Airline Leader Nov-2013 Finance Issue: Living on the edge in an 'uncertain' world


CAPA's Airline Leader Finance Issue of Nov-2013 was released this week. It can be seen on the AirlineLeader.com website or read in magazine style by clicking on the CAPA home page Airline Leader drop down on this home page. The following text contains the introductory overview of the Finance Issue.

Part of the theme is taken from a recent study by the Bank of England which, among others, looked at measuring uncertainty levels and their impact on consumer behaviour. We reviewed airline statements around the world to gain a region by region impression of what the future might hold.

The 116-page Finance Issue also covers a wide range of airline financial matters, from the big picture, to looking at and comparing unit CASKs for most of the leading airlines around the world.

  • The Finance Issue of CAPA's Airline Leader magazine focuses on measuring uncertainty levels and their impact on consumer behavior in the airline industry.
  • Consumer confidence and uncertainty are closely linked, with lower confidence leading to increased uncertainty and altered behavior patterns.
  • Airlines are increasingly highlighting their cash reserves and efforts to reduce debt exposure in response to uncertainty in the industry.
  • The Bank of England's study found that uncertainty levels since the Global Financial Crisis have continuously shown one measure of standard deviation above the long-term average, resulting in a negative impact on GDP and travel behavior.
  • Airlines are facing uncertainty not only from economic conditions but also from industry restructuring, competition from low-cost carriers, and the rise of long-haul low-cost operations.
  • While uncertainty poses challenges for airlines, it also presents opportunities for those in a favorable position, such as low-cost carriers in high-growth markets and Gulf carriers benefiting from liberalization and geographic advantages.

CONFIDENCE IN THE FUTURE - FOR BUSINESS AND CONSUMERS- is generally recognised as a constant underpinning of the demand for air travel. Where there is confidence, there is travel, where fear reigns, people stay at home.

Confidence is an intangible, sometimes bearing questionable relationships to economic conditions, as for example recent continuing modestly positive consumer attitudes in Europe despite apparently serious national debt problems.

Consumer confidence is relatively easily measured. To the extent that surveys are accurate, merely polling a sufficient sample of the public can display trends that should represent an accurate picture of popular feeling - and therefore of the likely propensity to spend. This in turn, for consumer industries such as the airline business, should convert to travel decisions, or not.

Uncertainty is harder to pinpoint. Merely asking someone if they feel uncertain is hardly likely to produce an accurate picture that has utility. The two concepts are linked, if not joined at the hip, as in lower confidence tends to travel with uncertainty; but they are not the same. And each affects the other. Where uncertainty is in the air, confidence tends to decline, or at least to alter behaviour patterns more consistent with a lack of confidence.

Uncertainty refers to the difficulty of predicting economic (and social) outcomes, implying that any likely range of projections, the up and down spread, is likely to be greater. So, for example, whereas an economic outlook in stable times could anticipate GDP growth between 2-3%, when there is greater uncertainty, the spread can be 1-4%. The effect is to make companies and consumers behave more conservatively, to lack the confidence to make financial and life decisions. It also tends to make companies more conservative in their investment decisions.

Several outside factors can also come into play here. These are especially apparent where in turn airlines are pressed also by analysts to limit debt levels and to squirrel away cash - a prudent strategy when you have less idea of what is around the corner. It is one that becomes essential if the share price is to be preserved. Having a consensus of analysts with "sell" recommendations is not the way to bolster the capital value of the airline.

Thus, post-Global Financial Crisis (GFC), there is rarely an airline annual report - at least for the legacy carriers - which does not highlight the cash reserves of the airline and the steps it is taking to rein in debt exposure. Where once the accent was more likely to be on aircraft purchases and first class refits, it has become de rigeur to stress the company's ability to withstand the ravages of uncertainty. Passing off debt risk to leasing companies is an integral part of this, a factor that is playing no small part in the fast expanding role of the leasing sector.

Recent analysis by the Bank of England, among others, has looked at measuring uncertainty levels and their impact on consumer behaviour. Rather than resort to popular surveying, the Bank's study developed an index based on recording a number of features including share and currency fluctuations, as well as economists' GDP growth forecasts; it also tracks media references to "uncertainty" and business reports that uncertain demand is slowing investment.

One conclusion the Bank reached was that uncertainty levels since the GFC have continuously shown one measure of standard deviation above the long-term average. The result: a negative impact on GDP of about 0.5%. Where there is typically such a close correlation between GDP and travel behaviour, this is a serious shortfall.

Although there have been many instances where uncertainty has dominated before, their effect had generally not lasted much more than a year. The difference since the GFC is that the effect did not go away. This has created a deeper sense of uncertainty. Logically therefore it should have a more profound impact on corporate behaviour.

Analysing trends on airline outlooks - as the airlines tell it

One indicator the Bank used was the range of dispersal anticipated in corporate earnings reports. In our analysis of financial performance, we have sought to examine the extent of this uncertainty phenomenon and whether there are variations among the different regions and airline categories.

