Low-cost carriers from emerging markets struggle to reach profitability

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The low-cost carrier sector has boomed, driven by growth in emerging markets. So far there have been remarkably few casualties despite a lack of profitability, but how many will survive?

Low-cost carriers seem to spread like wildfire. Last year they transported more than 550 million passengers, an increase of 24% compared with 2006. There are now more than 100 low-cost carriers, 65 of which have launched over the last four years. A majority of the start-ups have cropped up in emerging markets, in particular Asia, where low-cost carriers grew 35% last year and now account for 19% of the world's total low-cost market. Since 2004, 28 carriers have launched low-cost operations in the Asia-Pacific region, 18 in Europe, 11 in the Americas, five in ­Africa and three in the Middle East.

But unfortunately low-cost carriers have failed to turn the traffic increases into profit gains. While nearly every low-cost carrier in the top 15 continues to turn healthy profits, most of the sector is struggling to post sustainable margins. In several regions which have seen a sudden spurt of low cost activity this decade, such as Eastern Europe and South Asia, no one is making any money yet. But incredibly there have hardly been any casualties in these and other emerging markets. With the industry likely on the cusp of a global downturn, oil prices reaching record highs and capital markets tightening due to the credit crunch, will this be the year of massive consolidation and fallout?

There have already been four low-cost ­carrier casualties this year - Indonesia's Adam Air, Oasis Hong Kong and US-based ATA and Skybus. Another US low-cost carrier, Frontier Airlines, filed for bankruptcy in April and two budget carriers in the fiercely competitive Spanish market, Clickair and Vueling, will likely merge. Observers expect more casualties but mainly in Europe and North America, saying Adam's problems were unique in an otherwise promising Indonesian market and Oasis was an exception because it was the only low-cost carrier operating on sectors of over 10 hours.

"There will be more carnage in the mature markets and less carnage in the emerging markets because there are more opportunities in the emerging markets," predicts Seabury Group managing director Joseph Schottland.

In fact, most low-cost carriers in developing markets do not seem overly concerned about the looming global downturn. They are confident their markets will continue to grow even if Europe and North America enter a recession. "For first time ever if the US sneezes, Asia won't catch a cold," says Tony Davis, chief ­executive of Singapore-based Tiger Airways.

Adds the chief executive of Thai low-cost carrier Nok Air, Patee Sarasin: "The recession may not hit Thailand. At the moment we're pretty well off."

India's economy is also continuing to grow at 10% annually, says Air Deccan chief executive Ramki Sundaram. "At the end of the day the Indian middle class is still 200-odd million people and Indian domestic demand is still ­robust. The economy is still growing," he says.

Sundaram points out that India's low-cost market remains in the infancy stage and, unlike mature low-cost markets such as Europe, will grow through a recession. Schottland agrees, saying the penetration of low-cost carriers in Asia is still only half that which low-cost ­carriers have achieved in the USA and Europe.

SkyEurope chief executive Jason Bitter believes Eastern Europe can also escape a potential global downturn relatively unscathed. "We have two markets that even in a recession will grow," he says, referring to SkyEurope's home base of Bratislava in Slovakia and Prague in the neighbouring Czech Republic.

Bitter adds that even if a recession impacts some of its spokes in Western Europe and its third base, which is in Vienna, SkyEurope could benefit because low-cost carriers have historically attracted more business travellers during recessions. "We are positioned to take advantage of a recession," he says.

Tiger's Davis agrees: "Generally, well-run, efficient low-cost carriers better weather these storms [than full-service carriers] because there is a trading down" by consumers.

Mango chief executive Nico Bezuidenhout also predicts "a migration to low-cost carriers and more price sensitivity in the business market" in Mango's home market South Africa. He says growth in South Africa's domestic market may slow from about 20% annually to 10-12% but the country's three low-cost carriers could see their market share increase significantly. "A recession in a twisted way is advantageous to low-cost carriers," Bezuidenhout says.

