Just what is the best way to measure low-cost airline profits? The measure that counts is relative "Total Shareholder Return" - and relative not just to other airlines but to other businesses - not simple profit margin
Historically, the airline business has not been run as a real business designed to achieve a return on capital that is passed on to the shareholders. It has been run as an extremely elaborate version of a model railroad in which you try to make enough money to buy more equipment.
So said Michael Levine of Northwest Airlines in 1996 [he was executive vice-president at the carrier until 1999 and is currently a Distinguished Research Scholar at the New York University School of Law] and it seems not much has changed since. Light hearted as the analogy may seem, it has very serious implications - what happens when there is not enough pocket money to buy new carriages?
The US airline industry provides perhaps the best illustration of the answer. The US domestic airline market, the world's largest single market, now has one of the oldest fleets in the world - with an average age of greater than 12 years. Even developing nations such as Brazil, China and India have younger fleets. Without adequate returns to shareholders (and creditors), there's no money to invest to buy new aircraft.
What is the cost to the global environment of having the world's largest fleet guzzling maybe 20% more fuel and spewing out proportionally even more C02 and other pollutants per seat than in other domestic markets?
Travelling Americans receive among the worst domestic in-flight product and service standards outside of communist and former communist nations - this is not how it was when American carriers were profitable and not cutting every corner just to survive.
The point here is not to lambaste the management of US carriers, who labour under difficulties such as bankruptcy laws that inhibit the removal of inefficient carriers from the system, draconian security requirements and antiquated air traffic control infrastructure. While money is often said to be the root of all evil, in the case of the US airline system, lack of money is a primary cause of its evils and a self-perpetuating downward spiral, broken only by periodic spells of profitability.
By contrast, in the relatively small Australian domestic airline industry there are two very profitable airline groups. Qantas is the second oldest airline in the world, which places it decidedly in the "legacy carrier" category, while Virgin Blue at just seven years old is representative of the crop of "low-cost airlines" and rapidly morphing into a new generation network carrier (or "new world carrier" in its parlance).
But they have among the youngest and greenest short-haul fleets in the world between them (average age six and a half years), with both airline groups also about to take delivery of new long-haul fleets. Profitable long-haul carriers such as Singapore Airlines (average fleet age of 6.3 years), Emirates (5 years) and Cathay Pacific, make a point of refreshing their fleets to keep them young - but they can only do that because their shareholders believe this is good use of their money.
The situation in Australia arose in part because an airline that accounted for half of domestic capacity was allowed to die instead of being kept on Chapter 11 life support as would likely have been the case in the USA. A former chief executive described this airline, Ansett Australia, as "a great airline but a lousy business" as some kind of justification for its existence. To paraphrase Mr Levine, it may have just as well been a great model railroad for all the good it did its shareholders. Without shareholders there is no business and it was the shareholders, not creditors, who pulled the plug on Ansett, refusing to throw good money after bad.
This lack of focus on the raison d'etre of businesses, which is to create value for shareholders, no doubt has many culprits. But surely among the worst reasons is the insistence on measuring and celebrating the wrong things - like profit margin.
Why is this wrong? It's simple really. Investors invest capital, not revenue. So they want a return on their capital, not on the revenue of the business. Imagine depositing $1,000 in a bank account expecting 10% interest on your investment and then returning in a year's time to be told "we're going to give you 20% of revenues that your money earned when we lent it out - here is your cheque for $20".
The investor's reply would be: "No deal - I want 10% on the money I invested, that's 100 dollars" The bank replies: "But we can give you 20% of revenue - isn't that great?" Anybody can make a profit by throwing money at a problem. What makes for good management is making large profits with little investment.
So let's have a quick look at capital. What makes airlines different from industries where profit margin is a more telling measure is their capital intensity. This can be illustrated by "asset turn" or the amount of revenue produced by a dollar of assets. For a typical legacy carrier, its asset turn may be 0.5 times - a dollar of assets producing only 50¢ of revenue. For a logistics company the figure may be 1 times, for an insurer 1.5 times and for a department store 2-4 times. Remember, this is just revenue we're talking about, we haven't got to profit yet.
Typically, aircraft make up 50-60% of assets on the balance sheet and when non-cancellable operating leases are taken into account aircraft may account for 60-70% of assets actually employed by the company.
So, between airlines needing a lot of assets to produce revenue, and aircraft making up most of those assets, it is evident that how efficiently aircraft are used goes a long way to explaining the return made on capital invested in airlines. Not that you would pick this from the most boasted about metrics in the airline industry - unit cost and profit margin.
The following example shows how misleading these measures can be when (mis)used on their own. Let's take a pair of fictitious airlines A and B. Airline A has an industry leading, very low CASK (Cost per Available Seat Kilometre) of say 3¢, and an excellent pre-tax profit margin of 14.3% on revenue per ASK of 3.5¢ - that is a profit of 0.5¢ per ASK.
Airline B operates on the other side of the world in a totally different environment, and maybe even a different business model, with a CASK of 6¢ and a pre-tax profit margin of only 11.1%. You would confidently predict never hearing the end of Airline A telling the world that it has industry leading margins and among the lowest costs in the world. Sounds impressive, but so what? Does this make Airline A a good investment from the perspective of a shareholder?
Let's say both airlines operate a fleet of Airbus A320s with similar configurations and utilisations, thus producing the same ASKs per aircraft. Much as every airline likes to think it has negotiated an outstanding deal with Boeing or Airbus, at the end of the day there is not a great difference in what is paid for aircraft in a global market where the product is in high demand.
