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AirlinesWhat’s next?
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Key Issues facing the Airline Industry: 2011
Airlines – what’s next? 1
Contents
Sector overview 2
The need for fuel efficient fleet and the challenges of ownership decisions 3
Biofuels as a strategic hedge to oil volatility and carbon costs? 4
Capacity growth — Too much too soon? 5
Consolidation and mergers to continue in 2011 6
Airlines’ ability to weather further shocks to the industry? 8
For more information please contact 9
PwC2
Sector overview
The improvement in Airline fortunes in 2010 was more rapid than expected, despite the impact of volcanic activity, industrial unrest and delays in aircraft deliveries. This improvement was driven by economic growth and yield recovery, assisted by prudent capacity management, more disciplined focus on costs and ongoing sector consolidation.
Opportunities for recovery continue in 2011 and we believe airlines have come out of recession in a more robust position than they entered:
Demand is returning, particularly •in the faster growing regions of the world (Asia, India and South America) and importantly the recovery in business travel is well underway
There is continuing growth in •LCC’s in emerging markets where these operators are tapping into a growing middle class for whom air travel is becoming affordable
Large new aircraft orders are •again being seen in the market, asfinancingopportunitiesstartto improve and we expect to seetheglamourofflyingreturnasevermoreflagshipaircraft(A380, 787) start to come into fleetsduring2011/12,bringingwith them promises of improved efficiencyandbettertravelexperience
The actions taken by airlines •during the recession to reduce costandimproveefficiencyshould be embedded into businesses this year and, aligned withnewfleetshouldcontinuetodeliveroperationalefficiency
Airlines are investing in potential •biofuel technologies to manage carbon emissions and oil price exposure
Participation in alliances and •code shares has increased during the downturn improving the connectivity offered to customers
However,thereremainsignificantheadwinds:
Rising fuel costs are again a key •factor. The spike in oil prices due to Middle East and North African unrest is worrying. If oil remains in excess of $100 a barrel for any prolonged period of time it could jeopardise the return toprofitabilityofmanyofthesectors key players. It has negative implications for both costs (although there would be a lag dependant on hedging position) and the demand environment where fuel surcharges / price increases will likely reduce demandforprice-consciousflyers.The impact of rising fuel prices has a disproportionate impact on low cost carriers where fuel isasignificantlyhigher%ofthecost base.
Airlines have all added capacity •to the winter schedule and many airlines (particularly the Middle Eastern long haul carriers) areexpectingsignificantnewdeliveriestotheirfleetsinthecoming years. Management of this rise in capacity whilst balancing the load factor / yield dynamic will again be a concern for airlines as more supply comes to the market. Any short term economic slowdown could again lead to yield pressure for airlines.
The regulatory environment is •stillnotsufficientlyopenenoughto allow consolidation within the industry at the pace required. Therehasbeensomehighprofileconsolidation activity to date (BA-Iberia, TAM-LAN, Continental-United, South West and Air Tran) and we have also seen the granting of anti-trust immunity ontheNorthAtlanticandPacificroutes. However, for many airlines theabilitytoaccessthebenefitsof consolidation (access to growing markets, cost reduction and achieving sustainable profitability)continuetobestymied by legal and regulatory barriers.
Flexibility, route optimisation, contingency planning, M&A and alliance opportunities and balance sheet strength remain areas of focus for airline executives over the next 12 months.
Airlines – what’s next? 3
The need for fuel efficient fleet and the challenges of ownership decisions
For both long haul and short •haul operators the ongoing volatility in fuel price and the expected future cost of carbon is asignificantfactorinassessingstrategyinrelationtofleetgrowthand renewal. Well publicised new aircraft programmes such as A380, A350, B787 and A320Neo all offer the opportunity toreplaceageing,inefficientaircraftwithsignificantlymoreefficientvariants.Theoperatingcostbenefitsoftheseaircraftareamplifiedasoilpricescontinueto rise
The well publicised delays in a •number of these programmes is however creating challenges for airlines which are seeking to replace ageing airframes as soon as possible and who, in some cases, are having to default to existing, rather than new technology aircraft to plug their delivery schedule gap
Furthermore the hegemony •of Boeing and Airbus is being challenged, particularly within the narrow body market with new aircraft from Bombardier (Canada), Embraer (Brazil), UAC (Russia) and Comac (China). These next generation, fuel efficientaircraftarecomingontothe market in direct competition with the A320 and 737 series
Thecommitmenttonewfleetis•howeverasignificantdecisionfromafinancingandliquiditystandpoint given the cost of these assets. In addition airlines are seeking to continually introduce furtherflexibilityintotheircostbases in order to respond to the cyclicality of the industry and the ever increasing frequency of “shocks” that impact longer term growth trends. (Delta’s announcement in Feb ’11 of a reduction in capacity growth and a deferral of capital expenditure in response to the sudden rise in the oil price is a good example of this)
Airlines need to consider:•
Inadditiontofleetmixthe –challenge for airlines is also to assess which ownership structure to utilise in order to best balance the needs of lowest unit cost per ASK, level of flexibilityandoptimisingthetaxposition. Assessing the relative advantages and disadvantages of lease vs buy is therefore key
The lease vs buy decision is –further complicated by the proposed imminent changes to lease accounting. Whilst not changing the economics of leasing arrangements these proposals will result in aircraft, and all other assets, under operating leases that would have been off balance sheet for reporting purposes now being recognised on balance sheet with a related liability. This will have the effect of increasingreportedfinancialdebt (and raising the gearing ratio) whilst also increasing operatingprofit(aportionofthe operating lease charge will be accounted for as interest, belowoperatingprofit).Theimplications of this proposal on both reporting and shareholder and stakeholder communication and management need to be carefully considered
PwC4
Biofuels as a strategic hedge to oil volatility and carbon costs?