He adds that a downturn could also help free up aircraft for carriers like Mango, which has struggled to secure additional Boeing 737-800s at reasonable rates. "The lease rates in my view are at an all-time high," Bezuidenhout says. "The market is bound to turn down."

AirAsia chief executive Tony Fernandes says the other "silver lining" in a recession is oil prices may finally start to fall. "Obviously we will benefit from a recession," he says.

A recession, however, will likely have a slowing effect on start-up activity. For the last several years entrepreneurs proposing new low-cost carriers for emerging markets have had little trouble securing capital. But Seabury chief executive John Luth says investment firms in recent months have become more reluctant to invest in low-cost carriers and more selective in choosing which start-ups to back. "Attracting capital for today versus three years ago for low-cost carriers is more difficult. But there are exceptions," he says.

Start-up activity

Luth adds that there are still plenty of business proposals out there but they are now unlikely to see the light of day, unless they are in a market where there is still a lot of untapped potential and are backed by seasoned industry executives like JetBlue founder David Neeleman, who earlier this year secured capital that will be used to launch a new Brazilian carrier in 2009. "You need a very significant niche in a good market," Luth says. "There is equity out there but you need a solid, well thought-out plan."

Michael Coltman, co-founder of UK-based low-cost carrier advisory firm Mango Aviation Partners, adds: "Investors are more savvy now. It's no longer a license to print money. You need to have the right management."

The chief executive of Poland's Centralwings, Waldemar Krolikowski, says it has also become more difficult for established low-cost carriers to secure additional capital. "For the time being it's not easy to convince banks that aviation or carrying passengers is a good business. They can see aviation is not such a good business after all," he says.

Centralwings has been struggling to compete against Western European low-cost carriers and earlier this year pulled out of several routes. Krolikowski says the carrier wants to escape the "violent competition" in the scheduled market and focus more on charters, but will need more capital to support expansion under its revised business plan. "We definitely need more capital like any entity that wants to grow up," he says. "I'm trying to find a more profitable market. At the time being it's very difficult and very competitive because a lot of big players are in this market."

Krolikowski adds that Centralwings has been trying to secure additional funding from Polish banks but recently the reception has not been too positive. Most low-cost carriers in emerging markets, however, do not seem too concerned about the prospect of running out of cash. Says the chief executive of Indonesia's Mandala, Warwick Brady: "We may need to raise more capital [but] our owners have invested real heavily in us and see a good future for Mandala.

"We are not profitable but we are on our way," adds Brady, who joined Mandala from Deccan last year to help restructure the carrier and lead a fleet renewal. "With 240 million people and a low cost base there's a lot of ­opportunity here."

He adds that Mandala is the only Indonesian carrier with an international investor, which gives the carrier "a good foundation". Indigo Partners, a US investment firm founded by Bill Franke and David Bonderman in 2002, acquired a 49% stake in Mandala in late 2006. Indigo also has stakes in Tiger and Hungarian low-cost carrier Wizz Air and, according to Brady, is still "looking at airline opportunities but is picky with who it invests in".

Bitter is also confident SkyEurope can ­secure more capital if necessary, even though the carrier has incurred over $150 million in losses over the last five years. "I think we can find capital. It's not easy to get in this environment and we don't want to ask, but I think it won't be a problem for us," he says. "We have some strong shareholders backing us [and] we're showing real continued improvements on an ongoing basis."

He points out that SkyEurope halved its losses from $71 million for the last fiscal year to $32 million for the fiscal year ending 30 September 2007. Bitter says the carrier is on track for another 50% improvement for the current fiscal year.

"If I had last year's fuel price we'd be a profitable airline now," says Bitter, who has overseen a drastic restructuring plan since taking over as chief executive one year ago. "We're not far away. We're closer."

Elusive profits

Sundaram is also confident Deccan, which seems to compete neck and neck every year with SkyEurope for the prize of world's most unprofitable low-cost airline, can secure more capital. He says the carrier's board has just approved the provision for another $400 million in capital and Deccan is now looking to secure these funds. "The capital situation is much different than it was one year back," ­Sundaram says. "The overall worldwide ­capital market is very unpredictable. At this stage the availability of capital is not ­something you can take for granted."

