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Market Outlook: High hedges ruin the view

As we approach the results season for the third calendar quarter it is worthwhile taking a look at some of the recent "mood music" as it seems expectations have largely been conditioned. As a consequence, there should be few surprises in terms of results or outlook.

For many of the airlines in the northern and western regions of the world the issue is still how bad can it get, while the key question is what has been done to minimise the downside risk. For some airlines the issue of survival, and in what form, will have moved on to the agenda again.

The share price reactions in a number of cases have ranged from being "quite marked" (Lufthansa) to outright collapse (Flybe, where shares have lost 80% of their value since the December 2010 flotation, though in this case it was its second profit warning, its shares are illiquid and the company is not widely followed). In the case of AMR, concern in the market that it was going to file for Chapter 11 bankruptcy protection resulted in a precipitous fall in the price and the suspension of shares until the company provided reassurance.

There are now significant question marks over almost any forecast and, using aviation parlance, it is perhaps more a question of "flying by the seat of the pants" and the judicious use of rule of thumb that will be evident for at least the next few months.

In terms of a view on any company in such circumstances, given the lack of confidence in forecasts - which are ever changing - judgments should be based on its fundamental strength.

If looking at a single measure, we would choose the liquidity ratio where available as liquidity - including cash and access to bank lines - is expressed as a percentage of turnover. At times like this airline CFOs, when asked what amount of cash they should hold is, will answer "more".

It is no surprise that one of the key conclusions from the recent CFO study by Deloitte is that one of the priorities of CFOs of UK companies is "raising cash flow".

Companies hit trouble by running out of cash and while it is essential to look at any business individually, a liquidity ratio of 25-35% should give some comfort, at least as a starting point.

Generalisations are dangerous but for now our focus is on what are described, in economic terms at least, as the problem areas of the world and for its airlines the issue of a combined revenue and cost squeeze is clear.

On the cost side, fuel remains the real issue and while it has fallen from the peaks reached in May it is still 30% above the levels of 12 months ago.

IATA's latest forecast suggests that pre-hedging the industry fuel bill will be $60 billion higher in 2011 than 2010.

Although the recent dip in the barrel price of Brent below $100 will have provided an opportunity to hedge, it was short-lived.

Given that the benefits of previous hedging have unwound during 2011 - particularly in the last quarter, where costs were rising against a background of broadly unchanged revenues.

Beyond this, the outlook for 2012 is for high fuel prices and weak demand.

Indeed we have already had warnings of a slowdown in September and the outcome here is one where forward bookings and actual revenues are falling compared with 12 months ago, resulting in a vicious squeeze.

However, as we suggested last month a number of airline managements were already anticipating a darkening of the skies and know what steps to take. It may be they are now more pronounced and prolonged.

The latest data from the IMF shows that it expects the economies of 24 countries in 2016 to be no more than 10% bigger than they were in 2007. This ties in quite neatly with one of the risk factors highlighted in US lessor International Lease Finance's (ILFC's) notice of its planned IPO, which raises the issue that "a full recovery in the airline industry may not be imminent".

However, in the more immediate future - and from a purely analytical perspective - the only real focus is on the cash position and the cash performance.

This is what we will be focusing on when the results are revealed, and in this respect it is perhaps inevitable that the gap between what we would describe as the "haves" and the "have nots" is likely to widen.

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