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Mexico’s airlines: Trump
and now AMLO June 2018 Download PDF

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The past couple of years have been challenging for Mexican aviation, with the US-Mexico open skies regime coming into force, competition intensifying in the domestic market, and Trump effects hitting the Mexican peso, business sentiment and travel demand. The July 1 presidential election and the ongoing North American Free Trade Agreement (NAFTA) renegotiations pose further economic uncertainty. How are Mexico’s main airlines — Aeroméxico, Volaris, Interjet and VivaAerobus — dealing with it all?

Mexico is heavily dependent on its northern neighbour, with 80% of its exports going to the US. The airline sector is heavily exposed to the Mexico-US air travel market — about 30m passengers in 2017, or two-thirds of the total international travel to and from Mexico.

So President Trump’s protectionist trade policies and anti-immigration rhetoric, including his campaign promises to build a wall on the US-Mexico border and terminate NAFTA, were devastating blows to Mexico’s economy. Business confidence declined, investment plans were put on hold and the Mexican peso plummeted.

The peso’s depreciation played havoc with Mexican carriers’ financial results. The airlines have up to 60% of their costs denominated in US dollars (fuel, aircraft rentals, etc), so they saw terrible cost headwinds and foreign exchange losses. After being consistently profitable, the four largest carriers all plunged into losses in the first quarter of 2017.

After the initial shock, though, it looked like things were going to get better. Trump softened his policies or found his proposals blocked or delayed in Washington. He conceded that NAFTA could be renegotiated and that there would be no mass deportations of Mexicans. Funding the border wall was a non-starter in Washington. By June 2017, the peso had recovered to its pre-election level, and there was optimism that Mexico’s airlines could see a quick recovery in profit margins.

But in the past two months Trump’s rhetoric and actions have taken a turn for the worse.  Although his primary target is China, the EU, Canada and Mexico have all been hit by new tariffs on their steel and aluminium exports to the US. All have retaliated; in early June, Mexico announced 15-25% tariffs on $3bn of US products.

Second, in mid-June Trump’s inhumane policy of splitting up undocumented immigrant families at the southern border blew up into a full-blown crisis. Reportedly at least 2,300 children (mainly from Central America but also from Mexico’s most violent areas) have been separated from their parents since mid-April, while the parents are being prosecuted for crossing the border illegally.

On June 20 Trump bowed to intense pressure and signed an order ending the separation of children, but it is not clear whether the damage can be undone. Trump then revived the claim that Mexico will pay for the border wall (to which President Enrique Peña Nieto responded on twitter that Mexico will “never pay for a wall. Not now, not ever”).

Unsurprisingly, the Mexican peso has again lost value: since mid-April it has fallen from 18 pesos to the dollar to the 20-21 level. The weakness also reflects the mid-June increase in the US benchmark interest rate; Mexico’s central bank limited the damage by raising its own key interest rate. With more US Fed tightening on the cards, analysts expect the peso to remain under pressure.

Mexico’s central bank cited two big unknowns: NAFTA renegotiations and the July 1 elections. The airlines, too, noted in their latest earnings calls that those two factors made it hard to predict customer behaviour.

The NAFTA talks, which began in August 2017, could now take longer, and the risk of the talks failing is higher. Many in the financial community now assume that there will not be a NAFTA deal this year but that a positive outcome is still likely. Fitch said in early June that it believed that the outcome of the NAFTA talks would “not seriously affect Mexico’s trade access to the US”. In the meantime, though, Mexican companies can be expected to continue to delay investments, and hence probably also travel decisions.

The uncertainty around the upcoming presidential election is not about who will win but what the likely winner will do. The candidate with an overwhelming lead in the polls (90% odds of winning), Andrés Manuel López Obrador (known by his initials AMLO), is a left-leaning populist with some controversial ideas but who is mostly an unknown quantity.

According to Forbes, AMLO, like Trump, is not a fan of NAFTA. With two populists clashing, US-Mexico tensions could worsen. The economic implications of AMLO’s victory are not at all clear: on the one hand, he could turn out to be a moderate and his increased social spending could boost growth in the near term; on the other hand, his plans to reverse Peña Nieto’s key reforms, such as the opening of the oil and gas industries to the private sector, would adversely affect investment in the longer-term.

In its June 23 issue, The Economist called AMLO “Mexico’s answer to Donald Trump”, noting that he has a “folksy air of incorruptibility that enchants many Mexicans”. The article continued: “But the nationalist populism he offers is unlike anything Mexico has seen since the early 1980s. When AMLO promises a ‘radical revolution’, some worry that he will be as good as his word.”

AMLO’s victory could have specific ramifications for airlines: he does not approve of the New Mexico City Airport project. But there is hope because he appears to be softening his stance (discussed more in the last section).

