Although the performances of many carriers have improved so far this year, there is still a need for a cautious outlook, writes Chris Tarry of CTAIRA
Over the past few months this magazine has been suggesting that 2004 may well have been the industry’s peak year. That peak saw carriers reporting an operating margin of just under 1.0%.
This cautious view regarding near- and medium-term financial performance for the industry overall holds despite the raft of promising recent results. For example, in Europe, results have mostly been better than forecast. Leaving aside for the moment the process underlying the formation of stock market expectations, an immediate question is whether or not these “better than expected results” should be taken to mean that we are “laughing all the way to the bank” or that we should “fill our boots” with airline shares?
The answer is an unequivocal “not necessarily”. Overall industry returns remain unattractive. However an investor does not invest in an industry, but in a particular company. As ever selectivity remains the key criteria.
Looking at operating performance, among the majors, British Airways reported an operating margin of 8.5%; Cathay Pacific 8.9% and Singapore Airlines 8.3%. For the record, American reported an operating margin of 4.3% and United 1.1%. In the low-cost sector, Ryanair, with an operating margin of 19.7% in the quarter to 30 June, and Southwest Airlines with 14.2%, are clearly in a different league. Air Asia’s results are not yet available, although it has said it will miss the forecast contained in the prospectus published at the time of the airline’s share issue.
The situation is similar at easyJet, where although expectations have recently been revised upwards and the outlook is now for a pre-tax outcome similar to that of the previous year, this will in fact represent a very significant decline in margins. The latest figures suggest that the 12-month rolling revenue total at the carrier is up some 23% compared with a year ago.
For a potential investor the real test, however, is not whether they are prepared to buy shares already in issue in the expectation that they will rise – as has been the case for many airlines as a quick review of the price and volume trends show. This does not take into account the near- and medium-term effects of higher oil prices. The more pertinent question is whether an investor is prepared to either put money into a new venture or put new money into an already quoted airline – in effect taking a longer-term view on the “investment story” that the business offers.
There is clearly still no shortage of entrepreneurs wanting to enter the industry. For investors this presents both a challenge, as the failure rate of new entrants remains high, but an opportunity too. Careful assessment is critical.
The reality is that markets do mature both in terms of traffic and competition. Just because an airline model has some success in one area does not mean that it is transferable to another region or market. At the simplest level success will depend upon market access and the relative strength of the incumbent competitors. Initially lower fares will usually increase the size of the market and is likely to result in some move away from the established carriers to the new entrants, if they offer services which are sufficiently close substitutes. However, once the market resets; generally through a structural reduction in short-haul fares as it has in the UK and is doing in Europe, all that the lower fares will tend to do is redistribute traffic rather than grow traffic for a “steady state“ route network.
As a consequence airlines, particularly the no-frills carriers, in order to grow need to open new routes at a high rate to absorb aircraft deliveries. This may result in an adverse mix between mature and immature routes with the accompanying effect on profitability given the time taken for a new route to contribute.
Stock markets can be very unforgiving. The difficulty generally lies when reality differs from a more positive expectation. This industry is no different from any other in several ways; the ability to generate cash and have access to affordable (low cost) capital are fundamental. The fact that a set of results might have beaten expectations and share prices may have risen, needs to be kept in context. Any company’s results are historic and tell us what has happened not what is about to happen. In this respect the outlook for many airlines remains tough. As a result, despite the recent and welcome positive news for many, industry health warnings still apply.
Source: Airline Business
