CAPA Chairman’s Update: Midnight’s approaching. Who’s going to turn into a pumpkin?

Transcript

Peter Harbison:

Hello and welcome again to Capa Live for February 2021. My presentation today is called Midnight's ApproachingWho's Going To Turn Into A Pumpkin? A story of hope and delusion and some hope. I hope that during this you'll start to appreciate what I'm talking about here. Half a dozen key points. The first one is that reality starts to bite in the second quarter of this year as government supports dry up, as the cash needs to start coming in. In fact, we're approaching the new tipping point. The next one is, are we actually seeing the light at the end of the tunnel? Then a little bit about business travel, how it undermines the full service airline model by the loss of a great part of it. Then where are the governments when you need them? Good question. A little bit about jab wars, the vaccination process. Then I want to finish with some future industry directions as I see them, some fairly big picture ones.

Peter Harbison:

So until now, airlines have enjoyed some very strong tailwinds that have helped them remain liquid over the past year, despite a massive, massive slump in the market. But of course, in the process, their debt profiles have deteriorated quite substantially. Government generic economic aid has paid wages. Many countries have given loans and/or acquired equity in their airlines, fortunately, in terms of tailwinds. Fortunately, the stock markets remained strong. So raising equity has also been possible. Asset values have remained high, so the debt raising has been possible.

Peter Harbison:

Quite frequently, well-funded lessors have been relatively generous in helping airlines stay afloat. And, of course, interest rates are uniquely low and look like staying like that for a long time. As a result, remarkably fewer airlines collapsed. There is a list of them, but what's surprising about the year was not how many collapsed, but how many didn't collapse. It was just a remarkably dreadful year. International capacity was down to about a 10th of its previous levels and lots of domestic operations didn't really fare much better from February, March 2020 right through the rest of the year. But at the same time, some new airlines actually entered the market.

Peter Harbison:

So now we're almost halfway through the first quarter of this new year and the situation still remains dire. What's going to happen next? Government generic economic supports are going to continue until probably the second quarter, maybe more in the US depending on what happens in Congress. Airline income, meanwhile, is likely to remain static, and cash burn, at quite frightening rates, is continuing. Vaccine rollout is gradually improving consumer sentiment and helping to reduce death levels and new cases, hopefully. But cash flow is now critical. We're approaching the tipping point. Cash burn can not continue indefinitely. So airlines are going to have to start becoming proactive rather than just burning the furniture to keep themselves warm. In that process, hope is not going to be an adequate strategy. It's nearly midnight.

Peter Harbison:

So how different are things going to be in the second quarter? First of all, as government aid taps are turned off, which markets will do best? Vaccinations tend to improve the consumer and general outlook, particularly in the US, the UK and in Israel, obviously, which has been very fast to move, and probably China, but importantly, not globally. Business travel is going to remain heavily subdued. International capacity still remains below 10% of pre-pandemic levels, and many borders effectively are closed still. But domestic US and domestic China should show some pretty good signs of improvement.

Peter Harbison:

Let's look at Europe first. With only a few weeks to go for bookings to recover for the second quarter, which is a key period for European airlines, government border responses are still fragmented and uncoordinated, vaccination progress is slow and uneven, and I'll talk a bit more about that later. Passengers are booking late and are reluctant to fly internationally now when they risk snap quarantines or cancellations of flights. Eurocontrol, which covers the wider Europe, suggests that activity will remain low right through the first quarter and only start to rise gently in April and May of this year.

Peter Harbison:

Meanwhile, Europe's airline seat capacity continues to underperform the rest of the world. The Middle East is down 56%. Africa is down 50%. North America is down 48%, Asia Pacific 45% and Latin America 42%. Europe's seat capacity is down 74%. Even Europe's LCCs, who generally across the world been performing better, are starting to do it tough. Their revenue decline actually accelerated in the last quarter of 2020, easyJet's most heavily because for various reasons they have not expanded their capacity. But that overall decline for the LCCs I think is very important, Wizz and Ryanair particularly.

Peter Harbison:

Europe's airlines need first quarter cash badly. Will it arrive in time? Probably not. The UK vaccine rollout is looking pretty good, but the timing is too short either to generate public confidence or to give governments the willingness to open up their borders. So selling into the markets before Easter in Europe is going to be very complex. There's a very optimistic graph here from The New York Times which suggests that vaccines could quite blunt the UK epidemic in weeks, looking at everyone being covered by the end of June, which is an optimistic approach, and maybe we really don't know in these circumstances what it will be. On the other hand, the Financial Times last week suggested that health authorities say that there are three different variants of the virus circulating in England with a mutation that's believed to undermine the immune protection provided by the prior infection and by the current vaccines. So, that's not good news.

