The outlook remains cloudy but the industry could be on the cusp of a sharp rather than smooth downturn, writes Chris Tarry of CTAIRA.
It is often said the only constant in the turbulence that is the airline industry is change. This also applies to views on economic prospects.
The outlook appears to change almost weekly. Early in September there were signs global economic growth in 2006 would be better than expected. Indeed, for many airlines the second quarter was good and perhaps better than expected, especially in Europe and North America.
On the other hand, in early September there also appeared to be increasing concerns of the so-called “downside risks”. In particular concerns surfaced that there would be a sharp rather than smooth transition from growth to at least a slowing rate, if not a recession, beyond 2007.
As September progressed the messages became more mixed. As things stand all that might be said of this year is that for many 2006 will be the peak. Economic growth in 2007 will be slower but there are concerns over just how slow, in particular in the USA.
We have argued that underlying economic activity provides the key driver to traffic. But if we are now at or close to the peak of the cycle and the likely industry operating margin is in the order of 2-2.5%, investors need to be even more selective.
The reality is that the latest likely peak profit margin forecast by IATA for 2007 is less than half that achieved in either past peak years of 1988 (6.1%) or 1997 (5.6%). It is also less than the 3.3% reached in 2000. The expectation is that the industry will still be in the red at the net level in 2006 and perhaps only marginally profitable in 2007. Perhaps even more significantly, the forecast return represents only one quarter of the industry’s estimated cost of capital.
It is all very well to ride the cycle and report peak margins, but the real success at company level is in minimising the operating margin spread between the top and bottom of the cycle while achieving a satisfactory result at the peak – something the industry will find impossible.
The reality is still that the sensitivity of the industry to revenue swings is absolute – less revenue simply means less cash. In this respect IATA estimates the industry has been boosted by “exceptional revenue growth” of some $20 billion but is concerned by the prospect of a slowdown in revenue growth next year. In such an environment we fear little can be done to counter this effect in the near term and the consequent feed through into financial performance.
This in itself raises an important point – the need to differentiate cyclical growth and/or recovery from structural opportunity.
So how does an airline operating in a mature market access revenue that is growing structurally rather than just following the cycle? A rather cheap but not particularly useful answer is “with difficulty”, but more realistically it relates to access and affordability.
For an airline outside the region offering structural growth, access will in the first instance depend upon the regulatory environment. So should we expect a rush of European and North American capital into airlines or airline ventures in Asia?
While Asia is rightly recognised as the area of structural opportunity, this may provide no guarantee of profitability as there is a dash to put capacity into the market – volume is important but what counts for profitability is the value of that traffic.
What then of acquisition in an airline’s own region where the regulatory environment – subject to the renegotiation of bilaterals – is more favourable? In this respect both Alitalia and Iberia appear yet again to be the focus for some analysts. In stock market terms, however, there seems to be a lot of what is seen as top of the market behaviour which also usually results in a widening gap between price and value which will benefit the vendor.
A key question in any acquisition is where will the real benefit emerge because size alone is no guarantee of success? On the one hand an acquisition may give access to the revenue streams of the acquired company, but unless costs are taken out there is no structural gain, particularly as post-acquisition cost savings tend to fall short of expectations.
In the very near term there is still the scope for expectations to improve – even more so if the fuel price cuts continue. Longer term it appears that little can be done by an individual airline, let alone the industry as a whole, despite the efforts on cost over the last five years, to offset the inevitable slowdown in revenue that moves closer. ■
Source: Airline Business
