Recent announcement that BA/IB are merging brings into focus the airline business in Europe. Here ACNFT senior contributing editor Gordon Feller casts a wider net with an overview/outlook of the airline business in Europe as 2009 draws to a close. In this special report, “FY08” refers to the most recent financial year ending: September 2008 for EasyJet; December 2008 for Lufthansa, Iberia and SAS; and March 2009 for Air France_KLM, BA and Ryanair.
     The European airline industry is highly vulnerable to external shocks such as falling traffic demand, oil price fluctuation, adverse regulation and industrial action. Downward pressure on margins has barely been reduced by the stabilization in traffic demand during Q309, which was viewed by many as having only a temporary effect. Seasonally weak demand from October to March will put continuous pressure on earnings that have already been significantly impaired due to persistently weakened yields. Capacity is to be further reduced to improve the load factor.
     Airlines’ efforts on cost-cutting have provided breathing space for them in this severe downturn. However, it is insufficient to bring earnings out of distress solely on the merit of rigorous internal cost controls.
     Despite being generally well covered for immediate financial obligations, airlines’ cash flows will need to be enhanced to meet substantial capital expenditure requirements in the medium term, otherwise they will be forced to raise more debt to fund such needs — leading to a further deterioration of credit ratios in the absence of any meaningful improvement in operating margins. Historical peak leverage ratios and weak interest coverage ratios are inevitable at end of 2009.
     The highly leveraged capital structure of many airlines is not sustainable, neither is a dependence on internally retained cash flows, as longer term sustainability is driven by fundamental demand growth. Analysts anticipate no early return of airlines’ financial strength, due to the absence of a sustained improvement in real consumer spending power and premium traffic demand. Outlook on the European airline industry remains negative for the next 12-18 months.
     Despite some major European economies (France and Germany) having announced that they were officially out of recession in August, European economies overall continue to be overshadowed by high unemployment, sluggish business activities and low consumer confidence. The European airline industry continues to struggle under such gloomy conditions, experiencing extremely weak profitability in the summer of 2009 — normally the most buoyant calendar season — with traffic down by 4% and yield down 17% on summer 2008.
     In September 2009, the International Air Transport Association (IATA) revised its forecast on net losses in the global airline industry to USD11bn for 2009 from the USD9bn forecast in June, more than doubling its original forecast in March of a USD4.7bn loss. In Europe, the network carriers are expected to make a combined operating loss of EUR2.9bn, according to the Association of European Airlines (AEA). This would be a new record loss, 50% higher than the post 9/11 downturn in 2001-2002.
     The unprecedented scale of the recession continues to stretch the limits of the industry. Despite having emergency plans in place, airlines are not in the driving seat as they have exhausted the costcutting potential to match revenue shortfalls. A further stress test will be faced as these challenges persist in the coming winter. Airlines usually operate on a wafer thin margin, with only single-digit profitability. Even at their cyclical peak, most of the network carriers’ profitability was between 5%-10%. During the current economic crisis, operating margins are being further squeezed by many aspects — from a significantly weakened revenue stream driven by poor air traffic demand, and a seriously damaged yield as a result of the intense competition in price discounting, to a high operating cost base including growing fuel costs, increased airport fees and high labor costs.
     Many anticipate the accumulated operating loss amongst the five largest European network carriers — Lufthansa, Air France-KLM, British Airways (BA), Iberia and SAS — at around €EUR1.5bn-2bn in 2009, and a return to profitability is not expected until possibly 2011. Premium fares have declined by between 25%-40% during the summer of 2009 compared with a relatively moderate decline of less than 10% for economy fares. Due to the severity of this downturn, many analysts expect a permanent structural shift of a certain amount of passengers traveling from premium to economy class, particularly in the short-and medium-haul routes.
