Compared with the historical financial averages, these are relatively good times for airlines. The expected 2015 profit of $29.3 billion on revenues of $727 billion will net them a 4.0% margin. A stronger global economy, record load factors, lower fuel prices, and a stronger US dollar are all playing their part in bolstering the figures.
Most significantly, the return on invested capital (ROIC) will be above the cost of capital for the first time in industry records, at 7.5% (see graph, overleaf). Lower bond yields have pushed the cost of capital down to 6.8%. Not surprisingly, the latest IATA business confidence survey suggests airline bosses are positive about the future.
But there are still challenges. The stronger US dollar is hindering some airlines as much as it is supporting others, for example. This has led to some significant regional differences. While all regions will return positive results, profit and ROIC are heavily weighted toward the US market. More than half the global profit ($15.7 billion) is expected to be generated by US airlines. They are expected to post margin on earnings before interest and taxation (EBIT) in excess of 12%, more than double that of the next best performing regions of Asia-Pacific and Europe. It means the average non-US airline is still struggling with returns below the cost of capital and a significant debt burden.
Overall, the 2015 per-passenger profit is predicted to be just $8.27. When compared with Apple, which makes approximately $177 per unit and recorded a similar total profit ($31.6 billion) in just the first six months of 2015, the airline figures are brought into sharper focus.
All this begs the question of whether airlines are investible. This is not just a thought experiment. It is estimated that the industry will need to find $5 trillion in the next 20 years to buy the aircraft to serve the growth in air traffic, particularly in emerging markets. Attracting investment is vital to airline sustainability.
This challenge was discussed by a distinguished panel at the recent 71st IATA AGM in Miami. Valuable contributions were made by Christopher Luxon, CEO, Air New Zealand; Calin Rovinescu, President and CEO Air Canada; Robin Hayes, President and CEO, JetBlue; John Luth, Chairman and CEO, Seabury; and Chris Tarry, CEO, CTAIRA.
The three airline CEOs were able to report strong increases in share value in recent times. Air Canada shares have grown around 1,500% in the past half a dozen years or so, JetBlue’s have quadrupled since 2012, while Air New Zealand has seen a threefold increase in a similar period.
But this wasn’t the prelude to a resounding “yes” to the investible question. Air Canada is still valued at only about $9 billion, according to Rovinescu, which considering its brand, its reputation, and its reach is quite low.
“To be investible, we need to be clear and transparent about targets, about our earnings, and about our costs,” said Rovinescu. “And as an industry, we need to have a level of indebtedness that is serviceable even in the bad times.
“Investors want a continuity of metrics. They want to see that the balance sheet is moving in the right direction. They will then come onboard even if the current situation isn’t great. Other businesses chase profit, and airlines need to get into that mindset.”
A great business
It is also the case, however, that US airline stock has been offloaded in recent months. That could be partly because people are realizing the profits they have made on the shares. But it does also suggest many investors believe that these are indeed the good times and airline stock prices are reaching their maximum value.
Air New Zealand’s Luxon had some sympathy with that rationale. He noted that airlines in general too often focus on the uncontrollable, blaming the price of fuel for bad finances and bad weather for delays.
Strategy tends to center on network, fleet and operations, he said. “This is important too, but we must never forget we are a consumer business,” Luxon continued. “The industry is too insular. The way we run our product at Air New Zealand is essentially no different from the way many other companies run their products. We want to be a great business, not just a great airline.”
JetBlue’s CEO, Robin Hayes concurred that airlines are easily panicked by other airlines and their decisions and routes. “That is wrong,” he said. “You need to stick to your business model.” He blamed the prevailing “metric du jour” for airlines’ wayward focus, and said the long term must be the prime consideration.
Challenges to investment
This mismatch between airline short-termism and the investor’s horizon-bound gaze is a major challenge for the industry. Capacity is another.
Luxon suggested that there doesn’t need to be hundreds of airlines in the world. A good portfolio of choice would suffice, he said—as long as each of those airlines possessed a compelling customer proposition.
But consolidation should not be seen as the panacea for a lack of investment, the panelists agreed. Two unprofitable companies don’t necessarily add up to one profitable one. “And anyway, there are so many restrictions on ownership,” said Rovinescu. “But handled properly, joint ventures and partnerships can bring shareholder value.”
Another threat to airline investment is the rise of the e-retailers, that could effectively make a physical airline a less attractive proposition. There is Uber Technologies, for example, and, within the travel sector, Airbnb. These companies have no assets and yet hold market caps in excess of most airlines. Similar concepts may well disrupt the investment potential of airlines.
The power of partnerships
But it is not just about airlines. For the airlines to be attractive investments, much also depends on their partners in the aviation value chain, such as airports and air navigation service providers (ANSPs). In other words, joint advocacy is required even though each stakeholder has a different motivation.
Charles Schlumberger of the World Bank has estimated that $9 trillion is needed for infrastructure development to 2025. On the one hand, airlines need the development to fulfil their business potential and realize the ROIC investors demand. On the other hand, however, they must compete for investment capital, requiring $5 trillion for new aircraft.
While ANSPs are still largely government-owned, airports are slowly turning to privatization and so are mindful of attracting investors. Public-private partnerships have received windfalls in recent years in a variety of locations from Brazil to Turkey. Airlines will find it hard to match the returns seen in the airport arena, which far exceed the low, single-digit margins experienced in aviation even in the good times.
Governments, too, will have a say in whether airlines are investible. As Brian Pearce, IATA’s Chief Economist, points out about the industry’s 2015 profit, “it is important for regulators to understand that making profits is normal and not exceptional.”
Airlines are often the target of taxation even when performing badly, and aviation’s history is littered with poorly conceived taxes. Not being subjected to onerous and ill-judged taxes will be crucial to airline financial sustainability.
Overall, concludes Pearce, a positive economic environment prevails—but not a strong one. Air traffic and air cargo are experiencing solid growth but there is a wide divergence between the regions.
In that sense, airlines might be best described as an intriguing investment prospect rather than a sure thing.