Russia's experiment with budget airlines falls to earth

By bne IntelliNews November 3, 2011

Anna Kravchenko in Moscow -

The bankruptcy of Russia's last two low cost carriers, Avianova and Sky Express, in the past month has brought an end to the short era of budget flights in Russia.

On November 1, federal air transport agency Rosaviatsia suspended Sky Express' licence, citing weak financial and operational results as the reason. Now the carrier is about to be taken over by oligarch Oleg Deripaska's Kuban Airlines. Talks between the two companies started last summer after Sky Express' debts to its home airport Vnukovo had topped nearly RUB2bn (€47.5m) as of April.

Sky Express was set up in March 2006 by KrasAir CEO Boris Abramov, the European Bank for Reconstruction and Development (EBRD) and others as the first attempt to introduce a low-cost carrier that would cater to Russia's holiday-mad population. Its maiden flight was on January 29, 2007 from Moscow to the popular Black Sea resort of Sochi. But on October 29, just 20 days after its low-cost rival Avianova ceased operations, Sky Express also grounded its fleet for good. "It's really hard for a small, low-cost company with small capital to survive," says Sergei Babichenko, head of the press office of BasEl, the holding company that owns Kuban Air. "Sky Express started to sink in 2008 with the beginning of the global financial crisis. Company debts were growing, planes stayed idle. Our shareholders decided to save the business and staff, which was almost a charitable act. This company could not operate on its own."

Cheap tickets should have been a winner in Russia where domestic flights are often more expensive than those to European destinations. Avianova managed to transport 2.5m people in two years and climbed to an impressive sixth position among Russian domestic passenger carriers. But intense passenger traffic didn't translate into profits. Avianova gave up the ghost on October 9 and began to pay compensation to more than 60,000 ticketholders booked on flights after this date.

Monopoly in the making

What mainly contributed to Avianova's demise was very high fuel prices. Kerosene supply is a monopoly market and the price continues to rise, but the issue has been ignored by Russia's Federal Antimonopoly Service (FAS). The other big reason for Avianova's failure was the impact of inefficient ground maintenance at airports, which reduced the number of miles a year the company's fleet could fly. Even the international hub of Moscow can't compete with western standards, let alone Russia's regional airports.

Avianova deputy CEO Konstantin Teterin blames existing legislation. "In Russia, the low-cost business model in its classic realisation, like Ryanair or Southwest, is impossible. Regional airports can't offer any special conditions for low-cost companies, there are no secondary hubs [and] taxes for planes with passenger capacity of 180 seats, which is ideal for a low-cost company, are very high. Avianova's experience showed huge demand for cheap tickets. I think if the government admits low-cost companies are needed, new airlines with a hybrid business model, like AirBaltic, EasyJet, may appear."

The upshot is that the current conditions on the Russian aviation market make it impossible for low-cost airlines to operate without government support. Yet moves by the regulator make it clear that the government's strategy is to increase the monopolisation of the sector.

Moscow airports Sheremetyevo and Vnukovo are ready to merge, and the national carrier Aeroflot will get preferential treatment, while smaller companies will in effect be pushed out of the market. "The aviation sector does need consolidation to make it more profitable in general and also more safe," admits Alfa Bank analyst Yuly Matevosov. "There is the same tendency in other sectors - government wants to clean them up from minor players and make them more transparent."

The real war against small airlines started in September after President Dmitry Medvedev said the nation's aging fleet was becoming unsafe and should be scrapped. As if to prove his point, Russia suffered from a string of catastrophic air crashes, culminating in the crash of a Yak-42 that went down in Yaroslavl in September, killing most of the much-loved Lokomotiv Yaroslavl ice hockey team.

The government reacted quickly, proposing changes in legislation to improve safety: from 2012, all planes must be equipped with the crash prevention system (which is absent on most airliners now) and companies with fleets of less than 10 airplanes are forbidden to offer regular flights. The transport ministry also announced it will suspend the company licence if the number of flights with two-hour delays exceed 10% of all flights in a season.

However, a result of the new rules will be to reinforce Aeroflot's monopoly, as well as help second biggest Russian airline Transaero. Tellingly, both said they're not worried with the new legislation.

On October 26, Aeroflot deputy CEO Shamil Kurmashov claimed the company's market share would grow to 36.6% by the end of 2015. Considering many competitors will have to leave the market after new the regulations come into force, Aeroflot's ambition is well within its reach, says Investcafe analyst Kirill Markin.

Alfa's Matevosov reckons Russia won't seen any new low-cost carrier for a couple of years; the aviation sector requires long-term investments and there is no big investor interested in creating an independent low-cost company right now. More likely, he says, one of the leading airlines will start its own low-cost daughter company. However, Kurmashov says Aeroflot has no plans to create a budget daughter company in the foreseeable future, explaining that under current conditions it's simply impossible. For example, he notes, airport taxes for low-cost airlines are the same as for "traditional" companies.

So the niche is empty now with no signs of any of the big domestic airlines ready to fill it, especially as they can now snap up the losers' local routes, pilots, planes and customers. Further, foreign companies are banned from the Russian market and that's not going to change anytime soon.

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