Airlines are the lifeblood of the aviation market. When airlines succeed and prosper, the rest of the market prospers. The obverse, however, is also true: a general decline in the health of airlines impacts the whole market (albeit lessors have shown their ability to move aircraft quickly to where the demand is). Exogeneous shocks aside, the fortunes of airlines tend to be restricted to certain jurisdictions during downturns, which is when lessors show their ability to move aircraft quickly from stressed situations to areas of greatest demand, managing their fleet and profitability through the cycles.
Over the past decade, as the global economy has improved, airlines have grown in profitability, matured in terms of employing better capacity management and cost controls, and have benefitted from the explosion in demand for passenger air travel. Airframe and engine manufacturers have booked orders and reported record deliveries, with plans to further push up production to historically high levels. Leasing companies are busier than ever as demand for lift continues, which is attracting many new entrants – backed by new investors – into all sectors of the leasing market, from brand new aircraft to mid-to-late-life equipment. Banks, too, are eager to lend despite impending constraints imposed by new capital regulations; commercial debt finance is more popular than ever despite the lower yields, while structured capital markets transactions are becoming more standardised and tradable as investors pile into the sector.
Airlines, lessors and banks are operating within a global environment where a multitude of exogenous factors are colliding at once presenting numerous challenges.
Geopolitical threats are building. Notably the ongoing US-China trade dispute has resulted in forecasts that 25% tariffs could drive a 2-3% decline in global GDP, which is historically linked to traffic growth. IATA is predicting just 4% traffic growth in 2019 if tough and restrictive protectionist measures are implemented. The departure of the UK from the European Union (EU) is categorised as a restrictive and protectionist measure that could severely impact the aviation industry there, especially in a no-deal Brexit scenario (at the time of writing, an exit agreement has not yet been passed by the UK parliament).
Interest rates are rising globally, but particularly in the US; this impacts currencies as a higher US dollar exchange rate pressures airlines with revenues in non-dollar currencies, slicing margins. In India and Indonesia for example, currencies are at a 20- year low against the US dollar. This is a punishing situation for airlines that pay for their costs – mostly jet fuel and lease rentals – with US dollars but book revenues in local currencies.
The US Federal Reserve increased interest rates in September 2018 by 25 basis points (bps) to a range of 2%- 2.25% and a further rise of 25bps in December 2018 to the 2.25-2.5% range. The US central bank had planned for at least two further rate rises in 2019, but this may change depending on the fallout from the trade war between the US and China and the general health of the US economy.
In Europe, the European Central Bank (ECB) ended quantitative easing (QE) in December 2018 and is expected to plan the first in a series of interest rate hikes from September 2019. A “hard” Brexit, however, could radically alter these plans. The Bank of England has stated that after an increase in August 2018, there will not be another rate rise before Brexit in March 2019, but that too could change in the event of a hard Brexit.
Passenger travel continues to grow above the long-term ten-year average of 5.5%. However, the latest Economic Performance of the Airline Industry report from the International Air Transport Association (IATA) has shown a slight cooling in passenger demand. In 2018, demand measured in revenue per kilometre (RPK) grew by 6.5%, down from 8.0% growth in 2017. IATA expects passenger demand to drop to 6.0% growth in 2019. Capacity measured in available seat kilometres (ASKs) rose by 6.0% in 2018 compared to 6.6% in 2017, with predictions for 5.8% growth in 2019. Passenger load factors have therefore continued their slight upward trend from 81.5% in 2017 to 81.9% in 2018 and are forecast to reach 82.1% in 2019.
The same IATA report also highlights the profitability of the world airlines. Net post-tax profits stand at $32.3bn for 2018 (down from $37.7bn in 2017). Profits as a percentage of revenue fell to 3.9% in 2018 (from 5% in 2017), with return on invested capital of 8.6%; this has been driven by a strong economy and a change in industry structure and behaviour – with airlines focused more on delivering returns for investors. IATA forecast profits of $35.5bn in 2019 but the various headwinds could impact this.
Analysts are broadly positive on the fundamental strength of the market. Betsy Snyder, director of S&P Global Ratings, is optimistic regarding the growth prospects of the airline industry pointing to the desire among millennials and Generation Z to travel and experience the world, while the older generation are also spending their retirement traveling. “The trends for continued traffic growth look very good, at least for the next few years barring some unforeseen event or a steep decline in global economic growth,” she says.
