The Changing Context

January 2012

The year has had a rather gloomy start.

The European economic and financial crisis continues, and with some risk to political stability if high unemployment and harsh austerity measures continue in some countries.

The price of oil remains high at above $100 a barrel, too high for most airline budgets, and concerns over the tension with Iran may drive it higher.

Austerity measures and recession have reduced passenger numbers and yield, whilst cargo demand remains very weak.

Europe has been identified as the likely worst performing region in the world by IATA in their latest forecast. This both reduces their September forecast of the likely profitability of European airlines in 2012, and adds a second even more pessimistic scenario which would see the whole industry plunging into loss if a second banking crisis were to strike.

The pressure on banks to meet new more onerous tier one capital requirements under the Basel III agreement, and their disclosure of risk weighted loans may impact airlines. A concern is that the amount of capital for new aircraft purchase may be reduced, constraining such purchases. Interest rates associated with capital funding for aircraft are also rising, further impacting airline costs.

The rise of protectionism?

Of concern for European airlines is the perception that some countries, including European States appear to be considering protectionist trade policies. These would almost certainly impact upon airlines.

In the USA Richard Anderson, ATA Chairman and Delta CEO stated US carriers believe foreign airlines are starting to flood international routes, including routes to the United States, with excess capacity, subsidized by the US Government.

His initial target is the role of the US ExIm Bank that has provided low interest loans to support the purchase of Boeing aircraft by foreign airlines, especially from the Gulf States. There are, however, as many US citizens employed in aircraft manufacture as there are in airlines, and arguably their economic contribution is far greater. So the role of the ExIm Bank is unlikely to change.

Although the main target for such allegations are the Gulf State airlines such as Emirates and Etihad, there are also implications metal neutral joint ventures agreed under ‘Open Skies’ are starting to impact US employment. There is also a perception that Anderson and others are preparing the US politicians for a further round of airline consolidation. Delta has expressed interest in possibly buying American Airlines and there is a long held view that US Air will be taken over. Not necessarily by American Airlines. Some analysts believe that the US should consolidate down into only two major international carriers who will compete strongly in global markets, with a number of low cost largely domestic airlines such as Jet Blue and Southwest.

In the USA both Mitt Romney and Newt Gingrich – the front runners in the contest for the Republican Party nomination for the Presidential election – are arguing for a hard line on trade with China. Partly in response President Obama used his State of the Union address to express his concerns at companies that outsource jobs outside the USA and hinted at possible legislation.

At the recent IATA AGM the Chief Executive of Qatar Airways accused several airline chiefs, including of Air Canada and Lufthansa of protectionism with their lobbying of their governments to limit sixth freedom traffic for Gulf State airlines. He also suggested that maybe IATA did not reflect a sufficient diversity in its staffing, especially at senior levels. An unusual intervention for a meeting that is traditionally rather polite and non-controversial.

ETS, taxes and airport regulation

European airlines are also facing some structural challenges.

Emissions Trading Scheme

The Emissions Trading Scheme has been implemented, despite fierce international opposition. The USA is still progressing legal challenges, and the Chinese airlines are threatening not to pay any charges. The Chinese government also appears to have threatened to prevent Hong Kong Airlines from purchasing Airbus aircraft in direct retaliation.

For European airlines compliance with the scheme is estimated to raise their costs significantly. Initial estimates by airlines that use EU airspace claim that they will incur significant additional charges. The estimate for the total industry is for an additional cost of £830 million in 2012, rising to £2.3 billion annually by 2020. Lufthansa puts the likely annual cost at Euro 108 million, and IAG at £75 million. Both are imposing passenger surcharges of about £3. Even Ryanair is planning to impose a surcharge.

Airports

The EC is also consulting on a wide ranging change to regulations covering airport management, slots and passenger rights.

The raising of the use it or lose it rule threshold to 85% will further pressurize airlines to use slots effectively, whilst the proposed licensing of a slot trading market may persuade some airlines to capitalize on asset sales. Smaller airlines may be squeezed out of major airports, however, as their thinner routes may not justify the use of very valuable slots. This could well apply especially to smaller airlines that are not members of one of the global alliances, and be a further trigger for consolidation.

There are some tricky details in the passenger regulations, especially concerning access for less able passengers, and these could lead to some difficult negotiations with airports, airport service providers, and increase some costs. It will be interesting to see how the UK handles the para Olympics competitors and supporters with the current infrastructure.

Taxes

Taxes continue to attract fierce criticism from airlines in the affected countries. The rises in the UK APD and the German travel tax are both argued and with some evidence to have significantly reduced demand. Environmentalists regard such data and arguments as proof that the policy is effective in curbing unnecessary air travel. Meanwhile investment in high speed rail continues although the looked for entry of Deutsche Bahn into the UK market via the Channel Tunnel has now been delayed for three years.

