Debt burden

Three years of industry losses and steeply rising debts have put airline balance sheets under pressure, but what is the true extent of the problem?

The past three years have seen tremendous turmoil for the airline industry, raising serious questions over its financial robustness. The unprecedented scale of airline losses have further increased the pressure on balance sheets around the world, with deepening concerns over the level of debt, especially for the most stressed North American major carriers. So as the industry prepares to report another set of annual results, it is worth asking just how bad the global airline balance sheet now looks.

It comes as little surprise that the overall position has worsened sharply ever since the events of 11 September 2001 set in motion what turned out to be a series of industry crises. Neither is it surprising that the North American balance sheets have borne the brunt of the damage, with debt all but doubling. Indeed, the true position could look bleaker still if off-balance sheet gearing, such as aircraft leases, were added into the equation. However, more encouraging is evidence of relative stability in Europe and beyond.

Assessing the damage

This analysis explores what has actually happened to liquidity, debt and capital of the world's leading carriers, comparing the pre-crisis figures from 2000/1 with those for 2003/4. The figures are for financial years that run through to June, so the base years finish well before 9/11 and run through to the end of 2003 or first half of 2004. The sample is based on the top 25 airline groups ranked by revenue, a group which presents well over half of the industry's turnover (see World Rankings August 2004). The figures also borrow from the extensive 10 year balance sheet and profitability analyses that appears each year in Bridging the GAAP, the benchmark guide to accounting standards and industry results.

First, a few words about the measures used to judge the health of a corporate balance sheet. Among the most common for airlines is the ratio of net debt to total capital. Essentially this shows the amount that a company has borrowed from external lenders as a percentage of the total amount that it holds in terms of borrowings and shareholder funds. The lower the ratio then the less reliance there is on external lenders: the higher the ratio, the greater reliance on external funding, with all the pressures that can bring in terms of interest payments and the need to repay capital. In effect the ratio can also be seen as an indicator of balance sheet risk.

Before going further it is worth running through a few quick definitions of the key balance sheet items that go to make up this ratio.

Gross debt: the total of all outstanding short and long-term borrowings.

Cash & cash equivalents: holdings in cash or other highly liquid short-term investments that can easily be turned into cash, such as bonds.

Net debt: the amount owed after gross debt is offset by cash holdings.

Capital: usually shareholders funds comprising share capital and reserves.

Total capital: net debt plus capital.

So what exactly has happened to each of these elements over the past three years?As may be expected in such troubled times, airline groups have tended to raise their holding of cash and equivalents of late. Generally corporations will increase their cash increases through operational earnings or asset disposals, although better use of working capital can also have a positive impact on the cash levels. Cash would normally decrease through the purchase of assets or the repayment of debt.

As a glance across the figures shows, the leading airlines have indeed raised their cash holdings sharply since 2000/1, adding an additional $14.5 billion to take the total up by 67% to reach $36 billion. The largest increase has been in Europe, where cash holdings have more than doubled, while there is a 63% rise in North America and 40% in Asia-Pacific (a region extended to include Emirates). The cash element of this alone has increased by $10 billion as an analysis of cashflows demonstrates.

Initially this was an immediate response to the uncertainty in the industry following the 11 September terrorist attacks. However, since then most airlines have continued to hold higher than average long-term cash levels signifying the continued risk felt within the industry. That is, in part, due to continuing uncertainties over terrorism, but also as a result of soaring fuel prices and concerns for the future of an industry still dogged by overcapacity, especially in North America. The collapse of Swissair and others in the aftermath of the crisis has also acted as a stark warning about the dangers of running out of cash.

It is also clear from the analysis of cash that not only have the North American majors generated the least cash from operations over the past three years ($8 billion), but that they have also paid out most on investing activities ($23 billion) and borrowed most extensively too ($21 billion). In short, while these majors have generated positive operating cashflows, they have also borrowed fairly extensively to fund aircraft purchases and other investments, so increasing debt levels.

In Asia-Pacific, cash outflows on investments has been only $1 billion higher than operating cash surpluses and additional borrowings stand at only $2 billion. In Europe, the cash that has flowed out on investments has been only around half the level of cash flowing in from operations. This surplus cash has been used to lower rather than build up borrowings, with carriers spending $2.7 billion to pay down debt.

The extent of the growing debt burden in North America shows through clearly in the analysis of how cash, debt and capital positions have changed over the past three years.

Rising debt

Gross debt for the 25 airline groups in the sample rose by nearly $45 billion over the three years. The bulk of that came from North America where debts climbed by some $25 billion to above the $60 billion mark. Over the same period Europe's majors increased their debts by $7 billion, while carriers from the Asia-Pacific by over $12 billion. Taking the cash holdings into account, net debt therefore rose by $30 billion over the period, led by a $19 billion increase in North America and $10 billion from carriers in Asia-Pacific, while Europeans saw a modest increase of only $1 billion.

While it is true that debt is usually seen as a cheaper source of finance than raising funds on the equity markets,it comes with a health warning that it also requires extremely careful long-term planning.

The prime reason for an increase in debt is to fund asset purchases, mostly aircraft, but equally for slots, routes licences and business acquisitions. Operational losses may also result in airlines taking out general purpose loans to cover shortfalls. To reduce the debt burden businesses simply use free cash to pay down loans. However, airline treasury teams endeavour to ensure repayment profiles match future cashflow expectations, and ensure there are no spikes that could raise the pressure to generate sufficient cash.

