Aeroflot and Transaero merge
amid turmoil in Russia September 2015

A depressed Russian economy exacerbated by sanctions over Russia’s meddling in the Ukraine has resulted in troubled times for the Russian aviation market — and has given the government a rationale/excuse to merge Aeroflot and Transaero. But are Russia’s two largest airlines a good fit?

There’s little doubt that the Russian economy is in deep trouble — according to the IMF, the economy is expected to contract by a substantial 3.4% in 2015 — and that’s not all due to macro-economic factors such as the falling price of oil (with Russia the world’s second largest oil exporter, selling 3m barrels a day).

It was inevitable that Russia’s interference in the Ukraine/Crimea would attract reaction, and the EU, US, Japan and others started imposing sanctions against Russian individuals and entities in 2014. The US and EU sanctions targeted financial services and the energy sectors, among others, and the result has been immense pressure on the Russian economy. The IMF observes: “It is very difficult to disentangle the impact of sanctions from the fall in oil prices, but our estimates suggest that sanctions might have initially reduced real GDP by 1 to 1½ percent; prolonged sanctions may compound already declining productivity growth.”

The Rouble has been in freefall for the last 18 months: a US Dollar bought 33 Roubles at the start of 2014, but 68 Roubles in September 2015. The Russian government has raised interest rates in order to stem the fall in the Rouble, but this has just accelerated economic downturn.

The result is a perfect storm of trouble for Russia’s airlines, and one that the two leading carriers — Aeroflot and Transaero — have not been able to avoid.  A government-mandated merger between the two was announced in early September, with Aeroflot stating: “Following a comprehensive discussion, and taking into account the social tensions surrounding the passenger air transport market and the extremely difficult financial position of Transaero… the board decided that it was necessary to involve Aeroflot Group in the restructuring of Transaero.”

The majority acquisition of Transaero by Aeroflot is due to be completed by the end of September, after which “operational management” of Transaero will be transferred to Aeroflot.

Market position: Aeroflot

Still burdened by majority state ownership (state agency Rosimushchestvo owns 51.17%) and with major strategic decisions such as merging with other Russian airlines taken out of its hands (see Aviation Strategy, August 2013), Aeroflot has been struggling to transform itself into a modern, profitable airline for many years.

Altogether, the Aeroflot group operates to 140 destinations in more than 50 countries, and in 2014 it carried 34.7m passengers, of which 23.6m were flown by the mainline Aeroflot. That gave the group a 38.1% share of the domestic market and a 26.1% share of the international market to-from Russia last year. That compares well with the respective market shares of 20.6% domestically and 18.9% internationally it had back in 2009, though while the domestic share has been rising constantly over the last few years (thanks to government-mandated domestic consolidation and a significant decline in long-haul domestic rail passengers, as train fares have risen, from 119.6m passengers in 2009 to 102.8m in 2014), the international share is down from a peak of 28.5% in 2012.  

Internationally, Europe is by far the most important market for the group, accounting for 26.8% of all scheduled revenue in 2014, followed by Asia, with a 14% share. Unsurprisingly the group’s routes to the CIS saw passengers carried fall by 15.2% last year, thanks to the turmoil in Ukraine, and its share of total group scheduled revenue fell from 8.2% in 2013 in 6.3% in 2014.

Overall, in 2014 the Aeroflot group had a 31% share of the total Russian market (domestic and international combined), and had a significant lead over its closest competitor, Transaero.

Market position: Transaero

Also based in Moscow, Transaero Airlines became the first privately-owned carrier in Russia after the demise of the Soviet Union when it was launched in 1991 by Alexander Pleshakov and Grigory Gurtovoy. Pleshakov is still chairman of the airline today, and — until the takeover by Aeroflot is completed — he and his wife were the main shareholders, between them owning 36.6% of the equity.

From 2006 to 2013 Transaero grew more than fivefold, and was firmly established as the main challenger to Aeroflot — in 2014 it had a 11.8% market share in terms of passengers carried in the Russian domestic and international market combined. The problem for Transaero is that this share was significantly behind Aeroflot and didn’t give it enough scale to become financially sound —  or to challenge the political status quo.

