Privatization in Lebanon Middle East Airlines; A Case Study

1. Privatization in LebanonMiddle East Airlines; A Case Study Faisal M. Nsouli, Ph.D. January 2007 L.E.A. Special acknowledgements to my research assistants: Mr. Joseph Reaidy, Mr. Ehab Salameh and Ms. Souad Daher

2. Table of contents Slide # I.Definition5 Why To Privatize6 Economic and financial effects of privatization 7-9 • Company performance 7 • Fiscal Adjustments 8 • Foreign Investment 8 • Capital Market Development 9 • Employment 9 II.Privatization process 10-14 • Feasibility study 10 • Preparation 11 • Enterprise valuation 12 • Privatization Techniques 13, 14 III.Current economic situation in Lebanon15 - 19

3. Table of contents Slide # IV.TheNeed to privatize in Lebanon20, 21 V.MEA Background22, 23 Restructuring24 After Restructuring25 MEA Potential for Growth26, 27 Current/Future Status 28 - 30 MEA Fleet characteristics31 - 33 Valuation 34 - 43 MEA Expected Value44 MEA Share Price45 Privatization Technique46 Expected Results 47 - 50 • Lebanese Government 47 • MEA’s Benefits from Strategic Partner 48 • MEA 49 • Consumer Satisfaction 50 VI. Conclusion 51 - 53

4. Abbreviations and Acronyms

5. I. Definition • "Privatization is defined as the transfer of assets and service functions from the public to the private sector" (Manzetti 1999, 1). • While there are different forms of privatization, a widely accepted definition of privatization encompasses the privatization of management as well as the privatization of ownership.

6. Why To Privatize Privatization has been a growth business all over the world in the past decade, there are many reasons behind governments’ will to privatize; which include: • Maximizing return. • Increasing capital market. • Restructuring debt position. • breaking up monopolies. • promoting investment. • reducing public expenditure. • ensuring continuity of service. • improving efficiency. • Reduce corruption.

7. Economic and Financial Effects of Privatization Privatization usually leaves a positive impact on the country, which affects: • Company performance: There is near unanimity that Privatization had lead to improvement in company performance (both financial and operational). The impact can be measured by looking at the following firm’s positive performance indicators: • Profitability • Labor productivity • Investment • Output • Financial leverage Improved performance is primarily due to the fact that once the private sector takes over a SOE, profitability becomes paramount.

8. Economic and Financial Effects of Privatization • Fiscal Adjustments: governments often implement privatization to either reduce the burden of loss-making enterprises on public funds or to raise additional revenues to refill a financial gap. Governments have to accompany privatization with parallel measures to manage the public debt efficiently and to reduce the budget deficit. • Foreign Investment: Privatization and foreign investments are linked in ways: direct impact, indirect impact and catalytic impact. • Direct impact: privatization attracts foreign investors by giving them the right to develop a new infrastructure facility or the right to deliver infrastructure services, but in both cases they should give in new investments. • Indirect Impact: Privatization leads to the development of capital markets which with the proper regulatory framework attract foreign portfolio investments. • Catalytic impact: is when privatization puts the developing country on the investor's radar screen and generates interest in it.

9. Economic and Financial Effects of Privatization 4. Capital Market Development: privatization has been the most important factor in the development of capital markets. It has led to growth and liquidity of the financial markets. 5. Employment: the impact of privatization on employment is not clear yet but it can be observed as neutral or positive. If the government couples privatization with adequate labor policy and social safety nets, the impact on employment will definitely be positive.

10. II. Privatization Process 1. Feasibility study The feasibility study should address the following aspects: • Present financial viability and the need to minimize costs and financial losses and to preserve asset values. • The nature of the industry, the existing technology involved and the need for new technology or market access. • The known or expected type and level of investor interest. • Consumer interests • The constraints to privatization. • The need, if any, to preserve part public ownership. • The need, if any, to preserve the interests of shareholders or managers. • The short and longer term impact on employment. • The need to maximize the proceeds of privatization. • The need to maximize the eventual returns to Treasury.

11. II. Privatization Process 2. Preparation: In a typical transaction, the Privatization Commission, in consultation with the relevant ministry, submits a Summary of the proposed transaction to its Board. The Summary justifies the need for privatizing the property, the feasibility study, outlines the likely mode of privatization, and sometimes seeks guidance on issues relating to such matters as pricing, restructuring, legal considerations, and the regulatory framework. Once endorsed by the Board, it is submitted to the Cabinet for approval.

