma may be that, should norwegian be successful in creating a true low cost long haul operation, others with better balance sheets will follow.

norwegian fleet
Fleet Order Options
A320neo 100 50
737-300 8
737-800 83 50 6
737 MAX 8 100 100
787-8 7 1
787-9 9
Total 98 260 156
norwegian: Unit revenues, costs and yield
norwegian: Unit revenues, costs and yield Produced by GNUPLOT 4.6 patchlevel 3 0.30 0.35 0.40 0.45 0.50 0.55 0.60 2011 2012 2013 2014 NOK gnuplot_plot_1 gnuplot_plot_2 gnuplot_plot_3 Unit Revenues per ASK Unit costs per ASK Pax yield per RPK
norwegian: Strong growth record
norwegian: Strong growth record Produced by GNUPLOT 4.6 patchlevel 3 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000 2005 2006 2007 2008 2009 2010 2011 2012 2013 Jan-Nov 2014 0 10 20 30 40 50 60 m Year-on-year percentage change Capacity growth gnuplot_plot_1 gnuplot_plot_2 gnuplot_plot_3 ASK RPK
Norwegian Air Shuttle share price
Norwegian Air Shuttle share price Produced by GNUPLOT 4.6 patchlevel 3 0 50 100 150 200 250 300 350 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 NOK gnuplot_plot_1
norwegian Route network - bases in USA and Asia
norwegian Route network - bases in USA and Asia
Norwegian Air Shuttle: Financial results
Norwegian Air Shuttle: Financial results Produced by GNUPLOT 4.6 patchlevel 3 -600 -400 -200 0 200 400 600 800 1,000 1,200 1,400 2006 2007 2008 2009 2010 2011 2012 2013 2014e 2015e 2016e 0 5 10 15 20 25 NOKm NOKbn gnuplot_plot_1 gnuplot_plot_2 gnuplot_plot_3 Operating profit Net result Revenues
norwegian fleet plan
norwegian fleet plan Produced by GNUPLOT 4.6 patchlevel 3 0 50 100 150 200 250 300 350 400 450 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 gnuplot_plot_1 gnuplot_plot_2 gnuplot_plot_3 gnuplot_plot_4 gnuplot_plot_5 6 8 11 13 22 32 40 46 57 62 68 85 95 99 117 141 154 189 230 259 420 Base fleet Planned net growth Flex growth Purchase rights
Battle for supremacy
Battle for supremacy Produced by GNUPLOT 4.6 patchlevel 3 -30% -20% -10% 0% 10% 20% 30% 40% 50% 60% 2013 2014 Year-year percentage change gnuplot_plot_1 gnuplot_plot_2 gnuplot_plot_3 gnuplot_plot_4 norwegian unit revenues norwegian Capacity SAS unit revenues SAS Capacity

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