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Ishka Insights Indispensable Analysis and Opinion

Volume One. June 2016

Brexit and Aviation Investors. SAS Reforms. LOT Fleet Overhaul. Transforming Qantas. Monarch Transition to LCC. Spirit Strategy Change. Alaska and Virgin America Merger. Potential $10bn Loss For Asian Carriers.

8 July 2016

Ishkaglobal.com

Insight

© Ishka Ltd ishkaglobal.com

8 July 2016

Ishka Insight Volume 1

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Contents

What does Brexit mean for aviation investors?

SAS needs to continue reforms to counter losses

Can LOT Polish Airlines afford to overhaul its fleet?

A quantum leap for once-struggling Qantas

Can Monarch survive as a low cost carrier?

Robust finances will help Spirit’s strategy change

Alaska’s merger with Virgin America expensive but will aid growth

Asia Pacific: Low fuel price masks potential $10bn loss

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The information used in this document has been assembled from many sources, and whilst the utmost care has been taken to ensure accuracy, the information is supplied on the understanding that no legal liability whatsoever shall attach to Ishka Limited, its subsidiaries, officers, or employees in respect of any error or omission that may have occurred.

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8 July 2016

The Team

Eddy Pieniazek Head of Analytics and Advisory

Eddy has supported thousands of aircraft transactions during his 35 years’ career, advising leaders of the world’s top aviation finance, investment and leasing companies, airlines and manufacturers. A respected and valued influencer, Eddy was one of the original pioneers of today’s aircraft valuation and appraisal industry, developing the industry’s first online valuation tool and associated analytics, fulfilling the rigour and consistency demanded by investors.

Eddy began his career at Ascend (formerly known as Airclaims) in 1982. He founded and led Ascend’s rapidly expanding data and advisory business, spearheading flourishing relationships with industry leaders which continue to this day.

Eddy is a frequent speaker on the international conference circuit and is a visiting lecturer at the Air Business Academy in Toulouse.

Dickon Harris Editor

Dickon operates at the very heart of the aviation financial community and is one of the sector’s most respected journalists. Dickon has been a financial journalist for nine years and spent four years as editor of Airfinance Journal leading the aircraft and leasing finance news and data service from Euromoney. He was also integral to the expansion of Airfinance Journal’s deals database, editorial and international events portfolio. Before his career in financial journalism, Dickon worked for the former UK MP and Energy Secretary, Ed Davey and has worked on several UK regional newspapers.

Since joining Ishka, Dickon has led the foundation and development of the editorial team and specialist reporting capabilities, delivering breaking news, exclusive features and in-depth interviews with key industry leaders.

Stuart Flaye Analytics and Advisory

Stuart has over 15 years’ experience within the aviation industry. Prior to joining Ishka, Stuart was Technical Director at Hong Kong Aviation Capital (formerly Allco Finance Group) where he was responsible for the day-to-day technical asset management of the HKAC portfolio, the drafting of technical lease documentation, co-ordinating and managing aircraft valuations and investor reporting, along with analysing trends in the aviation market. Stuart previously spent seven years as Senior Analyst at Ascend where he provided advisory services to banks, financiers and lessors.

Stuart holds an HND Engineering qualification from the University of Hertfordshire and a BEng (Hons) Aeronautical Engineering from City University, London.

Siddharth Narkhede Analyst

Siddharth has over five years’ experience in aviation research and analysis. He has a strong background in airline financial research and strategic analysis and has written many business and credit research reports on airlines and other industries alike.

Siddharth holds a MSc in Finance degree from the University of Edinburgh Business School and a Bachelors degree in Business Studies from the University of Mumbai. As part of his masters’ thesis, he had researched the impact of the US Bankruptcy Code (Chapter 11) on the financial performance of US based airlines.

Connor Lovell Analyst

Connor graduated from Kings’s College London in 2014. He worked as an academic researcher before training as a journalist and joining Ishka in 2016. He currently supports the news and analytics team, researching and analysing market trends for Ishka Insights.

© Ishka Ltd ishkaglobal.com Any questions? Email us [email protected]

Eddy Pieniazek Head of Analytics and Advisory

What does Brexit mean for aviation investors? As Winston Churchill once said, “Democracy is the worst form of government, except for all the others”. The UK’s vote for Brexit is clearly part of a much wider argument - a signal of dissatisfaction, some have even said “an act of self-harm”, of polarisation between young vs old, rich vs poor, urban vs countryside, nationalist vs internationalist. That analysis is best left to the macroeconomic experts, although astrologers and tea-leaf readers will also volunteer. What does Brexit mean for investors in aviation? We have looked briefly at three key areas in aviation – the hardware (i.e. metal - airplanes, fleets and manufacturing) the software (passengers, traffic and the economy) and the operating environment (regulation and legislation, the means to deliver a safe system, and infrastructure). All are clearly interlinked. An excellent place to start is IATA’s non-‘knee-jerk’ analysis, ‘The Impact of ‘BREXIT’ on UK Air Transport’. It was not formulated on the day, and clearly much was considered in advance. For Ishka, probably the key take-away from this report is the suggestion that the number of UK air passengers could be 3%-5% lower than the ‘no Brexit’ baseline forecast, by 2020. This is anticipated to happen as a result of an expected downturn in economic activity (some suggest stagnation, even recession) and the fall in the sterling exchange rate. IATA also notes that the impact of Brexit is expected to be a permanent downward shift in the level of GDP, not a temporary impact that is recovered. IATA referenced a wide range of GDP estimates including from HM Treasury, OECD, CBI and NEISR. A weaker Sterling means air travel from the UK will become relatively more expensive – rising prices will dampen demand, although conversely overseas visitors would have greater spending power in the UK, which could lead to more inbound tourism. UK outbound traffic in 2015 was twice that of inbound (53.9 million visits overseas compared to 26.2m visits to the UK). The net effect is an anticipated drop in passenger traffic, relative to the forecast baseline, over the next three to four years.

Ishka Insight Indispensable Analysis and Opinion

27 June 2016

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27 June 2016

How are the UK’s airlines positioned? Without a fleet adjustment, such a forecast decline in passengers would lead to lower load factors and reduced revenues. The recent drop in IAG’s share price reflects weaker trading in recent months, more so than the Brexit effect, so maybe the signals are already there. However the beauty of the easyJet and Ryanair operations is that they are truly European, they have no qualms in moving capacity around their networks in the European arena, to match capacity to demand and seek opportunities elsewhere as and when circumstances dictate. We don’t foresee a material impact of Brexit on their long-term strategy or growth. The airlines that are more vulnerable are the UK based carriers that don’t have that wider network. However, they should have enough time to ‘right size’ their operations should traffic levels start to depart from expectations. From a manufacturing perspective, initial thoughts turn to Airbus, Rolls Royce and a host of companies in the supply chain. A weaker pound makes UK exports cheaper for foreign buyers, which is good news for companies like Rolls Royce, which has a large exposure to foreign exchange, especially to the US Dollar. With the majority of its revenue and backlog emanating from outside the EU, Brexit is not likely to have a material impact on its day to day business. Airbus’ exposure to the UK is a little more complicated. Airbus has confirmed business as usual in the near term, and will work with the UK Government to minimise any impact on its current UK investments – however future investments in the UK will be under review. When considering sector financing and infrastructure investment, the UK is not the only country in the world that is an investable proposition. In a post-EU environment the UK will need to sharpen its fight for investment, not just against the rest of the world but against the EU too.

