Airlines rush to manage their debt while the going is good

This is particularly prevalent in North America, where many airlines are also returning surplus cash to shareholders in the form of share buybacks. However, the cycle of the past decade has driven wide fluctuations in airline indebtedness.

The use of debt in the capital structure of airlines has always been high. In fact it has been said that, with its dismal record of returns on equity, the airline industry only exists because airlines repay their debts. The average level of net debt as a percentage of total capital in the 10 years from 2005 to 2014 was 70%, based on stock exchange-listed airlines tracked by research analysts at UBS, an investment bank (data throughout this report is based on this sample of airlines). This was roughly evenly sub-divided between on-balance sheet debt and off-balance sheet debt.

Globally, the highest level of debt as a percentage of total capital in this 10 year period was in 2005, when it was 82%. The level of debt was inflated by the situation in the Americas, where it was 180% of total capital in 2005, reflecting the negative equity value of many major US carriers that experienced Chapter 11.

By contrast, it was only 53% in Europe, while in Asia it was 70% in 2005. All regions lowered the proportion of debt in their capital structures until 2007, the result of a strong global economy driving increasing profitability and cash flow. The global figure had fallen to 60% in 2007, with the Americas seeing a rapid fall from its earlier high point to 67% as its leading airlines embarked on restructuring. In Europe, it fell as low as 41% in 2007, the lowest level of any region in the period 2005 to 2014.

The global financial crisis then pushed these debt levels up across all regions. Globally, debt bounced up to 74% of total capital in 2008 and 2009. In the Americas, it went back up above 90% and in Europe, it was more than 60% by 2009. Asia trod a middle path between the other two major regions, staying close to the global average.

In 2010, a recovery in profitability brought the global level of debt down once more, but it has not varied sharply from roughly the 70% mark since then. Although the Americas brought its level down to 67% in 2013, in line with the global average for the first time in this 10 year period, Europe's airlines have been on an upward path of debt as a percentage of total capital since the recovery, reaching the 80% mark in 2014. This pushed Europe well above the global average of 73%, the Americas' 71% and Asia's 72% in 2014.

According to UBS forecasts, improving profitability and cash flow will take the global average down to 60% in 2016. Europe and Asia are forecast to fall to somewhere a little above this level, but UBS sees the Americas falling as low as 50%.

By individual airline, or airline group, Air France-KLM had the highest level of debt in its capital structure, at 228%, in 2014. On an individual basis, there were many other significant variations from the 2014 global and regional averages for debt as a percentage of total capital noted above. Among the 36 airline groups tracked by UBS for which it has data both for 2014 and for 2008/2009, 20 reduced debt as a proportion of total capital in 2014 compared with the global financial crisis, but 16 increased this ratio.

In addition to Air France-KLM, there were four others with levels exceeding 100%: Air Canada, airberlin, GOL and Cebu Pacific Air. Of course, debt that is more than 100% of total capital means that equity has a negative book value. Worryingly, and bucking the global trend, four of these five airline groups with negative equity have seen debt increase its share of total capital since the global financial crisis (Air Canada is the only one of the five to have reduced it).

In addition, there were two airlines with more than 90% debt levels in 2014 that have also seen this ratio grow since the crisis: Korean Air and Garuda Indonesia. The biggest increase in net debt as a proportion of capital has been for US LCC Allegiant. However, this is only because its balance sheet has moved from a net cash position (cash greater than debt) in 2008 to a net debt position. Its 2014 net debt figure of 62% of total capital is below both the global and the Americas averages.

Among those airline groups with high debt levels in 2014, the most impressive declines from crisis levels have been for American (148% to 91%), United Continental (138% to 86%) and China Eastern (121% to 82%). Delta has also brought its debt down sharply (99% to 49%). The big three US legacy groups benefited over this period from the consolidation process in that market. Tiger Airways (127% to 72%) and Alaska Air (74% to 18%) have also achieved dramatic reductions since the global financial crisis.

At the other end of the scale, JAL is the only airline with a net cash position (after including capitalised operating leases in debt) in 2014, with a net debt to total capital ratio of -7%. This followed its bankruptcy filing in 2010 and subsequent recapitalisation in 2012, which has left it with a significant cushion against any future downturn. Its local rival ANA was only fractionally above 50% in 2014 and also saw a reduction from the global financial crisis, by JAL is the better capitalised of the two.

