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OPERATIONAL REPORT

SOUTH AFRICAN AIRWAYS (SAA)

• Turnover up 12,5% to R19,6 billion • Now member of Star Alliance • Capital expenditure of R1,7 billion planned

SAA is Africa’s leading airline, accessing 842 destinations in 152 countries.   BUSINESS OVERVIEW South African Airways (SAA) serves 842 destinations throughout the world, carrying more than 7 million passengers each year. With a staff complement of almost 12 000 employees worldwide, including 3 600 at SAA Technical, SAA is Africa’s dominant airline. SAA Technical, the technical maintenance division, is situated at the Johannesburg International Airport. As the largest maintenance facility on the continent, it performs maintenance for more than 40 major airlines.

 SAA Cargo, the freight services division, facilitates global exporting and freight transportation services.

During the year, SAA became a member of the 18-member Star Alliance. The airline now offers passengers access to 842 destinations in more than 150 countries.

STRATEGIC OBJECTIVES

SAA’s strategic objectives include:

• Ensuring long-term sustainability and future profitability through targeted cost-cutting initiatives.
• Establishing SAA’s market leadership position on the continent as a safe, efficient, innovative and reputable provider of passenger and freight transportation services.
• Growing business opportunities for SAA Cargo and SAA Technical.

PERFORMANCE HIGHLIGHTS AND OPERATIONAL ACHIEVEMENTS

• Overall departures in the South African market increased by more than 11% in the year. Whilst SAA lost market share to increasingly competitive low-cost carriers, passenger numbers grew by 4,5% to nearly 7,2 million. Despite the higher passenger load, passenger revenue edged up only 0,8% to R13 billion and yields declined by 3,5%, resulting in lower-than-anticipated profits.
• SAA actively and successfully sought to reduce the costs of sales and distribution during the year, resulting in a sharp increase in sales by direct channels such as the www.flysaa.com website and telephone call centres. This, however, came at a cost to yields, as the average domestic sector fare dropped by approximately 11% due to a price war with established ‘no-frills’ carriers.
• SAA faced a sharp rise in fuel costs, which increased by R1,7 billion to R4,9 billion. Energy now represents more than a quarter of overall operating costs. A number of initiatives aimed at reducing expenses have yielded significant results. Changes in the Group’s fuel policy and fuel procurement agreements – following negotiations with suppliers – have yielded savings of R73 million.
• SAA’s five-year fleet renewal programme was completed during the year, after taking delivery of two Airbus A340-600 aircraft and three Airbus A319-100 aircraft. SAA currently owns 17 aircraft and leases 56. The renewal programme, coupled with the signing of sale and leaseback agreements, reduced capital expenditure significantly and strengthened the balance sheet.
• SAA repaid Transnet Ltd R1,6 billion of the R4,0 billion compulsory convertible subordinated loan provided by the holding Company in the previous year. Transnet also agreed to convert to shares the remaining R2,4 billion of the loan.
• SAA agreed to pay the Competition Commission R100 million over two years to settle a complaint, launched more than six years ago, regarding incentive schemes to travel agents. Rather than appeal the penalty, SAA elected to focus its energies on building awareness of competition law throughout the organisation.
• The Bambanani turnaround programme, introduced in 2004, continued to yield cost-cutting achievements during the year. The programme targets to deliver approximately R1,6 billion in total savings over a three-year period. Whilst SAA did not meet its savings target of R900 million set for the year, costs were cut by more than R500 million.