The Ishka View So from the hardware and software perspective, yes we have had a shock, but shocks are typically short term and with hindsight will appear as only a blip on future charts. Airlines have the time and flexibility to adjust to a change in traffic flows, if/when they materialise. However, as far as airlines are concerned, there is still the operating environment, and this is where there may need to be a more significant re-alignment. Europe has a Single Aviation Market, the European Common Aviation Area (ECAA) to which EU members plus Norway, Iceland and eight South-East European states, have access to and the freedom to operate routes within Europe, in accordance with EU aviation law. UK airlines and UK passengers will inevitably seek access to the Single Aviation Market, however the UK will presumably also seek policy freedom to set its own regulations. To be part of the ECAA requires acceptance of EU law. Bilateral agreements with the rest of the world will also need to be addressed. How these scenarios play out will dictate the shape of the UK’s airline industry. There are models in place, involving other countries such as Norway and its participation through the EEC, that could serve as a template for the UK. The UK will negotiate for access to the EU markets, but Brexit means its ability to influence future EU policy will evaporate, including that of EASA, in terms of Airworthiness and Safety regulation. The landscape will change, but time and preparation are some of the key tools available to the UK airlines and manufacturers as the extraction from the EU progresses. The landing should therefore be a smooth one, not hard. If UK aviation struggles, it will be issues larger than Brexit that will be responsible.



SAS needs to continue reforms to counter losses Ignoring the non-recurring revenue and cost items, SAS posted losses in both the quarters of the first half of FY 2015/16. The Scandinavia based airline needs to boost its capacity utilization in H2 2015/16, especially on its intercontinental routes, in-order to post a profit in FY 2015/16. SAS completed its 4XNG restructuring program in 2015 – significantly cutting its cost base (by SEK4 billion (USD477 million) as per SAS) and overhauling its fleet composition and network structure. While its previous restructuring efforts should help the airline better face competition especially the low-cost carriers, the airline needs to continue to undertake further restructuring and reforms in-order to achieve sustainability in profits. In addition, to achieve growth in the medium to long-term it also needs to capture a larger share of the frequent flyer market. Losses despite a strong recovery After posting a positive performance during FY 2014/15, SAS recorded a loss before tax and non-recurring items of around SEK1 billion (USD119 million) during H1 2015/16. The positive non-recurring items helped to reduce the extent of the net loss, however, the subdued financial performance is particularly concerning at a time when airlines globally were enjoying record breaking profitability and the fuel prices were at a record low. Increasing competition from the low-cost rivals and recent increases in capacity have put downward pressure on yields which in-turn has substantially hampered revenue growth. The growth in SAS’ capacity has not been accompanied by an equivalent increase in traffic. In addition, currency exchange losses and higher maintenance charges than usual all contributed to the weak H1 2015/16 results. While the restructuring program has helped to lower SAS’ unit costs, its yields have also been under pressure due to reasons mentioned earlier. However, the Ishka view is that SAS’ net results are likely to improve in the second half of the year, as traffic is usually stronger over the summer months. SAS had a tough first half in FY 2014/15 as well; they posted an almost identical loss of SEK1.2 billion (USD143 million) compared to SEK1 billion (USD119 million)


30 June 2016

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30 June 2016

in H1 2015/16, but still managed to end the year with a profit before tax of SEK1.2 billion (USD142 million) before accounting for exceptional items. However, it remains to be seen how much of an impact Brexit will have on the summer traffic in Europe in the second half of FY 2015/16. 31-Oct-15 31-Oct-14 31-Oct-13

Revenues (SEKm) 39,650 38,006 42,182

EBITDAR Margin 13.8% 9.7% 12.9%

Net Profit Margin 2.4% -1.9% 3.2%

Adjusted Net Debt/EBITDAR 4.0x 5.5x 3.9x

Adjusted Net Debt/Equity 3.5x 4.1x 6.5x

Cash as % of Total Revenues 20.7% 19.5% 11.3%

No. of months Unrestricted Cash to cover EBITDAR Expenses and Aircraft Rental

2.68 months 2.44 months 1.48 months

Passenger Revenue per RPK (Pax Yield) (SEK) 0.9028 0.8270 0.9488

Fuel Cost/ASK (SEK) 0.1903 0.1950 0.2027

Breakeven Load Factor 73.6% 76.6% 71.4%

Load Factor 76.3% 76.9% 75.0%

Revenue per Passenger (SEK) 1,056 976 1,043

RASK (Unit Revenues) (SEK) 1.1737 1.0948 1.2610

CASK (Unit Cost) (SEK) 0.8634 0.8387 0.9006

RASK-CASK Margin (SEK) 0.3103 0.2562 0.3604 Source: Ishka calculations and SAS annual reports It is important to note that SAS has achieved commendable improvement across its bottom-line between 2013 and 2015. While the margins, liquidity position and leverage are still modest, Ishka views the trend of improvement as a positive sign considering the challenges faced by other network carriers in Europe from the low-cost carriers.

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30 June 2016

Source: SAS Group Investor Presentation The Ishka view is that SAS’ restructuring plan has targeted the right areas and has achieved credible progress. The carrier has overhauled its fleet - reducing the number of fleet types as well as adapting its network based on the market need. SAS has also cut the numbers of employees and centralized some of its shared services, and outsourced its non-core activities. It has also sold stakes in struggling airlines like Blue1 and Widerøe. SAS has restructured from being an elaborate airline conglomerate operating in various segments of the airline value chain to a leaner and more efficient airline focusing primarily on passenger and cargo transportation. The table above clearly demonstrates the changes in the business model and company structure. The carrier has improved its bottom line and SAS is in a better position now than it was 5 years ago to compete against low-cost carriers. However, the carrier still needs to increase the pace of its reforms especially with regards to labor costs, supplier contracts, and its IT systems.

Targeting frequent flyers One of the challenges SAS faces, is how to increase the number of frequent flyers within the Scandinavian market. As part of its restructuring, SAS increased its focus on frequent flyers within the Scandinavian market. As per the airline, nearly 11% of the 20 million people in Scandinavia take five or more return flights every year and SAS, as of 2015, served around 74% of this market at least once. SAS upgraded its frequent flyer program and improved its customer service in a bid to build more loyalty from its customers; however, its efforts have not yet yielded substantial positive results. In addition to its overhauled fleet, the airline also upgraded its inflight entertainment systems and waiting lounges. These steps are in the right direction and should help SAS to capture a higher market share. However, competition from the LCCs has not gone away.

