Singapore Airlines (SIA) - CGS-CIMB Research 2019-11-11: Managing The Airline Portfolio Deftly

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SINGAPORE AIRLINES LTD (SGX:C6L)

Singapore Airlines (SIA) - Managing The Airline Portfolio Deftly

• At SINGAPORE AIRLINES (SIA, SGX:C6L)’s analyst briefing and post-results luncheon last week, the SIA team described how it was continuing to push forward at multiple levels.
• Product upgrades at SIA/SilkAir underpin the full-service brand, even as SilkAir/Scoot struggle with technical challenges not of their own making.
• Maintain HOLD with unchanged target price of S$10, still based on 0.9x P/BV, 1 s.d. below the mean since 2001, as economic headwinds begin to blow in.

Advances at SIA mainline push the group forward

• SIA group’s 3-year transformation plan since 2017 has had a major impact on SIA mainline, the flagship full-service carrier (FSC) in the group, with the revenue management system helping to push up its local currency yields by 3.6% y-o-y during 1HFY20, although S$ appreciation against major revenue currencies reduced the yield upside to only 1% y-o-y.
• Non-stop US flights have helped to lift premium demand on connecting short-haul sectors such as India/Indonesia to Singapore.
• Passenger load factors reached an all-time high of 85.9% for SIA mainline, as the new revenue management system prescribed a successful strategy of lowering yields in exchange for even higher traffic, with the net result of higher overall revenue per unit of capacity.
• On the product front, SIA mainline will introduce a new generation of cabin products once the 777X begins delivery in 2022F (to replace the 777-300ERs), while SilkAir will also retrofit its existing 737-800NGs (and eventually its MAX 8s) with a new short-haul product.
• See Singapore Airlines Announcements; Singapore Airlines Latest News.

Near-term challenges at SilkAir and Scoot can be overcome

• SilkAir’s 6 x 737 MAX 8 planes were grounded since Mar 2019, while Scoot now has two 787-9s grounded due to TRENT 1000 engine issues. These issues have affected aircraft productivity and increased both airlines’ unit costs. However, there is light at the end of the tunnel.
• The US/EU aviation regulators will likely permit the reactivation of commercial flights for the MAX 8s from Dec/Jan, to be followed in due course by Asian regulators. After retraining its pilots on the MCAS system, SilkAir may be able to reactivate its MAX 8 fleet sometime next year, in our view.
• Meanwhile, one of Scoot’s grounded 787-9s has just been fitted with new engines, while the other plane should be fitted in six months’ time.
• Separately, while Scoot has had teething issues after taking over several routes from SilkAir, we believe that they will be resolved in time, helping Scoot boost its yields.

New airline partnerships and New Distribution Capability (NDC)

• While SIA group’s structural costs have risen, its new A350/787 fleet has helped improve fuel efficiency by almost 30% when compared to legacy models. It is also continuing to develop deep commercial airline partnerships, with the latest being with Malaysia Airlines. Vistara continues to push ahead with its international route expansion, and took advantage of Jet Airways’ demise in several ways, while new management at Virgin Australia can hopefully help to address its ongoing losses.
• SIA group is also pushing ahead to build ancillary businesses like KrisShop and KrisFlyer. Finally, SIA is pushing to develop the NDC platform for ticket sales that promises to reduce distribution costs.

