Against heavy odds Aeroflot is heading for a profit in 2016

Following a challenging 2014 which saw losses of RUB 17.1 billion ($267 million), Aeroflot has managed to stem the tide in 2015 and is on track to make a profit in 2016.

Aeroflot continues to benefit where its competitors fail.  Despite tough economic conditions in Russia, the carrier increased its market share last year by 5.6%, mostly by acquiring its failed competitor Transaero. 

Unwinding fuel hedge positions will bring Aeroflot back into profit

Losses in 2015 were reduced to RUB 6.5 billion ($101 million).  Revenues increased 23%, however fuel hedging losses of RUB 23.7 billion ($369 million) – up 97% on 2014 – pushed the carrier back into the red.

Aeroflot has also been saddled with RUB 1.5 billion ($23.6 million) in obligations relating to its now bankrupt competitor, Transaero.  Under government tutelage, Aeroflot bought Transero for one rouble and acquired most of its assets and obligations.

As the airlines hedging positions are allowed to unwind, Aeroflot’s CEO, Vitaly Savelyev, is confident that the carrier will match last year’s operating profit of RUB 44 billion ($685 million).

However, yields remain under pressure. In dollar terms, they fell 25% in 2015, reflecting the steep fall in the value of the rouble. Liquidity also remains tight. Cash as a percentage of total revenues fell by 0.9%, although this is most likely a short-term pressure due to Transaero obligations.

A further weakness is that only 35.8% of revenue in 2015 was in the form of hard currency. By contrast, 50% of its operating costs are in dollars and euros.  Fortunately, Aeroflot’s acquisition of 56 international routes from Transero will help to reduce this currency mismatch.

Aeroflot makes gains where others fall  

The Russian aviation market is remarkably buoyant despite turbulent economic conditions. The rouble depreciated by 60% against the dollar in 2015, while GDP contracted by 3.7% and traffic fell by 4.1%.  Yet Aeroflot increased its revenue and market share by 5.6%.  It seems that, aside from failing to exploit a drop in oil prices, Aeroflot is capitalising on the exogenous shocks that are disrupting its competitors.

While other Russian airlines collectively reduced capacity by 27.5 billion available seat kilometres in 2015, Aeroflot’s ASK jumped by 8.9 billion, or 7.2%, mostly as a result of acquiring routes from Transaero. Furthermore, as Western carriers such as easyJet, Lufthansa, Finnair, Delta, and Scandinavian Airlines stopped serving Russian routes in 2016, the opportunities appeared for Aeroflot to fill the gap.  

In 2015, 40% of Aeroflot’s growth came from international markets and 60% from domestic demand.  Strong international growth helps to lower foreign exchange exposure, while strong domestic demand is remarkable, given that real wages fell by 9.5% in Russia last year.

Fleet expansion offers opportunities for lessors and investors

Aeroflot is looking considerably more bankable than it was a year ago.  In March 2016, Fitch removed its negative outlook warning for Aeroflot, and the carrier is now positioned to expand its fleet over the next few years.  Of the 258 aircraft in the Group’s current fleet, 201 are on operating lease and 57 are on finance lease.

The airline, together with its subsidiaries  Rossiya, Aurora, Orenair, Podeba and Donavia, is expecting a net increase of 38 aircraft to its fleet by the end of 2016.  While 24 aircraft will be phased out, there are 62 scheduled deliveries for this year.

Aeroflot also intends to acquire 34 of Transaero’s fleet, including 10 B737s and six A321s from their order-book. Other aircraft that were already in operation with Transaero will join Aeroflot’s subsidiary, Rossiya. Consequently, Aeroflot and the Aeroflot Group airlines no longer needs all of the aircraft it has on order. The group is reviewing an order for 22 A350s from Airbus, and has reached terms with Boeing for an equal number of B787s.

Aeroflot’s delivery schedule

Regardless, Aeroflot still has 80 new aircraft due for delivery in the next three years and its financing demands are likely to remain high, bearing in mind its whole fleet at the end of 2015 was either on operating or finance lease.

Government intervention is actually lighter than often assumed

Aeroflot is 51.2% state owned and can sometimes come under pressure to make decisions based on government policy, rather than commercial logic.

In 2015, Aeroflot’s board was strongly encouraged to take over its ailing, and heavily indebted competitor Transaero, but successfully resisted taking on its debts after the carrier folded.  While the government would certainly like the airline to fly more Russian-made aircraft, its fleet of mostly Boeing and Airbus types have made the carrier efficient and competitive.

Moreover, Aeroflot receives no formal guarantees from the government, or cross default provisions. Fitch, the rating agency, takes the view that the credit position of the company would actually improve if the state was more forthcoming with cash and financial support. However, this is unlikely to happen while the Russian economy continues to be impacted by sanctions, low commodity prices and a devalued rouble.

Instead, the government has touted Aeroflot as a possible candidate for its privatisation programme. The Kremlin is looking to raise RUB 1 trillion ($12.8 billion) through such sales. On current trends, the carrier may have a promising future as a privatised company.

Arkady Rotenberg, a billionaire friend of President Putin, is said to be interested in acquiring a 25% stake in the business.  But Aeroflot’s CEO, Savelyev has cautioned against a sale, arguing the fall in the rouble has left the carrier’s share price undervalued. Regardless, the government is under increasing pressure to reduce its budget deficit, currently running at 4.3%, so Aeroflot could make it onto the government’s privatisation shortlist for 2017.

Scenarios

What if consolidation in the Russian airline industry continues?

Following the collapse of Transaero, Aeroflot is closing in on a monopoly position in the domestic Russian market, with 36.7% of sales. As this number is set to rise along with the fleet expansion, Aeroflot may soon be a position where it could dictate matters and push prices up which could also affect demand.

In July 2016, the Armenian authorities complained that Aeroflot had doubled ticket prices after a mud slide blocked the land crossing into Russia on the Georgian border.

As recently as 2011, 150 companies held air operating certificates in Russia. If the process of consolidation continues, then within five years there may only be two or three full-service carriers and a handful of discount operators left, several of which are Aeroflot subsidiaries themselves.

Moreover, while Aeroflot’s multi-brand approach provides the airline with diversified income streams, one of its subsidiaries, Pobeda, is now Russia’s only LCC and the world’s fastest growing airline.  Aware of the criticism, Savelyev says that Pobeda is not expanding as quickly as it could and says fears of a monopoly are “greatly over exaggerated.”

The Ishka View

Aeroflot’s performance during Russia’s recession and currency devaluation has been impressive and it is very likely that the carrier will return to profit this year. It has successfully exploited the weaknesses of competitors in a volatile business environment. Aeroflot’s fleet expansion plans have been complicated to some extent by the acquisition of Transaero’s fleet and order book, but the airlines’ growth still offers prime opportunities for lessors and investors.

Although the airline is majority state owned, this has not been a major obstacle to strong commercial performance. In time Aeroflot is expected to be a convincing candidate for privatisation. However, Aeroflot’s dominant and expanding position in the Russian market may assume the characteristics of a monopoly if it is allowed to go unchecked by the government.

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