In a global industry like aviation, assessing a company's true financial performance is a difficult task. Carriers around the globe report their results in a variety of ways, under different accounting rules. Airlines themselves could begin to ease the process of comparison, not least in providing clearer information on how non-operational factors, ranging from currency fluctuations to asset sales, have influenced their reported results.
There have been recent moves to harmonise reporting rules through the International Accounting Standards (IAS), championed by securities authorities and accountants around the world. But only two major carriers, Lufthansa and SAirGroup, have so far moved over to IAS standards and even as others start to align their financial reporting, pitfalls will remain for investors in search of a true measure of underlying performance.
It was to help in that elusive quest that Airline Business launched Bridging the GAAP, a guide to world accounting principles and airline financial performance. Six years later, with the launch of a revised edition (see panel), we look again at some of those distortions that can influence the figures which are reported on an airline's bottom line.
Economic factors
Not all of the factors that can distort a company's accounts are within its control. No business is immune to the trading conditions of the economies it serves and airlines are no exception. But there are aspects of the economic cycle that can be measured to help evaluate an airline's underlying performance. Most obvious are currency fluctuations, interest rates and fuel prices.
To a degree, a company can hedge against some of the impact of external factors, although this only tends to be cost effective in the short or medium term. While an airline might hope to damp down the immediate effect of fuel price rises, the cost eventually feeds through.
Equally, it is almost impossible to protect against the radical impact that an exchange rate shift can have on the value of ticket sales in a foreign market. Although the risk could technically be offset by paying out costs in the same currency (known as "natural hedging"), in practice it is not so easy to balance streams of revenue and cost. Most airline costs are either denominated in US dollars (such as fuel) or paid in the national currency of its home market. Currency risk hedging on more definable costs, such as borrowing and fuel purchases, may be realistic.
While many carriers provide analysis of fuel hedging (and in particular how far they are hedged in for future trading periods), few give information on the overt financial impact of currency shifts on their operating incomes and expenses. That alone would give investors a clearer understanding of underlying earning potential.
Special items
Even without these external economic factors, there are questions to ask about how a carrier has treated items on its profit and loss account. Leading indicators of profitability, such as net income or operating result, give no guarantee of a meaningful comparison unless it is clear what definitions have been used. Is the net result given before or after tax? Are items such as depreciation included in operating costs? Has interest received been treated as income?
These variations make understanding underlying performance difficult and even more so if there are special gains and charges further clouding the picture. Take the following example (see table below): if Company A reports a pre-tax profit of $375 million, it would appear to have significantly underperformed in comparison to Company B with profits of $625 million. However, in this example, both companies have actually performed identically at the operating level. The gap is due to the fact that Company B has twice the level of non-operating gains on asset disposals and exceptional or extraordinary items.
Profit and loss is only part of the story. The cashflow statement and the balance sheet will be needed to make the performance judgement. So Company A may end the year with more of its saleable assets still in place. But in that case it may have performed worse as measured by return on assets. In short, there can be as much judgement as science in calculating underlying success. But investors need the information on which to base that judgement.
Airlines, in particular, have a tradition of accumulating non-core assets that, when trading conditions demand, can have considerable benefits. Selling non-core operations or aircraft has been a common method of realising gains in the bad years.
The IAS accounting guidelines already attempt to define extraordinary items. The rules state that they are income or expenses arising from events or transactions that are clearly distinct from the ordinary activities of the enterprise and therefore should not recur frequently. Ordinary activities are any which an enterprise undertakes as part of its business and related activities to further the business whether incidental to or arising from these activities. The nature and the amount of each extraordinary item should be separately disclosed. But that is not always the case.
The recent round of year-end reporting by the major US airlines shows the extent to which headline profit figures can be distorted by gains made on the disposal of non-core assets, including the sale of stakes in global distributions system (GDS) companies such as Amadeus and Galileo, as well as shares in Equant, the commercial systems company floated off from SITA. That allowed many of the groups to show net profits that were ahead of their operating result:
* Continental Airlines saw its operating performance fall by 14%, yet the sale of its investment in Amadeus increased its net income by 22%.
* Delta's operating performance was also down 25%, but it reported non- operating benefits, excluding interest charges, of $901 million. That reflected gains from disposals of stakes in online auction site priceline.com, former partner SAirGroup and in Equant. After taking off charges for early retirement of aircraft, that left net income up 19%.
* Northwest Airlines also had a major non-operating benefit of $123 million, again mostly from its sale of part of its investment in Equant. However, its results were already distorted by recovery from the damaging pilots strike of 1998, which had sent it to a loss of $191 million.
* United Airlines saw operating performance fall by 6% while net income improved by 50% as a result of a $669 million gain from the sale of its Galileo investment and a further $62 million from Equant.
* US Airways' operating performance fell by 86%, but its net income by only 51%. Again this principally reflected disposals of shares in Galileo and Equant.
Together, these five US majors experienced a 12% fall in operating profits for 1999, but reported a 39% rise in net income thanks to non-operating items. Of course, all of the carriers have appropriately disclosed the impact of these exceptional charges. Otherwise it would have been near impossible to use the example. However, it does illustrate the dramatic impact that non-core gains can have on results. Other airlines over the past year have similarly benefited from stock sales, in particular in the information technology sector. But not all have given the same level of disclosure.
It is to be hoped that a growing number of carriers will see the longer-term advantage of such disclosures, helping financial analysts to maximise their understanding of underlying company performance and have greater confidence in investment recommendations.
| US major results and exceptional items – YEAR 1999 | ||||||||
| Airline Group | Operational result | Exceptional items | Net income | Main source of exceptional gains | ||||
| $ (m) | change | 1999 | 1998 | 1999 | 1998 | Change | ||
| Continental Airlines | 600 | -14% | 305 | 11 | 488 | 400 | 22% | Amadeus |
| Delta Air Lines | 1,359 | -25% | 901 | 39 | 1,285 | 1,078 | 19% | Equant, priceline, SAir |
| Northwest Airlines | 714 | -474% | 123 | 16 | 300 | -285 | -205% | Equant |
| United Airlines | 1,391 | -6% | 771 | -31 | 1,243 | 827 | 50% | Galileo, Equant |
| US Airways | 139 | -86% | 298 | -2 | 273 | 559 | -51% | Galileo, Equant |
| All five carriers | 4.200 | -12% | 2,398 | 33 | 3,589 | 2,579 | 39% | |
| Example: profit and loss sheet comparisons | ||
| Operating result | Company A | Company B |
| Operating revenue | 1,000 | 1,000 |
| Less: Operating expenditure | -850 | -850 |
| Operating profit/(loss) | 150 | 150 |
| Non-operating items include |
|
|
| Profits from associates and other investments | 25 | 25 |
| Interest payable and receivable | -50 | -50 |
| Profits on disposals | 100 | 200 |
| And exceptional or extraordinary items | 150 | 300 |
| Profit before tax | 375 | 625 |
| Tax – 40% | -150 | -250 |
| Profit after tax | 225 | 375 |
Source: Airline Business
