South African Airways on African Expansion Programme, Airbus Deal and Hedging

Meeting report

African Expansion Programme
The Chief Executive Officer, Ms Siza Mzimela, said SAA had already achieved substantial African operational scale and continued to plan for additional routes. SAA currently flew to 26 destinations on the continent with an average daily carriage of 4 600 passengers. SAA’s Johannesburg Hub Strategy had grown traffic to continental destinations from outside Africa and increased the number of passengers using Johannesburg as an easy transit point from Beijing, Sao Paulo, Bueno Aires, Mumbai, Perth and Hong Kong. Emirates remained a major strategic challenge to SAA – Emirates had experienced a 230% increase in the last six years, covered 23 African destination with an average of 484 525 seats. Other African airlines continued to grow in relation to SAA, some expanding aggressively seeking to emulate the Emirates model, including leveraging higher and mid hemisphere positions. Their expanding networks reduced the need to travel via Johannesburg and provided greater access to competing tourist markets. They also enjoyed state subsidies. Their fleets had also grown- Egypt Air had 72 passenger aircraft, Ethiopian Airways 33 and Kenya Airways planned to double their fleet in five years from 32. SAA and its subsidiary, Mango had 53 passenger aircraft.

In responding to the challenges, SAA had developed its own growth and optimisation strategy:
• New route development or increased capacity from Johannesburg hub;
• Replicating brands and operating hubs in new African markets, including Mango regional operations;
• Expanding the role of non-airline subsidiaries such as SAA Technical (SAAT), Air Chefs, Air Cargo, on continent.

SAA routes launched from Johannesburg in the Financial Year 2011/12 were Ndola (Zambia), Pointe Noire (Republic of Congo) and Bujumbura/Kigali (Burundi and Rwanda). SAA routes launched in Financial Year 2012/13 included Cotonou (Benin), Abidjan (Cote d’Ivoire) and Brazzaville (Republic of Congo) to be launched in September 2013. Some of the destinations presented challenges regarding traffic rights and there remained plans for further route development from the Johannesburg hub. In some core markets such as Mozambique, DRC and Angola, SAA’s growth had been limited by restrictions in bilateral air traffic agreements.

In replicating brands and hub, SAA had taken the approach of examining success stories of others. SAA examined the LAN Chile’s recent success stories closely. To overcome its ‘end of the hemisphere’ disadvantage, LAN established branded hubs in other, more northerly parts of South America. LAN’s only hub in 2001 was Santiago, over the next four years, it ‘climbed the hemisphere’ with strong Department of Transport support; a focus on weaker markets with no defending airlines; and a very strong balance sheet. Today, LAN had investments in Chile, Ecuador, Peru, Dominicana, Argentina and was about to merge with Brazil’s TAM. SAA had also examined the Ethiopian strategy. Ethiopian Airlines hub, Addis Ababa, had a strong, almost mid hemisphere position; it followed a long term growth strategy of new route development; it had grown passenger numbers by 79% and freight tonnage by 117% with freight making up 17% of its revenue; it had expanded its geographical advantage and reach by establishing Asky in Togo with a 26% equity stake; it operated up to 13 of 18 Asky West and Central Africa destinations, including the Asky hub in Lome. Subject to shareholder approval, SAA’s strategic exercise was to examine whether this east-west partnership could be a model for a north-south axis involving SAA and South African Express (SAX).

SAA had considered the feasibility of a West African SAA/SAX/Mango hub. Current Economic Community Of West African States (ECOWAS) air traffic analysis showed that the West African region was substantially under served. Ghana had been identified as the prime location for a potential joint venture and discussions with that government were on going. Critical success factors for this venture were: SAA holding a 49% equity stake; sound local partner with capital; SAX or Mango as the preferred brand for market entry; increased SA-Ghana capacity for long haul feeder traffic, especially to South America, Asia and Australia; skills and technology transfer to new airline provided by SAAT and Air Chefs and Ghana to ensure Ghanaian government support. SAA also considered the feasibility of expanding Mango into regional leisure markets. Mango’s low cost base made it a very competitive airline within Africa. Flight operation evaluation of targeted leisure destinations included: Mauritius, Zanzibar, Kilimanjaro, Mombasa and Livingstone. Mango’s use as a regional market growth tool would support the Group’s growth objectives.

