Aviation Report 2018 | Airlines | KPMG | IE

Airlines

Airlines

The airline industry is experiencing an extended period of growth and profitability. Top airline executives share their views of the current market and future strategies.

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Airlines are enjoying a period of record profits, with 2017 setting the fourth highest year of profits on record, according to IATA. However intense competition and a rising cost environment is squeezing margins: “The decline in airline margins and ROIC in 2018 is being driven by a rise in breakeven load factors, as unit costs are now rising, offset partly by a rise in achieved load factors, as capacity slows more than demand growth,” says IATA’s latest semi-annual economic forecast published in December 2017.

Most analysts predict jet fuel bills to rise by double digits as a percentage of total costs as oil prices continue to rise slowly impacted by OPEC cutbacks. IATA estimates airlines fuel bill to rise to $156bn, which will represent 19.6% of average operating costs. Despite rising costs, as mentioned above and shown in the chart, IATA has increased its estimates for 2018 industry net profit to $38.4 billion due to strong demand, increased efficiency and reduced interest payments. Passenger numbers are expected to increase to 4.3 billion in 2018 with passenger traffic, measured in RPKs expected to rise 6.0% and the average load factor pushing up to a record 81.4%.

Cost, Competition and Consolidation

Rising costs and intense competition are the two most common challenges highlighted by airline executives. Airport slot restrictions or the lack thereof is another.

“In October 2016, the FAA removed the slot restrictions at Newark, so unlike LaGuardia and JFK, Newark is no longer slot-restricted, which is a problem for us because during peak times, flights have increased,” says Laderman. “Newark was hit constantly with FAA-imposed delay programs [in Summer 2017]. In some airports, there are limits to growth, and some airports, less so. We work closely with the airport authorities in every hub to maintain a good relationship.”

New entrants are an issue for many of the established players. In 2017, the long-haul, low-cost travel model dominated by Asian carriers – AirAsia X is one good example – was brought to the western world with Norwegian flying to the US for the first time in June, which added pressure on the established transatlantic airlines in the US and Europe.

“AirAsia X picked up where Freddie Laker left off many years ago and now Norwegian is offering long-haul, low-cost services,” says Mark Lapidus, CEO of Amedeo. Lapidus is considering, in addition to being a lessor, obtaining an AOC to use some of its potentially returning A380s in mid-2020s in an airline-for-airlines model providing scheduled lift to more than a single airline on a flight thus alleviating the too big-to-fill issue for the A380s. “There is acknowledgment from most people in the industry that long-haul, low cost is here to stay. It will work. Low-cost, long-haul is an amazing proposition and it is consumerising the business and stimulating significantly more demand.”

For Ethiopian Airlines, the main challenge is from new entrants into the African market, specifically from the Middle East and Asia.

There has been a lot of penetration from the Middle Eastern carriers: Turkish, Emirates, Etihad, Qatar – less from European carriers but I see that in the future. More Chinese carriers coming to Africa… will be a game changer on the continent because their cost-base … is almost unbeaten. Thus far, the Chinese carriers are very busy in the domestic market, but now we see significant pressure from the government to see the Chinese carriers going out. For the time being they’re busy in Europe and America, but eventually they’ll come to Africa and that will be a game changer.”

Airlines continue to juggle their business models to transition from mainline, full service carriers, to low-cost and ultra-low-cost carriers, while some full service carriers are expanding their product offerings to offer a more hybrid model to cater for the ULCC customer and premium carriers. Ancillary revenues are more essential than ever to continued profitability. Traditionally, full service carriers have had varying success experimenting with changing models.

Changing business models are going to begin to create some areas of stress where carriers may need to reinvent their business models, warns ORIX Aviation’s David Power. Some examples he gives refer to the number of twin aisle aircraft flying out of China directly to Europe and the US, which means the hub carriers on the East of Asia will need to rethink their strategies because they are being overflown. Further out, he adds, with the arrival of long haul aircraft that can fly directly from Australia to Europe, airlines with hub strategies flying out of those airports sitting between Australia and Europe, will also need to revise their current strategies.

European airlines are grappling with the potential impact of Brexit, with most preparing for a doomsday scenario when UK-owned airlines would automatically lose existing flying rights to Europe, and vice versa for European airlines flying to the UK. Low-cost airlines – namely easyJet and Ryanair – have both set up parallel companies in Europe and the UK, respectively, to ensure they can continue operations from new hubs should the worst happen. The industry is lobbying hard for a more practical approach to transitioning flying rights post-Brexit but for now airlines are preparing for the worst. Other global airlines regard Brexit as a problem solely for the UK and Europe airlines, which may even present some areas of opportunity for airlines from outside those regions.

Most respondents see consolidation in the airline industry continuing but with more emphasis in Europe and South East Asia, with little happening in the Americas.

“Little consolidation is likely in North or South America, simply because so much has happened already,” says one observer.

Many consider the airline bankruptcies in Europe as a positive development, and expect the slow consolidation of airlines in the region to continue, potentially with more insolvencies among financially weak airlines that will lead to more mergers or consolidation.

