Financial Analysis

The airline industry is facing a crisis of gigantic proportions. In early 2001 the onset of slow down in the global economy strains growth prospects for the air travel industry. On September 11, 2002 the industry was dealt with a severe blow when two airliners plough through New York Twin Towers.

Fear of terrorist attack grips the world and the airline industry faced an unprecedented downturn. Just as the traveling public's confidence picks up slightly, the world was plunged into US-led war against terrorism. With the backdrop of ever increasing threat of terrorist attack and an imminent war in Iraq looming around the corner, Malaysian Airlines emerges from a government-sponsored restructuring exercise.

Malaysian Airlines, which have been sustaining heavy losses for five consecutive years from FY1997/98 to FY2001/02, is not in the best of condition to compete in the hostile post-September 11 operating environment.

The objective of this report is to evaluate the past performance of the company with the aim of gaining insights into its future prospects. Of particular interest is the effects of the "Widespread Aircraft Unbundling" or WAU Agreement on the financial positions of the company.

Our analysis was initially limited to the annual report and financial statements for FY2001/02 and the quarterly results Q2 FY2002/03. However, there were many gaps in the information on the restructuring exercise. This is because some of the transactions were still on-going at the end of Q2 FY2002/03. Fortunately, Malaysian Airlines recently released Q3 FY2002/03 financial results. In this financial statement the full extent of the corporate re-structuring can be analysis. Therefore, in order to provide a more complete picture of the WAU agreement, Q3 FY2002/03 is presently included in our analysis.

The revenue of the group fell by 6.46% (- RM 578 million), from RM 8.956 billion in FY2000/01 to RM 8.378 billion in FY2001/02. This was mainly due to the effects of September 11 attacks in the middle of the financial year.

Comparison of Q2 FY2002/03's revenue of RM 2.389 billion with preceding year Q2 FY 2001/02's revenue of RM 2.177 billion, showed a 9.73% (RM 212 million) improvement in revenue. Similarly, comparison of the just released results of Q3 FY2002/03's revenue RM 2.166 billion with the preceding year Q3 FY2001/02's revenue RM 1.975 billion showed a 9.65% (RM 191 million) improvement. However, it must be noted that Q2 and Q3 of FY2001/02 received the maximum effects of September 11 attacks.

Comparing Q3 FY2002/03 with Q2 FY2002/03 results, we find that revenue declined by 9.33% (- RM223 million) from the previous quarter. This is probably due to the severe downturn of the global economy. We can only expect revenue to worsen in the final quarter as possibility of war in IRAQ, fear of terrorist attacks and the sick global economy put a tremendous amount of strain on air travel industry.

The operating loss of the group for FY2001/02 was RM 777 million (- 9.27% margin), which is a little bit worse than the operating loss of RM 798 million (- 8.91% margin) made in FY2000/01.

MAS's quarterly results for Q2 FY2002/03and Q3 FY2002/03 are quite misleading as they have included "Other Incomes" in the calculation of Operating Profit. In the Income Statement for FY2001/02 ended 31st March 2002, MAS correctly excluded this item from the calculation of operating loss. As described in the notes, "Other Incomes" consisted of interest income, gains on disposal of investment, bad debts recovered, rental income, dividend income, insurance claims, foreign exchange gains, property sale gains, etc. This is certainly not income resulting from operations.

To ensure consistency and correctness, I have excluded "Other Incomes" from Q2 FY2002/03 and Q3 FY2002/03 results in my calculations of operating profit. Q2 FY2002/03 operating profit of RM 27.8 million resulted in a small operating profit margin of 1.16% (against 9.08% operating loss margin in the preceding year corresponding quarter). Similarly Q3 FY2002/03 operating profit of RM 18.9 million resulted in an even smaller 0.87% profit margin (against 14.77% operating loss margin in the preceding year corresponding quarter).

MAS have consistently made operating losses for the last 5 financial years. The small operating profit of RM 18.9 million in the Q3 FY2002/03 reveals the precarious position that MAS is presently in. The urgent problem of its mounting debts has been temporarily dealt with by the corporate re-structuring. However, the critical factor that would determine the survival of MAS is whether it is able to revamp the serious inefficiencies in its operations. Unless the group can quickly learn to minimize its expenses and offer a decent return to its shareholders, the future of the company remains bleak.