12. Privatization Process 3.Property valuation : • In order to obtain an independent assessment of the value of the property being privatized, the Commission relies primarily on external firms. The Financial Advisor, where there is one, carries out the valuation to obtain a “reference price” for the property. In other cases, the Commission contracts with an external valuation firm or accounting firm as specified in the rules on the valuation of property. The methods used for the valuation vary with the type of business and often more than one method is used in determining the value. These include the discounted cash flow method, asset valuation at book or market value, and stock market valuation. The true value is dependent on many variables such as country risk, corporate strategy, and perceptions of future macroeconomic performance. Only the market can determine the true value.

13. Privatization Process 4.Privatization techniques • Initial public offering (IPO) IPO is designed to achieve equity through widespread public shares. It relies on sale of low priced public participation shares. • Build-Operate-Transfer (BOT) The private sector designs, finances, builds, and operates the facility over the life of the contract. At the end of this period, ownership reverts to the government. • Contracting Out The government competitively contracts with a private organization, for-profit or non-profit, to provide a service or part of a service. • Management ContractsThe operation of a facility is contracted out to a private company.

14. Privatization Process • VouchersGovernment pays for the service; however, individuals are given redeemable certificates to purchase the service on the open market. • Asset Sale or Long-Term Lease • Government sells the asset to a private sector entity and then leases it back, thus turning physical capital into financial capital. • Another asset sale technique is the employee buyout. Existing public managers and employees take the public unit private, typically purchasing the company through an Employee Stock Ownership Plan (ESOP).

15. III. Current Economic Situation in Lebanon • The direct and indirect costs of the July 2006 war far exceed the capacity of any middle-income country to bear, let alone a country that has been saddled with a very large public debt and a country that had just come out of a major setback associated with the assassination of Prime Minister Hariri, which has left deep scars on the economic and political landscape. As a result, the burden of Lebanon’s public debt has become even heavier. • Based on assessments carried out by independent consultants retained by the Prime Minister’s Office, the total direct costof early recovery and reconstruction is now estimated at around US$2.8 billion.

16. Current Economic Situation in Lebanon • In the early 1990s, the government undertook the task of reconstruction of public infrastructure, and of investing in social peace. • With eroded revenue base, the government relied heavily on borrowing domestically, in addition to some external loans. • The gross public debt started rising sharply from $2 billion in 1990 to $15.3 billion in 1997 and to $25 billion by the year 2000 equivalent to 150% of GDP. Then increasing at a rough $3 billion per year and reaching $36 billion in 2004 and $38 billion in 2005 equal to 175% of GDP.

17. Current Economic Situation in Lebanon • Saddled with such a large public debt, and just coming out of a major setback associated with the assassination of Prime Minister Hariri (2005), which has left deep scars on the economic and political landscape, Lebanon further took another shock represented in the July war; and the burden of Lebanon’s public debt has become even heavier. • As a result, total gross public debt reached US$40.5 billion end of 2006—equivalent to 180% of estimated post war 2006 GDP.

18. Current Economic Situation in Lebanon Debt To GDP

19. Current Economic Situation in Lebanon • 65% of the public debt outstanding matures between 2007 & 2010, in addition to most of the new borrowing during and subsequent to the July war. Close to US$16 billion of the debt outstanding as of mid-2006 matures in 2007and 2008.

20. IV. Need to Privatize in Lebanon • The IMF has long maintained that privatization is not an end in itself, but a means to achieving an end. • In Lebanon, the end should not be seen solely in terms of getting the highest return from privatization to reduce the public debt. Indeed, the total valuation of enterprises with the potential for privatization is quite small in relation to the total debt (around 10-15 percent). • Rather, the end should be to reduce the cost and enhance the quality of service in key industries such as power, telecommunications, and transportation, with the ultimate aim of spurring economic growth.

21. IV. Need to Privatize in Lebanon • A Public-Private Partnership Strategy needs to be developed which conceives of the full scope of private participation options, from service contracts all the way to full privatization, and is applied differently to SOEs that are very different in nature (water, electricity, telecommunications, tobacco, ports, casinos, MEA). • MEA is one of many promising SOES , following is a study of MEA privatization.

22. V. MEA Background • MEA was established in 1945.The Lebanon based airline lunched its first service routes to Syria, Cyprus and Egypt; it then establish regular passenger service to the gulf region. • By the early 1970’s MEA was going through its golden age earning a total revenue in 1974 approximately equal to $140 million. • From 1975 till 1990 MEA suffered losses as a direct result of the civil war.