Preparing for a Downcycle

Although airlines are enjoying the fruits of an extended period of growth in passenger demand due to the prolonged low-interest rate environment helping economies return to growth, like lessors, most airline respondents recognise that a correction should occur at some point and are making appropriate contingency plans.

“No upcycle can last forever,” says Laderman. “We don’t have any more of a crystal ball than anybody else, so we want to make sure we remain flexible. Should areas of weakness emerge, such as generally a deceleration or shrinking of the economy, we have the ability to adjust capacity as necessary.”

Generally, fuel prices rise with economic growth but over the past years, oil prices fell while passenger demand continued to rise giving airlines the ability to invest in growing capacity and networks, adding destinations and planes. The steep rise in competing routes and additional capacity pushed down ticket prices. Now oil is rising, competition remains and fares remain depressed, particularly in the South East Asian market. This situation, says one airline executive in the region, is why the next financial or economic crisis will impact the market hard: “When the downturn comes, airlines will batten down the hatches and return to their core markets. We are still every month yields were lower, and the fuel price every month was higher. For now, fuel prices and yields seem to have stabilised.”

Airlines constantly monitor jet fuel prices and are acutely aware of the upward trajectory of the oil price, but this is not a sign of weakness, rather of economic strength. “If fuel prices are going up because of strong demand for oil products, that means the economy is healthy, which is good for airlines, and ultimately, prices get adjusted for higher fuel. But if spikes are caused by geo-political activity that also causes travel to come down, you need to move quickly to adjust capacity,” says Laderman.

Falling demand and load factors remain a key judge of airline health, which is why there has been so much concern about the Middle East region, and many airlines are predicting a correction.

“In certain regions – notably the Middle East – we do see a correction coming, generally in the form of a slowdown and then, (in a few years once new aircraft technology kicks in), by means of a structural shift in long-haul operations, particularly on the kangaroo routes,” says one airline chief financial officer.

But where there are areas of weakness, there are also opportunities. Shamini Law, CEO and principal shareholder of flyGlobal Charter, a Malaysia-based international ACMI/wet lease operator, sees great opportunities in the Middle East, specifically providing additional lift for the growing numbers around the world wanting to complete the Umrah and the Hajj religious pilgrimages.

“The Middle East is the base for the Muslim population, and come any kind of downturn, people can still only go to one location to complete their religious pilgrimage, ” she says. “This on its own is huge traffic, but South Asia too has a growing population of Muslim people – and its religious travel market is huge. So, while everybody else is competing on the normal long-haul, premium business class, first class segment the real growth area for passengers is religious travel.”

Ethiopian Airlines has a strong presence in many market segments, including pilgrimages, which GebreMariam describes as a natural hedge in terms of the airline’s global exposure both geographically and by product. “We are not concentrated in only a few market segments,” he says. “We are in business travel, leisure and religious pilgrimages. We are one of the participants in Hajj and Umrah religious traffic, which gives us diversity.”

Financing Trends

Interest rates have been rising lately, which is being monitored closely as a trigger for a possible downturn as it could impact sources of funding as well as depress global travel demand. Airlines, such as United, are prepared for further interest rate rises.

“That’s one of the great benefits of pre-funded EETCs,” says Laderman. We closed our most recent couple of EETCs in the fall of 2016 when we hit an all-time low with coupons below 3%. That covered us through the first half of 2017, which constituted the majority of our 2017 deliveries.”

As discussed above, rising interest rates are not yet impacting funding but it is becoming more of a concern than it was in the past as more airlines seek to access financing using the capital markets. For now, however, the bank markets are very healthy and very open for aviation finance. In a bid to diversify away from EETCs, in 2017 United sought financing for all 24 of its E175 deliveries and Laderman was pleasantly surprised to be able to fund all 30 aircraft. “That shows the strength of the bank market,” he says, “We worked with some new banks that we have never worked with before from Asia. I expect that we will continue to use EETCs for most of our new aircraft financing needs, which has been our least expensive source of capital, but we will continue to mix that with bank debt.”

United and other US carriers tend to buy their aircraft and operate them for their full useful life and so do not lease many aircraft. Many other airlines tend to rely on the sale-leaseback market to fund their new deliveries, which is so competitive at the moment that most airlines are reporting attractive deals that traditional bank debt or capital markets deals simply cannot beat.

Capital market financing

The prevailing notion for airline executives is that the capital market deals are the purview of US carriers, with few deals being closed in the capital markets for non-US airlines over the past few years.

“The fact of the matter is that although people bang on about this at aviation conferences, capital market financing is really a US thing,” says one treasurer of an Asian airline. “The number of deals closed outside of the US can be counted on one hand. We need to see a lot more deals in Europe before we can see any more in Asia.”

Although a few non-US EETCs were closed successfully – Emirates and Doric, British Airways and Virgin Australia – few airlines followed suit. A variety of reasons have been given – few non-US airlines have enough aircraft delivering to justify going to the capital markets, the prohibitive cost, reluctance to seek a corporate credit rating – but one of the most resonating reasons is simply the attractive prices of the ultra-competitive leasing market.