FINANCIAL OVERVIEW

	Year ended	Year ended
	31 March	31 March
	2006	2005	%
	R million	R million	change
Salient features
Turnover	19 625	17 442	13
Operating profit	345	870	(60)
Profit before taxation	75	650	(88)
Net asset value	1 246	2 705	(54)
Profitability measures
Operating margin	1,8%	5,0%	(64)
Return on net assets	6,0%	24,0%	(75)
Capital expenditure
Total	325	1 963	(83)
Employees
Number of employees	11 524	11 601	(0,7)
Turnover per employee	1,7	1,5	13,3
Operating data
Passengers uplifted (thousands)	7 158	6 851	4,5
Cargo (thousand tons)	185	176	5,1

FINANCIAL PERFORMANCE

Operating profit decreased from R870 million last year to R345 million. The decline is attributable mainly to the impact of oil price increases of more than 50% and the disappointing growth in passenger revenue as a result of the increased competition from low-cost carriers in the domestic market. In the previous year, operating profit was boosted by favourable fair value movements and translation gains. During the year, SAA’s operating margin decreased to 1,8% – from a restated 5,0% in the previous year – falling below the target of 9% for the year. Profit before taxation declined from R650 million to R75 million.

Operating costs increased by 17,7% during the year to approximately R19 billion, due mainly to a 51,5% increase in energy costs, from R3 257 million to R4 933 million. The monthly average oil price was US$58,43 per barrel compared to US$40,54 per barrel in the previous year. In an effort to control fuel costs, SAA hedged 40% of its fuel uplift at an average oil price of US$62 per barrel. It recorded a net realised cash inflow from fuel hedging of R292 million during the year.

In addition, financing costs increased as international interest rates – on which the airline’s leases are based – increased. In the previous year, interest earned on higher cash balances, mainly the Transnet loan, assisted in offsetting some of SAA’s financing costs. Excluding energy, the rise in overall operating costs was in line with inflation, at approximately 5%. However, unit costs, measured in rand per available seat kilometre, increased by 13,9%.

SAA experienced difficult conditions in all its operating markets, except in flights to other African countries. Labour disruptions in July 2005, coupled with the loss of market share to low-cost operators, resulted in an 11% reduction in the domestic yield for revenue passengers. International business was also affected by the later-than-expected launch of flights to Washington, Zanzibar and Livingstone.

During the year, passenger revenue remained relatively static at approximately R13 billion, while revenue passenger numbers increased by 4,5%. Overall average yields declined by 3,5%. Recorded revenue was lower than anticipated, despite a 5,6% increase in capacity, while the average load factor remained constant at 70%.

The tonnage of cargo carried on SAA aircraft increased by 5,1% to 185 000. Turnover from cargo and mail rose by 7,9% to R1,6 billion, mainly as a result of strong increases in cargo revenue on international and regional routes. The average cargo flight yields on international routes decreased during the year, while flights to domestic destinations increased. Turnover from SAA’s technical services increased by more than a quarter, to R470 million.

Other airline revenue increased to R3 781 million, from R1 867 million the previous year. The increase was mainly due to higher fuel levies required to cover the sharp increase in fuel costs, as well as the accelerated release of unused passenger tickets to revenue. The accelerated release amounts to an additional R600 million when compared to the prior year.

Direct sales in the domestic market increased to 50% of total sales from 32% in the previous year. Although this was at a cost to yields, SAA will continue to develop sales through its website and call centres, in line with international trends, while continuing to enhance yield management. The higher proportion of direct sales resulted in savings on distribution costs and improved cash flows.

CAPITAL INVESTMENT

Despite relatively static revenues in the year, SAA generated cash from operations of R336 million and recorded a net decrease in working capital of R1 057 million.

The fleet renewal programme was completed during the year and as a result capital expenditure was reduced from R1 964 million to R335 million. In addition, SAA introduced a new capital expenditure framework, which has assisted in curbing unnecessary spending.

The capital expenditure for the next year includes:

Projects	R million
Aircraft	456
Furniture and equipment	108
Computer equipment	200
Total	764

SAA has planned for the following major capital expenditure (greater than R50 million) over the next four years:

Projects	R million
Aircraft	1 356
Furniture and equipment	116
Computer equipment	273
Total	1 745

OPERATIONAL PERFORMANCE

SAA’s landmark admission to the Star Alliance of major international carriers was a priority during the year. It improved performance, policies and systems ahead of joining the Airline Network for Earth™, which will deliver substantial benefits in the years ahead. SAA successfully fulfilled the 53 stringent joining requirements and became the Star Alliance’s 18th member in early 2006.

