Latam Files for Bankruptcy, and Cargo is a Winner for Turkish

Madhu Unnikrishnan

May 31st, 2020

  • As discussed in this week’s feature story below, South America’s Latam reported a massive Q1 net loss due to special accounting items. But its operating margin was positive 4%, which actually marked a y/y improvement. The company was scheduled to discuss the results in a conference call on June 1. But the call was cancelled after Latam filed for bankruptcy, the biggest filing yet of the Covid era.

    The airline entered the crisis challenged by currency, cargo, debt, and other headwinds. But the tailwinds were just as significant, including lower fuel prices and bumper profits in the consolidated Brazilian domestic market. It was hopeful of greater international profitability as well, following its blockbuster alliance with Delta announced last fall. That alliance will remain a bedrock of Latam’s future strategy as it works to lower its cost base in bankruptcy.    
  • Turkish Airlines, which earned a modest 4% operating margin in 2019, is a highly seasonal airline that almost always loses money in the offpeak first quarter, even in good years. There’s nothing too alarming, therefore, about its negative 12% operating margin last quarter, which compares to its negative 7% margin in the same quarter last year. Revenues dropped 8% y/y as Turkish cut ASK capacity 10%. Operating costs declined only 5%.

    Results for the current April-to-June quarter, unfortunately, will be alarmingly bad, as they will be for every other airline on Earth. The peak summer quarter will be bad too, though hopefully salvageable to some degree as Turkish resumes flying this month. Domestic flying will be first, initially from five cities this week (Istanbul, Ankara, Izmir, Antalya, and Trabzon). Next week, it plans to restart a few shorthaul international routes, though as of Sunday hadn’t yet said which ones. It only said they’d be destinations where the Covid outbreak is largely under control.

    Turkey itself was late to see an outbreak, but then mostly commended for handling it well. The airline in fact hopes the experience will burnish Turkey’s image as a top spot for medical tourism. That’s for another day though. And it could be years, in management’s estimation, before the airline’s long-bustling sixth-freedom market returns to form. This refers to its transport of passengers from one foreign country to another via Istanbul, a city recognized for its strategic geographic centrality for centuries.

    During its Q1 earnings call, management mentioned North America and Asia as its most profitable markets during normal times. So it will be keen to resume flying there as soon as possible. But longhaul markets, almost everyone in the industry concedes, will take longer than shorthaul to recover. The two are of course not mutually exclusive — a large portion of Turkish Airlines shorthaul passengers are connecting to or from a longhaul flight. Still, the carrier thinks it will be among the earliest to recover, based on expectations of an early return of vacationers to Turkey’s beaches (most of the country’s Covid cases have been in Istanbul).

    Officials are eagerly reopening resort destinations like Antalya, balancing health concerns with Turkey’s heavy economic dependence on tourism. Foreign exchange troubles, meanwhile, continue to plague the country, but much less so its national airline, which generates a large majority of its revenues in euros, dollars, or dollar-linked currencies. The impact of forex movements on operating results was actually positive last quarter.

    Importantly, Turkish entered the crisis with a significant cost advantage relative to European competitors. And it’s now lowering costs even more. It plans to negotiate longterm wage concessions with unions. Many of its workers are currently on unpaid leave or part-time employment. Labor costs could thus fall as much as 30% this quarter. Last quarter, it cut sales and marketing costs by 30%. Though it hasn’t received any meaningful direct government aid, Turkish is benefitting from sharp tax reductions and lower airport fees. It’s also freezing recruitment, cutting back airport project spending, and talking to Boeing and Airbus about delivery deferrals. Executives say they have enough cash to cover its needs through 2020 but are exploring additional ways to raise capital, including aircraft sale-leaseback deals. A key goal is to not have any layoffs this year or next.

    One bright spot is cargo, which accounted for 18% of Q1 revenues. April and May cargo revenues were in fact up y/y on sharply higher yields. And low fuel prices are making cargo flights all the more profitable. They’re big cash generators too: $150m worth in both April and May. Turkish still intends to replace mainline flying at Istanbul’s Gökçen airport with low-cost flights operated by its wholly-owned subsidiary Anadolujet.

    One concern is the domestic fare caps Ankara is imposing. But longterm, Turkish expects to emerge a winner from the pandemic as the crisis “eliminates insolvent players.”

Trouble Brews in Scandinavia

  • Norwegian’s near-implosion is only small consolation for SAS, which itself is in trouble. The carrier reported an ugly negative 63% operating margin for its fiscal quarter covering the months of February, March, and April. During the latter half of that period, demand was all but nonexistent. April ASK capacity decreased 95% y/y. For the entire three months, ASKs were down 47%. More than 90% of employees are on temporary leave. It’s the first gory look at Covid’s impact on airline finances for a period that includes April, with other airlines having reported results only through March.

    SAS, remember, was a weak airline even before the crisis. It made money in 2019, but not much (a 2% operating margin). Momentum was building as Norwegian’s downsizing and Europe’s MAX and NEO shortages lifted unit revenues. But Nordic currency weakness was a big drag, and chronic strategic shortcomings like lack of longhaul heft and undersized hubs persisted. The only real bright spots now are cargo and some government travel in Norway.