The negative Return on Capital Employed, ROCE, for FY2000/01 of -4.26% has worsen to -14.36% in FY2001/02.

However, the situation seems to be improving as Q2 FY2002/03 and Q3 FY2002/03 results showed a small positive return to profitability. Q2 yielded a minute return to shareholder with quarterly ROCE of 0.09%. Q3 FY2002/03 seemingly presented a dramatic return to profitability with quarterly ROCE of 50.09%.

However, there is little reason to cheer as this "impressive gain" is the result of the following:
- RM800 million reduction in shareholder's equity due to conversion of RCPS to debt and subsequent transfer of the debt to Penerbangan Malaysia Berhad (PMB)
- Elimination of RM4.68 billion debt due to WAU corporate restructuring
- Inclusion of RM229.4 million extraordinary gain on the execution of WAU
- Inclusion of RM77.1 million extraordinary gain on the sale of aircraft and engines
- Exclusion of 483,243,865 shares valued at a total RM1.86 billion, which was issued to PMB on 15th January 2003 as consideration for the WAU initiative (Refer to Note A10 of Q3 FY2002/03 results)

Therefore, the joint effect of reduction in capital employed and inclusion of extraordinary gains created an illusion of turnaround in quarterly ROCE. Operating profit of RM 18.9 million for Q3 FY2002/03 remains too small for comfort.

Excluding the extraordinary gains due to WAU and sale of aircraft and engines in our ROCE calculation, the adjusted ROCE for Q3 FY2002/03 is only a 4.07% per quarter. When we consider also the recently issued shares to PMB, the re-adjusted ROCE yielded an even less impressive 1.07% per quarter.

The future remains very bleak as MAS faced a challenging task of reforming its operations, albeit with the lower capital employed and increasingly difficult operating environment.

The current ratio for the group fell 43.49% from 0.51:1 in FY2000/01 to 0.29:1 in FY2001/02. These ratios illustrated the increased risk and worsening short-term liquidity faced by MAS prior to government's initiative to re-structure the group.

In the Q2 FY2002/03 the effects of the corporate restructuring can be seen with the increase of 24.95% of Current Assets and the reduction of 31.65% in Current Liabilities from values at the end of FY2001/02. Therefore, the current ratio showed an impressive 82.81% improvement to 0.53:1 at the end of Q2 FY2002/03 compared with 0.29:1 at end of FY2001/02.

The situation continues to improve in Q3 FY2002/03 to register an increase of 4.36% of Current Assets and the reduction of 1.46% in Current Liabilities from the values in Q2 FY2002/03. The current ratio continues to improve 5.91% from Q2 FY2002/03 to 0.56:1.

The average trade debtor collection period increase by 11.68% from 50 days in FY2000/01 to 56 days in FY2001/02. In my calculation, I have divided Trade Receivables with the total revenue of the group.

The average trade creditor payment period increase by 36.88% from 71 days in FY2000/01 to 97 days in FY2001/02. In my calculation, I have assumed that total purchases consist of the following:
- Fuel and Oil
- Handling, enroute charges, catering and other related costs
- Hire of aircraft, operating plant and equipment
- Landing, parking and other related costs
- Sales commission and incentives
- Rental of land and buildings
- Operating inventories used

The gearing ratio which is calculated as the ratio of (Preference shares plus Long term loans) to (Total Shareholders' Equity plus Long term loans) is used to determine the long term financial risk. During the end of FY2001/02, the gearing ratio was 92.93%, which is extremely high gearing. The gearing ratio worsens slightly to 93.73% in Q2 FY2002/03.

The latest financial results for Q3 FY2002/03 displayed an amazing turnaround with 0% gearing due to the corporate re-structuring kicking in. All borrowings including the liabilities posed by the preference shares have been transferred to PMB. In principle there is still some financial risk to MAS should PMB defaults on its payment to the creditors. The contingent liabilities of MAS presently totaled at RM 5.8 billion.

