29-Apr-2013 4:18 PM

CAPA Global Aviation Industry Outlook 2013 – Pursuing certainty in an uncertain world – Part 1

Analysis

Uncertainty has become the new normal - and risk reduction takes on a high priority for many airlines as Europe's economy stutters and the US struggles for traction.

Over recent months, certain words frequently recur in airline reports to describe their outlook for the market: "challenging", "volatile", "uncertainty" are among the most popular. These are understandably in turn accompanied by corporate goals of enhancing the financial position and paying down debt, aligning capacity to demand, reducing costs and adopting more conservative fuel hedging positions, among others.

This is Part 1 of two parts: CAPA's Global Aviation Industry Outlook 2013, extracted from CAPA's Airline Leader, Issue 17, Apr/May 2013, to be released online shortly.

Summary

Uncertainty and risk reduction are top priorities for airlines as the global economy struggles.
Gulf carriers have had a significant impact on the industry and seem to be unaffected by the challenges faced by other airlines.
Asia, particularly China, is rising and will dominate the aviation industry within five years.
The industry is undergoing significant transformation and faces threats as well as new opportunities.
Fuel prices remain a major concern for airlines, with little expectation of a decrease.
The economy, particularly in Europe, is uncertain and poses challenges for airlines.

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In these conditions, it is hard for a company to avoid adopting behaviour which is much more cautious and short-term reactive. Analysts and shareholders want restraint, in turn influencing share prices; executives, motivated by incentives issued by their boards, want to achieve share price targets; and in many ways the market simply leaves little option but to follow the herd.

Yet, aside from the lookalike profiles being created in this way, there are real dangers where all companies in an industry adopt the same approach.

This is a global market undergoing transformation, even turmoil, as age old norms are challenged, as the earth's aviation axis shifts eastwards and as the apparent stability of the global alliances is threatened.

Change on this scale spells threats, but it also opens up new opportunities, often one-off openings. And as the established airlines line up to follow suit by being more conservative, it is the new breed, lower cost, aggressively expansive, that are moving to centre stage.

The result - to embed the process of decline even more rapidly for those legacy airlines unable or unwilling to be innovative. It will not lead to overnight collapse of the old regime, but it does risk locking in that progressive erosion of an earlier pre-eminence.

Three main themes stand out for CAPA's 2013 Aviation Industry.

The Outlook in Brief:

• Uncertainty has become the new normal - and risk reduction takes on a high priority for many airlines as Europe's economy stutters and the US struggles for traction

• The Gulf carriers have changed the world, seemingly impervious to the pressures of most other airlines

• Asia is rising - particularly China - and will dominate within five years. The impact may be greater and more rapid than forecasts suggest. Some of the aviation industries of fast economic growth nations, in Latin America, Eastern Europe, India and Africa are performing well , but need to consolidate their base

• Together these factors create a new paradigm for the aviation industry.

The world's top 20 airports by Capacity offered

The world's regions by capacity offered

The world top 20 airlines by seats offered

(a) Fuel:

Over a year ago, prices climbed to and remained stubbornly around USD100 a barrel for Brent Crude - and this despite a soft international economy and relatively weak demand for oil. According to BP.com, OECD consumption actually declined by 1.2% in 2012 to "the lowest level since 1995", but overall global consumption grew marginally, by 0.7%.

Uncertainty in certain politically unstable areas of the Middle East is one factor that is keeping buyers (and speculators) nervous. Instability is not unusual for the region, but there are more potential flash points than usual, as the Syrian crisis is exported and the backwash of the Arab Spring ricochets around various countries.

Most expectations are for fuel prices to remain around current levels for 2013 - a relatively positive scenario, given the many variables. Almost no-one is projecting a fall. Fuel surcharges have provided partial refuge to airlines, but these can only be supported against a relatively healthy economic background; also,as underlying ticket prices are discounted, surcharges do little more than help avoid agency commissions.

Brent crude prices, Mar-2012 to Mar-2013 (USD)

But either a fuel price spike or another grind upwards will create great discomfort for airlines, progressively squeezing them to reduce capacity on marginally profitable routes or to withdraw completely. Whereas in the past full-service airlines may well have persisted with ailing routes, today's heightened levels of competition are prompting a greater focus on the short term bottom line. The long term has become a luxury few airlines can afford.

(b) The Economy:

Some observers, talking of global commercial influence, have suggested that "Europe is the past, the US the present and Asia the future". This is a sweeping assessment, but there are grains of truth, as Europe's economy looks firmly rooted in debt for at least several years; the US, still a massive aviation market, appears to be forging a shaky recovery, albeit heavily founded on debt and with a political melange more appropriate to a fairground.

Asia meanwhile is robust and gearing up for a bigger future, even faced with a slack global economy.

Europe's economic uncertainty however still contains unknowns that threaten to re-emerge. Austerity is not something that the powerful and varied underlying social forces in Europe are prepared to tolerate for extended periods. And, to continue to "kick the can down the road", hoping that things will eventually get better is a journey into the unknown. Waiting for time to heal the wounds may even aggravate the initial hurt.

