Monday 7 August 2017
What went wrong with Etihad’s equity alliance strategy?
Etihad Aviation Group (EAG), last week, declared a net loss in 2016 of $1.87 billion on total revenues of $8.4 billion – an eye-catching figure for an airline that has boasted consistently strong profits over the last five years.
There are several macro and micro issues that can be attributed to Etihad’s change in fortunes. However, with only a partial glimpse at their financials most industry observers have blamed the losses on Etihad’s stakes in several underperforming airlines, including Alitalia.
However, Ishka does not see anything fundamentally wrong in the inorganic growth strategy. In Ishka’s View, the Abu Dhabi based carrier’s problems emanate from its failure to acquire a large enough controlling stake in its partner airlines to force the required changes and restructurings in its airline investments.
Minority stakes a risky choice for weaker credits
Etihad Airways (Etihad), is the youngest among the ME3 carriers, having begun operations in 2003; later than either Emirates (1985) or Qatar Airways (1993). To catch-up with its larger, and more experienced rivals, the airline chose an audacious approach to create a global network by acquiring minority equity investments in several underperforming carriers. The expectation was that an alliance of partner airlines would feed connecting traffic to Abu Dhabi which in-turn would boost Etihad’s long-haul network. And this, according to Ishka, appears to be the strategy’s biggest limitation - concentrating on traffic feed alone.
It appears that Etihad prioritised revenue and traffic generation over cost and internal operational efficiencies of its partner airlines. While these minority investments did manage to increase the flow of traffic into Abu Dhabi, the airlines continued to suffer from weak business models and weak net profitability. Despite Etihad’s financial muscle, it appears its position as a minority shareholder was not enough to drive any meaningful influence on the operations and business models of its partner airlines. Etihad’s investment merely helped ‘prop-up’ several failing businesses.
The airlines that Etihad invested in were all weaker credits and in need of financial support. While these airlines have been given the cash they needed to survive, the financial support has not managed to completely resolve the fundamental issues that were plaguing them in the first place. This is especially true for Etihad’s major investments, namely airberlin, Alitalia, Virgin Australia and even Jet Airways. While airberlin, Alitalia (now operating under administration) and Virgin Australia still continue to bleed cash, Jet Airways managed to turn its fortunes around by benefitting immensely from the fall in oil prices and its position in the fastest growing aviation market in the world. The partner airlines failed to evolve and adapt their business models in-line with the changing market dynamics. Etihad appears to have failed to drive the necessary change in each of the airlines.
Rivals have made equity alliances work
There are several examples of successful airline groups – the Lufthansa Group and IAG own a number of major airlines across Europe, while Singapore Airlines Group operates a portfolio of airlines catering to all market segments in Asia. However, the fundamental difference lies in the business models of these groups where the parent company owns major controlling stakes in all of the group airlines. This ensures a group-wide consistent strategy that rationalises network and fleet planning, ticket pricing, product offering and even sharing of support functions where possible. Ultimately, the group airlines work towards achieving a common objective and have a leaner and more efficient organisational structure. This has not been possible in the case of Etihad’s alliances as it does not have the controlling influence over its partner airlines.
Etihad has clearly made an effort to manage its airline partners. The carrier unveiled a new group organisational structure in the first half of 2016 under which a separate and dedicated team was instituted for managing its airline partnerships. The department even has its own CEO to drive identification and realisation of synergy benefits across the airline’s strategic partners. While it is still early days for the new structure there are no real signs of any meaningful change yet. The new structure established recently appears to be a reactive measure. Alitalia is under administration, with Etihad having pulled out of the Italian carrier, while the airberlin’s deteriorating situation has continued to necessitate fresh cash infusions. Although Etihad has stated that it would extend another financial lifeline to airberlin and as per news reports, it is also in the race to fully acquire Alitalia, it remains unclear whether Etihad’s new management (Ray Gammell was appointed the interim Group CEO following James Hogan’s decision to step down) and strategy review would maintain status quo or not.
