Gokongwei: Correcting mistakes at Cebu Pacific

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Asia's first low-cost carrier Cebu Pacific is returning to strength with improved efficiencies and a firm belief in its business model

This is a classic story of an airline that had a promising start but which lost its way as it branched out beyond its core areas of expertise. Fortunately for Cebu Pacific, however, the story does not have an unhappy ending. The Philippine carrier recognised its problems early enough and was able to recover.

Launched in 1996 by JG Summit Holdings, one of the Philippines' largest and most diversified conglomerates, Cebu Pacific originally stayed fairly true to the model of former US carrier ValuJet, now AirTran, which it adopted in its first years of existence. Strong traffic growth was recorded through 2004 - despite a fatal accident in 1998 - but that all changed when rival Philippine Airlines began to match its fares and aggressively clawed back market share.

President and chief executive Lance Gokongwei, who also now runs the mammoth JG Summit conglomerate which was started by his father John, remembers clearly when he realised things needed to be changed.

"It was mid-2004," he said in an interview at one of the group's hotel properties in central Manila.

"Historically PAL had given us a 30-40% price advantage and, as we only had two prices, it was easy for them to match our prices. Second, from 2004 you started to see fuel prices moving up. We were still making money but I could see the writing was on the wall. Our cost structure was probably higher on a unit basis than Philippine Airlines' was in a high fuel environment as we were operating [McDonnell Douglas] DC-9s six hours a day. We recognised that in the middle of 2004 and luckily we moved fairly quickly."

Since then Cebu Pacific has gone from strength to strength and has placed several aircraft orders to keep up with growth projections. Profits are rising along with traffic, and it is no secret that an initial public offering is planned for the near future - although Gokongwei will not talk about this on the advice of his lawyers.

Before looking at growth plans, however, it is worth examining just how bad things got for Cebu Pacific and how it could have fallen further into despair had the decision not been taken to return to its roots as a true low-cost carrier and differentiate itself from PAL.

In its first year of operation, Cebu Pacific carried 360,000 passengers and this grew steadily through to 2004, when it carried 2.45 million passengers. But in 2005 it suffered a 10% drop in passenger numbers after PAL slashed fares. By 2004 Cebu Pacific's domestic market share had grown to 31.6% but the following year it fell to 27.5%.

Cloning the competition
By that time the airline had effectively lost focus and by its own admission was no longer a true low-cost operator. It had a frequent-flyer programme, lounges in key airports, a mixed fleet of DC-9s and Boeing 757s, several dozen interline agreements with other airlines, business class for regional international services, hot meals in economy class for some flights and complimentary newspapers on board. In effect, it was becoming a PAL "clone", says Gokongwei.

"I think we were too inward looking. We were looking at the market purely from a Philippine airline perspective, whereas clearly this is now a global business. So we had to bring in a fresh set of eyes and people from outside," he says.

"We brought in a couple of experienced people from the low-cost carrier business and we brought in people who are not from the business. When you have fresh eyes you are much more critical about the way things can be done. There is so much available information anyway now. You try to be innovative but there are so many successful models that you can just copy and then it is all just a matter of execution and working very quickly.

"The mistakes we made were basically from not being confident in our own model and trying to duplicate what PAL was doing. We ended up being a light version of Philippine Airlines whereas clearly we should have stayed very consistent with the business model. And of course the high fuel costs really killed the DC-9 model."

Fleet modernisation was the highest priority and in September 2004 Cebu placed an order with Airbus for 10 A319s and two A320s, in addition to lease orders for two more A320s. In 2005 and 2006 the DC-9s were progressively retired and by March 2006 the remaining 757s had been sub-leased out.

Turnaround times improved to 30-35min from 40-45min for the domestic operation, and fleet utilisation increased from around 6.5 hours per day to around 13.5 hours now.

New fare structures were introduced and ticket prices slashed by more than 50%, sparking a fare war. At the same time complimentary newspapers were removed, an online booking capability was launched, airport lounges were closed and the frequent-flyer programme eliminated. Complimentary snacks stopped being provided and passengers now pay for in-flight frills.

Domestic destinations
It was not all about making cuts, however. In 2005 and 2006 the number of domestic destinations served was increased to 20 from 13, while new international services were added to Singapore, Kuala Lumpur in Malaysia and Bangkok in Thailand, and frequencies were increased to Hong Kong and points in South Korea. More destinations have since been added, such as Jakarta in Indonesia and Taipei in Taiwan, with plans for many more destinations to be added in the coming years.

The return to its roots has proven a phenomenal success for Cebu Pacific. In 2006, passenger numbers soared 57% over 2005, to 3.46 million, while domestic market share in terms of passengers carried increased to 35.9% from 27.5%. This year Cebu Pacific expects to carry more than 5 million passengers, representing year-on-year growth of around 45%.

