Financial markets have begun to recover from their lows of earlier this year and airline shares along with them. But that should not deflect from the task of restructuring, warn Chris Tarry and Dominic Edridge
To read some of the more upbeat reports from market analysts it is possible to form the view that the industry is getting back to normal. Undoubtedly traffic is recovering, but as regularly argued in these pages, it is value rather than volume which is the key for the future. Even then it needs ongoing action by management to ensure that the cost base is appropriate for the new revenue stream.
The reality in the US domestic market is that although passenger traffic in May was more or less unchanged, it was still 10% lower than the peak in 2000 and that fare levels are similarly down. In sheer mathematical terms it will take a lot for revenue to get back to normal and the key to restoring profit remains cost reduction. A recovery to "normal" conditions is not enough.
The real risk with an improving external perception is that some of the harder decisions over costs may be put off as mindsets change. Also, the willingness of certain groups to accept fundamental change, particularly labour, will clearly diminish when all around they hear that the airline operating environment is getting better.
The recent buoyancy in world stock markets may have added to that perception. There has clearly been a sharp upturn in markets from the depths of the first quarter this year when war in Iraq still dominated the horizon. Compared with their lows in March, the Dow Jones Composite index has bounced 26%, while the UK's FTSE 100 rose 27% and Germany's Xetra Dax was up by 49%.
So what of the airlines? A representative industry sample illustrates the point. We have taken American, Delta and Southwest Airlines in the US market; British Airways, Lufthansa and Ryanair for Europe; and Singapore Airways (SIA), Cathay Pacific and Qantas Airways for the Asia-Pacific region. Only for American and BA did their lowest historical share price over the last 10 years coincide with the stock market lows of March 2003. For the others in this group, their 12-month lows were between 28% and 438% higher than the lowest price reached in the last 10 years. For the Asian airlines there was greater consistency, with the 12 month low being 60-70% higher than the 10 year low. Interesting though this may be, the focus should perhaps also be on the relationship between the current share prices and the 12 month and 10 year highs.
Other than Southwest, which was trading at its 12 month high during most of June, the others ranged from 47% (American) to 85% (Cathay Pacific) with the overall average 75%. The conclusion then is that the industry, at least in stock market terms, is well on the way to recovering towards recent share price highs.
But what of the longer term picture and current price levels compared with the halcyon days of the last 10 years? As might be expected there are marked differences in experience, with Southwest and Ryanair currently trading at 75% and 67% of their 10 year highs, Cathay and Qantas are at over 60% and SIA over 50%. However, for the rest the range is between 18% (American) and 38% (Lufthansa) with BA and Delta at 21% of their 10 year highs.
But is the past any guide to the future particularly when the rules of engagement have changed to such a degree? Consider for a moment the extent to which headline profit figures may not tell the complete story - there are many others. A decade ago, BA in its 1992/3 financial year reported an underlying operating profit of £353 million ($588 million) which resulted in an operating margin of 6.2%. Move ahead 10 years and in the latest 2002/3 results, BA's underlying profit was almost 10% higher at £379 million, yet that translated into a margin of less than 5% due to the effects of growth and inflation on the revenue side.
The sector's volatility tends to mean that airline shares are regarded as trading stocks and the continuing challenge for airline managements is to reverse this perception. But that will only happen when potential investors gain confidence that shareholder value will be enhanced rather than reduced.
At times when financial markets are undergoing a change of direction the underlying determinants of market behaviour, chiefly fear and greed, tend to come to the fore. Reality may later set in after the bandwagon has stopped rolling. In this respect there is a significant difference between taking a short-term perspective, for example looking at the direction of an airline's passenger yield as a buy or sell signal, and having the confidence to take a longer term view. The key determinant of that is confidence in the ability of management to make a fundamental transformation in the economics of the business. Given the shift in fares, more traffic and lower costs are needed even to get close to previous profit levels. In the end, taken in isolation, traffic is not everything and neither is a change in the yield. Managements and stock analysts alike need to look at the bigger picture, while for share investors the old warning, buyer beware, applies.
Source: Airline Business
