Global outlook:
Is this the nadir? Oct/Nov 2020

In the course of producing this article the British government reversed its Covid policy, imposed a lockdown and in effect suspended air services to/from the UK for at least a month, resulting in unremitting gloom. Then came news of a break-through in a Covid-19 vaccine and the prospect of it being fairly quickly available, resulting in a burst of euphoria.

Airline share prices have perked up, at least confirming that there is still investor belief in the industry’s ability to stage a recovery. And Zoom shares, which had been soaring, dropped off sharply, which might also be a source of comfort to airlines.

But the fundamentals have not changed yet. All long-haul markets remain comatose, though domestic and short/medium haul markets have at least come off the bottom, with the latest traffic numbers for indicating a mere 60-80% fall in RPKs compared to a year ago. But, with the exception of the Chinese domestic market where capacity has been restored to pre-Covid levels, the traffic upturns or upticks seem to be very fragile.

The economic recovery will take place but when and how is the big question. Drained by fruitless discussion about whether the recovery will be V, U or L-shaped, some economists have come up with the idea of a K-shaped upturn. What this means is a sectorally unbalanced recovery — that some elements of the economy, represented by the upwards stroke of the K, have been turbo-charged by the Covid crisis — IT, online retail, video conferencing, for example — while other sectors are stuck in the downward stroke. Aviation was clearly meant to be represented by the downward slope.

The more conventional IMF produced its latest forecast in October — see graph. What is particularly apparent in the geographically unbalanced recovery pattern. China is set for a full recovery, its economic influence further enhanced by the signing of the Regional Economic Partnership Agreement, establishing a comprehensive free trade zone in the SE Asian region. Europe and the US (pre-Bidon) and expected to scarcely recover the 2019 GDP levels in 2021, even assuming an accommodation with the virus. The UK’s prospects are marred by the threat of a no-deal Brexit (though from our discussions with interested parties, it is likely that a trade deal will be reached before the end-of-year deadline).

Boeing being courageous

Meanwhile, Boeing has been reconsidering the longer-term aviation demand trends, and has been courageous in producing its annual Current Market Outlook for 2020-39 (Airbus will not publish its global forecast this year). Basically, Boeing has reaffirmed its belief in the fundamental linkage between economic output — which Boeing assumes will be 2.5% pa globally for 2020-39 — and traffic demand. The 2020 CMO forecast assumes that the global RPKs will rebound from the Covid depression, though Boeing has not attempted to specify the timing or the quantum. It expects a resumption of a long-term growth trend: for the period 2019-29 the average annual traffic growth rate is put at 3.7%,pa which is a bit lower than but not radically different from, the previous forecast, made in 2019, of 5.1% pa growth for 2018-2028.

This gets global traffic up to 12.5tr RPKs by 2029 compared to 8.5tr in 2019. For historical perspective, Boeing’s CMO published back in 2000 projected an increase from 3.2tr RPKs in 1999 to 8.1tr RPKs in 2019. That forecast proved to be quite impressively accurate, especially considering September 11, SARS, Global Financial Crisis, etc. intervened in the following 20 years. But, as the graph illustrates, the 2020 air traffic collapse, has been like no other.

The projected aircraft delivery forecast has been shifted down to 43,110 units for 2020-39 from 50,660 in the previous forecast. In the medium term, to 2029, the majority of deliveries, 56%, are for replacement of obsolete aircraft rather than growth. The expected replacement percentage in the previous 20-year forecast was 44%.

Zombie airlines?

The simple question is: how will airlines be able to pay for these new aircraft?

Even a full traffic rebound in itself does not mean an industry recovery. The legacy of 2020 will be a pile of debt that threatens to turn airlines into Zombie companies, viable just at the operating level but using all their free cashflow to pay down debt rather than for capex, building reserves for the next downturn or even returning cash to shareholders through dividends and share buy-backs.

Global airline debt, according to IATA, was $430bn at the end of 2019; in 2020 governments worldwide will have lent over $100bn to airlines (in addition to injecting about $10m in equity and providing wage and other subsidies worth about $60bn). As a rough estimate, commercial banks, capital markets and lessors will have provided another $70bn. This brings the global airline debt pile up to at least $600bn by the end of this year (our estimates based on original IATA numbers).

Near zero base interest rates are not relevant to indebted airlines, especially those that have received state aid loans. The terms of these loans, in both Europe and the US, typically include escalation of the interest rates from 3-4% pa to 7-8% pa, in order to incentivise conversion of the government debt to commercial loans or equity.

Sale and leasebacks and asset-based-loans have been a welcome source of funding through the crisis. But it is becoming clear that the lessors are under increasing pressure from deferrals, defaults, and demands to convert leases to power-by-the-hour agreements. The structured finance operations of many investment banks have been frozen.

Legacy CEOs in Europe and the US have started to make semi-optimistic noises about emerging from the crisis and the basic soundness of their business models. Cynics might observe that their remarks are primarily targetted at governments rather than investors, with the aim of ensuring that support is available if/when needed.

Again according to IATA’s analysis, the global industry’s cashflow will stay negative until the end of 2021 — see chart. But there is a wide variation in the financial positions of airlines.

Liquidity is not now such a pressing issue now for the leading European and US carriers. Through state loans, junk bond issues and emergency rights issues, the Legacies have built up enough liquidity to last one to two years, though at the expense of greatly increased debt — see table. IAG’s €2.7bn equity raise looks like an excellent move especially now that the share price has recovered with news of the vaccine. The two major LCCs are in a similar position, but without having had to increase debt significantly (in fact, a decrease in Southwest’s case).

