David Fullbrook – Cutthroat cost competition, overcrowded airports and perennial safety concerns, including a tragic accident involving an aged plane that killed at least 90 people on Monday, would on the surface seem to conspire against the prospects of Indonesia's historically up-and-down aviation industry.

But rapid deregulation has initiated an aviation boom, with growth prospects buoyant enough to hold and draw big new foreign investors to Indonesia's opening skies. Nineteen different domestic carriers are competing for an estimated 34 million passengers per year, according to Indonesia's Directorate General of Air Communication. The agency predicts 54 million air travelers will buckle up annually by 2010, skyrocketing from the mere 6.4 million who traveled in 1999.

By comparison, India, with four times Indonesia's population but comparatively heaps more red tape, is currently looking at only 27 million air passengers annually. If Jakarta finally sorts out some of the economy's biggest problems, such as expensive energy and a half-drawn investment picture, as it promises, traffic could grow even faster. With incomes rising and migration increasing there is huge scope for demand to grow, aviation analysts say.

Intense competition, which has sliced average ticket prices, has left many Indonesian airliners struggling to turn profits as they sell seats below cost to undercut their rivals. "The reality in Indonesia is that some airlines have managed their inventory well so they can lower fares, but there are also many other airlines that are offering fares that are not sustainable, especially with high oil prices," said Lim Liang Song, principal of Indigo Partners, a private-equity fund that recently invested in an Indonesian airline.

Half of Indonesia's estimated 262 airliners are at least 20 years old. Such aircraft require more maintenance checks to comply with international safety regulations and use at least 25% more fuel than new aircraft. Indonesian safety authorities have banned airlines from importing any more aircraft more than 20 years old. They have also stepped up inspections in recent years, worried that airlines may be cutting corners in maintenance or using fake parts to keep ticket prices low.

Accident-prone carriers

Still, a string of tragic accidents raises new safety concerns and questions about whether Indonesia's airline industry has opened too much, too fast. An Adam Air Boeing 737 crashed on Sulawesi island on Monday, killing at least 90 of the 102 passengers. The plane had reportedly flown 45,371 hours in its 17-year life, according to news reports.

It's not the first time tragedy has touched Indonesia's airline industry. A Mandala Airlines Boeing 737 crashed shortly after takeoff from Medan, killing 143 people; that jet had flown more than 50,000 hours in 24 years. A similarly well-used Lion Airlines Boeing MD-82 crash-landed at Solo, killing 25 of the 141 people on board in November 2004 after having notched up 43,940 landings in 56,674 flight hours. While the Mandala and Adam crashes are under investigation, weather was blamed for the Lion crash. However, some independent experts remain circumspect because corruption is rampant in Indonesia and government regulatory departments are often underfunded and understaffed. Airlines, especially smaller carriers, also face a high turnover of pilots and engineers who can find better offers and employment security with larger airlines or further abroad in India and the Middle East, where aviation is also booming.

Indonesian airlines "have used a lot of the older narrow-body equipment for their expansion. This is very expensive; to replace their fleets is going to take a significant investment. How many airlines can do that? Lion, Garuda? But they're limited in how much they can take on," said an executive of aircraft manufacturer Embraer.

Moreover, Indonesia, like China, has yet to effectively dismantle a state-sanctioned monopoly on air fuel that makes prices higher than in other countries in the region. Rising fuel prices are but one part of a complex competitive vice squeezing Indonesian carriers. Breakneck expansion is swamping Indonesia's major airports, where overcrowding and delayed departures have become the norm. That has likewise increased carriers' costs and prevented some players from opening new routes. Jakarta's Cengkareng Airport is currently running at 50% above capacity.

Furthermore, many smaller airports servicing far-flung provincial islands are only equipped for day flights by small aircraft that increasingly are not economic in the current competitive environment. Airport-capacity issues are just one reason airliners in Indonesia typically fly six or seven hours a day, compared with at least 10 hours low-cost carriers generally aim to fly daily to make money.

This was less of an issue three or four years ago because aircraft lease prices were at rock-bottom after the industry globally entered a severe recession triggered by the terrorist attacks on the US in September 2001. That price plunge came shortly after the Indonesian government finally began deregulating the airline industry in late 1999.

Ready for take off

With about 230 million Indonesians scattered across a 5,000-kilometer-wide archipelago stuck with slow, crowded and accident-prone buses, trains and ships, or pricey flights courtesy of a handful of airlines connected to cronies of former dictator Suharto and the military, budget airlines were prime to take off in Indonesia.

The worldwide airline industry is thriving again as lease prices have sharply risen, but for Indonesia that has made fleet expansion or replacement more costly. And increasingly those costs cannot be recouped through higher ticket prices because of the market's intense price competition. And pressure to replace aged aircraft will become more severe for all airlines using second-hand aircraft after Monday's Adam Air crash.

Unfortunately, Indonesian airlines face greater costs than other regional countries in funding aircraft replacement or expansion. Many foreign lenders consider Indonesia, and by association its airlines, a risky investment, so they charge higher interest rates to accommodate the risk premium. Indonesian airlines are also locked out of corporate bond markets for similar reasons.

