The recovery may at long last be under way, but some key questions remain on the health of the industry

The elusive recovery seems to have finally arrived. Analysts are pencilling in improved performances for the 2004 financial year as economic indicators pick up and business travellers are more willing, or more able, to sit in the front end of the cabin.

Airline boardrooms and their long-suffering shareholders are not popping champagne corks just yet. On the face of it revenues appear to have recovered. As this year's financial ranking shows, the top 150 airline groups managed revenue growth of 6.5% in 2003 (see pages 52-62).

However, that is expressed in US dollar terms, and currency exchange rate changes account for the bulk of that gain. For example, the USdollar fell by over 15% against the euro last year.

Factoring out currency exchange rates, underlying revenues for last year remained virtually unchanged, with the industry achieving just half a percentage point of growth in constant dollars. With revenues almost static the industry's positive operating margin looks more impressive, showing how carriers are succeeding in lowering their costs.

It was left to low-cost and regional carriers to post the most decent results, pitching in with margins of 10%, but major carriers were still in the red. The low-cost sector also accounts for over half of the industry's operating profits. And with a restructuring US industry seeing net losses of over $8 billion, the industry as a whole saw a net loss of nearly $7 billion.

On top of the usual worries on capacity, fuel is high on the list of industry anxieties. Speaking at this year's IATA annual general meeting, director general Giovanni Bisignani warned: "The price of oil could add up to $1 billion a month to our costs and deny us profitability yet again. Our projections of a $3 billion profit this year were based on an average oil price of $30. If oil prices average $33, we break even. At $36 we could expect a $3 billion loss."

For Asian and European carriers, the fuel price hike has at least been tempered by a weaker dollar, which also flattered their 2003 financial year results when translated into US dollars.

This is not the case in the USA, which continued to be the industry laggard in 2003 and, despite an expected improvement in the revenue position this year, 2004 is not expected to be much better, thanks to the increase in fuel costs. Michael Linnenberg, airline analyst at Merrill Lynch, estimates that while 2004 revenue for the largest nine US network carriers will come in $2 billion above what was being forecast a year ago, at $88 billion, costs will be $3 billion higher at $89 billion.

This is being driven by higher fuel prices, with the major carriers expected to spend around $15 billion on fuel this year, compared with $12 billion in 2003. Linnenberg points out that if fuel prices were at similar levels to what they were a year ago, already high by historical standards, then the majors would be looking forward to achieving break-even this year.

Low-cost growth

While fuel prices may eventually deflate, low-cost carriers are here to stay. As well as accounting for half of industry operating profits on less than 5% of revenues, operating margins, at 10%, were around 10 times the industry average. With the sector growing rapidly on both sides of the Atlantic at a time when yields are under pressure, there are concerns within the analyst community at what this will mean for the second half of 2004.

"We don't expect the fare discounting to let up anytime soon," says Linnenberg. Pointing to the fact that the US low-cost carriers and regionals are growing at annual rates of 12.6% and 22.3%, respectively, he says the cost of these seats is low enough for these airlines, in the most part, to still earn a reasonable return for the summer season. "But, as we move into a seasonally weaker autumn, this type of collective behaviour could become problematic for many airlines." While he thinks that mainline carriers are most at risk, he adds that some low-cost and regional carriers could be susceptible as well.

The double whammy of high fuel prices and intense low-cost competition is also being felt in Europe. Ryanair chief executive Michael O'Leary warns that there will be a "bloodbath" in the European low-cost sector, where there have been a host of start-ups over the past year. Both Ryanair and easyJet have seen their share prices take a hammering as intense competition from low-cost carriers and an aggressive response from mainline carriers prompted both airlines to issue profit warnings.

John Mattimoe, analyst at Dublin-based Merrion Stockbrokers, warns that a significant recovery in the budget-carrier share prices is unlikely, with the price war set to intensify further through the winter. A pick-up in stock values may have to wait until higher-cost players either fail or retrench, allowing yields to recover, he says, warning: "The timing of this market restructuring is uncertain."

As in the USA, however, the higher cost bases of the mainline carriers are in danger of being exposed by a low-cost price war. In addition to easyJet and Ryanair, British Airways and SAS have each warned that the European yield situation is still challenging.

"We believe managing capacity deployment and making the necessary changes to the cost bases are the keys to competing with low-cost carriers," says Chris Reid, European airline analyst at CSFB. With some long-haul routes, particularly Asia-Europe, showing signs of overcapacity, he warns: "Overall, we need to see either more capacity discipline, more rational pricing or improving lead economic indicators - or else there is a risk that the yield recovery will peter out towards the end of 2004."

As in the USA, there is some way to go on the cost-base front. However, Europe can boast one airline that has shown it is possible: Aer Lingus. Virtually on its deathbed in the immediate aftermath of the 11 September attacks, the Irish flag carrier is now profitable, with a queue of potential buyers forming as the government seeks to privatise.

Operating costs at Aer Lingus are estimated by CitiGroup Smith Barney to be around the 5¢ per ASK (euro cents per available seat kilometre), even better than slimmed-down BA. In contrast, Alitalia is relying on government-backed money to help keep it afloat. The traditional way to tackle costs in "normal" industries is through consolidation, so undoubtedly the most significant event of the last financial year was the Air France/KLM merger, which when taken together next year will see the new company leap to the top of the ranking.

Cost issues

If European airline chiefs are looking wearily ahead to the second half, the stress levels on the other side of the Atlantic are even higher. United Airlines is still to emerge from Chapter 11 protection, while US Airways is showing signs of joining it, having only emerged from court protection last year.

Elsewhere, the financial figures for the Asian carriers are greatly affected by the SARS crisis, but forward-looking statements from the region's carriers have tended to be more positive than their European and North American counterparts for well over a year now.

The recovery in the second half of the year at the major Asia-Pacific carriers has been remarkable. Most report that they are back in rude financial health. Cathay Pacific, for instance, managed to turn a HK$1.24 billion ($159 million) first-half loss into a full-year profit of HK1.3 billion.

While Asian carriers are looking forward with optimism as the Chinese economy continues to power ahead, for European and North American carriers, the winter season looks like being a real test of nerves.

Source: Airline Business