The real issue is how to rebuild — or in cases like Alitalia, build for the first time — a commercially successful company. To avoid Zombie status, the deeply indebted airlines need to go through a capital restructuring. In other words, they need to attract equity. And in order to attract equity they will have to greatly improve their commercial fundamentals. Financial engineering will not work on its own.

To put the $600bn debt figure to some form of context: in 2019, a goodish, normal year, the world’s top 70 airlines achieved $735bn in revenues and a generated operating profits of $46bn, a margin of 6.2%. With the impact of Covid-19 on balance sheets, a minimum 10% operating margin will be needed. But the chart indicates the extent to which most airlines fail to meet that target — the red bars show the shortfall in operating profit required to achieve a 10% margin. Big names like American, Lufthansa and Air France-KLM fail on this measure; those exceeding the target were Delta, Southwest, Alaska, Ryanair and IAG.

Post Covid models

Rebuilding networks in the post-Covid world is going to be challenging. In the short/medium term no one can be confident about how much demand will recover in the Leisure, VFR and Business segments, nor be sure to what degree the algorithms in yield management systems (YMS) are still valid. YMSs depend on data on booking profiles built up over years in order to manage fares and allocate capacity between different classes or buckets; the old relationships between price and demand may be re-established, or they may not.

The LCC model is more manageable in that route P&Ls do not have to factor in the complexities of connecting traffic and different aircraft types. When a service is restored it has to generate, after a reasonable time period, enough traffic and revenue to return a profit, or it is terminated.

This is something that the LCCs, or at least the ULCCs, can do fairly smoothly because they do not have sunk costs in a particular but do have alternative routes on which the aircraft can quickly be allocated. They do not have to factor in the impact of closing a route of the profitability of connecting routes.

Michael O’Leary, CEO of Ryanair Holdings, as usual cuts through the analytical agonising. Once Covid-19 restrictions are lifted Ryanair will stimulate its markets back to 2019 levels through reducing fares to whatever level is necessary.

Things are a bit more complicated for the European network carriers whose hubs focus on connecting short/medium haul passengers onto intercontinental flights.

Their recovery depends not only on the re-opening of long-haul markets, which is a political decision, but also on the strength of the long-haul traffic demand.

The worrying prospect is that intercontinental, in particular North Atlantic, traffic may be suppressed for some time even if all the Covid barriers are removed. The reason is that long-haul business travel will probably not rebound to anything like pre-Covid levels, partly because of new communication technology, partly because corporate travel budgets will continue to be squeezed, partly because the top echelons will switch to business jets. This means that the old revenue rules — for example, premium class accounts for 10% of the passenger load, 40% of passenger revenue — no longer apply. Business classes will no longer be capable of “cross-subsiding” Economy classes, which implies higher Economy fares and suppressed demand from leisure passengers, already uncertain about resuming long-haul flying.

For the European network carriers, a key strategic issue will be right-sizing feed networks to match the new long-haul networks, culling short-haul capacity to mitigate competition from the LCCs and abandoning non-hub short-haul operations. The European hubs that appear to be most vulnerable in the post-Covid world are those like Amsterdam, and even Frankfurt, which do not have strong Origin and Destination flows and have to funnel larger volumes of connecting, and lower yielding traffic through the systems. London, with very strong and high yielding intercontinental O&D markets, would appear to be the best positioned hub as it has a high proportion of local traffic in its overall passenger mix.

US network carriers, which operate hubs that principally connect domestic routes, could see their traffic surge in a robust recovery. As individual flights are added back into the hub and spoke systems, the number of connecting opportunities between city-pairs increases exponentially. All those thin O&D segments agglomerate through the power of the hub. Then restoring full waves of flights further reinforces the traffic upturn (the classic S-shaped demand curve).

But Covid-19, despite the hope of an effective virus, may now pose more of a threat to the US than to Europe. Up to now President Trump’s response has been, well, laissez-faire; under a Biden Administration, there will be a more proactive policy, with the prospect in 2021 of lock-downs on a European scale.

Sixth freedom global networks have been the hardest hit by the Covid-19 shutdowns, losing up to 90% of their passenger traffic (cargo providing a bit of life support). Emirates’ first-half loss of $3.4bn suggests that its total losses for this year will wipe out its accumulated profits for the past five years. State aid received by SIA so far more than 20% higher than its 2019 revenues. The only solution would appear to be downsizing and reliance on government support until travel restrictions are lifted and international travel resuscitates.

A bit of optimism

Airlines will make a total net loss of $84bn in 2020, IATA estimates. maybe more as everything that can feasibly be written off should be dumped into the 2020 financials. But, because of the vaccine, this could be the nadir, and there are opportunities at this point in the cycle. IAG has recapitalised through the equity markets. Air France; if it is allowed to fully implement it, has an effective turnaround strategy; Delta and United remain powerful; the Chinese network carriers are growing, being boosted by China’s increasing economic and political power in Asia; LCCs like Ryanair, Wizz, Southwest, JetBlue and Spirit will rebound as markets reopen; investors are willing to take punts — Bain Capital with a reinvented Virgin Australia, individuals with Breeze, David Neeleman’s new A220 venture scheduled for next year; new start-up business plans, of varying plausibility, are appearing.