Improving traffic figures have brought some early New Year cheer for airline stock prices, but the fundamentals suggest that recovery in demand could take a little longer writes Chris Tarry of CTAIRA
Stock market watchers in Europe cannot have failed to notice a sudden upward surge in airline share prices at the start of the year. It does not take much detective work to uncover the fact that this swing followed swiftly on from the release of some upbeat December traffic figures from British Airways. Price hikes followed, ranging from nearly 10% at Lufthansa to over 25% at BA. The question is whether such stock market optimism is well founded?
For some months now there has been an apparent balance between demand and supply, evidenced by stable, then rising load factors. Yet capacity, traffic and price, are still generally below the levels of 2000.
According to the USAir Transport Association (ATA), traffic may have been down by only 1% for the year, but nevertheless remained some 9.5% lower than that in 2000. On transatlantic services, traffic was almost 17% below the peak and some 7% down for domestic, albeit now growing again.
The real test of market recovery, however, is not how many seats are being filled, but at what price. That will rest in large part on the balance between seat supply and underlying market demand, which in turn will be largely driven by economic growth. It is true, as argued in the past, that the relationship between traffic and GDP growth is regularly distorted by fare discounting. Certainly the traditional multiple of traffic growing at twice the rate of GDP is overdone. But the fundamental relationship nevertheless still applies.
So what messages does the economic outlook hold? Latest forecasts for the US suggest GDP growth of some 4.5% for 2004. However, despite this strengthening in the economic fundamentals, some lingering issues of consumer confidence could continue to act as a brake on domestic air travel.
For Europe's Euro currency area, growth is forecast to be close to 2% this year, against 0.5% last. Although the latest data suggests that Germany may well have experienced a technical recession during 2003, growth of 1.5% is forecast for 2004. For Asia there is the usual wide range of forecasts: the latest suggest 2.8% growth for Hong Kong, 4.2% for Singapore and 5.3% for Malaysia.
Just as important, is the direction in which the forecasts are moving. The forward momentum is visible, for example, in forecasts for the US economy in 2004. They are now close to a percentage point higher than those made nine months ago and have risen by around half a point even over the last quarter.
So what does this mean for air travel? IATA recently suggested that it expected international traffic to grow at a rate of 7-8% in 2004. Our view is a little more modest. Overall we expect underlying demand for air travel to drive growth by the order of 6%, although actual traffic levels will depend on whether airlines concentrate on raising volume or yield. For its part, ICAO expects world traffic growth to come in at around 4% this year.
There are at least a couple of serious risks attached to the perception that the market is improving: first, the temptation to introduce capacity; second, the reduction in management ability to make the necessary ongoing cost adjustments.
Capacity re-introduction is a real concern and it is worthwhile re-visiting BA's traffic statement, which caused so much excitement. Whilst long haul premium traffic volumes were positive all other traffic clearly remains price sensitive, and it is reasonable to conclude that BA is not alone in seeing this. Consequently any rapid increase in capacity could be damaging. Despite this, there are some quite aggressive capacity plans from a number of airlines for summer 2004.
Whilst a growing revenue stream is essential for long-term profitability, there is still a need for structural cost reduction in the industry. The problem is that the more the perception that things are back to normal, the harder it becomes to make the necessary reductions on the one hand and the greater the risk that concessions are "snapped back" earlier.
It is perhaps necessary to put these welcome signs of recovery into context. For example, it is worth asking where traffic would have been today if the trend of the mid-late 1990s had continued unchecked. The answer is that traffic in 2003 was a good 20% below this trend line. Indeed if IATA's forecast holds true for a 7-8% growth rate over the next few years, it would take until 2010 before traffic met the original trend.
It is also important to understand the motives that have spurred the rise in share prices. There is a big difference between an investor who buys an undervalued share in the expectation that it will recover over the medium term and one who is putting fresh money into the industry. Airline shares are generally regarded as trading stocks for those who take a short- or medium-term perspective. There is still some way to go before the profitability ratios appear attractive for longer-term investors.
Source: Airline Business
