Airline profits to rise but margins remain miserable

A quick comment on what in normal circumstances would be seen as positive forecasts to emerge from the International Air Transport Association (IATA) suggesting that airline profits should reach $19.7bn for the year 2014 – up from an already upwardly revised figure of $12.9bn profits expectation for 2013. Any improvement is welcome of course but given that the $19.7bn suggested is based on revenues of $743bn any finance or investment manager worth his or her salt would be forced to conclude that based on the financial risk of airlines, the margin remains unacceptably low.

IATA sensibly points out in its forecast revision and expectations of 2014 that competition remains very tough, that yields are deteriorating and that in terms of net profit contribution per passenger carried, the figure is barely $5.94 each. Naturally, investors and commentators will be pleased to see any improvement in profit but they will also recognise that if the world economy is improving, as a great many believe that it is, there will be potentially better investments to look at than airlines.

Virtually all airlines that had not taken the plunge to order new aircraft over the past five or six years are now modernising their fleets. In doing so they are replacing older, far less efficient aircraft, with more fuel efficient planes that probably seat more passengers than the aircraft they replace and also come with a reduced operational cost. If there is any good news for airlines it is that fuel costs are off their previous peak and appear to have now steadied. However although cost of aircraft operation is shrinking, the cost of airline operation certainly is not. The big trouble is that the industry is now so competitive and the business models inefficient that any benefit from new aircraft is all too easily mopped up by the airline needing to reduce fares to stay competitive on the route. Ryanair is one such airline that having found its profits squeezed partly through increased competition, and maybe through its own fault, has been forced to reduce ticket prices and other additional costs charged to customers – an example of this apparently being a cut on the cost of putting baggage on the plane.

On international routes the rise and further rise in size and capacity of Middle East airlines to compete on world airline routes is another factor that is already having a negative impact on the earnings of mature legacy or flag carrier airlines. While profits at US based airlines such as Southwest are growing well as the airline spreads its wings further away from reliance on discount ticketing the outlook for other airlines is far from clear. Clearly there are continuing consolidation benefits to be had provided regulatory deals that allowed airlines to merge (US Airlines and AMR) are not too onerous. But the worry is that some US based airlines have been putting forward heady expansion plans rather than doing what investors would prefer, reining in costs. The federal budget sequester also had some negative impact on earnings during 2013 and air traffic problems, and an increase level of bad weather, have also impacted negatively during the year. These problems may be less than predictable but they could all resurface again in 2014.

In Europe, Alitalia’s struggles continue just as they have for the best part of one or maybe as long as two decades! While Alitalia’s large shareholders have I understand backed yet another financial initiative to prop up the airline no one is in any doubt that removing the life support machine would see Alitalia quickly disappear.

IAG which includes British Airways and Iberia looks to be doing very well and with an even stronger outlook in prospect. Air France KLM continues to struggle but latest indications are that the airline will at least make an operating profit in 2013. German airline Lufthansa is also struggling to grow profits by much but at least the airline remains profitable overall. So a mixed picture that doesn’t quite stack up to nice headlines that the latest IATA forecasts for 2014 might better portray. Indeed, for a great many airlines in Europe both the current position and the outlook remain tough. Thankfully EasyJet is doing very well and buoyed in part by having great management, a sound business model and what’s more, sticking to it. I suspect I may be shouted down in flames by those for whom it doesn’t always work like that but suffice to say that the success of EasyJet may be because it has learnt from the past and that it is now offering customers far more of a decent service than other so-called no-frills/budget airlines do. Last but not least in this quick round up is to remind that on the other side of the world the picture is no less good either with Qantas Airlines causing analysts much angst just last week through issuing a very serious profit warning.

The bottom line is that there are still far too many western based airlines chasing a broadly similar number of customers looking to fly. While ticket prices have in theory fallen as a response to greater competition another negative factor to take into account is the increased level of regulation requirement. Insurance, environmental and emission based taxes also continue to chip away at any bottom line cost or profit benefit available to customers and airline management. Airlines also have to pay substantial amounts to buy or lease the vast number of new planes on order. Right now financing is not that much of a problem but if interest rates go up and supply of finance dries up there could be trouble ahead. Of course financing is not a problem if your airline is state-owned or controlled such as most in China and across the Middle East. For these, expansion is the order of the day and made all the easier for that. But for airlines in mature western states there is no such government support available meaning that the competition playing fields are hardly to be considered flat. Soon it may even be possible to envisage an even larger gap emerging between ticket prices of western based airlines and those that are based in the Middle East.

Another factor that goes against the potential for airlines to raise margins is the rise of airport costs. Britain is the perfect example with its airport system nothing short of a joke in terms of meeting current, let alone future capacity increase, requirements. Britain has already lost out on its ability to be the major hub for intercontinental traffic but at least its government remains keen on railways! Next week the Davies Airport Commission will probably kick the proposed Boris Airport into touch and as a preliminary recommendation suggest that three different options for the expansion of airport capacity in the south should be considered. One will be for an additional runway at Heathrow; one will maybe suggest two additional runways being built at Heathrow and a third will be to look at building one new runway at each of Heathrow and Gatwick. I have no problem with any or all of these provided that the digging starts very soon. But that isn’t going to happen any time soon not least because the Government in its infinite wisdom has decided that the Davies airport commission will not be allowed to report it final findings until after the next General Election. Just how ridiculous is that!

Howard Wheeldon FRAeS
Wheeldon Strategic Advisory Ltd,
M: +44 7710 779785
hwheeldon@wheeldonstrategic.com

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