Case for radically restructuring Srilankan Airlines

Disruption and innovation are closely interlinked phenomena, which are coalescing at this critical juncture in time when the established world order is becoming increasingly under strain and unpredictable. It is therefore essential that Sri Lankan leaders start thinking out of the box, applying creative disruption as a means to radically reform and modernise the country’s economy.

The Sri Lankan economy requires major restructuring at multiple levels. Over the past four decades, successive governments have taken a piecemeal approach to economic reform. Shortterm political compulsions and partisan politics have prevented leaders from taking the hard decisions that are required to reset the economy towards a growth trajectory.

Against this backdrop, the Pathfinder Foundation will be presenting a series of articles entitled ‘Economic Disruptors’ and hope that the policymakers will seriously take these into consideration in their policy formulation process. As the global economy becomes increasingly competitive and unpredictable, the Sri Lankan economy will have to be radically reformed to survive.

The Pathfinder Economic Disruptors series has been deliberately designed to provoke debate and healthy argument. For the country to survive in this shifting economic climate, it is important that we shift the debate on the Sri Lankan economy away from conventional frames and move outside of our comfort zones. The first in the series of articles begins with the case for the radical restructuring of Srilankan Airlines.

Background

Srilankan Airlines is on the verge of its 40th anniversary – having launched operations as Air Lanka in September 1979. During its 40-year history, the entity has been unprofitable in 24 of the years – whilst the losses made during this period far exceed the profits earned in 16 years.

The airline industry is a high investment, lowmargin business, which is intensely competitive. It has historically delivered shareholder returns that were below the cost of capital. To be successful in the business, an airline requires a market with high revenues (yields) and economies of scale for operations. Being a smallscale operator from a small market, which has very little premium revenue and in fact the lowest yields of all Asian countries – the prospects of a national airline becoming profitable in Sri Lanka are low. Whilst there is an opportunity to develop a large-scale hub carrier similar to Emirates or Qatar Airways using the location of Sri Lanka – such an exercise would require a very large investment into the airline, expansion of airports as well as the ability to withstand the losses during an initial five to 10-year term – none of which are at Sri Lanka’s disposal.

The losses of Srilankan for the current financial year can be estimated to exceed US $ 200 million – with the impact from the Easter attacks – and the continued operation of the airline will require a significant funding injection from the Treasury.

These negative returns and the high funding requirements can be identified as the key reason why governments in most developed countries have moved out from the airline business. The few national carriers that are still government owned – such as Air India, Biman Bangladesh and Pakistan International Airlines as well as Etihad and Qatar Airways – continue to incur sizeable losses each year.

The likes of Air New Zealand and Finnair, where the government holds a stake but have been publicly listed and are entirely run as private companies, continue to make small profits. The fully privatised national airlines of Europe, such as British Airways and Lufthansa, etc. remain highly profitable.

In the current situation, if no funding is made available – it is highly likely that Srilankan may have to cease operations. This article looks at possible transition solutions that will minimise the impact to the national economy whilst safeguarding the availability of international air links.

Transition of operations Safeguard of existing profit centres

Despite losses being made at a group level, Srilankan has several profitable business units which could generate a significant income to a potential future owner. Further, the continued availability of these ground infrastructure-related services will be essential for the undisrupted operations at Colombo and Mattala airports. Therefore, it is proposed that a governmentowned limited liability vehicle be created to house the following profitable businesses: Ground handling, engineering MRO (line and base maintenance), in-flight catering, Aviation College and aircraft security services.

These profitable businesses could then be developed, without the current hindrances those units face for expansion due to the parent’s financial issues. These units have significant potential for expansion with trained manpower and a strong reputation in the region for quality of work but have not been able to expand due to lack of capital.

Safeguarding air links

The government shall call for proposals from internationally renowned airlines to set up a local operation in Sri Lanka. The licensing of the selected operator shall be subject to the condition that they continue to operate on a set of minimum guaranteed routes at all times to secure the vital air links.

This may include the following routes out of Colombo: Chennai/delhi/mumbai/male.

As well as the following services out of either Mattala or Jaffna: Chennai/male – to use this as an opportunity to develop air services from those airports.