Whatever the case, there are many potential flash points, with major banks erecting barriers to protect themselves from shocks - one downstream effect being to make funding and financing more difficult.

At the IATA AGM in 2012, a straw poll of airline CEOs on what kept them awake at night indicated overwhelmingly that fuel prices and the economy - each non-controllable - were the two leading concerns, followed closely by over-capacity.

The dangerous news is that there are considerable and potentially growing problems in each of these two leading concerns.

Fuel prices have fastened at levels they were at when passenger demand was strong; today it is much weaker. The fact that price increases have been steady was important, avoiding the sort of quick and highly disruptive spike that occurred in 2008.

The industry has managed to adjust to the increases, but often at the price of profitability, where fuel accounts typically for around 30-40% of airline costs.

Viability threats according to IATA CEOs 2012

The adjustment has been painful, but possible. Capacity management and higher load factors, usually combined with higher yields, have often made continued profitability possible. This has been against a background of surprisingly strong - considering economic fundamentals - business sentiment.

However as that skin is stretched further, the ability to withstand further fuel price increases diminishes rapidly.

Where profitability depends on static capacity combined with higher load factors and yields (and a bit of non-fuel cost reduction), any decline in demand offers few levers left for airline managers to pull.

Once economic winds stiffen, so yields soften and the cost/revenue margin diminishes or disappears.

Cost reduction - in areas where there is some control over it - is an obvious place to go.There are few airlines which do not have a continuing, often brand-name catch phrase, programme to cut costs out of their businesses.

For full-service, legacy airlines, that is necessary merely to keep pace with peers; it cannot significantly narrow the margin between theirs and LCC levels (unless those LCCs are hybridising, adding costs in pursuit of higher yield traffic).

Frustratingly, the proportion of costs now dedicated to fuel barely makes "non-fuel" cost reduction worth the effort. If so much pain is expended on reducing the residue of costs by 3% or 4% (which translates to perhaps 2% of total), the fact that a short burst in fuel prices of USD5 a barrel can neutralise that improvement is disheartening to management and staff alike.

Similar problems are arising as governments actively soften their currencies by printing money. In the year to Mar-2013, the USD-euro rate has fluctuated between USD1.20 and USD1.36; the Irish don't call the euro the yoyo for no reason. Such shifts too must be covered and accounted for.

Investors meanwhile vote with their feet. No airline's treasury can today afford to front analysts without a carefully worded strategy that involves very careful capital exposure and a handy cash balance.

In short, the industry has been forced to improve its risk management profile.

As airlines pull all the levers, only capacity reduction remains as an option to protect against losses.

Airlines have only a limited capability to protect themselves against rising fuel prices. Hedging costs money and is really no more than a risk reduction strategy, a partial and temporary safety net. So, though many will have perhaps a third to a half of their fuel demand hedged for a year or even two, it is no longer realistically possible to buy a long term insurance policy that will protect comprehensively against the threat of prolonged price increases.

Meanwhile, if oil prices were to increase another USD30, there is a real prospect that airlines will extensively reduce flying, with long-haul operations the most sensitive.

Contingency route reduction plans are in place at most airlines - or they should be. There are few options left.

In today's more intensely competitive, price-competitive market, managements have become much more clinical in analysing marginal or loss-making routes, allowing selective capacity cuts: reduced frequency where possible, or complete route withdrawal where necessary, can occur quickly, as soon as bleeding begins.

Given the stretch that airlines are already feeling, there is little space for absorbing more pain. If oil prices were in fact to increase to USD130, it is not hard to envisage as much as 15-20% reductions in long-haul seat offerings. This would not be evenly applied; route yield profile will be a main determinant, with the first to go the predominantly leisure routes.

Changes on that scale could be devastating to some tourism-based economies that are heavily reliant on long-haul origin markets. Eventually, lower cost airline models might fill the breach in these markets, but there is no clear evidence yet that long-haul low-cost operations are effective beyond nine hours flying time. At that stage, fuel becomes such a high proportion of cost that differentials in other cost areas pale.

There are exceptions to the pain scenario. Short-haul airlines with markedly lower costs - LCCs and others - have expanded and even flourished while the full-service airlines have stood still; on long-haul, the Gulf airlines are growing as fast as any airlines in history and, with their yield profile are probably best equipped to handle any such headwinds.

(c)… and then there are the Black Swans:

Despite their supposed diffidence, so called black swans, or one-off unpredictable events, tend to plague the airline industry, a consequence of its pervasive and, in reverse, equally pervaded nature. Very little happens in the world that does not affect airline operations in one way or another.

And because it genuinely is an airline "system", a volcano in Iceland can play havoc with an airline in Australia, disrupting its schedules, stranding passengers all around the world. Anything from pandemic in China or Mexico, to terrorist threat in the US, to snowstorms in London, to the iconic butterfly in Brazil, can disrupt a complex assortment of personal and commercial interactions.

