07-Aug-2017 10:26 AM

CAPA airline profit outlook: margins slipping as cost reduction intensity dims. Discipline needed

Analysis

The latest six monthly update of the CAPA world airline industry operating margin model increases its forecasts to 2018 relative to the Jan-2017 update. 2016 was probably a cyclical peak, but the current outlook is for a more sustained period comfortably in excess of previous peak margins of around 6% - whereas previous peaks were often followed by rapid downturns.

The most fundamental reason for improved airline industry profitability is better capacity utilisation. Load factor continues to drive upwards to new highs and both daily aircraft utilisation rates and the proportion of the world airline fleet in use have been improving for almost a decade. In addition, lower oil prices have boosted traffic growth and airline industry margins since 2013.

However, the airline industry cannot afford to be complacent. The International Monetary Fund, in the Jul-2017 update of its World Economic Outlook, noted that its GDP growth forecasts were still below pre-crisis averages and that medium term risks are "skewed to the downside". CAPA forecasts margins to ease back in 2017 and 2018 due to increases in oil prices and in the rate of fleet growth, although both factors are moderating relative to the Jan-2017 update.

The CAPA world airline operating margin model Aug-2017

The CAPA operating margin model is based on the following data and projections:

	2015	2016e	2017f	2018f	Note/source
Brent crude USD/barrel	52.3	43.6	54.0	57.4	Reuters consensus 30-Jun-2017
World real GDP growth* %	2.6	2.5	2.9	3.0	IMF Apr-2017 forecast/Jul-2017 update

Fleet** growth %	3.6	3.9	4.1	4.2	CAPA model
World RPK growth %	7.6	7.4	7.3	6.9	CAPA model

World airline operating margin %	8.0	8.8	7.9	7.5	CAPA model

Changes to the CAPA model from the Jan-2017 update

The key inputs to the CAPA world airline operating margin model are world GDP growth (which drives demand), growth in the global fleet of commercial jet aircraft (which represents supply) and Brent crude oil prices. The outputs are world RPK growth and operating margin.

This revision of the model updates and replace the last forecast published in Jan-2017.

The main differences between CAPA's Jul-2017 model and the Jan-2017 forecast are as follows:

Estimate of 2016 margin revised from 8.3% to 8.8%, in line with IATA's most recent figure published in Jun-2017. IATA gathers bottom up data from airlines and so this should more closely reflect the outturn. Note that 2016 RPK growth has been raised from 6.2% to 7.4%, reflecting IATA's revision based on a wider sample.
CAPA's forecast of 2017 margin is increased from 7.4% to 7.9%, due to the lower oil price outlook (lowered from USD57.4 to 54.0) and higher RPK growth (raised from 6.4% to 7.3%).
CAPA's forecast of 2018 margin is increased from 6.6% to 7.5%, due to the lower oil price outlook (lowered from USD59.8 to 57.4), higher RPK growth (raised from 6.6% to 6.9%) and slower fleet growth (lowered from 4.7% to 4.2%).

IMF GDP growth forecasts, which are the starting point for CAPA's RPK growth forecasts, are each only 0.1ppt higher than the forecasts used in the Jan-2017 CAPA update. The most recent IMF forecasts, updated in Jul-2017, predict GDP growth of 2.9% in 2017 and 3.0% in 2018, both still below the long term historic trend rate of 3.1%.

However, CAPA's RPK growth forecasts are increased more significantly (see above). This mainly reflects the high RPK growth reported by IATA for the first five months of 2017, when it reached 7.9% in spite of the modest global GDP forecast. RPK growth looks set to remain above its long term trend rate of 6.2%.

According to the CAPA model, the outlook for fleet growth is a small rise in the rate of increase. It is forecast to go up from 3.9% in 2016 to 4.1% in 2017 and 4.2% in 2018. However, the 2018 forecast is lower than the 4.7% growth in the Jan-2017 update, reflecting a clearer view of the outlook from manufacturers.

The new forecast would still mean that fleet growth in each of the years 2016, 2017 and 2018 is higher than any year since 2001 (when it was 5.6%).

This suggests a slight loosening of the airline industry's improved capacity discipline, the result of lower oil prices, although fleet growth is still some way short of previous peak growth rates of more than 7%.

