Focus on the Airline Industry: The Perfect Storm or a Bumpy Ride?
You may be surprised to learn that, during the course of its lifetime, the aviation industry has not made an overall profit. So, who would choose to run an airline? Lambasted by the environmental lobby, at the mercy of fluctuating oil prices, and dictated to by the inefficiencies of airport operators, airlines now face an even harder uphill struggle to stay aloft when customers are choosing to hunker down and save their pennies.
It is no secret that there is likely to be a surge in restructurings and potential bankruptcies across all industry sectors during the course of the next two years. The deadly combination of tightening credit conditions and depressed consumer spending will hit many businesses hard. In fact, it will not be long before all business sectors are riding a wave of distress unlike anything we have seen before.
The airline industry has had its fair share of problems for years. The number of airlines that have filed for bankruptcy protection in the US this year may be fast approaching double figures, but the industry is no stranger to restructuring, bankruptcy or Chapter 11. Now, however, the environment in which companies must restructure is different. Banks are being much more cautious about debt levels due to the credit crisis.
Airlines have been hit by rising costs during the last few years. Leasing is the largest operating cost item for an airline. The movement towards new generation aircraft – which provide better fuel efficiency and therefore lower emissions – is in some cases increasing costs for a single aircraft by 300%. Large order books and long waiting lists for new aircrafts have meant that exceptional deals were difficult unless an airline, such as Ryanair, has been able to place large orders.
After lease costs, fuel is the largest operating cost item. This year’s fuel price rises (a doubling from last summer and impacting the peak summer period) returned the airline industry to a collective loss, just one year after carriers had entered net profit for the first time since 2000. Fuel rose to US$120 a barrel and airlines that had managed to hedge at US$85 a barrel were considered fortunate. Those airlines that hedged their exposure to oil prices into 2009 by predicting a continued rise have been caught out, however. For those that didn’t, the fall in the fuel price has coincided with the rise in the value of the US dollar, which has balanced out much of the impact. The rise in the dollar has further impacted upon European and Asian airlines because aircraft lease payments are also usually in dollars. So, currency hedging can be very important for non-US airlines when looking to manage their costs.
Now, the weakening economy is making its presence felt. Customer confidence and spending power is being hit. The impact of the earlier inflationary pressures and sky high commodity prices, the fall in house prices and rising unemployment are impacting upon the purchasing decisions of consumers, which will have a severe impact upon airlines’ sales and, therefore, squeeze profit margins and working capital. The full-service, long haul carriers’ profits are largely made via business class sales, which are falling as companies tighten travel budgets. BA recently announced an 8.6% fall in premium cabin sales. Low cost carriers, which have fuelled the boom in city breaks, will be affected as travellers choose to cut back.
BAA recently reported a 6% drop in passengers travelling through its seven UK airports year-on-year in October, the seventh monthly consecutive drop. ACI Europe reported a 3.3% drop in passenger numbers across Europe in September. Tour operators are cutting capacity, or even going out of business, in response to depressed consumer spending. In the UK, both Thomas Cook and TUI have announced reductions to capacity next summer of 15% and 27% respectively.
There appears to be a stark choice: collapse – XL, Zoom, Maxjet – or consolidation – Brussels Airlines and BMI with Lufthansa. Many in the industry believe profound change will be required to lift the sector out of the doldrums. The winners will be those with good cash reserves, low debt, an optimised fleet size, and new and fuel-efficient aircraft. For those without all these advantages, however, there is hope. Companies that tackle difficult decisions now before it is too late will emerge relatively intact. In our experience, management tends to be so focused on keeping its head above water that it neglects to step back and be honest about the action needed to tackle threats to the business, even if it means cutting down on capacity and reducing fleet size.
For those in distress, there are steps that can be taken towards restoring company health and riding out the economic storm. Essentially, airlines need to manage their cash carefully, cut costs and raise revenue.
A 13-week rolling cash flow planning process is needed to establish and predict the available cash in the short term. This includes reviewing large ‘cash outs’, such as heavy aircraft maintenance in the off-peak winter season, and restructuring costs, such as severance payments.
