After a few early failures, potential western investors are again showing an interest in FSU aviation. But a more upbeat view of future traffic growth is needed. Colin Smith reports.More than three years have elapsed since the demise of the Former Soviet Union (FSU) and the ensuing disintegration of the political and economic structures which characterised the Communist system.Throughout this time former soviet industry in general has been regarded with a combination of scepticism, wariness and misperception, making commercial investors slow to react.

The aviation industry is no exception. The rapid disintegration of Aeroflot led to newly-formed states, regions and even individual airports seizing their independence from Moscow. A string of much publicised accidents, rumours of poor maintenance and the increasing bankruptcy of the manufacturing sector have all acted to delay interest in this potentially vast transportation market. Those who did attempt to enter the market early - such as BA with its Air Russia plans and Lufthansa's efforts to redevelop Moscow/Sheremetyevo 1 - met with delays, indecision and frustration. BA has formally abandoned the Air Russian project and Lufthansa's venture is all but moribund.

These experiences, along with general insecurity and fears of political instability, have limited the amount of western involvement to a handful of joint ventures and commercial contracts.To date there has been no major investment in the FSU airline sector by a western airline, manufacturer or financial institution.

Interest is growing, however, and potential investors are again beginning to evaluate the opportunities offered. But myths and misperceptions still prevail in a market where physical distance alone adds to the constraints on good information. The airline sector has been in a state of flux for the last three years and it has been difficult to get a clear picture of the real emergent opportunities.

Aeroflot, once the largest airline in the world with more than 3,000 aircraft, was typical of the command-driven economic structure which characterised soviet industry. It was not so much a single commercial entity than a series of semi-independent 'production enterprises' operating under a single name and held together by a central revenue collection and resource allocation system.

These 'production enterprises' typically comprised an airport, airline operations and sometimes maintenance facilities. Routes were determined centrally, aircraft were allocated according to needs, capacity was artificially supported by subsidies, pricing decisions were centralised. The role of the production enterprise was to fly an agreed number of frequencies on the route as efficiently as possible with the prescribed equipment.

In varying forms these 'production enterprises' constitute the 220 plus airlines that emerged from the former Aeroflot (see table 1). The airline with the sole right to use the original name, Aeroflot Russian International Airlines (Aria) based at Moscow-Sheremetyevo, today operates only around 100 passenger aircraft, including four Airbus A310-300s and two Boeing 767-300ERs - plus 20 to 30 freighters.

The main focus of Aria is international: the carrier dominates the international network from Moscow to more than 130 countries, including the major CIS cities. Aria also offers connections to around 30 domestic Russian destinations, although these services are actually performed by other domestic airlines, based in Moscow and throughout the FSU. Domestic connections can be made by transferring to Sheremetyevo's domestic terminal, but they often involve a connection from one of the two other principal Moscow airports, Domodedovo or Vnukovo, both an hour's, often hair-raising drive away. Aria is also rumoured to be considering services to major domestic destinations.

The remaining airlines serving the FSU are at varying stages of development. Some continue as state-owned enterprises and, apart from a change of name, operate much as they did under the communist system. Others are much further along the road towards establishing themselves as independent joint stock companies trying to emulate the structure and services of a typical western airline.

Of the 220 or so airlines registered in the FSU some 195 are based in Russia and a little more than half operate services to and from Moscow, still an important line of communication for many of the newly independent states.

Many of the airlines serving Moscow carry the name of the particular city served. In some cases they operate as an independent airline, in others they form part of a grouping from that particular region. Aerovolga, for example, represents the various 'airlines' based at the city of Samara.

Any classification is problematic. Virtually any operator or owner of aircraft can become an airline - including factories or design bureaux. Carriers are also changing their business in response to market opportunities. Currently there are six broad categories:

1 Major airlines based either in Moscow or the principal industrial cities of the FSU, formed from the larger production enterprises. ARIA, Domodedovo Civil Aviation Entreprise and Vnukovo Airlines are the three main Moscow-based carriers. Yugavia, Sibavia, Aerovolga, Krasnoyarsk Avia and Pulkovo (St Petersburg) are examples of the larger airlines based in the Russian regions.

With the exception of Aria and St Petersburg, these airlines' scheduled operations are limited to Russia and the CIS. However almost all have set up overseas charter operations as a lucrative additional source of income. Table 2 illustrates the top 20 airlines serving Moscow by available seats per week based on scheduled flights only. Table 3 shows the top 40 destinations from Moscow in terms of weekly capacity offered.

