CTAIRA's Chris Tarry discusses industry forecasts and what the outbreak of acquisition fever means
In reality there was perhaps little surprise when IATA's latest forecasts were unveiled with an expectation that the industry is likely, at long last, to return a net profit in 2007.
However, before getting too carried away, it is important to recognise that the forecast net profit of $2.5 billion will only be two-thirds of that achieved when the industry last reported a profit at this level in 2000 and only 30% of the average reported for the three years prior to that. To put it another way, over the period 2001-06 the accumulated net losses of the industry, which include the costs associated with restructuring, are estimated to be $41 billion.
At the operating level the expectation is that the outcome for 2007 will be unchanged from that of 2006 at $10.2 billion a margin of 2.3% in 2006 and 2.2% in 2007 or just under 40% of that achieved at the last peak of the cycle.
The betting is increasing on 2007, or at the outside 2008, being as good as it is likely to get for the industry and then the only way is likely to be down. The ability of an airline or any business to transfer revenue into profit and particularly cash is fundamental and if, as we and IATA fear, there is a slowdown in the rate of revenue growth, life could quickly become tougher.
One relationship that should be of particular interest is that between the operating result and the cost of servicing debt. When expressed as a ratio it shows how many times interest payable is covered by operating profit. As a rule of thumb, four times has generally been regarded as a pretty good number. For 2005 we estimated that cover was just over once for the end of this year it will be closer to three times or similar to that of 2000 by 2007 it could reach the magic ratio of four.
However, the sustainability of high levels of interest cover has been transient rather than permanent and has reflected a peak rather than a plateau. Similarly, now attention should begin to focus on what happens beyond 2007 and here the prospect is for an environment in which net debt is increasing as a result of a high rate of new aircraft deliveries.
At the same time, the sum required to service the debt measured through interest payable will rise and the reported operating profit will fall (although not the cash associated with it) as depreciation charges increase to reflect the presence of the new aircraft.
Add to this the prospect of higher interest rates, which remain a real possibility, then there is scope for some additional pressure to come back into the system.
This is interesting against a background where there is an outbreak of "acquisition fever" in the sector - albeit with each transaction having one common theme, the realisation of an improved performance and value - beyond which there are few similarities. However, change and the realisation of potential benefit are not without cost.
With revenue growth peaking and flat operating profits the inescapable conclusion is that there is a need to address costs again. However, this is harder in an upswing and where the industry is reporting profits rather than losses. Experience has shown that even without the provisions of Chapter 11, or similar bankruptcy legislation, cost-cutting is easier when business fortunes are in decline or just in loss or when there is perceived to be a tangible external threat.
Clearly management should take a view of whether or not they would rather be the acquirer or an acquiree in a consolidating industry. Indeed, being the acquiree may be a way to maximise the price paid. It is quite likely that at least in the boardroom the recent spate of activity in the sector has focused attention on just this issue.
One defence, or one way to maximise an asking price is clearly through improved performance. For some airlines this means leaving poorly performing or non-core activities as well as improving underlying performance. This is fine in theory, but is the threat of a change in ownership sufficient to drive through necessary changes in working practices and other business processes? The answer is probably only in cases where employees perceive a real threat.
Against this background is the possibility that 2007 could become exciting for many reasons, but not everybody can be a winner. In particular it is important to be clear on the difference between price and value. Furthermore the risk in a marketplace where the basics appear to be becoming less favourable is likely to continue with the acquirer.
Source: Airline Business