SIA mainline yields have done well

• Local fares across the SIA mainline network have improved by 3.6% y-o-y for 1HFY20, but after accounting for S$-appreciation against revenue currencies (such as the Australian dollar, euro and Chinese renminbi), SIA mainline’s yields were ‘only’ 1% higher y-o-y.
• The strong yield performance was due to the following reasons.
  • The new revenue management system that was put in place in 2017, has worked well to price fares dynamically at levels that customers would be willing to accept.
  • Strong premium travel demand has more than offset weaker economy class yields.
  • Non-stop direct US flights have helped improve the load factors of the premium cabins on short-haul flights from India-Singapore and Indonesia- Singapore, and to the extent that short-haul flights have higher yield, the overall SIA yield also rises. Furthermore, the non-stop US flights on the A350-900ULR have a higher premium content, as there are no economy class seats, only business and premium economy seats.
• SIA disclosed that since the launch of the direct Singapore-US flights, SIA’s weekly frequencies to the US have increased by 16 flights, passengers to the US have increased 35%, and SIA’s market share from Singapore to the US has risen by 21% pts.
• Also, SIA gained market share on regional flows to the US (via Singapore). For instance, SIA’s market share on flows from Southeast Asia (ex- Singapore) to the US rose by 1% pt, market share from India to the US West Coast rose 2% pts, and market share from Southwest Pacific (Australia and New Zealand) to the US East Coast rose 1% pt.
• SIA said that it was still seeing healthy premium bookings across all the major markets, especially for US long-haul, non-stop flights. The IT and professional services sectors are still doing well, even though the finance sector may be a bit muted. While the manufacturing sector and the physical movement of goods may be affected by trade wars, the services industries are still doing well and are helping to driving premium passenger traffic demand.
• SIA mainline will introduce its 777X replacement for its 777-300ERs in 2022F, with cabin-leading products, hence keeping its tight grasp on product quality and rankings among premium travellers.
• SIA mainline’s passenger load factor (PLF) hit a historic high of 85.9% in 2QFY20F, which is another significant achievement. For its economy class cabins, SIA mainline has been willing to price competitively to build load factors, as lower yields have resulted in higher overall revenues since passenger demand has increased by more than the decline in yields.
• On the other hand, there is an inverse correlation between SIA’s net promoter score (loyalty of its customers) against the PLF, hence SIA needs to balance these two objectives.

SilkAir will have to grapple with the MAX 8 grounding for a couple of months more

• SilkAir has not been doing too well lately because of the issues surrounding the grounding of its 6 x 737 MAX 8s. The SIA group saw ‘other passenger revenue’ decline in 1HFY20 due to lower charter flights revenue, mainly because SilkAir had no excess aircraft to lease out to third-party operators given that its 6 x 737 MAX 8s have been grounded.
• Also, SilkAir continues to incur maintenance costs and depreciation costs for the 737 MAX 8 planes, which are currently parked in the Australian desert in Alice Springs. The planes were flown there in October because the humid climate in Singapore made it difficult to maintain.
• The reactivation of the 737 MAX 8s will depend on regulatory approval in Asia, not just the Federal Aviation Administration (FAA) in the US. The FAA will likely allow the 737 MAX 8 to resume flying in December 2019, and the European regulators have agreed on a preliminary basis to allow reactivation in January 2020. The reactivation of SilkAir’s 737 MAX 8 fleet will likely depend on their recertification by the Civil Aviation Authority of Singapore (CAAS) and other regional aviation regulators in Asia and Australia which could take several months. In addition, it may also take a number of months to train SilkAir’s pilots to operate the Maneuvering Characteristics Augmentation System (MCAS), which is at the heart of the issue behind the two 737 MAX 8 plane crashes. In our view, it may be possible for SilkAir to reactivate its 6 x 737 MAX 8 planes sometime during 2020F if all goes well on the regulatory front.
• On a separate note, SilkAir is finalising upgrading of seats on its 737-800NG planes to the new short-haul product that was actually intended to be fitted on the currently-grounded 737 MAX 8 fleet. Apart from the 6 x 737 MAX 8 planes that had already been delivered, SilkAir also has a further 31 orders for the aircraft type. The current MAX 8 product has recliner business-class seats and no seatback In-Flight Entertainment (IFE). SilkAir had originally intended to retrofit all of its existing MAX 8 planes with lie-flat business-class seats and seatback IFE on all seats, and equip all the new MAX 8 deliveries with the same product, so as to standardise the product with SIA mainline prior to a full merger of the two brands. The MAX 8 planes would then be the cornerstone SilkAir product, with SilkAir planning to transfer 14 x 737-800NGs to Scoot (which will be retrofitted to an LCC product) and to retire the remaining 3 x 737-800NGs.
• However, the subsequent issues with the MAX 8 planes put paid to SilkAir’s original plans, such that the 14 x 737-800NGs will no longer be transferred to Scoot, but will instead be retained by SilkAir. Because the merger with SIA mainline is still on the cards, SilkAir will proceed to retrofit the 737-800NGs with the new short-haul product that was originally intended for the MAX 8s. When the MAX 8s are reinstated to full service, SilkAir will presumably retrofit those as well. The timeline for the 14 x 737-800NG product retrofit was not disclosed, but we expect these to be done on a progressive basis over the next 1-2 years.

