The US majors have already begun to struggle with rising costs and weakening demand, while latest results from Europe hold some warnings. Chris Tarry analyst at Commerzbank asks where the market is likely to go from here?
Stock markets are often described as expectational. While history may be interesting, it is what comes next that really matters in terms of influencing share prices. (Or more accurately the expectation of what is likely to come next) So although markets have keenly awaited the latest round of airline results for the first quarter - and full year results for those reporting on a March financial year-end - the real focus is on the future.
In fact, the first quarter results from the US majors held few surprises (see results on page 121). The no-frills sector in the shape of Southwest Airlines again stands out against the crowd as the network majors run into difficulty. The culprits have been clearly identified. Last year attention was focused on fuel and although the spot price may since have eased a little, the average buying price for many airlines will be higher as their forward hedging unwinds. This year the attention is clearly on labour. That is not only in terms of the impact of the settlements already reached - led by the United Airlines deal - but also in respect of those negotiation which have still to be concluded.
It has often been said that as soon as airlines become profitable two things occur. First they buy aircraft and second they pay more. Or to put the second point another way, the labour unions enter into negotiations which result in a structural change in the carrier's cost base. In both cases there is a lagged effect in that the result of a pleasurable past experience _ that is a profit _ has tended to result in an increase in cost; capital expenditure on the one hand and wages on the other. That presents no problem if the conditions that produced the profit continue to exist. However the world has not proved quite so reliable in the past and does not look as if it will behave so in the future.
The good news comes on the capacity side of this equation. There the industry looks relatively comfortable. Indeed, one of the positive aspects coming out of the recent raft of annual results statements is an apparent willingness (or even determination) to cut rates of planned capacity growth if not see through an outright reduction in seats.
However, the outlook on the labour front is somewhat more challenging. Given that labour claims are based upon a reaction to a company's past performance, it is highly instructive to look at the changes that have occurred in labour in relation to profits in previous years. A couple of such measures have been applied to figures from American Airlines and United (or rather their parent AMR and UAL corporations) in the example shown (see table right). The labour multiplier shows quarterly operating revenue as a multiple of overall labour costs. The lower the multiple the more the company is struggling with wage costs. The second indicator shows the quarterly change in labour costs as a percentage of operating profits a year earlier. So for example, American's labour costs grew by $129 million the first quarter of 2001. And although it had made a loss in this quarter, if you look back to the first quarter of last year, the group showed an operating profit of $212m. So the change in labour costs represents 60.8% of last year's profits.
Of course the ratios can be affected by movements on both sides of the equation _ labour and profits. But, the linkage is all too clear. Furthermore when compared with the labour multiplier last year there has also been a downward trend.
Everyone is well aware of the high operational gearing of an airline in normal times or during an upswing. Once beyond breakeven some 80-85% of the incremental revenues come straight through to profit. The problem is that the effect is equally true in reverse. Any revenue slowdown comes straight off the bottom line as well. If evidence were needed of this then it was duly provided in the first quarter results of the US airlines. The run rate of the shortfall in some cases was as much as $120 million a month.
In Europe British Airways at the time of releasing its March traffic figures suggested that it was experiencing a revenue shortfall of some £15-20 million ($20-30 million) a month. These arose from the US slowdown and computer problems. Foot and mouth disease in the UK did not help either although BA has found it impossible to allocate the exact impact of each negative.
Whilst the main focus falls on the revenue/cost equation, the gap between actual and break-even load factors remains a closely related issue. Going back to a well-worked theme, it is relatively easy to achieve a high load factor - low fares tend to do the trick. The need is to ensure that the break-even load factor is low enough to justify those fares. In the last downturn, traffic growth was not necessarily the problem (there was nominal growth of some14%), yet the collective losses made from carrying that traffic stood in the region of $8 billion.
It is clear that progress has been made since then in structurally lowering breakeven load factors. This time around the potential for the degree of excess supply that existed is largely absent. BA's break even load factor, for example, ended last year at around three percentage points lower than it was a decade ago.
There is no doubt, however, that the impact of the economic slowdown in the US has been faster and perhaps deeper than might have been expected at this stage. Clearly we are reviewing our Traffic Demand Indicator (TDI) forecasts in the light of this. Furthermore the impact of expectations is very real and appears to have accentuated the slowdown. The issue as always is how much deeper and how much longer? The honest answer is who can tell? The realistic answer is that it may well get worse before it gets better. But if as seems likely most of the industry is planning on a downturn with a 12-18 month duration then the hatches are already being battened down.
It is clearly going to be a testing time but as with any industry there will also be those who emerge from this difficult period structurally stronger _ we watch and wait to see.
Looking in more detail at the recent set of European results reveals a mixed picture. Selectivity is always a key word for investors and last year's European results have certainly provided plenty of variety from which to choose. The first quarter of this year too has provided a period of dramatic change.
Even at this stage of the year two key events are likely to be remembered. First is the near implosion at the renamed Swissair Group, with the abandonment of its "hunter strategy" and the accompanying management change. The second is the strength of feeling amongst the Lufthansa pilots which could have a long lasting and structural (negative) impact. The March quarter results for Lufthansa were partially surprising although given the current circumstances it is difficult to gauge the full year outcome as neither the costs nor the traffic impact of the action has yet been assessed.
BA turns up
BA, meanwhile, continues to implement its strategy having increased its planned capacity reduction across the North Atlantic to 13% from 10%. Its eagerly-awaited financial results for the 2000/01 financial year to March came in at the top end of the market's expectations with an operating profit of £380 million ($540 million) compared with last year's £84 million. The airline not only showed some real progress on cost - even allowing for the absence of loss-making Air Liberte - but also on yields. In the March quarter revenue per available seat kilometre was up 13.9% and for the full year by 10.8%, most of which came from improved in-cabin mix. No airline can immunise itself from an economic slowdown but with a capacity cut across the network of 8% for this year and next, BA has already factored a large part of this in. However the real benchmark in the future will be the extent of the structural change that has occurred and the benefits it will bring.
Elsewhere Europe's "no frills" sector remains of interest. Ryanair continues to make good progress out of Dublin and London Stansted. Its Luton-based rival easyJet is focussed on cost reduction, however, as it realeased a £10.3 million net loss for its first half to March. first half to March. Calculations suggest that easyJet's break-even load factor is more than 15 percentage points higher than that of Ryanair.
Furthermore there is evidence, backed by a Cranfield University study, which suggests that business travellers using the no-frills airlines will tend not to travel at all in an economic slowdown. Of course there should equally be defections among mainline passengers seeking a lower fare solution, but that is also dependent on airport location. Everyone is well aware that their preference of airport is linked to where they live or work. It may be more convenient to downtrade on a mainline carrier than to move airports.
As ever the results will be watched with great interest - not for what they tell us about the recent past but more for what they suggest about the future. It is probably important to keep those seatbelts fastened for now.
Source: Airline Business