JAL was one of 10 airline groups among those followed by UBS with net debt at less than 50% of total capital in 2014. These were, in descending order, JetBlue, Delta, Lufthansa, Copa, Southwest, easyJet, Singapore Airlines, Alaska Air, Ryanair and JAL.

Four of these 10 are low cost carriers (LCCs), namely the two leading LCCs of Europe, Ryanair and easyJet, and of the US, Southwest and JetBlue. All four have brought this ratio down since 2008/2009. There is nothing in the LCC business model that prescribes a conservative approach to balance sheet management (as noted earlier, LCCs outside Europe and North America, such as Cebu and GOL are at the high debt end of the list). Rather, a consequence of the more successful LCCs' approach is high profitability and the resulting strong cash generation reduces the need for debt finance.

The world's leading legacy airline groups are spread widely across the range of net debt to total capital. The Americas have Air Canada, American, United Continental and Avianca towards the higher debt end of the range (even if they have moved downwards) and Delta and Copa at the lower end. Europe has Air France-KLM right at the top of the range, IAG somewhere in the middle and the always conservative Lufthansa towards the bottom.

Asia has Korean near the high end, Singapore Airlines at the low end and a fairly even distribution of other airline groups between these two.

Although the proportion of debt in the capital structure is an important measure, it is not the be-all and end-all. It is possible for airlines, and other businesses, to sustain high levels of indebtedness if they are able to service the debt. Net debt to EBITDAR, expressed as a multiple, is an indicator of an airline's debt repayment burden (see box).

As a proxy for gross cash flow, many airline analysts and investors look at EBITDAR (earnings before interest, tax, depreciation/amortisation and rental payments for operating leases). This is the profit generated before paying for aircraft ownership and sending a cheque to the taxman. Comparing this cash flow with net debt (including capitalised operating leases) gives an approximation of how many years it would take to pay down the debt. The ratio of net debt to EBITDAR is commonly used by debt rating agencies in their assessment of credit worthiness, amongst other measures.

Net debt to EBITDAR fluctuates through the cycle more widely than does net debt as a percentage of total capital. In a downturn, debt tends to increase (as seen above), but EBITDAR can collapse much more dramatically. A sharp increase in net debt to EBITDAR is likely to be driven more by a slump in cash flow than a rapid increase in debt.

Net debt to EBITDAR was falling globally prior to the financial crisis, the global average dropping to 3.4 times in 2007 (based on airlines tracked by UBS). Europe was as low as 1.7, while Americas and Asia were both close to 4.0 times in 2007.

The global financial crisis led to a sharp increase in this measure and the global average jumped to 6.4 times in 2008 and 6.6 in 2009, by when Europe had deteriorated from best to worst, with a ratio of 9.0 times. Net debt to EBITDAR for the other two regions peaked a year earlier, in 2008, at 7.5 for the Americas and 8.5 for Asia.

In 2010, all regions improved significantly as profit margins rose and stimulated better cash flow, all clustering close to the global average of 3.6 times. Since then, the global average has barely moved (it was 3.7 in 2014). However, this masks differences in the performance of the three main regions.

The Americas lowered its net debt to EBITDAR ratio from 3.3 in 2010 to 2.5 in 2014, but Asia's ratio increased from 3.7 to 5.1 over the same period. Europe's fell slightly, from 4.0 to 3.6 times (after first rising to 4.6 in 2012).

The Americas' most improved status since 2010 reflects both an increase in EBITDAR and a lowering of debt. By contrast, Asia has seen debt levels grow, while its EBITDAR was little changed in 2014 versus 2010. Europe has seen only a modest reduction in debt, accompanied by a modest improvement in EBITDAR over this period. All regions are forecast by UBS to lower their net debt to EBITDAR ratios in 2015 and 2016.

Thai Airways had the highest level of debt repayment burden in 2014 among airlines tracked by UBS. Thai's net debt to EBITDAR was a vertiginous 30.7 times in 2014, having deteriorated from its global financial crisis level of 9.6 times in 2008. Ranking airline groups by this measure reveals some significant differences from the ranking by net debt to total capital, particularly among those with a high ratio.

Only four airline groups are in the top 10 for both rankings: Thai, airberlin, Garuda and Korean. As was the case for Thai, net debt to EBITDAR worsened from the financial crisis to 2014 for both airberlin (7.1 to 14.8) and Garuda (2.8 to 9.5), while Korean saw this measure improve (13.1 to 7.8). For Thai and airberlin, the deterioration resulted both from increased debt and lower profitability, while for Garuda it was due to EBITDAR falling more rapidly than net debt.

