This article first appeared in The Edge Malaysia Weekly on January 27, 2020 - February 2, 2020

PRIME Minister Tun Dr Mahathir Mohamad has said that the government, via Khazanah Nasional Bhd, has three options for Malaysia Airlines Bhd (MAS) — continue injecting funds to keep it flying, sell it or shut it down.

Despite his threat, few believed Mahathir was serious about closing down MAS. “I love MAS,” he said last March. “I want MAS to be a national airline, but it seems like we are not capable of achieving this.”

There was too much national pride (ego, critics would say) at stake and the political backlash from right-wing nationalists would be too much for the besieged Pakatan Harapan government to handle.

The first option would mean pumping in an exorbitant amount of cash.

A 2014 restructuring that included laying off 6,000 employees and a RM6 billion cash injection has not turned the company around.

Sources say MAS is currently burning RM4.0 million in cash a day to keep its planes in the air. This works out to RM1.5 billion a year. To keep the company afloat, shareholder Khazanah would have to inject at least RM7.5 billion over the next few years if MAS cannot reverse course.

And there are no signs of that happening under the current set-up, in Khazanah’s view.

As such, the second option of selling the company needs to be given serious consideration. It will not be a complete sale, but rather the sale of a significant or controlling stake to another airline, which will then manage MAS.

Many airlines have been named as potential partners, but sources say the only serious bids on the table are from Japan Airlines (JAL) and MAS’ fiercest competitor, AirAsia Group.

JAL’s offer, sources say, is quite straightforward. It will pay RM1 billion for a 25% stake in MAS and take over its management. This values MAS at RM4 billion. Considering the staggering losses MAS is incurring, it appears to be a rather generous valuation,

Sources say Mahathir, who is also Khazanah chairman and who will probably have the final say in the matter, is inclined towards the JAL proposal.

The AirAsia Group option, sources say, is the one favoured by Khazanah CEO Datuk Shahril Ridza Ridzuan because it addresses the problem from a more holistic perspective.

Intense competition between two AirAsia group airlines — AirAsia Group Bhd (AAB) and its long-haul sister airline AirAsia X Bhd (AAX) — and MAS is deemed to be the main reason why MAS has been losing money. Indeed, AAX is also suffering because competition with MAS has forced both to keep fares low.

Shahril sees no option but to consolidate all the Malaysian airlines into one. He hinted as much in an interview with The Edge last February.

He said then: “The aviation sector has become very complex because of the competition and quite clearly in Malaysia, you have a very clear market leader in low-cost airlines, which is AirAsia. The reality is that AirAsia now dominates that segment. So, the problem we’re facing is that it is very different from 20 years ago, when MAS was a monopoly. That’s not going to happen ever again. There is no point in pining for the good old days. You have to accept reality and move on.”

Sources say Shahril believes MAS cannot be turned around unless a deal is struck with AirAsia Group CEO Tan Sri Tony Fernandes and AirAsia Group.

This, however, is not the first time this approach has been considered.

In 2012, under a share swap agreement, Tune Air Sdn Bhd was to take a 20% stake in MAS while Khazanah was to take a 10% stake in AAB. Fernandes and his partner Tan Sri Kamarudin Meranun were appointed to the MAS board.

But the marriage did not last long. They went their separate ways and the competition between them has often been extremely bitter and public. The acrimony also spread to the other Khazanah-controlled company, Malaysia Airports Holdings Bhd (MAHB). In fact, AirAsia Group and MAHB are mired in legal suits against each other.

In an interview with The Edge last September, Fernandes said emphatically that he was not interested in looking at MAS again after that unhappy episode.

“You try to not make the same mistake [after the failed share swap deal in 2012]. Life is never as easy as one plus one equals two. There is politics [involved],” Fernandes said.

So, why the change of heart?

Sources say despite the bitterness of the past, the reality is both MAS and AAX will continue to lose money unless the competition between them ends.

“Both can’t co-exist and be profitable at the same time,” says one source. “If it continues the way it has been these past few years, both will go under, unless their shareholders continue to pump in cash.”

MAS’ net loss for the financial year ended Dec 31, 2018 (FY2018) dropped by a marginal 2.5% year on year to RM791.71 million, as revenue improved by a slight 0.8% y-o-y to RM8.74 billion. It has incurred RM3.17 billion in accumulated losses between FY2015 and FY2018.

The financial performance of AAX, which is listed separately from AAB, has been fairly volatile since its listing on Bursa Malaysia in 2013. In the past six years, it has only been profitable in two financial years —FY2016 and FY2017.

Liquidity is also an issue at AAX. In a Nov 18, 2019 report, The Edge Financial Daily noted that the airline’s 3QFY2019 cash flow statement shows the airline’s net cash generated from operating activities was only RM352.91 million. In comparison, it needs RM1.14 billion to fund its financing activities.

If not for the RM887 million generated from AAX’s investing activities in the nine months to end-September 2019 — largely due to aircraft sales — the airline would have recorded a net decrease in cash during that period.