Short-term challenges and areas of further reform As mentioned earlier, SAS needs further reforms in-order to achieve consistent profitability. The CEO, Rickard Gustafson, has already identified labor as the next area of restructuring. SAS’ labor agreements are covered

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30 June 2016

under Scandinavian terms and as a result employee expenses are its largest expense category, contrary to most airlines. SAS has already finalized new collective agreements with its pilots, however, the airline could face challenges from other unions who would resist attempts at reforming their terms. In addition, with further capacity increase already planned for the remainder of FY 2015/16, yields and unit revenues would continue to remain under pressure.

What if SAS’ strategy of targeting the frequent flyers fails to deliver the expected results? SAS has bet significantly on capturing more of the frequent flyer market, as it has plans to expand capacity. Failure to do so would require another re-think in strategy. It could force the airline to undertake further restructuring cuts and bring down its costs further in order to allow it to charge lower fares. In the face of competition from the LCCs, it would be imperative for SAS to re-work its strategy to better compete with the LCCs. SAS has 30 A320s on order and therefore will continue to have significant exposure to the short-haul European market that is dominated by the LCCs.

The Ishka View Positives/Strengths

Negatives/Challenges

Lower cost structure as a result of restructuring Yields under pressure as a result of increased capacity and lower air fares from LCCs

Improvement in fundamental position Uneven profitability and therefore the need to continue with the pace of reforms achieved during the 4XNG program, especially in further reforming labour agreements and operations

More efficient and leaner airline with a less complicated business model

Yet to capture a larger share of the frequent flyer market

Only FSC in Scandinavia offering domestic and intercontinental flights to North America and Asia

Competition from Norwegian Air Shuttle on transatlantic routes

Having reorganized its complex organization structure and trimmed its cost structure by several notches, SAS is now better positioned to face competition especially from the LCCs. SAS has the advantage of being the only network carrier out of Scandinavia and there is potential to build a fairly successful and sustainable model connecting the frequent flyers within Scandinavia to long-haul destinations across the Americas and Asia. With a lower cost structure and improved product offerings including its fleet overhaul, in the medium to long-term, SAS should be able to attract a bigger share of the frequent flyers by providing good quality service at attractive pricing. The carrier still needs to increase the pace of its reforms especially with regards to labour costs, supplier contracts, and its IT systems. Competition from LCCs remains a concern and with rivals like Norwegian offering low-cost travel options across the Atlantic and within Europe from Scandinavia, SAS will have its work cut out.



Can LOT Polish Airlines afford to overhaul its fleet? The Polish carrier’s newly appointed CEO, Rafal Milczarski, recently told Reuters that he is considering overhauling the carrier’s narrowbody fleet, starting as early as Q1 2017. While LOT now operates the state of the art Boeing 787-8s on its long-haul routes, it is struggling to compete on the short-haul routes with its fleet of 20-year old Boeing 737-400s and smaller capacity Embraer jets. Ishka sees a short-haul fleet overhaul as a step in the right direction but the question is whether LOT can afford a substantial fleet expansion just three years after the carrier was on the verge of bankruptcy. Challenges with the current fleet composition Currently, in terms of narrowbody fleet, LOT has 3 737-400s with an average age of nearly 20 years and the rest is comprised of Embraer 170/175/195s and Bombardier Q400s.


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Source: Aerotransport Data Bank

Since the start of the financial crisis of 2008, LOT has returned around 15 737s, 9 E145s, 4 E170s and 12 of its widebody fleet consisting of primarily of 767s.

Source: Aerotransport Data Bank As replacements, the airline started inducting, and also retained, more of the E175s and E195s. Most of the returned aircraft were ageing and considering that passenger traffic growth had stalled in Europe as a result of the financial and debt crises, it seemed like a good strategy back then to rationalize capacity and operate short-haul routes with a family of smaller capacity aircraft.

0

1

2

3

4

5

6

E145

B767-200ER

B737-300

B737-500

B737-400

E145

E175

B737-500

B737-400

E145

B767-300ER

B737-500

B737-400

B737-500

B767-300ER

A330-200

B777-200ER

B737-400

B737-500

E170

B737-800

E170

2008 2009 2010 2011 2012 2013 2014 2015

Aircraft exiting the fleet

0

2

4

6

8

10

12

E175

B73

7-40

0

B76

7-30

0ER

E175

E195

B76

7-30

0ER

E195

B78

7-8

B78

7-8

A33

0-2

00

E195

B76

7-30

0ER

B77

7-20

0ER

B73

7-80

0

B78

7-8

Q40

0

2009 2010 2011 2012 2013 2014 2015

Aircraft Inducted

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Source: Eurostat Air Transport Statistics

However, after 2009, Poland continued to witness relatively strong growth in passenger numbers between 2010 to 2015. As LOT trimmed capacity and started operating with lower capacity aircraft, it began losing market share against Ryanair, Wizz and even Enter Air, a local Polish airline, who operate with higher density aircraft such as 737-800s, A320s and A321s. The Ishka view is that this created a vicious circle for LOT – not only does it lose traffic because of its older and smaller capacity regional fleet, but its unit costs are also higher than its competitors’ as the larger capacity aircraft help to keep unit costs down. This invariably means that LOT has to charge higher airfares in-order to cover its costs, further alienating flyers towards the low cost rivals. In addition, as a pre-requisite to obtaining a $130 million capital increase from the Polish Government, the European Council required LOT to give up a number of intra-European routes, which meant LOT was restricted in efficiently utilizing its existing capacity. However, now that the restrictions have ended, there is a strong case for introducing more high density aircraft if LOT is to regain market share.

Weak financial situation? LOT has been undergoing restructuring since 2013. As a part of the restructuring program, it reduced its workforce, returned several aircraft and rationalized its network as well its business model. The restructuring seems to have had some positive effect as the airline returned to the black in 2014. LOT does not disclose any detailed financials, however, it did announce in April 2015 that it had made a profit of $26 million in 2014 on its core operations. EBITDA also seems to have improved considerably – from a negative $91 million in 2012 to a positive $41 million in 2013, improving further to $77 million in 2014. While this is a positive development, there are still concerns on the sustainability of these profits - the airline hasn’t made public any of its latest financial figures and therefore it is difficult to judge whether the fundamentals have improved in 2015 and 2016. Judging by the airline’s hesitation in disclosing even summary numbers for 2015, in a year when the airline industry has seen record profitability, Ishka suspects that it is highly unlikely that the airline performed well financially.

LOT’s change of CEO When LOT began its restructuring, the plan was to privatize the airline in due course. The previous CEO, Sebastian Mikosz who was overseeing the restructuring was keen on privatizing the airline in 2015, however, the then government deferred the process due to upcoming parliamentary elections in the country. It was reported that LOT was in talks with Indigo Partners, a US based private equity firm, however those talks ultimately foundered. This led to Mikosz resigning from the airline in August 2015. At the time of his departure

26.6%

9.2%

-8.7%

7.8%12.2%

5.8% 6.5%

10.5%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

0

5,000

10,000

15,000

20,000

25,000

30,000

2007 2008 2009 2010 2011 2012 2013 2014

Annual Passengers Carried - Poland

Number of passengers ('000) Y-o-Y change

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he had reportedly said that, “Without a private investor who will finance the expansion in the medium-term perspective, the company may disappear”. This corroborates our concern that fundamentally LOT may not be able to self-finance any kind of major fleet overhaul and that financiers also may be wary of extending support.