    Things should get somewhat better this summer; SAS sees enough positive demand trends to double its aircraft in service by the middle of this month. That’s still just 30 planes, flying to selected destinations within Scandinavia and to points in greater Europe and the U.S. But the weak Norwegian and Swedish currencies remain a major problem (Denmark’s krone has been more stable). Hedges are another pernicious problem, and the combined impact of forex and hedges caused fuel costs to increase 15% y/y, despite flying almost 50% fewer ASKs.

    Management sees the recovery unfolding in three phases, the first with minimal traffic. Phase two will start later this year, evident first in domestic markets but delayed internationally due to uncoordinated government policies on lifting travel restrictions. Sometime in 2022, phase three will bring a more meaningful recovery, but still leave traffic depressed versus pre-crisis levels for many years due to economic factors and anticipated changes to corporate travel behavior. SAS did receive some government financial support.

    But it still expects to burn through $50m to $70m in cash a month for the remainder of 2020. It will need cash to rebuild schedules as demand returns. And current projections show potential liquidity troubles this fall. So SAS is talking to shareholders, including the Danish and Swedish governments, about contributing more equity. It absolutely needs more capital, management insists. It’s at the same time rethinking its business model, while delaying Airbus deliveries, phasing out older planes, cutting 5,000 jobs, renegotiating supplier contracts, and again turning to unions for concessions, most importantly more flexibility to adjust its staffing by season.

    Copenhagen will remain its chief longhaul hub, with incoming A321 LRs potentially useful for Oslo and Stockholm. It’s still bullish on Eurobonus, its loyalty plan. Consolidation should come but not until airlines start recovering. SAS is happy that Norwegian will be a shadow of its former self in terms of size, but surely concerned as well about its extreme cost cutting.

    Looking ahead, pricing and revenue management will be difficult for a while because the forecasting and optimization algorithms airlines use make heavy use of past demand patterns, which the crisis is rendering irrelevant (i.e. the systems will see near-zero demand this spring and factor that into forecasts and pricing recommendations for future flights).

    On a more encouraging note, SAS says corporate clients are eager to get flying again, and that companies already cut their travel to a minimum even before the crisis. Videoconferencing as a travel substitute, the airline said, will be marginal.
  • Norway’s government took a carrot-and-stick approach to saving Norwegian. It would help with credit guarantees, but only if the airline greatly cleaned up its balance sheet. In most cases, doing so would require aid from the bankruptcy courts. Ask Latam and others about that.

    But Norwegian managed to get the job done by getting enough creditors to voluntarily swallow big concessions. Aircraft leasing companies, for example, rather than repossess their planes in a deeply depressed market, agreed to take substantial ownership positions in the newly-restructured Norwegian. The long-struggling LCC reported a negative 24% operating margin for Q1, without providing as much detail as usual, or even holding an earnings call. It’s more importantly focused on awakening the airline from “hibernation mode,” and creating a slimmed-down and less-ambitious but more financially sustainable version of its former self. It won’t be easy.

    But understand that the reforms Norwegian was able to achieve are highly significant. It will exit the crisis a much leaner, less complex, and lower-cost airline. It expects to have lower unit costs than easyJet, in fact. Crazy ideas like flying locally in Argentina are in the distant rearview mirror. Unions granted much more flexible contracts which help with managing seasonality. Also helping with seasonality are power-by-the-hour aircraft leases, in which payments vary with hours flown.

    The new Norwegian wants to be more aggressive with ancillary revenues. It will focus its B787 flying on the largest markets of Europe and the U.S. Much like a bankrupt company, it’s only paying “absolutely vital operational invoices.” At the close of Q1, Norwegian had a fleet of 147 planes, including 18 grounded MAXs. It has another 92 MAX 8s on order, plus five more B787-9s, 63 A320 NEOs, and 30 A321 LRs. Surely, it will try to negotiate a downsizing of its order book.

Kenya Airways’ Struggles Continue

  • In Africa, Kenya Airways was already struggling long before Covid. It was forced to restructure its balance sheet in 2017, aided by a group of local banks that agreed to take a large ownership stake in the company. Last year, the government stated its intention to fully renationalize the carrier in 2020, which foreshowed an end to Air France/KLM’s ownership stake. The plan also included the establishment of an entity to jointly manage the airline and Nairobi airport.

    It’s in this context that Kenya Airways last week disclosed its financial results for all of 2019, which showed a modest negative 1% operating margin but heavy net losses. The burden was weighty enough to require more taxpayer money to keep the carrier aloft. Management in fact issued a profit warning in December, months before the current crisis. It’s now largely grounded but hoping to partly relaunch this month. Oddly, the airline increased ASK capacity 15% last year, which accounts for a full-year of B787 flying to New York JFK, a route that likely lost lots of money. It also added routes to Geneva and Rome. And it took back a Dreamliner it was sub-leasing to Oman Air.

    Kenya Airways is now run by the executive who previously ran the group’s LCC JamboJet. He’s not terribly optimistic about a speedy recover. But a shift to relying more on cargo and maintenance revenues should help.

Madhu Unnikrishnan

May 31st, 2020