AIR PLAY
Despite the odds, a low-cost carrier takes off in Malaysia. Next stop: the region.
By Abe de Ramos

There are many words to describe Raja Azmi Raja Razali, and modest isn't one of them. By the time you read this, the straight-talking CFO of AirAsia will have just announced that the Malaysian no-frills carrier made around 20 million ringgit (US$5.2 million) in profits on sales of 350 million ringgit in the past 12 months - quite a feat for a 20-month-old startup in an industry beset by war and pestilence. But Raja Azmi has a more colorful way of describing this achievement. "I'm sure our share valuation is higher than theirs," he scoffs.

"Theirs", of course, is a reference to Malaysia Airlines (MAS), the state-controlled veteran which AirAsia has engaged in a deft, and very public, us-versus-them game. Mention that to Low Chee Teng, however, and the CFO of the flag carrier is likely to give an eloquent shrug. MAS shares are doing very well, thank you very much. After a major balance sheet restructuring last year, the airline made its first profit in five years, and now, at 15 times price-to-earnings ratio, its stock is one of the more expensive among its regional peers.

As the industry tries to recover from its worst slump in history, MAS is focusing on increasing its revenues from international operations. Trivial domestic rivalry is simply not on its radar screen. "We're in a globally competitive business, our competitors are other international carriers," says Low. "AirAsia is a very insignificant competitor, if it is [anything] at all."

On the surface, it sounds like fighting talk between a tarnished favorite and a rising star. On one side is a defensive full-service airline once known for losing one million ringgit a day on its domestic operations. On the other is an aggressive discount carrier that sells seats for 70 percent off the incumbent's price, yet claims to have been cash positive since its first day of operations. The former is state-owned and run by airline veterans; the latter (echoing Richard Branson's Virgin) was established by a music executive and is run by managers with little or no airline experience.

It's a classic case of David and Goliath, and one that invites free-market activists to rub their hands in anticipation of hurling criticism against the evils of state monopoly. Aviation, conventional thinking goes, is one of the most protected industries in the region. Most Asian governments have huge equity stakes in incumbent airlines, and threatening their market position by letting in new carriers could be contrary to their own financial interests. Surely, skeptics said, things would not be easy for AirAsia, and it wouldn't last long.

Coming up for Air

Yet that doesn't seem to be the case. While MAS and AirAsia's mutual acrimony was genuine at the start, it now seems to have diminished into a publicity stunt. A closer look at this air show reveals that a peaceful coexistence between a state-backed incumbent and a private low-cost carrier is achievable, and probably replicable elsewhere in the region. AirAsia continues to thrive for three reasons.

First, in the eyes of optimists, the time is ripe for low-cost carriers in Asia. Peter Harbison, managing director of the Center for Asia Pacific Aviation in Sydney, says rising GDP per capita and pent-up demand for cheaper travel - conditions present in Malaysia - clearly point to the need for alternatives to full-service airlines. "There's a growing pressure [in the tourism industry] to influence the access to low-cost airlines, and it will influence governments to open up," says Harbison. "There is a massive undergrowth of economic activity in areas which are underserved. You can't keep the cork in the bottle any more."

Second, AirAsia didn't turn out to be the threat the government thought it was. When the company published promotional 10-ringgit fares for a one-way flight from any of its destinations to Kuala Lumpur, the government might have been forgiven for thinking that AirAsia would steal the market from MAS. But its worst fears were not realized, and in fact, MAS traffic has slightly grown. "It's good that AirAsia is around, because it stimulates traffic," says Low. "As far as we're concerned, AirAsia is encouraging a new [market] segment to be formed and therefore is creating a larger base for domestic demand."

Third, and most important, there are AirAsia's survival instincts. Shrewdly playing the Malaysian government at its own game while adhering to the business model that makes low-cost carriers viable, is no mean feat - it takes a lot of gall to stand up against the status quo. "If you look at the success of companies like Ryanair (the Irish low-cost carrier), it's not just about being low-cost as such," says Peter Negline, regional aviation analyst at JP Morgan in Hong Kong. "All of the successful low-cost businesses are run by significant extroverts - that disposition is incredibly important." To hear CEO Tony Fernandes and Raja Azmi talk is to be reassured there is no shortage of that disposition in AirAsia.