Airport capacity

All these developments also emphasize the realization that Europe simply does not have enough airport capacity and that the Gulf airports are an increasingly attractive alternative hub for many international routes.

In the UK an innovative scheme to build a new airport in the Thames Estuary has garnered some political support, but not from British Airways who have invested heavily in Heathrow. For some the scheme seems reminiscent of the ill-fated plan for Maplin Sands that sank amidst the economic recessions of the 1970’s, but his scheme appears much better thought out as new multi-modal travel hub. Unfortunately with a very large proposed price tag.

Consolidation of European airlines?

One result of this continuing economic recession, especially if it worsens, is the likely acceleration of the consolidation of European airlines.

With Europe the sale of bmi to IAG is proceeding, but the price reflects that bmi is not regarded as a going concern. The only attraction for IAG is the slots and terminal facilities at London Heathrow airport, and perhaps the UK accredited pilots.

Spanair has not been rescued by Qatar Airways as hoped, and has been closed down, and AlitaliaCargo appears to have suffered a similar fate. Czech Connect has suspended all flights until the end of the winter season and Alitalia has tentatively agreed to merge with fellow Italian operators Blue Panorama and Wind Jet.

The list of European airlines that appear to be available for equity investment, and probably sale, includes Aer Lingus, LOT, Malev, TAP and Virgin Atlantic. Rumours continue about the future of SAS. Lufthansa is the obvious candidate but the German Group is preoccupied trying to turn Austrian Airlines and Brussels Airlines around, and restructuring to reduce cost.

Air France KLM is similarly preoccupied by trying to reduce cost as losses mount. Reduction in capital spend, services and staffing have been indicated, but the major announcements will not be made until the late Spring.

The low cost segment

The performance of the low cost segment remains much more optimistic. The ability of these airlines to a quickly adapt their networks and prices to demand, including grounding aircraft, has resulted in far better results than for the network carriers.

EasyJet has reported a return to significant profitability. Ryanair reports lower profits than usual, but still significant profit. Wizzair appears to have revitalized and is expanding once again. Norwegian Air Shuttle has announced a further large order for new aircraft and is now the dominant short haul airline in Northern Europe. Vuelling is growing in the Spanish market and will benefit from the demise of Spanair.

The mixed product or regional airlines are not reporting such good results. UK based Flybe has seen its share price plummet as it seeks to cut losses on many thin routes. Air Berlin is struggling to survive after overexpansion and is cutting routes, aircraft and services just as it seeks to attain a dominant position at the new Berlin Brandenburg International airport.

Southwest Airlines

In this context the recent comments by Gary Kelly, the Chief Executive of Southwest Airlines in the USA may be relevant. In a series of memos and statements he has bluntly warned Southwest staff that the world has changed over recent months in the US market.

He is not celebrating American Airlines entering Chapter 11 protection even though the cutting of services may offer more opportunities for Southwest. He points out that as with Delta and United before, American Airlines is likely to emerge from Chapter 11 as a much more efficient, lower cost and therefore competitive airline. He points out that Southwest faces a squeeze on its own competitive positioning because all three of the major US airlines will have halved the cost advantage that Southwest used to have over them.

He also points out that new even lower cost operators such as Jet Blue and Spirit Airlines are now competing on ever more routes. On top of this he observes that over the year the low cost model offered by Southwest has suffered from cost creep. Slowly but surely staffing levels, burdensome procedures and salaries have increased. So to maintain their position Southwest will also have to embark upon a significant reduction in costs.

For the European low cost airlines a similar pressure may grow, especially if total demand is further impacted by taxation and regulatory cost.

At present easyJet, Ryanair, Wizzair and Vuelling are all adding additional product in terms of seat allocation, early boarding, and in some cases onboard catering. As is Monarch Airlines which is increasingly focusing on the low cost scheduled routes market. These additional products are currently justified by their generation of ancillary revenues but over the longer term some low cost airlines may need to reappraise costs whilst avoiding the operational problems faced by easyJet two years ago when it inadequately resourced its operation.

Staff morale

As ever in an economic decline punctuality and operational service remain key. American Airlines and United Continental have suffered in the USA through perceived poor punctuality, loss of bags etc. The one as it attempts to reduce cost, the second as it struggles to merge two workforces and systems. Staff morale remains important and as Iberia struggles with threats of renewed strikes next month, and there is rumoured unrest amongst airline staff in France, Italy and Greece, this could be a difficult Spring for airline executives.