Leasing used aircraft could work

Source: Aerotransport Data Bank *2 E195s which are part of Nordic Aviation Capital (NAC) were originally part of Jetscape Aviation Group’s (Jetscape) Eagle I Series 2014-1 portfolio. NAC announced its acquisition of Jetscape in March 2016. LOT’s plans of doubling or tripling its fleet is too ambitious at the moment; and obtaining sufficient financing to overhaul the fleet would most certainly be a challenge in the current environment. This leaves the airline with exploring the option of leasing older (possibly 7-8-years old) used aircraft. Lessors already have spare capacity at the moment and could be interested in leasing out to LOT. However, leasing has a cost and considering LOT’s financial situation it is not known whether LOT is in a position to afford the higher lease expenses.

What if banks and lessors are hesitant to finance the fleet expansion? If the banks and lessors are cautious and do not support LOT’s growth strategy, then we could see the airline sliding into further difficulties. As things stand, LOT has already been pushed down to being the third or fourth largest carrier in its home market. There is tremendous potential in the Eastern European market compared to the rest of Europe and to take advantage of this growth, LOT needs to invest in its fleet. On a more positive note, it is also possible that the government might be forced to quickly find a strategic investor and privatize the airline. Transferring the airline to private hands might actually augur well for the airline in terms of survival and growth.

0

2

4

6

8

10

12

Q400 E195 E175 B787-8 E170 E195 E175 B737-400 E175 B787-8 B787-8

Nordic Aviation Capital Owned Castlelake Zuma Leasing Ltd

BRE Leasing

Kahala GECAS Intrepid Apple Bank

Current investors in LOT's fleet

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The Ishka View With LOT losing out against its competitors in its short-haul markets, an update in the short-haul fleet will be critical to enable future growth and to be competitive. Fundamentally, LOT is not in the strongest position to self-finance an ambitious fleet expansion program. A capital injection from new ownership or investors is an obvious route. On the other hand, leasing used aircraft could be the most feasible, maybe the only strategy at the moment for the airline to acquire near term deliveries. There is traffic potential in the Eastern European market and it is in LOT’s interest to further cut costs and build capacity to target greater market share.



A quantum leap for once-struggling Qantas The Australian airline is two years into its three-year Transformation Plan which aims to permanently increase the airline’s productivity and competitiveness. Early indications are that the carrier appears to be on track for a sustained recovery. Qantas has eight Boeing 787-9s which are scheduled to begin delivering in late 2017 through 2018. Ishka believes that the new aircraft, which will mostly be used to replace the airline’s ageing 747-400s, will not threaten Qantas’ profitable codeshare agreement with Emirates but will allow the airline to benefit from the high rise in Chinese traffic to Australia. On the road to recovery Qantas’s Transformation Plan was introduced following heavy losses in 2013 – the first since Qantas was fully privatised in 1995 – and a revenue drop of AUD 550 million ($421 million). So far the carrier is $1.4 billion into the programme that intends to deliver $2 billion in gross benefits by the end of 2017. And last year Qantas made a convincing recovery, regaining their investment grade status and posting $975 million in pre-tax profit. Further, the plan saw debt reduction of more than AUS 1 billion ($765.5 million), 4,000 job losses and a group expenditure reduction (excluding fuel) of 10%. Codeshare agreements with Emirates, China Southern and American Airlines have helped ease competition while the airline gets its finances in order. The restructuring plan appears to be sustainable. The early indicators are pointing in the right direction. EBITAR is up, Revenue Seat Kilometre (RPK) is up by 2% and capacity growth has remained flat, ending the overcapacity that had previously damaged revenues. Like many other airlines with a favourable fuel hedging position, the airline has benefited tremendously from lower fuel prices; also, the positive impact of reduced depreciation expenses resulting from the non-cash write down of Qantas International Fleet in 2013/2014 and the repeal of the Australian carbon tax.


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Qantas Financial Data 2013-15 30-Jun-15 30-Jun-14 30-Jun-13

Revenues (AUS $m) 15,816 15,352 15,902

EBITDAR margin 17.1% 7.7% 13.9%

Net profit margin 3.5% -18.5% 0.0%

Adjusted net debt/EBITDAR 2.4x 6.5x 3.4x

Adjusted net debt/Equity 1.9x 2.7x 1.3x

Cash as % of total revenues 18.4% 19.5% 17.8%

No. of months unrestricted cash to cover EBITDAR expenses and aircraft rental

2.57 months 2.45 months 2.39 months

Passenger Revenue per RPK (Pax Yield) (AUS $ cents)

12.1438 12.0756 12.3286

Fuel Cost/ASK (AUS $ cents) 2.7669 3.1479 2.9691

Breakeven load factor 73.5% 81.2% 78.1%

Load Factor 79.1% 77.4% 79.3%

Revenue per Passenger (AUS $) 277.89 271.49 283.23

RASK (Unit Revenues) (AUS $ cents) 14.0533 13.9998 14.3384

CASK (Unit Cost) (AUS $ cents) 10.3312 11.3686 11.1923

RASK-CASK Margin (AUS $ cents) 3.7221 2.6312 3.1461 Source: Qantas and Ishka calculations

Half of the group’s fleet – valued at over AUD 3.5 billion ($2.7 billion) – is now unencumbered, adding to a strong total liquidity position. And as part of the Transformation Plan the fleet has also been simplified from 11 types to seven and has an average age of 7.7 years – three below the targeted 8 to 10-year range. Full year financial data is not yet available for 2016, but the first half results show continued improvement. The group continues to expand margins through both revenue growth and cost discipline. Revenue increased by 5% to AUD 8.5 billion, ($6.7 billion) while total unit costs were down by 7% compared with the first half of last year. The full year results are expected to show a cautious 5% increase in capacity well in line with the long-term average for Australia. And transformation benefits including fuel efficiency, cost and revenue are projected to be AUD 450 million ($376 million) for the year.

Ultra-long haul ambitions Qantas has eight Boeing 787-9 due to be phased in during 2017 and 2018. They will replace five of the airline’s ageing 747-400s but will undoubtedly be deployed on new routes. The longer range of the 787 presents new opportunities. Qantas’ CEO, Alan Joyce, has recently mooted direct flights between Melbourne and Dallas, Brisbane and Dallas, Sydney and Chicago and even Perth to London as a possibility, however Ishka doubts whether this route could be done directly without being payload restricted during parts of the year. The airline is expected to exercise more of its (45) options for the 787, although the timing of this remains unclear. Ishka believes that the incoming aircraft will not affect the codeshare agreement Qantas has with Emirates. The arrangement has been successful to date with AUS 2 billion ($1.5 million) in bookings, amounting to a

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four-fold increase since 2013. Joyce himself has touted the success of the joint partnership model and it also frees up aircraft for use in the high-growth Asian market.

