Kenya Airways net operating loss worrying! Company highly indebted to a tune of Kshs 90 billion as of 31st March 2014

Contents1 Will KA’s struggles end soon?2 Threat of substitute products or services 3 Bargaining power of suppliers is high4 There is high rivalry among

There may be something wrong at Kenya Airways (KA) investors are yet to know. The region’s leading Airways Company has reported a loss per share of Kshs 2.25 (US $0.025) for the year ended 31st March 2014; a slight improvement compared to Kshs 6.35 in y/e 2013.  For published summary financial results, download Table 1.

Will KA’s struggles end soon?

The performance of KA has been wanting for the last few years despite the high investment. Although the Airline’s net loss reduced from Kshs 7.9 billion to Kshs. 3.4 billion, the current loss is still on a higher side considering the capital injected. Financial institutions and other businesses like manufacturers are making lots of profits with considerably low capital invested. Kenya Airway’s return on capital is very low compared to other industries – something making analysts wonder whether investment in air transport is a good bet.

KA, a cross listed company on Uganda Stock Exchange, is operating in a tough market with stringent regulatory regime, high operating costs and increasingly demanding customers amid tough competition. A report published by IATA provides an insightful analysis of the Airline’s industry using M. Porters Five Forces model. An application of this model to KA reveals tough times ahead, unless diversification efforts are introduced with a strategy to spread risks.

Threat of substitute products or services

The airline industry in general has high threat to substitute products or services, and this is always rising. Technology for web conferencing is improving, this is anticipated to reduce travels. Recent reports indicate that the East African President’s approved the project to construct the fast train linking all the major regional cities – Nairobi, Mombasa, Kampala, Kigali and Dar.

“Fast trains are competitive with airlines on short haul due to security measures” the IATA report notes. Given that the EAC community is a short haul, completion of the fast train might become a preferred alternative due to cost – as other factors like safety and time will not matter. In addition, the environmental issues challenge air travel. Such factors are likely to impact negatively on the future profitability of KA.

It makes a lot of sense for KA to start considering investing in the fast train. They must diversify so that shareholders are able to tap into the profits arising from railway travel once operations start when complete.

Bargaining power of suppliers is high

Airlines operate in a near monopoly supply side environment. “Airlines and engine producers are both concentrated oligopolies. Airports are local monopolies with significant power. Airport services (handling, catering and cleaning) are also concentrated in a small number of firms, but low switching costs. Plus powerful labor unions especially when controlling operations at network hubs”, the IATA June 2013 report on the profitability and air transport value chain, notes.

As a key player in the region, KA is the most vulnerable to bargaining power of suppliers and this could partly explain the reasons for continued dismal results. The high bargaining power of suppliers is usually reflected in high operating costs (under fleet ownership costs). In the year ended 2014, KA reported total costs of Kshs 108,730 million of which 69% were direct costs and fleet ownership costs were 11.4%. Total operating costs increased by 0.8% in the year ended (y/e) 2014 compared to y/e 2013.

There is high rivalry among existing competitors.

The IATA report further notes that “Airlines have a big challenge that the (i) product is perishable, (ii) limited product differentiation due to similar company structures, (iii) high sunk costs per aircraft, low marginal costs per passenger, (iv) limited economies of scale, (vii) significant exit barriers and (viii) multiple direct and indirect rivals”, and they are right.

The airline products are highly perishable. It is common to travel in an almost empty aircraft yet the fixed costs – fuel — for the route are almost the same.

Limited product differentiations means that it is difficult to create customer royalty in airlines. A passenger will prefer any convenient and cheaper available flight. Once an airline is allowed to operate, it is assumed to have met all the minimum regulatory requirements pertaining safety – the single most factor an average passenger considers.

This limited differentiation is clear in KA’s recent results. The company’s y/e 2014 revenue increased marginally by just 7.2%. This poor revenue performance is attributed to increased terrorism threats in Kenya specifically fires at Jomo Kenyatta International Airport (JKIA) on 7th August 2013 and Westgate Mall shopping attack on 21st September 2013.  This is said to have turned many travelers from connecting through Nairobi thereby negatively impacting on KA’s revenues despite a recorded slight increase.