Deccan has chalked up nearly $300 million in losses over the last two years, including a $64 million loss in the quarter ending 30 ­September 2007. Sundaram says Deccan is continuing to incur losses at a similar rate this year despite a restructuring initiated last summer, after Kingfisher Airlines parent UB Group became Deccan's largest shareholder and Sundaram was promoted to chief executive. In ­recent months Deccan has slowed capacity growth, restructured its network, increased its focus on revenue management and turned off its cheapest fare bucket. Sundaram says revenues and yields have already improved significantly, "but over the same period oil prices have shot up so it's a zero sum game".

He adds: "Our focus is to get to profitability soonest. In earlier phases the strategy was to get as much market share as possible."

It has taken Deccan only five years to build up a 15% share of the domestic market, which tops India's other low-cost carriers, but it has been an expensive mission. Like other Indian low-cost carriers, Deccan has partly funded its unprofitable operations through the sale-and-leasebacks of aircraft. Sundaram says Deccan has sold for a profit and leased back most of the 23 A320s in its fleet. Rivals Indigo and SpiceJet have done the same with their fleets of nearly 20 A320s and 20 737s, respectively. Bitter and Davis say SkyEurope and Tiger have also benefited from sale-and-leasebacks.

Luth says sale-leasebacks "have been a very substantial source of capital" for several carriers in emerging markets and "it has funded a lot of loss-making low-cost carriers". He says some low-cost carriers have also profited from selling aircraft back to the manufacturer, which in the current market is able to place the aircraft with another carrier for a higher price, and from selling aircraft to another carrier through an intermediary. But Luth adds that carriers may find it harder to do this as the aircraft market starts to shift. He says ­already lessors are more reluctant to do sale-and-leasebacks because they fear aircraft prices may start to go down again.

"There's an effort by lessors to be more careful in what they are doing," says Sundaram, who before joining Deccan worked in ­aircraft and aviation financing for South ­African banking group Investec. "There is a nervousness around."

Lion Air chief executive Rusdi Kirana also says it has become more difficult to finance aircraft but claims so far he has not had problems financing any of the 178 737-900ERs Lion has ordered from Boeing. "There is a change - they are being more selective. If you check with the bankers it is only Lion Air which has gotten financing in Indonesia [for new aircraft] up to today, and it is because we are proven and we are a successful airline," Rusdi says. "We have good growth in our company and good profits and the banks are confident in us."

Lion now operates nine 737-900ERs and Rusdi says new deliveries have already been financed through August. He expects financing covering deliveries up to 2010 to be finalised within the next month or two. "We have the largest market share in Indonesia so we have not had any problems," he says.

Sundaram says Deccan is confident it can conclude sale-and-leaseback deals for the four A320s scheduled for delivery later this year. Sundaram adds that while Deccan has benefited from selling A320s at a profit, it has also tried to keep lease rates low and in the last year the profits realised from sale-and-leasebacks have not been significant "in the big scheme of things".

The chief executive of India's GoAir, Edgardo Badiali, says the danger is that low-cost carriers with very large orders such as Deccan, Indigo and Lion could find themselves forced to take aircraft in a market that is already oversaturated. "If suddenly the market for aircraft isn't there you have a big problem," he says.

Badiali says GoAir, which so far has only ordered 20 A320s compared to the 100 ordered by Indigo and the nearly 100 initially ordered by Deccan, has resisted ordering more aircraft over the last year because it believes other carriers have over-ordered and new aircraft prices will start to come down. With only six aircraft GoAir is now by far the smallest of India's six low-cost carriers but Badiali says this is by design. "We believe it is much better to have a more sustainable growth and position the company to be there when the time is right. We have a more conservative strategy and we think that's the right strategy," he says. "This is just the beginning of a long journey. The penetration of the market is just beginning."