Chinese Market Leisure demand from China is experiencing a growth spurt, and increased by 22% in 2015. Joyce expects this to quadruple in the next decade. Qantas is well placed to exploit this both as a full-service carrier and through its low-cost subsidiary, Jetstar. The different subsidiaries of the Qantas Group allows a greater flexibility to manage incoming aircraft orders. If there is sufficient demand Qantas could deploy its 787s to serve the Chinese market. Around a million Chinese tourists visit Australia each year and they typically take two or three domestic flights with each visit. Qantas currently has a codeshare agreement with China Southern Airlines and joint venture partnership with China Eastern on routes between China and Australia. However, there has been on-going speculation that Chinese investors may want to buy in to Qantas after two Chinese conglomerates, HNA Group and Nashan, took equity stakes in domestic rival Virgin Australia. Around 5% of the carrier is available for foreign investors, and this might be enough to tempt a competitor airline to invest in a seat at the board.

Scenarios What if Qantas decides to reject the Emirates codeshare? Qantas entered into the agreement with Emirates in 2013, conceding that it was struggling to compete with the carrier amid soaring fuel costs. Although the partnership has been profitable for Qantas, it has been more advantageous to Emirates who had no trouble in the Australian market before this and have increased their market share, as hub flights now come via Dubai rather than Singapore. With robust finances and 787-9s on order, Qantas is in a far better position to compete with direct flights to Europe. The airline is also eyeing the next generation of long-haul aircraft – the A350-900ULR and Boeing 777-8 – both of which are under development and currently due to enter service in 2018 and 2021 respectively. If the agreement did collapse before it is due to expire in 2023, there would be a strong case for ordering these aircraft. What if the fuel price goes up? Qantas have strong hedges in place so should be able to manage well. The carrier was seriously affected by high fuel prices in 2013-14. Costs reached a company record of AUS 4.5 billion ($ 3.67 million) – up 5.6% on the previous year. However, with new fuel hedges in place the benefit of a fall in prices over the course of 2015 has been protected for the full year 2016, with 73% participation to lower prices. In fact, Moody’s says that Qantas has a strong enough balance sheet to withstand a more than doubling in the price of jet fuel without losing its hard-won investment grade credit rating.

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The Ishka View Qantas’ bottom line has recovered well, vindicating the transformation plan, and presents solid opportunities for investors. It has a young fleet, expansion plans, and is well positioned to exploit the growth in Asian – and especially Chinese – demand. It is too early to say whether Qantas’ ultra-long haul plans will be successful; others airlines have grappled with this segment in the past and withdrawn such services, though on their present course Ishka anticipates a sustained recovery for the airline.



Can Monarch survive as a low cost carrier? Britain’s two largest LLCs, Ryanair and easyJet, are both rumoured to be interested in acquiring Monarch Airlines which has recently made the transition from a charter to a low-cost carrier. A sale to either would represent a win for Monarch’s majority stakeholder, the private equity firm Greybull, although the carrier is also interested in airlines acquisitions itself. However, if Monarch is not acquired then it faces the greater challenge of building a successful low-cost business model. Currently its CASK rates are 5.66 pence, far above its rivals. This will have to come down if it is to compete against other UK LCCs in the long-run. Monarch moves off life support Monarch returned a £44.3 million ($65 million) net profit last year following a successful restructuring programme under Greybull Capital. The private equity firm took a 90% stake in the previously family run business in October 2014, following consolidated group losses of $191.1 million. Greybull injected £125 million ($183 million) into Monarch to save it from collapse and began an austere consolidation programme to return the carrier to health. Long-haul and charter flights were jettisoned, along with 8 aircraft and 700 jobs as a £200 million cost cutting measure. For the remaining staff, pay has been reduced by 30%. Monarch was also able to reach a deal with the UK Pension Protection Fund which took the remaining 10% equity stake in the business.


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Full Year Financial Results 2014/15 2015 2014 % Change

Gross Revenue (£m) 655.5 764.4 (14.2%)

Total capacity in term of passengers (‘000) 7,196 8,730 (17.6%)

Total booked passengers (‘000) 5,975 7,210 (17.1%)

Load factor (%) 83.0% 82.6% 0.4%

Average number of aircraft 35.3 38.9 (9.3%)

EBIT – pre exceptional (£m) 45.0 (113.3) 139.7%

EBITDA – pre exceptional (£m) 68.3 (87.1) 178.7%

EBITDAR – pre exceptional (£m) 138.4 (2.1) 6690.5% Source: Monarch Airlines As of October last year, the group’s free cash had improved by £35 million ($51 million) yields are up by 9.5% and passenger revenue per available seat kilometre is up 7.2% on 2014.

Monarch’s switch to become a low cost carrier In August 2014 Monarch announced it would begin transitioning from a charter airline into a low cost carrier. This was a good move considering the decline of the charter-based model, which its CEO says is dying, and the fall-off in demand from key charter destinations like Egypt and Tunisia due to terrorism. Flights to Sharm el-Sheikh in Egypt alone account for 10% of Monarch’s revenue. At the same time a reduction in the number of routes has resulted in a heavy concentration of routes to Spain, which now accounts for almost 59% of the airlines flights during August. Monarch is also radically moving from an all-Airbus fleet to an all-Boeing fleet. It has 30 B737 MAX 8 on order as part of its transition to a scheduled leisure airline. Monarch says it will save them around 15% in fuel costs each year. They are due for delivery from the second quarter of 2018. Current fleet leases are scheduled to terminate as each new aircraft arrives.

Greybull looks for the exit In early 2016, Greybull appointed Deutsche Bank to explore ‘inbound and outbound’ growth opportunities in Europe. These could include a sale to, or a merger with, another airline. EasyJet and Ryanair are said to be looking at the carrier, and China’s Hainan Airlines has confirmed interest. easyJet is after Monarch’s highly-prized slots at London Gatwick, which also happens to be easyJet’s largest base in the UK. However, easyJet’s founder and majority stakeholder, Stelios Haji-Ioannou, has said that such deal would be destructive of shareholder value. If no one is willing to purchase Monarch, then the airline will have to earn its bread as a low cost carrier. So far it has been aided by a weak euro and £30 million in savings from low fuel prices, but these are variables that could easily change. Crucially, Monarch’s cost per available seat mile (CASK) will have to come down if it wants to compete as an LCC on price alone. Last year Monarch’s CASK rose by 12% to 5.66 pence. By contrast, EasyJet’s was 4.77 pence last year while Ryanair’s was lower still at 2.90 pence. Monarch’s CEO, Andrew Swaffield, says there are too many airlines in Europe today and that around half are challenged by a high cost base. He predicts further consolidation and a growing divide between those which have restructured their cost base and those that haven't.

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The move to a Boeing fleet will likely cost Monarch in terms of training, new infrastructure and spares, although Boeing have almost certainly factored some of these considerations into a sweetened deal for the airline to agree to switch aircraft supplier. On the other hand, Monarch is as likely to be the acquirer as the acquired. In April, Swaffield said the carrier was not for sale but was alert to possible acquisitions itself. Any acquisition would preferably have a Boeing-heavy fleet. Monarch has expressed an interest in Air Berlin, TUIfly, and Thomas Cook Airlines but only TUIfly operates an exclusively Boeing fleet.