2 Independent airlines based within CIS states such as Ukraine, Kazakhstan and Armenia. These carriers are now beginning to extend their own international networks in addition to the traditional links with Moscow and the Russian regions. As well as the principal carrier there are often several airlines operating from different regional cities. Ukraine alone boasts a further eight, all of which fly direct to Moscow.

3 Charter carriers. Often little more than an office and a name, these lease in capacity to match demand. Smaller domestic carriers and virtually any aircraft owner, including flight test centres, also engage in charter work whenever they can.

4 Smaller domestic airlines usually with a limited network, but often also serving Moscow and sometimes operating internal and external charter services. Many of these airlines are flying aircraft that are nearing the end of their economic life with a significant seat penalty to achieve greater range.

5 Cargo airlines typically operating on a charter basis but also sometimes providing the only regular connections to more remote locations. One or two of these airlines also provide limited passenger services.

6 New start-ups and joint ventures. Transaero is perhaps the best example of the first non-Aeroflot airline approved for international passenger services. Ukraine International Airlines, a Ukrainian joint venture with GPA, has also developed links between Kiev and the major European capitals.

A significant factor in the development of this segmentation has been the change in ownership patterns. From a single state-owned monolith the FSU's 220 airlines now represent all levels of private participation from fully-independent Transaero, through partially privatised airlines such as Vnukovo, to the numerous entities which remain wholly in the hands of the state.

The Russian State Property Agency is charged with privatising all of the Russian 'businesses' and thus the ownership structure is itself now beginning to exert stresses upon an industry which can no longer depend upon central support.

The most obvious feature of this market over the past three years - and the one which has created the greatest sense of uncertainty - is the collapse of demand. In 1994 total Russian passenger numbers were 32.7 million, a fall of 60 per cent from the 1991 level. At 72 billion total RPKs are less than 10 per cent of the US total. Without the 'created demand' of artificially low prices and sponsored travel, passenger volumes have been decimated. Some forecasts have suggested that even if the most optimistic view is taken, demand will not recover for 20 years.

But such a pessimistic outlook fails to recognise many of the structural social and economic changes taking place. Although GDP throughout the FSU has itself collapsed, two factors are in favour of the airline industry recovering at a faster pace.

First, measures of GDP have tended to focus on the official publicly-reported sector of the economy. Measurement of GDP from the privatised portion of the economy has failed to keep pace, underestimating not only output from newly- privatised enterprises but also from the large 'shadow' economy. A recent London School of Economics forecast estimated expansion in this latter part of the Russian economy is capable of pushing overall GDP growth to as much as 10 per cent per annum. Added to which a few extremely wealthy 'New Russians' are estimated to hold up to US$20 billion in western banks.

The second major influence is the latent hunger for travel throughout the FSU. Two generations of the population have faced significant travel restrictions until recently - both outside and within the FSU. The desire to explore new places is conditioned only by the ability to fund the travel. As many of the newly-independent airlines compete to expand their income, the opportunities for travel, often at quite modest fares by European standards, have increased.

In order to make a realistic assessment of the recovery potential for passenger traffic it is important to recognise the very significant differences between the three market segments: domestic; international travel between the CIS and former 'Soviet sphere'; and all other international travel.

Domestic passenger volumes have collapsed and even where there is true demand for domestic travel inflation has restricted demand. In 1994 domestic passenger volumes fell by a further 18 per cent over the previous year but a modest improvement on some routes may indicate the market has at last 'bottomed out'.

In contrast there is an emerging international travel market. Traffic between the newly-independent states, the so-called 'Near Abroad', and Russia has been developing on the back of the historic commercial and economic links with Moscow. Meanwhile, Russian travel to non-CIS destinations in-creased by a staggering 34 per cent in 1994, with international air traffic up by 4 per cent and expected to grow by a further 10 per cent in 1995. A good deal of this traffic is based upon the 'shuttle' business or overseas travel to buy up a wide range of consumer goods for resale. But there is also genuine growth in demand for external travel, especially charter.

Two million foreign trips in the 1980s have now doubled and is expected to be two to three times higher by the year 2000. Taking account of all this a more optimistic forecast would see traffic back to 1990 levels by around 2002 - 04 using the most optimistic assumptions of GDP recovery and 2015 at the most pessimistic (see graph).

What then are the implications for the airline industry as it struggles to establish itself on a new footing? What opportunities does the market offer for inward participation and investment?

