Partial privatisation is back on the agenda at LOT Polish Airlines after a two-year delay and the carrier has emerged as a more attractive proposition. Mark Odell reports from Warsaw.

Delays in the airline business are rarely beneficial, but the management at LOT Polish Airlines has used the time 'gained' from the postponement of the sale of a major chunk of the airline to good effect. Not only have the managers of the eastern European carrier learned some salutary lessons from the hasty equity sales by other airlines in the region, they have also ensured that the transformation of LOT into an airline with 'western' standards is firmly on track.

LOT is the exception rather than the rule in eastern and central Europe. The all-western fleet, the only one of its kind in the region, bears witness to that fact. Moreover, the carrier has gone without any help from its government owner, leaving it with one major problem in common with its neighbours: a lack of cash.

Elsewhere in the region, Malev and CSA (now CSA Czech Airlines) rushed into equity alliances with Alitalia and Air France respectively in 1992. But neither partnership produced any real benefit: one is now defunct and the other is very nearly dead.

LOT's president and chief executive, Jan Litwinski, and its plenipotentiary for privatisation, Zbigniew Kiszczak, constantly highlight the experiences of CSA and Malev when discussing the proposed sale of 49 per cent of the carrier. But they do not revel in the misfortune of the others, rather their words are laced with relief. 'When we discuss the issue of privatisation internally we sometimes say that we were blessed with the delay,' admits Kiszczak.

LOT was set up as a joint stock company in December 1992, with the aim of selling up to 49 per cent of the airline by the end of 1994. Bankers Trust, which worked on the Eximbank-backed financing of LOT's Boeing fleet, was appointed advisor by the airline in March 1993, but the government ruled the process invalid as it had not been preceded by an open tender. A change of government in 1993 led to a further delay and the deadline was eventually extended by a further two years at the end of 1994.

A tender process for an independent advisor, initiated in October 1995, produced 14 submissions, which had been whittled down to a shortlist of six by the end of February. Kiszczak admits that the selection of an advisor is already taking longer than envisaged: 'Perhaps we were a little naive.' But he believes that the final decision should be reached by mid-April with the successful consortium starting work in May. However, he warns that this will almost inevitably lead to a further delay. The original timetable envisaged an advisor in place by January, so the government will probably have to extend the privatisation deadline beyond the end of 1996.

Litwinski has no fixed concept of how the partial privatisation may shape up. But he strongly supports the disposal of the full 49 per cent permissible. Of this up to 20 per cent has been set aside for employees at a preferential price but Kiszczak believes the government will look at capping this at 15 per cent and distributing the shares free of charge.

Whether the remaining 34 per cent will be taken up by a strategic airline partner is highly questionable. Privately airline officials have hinted that a neutral partner, in the form of a foreign bank, is the preferred choice. Kiszczak adds credence to this when he observes: 'Being realistic we are not convinced any airline would want to take a single large stake and, in view of the Malev and CSA situation, the government will have to be convinced that an airline partner would bring benefits to LOT in terms of continued existence and cooperation.'

The only strong commercial link with another carrier - the agreement LOT signed with AMR and American Airlines in May 1994 - has weakened since. The proposed codesharing between the two carriers still awaits US government approval and the Polish carrier terminated AMR's management contract for its groundhandling services at Warsaw in late 1995. Moreover, it is not part of AMR's philosophy to take equity stakes in airlines.

Kiszczak rules out a stock market listing but believes the government could opt for this instrument 'later down the road', hinting that the state should consider relinquishing control of the flag carrier.

But some concerns remain among political analysts about the commitment of the new Polish president, Aleksander Kwasniewski, to economic reform. The former communist ousted incumbent Lech Walesa last November and by the end of the month the financial community was in uproar. The government announced plans to merge Bank Przemyslowo-Handlowy, 53 per cent of which had been floated on the stock exchange in late 1994, with Bank Handlowy, a 100 per cent state-owned entity, as part of a wider consolidation programme. No warning had been given to minority shareholders and although the decision may yet be overturned it left a bitter taste.

The partial privatisation of LOT will send the right signals to the rest of the world about Poland's commitment to economic reform, agrees Litwinski. However one of the main sticking points is LOT's demand that the government write off some $23 million in debt, owing from a special tax that was scrapped in 1991.

