A Common Goal
Fresh thinking is required to reward airline investors and allow carriers to continue creating value for the global economy
It is estimated that $4 trillion to $5 trillion will be needed to buy the aircraft necessary for growth in the next 20 years. Most of these aircraft will serve the booming Asia-Pacific markets and other emerging economies. At the same time, it is estimated that 75% of the world’s airlines are at least majority owned by the private sector. So, if airlines are to continue creating value for the global village, it is essential to make the sector attractive to the private investor who will provide the capital. At the moment, it isn’t. Financially-speaking, it never has been.
But in times past new business models, more buoyant economic conditions, and the allure of aviation have proven enough to keep the capital rolling in — not to mention government ownership. The very different economic conditions following the 2008 global financial crisis have changed the investor mindset, however. Investors measure the success of their investments by the Return on Invested Capital (ROIC). This shows the rate at which the assets of the business are generating after-tax profits. The Weighted Average Cost of Capital (WACC) is the figure an investor should expect to get from investing in a particular sector. A strong industry will reward investors with a ROIC well above WACC.
But, according to a new IATA study, Profitability and the Air Transport Value Chain, in the airline industry — hyper-competitive and suff ering from numerous structural problems —investors have never reached WACC. During 2004–2011, the airline industry worldwide averaged a ROIC of 4.1%. This is an improvement on the average of 3.8% generated in the previous business cycle 1996–2004 but it is nowhere near WACC (7.5%).
“In 2012, airline profits were $7.6 billion,” says Brian Pearce, IATA’s Chief Economist. “It boils down to airlines making just $2.56 per passenger. Clearly, any increase in costs, a rise in government taxes or a drop in demand will eradicate that slim profit margin very quickly. And even without those dynamics, $2.56 is not enough to pay investors who are risking considerable sums of money.” Looking at the overall investment picture, investors would get $17 billion more per year if they put their money in equities and bonds of a similar risk profile outside the airline industry.
Of course, individual airlines have proven capable of generating a ROIC above WACC. But figures prove that the challenges are system-wide and not dependent on the business model or geography. “At first glance it is hard to see why this should be,” says Pearce. “Logically, risk should be balanced with reward. So, if market forces are working properly, the sector bearing most of the risk in the aviation value chain—the airlines—should get the biggest reward. But this is clearly not the case.”
Airlines are surrounded by stronger business partners and other sectors generate far healthier returns. Distribution and freight forwarding stand out as excellent investment opportunities. “But it is hard to put the blame for airlines’ poor profit performance on the money made by other sectors in the value chain,” warns Pearce. “These sectors are relatively small in their impact on airline profitability, relative to the problems caused by the fragmentation of the industry and the commoditization of the air transport product.” Two areas stand out as major concerns though; fuel and labor.
Fuel has risen to become more than 30% of an airline’s operating costs despite far more efficient operations and engines. The price of fuel has gone up enormously and the problems have been compounded in some countries with taxes on domestic fuel. Brazil, Japan, and India are cases in point. Air transport generates somewhere between $16 billion and $48 billion in profi ts for fuel companies every year. Most of this money is made upstream by crude oil suppliers. It is difficult to imagine how market forces alone will remedy the situation as so much power is in the hands of the OPEC cartel notwithstanding the recent discoveries of shale oil and gas in the US and elsewhere.
“There is clearly scope for improving the efficiency of the supply chain,” says Pearce. “But in fact the airline industry has done a pretty good job at cutting cost, with a 60% fall in real terms over the past 40 years. The problem from an investor perspective is that all of those cost reductions have been passed through to customers, leaving equity investors unpaid for risking their capital.”
Read more about the solutions to airline industry profitability challenges.