The involvement of the government in the "rescue package" somewhat reduces the risk of complete financial failure. However, the viability of MAS still hinges on its long term profitability. It is not likely that the government will continually absorb the mounting losses.

Investors in MAS have been very patient with the group for such a long time. The group has consistently reported heavy losses for five consecutive years. The problems faced by the group seem to be deep-rooted in its management and operations. Although the re-structuring exercise has managed to stave off its creditors, the inherent problems within have not been addressed.

MAS registered a 100% increase in loss per share (EPS) to 108 sen in FY2001/02 from 54 sen in FY2000/01. Things improved in Q2 FY2002/03 with 40 sen loss per share and Q3 FY2002/03 with 43 sen earning per share. The Q3 FY2002/03's result is due to the inclusion of extraordinary gains due to the corporate restructuring.

The P/E Ratio as on 25th February 2003 is 8.39. This is based on a closing price of RM3.60 per share.

The management team with the help of the media tried very hard to excite potential investor on MAS's return to the black in 3Q FY2002/03. A closer examination of the figures showed that they have managed to reduce operating loss. However, there is no clear indication that they are able to operate profitably over the longer term.

In the FY2001/02 financial report, investors received a rude shock in Note 23: Prior Year Adjustment. As a result of change in accounting policy a total of RM 1.55 billion was wiped out from the Shareholder's Equity. The RM 1.55 billion of accumulated loss due to foreign exchange transactions was written off at the Equity section of the Balance Sheet.

The new accounting policy requires foreign exchange losses to be written off immediately in the income statement. Previously, treatment of foreign exchange losses involves transferring it to the Exchange Fluctuation Account and amortizing over the remaining lives of the liability.

Although, this prudent measure can be commended, MAS should have declared this item as an exceptional expense in the income statement, rather then try to sneak it by investors in the "Statement of Changes in Equity". The investor saw the book value of his share dropped from RM 3.56 before implementation of the new policy to RM 1.56 at end of FY2001/02.

Examination of FY2000/01 financial report revealed that there was no mention of this significant item anywhere in the report. A foreign exchange loss of such magnitude should have been indicated earlier to investors. Therefore, this move towards prudent accounting only serves to alienate potential investors, who fears that other significant items may also be hidden from their views.

The profitability of the group is threatened by falling revenue. Although Q2 FY2002/03 and Q3 FY2002/03 saw some improvement over the preceding year, the growth in revenue is slowing down again due to the worsening global economy and impending US-led war with Iraq.

The results announced for FY2002/03 are probably the worst in MAS's history. The hope for turnaround after the corporate restructuring fails to materialize as nothing significant has changed within the organization's management and operation. Q2 FY2002/03 and Q3 FY2002/03 results did not prove conclusively that MAS is capable of running a profitable enterprise. The very small operating profits registered in both quarters do not instill much confidence that a fall in load factor or a rise in fuel price would not translate into loss in the final quarter.

The ROCE of only 1.07% is disappointing as a fixed deposit would provide three times the rate of return with insignificant risks. Prospective investors would not be attracted by such a low return.

Although the current ratio of 0.56:1 is hardly impressive, MAS does not presently face any liquidity risks in the short and medium term. In the corporate re-structuring scheme, the Ministry of Finance through its subsidiaries demonstrated its committed and unwavering financial support to MAS. Being a national carrier, it is hardly imaginable that the government will let MAS fail without a fight. Therefore, I believe that the suppliers and sub-contractors would still do business with the group despite the weak current ratio.

MAS seem to be doing an admirable job in staving of its creditors. It is taking longer to pay its creditors because of its worsening short term liquidity. The group seems to be managing quite well with the limited working capital by forcing its creditors to finance its operations. The trade creditor payment period is 15 days longer than its trade debtor collection period for FY2001/02.

Suppliers and sub-contractors to MAS would be more careful when doing business with MAS due to the longer payment period. Ultimately, they may quote higher prices to cover the additional cost of funds.

With a 0% gearing, MAS is secure for the time being. Probably the bankers would be again eager to lend to MAS. However, the financial reports did not disclose the quantum of payment required to lease back its aircrafts from PMB. The quantum of the lease payments to PMB will be vital to ensure that MAS maintain its zero gearing status. If the group gets into debt again, there will be no longer any assets to "unbundled".

