A super-normal
2016 December 2015

IATA has brought us tidings of comfort and joy. Well, not quite; but its end-year industry outlook is the most positive ever. The global airline industry is expected to produce profits of around $36bn in 2016, a net margin of 5.1%. The EBIT margin continues its steady rise since the depth of the recession in 2012, reaching a record rate of 8.2% in 2016.

The economic background is described as “uneven but rising”, certainly not the surging conditions of pre-2008 but a perhaps more sustainable 2.5-2.7% annual growth in global GDP, according to the IMF’s November Economic Outlook.

Oil prices, however, are the key driver, and recent developments make IATA’s forecast look conservative. Its assumption is for a 2016 average crude price of $55/barrel (compared to a peak annual average of $112/bbl two years ago). By late December the crude price had slumped to $36/bbl. Oil market analysts are as bearish as airline analysts are bullish: OPEC has given up on production limits, the US has moved towards self-sufficiency, China has slowed down, Iran is about to re-emerge as a major exporter and Russia has to keep its volumes up to obtain foreign currency. Future purchase options are being traded at around $25/bbl, a few as low as $15/bbl.

IATA’s analysis of the impact of the oil price on airline profitability is also surprisingly muted. Between 2015 and 2016 operating profit goes up by just $4bn whereas the airlines’ fuel expense falls by $46bn. This is despite the fact that almost all the adverse hedging positions (where airlines predicted and fixed future fuel deliveries at prices above the actual price) have been wound down.

Passenger yields are forecast to decline by 5% in 2016 but volumes are forecast to grow by 6.9%. The cargo business continues to deteriorate, but the major reason for the 2016 operating profit outcome is IATA’s expectation of a substantial surge in non-fuel operating costs. It is not clear why IATA thinks this will happen.

In any case, assuming away unforeseen negativities (always dangerous in the airline industry) the year 2016 should be either a good one or a very good one.

One possible negative is that low oil prices will extend the operating life of older aircraft which, combined with increased new aircraft production rates, will lead to overcapacity in the short/medium term. However, in this regard, a December report by Deutsche Bank — 2016 Outlook for the OEMs — paints a positive picture.

DB set out to compare current production plans for OEMs against global capacity demand — modelling seats delivered into the airline system, annual retirements and changes in parked fleet. One of the key assumptions is the pace of annual retirements: the historical average retirement age since 1970 has been 23 years. Applying this retirement age to the current fleet shows that a material rise in narrowbody retirements is due in around 2018-20, reflecting the age profile of aircraft delivered in the 1995-97 upcycle. This increase in retirements from 2018 aligns well with Airbus' plans to raise A320 production rates from 2018 from 52 to 60 per month and with Boeing’s likely response of raising 737 rates to match Airbus.

Returning to IATA, it is evident that there are marked divergences in profitability by region.

• North America now accounts for 53% of total operating profits; the operating profit margin is set to remain at about 2015’s 14.3% in 2016, which seems a bit pessimistic given the degree of consolidation in this market and the very tight capacity situation — unless airline managements are starting to worry about a consumer backlash.
• Europe’s 2015 margin of 5.3% is expected to improve to 6.4% in 2016; the regional results are the sum of contrasting individual airline performances, notably IAG vs Air France; the leading LCCs seem to be in a strong position to exploit falling fuel prices and boost their profitability, so the IATA prediction implies continuing struggles for most of the Legacies.
• For Asia/Pacific an EBIT margin improvement from 6.6% to 6.9% is forecast by IATA; while underlying demand conditions should remain strong, multi-airline competition characterises the main city-pairs which, along with the incursion of LCCs into new markets, may curtail increases in profitability.
• Middle East airlines, perhaps surprisingly, are only expected to produce a 2.9% EBIT margin in 2015, reflecting the fact that only Emirates is truly profitable; the EBIT margin is predicted to increase marginally to 3.2% in 2016.
• South American super growth, particularly in Brazil, has evaporated and the fortunes of the leading carriers have been reversed; nevertheless, 2015’s minuscule 1.3% EBIT margin is forecast to improve to 3.2% in 2016.
• Africa's operating loss margin of -1.7% in 2015 may go to break-even in 2016; with such a contrast in efficiency between the leading national carriers — Ethiopian and SAA — plus the huge as yet unfilled LCC market, the losses simply reflect the frustrated potential of the continent.

Overall, for IATA, other airline trade bodies and many industry commentators something deeply disconcerting has happened: after decades of financial self-flagellation over the airline industry’s poor performance, the sector has become “normal”. With ROIC exceeding WACC, the industry has stopped destroying capital — see chart. (The “abnormal” interpretation of the airline business has always seemed a bit parochial as many, probably most, industries complain of over-capacity and too thin margins, while some high-profile and dynamic sectors are much more adept than airlines when it comes to destroying capital — investment banking and the 2008 financial crisis or IT and the dotcom boom and bust, for example).

Interestingly, IATA has compared the US airline EBIT with leading companies in other sectors. US airlines with their 14% margin are now firmly in the mid-range of leading US corporations, well above Boeing’s 7% but still dwarfed by Apple’s 30%. European comparisons are (even) more difficult to make but the European airlines’ 6% exceeds that of all but one of the top largest corporations including Airbus (Siemens is the exception with 10%). So the airlines might be becoming “super-normal”.