SAA was considering expanding subsidiaries into new markets as a possible complement to potential airline expansion and as a standalone growth element. New route developments were planned for SAA Cargo. Kenya had been identified as a potential first market for in-flight catering services by Air Chefs. SAAT had commenced initial support set up for SAA/alliance partner start-ups in West Africa. The plan included scheduled/non-scheduled maintenance services and component/part logistics support.

SAA was on a growth path. In Financial Year 2011/12 SAA introduced services along new routes and added capacity to other profitable destinations within Africa. There had been an increase in revenue paying passengers and load factor due to increased demand and SAA had absorbed demand following the close down of Air Zimbabwe, Zambezi Airlines and Air Malawi.

Airbus Procurement
Mr Theunis Potgieter, General Manager: Commercial, said the initial contract for Airbus procurement was signed in 2002 for 15 aircraft but was renegotiated in 2008. The renegotiation covered price reductions, inclusion of five additional aircraft bringing the total order number to 20, deferral of deliveries, flexibility of choice between A320s and A321s and deliveries between 2013 and late 2017. Financial obligations of the Airbus transaction were onerous and SAA had considered various alternative financing options with a view to transfer the acquisition price obligations of the A320s to a financier and re financing the Pre-Delivery Payments already made by SAA. SAA was currently engaged with three major European Export Credit Agencies who provide credit services on many aircraft purchases. SAA issued a Request for Proposals (RFP) on alternative financing possibilities and was currently considering responses received from a broad range of potential bidders. SAA was also currently engaging Airbus on potential alternative financing options.

Hedging
Mr Potgieter continued the presentation on the meaning, advantages and disadvantages and philosophy of hedging. The underlying philosophy in hedging was introducing some form of certainty in periods of volatility in order to reduce risk. Despite its erstwhile advantages, hedging can be extremely expensive, negate positive markets movements and it was unadvisable to hedge 100% of exposure. The most important risks faced by airlines were foreign currency rate fluctuations and oil price fluctuations. SAA’s hedging philosophy was hinged on- reducing the volatility of jet fuel costs and its effect on SAA’s cash flow and earnings; occupying a competitive position in the industry in terms of jet fuel price risk management; providing a protection buffer during times of very high jet fuel prices; and being specific rather than speculative in hedging.

SAA ensured review and monitoring of its hedging. It reviewed its Financial Risk Management Policy (including hedging policy) yearly; the new hedging policy was supported by an analytical framework which allowed SAA measure the cash flow at risk from hedging; all hedge positions were monitored by the Financial and Risk Sub-committee and reported to the Executive Committee, the Audit Committee and the Board; limits were monitored daily by the Treasury Back Office. All limits were reviewed quarterly.

SAA’s hedging policy included currency hedging limits and fuel hedging limits. SAA used the Oliver Wyman model of hedging and considered ‘net exposures’ to determine value at risk, meaning that natural hedges were also taken into account. Hedging instruments used included options, swaps and forwards. SAA’s hedging policy was in line with industry best practices when compared with international carriers worldwide. In this regard, SAA maintained one of the most conservative hedging policies, with approved target range for fuel at a minimum of 0% and maximum of 60% on a 12 month rolling basis and approved target range for foreign exchange at a minimum of 0% and maximum of 75% of future exposure.