The dilemmas faced by the export credit agencies in the US and Europe has impacted airline financing, specifically for Ethiopian Airlines, which has relied on ECA support for some time.

“The ECAs will continue to play a dominant role,” says GebreMariam. “Eximbank has been facing challenges from the new administration and the previous administration, we see that in the end this is going to be resolved so the ECAs will continue to be an important facilitator in the financing of the airplanes. But the diversification of financing and the expansion of the leasing industry is a welcome phenomenon for airlines.”

Useful Economic Life

Airlines and their customers are becoming accustomed to purchasing new aircraft, even airlines located in jurisdictions that would traditionally be homes for older aircraft – Africa for example. That traditional dynamic has changed significantly in the past decade or more, driven by cheaper aircraft purchase prices, lower funding costs, age restrictions on importing aircraft, as well as the strong leasing market.

“Empirical evidence suggests that more and more airlines (and therefore lessors) are phasing older aircraft out earlier, 20 years may be closer to the average useful life of an aircraft, says one airline CFO. “There also seems to be a greater acceptance to park under-performing new models.”

“Airlines need to hedge fuel price as well as fuel consumption,” says Ethiopian’s GebreMariam. “A new fleet has high cost of ownership but a low cost of operation, while for an aged fleet, the cost of ownership is relatively low, but the cost of operation goes up. Maintaining the right balance is essential but the consumer preference is always for new airplanes.”

He adds that the useful life of aircraft depends on the type of maintenance the aircraft has had, highlighting the fact that advancement of aircraft maintenance technology is helping to expand their useful life beyond the traditional 25 years.

Retaining vs leasing aircraft

Others are not so convinced. One veteran airline executive comments that most airlines tend to depreciate aircraft over 20 years to 10%. “In the early years that means you’re usually under water on that book value but it sorts itself out in the end, if you actually keep the planes for 20 years, but if not, you have a bit of an issue. The days of running planes for 20 years are numbered. The US had the oldest fleet in the world, but now that they are all profitable again they are re-fleeting with new equipment.”

Although United has traditionally bought new and retained aircraft, which means leasing aircraft doesn’t make economic sense, the airline has leased older aircraft, which have the benefit of more relaxed return conditions. Both GebreMariam and Laderman pinpointed return conditions for the reasons they prefer to own aircraft rather than lease aircraft.

“All the new aircraft that we are taking, we expect to keep 25 to 30 years, and leasing just doesn’t make sense,” says Laderman. “Even so, we look at it every year. On the used aircraft side, we are in the middle of a programme to take midlife A319s on a mutually attractive lease that worked out fine. One of the problems of leasing is return conditions. Because we are keeping these aircraft their remaining useful life, the return conditions are much easier to manage when it’s likely the next use of that aircraft will be for parts.”

Technology Impact

The advance of technology and the ubiquity of the internet and social media around the world has changed the business environment for airlines, more so than for leasing companies and banks in the aviation community. Mark Lapidus referred to the consumerisation of airlines, which touches on the changing consumer environment as service expectations are heightened, while complaints are easily going viral and impacting airline reputations and ultimately their bottom lines. As a result airlines are exploring how advances in technology can assist from a customer relationship/sales point of view but also help improve operational efficiencies and reduce costs.

Despite significant changes, Laderman says that United is only at the very beginning of being able to exploit technology throughout its business. “All of our frontline employees have handheld devices, but we are working on enhancing that functionality to solve problems more quickly and efficiently.”

In one example, he cites how flight attendants will be able to report a maintenance issue in the cabin in flight and have a technical team ready and waiting to address the issue on landing.

Lapidus expects the industry to be disrupted by new entrants into the space that are capitalising on new technology and big data, much like Airbnb has disrupted the holiday market. “Airlines need to be prepared to become consumer not transportation companies,” he says, warning that if they don’t, companies like Airbnb or Google, will figure out how to connect their consumer knowledge with the physical delivery.”

GebreMariam states that the world is undergoing a fourth industrial revolution and he recognises the need for airlines to evolve and take better advantage of new technologies. “Airlines have to prepare,” he says. “There is more and more customisation occurring in the airline industry, more personalised services – assengers want to be connected with the airline through their mobile phone at the airport, in the air, which means airlines have to invest heavily in big data.”

The Future of the Aviation Industry

The new lease accounting standard – IFRS 16 – has the potential to change the way airlines fund their aircraft since it brings all leased assets onto their balance sheets. But, despite the column inches and white papers dedicated to the potential fallout of the new rules, airline executives believe that the impact will be slight. “Practically, it will have very little impact,” says one airline CFO. “Most airlines and investors already take leased assets into account when analysing credits.”

Another airline treasurer says: “Everyone has already figured this out a long time ago; I think it’s a good thing, it will be very helpful.”

A major worry for many airlines located in South East Asia particularly are concerned more about the health and provision of suitable infrastructure. Even in Europe, IATA maintains that the inefficient airspace management will cost the industry over €3 billion next year, as well as generating unnecessary CO2 emissions. The US too is plagued by delays caused by its ageing infrastructure, with many power and technology outages being highlighted in the media in recent years.

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