AirAsia-MAS share swap

AirAsia-MAS share swap: The barbarians have entered the gates — William Leong

SEPT 1 — In the 10-year war for control of the Malaysian skies, while a besieged MAS was desperately fighting for survival, someone opened the gates for the barbarians to enter.

Barbarians at the gates

The AirAsia-MAS share swap reminds me of the takeover saga of RJR Nabisco. The company was a merger of RJ Reynolds, the tobacco company selling "Camel", "Winston" and "Salem" cigarettes and Nabisco, the biscuit company selling "Oreos", "Ritz Crackers" and snacks.

The financial firm of Kohberg Kravis Roberts & Co (commonly referred to as "KKR") made a hostile takeover bid for the company. There was a fierce battle for control of the company. The board, in protecting the company's and shareholders' interest, drove KKR and the other bidders to increase their bids several times until KKR won with a bid of US$31.1 billion (RM93.3 billion). It was the largest leverage buyout in history and the record stood for 17 years. RJ Reynolds was subsequently spun out of RJR Nabisco due to tobacco legislation. Nabisco is now owned by Kraft Foods. The RJR Nabisco leverage buyout was considered to be the pre-eminent example of corporate and executive greed. The events were chronicled in a book called "Barbarians at the Gate: The Fall of RJR Nabisco".

The fight for control of the Malaysian skies has been an uneven battle from the beginning. In the end those responsible for MAS's defence not only did not put up a fight but opened the gates to allow AirAsia into MAS's management. The share swap has given rise to concerns on the pricing and whether it will benefit the public-funded MAS.

Pricing issues

One of the favourite sayings of corporate raiders and businessmen is "OPM", that is to operate using "Other People's Money". In the case of the AirAsia-MAS share swap, it is the people's money because MAS is funded by taxpayers.

The pricing of the share swap has raised eyebrows. The parties, in using the August 5 closing market price of both airlines as the basis for the share swap, have raised several concerns.

Datuk Seri Anwar Ibrahim, in his August 10 article "MAS-AirAsia share swap deal raises serious concerns over effective control and governance", referred, among others, to issues of insider trading and asset stripping.

A look at the price charts of the two companies for the past six months supports Datuk Seri Anwar Ibrahim's concerns. The MAS share price fell sharply on May 30, 2011 to RM1.34. It continued to be in the doldrums until August 5, the date of the share swap announcement. AirAsia's share price was on a steep and sharp climb from May. It surged to a height of RM4.20 on August 4, 2011. This is on the eve of the announcement.

There may be good reasons for the share prices of the two counters moving the way they did. However, it seems improbable for this to be coincidental. AirAsia's price was trading around its highest and MAS among its lowest when the share swap took place. AirAsia's price fell immediately after the announcement. It could be that those who held AirAsia shares did not like the deal. It could be whoever was playing up the AirAsia shares stopped doing so. There is therefore cause for investigations to be made.

Others have raised concerns with the price. Khazanah exchanged 20 per cent of MAS at RM1.60 per share for 10 per cent of Air Asia at RM3.95 per share. They believe the price should not have been based only on the closing market price of the two counters on August 5. They point out that MAS in fact is worth more than the price traded because it is an asset-backed corporation. It has a paid-up capital of RM3.34 billion represented by fixed asset value at RM8.4 billion, net asset at RM6.92 billion. AirAsia, on the other hand, is a debt-laden company. It has borrowings of RM7.7 billion. MAS's cash position is RM2.086 billion while AirAsia's is RM1.7 billion. Those who approved the deal will need to justify the pricing.

One other issue on pricing is the timing of the deal. The share swap was announced on August 9. This was within 30 days before both AirAsia and MAS announced their respective 2nd quarter financial results on August 23. Under the Bursa Malaysia Listing Requirements, this is known as the "closed period". Those in possession of the financial results during the closed period are not allowed to deal with the shares until the results are announced. This is to prevent insider trading by those with possession of price-sensitive information. Those who trade in the shares with such information will be taking unfair advantage of the public who are unaware of the situation. Paragraph 14.08 of the listing requirements allows principal officers who do not possess the information to deal during the close period by giving the requisite notification. Although the listing requirements allow such dealings, it would have been more prudent not to enter into the share swap during the closed period.

If the share swap was made after the financial results of both airlines were announced, the market price may have given a better reflection of the share price of both airlines. This may be seen from the share price of AirAsia after the results were announced on August 23. Although AirAsia announced it made a profit, it was 48 per cent less than the previous year. The AirAsia share price fell to RM3.57 at 9.04am on August 24, the day after the results were announced. Those involved will have to explain why the share swap was done before the 2nd quarter results were announced.

Opening the gates for the barbarians

Unlike the RJR Nabisco takeover where there was a fierce battle for control of the company, in the fight for control of Malaysia's skies, AirAsia were allowed to enter the MAS gates without hindrance. The gates protecting MAS's control of Malaysian skies were opened wider and wider for AirAsia over the past 10 years due to inconsistent government policies.

Regulation determines airlines' fortunes

International air transport operates within the framework of the 1944 Chicago Convention for International Air Transport. Governments enter into bilateral agreements setting out the landing rights, restrictions on capacity and pricing. Sectors within a single country are normally denied to foreign airlines. This restriction is called cabotage. It is recognised that cabotage is the prerogative of the domestic carrier. The system of bilateral agreements between two governments has led to the aviation industry to be highly regulated. There has since been a change towards deregulation and liberalisation. Nevertheless, the industry remains one where regulation plays an important role.

