INSIGHT: New fortunes, same old pitfalls for Russian airlines

Transaero’s demise turned out to be one of the reasons why Russian air carriers ended 2016 with profit (Photo by Leonid Faerberg // transport-photo.com)

Russian airlines collectively flew into profitability last year – for the first time since 2010 – a considerable surprise given the country’s concurrent economic woes. But a sudden 12.5% increase in seat capacity has since obliterated the positive benefits of Transaero’s disappearance from the market and, from the last quarter of 2016, the industry has been dragged back into a dogfight of tough price competition. Typically, Rossiya and VIM-avia have introduced new services (the latter more than doubling its capacity last year) and Aeroflot’s domination has become so potent that rival companies have been forced to pursue alternative niches to avoid direct competition with the national carrier. For example, S7 Airlines is to receive regional Embraer E170s in 2017 and is returning to Novosibirsk with a new regional hub concept.

Although financial results for Q4 2016 have not yet been officially released (and most likely they will not be positive), the industry statistics for the first nine months indicate that Russia’s airlines had gained accumulated profit. Several carriers have managed to secure net profits in the 2011-2015 period, but those were rather exceptions to the overall negative balance at that period.

Much of the unexpected upturn amid the financial and economic crisis was driven by three main factors: the collapse of Transaero, the frantic dumping by some air carriers of their excess fleet in 2014-2015, and the introduction of a 10% VAT rate for domestic flights. Calculations made by Russian Aviation Insider show that airline capacities in 2015 shrunk by as much as 19%, causing a significant shift in the balance of supply and demand. Despite the fall of GDP and real household earnings in the first half of 2016, the revenue per available seat-kilometers on domestic flights grew by almost 23%. Then, in 2016, Russian airlines recklessly replenished their capacity levels by an amount more relevant to more prosperous times, thereby guaranteeing themselves substantial future losses ( See Chart 1).

Chart 1. Capacity increase/decrease and net surplus of Russian airlines in 2011-2016

Serious Russian airline players are so few that you can count them on the fingers of one hand – with not all fingers required. The industry consists mainly of a single major public company with its numerous subsidiaries; some transport departments of major corporations; a few minor players that piggyback on regional budgets; and a procession of repeatedly emerging ‘soap-bubble’ operators sponsored by various sources and which rarely achieve significant market status. Generally, these ‘zoos’ have little understanding of rational business behavior theory, and their widespread use of synthetic economic tools (such as compensation payments from foreign carriers, ‘non-repayable’ loans from public banks, budget subsidies, etc.) make the life of the few true market players even harder, often plunging them into an unequal and unfair competitive environment.

Unlike the mature western market economies, in Russia it is not strict capacity discipline that secures profits for airlines, but rather a lucky coincidence. When the euphoria is gone, the industry keeps stepping on the same old rake with the same result being insane market share races, excess supply, fare dumping, losses – and a number of notorious bankruptcies.   

It seems almost impossible for companies operating under such quasi market conditions to build a ‘nest egg’ foundation that will later help smooth out either cyclic or acyclic economic spikes. And, as a rule, those few big airlines which previously had been pursuing aggressive expansion, cross the Great Divide as soon as a new crisis breaks out. The subsequent reduction of capacity shifts the market balance point so that, despite sagging demand, the survivors manage to retain or even increase their PRK yields. In 2008-2009 the bankrupted leaders were AIR Union alliance, Dalavia and KD-avia (13% of the market RPKs combined). In 2015, Transaero, which controlled 20% of the market, stopped operations.

Compared to 2010, when the industry suddenly benefited from a skyrocketing demand for air transportation services (+30% in the first half of that year), the profit in 2016 was stimulated by a decrease in supply, which occurred much earlier than the crisis-driven decline in demand, as well as other contributing negative factors like bans on flights to popular leisure destinations, Turkey and Egypt. The value compass of many top managers of Russian airlines appears to be dominated by quantitative factors (such as market share, or passenger numbers) rather than qualitative criteria (profitability, for example), so the industry merely then slides into another bout of adding extra capacity. In 2011-2014, the growth in demand for air transport services exceeded the GDP index 5-6 times which could have had only one explanation given there was no large-scale export of the services at all. Unfortunately, the worst expectations proved true when Transaero’s financial reports were ‘revised’ in 2015 and UTair’s IFRS statements were finally published.

It is almost certain that the year 2016 will go down in modern history as one of the few rare moments when the airline industry managed to accumulate profit. The striking 12.5% increase in capacities, unjustified either by GDP forecasts, or the lifted ban on charter flights to Turkey, or even anticipated restoration of air connections with Egypt, has left no chance of continued financial success in 2017 though. As a reminder, most of this year’s GDP consensus forecasts vary between zero and one per cent. More to that, the growth of both corporate and real market-driven demand for air transport services, which is much dependent on macroeconomic performances, is also expected to be within a one to three per cent range.

