Strike pushes KQ into a headwind

The settlement of a trade dispute between Kenya Airways and its workers is expected to give management breathing space as the airline battles with a host of internal challenges and external threats over the next two years.

Officials at KQ estimate that the strike cost the airline between Sh150 million and Sh200 million per day over the two and half days it lasted meaning at least Sh375 million may have been lost.

But the big question in investors’ minds is whether the airline will really be able to turn the corner in the next two years, after reporting Sh5.66 billion losses in 2009.

KQ’s share price has fallen by over 80 per cent in the last three years from a high of Sh130 to the current price of Sh25.

Like most cyclical stocks, Kenya Airways would be expected to benefit from a recovering global economy, but the months ahead look even more challenging due to factors that the management can control and some beyond reach.

Last week’s events offer surprising insights into how the airline’s aggressive expansion over the last five years has systematically yielded to the management and operational challenges that culminated in the labour strike. This serves to remind investors of both how lucky KQ has been with its workers and how vulnerable it can be to poor labour relations.

Airlines the world over have been facing deteriorating labour relations as they struggle to cut costs in the face of the global recession.

Since August last year, KQ’s management seems to have been lurching from one labour crisis to the next. First it was the engineers in August, then pilots in November and now the recent strike by some cabin crews and assorted range of ground workers.

Though Sunday’s settlement which will give workers a 20 per cent pay increase staggered over two years will buy time for management to address relations, it is not cheap as it will add nearly Sh1 billion to the airline’s wage bill in two years.

Assuming the airline will continue growing at its historical pace and operating costs do not change much, creeping labour costs might depress its operating margins by nearly one per cent at a time when financial markets are still volatile and KQ’s debt levels are rising.

This means after accounting for currency fluctuations and payments to banks, investors will be getting much less from every shilling of revenue generated.

Over the last five years, the airline’s ability to make money has reduced significantly as it expanded. In 2004, with revenues at Sh40 billion, it would make 16 cents for every shilling generated; last year, this had fallen to 5.75 cents with sales at Sh70 billion.

Hard times
However, at a deeper level, when the business is examined from a pure operations standpoint when the effects of capital structure (debt) and the huge costs of renting aircraft and engines are taken into account, KQ has maintained its earnings power over the last five years.

This phenomenon is captured by a metric used to value airlines and compare them known as EBITDAR (earning before interest tax depreciation, amortisation and rent) which shows that KQ delivered an EBITDAR of Sh13 billion in 2008, compared to Sh14.4 billion three years earlier.

When this performance is evaluated from a traditional accounting perspective of looking at operational profits, the business seems to be doing significantly badly, which is misleading.

However, one thing that is clear is that the expansion has been sucking all its free cashflows — the cash profits that can be distributed to shareholders — as the management invested into the future. This has somewhat improved in the last three years, which means that as other global airlines have been struggling with liquidity, KQ has a fairly strong balance sheet.

The airline, however, is still facing hard times as it tries to navigate the skies during these turbulent times that have seen it report low passenger numbers.

Before the strike, the airline had just started to record improved passenger numbers as the peak travelling season took off and was expected to improve its passenger numbers for the second quarter after a difficult first quarter this financial year.

Its ability to fill in the seats offered on its planes as measured by load factors have been down due to the ongoing slump in the global travel industry leading to the airline recording a four per cent drop in passenger traffic to 639,348 compared to the same period last year in the first quarter.

For the year ending March 2009, the airline reported losses of Sh5.66 billion, compared with pre-tax profit of Sh6.52 billion the previous year, due to fuel hedging contracts that saw it write down losses amounting to Sh7.5 billion.

The loss was attributed to new accounting requirements.

Fuel costs remain a major risk and concern with the airline now keenly watching the price of fuel as an increase in prices would reduce the airlines exposure and would translate into earnings under its hedging arrangements.

According to analysts, the airline is still not out of trouble despite the slight increase in fuel prices. African Alliance says that the price of jet fuel would have to reach over $100 for the airline to see a shift of the unrealised losses to profits. It hedged against jet fuel price movement till the end of 2010 at the height of turbulence in crude oil prices last year.

It is paying for jet fuel at between $108 and $110 a barrel as per the hedging agreement.

The same hedges had cushioned the airline from recording major losses as fuel prices sky-rocketed. Compared to other global airlines, KQ is heavily exposed to fuel price risks which can easily swing its fortunes into deep losses or profits.

For now, the airline has hedged 56 per cent of its fuel requirements, at a time when global carriers are balking at taking a bet on the movement of oil prices. As long as crude oil prices remain below $110, KQ will continue losing more on its hedges.

In the recent months, there has been an upward movement of crude prices to about $70. IATA statistics show that jet fuel prices are currently at $79.8 per barrel, a 17 per cent increment in the past one month.

Though this works for the airline, management will have to deal with balancing increased fuel prices with increased fuel surcharges as was the case when prices shot up last year.

In a slow travelling industry, the sector will have to balance increasing surcharges and cushioning their costs should fuel prices continue to move upwards. Already the industry has been forced to heavily discount travel in a bid to attract the ever shrinking passenger numbers. Kenya Airways has been unveiling reduced prices on some of its competitive routes like Mombasa, Dubai and Europe.

Increased costs
In addition, the carrier is facing a fresh threat to its earnings due to delays on the delivery on the Boeing 787 Dreamliner that were expected in 2010 to help it expand to new routes, increase frequencies on profitable destinations and replace the ageing Boeing 767s. The planes were expected to increase its earnings through fuel efficiency as fuel accounts for a significant chunk of its operation costs.

The manufacturer, Boeing, has pushed delivery by three years, forcing the airline to look at other alternatives including acquiring an Airbus fleet that would lead to increased costs of setting up a maintenance and operations unit for the model.

As the airline tries to resume normal operations, its management and union leaders were summoned by the Prime Minister Raila Odinga yesterday evening to discuss lasting solutions that would ensure this did not happen again as it had a major impact on the country as a whole.

“We shall sit and see where talks broke down and ensure this does not happen again,” CEO Titus Naikuni said. The airline signed a recognition agreement with Aviation and Allied Workers Union in March this year.