To do this we have reviewed recent outlook statements by airlines in their financial reporting.

These statements have to be more than rhetoric, as the companies are accountable to their stock exchanges; that does not mean they completely reflect the outlook as each airline sees it, but they should at least be reasonable indicators, self regulated by the need for honesty and candour.

In some cases, there is a direct and measurable effect of ingredients used in the Bank's index. For example, the unique importance of the US dollar in the airline industry - with fuel prices and many financing costs denominated in that currency - means that any fluctuation of the airline's home currency against the USD has an immediate and sometimes large impact on the bottom line, positive or negative.

To a lesser extent a similar predictable impact is felt when a key foreign market's currency value declines. The steep decline of the yen is a good example of this, greatly influencing the value of the Japanese market for those airlines that rely on it as an origin market. Others include the Indian rupee and the Australian dollar. Hence each of the Indian airlines cited in the next section headlines the "significant depreciation" and the "continued weakness" of the rupee, which creates "a big challenge for the industry".

Japan is a sufficiently large origin market that the lower yen has a substantial effect on entire route groups, notably the trans-Pacific. A sudden 15%+ fall in the Australian dollar is meanwhile estimated to cost foreign airlines as much as USD1 billion annually, given the strong outbound profile of that market (and that assumes passenger demand continues at the same level, even though foreign holidays become 15% more expensive).

For many airlines this added level of macro-uncertainty comes at a doubly difficult time. Not only are economic and social conditions undergoing a once-in-a-generation upheaval, the industry itself is facing a once-in-a-lifetime restructuring. This creates operational and strategic uncertainty as another layer on the external effects.

Just as the impact of LCCs in short-haul markets was beginning to be absorbed and adjusted to, the Gulf carriers (and one or two others, notably Turkish Airlines) have greatly destabilised traditional long-haul preserves of the major flag airlines.

Just around the corner, there is the threat of further intrusions by the very large Chinese airlines, likely to create even greater shocks. Then too, the gradual rise of long-haul low-cost operations is adding pressure for change; for now the model works best on routes up to eight hours, but the advent of the 787 opens up new horizons. Several of the long-haul LCCs have orders for the cost-effective model.

Given the crosswinds, you could argue that airlines are not doing badly.

In Australia, the two main airlines, Qantas and Virgin Australia, recently reported their annual financial results for the period to 30-Jun-2013. Neither delivered a heart-warming message for shareholders, as the two had been at loggerheads in a capacity-driven battle for leisure and business travellers for most of the period. Qantas managed a small profit (in which a very strong result from its frequent flyer programme played a large part), while Virgin Australia slipped into loss.

In reviewing the results, most analysts treated it as a year like any other, looking at debt levels and assessing market conditions as they delivered their conclusions on how the carriers were faring.

Yet only passing attention was paid to the exceptional transformative processes that both airlines had been through during the period. It was as if this were merely another session to be compared along the same lines as previous years.

In Qantas' case, aside from establishing a completely new airline (a Jetstar joint venture with JAL in Japan) and setting up another (a further Jetstar joint venture with China Eastern, this one in Hong Kong), it completely reworked its international long-haul operation with a remarkable, industry-altering partnership with Emirates. The latter involved a previously unplanned and massive refocussing of its international operations; aside from the myriad issues in fundamentally rearranging sales and marketing, fares, scheduling and route integration, obtaining regulatory approvals at home and internationally, it also involved moving its international hub from Singapore to Dubai.

All this was achieved in the space of about seven months, meanwhile fighting a fierce battle at home (and abroad) with a resurgent Virgin Australia, eager to capture corporate business and challenge more aggressively for leisure traffic.

And the smaller carrier had meanwhile also weathered an extraordinary year. It took another giant step in its metamorphosis to full service airline as it expanded its business service, with new premium lounges and new widebody aircraft. There was also constant activity on its ownership structure as foreign airline partners vied for position on Virgin Australia's share register at the same time as it was bedding down new airline partnerships to expand its international coverage.

Then it went through the new birth experience of moving distribution and sales platforms, migrating to the Sabre system, buying a regional airline, then buying control of Tiger Airways (Tigerair), the country's independent LCC.

In the previous year, Qantas had experienced the trauma of a complete, management-led, shutdown of the entire airline as pilot and ground-handling disruption threatened to become overpowering. The generational clock had ticked over.

They are not alone; in Latin America, LAN is bedding down a remarkable merger/acquisition with TAM, propelling it to 15th largest airline group in the world; the US airlines, albeit cocooned in a protected domestic world of Chapter 11-lightened operations, are also going through the contortions of blending already-massive organisations; European legacy airlines are invoking full and quasi-subsidiaries in their fight to recapture lost ground on short-haul feeder services; and many airlines are having to refashion long-haul strategies, faced with a real and present threat of the Gulf carriers moving to dominate long-haul and premium markets.

