16-Dec-2013 6:28 PM

IATA raises its airline profit outlook, but the cracks are still clearly visible under the surface

Analysis

IATA's Dec-2013 forecasts of airline industry profits make positive reading at first glance. IATA has increased its profit forecasts for both 2013 and 2014 and its 2014 margin forecast is close to 2010's cyclical peak. However, beneath the surface the cracks are still clearly visible.

Higher profit forecasts are entirely due to lower fuel prices and the drive to reduce non-fuel costs has lost some momentum. Cargo is a drag on industry profits (particularly in Asia) and regional divergence is increasing. Top-performer North America is benefiting from consolidation, but this is impeded at the global level by restrictions on ownership and control. Under-achiever Europe is held back by legacy cost issues, a still weak economy and government-imposed taxes and regulation.

Our previous observation that we may be witnessing a structural improvement in world airline profitability remains valid, but beating the cost of capital remains distant. This will require not only an even sharper focus on cost and capacity discipline from airlines, but also concerted moves by governments to lower taxes and charges and to remove the restrictions on ownership and market access.

Summary

IATA has increased its profit forecasts for the airline industry for both 2013 and 2014, largely due to lower fuel prices.
Cargo operations are dragging down industry profits, particularly in Asia.
Regional divergence is increasing, with North America benefiting from consolidation and Europe struggling with legacy costs and weak economies.
Governments need to lower taxes and charges and remove restrictions on ownership and market access to help the industry achieve financial sustainability.
Passenger traffic growth is expected to be higher than GDP growth, indicating a positive outlook for operating margins.
Despite rising profits, the airline industry still struggles to cover the cost of capital and needs to improve profitability to attract investment.

IATA increases 2013 profit forecast by 11% and 2014 forecast by 20%

In its latest quarterly update of its world airline industry financial forecast, published in Dec-2013, IATA has raised its 2013 net profit forecast by almost 11% from USD11.7 billion to USD12.9 billion. This represents a net margin of 1.8%, an increase of just 0.2 ppts from its last forecast, published in Sep-2013, and is 74% higher than the result recorded in 2012.

IATA's 2013 operating margin forecast is now 3.3%, up from 3.2% previously.

Summary changes to IATA world airline industry profit forecasts for 2013

	Mar-13	Jun-13	Sep-13	Dec-13	Change vs Sep-13 forecast
Operating profit, USD billion	22.3	23.9	22.4	23.6	5.4%
Operating margin %	3.3	3.4	3.2	3.3	+0.2ppts
Net profit, USD billion	10.6	12.7	11.7	12.9	10.7%
Net margin %	1.6	1.8	1.6	1.8	+0.2ppts

For 2014, IATA has increased its net profit forecast by 20% to USD19.7 billion, which would be 52% higher than the net profit forecast for 2013. This represents a net margin of 2.6%, up 0.4 ppts from the Sep-2013 forecast. The operating margin of 4.7% forecast by IATA for 2014 is not far short of the 5.0% margin that represented the peak of the last cycle, seen in 2010, as the industry temporarily rebounded from the GFC.

Summary changes to IATA world airline industry profit forecasts for 2014

	Sep-13	Dec-13	Change vs Sep-13 forecast
Operating profit, USD billion	30	34.7	15.7%
Operating margin %	4.0	4.7	+0.6ppts
Net profit, USD billion	16.4	19.7	19.9%
Net margin %	2.2	2.6	+0.4ppts

Passenger traffic forecasts raised in spite of unchanged GDP growth forecast

In spite of keeping its 2013 world GDP growth forecast unchanged at 2.0%, IATA has increased its forecast of 2013 passenger traffic growth from 5.0% to 5.3%, noting that "The robustness of air travel, despite high oil prices and relatively weak economic growth, is one of the positive developments in recent years." However, IATA has very slightly lowered its forecast of passenger yield growth in 2013 from flat to a fall of 0.2% due to competitive pressures.

It has made a very small upward revision to outlook for cargo traffic, which it sees growing at 1.0% in 2013, and it continues to expect a 4.9% drop in cargo yield.

IATA has also made an upward revision to its 2014 passenger traffic growth forecast (but no change to world GDP forecast) and it now forecasts 2014 passenger load factor will exceed 81% for the first time. IATA has made a significant cut to its 2014 cargo traffic growth forecast (from 3.7% to 2.1%). It continues to forecast declines in both passenger and cargo yield in 2014.