Moreover, airline profitability has improved to such an extent that analysts see many airlines being cushioned from some of the sharper shocks to operations, such as fuel cost increases and fluctuations in the value of the US dollar. “The profitability of airlines in the past few years has really improved,” says Marjan Riggi, senior managing director, Kroll Bond Rating Agency. “It’s almost like there’s been a little bit of a structural shift in their cost management. Many of them have delivered. Their costs have gone down. The load factors are up because that affects revenue. In general, airlines are healthier. This year, however, the cost of running an airline has risen due to fuel. All that said, airline profitability, as a whole, was very strong last year and although lower this year, will still be profitable.”
While the IATA figures remain a growth story, the cooling in industry- wide RPK growth is tied to the increasing number and strength of macroeconomic headwinds that are beginning to affect carriers around the world, putting pressure on margins.
Craig Fraser, managing director, FitchRatings, agrees that on the surface the industry looks healthy but when you dig deeper, there are many reasons to be cautious. “One of the biggest risks in the industry right now is actually complacency,” he says. “Things have been going so well for a long time. By some measures, this is the longest upturn we’ve had in the aviation sector, but we need to keep in mind that this is a sector with a high structural risk profile. Performance can turn very quickly, and there are a lot of signs of complacency if you look around, whether it is executive commentary about cyclicality, discussions about future production rates, or cash deployment choices.”
Fraser also highlights the dampening global GDP forecast, volatile oil prices and rising interest rates, along with the continued increase in capacity. “We still see a lot of capacity coming in to the market, with production rates going up,” he adds. “From a rating agency perspective, one of the biggest suppliers to the aviation sector is the credit markets, and our firm’s view is that we’re late in the credit cycle, with the overall market starting to turn, and I think we’re seeing some indication of that, in the aviation credit markets as well.”
Airlines are particularly impacted by rising interest rates in terms of debt finance contracts as well as escalation on any aircraft orders they have made. One banker points out that even a 50 basis point increase in interest rates could have a significant impact on borrowing costs for airlines with floating rate debt, which has been the norm in the low interest rate environment of the past decade.
“Some airlines have been requesting interest rate hedges for new aircraft deliveries,” says Korea Development Bank’s Winston Yin, who adds that he has seen more requests for proposals (RFPs) from airlines explicitly for fixed-rate funding than ever before. “Increasingly, airlines are requesting fixed-rate funding from the outset, but “By some measures, this is the longest upturn we’ve had in the aviation sector, but we need to keep in mind that this is a sector with a high structural risk profile. Performance can turn very quickly, and there are a lot of signs of complacency if you look around,” Craig Fraser, FitchRatings if not they are certainly insisting on the optionality to fix funding rates in the future.”
Oil prices increased significantly in 2018 peaking at US$86/bbl (Brent Crude) in October but fell to US$55.63/ bbl in late December 2018. While the drop in the oil price during the fourth quarter of 2018 gave airlines a slight reprieve, it is likely that they will rise again. Citi, however, predicts that the average oil price will be $60/bbl in 2019 but it could be driven higher for a variety of reasons.
IATA reports that airline fuel costs will rise from an annual worldwide spend of $180bn in 2018 to $200bn in 2019 , representing 24% of total airline operating costs. Fuel costs will always represent a headwind for airlines to tackle but oil price rises may provide opportunities for Original Equipment Manufacturers (OEMs) and lessors as airlines turn to more fuel-efficient aircraft. Fuel hedging has been sporadic for the younger airlines. Legacy carriers continue to hedge their fuel requirements despite having experienced losses in the past. Whether or not airlines are hedged, and to what extent, will be a deciding factor in the coming period if fuel turns upwards once again.
Labour costs are becoming a more significant threat to airlines, specifically because pilots and skilled technicians are in scarce supply and are backed by stronger unions. Maintenance costs are rising due to more expensive labour and rising interest rates, pushing up prices for airlines and aircraft owners. IATA is forecasting an average increase of 2.1% for unit labour costs in 2019, which will further squeeze airline profit margins over the next 12 months.