CAPA global airline financial outlook
Operating margin to reach new high in 2016, but this may signal a subsequent downturn. CAPA's global airline operating margin model indicates that the industry was more profitable in 2015 than it has been for almost five decades. Moreover, the model predicts that world airline operating margins will rise further above previous historic peak levels in 2016. These new levels of profitability are mainly thanks to the low oil price environment, coupled with strong demand growth in spite of global economic growth rates that are far from exceptional.
Much of the industry is also benefiting from a period of relative capacity discipline. New revenue sources may also be helping, although their role in airline profitability is still emerging.
The macroeconomic and geopolitical backdrops provide the main risks to this forecast. Beyond that, the biggest challenge for the industry will then be to try to sustain margin levels, rather than to allow a peak to be followed by a rapid downturn, as has always happened in the past. But downturns can play a positive role in industry development, possibly even stimulating consolidation.
- The global airline industry experienced record profitability in 2015, with operating margins reaching levels not seen since the 1960s.
- The low oil price environment and strong demand growth were the main drivers of this profitability.
- The industry has shown improved capacity discipline, with fleet growth remaining stable and lower than in previous cycles.
- New revenue sources, including ancillary revenue, have contributed to higher airline margins.
- The macroeconomic and geopolitical risks pose the main threats to the industry's profitability.
- The challenge for the industry will be to sustain these high margin levels and avoid a rapid downturn, although downturns can stimulate consolidation and industry development.
CAPA world airline operating margin model Jan-2016
The airline industry's profitability has always been characterised both by cyclicality and by thin margins. Not since the 1960s has the global airline operating profit margin reached a level approaching double figures. In every cycle since then, it has peaked at around 6% or lower - until now.
World airline operating margin (operating profit as % of revenue) 1947 to 2014
In any capital intensive industry with high fixed costs, the balance between supply (or capacity) and demand is fundamental to profitability. Although flown seats are the basic unit of airline capacity, a more reliable outlook can be devised for the number of commercial jet aircraft in the world fleet. Capacity analysis based only on flown seats, or ASKs, does not take account of other wider measures of capacity utilisation such as stored aircraft or daily hours flown.
Demand is represented by revenue passenger kilometres (RPK) carried by the world's airlines. Although these two measures (RPKs and aircraft numbers) are slightly different, the balance between them is historically a good indicator of the airline margin cycle. When RPK growth is higher than fleet growth, this is generally good for airline margins and vice versa.
For more than a decade now, however, fleet growth has remained more stable and lower than previously. Indeed, fleet growth has been less than its long term average of 4.4% every year since 2002, demonstrating a much better level of capacity discipline than in the past. This reflects both a lower level of deliveries as a percentage of the total fleet than in previous cycles and a higher level of retirements.
However, fleet growth is creeping up again. It climbed from 3.0% in 2013 to 3.9% in both 2014 and 2015. According to CAPA's model, fleet growth is expected to edge up a little higher to 4.1% in 2016 and to step up to 4.9% in 2017. This will take it above its historic average rate of 4.4% for the first time since 2001, sounding alarm bells for some long term industry observers. An increase in the rate of supply growth can lead to extra downward pressure on airline yields.
The principal driver of this accelerating fleet growth rate is the introduction and ramp up in production of new aircraft types. In addition, although aircraft retirements as a percentage of the fleet are at historically high levels, they are no longer rising as a percentage of
World airline 1971 to 2014
World aircraft deliveries and retirements as % of fleet & fleet growth 1971 to 2017f*
deliveries. After rising steadily from 8% of deliveries in 1990, retirements peaked at 50% of deliveries in 2011 and dropped to 38% in 2014.
It is likely that the lower fuel price environment is tempting some operators to retain older aircraft for longer and so retirements are unlikely to have a significant moderating impact on fleet growth, at least in the next year or two if oil prices remain low.
Demand, or RPK growth, is driven by the economic cycle. CAPA's world RPK growth model is based on the historic close relationship with world GDP growth and uses GDP growth forecasts published by the International Monetary Fund (IMF).
The IMF has generally been lowering its world GDP growth forecasts over the past couple of years, reflecting the uncertainties surrounding the global economy.
Global GDP has not been above its long term trend rate since 2010, as emerging markets have been a less vigorous engine of growth than previously and developed markets have not reached full speed since the global recession. The IMF and other economic commentators continue to highlight both macroeconomic and geopolitical risks.
