The pace at which airline financials continue to improve, despite earlier expectations that the peak of the cycle had passed, has hardly slackened. More gains are predicted for the next year or two but the longer-term outlook remains uncertain.
This is turning out to be a cycle airline executives and investors dream about. Revenues have now grown by double digits for three consecutive years and operating profits have improved for five consecutive years. More importantly, the peak keeps on being extended. At this time last year many feared the peak had been reached in 2005 but based on the figures posted by the world's top 150 airlines, 2006 in the end turned out to be significantly better than 2005.
Many leading forecasters have recently revised their forecasts upward and now expect the industry to collectively turn an even higher profit in 2007 followed by a yet bigger profit in 2008. "We're positive we'll continue to see improvement into next year," says IATA chief economist Bryan Pearce who now expects a $5 billion net profit in 2007 and a $9.6 billion profit for 2008.
IATA members reported a $500 million net loss in 2006. The Airline Business World Airline Ranking, which is based on the world's top 150 airlines including low-cost carriers and other non-IATA members, show a net profit last year of $2.14 billion. This was the first time the top 150 collectively turned a net profit since 2000. The top 150 has been chalking up steadily rising operating profits every year since 2002.
"The cycle has been longer than many people expected," explains ABN Amro analyst Andrew Lobbenberg. "World economies have been healthy, stock markets have been strong and premium traffic has remained strong on the back of capacity restraint."
But do not get fooled by the short-term predictions. This is a cycle in which carriers have banked far less than previous cycles, including the last cycle which peaked in 1997. Predicting exactly when the next downturn will occur is very hard, but many fear it will be sooner rather than later, and harsh.
"We still think there will be a downturn," says Lobbenberg, one of many leading airline industry analysts who originally thought the cycle had peaked in 2005. "We're cautious," he adds.
Blair Pomeroy, a senior partner at the Oliver Wyman management consultancy, also predicted last year the peak had passed and now says it is too hard to predict when the downturn will begin. Economies across the world have remained healthy, at least for now, but oil prices are spiking again and there are a lot of uncertainties. "You put all these things in the witches' brew and what comes out, who knows?" Pomeroy says. "We're long in the cycle and there's a variety of headwinds and tailwinds."
Most likely the scenario is for the industry's financials to improve over the short-term on the back of a return to profits at US majors. North American carriers among the world's top 150 collectively turned an operating profit of $8.2 billion in 2006, although one-time items related mainly to bankruptcies led to a $6.6 billion net loss. Both figures represented significant improvements over 2005. While North American carriers will likely finally return to the black this year because they are now all out of bankruptcy, the operating profit could start to fall again after three years of steady improvements.
The US-based Air Transport Association (ATA) forecasts the US industry will collectively turn a $4 billion to $5 billion operating profit this year and an even smaller operating profit in 2008. "I think 2007 will be the peak of the cycle," says ATA chief economist John Heimlich.
The US downturn
Heimlich expects a slowdown in the US economy plus capacity additions caused by the launch of Skybus and Virgin America to usher in the start of a downturn next year. The recent surge in operating profits was made possible by capacity constraints that led to a 1.3% drop in US domestic capacity last year and significantly higher yields. But US carriers may find it difficult to squeeze yields any higher. "There are clear signs of saturation at the current price point in the domestic US," Pomeroy says.
Over the last two years US carriers have been aggressively transferring capacity to international markets with successful results. But some international markets, including the transatlantic and USA-China, may become oversaturated. Heimlich warns EU-US open skies and liberalisation in the USA-China market could lead to even more capacity and competition. Pomeroy says US carriers are enjoying another fantastic summer over in the North Atlantic despite big capacity gains, but "things are cyclical" and "eventually some of this will be pruned".
Asia and Europe are expected to start cooling off even sooner. "We believe there should be a downturn on the way but we believe it should be manageable," says the Association of European Airlines (AEA). For European carriers, the peak was likely 2006. Revenues among European carriers in the Airline Business top 150 surged by 16.5%, beating a 9.3% increase in 2005. Operating profits increased from $4.9 billion to $5.5 billion and net profit inched up.
However, the AEA says there has been "a distinct slowdown" in recent months, which has forced it to shelve its previous forecast for a higher profit in 2007. It says 2007 is now expected to be less profitable than 2006, when its members chalked up a 3.5% operating margin, a €2.6 billion ($3.6 billion) operating profit and a record 76.5% load factor. AEA will issue a new forecast but for now says "we're not talking about a crash, a slump or a hard landing".
The gloomier outlook has been caused by an unexplainable sudden drop in the Europe-Asia market, which in recent years has grown steadily and fuelled much of the profit improvements at European majors. In fact IATA's Pearce cited in part strength in this market for raising his global profit forecast for 2007 and 2008.
But AEA figures for recent months show that traffic growth for European carriers in Asian markets has been less than 2%. "Asia has been in boom mode for so long. It started to drop at the end of 2006 and it has continued into this year."
For Asian carriers the peak was back in 2004, when Asian carriers in the Airline Business top 150 turned a combined net profit of $4.5 billion. Net profits surged from $1.8 billion in 2005 to $3.3 billion in 2006 as restrained capacity led to impressive load factors and yields. Asian carriers are expected to roughly match in 2007 their result from 2006 but it will be a long time before the record profit of 2004 will be surpassed.
