A Risky Business

The pessimists were proved right this fall. As many feared, Russia’s foray into the low-cost carrier (LCC) market has been tough—too tough for Avianova, which ceased operations in October. Meanwhile, Russia’s LCC pioneer, Sky Express, has seen major management and business strategy changes that from October effectively ended its almost five-year run. These events have left industry observers questioning whether the LCC model can ever become a viable business in Russia.

 On Oct. 4, Avianova announced that it would stop flights from Oct. 10 and that all passengers who bought tickets for flights after that date would be refunded. The outcome had been predicted by many since the end of the June when the carrier terminated its contracts with its western management team. In late June, CEO Andrew Pyne and several of his colleagues were fired by the company and barred from entering Avianova’s office. The initial explanation was that there was a conflict between the company’s shareholders—Russian A1 investment company, which owned 51% of Avianova, and American Indigo Partners, which held the remaining 49% stake. But two weeks later, Avianova general director Vladimir Gorbunov said the decision was made because Pyne didn’t comply with Russian legislation.

 “From the very beginning of his cooperation with Avianova, Andrew Pyne demonstrated his unwillingness to work in compliance with Russian laws and emphasized his intention to work solely in accordance with his own rules,” Gorbunov said in the statement released by the company.

Pyne was also accused of causing “unreasonable flight cancellations”and constant delays. Neither A1 nor Indigo Partners commented on the situation.

In truth, the fact that Pyne, a UK citizen, was running a Russian airline that was illegal from the moment he was appointed CEO after starting the business in 2007. Russian rules require an airline chief to be a Russian citizen. That’s why Gorbunov was the official head of Avianova and why he was invited to the company as general director after Pyne’s appointment. When the airline launched services in August 2009, Pyne’s job description was “representative of the shareholders.” Later, his title was changed to CEO, but this abbreviation is not used in Russia so his true position was never made official even though he clearly ran the airline and was its front man. The non-compliance accusation was therefore late in coming, if not flat-out contradictory.

Avianova had other, more real, problems, however. The first significant disruption happened in December 2010. Two out of five planes were moved abroad for routine heavy maintenance in November 2010 and were expected back at the beginning of December. Problems with Russian customs over their re-importation, however, meant they did not return until the end of the month so the airline had to operate three planes instead of five for those two months. According to Pyne, the carrier was forced to cancel around 400 flights. Avianova’s financial loss for 2010 was $35 million against a planned loss of $25 million set in the carrier’s original business forecast.  The cancellations were a major cause of the gap and they further impacted early 2011 financial performance as passenger confidence was eroded.

Saint-Petersburg Disappointment 

At the beginning of 2011, Avianova was forced to revise its development strategy for Saint-Petersburg—Russia’s second largest city. Company managers wanted to create a base at the local Pulkovo airport and launch flights between Moscow and Saint-Petersburg (the most competitive market) and from Saint-Petersburg to several regional cities. The airline insisted that it should receive discounts from Pulkovo to recognize its developing low-cost business. Sergey Emdin, CEO of Northern Capital Gateway company, which runs Pulkovo, said that Avianova wanted slots during the daytime peak periods and asked for sizeable discounts (around 50%.) The airport management would not provide Avianova with such terms and so the carrier cancelled flights from Saint-Petersburg. According to Pyne, another 400 flights were cancelled, although he added that few tickets had been sold for the Saint-Petersburg services.

However, according to Avianova deputy general director Konstantin Teterin, who was appointed in June after Pyne was forced out, the carrier cancelled 1,400 flights to and from Saint-Petersburg during that crisis. Teterin also blamed Avianova’s former management team for releasing an excessive amount of promotional fare tickets—the carrier’s lowest prices started at 250 rub ($8) before taxes. According to Teterin, around 50 seats on every flight were sold at ultra-low promotional fares in 2010 and 2011.

Pyne says that relations between Avianova and A1 changed markedly for the worse when A1 management changed at the end of 2010. The new A1 team had less interest in the airline business, he said, and by April was refusing to make further investments, a move which Indigo then followed, according to Pyne. Each company invested around $32 million, according to Pyne, and he estimates an LCC carrier typically needs an investment of $80 to $100 million to reach profitability.

As neither of the investors would comment on the situation, it is hard to determine who decided to quit the game first. As soon as the cash flow dried up, however, the airline stopped paying its suppliers, beginning with the leasing companies. In September, ILFC said that it wanted two of its aircraft returned because there had been no payments for several months. Other leasing providers—ACG and RBS Aviation Capital—did not make similar announcements.

From LCC to Charters  

Russia’s LCC pioneer, Sky Express, has fared better than Avianova, but it still has had a difficult time since launching services in January 2007 and its original budget niche plan had been effectively wiped out through a merger and an expansion of charter operations.

