Huge Domestic Market Buoys Aeroflot

Madhu Unnikrishnan

December 6th, 2020

  • Russia’s airline industry was never known for its dynamism. But lo and behold, it’s become the fastest market to recover from the Covid crisis, with domestic passenger counts rising 6% y/y in August. Not even China’s domestic market has recovered as much. The word “recovery” though, comes with caveats. Airfares are not what they were a year ago. And the buoyancy of domestic demand is heavily linked to the closure of international markets — a substitution effect, in other words.

    Still, a busy domestic market is more than most airlines could hope for at the moment, and Aeroflot’s Q3 figures were correspondingly better than most. Its operating margin was just negative 13%, or negative 17% stripping out revenue from the fees foreign carriers pay to fly through Russian airspace. Total revenues declined 60% y/y while operating costs dropped 42%. That was on 53% fewer ASKs. Note that unlike other intercontinental airlines with relatively mild losses last quarter, Aeroflot’s “success” was not attributable to cargo. Indeed, cargo accounted for just 6% of total revenues, up from 3% normally.

    More important was robust demand for Black Sea, Baltic Sea, Arctic Sea, and Caucus mountain resort spots. It mentioned Sochi, Makhachkala, Kaliningrad, Murmansk, and the Kola Peninsula. Other routes held strong just because of Russia’s enormous distances, making air travel the only means of transport between many cities. There wasn’t much business internationally, but Turkey for one was a “star market” this summer.

    Then there’s the emerging superstardom of Aeroflot’s low-cost carrier Pobeda. Capitalizing on the bullish domestic demand, it grew its ASK capacity 6% y/y last quarter, with domestic ASKs alone up 39%. Revenues were down to be sure, by 18% (blame that on the closure of higher-fare international routes). But no matter, because Pobeda still managed to make money last quarter, and with a stunning operating margin of positive 34%. No wonder why Aeroflot has grand ambitions for Pobeda, believing it can capture 30% of the entire Russian domestic market by 2028. It’s currently taking all of the group’s B737-800s and will eventually get B737-MAXs.

    Rossiya, on the other hand, a subsidiary based in St. Petersburg, will do a lot of the group’s dirty work, so to speak. That means flying its Russian-built planes, acquired for political reasons, and handling social obligation routes in underserved regions. The main Aeroflot-branded airline itself meanwhile, will attempt to revive growth in sixth-freedom traffic through Moscow once international markets reopen. It’s getting A350s for intercontinental routes. To Europe, its focus will be on routes with a lot of business-class demand like London, Zurich, and Geneva, as well as distant routes like Madrid and Lisbon that might be out of range for Pobeda.

    Normally, Aeroflot is a highly seasonal airline that does best in the summer. That’s still the case, with autumn demand weakening and winter looking bad. Though Russia was early to roll out a Covid vaccine, distribution has been slow, and the virus is still spreading at a dangerous clip. That’s causing some regional government to impose local travel restrictions. And in response, Aeroflot is now cutting winter capacity. It also, by the way, warns of tougher domestic competition as rivals likewise reposition planes from the international market. Financially, it’s getting by with government guaranteed loans and the proceeds from selling shares. Revenues from its loyalty plan have been pretty resilient.

    To navigate the remainder of the crisis, and to lead Aeroflot out of it, will be a new CEO named last month: Mikhail Poluboyarinov.
  • Having sizable domestic markets — and lacking heavy longhaul exposure — helped SAS limit its losses this summer. As summer turned to fall, however, and as Covid began re-closing markets throughout Europe, the airline’s options were limited. For its odd quarter that covered August, September, and October, SAS posted a negative 83% operating margin, on a 73% y/y reduction in ASK capacity. Revenues declined 77%. And operating costs? Just 54%. As management mentioned, removing fixed costs can’t happen overnight.

    When SAS suddenly had to curtail capacity as demand reacted adversely to new travel restrictions, it still had obligations to customers with booked flights — either fly them, which costs money, or refund them. Worker furloughs too, don’t create immediate cost savings. “For us,” said CEO Rickard Gustafson, “it takes us a couple of weeks to really scale down because we need to honor those passengers that we have sold tickets to, we have rosters out for our crew, and also the furlough schemes — you apply for them in advance…   You can’t get rid of the cost that quickly.”

    This delayed reaction caused the airline to have more capacity in the fourth quarter than it needed. To meet longterm savings goals, SAS is cutting thousands of jobs and renegotiating contracts with unions. One pre-crisis demand on unions was permission to create a separate subsidiary, with inferior contract terms, to operate a new fleet of small narrowbodies. That project is on hold for now. But replacing B737-700s and A319s with A220s perhaps, remains an objective.

    As the largest airline in the Nordic region, SAS is surely delighted to see its rival Norwegian on the ropes (see Covid crisis section below). Already during the crisis, SAS is seeing a rise in its regional market share. A new Norwegian carrier, however, with links to the old Braathen group, is well along the path to launching. At the same time, Wizz Air is taking a greater interest in the region, offering domestic routes in Norway. Ryanair and easyJet, fortunately for SAS, have yet to show much interest in Scandinavia. But they might. A more general concern is that competitors will likely charge rock bottom fares just to raise cash.

    The region, meanwhile — Sweden especially — is experiencing a bad Covid outbreak this fall. When its fiscal Q4 began in August, 41% of SAS’s revenue was exposed to markets where travel was either not allowed or allowed only with a two-week quarantine. By the end of the quarter, the figure was 65%. Even Norway now is recommending citizens against traveling domestically. No surprise then, that SAS is expecting a tough winter. With a government-backed recapitalization effort now complete, bankruptcy isn’t a near-term risk anymore. But the company is nevertheless seeking to raise more cash still, in part via the aircraft sale-leaseback market.
  • Latam, required to file monthly financial statements while in bankruptcy, showed a $153m net loss and a negative 39% operating margin for October. South America, remember, is entering its peak summer season. And countries, to varying degrees, have relaxed restrictions on travel and flying. A recent IATA presentation showed that Chile, Argentina, Uruguay, Suriname, and Venezuela were still closed to foreigners in October. On the other end of the scale were Mexico and Brazil, both completely open. Others like Colombia, Peru, and Ecuador were open but only for travelers presenting a negative Covid test.

    If South America can avoid a new wave of Covid cases when fall and winter arrive around the second quarter of next year, Latam could be on track to exit bankruptcy in late 2021. It hopes to emerge with a cost structure competitive with LCCs. A north-south joint venture with Delta remains a top strategic priority.

Madhu Unnikrishnan

December 6th, 2020