Growing competition is expected to keep earnings under pressure



July 05 - 11, 2004





Expensive valuations, dilution of earnings, subdued revenue growth and a volatile bottom line are some of the threats being faced by the shareholders of Pakistan International Airlines (PIA). The share is being traded at above 30% premium to its fair value. Fresh equity injection by the Government of Pakistan (GoP) is expected to further dilute the earnings per share. After 2003 earnings are expected to be diluted by 43%.

According to a report by Elixir Securities Pakistan, the GoP's holding of PIA is likely to increase to 89% from the current 87%. Revenue is expected to grow by 3.2%. A dent in passenger traffic and diversion to foreign airlines is likely to impact negatively on PIA's revenues, hurting bottom line growth. Profits are expected to fall by 18%. Profits will be volatile owing to (1) rise in fuel prices, (2) increase in depreciation charges, (3) decline of 6% in financial charges coverage over the next 6 years, and (4) deferred tax impact.

The main reason for the deterioration in PIA's value is earnings dilution caused by equity injection. This equity injection is due to the balance sheet restructuring and fleet up gradation plan. According to Elixir report, equity injections after 2003 shall dilute earnings by 43%. Moreover, the increase in the GoP's holding counters the rationale behind the recent secondary offer of the stock, to increase the general public's holding. As a result of debt-equity swap, the GoP's holding of PIA is likely to increase to 89% from the current 87%.

PIA's Business Plan (2003-2011) mainly focused on improving the balance sheet by taking two measures. The first is raising government guarantees up to Rs 20 billion to cover the restructuring of Rs 4.86 billion debt and future debts undertaken to pay off overdue creditors of approximately Rs 15 billion. The second is by paying off the mark-up on the TFC issue and the syndicated loan in return for equity to be issued to the GoP at the face value of Rs 10 per share. The total mark-up to be reimbursed to PIA is Rs 7.88 billion, 68% of which remains to be paid. In the post 2001 period the company's balance sheet has improved with leverage declining by 19bps to stand at 80% of the total assets as at December 31, 2003. Improvement in the bottom line has also brought about an improvement in the interest coverage ratio. Going forward, it is believed that the interest coverage ratio will increase in 2005 and 2007 on the back of falling financial charges. Thereafter, the coverage will fall in 2009 owing to a fall in net profits as a result of heavy depreciation charges.



Over the next 6 years PIA is expected to witness marginal growth of about 3.2% in its revenue stream. It is believed that a dent in passenger traffic and diversion to other airlines is likely to impact negatively on PIA's revenues, hurting bottom line growth. The revenue growth is likely to remain subdued because of (1) foreign airlines making a dent in PIA's revenues, (2) resumption of flights to India and other South Asian destinations may not result in the expected revenue growth; and (3) a lack of diversification of revenue lines.


The competition from foreign airlines emerges to be a serious threat for PIA's earnings, due to the high vulnerability of its revenue stream to the passenger traffic. Foreign airlines, which had stopped their operations in Pakistan after 9/11 owing to terrorism concerns, are expected to renew operations. British Airways and Sri Lankan Airlines resumed their operations last year. KLM, Alitalia, Air France, Lufthansa and Singapore Airlines are also considering resumption of their operations in Pakistan. In addition to the above, airlines based in the Middle East are expanding their operations and are offering connecting flights to destinations in the UK, Europe and US. Among others Qatar Airways, Emirates and Gulf Air have been aggressive in their marketing campaigns and are reported to offer better services than PIA. Reportedly, PIA has posted losses amounting to Rs 16.5 billion (34% of 2003 revenues), since the airlines were given the sixth freedom right (the permission to carry passengers between two foreign countries with a stopover in the airline's home country).

The Open Sky Policy 1993 and The National Aviation Policy 1998 have dented PIA's revenues over the past 10 years. The National Aviation Policy opened the Northern Gateways for foreign airlines allowing them to operate from Lahore, Islamabad and Peshawar apart from Karachi. According to some reports, the provision of the sixth freedom right to these airlines has resulted in the closure of 19 international stations. It is feared that PIA's market share in international traffic flows is going to fall significantly. According to the figures for 2002, PIA enjoyed the lion's share (26%) of international passenger traffic flows from Pakistan.