Among the other airline groups in the top 10 for net debt to EBITDAR in 2014, LATAM's ratio also increased from the financial crisis to 2014 (from 7.8 to 11.2), mainly due to lower profitability. This means that all of the top five saw a worsening of this measure over this period. By contrast, the ratios of China Eastern, AirAsia, China Southern and Tiger (which are also in the top 10) were lowered, in all cases because EBITDAR increased more rapidly than net debt.

Air France-KLM, which had the highest level of net debt as a percentage of total capital in 2014, was outside the top 10 for net debt to EBITDAR. Its ratio of 5.3 in 2014 was less than half of its 2009 level of 11.3. Its net debt increased slightly over the period (due to increased operating leases, while on balance sheet net debt fell), but its EBITDAR more than doubled.

Other airline groups that experienced a particularly sharp improvement in net debt to EBITDAR (i.e. a decline in this ratio) from the global financial crisis to 2014, in addition to China Eastern and Tiger, are China Airlines, Cathay Pacific, ANA, United Continental, JetBlue, American, IAG, Delta and Alaska Air. These improvements were mainly due to increased EBITDAR, but Delta, JetBlue and Alaska Air have also reduced debt significantly.

For the airlines with high net debt to EBITDAR, it can often be the result of a slump in earnings, although, five years into the recovery from the global financial crisis, this may indicate structural problems with profitability. Those at the lower end of the range tend to combine low levels of debt in their capital structure with relatively high levels of EBITDAR.

Many of the airlines with low debt as a proportion of capital also have a low debt repayment burden. The list of airline groups with net debt to EBITDAR at the lower end of the range, with a multiple of less than 2.0 times, is very similar to the earlier list of airlines net debt to total capital of less than 50%. Copa, Lufthansa, Delta, Singapore Airlines, easyJet, Southwest, Alaska Air, Ryanair and JAL are common to both lists.

There are three airlines that appear in one, but not the other, of these lists. JetBlue is missing in the low net debt to EBITDAR list, but appears in the low debt to total capital list. However, with a 2014 ratio of 2.6 times, it is not far away and its absence reflects a relatively low level of profitability compared with the others. IAG and Allegiant have 2014 net debt to EBITDAR ratios of less than 2.0 times, but have more than 50% of their capital as debt (but, at 64% and 62% respectively, they are not far away).

A major reason for high debt levels in the airline industry is the high level of capital expenditure compared with cash generated from operations. From 2005 to 2014, the airlines tracked by UBS allocated an average of 89% of their cash inflow from operations to capital investment annually. In Europe, this was 104%; in Asia 99%; and in the Americas 80%.

Globally, capex as a percentage of cash from operations spiked up to 130% in 2009, based on airlines followed by UBS. In the years immediately prior, capex was comfortably less than cash from operations, but the global financial crisis caused a collapse in cash flow in 2008 and 2009. Airlines quickly cut capex, but not as quickly as the drop in cash flow. The recovery of 2010 reversed the situation once more and cash flow from operations has exceeded capital investment every year since then.

Europe suffered the heaviest collapse in cash flow from operations in 2009, but also made the smallest cut in capex. This led to a leap in capex as a percentage of cash from operations to a dizzying 366% for Europe in 2009. Since 2010, European airlines tracked by UBS have kept capex levels below cash from operations. Europe's problem has not so much been a lack of capital discipline since the recovery, more a lack of cost discipline on the part of some of its airlines.

Asia matched its capex to cash flow levels during the crisis more closely than did Europe, although this ratio reached 130% in 2009. Moreover, in the recovery since 2010, Asia's capital investment has risen to higher levels (as a percentage of cash from operations and as a percentage of sales) than in the other regions. This has contributed to pockets of surplus capacity in Asia and the lowering of collective profit margins in the region from their 2010 levels.

Even before the crisis, the Americas had been maintaining lower levels of capex, when compared with sales, relative to other regions. The wide experience of Chapter 11 bankruptcy among the leading US airlines led to tighter discipline over both capital and capacity. This has undoubtedly helped return on capital in the Americas (North America in particular).

These figures do not include aircraft acquired through leases and do not factor in the need for cash to service debt and taxes. Thus, external financing is vital to the survival of the airline industry.

