It is a lousy business,’ says Kevin Murphy, senior airline analyst at Morgan Stanley Dean Witter, who has been covering this sector for almost two decades.
The aura of glamor and optimism surrounding the fledgling air-travel industry has faded, certainly for passengers, who contemplate mystery-meat meals in brown paper sacks from their crammed seats. But the good times have also passed for investors, who find themselves watching airlines with razor-thin profit margins go in – and sometimes out of – bankruptcy with alarming frequency in this now mature and highly cyclical industry.
After a sharp downturn in the early 1990s, recent times have been good. Indeed, 1998 was a record year for the industry. But the airlines are facing the uncertainties of global deregulation, shifting alliances and cut-throat price wars – now including internet ticket auctions, a fluctuating labor environment, the vagaries of world oil prices, and rising customer expectations. In this climate, gauging winners and losers is not easy.
Big issues
One thing everyone agrees on is that the big issue of the moment is overcapacity. ‘There’s simply too much supply now, and it’s not being cut. It’s just being shifted,’ argues Glenn Engel, airline analyst at Goldman Sachs. ‘Mobile capital will go where profits can be maximized. So if volume slows in Asia, it’s moved to South America or brought back domestically.’
While US carriers have cut back trans-Pacific capacity, Asian airlines have transferred planes from intra-Asian to trans-Pacific routes. And both European and US carriers have redeployed aircraft from Asia to trans-Atlantic markets, where yields have begun to fall for the first time in five years. ‘The issue of capacity,’ points out Lehman Brothers airline analyst Daniel Ward, ‘is always relative to demand. If demand is strong, who cares how much capacity there is?’ But, for the first time this decade, according to Engel, US airlines are adding domestic capacity at a faster rate than GDP growth.
What this means is that too many empty seats are likely to be chasing too few passengers. So even though at the beginning of the year airlines could still raise fares (2 percent for business and 4 percent for leisure travelers) they could soon be spiraling downward. Falling margins are never good news, but they are an especially grim prospect for an industry notable for price elasticity.
‘There is an inefficiency in the pricing structure,’ argues Brian Harris, who covers the industry for Salomon Smith Barney. ‘Business fares are too high relative to leisure fares. Over the past three years, business fares have risen 31 percent while leisure fares have declined 17 percent. Corporations have already begun curbing travel budgets and encouraging employees to look for lower-cost alternatives to sky-high business class prices, and airline profit margins could get increasingly narrow.
Some carriers, such as American Airlines, are scaling back. ‘We have taken action to cut capacity,’ reports Michael Lenz, director of investor relations at AMR Corporation, the holding company for the airline. ‘We cut our growth target from 6 percent to 4 percent, including some domestic capacity, but mainly international. People have been dumping so much capacity to Europe.’
Others, however, continue to go forward with their expansion plans. For example, Continental Airlines is aiming for an 8.6 percent increase in capacity this year, even after 10.6 percent last year, and plans to achieve it by developing hubs it underinvested in during two bankruptcies.
In fact, Diane Schad, Continental’s finance VP, maintains her biggest challenge is trying to deal with the skeptics. ‘We should be getting PEs like a growth stock, but we’re not because of the airline’s history. If the economy turns south, we do know how to pull capacity out, but what they say is You have to prove it first, which is like saying, We want to make sure you know how to swim, so we’re going to throw you into the deep end of the pool.’
Alliance options
To create cost and revenue synergies while avoiding the hassles and capital outlay of a merger, airlines have been forming alliances. At first, regional airlines formed relationships with and began feeding traffic to the major airline hubs. Now they are code-sharing, which means alliance partners tell the computer reservation system through which 80 percent of bookings are made to consider the two airlines as one, which, in effect, doubles the shelf space for each airline. ‘US code-share just took hold in December, but it’s been around internationally for about a decade,’ explains Kevin Murphy, adding, ‘I’m surprised at the lack of negative reaction from consumers: you literally don’t know whose plane you’ll be on when you get to the airport.’
Though airlines have embraced alliances with fervor, often there is friction. For one thing, the benefits may not come to both partners equally. Should, for example, a regional airline set fares and schedules to maximize its own revenues or the revenues of the team?
Despite the difficulties, many analysts expect merger activity to increase among airlines. ‘Market forces will prevail,’ according to Murphy. ‘There’s a poor return on capital for this industry, and the only way to improve it is through consolidation. As airlines increase code-sharing, one of them will break ranks and merge. After all, you’ve got to date before you get married.’
SSB’s Harris concurs, ‘Alliances are really a poor substitute for mergers,’ though he disagrees with the courting sequence: ‘There’s a more Neolithic approach to dating in the airline industry. The reality is you take what you want.’
