This article first appeared in The Edge Financial Daily on November 14, 2019 - November 20, 2019

Aviation sector
Maintain neutral: The US Federal Aviation Administration (FAA) yesterday downgraded the Civil Aviation Authority of Malaysia (CAAM) to the status of a Category 2 regulator, from the previous Category 1. The downgrade was the result of an audit conducted in April 2019 covering legislation, regulatory oversight and adequacy of technical personnel employed by CAAM. Malaysia’s aviation safety is regulated by CAAM, while commercial regulation is undertaken by the Malaysian Aviation Commission (Mavcom). CAAM acknowledged that it has shortcomings which it hopes to resolve within 12 months, upon which it will invite the FAA to conduct another audit with the hope of having its Category 1 status restored. CAAM was audited by the International Civil Aviation Organization (ICAO) in mid-2019, but the results are not yet known. The FAA downgrade is not an assessment of the safety of airlines, airports and air traffic control services in Malaysia. Rather, it reflects FAA’s judgement that CAAM may not be able to perform its regulatory oversight function properly given its various shortcomings.

Malaysia Airlines does not fly to the US directly, but code-shares with American Airlines (AA) on US domestic flights within the Oneworld alliance. AA code-shares on Malaysia Airlines flights between Kuala Lumpur and Hong Kong, London Heathrow, Tokyo Narita and Penang. These code-share arrangements will have to be terminated while Malaysia remains on Category 2. Malaysia Airlines will lose the ability to sell connections to US domestic cities, and will not be able to accept AA code-share passengers, which is a loss for both airlines. AirAsia X Bhd (AAX) flies to Honolulu via Osaka seven times weekly, and will not be allowed to increase services to the US while Category 2 is in place. AAX may also have to freeze its plans to serve the US west coast via Tokyo Narita in 2021 forecast (2021F) using the A330- 900neos that it will begin to take delivery of from 2020F onwards.

Japan and South Korea may not impose restrictions on airlines from Category 2 countries, if these countries pass their ICAO audits. But if ICAO issues a significant security concern (SSC) against Malaysia resulting from its mid-2019 audit of CAAM, Malaysian carriers are likely to face restrictions on their flights to Japan and South Korea. For instance, neither Japan nor South Korea will allow new services from existing carriers to additional cities. Japan will not allow new capacity on current services, although South Korea may permit capacity additions by existing carriers on existing routes on a limited basis. Malaysia Airlines flies 12 times weekly to Seoul, 12 times weekly to Tokyo Narita and seven times weekly to Osaka Kansai. AAX flies 22 times weekly to Japan — Tokyo Haneda (seven times), Osaka Kansai (seven times), Fukuoka (four times) and Sapporo (four times); and 28 times weekly to South Korea — Seoul (18 times), Busan (six times) and Jeju (four times). These existing flights will not be affected, and AAX also has no plans to increase frequencies in 2020F. From Nov 20, AAX will commence four-time weekly flights from Kuala Lumpur to Tokyo Narita. Japanese regulatory approvals have been received, although we are unsure if Japan will allow AAX to continue with these flights due to the Category 2 downgrade. If ICAO issues an SSC warning against Malaysia, the risk to this service rises. AAX is now selling four-time weekly Taipei- Okinawa flights commencing Jan 22, 2020 — this route is also subject to some uncertainty.

If ICAO does not issue an SSC against Malaysia and Japan and South Korea do not impose limits on Malaysian carriers, we think the impact on Malaysia Airports Holdings Bhd’s (MAHB) passenger traffic will be marginal, if any. If an SSC is declared on Malaysia, MAHB’s growth may be impacted slightly, as AAX may not be able to continue its Kuala Lumpur-Narita flights. However, since all existing MAS/AAX flights to Japan/South Korea can continue as usual, the impact on MAHB will be small.

Higher costs from the sale and leaseback transactions for AirAsia Group Bhd (“reduce”, target price [TP]: RM1.56) aircraft assets will hit the profitability of the group, even though its Malaysian, Thai, Indonesian and Philippine operations are expected to do better from a revenue perspective.

AAX’s (“reduce”, TP: two sen) outlook remains challenging due to the weak outbound Chinese tourism flows, more competition from Chinese carriers, and continued losses from its Indonesian charter operations.

Our top pick is MAHB (“add”, TP: RM9.30) as we expect the company to benefit from the implementation of regulatory asset base from Jan 1, 2020F, whereby the average aeronautical tariffs may rise by 25% against the actual earned in 2018, as proposed by Mavcom. However, the Malaysian government has not indicated whether it will support the proposed tariff increases. — CGS-CIMB Research, Nov 12