Forecast of total revenues remains unchanged

Changes to IATA world airline industry revenue driver forecasts for 2013

	Mar-13	Jun-13	Sep-13	Dec-13	Change vs Sep-13 forecast
World GDP growth %	2.4	2.2	2.0	2.0	+0.0ppts
Passenger traffic growth %	5.4	5.3	5.0	5.3	+0.3ppts
Cargo traffic growth %	2.7	1.5	0.9	1.0	+0.1ppts
Passenger yield growth %	0.4	0.3	0.0	-0.2	-0.2ppts
Cargo yield growth %	0.0	-2.0	-4.9	-4.9	+0.0ppts
Passenger load factor	79.8	80.3	80.2	80.3	+0.1ppts

Changes to IATA world airline industry revenue driver forecasts for 2014

	Sep-13	Dec-13	Change vs Sep-13 forecast
World GDP growth %	2.7	2.7	+0.0ppts
Passenger traffic growth %	5.8	6.0	+0.2ppts
Cargo traffic growth %	3.7	2.1	-1.6ppts
Passenger yield growth %	-0.5	-0.6	-0.1ppts
Cargo yield growth %	-2.1	-2.1	+0.0ppts
Passenger load factor	80.7	81.3	+0.6ppts

The net impact of IATA's forecasts for these various elements of revenue drivers is to leave its 2013 and 2014 total industry revenue forecasts unchanged.

Changes to IATA world airline industry revenue forecasts for 2013

	Mar-13	Jun-13	Sep-13	Dec-13	Change vs Sep-13 forecast
Passenger revenues	539	572	565	566	0.2%
Cargo revenues	68	62	59	60	1.7%
Other revenues	64	77	84	82	-2.4%
Total revenues	671	711	708	708	0.0%

Changes to IATA world airline industry revenue forecasts for 2014

	Sep-13	Dec-13	Change vs Sep-13 forecast
Passenger revenues	595	596	0.2%
Cargo revenues	60	60	0.0%
Other revenues	88	87	-1.1%
Total revenues	743	743	0.0%

Lower jet fuel prices lead to reduced cost forecasts

The increased profit forecasts for 2013 and 2014 are due to lower jet fuel price forecasts. For both years, IATA now expects jet kerosene to be almost 2% lower than it did in Sep-2013, following the easing of geopolitical tensions over Iran. This is more than the reduction in the crude oil price forecast, reflecting a reduction in the crack spread.

IATA's forecasts do not see much change in non-fuel costs per ATK relative to its previous outlook.

Changes to IATA world airline industry cost driver forecasts for 2013

Forecast for 2013	Mar-13	Jun-13	Sep-13	Dec-13	Change vs Sep-13 forecast
Crude oil, Brent USD per barrel	109.5	108.0	109.0	108.2	-0.7%
Jet kerosene, USD per barrel	130	127.4	126.4	124.0	-1.9%
Non-fuel cost per ATK change %	0.4	0.0	0	0.1	+0.1ppts
Non-fuel cost per ATK US cent	41.3	44.3	44.3	44.4	+0.1ppts

Changes to IATA world airline industry cost driver forecasts for 2014

Forecast for 2014	Sep-13	Dec-13	Change vs Sep-13 forecast
Crude oil, Brent USD per barrel	105.0	104.5	-0.5%
Jet kerosene, USD per barrel	122.9	120.6	-1.9%
Non-fuel cost per ATK change %	0.5	0.5	+0.0ppts
Non-fuel cost per ATK US cent	44.5	44.6	+0.1ppts

The increase in IATA's Dec-2013 forecast operating profit relative to its Sep-2013 forecast is around USD1 billion for 2013 and around USD5 billion for 2014. Almost all the difference for both years is explained by lower fuel costs in the new forecast.

Changes to IATA world airline industry cost forecasts for 2013

	Mar-13	Jun-13	Sep-13	Dec-13	Change vs Sep-13 forecast
Fuel costs	216	214	213	211	-0.8%
Non-fuel costs	433	473	473	473	0.1%
Total costs	649	687	686	685	-0.2%

Changes to IATA world airline industry cost forecasts for 2014

	Sep-13	Dec-13	Change vs Sep-13 forecast
Fuel costs	215	210	-2.3%
Non-fuel costs	499	498	-0.2%
Total costs	714	708	-0.8%

North America to remain most profitable region

By region, North America is still forecast to have the highest operating margins in the world, increasing from 3.4% in 2012 to 4.8% in 2013 and 6.4% in 2014, significantly higher than the 4.7% global operating margin forecast. A stronger US economy and the benefits of industry consolidation are the two key factors in driving this upward trend.

Latin America is now forecast to rise from being the third least profitable region in 2012 to being the second most profitable in 2014, when IATA forecasts its margin at 5.1%. Expansion of hub carriers in the Persian Gulf is set to push the Middle East's margin to overtake that of Asia Pacific, whose profitability is weighed down by the weakness of cargo operations and poor profitability in markets such as India.

