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Finance - The Debt Trap

Industry debt will continue to have a significant impact on aviation’s sustainability

It’s a common theme in the present geopolitical environment: debt levels are too high and must be brought down. But it isn’t only governments that are affected. Aviation, too, has a high level of debt to service.

IATA estimates the industry debt at about $211 billion. At no point in the past decade has this figure fallen below $150 billion. That financial burden has a big impact on how airlines go about their business.

“Airlines basically finance their balance sheets with debt,” says IATA Chief Economist Brian Pearce. “This puts huge pressure on earnings because you have to keep money coming in to finance debt. When you are in debt you risk losing flexibility. Interest  eats up cash reserves and, without liquidity, your options become limited.”

The recent recession added to the problem. In 2009, airlines raised $44 billion in cash: $13 billion from the selling of assets and $31 billion in fresh debt. US airlines in particular are heavily geared, which makes them vulnerable to market dips. This was essentially the problem a decade or so ago when 9/11 triggered Chapter 11 bankruptcy filings. The current cash cushion effectively prevented bankruptcies last year as credit lines had dried up

Now, with the economy slowly improving and with US airlines showing capacity restraint and good cash flows, there appears to be no immediate problem. But aviation is a cyclical industry. When  the next downturn comes—and it will—airlines that are in heavy debt will have a problem. Even now, with the economic outlook uncertain, the question is whether cash reserves are large enough. Highly leveraged airlines will have nowhere to turn if a double dip materializes, other than ever more severe cost cutting.

Under pressure

Deutsche Bank European Aviation Analyst Geoff van Klaveren believes debt, combined with reduced cash flows, has put significant financial pressure on many airlines. “It has forced airlines to cut costs like never before and to consider mergers that would have been unthinkable a few years ago,” he says. “Airlines are being more rational with their capital expenditure and have shown encouraging capacity restraint, although there are signs that this discipline could deteriorate in 2011.”

The latest IATA figures back this up. In 2010, an 11% increase in demand has been met with a 7% increase in capacity. “As a result, yields are improving and have risen 7-8% this year,” says Giovanni Bisignani, IATA Director General and CEO. “That  is driving improved profitability.” He also warns, however, that 2010 is as good as it gets in this cycle. “Next year, global capacity will grow 6% ahead of a 5% demand improvement,” he says. “Yields  will stop growing and industry profitability will fall back to $5.3 billion.”

Nawal Taneja, Chairman of the Aviation Department at Ohio State University, agrees that it is airlines’ obsession with winning market share through capacity that is most to blame for the debt burden. “The industry has had too many seats for too long,” he suggests. “Even now, when load factors are high, discounted fares are responsible. At a more realistic price, we would see a sharp decline in load factors.”

Other elements contribute to the debt burden. Fleets  need updating for environmental, economic, and commercial reasons. Airlines have a $1.3 trillion commitment to new aircraft over the next decade to meet these challenges. Low-cost carriers are always a threat, as is the increased competition from Gulf carriers to European and US airlines. Global recessions or potential hikes in the oil price do not help. And, although some European banks have pulled out of the aircraft financing market, Chinese banks have begun stepping into the fray. It makes perfect sense for them as they have large surpluses and aircraft are valuable, mobile assets.

Fortunately—or unfortunately—airlines will always find someone willing to back their new purchases.

Tough decisions

But if getting into debt is easy, escaping it is something else. Taneja is optimistic, however. An obvious solution is to buy fewer aircraft. If airlines still feel the urge to get market share through capacity, he argues, joint ventures along the American Airlines/British Airways/Iberia lines are the right way to go. That gets an airline extra seats without extra aircraft.

“Airlines finally understand that market share isn’t driven by capacity alone,” says Taneja. “Customer service is now integral to future strategy, and innovations such as Web 3.0 marketing will be vital. This gives mass customization—an individual product for everybody—at mass production prices.

“In any case, you don’t need market share to be profitable,” he adds. “Some hotel chains are very profitable despite having a small market share. And some carriers are beginning to understand this point too.”

Deutsche Bank’s van Klaveren goes further. “The only sustainable solution for the airline industry is to remove the archaic ownership restrictions that prevent worldwide consolidation, which is badly needed in such a capital-intensive industry,” he says. “We believe governments don’t need to hold strategic airline stakes: the market will provide.”

IATA’s Pearce agrees that structural changes are needed. Ownership rules, he says, must be revised: “It is the only long ‑term solution for the industry. Without this fundamental change, other efforts to realign the business model along sustainable lines will ultimately fall short.”

Equity highlights the point. Although $13 billion was raised in new equity last year, this is nowhere near enough. Having more equity would provide airlines with a means of reducing the debt burden. But increasing investment in the industry is unlikely given the historical returns of aviation.

The profit margin for 2010 is likely to be just 1.6%, which is way below the 7-8% cost of capital. Investors can easily find a more profitable use of their money. There are those that still find the lure of aviation too strong to resist but, as figures continue to struggle, financial angels will be harder to find—especially if an airline can’t search beyond its home country’s borders.

Pearce reaffirms that the ultimate goal for airlines is to make money—not to fly passengers around the world at cheap prices. “Flexibility is vital in aviation and you can’t have that while you’re shouldering huge amounts of debt,” he concludes. “Cash remains king while the industry remains in debt.”

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Cheap Finance

Aviation is a capital-intensive industry. Aircraft cost a lot of money and going into debt to buy one is almost inevitable. On the face of it, inexpensive finance seems a boon. But export credit agencies (ECAs) could be accused of aggravating the debt burden. There is an argument that the money they supply to support the export efforts of Airbus and Boeing is simply too tempting.

“Government-backed financing needs to be examined because it misprices risk, exacerbating the global airline debt problem,” says Deutsche Bank European Aviation Analyst Geoff van Klaveren.

IATA has called for a level playing field on two counts. First, ECA finance should apply to all airlines or none. Having different rates for different carriers depending on where they are situated doesn’t sit easily in a global industry.

Second, it should apply to all aircraft or none. Originally, applying ECA finance to only Airbus and Boeing made sense because the two manufacturers were distinct in their widebody offerings. But these days the larger Bombardier and Embraer regional jets are direct competitors to smaller Airbus and Boeing products. There needs to be a level playing field for all manufacturers, especially with new players from China, Japan, and Russia looking to enter the market.

“The need for a level playing field is being discussed at the Organization for Economic Cooperation and Development (OECD),” says Brian Pearce, IATA Chief Economist. “The ECAs and the home country rule are embedded in the OECD Aircraft Sector Understanding. This is due for revision. Remodeling finance to ensure parity will be difficult, however, so it’s hard to be precise about the timeframe involved.”


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