Airlines remain, literally, the poor relations in the aviation family. A new report commissioned by IATA and using analysis carried out by McKinsey & Company compares the return on invested capital achieved by airlines and by other players in the aviation value chain.
All other parts of the value chain make higher returns than airlines, whose returns are consistently below the cost of capital. The fuel supply industry and labour capture significant value from air transport. With an estimated USD4-5 trillion of new capital required to fund the growth of air travel in emerging markets over the next 20 years, this situation may become unsustainable, the more so as governments increasingly resile from supporting their national airlines.
The IATA report was intended to provoke fresh thinking and calls for a more partnership-based approach across the value chain. The biggest hurdle is likely to remain the highly complex web of bilateral air service agreements restricting market access and airline ownership and control.
ROIC is consistently below WACC
According to IATA’s Jun-2013 report “Profitability and the air transport value chain”, the airline industry generated an average return on invested capital (ROIC) of 4.1% in the 2004 to 2011 business cycle, a very small improvement on the 3.8% achieved in the 1996 to 2004 cycle. This remains well below the weighted average cost of capital (WACC), which falls in a range of 7% to 9%.
The cost of capital is the return required by investors, or the return that investors could expect to achieve by investing their capital in other industries with a similar risk profile.
The weighted average cost of capital is the average return expected by both debt and equity investors, weighted according to the proportion of each in the overall capital of the industry. It is calculated using a formula known as the Capital Asset Pricing Model, which has long been the standard approach adopted by investors and bankers.
World airlines return on invested capital and their weighted average cost of capital (WACC)
ROIC is calculated by using an after tax operating profit figure (i.e. profits before paying debt interest) and the total capital invested in the industry (excluding goodwill). Both are adjusted to reflect operating leased aircraft, which are not included in invested capital under current accounting standards.
The profit figure is adjusted by adding back a portion of lease payments considered to be the equivalent of debt interest (the remaining portion of lease payments is equivalent to depreciation) and the invested capital figure is adjusted by adding the value of capitalised operating leases.
Airlines have one of the lowest levels of ROIC of any industry
In theory, in an industry where market forces operated freely to create an efficiently competitive market, ROIC should equal the WACC. If ROIC is greater than the WACC, this should attract new entrants until the excess returns are competed away.
Similarly, if ROIC is less than the WACC, this should create an incentive for investors to withdraw their capital, thereby reducing the number of competitors until returns increase to the required level (i.e. the WACC).
In reality, some industries consistently achieve excess returns (ROIC > WACC), often due to structural or regulatory factors. In any regulated industry, entry - and exit - are typically distorted in some way. The airline sector achieves one of the lowest levels of ROIC of any industry and is one of the few that consistently fails to meet its WACC.
Industry median ROIC*
LCCs and network airlines fail to meet WACC in all regions
There is some evidence that returns vary by airline business model and geographical region, but, in aggregate, all have failed to generate ROIC in excess of WACC through the business cycle. On an individual basis, there are some airlines that have achieved their WACC through the business cycle (e.g. Ryanair), but they are very much the exception.
In all of the major global regions for air transport, low-cost carriers have generated higher returns in aggregate than network carriers. However, during 2004 to 2011 even the LCCs failed to meet their WACC in aggregate, although they came closest in Europe.
ROIC and WACC by region and business model: 2004 to 2011
The rest of the aviation supply chain does much better
The failure to generate economic returns (i.e. where ROIC > WACC) reflects problems both with the airline industry supply chain and the structure of the industry. Every other element in the supply chain generates higher returns than airlines themselves, in some cases significantly higher.
Over the period 2004 to 2011, airlines achieved an average ROIC of just 4%, versus a WACC of 7%-10%. At the ‘downstream’ end of the chain, freight forwarders, travel agents and Computer Reservation Systems (CRS) all earned double digit returns comfortably ahead of their WACC.
Suppliers to airlines had a more mixed performance: aviation services companies and air navigation service providers (ANSPs) beat their WACC; lessors and airports just about met their WACC, but manufacturers fell short. All however made higher returns than airlines.
The returns generated by airports are weighed down by the US, where airports are owned by local governments and funded by tax-efficient municipal bonds. They are not run to generate a return in their own right, but to bring wider economic benefits. Outside the US, airports generally produce higher returns, often aided by price regulation.
Return on capital and weighted average cost of capital through the aviation value chain
Economic losses of USD16-18 billion across the supply chain
If the ROIC percentages are translated into economic profits in absolute terms (economic profit is the amount of profit earned over and above that needed to pay the WACC), the IATA/McKinsey study calculates that the entire aviation supply chain made economic losses of around USD16 billion to USD18 billion annually in the period 2004 to 2011.
An economic loss does not necessarily mean there was an accounting loss, but the aviation industry made USD16 billion to USD18 billion less profit than investors required to reward them adequately for their investment. Investors could have made more profit by investing their capital elsewhere. This shortfall is called an economic loss.
Other links in the chain generate economic profits
Within the aviation industry, MRO, ground handling, catering, CRS and freight forwarding created economic profits, but these were much more than offset by economic losses by airlines and airports.
Airlines were responsible for the large USD17 billion of economic losses.
