As anticipated, the sustained increase in propellant prices took the most headlines in the September reporting period, when earnings fell across the region for the third quarter in a row. The spot price for Singapore jet kerosene rose 45% on average, compared with the third quarter 2004 and the weight of this anchor was too much for most carriers.

Those that did advance, did so largely on the basis of currency and local interim accounting treatment (China Eastern and China Southern) or benefited from a rival’s misfortune (Korean Air). The only airline to show rises in revenue, operating profits and net profits without these influences was AirAsia, as demand for its low fares continued to expand rapidly, although growth here was impaired compared with previous periods.

In addition to higher energy costs, which were pretty much a constant across the group, the flagging positive impact of freight growth featured. For the September quarter, freight carried by members of the Association of Asia-Pacific Airlines (AAPA) grew by 1% and by the end of October (the most recent figures available), year-on-year growth continued to limp along at 2%.

Under pressure

Third-quarter freight loads dropped by over one percentage point, suggesting that, excluding fuel surcharges, yields were likely to be under pressure. This trend remains a concern because it has typically been associated with slower economic growth, which, in turn, translates into reduced passenger demand.

Fuel surcharges continued to buoy passenger yield growth in Asia-Pacific, with all carriers having hiked them since they were imposed – generally in the first half of 2005. However, there were signs that airlines had reached the limit of their ability to levy these without rebating some of the surcharge in discounted fares. Malaysian Airlines was the only one brave enough to admit this, but it could be deduced from the releases of most carriers.

There were also signs that carriers could actually be rolling back their surcharges (Philippine Airlines and Virgin Atlantic being two examples) as fuel prices fell back, suggesting this support to revenue growth could also be missing in forthcoming earnings periods.

On the cost side, year-on-year increases were universal, although the rate of rise varied. Fuel was partially to blame, with rising labour costs another factor. Also, while some currencies firmed against the US dollar (notably the South Korean won), most were largely flat and did not provide the same insulation against the higher dollar-denominated costs that have characterised results in the region for the past two years.

The most significant increase was at Malaysian Airlines, where unit costs, including fuel, leapt by 30% as staff costs and all line items accelerated. Analysts speculate that some of this may have been costs reallocated to international and listed business to make the restructuring task easier for the new chief executive. A strike-related reduction in flying and unhedged fuel positions caused the spike at Asiana, and fuel costs were a common thread at most other airlines.

Fuel hedging

Fuel hedging has also emerged as a recurrent theme, with carriers either carrying less coverage or executing hedges poorly. Some, such as AirAsia, had collar-type structures that saw their year-on-year change in jet fuel costs match the change in underlying spot prices, although the absolute price remained below the average. But generally, the situation was typified by limited protection (such as Asiana, Korean Air, the Chinese carriers and Thai Airways) or the wrong bets (Malaysian, EVA, China Airlines).

Financial leverage also appears to have edged higher at most carriers. Aircraft ordered over the past two years are now beginning to arrive. AAPA members may have only 46 jets due for delivery in 2006, but many of its members are small and unlisted. Among the larger sample of the Asian listed population, the number is far higher. As interest rates firm and list prices rise, debt levels and ownership costs are both likely to rise into 2006.

Key drivers

One of the only other improvers as the year ended was Thai Airways, whose operating profit in the fourth quarter of 2005 actually rose by 2% on 8% revenue growth, after having reported fairly dismal numbers in the third quarter. Some pick-up in the freight business and a reduction in unit costs (probably the only airline to have achieved this over the September period) were the key drivers, although this was largely a function of reduced ownership charges – depreciation, operating rentals and interest costs all fell.

The current quarter should see some relief from the record prices that jet kerosene struck during the third quarter, but this line item is still expected to account for more than 30% of operating costs this year – up from about 25% last year.

Also, the increase in other costs and the potential for the revenue line to start turning downwards continue to sound warning bells. Fuel looks like it has killed the profit peak that should have characterised 2005 and the focus is back to the demand cycle-driven revenue line, which appears to have crested already. ■

Timothy Ross is a director of Malaysia’s AirAsia and is the founder of Ross Aviation Finance & Consulting

Source: Airline Business