The division of Aeroflot into numerous companies has created many new demands for those running the airlines. The collapse of the command structure and the emergence of markets, albeit often rudimentary, have generated a whole new set of pressures including shortages of quality equipment, infrastructure, management skills and finance. The effects of this infrastructural backlog will worsen if demand recovers.

As the recovery gathers pace most Russian airlines will find it difficult to find enough serviceable equipment of sufficient quality to satisfy demand and passenger expectations. Obsolescence, a record of poor maintenance and poor operating economics will transform overcapacity into a serious shortage, even if the omnipresence of idle equipment at virtually all FSU airports currently makes this seem implausible.

While at current levels of demand there is no shortage of individual aircraft, there is considerable scope for investment in new aircraft due to major problems of serviceability, fuel efficiency, overall quality and remaining economic life.

Some carriers, notably Aria, Transaero and Ukraine International, have chosen to bypass the problem by leasing in western-built aircraft. But so far the numbers are modest and there is a major question mark over the industry's ability to sustain large numbers of leased western aircraft.

Large parts of the indigenous manufacturing sector are in chaos and either bankrupt or on the verge of it. The major heavy maintenance bases are trying to improve their own fortunes by ratcheting up prices to the airlines. Central government decision-making on new aircraft types has become hopelessly protracted and it is not clear that the newly-independent airlines would have the resources should they wish to buy anyway. Meanwhile the various proposals to employ western engine and avionics technology on Russian-built airframes such as the Tu204 and Ilyushin 96 hinge crucially upon achieving sufficient orders from a now fragmented industry.

There are also severe problems getting to and through many of the airports in the FSU. With a few notable exceptions - including the recently refurbished Kiev/Borispol or Ashgabar airport in Turkmenistan - many FSU airports are now characterised by poor materials, inadequate layout and lack of maintenance.

Several initiatives to improve the air traffic control system in conjunction with western agencies are underway but other aspects of the infrastructure - runways, lighting, consistent fuel supplies, and ground-transport arrangements - are in need of investment.

At the distribution level, there is no adequate central reservations system for the new airlines to market their product. Ticketing remains at best rudimentary and most of the domestic Russian airlines, as well as some of those from the newly-independent states, are forced to rely upon the former Central Sales Agency in the absence of a network of GSAs.

For many senior managers used to the former 'production enterprise' structure, strategic planning, marketing, financial control, cash management and capital budgeting are unfamiliar territory in the day-to-day running of an airline. There is also a great deal of work to do in specific areas such as reservations control or yield management. Levels of technical education and competence are high but there is a fundamental need for the rapid development of management skills.

Underlying all of these issues is the need for new capital to fund the redevelopment of the industry on a much broader scale. What then are the opportunities for potential inward investors, be they western airlines, banks, manufacturers or even individuals?

First investment has to be viewed as a long-term proposition, not least because much of the capital needed is to make up for past shortcomings and neglect. Second, the opportunities for western airlines to hub through Moscow will be limited for some considerable time. There are three main reasons for this: the protectionist rumblings from the Aria management about the predatory intentions of British Airways and Lufthansa; the volume of international scheduled traffic to and from FSU destinations and through Moscow remains limited; and routes remain split between three Moscow airports/airlines and the independent Transaero. It is therefore evident that any airline investment in a domestic Russian or other CIS carrier needs to be evaluated on the basis of its domestic network and demand. Large-scale international codesharing or integration is only an option in the longer term. The only existing Russian joint ventures, by Austrian Airlines in three different regions, will take some time to reap substantial benefits.

Third, there is obvious and very real potential for investment, in service improvements for both airlines and airports to develop the 'product' on offer, market it better and monitor ongoing performance. As the market stabilises and pricing becomes more realistic, opportunities for service enhancement and premium pricing will grow.

Fourth, outbound charter development will allow a variety of shorter-term cooperative ventures with western tour operators. It has been estimated that outbound travel for Russia alone will rise to 10 million trips per annum by the year 2000.

Finally, pricing and capital values in the FSU still bear little relationship to western criteria when viewed against the last three years' rampant inflation. However as economic conditions stabilise the value of assets relative to market opportunity - in terms of procuring a future income stream - will become more obvious to investors.

There is probably no better time for the west to think again about serious participation in this market. The many opportunities are growing though the inherent risks have not gone away. While the airline sector can potentially develop much more quickly than elsewhere, any investment will require serious long-term commitment and a clear understanding of the emerging priorities. These are undisputably the growing demand for new aircraft, an urgent need to improve infrastructure and a requirement for management support in the widest sense.

Source: Airline Business