Such are the massive underlying shifts that many airlines are having to confront as almost a daily occupation as the international aviation world is turned on its head.

So, while on the one hand, the uncertainty factor is forcing airlines to be much more financially prudent - even excessively so for their own long-term good - they are often being propelled into previously unthinkable strategic leaps that are untested and potentially fraught with risk.

They are obliged to display prudence, but equally inevitably must take giant leaps of faith. Standing still is not an option, no matter how loudly the financial instinct says to stay put.

Yet there is another side to uncertainty. Whereas predictability holds out the promise of safer outcomes, an absence of either safety nets or constraints can also spell opportunity. For those airlines that are at a sweet spot in their evolution, these are exciting times; they are in adventure territory. While their established counterparts are pulling in their horns, market opportunities become bigger than ever.

easyJet in Europe for example, with a low cost base and a suitably business-oriented product, is finding rich pickings, watching yields grow as it intrudes into territory that was previously the impregnable preserve of the "full service" airlines. Those same full service airlines are meanwhile reducing capacity and frequency on many routes.

In another environment, easyJet would have been unlikely to enjoy a near-trebling of its share price in the space of a year. And IAG group member Vueling, with one of the lowest unit costs in Europe, is lining up to emulate the example.

Ryanair, with rock bottom cost levels, manages to report a record half a billion dollar profit in the year to 31-Mar-2013, while remaining the largest airline in its region.

And there is room for innovation even in mature markets. JetBlue, a now-hybridised low-cost operator based out of New York JFK and now dominant in Boston, has for example managed to deliver arguably the best service quality, while retaining its youthful vigour and a still-low cost base, expanding in both real and virtual ways.

Then too, where there is significant overall growth potential, risk becomes less important than opportunity on the strategy scales. In the fertile territory of Asia, market maturity is a long way off. The next decade's Asian expansion will be so big it is impossible to forecast. Asian carriers are more accustomed to rough and tumble, rapid growth and the expansion of LCCs. This is a market where establishing a strong foothold is an important driver of strategy - although, for the flag carriers, much of that growth is often being anticipated, uniquely, through their low-cost subsidiaries. Accordingly the Asian response to uncertainty is typically much more upbeat, even while casting a nervous eye at fuel prices.

At least that is the case in Southeast Asia, where LCCs have taken over nearly 60% of the intra-regional market by seats flown.

Yet this is a region of many variants. North Asia contrasts dramatically: only 9.2% of the international seats there are on LCCs. The implication: a potentially massive upside for travel between China-Japan-Korea-Taiwan. These are the plains where dinosaurs still roam, protected by government and by closed systems that are highly resistant to change. Nothing is more obvious - given global experience - than that this will change. Previously sleepy tourism bodies and un-commercial airports are gradually becoming aware that there are big opportunities pending, once the regulatory dam walls are breached. Japan, with its open skies agreements, is a leader, but these are still early days.

Overview of this issue: section by section

In the section entitled "Market trends on key routes groups" we look at major developments on significant routes and the consequent effects on airline profitability.

We then try to get to the heart of the industry by deriving comparative CASK (cost per available seat kilometres) in "Airline costs: counting pennies and making money". Here, we assess the strategy starting points for many of the world's key airlines. This is not a simple task and for obvious commercial reasons, many companies mask the transparency of their cost bases.

Nonetheless, some general observations are possible, especially where there are wide discrepancies with a region and among direct competitors. Nor surprisingly, the lowest unit costs are seen in the Southeast Asian LCCs, while the highest are among full service carriers directly to their north.

The section entitled "Is big beautiful in the airline business?" presents in graphic form the correlation - or otherwise - between actual airline size and market capitalisation in the airline industry. As would (or should!) be expected, the biggest airlines tend to have the biggest market capitalisations, but not always...

We conclude this issue of Airline Leader with a close look at airline fleet profiles. The outstanding feature here is a torrent of single-aisle aircraft. But it also gives a great pointer towards the overall direction of the industry as the Gulf carriers disproportionately gobble up the widebody orders.

The complexity of the airline industry is such that it is remarkable companies can even contemplate regular profitability. The extreme and unpredictable impacts of anything from volcanoes to infectious diseases, fuel prices or economic fluctuations make an already challenging management role near-impossible.

Today, as a churning process of change occurs, few airlines can reasonably expect profitability. Notable standouts include some low-cost airlines in high growth Asia and now the "ultra-LCCs" in the US and Europe; along with the bankruptcy-cleansed and consolidated US majors. Then there are the surging Gulf carriers, as liberalisation propels their natural geographic networking advantages through critical mass to almost guaranteed profitability.

Effective management is indeed a critical need in these times. But achieving profitability demands a host of different skills, innovation included - but not the least a good dose of luck.

(These other sections of Airline Leader Nov-2013 Finance Issue will be posted over coming days. Meanwhile the full issue can be viewed in digital form by clicking the "Airline Leader" bar near the top of the home page.)

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