Kevin O'Toole/LONDON
A casual observer might assume that the world airline industry had cause to congratulate itself. Profits are up and growth is more or less rolling along nicely, despite the economic crisis in Asia. But the airline industry has been here before. Ten years ago, carriers were similarly riding high on the boom of the late 1980s, then blew it spectacularly as recession and the Gulf War plunged the world into deep recession.
As traffic boomed, so airlines battled for market share and fought to book positions on aircraft production lines lest they should run out of capacity. Profits hit a plateau and costs rose while the new capacity came into fleets on the promise of boundless future growth.
By the time aircraft production was starting to peak in the early 1990s, the world had plunged into unceremonious recession and the airlines were bleeding red ink - as the chart on the next page amply demonstrates. Estimates suggest that airline groups had collectively posted losses of more than $20 billion by the time the recovery began in earnest three years ago.
In short, the airlines went through a similar, albeit more severe, version of the boom-to-bust cycle that has repeated itself over decades. On the face of it, the stage is now set for a recurrence within the next couple of years. The question facing the airline industry is whether it can break with history and avoid going into a profits tail-spin if and when the downcycle does take place. There is quiet confidence among some that it can.
The current state of aviation has all the characteristics of an industry on the top of the cycle, looking down. Aircraft orders have soared over the past two years, with 1997 looking like becoming the high point of this cycle. Production lines at Airbus and Boeing are now gearing up to hit new peaks some time next year. Between them they should be producing some 800 jet airliners annually from 1999 onwards.
Neither is there much dispute among economists that some kind of downturn in the world economy is on the cards. The only uncertainty is over how severe and how soon. The best estimates suggest it will come within the next two to three years, but in the shape of a steady decline rather than the precipitous drop of mid-1990. In turn, that means lower short-term traffic growth. As a rule of thumb, up to three-quarters of airline traffic growth is directly linked to the health or otherwise of the general economy.
Airline profits already appear to have hit their traditional plateau. Figures from the International Air Transport Association (IATA) suggest that returns from its members have been bumping along the top. Its figures for international scheduled services (one of the more dependable series of statistics) show that a vigorous return to collective profits of $5.2 billion in 1995 dipped back again before righting itself a little last year to regain the $5 billion mark. The hope had been that it would rise steadily.
The returns last year would clearly have been higher but for the unfolding economic crisis in Asia, and IATA expects worse to come. Its latest estimate is that the regional downturn will shave some $2 billion off airline international results this year, taking the total again below $4 billion, despite boom times elsewhere in the world.
Perhaps a more positive picture emerges on corporate profits, taking into account all airline group activities. IATA reckons that the net result here rose to $7.2 billion in 1997, helped by booming domestic markets in the USA and Europe, as well as some tougher corporate housekeeping, including paying down the debts built up during recession.
A similar steady improvement in the industry's overall profitability also comes through from the tentative figures issued by the International Civil Aviation Organisation (ICAO). Its preliminary results, covering the bulk of scheduled airlines, suggest that the industry set a clear record on operating profits of some $16.5 billion last year. That represents its highest operating margin for three decades, at 5.7%, only bettered in the late 1960s as jet transport came of age.
The improvement comes with cautions. Even at these levels, the return on sales is hardly thrilling, as IATA director general Pierre Jeanniot has pointed out more than once. The most optimistic figures coming out for last year still peg the industry's net margins at less than 2.5% - incidentally, below the level of the boom ten years ago. That is a wafer thin fair-weather margin to defend when going into recession and not a great advertisement to attract investors.
Admittedly, the headline figure disguises better individual performances around the world, as a glance across this year's top 50 rankings shows. The major airlines included in the ranking - essentially those with annual sales of $1 billion or more - have themselves outperformed the industry as a whole. Their collective operating margin rose to above 7% for 1997 and the net profits came close to doubling, to reach $8.4 billion.
The figures come with the inevitable health warnings about variations in accounting standards and exchange rates. The continuing rise of the US dollar alone has imposed heavy penalties on airlines with revenues in weakening currencies, but with dollar costs on fuel, aircraft and often debt.