Yet despite all the politics, Mexico’s economy has remained relatively healthy. The IMF expects Mexico’s real GDP to expand by 2.3% in 2018 and by 3% in 2019, following 2% growth in both 2016 and 2017.

Financial losses and new strategies

Mexico’s challenges and intensified competition in key markets have taken their toll on airline profits: An industry that was doing well right through the end of 2016 is now reporting weak results and even heavy losses for the seasonally weakest quarters.

Volaris has been hit the hardest. In the latest period (Q1 2018), the leading ULCC incurred alarmingly high operating and net losses of 906m pesos and 1,118m pesos, respectively (negative margins of 15.5% and 19.1%). The operating loss was blamed on higher fuel prices and lower base fares. Domestic fares fell by as much as 17%.

Those losses followed a weak 2017, in which Volaris achieved a mere breakeven operating result (after double-digit margins in previous years) and a net loss of 595m pesos (2.4% of revenues).

The latest results would have been truly dismal had Volaris not seen continued strong growth in ancillary revenues (non-ticket revenues rose 17.4% to account for 34% of total revenues) and good cost controls (ex-fuel CASM fell by 9%).

VivaAerobus, the other ULCC in Mexico, incurred operating and net losses of 192m pesos and 37m pesos, respectively (9.6% and 1.8% of revenues) in Q1 2018 — both steeper than in the year-earlier period.

However, the airline also grew at a breakneck pace with very promising results. Despite 37% ASK growth, VivaAerobus achieved a 87.4% load factor, 8.8% higher unit revenues and a 12.7% higher average fare. The secrets: aggressive fleet renewal, strong ancillary revenue growth and (evidently) improved yield management.

VivaAerobus has rectified its biggest initial mistake, which was to operate old aircraft. In 2013 it opted to replace its used 737-300s with new A320neos/ceos, placed a $5.1bn aircraft order and completed the fleet transition in November 2016. As of March 31, the airline operated 23 A320ceos and two A320neos. The aim is to have a 55-strong A320 fleet by 2022, of which at least 70% will be neos.

The carrier’s ancillary revenues surged by 53.2% in Q1 (or by 18.7% on a per-passenger basis), to account for 46% of total revenue — an indication of a very successful implementation of the fare-unbundling strategy.

Interjet, the up-market LCC, reported operating and net losses of 567.1m pesos and 593.5m pesos, respectively (10.7% and 11.2% of revenues) for Q1 2018, which were similar to the year-earlier losses.

Interjet’s annual results have deteriorated steadily in the past two years. Last year’s operating margin was 1%, down from 7.3% in 2015. And 2017’s net loss was 236m pesos, contrasting with net profits of 412m pesos and 277m pesos in 2015 and 2016.

Aeroméxico has not fared quite so badly because it benefits from a diversified global network. The carrier achieved a tiny 24m peso operating profit in Q1 (a breakeven effectively), enabling it to claim a 32nd consecutive positive EBIT result. Net loss was 722m pesos, reflecting a large foreign exchange loss.

The sharp deterioration in Aeroméxico’s EBIT reflected weaker international demand, yields and load factors. The airline has focused on the international segment (ASMs up 25.5% in Q1) and reduced domestic exposure (ASMs down 5.2% in Q1).

The two ULCCs, Volaris and VivaAerobus, are both benefiting from successful ancillary revenue strategies, especially in the cross-border market where checked bag fees are allowed. Those fees are helping to compensate for the base fare declines as the markets have become more competitive.

The other positive development is diversification in terms of markets. The best example so far is Volaris’ venture into Costa Rica. Volaris created a new AOC, which replicates its business model, and obtained a new foreign air carrier permit in the US. The unit launched US operations in March, currently serving Los Angeles, JFK and Washington Dulles from Costa Rica, with some of the flights stopping in San Salvador and others in Guatemala City.

The other potentially promising area is alliances with foreign carriers. Volaris has again stolen the show by signing a codeshare deal with the US ULCC Frontier in January (sales will begin in Q3). The airlines claim that it is the first-ever codeshare agreement between two ULCCs.

Interjet was the first Mexican LCC to embrace codesharing (currently with American, Iberia and LATAM) and is now reportedly seeking cooperation with Hainan and a deeper JV with American. But the latter could take years to materialise.

Aeroméxico has been implementing its immunised JV with Delta since May 2017, which probably helped it weather some of the capacity pressures on US-Mexico routes. However, Bradesco analysts suggested in April that macroeconomic headwinds may delay Aeroméxico’s plan to extract the full US$200m annual synergies from the JV within five years.

Of the three LCCs, despite its steep Q1 losses, Volaris is clearly the best-positioned to return to solid profitability when the dust settles (the ULCC model, lowest costs, robust ancillary revenue strategy, the Costa Rica unit, strong balance sheet, etc).