The presentation further discussed hedging losses in financial years 2002/03, 2008/09 and lessons learnt from the past failures including: developing a more dynamic approach towards managing risk exposure; recognising that changing market conditions require more than just taking a view without sufficient flexibility; the risk of imposing minimum hedge ratio limits removed discretion to increase/decrease hedging ratios during times of volatility; putting more emphasis on the upside risk when reviewing market context; recognising that simpler was better; and keeping away from exotic instruments.

Discussion
Ms N Michael (DA) commented that it was disturbing that it seemed SAA could not compete without breaking competition rules. She sighted instances where the airline had been fined around the world for breaking competition rules and in particular the price fixing saga on Hong Kong routes. She asked what SAA was doing to address this issue as it related to its reputation.

Ms Siza Mzimela, Chief Executive Officer, clarified the issues surrounding SAA’s payment of R80 million in competition fines. She stated that the sum represented the total sum for all backlog payments and was not a recent or fresh fine on the airline. To stop future reoccurrence, proper training for staff had been embarked upon and was ongoing on issues regarding competition.

Ms Michael asked why SAA’s prime landing spot at the Heathrow Airport in London was sold and what advantages were derived from the sale.

Ms Mzimela responded that the philosophy of landing slots at Heathrow Airport was ‘use it or lose it’ and airlines must fly a minimum number of flights to retain the landing slot. Upon rerouting its flight from London to Cape Town to London to Johannesburg, SAA initially looked for a counterpart airline to hold down the slot but upon failure to secure any, it sold its slot. The sale was not financially motivated on the part of SAA but a question of practicality.

Ms Michael made reference to SAA’s failed attempts to establish an airport hub in Tanzania and South Africa Express’s several failed attempts to establish hubs around Africa. She asked why SAA still planned to establish hubs when it had made attempts in the past and suffered huge financial losses.

Ms Mzimela replied that SAA had learnt from the lessons of the past and planned to take those experiences into the establishment of its new hub and use them to its advantage. On the planned West African hub, it had indicated the need for a strong local partner with government support if it was to be successful. . On the failure of the Tanzanian hub, SAA had established the hub on the wrong assumption that it would have feeder traffic from neighbouring countries. Hence the need to partner with already established local partners with proven passenger traffic in its new attempts.

Ms Michael, referring to the Airbus deal, noted that there was a six-year time lapse between when the contract was initially signed and when it was renegotiated. She asked what had been paid so far by SAA on the procurement of the Airbuses and what financial losses had been recorded. Would SAA require government financing to pay for the Airbuses and was cancellation of the contracts an option? What were the ‘onerous’ financial obligations referenced in SAA’s presentation on the Airbus deal?

Ms Mzimela clarified that SAA’s Airbus transaction was not for the provision of additional aircraft but for replacement aircraft. This helped to secure funds from lenders as they were replacements on routes that were already proven to be economically viable.

Mr Theunis Potgieter General Manager Commercial, added that the term ‘onerous’ referred to contracts terms that spanned over ten to twenty years.

Mr Stuart Laird-Smith, SAA Division Finance: Route Planning, Pricing, Sales & Marketing, added that to date SAA had paid a total of $96 million to Airbus on pre delivery payments.

Mr E Marais (DA) asked for clarification on SAA’s competitiveness in the freight sector of the aviation industry.

Ms Mzimela agreed that the freight sector was indeed a very important part of the aviation industry business. On its planned new routes expansion, SAA had reviewed both passenger and cargo expectations. In domestic markets, SAA claimed 40% of the freight sector and 35% regionally. Freighting was a highly contested but very viable sector of the industry and a great area of opportunity for SAA.

Mr Marais asked what the daily percentage seat allocation per flight was on the DRC and Angola flights where SAA faced restrictions as a result of its bilateral flight agreements.

Ms Mzimela responded that there were daily variations attributed to a number of factors but on the average there was a daily 70% seat allocation on these flights.

Mr Marais suggested that SAA considered other ‘horizontal routes’ such as New Zealand. He also referred to the recent investments in the Centinela Island airport and asked if SAA had secured its position as a major carrier at the airport.