The potential for an economically •viable aviation biofuel is becoming a very real opportunity for airlines seeking to reduce dependence and reliance on oil (jet fuel being the largest single cost for an airline). Sustainable biofuels offer the aviation industry an effective way to provide some protection from fuel cost volatility whilst significantlyreducingcarbonemissions and associated compliance costs
Aseriesoftestflightsbyseveral•carriers in 2008 and 2009 demonstrated the viability of aviation biofuel with some biofuel blends outperforming conventional jet fuel in terms of fuelefficiency.Thishasdriveninvestment in biofuel research projects that are testing a range of feedstock options from waste biomass to micro-algae generation. A number of airlines are participating / sponsoring such research including Lufthansa, BA and Qatar
Current biofuel costs are •estimated at approximately USD100 per barrel. Given the recent destabilisation in the Middle East and North Africa and underlying growth in demand from the BRIC’s for oil, biofuel is becoming increasingly price competitive. It is expected that commercial scale production will drive this cost down further, with forecasts ranging between USD50 and USD80 per barrel by 2020 which would represent a significantsavingfortheindustry
Furthermore biofuels offer •EU Emissions Trading System savings. EU-ETS assigns zero CO2 emission to biofuel which will lower compliance costs and thereby stimulate adoption of biofuels by participating airlines. It is estimated that the EU aviation industry could avoid 35m tonnes of CO2 emissions by 2020 with a carbon cost saving of $2bn based on an assumed biofuels’ shareof15%
In the next two decades, as •standardisation occurs and production increases, biofuels are expected to be adopted wholesale by airlines. Best case industry estimates forecast 50-70%ofjetfuelcouldbereplacedwith biofuels by 2035, and potentially even full replacement (particularly when combined with synthetic fuels). Even the worst-case estimates put biofuel use in aviationashighas40%by2035
There remain ongoing challenges •to biofuel development including; competing policy incentives in favour of biodiesel, the lack ofcommoncertificationandthe need for internationally compatible biofuel standards. In addition the commercial scale production of viable biofuel options is hampered by a lack of private capital and competition for biomass feed stocks
Airlines considering biofuel •need to consider:
thenetfinancialand –strategic return on the options they are assessing;
howbiofuelsfitintotheir –wider CSR agenda;
how they participate in the –market (sponsor, JV etc) and secure supply; and
at what point is it optimal –for them to participate (early adopter vs market follower).
Airlines – what’s next? 5
Capacity growth — Too much too soon?
