11-Jun-2013 10:29 PM

IATA raises profit forecasts - the world’s airlines can now upgrade from an espresso to a sandwich

Analysis

Speaking at IATA's AGM in Cape Town in early Jun-2013, IAG CEO Willie Walsh expressed his optimism about the airline industry: "Anybody who looks historically at what has happened to try to forecast what's going to happen in the future should forget about it and start with a blank sheet of paper. I genuinely think we're an industry that for the first time will start exceeding our cost of capital" (Bloomberg 3-Jun-2013).

At the same time, IATA raised its 2013 industry net profit forecast from USD10.6 billion to USD12.7 billion, an increase of 67% on 2012, but still only 1.8% of revenues. As IATA CEO Tony Tyler put it, 2013 airline profits will be around USD4 per passenger, "less than the price of a sandwich in most parts of the world". Moreover, IATA's forecast represents a return on capital of 4.8%, well below the 7%-8% cost of capital (the return expected by investors).

At least this year's sandwich should be more than the espresso coffee covered by last year's profits. But it's not yet time to break out the champagne.

Summary

IATA raises its 2013 industry net profit forecast from USD10.6 billion to USD12.7 billion, but this is still only 1.8% of revenues.
Weaker global economic growth is offset by lower oil and jet fuel prices and a reduction in non-fuel unit cost growth.
Passenger traffic growth is close to the long-term trend, while cargo growth outlook weakens due to sluggish business confidence.
Cargo's share of revenues has declined, with passenger revenues accounting for 80% of total revenues in 2012.
Total revenue growth is forecasted to be 4.6% in 2013, with passenger revenue growth driven by traffic growth and cargo revenues expected to be flat.
Operating profit forecast for the industry in 2013 is 7.2% higher than before, with an operating margin forecast of 3.4%. However, the industry still falls short of the cost of capital.

Weaker 2013 world economic outlook mitigated by lower costs

IATA's latest forecast for 2013 airline industry results sees an improving outlook for profits, in spite of a modestly weaker global economic growth forecast. The resultant weaker revenue growth is more than offset in IATA's forecast by lower prices for oil and jet fuel and a reduction in non-fuel unit cost growth.

The key changes to the revenue drivers in IATA's Jun-2013 forecast compared with its Mar-2012 forecast are shown in the table below. A slightly lower global GDP growth forecast (from 2.4% to 2.2%) leads to slightly lower growth in passenger traffic (from 5.4% to 5.3%), although ongoing capacity discipline nudges up the load factor forecast from 79.8% to 80.3% (2013 would be the first time ever that industry load factor beat 80%). Passenger yield growth is now forecast a little slower than previously (from 0.4% to 0.3%).

The changes to IATA's forecast for growth in cargo traffic and yield are more significant. Cargo traffic growth is now forecast at only 1.5%, down from 2.7% previously and cargo yield is now forecast to fall by 2.0%, versus a flat forecast previously.

Changes in the key revenue drivers in the forecast for 2013

	Mar-2013 forecast	Jun-2013 forecast	Change
World GDP growth %	2.4	2.2	-0.2ppts
Passenger traffic growth %	5.4	5.3	-0.1ppts
Cargo traffic growth %	2.7	1.5	-1.2ppts
Passenger yield growth %	0.4	0.3	-0.1ppts
Cargo yield growth %	0.0	-2.0	-2.0ppts
Passenger load factor	79.8	80.3	+0.5ppts

Key revenue drivers of IATA forecasts

	2007	2008	2009	2010	2011	2012E	2013F
World GDP growth %	3.8	1.7	-2.3	3.9	2.6	2.1	2.2
Passenger traffic growth %	7.5	2.7	-2.4	8.8	6.2	5.3	5.3
Cargo traffic growth %	4.7	-0.7	-8.8	19.4	-0.1	-1.1	1.5
Passenger yield growth %	1.7	8.2	13.7	9.6	5.0	3.5	0.3
Cargo yield growth %	5.6	7.0	-15.2	14.4	1.3	-6.3	-2.0
Passenger load factor	74.9	76.0	76.0	78.4	78.4	79.2	80.3

Passenger traffic growth forecast close to long term trend

Passenger capacity (ASK) and traffic (RPK) growth forecasts for 2013 vary significantly by region. IATA forecasts 15% RPK growth in the Middle East, but only 1.7% for North America. It forecasts RPK growth ahead of ASK growth in all regions.

