Airline profits will peak next year but certain structural growth opportunities will remain, writes Chris Tarry of CTAIRA, with analyses from Antonio Panariello of Flight Insight
To recall and paraphrase the words of a popular Johnny Nash hit from 1972, there are perhaps "more questions than answers" when it comes to understanding the current economic cycle.
The recent IATA annual meeting in Vancouver brought a number to the fore. The most pressing of these from an operational and financial perspective is when the current cycle is likely to turn. A year ago, some observers expressed the view that we were in the upswing phase of some type of "super-cycle". But there is no escape from the view that what goes up must come down, and the issues here are when, and how far?
Our own view is that globally airline profits will peak in 2008 and downward pressure will increase beyond this point as aircraft deliveries continue to increase (at least on current plans) and capacity is forecast to grow at a faster rate than traffic. However, we do not expect all airlines to experience the same effects because structural growth opportunities remain, particularly in Asia.
The view that there are some differences in this cycle cannot be ruled out, but we would stop far short of saying that it is much different this time. Some argue that the delays to the Airbus A380 programme have been positive - except for Airbus. This is also partly true, but needs to be kept in perspective as the impact is essentially route specific. The risk though is that A380 capacity comes on stream against a weaker economic background.
Of course the A380 delays have no impact whatsoever on the performance of short-haul European airlines, as explained in last month's issue. Here the risk remains on the downside and even a month on the fear is that it might have increased.
For a several carriers in the wider Asian regions there are significant prospects for growth. The economic outlook in terms of both absolute and relative growth remains positive with an effect on household wealth and thus consumption and the demand for travel. But why, if it is so good in terms of demand, are the financial returns relatively unappealing?
Making a return
Volume is one thing but profit does not necessarily follow. Even at the peak of the cycle, only a few airlines will be generating a return greater than their cost of capital (currently estimated to be 8%). Furthermore, the challenge even for this group is to generate such a return across the cycle and increase rather than reduce shareholder value.
The importance of revenue, given the overwhelming focus of managers on cost, has been written about often. Now the need to identify structural revenue growth becomes ever more important and attention should focus on cost reduction. The problem is that in an upswing not only is it harder to cut cost, but the consequences of a strike or other disruptions are greater in revenue terms.
From a behavioural perspective our recent experiences will tend to condition how we view the future and often underpin assumptions in models. Straight line extrapolation can easily lead to misleading assumptions and tough consequences. The need is perhaps greater need than ever for airline managers to act as private equity investors.
This is not to say that all airlines are necessarily a target they clearly are not for many reasons. However, the discipline of improving performance and ensuring that there are no underperforming assets is positive for any business. While an important measure of success is to produce returns greater than the cost of capital, another way of looking at this is to suggest that those airlines that are successful have access to affordable capital.
In theory, the better and more sustainable the returns, the lower the risk and the cheaper the cost of debt and equity. Against the background of a more difficult environment for some, this remains a challenge. For those that have not achieved returns greater than the cost of capital in this upswing, what could become a virtuous circle if they were to succeed will again turn vicious. From an investor's point of view selectivity is even more important than usual, and attention should focus on structural opportunities - as long as it is profitable - as well as cyclical risk.
Source: Airline Business