Scoot continues to manage the TRENT 1000 engine issues

• Scoot had three major issues in the past six months or more which had impacted its profitability. The first issue has been the technical problems with the TRENT 1000 engines that are fitted on its 10 x 787-9 aircraft. The second issue lies with the teething problems faced when it started taking over several SilkAir routes. And the final issue is with slowing outbound Chinese travel demand and the heightened competition with the Chinese carriers which had deployed more capacity to Southeast Asia.
• In relation to the first issue, Scoot has had two ‘gliders’ for the past two months, i.e. 787-9s that have had their TRENT 1000 engines removed to enable a technical fix by Rolls-Royce. The shortfall in capacity caused lengthy flight delays in late-2018 when technical problems affected other planes, causing serious passenger dissatisfaction which was played up in the media and caused Singapore-origin bookings to fall. In response to these problems, Scoot decided to increase the number of spare planes and to reduce the aircraft utilisation from 13+ hours a day to 11+ hours, down 15%. This caused non-fuel unit costs to rise due to the lower ASK production and fleet inefficiency. However, Scoot saw this move as necessary to restore passenger confidence.
• The technical issues surrounding the TRENT 1000 engines are in the process of achieving a near-term resolution. One of the two ‘gliders’ has just been re-fitted with engines. The second aircraft will still need a further six months to return to service. However, as the engines age, Scoot has to do more inspections for the blades and the drums, which can be time consuming. A more permanent resolution will be available when Rolls-Royce readies newly-certified parts to be installed on the fleet of 10 x TRENT 1000 engines (Scoot has 10 x 787-9 aircraft in its fleet); however, this may not be available so quickly and Scoot will have to remain on guard for any technical issues that may arise in the future. Thankfully, Scoot’s fleet of 10 x 787-8s are not affected as they are fitted with different engines.
• In terms of the second issue, Scoot is in the process of taking over the SilkAir routes, having already taken over seven routes up to 30 September 2019, with another 10 route transfers to be completed by June 2020. However, Scoot has had some teething issues when taking over the routes. Scoot had issues building demand for all the new routes taken over from SilkAir, as Scoot’s aircraft seat capacity is larger and Scoot needed to discount fares to build demand. Scoot deployed larger-capacity narrow-bodies on these ex-SilkAir routes, with 180 all-economy class seats on the A320s, against SilkAir’s 150- seat A320s or 162-seat 737-800NGs. The larger seat capacity required Scoot to discount its prices in order to clear the seat inventory.
• Separately, Scoot also needed to remarket the flights as LCC flights instead of full-service carrier (FSC) flights, working with different sales agents as that of SilkAir’s, using different ground handlers, and other kinds of new infrastructure needs that have been established by Scoot.
• In terms of the third issue, while there has been no incremental worsening in the level of competition with Chinese carriers, the capacity that the latter has deployed to Southeast Asia remains intact, and the market still needs time to absorb the capacity. The slowdown in Chinese outbound travel due to the weaker renminbi and weaker economic growth has not helped.

Cargo markets expected to remain weak

• SIA said that the China-US and Europe-Asia cargo markets have become weaker for its cargo business in recent months. SIA retains its bearish view on the airfreight markets, saying that it does not see signs of an upturn, and excess capacity that had been in place since the airfreight boom in 2017-18 is still in place and is now placing pressure on cargo yields.