SAA achieved significant cost reductions across the organisation during the year. These included the successful renegotiation of burdensome contracts with suppliers, thereby locking in savings of approximately R1,3 billion over the next five years.

The Voyager frequent flyer programme has been improved and simplified. The new ”book by miles” online feature now offers customers more booking options. SAA’s increasingly popular www.flysaa.com website was upgraded to offer superior functionality and ease of use. As a result, the website generated more than one million passenger sales this year, an increase of 182% on the previous year. Together with SAA’s other direct sales channels, more than 1,8 million passengers purchased their tickets directly from SAA, contributing to substantial distribution cost savings.

Revenue accounting systems were improved during the year, resulting in an accelerated release of tickets and waybills to revenue of R1 028 million, up from R423 million in the previous year.

The airline’s service to the travel trade was improved during the year by upgrading IT platforms and replacing the existing reservations system with the new Amadeus platform. It will enable SAA to improve on delivery by offering a consistent, professional flight booking service to the travel industry. In line with international trends and efforts to improve transparency, SAA phased out commissions to travel agents, which initially amounted to approximately 7%.

Significant product and network improvements were achieved with the delivery of five new aircraft: two long-haul A340-600s and three A319-100 twin jet short-haul aircraft. This completes SAA’s fleet renewal programme, providing the airline with a modern and environmentally friendly fleet.

As part of SAA’s strategy to connect Africa, it opened routes to Zanzibar in Tanzania and Livingstone in Zambia during the year, resulting in a continental airline network serving 23 destinations. Outside Africa, the network was boosted by adding flights to Washington and increasing the daily frequencies of flights between Cape Town and Frankfurt. In the domestic market, unprofitable flights were discontinued.

In March 2006 SAA made a decision to discontinue the investment in Air Tanzania Company Ltd and is treating the stake in the loss-making East African carrier as a discontinued operation.

SAA Technical procured additional business from other airlines during the year. It aims to grow its client base over the next three years to a point where the customers other than SAA will constitute half its revenues as opposed to the current 25%.

SAFETY, HEALTH AND ENVIRONMENT

SAA recently attained IOSA accreditation, which aligns safety practices with an internationally recognised safety and security evaluation system. IOSA is designed to assess the safety and quality of the airline’s operational management and control systems.

As a member of the Star Alliance, SAA is committed to complying with the world’s most stringent safety and security standards.

HUMAN CAPITAL MANAGEMENT

Employee numbers declined by 0,7% to 11 524.

In July 2005, SAA experienced its biggest industrial action ever, which grounded operations for almost a week. Management settled with labour unions on a 5% increase in pensionable wages, with medical and housing benefits and an additional 1% increase in non-pensionable allowances. Moreover, a three-year agreement was signed with cabin crew and ground operations staff to improve employment conditions. SAA has since improved its labour relations initiatives to ensure better communication with all staff across the organisation.

MANAGEMENT CHALLENGES

SAA faces the following management challenges in the coming year:

• Stepping up the cost-cutting drive to ensure long-term sustainability and profitability, particularly in view of increased competition from low-cost carriers and sharply rising oil prices;
• Enhancing operational performance and efficiencies;
• Further improving customer service and client relations;
• Managing capacity and scaling back unprofitable routes;
• Enhancing yields on domestic and international routes; and
• Ensuring sufficient working capital for the year ahead.

PROSPECTS

In the year ahead, Transnet’s stake in SAA will be transferred to the Department of Public Enterprises. It is anticipated that this process will be finalised by 31 December 2006.

Despite increased competition from low-cost operators and a volatile oil price, SAA anticipates improved financial results during the next year. Organisation-wide cost-cutting initiatives are gaining momentum while SAA’s launch of its own low-cost carrier will contribute to its improved financial position. SAA will manage capacity more dynamically in the coming year, scaling back unprofitable routes and leveraging the Star Alliance network.