The economic crisis of 2008-•09 led to large scale capacity cutbacks from major airlines around the world. Although the primary reason was to match supply with dwindling travel demand there was also a key objective of reducing overall operating costs to preserve precious cash
The increase in travel demand •in 2010 driven by recovering economies around the world saw yieldsimprovesignificantlyandled to airlines adding back some capacity over winter 10/11 to take advantage. The level of capacity growth varies by region and by airline. Invariably airlines in the emerging markets are adding more capacity than the developed markets
In particular, the approach taken •by the Middle Eastern airlines over this period differed from that of most legacy carriers in the Western economies as these airlines maintained their long term expansion plans and added significantcapacityduringthedownturn. This approach does not appeared to have impacted theirprofitabilitysofar(Emiratespostedrecordprofitsinexcessof $1bn in 2009/10) however continuing to manage the capacity growth implied by future aircraft orders will be key and likely require continued share gain for the region
Although recent trends in capacity •growth have closely matched the increase in demand, helping yield improvements, the risk of overcapacity remains a key challenge in the coming months. Furthermore there remains the tempting short term advantage for individualairlinesofbeingfirsttoincrease capacity. Winter 10/11 capacity on key routes such as the North Atlantic has increased by7%acrossmostplayerswhilstcapacity on Europe to Middle East hasincreasedby8%.Thecapacityincrease risk could be exacerbated byadownwardswingintrafficdemand if the fragile recovery in western economies is knocked off course
If future capacity growth is not •managed, which the industry is notoriously poor at, then yields will come under pressure and become the second biggest challenge for airlines, after rising fuel prices, over the next year
PwC6
Consolidation and mergers to continue in 2011
All airlines, big and small, •low cost or full service, have restructured their cost bases in the downturn. Therefore, as cost pressures continue, consolidation represents one of the few opportunities still available for them to drive out cost
We therefore expect consolidation •to continue through 2011 and beyond, with speculation continuing around a potential suitor for Virgin, IAG vocal about potential targets and a decision expected on TAM-LAN’s creation of a major South American force
However, considerable legal and •regulatory barriers to full merger remain in place, including limits to foreign ownership, and ongoing government shareholding. This is further heightened by the role whichflagcarriersareseentohave in delivering in the national interest. Arguably government regulation has not kept pace with the commercial realities of operating a global airline and the need to generate a consistent return on capital. Consequently, cross-border (or for Europe cross-regional) airline mergers often remain untenable even in geographies where a healthy M&A industry exists
The alternative routes of alliances •and code shares are attractive in enabling airlines to satisfy customer demands for global connectivity, often in tandem with joint sales and shared aircraft. We expect to see further participation in alliances and joint business arrangements in 2011 and beyond and competition amongst the big 3 alliances for new members. Whilst cost synergies from such agreements remain limited they provide airlines with the opportunity to “get to know each other better”, potentially as a precursor to merger / acquisition as and when the legislative and regulatory landscape changes
The push to consolidation and drive for scale •therefore remains the ultimate vehicle for top tier global carriers to:
access to growing markets; –
become a long term winner in the market; –
achieve cost reductions; and –
deliversustainableprofitability. –
Airlines – what’s next? 7
PwC8
Airlines’ ability to weather further shocks to the industry?
During the recession airlines around the globe undertook significant initiatives to try to achieve structural changes to their business models and increase cost flexibility. Airlines reassessed capacity allocations, achieved employee cost reductions and productivity gains, renegotiated supplier agreements and took steps to improve liquidity
The airline industry has managed to address some of its legacy cost issues, however airlines continue to remain highly operationally leveraged and therefore susceptible to shocks. Whilst airlines are experienced in managing such shocks the extent of the restructuring undertaken over the past two years means that the levers available for management to
pull in response to future shocks are likely to have more limited benefit
Over the past decade the airline industry has experienced the impact of terrorist attacks, global health scares (SARS), oil price spikes, employee disruption (particularly in Europe with employee and air traffic controller strikes), and weather related airport closures, including the impact of the Icelandic volcano. With the current political instability in the Middle East, rising oil prices, and the global economic recovery appearing uncertain, airlines must enact new measures to preserve cash and ensure there is a “Plan B” for weathering new storms
Balance sheet strength, maintaining liquidity and focussing on cash management must continue to be priorities for management as a cash buffer is the ultimate backstop in this industry
Airlines – what’s next? 9
For more information please contact
UK airline sector leader Roger de Peyrecave [email protected] 01727 892106
Consolidation and alliances
Airline M&A Ken Walsh [email protected] 020 721 31228
Will Inglis [email protected] 020 780 49246
Post merger integration Mark Hudson [email protected] 020 780 45141
Airline distress Steve Russell [email protected] 020 721 25334
Ian Oakley-Smith [email protected] 020 721 26023
Capacity and yield management
Strategy consulting Neil Hampson [email protected] 020 780 49405
Anna Sargeant [email protected] 020 780 44127
Econometric modelling and forecasting YaelSelfin [email protected] 020 780 47630
Coping with commodity price uncertainty
Biofuel developments Jeroen Kruijd [email protected]+31 88 792 6472
John-Mark Zywko [email protected] 020 721 31755
EU-ETS monitoring, reporting and verification
Atul Patel [email protected] 020 721 26618
Carbon markets stategy Jonathan Grant [email protected] 020 780 40693
Hedging effectiveness Carl Sharman [email protected] 020 780 46421
Maximising the cost base
Business services transformation Nick Atkin [email protected] 020 780 43166
Rob Banham [email protected] 020 721 25692
Risk Assurance Helen Nixseaman [email protected] 020 780 44442
Delivering deal value Cameron Roberts [email protected] 020 780 40133
Sourcing financing and maintaining liquidity
Debtfinance Simon Boadle [email protected] 020 721 24118
Tax Planning Paul Nash [email protected] 020 780 44040
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EP6-2011-04-05-1803-CP_Airlines
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