Investors are disillusioned with the continuous losses. They are also hurt by the sudden revaluation of the book value. They want to see results and transparency in the financial reporting.

The major challenges presently faced by the senior management are described as follows:

The fear of long term disruption to the world's oil supply should the US-led war on Iraq spirals out of control has sent oil price to record high. As fuel price is the largest component (21.25%) of total expenses, a rise in oil price could easily wipe out any gains due to operational efficiencies. The risks of higher oil prices can somewhat be mitigated by the use of fuel hedging contracts. However, it can be very costly to hedge all fuel needs. Current spot prices are already at record high.

Notes 2 (i) of the Financial Statements as at 31st March 2002 indicated that the aircrafts has a useful life of between 7 to 15 years and leaves a residual value of 20% of purchase price. Therefore, a depreciation rate of between 5% to 11% must be used. Taking Q3 FY2002/03's quarterly ROCE of 1.07% per quarter or 4.28% per annum into consideration, we begin to wonder why anybody would want to invest in the airline industry. Senior management is constantly under pressure to produce results that justify the high capital investments.

The declining load factor due to weak demand for air travel is the main threat to MAS's survival. When a flight is scheduled, most of the costs such as fuel costs, staff salaries and allowances, landing costs, parking costs, etc. are fixed costs. There is very little variable cost involved. Due to the high fixed cost, the break even point is quite high. Additionally, as air travel is a service, there is no way of preserving the benefits for future consumption. Any unused capacity on the flight is wasted. A flight with small load factor would be unable to cover the high fixed costs and will definitely result in a loss for MAS. To improve the load factor, MAS can do several of the following:
- Cancel some of the less demanded flights to the destination. This will result in some loss of customers to competition and increased customer dissatisfaction. Although revenue will fall, system wide load factor will improve.
- Code sharing with other airlines plying the same route. Passengers are transferred to another airline when demand is not sufficient to fill a plane. The main disadvantage is that MAS's customers are handed over to the competition. The customers may feel betrayed or may end up liking the other airline more. However, code sharing is beneficial to the bottom line of participating airlines in the short term.
- Implement discounted pricing to increase occupancy on scheduled flights. Since the flight is a service and the benefits cannot be stored, a heavily discounted fare would still provide more contribution than an empty seat
- Implemented segmented pricing to maximize the contribution from each segment. Different pricing strategies should be used to attract segments such as business travelers, travel agencies, group travelers, families, senior citizens, children, etc. To ensure timely and efficient allocation of seats for each flight, the internet and IT should be used.
- As management needs timely and accurate information about customer demand to implement the above-mentioned strategies, sufficient resources should be invested into an effective demand forecasting system.

As can be seen from the five straight years of operating losses, MAS has some serious structural problems in its management processes and operations. The difficult operating environment is not a good excuse for its poor showing to date. Singapore Airlines which operates in the same region under the same difficult operating environment reported a respectable operating profit margin of 10.4% in FY2001/02 against MAS loss of -9.27%. One would expect MAS to be more profitable as staff costs, which make up approximately 15% of total expenses, are lower in Malaysia then in Singapore.

To ensure efficient utilization of resources, there is a need to revaluate all planned projects to ensure its absolute necessity and viability. Future contributions to the bottom line should be estimated before approval is given. Projects with no clear benefit to the profitability of the company should be deferred.

Re-assessment of contracts for future deliveries of aircrafts is a must due to the lower growth projections in air travel. Renegotiation to cancel or defer the delivery of unneeded aircrafts can saved MAS millions of ringgit in capital expenditure.

The management of MAS often complains in the past that its poor performance is partly due to losses in the domestic market. However, the emergence of Air Asia with its cut-throat pricing has shown that there is money to be made in the domestic market. One wonders how Air Asia can turn in a healthy profit when it charges a significantly lower fare than MAS. The use of direct marketing via its website could be one of the reasons. Direct selling of airline tickets through the internet is very cost-effective and efficient method filling all seats on the plane.