IATA forecast for 2013 RPK and ASK growth by region

The global RPK forecast of 5.3% is not far from the long run average of 6.0%, in spite of the global economic growth forecast of 2.2% being more significantly below its long run average of 3.1%.

IATA suggests a reason why travel markets are expanding faster than the historic relationship with global GDP growth: "because growth has been concentrated in the emerging economies, where economic activity generates proportionately more air passengers than the mature developed markets".

World GDP growth and world economic growth: 1971 to 2012

Cargo growth outlook weakens

Air freight and passenger volumes

While passenger traffic growth is outperforming by comparison with global GDP growth, the weakening outlook for cargo traffic reflects sluggish business confidence. Air freight volumes are closely related to business confidence, as illustrated in the chart below. Neither have recovered their peak levels of 2010, in spite of what IATA refers to as 'false dawns' in 2011 and 2012.

Business confidence improved again in late 2012, but has stalled in recent months, leading to fears of another false dawn that could weigh on air cargo.

Business confidence and air freight volume

Air cargo is driven more by international trade than by GDP growth. The developed economies have not recovered to pre-recession levels of trade, while emerging economies have seen trade increase by 20% over pre-recession levels.

International trade in goods

Cargo's share of revenues has declined

The underperformance of cargo versus passenger traffic has been evident in revenue trends for some time. In 2003, cargo accounted for just over 12% of airline industry revenues, according to ICAO data. By 2012, this had fallen to just over 9%. Passenger revenues grew from 77% to 80% of the total over the same period. The weakness of air cargo revenues has been particularly evident since the global financial crisis. Although all revenues were badly hit in 2009, passenger revenues in 2012 were 22% above their pre-recession peak levels of 2008, while cargo revenues in 2012 were 2% below their 2008 levels.

World airline industry revenues by category (% of total): 2003 and 2012

Index of passenger, cargo and other revenues (indexed to 2003 = 100): 2003 to 2012

Revenues projected to grow by 4.6% in 2013

Compared with its Mar-2013 forecast, IATA now sees total revenue growth in 2013 of 4.6%, which is 0.5ppts lower than previously. Forecast passenger revenue growth of 5.5% is mainly driven by traffic growth. Cargo revenues are now forecast to be flat, versus 3% growth forecast previously, as volume growth is expected to be offset by cargo yield declines.

Changes in IATA's revenue growth forecasts for 2013

	Mar-2013 forecast	Jun-2013 forecast	Change
Passenger revenue growth	5.9	5.5	-0.4ppts
Cargo revenue growth	3.0	0.0	-3.0ppts
Other revenue growth	1.6	1.3	-0.3ppts
Total revenue growth	5.1	4.6	-0.5ppts

Cost increase forecast cut from 4.2% to 3.3%

On the cost side, IATA is now forecasting Brent Crude oil prices 1.4% below its previous forecast and jet fuel 2% lower. Moreover, it sees non-fuel unit costs staying flat year-on-year, rather than growing slightly. All this combines to give forecast growth in total costs of 3.3%, compared with 4.2% in the Mar-2013 outlook. A 0.9ppt reduction in cost growth outweighs the 0.5ppt reduction in revenue growth and this explains the increased profit forecast.

Changes in IATA's cost driver forecasts for 2013

	Mar-2013 forecast	Jun-2013 forecast	Change
Crude oil, Brent USD per barrel	109.5	108	-1.4%
Jet kerosene, USD per barrel	130	127.4	-2.0%
Non-fuel cost per ATK year on year change %	0.4	0.0	-0.4ppts

Operating and net profit forecasts raised

IATA's operating profit forecast for the industry in 2013 is now 7.2% higher than before, although the operating margin forecast is virtually unchanged at 3.4%. The increase in the forecast of net profit is almost 20%, although the net margin forecast of 1.8% is only 0.2ppts higher than previously. IATA does not give details of forecast costs of interest and taxation and so we can only guess at the reasons why a USD1.6 billion increase in the forecast of operating profit becomes a USD2.1 billion increase in the forecast of net profit.