Yet there is no disguising the success at the top of the table. Major US carriers are now consistently hitting operating margins of close to double digits or above, helped by their strengthened grip on a thriving domestic market, the full impact of low fuel prices and another couple of months without the domestic ticket tax. Net profits from the US big three of American, United and Delta Air Lines are now touching the $1 billion mark. Only a few years ago their losses were equally impressive.
In all, seven of the world's top ten largest profit-makers are from among the US airlines, including those miracle recovery stories of Continental, Northwest and US Airways.
The European carriers are still lagging, with a strike-hit British Airways falling a little from grace, but the dramatic turnarounds have begun. Previously state-owned carriers such as Air France and Alitalia are on their way back, albeit with a generous helping of state aid.
ASIA's FLU
Perhaps unsurprisingly the list of loss-makers is headed by the Asian carriers now struggling with what looks like a descent into recession. More of the bad news is still to unfold. Garuda Indonesia is clearly struggling to survive under its debt mountain, while Philippine Airlines took out full page newspaper advertisements to spell out the damage caused by its recent pilots' strike. Both have announced plans for swingeing cuts in international services as they send back leased aircraft they can no longer afford. Neither has yet published its final accounts for the latest financial year, but heavy underlying losses seem inevitable.
Japan has officially entered recession and Chinese airlines have begun to suffer this year as the country struggles to meet even its reduced economic growth targets.
The bad news has already had airline economists rushing to recalculate their figures. Boeing market forecaster in chief Tim Meskill admits that the company was still hoping until the end of last year that the crisis in South East Asia would prove a temporary blip in the region's growth rates. It has since become clear that what started with turmoil on financial and currency markets a year ago is fast developing into a full-blown economic downturn. Boeing delayed the launch of its latest long-term forecasts by two months as it tried to assess the impact of prolonged recession.
When the forecast did arrive, Boeing had trimmed its world traffic estimates for the next five years by 2.5 points on major routes within Asia and another 1-1.5 points for intercontinental travel. That in turn led to an outlook for 150 fewer aircraft deliveries than expected. A relatively modest cut, which would still leave production lines running at near record levels.
That is based on Boeing's estimate that the worst-hit Asian tigers will go into outright recession within the coming year and not return to their historic growth rates for another four or five years.
Investment analysts at Salomon Smith Barney forecast an overall 1.5% decline this year in the Asia-Pacific economies outside Japan, compared with 6.5% growth in 1997. It warns that heavy and occasionally "excessive" discounting of airline tickets will intensify as the region's carriers struggle to cope with too much capacity and inelastic demand.
Hopes that weak currencies will stimulate in-bound tourism have yet to materialise for many. There are signs of some increase in travel to Thailand, although to the benefit of European airlines as much as Thai Airways, but elsewhere the television images of rioting and social unrest are unlikely to have the holidaymakers flocking.
Earlier this year, IATA slashed its passenger traffic forecast for Asia Pacific through to 2001 as evidence mounted of a prolonged slump. An above average 7.7% annual growth rate is now set at a more modest 4.4%. It expects that this will translate into a cut of $1.5 billion for airlines flying out of the region.
The problems have started to show through in the 1997 financial returns from the major carriers in the top 50 ranking (see table). Load factors are almost universally down as traffic rates sink, but new capacity continues to arrive at a rate of 8-10%. Heavy discounting has put pressure on yields, while currencies in free-fall have raised dollar costs.
Already in 1997 the lack of economic confidence among the former Asian tigers had fed through into depressed traffic figures. While intercontintental traffic flows from the region were still bearing up strongly, there was a 3% fall in passenger numbers for the intra-Asian services, which are the staple of the region's international business. Returns from the region so far this year show abundant evidence of further deterioration. By March traffic was down by 8% and load factors off by six points.
In short, the region is experiencing its own local version of the boom-to-bust cycle that the rest of the world experienced five years ago, but which Asia largely escaped, courtesy of its apparently unstoppable traffic growth.