Asia Pacific profitability is also likely to be subdued in the impact of an expected delivery of 710 new aircraft in 2014, according to IATA. The region is the only one among the big three global air traffic regions to see its EBIT margin forecast for 2014 reduced by IATA.

Europe's margins are forecast to follow an upward trend as the Eurozone economy returns to growth and long haul markets perform reasonably well, particularly for those carriers involved in North Atlantic joint ventures. Nevertheless, the gap between the region's profitability and that of the world airline industry globally is set to widen as the economic backdrop remains slow and as Europe's larger legacy carriers continue to grapple with restructuring programmes.

IATA argues that Europe's airlines are "burdened by high costs, cumbersome regulation and high taxes".

IATA expects Africa to remain the least profitable region, with EBIT losses in 2013 and reduced margin forecasts in both 2013 and 2014.

EBIT margin (%) by region 2009 to 2012 and forecasts 2013 and 2014

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2014 passenger traffic growth is in line with long term average, although GDP growth is below average

IATA's Dec-2013 forecasts continue to see world GDP growth of 2.7% in 2014. This is below the long term average GDP growth rate of 3.1%, but IATA forecasts passenger traffic growth of 6.0%, in line with its long term average. It seems that the airline industry is generating higher traffic growth from a given level of world GDP growth than in the past, possibly reflecting the growing weight of emerging markets in global air traffic. Modestly lower forecast yields may also be stimulating traffic growth, but are also counteracting it to result in broadly unchanged revenue forecasts.

IATA sees cargo traffic growth picking up from 1.0% in 2013 to 2.1%, in 2014, but this is lower than its previous 2014 forecast and well below long term average rates of growth in cargo traffic. On the cost side, a modest fall in oil prices is forecast, with little change expected in non-fuel cost per ATK.

2014 operating margin forecast close to last cyclical peak

The result of these elements for 2014 is that IATA forecasts revenues up by 4.9%, faster than cost growth of 3.4%. This drives an increase in the forecast industry operating margin from 3.3% in 2013 to 4.7% in 2014 and net profit growth of 52% to USD19.7 billion. The 2014 operating margin forecast is almost twice the average figure from 1971 to 2012 of 2.4% and is close to the 5.0% reached in 2010, which was the peak of the last cycle.

Previous cycles had seen operating margins peak at around 6%. Whether the industry can go on to achieve, or exceed, this level in the next few years will depend on economic growth, capacity discipline and the absence of shocks to demand or oil prices.

World airline industry revenues, costs and profits 2003 to 2012 and IATA forecast* 2013 to 2014

USD billion	2003	2004	2005	2006	2007	2008	2009	2010	2011	2012	2013F	2014F
Passenger revenues	249	294	323	365	399	444	374	445	497	538	566	596
Cargo revenues	40	47	48	53	59	63	48	66	67	62	60	60
Other revenues	33	38	42	47	52	63	54	68	72	79	82	87
Total revenues	322	379	413	465	510	570	476	579	636	679	708	743
Total revenue growth	-	17.7	9.0	12.6	9.7	11.8	-16.5	21.6	9.8	6.8	4.3	4.9
Fuel costs	44	65	91	116	133	187	123	139	176	210	211	210
Non-fuel costs	279	311	318	334	356	384	351	412	446	455	473	498
Total costs	323	376	409	450	490	571	474	550	622	665	685	708
Total cost growth	-	16.4	8.8	10.0	8.8	16.6	-17.0	16.0	13.1	6.9	3.0	3.4
Operating profit, USD billion	-1.4	3.3	4.4	15.0	19.9	-1.1	1.9	28.9	14.1	14.8	23.6	34.7
Operating margin %	-0.4	0.9	1.1	3.2	3.9	-0.2	0.4	5.0	2.2	2.2	3.3	4.7
Net profit, USD billion	-7.5	-5.6	-4.1	5.0	14.7	-26.1	-4.6	19.2	8.4	7.4	12.9	19.7
Net margin %	-2.3	-1.5	-1.0	1.1	2.9	-4.6	-1.0	3.3	1.3	1.1	1.8	2.6

Cargo revenues have lagged

Total airline industry revenues more than doubled from 2003 to 2012, with passenger revenues outpacing the total and cargo revenues lagging behind. As dedicated freighters continue to fall out of favour, passenger belly space is taking a growing proportion of air cargo. However, air cargo is suffering a structural loss of share to sea transport and world trade remains relatively weak overall as a result of the 'on-shoring' of production.

This means that total cargo capacity is still growing faster than demand for air cargo. IATA's forecasts see cargo revenues stagnating at USD60 million, around the same level as in 2007, while 2014 passenger revenues are forecast to be 50% higher than in 2007.