"We see the industry now in a sweet spot. Things aren't going to get better, but they are not going to get too much worse," says Centre for Asia Pacific Aviation (CAPA) chair Peter Harbison.
He expects yields in Asia "will start to bite" later this year and further drop in 2008 as the arrival of Airbus A380s adds significant capacity. Competition is also increasing, with the growth of long-haul start-ups and more expansion by Middle Eastern carriers in the region. Plans for pan-ASEAN Open Skies, which was expected to lead to big traffic gains in several key markets from the end of 2008, are also in jeopardy. "We've temporarily run into a road block in terms of liberalisation, which is a bit of a concern," Harbison says.
While the region as a whole remains profitable, Chinese and Indian carriers remain unprofitable although revenue gains have moved many of them several places up the ranking. "The region outside China and India is healthy with JAL the major exception," Harbison says.
In the Middle East, there simply may be no downturn because the cycle there beats to a different drum. Middle Eastern carriers in the top 150 saw their revenues surge by 21.7% in 2006. Middle Eastern carriers are expected to continue posting revenue gains of 20% and higher for the foreseeable future, given the huge number of aircraft they have on order. "I don't think growth in the foreseeable future will stop or come to a standstill," says Arab Air Carriers Organisation secretary general Abdul Wahab Teffaha. "Ultimately there will be a normalisation of growth factors but I don't think it will happen soon."
Net profits among Middle Eastern carriers in the top 150 dropped from $606 million to $89 million, driven by big losses at Gulf Air and Saudi Arabian Airlines. But the region's operating profit only dropped slightly. Teffaha expects operating margins will remain healthy and overall financials will improve even as revenues explode.
Arabian advantage
He adds that Arab carriers will be able to profit from the region's natural position as a hub and their ability to quickly expand airports while competing hubs in Europe suffer from capacity constraints. Arab carriers also have lower labour and tax costs than their European counterparts, says Teffaha. "Overall we have an advantageous cost structure. The important thing is to maintain that cost control so it doesn't spin out of control."
So far the rapid rise of the Middle East carriers has not had an impact on European carriers, partly because they now only account for less than 10% of the world market. "The Middle East gets a lot of attention but it's still tiny," says Pomeroy. "They are stealing market share clearly but they are stealing from a growing pie so it's not so noticeable yet."
But Lobbenberg says the impact "has got to come at some stage" and business will be taken away from European hubs. "The scary thing is when they [European carriers] are asked what the strategic response is - there is none," he adds. "We see that as a medium-term threat rather than a long-term threat," says the AEA. "All we can do is keep an eye on it and make sure no law is broken."
In Africa, revenues only grew 3.5% and both operating and net profits dropped by almost 50%. But the region remained profitable overall. There are nine African carriers now in the top 150, including four AACO members from North Africa and five carriers from central and sub-Saharan Africa.
In Latin America, the woes at Varig drove a 6.3% drop in revenues but an improvement in operating and net profits. The region's 5.3% net margin was by far the best among all regions. Varig dropped in the top 150 ranking from 38 to 80 but TAM rose from 43 to 33 and low-cost carrier Gol, which has since acquired Varig, surged from 76 to 54.
Across the world, low-cost carriers continue to rise in the rankings. Besides Gol other big winners include WestJet, which rose from 73 to 60, and Flyglobespan and Sterling, which made the top 150 for the first time. Overall revenues for low-cost carriers in the top 150 grew 29% while revenues at major carriers grew by 12%. Low-cost carriers were also more profitable, chalking up a 5.1% profit margin. Major carriers were unprofitable as a group.
But not all low-cost carriers are profitable and as major carriers restructure the two groups are becoming increasingly hard to differentiate. "I'm a firm believer in convergence," Heimlich says. "Low-cost is a useless definition. There are airlines that make money and there are airlines that don't. That's what matters." Pearce agrees: "This distinction is an erroneous one."
IATA may be confident profits will continue to rise in 2007 and 2008 but also points out margins are not as high as they were during previous peaks. "We're not at a point where airlines are earning enough to cover the cost of capital," Pearce says.
Mature market pressures
This is particularly true in the USA and Europe and Pearce says carriers there have not banked enough profits to resist a shock. Over the medium- and longer-term the outlook in Europe and North America is even gloomier due to the prospect of higher labour costs and regulatory fees, which could make their carriers even less competitive compared with carriers from emerging regions.
Heimlich says ATA is carefully monitoring ongoing negotiations between major carriers and unions, which are demanding a snap back in wages now US majors are back in the black. It is equally concerned several government agencies are proposing new taxes or fees partly because they think airlines can now afford them. "A lot of folks don't want us to be profitable," Heimlich says. "You make an ounce of a profit and you have all this burden." In Europe the AEA has a similar concern and says the potential annual cost of new regulation and taxes is clearly in excess of recent profits.
Heimlich says the impact of new regulations and taxes are impossible to quantify but he expects they will start "chipping away" at profits in 2008. He adds that the "boom or bust cycle" will continue unless labour costs are more closely linked to the demand environment.
Lobbenberg says some European majors think there will be no downturn this time around and consolidation could break the normal cycle and drive an unprecedented string of profits. "Some people are talking about a structural change. I don't buy it," he says. "I just think it's a peak of the cycle."
He adds that while a few carriers have merged and a few others have been privatised, there is nowhere near enough change to fix the industry's affinity with a boom and bust cycle.
Source: Airline Business