The Ishka View The question is how Monarch will expand following its painful restructuring process. Ishka believes that the airline’s existing slots in the UK make it an attractive target for easyJet which would provide a straightforward exit for its private equity owner. A more involved approach is for the airline to acquire other airlines to build enough scale and slots to compete as a standalone low cost carrier. This approach represents a challenge as Monarch works to drive down its own costs.



Robust finances will help Spirit’s strategy change Spirit Airlines’ (Spirit) new CEO has announced a new strategy for the Ultra-Low Cost Carrier (ULCC) which will include targeting 500 new domestic routes, cutting capacity by 10% and changing the culture of ‘America’s most hated airline’ in an attempt to improve customer service. Ishka believes Spirit is sufficiently capitalised to acquire additional aircraft to begin operating new routes and believes a slightly slower growth rate makes sense for Spirit’s new expansion policy and that investment to improve the airline image among customers is necessary to improve the airline’s bottom line in the long-term. Spirit moves to target uncompetitive short-haul routes Spirit appointed a new CEO, Bob Fornaro, after investor jitters last year which wiped 50% off the share price as the carrier reported a 17.5% drop in revenue for its fourth quarter in 2015. The new CEO has identified three key strategic changes for the airline: a push to open 500 new regional domestic routes, a reduction in capacity growth and an improvement in the airlines’ customer service. The airline currently serves 190 routes with 85 aircraft. Spirit faces increased competition from full service carriers, most notably American Airlines, which are now competing directly with Spirit on fares as a result of lower fuel prices. Spirit occupies a unique position in the US market, straddling primary and peripheral routes. Unlike other ULCCs, such as Frontier and Allegiant, it is mostly in competition with full service carriers like American and low cost carriers like Southwest who account for 50% and 55% of network overlap respectively. CEO Fornaro plans to exploit market opportunities on routes below 1,000 nautical miles believing that these have become less competitive. Spirit maintains that there are around 500 routes where, on its current cost structure, it could earn an operating margin in the mid-teens or higher. The airline initially plans to move into 125 new markets over the next five years including 20 in 2016. The move to shorter routes, out of the orbit of the larger carriers will allow Spirit’s to utilize its ultra- low cost structure more effectively. With costs at 5.59 cents per available seat mile (excluding fuel) this remains the


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carrier’s major competitive advantage. By contrast American’s CASM is currently 8.99 cents. In addition, Fornaro wants to slow down Spirit’s capacity growth by 10% to around 20% this year. However, there are several unknown aspects about the strategy. Spirit has not named which routes it wants to target, making it hard to assess either potential demand or potential competition from other carriers.

America’s most hated airline’ courts customers Spirit is currently the worst performing US airline both in terms of passenger satisfaction and scheduled reliability. Clearly, the worry is that this may be affecting sales. Low fuel prices have allowed American to fill excess capacity and drive down fares. Scott Kirby, President of American Airlines, explained that 87% of its customers and half of its total revenue comes from infrequent flyers — a key demographic that can no longer be ignored. In the short term at least, the superior customer service offered on a carrier such as American or Delta is a weakness for Spirit. The approach of Spirit’s previous CEO, Ben Baldanza — famous for publicly mocking customers for their complaint — appears to have run its course. “Reputation does matter,” Fornaro has stated repeatedly. Fornaro appears to be following Ryanair’s successful pivot towards better customer service which saw profits jump by 32% following the start of its ‘Always Getting Better’ programme and has successfully salvaged the company’s reputation. Ryanair’s customer service push was primarily though a new designed website, allocated seating, and a friendlier customer service at check-in, while booking errors could be changed within 24 hours with no extra charges. These were relatively cheap changes to implement. Spirit is focusing primarily on performance. The carrier is putting more aircraft and staff on standby to reduce delays, which has helped, in part, to improve customer satisfaction by 15% on 2015, albeit from a low base.

Sound fundamentals The airline’s fundamentals remain strong. Total revenue jumped from $1.93 billion in 2014, to $2.14 billion last year. Spirit also netted $317.2 million in profit last year, up 40% on 2014. And CASK is actually 2.3% lower than last year due to lower aircraft rent and fuel expenditure. Under Fornaro, Spirit’s first quarter performance for 2016 remains strong. Despite a marginal dip in passenger revenue, total revenue was up by 9.1% mostly on the back of a 20.8% rise in revenue from fees and charges. Load factor, debt and leverage ratios remain stable. However, net profit did decline in 1Q 2016. One reason for this is higher aircraft depreciation costs as a result of Spirit’s changing fleet composition. Spirit has been buying aircraft as they come off lease, making 15 purchases in the last 12 months including two so far in 2016. Likewise, there has been a rise in special charges from $0.4 million to $16.2 million. This is attributed to lease termination charges as a result of these purchases. Spirit reports that buying a used A320 versus leasing one, equates to an estimated annualised pre-tax benefit of $1m per aircraft.

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31-Dec-15 31-Dec-14 31-Dec-13 31-Dec-12

Revenues ($m) 2,141 1,932 1,654 1,318

Net profit margin 14.8% 11.7% 10.7% 8.2%

Adjusted net debt/Equity 1.3x 1.1x 1.1x 1.3x

Cash as % of total revenues 37.5% 32.8% 32.1% 31.6%

Passenger Revenue per RPK (Pax Yield) ($ cents)

4.0377 5.0244 5.1052 5.0333

Load Factor 84.7% 86.7% 86.6% 85.2%

Revenue per Passenger ($) 65.25 80.10 79.43 75.10

RASK (Unit Revenues) ($ cents) 7.3944 8.4763 8.5658 8.4772 Source: Ishka Calculations and Spirit Airlines’ SEC Filings

Fleet and financing Spirit recently swapped out 10 A321neo orders for A320neos instead. Spirit has also been buying up its A319s as they come off lease. It bought two previously leased aircraft in 1Q 2016. As of March 2016, 71.6% of Spirit’s fleet is currently leased and they currently have 29 active A319s, although in the current fleet plan this will reduce down to 8 over the next five years. The focus on downsizing from A321s to A320s and owning more of its aircraft fits with its new strategy of focussing on smaller markets. Disposal of the A319s, with an average age of 9.9 years, will help Spirit maintain its claim to have America’s youngest fleet.

Spirit has healthy access to both the public and private markets. The airline has $308.5 million of committed debt financing for the eight aircraft it has scheduled for delivery in 2016. In addition, Spirit has secured financing for five aircraft to be leased directly from a third party, also due for delivery in 2016. Last August Spirit signed a $576.6 million EETC to finance three new Airbus A320-200 aircraft and twelve new Airbus

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A321-200 aircraft. The company does not have financing commitments in place for the remaining 75 Airbus aircraft currently on firm order, which are scheduled for delivery in 2017 through 2021 but liquidity, for first and second tier airlines, remains easily accessible according to banks and lessors.