Given the market nature of Sri Lanka, it is likely that a low-cost carrier may provide the best benefits to the economy as they will be able to stimulate demand into and out of Sri Lanka and grow the market – whilst also being able to serve even thin margin routes due to their low-cost base.

The short-haul routes currently being operated by Srilankan could then be ceased – with an agreement for the new operator to take over the leases for narrow-body aircraft that are excess to Srilankan. This will relieve Srilankan as well as the Government of Sri Lanka (GOSL) from liabilities in relation to leases committed on these aircraft – which could otherwise result in future claims. It may benefit GOSL to select a large operator as the chosen party, as they would be able to easily induct these aircraft and agree terms with the existing aircraft lessors and redeploy them elsewhere within their group of airlines.

Transition of operation

The transition of operation shall be carried out in three stages to safeguard a non-interrupted access to international points.

Stage 1: Call for proposals and setting up of new airline

Stage 2: Transfer of short-haul operations and excess narrow-body aircraft

Stage 3: Continuation/transition of long-haul operations

In Stage 3, Srilankan would be operating the long-haul routes out of Sri Lanka with its widebodied aircraft fleet. However, if the airline’s financial conditions have deteriorated further or no longer in operation, the chosen operator for the short-haul operation will be requested to expand operations to include long-haul routes.

The existing wide-body aircraft fleet of Srilankan carry high lease rentals as well as certain maintenance obligations. Thus, the new operator shall be provided freedom to either take over Srilankan’s aircraft or induct their own fleet.

Previous studies have shown that most inbound travellers into Sri Lanka are price conscious. Thus, a low-cost operation may be most suitable for this aspect as well and permit stimulation of tourist arrivals.

Liabilities

Cessation of operations by Srilankan could prompt several liabilities. Key among these would be the US $ 175 million sovereign guaranteed bond issued by the airline, staff liabilities and any aircraft lease or maintenance commitments made by the airline.

Of these, the US $ 175 million bond was originally due for maturity in 2019 and then reissued with interest being serviced. GOSL may need to evaluate whether the new bond contains clauses, which trigger immediate payment at the event of cessation of operations by Srilankan – or if not to transfer this bond to a dormant vehicle under GOSL and service the interest. There are other debt liabilities of the airline – the majority of which are owed to state banks and Ceylon Petroleum Corporation and are within the control of GOSL.

The staff liabilities may require US $ 6 – 8 million if all the (air transport section) employees are being laid-off prior to ceasing operations. Airline professions are specialised roles and the new operator to be based in Sri Lanka will require pilots and flight attendants to be hired locally. Should GOSL enter into an agreement for the new operator to recruit a bulk of these employees, this liability can be reduced substantially or even eliminated entirely.

The aircraft lessors would typically end the contract and repossess the aircraft in an airline bankruptcy without raising any further claims. Same principle generally applies to maintenance contracts. Thus, it is highly unlikely that there would be any claims against GOSL from these liabilities. However, as Sri Lanka is currently not party to the internationally recognised Cape Town Convention for standardisation of transactions related to movable property (such as aircraft) – it may be advisable to either transition these aircraft to the new operator or co-operate with lessors and quickly process deregistration and re-exportation of the aircraft.

Conclusion

The potential cessation of operations by Srilankan would relieve the GOSL of a major financial burden and with the right framework and commitments, a replacement airline(s) could provide uninterrupted connectivity and employment.

In order to minimise the complexity of aircraft transition and employee transfers, it may be advisable to seek a large existing Airbus operator to set up operations in Sri Lanka. This would not only enable convenient aircraft transition and employee transfer, thus minimising the liabilities of the GOSL but also provide opportunity for revenue growth at the subsidiaries, which are certified to support the Airbus aircraft.

Further, the use of an internationally recognised airline to set up an operation would ensure a quicker ramp-up of operations without sacrificing on safety requirements, which may be the case with a local private airline with limited funding. (This is the first of the Pathfinder ‘Economic Disruptors’. Hope that the policymakers will seriously take these into consideration in their policy formulation process. Comments are welcome at pm@ pathfinderfoundation.org)