Barriers to exit must come down to raise airline returns, attract investors
CAPA ANALYST PERSPECTIVE - a series where CAPA - Centre for Aviation's analyst team provide their personal views on a hot topic facing aviation around the world.
The world airline industry has broadly recovered from COVID-19: in 2024 global passenger traffic is expected to exceed 2019 volumes, and IATA forecasts industry net profit at 97% of the 2019 result.
However, for decades, the industry's return on capital has failed to meet its cost of capital. Low returns suggest too much competition, despite modest increases in consolidation.
The Herfindahl-Hirschman measure of market concentration shows that five of the six global airline regions are highly competitive at the macro level. Only North America can be classified as "moderately concentrated".
Airline consolidation is hindered by low barriers to entry and high barriers to exit, although supply chain and labour constraints are modestly raising entry barriers currently.
However, perhaps more significantly, exit barriers remain high. These include government support, bankruptcy protection and obstacles to mergers and acquisitions from competition authorities and foreign ownership limits.
The transition to a sustainable future requires huge investment. In order to attract airline investors, barriers to exit - largely erected by governments and regulators - need to come down.
Jonathan Wober, Chief Financial Analyst at CAPA - Centre for Aviation shares his viewpoint.
IATA forecasts 2024 RPKs at 104.5% of 2019 levels, revenue at 115%, and net profit at 97%
IATA's most recent passenger traffic forecast, issued in Dec-2023, predicts global RPKs at 104.5% of 2019 levels and passenger numbers at 103.6% in 2024.
This puts the world's airline industry five years behind its pre-pandemic growth path. Nevertheless, recovering from a crisis of unprecedented severity - RPKs collapsed by 66% in 2020 - is a remarkable achievement.
Turning to financial indicators, IATA estimated in Dec-2023 that total airline industry revenue in 2023 was already above its 2019 level by 6.9%, boosted by strong yields. IATA forecasts that 2024 revenue will be 15.0% above 2019's.
IATA estimated airline industry net profit at USD23.3 billion in 2023, still 12% short of 2019. It forecasts net profit rising in 2024 to be USD25.7 billion - or 97% of the 2019 result.
But net profit per passenger is "less than a cup of cold coffee"…
A return - more or less - to 2019 levels of airline traffic, revenue and profit is welcome.
However, world airline industry financial performance is really not good enough.
To give some context to the industry's profitability: IATA uses the measure airline net profit per passenger.
Its forecast for 2024 is USD5.45 per passenger, which it says is "less than a cup of cold brew coffee" in its HQ town of Geneva. This figure is slightly below the USD5.80 net profit per passenger generated in 2019.
…and return on capital consistently fails to meet the cost of capital…
Net profit per passenger is easy to understand, but a more rigorous financial indicator is the industry's return on invested capital (ROIC). This measures the profit generated as a percentage of the capital invested in the industry.
IATA's 2024 forecast ROIC is 4.9%. This is fractionally up on the 2023 estimated figure of 4.7%, and a huge improvement on 2020's record low ROIC of -19.3%.
However, it is still below the 2019 figure of 5.8%, and the average of 6.0% achieved in the 10 years leading up to the COVID-19 crisis.
…even in the 10 straight years of profits before the pandemic
The problem is that, even in that unprecedented decade of 10 straight years of positive net profits (2010 to 2019), ROIC levels were not good enough.
This is because ROIC did not consistently meet the cost of capital during that period (it only did so in four years - 2015 to 2018).
The cost of capital is the return on investment required by financial investors. Simply generating a profit - where revenue exceeds cost - is not enough.
Investors need a minimum level of return, defined as the cost of capital. Capital is a scarce resource, so, if returns fail to meet the required minimum, investors will seek better returns from another sector.
The return required by investors is typically expressed as the weighted average cost of capital. This takes account of both equity and debt capital and a level of return that takes account of the risk of investing in the sector (the higher the risk, the higher the expected return).
A fluctuating measure, the weighted average cost of capital for the global airline industry has varied in the approximate range of 7%-10% over the past two decades.
However, ROIC has typically fallen short.
According to charts published by IATA, the industry's ROIC varied in the range of 1%-8% for most of the same period (ignoring the massive negative returns in 2020 and 2021).
World airline industry: return on invested capital and weighted average cost of capital, 2003 to 2024F
Low returns indicate too much competition, or not enough consolidation
Financial theory says that excess returns (i.e. where ROIC is above the cost of capital) are typically competed away as competitors are initially attracted by the high returns, until they no longer exist.
Conversely, where returns are insufficient - as in the airline industry - this generally is a sign of too much competition.
In theory, this should lead to competitors leaving the market or stronger ones buying weaker ones. The resulting increase in consolidation (or reduction in competition) allows returns to rise.
In the case of the airline industry, this has not happened, at least not consistently enough on a global basis.
Using the HHI measure of market concentration,…
There has been some consolidation in recent years, led by North America, but low returns in the global industry indicate that this has not gone far enough.