Despite their surprise value, there can be little more certain than that there will be more black swans - or what, in the wake of China's 2003 SARS near-pandemic (severe acute respiratory syndrome, which quickly spread through Asia and to Canada), CAPA once named the "Constant Shock Syndrome". Just one more reason for airlines to keep their stocks of nuts topped up.

The regulatory system is opening up new avenues of competition so that old market responses (chasing market share, discount pricing, adding seats etc) do not provide lasting solutions.

For many airlines, change is more obdurate and more difficult to deal with. It is invisible, but everywhere. Older airlines are heavily constrained by legacy issues; SAS for example last year had to obtain the approval not only of its unions but also of its three government owners to introduce large cost savings. For them, the ability to be innovative and flexible - crucial attributes in a volatile market - is near impossible.

Archaic regulation, with its rigid controls on ownership and entry, has also, paradoxically, made the industry artificially competitive; that's because inherent in the controls is a restraint on market exit. Aside from constraints against mergers, this no-exit effect is not typically explicit, but manifests itself in subsidy and other more subtle forms of protectionist support.

The result is there are too many airlines - and they can't merge. And, despite a handful of bankruptcies and exits, there are still many protective barriers to support seriously ailing flag carriers. The corollary of this should be that as regulation is removed, formally or tacitly, the level of competition is likely to diminish, at least in the mature markets - and for the "mature" airlines.

2013 is the Chinese Year of the Water Snake

The legacy airlines are responding, typically by not expanding. An important feature of the snake's year is "saving money and being thrifty" and ... in order "to gain the greatest benefits from this year, you must control spending and use your talents wisely."

So the second major response by established carriers, after stocking up on cash, is to hold capacity levels down, hoping better to match with demand and thereby to improve yields.

In the US for example, the main legacy carriers, and the even bigger Southwest Airlines, have applied "capacity restraint" ever since the global financial crisis hit - the thesis being that they would not sell seats which did not cover the cost of fuel. Raymond James estimates the prototype LCC Southwest's fares have risen by about 25% during that time, very much in line with the full-service airlines.

Capacity management and higher load factors, usually combined with higher yields, have in many cases and notably in the less competitive US market, thus helped make continued profitability possible.

The result is that legacy airlines have also pushed towards higher load factors, to the extent that this is no longer a distinguishing factor between old and new (seating configurations still tend to be much denser on the newer cost-sensitive airlines, delivering lower unit seat costs - but lower average yields).

No longer an identifier: Average load factors of selected major airlines

Sideshows to this strategy, also aimed at yield enhancement, are:

• attempts to grow ancillary revenues. Thus for example, revenue from the baggage charges that US legacy airlines added in recent years have been larger than their aggregated profits. This unbundling of pricing, learned from LCCs in a different context, is spreading quietly across the world;

• recapturing control of distribution, designed to allow airlines to regain control of marketing from the GDSs and OTAs, with the intention of de-commoditising the airline product (ie allowing more effective price/product discrimination and yield management, rather than merely selling based on price).

There is still upside for many in the ancillary expansion, but the distribution battle, now made further engaging by the introduction by IATA of its New Distribution Capability (NDC), has a more doubtful future, encountering opposition from corporate groups in particular.

As a consequence of this capacity restraint, the new growth is mostly from new Airlines. Nowhere is the contrast between old and new more stark than in Asia and the Middle East; here full-service airlines are suffering from similar forces as their global peers. And their responses are in many ways similar: conservative capacity restraint and strategic route pull-backs, along with reshaping aircraft configuration thinking.

Passengers % increase: Legacies stand still

There is one big difference in Asia though. There, a common legacy airline response is to establish a low-cost subsidiary - or two - to account for the parsimony market. In 2012, three new subsidiary/joint venture LCCs were established in the high cost/high yield Japanese market alone.

Two of them are part owned by All Nippon Airways (Peach and AirAsia Japan) and one by Japan Airlines (Jetstar Japan) - whose names also betray the parallel development in the region, which is for the leading low-cost carriers to establish cross-border JVs.

The only high profile network airline to resist this trend is Cathay Pacific - and it is seemingly only a matter of time before it finally concedes, as two new LCCs are planned for establishment at Hong Kong Airport, one of them another Jetstar subsidiary JV, daughter of Cathay's arch-rival Qantas.

Aside from these subsidiaries and JVs, it is the region's LCCs that are reaching for the stars, with mind-boggling order lists. The listed AirAsia Group has a modest 387 Airbus aircraft on order; Indonesia's privately held Lion Air has 563 orders, for Airbus and Boeings; India's IndiGo has 203, to name but three, accounting for over 1,100 between the three. All Western European airlines in aggregate have a smaller order book.

Now, as European majors struggle with too-high costs on their short-haul spokes, they too have resorted to attempting a similar form of subsidiary operation, at least in operational terms.