Indeed, IATA data for 2015 showed global RPK growth of 6.5%, above its long term trend rate of 6.1% in spite of a global GDP growth rate below its trend rate.
Based on current IMF world GDP growth
Aircraft RETIREMENTS 1970 to 2015
forecasts, CAPA's world demand model forecasts RPK growth rising from 6.7% in 2015 to 6.8% in 2016 and 7.4% in 2017.
These rates of RPK growth are all higher than the fleet growth that the model forecasts, although the difference between RPK growth and fleet growth narrows slightly with each year of the model. Moreover, the same risks and uncertainties that apply to GDP forecasts also apply to the RPK growth outlook.
The supply/demand balance remains the fundamental driver of airline industry margins, but changes in oil prices can also have an impact. The fall in crude oil prices that began in 2H2014 has led to Brent prices falling below USD40 per barrel for the first time since early 2009 and a growing consensus that they may not return to the USD100 plus level for quite some time.
Although lower jet fuel prices have added to downward pressure on airline yields, they have also undoubtedly boosted airline margins. According to IATA, the global airline industry enjoyed a 20% reduction in its fuel bill in 2015, compared with a 6% fall in revenue.
However, the fall in the fuel bill was less than the 47% year-on-year drop in oil prices. Fuel hedging policies locked in higher prices for many airlines and the strength of USD also reduced the benefit of lower oil prices for airlines with reporting currencies that were weakening against USD. The full benefit of lower oil prices should be felt in 2016, when most fuel hedges will be based on the lower price environment seen in 2015.
CAPA's model expects fuel expenses to consume 19% of airline industry revenue in 2016, down from 25% in 2015 and 30% in 2014. Lower fuel prices can often lead to additional downward pressure on yields, especially if the underlying cause is a weaker economy. Nevertheless, airline profitability should again be boosted by lower fuel costs in 2016.
World airline RPK growth and world GDP growth 1971 to 2017f*
CAPA's world airline operating margin model estimates that world airline operating margins rose from 5.5% in 2014 to 7.1% in 2015. This 2015 estimate takes the global airline industry above its historic cyclical peak operating margin levels of around 6% and higher than any year since 1967.
For 2016, the model forecasts operating margins rising further to 8.2%. This would mean two successive years of airline margins that are higher than the historic 6% peak level and herald an era of profitability only ever seen in the mid 1960s.
A disproportionately large part of global airline profits will continue to come from the heavily consolidated US market, where historically high margins were delivered in 2015. Even there, in one of the world's stronger economies, yields slipped in 2015 with renewed competition from smaller airlines and as lower fuel costs and a price sensitive market pressured levels.
The higher growth and increasingly important markets of Asia Pacific are meanwhile going through an extended period of restructuring, with
World airlines: ancillary revenue and operating margin as % of total revenue 2010 to 2014
very high levels of new aircraft orders and new entry. This has depressed margins in Southeast Asia particularly.
In addition to improved capacity discipline, new revenue sources have been considered by some to be a reason for higher airline margins in recent years. According to IATA, between 2010 and 2015, total airline revenue increased by 26% (although IATA estimates that it fell by 6% in 2015 due to falling yields).
Over this time frame, passenger revenue increased by 18%, while cargo revenue shrank by 21%. Other revenue increased 2.5 times between 2010 and 2015 to double its share from 9.4% to 18.7% of the total. This latter category consists of every other activity carried out by the world's airlines, including MRO, catering and other non-flying services, but also ancillary revenue.
It is not possible to disentangle ancillary revenue from all the other activities in the 'other revenue' category. However, IdeaWorksCompany publishes an annual survey with estimated figures and analysis of ancillary revenue for the world's airlines.
According to its 2015 estimate, published in Nov-2015, world airline ancillary revenue increased by 18.6% in 2015 to USD59.2 billion. This is 8.3% of the total airline revenue figure estimated by IATA at 710 billion in 2015, compared with 6.6% of total revenue in 2014 and 4.0% in 2010.
This increase in ancillary revenue as a percentage of the total has accompanied the increase in airline operating margins in recent years and it is tempting to assume that one has caused the other. This may be so, at least to some extent, but it is first worth considering the sources of ancillary revenue.
For US majors, more than half (55%) of ancillary revenue comes from the sale of FFP miles, according to IdeaWorksCompany's 2015 estimate, the same figure as for 2014. This compares with just 15% from FFP sales outside the US, up from 10% in 2014.