Structural non-fuel costs have risen, but fuel efficiency has increased

• The SIA group has incurred higher staff costs due to headcount increase, higher pay/allowance rates for cabin crew and pilots, higher crew allowances due to non-stop services to the US, increased flying hours, and higher provisions for bonuses due to the higher PLF.
• The SIA group has taken onto its balance sheet 26 more planes y-o-y, hence causing depreciation expense to rise, although this has been mitigated by the return of 10 planes to lessors, with a net fleet increase of 16 planes.
• SIA has raised more borrowings to finance aircraft purchases, resulting in higher interest costs. Interest and depreciation costs also rose due to IFRS 16 implementation from 1 April 2019, which saw a reallocation of operating lease charges into their respective interest and depreciation components.
• Group sales costs rose 14.8% due to higher commissions, advertising, fees, transaction costs paid to various booking engines, as building business for the future. SIA has pushed sales by incentivising agents through higher commission rates. Advertising spend has increased in relation to new routes such as Busan and Seattle.
• Meanwhile, SIA has “struggled” with suppliers in monopoly positions such as payment gateways, credit card companies, where their rates are being raised.
• The structurally-higher non-fuel costs enumerated above have been partially offset by an increase in fuel efficiency as a result of SIA group’s newest-technology planes.

Commercial airline partnerships

• SIA mainline maintains deep commercial partnerships with Virgin Australia, Air New Zealand, Lufthansa, and SAS, with the newest addition being Malaysia Airlines (MAS).
• The SIA group and MAS announced a commercial tie-up on 30 October 2019, which involves SIA mainline, SilkAir, Scoot, MAS and Firefly (MAS’s turboprop operator). The tie-up requires regulatory approvals from the competition authorities in both Malaysia and Singapore.
• The commercial tie-up involves the following:
  1. On all flights between Malaysia and Singapore, SIA group and MAS group will revenue share, coordinate their flight schedules, and offer “joint fare products”.
  2. MAS will codeshare on SIA group’s flights to Malaysia, Europe and South Africa, and other international destinations to be introduced in the future. This is likely to include SIA mainline/SilkAir’s flights to Malaysia, as well as Scoot’s flights between Singapore and seven destinations in Malaysia (Ipoh, Kota Bahru, KL, Kuantan, Kuching, Langkawi and Penang).
  3. Codesharing of SIA mainline/SilkAir/Scoot on MAS/Firefly domestic flights (SIA mainline/SilkAir already places its code on international flights between Singapore and Kuala Lumpur, Penang, Kota Kinabalu and Kuching), which will expand SIA group’s coverage of Malaysian destinations from four to 16 cities (Alor Setar, Johor Bahru, Kota Bahru, Kuala Terengganu, Kuantan, Langkawi, Bintulu, Labuan, Miri, Sandakan, Sibu, and Tawau, in addition to Kuala Lumpur, Penang, Kota Kinabalu and Kuching.
  4. SIA group and MAS group will also explore potential tie-up of their frequent flier programmes, KrisFlyer and Enrich.
  5. Joint marketing to promote tourism to Malaysia, by allowing passengers arriving in Singapore to travel to multiple cities in Malaysia on a single ‘airpass’ ticket.
• The rationale for MAS to enter into this commercial partnership is as follows:
  1. Joint schedule coordination and revenue sharing of all flights between Singapore and Malaysia will benefit MAS group and SIA group as the market is very competitive with AirAsia operating multiple daily frequencies. AirAsia X also recently deployed widebody A330s on the KL-Singapore route, increasing LCC capacity on the route. Joint schedule coordination means that te flights between Singapore and Malaysia are spaced out across the day, rather than having several flights lumped together in a narrow time corridor. This may help MAS group and SIA group to increase their load factors.
  2. MAS has a very limited network outside of the Asia-Pacific region after having cut most of its European, Middle Eastern, and African flights in 2016 or earlier. MAS has previously tied up with Emirates to provide connectivity to Europe, Middle East and Africa, but it is very likely that many Malaysians rather book directly with Emirates or other Gulf carriers, rather than book through MAS. As a result, we think that MAS is not extracting much value from its Emirates tie-up, leading MAS to explore another alternative through the SIA group.
