I remember around early 2000 local popular Sunday Newspaper ran a story in its pullout, Lifestyle magazine, on how people who had managed to get in the National Airlines shares (Kenya Airways) had grown incredibly wealthier from the investment. Some of them had got into the share when it very cheap and managed to register super-normal profits in paper form, since I do not recall any of them saying they had liquidated though they probably did later. At that time the general perception towards the airline industry was that it was a very lucrative investment and that there was, no way one could not turn a profit if made long-term investments in the business. The share managed to rally sharply to above a 100 shilling a share (barely above a dollar at current rates) before peaking and plummeting to present value of around 7 shilling a share (account for dilution through rights issues as it raised money to fund expansion). From a very remarkable growth and promising future great profits, about slightly over a decade after, the airline is now staring at insolvency and has been actively looking for additional debt financing aside from most recent extended KSh. 4 Billion. This year it reported half year losses of about KSh. 10 billion and it is reasonable (considering financials & managing director press release statements (funding wages through additional debt)) to expect second half losses much larger than first half losses enough to more than wipe out its previous total equity.
What is ailing the business? There is a high possibility there is two sides to it, an industry with historically very low margins (net profits made against sales made) and an airline that has lagged its peers in terms of efficiency and competitiveness.
Ordinarily, you would expect if an investment is high risk, it should offer high returns to compensate for the risk but this is hardly the case in airline businesses. Airlines earn the lowest return on capital yet face the second highest volatility of returns and risk (among businesses surrounding airline businesses). According to a 2013 IATA report, airlines have earned the lowest returns on invested capital among all industries over the last 30-40 years. Warren Buffett famously remarked during one of his lectures, in response to a student’s question, that he had a special line he calls when he is about to make an investment in an airline business so that they talk him out of the idea. Obviously, it was for a reason, he had burnt his fingers while buying into an airline because it was an attractive security (on valuation) only to learn through loss of his investment that it was a bad business.
This is not to say that no airlines consistently deliver value to investors, there are but very few of them manage to achieve this. In most instances returns are usually, just enough for servicing debts but hardly leave anything for those who buy shares in the business and risk capital while there were alternative high return investments.
National airlines serve national interests as primary before profits. This is because they help in for instance marketing economy and enabling trade, that is why governments are usually very willing to bail them out. Very few of them are generating profits, Zimbabwe and South Africa airlines were earlier on in the year insolvent and have been getting assistance from their governments.
Most other network airlines around the world have been facing stiff competition from low cost carriers (airlines that target cost sensitive clients) who not only are low cost but also on average record higher return on investments. But in the local context, there is only one low cost carrier which is a subsidiary of Kenya Airways but which also appears (from impression created) to be struggling to break even.
Kenya Airways has found itself falling deeper and deeper into debt, initially due to its ambitious expansion plans and now because of inability to break even. Debt isn’t necessarily an evil, in fact it is recognized for its usefulness in economies compared to re-investing internally generated profits since it tends to make the company that uses debt more efficient so that it can be able to finance cost of the debt (in form of interest). What happens when a business that is struggling to break even, is inefficient and has most of its financing in form of debt? It means it very easily falls into a debt trap that inevitably leads to insolvency.
The business is very low margin (estimated at around sh256 a seat-IATA $2.56), it has to operate efficiently otherwise it would not be able to generate profits. It does not take much of government tax, demand stock or rise in costs to eliminate profits. This also makes it questionable how it will fare in a high interest rate environment unless again its debt was guaranteed by the government.
The problem with airlines where the government is big shareholder, it is quite easy to hide internal inefficiencies through the problems inherent in airline industries outside their control. Contacts within the airline have been highlighting low employee morale (later denied during recent senate probe). There have also been alleged cases of lost baggage especially on the West Africa flights. Due to information asymmetry issues (management knows better), it is difficult to determine what exactly is going on and as to whether rumors that have been swirling around are true. Something that is quite for sure is that even if debts were restructured, operating a network airline (not sure about LCC) without superior customer service and improved efficiencies will make it an unsustainable business model.
My take would be that most of the issues raised are addressed and accompanying measures such as requiring more efficient suppliers/external service provides, subsidized airport charges be effected.
Maybe low fuel costs will help improve profitability and new routes especially to the US, but it will be no mean feat to turn around a company facing serious debt overhang problem denominated in a foreign currency while the domestic currency is depreciating but will be watching commentating from the sidelines how it fares. In the meantime, my view is that it is still a too high-risk investment even for a contrarian although it is highly probable government will try to rescue it.