Aviation Industry : Back Into The ‘Friendly Skies’ By Farnborough 2010?

Aviation industry : Back into the ‘friendly skies’ by Farnborough 2010?

SUNIL KEWALRAMANI February 18, 2009

As investments, airlines are best left to relentless optimists and colourful egomaniacs. Over the long term, a diversified portfolio of airline stocks has reliably lagged behind broader market averages. Airlines’ long-run operating margins have averaged just 2 per cent since 1950, says UBS.

In 2007, during the Paris Air Show, the aviation industry was flying high….the world economy was booming and credit was plenty. Customers who had booked from Boeing and Airbus could get a premium for waiving their bookings in favour of companies interested to jump on the aviation industry growth story. Today, airlines are happier returning their aircraft than taking delivery. In 2008, the Amex Airline Index has plunged more than 70 %. Not only has the game changed, the dominant players have changed as well. At Farnborough this year, Middle-East’s Etihad Airways has ordered 45 aircraft from Boeing and 55 from Airbus, worth about $ 20 Billion at list prices. It reinforces Middle East’s position as one of the few regions where airlines have the financial clout to expand aggressively.

Singapore Airlines, which reported its third-quarter results on 10th February 2009,, is one of the less terrible operators. It has the two qualities every carrier needs to withstand troughs: a strong brand and a patient majority shareholder (state-owned Temasek, in SIA’s case). On top of that, it has one of the world’s better-looking balance sheets: cash in the bank exceeds long-term liabilities by more than three to one; a youngish fleet of fuel-efficient aircraft; and one of the most highly rated management teams around. As such, the world’s largest airline by market capitalisation is an industry benchmark. If SIA is struggling, pity the rest.

SIA is indeed suffering. The September to December period, traditionally its most profitable, saw net income almost halve. Operating metrics were solid: passenger load factors down only 3 per cent, while costs (excluding fuel) fell 5.5 per cent. But it came a cropper on hedging, locking in purchases of jet fuel at much higher rates than the period’s average of $99 a barrel. Losses should widen: 44 per cent of fourth-quarter fuel requirements – well above the industry average – have been pre-bought at $131 a barrel, compared with today’s spot price of $56.

As those hedges fall away, however, SIA has a real opportunity to stand out from the pack by protecting its dividend. China Eastern had recently rejected Singapore Airlines’ bid to expand its operations. What is more, cash flow after capex over the first nine months almost covers last year’s dividend. In an industry that oscillates between varying degrees of over-capacity, preserving the payout would really hammer home the difference between the leaders and the laggards.

For Vijay Mallya—the self-proclaimed “king of good times” who patterns himself after Richard Branson, the launch of Kingfisher Airlines three years back seems to have come as a cropper. Slower economic growth due to unexpected world crisis along with dramatic fuel price rise earlier this year has taken the tails out of the airline industry. There are urgent demands being made for reducing sales taxes from 26 per cent to 4 per cent which could help reduce air fares. A sanguine Mallya has called for India to ease its restrictive FDI policies, which currently prohibit foreign airlines from holding stakes in domestic Indian carriers.

Although oil prices have retreated of late, threats by OPEC to cut production coupled by the threat of inflation which could return in the wake of extremely expansionary monetary policies of the world central banks, could cause fuel prices to go up again. Fuel costs make up about 65 % of costs on long-haul flights but only about 30 per cent of costs for short-haul flights. Qantas, one of the world’s most profitable airlines has recently grounded aircraft, suspended routes, chopped capacity, cut jobs and struck a deal with its long-haul pilots to lock in the company’s 3 per cent per annum wages policy until 2013. In the wake of 9/11 and SARS, the Australian carrier had performed better than its peers, picking up market share as well as aircraft abandoned by airlines who could not afford them.

According to a report by Frost & Sullivan, the price of Indian fuel is based on international parity pricing, despite the fact that international crude is refined in India. Aviation turbine fuel (ATF) rates in India, represent 40-45 % of ticket costs as compared to the global standard of 35 %. In the backdrop of high fuel prices, domestic passenger numbers has fallen significantly from a year ago according to the Indian aviation industry. Jet Airways recently laid off 10 % of its workforce, only to relent and take them back under duress. GoAir has laid off a significant chunk of its expatriate pilots. SpiceJet has announced reductions in its daily flights from 117 to 100. Kingfisher Airlines is negotiating sale of two of the five A340-500 aircraft it had committed to buy from Airbus in 2007. Both Spicejet and GoAir are returning planes to lessors. It is also contemplating deferring taking deliveries of 29 narrow-bodied A320s . In response, some have adopted the use of winglets on the wing tips to reduce fuel consumption, others are flying their aircraft at higher altitude, choosing parking bays closer to the runway to reduce taxing time. Some are cutting down the amount of water in toilets and for human consumption they carry while others are carrying lighter plastic cutlery, food trays etc. Even the Indian government has recently pitched in by withdrawing the customs duty of 5 % on jet fuel. In addition, oil companies are reducing ATF prices by Rs 9429.87 per kilo litre with immediate effect.