The CAPA model uses Brent crude oil price forecasts from the most recent monthly consensus poll published by Reuters (in this case, the one on 29-Jun-2017). This gave an average Brent price forecast of USD54.0 per barrel in 2017 and USD 57.4 in 2018. (As of 07-Aug-2017, Brent crude was USD52.4 per barrel, at the high end of recent prices.)

These figures compare with USD43.6 in 2016, indicating that prices are expected to rise (the average in 1H2017 was USD51.6). Increases in oil prices help to explain the decline in forecast airline margins in 2017 and 2018 from the 2016 peak.

Margins to remain comfortably above previous historic peaks, but falling

The operating margin forecasts in the Jul-2017 update for are higher each of 2016, 2017 and 2018 than in the Jan-2017 update of the CAPA world airline industry operating margin model.

Moreover, the forecast margins for the world's airline industry are unprecedented in an historical context. Previous cyclical peaks almost never exceeded a margin of 6% and were typically followed by a rapid decline.

Nevertheless, the model continues to forecast a declining margin trend through the period from 2016 to 2018.

World airline industry operating margin (% of revenue) 1975 to 2018f*

Better capacity utilisation is improving airline industry profitability

The most fundamental reason for the improved levels of airline industry profitability is better capacity utilisation.

The most commonly reported and observed measure of airline capacity utilisation is passenger load factor - how full the aircraft are - but this does not tell the whole story. Global average load factors have steadily climbed for decades, from around 55% in 1970 to around 80% in 2016; meanwhile however airline profitability has not consistently followed a similar upward path throughout this period.

A fuller view of capacity utilisation needs to include how many hours per day aircraft are utilised (there's no point in having a full aircraft that only flies a few hours a day) and the percentage of the fleet that is actually flying and not parked or in storage (if that full aircraft is flying 24 hours a day, but is the only one that is in service, then the fleet is not enjoying high overall capacity utilisation).

In contrast with the broadly upward trend in load factor, daily aircraft utilisation and the percentage of aircraft in use have both followed a cyclical pattern over several decades. However, following the global financial crisis, daily utilisation and the percentage of the fleet in use have been on a more clearly defined upward path since in 2009. At the same time, load factor has also continued to track upwards.

The combination of these three measures of capacity utilisation goes a long way towards explaining variations in the operating margin of the world airline industry, as illustrated in the chart below (note that the chart shows daily aircraft utilisation hours as a percentage of the historic maximum level of 9.26 hours in 1996).

Daily utilisation and the proportion of the fleet in use are within a few percentage points of their historic peaks (but are below these high points), while load factor is pushing ever new peak levels and appears to have become the main driver among the three measures of capacity utilisation in terms of their impact on airline profitability.

World airlines: operating margin (%) vs load factor (%), daily aircraft utilisation hours (as a % of the maximum) and aircraft in use (as a % of the total fleet), 1972 to 2016

Lower oil prices have boosted margins since 2013

As described above, capacity utilisation in its widest sense, is the most important driver of airline industry operating profit margins.

However, movements in the price of oil (and its derivative, jet fuel) can also have an impact on profitability.

The price of Brent crude oil rose from a range of USD20-USD40 per barrel for most of the period 2000-2005 to a range of USD100-USD120 in 2011-2014 (with a good deal of volatility in between, including a spike to more than USD140 in 2008). More recently, Brent prices have fallen to a range of roughly USD40-USD60 since early 2015 (and briefly falling below USD30 in Jan-2016).

The fall in oil prices has translated to a reduction in airline industry fuel costs as a percentage of revenue and this has had a beneficial impact on airline margins since 2013.

Brent crude USD per barrel Jan-2000 to Jul-2017

Historically, the relationship between oil prices and airline profits has been affected by a range of factors including fuel hedging, currency movements, aircraft fuel efficiency and the relationship between fuel prices and airline yields.

In the period 2003 to 2007, oil prices and airline margins both rose together, thanks to a good supply/demand balance, which allowed airlines to raise fares in order to absorb higher fuel costs.

Since 2007, however, airline operating margins and fuel costs as a percentage of revenue have followed a broadly inverse relationship.

During the period of USD100-plus Brent crude oil prices, airlines were forced to adjust their non-fuel costs in order to survive. Fuel costs were 32% of revenue for the world airline industry in 2013 and dropped to around 19% of revenue in 2016.