23. MEA Background • After the return to normality in 1990 till 1998,MEA started to become a burden for the Lebanese government especially with its continuous losses due to many reasons; mainly: -The direct consequences of the war. -The overstaffed employees. -The relatively old fleet (unable to compete). -Corruption/heavy expenses. • As a result, restructuring was a must to solve these problems (it also served as a first step towards privatization).

24. Restructuring • Due to the study conducted by the International Funding Corporation (IFC), the following steps were imposed: • Laying off around 1500 employees; this was accompanied by the Union’s opposition, but with Government’s support. • Down sizing destination/Fleet where many destinations were closed, all old Aircraft were sold (B707, B747) and replaced by leased Airbus A310 & A320. • Reorganization into affiliated companies: MEA, MEAS, MEAG, MASCO.

25. After Restructuring • As a result, MEA income statement changed from suffering great losses to breaking even in 2002, and earning profits in 2003. • 2004: $ 50 m net profit were declared. • 2005: $46 m were declared despite the political instability (Hariri assassination ). • 2006: $10 m are expected despite the latest destructive war on Lebanon.

26. MEA Potential for Growth • MEA may increase its market share due to the presence of many potential destinations like: Berlin, Copenhagen, Brussels, Doha, Bahrain, Dhahran, Tehran, Montreal, New York, Sao Paolo, Singapore, Sydney, Beijing…(Most of them were old destinations). • Potential to increase flights’ frequency of some of the demanding destinations namely to: Dubai, Riyadh, Paris, and London (especially during summer season).

27. MEA Potential for Growth • Potential to reduce costs by adding more airplanes to the Fleet, which will lead to: • Reduce costs of leasing. • Benefit from some economies of scale (crew/employees/operating fees).

28. Current/Future Status • MEA currently owns 6 Airbus A321 fully equipped, capacity: 31J/118Y. In addition MEA leases 3 Airbus A330-200 capacity 42J/208Y. • In mid December 2006 MEA signed a contract to purchase 4 additional Airbus A319, proposed capacity 24J/80Y and 4 additional Airbus A330 to replace the current leased ones. • Delivery of these Aircrafts is expected to be in 2008 and 2009.

29. Current/Future Status • This new purchase is expected to open new horizons for MEA where: • New routes/destinations will be added. • Frequency flights on current routes will be increased . • Potential to add more Aircrafts in the future. • Better cross utilization of the Fleet. • The company is also studying an option to add another 5 Aircrafts in 2010 and 2011

30. Current/Future Status * Additional destinations during special holidays and seasons e.g. Sharm El Sheikh

31. MEA Fleet characteristics • Economics: The Airbus A320 family are the world’s most profitable single aisle aircraft. Their advanced technology and maximum operational flexibility result in lower fuel burn and reduced maintenance costs. • Technology: Airbus pioneered the fly by wire concept. It also introduced the latest technology and innovation in aviation especially in the cockpit. MEA is the first company to have personal videos for passengers in the cabin of a single aisled Aircraft namely, the A321. • Commonality: Pilots can fly the A318/319/320/321 or A330/340 due to their identical cockpits and operating procedures thus tremendously cutting costs and using crew efficiently. MEA further adopted the CCQ (cross crew qualification) in which crew can fly both A321 and A330, thus making further benefits.

32. MEA Fleet characteristics • Route Optimization: the different capacity and range of the different Airbus family enables companies to better optimize their routes: • The A321 can be used for most of the demanded routes of the MEA network. • The A330 can best be utilized on long routes like: New York, Montreal, Sao Paolo, London, Paris … it could also be used to cover highly demanded short and medium routes (Dubai, Riyadh, Cairo, Kuwait) • The A319 with its lowest passenger capacity can be used for the less demanded routes (Istanbul, Athens, Geneva …) and thus benefit from savings on fuel, over flying fees, and landing fees.

33. MEA Fleet Characteristics

34. Valuation • Due to the absence of any financial data from MEA and knowing when companies are profitable; • then the going concern principle, discounted NPV (that is approved by the US GAAP, UK GAAP, French GAAP, Japanese GAAP, Chinese GAAP and the international standards), shall be used in this model • let us assume that the cash flow of any year “t”: is the net income + depreciation – leasing cost; and going to infinity using different growth figures.

35. Valuation • Different growth rates are used for the first six years, constant growth for the next 6 years, and zero growth thereafter. • Five scenarios of expected net Incomes are estimated: • Upper-bound optimistic • Optimistic • Recession • Worst • Lower-bound worst • Each scenario is given an estimated probability taking into account historical data.