  3. Allowing SIA group to codeshare on 12 domestic flights operated by MAS/Firefly in Malaysia is essentially asking SIA group to be the marketing agent for these domestic flights. This will help MAS because SIA group has vast global reach.
• The rationale for SIA group is as follows:
  1. Joint schedule coordination and revenue sharing of all flights between Singapore and Malaysia will benefit both airline groups, as explained above.
  2. With MAS codesharing on SIA group’s flights to Europe and South Africa, and other international destinations, MAS is effectively being SIA group’s sales agent in Malaysia. This may help SIA group fill up more seats on its flights between Singapore and Europe/South Africa. Apart from SIA mainline’s flights to Europe, Scoot also flights to Athens and Berlin.
• While the deep commercial partnership with MAS is positive, we think that the positive impact for the SIA group may be limited for the time being because:
  1. Not many Malaysians travel to South Africa, so the incremental passenger contribution to the SIA network is minimal. As for Europe, Malaysians tend to prefer flights by Gulf carriers like Emirates, Etihad or Qatar, because travelling south to the Singapore hub is a diversion before backtracking to the north.
  2. SIA group’s network in Asia-Pacific and Australia has not been included in the new codesharing arrangement, because MAS already has a good network within these geographies.
  3. Strangely, SIA mainline’s direct flights to the US are also not included in the new codesharing arrangement, at least for now. This is potentially one of the areas which SIA group will include in the future expansion of codesharing. Malaysians flying to the US have to take one-stop flights via hubs in North Asian, Middle Eastern, or Europe, so a one-stop in Singapore makes the SIA one-stop offering to the US no worse off than other options available to Malaysians.
  4. Finally, we do not think that codeshare domestic flights by MAS to the 12 new Malaysian cities will see much demand among SIA’s customers, because these are secondary or tertiary cities.
• In conclusion, we think that the new SIA-MAS commercial agreement is beneficial in terms of coordinating schedules and sharing revenues for flights for the full-service carriers between Singapore and KL/Penang/KK/Kuching. This will reduce flight overlap, spread out flights throughout the day, and increase load factors for specific flights for both airlines. This will also help the FSCs improve their fleet deployment efficiencies in an environment where LCCs are constantly keeping fares low. However, we think that the bigger beneficiary will be MAS group, because it can ride on SIA/SilkAir’s superior product.
• On the other hand, SIA/SilkAir customers may see service deterioration if they are forced to sit in an MAS/Firefly plane in that specific travel time slot. Overall, we do not expect the benefits to be significant to either MAS group or SIA group.

Updates on airline joint-ventures

• Vistara’s 1HFY20 net losses rose slightly vs. 1HFY19, as it had recruited 500 staff from Jet Airways, took over Jet Airways’ 9 x B737-800NG, increased its domestic routes network, and launched international flights. This was partially offset by higher domestic yields after the demise of Jet Airways from April 2019. Vistara currently flies to 34 destinations, including three international routes (Singapore, Bangkok and Dubai) with Colombo starting soon. Vistara will have 42 aircraft by March 2020F (vs. 22 planes in March 2019), with 2 x 787-9s, 6 x A320neos and 1 x A321neo to be delivered soon.
• Virgin Australia continues to make losses in its international business and on its Tigerair Australia business, although its domestic business is profitable (which is not surprising given that the domestic market is a duopoly with Qantas). SIA has a 20% equity stake in Virgin Australia, so it continues to account for its share of Virgin Australia’s losses. Nevertheless, Virgin Australia has a new CEO and management team, and which will need some time to tackle the underlying issues. In the meantime, SIA continues to benefit from the flow of traffic feed from the partnership with Virgin Australia, and can also offer SIA’s passengers more destinations in Australia through the code sharing arrangement.