Stripping out FFP mile sales, the vast majority of the remaining ancillary revenue (89% for US majors and 82% elsewhere) comes from baggage fees, other a la carte services and onboard retail. These activities are essentially the unbundling of what was once part of the core product. It is at least debatable whether these represent new revenues, or just a re-labelling of existing revenue streams.
Only a small proportion of ancillaries are new products (labelled as travel retail in the charts below). This suggests that the apparent growth of ancillary revenue may be as much a reallocation of existing revenue as anything else. Nevertheless, it seems that the industry is widening its revenue base and this analysis certainly highlights the opportunity for airlines to develop genuinely new ancillary revenue.
Improved profit margins have also taken the airline industry into a rare period of spending within its means. Historically, capital expenditure - mainly investment in new aircraft - has typically exceeded operating cash flow generated by airlines. From 1979 to 2005, global airline capital expenditure averaged 130% of operating cash flow.
The situation became even worse in cyclical downturns, when cash flow can fall rapidly, but airlines typically cannot capital expenditure fast enough. According to CAPA estimates, in 2001, capital investment was five times operating cash flow.
In good times, the ratio improves, so that capex is less than operating cash flow, but not by much and, in the past, not for long.
However, it seems that the improved capacity discipline of the past decade or so has also translated into better capital discipline. In 2016, capex is set to be less than operating cash flow for the seventh straight year and the ratio has only exceeded 100% twice since 2006 (in 2008 and 2009).
As with other industries that enjoy a period of surplus cash, the airline industry has been taking the opportunity to honour its responsibilities towards investors. Many airlines around the world are repaying debt and making cash returns to shareholders in the form of dividends and share buybacks.
However, in another important aspect, the airline industry is impeded from behaving as many other global industries might when generating free cash. Such periods often prompt a wave of consolidation as a use of surplus cash, but the airline industry faces restrictions due to limits on foreign ownership and control.
Estimated sources of ancillary revenue (as % of ancillary revenue) for US major airlines and airlines outside US, 2015
Estimated sources of ancillary revenue excluding FFP mile sales (as % of ancillary revenue ex FFP sales) for US major airlines and airlines outside US, 2015
World airlines: revenue by category (USD billion) 2003 to 2015e
CAPA's world airline operating margin model estimates that world airline operating margins rose from 5.5% in 2014 to 7.1% in 2015. This 2015 estimate takes the global airline industry above its historic cyclical peak operating margin levels of around 6% and higher than any year since 1967.
For 2016, the model forecasts operating margins rising further to 8.2%. This would mean two successive years of airline margins that are higher than the historic 6% peak level and herald an era of profitability only ever seen in the mid 1960s.
A disproportionately large part of global airline profits will continue to come from the heavily consolidated US market, where historically high margins were delivered in 2015. Even there, in one of the world's stronger economies, yields slipped in 2015 with renewed competition from smaller airlines and as lower fuel costs and a price sensitive market pressured levels.
The higher growth and increasingly important markets of Asia Pacific are meanwhile going through an extended period of restructuring, with very high levels of new aircraft orders and new entry. This has depressed margins in Southeast Asia particularly.
World airline capital expenditure as a percentage of operating cash flow 1979 to 2016E*
In a cyclical industry, the good times do not last forever. Margins will not continue to climb indefinitely, even if they can now reach higher peaks than previously. The CAPA model forecasts that the operating margin will ease back from 8.2% in 2016 to 7.5% in 2017, due to the increase in the forecast both of the oil price and fleet growth (offsetting the higher RPK growth forecast).
This 2017 margin would still be higher than at any time since the 1960s. However, history suggests that peak margins are followed by a downturn and it will be a significant test for the airline industry's capacity and cost discipline to maintain margins in the region of 7% or more.
Nevertheless, if there is to be a downturn at some point in the next few years, this can also benefit the industry in the long term. A downturn can act as a stress test for airline restructuring programmes, by revealing whether cost reduction has gone far enough. It can also provide a test of revenue sustainability, particularly with regard to new revenue sources, as demand weakens.
A downturn may even stimulate consolidation as lower valuations facilitate acquisitions by those that have hoarded cash in the upturn. A period of financial weakness for some airlines could even increase pressure on governments and regulators to lower the limits on foreign ownership in order to widen the pool of potential purchasers of struggling carriers. Consolidation through market exit by weaker players is also a common result of a downturn.
The precise timing and impact of a downturn are impossible to call. But there will be one.