To be sure, the realization that AirAsia did not eat away the market share of MAS came well within the first year after the launch. Before that, however, AirAsia faced hurdles nearly every step of the way. To begin with, expanding its route network invited more criticism and scrutiny than it warranted. "What we really wanted was to get free access to routes, but it was tough getting them," says Raja Azmi. "Every time we wanted to go to a new destination, MAS would make noise."

Bargaining Chip

The battle reached the public arena in April last year, when the government required AirAsia to move its base from the old international airport in Subang, to the new Kuala Lumpur International Airport (KLIA) in Sepang. The move was a blow to the core of AirAsia's business model. One critical factor for the survival of low-cost carriers is operating from secondary airports, where aircraft landing and parking fees are cheaper, and ground handling is simpler. Instead of using aerobridges, low-cost carriers can board and disembark passengers the old-fashioned way - via steps on both ends of the airplane. Smaller airports also tend to have a straightforward baggage-handling system, which means faster loading of checked-in baggage. All this - together with the absence of catering - makes for a quick turnaround time, resulting in higher aircraft utilization.

Moving the headquarters to KLIA threatened to change all that. Not only was it a more expensive and elaborate proposition (its baggage handling system alone involves 22 kilometers of conveyor belts) but also KLIA is three times farther from the city center than is Subang. As such, passengers from Penang, for example, could end up paying more for their taxi fares to the city center (about 60 ringgit) than they would for their AirAsia airfare (48 ringgit).

"They wanted us to move because they wanted to fill this airport up. It was, and still is, an under-utilized airport," says Raja Azmi. "Subang is ideal for us, because it's simple. Moving to KLIA takes the simplicity out, but we were not given an option."

Before AirAsia could be budged, however, it demanded - and got away with - several major concessions, including the same landing and parking fees that it was paying in Subang, preferential gates, free use of aerobridges for a period of time, and free land for AirAsia to build its hangar. It also negotiated with public bus operators to give its passengers special rates getting into Kuala Lumpur.

The way Fernandes and Raja Azmi won these concessions demonstrates precisely their irresistible combination of cunning and charm. The scheme worked like this: AirAsia, Raja Azmi says, knew from the outset that the government wanted the carrier to operate from KLIA. But instead of launching there in April 2002 as planned, AirAsia opened in Sepang a quarter earlier.

"When we started offering fares that were unheard of in Malaysia, people were lining up for hours, and we were ill-prepared for that," Raja Azmi explains. "But we wanted to prove to the government that the low-fares model works, so we went in earlier." By the time the government announced the KLIA move, the public had begun to understand the economics behind AirAsia's low fares.

"The public was essentially on our side, and we got more publicity out of that," says Raja Azmi. "In the end, we still fought to stay in Subang. We lost, so to speak, but gained in other ways."

Magic Formula

AirAsia's next major battle came in August 2002, barely a month after the restructuring of MAS. The restructuring cleaned up the flag carrier's balance sheet, clearing its massive debt, and surrendering its aircraft assets to a specially created government entity called Penerbangan Malaysia Berhad (PMB). Under the deal, MAS would only have the international business (using planes leased back from PMB) in its accounting books; the domestic business would be taken over by PMB, but still run by MAS for a fee (see box).

Days after the restructuring was finalized, MAS introduced its Super Saver promotion, which slashed domestic fares by 50 percent, narrowing the gap with AirAsia's fares. The plan was good for 14,000 seats a week, almost four times the discount carrier's total capacity of 3,800 seats a week at the time. Not surprisingly, AirAsia cried foul. "They have just cleaned up their balance sheet, what the hell did they do that for?" says Raja Azmi. "That was predatory pricing, their action was basically to kill us."

