ANALYSIS: Financial problems at airlines cannot be solved until they are identified

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This story is sourced from Airline Business
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The phrase "better late than never" is used in many instances and is relevant for airlines as they tackle structural problems and take action in today's market environment. It is clear that you cannot solve a problem until you are prepared to recognise it and appreciate the full extent of the issue.

Contrary to the view in economics textbooks that market adjustment is instant and costless, in the real world it takes some time between the initial recognition of the problem and the full appreciation of the actual challenge. This has to come even before deciding what might need to be done, bearing in mind that there are costs associated with both inaction and action. There is also the issue of reaching the wrong conclusion and encouraging or taking action that at best fails to solve the problem, or indeed makes it worse.

This applies, whether in the case of politicians dealing with economic and financial problems or the recent European meeting of the International Society of Transport Aircraft Trading. This focused on the need for shorter economic lives for aircraft, in light of the fact that the aircraft finance liquidity bubble has burst.

Another example is the realisation in Europe of the depth of the structural problems faced by a number of major airlines including Air France, Iberia and Lufthansa. The airlines' woes have been exacerbated by what we describe as the "new norm" in terms of the economic outlook, where the ability to "ride the cycle" to improve results has been reduced, resulting in companies having to draw up a raft of new cost cutting programmes.

Although we have considered the economic and financing issues on a regular basis in these columns and have touched on the issues facing some of the airlines, it is worth focusing on these again. This is especially so against the backdrop of the European Commission's latest push for a relaxation in foreign ownership rules for US airlines - something that was supposed to have been achieved when European skies were opened to US airlines.

One of the arguments put forward by the Commission appears to be that consolidation between EU and US airlines could result in better-capitalised groups that could afford the next generation of fuel-efficient aircraft.

Consolidation in a mature or maturing market is about getting more (revenue) for less (cost) and this inevitably requires not only decisions but also actions to materially reduce cost, and duplication in particular. However, some costs are necessary to achieve the desired outcomes.

This means that in the absence of the required "internal medicine", consolidation will result in larger businesses but not necessarily more efficient ones that will report better results or more attractive financial ratios - the keys to "better capitalised airlines".

At the end of the day, it is the actual and expected performance that will drive share prices and, by definition, market capitalisation. As such, companies do not need consolidation as a catalyst to apply the best practices and have the lowest structural costs.

The reality, as Air France-KLM and IAG management will attest, is that consolidation might result in a bigger company to manage, but it does not mean that the resulting business is better capitalised. Nor does it mean it will be more profitable. As we see in both cases, major changes are needed. Air France has announced its programme for "structural change" through Air France-KLM's "Transform 2015" programme, under which there are some planned 5,100 (non-compulsory) redundancies.

Meanwhile at Iberia a restructuring programme, rumoured to involve some 6,000 lay-offs, is expected to be detailed at the IAG Investor Day in November.

While these appear to be dramatic moves, the key question is whether the outcome will only restore these businesses to profit or get them "ahead of the game". However, given the time taken to implement the changes, the former outcome is more likely than the latter.

Developing a structural cost-reduction programme is one thing; implementing it is another. In the case of IAG, its latest results statement raised the prospect of the need to impair the carrying value of Iberia.

This relates to the value held in the accounts for the intangible assets at 31 December 2011, in particular, Iberia's brand (€306 million, $397 million), loyalty programme (€253 million) and the goodwill arising from the transaction (€249 million) - while there would not be a cash effect, there would be an impact on the balance sheet.

As a result, the outlook for the Spanish economy and the success of the cost-cutting programme assume even greater importance if IAG is to avoid impairing the carrying value of Iberia and focus attention on the terms of the transaction.

Recognising the problem is an important stage in beginning to solve it, but even more so is selecting the right solution. Managing an airline has never been easy, but in some cases it may be about to become even more difficult.