Scenarios What if fuel costs rise to above $65 per barrel? Like many other carriers, Spirit ended 2015 with hedges in place against a rise in the price of fuel. In Spirit’s case 17% of total volume was hedged at $1.94 a gallon. However, at the start of 2016 Spirit abandoned all of its positions as the fuel price crept lower. Absent hedging, the airline has no means of protecting itself against a fuel rise. Spirit’s ability to react is limited by the fact that ticket prices are set in advance which will make it harder to pass on any fuel increase via fare prices. Spirit does have the option to introduce a fuel hedge fairly easy if oil prices rise but it is something for investors to watch out for if the carrier does not hedge. A fuel rise could however potentially benefit Spirit, as they have one of the lowest CASMs (ex-fuel) and a fuel price rise would make it harder for full service carriers to discount tickets – allowing Spirit to win back market share.

The Ishka View The net effect of Spirit’s strategy shift could be a ‘new’ airline, much like Ryanair’s renaissance – but based on an expansion of new regional routes to be served by a larger core fleet of A320 aircraft – with improved reliability and customer service. Ishka believes that if Spirit manages to achieve a significantly better perception of its customer service, it would benefit, in the same way as Ryanair has, with improved profitability. Spirit remains poised for greater growth and presents significant opportunities for financiers. Its long term financial indicators are steady and its not significantly leveraged with no perceivable barriers for the carrier to raise additional debt for its incoming deliveries. Moreover the carrier is slowing its capacity growth from an aggressive annual growth rate of 30%. Ishka anticipates that Spirit will benefit from targeting new routes although there is no clarity yet on the routes Spirit is set to choose. This makes forecasting competitive behaviour and expected profitability difficult. The suggestion on new routes is that the carrier will go for mid market cities, but this begs the next question whether Spirit aims for the markets served by other ULCCs such as Allegiant or Frontier, or the ones served by the majors. Ishka believes Spirit may attempt both, adopting a “suck it and see” approach, to identify where it could make the most headway.



Alaska’s merger with Virgin America will be expensive but will aid growth Alaska Airlines and Horizon Air’s parent firm, Alaska Air Group, Inc., is set to acquire Virgin America, Inc. Despite the limited commonalities, Ishka believes that this merger makes strategic sense for both the airlines, especially in a consolidating US airline market. However fleet integration, Virgin’s shareholders and the increased leverage could still challenge Alaska’s attempt at expanding its market share beyond the Pacific Northwest. Inorganic expansion Alaska Airlines (Alaska) is a strong player in the Pacific Northwest through its bases in Anchorage, Seattle and Portland, however, it has limited reach in rest of the US domestic market. Acquiring Virgin America (Virgin) gives Alaska access to Virgin’s bases in California thus helping to consolidate against competition on the West Coast and also expand operations on the East Coast by getting access to the slot controlled airports in New York, New Jersey and Washington. Any attempt to expand organically in these areas would have put Alaska in direct competition with Virgin and therefore Ishka believes it makes strategic sense for Alaska to merge with Virgin as it seeks to increase its market share. In addition, the proposed merger is in-line with the trend of consolidation in the US aviation market. The following graphic demonstrates the level of consolidation over the course of the last 35 years. As of 2015 both Alaska and Virgin sit in the cramped space of the US low cost carriers and this merger is Alaska’s attempt at growth in a competitive environment. Compared to jetBlue and Hawaiian Airlines, both of which have a low cost premium product offering similar to Alaska, Virgin is the smallest airline in this group, making it more feasible for Alaska to acquire and to expand its reach and increase its market share in North America.


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Source: Alaska Air Group, Inc. Investor Presentation


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Downgrade in investment grade credit rating? Alaska Air Group, Inc. Virgin America, Inc.

31-Dec-15 31-Dec-14 31-Dec-15 31-Dec-14

Revenues ($m) 4,901 4,693 1,530 1,490

EBITDAR Margin 21.6% 14.1% 27.2% 19.8%

Net Profit Margin 17.3% 12.9% 22.3% 4.0%

Adjusted Net Debt/EBITDAR 0.2x 0.7x 3.8x 4.1x

Adjusted Net Debt/Equity 0.1x 0.2x 1.9x 2.6x

Cash as % of Total Revenues 27.1% 25.9% 32.4% 26.5%

No. of months Unrestricted Cash to cover EBITDAR Expenses and Aircraft Rental

4.04 months 3.53 months 4.47 months 3.43 months

Passenger Revenue per RPK (Pax Yield) ($ cents)

8.8696 9.2625 8.1147 8.2288

Fuel Cost/ASK ($ cents) 1.4852 2.4422 1.7023 2.5337

Breakeven Load Factor 73.3% 80.5% 72.7% 77.0%

Load Factor 84.1% 85.1% 82.2% 82.3%

Revenue per Passenger ($) 150.33 156.40 193.70 205.02

RASK (Unit Revenues) ($ cents)

9.0695 9.4931 9.1073 9.1902

CASK (Unit Cost) ($ cents) 6.6443 7.6401 6.6213 7.0745

RASK-CASK Margin ($ cents) 2.4251 1.8530 2.4860 2.1158

Source: Ishka Calculations and Alaska Air Group, Inc. and Virgin America, Inc. SEC Fillings Alaska Air Group, Inc. (Air Group) is among a handful of investment grade airline companies in the world. Lean operations have contributed to consistent profitability and have allowed the airline to maintain an extremely healthy balance sheet with very limited debt. As can be seen from the table, Air Group’s fundamentals are in an extremely healthy state. However, the acquisition will clearly impact the capital structure and result in an increased leveraged position for the company.


Pre-Acquisition Post-Acquisition*

Balance Sheet Debt 686 2,686

Capitalized Lease 840 2,240

Cash 1,328 1,224

Adjusted Net Debt 198 3,702

* These are approximate figures Source: Ishka Calculations and Alaska Air Group, Inc. and Virgin America, Inc. SEC Fillings

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As per Ishka analysis, Air Group’s adjusted net debt will approximately rise from a negligible $198 million at the end of 2015 to a significantly higher $3.7 billion as a result of this acquisition. This will certainly lead to higher interest expenses as a result of the higher leverage and will also lead to higher contractual obligations in the future. Ishka’s views are corroborated by the fact that S&P recently put both Air Group and Alaska on ‘CreditWatch Negative’ on the Virgin acquisition. In addition, there is a possibility that the offer price would have to be revised upwards as Virgin’s shareholders were yet to approve and accept Alaska’s offer.

Pressure on short-term profitability Ishka estimates that there could be pressure on the bottom line in the short-term. Air Group anticipates it could incur between $300 and $350 million towards integration and merger related expenses before it starts to realize annual synergies of $225 million. If the deal goes ahead as planned and Virgin becomes part of Air Group by 1st January 2017, the synergies are expected to be realized as shown in the chart. As a result, before it realizes any benefits, there are integration costs in the short-run which could impact profitability. In addition, as mentioned above, the increased debt burden will lead to higher interest expenses which could further impact the bottom line.

Estimated realization of synergies Alaska estimates the full $225 million synergies to be realized starting only from 2020.