The carrier’s owners, Russian investment company Basic Element, are keeping the Sky Express brand in the market, but there is little left of the LCC model that the carrier started out with. The company is consolidating with regional carrier Kuban airline, based in Krasnodar in the south of Russia, which is also owned by Basic Element (the company wants to operate two brands). As soon as the winter schedule of both carriers was announced in October, it became clear that Sky Express’ network of scheduled flights would be cut from 10 to three domestic destinations. The carrier will continue to fly from Moscow to Krasnodar, Chelyabinsk (South Urals) and Vladikavkaz (Nothern Ossetia, Caucasus). But Kuban also cut the number of scheduled routes from Krasnodar, leaving it with just five regular routes. Conversely, the combined company plans to increase its number of charter flights by 70% this winter.

Although Sky Express was launched as an LCC, it has experience in the charter market, which it started operating in 2008.  Sky Express CEO Marina Bukalova said that the carrier must diversify its business to survive. At the beginning of 2008 it became clear that the fuel crisis was hitting the market significantly. Sky Express re-examined its business plan and realized that instead of the planned $70 million investment, it would need $100 million to fulfill the original plan. Trying to cope with escalating fuel costs while maintaining profitability forced the carrier to put on hold its fleet extension—taking only nine of the 14 Boeing 737s it had planned—and to launch charter flights from Moscow and other Russian cities. As a result, 25% of Sky Express’ business became charter, but this was intended to be a stop-gap until the market recovered.

“We didn’t plan to stay in the charter market; we thought that as soon as the domestic market recovered, Sky Express would leave the charter niche,” Bukalova said.

That hoped-for return to Plan A never happened. Sky Express survived 2008, but 2009 was even tougher and foreign investors who founded the company—the group included the European Bank for Reconstruction and Development and Altima Capital and also some private investors– insisted the carrier bring in additional investors. Finally, in 2010, the carrier attracted Basic Element. By that time the investment company already had assets in the airline market. It owned several airports in the South of Russia (in Krasnodar, Sochi, Anapa and Gelendzhik) and Kuban. According to the market experts, however, the owners were not satisfied with how business was going and there was particular concern about Kuban’s lack of modern technology.  So it was agreed that after buying Sky Express, the LCC’s management team would apply their new technology tools to help modernize Kuban.

In August 2010 the new owners said they would work out a common strategy for both carriers, but that plan was kept under wraps for more than a year and the carriers continued to work separately, with Sky Express continuing its charter business. Finally, in October this year, officials said that Sky Express would lose its Aircraft Operator’s Certificate as part of the consolidation plan.  Both brands will be maintained, because the Sky Express name has gained popularity, but in effect the LCC that was launched in January 2007 ceased to exist from the end of October.

Bleak Future? 

So why is it that the LCCs do not endure in Russia and can the low-cost model ever be viable in the region? Before Sky Express launched its flights, many experts said the market was not ready for budget carriers. At that time, electronic ticketing was illegal in Russia, so during its first two weeks of operations, Sky Express sold e-tickets on its website, but had to issue paper tickets at the airport to comply with national rules. Then, two weeks into services, Russian authorities changed legislation to make e-tickets legal, an important step for the LCC because it lowered costs.

Russians eventually became accustomed to the e-ticket system, but another regional problem remained: many people were afraid to use their credit cards to make online purchases. Sky Express therefore invented new ways of paying—the carrier signed an agreement with Euroset and Svyaznoy, large consumer electronics retail chains, so that passengers could pay for the ticket at their offices after making an online booking. To facilitate this form of payment, Sky Express agreed with booking system provider Navitaire to make some changes in booking process technology. According to Bukalova, Sky Express sold nearly 50% of tickets via its website, but only 25% of them were paid for using online credit card transactions.

Avianova’s Pyne says Internet bookings at his carrier eventually exceeded 90% , but the airline still had to offer alternative ways of payment and reservation for those unwilling or unable to buy online.

High fleet utilization, necessary for the LCC model to be sustained, also seemed unachievable to many experts, but Avianova proved it could be done and flew its aircraft 12 hours a day. Avianova management also reached an agreement at most of the airports it used, especially at Sheremetyevo in Moscow where the airline was based, to turn planes around in 35 minutes.

 But airport charges remain a problematic issue for Russian LCCs to overcome. According to the Russian legislation, fees must be approved by the Federal Tariff Service and they cannot vary for different types of airlines. Discounting, therefore, is almost impossible.

Willis Lease Finance business development VP George Voskresensky says that the events that happened at Avianova—western management removal, rejection of payments for ILFC that leased two out of six aircraft to the airline and finally the bankruptcy—paint a bleak picture of what happens to Russia’s LCC entrepreneurs and serve as a warning to other potential investors. “Bankruptcies in the airline market are happening all over the world, but evicting the foreign team which was appointed with one of the most respected airline investors—Indigo Partners— became a warning for those few companies that wanted to invest in the Russian airline business,” he said.

But not everyone is giving up. Pyne says he still believes 100% in the Russian market and points out that because the LCC market niche is now essentially void, there are clear opportunities for new carriers. He says he remains committed to seeking out the next opportunity to build a new and successful LCC in Russia.