Lower forecast interest costs may result from improved operating cash flow and lower debt levels and this is probably the most likely explanation. Higher profits would not normally lead to lower taxation, but it is possible that capital expenditure could be higher and this could lead to higher levels of capital allowances, which could reduce taxation.

Changes in IATA's operating and net profit forecasts for 2013

	Mar-2013 forecast	Jun-2013 forecast	Change
Operating profit, USD billion	22.3	23.9	7.2%
Operating margin %	3.3	3.4	+0.0ppts
Net profit, USD billion	10.6	12.7	19.8%
Net margin %	1.6	1.8	+0.2ppts

Above mid-cycle margins in spite of below trend GDP growth

The margins that IATA now forecasts for 2013 - an operating margin of 3.4% and a net margin of 1.8% - have only been bettered twice in the past decade. The first time was the pre-recessionary peak year of 2007 and the second time was the immediate post-recessionary year of 2010, when a strong bounce-back in global GDP growth drove strong revenue growth (in particular, cargo revenues) while the oil price remained below USD100 per barrel.

IATA revenue and cost forecasts

	2007	2008	2009	2010	2011	2012E	2013F
Passenger revenues	399	444	374	445	497	542	572
Cargo revenues	59	63	48	66	67	62	62
Other revenues	52	63	54	68	72	76	77
Total revenues	510	570	476	579	636	680	711

Fuel costs	134	188	123	139	176	210	214
Non-fuel costs	356	383	351	412	446	455	473
Total costs	490	571	474	551	622	665	687

Operating profit, USD billion	19.9	-1.1	1.9	28.9	14.1	14.8	23.9
Operating margin %	3.9	-0.2	0.4	5.0	2.2	2.2	3.4
Net profit, USD billion	14.7	-26.1	-4.6	19.2	8.8	7.6	12.7
Net margin %	2.9	-4.6	-1.0	3.3	1.4	1.1	1.8

The forecast 2013 operating margin is above the typical midpoint of the airline industry cycle, although forecast global GDP growth is still below mid-cycle levels. Indeed, in previous cycles, world GDP growth of around 2% or lower has usually been accompanied by airline industry losses. The old relationship between economic growth and industry margins would have seen losses in both 2012 and 2013. It seems that this relationship is changing and that the industry is better able to make profits in relatively weak economic conditions than in the past.

IATA attributes this apparent structural improvement in industry profitability to consolidation (particularly in North America), increased barriers to entry (and lower barriers to exit) and rising ancillary revenues.

In 2006, ancillary revenues accounted for 0.5% of revenues; in 2013, IATA expects this to be more than 5%.

World airlines net profit margin (% of sales) and world GDP growth (%): 1971 to 2013

World airlines net profit margin and operating profit margin (% of sales): 1971 to 2013

Asia-Pacific and North America lead in profitability

The outlook for margins varies by region, with Asia-Pacific and North America continuing to lead the rest of the world and Africa and Europe lagging behind.

One important reason for regional differences in margins is the different levels of consolidation (see related report: European airline consolidation to enhance financials? Few deals to be done, at least locally, which analyses the relationship between market concentration and operating margins).

Operating margin by region (% of revenues): 2009 to 2013F

Industry returns still fall short of the cost of capital

Forecast margins are above mid-cycle and there seems to be evidence that there has been a structural improvement in industry margins. Nevertheless, the industry is not yet sufficiently profitable to be able to cover its cost of capital (the return on capital expected by investors). Fuel prices remain at historically high levels and this has prompted significant developments in aircraft and engine technology aimed at improving fuel burn.

Improved industry margins have encouraged airlines to order new generation equipment and improved fuel efficiency should help to boost margins further, provided that capacity discipline holds and unit revenues are not compromised by any over-supply situation.

However, return on capital = profits divided by invested capital; it will only increase if profits grow faster than the capital base.

Viewed through the lens of investors seeking a sufficient return on capital, the industry has yet to justify Mr Walsh's claim (reported by Bloomberg) that it has been "transformed" and will be "very, very different" in the future.

World airlines return on invested capital (ROIC) and weighted average cost of capital (WACC)