Pushing ahead on ancillary businesses

KrisShop

• KrisShop became a 70% subsidiary of the SIA group in December 2018, and its revenue is now recognised under the “others” category.
• SIA reported that KrisShop is heading towards an annual revenue of S$60m, up 30% y-o-y. However, we believe that the profit margins are likely thin.
• KrisFlyer has evolved from being managed by third-party service providers, to being managed internally by SIA, and it has transformed from being a sales channel for the captive in-flight audience, to an “omni-channel e-commerce player” with its own website that is offering a growing product range with over 5,000 items for sale from more than 350 brands.

KrisFlyer

• The KrisFlyer membership has risen to over 4m in FY19, and it delivered 18% y-o-y growth in revenue to over S$700m in FY19, with a similar pace of growth expected for FY20F. Over 70% of this revenue was generated from over 200 partners. SIA is targeting to keep growing KrisFlyer by tying up more merchants. The KrisPay platform has also been introduced to enable KrisFlyer members to utilise their frequent flyer miles to redeem everyday items.
• In general, frequent flier programmes earn revenue by charging merchants for the points awarded to the latter’s customers. These merchants offer KrisFlyer miles to their customers in exchange for their patronage, and part of the revenue earned by the merchants is used to pay for the KrisFlyer points that are awarded to those merchants’ customers. KrisFlyer records the cash received from the merchants as unearned revenue (booked in the balance sheet as a liability), and once the points are used to redeem SIA flights or other goods/services, KrisFlyer will derecognise the unearned revenue and transfer the equivalent sum to revenue. KrisFlyer then pays the airline or the merchants for the cost of the flight or the goods/services purchased from the points, and the difference is recognised as profits.

New Distribution Capability (NDC)

• SIA spoke in more detail about its adoption of the New Distribution Capability (NDC) and how it may help to reduce its distribution costs.
• Currently, there are only 4 Global Distribution Systems (GDS) globally, and some of them are specific to markets in China and Japan. Airlines rely on GDSs to distribute their seat inventory to travel agents around the world, and GDSs control the visibility of seat inventory to potential air travellers.
• In order to gain more control over sales and to increase personalisation of the offers to passengers, SIA is pushing a new set of standards and infrastructure which IATA has developed, called NDC. SIA targets to have 20% of its business booked through NDC in the next 12 months. SIA says that it is still in the very early stages of NDC implementation, but NDC may eventually lower unit distribution costs for SIA, and drive more relevant content to passengers.
• Traditional GDS systems offer seat bookings on specific flights for travel agents, but cannot offer other ancillary services like seat selection, meal bookings, etc. On the other hand, airline websites can offer the entire suite of ancillary services. On behalf of their customers, travel agents are asking for more features, and GDSs have to respond by linking their systems to airlines’ NDC systems.
• The link is enabled by an interface called KrisConnect, which is an Application Programming Interface (API) that acts as an enabler to link SIA’s NDC to various GDS systems. In this way, the travel agents have access not just to seats but also to the ancillary services, and GDSs can enhance their offerings to the travel agents. The end result is for SIA to ultimately negotiate down the GDS booking fees.

Valuation and recommendation

• We maintain our HOLD recommendation, with an unchanged target price of S$10, still pegged to P/BV of 0.9x (1 s.d. below mean). With the cargo business remaining weak, there is a risk that premium passenger demand that has underpinned SIA’s profitability so far this year will eventually come under some pressure. See Singapore Airlines Share Price; Singapore Airlines Target Price.
• There is a historical lagged correlation between cargo demand and the demand for premium-cabin and business-related travel, which poses a downside risk.
• Upside risks include the potential for SilkAir to rethink its long-term capacity growth by renegotiating the 737 MAX 8 orders with Boeing.
• See Singapore Airlines Analyst Reports.

Raymond YAP CFA CGS-CIMB Research | https://www.cgs-cimb.com 2019-11-11

SGX Stock Analyst Report HOLD MAINTAIN HOLD 10.000 SAME 10.000