Mr Phetolo Ramosebudi, SAA Group Treasurer and Head of Corporate Finance, stated that there were no immediate plans for New Zealand because of its distance from South Africa. There were also no immediate plans for Centinela. The planned Centinela airport was still in the initial drawing phase and there was need to establish the existence of substantial local market before investing.
 
Mr Marais commended the SAA’s initiative to increase traffic along leisure routes and noted that with the current economic downturn the leisure routes were a more suitable and cost effective alternative for holidaying.

Ms Mzimela responded that Mango intended to cash in on the leisure market routes and further make the market accessible to more passengers with cheaper flights.

Mr Marais asked whether SAA carried out its maintenance of its fleet itself or contracted out its maintenance.

Ms Mzimela responded that SAA carried out its own maintenance through its technicians in its subsidiary - South African Airways Technical (SAAT), but on rare occasions with regard to engine work of its aircraft it had outsourced. She recalled only two incidents when this had happened. SAA also serviced the aircraft of other carriers on the continent and to improve its capacity had recently contracted with Pratt and Whitney, world leaders in the design, manufacture and service of aircraft engines, to carry out particular aircraft engine work.

Mr A Mokoena (ANC) commended SAA on flying the country’s Olympic team to London and stated that this amongst other reasons was why it was important to maintain SAA as a national carrier.

Mr Mokoena commended Air Chefs, a subsidiary of SAA, on its achievements and its infrastructure as observed during the Committee’s oversight visit. What were SAA’s plans on the proposed inroads of Air Chef into other Africa countries. Was the plan to set up similar infrastructure in these countries or would Air Chefs ship prepared meals on a daily basis?

Ms Mzimela responded that it was planned that Air Chef replicated its infrastructure and system in the countries identified.

Mr Mokoena expressed the Committee’s displeasure on the absence of SAA’s Financial Director at the briefing. The presentation alluded to the rationale behind SAA’s hedging strategy but failed to provide details in terms of figures.

Ms Mzimela apologised for the absence of the Chief Financial Officer and stated that she had believed the delegation with her would be sufficient representation to address the concerns of MPs, hence his absence. Although the Group Treasurer and Head of Corporate Finance, Mr Phetolo Ramosebudi reported to the CFO, he was directly responsible for driving hedging in SAA.

Mr Mokoena asked whether SAA’s dealings with Airbus were similar to those of Denel and Airbus.

Ms Mzimela responded that there was no similarity as Denel had ordered military type aircraft while SAA was ordering commercial aircraft.

Mr K DIkobo (AZAPO) asked for further explanation on the hedging issue. Common practice did not always infer right. Was hedging ethical?

Mr Louis Rabbets, Non-Executive Director, explained that aircraft and jet fuel were priced in foreign currency. And although jet fuel was paid for in Rands, it was still priced in foreign currency. Without hedging, revenue may become static because airlines could not double seat prices on fluctuation in foreign currency rates. Hedging helped to safeguard against these uncertainties. Successful hedging required competent personnel, good systems that calculate risk and right policies in place. Hedging was not speculative but a calculated risk. Proper instrument appraisals needed to be carried out before hedging and limits set before escalation was effected. Different approaches to hedging existed: prediction of future prices (which may be entirely wrong or right); decide best position on a variance of probabilities, for example, the use of options whereby should prices decrease, the business was not locked into high prices.

Mr Mokoena asked whether other businesses practiced hedging besides the aviation industry.

Mr Rabbets responded that hedging was commonplace in a lot of businesses and was used to reduce exposure to risk. The agricultural and mining industries also practiced hedging.

Mr Potgieter added that SAA’s best practices on hedging were similar to international practice of competitors in the industry. SAA was currently hedging at about 40% and its hedging was on a positive for the current year.

Mr Dikobo noted that the CEO’s presentation sounded positive compared to the presentation a few months ago with negative forecasts.