VivaAerobus may have a bright future — if it can consolidate its new strategies, manage growth and build a better position in the Mexico-US market. As of April, it still had only a 1.6% share of Mexican carriers’ international traffic.

Interjet is currently the weakest of the three, not just because of the recent issues with the Superjet SSJ100 engines. The balance sheet looks weak, with current liabilities exceeding current assets as of March 31 (14,166m/5,567m pesos). Cash reserves were only 5.7% of last year’s revenues. Rapid growth does not help, and nor does having to compete in a domestic market dominated by ULCCs.

Demand strength, yield pressures

Air travel demand has remained strong in most markets. Domestic passenger numbers in Mexico rose by 7.9% in both 2017 and January-April 2018 — lower than 2016’s 12.3% growth, but April actually witnessed a 10% surge. The domestic market has doubled since 2006, from 22.2m to 45.2m passengers —  entirely attributable to the growth of LCCs.

Domestic demand has remained strong because of healthy GDP growth and because a weaker peso has prompted more Mexicans to vacation at home. But the sharp decline in domestic fares and yields, especially in Q1, and the comments made by some airline executives indicate that significant capacity addition and fare wars played a part in stimulating demand.

Some analysts have expressed concern about what they see as unsustainably low domestic fares. Brazilian airlines saw a similar situation in late 2015 and early 2016, albeit for different reasons; they reduced capacity drastically and fast, and stopped burning cash. Why can’t Mexican airlines do that?

Aeroméxico and Interjet have done that. Aeroméxico Group reduced domestic capacity by 1% in 2017 and by 5.2% in Q1 2018, with promising results: in the first quarter, its average fare recovered by 12% and its load factor rose by seven points.

But the problem is that, unlike Brazil where there are no ULCCs, in Mexico ULCCs account for 45% of domestic passengers (April data). Being the lowest-cost producers by a wide margin, airlines like Volaris feel justified in continuing to add capacity domestically. They stimulate the market and continue to switch passengers from bus to air. They also know that they will be the eventual winners.

Volaris grew domestic capacity by 10% in 2017, 12% in Q1 2018, 11% in April and 14% in May. The leadership stated recently that they had no intention to reduce capacity in the domestic market. “We’re convinced that volume-generation remains the most important driver of the top line and a healthy corresponding increase in our ancillary business.” Volaris especially wants to maintain capacity leadership in the “core markets of the Mexico Pacific corridor”, as well as Cancun.

But the international market is a different matter. There Mexican airlines compete against at least 10 US carriers, including ULCCs, LCCs and the legacies. The latter enjoy feed from their huge domestic networks and can now match ULCCs’ fares with their Basic Economy product. In recent months, Volaris has followed United’s and Aeroméxico’s example and cut capacity in the US-Mexico market; its total international ASMs declined by 4.1% in April and by 5.5% in May.

Mexico’s international market, which at 44.4m passengers in 2017 is similar in size to the domestic market, remains extremely imbalanced. Almost two-thirds of international passengers travel to or from the US. Mexican carriers account for only 29.5% of Mexico’s international passengers, while US carriers have a 47.2% share.

The Mexico-US market has seen a substantial increase in flights and frequencies under the open skies regime, which became effective in August 2016. However, airlines from both countries had already benefited from a liberalised regime in the secondary markets, which had led to an influx of new flights and operators. That explains why Mexico-US passenger numbers surged by 12.1% in 2015 and growth then moderated to 8.6% in 2016 and 9.1% in 2017. 

But the Trump effects and other negatives have meant that demand could not keep up with the capacity addition, resulting in lower load factors, weaker yields and financial losses in the Mexico-US market. So this year is seeing a correction. The first quarter saw an estimated 6.2% reduction in available seats. April saw a 0.5% reduction in passenger numbers.

The cutbacks, which are also in response to the recent surge in fuel prices, were initiated by US carriers such as United and Alaska, but Aeroméxico and Volaris followed quickly. Volaris has retrenched in large markets such as New York and Los Angeles in favour of refocusing on its traditional strengths — VFR and niche markets between Mexico and the US, which have been “tremendously successful”.

New MEX under threat?

But the biggest problem Mexico’s airlines face is lack of slots at Mexico City’s Benito Juárez International Airport, which now handles 47m passengers annually — almost 50% over its design capacity of 32m — and cannot be expanded. The airlines have done a remarkable job in squeezing more growth there, but the strategy of relying on aggressive upgauging has its limits.

In September 2014 President Enrique Peña Nieto announced plans to build a new six-runway airport for Mexico City to replace Juárez. Construction began in 2015. The airport, officially referred to as NAICM (Nuevo Aeropuerto Internacional de la Ciudad de México), is being built on government-owned land just three miles away. It will be able to handle 125m passengers a year. The initial three-runway airport, with capacity to handle 68m passengers, is scheduled to open in October 2020.