     The major low-cost carriers (LCCs) such as Ryanair and EasyJet are experiencing strong performance compared with premium passenger-focused network carriers, since their cost-leadership positioning is paying back under the economic contraction. Growth is seen in both traffic and revenue as they capture market share as a result of passengers being increasingly price-sensitive. EasyJet received a 5% increase in traffic from July to September 2009 versus the same period the previous year. Ryanair’s traffic volume over Q309 has jumped by 18% yoy. Both also gained efficiency on load factors. One can expect both companies to reach financial year-end 2009 (FYE09) with a double-digit growth in revenue.
     Since end-2008, many traditional network carriers have adopted the practice of unbundling service fares from base air fares, in order to make the base fares more competitive whilst seeking new sources of revenue in the downturn.
     Ancillary revenues, which used to be mostly associated with LCCs, have been increasingly pursued by network carriers in 2009. Airlines have become more and more innovative with regards to the product they offer. Additional revenue has been generated from additional charges for insurance, in-flight entertainment, additional check-in baggage, seat selections, loyalty point accelerator, priority boarding, and use of airport lounges. For example, BA’s series of cost-cutting and revenue-boosting measures included reducing meals on medium-haul European routes to charging fees for seat selections, clearly demonstrating the airline’s desperation in improving headline numbers. While airlines are under significant pressure to implement such incremental revenues, these measures have caused considerable irritation to passengers. However, some of the methods, especially if they are not truly value-adding, are counter-productive in public relations terms when a healthier market returns.
     The airlines have already cut staff, deferred marketing expenses, reduced capacity, retired aircraft earlier, and cancelled or postponed fleet deliveries.
     While these initiatives are crucial to help airlines survive the severe downturn, they would probably not be sufficient on their own to bring back airlines’ profitability in the medium term. The industry will also need to make longer-term adjustments (“Round Two”), which would include improving fuel efficiency, optimizing finance structure for the fleet, and effectively renegotiating labor agreements.
     When analyzing airlines’ cost base, look at the cost per available seat kilometre (CASK) excluding fuel, because the significant volatility in airlines’ fuel cost is largely influenced by external economic and political factors; and, if included, it could distort the unit cost figures and become less meaningful when drawing comparisons between different airlines.
     It’s useful to compare the underlying cost movement between airlines in the past three years. Air France-KLM is the only company in the sample to experience constant unit cost reduction during the period, demonstrating a good degree of flexibility in its cost structure. Lufthansa, Iberia and Ryanair are also maintaining a certain stability in their cost base. BA’s unit cost, on the other hand, has fluctuated dramatically between the 2006-2008 analysis points; and SAS’s cost base keeps increasing — showing inflexibility in its cost structure. Therefore, both BA’s and SAS’s baseline cost structure are seen to be more risky.
     Airlines’ operating cost structure typically contains the following six elements: fuel; staff; fees (including airport handling charges and landing fees); leases; selling and distribution (S&D); and depreciation and amortization (D&A). The first three items account for most of the total operating cost ranging between 53% and 80% — with Lufthansa at the lower end, and LCCs at the top.
     Fuel price volatility plays a big risk in airlines’ cost structure, and is the most heavily-weighted item in the operating cost structure for airlines like BA and Iberia. To help mitigate the exposure to rising fuel prices, European airlines use hedging instruments such as swaps, forward contracts and options. Airlines are very vulnerable to both fuel price increases over the medium-term (as airline fuel hedges tend to run out over a one- to three-year time horizon) and short-term decreases (which can swiftly put expensive hedging positions out-of-the-money). The latter risk was crystallized in Q308, when the collapse of the fuel price led to dramatic losses on out-of-the-money hedging instruments.
     Since Q408, some airlines such as Air France-KLM have temporarily frozen any further hedges to capture the benefit of the falling fuel prices, which were lower than the hedged prices. However, the sustained downward trend of the fuel price in Q109 continued to penalize airlines’ hedging positions that were locked in some time ago.