Peter Harbison:

In the UK, IHME, which has been very accurate in its projections over the last 12 months or so, projects, again, rising and accelerating deaths in the UK up to about possibly 170,000 by the end of May, which obviously has an effect across the board in terms of government and consumer sentiment. Spain, which is relying very heavily on a regrowth of tourism, is projected actually to steepen in February, March right through to April in terms of deaths. Not a nice sign. In France, the trajectory also is trending upwards. So these are all signs that make it difficult to see how Europe can make a rapid recovery.

Peter Harbison:

I mentioned before that US domestic aviation should come back first, and it's interesting for a number of reasons. First of all, there's a very stark contrast between the attitude of the US and most other developed nations to the whole process and that's for various reasons. It's a unique country in many ways. The ability though, to tolerate nearly 4,000 deaths a day is really something that most governments are not prepared to do. Contrast that with China, where the initial outbreak was really extreme and they've since recovered and got things mostly under control. Their travel restrictions really clamp down whenever there's a new outbreak, and I'll talk a little bit more about that in a moment. As a result of that process and of the original attitude and actions taken to slow the growth, China's domestic travel is about the same level as it was pre-COVID. Whereas, the US remains about 50%. But both countries are projecting rapid recovery as the vaccines roll out.

Peter Harbison:

Now, these pictures actually are probably worth a thousand stories. First of all, it's interesting that both markets are now about comparable size. These graphs are showing in red the trajectory of capacity in 2020, and you can see China there slumped very rapidly at the end of February as the capacity was cut back and the market closures just occurred. The US, by contrast, was well through March before things were closed down there. The red line at the top, which shows a much slower response and in a lot of ways, it has been suggested, has changed the entire approach of the US.

Peter Harbison:

The dotted green line and the solid green line, the solid green line shows where we are in 2021. China's back to about the 2019 level. But interestingly, this is a key time of year. The Chinese New Year, the Lunar New Year is a major travel time, and there've been significant restrictions on travel in order to dampen any further outbreaks. But the dotted lines, ignore the downturn on the Chinese one after the middle of March to the end of March because that's just a schedule filing issue. But as you can see, both the US and China are looking fairly optimistic beyond the end of this month. The US trending up to 15 million passengers, 15 million seats rather, by the end of March and China up to probably maybe a couple of million more.

Peter Harbison:

The US, however, is going to pay a heavy price for reopening. IHME, to go back to the projections again, is projecting up to 700,000 deaths by the end of May, whereas we're about 450,000 now. This week's Superbowl is obviously going to be another super spreader, and passenger sentiment really doesn't need to improve dramatically as vaccines are rolled out. That seems to be being reasonably successful under the new administration, but time will tell. Asia Pacific, as I implied before, is much more risk averse, generally. Despite many countries having controlled the spread of the virus, Asia Pacific governments are generally much more reluctant to open up their markets, and it's a much more international market of course. Exceptions to that are the Philippines and Indonesia and more recently Malaysia where significant outbreaks have occurred. Even Thailand, which has been relatively free, is now starting to experience some problems.

Peter Harbison:

But importantly still, we've seen totally uncoordinated approaches between governments, health authorities, and aviation authorities to opening markets for green bubbles or green corridors, whatever you want to call them. The Pacific Asia Travel Association sees negligible improvement for the whole year of 2021, which is a rather frightening thought. Latin America and the Caribbean in some ways rather similar to the US in terms of their attitude to continuing to grow. Seats, domestic and international, across the region have been around 55% of the 2019 levels, and despite continuing cases and high levels of deaths, that's continued to be the case. As you can see there, anticipation, some growth coming, not steep growth, but some growth coming in the next months.

Peter Harbison:

Middle East and Africa is very hard to cover in a few words because it's such a diverse region and really lots and lots of different ingredients in there. I think probably from a global point of view, what's been important recently has been the spike in the UAE, United Arab Emirates, particularly Dubai cases, which have come as something of a surprise, I think. But overall, relatively lower levels of infection. Vaccinations are going to be slow in Africa. They'll be faster in the Middle East, in the Gulf particularly. But both regions are around about 40% of 2019 levels. As you can see from the dotted green lines, looking at anticipating growing fairly rapidly as time passes.

