Airline Profit Cycle June 2015
The airline industry is a low margin business. We all know that. In the years from 1945 to the end of the twentieth century the global airline industry made total net profits of $36bn representing a margin of 0.8% to revenues. In the first decade of this century the industry generated net losses of $49bn — a third more than it had ever made. But in the last five years the industry produced net profits of nearly $59bn (a margin of 1.7%).
IATA, however, in its latest industry forecast is projecting that 2015 could see net profits of $29bn reflecting an operating margin of nearly 7% and a net margin of 4% — the latter last reached in 1978 and the former not touched since the introduction of the jet aircraft in the mid 1960s.
Since the introduction of the jet age the industry as a whole has generated operating margins fluctuating between a positive 6% and a negative 2% in exceptional years. For those who believe that historical performance is a basis for future development there may be a worry that the IATA forecast represents a suggestion of peak profitability in this cycle trending to a downturn from 2016. In previous cycles, however, there was always someone who would say that “this time it is different” just before the downturn appeared (a key signal that the cycle had indeed peaked). None has yet done so.
The IATA forecast is predicated on an acceleration in the rate of growth of capacity (to 6.5% up from 4% and 5% in the past two years) and demand (6.7% for passengers and 5.5% for cargo) but a 7% fall in yields, a 35% decline in fuel prices and a 3% decline in non-fuel unit costs. Integral in the forecast is an assumption that GDP growth will also accelerate to 2.9% this year up from 2.5% and 2.6% in 2013 and 2014.
Within this forecast there is a wide variation of performance by region of airline incorporation. North America is forecast to generate net profits of some $15.7bn (more than half the global total and more than double that achieved in 2013) representing a net profit margin of 7.5% of revenue and $18.12 per passenger.
Europe meanwhile is projected a net profit of $5.8bn — finally exceeding the peak of the last cycle in 2007 when it achieved $5.1bn — but only reflecting a margin of 2.8% and a profit per passenger of $6.30.
It is closely matched by Asia/Pacific airlines who are forecast to produce $5.1bn — the area's best performance since 2010 — at a margin of 2.5% and $4.25 per passenger.
Interestingly, for airlines in the Middle East IATA is projecting profits of $9.61 per passenger, $1.8bn in total and a 3% profit margin (“yields are low but unit costs are even lower”) — which no doubt could add fuel to the legacy campaign against the Middle East superconnectors.
Is this time different? The problem when looking at a global aggregate is that it can sometimes blind one to the conscious appreciation of changes at the micro level.
Some individual airlines will only start to benefit from the fuel price decline in 2016 as their relatively high fuel hedge positions unwind. There are of course many without fuel hedges in place.
One major consideration is that since the last cyclical peak there have been some substantial structural changes in the industry, not least of which is an increased shift from legacy to new (generally profitable) business models: the LCCs in Europe continue to grow profitably at the expense of flag carriers; the super-connectors (particularly Emirates and THY) are adding profitable services at high rates of growth.
Moreover, since the last downturn two of the largest aviation markets have effectively consolidated: the US domestic and the trans-Atlantic markets.
In the US domestic market, despite capacity increases at Southwest as it resumes a growth path (see Aviation Strategy November 2014) and growth at the relatively small ULCCs, there still seems to be no break to the capacity “discipline” in the US. As the chart above seems to show, the US domestic market seems set to increase total seat capacity (depending on assumptions of retirement of older equipment) at a modestly higher rate than aircraft units, implying that capacity will be introduced using increased aircraft utilisation and an upgrade in aircraft gauge both possibly leading to improvements in per aircraft cash flow and profitability.
At the same time the Delta-Virgin joint venture through Heathrow and the potential IAG acquisition of Aer Lingus (to be incorporated into the BA-AA transatlantic joint venture) further intensifies regulator-approved consolidation in that market.
These however are the more mature market regions and in the lowest growth segments of the industry — and other regions still see rampant competition and in some measures continued market fragmentation.
Whereas the airline industry profit cycle can be said to be primarily driven by economic performance, the world's economies are still running below perceived long term growth rates and the developed economies continue to operate in an era of significantly negative interest rates — seemingly, seven years on from the global financial crisis still unable to stimulate real performance.
This all may suggest that we could be in an extended cycle with a plateau or further upturn in profitability in 2016.
IATA points out that its forecasts suggest that the industry as a whole will generate “for the first time” a positive return on equity above the weighted average cost of capital. This immediately raises the thought that we have reached the peak.
However, the assumption that the industry should achieve this target is a peculiarly equity market focussed idea. (And on a global view there may be few industries that do it on a long term consistent basis.) There are a handful of quoted airlines that achieve the target. There are a handful that strive to achieve it. There are some airline shareholders for whom other returns may be more important: tourism, employment, connectivity.