When Russia was entering the last few days of normality in July and early August of last year, its national carrier Aeroflot was worrying about its new Boeing aircraft and grappling with a 25% increase in passenger numbers. A few weeks later and it was talking about schedule cuts, capacity reductions and a probable financial loss for the year.
It was not that Aeroflot didn't see the crisis coming. The timing came as a surprise to all but the closest of economic observers, although Aeroflot's reaction at the time showed that it was expecting big trouble ahead. It was right. According to the Russian Federal Aviation Service, in the period from the beginning of the crisis in mid-August to the end of September, the number of Russians travelling domestically in Russia dropped by about 30%. Those travelling abroad plummeted by 70% while incoming tourist numbers dropped by 40%.
Cargo handling also fell by 40% with importers, struggling to calculate exactly what was going on with a volatile rouble, hesitating on trade deals and leaving cargo aircraft on the tarmac. Traffic levels at airports also fell: 26% at Moscow's three airports, 30% at St Petersburg and 50% at Novosibirsk.
The Russian economy began to implode taking air passengers with it and leaving Aeroflot with a big revenue headache. The number of passengers using Aeroflot's international and domestic routes dropped by 21% and 30% respectively between September and August (year-on-year the numbers had increased by 1% but capacity easily outstripped this). How this will affect end of year revenues is still being calculated. "We can't talk about a profit now," is all that Aeroflot chairman Valery Okulov can now say.
Aeroflot Russian International Airlines is by far the largest of the several hundred carriers created from the break up of the monolith Soviet carrier of the same name in 1992. It was granted the prestige and lucrative international routes along with the best and newest of aircraft - a point that has sat uneasily with the other 'babyflots'.
Okulov took the reins in June 1997. Since then he has ploughed the carrier through an exhaustive restructure of its own and begun a fleet overhaul. But it is how Okulov and Aeroflot respond to the crisis now that will test just how well run the airline is. It will also be a good litmus test for the Russian economy as a whole because it is one of the few well run companies with international standing. "We are now wholly dependent on the economic situation in the country," says Okulov in a grim warning.
Aeroflot is still 51% owned by the Russian Government. That means for the time-being it can effectively avoid making a decent profit to satisfy shareholders and concentrate on developing its strategy instead.
In response to the crisis, it has already closed about 25% of its 700 routes, including unprofitable slots to Africa, Latin America and one medium-haul service to Dublin. It has also lowered capacity on several others. Aeroflot will also put the brakes on its planned expansion into Russia and it says it will even buy fewer spare parts and in-flight meals abroad to save on hard currency costs.
It is beginning to behave like a western airline. Aeroflot can no longer rely on state handouts to keep it afloat despite its close ties to the very core of Russian politics. Okulov says he is determined to see the fleet renewal programme completed, riding the financial storm even it means keeping prices at pre-crisis level.
The scale of the contagion infecting the Russian aviation industry was clear by the late autumn last year. Russia's second largest carrier, Transaero returned two of its three McDonnell Douglas DC-10-30s and two of its five Boeing 757-200s citing high costs. Transaero was also forced to slash the number of its international flights by about 30% and admitted it expected to lose up to 130,000 of its 1.6 million passengers in 1997.
Aeroflot's Okulov says he has no intention of returning its newly acquired aircraft or diverting from its broad strategy of domestic route expansion but the economic implosion could not have happened at a worse time. It was in the middle of a huge fleet renewal programme, was thinking about selling shares on the New York stock exchange and even looking at a modest profit for the year.
"It is very frustrating," he admits. "For the first part of the year, passenger numbers were up 24% and we had planned to end the year with a 25% rise. Now we will not be able to realise our plans." Aeroflot is also likely to lose much of its international traffic in an international flight to quality, but oddly, it is also likely to gain from the same effect domestically. Russian passengers still see Aeroflot as a more reliable airline than many of the smaller regional carriers.
Okulov's financial strategy to cope with the crisis was to keep Aeroflot's prices low, but change the way it calculated its exchange rate. Effectively this kept prices for Russians low but hiked them up for foreigners. With half of Aeroflot's costs and revenues denominated in hard currencies, it was never going to be as badly affected by a currency devaluation as its Asian counterparts.
But a recent report by Salomon Smith-Barney in London suggests that a rouble devaluation of 25% or more would see Aeroflot making a loss in 1998. In 1997 it made a profit of just $12 million on revenues of $1.4 billion, carrying 3.9 million passengers and 92,000t of cargo. In 1998 it had expected (pre-crisis) to carry almost 5 million passengers and more than 100,000t of cargo. With the rouble's devaluation, Aeroflot's books look like going into the red.
For the moment, Aeroflot is a net exporter therefore a rouble devaluation makes it more competitive on international routes. Its low rouble exposure is likely to change this year, however, as its hard currency costs rise with more western aircraft lease-payments while its dollar revenues fall as more domestic routes are added.
In a further reaction to the crisis, Aeroflot also cancelled its issue of American Depository Receipts in New York. But Okulov insists that this will not damage company coffers. "On the contrary," he says, "we would have made some financial losses if we had launched now. It can be relaunched at anytime when market conditions improve."