American, Continental and Delta have reduced flights to various destinations. Pratt and Whitney estimates that its EcoPower engine-washing process saves Hawaiian $ 1 million in fuel annually across 31 Boeing 767 engines. Eight senior pilots and the US Airline Pilots Association have filed complaints with the Federal Aviation Administration stating that US Airways is pressuring pilots to use less fuel than they feel is safe, in order to save money. By removing six seats, JetBlue reduced an A 320 weight by approx 904 lbs. Air Canada is considering removing paint and primer from its 767s to save 360 lbs per plane. Alaska Airlines indicated in 2004 that removing just 5 magazines per aircraft could save $ 10,000 annually in fuel. It’s new beverage cart, at 20 lbs lighter, could save $ 500,000 in annual fuel costs. Yet, fashion favouring turbo-prop aircraft, the most fuel-efficient and environmentally friendly in the skies, should help sustain order books for the same. ONEWORLDalliance of various airlines will jointly explore options for collective buying of fuel.

Mergers and Acquisitions enable capturing abandoned territories :

In 2003, Air France bought rival KLM Royal Dutch Airlines and has succeeded in luring passengers away from European rivals by offering long-distance connections through its Paris and Amsterdam hubs. Lufthansa acquired Swiss International Air Lines Ltd in 2005. It aims to match last year’s record profit by capitalizing on rivals’ weakness and by harvesting routes abandoned by competitors. This is analogous to Southwest’s model, where Southwest is capitalizing on players who have pulled off during the downturn in the aviation industry precipitated by high oil prices. Delta Air Lines and Northwest Airlines are planning to merge. Continental and United Airlines are also planning a close alliance.

Elite class of rising carriers emerges on the scene :

According to an article in The Wall Street Journal, the strength of this club (which includes Southwest, Emirates, Singapore Airlines, Ryanair and Deutsche Lufthansa) underscores the growing gulf between the haves and the have-nots. These powerful players are able to hedge costs, borrow money, buy new planes and pamper high-paying customers while their poorer rivals cut routes and seek cash infusions. On Singapore Airline’s five new Airbus A 380 super-jumbo jetliners, first-class passengers sleep on sheets made by French fashion house Givenchy, while coach passengers have USB ports for connecting their own electronic devices next to their seat-back video screens. In the face of a severe industry downturn, Singapore Airlines’ operating profit rose 60 % in the fiscal year ended March 31, 2008.

Southwest Airlines as a role model : It’s discount-model has kept it profitable for 35 years. It aggressively hedges fuel costs and thus has avoided current high fuel prices, to which most of the other carriers have succumbed. It has hedged fuel at $ 51 a barrel. The efficient hedges have enabled Southwest produce gains of $ 455 million in 2004, $ 892 million in 2005, $ 675 million in 2006 and $ 439 million for the first nine months of 2007. It has $ 3.7 Billion of cash in the bank and a market capitalization of $ 9.9 Billion, more than the combined market value of the six-largest conventional U.S. carriers.

Next-Generation aircrafts : Airbus has demonstrated its ability to fly its A380 aircraft with a synthetic liquid fuel processed from a gas called gas-to-liquid (GTL) in a three-hour flight between Filton, UK and Toulouse, France. The new A380 has fuel efficiency of 2.9 litres a passenger for every 100 kms and carbon emissions of just 75g per passenger per km—17% less than that emitted by the Boeing 747. Boeing 777 is the most fuel-efficient plane in its class. The 747-8 will be 16 % more efficient than the 747-400 (and 11 % more efficient than the A380). The A350 is the Airbus’s response to the Boeing 787 Dreamliner. Besides, EADS’s A400 M, once in service,will be capable of carrying a payload of up to 37 tonnes over ranges of up to 4700 nautical miles. Launched on July 8 2007—7/8/7 in US date format (date was chosen for impact), demand for the high-tech and futuristic 787 Dreamliner—a long-range 250 to 300-seat jet whose carbon-fibre body is set to make it 20 % more fuel-efficient than comparable models has been astounding. Dreamliner’s advanced aerodynamics (smooth wiring technology, spoilers that droop when flaps are deployed, and laminar flow nacelles lower drag) increase efficiency and reduce fuel consumption. Higher bypass ratio allows engines to be quieter. Boeing has received orders from more than 60 customers for 892 aircraft, worth $ 145 Billion at list prices. Boeing’s energy use and carbon dioxide emissions at its major facilities are believed to have fallen 24 % between 2002 and 2007. The Chinese white 90-seat ARJ21-700 jet is called “Xiang Feng” or “Flying Phoenix” and its appearance broadcast live on state television. 100 of the 180 bookings have come from Kunpeng Ailrines, a new venture between China’s Shenzhen Airlines and the US-based Mesa Air Group. The arrival of the “Flying Phoenix” will truly mark the ascent of China as a leading world superpower and will energize growth in the Asian subcontinent.

