(Fortune International Magazine) -- Fed up with 34 years of red ink on the domestic routes of state-owned Malaysia Airlines, the government has turned to low-cost carrier Air Asia to bail it out. Starting in August, Air Asia will take over 96 of the airline's 118 domestic routes, only four of which have been profitable.

Now it falls to Tony Fernandes, the 42-year-old founder and CEO of Air Asia, to prove that his low-cost model can work where Malaysia Airlines failed.

Fernandes, a former Warner Music (Charts) executive, says his lower cost structure - at 2.1 cents per seat per kilometer, the lowest in the world - means he needs to fill only 56% of his seats to break even, compared with 70% for Malaysia Airlines.

With nearly two-thirds of its passengers booking their flights online and no-frills service, Air Asia either breaks even or makes a profit on all 53 routes it serves within Malaysia and to destinations such as Thailand, Indonesia, and Macau, Fernandes says. His company reported a pretax profit of $24 million for the nine months ended March 2006 on revenue of $168 million.

"For four years I have been griping that we've been competing against a state-owned and subsidized airline," Fernandes says. "This will be significant to our earnings."

Terms of the deal weren't revealed, but the government agreed to pay Malaysia Airlines $236 million to compensate it for giving up domestic routes. Air Asia also got a number of unspecified incentives, including what some say is a $5 million subsidy to service some rural routes.

"Who can blame Fernandes for being confident of making headway where Malaysia Airlines couldn't manage its domestic routes profitably?" says Wee Kim Hong, head of research at M&A Securities in Kuala Lumpur. "He had already made Air Asia profitable, even when Malaysia Airlines was subsidized."

Citigroup aviation analyst Corrine Png predicts Air Asia's annual passenger load could increase from 3.5 million to 8.5 million as a result, contributing as much as $211 million a year in additional revenue.

Fernandes and Air Asia chairman Pahamin Rajab bought the company in 2001 for 27 cents. At the time it was a money-losing air-charter service with $13 million in debt owned by a Malaysian conglomerate.

After turning Air Asia into a highflying success, Fernandes started lobbying for a level playing field in the domestic sector. The government had reportedly been compensating Malaysia Airlines $135 million a year to maintain air service on its domestic routes and to provide fuel subsidies.

Even with those subsidies the airline reported a pretax loss of $416 million on revenue of $3.3 billion for the 12 months ended in March. But while Malaysia Airlines CEO Idris Jala shook hands with Fernandes on the government's plan to create two national champions in the aviation sector - one full-service, the other low-cost - it was clear his own rescue plan for the airline, announced in February, had been thwarted. Malaysia Airlines officials declined to comment.

Although Jala's plan didn't take off - save for manpower reductions of about 6,000, currently underway - analysts say it is crucial for the airline to overhaul its international routes, some of which were inaugurated for political rather than commercial reasons by former Prime Minister Mahathir Mohamed and continue to lose money. It also needs to focus on destinations like London and Vienna, usually profitable for Asian carriers, where it is said to be operating at a loss.

"International flights produce a higher yield by nature," says Joe Laughlin, a vice president at OAG Data, a London aviation-research firm. "So it makes sense from a financial standpoint to focus on premium international travel."

It might also make sense, says Wee of M&A Securities, for Malaysia Airlines to take a stake in Air Asia, similar to what Singapore Airways has done with low-cost carriers Tiger Airlines and Valuair. "The next logical step for Malaysia Airlines," says Wee, "is to consider the realities and make the most of the collaboration."

Neither Fernandes nor Malaysia Airlines would comment on future plans. But the next few months will make it clear whether one of Malaysia's best entrepreneurs can take a losing business off the government's hands and spin a profit.

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