Dreamliner Nightmare: Is El Al Heading Toward a Teva-style Crash?

El Al shares have lost 70% of their value in the last 12 months, and the sharp rise of the cost of fuel is only one of the reasons

The first of Israel's El Al Airlines' order of 16 Boeing 787 Dreamliner jets lands at Ben Gurion International Airport, near Tel Aviv, Israel August 23, 2017
Amir Cohen/ REUTERS

Airlines worldwide have been having difficulties for decades. In recent years, the list of carriers in crisis has included stalwarts like Alitalia and Swissair. Air France-KLM is heading groundward fast.

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Most of the airlines in trouble suffer from labor problems and rigid organizational structures that prevent them from nimbly adapting to the vagaries of competition. As for El Al Airlines, its share price on the Tel Aviv Stock Exchange has been in descent since last July. Somebody in the market must be thinking that Israel’s flagship carrier is also heading crisis for a crisis and restructuring.

El Al shares have lost 70% of their value in the last 12 months, reducing its market cap to a mere $128 million, 55% less than shareholder equity.

In that period the price of jet fuel rose by 56%. It makes sense for there to be a correlation between the drop in the El Al share price and the increase in the cost of fuel. Each penny rise in the price of jet fuel increases El Al’s costs by $2.6 million a year. And indeed, the soaring cost of jet fuel increased El Al’s expenses by $200 million a year. But the same applies to Delta, Lufthansa, Qantas and all the rest. The share price of the three carriers rose by 8%, 55% and 35%, respectively, over the past 12 months.

So while the increase in jet fuel costs hurts El Al, there are other issues behind its distress. Like another flagship Israeli company, Teva Pharmaceuticals, mega-investments have led to mega-headaches.

Teva bought companies and took on huge debt. El Al made its biggest-ever investment by buying seven Boeing 800-787s and 900-787s and leasing another nine. The impetus was the Open Skies reform, which gave Israelis more choice in airlines but left El Al under its previous CEO David Maimon and its new one Gonen Usishkin facing intense competition on its most popular routes.

No one deny that for purely operational and marketing reasons, El Al couldn’t keep using its grubby old planes, which on average were 13.5 years old. But the seven Dreamliners costs $1.2 billion, and leasing the other nine adds $922 million.

A move of this magnitude is akin to transplant of a crucial organ, like a heart or liver. The company should have prepared to ensure the operation goes smoothly, but El Al’s organizational structure prevented it from preparing.

Pilot featherbedding

One of El Al’s biggest problems is that as competition intensified in the past four years, the company neglected to scale back its workforce. In fact its wage costs climbed 21% to $625 million.

Another problem is that El Al has no master labor agreement with its pilots, including adjustment to the era of “flight time limitation” — a regulation that will come into force in October, capping the number of hours pilots are allowed to work per week, year and month.

Whatever else it does, the new rule means that El Al pilots will earn less, because currently much of their pay is based on overtime and being on call. For nine months pilots and management have been wrangling over the pilots’ demand for a pay raise to compensate them.

Reaching an arrangement with the pilots would have ensured that El Al can maximize its return on investment, in terms of customer service, competitive standing and return on equity. As the talks drag on, the old agreements are still in place, which results in the poor use of human resources and wasted money. The airline is not only paying a heavily for rejuvenating its fleet but failing to use its old planes to their full potential.

Under their contracts, El Al pilots may fly only one type of plane at a time. A 777 pilot who moves to the Dreamliner, for example, may no longer fly a 777 even if the pilot has not completed — or even begun — training on the new model. Ninety of El Al’s 537 pilots have qualified to fly the Dreamliner or are in the process, but as of early 2018 only four of the new planes had been delivered.

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In other words, there are 22.5 pilots per Dreamliner, compared with 12 pilots per plane in the old fleet. The result is hidden unemployment until the rest of the Dreamliners arrive — but El Al can’t (for instance) fly the old planes more than it does because the pilots have been “decommissioned”from them.

The provision could be rescinded, but talks with the pilots broke down over compensation terms.

Shifting pilots to the Dreamliner also reduced the number of pilots available to train new pilotspilots. New pilots must fly 25 flights with two teachers on board, but now El Al doesn’t have enough pilots to do that. This means it takes longer for each new pilot to be trained.