In the long term, Aeroflot's strategy is to develop its route network inside the Russian Federation and the CIS. In 1997, Aeroflot had only 5% of its business on domestic routes and says it wants to increase that to around half. In the last half of 1997 and the first half of 1998, Aeroflot began 18 new routes inside Russia - a move that looked good until the financial crisis slashed passenger numbers.
"The plan we had made for 1999 is now being corrected and of course we have had to reduce our ambitions. The load factor has to be economically effective and not less than 60%," says Okulov. That includes domestic routes. It is more economical for Aeroflot to use western aircraft, he adds, but a re-think over which aircraft will be used where is on-going.
Customer loyaltyBut the potential growth in rouble paying passengers is no substitute for dollar income and, in a bid to attract new foreign traffic, Aeroflot is to introduce a new loyalty scheme. Last year, it spent $1million on new computer equipment from Unisys to do just this. "If we are to compete with western airlines, then we have to follow the same standards as they do," comments Okulov.
It is also to introduce the "Z-tariff", a low cost pricing system that allows passengers to choose the destination and three month time period in which they want to travel while a computer chooses the date which is available. It is so confident of its originality, it has patented the system.
The strategy of route expansion is pivoting on its fleet renewal programme. Six Boeing 737-400s, two 777-200s and two Airbus-310s went into service in 1998, joining two 767-300s and 10 Airbus 310s already in the air. Four more 737-400s are also scheduled to be introduced before the end of February.
Last year Aeroflot acquired 16 new aircraft including several Russian-made types. "This is a very big event for any airline.The crisis has not changed any of our fleet renewal plans and everything is going ahead as scheduled," says Okulov. Aeroflot is paying for the new aircraft with the help of a $350 million syndicated loan arranged by Chase Manhattan. It was easy enough to secure the financing, but politically it proved to be a bit more difficult. The government told Aeroflot to either pay hundreds of millions of dollars in import duty on its new Boeing aircraft or place an order worth three times the amount of the tax with Russian aircraft manufacturers. It chose the latter, having to splash out a further $1 billion on Russian aircraft it probably didn't want. "Sometimes I think Aeroflot should have just bitten the bullet and paid the tax," comments one senior analyst in Moscow.
"The Iluyshin Il-96 [of which 20 were ordered] is quite comfortable and the level of service is similar to the western airlines," Okulov defends. "The western passengers are concerned about the safety of Russian aircraft and this attitude is kept up by western media."
Image problem
Aeroflot is no exception. Despite now flying some of the most modern aircraft available, it carries a public image of one with all the grace in the air of a flying donkey. Okulov is aware of this tarnished image and is going to lengths to correct it. "We have lots of good and bad in our history. We have the burden of the poor experience of our passengers in the Soviet period and we intend to change this image."
Part of this image change is the purchase of the new Boeing 747 and 777 aircraft, the introduction of a pink elephant in an advertising campaign and a change of design on the tail of its planes. "We have chosen the radical design in order to make people understand that we are changing," he says.
Introducing traditional Russian dress for its cabin crew, serving up Russian cuisine and Russian hospitality is all part of this change of image. "The service provided by Aeroflot is the same as any provided by any other western airline," continues Okulov. "We compete quite well in the international market and the service on our joint operation routes are the same as our partners."
But is the image change just papering over the cracks? What stays is the old hammer and sickle on the company insignia and while almost all of its international routes are now flown with western aircraft. Most inside Russia still use Russian built Tuplolev and Ilyushins. It also has other problems.
There is, for example, little that Aeroflot can do in the immediate future about the cramped conditions at Sheremetyevo Airport in Moscow. An expansion of Sheremetyevo is now a major company priority, says Okulov. He has grand plans for a new terminal which Aeroflot unveiled early last year which will be capable of handling 3.5 million domestic and international passengers a year. In the aftermath of the financial crisis, this plan is now on hold. Nor is Aeroflot a member of any world alliance with little prospect of it becoming one any time soon. Okulov retorts that he wants to develop existing alliances as well as find new ones.
Nikolay Lebedev, his deputy commercial director says he has one representative a week somewhere in the world talking up an alliance with Aeroflot. "This is not such a bad thing," says Evgeny Golossnoy, Aeroflot analyst at ING Barings in Moscow. "For the moment it should be concentrating on developing its route network and lowering costs before looking to join a global alliance."
Other difficulties for Aeroflot remain. Its revenue is falling from an already low base. It is roughly the size of Finnair, a national carrier of a country with just 3% of Russia's population.
Aeroflot also runs on extremely high costs. It has to pay social costs - payments for houses, schools and so forth - and also has high leasing costs on its new western aircraft. Overall costs will be lower in the future with higher maintenance costs likely to be offset by lower running costs on western aircraft - Boeings can spend up to 10h a day in the air, Russian built models average only seven.
When judgement day comes, we will probably find Aeroflot still standing. "No other airline is like it in Russia," says ING's Golossnoy. A largely untapped and huge market is thus far only countered by the inability of the Russian economy to realise its own potential. But Okulov remains the optimist. One day, he says, the crisis will end and people will start to fly again. "Until then we do not intend to make any radical change in our activities. We plan to continue flying," he says.
Source: Airline Business