Etihad’s alternatives
Etihad was likely hampered by regulatory constraints when it tried to pursue controlling stakes in its investment airlines. As an overseas airline, domestic ownership rules would probably have restricted Etihad’s, ability to acquire more than 50% in a partner airline. However, Etihad could have relied on a non-airline firm/investment arm of the Emirate of Abu Dhabi, which may have qualified local investment conditions to acquire the stakes. This is the basis of Qatar Airways’ plan to establish a wholly-owned airline in India with the help of investment arm of the Qatari state.
As mentioned earlier, Etihad is also one of the bidders in Alitalia’s auction process. While details are limited, this bid is likely to be for acquiring the Italian flag carrier in total as the government is seeking bids for the whole company. This demonstrates that Etihad, not only sees an outright total acquisition possible, but also the achievable merits of that strategy.
Alternatively, Etihad could have also partnered with local investors/affiliates with a common vision to overhaul and restructure existing business model and adapt the operations, not only, in-line with a common group-wide cohesive strategy, but also, the prevalent market conditions.
Ishka does not say that a majority position would have guaranteed a successful turnover because that ultimately depends on the adopted strategy. But, from a purely strategic point of view, an investor, particularly in a struggling business, would usually seek to resolve existing issues and overhaul the operations in-order to make the acquired business sustainable and eventually profitable. It can be difficult, or even impossible, for a minority stakeholder to drive a revamp process.
Non-recurring items
As mentioned earlier, EAG posted a net loss of $1.9 billion on total revenues of $8.4 billion. Almost all of the group’s losses were due to non-recurring impairment charges relating to aircraft and some of its equity investments. The airline group recorded impairment charges totalling $1.87 billion in 2016, with $1.06 billion attributable to aircraft while the remaining $808 million to certain assets and financial exposures to equity partners, mainly related to Alitalia and airberlin. Etihad also highlights that some of its legacy fuel hedging contracts had a negative bearing on its 2016 results. Since the airline does not release detailed financial statements it is difficult to gauge the operational efficiency of the business. However, Etihad does highlight that its yields were under tremendous pressure during the year which is consistent with the challenges faced by most airlines globally.
The important aspect to consider is whether the losses will be a recurring feature and what the airline is doing to counter the challenging conditions. The interim group chief executive Ray Gammell has already warned it would also not produce strong 2017 financial results.
Nevertheless, the ownership appears to realise the gravity of the situation and has initiated a savings programmes, ‘Right Size & Shape’. As per the company, the programme had already contributed to ‘total overhead savings’ of 4% during 2016. As part of the evaluation, Etihad has also declared that it will fully review its airline equity partnership strategy. The sudden departure of James Hogan, Etihad’s chief executive, and the CFO, James Rigney, does indicate a growing discomfort among Etihad’s owners over the acquisition strategy it had embarked upon. Until his departure, Hogan had presided over the carrier’s strategy for over 10 years and the equity alliance is one of his key legacies. Even so, the airline has also stated that it won’t completely scale back on its alliance strategy.
The Ishka View
Etihad’s return to red is on account of several factors rather than its equity investment strategy alone but the carrier’s equity alliance appears to have been a costly investment. Some consider that Etihad simply choose badly as an investor and picked airline that were destined to perform badly. The Ishka View is that the Abu Dhabi based carrier’s setback emanates not from its decision to invest in other airlines but from its failure to not acquire enough control in these airlines.
A majority position would not have guaranteed a successful turnover - ultimately that depends on the adopted strategy. However, from a purely strategic point of view, by taking only minority positions, it appears Etihad failed to exert enough influence in these airlines to ensure any meaningful change in their operations. For Etihad’s strategy to be successful it has to either ensure minority investments in more robust and healthy carriers or controlling stakes in weaker carriers in which it would have the influence to drive change.
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