"Access to capital will be a major issue for private carriers going forward," said Derek Sadubin, an analyst with the Center for Asia-Pacific Aviation. "At least some of them are looking to list offshore or, as in the case of Mandala, to go for private equity."

Adam Air, after reportedly turning down offers from Qantas Airways and private-equity outfit Texas Pacific Group, is now considering an initial public offering in Singapore for 2008. Those foreign approaches apparently foundered because Adam's owners refused to give up management control. It's unclear if those plans will change after the adverse publicity generated by the carrier's accident.

Still, foreign interest in the market remains strong. Malaysian low-cost pioneer AirAsia bought defunct carrier Air Wagon International in 2004, which went bankrupt in 2002. Unlike Malaysia and Thailand, where AirAsia has thrived, Indonesia has been a tough slog for the budget carrier. With only six aircraft, compared with 12 in Thailand, AirAsia remains a small carrier in Indonesia.

Indigo, a private-equity fund closely linked to Texas Pacific and which counts among its investors Singapore government investment fund Temasek, bought a 49% stake in Mandala from Cardig, an aviation engineering, cargo and support services firm, in September. Mandala was sold by the military to Cardig in 2005. In 2004, Indigo launched Wizz Airlines in Hungary and Tiger Airways in Singapore.

Indigo is now recruiting new management for Mandala and has started replacing the old fuel-guzzling Boeing 737s with more efficient, modern Airbus A320s. "We are in discussion with several lessors for aircraft for 2007 and 2008. I think in three to four years we hope to see an airline with 20 or 30 aircraft. That would be just about right in terms of the growth in demand in the coming years," said Lim.

Indonesia's overcrowded and underdeveloped airports are also a prime opportunity for foreign investors. In India, for example, foreigners have become key players in the privatizations of Delhi and Mumbai airports, and the redevelopment of airports elsewhere such as Bangalore. However, foreign interest has remained lukewarm while the Indonesian government reviews its privatization plans and foreign-investment laws.

Ambitious expansions

Despite these hurdles, the two largest private carriers, Adam and Lion, each with about 30 aircraft, have inked ambitious expansion plans. Adam has recently ordered 30 Airbus A320s, while Lion, whose current aircraft are on average 17 years old, with an order for 60 aircraft is the launch customer for Boeing's new 737-900ER. New aircraft obviously require less maintenance and crucially use less fuel than the old Boeing 727s, 737s and MD-80s most Indonesian airlines use. They will also help Adam to restore credibility about its safety standards after the accident involving an aged aircraft.

They also continue to add routes and increase services, moving into higher-yielding, but thinner, secondary routes where minnow carriers hide, unable to bear the competition of trunk routes. Following Adam and Lion are mid-sized airlines Batavia, Jatayu and Sriwijaya, with a dozen aircraft each. Despite the scrum, there remains plenty of scope for expansion. "There is no airline yet that can be said to be truly a pan-Indonesia airline. They either settle on a handful of major routes or a niche region, without the frequency or network you would expect," said Lim.

Some carriers, like Adam and Lion, are trying to stand out from the pack through better service, frequent-flyer programs and lounges. Adam, for example, has been serving McDonald's food on some flights. "The focus of passenger demand will be on service levels. That's when a sustainable fundamental product differentiation will be essential. I think the focus will have to be on building brand loyal customers," said the Embraer executive.

With competition intensifying and price pressures increasing bankruptcies, common since deregulation began, will continue. Bouraq, a large legacy carrier from the Suharto days, called it a day last May. Competition is unlikely to ease, however. "This is never a static industry, so that a shakeout at this early stage in the Indonesian market's expansion will only be a temporary rest. The upside potential is so great that there will be waves of new entry over coming years as the economy expands," said Peter Harbison, managing director of the Center for Asia-Pacific Aviation.

Foreign players such as Indigo and AirAsia do not necessarily have an edge over Indonesian incumbents, some industry analysts contend. Political connections remain important in the industry. Lion's commissioner, Halim Kalla, is the brother of Jusuf Kalla, Indonesia's vice president. Adam's chairman, on the other hand, is Agung Laksono, Speaker of the House of Representatives.

"It's a very high-growth market, but I don't think the government is going to give it carte blanche because of Garuda, political linkages and stuff like that. I don't think they want people like [Air Asia's] Tony Fernandes running over the top of the market, controlling it. If anybody's going to end up running a lot of it it's going to be an Indonesian carrier," said an aviation analyst with investment bank JPMorgan.

Or foreigners that choose the right Indonesian partner. Those that do thrive on the back of this huge market will likely be well placed to expand in Southeast Asia as governments slowly trim the red tape that restricts regional flights and household incomes rise in the years ahead. For that reason alone anybody serious about building a regional airline in Southeast Asia has to hold his breath, close his eyes and take the plunge into Indonesia's wild and wooly aviation.