For an airline whose domestic operation is haemorrhaging cash that action by MAS was certainly difficult to comprehend. Low contends that it was meant to revive air travel over time. "We're looking at how to generate more revenue," he says. "Perhaps we could free up 14,000 seats to help the Malaysian traveling public. It wasn't really directed at AirAsia." To Raja Azmi however, the motive was clear. "Pricing is the core of our product," he says. "They were deliberately trying to kill a market unfairly, using the government's financial strength, and that's not what pro-business is about."

That wasn't the kind of comment the government wanted to hear; it was already getting enough criticism from its perceived bailout of former MAS owner Tajudin Ramli. The transport minister, Ling Liong Sik finally decided to act, bringing AirAsia, MAS, and other government officials to the table together, and proposing that a formula be created to foster "healthy competition". Two ideas were put forward at the meeting - cross-equity investments and re-drawing their routes to make them exclusive of each other - but neither excited the airlines and so neither took off.

One suggestion that was seriously considered, however, was to divide the number of flights on a particular route. For example, 60 percent of flights to a certain destination would go to MAS, and the rest to AirAsia. "But that also went out the window," says Raja Azmi. The reason? By the last quarter of 2002, numbers showed that MAS had not lost market share in the nine months since AirAsia started operations. "We have always believed that we were complementary, that there was market segmentation, and that was proven to be right," he says.

The search for a formula has not been officially called off (Ling, the transport minister, could not be reached for comment) but both Low and Raja Azmi seem increasingly confident that one will not be found. "To my mind, there is no further development from that perspective," says Low, "but I believe that the government will always adopt what is best for the country -- We work hard and we work smart, and we should not be afraid of anything." Raja Azmi is more blunt. "They backed off," he says. "Now we have access to almost all domestic routes, and the number of frequencies that we want to do."

Brand Ambition

Is this the triumph of the free market in a country with a long history of state intervention? Raja Azmi certainly hopes so, because that would leave AirAsia free to concentrate on its next goal: to expand domestically and, by January 2004, become the first true no-frills carrier to fly across the region.

Currently, AirAsia flies to 12 destinations in Malaysia, using a fleet of seven Boeing 737-300s. By the end of the next fiscal year, it will have added four or five new domestic destinations, and increased the frequency of flights to existing ones. More interestingly, it will have started flying to secondary airports near Bangkok, Manila, Jakarta, and Hong Kong. Ultimately, the goal is to increase the fleet to 18 by June 2004, equivalent to the delivery of one aircraft a month beginning in September.

To support this goal, AirAsia has just concluded the sale of 25 percent of the company to three foreign private equity firms. Now, Raja Azmi is preparing his books for a possible 150 million ringgit bond issue in October. The equity sale, he says, brought his free cash to 100 million ringgit, which he currently invests in time deposits and double-A or better-rated Malaysian bonds. AirAsia's own bond issue would further increase Raja Azmi's war chest and ease the funding for the ownership of four aircraft (a decision made to take advantage of the industry slump) and the lease of seven others.

Already, AirAsia is looking to make Kota Kinabalu airport its base for flights to the Philippines and Hong Kong, and Senai airport in Johor Bahru for flights to Thailand and Indonesia. The plan has again rattled the status quo, particularly across the strait in Singapore, a mere half-hour's drive from Johor Bahru (downtown Singapore to Changi takes about 20 minutes). Last month, Singapore Airlines issued a statement, saying it is considering setting up a separate low-cost subsidiary. Earlier, it had said it could easily transform its full-service subsidiary, SilkAir, into a discount carrier.

"Obviously [our regional service] will be seen as competition, there's no running away from the fact," says Raja Azmi. "But it's a value proposition to consumers. They have alternatives, eventually it's up to them to decide." AirAsia is confident it can regionalize the same no-frills formula it has proven to work in Malaysia - including creating a new market.

In the Philippines, for example, AirAsia hopes to target the 60,000 documented Filipino workers in Malaysia (estimates of illegal ones run to 500,000). "A contract worker can only go back once every two years, basically because he can't afford it," Raja Azmi says. "But with our fares, if he planned early enough, he can go back twice a year, Easter and Christmas. He wouldn't have gone back twice if not for the cheap fare, and that's exactly the scenario that we played out throughout the region: you stimulate the demand, you encourage more passengers to travel, and increase the cake."