Thai growth slows

Thailand has seen an explosion of low-cost activity since the end of 2004, when One-Two-Go became the country's first low-cost carrier. By mid-2005 two more low-cost carriers launched, Thai AirAsia and Nok Air, marking a remarkable shift for a relatively small domestic market that had been controlled by flag carrier Thai Airways and a few small regional players.

The Thai market has since tripled in size from about four million passengers annually to more than 12 million, with the three low-cost carriers accounting last year for 8.5 million. But while all three of the new-entrants were profitable in 2006, last year was difficult and the first quarter of 2008 was even harsher as fuel prices increased further.

"Not many people are making money to be honest," says Nok chief executive Patee Sarasin. "The fuel price has gone up to a point where the market wasn't prepared."

He adds Thai carriers are constrained because it is difficult to pass on fare increases without significantly impacting demand. "What we have to overcome in Thailand is the fares. The load factor is great. It's been 80% the last few months."

Patee says the fares over the last year have been irrational and there is now a 200 baht ($7) gap per ticket that needs to be overcome for Thailand's low-cost carriers to be in the black.

He says Nok is now trying to increase its fares by focusing more on the business market through the launch of a corporate programme. It is also focusing on ancillaries and will begin selling holiday packages on its website later this year. Nok, which increased its Boeing 737-400 fleet last year from five to nine aircraft, is also slowing down growth and will not add capacity this year.

AirAsia Group chief executive Tony Fernandes says Thai AirAsia has also put a brake on expansion and will not expand its fleet this year. Instead the carrier will focus on getting rid of its remaining 737-300s in favour of new, more fuel efficient Airbus A320s.

In February Thai AirAsia, which operates 16 aircraft, said it ended 2007 slightly in the red. Fernandes says the carrier and AirAsia's other affiliate, Indonesia AirAsia, are now at roughly break even.

Profits in singapore in short supply

Singapore witnessed a sudden spurt of low-cost activity back in 2004 with the launch of three carriers, but the market has been slow to mature due largely to restricted bilaterals in the region, and none of the carriers were profitable in the first three years. Over the last year some profitability has finally been achieved, but the margins are not yet sustainable and Singapore's low-cost carriers are still relatively small.

The largest, Tiger Airways, only operates eight Airbus A320s with another four at its new Australian subsidiary. Tiger in January said it was profitable for the nine-month period ending 31 December, but chief executive Tony Davis in an interview in April refused to say if the carrier ended its fiscal year in the black and acknowledged the quarter ending 31 March was tough: "The quarter definitely was difficult due to the impact of fuel but we think we definitely performed better than our competitors.

"We're comfortable with our business plan. We believe our year-end results for Singapore will be in line with forecast and show solid improvement in the business."

He adds the Singapore operation is now cash flow positive and the Australian operation "has been cash positive from the start". He claims the launch of Tiger Australia was entirely funded by cash and Tiger has been able to expand with only the S$24 million in capital initially provided by its investors, which include the family of Ryanair founder Tony Ryan. "We haven't asked shareholders for cash since October 2005 and we don't foresee going back to our investors anytime soon," Davis says. "We've managed our cash flows very successfully. We've been able to grow the business by not asking shareholders for more capital."

The chief executive of Singapore's other two low-cost carriers, Jetstar Asia and Valuair, Chong Phit Lian says their parent company, Orangestar, has just completed its first profitable year. Chong says Orangestar turned only "a very modest profit" in the fiscal year ending 31 March 2008 but this is a major improvement compared to the losses incurred since Orangestar was created in 2005 from the merger of Jetstar and Valuair. "Within three years we have turned around the company," she says. "Our loads have gone up and we've given up some high loss making routes."

Jetstar Asia and Valuair have been focusing on reducing their cost base and have taken a very conservative approach to expansion. The carriers' combined fleet of seven A320s is slightly smaller than when they merged in 2005 but they have been improving aircraft utilisation. "If there is a business case for it we'll go for more aircraft," Chong says.