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ANALYSIS: Rising aircraft acquisition prices will upset the revenue/cost equation

CTAIRA analyst Chris Tarry says with aircraft expense a key factor in airline profitability, rising acquisition prices could upset the equation between cost and revenue

Part way through results season, announcements and presentations have shown costs broken down into what might be considered controllable and those that are determined by market forces or are "administered". Within such a breakdown, we regard aircraft acquisition very much as a controllable cost, whether in respect of the price of the aircraft and the cost of financing if owned, or the rental payment if leased.

While getting the cost of capacity "right" is fundamentally important, the other key issue is how effective the fleet is in generating revenue.

Sliding scales

In its latest results presentation, Ryanair's management brought the issue of cost efficiency and some of the metrics into sharp relief when it showed a slide using passenger numbers as the denominator in an analysis of cost.

It was not surprising that, in all areas, Ryanair had the lowest costs per passenger in all categories. Nor should it surprise anybody that Ryanair and EasyJet's aircraft ownership and maintenance cost per passenger - at €6 ($8) and €8 respectively - is far lower than those of the chosen reference group. This includes Norwegian (€15), Air Berlin (€14), Spirit (€16) and Southwest (€33). We can widen the reference group to include, among others, AirAsia where between the first and third quarters in 2012 the coefficient for the Malaysian business was €11.

Of course, the Ryanair analysis just focuses on cost and shows the advantage which it enjoys over rivals, but there is no difficulty recognising that the lower your costs relative to your revenue stream, the better. It is the relative relationship between costs and revenues that is more important. Our series of revenue productivity measures link costs and revenues. Ryanair scores well on both - low ownership cost and high revenue productivity is the ideal combination.

Looking at the figure in terms of the asset revenue multiplier, for Ryanair it is 10 times - in other words for each euro spent on aircraft ownership and maintenance there are €10 of revenue (fare plus ancillary); for Air Berlin, between the first and third quarter, the multiplier is 4.7 times; for Norwegian it is 5.7 times; and for AirAsia's Malaysian business it is 5.8 times.

In almost everything, timing is critical and, in this particular case, a decade ago Ryanair and EasyJet appeared to be the only buyers of aircraft around 150 seats in size. The consequent prices suggested to have been obtained by these airlines could be said to be entirely predictable.

In terms of business processes, there are clearly similarities between most if not all airlines that have been established over the last decade.

However, there are two areas of marked difference; the price at which they have been able to ­acquire aircraft and their cost of capital. Here the advantages that Ryanair and EasyJet were able to benefit from in 2002/03 are unlikely to be repeated. These developments will also have implications for both budget carriers.

Placing an order for the largest number of aircraft possible is no guarantee of success. Given the rise in the cost of ownership (rising prices and the cost of capital), the notion that some airlines may act profitably by leasing out subsequently unwanted deliveries is less clear-cut.

A low cost of capital helps, but it is the acquisition price that is viewed as the most important element in the equation. A panellist at a recent industry event said that he saw "airlines with weak balance sheets and significant order books" as a source of supply of new aircraft at potentially attractive prices.

Cash counts

While we are all able to draw up a list of which airlines we think will provide a source of supply to the lessors, this also acts to highlight another area of performance measurement from profit and loss.

There is no doubt that for ­airlines not only that cash is king, but that a cash heavy balance sheet is usually positive too. From a more dynamic perspective, earnings before interest, taxes, depreciation, amortisation and rent, or EBITDAR, has for sometime been the headline profit reported. It is also seen as a proxy for cash generated, but it is important to put this in context. In a number of ways, it is a relative measure and we also need to look on the other side of the equation.

Here, the fixed cost coverage ratio (EBITDAR/(rentals+interest cost)) gives us a useful view on the adequacy of the cash generated - albeit at a high level - and of the ability to afford and fund the future.

As the results-reporting season progresses, we will be examining the ratios relating to asset efficiency and cash generation, and its uses, particularly closely.

This will not only be for those airlines where we believe that the next 12-24 months will be seen as more of a challenge than an opportunity, but also where reality is rapidly overtaking previous hopes and expectations: I am sure that we will not be alone in doing this.

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