Peter Harbison:

So are we seeing a light at the end of the tunnel, or really, is it something that's, in the old colloquial, the express train coming the other way? The point I'd really like to stress is there's something very important that most airlines either don't recognize or don't wish to. The future airline industry will never be the same again. It will be different from the one we knew. Vitally, the industry, particularly in this year, 2021, will at best be half the size it was two years ago. This is IATA's projection, and IATA suggest it could be even worse if travel restrictions persist as new variants start to emerge. So it could be down to 40% of 2019's levels. That is, just to stress the point, an industry which is half the size of 2019's. Yet as far as I can see, most of the industry is betting their house on a substantial recovery in the second and third quarters of this year. I don't think there's a plan B.

Peter Harbison:

This is maybe a little controversial, but I suggest that in a lot of ways, cash burn, which has plagued the airlines of course for months now, will actually increase when short haul travelers return. International is very different and I'll deal with that later. But it's quite simple really. There'll be too many seats. In a competitive market, we're not going to see an orderly lineup to carry passengers. Market share becomes a key recovery strategy. That is, airlines are going to have to pile back in to retain or to establish market share in the new environment. They'll compete on capacity. There's only one outcome from that and that is depressed prices. Today, travelers are buying late, which prevents the airlines from storing cash in advance, two, three months in advance. Therefore, accumulating advanced cash is really much more difficult.

Peter Harbison:

That capacity won't stabilize for months, if ever. I mean, it's a competitive world we live in. There's a good chance that oil prices will surge as demand returns, not just in aviation, but generally across industry. A little side note too, in some cases, the conditions are ripe for new entry, particularly at underutilized, underused international hub airports which have got plenty of slots available. And there are cheap aircraft, a plentiful skilled workforce, cheap money, a lot of conditions which are actually quite attractive to potential new airlines.

Peter Harbison:

I want to talk a little bit about one of the undermining factors for the full service airline model, and that is business travel. I've dealt with this quite a lot, and everybody's talked about it a lot, but I think there's a lot of denial. It's important to recognize that we do need to change models because business travel traffic is not going to come back. Most long haul and many short haul markets rely very heavily on business travel. It's because it's less discretionary, it's less volatile, it's less seasonal and it's better yielding, obviously. So there are better unit returns and year-round consistency, which is really what you need as an airline allocating metal to particular words and resources.

Peter Harbison:

Now, the assumption that all business travelers fly in business class is a mythical one. It's about a lot more than business class, although that's very important. Business travel tends always to be high yielding. I'll just start that again. I'm thinking you can probably hear that truck. Starting again. It's a garbage truck, actually. Starting again. Business travel tends always to be high yielding, even when it's in economy or premium economy. Business travelers tend to book later, to have firm dates on which they must travel, and paradoxically, they need the flexibility to change bookings at the last minute. These are all premium priced products, regardless of whether they're sitting in comfort in business or first class or premium economy.

Peter Harbison:

I think it's important too that Europe, which is really going through a very, very difficult situation at the moment and doesn't really seem to have a clear light as to when it's going to emerge, Europe is responsible for a very large part of premium travel. The dark blue line is the revenue share in each of the markets, and which you can see for Europe, Middle East and the North Atlantic is around 50% comes from premium travel. The light blue lines, which are languishing right back around 10%, are the number of passengers who are paying that, or the percentage of passengers who are really disproportionately subsidizing those routes. So lose that and these routes in particular are going to change dramatically, and it has a massive impact on European and for the North Atlantic US airlines.

Peter Harbison:

The factors that are chipping away at business and corporate travel demand are things like sustainability, environmental sustainability. As it goes up the corporate agenda, companies will be flying less. International recovery is going to be spotty across the world. It'll be slow, which means less flying. Companies have found that online has become economically very effective in terms of sharpshooting as opposed to a scattershot, which means flying less to achieve the goals you need. Working from home and lifestyle changes mean that combined with the ability to work online, short travel and even some long haul travel will diminish. Obviously, it's going to have to continue in certain cases, but it's the proportion which will come back that is the more difficult thing.

Peter Harbison:

Some government support, there's actually financial support, has actually come with green strings attached. I'm thinking of France here and the Dutch and German governments in particular. And the new Biden administration is, I think, going to be quite tough on environmental issues. Then importantly, companies have cut costs dramatically during this past year. They're not about to reset to pre-pandemic levels. It's going to be a matter of justifying every new dollar, which again means fly less. So business travel is going to remain very depressed for many, many months, and airlines that rely heavily on that for their model will have to adjust or they're going to fail. But not necessarily quickly. It could be a painful process.