Those were exactly the influencers which rekindled price competition against an obvious supply-demand imbalance in the midst of the low season and a slight ruble appreciation that triggered the ramp up of passenger traffic at the end of 2016 (RPKs grew by 20.7% in November and December). The current data coming from online travel agency and meta search engines confirms the average purchase price is going down versus the same period in 2015. Precise figures reflecting a change in RPK yields will be available as soon as airlines reveal their quarterly reports.

Among the current aviation overachievers are Rossiya and VIM-avia, which together provided almost half of the net capacity surplus in 2016 ( See Chart 2). In particular, the former increased its capacity by 54% (not including the transferred fleet of Orenair and Donavia carriers), whereas the latter demonstrated a stunning 135% improvement. The two controlled only 11% of the total market (RPK).

Chart 2. Net capacity surplus and RPKs in 2016 for various Russian airlines

It seems as if a new Russian air transport soap-bubble could be inflated by these companies actions whereas, by contrast, S7 Airlines and Ural Airlines are more than moderate in their ambitions, by keeping their capacity growth rates lower than the actual market.

Rossiya’s story is very well known and much of the airline’s behavior can be traced back to Aeroflot’s absolutely self-denying support of three Russian lessors, which in their turn are affiliated with the country’s major public banks and have dozens of Transaero aircraft stuck on their balance sheets. Things are more mysterious with VIM-avia and, thus far, it remains unclear what that company’s owners are planning. It is hard to think of any plausible explanation for the decision to promptly introduce nine two-aisle, widebodied aircraft which were then inexplicably not reconfigured to reflect market conditions and instead retained a 10-12% business-class seat layout inherited from the previous operators. We cherish no illusions concerning VIM-avia’s position in the premium segment but perfectly understand that such a seat configuration guarantees huge losses compared with the policy followed by UTair when it launched Boeing 767-200 operations with each aircraft reconfigured to a 245-seat single-class layout.

As for Aeroflot, it consistently strengthens its hand each and every time the market spits out another unwise and unviable player. In 2016, the national flag-carrier (combined with its subsidiaries) dominated the market with a 52% share in RPKs (See Chart 3).

Chart 3. Market shares (RPKs) of Russian major airlines in 2014 and 2016

Taking into account Rossiya’s strategy of outpacing market capacity growth, the share of the Aeroflot Group will reach 55-57% this year. In a highly fragmented competitive environment, this will mean increased market power, an advantage which will not be challenged unless a measure of common sense or government interventions prevail.

But it appears unlikely that in the foreseeable future the government (Aeroflot’s major shareholder and at the same time the nation’s anti-monopoly authority) will come up with a meaningful decision to either de-merge the group or dispose of its sister airline Rossiya. It is not surprising then that, seeing no point in competing directly with the Aeroflot Group in the Moscow air cluster, several players have started to look for alternative market niches. For example, S7 Airlines is about to receive 17 Embraer E170 regional jets and is this month re-commissioning a hub at Novosibirsk in an effort to attract transfer flows, including those between China and Russia’s Far East and also between the Tyumen region and St Petersburg. Some of Russia’s regional markets promise a higher than average revenue rate so, considering the ongoing economic recession and predictions that the Moscow air cluster will soon be hit with overcapacity, the idea of relocating the hotbed of business growth to Novosibirsk seems a smart move. The fact that Tolmachevo Airport might not be ready to provide quick and easy handling of the rapidly growing transfer traffic may seriously hinder the process.

As for Ural Airlines, in 2016 the company opened up a new but very promising transfer niche between China and Europe. As of today, the number of transfer passengers flying to and from China via Koltsovo Airport is below 10,000 per month, but further development is hampered as the lengthy legs allow for no more than two streams per day – the morning service from China to Europe and the evening return in the other direction. Due to its relatively small size, the company is not yet able to offer several daily transfer flows; and complex aircraft turn-around patterns (like Ekaterinburg (SVX) – Bejing (PEK) – Bangkok (BKK) flights) do not allow the carrier to scale this Chinese business. At the same time, Ural Airlines is discovering the potential of Zhukovsky Airport which, significantly, is located outside the Russian capital and is thus not subject to current agreements that impose restrictions on the number of carriers and frequencies within the Moscow air cluster. For now, this airport lacks an efficient transport connection with the capital city, so offering undiscounted tickets would be a useless undertaking. International passengers are less demanding in terms of overall travelling time while the demand for international flights from Moscow can be considered as literally unlimited. There will be no surprise if, in a few years, Ural Airlines becomes Zhukovsky’s core operator instead of some low-cost, low-status company. This may not protect the airline from competition with Aeroflot, but will at least allow it to increase its earning power due to limited competition on international routes.

As competition becomes more dissipated within various market segments, the future of UTair, currently Russia’s number four airline in terms of serviced passengers, and number six in terms of passenger turnover, remains unclear. It is hard to discover either a coherent business development strategy or its competitive advantages (except for perhaps its shareholders). So, it is quite probable that following a stiffer price competition and inherent increased losses the owners of the airline may neither be interested in fleet renewal nor in keeping the company operational. Yet, UTair is definitely not the next player to leave the stage.