Not Quite There Yet

To skeptics, these are pie-in-the-sky assumptions - and, apparently, there are more skeptics than believers in the viability of regional budget carriers so they will be watching AirAsia carefully. One reason is cultural: Richard Stirland, director general of the Association of Asia Pacific Airlines, the trade organization for the 17 incumbent carriers in Asia, thinks even "unsophisticated travellers" would not hop onto a plane without the frills - the hot meal, the in-flight entertainment, and attentive cabin crew.

Another is infrastructure. One criterion for an efficient low-cost airline is direct booking via the internet - this does away with commissions and credits to travel agents and the cost of processing tickets. While Raja Azmi claims well over half of AirAsia bookings are done via the internet (the rest are through sales offices), Stirland is skeptical of its regional rollout. "The internet, as a booking tool for international travel, remains an exotic curiosity for a sophisticated few," he said in a recent report.

A third reason is logistical: Philip Wickham, aviation analyst at ING Barings in Hong Kong, says in a report that regional budget airlines could only become a reality in Asia "if the low-cost carriers develop routes from secondary airports that currently do not exist."

But Raja Azmi thinks that Asians are increasingly internet savvy and that they are ready for no-frills flights. He also believes secondary airports do exist. In the Philippines, AirAsia is eyeing the airport at Clark, a former US military air base 50 kilometers from Manila. In Thailand, he names an airport an hour's drive from Bangkok and very close to Pattaya. In Hong Kong, AirAsia may land in Macau. "We may or may not fly to Hong Kong direct, depending on the terms, because it's an expensive airport," he says. "We may fly to Macau where the airport is hungrier and wants more passengers." Will passengers take the bait? There is no proof they will. Another characteristic of budget carriers is point-to-point operations - connecting flights are costly, and they minimize turnaround time, and consequently aircraft utilization. This means that someone in Kuala Lumpur who wants to fly to Manila would have to book his flights from KLIA to Kota Kinabalu and from Kota Kinabalu to Clark separately. Raja Azmi's philosophy: if you price it cheap enough, they will come. "We don't interconnect, but at our prices, at half the price (of full-service carriers), they won't mind a little inconvenience."

While that remains to be seen, Raja Azmi is putting more effort into beefing up his cash position - both through generating more passengers and looking for new revenue sources.

On passenger revenue, AirAsia, he says, now has an average load factor of 70 percent - still below the 80 to 85 percent enjoyed by low-cost pioneers such as Southwest in the US, and Ryanair and easyJet in Europe. But he claims that it already has the lowest cost per ASK (average seat kilometer, the industry benchmark) in the world, so given its profitability at current load factors, any new fare that comes in would quickly translate into cash. "If you have a higher load factor, or revenue base, your unit cost just comes down even further, because a lot of it is fixed anyway," he says. "So it's a question of, to me, strategic formula to improve our top line."

On other revenue, AirAsia is pushing its merchandise, which seems to be selling well. On one Friday evening flight from Kuala Lumpur to Kota Kinabalu, its cabin crew sold 600 ringgit-worth of shirts, caps and mugs, all emblazoned with AirAsia's cursive logo. Annualize that based on its current traffic of 28 flights a day, and that amounts to a cool 6.2 million ringgit in revenues.

More recently, AirAsia struck an advertising deal with Time, which will have the local mobile phone operator's logo painted on one of AirAsia's planes. And there will be more of these, as well as advertisements on pull-down trays. "If we can generate a couple of million a year from advertising - it could be more than that - it's fine. That's ancillary revenue, but every little bit helps," Raja Azmi says.

As AirAsia goes regional, it will no doubt need as much help as it can get. In a rare show of modesty, Raja Azmi says of the regional strategy: "We will probably not be successful on certain routes, but we'll try. If it doesn't work, okay. We're quite flexible."

Abe De Ramos is Executive Editor, Hong Kong for CFO Asia