Privatisation will give LOT easier access to the capital markets and, with $600 million in current fleet obligations to service, cash is certainly in short supply. Fortunately in terms of balance-sheet debt, the fleet does not add an extra burden. Under Polish tax law the finance leases can be treated as operating leases, so the aircraft remain off balance-sheet. Financing its fleet obligations accounts for almost 20 per cent of LOT's total annual costs.

The carrier's recent financing activity underlines the fine line the airline is walking to generate enough cash flow to finance its lease obligations. Bazyli Samojlik, Poland's minister of finance in 1988-9, joined LOT last year as executive vice president and chief financial officer. Since then he has completed a $119 million refinancing of three B767s without any form of sovereign guarantee; secured a three-year, $25 million syndicated loan underwritten by Merrill Lynch and launched a PLN50 million ($19.5 million) domestic commercial paper programme arranged by ING Bank - the first by a Polish company.

The refinancing of the three Boeings last November through a Japanese consortium allowed the carrier to extend the remaining six-year term on the Eximbank financing by four years, producing annual savings of $5 million. This freed up enough internal cash flow to finance the fourth B767 that arrived last year. It also freed up cash deposits of $20 million demanded by Eximbank in 1989 because of the political risk factor, explains Samojlik.

The $25 million loan will be used to fund the carrier's investment in IT management systems, as part of a $40 million programme. Dollar loans from international investment houses are more attractive than anything on offer from Polish banks, explains Samojlik. Not only do domestic institutions offer a maximum six-month term but interest rates on Zloty loans are running at 26 per cent. With a 3.5 per cent devaluation of the Zloty against the US currency last year, rates on dollar loans are running at only 11-12 per cent.

The domestic commercial paper issue both improves the cash flow and acts as a confidence-building measure by giving LOT a presence in its home market prior to privatisation. While the notes only carry a one-month term (extendable to one year), they are still a cheaper way of financing than domestic bank loans.

Samojlik is also looking to free up more cash by restructuring the carrier's liabilities, moving away from relatively large short-term obligations towards medium and long-term debt. At the moment he estimates long-term liabilities only account for 30 per cent of total debt.

The carrier's investment in IT systems will see a number coming on-line in the near future, including a crew management system, Crossair's maintenance management system, and a revenue management system. Citibank will also host LOT on its cash management system from June at a cost of some $10,000 a year, giving the carrier estimated annual savings of $3-4 million on exchange rate losses.

LOT has also signed a letter of intent with EDS to develop its computer strategy with the aim of producing 'a fully integrated system to support all LOT's business functions,' explains Andrzej Slodownik, vice president operations. The carrier is also looking at changing its internal reservation system, currently based on Gabriel - it already runs the joint venture marketing company for Amadeus in Poland.

Samojlik says his broad aim is to cut some $12 million annually or 3 per cent of total costs, but admits 'we are at the beginning of the process.' This is the first year ever that the annual budget for LOT's 500 business units will be fixed within the first two months, which will allow 'the real cost cutting to begin.'

A proper grasp of the cost structure will certainly help management target those areas where inefficiencies are greatest, and should further boost gains in areas that are already the focus of continuing restructuring efforts under the current four-year programme, Strategy 2000, launched last year.

However, targets for Strategy 2000 were still being revised at presstime in the light of the carrier's impressive performance in 1995. LOT carried 1.84 million passengers last year against 1.58 million in 1994, including charter. Domestic traffic jumped 15.5 per cent to almost 270,000, while international scheduled passenger numbers grew 15.1 per cent to 1.5 million. This compares to just over 1 million passengers carried to and from Poland on other carriers - a mere 5 per cent growth. Average load factor jumped 3.3 percentage points to 69.6 per cent in 1995. LOT estimates it will carry some 2.5 million passengers by 2000, based on average annual growth of 8.5 per cent, a realistic target given Poland's strong GDP growth last year of 6.8 per cent and government forecasts for average annual growth of 5.5 per cent up to 2000.

The other main restructuring measures implemented so far include the expansion of the all-western fleet and the disposal of most of the Russian aircraft, as well as the hiving off of non-core activities and a realignment of the route network.