     Despite the huge losses, airlines resumed hedging strategies in Q209 when fuel prices started to rise — to protect against medium-term exposures. Since then, oil prices have doubled to above USD80 per barrel in October 2009. Some airlines have now shortened the contract lengths and monitor the market prices more closely by adopting dynamic hedging.      As a result of such efforts, many airlines’ fuel costs in H109 were almost halved yoy. With a persistent rise in prices, expect to see re-imposed fuel surcharges by airlines that are hoping to be able to pass on some of the cost increases.
Overall, expect the burden of fuel costs to significantly ease, and their share in total operating costs to fall in 2009. This will be helped by the 20% appreciation of the euro and 15% appreciation of sterling against the U.S. dollar from March to October — providing a welcome boost to European airlines’ jet fuel buying power. Consequently, amongst the five largest European airlines, around EUR2bn in fuel bills is expected to be saved in 2009. Nevertheless, the risk of a medium-term increase in fuel prices could very well coincide with a recovery in traffic and revenue, thereby limiting the positive impact any recovery may have on profitability.

Staff costs are composed of salaries, training costs, and employee benefits (including pensions) for both ground staff and cabin crew. Apart from temporary labor contracts and outsourcing, most of the staff costs are considered a fixed-cost element — driven primarily by the number and structure of the staff base, and partially by inflation. This is the cost item over which an airline has relatively more control; hence it is the preferred area where airlines look for cost-savings in a downturn. However, powerful labor unions, meaningful strike action, and sometimes legacy pension issues that cannot be ignored, keep posting challenges to implementing savings in this area. Amongst its peers, SAS’s staff costs have the heaviest weight in its operating cost structure, constantly accounting for over one-third of its total annual operating cost. The rest of the major network carriers have staff costs of between 22%-30% of their operating cost.      By contrast, LCCs’ staff costs were much lighter weighted in their cost structure thanks to their business model, accounting for between 10%-15% of total operating costs. The cost impact from headcount movement varies significantly from company to company. For some airlines, the staff cost movement is less sensitive to their headcount movement, and the impact on cost saving from staff reduction is limited.		We've Seen Enough Of        The oblique and indecipherable description/phrase “Sustainability.” Let’s add “shipped as booked” and “biodynamic” while we are at it.    All main course restaurant prices over $30. We are already paying $8 bucks for a side of brussels sprouts in Manhattan.    Promises that the “next air cargo trade show” will be better. We hear that one trade show operator, after delivering less than stellar results for multiple years, now has changed names and reportedly will try again in 2010.    Hearing that my friends are not doing well or are sick or deep in debt. We all are in the same boat and must insist on living a less stressful life and enjoying the blessings all around us—especially with holidays approaching.    Comparisons that the air cargo business each month is only less than double digits worse than the month before or less than 1% better or worse. Recent word that NCA Cargo, for example, was up 3.7% year on year for September sounded like a symphony.    Any company professing that it is into “green” or moving toward a” virtual air cargo product” and then printing a newsletter and mailing it around. like Traxon did this week—communicating by sending dead news on dead trees instead of embracing the digital revolution.    Anybody who prefaces a sentence or sales pitch or an emotion by saying “In these tough and uncertain times . . . ” Geoffrey

    For example, SAS’s staff costs were not significantly reduced from 2005 to 2008 whilst its staff base shrank by almost a quarter during the same period. Iberia, on the other hand, has demonstrated an effective cost-reduction resulting from labor redundancy. It managed to decrease the weight of staff costs in its total operating cost structure by 10 percentage points, from 34% in 2005 to 24% in 2008, on the back of continuous efforts to negotiate early-retirement for the more expensive senior crew, and re-shape its labor base — from a permanent to a temporary or seasonal base.
