A decade on from the last recession the cycle has again turned down and airline finances are back under intense pressure. But how well is the industry positioned to weather this latest storm?
History, so it is said, has a habit of repeating itself. That certainly appears to be true for the financial performance of the world's airlines. For the past half century the industry has followed the rollercoaster of the economic cycle, lurching from boom to bust. And a decade on from the last bust, the industry appears to be back struggling with the downturn. Yet each cycle brings with it fresh challenges of its own and the current downturn is no exception. Not least is the possibility that growth will not ride to the rescue this time.
The market collapse which followed the unprecedented terrorist attacks of 11 September was clearly deeper and sharper than at any time in the industry's recent history. The crisis that it has left in its wake is still causing severe stress, especially for those reliant on a depressed US market. Witness the huge reduction in stock values over the past year, which has wiped out many billions of dollars of market value among the mainline airline groups. United Airlines, for example, has seen its share price fall from close to $100 in 1997 to less than $2. Ansett, Sabena and Swissair have already disappeared while US Airways has become the first of the US majors to file for bankruptcy.
Perhaps more important are the unprecedented levels of uncertainty and risk that continue to hang over the industry more than a year after the crisis was triggered. While the end of the Gulf War in 1991 signalled the start of a recovery in the world economy, there are few hard indications yet of when the upturn will take hold this time. In the meantime, the industry remains under severe stress, with huge levels of debt and some unfinished business with restructuring.
So where exactly do industry finances stand going into this latest downturn and what strategies will it need to survive and thrive? Here, perhaps, history holds some lesson. And that history is clearly traced through the pages of Bridging the GAAP, the benchmark report on accounting best practice and financial performance which is published each year by Airline Business. Since the first edition back in 1994, Bridging the GAAP has tracked the operating results and balance sheet performance for a group of some 50 leading carriers. Inevitably, the composition of that group has evolved over the years, but the underlying trends of the last decade show through clearly enough.
A starting point is to look at the industry's balance sheet ratios. Not only do they provide a good guide to the industry's fundamentals, but they also ultimately determine the ability of companies to service debts and raise cash. And in the end it is lack of cash rather than lack of profits that causes bankruptcy.
In the main, the asset line of the industry balance sheet has remained remarkably stable over the past decade. Tangible fixed assets, which for airlines largely mean aircraft, have continued to account for a steady 60-63% of all assets. Inventories have come down a couple of points and there is a slight up-tick in cash holdings in the latest 2001/2 financial year, no doubt in preparation for approaching recession, but overall change is slight.
The bottom half of the balance sheet, however, tells a more interesting story in terms of liabilities. While current liabilities, such as short-term debts, have remained flat, there has been clear cyclical movement in the balance between long-term liabilities and shareholder funds. From the depth of the recession through to the height of the boom, theses have each swung by around 10 percentage points.
Shareholder funds decline
Shareholders funds, which typically include the share capital of a company, together with its cumulative profit & loss account, have mirrored the fortunes of the industry as it moved from bust to boom and back. At the start of the decade shareholders funds accounted for just 15% of overall liabilities, but by the late 1990s that had risen to 25%. Since then, they have started to slip and on present indications, as well as past experience, they may have a good deal further to fall.
Behind this volatility, of course, lie the steep swings in the industry's operating results. The decade started in 1992 as the industry hit its lowest point in the wake of the Gulf War crisis, with industry operating margins more or less at breakeven. Profitability then rebounded strongly as the US economy, fuelled by the unfolding IT revolution, led the world back into boom. Industry margins appear to have peaked around the 1997/8 financial year, coming in at 4.2% before hitting the customary plateau. However, results were already heading down again in 2000 as the US economy began to run out of steam. The terrorist attacks of 2001 then turned disaster into outright crisis, with the industry setting a new low as margins hit a negative of -4%.
What also becomes clear from the figures are the marked differences between the regions. The North American groups have shown by far the greatest volatility during the cycle. They started the decade at negative margins of -2.7%, then heading up to 8.5% at the peak, And they were already back in the red, even before the terrorist attacks sent profitability through the floor.
Europe follows a similar curve but much less pronounced. Growth is less explosive but so too are the declines. However, the Asia-Pacific carriers have turned in the most consistent performance despite the region's own financial crises of 1997/8. This shows through in the stability of shareholder funds. For the Asia-Pacific carriers, the ratio has remained fairly steady at around 25% of liabilities over the past 10 years. In contrast, North American carriers start from a low point of 4%, climb to 23%, and slip back to 15% last year even after the US government's cash injection into its industry.