Debt is typically cheaper and more available than equity and so provides the bigger share of external funding. In the 10 years from 2005 to 2014, airlines followed by UBS raised a net USD8.5 billion of new equity (net of buybacks) and a net USD37.4 billion of new debt (net of repayments).

If UBS forecasts are correct, the airline industry is now entering a new era of higher margins and tighter capital discipline. According to analysts' forecasts at the investment bank, improved levels of profitability will generate sufficient cash flow not only to pay for capital expenditure, but also to reduce indebtedness. Moreover, as equity levels recover and build to more comfortable levels as a proportion of total capital, it seems that shareholders can look forward to receiving some of their cash back through share buybacks to a level not seen previously.

Share buybacks are particularly fashionable in North America at the moment. United, Delta, American, Southwest, Alaska Air, Allegiant and Air Canada are all undergoing share buyback programmes. In Jun-2015 Delta estimated that US airlines had delivered USD4.3 billion in shareholder returns during the past year, putting its own shareholder returns over the past two years at USD3 billion. It has announced a new USD5 billion repurchase scheme scheduled for completion in 2017 and expects to return nearly USD2.5 billion to its shareholders in 2015.

In mid 2015, American revealed a USD2 billion buyback programme in addition to a USD2 billion repurchase unveiled in Jan-2015. During 2Q2015 American returned a total of USD823 million to shareholders through the payment of USD70 million in dividends and a USD753 million buyback. It returned USD1.1 billion to shareholders in 1H2015 and a total of USD3 billion since the close of the US Airways-American merger in late 2013.

United initiated a USD1 billion buyback programme in 2014, and in Jul-2015 announced a new USD3 billion share repurchase scheme scheduled for completion by 2017. The company planned to complete the initial USD1 billion buyback in 3Q2015, which is about two years ahead of schedule. Southwest returned USD811 million to shareholders through dividends and buybacks in 1H2015 and has also launched a new USD1.5 billion buyback programme. Air Canada has a buyback programme for up to 3.5% of its shares.

Many of the same US airlines (Alaska, Allegiant, Delta, JetBlue and United) are also in the process of paying down debt. Among the US groups, American is less focused on debt reduction, but sees financial crisis opportunities from current low interest rates.

In Asia Pacific, almost every major airline group is reducing its indebtedness, including Virgin Australia, Qantas, Singapore Airlines, EVA Air, Garuda, Korean, China Airlines, China Eastern, China Southern, ANA, Cathay Pacific, Cebu Pacific Air, Air China, Air New Zealand and AirAsia. Even JAL, already in a net cash position, is modestly repaying debt. In most cases, this is the result of improving earnings, but for the more highly geared airlines such as Thai, Korean and China Eastern, it also involves lower levels of capital expenditure.

Qantas announced an AUD505 million (USD368 million) capital return to shareholders after its restructuring led to improved earnings and cash flow and hinted at further returns in the future. In Sep-2015, AirAsia proposed a share buyback programme, but this was more about supporting the share price than signalling strong surplus cash
generation.

In Europe, Ryanair, SAS, Turkish Airlines, Finnair, IAG, easyJet and Lufthansa are either reducing debt levels currently, or are likely to in the next 18 months if profitability continues to improve. Ryanair also has a share buyback programme and will have returned EUR800 million to shareholders this year alone, including almost EUR400 million from the sale to IAG of its stake in Aer Lingus, and more than EUR3.3 billion since 2008 (in share buybacks and special dividends).

For airlines, as with other businesses, debt management is closely related to earnings health. The industry has always needed debt to make the difference in funding its assets, but too much debt can be fatal in a downturn, when earnings and cash flow can suddenly plummet. In good times, therefore, airlines typically take the opportunity to lower their financial gearing.

The US airline market is currently the most profitable among the world's regions, after some years of restructuring, consolidation and relatively low levels of capital investment. The strong cash flow that US airlines are now generating has allowed them to repay debt and to make cash returns to shareholders and this has, to some extent, enhanced their appeal to investors.

In Asia and Europe, too, airlines are taking advantage of the cyclical upswing to lower their indebtedness. Although only a few outside the US are engaging in share buybacks, the payment of dividends to shareholders has started to make a come-back.

As with many other aspects of financial performance in the airline industry, debt management is mainly a function of the cycle. Strong cash generation by airlines tends to be a sign of a cycle nearing a peak. The challenge for the industry is to maintain it.