Insight: Traffic flows

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For the aviation industry, the term “business as usual” has not seen much use over the past few years. But, after an unexpectedly strong year in 2005 for traffic growth and only a modest slowdown forecast for this year, the coming 12 months could be as close to a steady-state business as the industry has witnessed since the late 1990s. The most gloomy outlook remains in North America, but even there some bright spots are emerging.

traffic flowsIATA is forecasting international and domestic traffic to grow at 4.5% globally this year, says its chief economist Brian Pearce, compared with an expected 7.1% climb in 2005 when the final figures are announced. ICAO’s forecast is rather more optimistic, with traffic predicted to rise by 6.5% this year (see table). “World economies are slowing and the effect of fuel surcharges will affect volumes with a push back from customers,” says Pearce. As economies pick up again in 2007, IATA sees rates recovering to the 7% level.

Booming traffic helped revenues to grow by almost 10% last year as the industry reached the peak of the cycle. As the downward leg begins, revenues will slide back to grow at around 4% this year, says Pearce. Despite such strength, driven in equal measure by improving yields and fuel surcharges, sky-high oil prices have robbed airlines of the financial benefits of this upcycle, he explains. “These peak revenues did not translate to the bottom line.”

IATA’s forecast for the industry’s financial performance over the year has see-sawed with fluctuating oil prices, but it has tracked its expectation back from a total net loss of $7.4 billion to one of $6 billion for 2005. Although this is encouraging, “let’s not forget that takes total losses for the past five years up to $42 billion”, says Pearce. In nominal terms these losses have now entirely wiped out the profits made by the industry since ICAO started to publish the numbers in 1968.

These losses will continue in 2006, with IATA forecasting a net loss of $4.2 billion, following which the industry is expected to move into profit of more than $6 billion in 2007. While encouraging, this is an operating margin of just 3%, however, which is a long way below the cost of capital, notes Pearce.

The main reason for an improvement in the 2005 loss picture is an easing of oil prices. They are expected to ease again slightly in the next two years, but not by much. The average oil price per barrel was $54.5 in 2005, moving to $53 per barrel this year and $50 in 2007, according to IATA.

The industry’s global losses mask a stark divergence in regional performance. US carriers, which IATA forecasts will lose $10 billion in 2005, create a profound drag on the industry-wide figure. European carriers are likely to show a profit of $1.3 billion and Asia-Pacific carriers $1.5 billion last year, says IATA. Part of the reason is fuel hedging, which is almost non-existent among US carriers and much higher elsewhere.

Asia-Pacific profits

IATA forecasts that Asia-Pacific airlines will boost profitability to around $2 billion in 2006, but analysts are still expecting a more challenging year for Asia-Pacific airlines. Overcapacity is already hitting the region’s cargo market, Middle Eastern carriers are becoming more aggressive in Asia Pacific, currency swings are hitting some airlines particularly hard and slower-than-expected liberalisation developments are threatening to hold back growth.

“We do have a couple of major growth markets – the outbound market from China and the Indian domestic market – but I am cautious on the sector this year,” says Hong Kong-based JP Morgan regional airline analyst Peter Negline. “I think this will be a fairly ordinary year in this part of the world. I see pockets of optimism, but I see quite a few problems in general.”

Andrew Herdman, director general of the Association of Asia Pacific Airlines, warns that any global economic slowdown, which feeds quickly into cargo growth, will cause problems. “Cargo is a key revenue contributor for most Asian airlines, generating around 20% of total revenues, boosted recently by strong exports to the USA and Europe, as well as growing intra-regional trade,” says Herdman.

The Sydney-based Centre for Asia Pacific Aviation (CAPA) consultancy group is also warning of possible turbulence for some Asia-Pacific carriers in 2006, creating “uncertainty under an otherwise positive outlook”.

CAPA executive chairman Peter Harbison says 2006 “in many ways will be the quiet before the storm – a period when airlines need to consolidate and put in place the necessary foundations for a massive upgrading of fleets and route systems. If, for whatever reason, their efforts are thwarted, it places in jeopardy strategic development plans which are essential to their medium-term futures and, in some cases, to survival. There will be a delicate balance between traffic growth and meeting capital needs.”

Although US investors began their year with glee at the prospects of an airline rebound, as in Asia, some observers are urging caution. The upside is that demand is booming and yields are rising, and this has rallied shares in many airline stocks. After all, notes Soleil Securities Corp analyst Susan Donofrio, unit revenues have risen for several months in a row. JP Morgan analyst Jamie Baker thinks that yields system-wide for US carriers will continue to rise for several more months.

But John Heimlich, the chief economist of the Air Transport Association (ATA), says: “Whenever I hear someone say: ‘Demand is back,’ I ask: ‘Back to what?’ Passenger revenue is about $25 billion per year below where it ought to be based on the historical relationship between spending on air travel and the nation’s economy.” Compare domestic yields with Atlantic or Pacific regional yields on US majors and his point becomes clear: US-Europe yields rose over 7% for the year to November, and US-Asia yields were up by more than 5%, compared with the anaemic domestic performance of 1.3% over the same period.

Nevertheless, none will deny that things are better. Most analysts credit the dramatic steps that carriers have taken to reduce the impact of fuel costs, from schedule cutbacks to retirements of older aircraft and operational improvements. Heimlich makes a hopeful assumption: “Assuming lower fuel prices and higher domestic ticket prices as a function of tighter capacity, the industry should be able to pare its ‘breakeven’ load factor in 2006.”

IATA joins in the consensus that US carriers will reduce their net losses this year. However, the net figures “disguise an improvement in operating performance over the last few years”, says Pearce. He expects US carriers to be close to breaking even at the operating level this year with a return to net profits in 2007. Calyon Securities (USA) analyst Ray Neidl says that despite strong demand, moderating fuel prices and the prospect of capacity cutbacks, he sees the industry making net losses of $1.5 billion for this year and about $4.7 billion for last year. The ATA’s Heimlich sees 2006 collective net losses in the $2 billion neighbourhood.

US carriers turn the corner

Most of that cumulative loss will stem from the three large bankrupts – United plus Delta and Northwest Airlines. United, however, insists it will be making money by 2007, and most observers think that American and Continental stand a strong chance of profitability this year. JP Morgan’s Baker says that they and the new US Airways will make money, probably more than most anticipate. “The industry has finally turned the cyclical corner,” says Baker.

air traffic forecast icao 2005-07

The outlook for a rebound has spurred speculation about industry consolidation, especially since the America West takeover of US Airways (and of the US Airways name) has so far shown some positive results. One Continental executive even went so far as to say that Continental meshed with United would be a powerhouse.

Some have speculated about a possible Delta/Northwest merger. In fact, US transportation secretary Norm Mineta told a recent business meeting in Shanghai that he was “thinking out loud” that Delta and Northwest might combine. Heimlich has said he would not be at all surprised by moves toward consolidation this year, although most observers think a Delta/Northwest deal would be difficult.

Mergers, if any, are not likely to reach the stage of serious horse-­trading or detailed negotiating this year, say most. The year will be one of hesitancy as managers see if the incipient recovery becomes a fully fledged revival.

But Heimlich does say that industry fundamentals finally have improved, and, if fuel prices moderate, “we could be seeing record profitability rather than multi-billion losses. While we are far from being out of the woods, we are poised to turn the corner.” ■