Peter Harbison:

How much evidence do we need that business travel is going to diminish? GBTA says that spending losses will be 10 times larger than during the 9/11 and GFC crises. Importantly, even before COVID, business travel was already declining as a proportion of the total. In the UK, international leisure travel increased three and a half percent annually in the 20 years to 2019. International business travel just grew 0.2% annually during that period. McKinsey says international business travel from the US took five years to rebound fully after the GFC. Whereas, leisure travel recovered within two years. That'll be different this time, potentially.

Peter Harbison:

Deloitte says 90% of finance directors in the UK say that 44% of them, so of the 90 finance directors of the UK's largest companies, 44% of them will reduce discretionary spending like travel even further, even further over the next 12 months. They're anticipating a five fold increase in homeworking relative to pre-pandemic levels. Again, a proven factor or connection with not traveling internationally for business. And Bill Gates, that font of all wisdom, says business travel will be 50% of previous levels. I don't think he just made that up. He's got a lot of very, very skillful people working on these things, but it's a large number. It may be smaller. It may be bigger.

Peter Harbison:

Meanwhile, though, I think what's important is that hotel groups are recognizing this. Accor CEO says, "We've decided to go very, very deep on buffering what could be a major loss in business travel." They're in the early stages of making unused floors of the hotels available for companies to set up remote working hubs. These adjustment processes, Hilton and Marriott, similarly doing creative, innovative things. Meanwhile, what's happening in the airline industry? They're talking tough. It's not going to go away or, "We can get through it. We can work around it." But do they really have the ability or the good sense to adapt their models to meet the new reality? Soon going to find out.

Peter Harbison:

Next one, where are the governments when you need them? Restoring international travel is going to be a long and very difficult process. The whole of the past year has been characterized by nationalism in the approach to fighting out the pandemic. It's become a global war against each other as well as against the pandemic. But it needs multilateral action, and even the multilateral organizations, who are in some cases doing some very good things, seem to be acting almost unilaterally themselves in terms of connecting with the other multilateral bodies. This lack of international coordination and cross-border movement of people is going to continue throughout this year because new outbreaks are going to continue around the world and it's going to make regrowth incredibly difficult. The only real way of getting around that it's getting some standardization and coordination between governments.

Peter Harbison:

Davos, last month, which is admittedly not in governments, but a lot of governments attend, and these are the world's thought leaders, "Millions of jobs are at risk," says Luis Felipe de Oliveira, who's the ACI world director general. "The industry lost $112 billion last year and we lost 65% of expected global passenger traffic. It's not expected to recover before 2024 and '25, and in some markets, even later. There are some good developments in domestic markets with some recovery, but international traffic's still at a standstill."

Peter Harbison:

So what did they talk about at Davos? They talked about reducing aviation emissions, which, in fact, have reduced anywhere between 20 to 50% in the past year and they won't increase to 2019 levels for at least another five years. Now, there can be no doubt we're on the brink of an environmental catastrophe. I think that's recognized and it's vital to talk about it, but we have an existential issue as well. We're already in the middle of a humanitarian and economic catastrophe. It's a critical time for intergovernmental leadership on COVID and air travel coordination, and it's not happening.

Peter Harbison:

Let's talk about the jab wars, the process of getting vaccinations rolled out. The WHO director general talked about the world facing a vaccine and moral crisis. It's already become a political battle front in Europe. The EU versus AstraZeneca dispute caused distribution issues, practical issues, as well as a lot of angst between the various governments and threats of border closure. Pfizer risk also being dragged into that process. Many developed governments have ordered vaccines in numbers well above their requirements.

Peter Harbison:

The thing is with jab wars, everybody needs everyone else to be vaccinated. So how can access to vaccines be evenly distributed between the haves and the have nots? It's an issue of moral importance. It's also critical to the restoration of international air services. So things like how quickly can a digital passport proving vaccinations be introduced globally? What's the legal mechanism to do it? What happens in the case of countries that refuse to accept it? What happens to those who aren't digital? Would there be a paper version of the certificate? Would they be accepted? All these sorts of issues which really aren't being dealt with at the moment.

Peter Harbison:

There's a lot of logic, also, in a humanitarian approach. An ICC commissioned study said that unequal vaccination across among countries will lead to a total cost for the world of between two and $4 trillion, and up to half of those costs paid for by the wealthy nations. In contrast, the cost of vaccinating a fifth of the world's vulnerable population, as the WHO's COVAX initiative aims to do, would cost less than $40 billion. Again, global vaccination would also restore international aviation much faster.

