Market outlook: playing the cash generation game

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The bounce back in performance in 2010 to what was in money, although not in margins terms, a record year, is now history. The key question for some time has been how much lower profits will be in 2011 compared with 2010 and what shape the year-end balance sheets will be in. A recent investor presentation by Air Berlin (Abu Dhabi April 2011) summed up rather well the outlook for the year, and probably beyond, using the headline "challenge continues".

Whether we suggest that what we are now seeing and experiencing leaves us with a sense of déjà vu, or conclude that it is all rather depressingly familiar, the almost inevitable outcome is that attention has again focused on the fact that cash is king and that cash generation is once more coming under pressure.

The rise in the fuel price over the past 12 months has been well documented and is some 50% higher than a year ago. Against this background the latest IATA estimate for 2011 suggests the pre-hedged fuel bill will be about $52 billion higher than in 2010; after hedging, the net increase is expected to be closer to $27 billion. Clearly this is a snapshot of the outcome based on current assumptions as the actual path of the fuel price remains one of the great unknowns.

FOR MORE 
Read the Chris Tarry column from last month here
But while hedging can ameliorate the near-term effects in a rising market, it will only delay the inevitable. Historically, once the peak price for oil has been reached, it tends to fall back very quickly. Unfortunately, nobody knows quite at what level and when the turning point will be.

In Europe we are seeing a series of meaningful fare sales on short- haul routes where the issue appears to be more about getting cash in rather than increasing fares to recover higher fuel costs. Long haul is different and, while we have seen increases in fares and surcharges, there will be a point beyond which (at least in economy) the additional fuel cost is not recoverable.

CURRENT ENVIRONMENT

It is worth considering the consequences of the current environment. There will be less free cash generated from operations in 2011 and this will have direct results on balance sheet as well as affecting capital expenditure. For most businesses, less cash from normal commercial activities means a higher level of net debt. There is no "right figure" for the amount of cash airlines should have at any time - the answer is always "more rather than less". Furthermore, you should always try and raise cash from external sources when you do not need it.

Several years ago we suggested a measure of success was access to "affordable capital" - with the low-risk premium reflecting the money markets' view of the business. Against this background it is worthwhile reviewing some of the recent debt issues with that of Singapore Airlines in summer 2010, when it had two bond issues raising S$500 million ($398 million) with a coupon of 3.22% and S$300 million at 2.15%.

SAS in March issued unsecured bonds of SKr1.3 billion ($208 million) with a 10.5% coupon and some €75 million ($109 million) with a 9.65% coupon. American Airlines parent AMR issued $1 billion of senior secured debt with a coupon of 7.5%, saying it was taking advantage of a dip in the rates in the high-yield market. And Air Berlin has just issued a €150 million bond with a coupon of 8.25%, which was rapidly oversubscribed.

Given the seemingly inexorable decline in airline share prices (with some analysts lowering their expectations and recommendations) and the inverse relationship between share prices and the perception and pricing of risk, the cost of externally provided cash will increase by more than just the rising underlying interest rates.

This brings us to one of the capital expenditure outcomes and in particular the consequences that a "cash squeeze" might have on the ability of some airlines to fund pre-delivery payments. Even a cursory look at the undelivered backlogs of single- aisle aircraft suggests that the re-marketing departments may soon be busy and there could be some attractive opportunities for those airlines able to take a near-term delivery. This is clearly on area of opportunity to watch.

Whilst we would entirely agree with Air Berlin's management that the outlook is one of continuing challenge, we must not forget that there will also be opportunities. Some, although not all, may well be "game changers".