For some time now I have suggested that 2008 may be the year of peak earnings for the airline industry, but the changing economic landscape could result in 2007 fulfilling that role. Although it will be a while before we know if this is the case, it is worthwhile giving this view some serious consideration.
The analysis should focus not only on the industry reaching a profit target - which in margin terms is markedly below that of previous peaks - but also on what this might mean, given the unprecedented levels of new aircraft ordering that have been evident over the last four years and the consequences that might arise from this. Orders from Airbus and Boeing alone in 2007 are expected to be some 2,600 units. This follows on from net orders of 2,071 in 2005 and 1,834 in 2006. The ratio of backlogs to net deliveries - a proxy for how long it is to the next free delivery slot - is now stretched.
While the economic and traffic outlook is different between the various regions of the world, there should be considerable concern over three market areas in particular: US domestic Transatlantic and Europe. Despite the structural growth attractions in Asia, profitability here is disproportionately affected by the price of fuel given the generally longer sector lengths. This gives rise to some concerns over the outcome for 2008.
If we take a look at the economic "mood music", it is not only the recent statistics that are important, but also the future behaviour of both companies and consumers. At the first sign of a slowdown the key areas for budget adjustment by companies are new hires, marketing and travel, which can all be easily cut. On the consumer side, leisure air travel is also easy to cut.
What then of the data? The most recent GDP forecasts for the USA expect growth of just 1.2% for 2008 compared with an outcome of 1.8% for 2007 and some 3% in 2006. In Europe, GDP growth for European Union member countries is forecast to be some 2.4% in 2008 compared with 2.9% as the expected outcome for 2007, and 3% for 2006. Similarly, consumer confidence has continued to decline sharply towards the levels of 2005. Within the EU, GDP in the UK is forecast to increase by 2.2% in 2008, down from 3% growth in 2007.
As the recovery in profitability in the US airline industry has not been accompanied by an outburst of ordering, the downturn will not coincide with increasing numbers of aircraft. However, the economic slowdown will clearly impact load factors.
In Europe, the issue remains the growth in capacity of the low-cost sector and the consequences of this not only in respect of direct competition on a route or sufficiently close city pair, but also against the background of the "destination indifferent" leisure traveller. This adds further fare pressure and in a slowing market approaching exhaustion, the outcome is a redistribution of what traffic there is at ever lower fares.
For the Asian airlines, although the economic background remains strong, fuel will be the big swing factor and will act to dampen any profit improvement between 2007 and 2008.
An area of concern for some airlines is likely to be escalation clauses and pre-delivery payments as well as the ability of what will be a tightening market to absorb seven- to nine-year-old aircraft to create space for new deliveries. Over the medium-term I would expect the backlog/delivery ratio to fall by some 1.5 to 2 points through a combination of cancellations and a relative hiatus in ordering, especially in the 150-seat market.
While only our 20/20 hindsight will enable us to determine whether 2007 or 2008 will be the peak year for airline profitability, the signs are increasingly pointing to the former rather than the latter. It looks as if we may be in for a bumpy ride from 2008 - Happy New Year.
Source: Airline Business