It is not surprising the volatility has been at its most extreme for carriers in the mature and highly competitive North American market. While they have pursued growth most aggressively in the upturn, that has left them more heavily exposed once the cycle declines.
The consistency of North American accounting allows for an analysis of cash flows over the decade, which supports the view that airlines have indeed tended to turn today's profits into tomorrow's capacity growth. Cash from operations was averaging around 12% of revenues for the North American majors during the height of the boom, some three times higher than in 1992. But the outflow on new investments was higher still, peaking at around 15% in 2000, as new aircraft came into the fleet. In short, the profits of the late 1990s were used to raise the capital spend and therefore also to increase debt.
Debt mountain
The extent of the whole industry's rising debts can be captured by looking at the ratio of net debt to total capital. The higher the ratio, the more reliant the business is on borrowing. Again the North American industry provides the most dramatic highs and lows across the cycle. Its debt-to-capital ratio had virtually halved by the mid-1990s on the back of dramatic recovery. But debts again start to rise as aircraft continue to join the fleet, but profits begin to slump. This ratio nosedives after 11 September with the US government having to step in to support its troubled industry.
Although exposure to the cycle has been at its most extreme in North America, the same trends, albeit more muted, have been increasingly visible in other markets around the world too. So where exactly does the industry find itself a decade on from the last downturn?
Many of the leading indicators, such as levels of liquidity, appear to be no worse going into this recession than they were a decade ago. However, there is a much greater degree of uncertainty still lingering over the world economy than there was in the aftermath of the Gulf War and with few prospects of any rapid recovery taking place in the key US market. While traffic is showing signs of picking up in the Asia-Pacific region, for the most part carriers may not be able to rely on growing their way out of trouble. Instead of merely battening down the hatches until the storm blows over, the industry may need to put in place strategies designed to ride out a more prolonged period of bad weather.
Many carriers face significant debt repayment in the near term which will force them to look at fundamental restructuring. Net debt is almost $100 billion for the carriers included in the latest edition of Bridging the GAAP, which includes year-end figures through to June 2002. While cash is higher than short-term debt on average, this is not true for all carriers and hence they will have to find ways to create cash and reduce debt. And not all of the traditional techniques are as available as they once were.
After the Gulf War many carriers leveraged their aircraft assets to raise cash through sale and leaseback deals. But while such deals free cash in the short term, they also add yet more long-term debt on to the balance sheet. Without a recovery in prospect, that could look simply like mortgaging a very uncertain future. In any case, the aircraft upon which such deals would normally be based, including the Boeing 747, are trading at historic lows. Carriers are finding other assets to sell, but many, such as shares in the computer reservation systems, have already been sold.
Instead the pressure is for carriers to get back to the fundamentals and to re-examine their basic business models. Some appear to be doing just that. British Airways with its Future Size and Shape project promised to think the unthinkable as it looked for ways to strip out the unnecessary layers of complexity built up in the business. American Airlines is among those mulling some fundamental changes in strategy, including the possibility of de-hubbing. It may still be unwise to predict any fundamental shift in the industry cycle, but with no sure signs of when or where the next boom will come, it would be equally dangerous to gamble on growth to repair airline finances.
| Restricted BA fare as proportion of fully flexible fare – 8 November 2002 | ||||||
| From LHR to: | Lowest restricted return fare | Restricted out + flexible back | ||||
| 20-Nov | 27-Nov | 04-Dec | 20-Nov | 27-Nov | 04-Dec | |
| Frankfurt | 73.1% | 80.5% | 83.6% | 23.1% | 30.5% | 33.6% |