Although this is not the lowest ever level (fuel costs were only 9% of revenue in 1998), it is the lowest level since the industry had to restructure its non-fuel costs, leading to a positive impact on profit margins.

World airlines: operating margin (% of revenue) vs fuel cost as a percentage of revenue 1975 to 2016e*

Lower fuel prices have contributed to lower air fares

One of the key drivers of increasing rates of fleet growth is the relatively low fuel price environment since mid-2014. This has helped to keep some older aircraft in the air and has stimulated accelerating capacity growth.

Lower fuel prices have also contributed to lower air fares, through the mechanism of higher capacity growth. From IATA data on passenger revenues and passenger numbers, it is possible to calculate average passenger revenue per passenger. The rise and fall of this approximate indicator of passengers' average spend per journey coincides with the rise and fall of average oil prices each year, albeit with smaller rates of change.

From 2014 to 2016, passenger revenue per passenger fell by 19% from USD163 to USD129, while Brent prices fell by 55%. After the average annual oil price peaked in 2012, it had dropped by 60% in 2016, while revenue per passenger fell by 26%.

World airlines: passenger revenue per passenger* (USD) and Brent crude oil price per barrel (USD) 2004 to 2016e

Lower fares have stimulated traffic growth - along with emerging markets and LCCs

Lower fares have been a contributory factor in the high rates of passenger traffic growth by comparison with world economic growth in recent years.

The airline industry remains cyclical, with the economic cycle a key driver. Global GDP growth is an important determinant of growth in global RPK growth. However, as previously highlighted by CAPA, a given level of GDP growth appears to be driving higher traffic growth in the current decade than previously.

World GDP growth has been below its long term average of 3.1% since 2010, when it reached 4.1% and RPK growth reached 8.0%. Nevertheless, RPK growth was close to its long term average of 6.2% in 2014, when it was 6.0%, and exceeded it in 2015 (7.1%) and 2016 (7.4%).

RPK growth is forecast to remain above its long term trend in 2017 and 2018, although GDP growth is forecast to remain below its long term trend in both years.

Higher traffic growth rates have almost certainly been stimulated by lower average fares.

This also has two further aspects, namely the increasing share of world airline traffic of faster growing emerging markets and the growing LCC share of traffic.

World GDP growth* and world airline RPK growth** 1971 to 2018f

Capacity and cost discipline remain key - but low fuel and profitability reduce the ascetic edge

With fuel costs forecast to start rising again, albeit not as much as in the previous CAPA forecast, the challenges for the industry remain as highlighted in CAPA's Jan-2017 update of the model. These challenges are to maintain a tighter grip on its capacity discipline, which is necessary to shore up unit revenue, and to renew its efforts to cut non-fuel costs.

It is a commonly repeated theme across the industry that the intensity of cost reduction measures has been dimmed by the lower fuel prices. While there is little specific evidence of this (other than eg the retention of less fuel efficient aircraft in fleets that would otherwise have been grounded), this is a natural response where an (external) reduction in fuel prices can easily outweigh the fruits of internal cost management.

Furthermore, the US majors in particular are showing greatly diminished willingness to keep a lid on salaries, even locking in significant increases for future years. These again are arguably inevitable as the airlines emerge from the dark days of bankruptcy and as staff become more reluctant to show restraint when profitability is being trumpeted to Wall Street. Yet these developments do have sobering echoes of earlier periods.

In other areas where management do have direct control, the cut in forecast fleet growth for 2018 in this Jul-2017 update relative to the Jan-2017 model is encouraging for capacity discipline, although fleet growth is still rising in each year of the forecast.

CAPA's Jan-2017 update of the model noted the following:

"The airline industry's profitability is likely to remain cyclical, but if it can restrict the fall in margins in a downswing so that the midpoint of the cycle is higher than in previous decades, this will be a significant achievement."

The current update, with raised margin forecasts, suggests that the airline industry is getting closer to demonstrating that this is possible. If CAPA's margin forecasts are borne out, the world airline industry will have experienced at least four successive years of operating margins in excess of 7%, comfortably above the level previously associated with cyclical peaks.

While encouraging - and over this period airline stocks have consistently outperformed the wider market as a result - this is certainly no grounds for complacency. Maintaining similar margins beyond 2018 should be the goal of current planning, if the industry is to evolve from being viewed as mere trading stocks into an investment grade business.