36. Valuation • Leasing costs are deducted from the average net income, depreciation is then added to the average net income to get average cash flow. • Three different discounted rates are estimated each with an approximate probability. • The value of the Company is equal to: Net present value of the first 6 years plus NPV of the next 6 years plus NPV of the perpetuity thereafter, using the weighted average discounted rate.

37. Valuation • Growth Rate estimation: • Part of the growth is related to the country’s expected economic situation and the general demographic growth. • A second part is related to adding new Aircrafts, this effect is realized between 2008 and 2011. Each A319 attributes to approx 9% growth and the A330 attributes to approx 16% growth through out the three year period. • A final part is due to what is called the “after effect” of adding new aircrafts, it will be realized by years 2011 and 2012.

38. Valuation • The Five scenarios of expected net income are: • Upper-bound Optimistic: represented by a year like 2006,had there not been a war, in which MEA was expecting a $65 mil in net revenue. Probability of 35% • Optimistic: a year like 2004 which was stable, MEA earned a $50 million net revenue, this scenario is given a probability of 30%. • Recession: year 2005 is an example, which was politically and economically unstable, with a probability of 20%. • Worst: year 2006 is an example, a probability of 10%. • Lower-bound worst: a projected worst scenario, probability of 5% .

40. Valuation • Depreciation Calculation: The depreciation method used is the simple straight line method based on the salvage value of the Aircrafts and the life expectancy for Airbus aircrafts.

41. Valuation • Adding Depreciation to the Net income, then subtracting the cost of leasing (for the next 3 years as leasing contracts all end by 2010) to get Cash Flow.

42. Valuation • Three different discounted rates are used: • Normal of 10% which is the actual Lebanese bond yield, the probability of this rate to occur is 50%. • Optimistic discounted rate of 7%, which is the expected bond yield (Paris 3 benefits expectation), with a probability of 35% . • High discount rate of 12% which has a probability of 15%.

43. Valuation NPV • NPV of the cash flow up to year 12: $901.9 mil. • Value of Perpetuity at year 12 → ∞: $1983 mil. • NPV of Perpetuity: $686.0 mil.

44. MEA Expected Value • Adding the NPV of the cash flow up to year 12 with the NPV of the perpetuity, we get the average weighted value of MEA equal : ≈$1.588 billion

45. MEA Share Price • The price should attract the highest number of investors (domestic and international). • The Price should be attractive enough for “the small” investor. This will enhance the wide spread participation leading to widespread brand loyalty. • The most appropriate method to be used will be: IPO new issue (like: OTV ) or solidere split 10 for 1, (this will generate the maximum revenue possible) the proposed price :

46. Privatization Technique Three phases: • Phase one: 24% of total outstanding shares offered as IPOs to be listed in Beirut stock exchange. 25% of total outstanding shares to be sold to a strategic partner. 51% remains with BDL • Phase Two: 25%To be sold as IPOs in a period of 6 years. • Phase Three : 26%To be sold as IPOs in a period of 6 years following phase two and three might be re-adjusted in the years to come according to the government’s and company’s need.

47. Expected Results • Lebanese Government: • Maximizing treasury return. • Promote Lebanon international image. • Help financing public debt. • Meet some of the international requirements • Open the road map for other SOE privatization (Rafic El Hariri Int’l Airport) • Enhance Beirut stock exchange performance: • Increase capital market. • Increase daily volume trade. • Increase liquidity.

48. Expected Results • MEA’s Benefits from Strategic Partner: • A strategic partner will make the company more appealing for investors and customers at the same time. • MEA will benefit from the expertise and some management/employee skills of the partner who should be “older” in both experience and field of aviation. The partner should preferably be a major airline company. • MEA will benefit from all facilities regarding routes and airports in order to reduce its total cost. • MEA will benefit from the partner’s network, both airlines could serve as feeders for each other. • Further benefits could be taken when any of the two is in need of temporary extra flights, extra crew …

49. Expected Results • MEA : • MEA will be able to increase its market share. • MEA will be well prepared for new market entries and competition. • MEA will be able to enhance its subsidiaries companies performance (MEAS, MEAG and MASCO). • MEA will be able to generate more profit and increase share holder wealth.

50. Expected Results Consumer Satisfaction include: • High quality of services • Frequency of flights • New destinations • High security level • Attachment and confidence in MEA brand name