    To assess their cost efficiency, compare the unit staff cost (calculated as total staff cost divided by available seat kilometre (ASK)) amongst the major European airlines. Lufthansa, Air France-KLM and SAS, with above-average unit staff costs, have more room for efficiency improvement. Labor (pilot) unions are very powerful in Europe, and the execution of a painful staff restructuring could face severe delays or substantial strike consequences. However, the badly-hit airlines have little choice but to go through the pain. Towards early-2010, expect to see more announcements regarding headcount reduction.
     In FY08, most of the airlines covered in this report have experienced a rise of between 7%-11% in fees and charges by airports, navigation service providers and local authorities. The extreme cases — represented by EasyJet’s dramatic fee increase of 33% yoy and Iberia’s fee decrease of 6% — were a result of policy differences between geographical boundaries. Spain has the most relaxed policy regarding airport taxes/charges, whereas the UK represents the opposite case. Despite some government efforts in Spain, Belgium and Greece to reduce or freeze airport tax and passenger tax, many places are imposing higher fees — such as some German airports, the UK government, and the Polish air navigation services provider, which will further squeeze airline margins in 2009.
     The liquidity position for all the major European airlines is likely be adequate to cover short-term financial obligations, helped by European capital markets that were accessible in early 2009 — that allowed airlines to successfully issue debt to boost their cash reserves. Their liquidity position is also strengthened by a rigorous discipline — all of the top five European network carriers have maintained meaningful cash reserves or committed credit lines. With additional help from generally well-spread debt maturity profiles, European airlines are in a good position to cover the cash flow shortfall over the next 12-18 months.
     Cash flow from operations (CFO) has been extremely weak for European airlines in FY09, with SAS even experiencing negative CFO. Most airlines’ CFO/capex ratios were below 1x at financial year-end 2008 (FYE08). Since early 2009, European network carriers have scaled back capex plans for the next two to three years (whilst LCCs remain aggressive in fleet expansion). However, this is still considered high compared with the limited cash flow that has been internally generated.
     Due to long fleet lead times, airlines have to plan for continuous development ahead of recovery, and maintain investment on fleet upgrades to be able to capture the upside when a dynamic market returns. The size of fleet investment varies from airline to airline; since it depends on both the existing fleet conditions such as aircraft age and model, and an airline’s long-term strategy, which would include route focus and fuel efficiency.
     Owning the oldest fleet (average age of 11.3 years at December 2008) among the airlines mentioned in this report, Lufthansa’s order book is significant larger than the others. This means their earlier issuances totalling EUR1.6bn, which were primarily used to strengthen the balance sheet for further market turbulence, may not be sufficient to cover airlines’ investment needs. European airlines will therefore continue to rely on external funding to meet such a requirement in the medium term. Free cash flow (FCF) after dividends and capex is expected to remain negative for the foreseeable future due to a diverging movement between weakened cash low generation and less radically reduced capex.
     The prolonged economic crisis has shaken the fundamentals of the European airline industry, which is currently facing some of the most difficult operating conditions in its history. It will be a long and slow climb to regain “altitude” for the airlines, with further uncertainties likely to pose more threats during the next 18 months.
     The major market players such as Lufthansa and Air France-KLM are capable of battling through the downturn since they are well-positioned following their earlier market consolidations. Conversely, other major airlines with underlying problems such as BA and SAS face further — and more difficult — struggles, especially in the absence of government aid. Even if these struggling airlines succeed in surviving the recession, there is a risk that they shrink dramatically and become “airlines without wings” by the time the recession is over.
     Medium-sized airlines are also in a precarious position, with the key to their survival most likely to be the forming of alliances or further consolidation. However, given current market issues, the pace of any near-term industry consolidation is likely to be much slower than that seen in the past from 2003-2009. An inflection point in the downturn has been reached, the reaction to which will clearly determine airlines’ futures.
Gordon Feller

     National Air Cargo based in Orchard Park, USA kicks off the season of giving with a shipment of 1,000 blankets that were delivered recently to an orphanage in Afghanistan.
     Pictured at delivery is National’s Middle East Manager Dale Deacon based in Sharjah.