The airline industry is inherently unstable and airlines only have themselves to blame, writes Rigas Doganis
The airline industry lost $28 billion in the past two years and is expected to lose another $5-6 billion in 2010. Yet IATA director general Giovanni Bisignani and airline chief executives rarely accept any responsibility for their industry's failings. They are quick to blame external factors - high fuel prices, rising airport charges, health pandemics, terrorist attacks or financial crises. But there may be a more fundamental structural problem afflicting the industry.
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Air transport appears to deviate from one of the basic tenets of economics, namely that after periods of instability - when weak and/or loss-making companies leave the market - markets tend towards equilibrium. Equilibrium is when the supply of a particular item or service matches demand at prices at which suppliers can make an adequate profit or return on their investment.
The problem is that, rather than being in a state of stable or even unstable equilibrium, it appears to be in chronic disequilibrium. The industry seems to be in a permanent state of over-supply - in other words, of over-capacity. This is true even though in the short term, as in 2009, airlines may cut capacity by grounding aircraft, reducing frequencies or switching some flights to smaller aircraft.
Longer-term capacity growth means constant downward pressure on fares. Passenger load factors have risen, but high load factors belie the reality. They are only achieved by reducing fares. They do not ensure profitability.
While some better-managed airlines generate profits most years, many airlines are profitable only spasmodically. In the words of United Airlines chief executive Glenn Tilton, the industry has "systematically failed to earn its cost of capital".
The industry's chronic disequilibrium is primarily due to the interplay of two forces. The first is a strong, inherent and seemingly unstoppable tendency to provide too much capacity. The second is that ailing and bankrupt airlines, especially larger ones, take a long time to die. In fact, some airlines such as Alitalia, no matter how ill they get, never seem to die.
The strong tendency to over-order new capacity is driven by several factors. First, and perhaps most important, is the ease with which airlines can acquire new aircraft.
If airlines need debt finance to purchase aircraft directly, they can offer the aircraft as security to their lenders. Such asset-based financing is attractive to banks and other financial institutions because aircraft are moveable assets that can, in most cases, be readily repossessed and placed elsewhere. Repossession has been made easier by the recently agreed Cape Town Convention. Airlines suffering chronic losses are still able to acquire new aircraft.
Aircraft financiers may have further security in that loans may be guaranteed by one of the government-run export credit agencies such as the Ex-Im Bank in the USA or COFACE in France. These further reduce the risks to lenders. In 2009 such agencies provided guarantees for loans totalling $21 billion, which amounted to nearly one-third of the aircraft finance required that year.
CAPACITY GLUT
As an alternative to buying aircraft, airlines have the option of acquiring capacity on operating or finance leases from one of the many aircraft leasing companies, such as GECAS or ILFC. The lessors make it easy, even for airlines with weak balance sheets or new-entrant start-ups with only projected balance sheets, to acquire additional capacity.
To further facilitate debt finance or leasing agreements, many governments have been prepared to guarantee the loans raised or the lease payments themselves when the airlines concerned are partially or fully government-owned. Although no longer permitted within the European Union, this happens elsewhere.
The second driver of over-capacity is the manufacturers themselves. They claim their new aircraft have significant technological improvements - perhaps lower fuel consumption, longer range or higher payload - which will enhance their operational and financial performance. Executives can feel that buying such equipment will ensure profits. Too frequently it merely enhances their indebtedness and pushes up interest or lease payments.
The pressure from manufacturers to buy new aircraft is reinforced by their willingness, in many cases, to buy back some of the existing aircraft that an airline owns, even if they are built by a different manufacturer. In cases where airlines may have difficulty raising finance, the manufacturers may help. In 2009 the four jet manufacturers between them provided $2.5 billion in finance for new aircraft.
The third driver creating over-capacity in some markets is government policies. Many airlines are pressurised by their governments to expand services and widen networks in support of national policies to develop incoming tourism or local business. Such airlines tend to order or operate many more aircraft than required in the markets they are serving.
The most recent and vivid example of this is that of the Gulf airlines, Etihad Airways of Abu Dhabi and Qatar Airways, which have been tasked by their governments to match the worldwide network and success of their neighbouring carrier, Emirates. For these carriers profitability is seen as a long-term objective, not a short-term requirement.
The tendency towards over-capacity is reinforced by airline executives' obsession at maintaining or enhancing market share on key routes at almost any price. Adding more capacity is one way of doing this. Too often this leads to falling yields and increasing losses. In too many short-haul markets in Europe, the USA and elsewhere, the obsession of legacy carriers with market share has pushed them into costly head-on battles with low-cost airlines that they rarely win.
SURVIVAL OF THE WEAKEST
Economic theory suggests that, in any industry, firms making losses and unable to cover their cost of capital will collapse and leave the market to those who can operate successfully. In the case of airlines this process has been distorted by the direct and indirect involvement of governments in aviation.
Direct involvement has been through majority or minority shareholdings in major national airlines. Indirect involvement has arisen because most governments see their airlines, even if fully or partially privatised, as national assets generating employment and tourism and providing key communication links. As a result, their survival has to be ensured and governments will do all they can to bring this about.
In the mid-1990s European governments provided around $11 billion in so-called "state aid" to their government-owned airlines. Around the world, many airlines in financial straits, whether government-owned or private, have not been allowed to collapse by their governments. Currently the Japanese government is in the process of saving JAL, which has had long-term difficulties.
POLITICAL WEIGHT
As an alternative to saving collapsing or insolvent airlines, governments will often use heavy political pressure to induce local companies or investors to take over ailing airlines or resurrect carriers that have collapsed. Belgian, Italian and Swiss governments have all done this in the past decade.
The USA, Canada and other countries have bankruptcy laws that allow companies on the verge of collapse to seek protection from creditors while they try to restructure their operations and finances. While not specifically aimed at airlines, such laws, particularly in North America, have enabled carriers such as Air Canada, Delta, United and US Airways to survive. In the 2000s, some of the world's largest airlines managed to keep flying by using Chapter 11 of the US Bankruptcy Code when economic theory would have expected them to leave the market. They did not die. Nor was the aircraft capacity sloshing around the markets reduced.
The manufacturers' long lead times for deliveries create pressure on executives to get their orders in early and to over-order in case future demand is even better than anticipated. They tend to forget that the airline industry, like the world economy, tends to be cyclical. Repeatedly over the past 40 years, aircraft ordered during the boom years are scheduled for delivery during the following downturn when they are least needed.
Nearly 1,000 commercial jets were delivered in 2009 at the bottom of the cycle, although some replaced retired aircraft. Another 900 or so are due for delivery in 2010, while the current order backlog for all jet aircraft manufacturers is close to 7,000 aircraft.
While the industry might return to profit in 2011, profit margins in this and subsequent years are likely to be low and will be insufficient to cover airlines' cost of capital.
Inadequate profitability will continue to be inherent in the airline industry because of the ease with which airlines can, and do, continue to add additional capacity and because too many loss-making airlines are not allowed to exit the market.
Instead of blaming others for their problems, airline executives must find ways of reducing the inexorable growth in capacity. If not, they will continue flying off course.
Professor Doganis advises governments and airlines on air transport policy. He was chairman of Olympic Airways in the mid-1990s and formerly worked at Cranfield University. This article is based on the concluding chapter of Rigas Doganis' new book Flying Off Course: Airline Economics and Marketing, which was published in January 2010 by www.routledge.com
Source: Airline Business