So far, the crisis has largely been contained within the region, with Western carriers able to soak up capacity with growth elsewhere. Latin America for one is already being eyed up as a new Asia.
Not all are confident that Western markets will escape so lightly. Chris Avery, aviation analyst at Banque Paribas and an early pessimist over Asia, cautions that the crisis there could yet cause problems in other markets, such as that of the transatlantic, as capacity being pulled out of Asia has to find a new home. His prediction is that next year will now prove to be the current peak for new aircraft deliveries as the cycle turns.
Even if Asian flu fails to spread, the crisis may prove a timely wake-up call. The major Western economies are themselves being watched for signs of slowdown, with the most bearish suggesting that the beginnings could be no more than a year away.
The US economy is still enjoying its most sustained spell of continuous growth in recent history, but there is growing nervousness that it must soon end. There are also worries that the sterling growth within Europe's buoyant national economies, which produced last year's unexpected 10% rise in air traffic throughout the region, may be in danger of overheating later this year or early next. Uncertainties also hang over next year's introduction of a single European currency across much of the region.
THE CYCLE IS FOR TURNING
If the cycle does begin to turn down, Meskill nevertheless argues that there are at least a couple of good reasons why there need not be a repeat of the world glut of capacity that destroyed profits in the last slump.
First, a large proportion of the order backlog is for replacement aircraft rather than additional capacity. Some 60% of units to be delivered over the next 18 months are for narrowbody airliners, largely to replace an ageing US fleet that entered service during the 1960s boom. Those 30-year-old aircraft are not only reaching the end of their economic lives, but there is the added spur of meeting stage III noise regulations. Throughout the world, airline fleets have retained a relatively large number of ageing aircraft which could be retired comparatively painlessly if and when capacity needs to be cut, rather than parked as in the last downturn.
Second, and perhaps more encouragingly, the level of aircraft ordering has simply been more restrained this time around. "Despite any similarities, the current cycle has evolved at a more measured pace," says Meskill. Orders booked over the last couple of years have represented capacity of around 8-9% of the world in-service fleet. In the unprecedented spike of 1989, there were orders for over 2,000 jet aircraft in one year alone, equivalent to 21% of the world fleet.
Neither is the order backlog at the same dizzying heights. Boeing reckons that, today, it represents around 25% of the world fleet, compared with over 40% at the previous peak. Meskill points out that the current ramp-up in production may look dramatic, but that 1997 represented in fact the first real rise in output since the last decline.
Despite Boeing's hopes to the contrary, there is also some evidence that, after only a couple of years of modest growth, the latest order spree is already beginning to run out of steam.
Meskill admits that Boeing will be watching hard for signs that the cycle is indeed coming to an end for the manufacturers. Key indicators will be the take-up of options in the second half of this year, along with the ability of leasing companies to find takers for their aircraft over the next two years.
Manufacturers, themselves having been caught out by the last recession, have been working at strategies to smooth future cycles - not least becoming more responsive to market shifts by cutting the time it takes to build and deliver new aircraft.
The long-range rolling orders, like those Boeing signed with American and Delta, also allowed the major airlines to spread deliveries more smoothly over a decade or more and to make type changes along the way if markets dictate. The mantra of staying flexible has even led British Airways to talk of a "power by the hour" deal for its short haul fleet renewal.
There are signs that the airlines themselves have learned their lesson from the last slump. "The hurt of the early 1990s is still very vivid and very real," says Chris Tarry, lead aviation analyst at Dresdner Kleinwort Benson. He has long argued that there has been fundamental structural change taking place within the major carriers as they work to stay in control of cost and capacity. In short, that the airline market may at last be showing signs of becoming a more mature commercial industry.
He admits that, a year or so ago, the European market showed "worrying similarities" with previous cycles as the reins seemed to be loosening on cost and capacity, but, since then, the screw has again been turned. In previous recessions, the temptation was to let the business run ahead unchecked in a bid for market growth. Now, the structural cost reduction programmes put in place by the likes of BA, KLM and Lufthansa have come into action to check costs and keep capacity in hand.