Last year Transaero’s ASKs crept up by just 0.2% — while Aeroflot’s rose by 12.3%. Transaero argued that this was a more sensible strategy in a tough Russian market (for example its passenger load factor was 83.5% last year, compared with 78.2% at Aeroflot) — but this still hasn’t translated into profitability.

Financial woes: Aeroflot

In 2014, under IFRS standards, Aeroflot saw revenue rise 9.9% to RUB 319.8bn (US$8.3bn), but EBITDA fell a hefty 22.0% to RUB 24.8bn and a net profit of RUB 7.3bn in 2013 turned unto a net loss of RUB 17.1bn ($444m) in 2014. Despite increased traffic and revenue, at a net level there was a significant loss thanks to the slide of the Rouble as well as a raft of one-off items, ranging from bad debt, early return of leased aircraft and provision for unexpected repairs and maintenance. And the group’s cost per ASK increased by 7.1% year-on-year to RUB 2.66 (US¢6.9) in 2014 thanks largely to the negative effects from the Rouble’s weakening and some one-off costs.

While yield rose on Aeroflot’s international routes in 2014 — up from 3.05 RUB per RPK in 2013 to RUB 3.07 in 2014 — on domestic routes it fell, from 3.07 year-on-year to 2.98 RUB in 2014 — the latter due to “aggressive pricing strategies of domestic competitors”, according to Aeroflot.

In the first-half of 2015, under IFRS, Aeroflot saw revenue rise 25.8% year-on-year to RUB 176.5bn ($3.1bn), but while an operating loss of RUB 1.4bn in the first six months of 2014 turned into an operating profit of RUB 5.9bn in H1 2015, a RUB 1.9bn net loss in H1 2014 almost doubled, becoming a RUB 3.5bn ($61m) net loss in January-June 2015.

At the end of 2014 the mainline Aeroflot employed just under 19,000 (which rose 6.1% compared with 2013), with 12,578 employed elsewhere in the group (up 7.0% year-on-year), to give a total of 32,439 employees at the group — and as the charts on this page show, its productivity in terms of ASKs per employee lags behind Transaero.

What is particularly worrying about the Aeroflot group is its debt position — net debt more than doubled in just 12 months, from RUB 67.7bn as at the end of 2013 to RUB 146.8bn ($3.8bn) at end 2014. The group says this is “due to revaluation of finance lease obligations”, but it’s clear that this level of debt is unsustainable, and has to be brought down significantly.

Financial woes: Transaero

 In 2014 Transaero carried 13.2m passengers, 5.6% up year-on-year, with 9.3m of them carried on international routes. It reported revenues of RUB 117.3bn ($3bn) up by 6.9% over the previous year; an operating loss of RUB 0.3bn and a net loss of RUB 19.3bn ($0.5bn). At the same time it restated the prior year figures with little explanation. What had originally been reported as an operating profit of RUB 5.6bn and a net profit of RUB 1bn for 2013 now were shown as an operating loss of RUB 12.4bn and a net loss of RUB 16.4bn for that year. The accounts were also qualified.

That financial performance worsened in the first half of 2015, Even though Transaero carried 5.8m passengers — 0.4% up on the first half of 2014 — with a load factor of 82.5% (the same as in H1 2014) and revenue (again under RAS) rising 3% to RUB 50.4bn ($873m), the airline posted an operating loss of RUB 12.9bn, compared with a restated loss of RUB 5.1bn in the same six month period of 2014.

Most worryingly, Transaero’s short-term debt stood at RUB 45.8bn ($794m) at the end of June 2015 (a rise of 26% in just six months), with total debt totalling RUB 67.5bn at the same date (up 3% in six months).

At the end of 2014, the Russian government agreed to underwrite a three year loan from VTB bank (which is 61% government-owned) of up to RUB 9bn (US$234m) — enabling Transaero to repay a RUB 2.5bn bond in March — but  the poor results for the first-half of 2015 forced an urgent need to further restructure the airline’s burgeoning debt. The airline’s creditors — led by Sberbank — agreed a short-term covenant holiday until the start of October so that new financing could be agreed, and (prior to the Aeroflot deal) the airline was reportedly negotiating with a consortium of Russian banks for seven-year syndicated loan of up to Rub 29.5bn, potentially with further state guarantees.