Ms Mzimela responded that SAA was not entirely out of the woods, however recovery was underway and a return to normalcy was being experienced.

Mr Dikobo observed that the presentation had not reflected an increase in the number of aircraft to match the desired route increase. If this was the case, did this imply an under-utilisation of existing aircraft by SAA?

Ms Mzimela responded that the observation was indeed true. SAA had focused more on replacing rather than acquiring new aircraft. What had helped so far was using more of its long haul aircraft along its busiest routes to accommodate more passengers. This strategy was only sustainable to a certain extent and the requirement for additional aircraft was inevitable.

Mr Dikobo questioned whether Dakar could be a standalone route without being a stopover to the United States.

Ms Mzimela responded that Dakar was linked to the Washington route.

Ms G Borman (ANC) asked if SAA was confident that its financial and risk sub committees had closed all gaps – as there existed ample scope for malpractice and corruption in hedging.

Mr Potgieter responded that all gaps had been closed. The committee’s established were developed as a result of stakeholder consultation and complied with National Treasury regulations, particularly the Public Finance Management Act (PFMA). Top level SAA staff and Chief Financial Officers of its subsidiaries were members of the Committees.

Ms Borman asked if SAA was in a position to determine timelines for its planned expansion into Africa.

Ms Mzimela responded that there were clear timelines for some of the proposed new routes, however routes such as the proposed West African hub in Accra had no timelines yet because of the need to secure additional aircraft for those routes.

Ms Borman asked what needed to be done to remove the limitations on the bilateral flight agreements SAA had with Mozambique, DRC and Angola.

Ms Mzimela responded that SAA was working with the Department of Transport to help re-negotiate the agreements. The South African Department of Transport had indicated willingness to open up these routes for more frequent flights but counterpart countries were yet to make any commitments.

Ms Borman asked whether SAA had sufficient aircraft on order to ensure its planned expansion and whether it had costed its planned expansion programme.

No specific response came from SAA representatives to this question.

Mr G Koornhof (ANC) referred to conflicting statistics in SAA’s presentation on its growth and relevance within Africa. From the presentation, SAA was definitely not plying in league within the bigger picture of things and SAA was not growing.

Ms Mzimela explained that the discrepancies observed were in terms of figures shown from the South African hub to the whole of Africa. SAA was indeed playing a catch-up game in relation to its competitors and there was need for real growth.

Mr Ramosebudi added that SAA had not grown at the same pace as its competitors such as Kenyan and Ethiopian Airways. SAA could only go so far with the current number in its fleet and it needed to move quickly.

Mr Koornhof asked if SAA had considered establishing a hub within the SADC region and partnering on joint ventures within the region.

Ms Mzimela responded that while SAA had considered the creation of a hub within SADC, it had decided to place emphasis on Johannesburg as a hub in order to drive tourism and increase revenue into Johannesburg. There was potential for joint venture with other carriers within SADC.
 
Mr Koornhof stated that hedging was risky business that required daily management and highly skilled expertise and although SAA’s presentation had alluded to the establishment of monitoring by financial and risk committees, it was important to know who took the risk. He asked if SAA was geared for this risk and whether there was a better option to minimising the risk.

Mr Potgieter responded that SAA did in fact possess skilled personnel to run the hedge fund. The treasury team directly responsible for hedging was made up of accountants, statisticians and mathematicians. There was a good mixture of skills set to handle whatever challenges might arise.
On who took the risk, the ethics of the hedging in SAA were managed from the PFMA perspective and complied with other governance structures within the organisation. Thorough audit systems and processes ensured compliance.

Mr Koornhof referred to the current financial downturn worldwide and asked what the worst case scenario was for SAA on the Airbus deal.

No specific response came from SAA representatives to this question.

Adoption of Minutes and Oversight Reports
Members reviewed a committee oversight report and minutes and made minor corrections before adopting them.

The meeting was adjourned.