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. Last Updated: 07/27/2016

Airline Shakeout Is Going Full Speed Ahead

Dozens of regional airline companies are going to go under as financial troubles and licensing violations mount.

A big shakeout in the Russian airline industry is expected to accelerate in the next several years.

Since 1993 when the break-up of Russian airline giant Aeroflot resulted in the spin-off of several hundred under-funded carriers or babyflots, dozens of regional transportation companies have gone under because of financial troubles and safety violations. Now, as funding and safety concerns escalate, the number of passenger and cargo airlines is expected to fall to less than one-third, or 50, of the 186 now registered with the Russian Federal Aviation Service.

"The main thing that worries me about the whole airline industry at the moment is the question of funding," said Paul Duffy, an independent aviation industry analyst in Moscow. "You have inadequate funding in almost all the airlines."

Signs of trouble abound. For example, the Federal Aviation Service recently refused to renew the flight licenses of 13 regional airlines after announcing in January that it was imposing new tough safety and financial standards. Recent flight cancellations and a strike by workers over unpaid wages have led to speculation that Moscow's Vnukovo Airlines might be the next victim to collapse.

In March, FAS director Gennady Zaitsev said only 27 of the 315 existing airline companies from regional passenger and cargo airlines to crop-dusting companies were financially stable.

This came as no big surprise to those who followed the industry because the regional transportation companies were at a disadvantage since their inception. The air carriers were stuck with aging, expensive-to-maintain aircraft when the break-up of Aeroflot occurred because the best and newest planes had been allocated for international service.

In addition, many were serving routes to remote regions, which are less profitable than busier corridors, such as the runs from Moscow to St. Petersburg and other large hubs. They also had little chance to raise funds -- a problem in the capital-intensive airline business, where constant investment in aircraft is necessary.

During the break-up, most of the more than 500 regional airline companies were simply parceled out in stakes and given to employees, who in turn often sold them to regional business investors and local governments. However, the Russian federal government, which owns a 51 percent share of Aeroflot, tried to keep at least a 25 percent stake in most of the companies, according to Alexei Komarov, editor of the monthly Transport Observer.

Because of lack of financing and air traffic, the numbers have drifted down from more than 500 to 315 during the past five years, and everyone agrees that this number will inevitably come down much further.

"Consolidation is the only way of developing civil aviation in Russia," said Grigory Gurtovoi, a former vice president at Transaero, Aeroflot's biggest Russian competitor. Gurtovoi, who is now chairman of Atlas Project Management, which does consulting for regional airlines, said carriers need to consolidate to make more efficient use of their aircraft and staff.

Duffy agrees. "My feeling is that if you have 100 or 300 airlines operating in Russia, you will get nowhere. They need to start cooperating in order to become much stronger carriers."

Duffy said he thinks Russia will go the same way as Europe or the United States, where smaller airlines teamed up or were bought by larger ones, until a relatively few mega-carriers remained.

Earlier this year, FAS director Zaitsev said the number of airlines would eventually drop to between five and 10 larger carriers and about 40 smaller carriers serving remote parts of Russia.

Some disagree with that assessment. "You cannot unilaterally say 'we will have 10 airlines, 15 airlines or 200 airlines.' It will be as many as the market will require," Gurtovoi said.

However, Russia's vastness makes a purely free-market solution unworkable. Some towns are simply too small to support an airline and too far out in the boondocks to be connected with the rest of the country by any other means. If such a town loses its airline, "the town will die," Duffy said.

Gurtovoi said the answer lies in a combination of market forces and regional government support in special situations. "In some areas where it is not feasible to operate, airlines will have to be subsidized in order to support local development."

The problem of regional carriers' aging fleets will also have to be solved. The vast majority cannot replace their old planes with a fleet of Western planes, which can cost $150 million or more, plus an additional 30 percent import tax that must be paid on planes bought or leased from the West.

Ruslan Korzh, an aviation consultant for AT Kearney, said the Russian government imposes the tax to protect the Russian aircraft industry, although it is sometimes willing to compromise.

"One of the things the government will say is, 'ok, you can buy a Western airplane, but we want a certain amount of investment into the domestic aerospace industry,'" he said.

Analysts disputed general perceptions that Russian-made aircraft were less safe and defended air safety at Russian airlines. "In practice the safety levels the regional airlines are showing around Russia are up to an international level that's acceptable," Duffy said. "So I'm not, as yet, greatly concerned about the safety issues."

Whatever the kind of aircraft, the airlines that will be able to afford to replace their aging fleets and weather the next few years will likely be based in major cities where enough passenger and cargo traffic exists to bolster demand and, profits.

"The airlines that are based in the major hubs will have a good future," Atlas' Gurtovoi said. He named Khabarovsk, St. Petersburg's Pulkovo Airlines, Novosibirsk's Sibir and Yekaterinburg's Ural as the strongest contenders outside of Moscow.

Duffy picked Pulkovo and Sibir, too, saying the latter had done a lot to upgrade its Soviet aircraft. He also named Don Avia in Rostov-on-Don and Krasnoyarsk Air as probable survivors.

However, the regional and smaller national airlines face competition from Aeroflot and Transaero. The two companies account for around 30 percent of the market and are both working hard to increase their domestic business. Aeroflot, for example, has only 5 percent of its business on domestic routes now and hopes to boost that to 50 percent in coming years. "In general, the Moscow airlines are regarded as the major enemy by the regional carriers," Duffy said.

He said regional companies are beginning to realize that cooperation is going to be necessary for survival. For example, he said, some companies have too many planes of one category so they lease them to other companies.

Other consultants said airlines need to have a good business plan to survive. "What any airline has to do is have a vision of their own future," Gurtovoi said.

Some consolidated airlines with a strong business plan may be good investment bets in the future as the companies go to the markets for capital to finance expansion. But for now, few airlines have publicly traded stock, and what little there is often is illiquid because of poor market conditions.

The big exception is Aeroflot. Analysts are generally positive about the outlook for Aeroflot shares. "Frankly, I would recommend Aeroflot stock right now for long-term investors," said Mikhail Armiakov, an analyst at West Merchant Bank. "The current crisis will eventually be over and at $50 per share it's very cheap."

In about a year, the stock could easily reach its October 1997 high of $200 per share, said Armiakov, who added Aeroflot shares had consistently outperformed the market since February.

Alexander Gunia, an analyst at Rye, Man & Gor, said his company also considers Aeroflot to be a solid buy. "Aeroflot has been hurt less by the crisis than many other companies," he said. "Oil stocks have fallen since the beginning of 1998 some 58 percent, energy has fallen 45 percent, telecommunications has fallen 46 percent, but Aeroflot has only fallen 36 percent."

Observers have speculated that privately held Transaero was planning to go public, although analysts said that is unlikely to occur until the financial situation in Russia greatly improves.