| Paris CDG | -0.4% | 19.6% | 46.2% | -50.5% | -30.6% | -4.0% |
| Zurich | 76.3% | 82.0% | 78.8% | 26.3% | 32.0% | 28.8% |
| Rome FCO | 73.3% | 73.3% | 76.9% | 24.2% | 24.2% | 26.0% |
| Note: Percentages represent savings over fully flexible ticket both ways. Fare sample taken at 8 November 2002, for first flight out of London Heathrow and most convenient business return. | ||||||
| Balance sheet percentage ratios – Bridging the GAAP 4-02 | |||||||||||
| 92/93 | 93/94 | 94/95 | 95/96 | 96/97 | 97/98 | 98/99 | 99/00 | 00/01 | 02-Jan | ||
| Tangible | 62 | 62 | 61 | 60 | 62 | 61 | 61 | 62 | 63 | 62 | |
| Investments | 5 | 4 | 4 | 5 | 5 | 5 | 5 | 5 | 5 | 4 | |
| Intangibles | 7 | 8 | 8 | 8 | 7 | 8 | 8 | 8 | 8 | 9 | |
| Inventoires & Debtors | 20 | 20 | 20 | 20 | 19 | 19 | 20 | 19 | 18 | 17 | |
| Cash | 6 | 6 | 7 | 7 | 7 | 7 | 6 | 6 | 6 | 8 | |
| Total Assets | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | |
| Short Term Debt | 29 | 27 | 28 | 28 | 29 | 28 | 28 | 28 | 28 | 29 | |
| Long Term Debt | 56 | 55 | 54 | 52 | 48 | 48 | 47 | 48 | 48 | 52 | |
| Shareholders Funds | 15 | 18 | 18 | 20 | 23 | 24 | 25 | 24 | 24 | 19 | |
| Total Liabilities | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | |
| Operating margin by region – Bridging the GAAP 4-02 | |||||||||||
| Region | 92/93 | 93/94 | 94/95 | 95/96 | 96/97 | 97/98 | 98/99 | 99/00 | 00/01 | 02-Jan | |
| North America | -2.7 | 1.6 | 4.2 | 5.8 | 7 | 8.5 | 8.4 | 6.5 | 5.7 | -8.4 | |
| Europe | 1.2 | 1.2 | 3.1 | 4.8 | 3.6 | 5.8 | 6.9 | 3.1 | 4.1 | -1.3 | |
| Asia Pacific | 4.2 | 4.3 | 4.9 | 5.8 | 4.8 | 5.2 | 3.8 | 5.5 | 5.5 | 1.4 | |
| Average of all | 0.2 | 2.1 | 4 | 5.4 | 5.3 | 6.9 | 7 | 5.2 | 5.2 | -4.1 | |
| Net margin by region – Bridging the GAAP 4-02 | |||||||||||
| Region | 92/93 | 93/94 | 94/95 | 95/96 | 96/97 | 97/98 | 98/99 | 99/00 | 00/01 | 02-Jan | |
| North America | -5.1 | -2.9 | -0.5 | 1.7 | 3.6 | 5.4 | 4.4 | 4.4 | 2.9 | -6.7 | |
| Europe | -3.1 | -3.3 | 1.7 | 1.5 | 0.6 | 4 | 4.5 | 2.3 | -0.2 | -2.9 | |
| Asia Pacific | 1.4 | 1.9 | 2.3 | 3 | 2.7 | 2.2 | 2.7 | 3.4 | 2.1 | -0.7 | |
| Average of all | -3.1 | -1.9 | 1 | 1.9 | 2.4 | 4.2 | 4 | 3.5 | 1.8 | -4.2 | |
| NOTE: Figures are percentage ratios from Bridging the GAAP 4-02. | |||||||||||
| Financial definitions |
| All of the analysis is based on the airline group results contained in editions of Bridging the GAAP. Accounts are included for accounting periods which fall within the July-June year. Full copies of the tables appear in the latest updated edition Bridging the GAAP 4-02. |
| Tangible assets: Physical assets such as aircraft, property and equipment net of accumulated depreciation. Investments: Shares in associates and trade investments of a fixed nature. Intangibles: Goodwill, pension plan assets, cost of slots and other intangible fixed assets. Debtors and Inventories: Trade receivables, prepayments and short-term investments. Cash: Cash holdings or very short-term investments. Short-term liabilities: Typically trade creditors, forward sales, tax liabilities, accruals including aircraft rent accruals and current portions of debt. Long-term liabilities: Mainly the non-current portion of debt, deferred tax liabilities, pension obligations. Shareholders funds: Typically split into funds from shareholders in the form of share capital and share premium and funds generated within the company such as the cumulative retained profit and loss account. Cash from operations: Cash generated by the operating result adjusted for changes in debtors, creditors and inventories. Investing activities: Principally payments for new assets, mostly aircraft, less any proceeds from disposals. Financing activities: This will reflect either proceeds from new debt or repayments of debt. |
| Debt ratios – percentage net debt/total capital | ||||
| Region | 93/95 | 96/98 | 98/00 | 02-Jan |
| North America | 78.8 | 38.5 | 49 | 62.4 |
| Europe | 62.2 | 42.8 | 54.2 | 58.3 |
| Asia | 62.5 | 65.4 | 57.5 | 59.6 |
| All carriers | 68.4 | 52 | 53.7 | 60.7 |
About the authorIan Milne is financial controller customer service and operations at British Airways, previously held planning and analysis roles within the corporate finance department. He is also the author of Bridging the GAAP, the benchmark report on airline accounting policies and financial performance, first published by Airline Business in 1994. The latest update now includes analysis for fiscal years through to June 2002. For details visit the product section of our website: www.airlinebusiness.com
Source: Airline Business