Peter Harbison:

Finally, to talk about what I see as some of the future industry directions. There are many changes because, as I said, there won't be an industry that's the same as it was before, but these are some of the key ones, I think, which will really influence developments and growth in the next few years. First of all, airline revenue streams have to change greatly. They're already evolving, had been before COVID, but because passenger and yield profiles will be very different in the short-term, that means a new trajectory for the medium and longer term. It'll be driven by soft consumer demand, both economically driven and concerns about flying, by diminished business travel, and by lower average ticket deals, particularly in short haul markets.

Peter Harbison:

The inverse is necessarily that ancillaries in one form or another are going to have to play a much greater role if airlines are going to be successful in, for example, using their brand to generate revenues. The airlines that have done best in the last year are the ones who've been generating a lot of income from non-ticket sources. Several airlines have achieved 50% or more of much lower ticket prices, certainly, of their total revenue from ancillaries. For example, VietJet low-cost carrier in Vietnam, which was one of the few, if not the only, passenger airline in the world to be profitable through the whole of 2020, generated over 50% of its revenues from non-ticket revenue.

Peter Harbison:

Cargo too has of course helped, which is sort of for these purposes, to some extent, an ancillary. But other revenue streams which have been evolving in which will have to accelerate are things like loyalty programs. Qantas, for example, have talked about having half of it's EBIT from its loyalty program by now, by about 2023. Then the sort of brand leverage and diversification that AirAsia is talking about as it becomes a digital airline with airasia.com, which again, aims to generate 50% of its revenue from non-airline non-ticket revenues by the mid-2020s.

Peter Harbison:

Second issue, health and sanitation issues are not temporary. Internationally, from an operational point of view, it's going to mean the continuing hiccup effect as governments protect their borders from new infection, opening and closing, opening and closing. It'll cause airlines across the board health and sanitation issues, will incur higher operating costs. Airports too have been relatively slow to adapt, perhaps because of the lower numbers flying through their real estate. They're going to need to adapt very expensively to conform with future health needs because this is going to be something that goes on right through this decade and beyond. And standardized testing and recognition of vaccinations, which is at the heart of a lot of these issues, will be challenging for many years.

Peter Harbison:

Thirdly, and this one is really complex and hard to see a way through, but the entire foundation of competition regulation has been undermined. That's happened because of government support for airlines. It's been so widespread that, in fact, subsidy will drive much of the near future growth and even medium term growth, especially in international markets. This creates fundamental issues around competition and raises the real prospect of the regrowth of protectionism.

Peter Harbison:

Fourthly, as yield profiles slump, and I've talked appliedly about this previously, low costs are going to be even more vital for airlines. With a lower yield profile, you cannot afford to have high costs. As a result, across the world, almost without exception in international and domestic markets, LCCs have expanded their market shares over the last year. So full service carriers, in some way or another, are going to have to reinvent themselves, but particularly by reducing costs because losing business travelers means fewer trunk routes, fewer long haul services and fewer airlines, higher prices for long haul international travel.

Peter Harbison:

Talked about reducing airline revenues this year by 50 or maybe even 60%. That has to be transformational for the industry, and it can mean any or all of the followinga much smaller industry, which seems almost inevitable. Fewer or smaller airlines or both, which does have major implications, of course, for creditors and shareholders among others, not to mention the tourism industry, which is right at the tail at the end of this dog. Bankruptcies for airlines or slow painful decline as debt burdens weigh heavily. And short haul, where most of the future growth will come from, becomes much more competitive because everybody's going to be diving in there, particularly with some of the new model, very fuel efficient aircraft that are coming into the market now.

Peter Harbison:

Sixth point, international travel is going to remain problematic. Uncoordinated national responses and what I've called the hiccup effect of sudden opening and closing makes network planning very difficult and costly. The long haul trunk routes suffering from reduced business travel revenues will have reduced frequencies and fewer airlines. They will often be subsidized. Then higher fares for leisure travelers is sadly a likely outcome of that process. And not to overlook perhaps in the course of the decade the most important of all, environmental sustainability. I've talked about this before, but pressures will intensify to reduce emissions. This comes with costs and revenue losses, significant, and it's not going to go away.

Peter Harbison:

So in closing, just to reiterate, I want to stress that it seems to me that many airlines either don't recognize or don't wish to recognize the future industry will not look the same again. It'll be very different than the one we knew. These next few months are going to be critical in showing us what that shape will be. Thank you very much.

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