This means our two airlines are basically investing the same capital per ASK produced. So the capital providers of Airline A are earning 0.5¢ profit for the same amount of invested capital on which Airline B is returning 0.75¢ (profit margin of 11.1% times revenue/ASK of 6.75¢). Which airline would you rather be investing capital in (see table 1)? Here we have Lloyd's Law of low-cost carriers - the lower your cost base the higher your margin has to be to pay for your capital before making money for your shareholders. There is a corollary to this law. Lower cost airlines such as Ryanair generally have among the best profit margins in the industry but poor asset turns. Profit margin multiplied by asset turn is otherwise known as return on assets.
So with good profit margins but poor asset turns, it is no surprise that both AirAsia and Ryanair have quite average returns on assets - significantly lower in fact than airlines such as easyJet, which has both higher absolute costs and lower margins. As well as having better return on assets than both of its peers, easyJet has out-performed them in total shareholder returns (dividends plus the change in stock value) as shown in the graphic above.
This result is not a coincidence. While return on assets is not the same as returns to shareholders due to factors such as debt (on and off balance sheet), accounting policies and taxes, there is at least a correlation which is totally lacking from profit margin. As we have seen, profit margin is just a component of return on assets and on its own says nothing about how productive these assets are.
A poor return on assets cannot produce a good total shareholder return, while an ordinary profit margin combined with an excellent asset turn can produce a good return on assets and hence a good total shareholder return. This alone qualifies return on assets as a superior profitability measure over profit margin if you must use one measure in isolation to summarise financial performance.
A better measure of profitability is RoTGA. The most common definition of RoTGA is Earnings before Depreciation, Rentals, Interest and Tax (EBDRIT) divided by Total Gross Assets (original purchase price of assets and including capitalised operating leases).
Shareholder Return vs Value A positive Total Shareholder Return is essential for creating shareholder value, but there is a subtle difference between simply a positive total shareholder return and creating shareholder value. Total Shareholder Return tells whether the wealth of shareholders is increasing or decreasing in an absolute sense, but to tell whether this is creating value, it needs to be measured against alternative investment opportunities. If everyone in the world can invest in the stock market and get an 8% return, and a particular airline also returns 8% on equity, it's just treading water, not creating value for shareholders because they can get what the airline offers from elsewhere. However it is evident that the higher the Total Shareholder Return the better for investors and the more likely that value is being created for them [technically, shareholder value is created when capital is invested and it earns a greater return than its cost or opportunity cost]. Of course as well as being created, shareholder value can be destroyed. |
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Some analysts use measures such as ROIC which is Net Operating Profits After Tax (NOPAT) divided by Invested Capital. It is relatively easy to calculate from financial statements but its key feature again is that it includes capital rather than revenue in the denominator. Any of these measures are better than profit margin alone for indicating the profitability of an airline or comparing performance of airlines because they take into account in some way the profit being made on invested assets.
This is not to say that profit margin is a totally useless measure on its own - just not for the reason it is so often (mis)used. Continuing with our fictitious airlines, Airline A could suffer a 14% drop in revenues for a long period and remain solvent, while for Airline B the same 14% drop could prove fatal over the same period.
Then again, the same environmental factors that allow Airline A to achieve lower cost in the first place could make it more likely that it will suffer volatile revenues. So as a measure on its own of the performance of an airline, profit margin is more useful for measuring downside buffer than upside opportunity for value creation.
What is worrying about profit margin is how focusing on it excessively pervades airline management. Because profit margin is worshipped at the top, it is driven down into the business as a primary metric. How many airlines report route profitability based on profit margin alone, and allocate capacity on this basis?
Let's see where this can go wrong. Say an airline has a choice of operating some relatively long routes with 12% profit margin or allocating the same aircraft time to some shorter routes with only 10% margin. Using margin as the only criteria the choice is clear and easy.
But do the math based on profit per aircraft time (effectively the same as return on assets where there is a single fleet type) instead of profit margin (see table 2).
The total profit, and more importantly the profit per hour of aircraft time occupied, is maximised with the lower margin routes. While aircraft time is used in this example as a proxy for value of asset used, the problem becomes more complicated when dealing with choices between different fleet types. In this case a more sophisticated methodology needs to explicitly factor in aircraft asset value and consumption of its available time. Only by building measures that bear some relation to creating shareholder value into its route and fleet planning and reporting can an airline hope to end up with a network that creates shareholder value.
It used to be said that "revenue is vanity while margin is sanity". More recently, with the rise of low-cost carriers, cost has been the subject of boasting. But for low-cost carriers margin actually remains a poor measure of true profitability. Maybe the aphorism could more accurately be re-cast as "cost is vanity while margin is inanity".
If airline managers want to benchmark themselves against their peers there is only one measure that counts, and then only over a reasonable term. That measure is relative Total Shareholder Return - and relative not just to other airlines but to other businesses. Without shareholder returns we may just as well be playing with model railroads.
For more on the profitability of low-cost carriers, visit flight http://www.global.com/lowcost
About the author
Roger David is a senior executive in a well-known and widely respected airline (with a decent profit margin). We have changed his name and place of work to allow his views on profitability to be fully presented. Previously he worked for a global consulting firm in its practice area that dealt with airlines.
Source: Airline Business