LOT currently operates a fleet of four B767s, 10 B737-400s and -500s and seven ATR72s. The carrier is also currently negotiating the lease of a B767-300 for the summer season, but the aircraft are hard to come by. For the last two years LOT has had to wet-lease a DC-10 from MAS after a reciprocal deal with Air New Zealand on a B767 was terminated unilaterally by Air NZ because of capacity shortage. LOT still leases a B767 to ANZ, however, in the northern winter.

LOT is planning to add an extra B737-500 on a two-year operating lease from May and is due to take delivery of a B737-400 later this year and a B767 and ATR72 in 1997. However LOT is still looking to acquire up to six B737-400 size aircraft before 2000 and Slodownik says he is considering the B737-600 for a proposed charter subsidiary, which could receive board approval by mid-1996. The charter market grew by 50 per cent in Poland last year from a small base and LOT is aiming to shut out some aggressive foreign operators from the expanding market: charter only accounted for 2.8 per cent of the $355 million in revenues from airline operations, against group revenues of $492 million, in 1995. Slodownik has also been assessing the B777 and says he 'is thinking seriously' about incorporating it into the B767 fleet at the end of the decade.

Slodownik is also looking to replace the fleet of ATR72s, which may be converted into express parcel carriers. On regional routes he is considering bringing in 50-seat regional jets to match an increasing number of carriers operating similar equipment into Poland. The ATR72s are also too large for most of the current domestic network and daily utilisation of the turboprop fleet only averages around 5.4 hours against 6.7 hours for the 737-500s and 8 hours for the 737-400s. Utilisation of the B767 fleet is very high at 14.7 hours for the -300 series and 13.6 hours for the -200s. The carrier is considering setting up a 'Crossair' type of regional and domestic subsidiary.

LOT has also made significant strides in increasing productivity (see chart) through the outsourcing of its non-core operations into separate profit centres, including catering, ground services and its car pool. The result has been a reduction in employee numbers from 7,000 in 1990 to 3,900 by February 1996. The carrier is currently studying similar ideas for its maintenance operation and a fuel farm at Warsaw airport.

A thorough route review, carried out by AMR last year, focused on the potential of Warsaw as a regional hub by the end of the decade. Litwinski acknowledges that the critical mass does not exist yet to support even a medium-sized operation, but says the study helped reinforce 'our own thinking on what had to be done to reallocate resources more efficiently.' Over the past two years LOT has closed eight off-line stations and cut two long-haul routes to Kuwait and Singapore. This year the carrier will discontinue Abu Dhabi.

Instead LOT is focusing on increasing frequencies to London, Frankfurt, Amsterdam and Brussels - its main European destinations, says Krzysztof Ziebinski. This is where the carrier gets its best yields: LOT carries 20 per cent business traffic on its European services compared to only five per cent on the North Atlantic. LOT is also planning a number of route launches in 1996, mainly to Germany - its main European market. New services will start from Warsaw to Stuttgart and Munich, and from Wroclaw to Frankfurt, as well as between Poznan and Copenhagen.

In Asia, the carrier is considering launching flights to either Kansai or Seoul - and already operates once a week to Beijing and twice weekly to Bangkok to which it may increase frequencies. LOT has a limited commercial agreement with both Qantas and Air New Zealand in Bangkok, mainly for expatriate Poles transferring between Australasia and Poland.

The flag carrier has further limited codeshare agreements in Europe with Lufthansa, SAS and Austrian Airlines and is unconcerned about the prospect of having to compete under the European third package should Poland eventually gain access to the European Union. Management is confident the government will secure capacity restrictions during any phase-in period.

The proposed codeshare with American Airlines, which would put LOT's designator on the US carrier's Chicago-Los Angeles and New York/JFK-Miami routes and the AA code on LOT's transatlantic services, is still pending US government approval. The US is holding out until Northwest and United Airlines receive Polish clearance to codeshare with KLM and Lufthansa, respectively, over their European partners' hubs. Ziebinski suggests a compromise is near, which would see a phase-in of United and Northwest's codesharing rights.

LOT's management appears capable of delivering an attractive package to would-be investors, though a question mark remains over the political impetus behind the privatisation. With one of the stronger economies in the region the carrier will certainly have a solid domestic market to draw on. But LOT's managers appear to have concluded a big partner is bad. In the light of recent alliance spats in Europe and across the Atlantic, you can see their point.

Source: Airline Business