Hurdles towards the merger In Ishka’s view the integration of the different fleet types is a critical factor in this merger. While Alaska mainline operates an all-Boeing fleet, Virgin operates an all-Airbus fleet. Operating a single fleet type allowed Alaska to avoid fleet complexities in its operations, especially in training, crews and maintenance and this has helped to keep the operating expenses down. It will not be the same post Virgin’s acquisition and may have an impact on margins, at least initially. In its defense, Air Group successfully integrated Horizon into its portfolio, even though Horizon operates a different business model and fleet type to Alaska. Consequently, Ishka believes that, notwithstanding some initial teething issues, Air Group should be able to handle the fleet integration reasonably well.

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While the merger clearly seems advantageous to Alaska, the benefits to Virgin are not immediately clear. Virgin’s board believes that going forwards they will be in a better position to face competition by consolidating with another airline, however, Virgin’s shareholders may think otherwise. Ishka believes that commercially this is an ideal time for Virgin to execute this deal as it has generated a positive turnaround in the last 2 years and is now in a strong position fundamentally to negotiate an attractive price for its shareholders. While obtaining regulatory clearance on such deals can be a challenge, Ishka does not expect the merger to face any major regulatory hurdles as currently there is limited overlap between their routes, therefore any potential competition implications do not arise. Secondly, while this merger would allow Alaska to expand its market share, it does not create a situation in which Alaska will be able to achieve any market dominance.

What if the merger fails to happen? If the merger fails to happen, we return to the question as to how Alaska will achieve growth. It is likely that the carrier would have to invest in additional aircraft but would also be forced to hunt for attractive airport slots. In a saturated market a significant increase in capacity could put pressure on Alaska’s yields. Consolidation is likely to happen among the low cost carriers in the US even if this deal fails. Alaska itself successfully defeated a rival bid from jetBlue for Virgin. If this transaction fails to go through, it could open the doors for jetBlue to attempt to acquire Virgin again. Due to its size and business model, Alaska may also become a possible takeover target for larger airlines. .

The Ishka View

§ Both Alaska and Virgin exhibit strong fundamentals. Alaska has not recorded an annual loss for the past 11 years, while Virgin has crafted an impressive turnaround in the last 2-3 years. This augurs well for the Alaska management in acquiring a profitable airline.

§ The fundamental strengths of both the airlines should help overcome any short term pressures on the bottom line, however, the likelihood of a rating downgrade will remain.

§ Fleet integration may be a challenge, however, Alaska has demonstrated that it can be done effectively.

§ As demonstrated by all the previous cases of airline consolidation in the US, the coming together of two airlines in a tight market will help rationalize capacity, consequently contributing to higher yields and profitability.


Dickon Harris Editor

Asia Pacific: Low fuel price masks potential $10bn loss for Asian carriers Ishka estimates that without the significant decline of fuel price in 2015, Asia Pacific carriers could have posted losses exceeding $10 billion last year. Consequently many Asian carriers remain vulnerable to a rise in fuel price. While passenger traffic growth has remained steady, weak cargo figures and concerns about excess capacity could see aircraft rationalisation as airlines protect yields. AAPA carriers’ lucky break The latest figures from the Association of Asia Pacific Airlines (AAPA), a trade association reporting data on 31 airlines, show that low fuel prices pushed many carriers in the region back into black. These airlines collectively saved approximately $18 billion when fuel prices declined by 31.4%, but only turned their collective $1.2 billion loss in 2014 to a $6.9 billion profit for 2015. This suggests that without the fuel price decline in 2015 total losses for AAPA airlines would have been around $10 billion if not more. The results indicate that many airlines in the region do not have full control of their costs and remain extremely sensitive to external factors to make profits.


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(These figures include the aggregated financial data for 26 AAPA carriers: Net profit figures include exceptional items; Previous year data was adjusted for comparison purposes; All figures are provisional.)

AAPA airlines enjoy steady passenger growth but bleak cargo outlook for 2016 One of the positive factors behind last year’s profits was sustained growth in passenger markets. Looking at Jan-Apr 2016 period, passenger traffic is continuing to grow for the scheduled international airlines, RPKs have grown faster than ASKs year on year, and the load factor has consequently inched up from 78.2% to 78.5% on the same basis. However, the cargo picture for the year to date is weak, showing 2016 FTKs to be 4.8% down on 2015, and ATKs up 2.3% on the same basis, with the Load Factor now barely above 60%. Weak trading activity continues to put downward pressures on freight volumes, and the steady, continuing delivery of widebody passenger aircraft capacity into the Asia Pacific market (which deliver more belly hold cargo volume) makes achieving a higher load factor even more challenging, never mind an improvement in yield.

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What if fuel prices return to average 2015 levels? Judging by AAPA figures, carriers in the region would remain in the black if fuel prices rise back to $64 per barrel (which was their average in 2015) all else being equal. However, any rise above $64 per barrel would begin to eat away at their profit margin. Higher fuel costs beyond $64 could also translate into higher ticket prices and dampen traffic growth, compounding the impact on profit.

What if ASKs grow faster than RPKs? New aircraft deliveries continue unabated. Almost half of all new deliveries to Asia-Pac airlines in May 2016 went to Chinese airlines, who continue to absorb new deliveries at a significant rate and are key to the OEM’s production and revenue plans. There has been concern over the potential for overcapacity in the region and for ASK growth to exceed RPK growth. The region’s airlines are aware of this. Some are shaping up accordingly, in fact many had already adjusted their new aircraft delivery and acquisition schedules back in 2014, less so in 2015, while others are still in growth mode. NokScoot has announced plans to replace its three Boeing 777-200ERs with either the A330neo or the B787. Malaysia Airlines recently agreed to lease two more A350s from ALC to add to the 4 already contracted from ALC on long leases. And there are new carriers joining the fray - new Chinese carrier Hongtu Airlines began flying domestically in May 2016 with two A321s.

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If overcapacity becomes more than a short-term event, airlines can respond quickly with fleet rationalisation options including: • not extending aircraft leases beyond scheduled returns • retiring older aircraft in their fleets early, or storing temporarily • deferring or cancelling new deliveries • reducing utilisation of existing fleets (Which airline does what, will only be determined on an individual basis).

The Ishka View Many Asian carriers still appear to have a delicate grip on costs and remain vulnerable to either a market downturn or a rise in fuel costs. The recorded decline in revenues for the AAPA carriers is also a concern and reflects a decline in yields which is also being recorded in other regions. A bleak cargo outlook does not help this issue, although the latest April figures appear to be (slightly) more promising. Ishka predicts there will be more intense cost cutting, or more deferrals and lease returns in the second half of the year if the ASK growth in Asia-Pac becomes too strong or yields becomes too weak. Eight Asian budget carriers have already sensed a need to work together and have formed their own regional alliance, the Value Alliance, to offer codeshare and interline services. The Alliance includes Cebu Pacific Air, Jeju Air, Nok Air, NokScoot, Scoot, Tigerair, Tigerair Australia and Vanilla Air. We are watching this development carefully to see if such an alliance will generate the leverage and business growth that it has the potential to do.

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8 July 2016

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