Another factor influencing debt centres on currency fluctuations, primarily for non-US carriers who have taken out cross-border debt funding in US dollars. This creates currency revaluations at each balance sheet date, which can increase or decrease the repayment amount and hence the balance sheet value. For example, the US dollar has lost nearly 30% of its value against the Euro since mid-2001.

The final piece of the equation comes in the shape of the levels of capital in the business. This reflects share capital and reserves from the profit and loss account. Over the past three years capital has reduced across the 25 leading airlines by $21 billion. The nine North American majors showed a reduction of $27 billion, leaving them with zero capital. The only carriers in the sample to improve their capital balances over the three years are the perennially profitable Southwest Airlines and freight giant FedEx Express, together with US Airways as it made its way out of bankruptcy.

In both Europe and Asia-Pacific capital has increased by around $3 billion, with airlines such as Air France, Alitalia, British Airways, Iberia, Swiss, Emirates, All Nippon Airways, Qantas, Singapore and Thai Airways all showing increases. Both regions ended the 2003/4 financial year showing capital of more than $20 billion each.

Pulling all these factors together brings us back to the ratio of net debt to total capital. In total the ratio across these 25 airlines has worsened by nearly 18 percentage points to just under 70% over the three years. However, the experience is far from uniform across the three regional markets.

Although North America set out with the best ratio, coming in at just under 50% by the end of 2000, in just three years the landscape has completely changed with the ratio collapsing to 100%. Effectively, that means that carriers in the region have moved from a position where capital and net debt were evenly balanced to one where there is only debt.

By any measure North America is in an unsustainable position. And in 2004 it has only continued to worsen as further losses have prevailed. It will be many years before such balance sheet damage can be rectified as financial lenders will be pricing more risk into transactions in North America than for other regions. It should be noted that Fed Ex Express and Southwest stand out in the region with net debt/total capital ratios below 20%.

The Asia-Pacific market also saw its ratio edge up five points to above 60%, but that is still at a manageable level and the strength of market demand in the region should help.

By contrast, Europe is the only region to show improvement in its net debt/total capital, reflecting a reasonable operating performance combined with a natural break in the aircraft replacement cycles. The ratio crept down by a couple of points to 48%.

Only seven airlines showed a reduction in net debt over the three year period. The biggest came from British Airways at more than $2 billion with the next largest also from a European major in the form of Iberia at just under $1 billion. Only six airlines, two in each region, showed both reductions in net debt and improvement in capital. As the year-end reports start to come in for 2004/5 it remains to be seen whether any more will join them in strengthening their balance sheets.

Net debt position -2000/1
$billion	North America	Europe	Asia- Pacific	Total
Cash & Equivalents	9.5	6.0	6.1	21.5
Debt	(35.5)	(24.1)	(31.6)	(91.1)
Net Debt	(26.0)	(18.1)	(25.5)	(69.6)
Capital	26.7	17.8	20.3	64.7
Net debt/total capital	49.4 %	50.5 %	55.6 %	51.8 %
Net debt position - 2003/4
$billion	North America	Europe	Asia- Pacific	Total
Cash & Equivalents	15.5	12.0	8.5	36.0
Debt	(60.7)	(31.3)	(44.0)	(136.0)
Net Debt	(45.2)	(19.3)	(35.5)	(100.0)
Capital	(0.0)	20.7	22.9	43.6
Net debt/total capital	100.1 %	48.2 %	60.7 %	69.6 %
Net debt position - change over three years
$billion	North America	Europe	Asia- Pacific	Total
Cash & Equivalents	6.0	6.1	2.4	14.5
Debt	(25.2)	(7.2)	(12.4)	(44.9)
Net Debt	(19.3)	(1.2)	(10.0)	(30.4)
Capital	(26.7)	3.0	2.6	(21.1)
Net debt/total capital	-50.7pts	+2.3pts	-5.1pts	-17.8pts
Cash flows - change over three years

 

Cash from ($ billion)	North America	Europe	Asia-Pacific	Total
Operating activities	8.4	13.3	12.7	34.4
Investing activities	(23.3)	(7.5)	(14.0)	(44.9)
Financing activities	20.6	(2.7)	2.3	20.1
Net cash increase	5.7	3.1	0.9	9.7

NOTES :Figures for 25 leading airline groups by region as shown below. Years=all annual airline results reported within the July/June period for each year. Total capital=Net debt+Capital. () =brackets indicate negative/outflow. North America= Air Canada, AMR/American, Continental, Delta, FedEx, Northwest, Southwest, UAL/United, US Airways Europe=Air France, Alitalia, British Airways, Iberia, KLM. Lufthansa, SAS, Swiss. Asia-Pacific=All Nippon Airways, Cathay Pacific Airways, Korean Air, Japan Airlines, Qantas, Singapore Airlines, Thai Airways and Emirates. Source: Ian Milne/Bridging the GAAP

About the author

Ian Milne is financial controller at British Airways for the Customer Service and Operations division. He is also the author of Bridging the GAAP the benchmark report on airline accounting policies and financial performance. For details of the latest edition visit our website:www.airlinebusiness.com

BY IAN MILNE AT BRITISH AIRWAYS IN LONDON 

Source: Airline Business