Although MAS has registered losses for five consecutive years, there has never been down-sizing of the work force. Staff salaries constitute nearly 16% of total expenses and is the second largest component of cost after fuel costs. With the reduction in customer demands, there should be less scheduled flights. Therefore, the number of staffs should be reduced proportionately to improve productivity. Additionally, in these trying times a pay cut would be justifiable to maintain the airline competitiveness.

The WAU corporate restructuring scheme is a first in the world for an airline. Therefore, there is a great deal of uncertainty on whether it would work. With the implementation of the WAU, the holding company PMB bears most of the financial burden in return for lease payments from MAS.

Freed of its debilitating debts, the revived MAS must now focus on staging profitable operations. Based on history, the present management does not engender much confidence. The profitability of MAS would be highly dependant on the quantum of leased payments required by PMB. No information has been released to date for analysis or forecasting.

It would also be interesting to see if PMB itself would be profitable with its aircraft leasing business. As it is owned by the government, there will be significant cost to tax payers should this company fails.

1. MAS team should design a competitive pricing strategy for the various market segments and routes it serve. This requires both internally and externally generated information. All direct costs and indirect cost of providing and scheduling the flight are identified. It is classified as either fixed cost or variable costs.

2. Historical data such as load factor and seasonal variations for each route can be used to forecast demand. Knowing the demand for all possible routes, management can adjust the capacity to match the required demand. Canceling some non-profitable flights actually improves the load factor of flights at a different time slot. Smart scheduling of flights can drastically improve the profitability in operations.

3. In view of the challenging times, MAS's management team should implement a strict regiment of budgetary control on all economic activities. This ensure that there is no overrun in costs.

4. The implementation of Throughput Accounting is suitable for the airline industry as most cost components in providing the service are fixed costs. As this is almost a pure service, there is no stock nor inventory level is zero. Profit is created by responding to consumer demand. Through the use of Throughput Accounting Ratio, the performance of each flight route can be measured.

5. MAS can use benchmarking to improve its internal processes and increase its competitiveness. An ideal competitor to benchmark to is SIA as it has many similarities to MAS such as servicing the same region, puts cabin service as top priority, etc. However, SIA is one of the most profitable airline in the world.

6. Using managerial accounting techniques such as payback period, Accounting Rate of Return, Net Present Value and Internal Rate of Return to evaluate the benefits of proceeding with planned projects. Projects with no immediate effect on profitability should be deferred until the economic climate improves.

1. Build a sophisticated computer model to forecast traffic growth rate of each region covered by MAS. Complex model which incorporates variable and external factors such as GDP, population of the country, rate of economic development, geographical features, etc.

2. Measure the cost effectiveness of modernization of the fleet. Do newer planes translate to higher demand and lower operating costs?

3. Internet based clearing house or direct selling to sell unsold seats at a discount.

4. Invest in a sophisticated Management Information System (MIS). The MIS collects, tabulates and store company wide information in central database. Information is shared and maintained by all levels of management. The MIS is important tool in the knowledge-based economy as it facilitates quick and informed decision making within all levels of the organization.

1. Senior management needs financial statements and ratios to evaluate the performance of a company or a strategic business units. The financial statements of senior management's own companies as it is a measure of his own capabilities and performance. The financial statements of other companies is important to senior management too, as it provide large amount of information about the competition or may be a possible acquisition target.

2. Senior management makes extensive use of forecasted information for strategic planning.

3. To ensure that the company is in financially sound, senior management requires monthly report on revenue, operating costs, stocks, new orders, taxation, etc.

4. External or public data such as GDP, GDP per capita, demographics, spending power, average family income are important for senior management to sense the changes in the external environment.

5. Senior management often dictates the overall budget for the company.

1. Middle management frequently needs cost-benefit analysis to determine the viability of a project.

2. Middle management require information on the load factor to decide on the scheduling of flights.

3. Middle management often sets the departmental budgets.

4. Middle management often need competitors' information for pricing decision, process improvement, etc.

5. Middle management often need throughput information when considering new technology or new processes.

1. Junior management frequently needs effective measure of performance as feedback.

2. Junior management are often given financial targets to meet.