Thursday 23 June 2016
Can LOT Polish Airlines afford to overhaul its fleet?
The Polish carrier’s newly appointed CEO, Rafal Milczarski, recently told Reuters that he is considering overhauling the carrier’s narrowbody fleet, starting as early as Q1 2017. While LOT now operates the state of the art Boeing 787-8s on its long-haul routes, it is struggling to compete on the short-haul routes with its fleet of 20-year old Boeing 737-400s and smaller capacity Embraer jets. Ishka sees a short-haul fleet overhaul as a step in the right direction but the question is whether LOT can afford a substantial fleet expansion just three years after the carrier was on the verge of bankruptcy.
Challenges with the current fleet composition
Currently, in terms of narrowbody fleet, LOT has 3 737-400s with an average age of nearly 20 years and the rest is comprised of Embraer 170/175/195s and Bombardier Q400s.
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Since the start of the financial crisis of 2008, LOT has returned around 15 737s, 9 E145s, 4 E170s and 12 of its widebody fleet consisting of primarily of 767s.
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As replacements, the airline started inducting, and also retained, more of the E175s and E195s. Most of the returned aircraft were ageing and considering that passenger traffic growth had stalled in Europe as a result of the financial and debt crises, it seemed like a good strategy back then to rationalize capacity and operate short-haul routes with a family of smaller capacity aircraft.
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However, after 2009, Poland continued to witness relatively strong growth in passenger numbers between 2010 to 2015. As LOT trimmed capacity and started operating with lower capacity aircraft, it began losing market share against Ryanair, Wizz and even Enter Air, a local Polish airline, who operate with higher density aircraft such as 737-800s, A320s and A321s. The Ishka view is that this created a vicious circle for LOT – not only does it lose traffic because of its older and smaller capacity regional fleet, but its unit costs are also higher than its competitors’ as the larger capacity aircraft help to keep unit costs down. This invariably means that LOT has to charge higher airfares in-order to cover its costs, further alienating flyers towards the low cost rivals. In addition, as a pre-requisite to obtaining a $130 million capital increase from the Polish Government, the European Council required LOT to give up a number of intra-European routes, which meant LOT was restricted in efficiently utilizing its existing capacity. However, now that the restrictions have ended, there is a strong case for introducing more high density aircraft if LOT is to regain market share.
Weak financial situation?
LOT has been undergoing restructuring since 2013. As a part of the restructuring program, it reduced its workforce, returned several aircraft and rationalized its network as well its business model. The restructuring seems to have had some positive effect as the airline returned to the black in 2014. LOT does not disclose any detailed financials, however, it did announce in April 2015 that it had made a profit of $26 million in 2014 on its core operations. EBITDA also seems to have improved considerably – from a negative $91 million in 2012 to a positive $41 million in 2013, improving further to $77 million in 2014. While this is a positive development, there are still concerns on the sustainability of these profits - the airline hasn’t made public any of its latest financial figures and therefore it is difficult to judge whether the fundamentals have improved in 2015 and 2016. Judging by the airline’s hesitation in disclosing even summary numbers for 2015, in a year when the airline industry has seen record profitability, Ishka suspects that it is highly unlikely that the airline performed well financially.
LOT’s change of CEO
When LOT began its restructuring, the plan was to privatize the airline in due course. The previous CEO, Sebastian Mikosz who was overseeing the restructuring was keen on privatizing the airline in 2015, however, the then government deferred the process due to upcoming parliamentary elections in the country. It was reported that LOT was in talks with Indigo Partners, a US based private equity firm, however those talks ultimately foundered. This lead to Mikosz resigning from the airline in August 2015. At the time of his departure he had reportedly said that, “Without a private investor who will finance the expansion in the medium-term perspective, the company may disappear”. This corroborates our concern that fundamentally LOT may not be able to self-finance any kind of major fleet overhaul and that financiers also may be wary of extending support.
Leasing used aircraft could work
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LOT’s plans of doubling or tripling its fleet is too ambitious at the moment; and obtaining sufficient financing to overhaul the fleet would most certainly be a challenge in the current environment. This leaves the airline with exploring the option of leasing older (possibly 7-8-years old) used aircraft. Lessors already have spare capacity at the moment and could be interested in leasing out to LOT. However, leasing has a cost and considering LOT’s financial situation it is not known whether LOT is in a position to afford the higher lease expenses.
What if banks and lessors are hesitant to finance the fleet expansion?
If the banks and lessors are cautious and do not support LOT’s growth strategy, then we could see the airline sliding into further difficulties. As things stand, LOT has already been pushed down to being the third or fourth largest carrier in its home market. There is tremendous potential in the Eastern European market compared to the rest of Europe and to take advantage of this growth, LOT needs to invest in its fleet. On a more positive note, it is also possible that the government might be forced to quickly find a strategic investor and privatize the airline. Transferring the airline to private hands might actually augur well for the airline in terms of survival and growth.
Ishka View
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