How will Covid damage the Super-connectors? May/Jun 2020

Covid-19 tends to target those with underlying problems so the over-expanded connecting networks of Emirates, Etihad and Qatar are particularly susceptible to the coronavirus.

The Middle East Super-connectors essentially link 100 different countries by funnelling traffic flows through their terminals at Dubai, Abu Dhabi and Doha, a logistically superb system but potentially a super-spreader for disease. The operators are faced with the challenge of carrying 200-plus nationalities on each long-haul flight and complying with the relevant national health and safety regulations of each of the nationalities.

When business re-starts, the implication is that some traffic, especially premium traffic, will divert where possible to point-to-point competitors, notably the European and Asian traditional flag carriers. China was the originator of Covid-19 but it also dealt ruthlessly with the outbreak and is now in a position to resume international service. Chinese carriers are targeting not only direct traffic from China to Europe but also building up their own regional hub networks. Then there is THY, the fourth super-connector; Turkey claims to have been only mildly impacted by Covid-19, and business there seems to be moving swiftly back to normal.

It is ironic that Covid-19 has brought an end to US complaints about the Middle Eastern carriers state aid as US carriers have received their own support funds from the Trump Administration. When the Middle East to US market is re-opened one of the priorities for Emirates will be to establish some form of partnership with a US carrier.

Sir Tim Clark, president of Emirates, has guessed that it will take until 2023 for his airline to return to 2019 traffic levels, but is confident that Emirates can re-capture premium business travellers. But that assumes that an effective vaccine is available globally, which is a big uncertainty. Qatar maintained a relatively high degree of operations throughout the lockdown, but Akbar Al Bakar, the CEO, has indicated that perhaps 25% of his fleet, mainly elderly A330s and A320s, will not fly again. All three airlines have implemented drastic redundancy programmes and are intensely attempting to negotiate deferrals and cancellations with the manufacturers, at the same time as making some optimistic noises about service resumptions.

The Middle East super-connector system was under pressure long before Covid-19. Emirates was a dynamic, innovative airline producing 10%-plus net profit margins in the 1990s, but the emergence of state-funded competition in the form of Qatar and then Etihad caused structural over-capacity in the order of 10%, according to our estimates. Even with “normal” demand growth of 4-5% pa, this surplus was set to increase as a result of planned net deliveries. This over-capacity squeezed out profitability at Emirates while the other two super-connectors relied on their governments to fund massive negative cash flows.

The three graphs and update the results for the latest financial year. Emirates produced a marginal net profit in FY2020 equating to a margin of 1.1%. Both Qatar and Etihad were yet again severely loss making, pre-tax net loss margins of -17.6% and -15.5% respectively, and their financial reporting has again been opaque, more press releases than audited accounts.

At the same time as the super-connectors are attempting to rebuild their networks, the Middle East is facing a economic crisis because of the collapse in the oil price; as at the end of June the spot crude oil price was around $40/barrel. According to the IMF, the fiscal break-even price — the minimum price of crude required to cover government spending — was $70/bbl In the UAE and $84 in Saudi Arabia, the key economic driver for the region.

There must be serious doubts about whether even Abu Dhabi can afford to continue funding at levels needed to support Etihad. Construction and other investment projects are being reined in in UAE and Qatar, which will have a very negative impact on direct traffic to the super-connector hubs. Whether tourism to Dubai can be resurrected post-Covid is yet another unknown.

Etihad‘s policy of dubious investments has now totally collapsed as Jet Airways, India’s number two international carrier, which was 49% owned by Etihad, went bankrupt last year and Virgin Australia (in which it had a 21% stake — see Aviation Strategy, Dec 2019) threw itself into voluntary insolvency in April because of the virus. Qatar’s investment in Air Italy imploded in February with the bankruptcy of that carrier, followed by the failure in May of LATAM, in which it had a 10% stake. Still, Qatar will provide DiP financing to LATAM and has said that it is willing to up its 10% stake in Cathay Pacific and 25% stake in IAG.

The super-connectors also have to worry about the value of their fixed assets and order books. According to AVAC, the Covid-19 effect on widebody values and lease rates has been even more severe than on narrowbodies. AVAC estimates that new 787s and A350s are now valued at 30% below 2019 levels. (these are market prices, not “fair values”). A380s now have no substantial operator apart from Emirates, and the theoretical value of an A380-800 has been marked down by a remarkable 60%. All this is going to cause a major headache for the super-connectors’ financiers.

In the past we have emphasised the logic for a consolidation of the super-connector system, in particular a rationalisation of the overlap between Emirates and Etihad (estimated at 73% of their joint network) and in the current circumstances such consolidation has surely become inevitable.

The graph shows the top 20 countries served by the three super-connectors in terms of seat capacity allocated in the pre-Covid era. In the medium term, this capacity will have to be curtailed — our tentative suggestion is by 20%. At 20% the capacity eliminated would be equal to almost all of that previously provided by Etihad.

The rationalisation has to take place between Emirates and Etihad; Qatar Airways will continue to fly almost regardless of its economics, supported by the vast financial resources of the country which remains politically ostracised by Saudi Arabia and other Gulf states.

A final complication for the super-connectors is the incursion of LCCs into some of their markets using long range narrow bodies. Both flydubai and Air Arabia have ambitious expansion plans from their bases at Dubai and Sharjah while Wizz, as described in the previous article, is starting off its joint venture with ADDH in Abu Dhabi with plans to move to a fleet of 50 or maybe 100 A321s within ten years. Air Arabia has a similar joint venture planned with Etihad from the same airport. The key market for the LCCs is the Indian subcontinent which accounted for about 25% of the super-connectors’ pre-Covid passenger flows.