The turnaround has also come with financial gains for JG Summit, which - for now - owns all of the airline. Cebu Pacific's earnings before interest, tax, depreciation and amortisation jumped to 2.33 billion pesos ($51 million) in 2006 from 1.39 billion pesos in 2005, on revenue growth to 10.08 billion pesos from 7.96 billion pesos. Net profit increased to 196.7 million pesos from 81.9 million pesos over the same period and earnings are expected to improve further this year.

The carrier recently placed purchase orders for up to 20 more A320s, as well as up to 14 ATR 72-500s, in addition to having secured leases on four more A320s. If all the A320 and ATR 72 options are exercised, the fleet will more than triple in size to 46 aircraft by 2013, up from the current 14.

Adding a second aircraft type will add to the cost base, but Gokongwei says it is a pragmatic move needed to meet the unique requirements of the Philippine domestic market.

"The additional cost is really on the pilot side. Of course the maintenance is outsourced and it's a higher-cost aircraft, but it has a very specific mission," he says.

Viable sub-fleet
"When we looked at this we had a couple of considerations. We were not going to do it just to set up a fleet of two or three aircraft - we need to get above 10 or 12 aircraft to make it worthwhile, to have a sub-fleet that is economically viable. Second, there are 70 airports in the Philippines and only 25 can be reached with an Airbus. Third, the single largest tourist destination in the Philippines, Boracay, can only be approached by a prop. That is 600,000 passengers a year before our stimulation - we think we can grow that to a million. Fourth, we are flying some routes that are only 160km, like Cebu-Bacolod, and it is covered by water in between so you really need to fly. Below 400km or 500km it makes more economic sense to use the ATR and use that sub-fleet to free up capacity for other routes."

He adds: "Fundamentally we are still a point-to-point carrier and we have to have critical mass in each sub-fleet. We have to accept that the ATR has a higher cost per ASK than an Airbus, but at the same time the routes are generally shorter so the revenue per passenger kilometre is also substantially higher."

The ATRs will be used to open services to the many domestic destinations that cannot be served with A320-family aircraft. Internal plans call for Cebu Pacific to be serving around 45 domestic points within five years, up from the current 20.

Growth will also be bold on the international front, rising to 30 destinations from eight over the same period. This will include the launch later this year of new services to Guangzhou, Shanghai and Xiamen on the Chinese mainland as well as the Special Administrative Region of Macau.

As more air services agreements are opened up, such as the recently liberalised Philippines-South Korea bilateral, there will also be many more opportunities for new services to be launched within a four-hour flying radius, says Gokongwei. Japan is a market of particular interest, and he hopes a more liberal bilateral can be agreed soon to enable Cebu Pacific to launch regular services to several destinations there.

Meanwhile, Gokongwei is looking for even more ways to reduce costs.

"Our cost structure is best in class in the Philippines now but if I look at the cost of some of the other firms, especially AirAsia, then there is obviously still more room to reduce cost, especially on the distribution side," he says.

In addition, says Gokongwei, as more people in the Philippines become internet savvy and obtain credit cards, there will be many more savings realised from reduced distribution costs.

Cebu Pacific is still on several global distribution systems and currently sells only 23-24% of its domestic tickets on its website. More than half its international tickets are sold via the website.

Looking ahead, Gokongwei says the carrier will not be tempted to add widebody aircraft and launch long-haul operations like some of its peers. He also says there is no immediate interest in setting up bases in other parts of Asia. However, he does not rule it out.

"Never say never, but the opportunity in something we do well is already enormous. I don't think we should distract ourselves from any other thing now," says Gokongwei.

"It will be very interesting to see how some of the low-cost carriers' exercises [in long-haul operations] play out. The more I am in this business the more I am convinced that you cannot make it work without a substantial fleet, and I am not in a position to order 12 or 15 [Boeing] 777s today. The difference is I have been burned before. Hopefully I will always remember some of the pain we felt so that we stay focused."

Lance Gokongwei: taking over the family business
Cebu Pacific launched in 1996, several years after Lance Gokongwei's father, John Gokongwei, read an article in a US newspaper about then-US low-cost carrier ValuJet.

The elder Gokongwei thought the same model could be successful in the Philippines, where the market was being deregulated, and he acquired several ex-Garuda Indonesia McDonnell Douglas DC-9s and secured an operating licence.

Lance, the only son who was being groomed to take over the family empire - one of the largest conglomerates in the Philippines - was tasked with running the fledgling airline and he has been with it ever since.

Now 40, Gokongwei spends around 40% of his time on airline matters, with the rest spent overseeing other businesses in the group, which he also now heads up. These business interests include food, real estate, petrochemicals, telecommunications, power generation and hotels.

With Cebu Pacific back on course for profitable growth after having lost its way for a brief period, it is widely expected that he will hand over day-to-day management of the carrier to a new chief executive in the near future.

Gokongwei has twin degrees in business administration and engineering from the University of Pennsylvania. He is married and has two children.