Market outlook: What floats the profit boat?

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Chris Tarry takes a look at the driving forces behind this season's results improvements.

Regular readers will know that we tend to favour a few straightforward and observable measures, including cash generation and the gap between breakeven and achieved load factors, to check-up on the health of the industry.

The good news is that the recent round of results gives some very clear examples of both a widening gap and stronger operating cash flow. But they also clearly show the industry's revenue dependency and the very dramatic operational gearing effects airlines are exposed to.

A common, but not universal, theme among the results for the quarter, or in some cases the half year, to the end of September is a sharp improvement in financial performance. But for many airlines this has more to do with better traffic mixes and prices, rather than volume. It is not quite a case of "a rising tide lifting all boats", but for airlines where business travellers are an important traffic element, some results have been dramatic.

Also, while the distribution is different, the US airline aggregate third quarter result of some $2.2 billion is similar to the peak year of 2007. But the ATA latest figures suggest yields are stabilising at a lower level than at this peak.

It is worth looking at AMR's results, where passenger revenues increased 15% in the quarter. RPKs were up 3.9% and yields rose 10.7%, with stable load factors. Turning to freight, AMR's cargo increased 14.6%, yields were up 7.3% and the swing in operating profit - excluding special items - was $472 million. This means AMR's total revenues, including cargo, grew by $715 million, while its underlying costs, excluding special charges, increased by just $243 million.

Returning to operational gearing, a simple way of looking at this is to calculate the profit margin on incremental revenue beyond breakeven. Depending on the airline model, more than 90% of any additional revenue should flow through as profits and cash. Using this calculation, AMR's margin on incremental revenue was 66%.

On the other side of the Atlantic Ryanair's passenger number rose almost 12%, exceeded by its passenger revenue growth at 16%. Meanwhile neighbouring Aer Lingus reported a 6% fall in passenger numbers and an RPK drop of just over 8%. But, with capacity almost 12% lower, short-haul yields rose 11% and long-haul yields grew by almost 20%. This, combined with cargo gains and cost savings, boosted Aer Lingus' operating profit by over a third, giving it a 19.3% margin. The €20 million gain fed straight to net cash which grew by the same amount.

Elsewhere in Europe, British Airways reported its first quarterly profit since Q3 2008. This was triggered by effectively flat costs, a 1.5% fall in RPKs and sharply higher yields, which increased passenger revenue by 18.4%. Cargo revenues also rose 43%. The resulting £370 million gave BA a margin of almost 15% (the incremental margin was 95%), while cash generated from third quarter operations totalled £335 million.

Looking east, figures from Jet Airways highlighted domestic and international differences in India. A 26% increase in domestic RPKs exceeded capacity growth by three points, pushing load factors up to 71.4% from 69.8%. While yields climbed 7.9% and unit costs fell 19.4%, pulling the breakeven load factor back by 24 points, an adverse six point gap remained. However, pre-tax losses were cut from $76 million to $10.7 million.

At JetLite capacity fell 4.6% and traffic by 1.6%. Yet, despite a 28% yield boost and a 16 point fall in breakeven load factor to just over 88%, the actual load factor of 74% remains some way off. Still, JetLite roughly halved its losses to just under $14 million. Meanwhile, international traffic and capacity rose by 22%, with a stable 80.4% load factor. Yields were up 9% and unit costs fell by just over 1%, cutting the breakeven load factor to 76.4%. This shifted the business from an $8.4 million pre-tax loss in Q3 2009 to a $13.4 million profit and 3% margin - an important turning point.

Clearly the comparables will become more challenging as time goes forward. Also, because in some markets the increase in profit has not been volume-related, the key question - given planned capacity increases this winter - is where the earnings growth might come from. Perhaps the clue lies in IATA's latest forecast which suggests that 2010 operating profits will reach a new peak. Unfortunately, for most airlines, it will not be a case of onwards and upwards from this point in 2011.