By Morris Aron

Kenya Airways has flown into a hailstone.

Lately, seldom does any good news emanate from the national carrier, just bumps and turbulence that characterise a rough investment climate.

If it is not customers complaining about delays in their flight schedules, then it is the employees demonstrating over pay disputes or worse still its pilots and cabin crew withdrawing their goodwill and going on a go-slow.

The question many are asking is when did the rain start beating one of the most respected companies in the region and how can the problems bedeviling the company be addressed?

Those who understand the airline say that the root cause of the problem lies in a management that is preoccupied with cutting costs, particularly expenses related to labour, to fix dip in profitability.

Analysts also cite the airline’s ad hoc expansion strategies at a time when internationally airlines are going through a tough investment climate and an aloof management style not ready to engage employees in case of disputes, as some of the reasons that have brought Kenya Airways down to its knees.

Statistics show that KQ share price has gone down by 52 per cent one year to date, and 83 per cent since 2007 when the company undertook a rights issue.

A rights issue planned to facilitate an ambitious expansion programme was undersubscribed by Sh6.2 billion—a development which analysts say is a pointer to investor confidence levels in the airline’s future profitability.

The airline raised Sh14.48 billion from existing and new shareholders, representing a 70 per cent total subscription performance rate.

The plan was to raise Sh20.68 billion. The proceeds of the issue were to finance part of the airline’s 10-year ambitious growth and expansion strategy whose total cost is estimated at $3.6 billion (Sh306 billion).

The funds are to be used to purchase new planes ahead of a planned routes and flights expansion.

KQ’s ambitious programme, which is scheduled for completion in 2021, will include fleet expansion and growth of destinations.

Under this strategy KQ will increase its passenger fleet from 34 aircrafts last year to 107 in 2021 and grow its freighter fleet by 12 aircraft in a similar period.

But perhaps what has put KQ in sharp focus is its contradictory approach going forward.

In a surprise twist recently, KQ began retrenching workforce ahead of the planned expansion due to what it termed as increased labour costs.

The move has seen the management come into sharp focus with a key shareholder—Treasury—distancing itself from the development.

It also raised public uproar against the institution, and portrayed the management as insensitive and callous leading to go-slows even among pilots and a lot of questions on the whole expansion plan.

Company position

On its part, KQ has insisted that the retrenchment is part of a staff rationalization programme that is necessary, as labour costs have ballooned.

“It is important to note that our labour costs almost doubled from Sh7 billion to Sh13.4 billion,” said the airline Chief Executive Titus Naikuni.

“With such increase in costs not matching the increase in revenue, the airlines profitability is threatened.”

At the centre of the storm is Naikuni, a long serving KQ Managing Director since 2003,  a harvard  management graduate who time and again has been accused of ‘highhandedness’ and ‘headstrong’ in decision making by employees and co-workers alike.

Naikuni, a one time part of a ‘dream team’ assembled by World Bank to steer Kenya to economic prosperity after years of mismanagement, now finds himself in uncharttered waters with some calling for his exit, especially unionisable employees.

 An analyst who requested not to be mentioned due to prior dealings with KQ, however, reckons criticism heaped on KQ management for the current woes as unfair.

Interest rates

“First, airlines globally have never returned the cost of capital and remain heavily leveraged with very thin margins. Secondly, airlines are always dealing with factors beyond their control which include global crude oil prices, unstable foreign exchange and increasing financing costs, as indicated by interest rate changes.

 Statistics indicate that for the period between 2011-2012, KQ derived 88 per cent of its topline from passenger revenues.

KQ’s overheads grew 39 per cent between 2007-2011, while turnover grew by only 13 per cent in the same period.

As it stands, almost 75 per cent of KQ’s business factors are beyond its control, with the only option to hedge to minimize exposure. KQ is currently in the process of exerting its control over the remaining 25 per cent remaining factors under its control to force the airline into a growth curve.

“To arrest this, Kenya Airways is currently aggressively moving to have its topline growth outperform overheads growth through a two-pronged expansion spree — route and fleet expansion, as outlined in Project Mawingu,” explained the analyst

Whether the decision was a little too late remains unanswered.

Exchange risks

But even so, a substantial amount of the airline’s revenues and expenses are denominated in United States Dollars (US$) even as KQ enters into forward contracts to mitigate this risk.

The company has revised its fuel hedging policy and has entered into hedging contracts for approximately 80 per cent of its fuel requirements for the period to 30thS September 2012.

Figures from the firm’s financial books of accounts indicate that KQ has for the last several years banked on a stable fuel prices and the foreign exchange market to maintain its high profitability.

According to an analysis by Genghis Capital, KQ woes emanate from a trend where its total expenses have since 2007 been steadily outpacing its turnover in what is known in the finance jargon as margin compression.

In addition, KQ’s core earnings —revenue from its core business of passenger and cargo transportation — has declined over time due to a conscious management decision to grow its ‘topline at the expense of the bottom line.’

Genghis Capital reckons that this state of affairs is despite increased competition locally and on international routes, volatile foreign exchange and rising fuel prices.

“The airline industry is highly competitive with emphasis put on cost and service quality. This has a direct effect on the company’s margins considering that operating costs continue to increase at a similar rate,” explained Genghis Capital in its review of the performance of the company.

“Part of KQ’s strategy to combat the competition threat is to create a niche market within the African continent where yields are higher.”

With revenues from its core business tanking, the firm has in the last several months been forced to undertake a delicate balancing act.

In its operational results for quarter one, KQ put into the market place capacity totaling 3,363 million seat kilometers, which was at par with last year’s level.

The airline registered growth in capacity numbers only for its Northern Africa routes that grew by 21 per cent, due to introduction of double daily flights to Juba and, Middle East regions that grew by 15 per cent.

The rest of the routes remained virtually unchanged with domestic capacity reducing by five per cent.

According to the latest financial report, KQ posted a 57 per cent drop in pretax profit to Sh2.15 billion, mainly due to a sharp climb in costs owing to high fuel prices.

KQ also reported a 44 per cent jump in direct costs to Sh77 billion, far outpacing a 25.7 per cent gain in revenue over the same financial year.

KQ also realised gains on fuel derivative of Sh2.5 billion compared to Sh298 million the previous year.

Kenya Airways attributed the development to the sharp rise in oil prices since December 2011 and the effect of the Euro zone.

“Profitability in 2012 will be sustained due slower capacity growth,” KQ said in its statement.

Despite the emerging trend, Naikuni said during the announcement of the results that going forward KQ would focus on cutting costs and expanding its fleet to 40 passenger planes from the existing 34.

“You can’t let costs run away with you,” he told an investor briefing recently. Staff costs which have more than doubled over the last six years, having risen from Sh6 billion in the year 2007 to Sh13.4 billion in 2012.

Earnings

Cutting costs is important because KQ’s profits in the last financial year dropped by 53 per cent to Sh1.7 billion pulled down by high staff and fuel costs.

Analysts at Renaissance Capital had in a research note earlier this year expressed their concerns at the company’s high employee numbers.

“A thousand employees per one million passengers is an industry efficiency benchmark, and KQ lags behind this benchmark with around 1,500 employees per one million passengers,” read part of their research note to investors.

The cost of laying off the employees is expected to reflect in the profit and loss account of the airline for the six months period ended September 2012.

But with the airline still intent to say on course of its 10-year expansion plan in which it hopes to have tripled its current fleet of 35 aircraft, this means it will have to hire more staff, raising a few questions. It will be suicidal to offload employees it has invested so much in training when it is deeply involved in an aggressive expansion that would certainly require more workers. Time will tell whether Naikuni’s decision would stand the test.

 

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