Regulation is thus a critical determinant of an airline's performance. It can determine how competitive the market is as well as constrain an airline in its choice of fares, capacity and frequency. Most governments impose entry controls which are usually applied to particular routes. Most governments usually permit one airline to operate a route. The government therefore plays a critical role in determining the fortunes of an airline by deciding on the routes to be given to the airlines.

Golden service takes a beating

MAS's finance and operation problems to a significant extent are due to the government's inconsistent and contradictory air transport policy. Such decisions gave the MAS Golden Service a beating while AirAsia became the Golden Child.

The main asset of any airline is its route networks. The government first allowed AirAsia to compete with MAS and then gave MAS's domestic routes to AirAsia and had its route networks reduced while AirAsia increased theirs.

MAS's social and political obligations

In the fight with AirAsia, MAS had a handicap. As the national carrier it had to compete against a private-owned pure commercially-motivated AirAsia.

When Malaysian Singapore Airline ("MSA") split, the Malaysian government formed Malaysian Airline System ("MAS"). MAS, as the country's national carrier provided domestic flights at government-controlled prices. In performing its social and political obligations, it flew commercially unprofitable domestic routes. One of them is the rural air services. The airline suffered losses as a consequence. In return it made money in the lucrative international flights. Thus the international routes were a form of cross subsidy for the domestic sector.

It was thus assumed that MAS, as a national carrier performing national service, will enjoy exclusive rights to both domestic and international routes.

However, the government allowed DRB-Hicom to establish AirAsia to operate international flights. The original AirAsia management lost money. The present management of AirAsia then obtained approval from the government to take over the airline and to operate domestic and international services as a low-cost carrier.

This caught MAS by surprise because MAS never imagined that the government will allow such competition. In the absence of a clear policy MAS assumed it would operate domestic services subject to fares being controlled by the government. Idris Jala said in the MAS Business Turnaround Plan ("BTP") that studies showed incumbent airlines suffered a 30 per cent revenue decline when low-cost carriers were allowed to enter the market. What MAS did not expect was that the government would not allow MAS to mount an effective challenge to the low-cost competitor. The government did not allow MAS to lower its fares. As a result, AirAsia gained market share with its low-cost strategy. This continued until 2007 when MAS was allowed to determine its domestic fares. By then the red ink had sunk in.

Idris Jala warned in the BTP that political and social obligations presented the most overwhelming and significant constraints to MAS's ability to transform. As a government-controlled airline, MAS does not always have the freedom to act according to pure market principles. MAS is constrain from freely changing destinations, routes and pricing within the domestic sector. Even though there are no explicit constraints on international routes, MAS does not have the flexibility to make changes to destinations, schedules and pricing. Idris Jala said that while MAS was fully committed to serve the nation's interest, this did not necessarily fulfil MAS's commercial interest. At the time of the BTP, 66 of the 114 international routes were unprofitable and 114 of the 118 domestic routes were making losses.

Under the BTP, MAS proposed to the government that it be allowed to run the domestic routes and be given a free hand to operate them like AirAsia. The government, however, on March 28, 2006 chose instead to allow AirAsia to share 19 trunk routes with MAS while AirAsia was given 96 domestic routes to operate exclusively. This was called the domestic route rationalisation plan. Tan Sri Chan Kong Choy, the transport minister at that time, said the government wanted two national champions. The minister forgot that the aviation business is a tough business. There are no different divisions like a football league. There is only one where the fittest survive. In the battle for survival only one is finally standing.

MAS would have a tough time to implement the BTP but the domestic route rationalisation plan did not help. AirAsia was given 96 routes which included the rural air services. When the rural air services proved difficult to operate, AirAsia gave up and MAS was asked to resume the operations after one year. MAS had handed over to AirAsia the planes used for operating the rural air services. When MAS resumed operations, four out of seven Fokkers and one out of five Twin Otters were not airworthy. They were cannibalised and cost RM40 million to be repaired. MAS will always be called upon to undertake routes that commercial firms will not touch.

MAS had to perform social and political obligations and will be required to do so in the future. AirAsia, being a private-owned entity with the objective of making maximum profits for its shareholders, does not operate under such constrains. The government, in changing policies and priorities without taking into consideration the difference between the two entities, is forcing MAS to compete under a handicap. This is part of MAS's perennial financial and operation problems that have required three government bailouts.

Air transport policy needed

It cannot be denied that MAS has many problems and not all of them are due to government policy. It has a high cost structure, poor productivity yield and bad corporate culture. The latest results show the transformation talked about in the BTP has not occurred or had taken root. AirAsia's management has done very well in running a low-cost operation, employing a highly motivated workforce and operating an efficient organisation.

The government, in making its policies, must take into consideration that MAS, being government-owned, is financed by taxpayers' money. Public funds should not be put at risk in requiring a national carrier having to serve social and political commitments to compete with private carriers serving purely commercial considerations. The government must have a clear-cut policy. There is thus an urgent need for the government to come out with a comprehensive and transparent air transport policy. The policy should provide clear directions for the efficient development of the airline industry without imposing undue burden on the taxpayers and consumers.

The government, having allowed a rival airline to compete with MAS, cannot abdicate its responsibility to ensure that they are able to compete on a level-playing field. It cannot run away from this responsibility by forcing the two competitors enter into an unstable alliance. The AirAsia-MAS alliance is in truth an artificial solution to an artificial problem. The government needs to work with both MAS and AirAsia to resolve the issues which the government created. The government must remember it is not operating on OPM. It's the people's money.