Aeroflot goes multi-brand

Against those results and financial pressures, the two airlines have been pursuing their different strategies. Aeroflot group’s latest plan — for 2016-2020 — includes two main themes:  cost control/efficiency gains (particularly in fuel and maintenance costs, plus continued improvement in labour productivity); and development of a multiple brand approach to the market.

The latter is designed to enable the Aeroflot group to win passengers “in every market segment, from premium to low-budget”, and most pertinently this means further development of its latest attempt at a LCC.

The engine of the group remains the flag carrier, Sheremetyevo-based Aeroflot, which accounted for 68% of total passengers carried at the group last year. The unglamorous workhorses of the group are the regional airlines, which provide feed into Aeroflot’s international routes — Pulkova (Saint Petersburg)-based Rossiya (5.2m passengers; 14.9% of the group total); Rostov-based Donavia (1.7m; 5.0%); and Vladivostok-based Aurora (1.1m; 3.0%). The group also operates a charter carrier Orenair, based in Orenburg (3.0m passengers in 2014, representing 8.7% of the group total), but whose “strategic positioning is currently under review” according to the group.

The group portfolio is completed by LCC Pobeda (0.1m; 0.3%). A previous attempt at an LCC — Dobrolet — was launched in June 2014 but suspended after just 55 days of operation, in August, after the airline was placed on a list of sanctioned companies by the EU; its initial route was to Simferopol, which the EU said made it complicit in Russia’s attempt to annex the Crimea region. So in September last year the Aeroflot group launched another LCC, called Pobeda (which means ‘victory’ in Russian), with flights starting in December.

Pobeda currently operates 12 leased 737-800s (transferred over from the group) out of Vnukovo airport In Moscow on 15 domestic routes, utilising a standard LCC business model with paid-for food and drink, fees for carry-on luggage (generating 10-15% of total revenues) and the majority of sales coming from direct or online channels. Fares are around 20-40% lower than typical fares on services operated by competitors on those same routes, Aeroflot claims, but by operating out of Vnukovo, the group says that this “reduces cannibalisation risks”.

In July the group said it would transfer up to further 13 737-800s to Pobeda on “long-term lease” after the summer season was over, as part of its plan to operate 40 aircraft by 2018, when it is targeting around 10m passengers on up to 50 routes, both domestically and internationally .

A diversified portfolio is seen as a necessity strategically for Aeroflot in a challenged Russian economy, and it will be interesting to see what kind of market penetration Pobeda wins; if successful it will no doubt encourage other LCCs in the Russian market — subject to government permission.

The group is also pushing the concept of Moscow as an alternative transit point (to the Gulf super-connectors based in the Middle East) on passenger flows between Asia and Europe/North America. It says flights between Asia and Europe connecting at Moscow are always shorter than via connecting at Dubai; for example it claims a Paris-Tokyo route is three hours shorter, or that Milan-Beijing is 2.5 hours shorter when connecting via Moscow. Whether passengers will prefer to change aircraft at Moscow rather than Dubai is dubious, but Aeroflot says that its policy of increasing frequencies on key international routes is resulting in a steady increase in transit passengers at Sheremetyevo; international to international transit passengers accounted for 11.8% of Aeroflot’s total passengers at the Moscow airport in 2014, compared with 10.6% in 2012.

The total Aeroflot group fleet now stands at 251 aircraft, an increase of 42 over the last three years as the airline has modernised and expanded its fleet in an attempt to build, as Aeroflot calls it, “a “young western-built fleet easily transferable from one route to another”.

The average age has come down from 10.4 years to 7.0 years over the same period (see chart above), and the mainline Aeroflot fleet of 150 aircraft has an ever lower average age, of 4.1 years. But there still remains much to do in terms of fleet overhaul, in particularly at the other group airlines, where — for example — there are still nine DHCs and six An 148s in operation.