Green Ross to SpiceJet’s rescue : indicative of sound contrarian call

Spicejet of India has chose as its suitor W L Ross & Co. W L Ross has made his reputation on contrarian calls --- buying into the steel industry in the US when no one would touch it, for example, and snapping up a Japanese bank when it was saddled with bank loans in 2000.

Low cost model here to stay

Air Deccan pioneered new ticketing channels at internet kiosks, petrol pumps and India post offices which helped bring down distribution costs by 12%-15% as compared to opting for a GDS (Global Distribution System) and for travel agents through the legacy system. If the motive is to cater to the large inclusive consumer base at the bottom of the consumer pyramid then the business model must create a scaleable product that delivers higher volumes at lower price points above very low costs with wafer thin margins. The low cost model is about innovations, efficiency and enhanced asset utilization which are increasingly necessary in times of high fuel prices. The cost per available seat km of a low-cost carrier is significantly lower than that of full-service carrier. The average revenue per seat for Ryanair, Europe’s biggest budget carrier, is Euro 39, as against Euro 247 for British Airways and Euro 57 for EasyJet, another low-cost carrier. It therefore implies that the airline with the lowest revenue per seat is at a comparative advantage and has significant cushion to tide over this rather cyclical industry.

The Indian aviation is still one of the country’s sunrise industries and both airlines and investors consider India as a compelling market. In my opinion, the oil bubble would have burst due to more durable demand destruction by the time the next Farnborough show is held in 2010. The fundamentals viz. that India’s 1 billion people generate just 16 million domestic trips a year, is still very much intact. This, coupled with the emergence of investors with deep pockets will ensure that the industry emerges stronger after the chastening shock. Equilibrium is expected to be found in the next two years as airlines are working to optimize capacity, rationalize routes and cut loss-making routes.

By simply raising fares, the distinction between low-cost and full-fare airlines will diminish, resulting in an undifferentiated business model. The government, on its own part, has to up its ante and improve its infrastructure. It is not uncommon to witness planes circling over destination zones in Mumbai and Delhi several times before being allowed to land, thus causing wastage of precious fuel.

The current scenario is almost reminiscent of the last downturn in the aftermath of 2001 terrorist attacks on the US. That setback proved short-lived and so I believe will this one be.

Oil prices have retreated under the impact of unwinding of speculative positions by hedge funds and demand destruction is taking centre stage. The future belongs to the bold and daring, and not the timid and weak. The stage is set for survival of the fittest. In the process, men will be separated from the boys. The ongoing turbulence presents a tremendous opportunity for aviation industry players to emerge stronger than ever before. The 2010 Farnborough air show promises to be dominated by a new set of industry players, ones that emerge victorious after trial by fire.

Note : Mr Sunil Kewalramani is a WHARTON BUSINESS SCHOOL MBA and CEO, Global Capital Advisors. He may be reached at worldequity@sunilkewalramani.com.

Bullet Points :

1) The arrival of the Chinese “Flying Phoenix” will truly mark the ascent of China as a leading world superpower and will energize growth in the Asian subcontinent.

2) For Vijay Mallya—the self-proclaimed “king of good times”, the launch of Kingfisher Airlines three years back seems to have come as a cropper.

3) Launched on July 8 2007—7/8/7 in US date format (date was chosen for impact), demand for the high-tech and futuristic 787 Dreamliner—a long-range 250 to 300-seat jet whose carbon-fibre body is set to make it 20 % more fuel-efficient than comparable models has been astounding.

4) The fundamentals viz. that India’s 1 billion people generate just 16 million domestic air trips a year, is still very much intact.

5) Rather than lean on the government for largesse, the aviation industry players need to pull up their socks, adopt global best practices, learn the art of effective hedging of fuel requirements, stimulate consumer demand and capitalize on battle-routes abandoned by their weaker rivals to strengthen their position in the world aviation industry.

Article Source: http://www.articlesbase.com/business-articles/ aviation-industry-back-into-the-friendly-skies-by-farnborough-2010-- 778700.html

Mr Sunil Kewalramani is a Wharton Business School MBA, a CPA, CA and a leading consultant for multinational companies on global asset management, strategic planning and cross-border mergers and acquisitions