Trans-Atlantic alliances have proven successful, as code-sharing has contributed to more efficient use of capital and greater regional concentration, even to the point of driving out competitors. The United/Lufthansa partnership led to American and Delta’s retreat from German markets, while American and United left the Belgian and Swiss markets after the Delta/Swissair/Sabena combination.
But they create even greater friction than major regional networks because their routes tend to overlap, and the splitting of code-share traffic revenues is tricky. European carriers, which now offer 65 percent of transatlantic capacity, seem to have benefited more than US airlines from alliances. And because of the built-in conflict of interest between airline partners, international alliances tend to be volatile. In 1997 alone, while 121 new alliances were formed, 102 were dissolved. The movement into alliances is likely to continue, however, and most airlines will find global partners: the Star Alliance Group has United, Lufthansa, SAS, Air Canada, Thai Airways International and Varig; while the oneworld group includes American Airlines, British Airways, Canadian Airlines, Cathay Pacific and Qantas.
Young upstarts
The air travel market in Europe became fully deregulated for EU airlines on April 1, 1997, and that has already led to greater industry polarization and far less fragmentation. Deregulation has also caused upstarts, such as Ryanair, Virgin Express, Easyjet and British Airways’ low cost Go, to enter the fray, in an attempt to exploit under-used routes and undercut the major carriers.
The potential is huge, according to Martin Borghetto, London-based airline analyst at Morgan Stanley Dean Witter, pointing out that Europe has just 1 percent of travelers on low-cost airlines, compared to the US market’s 5-10 percent. Dublin-based Ryanair, for example, is a hot stock at the moment, trading at nearly 30 times earnings. Like Southwest in the US, it flies to and from smaller airports not far from main destinations, taking off from Dublin and London’s Stansted and Luton Airports, and landing in Beauvais, 45 miles north of Paris. And, beginning this summer, it will also be flying into Frankfurt’s Hahn airport, about an hour from the city. But it’s not safe from predators, as consolidation is expected to increase in Europe as well.
The current operating environment in Europe, however, remains uncertain. ‘This is mainly due to a slowdown in global traffic growth, as a result of slower economic growth rates, currently outpaced by capacity growth,’ explains Borghetto. He says airlines have pulled significant capacity from the Southeast Asian markets and switched it to their North Atlantic networks. Historically, North Atlantic routes have been the strongest profit contributor for European airlines,’ adds Borghetto. But there are, he says, growing signs that the ‘risks are finally beginning to tip to the upside of our economic growth estimates in the crisis economies of Asia and Latin America.’
So, while some airlines such as KLM and Swissair will continue to struggle, others, like British Airways, have been oversold and are a good bet for investors. That’s one stock, according to Borghetto, that could double in two to three years.
‘Some airlines are born to manage capacity, some achieve capacity management and others have capacity management thrust upon them,’ maintains Warburg Dillon Read airline analyst Timothy Ross. ‘Most of Asia’s carriers inhabit the last class of operator.’
The Asian economic crisis, says Ross, ‘has forced its carriers to reconfigure along more rational lines.’ So, as the millennium approaches, fewer seats are expected to be flown, although they will likely be flown further. As expected, hub market share is concentrating on Singapore and Hong Kong, at the expense of their regional rivals, and traffic growth has remained robust for some sectors, like the ‘Kangaroo route’ between Europe, Australasia and the US east coast. The crisis has also forced Asian airlines to abandon their long-held reluctance to join global alliances.
Investors had considered Asian airlines relatively immune to the perceived excesses of the US airline industry, but the premiums they had attached to Asian airline stock came crashing down when the crisis struck. With shares trading at deep discounts to book value, now may be the time to start bargain hunting.
In fact, many believe that Asian airlines are within reach of this cycle’s bottom. Ross identifies a ‘false dawn’ for traffic growth as the key risk to his recovery scenario. He cautiously recommends airlines which have brand visibility, good Asian distribution, a commanding presence on key in-bound routes (Cathay and Qantas) or serving growth markets (Thai).
Lack of control
Airlines remain tightly bound to the business cycle, and while managements can take steps to lessen the impact of a downturn, through alliances and capacity curbs, for example, they cannot control the economy. In looking to upgrade their airline portfolios, investors are concerned that US airlines appear to be too late in the cycle, with supply rising and demand peaking; Asian ones appear to be too early, with supply not yet contracting sufficiently, and economies not yet troughing. Only in Europe, perhaps, does the timing of the cycle seem right, though storm clouds seem to be gathering there as well.
In all the uncertainty, notes airline veteran Murphy, ‘Particular stocks can be, and often are, mispriced, and that’s my raison d’etre. After all, my patron saint is St Christopher.’
In this business, one needs all the help that one can get.