World airline industry revenues (USD billion) 2003 to 2012 and IATA forecast* 2013 to 2014

Revenues other than passenger and cargo revenues have seen the fastest growth since 2003. This revenue stream is ill defined, but includes ancillary revenues in addition to non-flight activities of airlines, such as MRO, handling and third party catering. These other revenues grew by almost 140% from 2003 to 2012 to become more important than cargo revenues. IATA forecasts further growth, broadly in line with passenger revenues, to 2014.

Reduction in non-fuel costs as a percentage of revenues has not continued

On the cost side of the equation, the industry's fuel costs increased from 14% of revenues in 2003 to 31% in 2012, after peaking at 33% in 2008. The increase in fuel costs prompted a strong focus on non-fuel costs, which fell from 87% of revenues in 2003 to 67% of revenues in 2008. However, the reduction in non-fuel costs as a percentage of revenues has not continued: after jumping back to 74% in 2009 (mainly the result of a collapse in revenues) it has fallen back to 67% again, where it is forecast to remain.

It seems that efforts to reduce non-fuel costs are driven by increases in fuel costs. When fuel costs have eased back a little, so has the pressure to reduce non-fuel costs. IATA's forecasts for improved margins in 2013 and 2014 rely in the industry holding onto the benefit of slightly lower fuel costs without allowing any increase in non-fuel costs.

World airline industry fuel costs and non fuel costs as a percentage of revenues 2003 to 2012 and IATA forecast* 2013 to 2014

Margins remain thin, but are in a multi-year phase of being positive

This trade-off between fuel costs and non-fuel costs has meant that, in spite of revenue growth over the past decade, operating margins have remained thin and volatile. If the two forecast years 2013 and 2014 are brought into the picture, the chart below suggests a broadly upward trend in margins over the past decade or so, perhaps reflecting the industry's efforts to reduce non-fuel costs and the more stable fuel price environment in the latter years.

If IATA's forecasts for 2013 and 2014 are borne out, the six years of positive operating margins from 2009 to 2014 will have been the longest period of uninterrupted positive margins since the 1990s.

World airline industry revenues and operating costs (USD billion) and operating margin (%) 2003 to 2012 and IATA forecast* 2013 to 2014

The long term margin trend is sideways, but recent years hint at a structural improvement

However, a chart with a longer time horizon, including previous decades, is less clear on any upward trend in profitability, although we have previously suggested that there is some evidence of a structural improvement in world airline profitability. If IATA's forecasts for 2013 and 2014 prove to be correct, it seems that the current decade is managing to achieve traffic growth and operating margins at a higher rate from a given rate of world GDP growth than in the past.

Our Capacity Index is an overall measure of the world airline fleet's capacity utilisation. It demonstrates a close relationship with world airline operating margins (see chart below). If passenger traffic growth is higher than fleet growth, our index will rise and this indicates a positive outlook for world airline operating margins.

The Capacity Index is turning up

This looks set to happen in 2013 and 2014, although the Capacity Index is set to remain well short of historic peak levels in the next two years, whereas IATA expects operating margins to approach their peaks more closely. As we have suggested previously, it seems that the airline industry is now achieving better margins from a given level of capacity utilisation than in the past.

Capacity Index* and global airline operating margins (%), 1970 to 2012

A cheese sandwich is more valuable than an espresso

Of course, it will take a few more years before this apparent structural improvement in profitability can become clearly established. The airline industry is notoriously susceptible to one-off events that hit demand and/or costs. It is also highly cyclical, with a pattern of profitability that is closely related to economic growth. Moreover, it has historically failed to cover the cost of capital as determined by investment market benchmarks.

To put rising industry profits into context, IATA forecasts that the world's airlines will generate USD224 billion of revenues per passenger in 2014. After paying all costs, including finance and taxation, they will be left with a forecast net profit per passenger of only USD5.94, enough to buy a cheese sandwich for each passenger. This is better than the cup of espresso represented by 2012's USD2.56 per passenger, but highlights what is still a very low margin, especially given the industry's capital investment needs.

Liberalisation of restrictions on ownership and market access is needed

These inadequate levels of profitability will have to increase if the industry is to continue to attract investment and to play its part in economic growth. This will require even greater efforts to control costs and capacity, but it will also require a more complete process of cross-regional consolidation than has been allowed to date.

Only full liberalisation of restrictions on ownership and market access can lead to a truly global market in which the more efficient operators can enter new markets, engage in genuine mergers and drive up returns.

In spite of reduced levels of state ownership of airlines compared with the past, governments still have a major role to play in allowing the industry the freedom to achieve financial sustainability.

On the positive side, at least some governments are awake to this need; but often they receive mixed signals from short term protectionist noises like those emitted by Airlines4America. More often however, governments are simply unaware of the negative impact of their inertia. Here there is still a job to be done by the world's airlines.

Return on capital invested in airlines and their cost of capital