ANALYSIS: How structural change holds the key to financial success

This story is sourced from Airline Business
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CTAIRA analyst Chris Tarry says that in the current climate airlines should look to make structural changes to drive financial improvement

Over the next few weeks we will have the results season for those airlines with a December year-end. Results, however, tell us only what has happened rather than what is about to happen and in this respect we will be watching the outlook statements and listening to what is best described as the "mood music" very closely.

The start of 2013 has seen some strong performances in most key stock markets and while these are generally considered to be forward looking, much momentum has come from a switch away from bonds and investors being prepared to take more risks as the economic outlook for most economies in 2013 will be less favourable than in 2012 - although in the eurozone there are a number of examples where 2013 may indeed be "less worse" and in at least one case (Ireland) better.

Against this background it will be of particular interest to look at the revenue performance of not just the airlines that are reporting, but all companies. This is because revenue provides the best indication of the impact of the economy on the performance of a company or an industry.

Within a region at a company level (where the companies compete) it will also show the impact of competition and changes in market share. Indeed, the greater the degree of maturity and absence of structural growth opportunities, the closer the relationship between changes in GDP and a company or industry's revenue.

Controllable costs

In the past it has often been the case that, other than in the event of dramatic movements in the price of fuel, it is changes in revenue that have the greatest impact on airline performance through a type of "revenue pull" or the reverse, rather than what might be described as "cost push". However, in what are now changed circumstances it is also important to consider the impact of what is best described as structural cost improvements and here the focus is inevitably on what is happening to controllable costs.

If we examine the relationship between "nominal" or "money value" GDP, expressed in terms of US dollars, and airline revenue we can see an increase in the share from 0.45% at the end of the 1960s to reach 0.8% at the start of the 1980s. Since then the share of revenue has been within a range of 0.8% and 1.02% (in 2000). Between 2000 and 2003 this percentage declined to 0.86% and since then has tended to follow the economy in that as the economy weakens airline revenue as a share of GDP tends to contract and vice versa.

In this context the next peak was 0.94% (2006) and the recent low point was in 2009 at 0.82%. In 2010, which was the recent profit peak for the industry, there was a recovery to 0.87% before falling back in 2011 to 0.85%; taking the IMF's forecasts for GDP and IATA's for airline revenue for 2012 and 2013, this suggests a share of 0.89% in both years.

Looking at GDP and airline revenue growth rates from 2010, actual and forecast increases are: 2010 - 9.1% (GDP) and 14.9% (airline revenue); 2011 - 10.7% and 9.2%; 2012 - 1.9% and 6.6%; and 2013 - 4.0% and 3.4%.

Operating profit was $17 billion in 2011 and is forecast to be $13.6 billion and $17 billion respectively in 2012 and 2013, which, if anything, highlights the impact of the cost changes on the profit performance.

Production models

Although the share of airline revenue expressed as a percentage of GDP has recovered from the 2009 low, a return to previous peak levels in the near or medium term looks unlikely. This adds further weight to the view that structural change, in terms of cost or competitive position, for the most part will hold the key to improvement. It is not, however, a zero sum game and those who take the opportunity will clearly strengthen their position.

For the legacy carriers the need is to grow revenue and reduce cost and here just as we have seen a change in the operating environment, the usual approach to cost cutting is now not enough and attention should focus on seeking to even more closely replicate the production models of the low-cost carriers, which means transformational change.

Conversely, for low-cost carriers competing against legacy airlines the need is to take a greater share of higher value traffic. This means that in some areas they will try to replicate aspects of the legacy carriers as markets converge, but with a need to keep costs controlled.

There is one additional aspect coming into play that may add particular interest during 2013. Recently, there has been a lot of discussion about the likely trend of the oil price, with some commentators suggesting that it could fall to $90 a barrel by the middle of the year, if not slightly below. The issue, however, is whether this would only be a short-lived benefit or whether it reflects a resetting of the oil price.

In either case, the need for continuing structural change remains not just for the current year but beyond - as ever the only constant in the airline industry is change and the more controlled it is, the better.