A common method used by economists to measure consolidation, or the level of concentration, in a market is the Herfindahl-Hirschman Index, or HHI.
This assigns a score, ranging from zero to 10,000, where a higher score means the market is more concentrated.
The score is calculated as the sum of the squares of the market shares of all participants. For example, a market with 10 participants each having a 10% share has an HHI of 1,000. A monopoly has an HHI of 10,000.
Very roughly, an HHI below 1,500 denotes a competitive market, while a score between 1,500 and 2,500 is regarded as moderately concentrated.
An HHI of more than 2,500 is categorised as highly concentrated.
…five global airline regions are highly competitive…
The chart below shows HHI scores for the six main global airline regions, calculated on the basis of the seat share of airline groups in each region in the first week of July in 2019 and 2024.
Five of the regions have undergone an increase in concentration in 2024 compared with 2019 (based on the first week of July in each case). Only the Middle East has become less concentrated (and only very slightly).
Nevertheless, five of the six markets are in the "competitive" zone. Indeed, they are so far below the 1,500 threshold that they might be described as highly competitive.
Herfindahl-Hirschman Index (HHI)* for main global airline regions
…while only North America is 'moderately concentrated'
North America is "moderately concentrated", but its score of 1,507 only just puts it into this category.
Note that this analysis is based on total seat capacity to/from/within each region, and so it is a macro view of concentration in airline markets.
It does not drill down into the more granular definitions of markets that competition authorities use in assessing mergers and acquisitions.
Airline profitability is boosted by consolidation
In the absence of regional ROIC data, the following chart plots EBIT margin against market concentration.
The horizontal axis shows market concentration, as measured by the HHI (first week of Jul-2019 and Jul-2024), while the vertical axis plots EBIT margin for each region in 2019 and IATA estimates for 2024E.
The plots for both 2019 and 2024 demonstrate that EBIT margin increases as market concentration increases.
North America is the most concentrated, and has the highest margin in both years.
Nevertheless, although most regions have increased concentration levels relative to 2019, most have lower forecast margins this year. This reflects a number of factors, including the recovery from the pandemic, oil prices, labour costs and other costs.
Broadly, however, the chart provides evidence that airline profitability is boosted by consolidation.
Airline EBIT margin (Percentage, vertical axis) vs market concentration (HHI score*, horizontal axis)
Low airline ROIC reflects low barriers to entry and high barriers to exit
The low levels of airline ROIC compared with cost of capital are an indication of too much competition.
It might be expected that consistently low returns would drive weaker participants out of the market so that returns would eventually rise.
However, with the possible exception of North America, the consolidation process has not been sufficient to raise returns to the level required by investors.
This reflects both low barriers to entry and, perhaps more importantly - high barriers to exit in the airline industry.
Returns are not helped by airline investors for whom ROIC is not the prime motive
Moreover, among airline investors and owners there have always been those for whom return on capital invested in the airline is not the prime motive.
These include governments that see their national airline as an expression of sovereignty, and a generator of broader economic benefits.
In addition, there are owners that could be termed 'hobbyists' - typically wealthy private individuals - for whom an airline might help to build a brand or bring other perceived benefits to their wider business activities.
Airline owners that are prepared to accept a lower return add to the levels of competition in the industry. This makes it harder for financial/commercial investors to achieve the returns that they require.
Barriers to entry in the airline industry are low
Barriers to entry mainly consist of the availability of aircraft and labour, and regulation on technical and safety standards.
True, relative to the pre-pandemic era, supply chain issues are currently restricting the supply of new aircraft, and trained labour - particularly pilots - is less plentiful.
Nevertheless, CAPA - Centre for Aviation's databases currently list 98 start-ups in the world airline industry at 5-Mar-2024, which is an indication of low barriers to entry.
It is generally relatively easy to secure aircraft via lessors and in the second-hand market. Fully crewed aircraft are available through wet leasing.
Barriers to exit are high, and slow the consolidation process
By contrast, barriers to exit remain high and continue to slow the consolidation process.
They include:
- government support, most notably in times of crisis;
- Chapter 11-style bankruptcy reorganisations;
- competition authorities' focus on airlines' share of city pair routes and individual airports when assessing possible mergers and acquisitions;
- barriers to cross-border mergers and acquisitions - particularly nationality restrictions on airline ownership applicable in many jurisdictions.
These barriers to exit all involve government, whether directly or indirectly through regulators (who are appointed by governments).
Barriers to exit must be lowered to attract investors
The airline industry is embarking on the crucial transition to a sustainable future. This is an existential challenge requiring massive investment over many years.
Against this backdrop, governments must find ways to lower the barriers to exit. This is the only way to ensure that returns can rise across the industry, thereby attracting investors.
A consequence of greater consolidation and higher industry returns may be that flying becomes more expensive to the consumer.
It is time to start that debate.