Economic profits* in the air transport value chain (excluding fuel and labour)
Jet fuel supply is profitable
The IATA/McKinsey report looked at how much value is being extracted from the aviation industry by the fuel supply industry. In spite of dramatic improvements in airline fuel efficiency, fuel costs rose from 17% of operating costs in 2004 to 30% in 2011, as a result of increases in jet fuel prices.
Energy intensity of new aircraft models
Crude oil accounts for around 75% of in-plane jet fuel costs (excluding any applicable taxes). Refinery costs and profits account for 13% and transport, storage and logistics for 8-12%.
In total, the IATA/McKinsey report estimated that air transport generates USD16 billion to USD48 billion in profits for the jet fuel industry, with the majority accruing to the crude oil suppliers. This is a very significant level of profit compared with the economic losses generated by airlines.
The jet fuel supply chain
Airline labour extracts value
Labour also extracts significant value from the industry, but not as much as does the fuel industry. IATA and McKinsey compared labour rates in the airline industry with those of comparable jobs in other industries and also compared rates paid by large mainline airlines with the median for airlines.
The study concluded that, while there is no evidence of a surplus being earned by flight crews in the US, there is such evidence in Europe and other regions, where airlines have not been through court mandated Chapter 11 labour cost reductions.
The report estimated that a surplus of USD3 billon to USD4 billion was earned by flight crews. This highlights the importance of labour productivity in the airline industry.
See related report: European airline labour productivity: CAPA rankings
Higher risk, but lower reward
While investors would normally expect a higher return as a reward for higher risk, the airline industry again defeats conventional wisdom. Airline profits are more volatile, and riskier, than those of airports and aviation services providers. In many cases, regulator-sanctioned airport fee increases are implemented in a traffic downturn, when airlines generally have to lower their prices to passengers.
This represents a transfer of risk from airports to airlines. However, airline returns achieve no risk premium over those of airports and services. On the contrary, airline ROIC is consistently lower.
ROIC for airports versus airlines
ROIC for services versus airlines
Inefficiency in monopoly suppliers
The IATA/McKinsey study also looked at the issue of inefficiency in the aviation supply chain, particularly among airports and ANSPs. A lack of competitive pressure for such monopoly suppliers may not always show itself in excess returns: it can also lead to inefficiency.
The report found evidence of inefficient provision of airport services in the wide variation in measures such as runway productivity and passengers per employee. It suggested regulatory changes to create incentives to reduce inefficiency through price regulation mechanisms.
Lower costs are passed to consumers
The inefficiencies in the supply chain do not fully explain airlines’ inability to generate economic profits. A lowering of airlines’ supply costs would not necessarily translate into better returns for investors in airlines.
Indeed, as IATA and McKinsey noted, the cost of air transport has more than halved in real terms over the past forty years, but airline ROIC has not improved. The benefit has been captured by consumers and the wider economy, but not by airlines and their investors.
The real price of Air Transport (USD/RTK in 2009 dollars)
Industry structure remains fragmented, mainly due to the bilateral system
The problem also lies in the structure of the industry, which remains very fragmented in spite of recent moves towards consolidation. Barriers to entry are relatively low and barriers to exit are high. Restrictions on market access and on ownership and control, enshrined in the bilaterals that still dominate the industry even after some limited liberalisation, contribute significantly to this picture.
These bilateral restrictions prevent the consolidation that would otherwise be expected in markets that are very competitive and protect inefficient incumbents in markets with only a few players. In spite of liberalisation within regions (e.g. the EU) and between regions (e.g. EU/US), the system is largely unchanged when it comes to majority control and internal market access.
The resultant highly competitive nature of the airline industry leads to a downward pressure on prices, exacerbated by the perishable nature of airline seats and the low marginal cost of flying an additional passenger. IATA rues the commoditisation of airline services, but an airline seat is essentially a commodity product and a product-based competitive advantage is hard to sustain.
Low returns have not stopped airlines from growing in the past
The continued existence and volume growth of the airline industry, in spite of its low ROIC, is evidence that, at least historically, the returns required by its investors are lower than those normally demanded by rational investors looking for purely commercial returns. Governments and ‘hobbyist’ investors may accept a lower ROIC from their airline investment if the airline brings them wider benefits, for example in the form of economic growth or synergies such as brand building for other business interests.
However, IATA Director General and CEO Tony Tyler argues that this is changing: “Now that 75% of the world’s airlines are at least majority owned by the private sector it should be a concern that today’s returns on invested capital do not justify retaining the existing capital invested in the airline industry.”
Increased pressure on government finances is also likely to lead to a greater focus on the level of ROIC generated by state-owned airlines. Mr Tyler is concerned that the industry may fail to attract the new capital required to fund the aircraft needed for growth in emerging regions.
“New thinking is required…”
IATA believes that new technology and process standards can help to improve returns, but it is calling for a partnership approach with other players in the aviation value chain to find “the most productive way forward”. This could include vertical integration “on a case by case basis” (for example Delta’s purchase of an oil refinery - although that experiment is far from proven). IATA also argues that more transparent information and cost benchmarking can improve supply chain efficiency.
IATA’s main aim in sponsoring the McKinsey report was to stimulate debate: “New thinking is required to bring about the improvement required.”
A partnership among the world’s governments to liberalise the bilateral system of air service agreements must be part of any new thinking. But that is at best a long term goal. In an industry beset by external risks, including the threat of fuel price increases, it may well take a crisis to provoke the cure.