High threat of new entrants

There are limited incumbency advantages, low switching costs, some demand side benefits of scale and easy access of distribution channels.

In an already small market like EA, new entrants are a big threat to existing operators. For a company like KA with already huge investment, it faces high risks of excess capacity in case of increased number of players.

Already, top providers like British Airways and other international players are becoming interested in the local market especially Uganda following discoveries of oil. New international players already have good will and pose a real threat to regional operators.

High bargaining power of channels and buyers

The websites increase price transparency and travel agents focus on the interests of corporate buyers to reduce travel costs. In addition, buyers are fragmented, air travel is perceived as a standardized product and buyers are price sensitive, note the study.

KA overhead costs increased by 7.7% in y/e 2014 from Kshs 19,469 million in y/e 2013, this is attributed to increasing demands in terms of quality meals, comfort, etc of customers amid a price sensitive regime.

Some good (or bad) news for Kenya Airways

On 17th June 2014, Civil Aviation Authority (CAA) suspended the operations of Air Uganda following a safety audit by the International Civil Aviation Organisation (ICAO) which is said to have found some gaps in the Airline’s operations. However, CEO Air Uganda, Cornwell Muleya, said in an official statement four days after the suspension that “the International Civil Aviation Organization (ICAO) concluded a review of Uganda Civil Aviation systems, structures and operations on June 17, 2014. After the review, airlines registered in Uganda received notification from the Civil Aviation Authority that all Air Operator Certificates (AOCs) for International Operations had been withdrawn and a new recertification process to be undertaken.”

It happened that Air Uganda’s Air Operator Certificate has been unnecessarily delayed thereby affecting travelers and the company’s performance. In the short-term, the Airline is rumored to be lax on passenger safely, something which travelers are very sensitive about.

The actions by CAA will most likely have both short and long-term impact on Air Uganda’s profitability. Already, KA Entebbe to Nairobi route is recording a huge increase in traffic following allegations of travel safety risks with Air Uganda. This is good music to KA ears!

NTV Uganda reported on 25th June 2014 during their 9:00 pm news that Kenya Airways (KA) has increased prices. Airfares between Entebbe and Nairobi have significantly shot up following the suspension from Operation of Air Uganda leaving Kenya Airways close to a near monopoly on the route. An NTV survey on 25th June 2014 revealed that an economy class ticket price was increased to highs of US $ 560 from 360 US dollars previously. That is a huge sudden hike and as shown above KA needs it.

KA financials under the microscope

The published KA accounts were audited by PwC which gave unmodified opinion indicating the financial statements prepared by the directors are fine in all material aspects.

KA has high operating costs at 1.03% for y/e 2014 and 1.09% in y/e 2013. Despite a slight improvement, this is a bad position for the airline. At worst operating costs must be kept below 75% of the total revenue. It is unlikely that KA can achieve such a level at which time, they would be able to report a 25% gross profit margin.

With a skyrocketing cost of capital at about 28% in Uganda and 24% in Kenya, KA is doing badly.

Based on the published financials, KA paid Kshs 2,424 million finance costs against its Kshs 89,012 million (see short term and long term borrowing under liabilities) loan.  That gives a 2.7% cost of capital in y/e 2014 against 3.09% during y/e 2013.

Given KA’s high financial gearing (Kshs 90 billion debts) against equity of Kshs 28 billion, the company is highly susceptible to financing risks. With a net loss margin of 3.2%, KA’s financial position is not rosy at all considering that their business is a cash business, and the company had sales in advance of carriage (income received in advance) of Kshs 10.8 billion at the year end.

It is not surprising that PwC opted to refer to the net loss margin as “net profit margin” in the accounts oblivious of the huge reported loss.

For detailed 20-page report featuring deep analysis of the Kenya Airways Group accounts for your investment insights, email or Fee US $990.

In this attachment, find the brief financials, with a two-year comparative horizontal analysis.

Copyright Mustapha B Mugisa, CFE, MBA, CHFI — Your Success Partner. All rights reserved. 

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