The group has reportedly put up for sale 21 A321s and a single A320, and in terms of its order book, Aeroflot did have 22 787s on order (placed back in September 2007), with initial deliveries slated for 2018, but the entire deal was cancelled in the summer, and there is much speculation that other outstanding orders will also be cancelled.

Currently Aeroflot has three 777s, 22 787s, 14 A350-900s and eight A350-800s on order. The latter are due for delivery from 2018, but though has been speculation that this may be scrapped, Aeroflot says that there are discussion with Airbus on the “mix” of the order only.

Transaero fleet adjusting

Prior to the Aeroflot takeover — and on the assumption that a successful refinancing was possible — Transaero Airlines was planning to intensify its pre-existing major cost cutting and efficiency programme, which was only initiated in November 2014.

The major focus had been on resizing/adjusting the fleet. Transaero currently operates 106 aircraft, of which 52 are widebodies, making it the largest operator of widebody aircraft fleet in Russia and eastern Europe — though many of those widebodies are placed onto medium-haul routes that just don’t justify those kinds of capacities.

This year two A321s and a 737-800 have joined the fleet, and through the rest of 2015 two further leased A321s will join. Though these will be direct replacements for widebodies, a post-integrated Transaero is likely to shed widebodies much faster.

Currently four A380s, 12 A320neos, four 747-8s and six Sukhoi Superjet 100s are on firm order direct from manufacturers. The first two A380s were due to be delivered this year, but these have now been rescheduled — though there is no public confirmation as to when they will now arrive.

Even prior to the merger with Aeroflot it was highly likely that, given Transaero’s finances and its excess widebody capacity, the A380s and 747-8s would be cancelled at some point. The direction of travel in terms of orders is clear — last year Transaero cancelled an order for 787s, and it has yet to firm up an MoU for 20 A330s placed at Farnborough in 2014.

Elsewhere, one of its subsidiaries — Shannon-based maintenance provider Transaero Engineering Ireland — entered bankruptcy protection in January this year as a result of its parent’s financial problems.  Formerly operating as Air Atlanta Aero Engineering, the Boeing maintenance specialist company was bought by Transaero in 2012 and employed around 230.

Given the imperative to cut costs, planned route expansion was limited at Transaero. In its summer 2015 schedule Transaero operated more than 200 routes domestically and to Europe, Asia, the Americas and Africa, with 65 of those operated out of Moscow Vnukovo, around 50 from Moscow Domodedovo airport and 23 from St Petersburg. Altogether there were 60 domestic routes, and while they provided feed into international routes they won relatively little revenue; domestic routes accounted for 18% of Transaero’s revenue in 2014, compared with 82% for international services. On the international sector, this summer new routes were launched from Moscow to Malta and Prague, and from St Petersburg to Shanghai.

So far Transaero has not gone down the LCC route. It did launch a “low cost service” called Discount class in January 2014, but while the product is offered on selected domestic and international routes (with 1.8m passengers booking the class through 2014), it can’t be described as a  LCC operation.   

In May Transaero also rebranded itself with a new logo, livery and colour scheme, but it’s unlikely that this, combined with a refinancing underwritten by the Russian government and renewed cost-cutting, would have be enough to save Transaero. Olga Pleshakova, the CEO of Transaero had urged the Russian government to offer more support to its airlines in general, such as by reducing VAT on domestic flights — which she said would save the airline RUB 2bn ($37m) a year — but regardless the prospects for Transaero’s continued survival as a standalone airline had declined markedly as 2015 progressed.

Time for downsizing

Once Aeroflot and Transaero are merged,  there will rationalisation of routes, fleet, outstanding orders and staff — the only question is just how much of that will occur, and how fast.

Inevitably Transaero — and most likely its domestic network — will bear the brunt of any adjustments. Aeroflot group’s goals of carrying 70m passengers a year and becoming a top five European and top 20 global airline by revenue and passengers carried by 2025 still remain, but Russia’s economic decline means that this year (and maybe the two or three years) is a time for consolidation and cost-cutting, not expansion.

Aeroflot’s plans for Transaero will become clearer in the next few months, and while it’s probable that Transaero name will remain for the short-term as part of Aeroflot’s multi-brand strategy, the brand will eventually disappear.