In part, the task has been eased by some long overdue restructuring of monolithic airline groups, which attempted to manage everything from mainline passenger services and maintenance through to cargo and catering. Now the units have been separated out into stand-alone businesses and, if necessary, outsourced. Lufthansa and the SAir Group (of which Swissair is merely another subsidiary) are both cases in point, as is BA's drive to strip out everything that is non-core. "It allows you to set clear targets and measure your performance and you can make people accountable," says Tarry.
Europe's once cosy state-owned flag carriers, also having to face up to some harsh commercial realities, no longer rely on governments for helpings of cash or protection in their domestic markets. The drive to attract new investors by the likes of Alitalia and Air France, now on the long haul to privatisation, has visibly focused minds, believes Tarry. "The presence of the shareholders standing there is a quite a powerful influence. You get much more rational market behaviour," he says, adding the reminder that investors need to be convinced by solid cost management. "Airline are not a must for an investor to have in their portfolio," he says.
The old pursuit of market share for its own sake does appear to have given way to a more selective approach to growth. Airlines in continental Europe, such as Lufthansa, cut back quickly in 1996 when demand wobbled and have shown the gains in their 1997 profits. Increasing sophistication in managing networks and yields seem to have added an extra edge in tailoring supply to demand. The Asian downturn is a case in point. "Western airlines cut capacity very quickly, which they simply wouldn't have done ten years ago," says Tarry.The past inclination was to tough out the bad times until the damage began to show.
As a result, passenger load factors have continued to edge up steadily around the world, with IATA figures showing that they crept up another point last year, to hit 70% on international services. In the previous up-cycle load factors had hit a plateau around the 68% mark until the recession hit.
The stellar results from the US airlines also show what can be achieved with a good tailwind from a strong economy. Passenger yields have been stable and capacity kept in check, although the current round of union wage negotiations coupled with any economic slowdown will put resolve on costs to the test.
The emergence of global alliances should also help in making the world airline market a little more manageable and possibly more rational. Assuming they can find a way through the competition issues now dogging the tie-ups on either side of the Atlantic, at least three dominant groupings should emerge, led by Lufthansa/United in the Star Alliance; BA/ American and KLM/Northwest (now with Continental and Alitalia in train). Swissair is leading a less ambitious fourth grouping with its Qualiflyer Group and transatlantic tie-up with Delta. On present standings, over half of the world's top 50 airlines would be signed up to one or other of these four groups, if the current US pacts pending between United/Delta and American/US Airways go through and the Asian airlines begin to throw themselves more wholeheartedly into the global alliance circuit.
Tarry for one is watching closely for signs that the Asian downturn will begin to force a little more commitment from the region's carriers in signing up to long-term alliances. "In the past, they have noted the trend in Europe and North America from a distance, but they were never fully convincing," he says. That may change as economic pressures come to bear. A key test will be if Singapore Airlines (SIA) follows through its link with Lufthansa (including joint bids in the forthcoming Thai and South African Airways share sales) and signs up as a full Star member. That would bring with it SIA's existing partners Air New Zealand and Ansett to create imposing Asia Pacific bloc. Cathay Pacific and Asiana are meanwhile flirting with BA/American, while Malaysian Airlines is edging towards KLM.
The presence of alliances controlling a sizeable wedge of world traffic need not mean reducing competition levels. The airlines now pleading their case to competition authorities argue that the battle will simply shift to fierce fighting between alliance groupings rather than individual players. What it does imply, however, is a reduction in the number of unaligned competitors, which at least should make the market more manageable and potentially less prone to the frenzied fight for market share.
It was American's former chairman, Bob Crandall, himself a veteran of some bloody US fares wars, who famously bemoaned the fact that the airline industry was "only as smart as its dumbest competitor". The hope now is that the industry has begun to wise up after learning its lessons from the last downturn.
Source: Flight International