Assessing what capital expenditure can be delayed and paying extra attention to capital structure are also critical. The maturity of debt should be extended to avoid repayments eating into cash needed for restructuring or investment. Covenants should be loosened where possible. Payments to key suppliers should not be halted, however. Quite obviously, aircrafts will be recovered by lessors if you default on payments, and aircrafts will be impounded if airport charges are ignored. Delaying payment to fuel suppliers could result in demands for cash in advance of receipt of the fuel, which would undermine careful management of cash and sends a worrying message to the market and customers.
The size, mix and utilisation of the fleet needs to be managed in order to cut costs. The inevitable drop in passenger demand during the credit crunch should be tackled by parking aircrafts to save on operating costs. If possible, maximise utilisation by handing aircrafts back to the lessor. The risk with this strategy is that the lessor will request that newer aircrafts being leased is returned first, leaving the airline with the higher-maintenance and less fuel-efficient classic aircrafts. Another alternative is to try to negotiate a ‘power by the hour’ agreement, only paying for hours flown. Requesting a payment holiday and agreeing to pay more at the time of peak cash collection in summer when aircraft utilisation is much higher could also help. Airline failures have now resulted in a large number of aircraft being returned and orders and options on new deliveries being cancelled. Consequently, for any company with cash, the downturn could be an excellent opportunity to add to or renew the fleet.
Fuel consumption initiatives, such as taxiing out to the runway with just one engine running, reducing take-off and landing speeds, and optimising flight schedules as efficiently as possible, will make a huge dent in the cost base. Catering efficiency programmes should take into account typical eating patterns on flights.
Apart from ongoing cost-saving initiatives, which many airlines have adopted during the oil price peak this summer, revenue management is a priority. Ancillary revenue streams can be exploited; charging for services such as excess baggage, catering, additional legroom, priority boarding and seat allocation are popular choices for airlines. However, many of these ancillary revenue measures are most effective on short haul flights of up to four hours’ duration.
Despite all of these measures, a merger might be the only way to guarantee mid and long-term sustainability. Many airlines are already embarking upon marriage (AirFrance/KLM, Delta/Northwest) or are actively seeking a suitable partner (BA, AA, Iberia, Quantas). Well-managed businesses with surplus liquidity may benefit from a downturn if it provides investment opportunities that would otherwise have been too expensive. Careful handling of staff and unions throughout the merger process is critical to safeguard the future form of the combined entity.
In the case of a merger, there are regulatory hurdles to overcome. Some governments have restrictions on international ownership of airlines. For example, Austria does not permit more than 50% foreign ownership, and the US only permits a holding of a 25% equity stake by a non-US company. Potentially, given the heightened state of distress of the sector and the need for swift remedial action, regulators could lift these restrictions on a country by country basis.
In extreme cases of distress, of course, seeking Chapter 11 protection in the US or entering administration in Europe or Asia could be the only routes open to an airline in trouble. For US-based airlines, Chapter 11 affords a stay or freezing of past debts to allow companies breathing room to prepare a turnaround plan or address core issues. In the UK, under the Enterprise Act, the system is moving towards recuperation and reorganisation of a company out of court, while creditors remain active in the process.
Labour relations in the aviation industry have, for some reason, never been easy. The compensation structure of per diems, salaries and flight hours is difficult to change in a heavily unionised industry. A clear message about the situation the company is in and the final objectives of any restructuring should be communicated with the unions in order to promote harmony.
The winners in this market will be those cash-rich airlines with an optimised fleet. Certainly, we expect to see continued consolidation in the coming months as airlines with low debt and decent cash reserves capitalise upon the misfortunes of weaker players. It is inevitable that a number of airlines will disappear from the market in the face of weakened liquidity and deteriorating financial performance. There are mid- to long-term growth opportunities, however. The Middle East and Asia will witness huge increases in passenger numbers. Premium travel, which has suffered from the fallout of the credit crisis in recent months, is likely to be a high growth area once the global recession is over. But for those in the midst of structural change in the industry right now, that rosy scenario must seem like a very long way off.