In fact, over the past five years, AAX only managed to generate higher net cash from operating activities than net cash used in financing activities in two years — FY2016 and FY2017, as shown in its 2018 annual report.

Given this situation, analysts have maintained that AAX would require an equity fundraising soon to remain solvent.

Sources say it is the dire situation faced by both MAS and AAX that has brought Shahril and Fernandes to the table to find a solution that benefits both sides.

Initially, sources say, Fernandes wanted to merge only AAX with MAS, leaving AAB out of the equation. However, Shahril insisted any merger would have to include AAB.

Fernandes relented, but sources say several Khazanah board members have balked at some of the terms set by him. These include total management control, only one board seat for Khazanah in the merged entity, absolutely no political interference and not giving the government a golden share.

AirAsia Group also wants some MAS liabilities to be taken over by Khazanah, which will also have to implement and bear the cost of layoffs that will have to be carried out.

Sources say these conditions are probably necessary for the merger to work, but some in Khazanah find them hard to stomach.

It is worth noting that in June last year, Mahathir had said a condition of sale would be that the identity of MAS be retained. He had also stressed that any effort to save the airline would not result in job losses for its employees.

The premier was also quoted as saying that the government must have some say in the carrier’s fate. “We may not have a majority share, but we have to preserve some role as the government or a shareholder, to maintain its identity as the national carrier,” he added.

Given what Mahathir has said, some observers are wondering if Fernandes set the conditions knowing that the government would not agree to them.

“Maybe Tony doesn’t really want to do it, but put in a proposal because he didn’t want to say no when he was asked if he could help,” says one source close to AirAsia Group.
 

Would a merger work?

However, views are mixed on whether a merger would create a sustainably profitable Asean champion — as touted by Fernandes and the Khazanah management — that can challenge regional competitors.

Sobie Aviation’s analyst and consultant Brendan Sobie is of the view that such a merger would not work. “The proposal is not logical and I do not expect it will be pursued,” he says.

Sobie had previously suggested that MAS relook its commercial and network strategy. “Evolving into more of a regional airline could be an option.”

However, an aviation analyst from a foreign research firm believes that a merger between MAS and AirAsia Group can work as long as overcapacity issues are addressed. “The formation of the new merged entity would also see less competition, particularly from the mid-haul segment.”

In his aviation sector outlook report on Jan 15, HLIB Research analyst Daniel Wong notes that Malaysia-based airlines such as MAS, AirAsia and Malindo Air have been cutting overall capacity and restructuring routes from international to domestic, ­owing to weakening consumer sentiment and competitive international segments.

Nomura Global Markets Research transport analyst Ahmad Maghfur Usman says the conditions, such as Khazanah bearing the cost of cancelling MAS’ 25 Boeing 737 MAX 8 orders and staff layoffs, and getting the approval of anti-competition regulators, are likely to be seen as favourable to AAB and AAX.

“However, we think that getting anti-competition regulators to approve the acquisition would pose a challenge, given that this would give the merged entity dominance in the domestic market, with over 70% market share,” he says in a Jan 21 note. Currently, AAB’s local market share stands at 60% while MAS’ is 25%.

Ahmad Maghfur is maintaining a “buy” call on AAB, with a target price of RM2.04, implying a 25% upside to its closing price of RM1.63 on Jan 20. The stock currently trades at 12.5 times its financial year 2020 (FY2020) forward price-earnings ratio, slightly higher than the global peer average of 12 times.

“We continue to like AAB for the stronger earnings turnaround into FY2020 on the back of some recovery in yields and improved profitability (and narrowing losses) from its associates,” he says.

AAB’s net profit dropped 96.6% y-o-y to RM80.72 million for the cumulative nine months ended Sept 30, 2019 (9MFY2019), ­owing to the accounting effect of adopting the Malaysian Financial Reporting Standard 16 (MFRS 16). Revenue for 9MFY2019, however, rose 16.8% y-o-y to RM9.09 billion.

MIDF Research analyst Adam Mohamed Rahim says the adoption of MFRS 16 will be a headwind in the coming few years as the majority of AAB’s fleet is leased. Nonetheless, he sees AAB gaining from a lower amount of interest beyond the fifth year of the lease term.

“We believe that AAB’s operations continue to remain sound. We continue to like AAB as the company continues to enhance its cost structure, along with its efforts of rationalising revenue and cost via digitalisation. Our positive outlook on AAB also hinges on its more prudent hedging policy, stable operations with added capacity and continuous improvement to drive its non-airline ancillary business,” he says in a report dated Jan 16.

Sources say the proposed merger is not dead yet despite the initial response of the Khazanah board. They say Khazanah’s management is working with AirAsia Group to rework the proposal to make it more palatable.

But observers say the differences are too great.

In all likelihood, the MAS saga will end up like that of PLUS Malaysia Bhd. After many months of deliberation over several bids, the government decided that the status quo — with some financial restructuring — was the best option. Highway users pay less, but for a longer period.

In the case of MAS, however, the status quo will mean taxpayers forking out around RM1.5 billion a year for the foreseeable future to keep the airline flying.
 

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