The wage cost of El Al’s pilots comes to $110 million a year. When 15% of them are only working part-time, the carrier is missing an opportunity to tap into the growing traffic through Ben-Gurion International Airport. In addition, it’s paying millions of dollars per quarter to pilots who are barely working, if at all. Others are getting overtime and extra pay because of the artificial shortage of 777 pilots.

This inefficiency is made worse by virtue of the fact that flight crews are structured on the basis of labor agreements rather than aviation law.

Aviation law requires a double crew only on flights that exceed 12 hours. El Al doubles the crew on flights of 10 hours or more.

Costs are also bloated by the slow, cumbersome transition from old to new models and by maintenance. The Dreamliner is expected to save El Al as much as 30% in fuel consumption. In addition, it will allow the carrier to increase annual flight hours by a third. The Dreamliner requires a basic maintenance check every three years, grounding it for about three days a year on average. Older planes are grounded an average of 30 days a year for testing and maintenance.

The slow transition is also holding up El Al’s efforts to reduce its fleet to just two aircraft — 737s and 787s. That will enable it stock fewer spare parts and reduce maintenance costs. Now 23% of its workforce is maintenance people.

Pound of flesh

Although the pace of the arrival of the new jets has been glacial, the pilots and maintenance workers hastened to get their pound of flesh from the vaunted, though as yet unrealized, efficiency. In December 2016 the pilots got an 8.75% raise; in August 2017 the maintenance people got a 5% raise. With 537 pilots and 1,400-plus maintenance workers, the added cost is significant.

In 2018, the price of jet fuel rose 28% , which is expected to jack up the El Al’s costs by $96 million a year (excluding hedging) — on top of the $47 million additional fuel outlay in 2017.

The carrier is also contending with rising costs for overseas operations after the shekel-dollar exchange rate climbed 2.8% from the start of the year, compared with the average for 2017. Meanwhile, the euro jumped 8.2% versus the dollar.

If El Al hoped to solve the problem of its climbing operating costs with increasing income from its new fleet, that hope had been dashed by fierce competition. The airline’s market share has hurt on all its routes — to Europe because of competition from low-cost airlines and to North America because of competition with carriers such as Turkish Airlines and United.

Worst is El Al’s losing 40% of its market share to the Far East in the last two years, an especially painful blow because these routes delivered a third of El Al’s profits. It had a de facto monopoly on routes to Beijing, Bangkok, New Delhi and Hong Kong. But it’s losing business to Cathay Pacific, Hainan and Air India. The latter has a significant edge because it has gotten permission to fly a shorter route through Saudi airspace, which El Al can’t do. It had no choice but to aggressively lower airfares, so despite increasing passenger volume, its profitability remains poor.

At this point, the Dreamliner looks less like a game-changer for El Al that will dramatically improve its situation and more like a weapon crucial to survival.

The fact that El Al has had to forgo for now plans to fly directly to San Francisco shows that even the improved customer experience the Dreamliner offers doesn’t let El Al to charge a premium, while competitors like United provide a decent customer experience for $500 less per ticket. El Al should reconsider locking its expensive pilot manpower onto a target that isn’t a money-maker.

Falling market share

In 2017, El Al’s market share fell by 12.5% to 28.5%, which forced it to pay increased fees to the Israel Airports Authority because the authority gives discounts based above a certain level of market share. El Al’s share is now about 27%.

Competition is only expected to intensify come the summer season as the Open Skies reforms enter their last stage. The Civil Aviation Authority anticipates a 14% increase in the number flights compared with last summer, mainly due to a 60% leap in the number of low-cost flights and new airlines servicing Tel Aviv, like Air India. Israeli airlines are only expected to increase available seats by 6%. The upshot is more pressure to keep airfares low and more cash flow pain for El Al, which has interest and principal repayments to make this year, as well as lease fees amounting to $275 million.

El Al management seems to share the pessimism about the impact of competition, rising fuel prices and the appreciation of the shekel. A company evaluation done ahead of the 2017 financial statement estimated that the capitalized value of the 26 planes it owns and 14 it leases at $858 million, $190 million less thanin the first quarter of 2017 and $522 million less than two years ago.

Meanwhile, the company has failed to make good use of its available cash to reduce its workforce. El Al accrued cash of $323 million in 2015 to 2017, but four years after the Open Skies reform began, the company has 8% more employees. El Al did expand its activity by 15% in that time, but given the sharp increase in expenses, it would have been wiser to invest $43 million in releasing costly long-time employees in order to get lean and mean as the competition roars, instead of paying the money as a dividend in 2016 and 2017.