But AMLO has slammed the US$13bn project as corrupt, too expensive and unnecessary. After initially threatening to cancel it outright, he has relaxed his stance somewhat in recent months. He is now talking about reviewing the project and conducting a “public consultation” or referendum in September. He is reportedly looking at three options: continuing it as a public-private partnership (as it is now); making it a private-sector concession; and scrapping it and instead building two new runways at the existing Santa Lucia air force base.

According to Bloomberg, 70% of the $13bn estimated cost of the new airport is already being financed by private investors. The project is managed by state-owned airport operator GACM, which has a 50-year concession on NAICM and is also the parent company of Juárez. At least $6bn has already been raised through private debt securities, which draw from passenger charges at the current and future airport. In January, the international passenger arrival fee at Juárez was raised by 25% to a relatively hefty $51 to help finance a $2bn bond for the construction of the airport.

The consensus is that the new airport will move forward. First, it is badly needed. IATA warned in April that without it there could be 20m fewer annual passengers, $20bn less in GDP contributions and 200,000 fewer aviation-related jobs in Mexico in 2035.

Second, it is probably too late to cancel the project. More than 75% of the contracts have been awarded and construction is at an advanced stage, with the three runways expected to be completed by the end of 2018.

Third, there are no viable alternative sites. MITRE, a US-government sponsored not-for-profit organisation, recently analysed seven locations and concluded that the current site is the best option. Developing Santa Lucia would not solve the long-term capacity needs.

Apparently AMLO’s preferred option would be to immediately auction the NAICM project to the private sector, but the consensus opinion (GACM, IATA, analysts, etc) is that an auction would make more sense after the airport has been completed.

% of total domestic passengers
Apr 2018 Apr 2017 2012 2009
Aeroméxico Group 28.2 28.8 37.7 32.3
Volaris 27.9 27.8 20.5 12.8
Interjet 21.5 21.1 23.9 12.7
VivaAerobus 17.4 16.7 12.5 5.8
Mexicana 27.2
Others 5.0 5.7 5.3 9.2
Total 100.0 100.0 100.0 100.0
Top 3 LCCs 66.8 65.6 56.9 31.4

Source: SCT/DGAC

% of Mexican airlines' total international passengers
April 2018 April 2017 2012 2009
Aeroméxico Group 53.9 56.0 67.0 31.1
Interjet 25.1 19.2 9.0
Volaris 19.3 24.3 21.9 2.9
VivaAerobus 1.6 0.3 2.2 0.4
Mexicana 65.4
Others 0.1 0.2 0.2
Total 100.0 100.0 100.0 100.0
Top 3 LCCs 46.0 43.8 33.1 3.3

Source: SCT/DGAC

Int'l sched. pax (000) % chg yoy
Aeromexico 635.8 +4.0%
American 417.5 -9.7%
United 405.5 -5.2%
Delta 337.3 +8.2%
Interjet 295.2 +41.2%
Volaris 227.7 -14.1%
Southwest 202.7 +8.5%
Alaska 171.3 +11.5%
WestJet 130.5 -1.5%
Top 9 airlines 2,823.5 +2.5%
Total market 4,000.1 +2.4%

Source: SCT/DGAC

Passengers Flights
('000s) % chg ('000s) % chg
2010 17,836 197.0
2011 18,219 2.1 201.7 2.4
2012 19,088 4.8 210.1 4.2
2013 20,737 8.6 219.2 4.3
2014 22,508 8.5 227.3 3.7
2015 25,232 12.1 248.8 9.5
2016 27,391 8.6 256.6 3.1
2017 29,873 9.1 270.6 5.5
Jan-Apr 2017 10,395 95.2
Jan-Apr 2018 10,846 4.3 99.2 4.3

Source: SCT/DGAC

gnuplot Produced by GNUPLOT 5.0 patchlevel 6 0 10 20 30 40 50 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 -20 -10 0 10 20 Domestic pax (m) %chg Domestic pax (m) %chg

Source: SCT/DGAC

gnuplot Produced by GNUPLOT 5.0 patchlevel 6 0 10 20 30 40 50 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 -20 -10 0 10 20 International Pax (m) %chg International Pax (m) %chg

Note: * Mexican and non-Mexican carriers

Source: SCT/DGAC

gnuplot Produced by GNUPLOT 5.0 patchlevel 6 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 2015 2016 2017 -25 -20 -15 -10 -5 0 5 10 15 20 25 EBIT margin (%) Revenues Pesos (m) EBIT margin (%) Revenues Pesos (m) 1Q18

Source: Company reports

gnuplot Produced by GNUPLOT 5.0 patchlevel 6 12 13 14 15 16 17 18 19 20 21 22 2014 2015 2016 2017 2018 USD/MXN

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