PIA has been accusing the foreign airlines of violations of bilateral Air Services Agreements (ASA). The national airline claims that it has been refused fifth freedom right (the permission for a foreign airline to pick up and drop off passengers during a stopover on the way to a final destination) by Japan, Turkey, Egypt and Italy despite the fact that these countries have been granted both fifth and sixth freedom rights. Reportedly, the President of Pakistan has issued instructions to rationalize the capacity and frequency by re-negotiating Air Services Agreements with 9 countries: Dubai, Qatar, Abu Dhabi, Kuwait, Oman, Bahrain, Singapore, Thailand and Switzerland. However, the instructions are yet to be implemented. It is unlikely that the Civil Aviation Authority (CAA), under who's purview these agreements fall, will take back the 5th and 6th freedom rights given to these countries. This is because a number of issues are involved including the fact that the CAA earns revenue in the form of landing and handling charges from these airlines.

It is believed that the expansion in PIA's network to over 50 destinations worldwide would fall short of yielding significant benefits. The much trumpeted revenue increase from flights to Indian destinations might not be visible in 2004 profits. Currently, the flights to India are operating at 43% load factor, 2400 basis points lower than the breakeven load factor of 67%. Owing to visa restrictions it will take time for the revenue from Indian flights to start materializing. The impact on the top line from flights to India will be about 3%. Moreover, a number of destinations in the planned network expansion are socioeconomic in nature and are therefore, not expected to yield considerable benefits.

A new airline, Airblue has started operations in the domestic market. It is operating on the Karachi, Lahore, and Islamabad routes and is also planning to expand operations to Sukkur and Multan. The airline has been plagued with delays in the start of operations. It is a point to note that a number of domestic airlines have failed in the past and the list includes Safe Air International, Raji Airlines, Hajvairy Airlines, and Bhoja Air. The record-high international fuel prices are a dampener on the hopes of a successful start for Airblue. It is yet to be seen whether Airblue will give PIA a tough time on domestic routes. However, analysts do not foresee any major threat to PIA's revenues from the domestic market owing to a number of factors including the relatively low frequency of flights of Airblue and low brand awareness.

PIA has focused on passenger traffic and has largely ignored the cargo transportation business so far. Revenues from passengers contribute about 85% and cargo contributes only about 9% to PIA's top line. However, PIA is making efforts in this regard as it has recently acquired a freighter on wet lease from a Turkish Airline with a twice-weekly freighter service between Karachi and London. The frequency of the freighter is expected to increase to five per week. Going forward, the analysts do not expect PIA to expand its cargo business aggressively due to which its contribution to the net revenue stream to remain more or less constant. It is believed that cargo is a more stable source of income and increasing focus on this segment can benefit PIA in the long run. It is also believed that foreign airlines are likely to be a much greater threat to PIA's earnings if is continues to overlook this revenue segment.

The increase in fares on international routes, effective from May 10, 2004 by an average of 24% in the Gulf regions and by 24% in the North American, European, Far Eastern, Asian and Australian regions, would cushion the impact of the rise in fuel prices. The impact of the increase in Hajj fares by 20% will be visible in the top line in 2005, this business segment constitutes about 20% of the total revenues. However, the impact is not expected to be visible on the bottom line as the Hajj operation has historically been loss making, owing to the fact that the flights are fully loaded only one-way. The rise in fares is expected to only decrease the losses on the Hajj operations.

The induction of six A310s, eight Boeing 777s, and seven Turboprops over the next five years will result in an increase in depreciation charges for the airline. This is expected to result in stunted growth in profitability. At a constant depreciation rate of 7%, depreciation charges are expected to grow by a CAGR of 10% over the next 6-year period. This is likely to result in a drop of about 13% in EBIT over the next six years.



The fuel cost is expected to comprise 33% of the total operating cost of PIA in 2004. The jet fuel prices are expected to increase by about 18% to Rs 61.24 per US gallon. The imposition of fuel surcharge on international routes is likely to cushion the impact of the rising fuel cost. Fuel prices are expected to remain on the higher side in the future.

The 2003 report included two qualifications by the auditors, Yousuf Adil Saleem & Co. and Taseer Hadi Khalid & Co. If the qualifications taken into account, 2003 profit would have been down by Rs 1,063 million to Rs 236 million. The auditors have pointed out that the provision for slow-moving inventory and spares has not been worked out taking into account the useful lives of the related aircraft and age of inventories. Moreover, the company has been providing for the spares on a prospective basis, whilst according to the auditors the provision should have been made on a retrospective basis. Had the latter been taken into account the net profit for the year would have been lower by Rs 493 million. The auditors have also pointed out that the interest-bearing long term advances to PIA Investments Limited (PIAIL), an associated company should have been lower than stated. This is due to the fact that according to a recommendation approved by the shareholders of PIAIL, the interest on the loan advanced by PIA had been reduced and the accrual of further interest on the repayment of the loan had been ceased. Thereby, the long-term advances should have been lower by about Rs 877 million, whilst the profit would have been lower by Rs 570 million.