Bloomberg News

Airlines Mired in ‘Crisis’ as Margins Shrink, IATA CEO Says

October 04, 2011

(Updates with closing declines for European airlines in sixth paragraph, today’s price for AMR in eighth.)

Oct. 4 (Bloomberg) -- Airline profits forecast to total $28 billion in the three years through 2012 may be unsustainable as over-capacity and looming regulatory costs weigh on margins, the head of the IATA industry association said.

Airlines will generate net income equal to 0.8 percent of revenue next year, a margin that may shrink further if economic growth slows to less than 2.4 percent, Tony Tyler, chief executive officer of the International Air Transport Association since July 1, said in an interview in London.

“The natural condition of the airline industry is crisis,” Tyler said. “Occasionally, we’ve had short periods where the conditions are quite benign and everything goes quite well, and the danger is to believe that’s normal -- and that’s wrong.”

IATA’s prediction for airline earnings to drop almost 30 percent to $4.9 billion in 2012 may prove too optimistic should the global economy slow further, said Tyler, who was CEO at Cathay Pacific Airways Ltd., Asia’s No. 1 international carrier, for almost four years. The industry has lost money in seven of the past 10 years, even as sales doubled to almost $550 billion.

“We’re assuming world economic growth will be just marginally down for next year,” Tyler said in the interview in London. “If we’re wrong with that then all bets are off.”

Stocks Tumble

Air France-KLM Group, Europe’s biggest airline, fell 9.1 percent today, the sharpest drop since Feb. 11, 2010. Deutsche Lufthansa AG, the regional No. 2, slumped 4.3 percent and International Consolidated Airlines Group SA, the No. 3 and parent of British Airways and Iberia, dropped 3.4 percent.

Lufthansa cut its full-year profit forecast on Sept. 20, saying operating profit would fall short of last year’s figure, while Air France is simply seeking to avoid a loss.

American Airlines parent AMR Corp. yesterday tumbled 33 percent, the most since 2003, triggering automatic trading halts, on growing concern that the third-largest U.S. carrier may be forced to seek bankruptcy protection. It was trading 16 percent higher as of 12:08 p.m. in New York today.

Figures released yesterday show growth in passenger traffic at IATA’s 230 member airlines slowed to 4.5 percent in August from 6 percent in July, including a 0.3 percent slump in U.S. domestic travel. Cargo demand, which is usually tracked by the passenger market, dropped 3.8 percent in the month compared with a year earlier, more than double the pace of July’s slide.

Downside Risk

“We are in a time now of declining profitability,” Tyler said. “The latest traffic figures would reinforce this and possibly point to risks, if anything, being on the downside.”

The industry’s precarious position is illustrated by a predicted net margin of just 1.2 percent this year, even after seat occupancy reached 81 percent in August and premium traffic rose 8.2 percent over the first seven months, allowing many carriers to raise business fares, the CEO said.

In addition to the global slowdown, airline profitability is being further jeopardized by the European Union’s plans to include aviation in the world’s largest cap-and-trade system for carbon dioxide emissions, Tyler said.

The plan, due to be implemented in January, is “misguided” because it’s not global and creates market distortions while infringing national sovereignty, Tyler said, citing opposition from countries including the U.S., China and India.

Naive Thinking

Program costs will amount to about $1.2 billion next year, IATA reckons, while estimates of the bill for the first decade of implementation range from $26 billion to as much as $85 billion -- more than double the $36 billion in net income from the industry’s three profitable years in the past decade.

“Airlines will try to recover it,” the executive said. “But it’s naive to think they will.”

Biofuels, which are carbon neutral and currently undergoing tests with airlines including Lufthansa and Spain’s Iberia, don’t yet offer a practical substitute for kerosene, Tyler said.

“We know it’s technically feasible,” he said. “The issue is commercializing it and producing biofuels in sufficient quantity to make an impact. But in due course there is no reason why they couldn’t be an alternative to fossil fuels.”

‘Badly Burned’

Airlines are becoming “smarter” at hedging fuel expenses, which make up a third of operating costs, following the surge, collapse and rebound of oil in the past four years, the CEO said. Carriers sought to protect themselves in the first half of 2008 by using financial derivatives, only to be left paying more after crude tumbled during the global recession.

“Many airlines got badly burned by the collapse of oil prices in 2008,” said Tyler, adding that Cathay Pacific earnings were crimped by its fuel-buying policies during his term as CEO. “What many people are realizing is that this hedging activity isn’t a clever way of buying fuel cheaper, it’s a way of managing volatility.”

While the industry itself needs to do more to eliminate excess capacity and regain control of yields, a measure of revenue per passenger that has been shrinking for decades, political sensitivities about the importance of flag-carrier airlines remain an obstacle to mergers, Tyler said.

“It would be a good thing for the financial health of the industry to have a more consolidated, less fragmented industry, but the big question is will it happen?” he said. “I’m skeptical. I think it will be a long and very slow process.”

Tyler, a British national born in Egypt, said Western governments are also holding back their airlines with tax regimes that “penalize” the industry and limits on infrastructure development.

‘Misguided’

Britain should change its policy on the expansion of London’s Heathrow airport and take steps to boost capacity at Europe’s busiest hub, he said. Prime Minister David Cameron scrapped plans for a third runway following his election last May, citing concern about the impact on the environment.

“It’s a misguided decision and will cost the U.K. dearly in years to come,” said Tyler. “In 15 years people will be sitting around asking ‘Why didn’t we let that happen?’”

Carriers themselves have struggled to safeguard profit margins by limiting seat supply when markets begin to pick up, as they did earlier this year, Tyler said.

“We do better as an industry when there’s capacity constraint,” he said. “But it’s only when the whole market really tanks that everybody says ‘Ok, I give up.’”

Never Easy

U.S. airlines have shown most restraint, partly because the industry there has been consolidating and also because of its “terrible financial straits.” Often, the concern of missing out on a rebound overrides other concerns, Tyler said.

“The difficulty when you’re running an airline is that you’re worried all the time that if you cut, the other guy won’t,” he said. “Airline managers are actually rational, but added together the effect is that they look irrational.”

Tyler said the airline industry remains almost uniquely exposed to volatility in areas spanning exchange rates to global politics, with the last 15 years punctuated by a series of shocks including the Asian currency crisis, the 9/11 terror attacks, the SARS and bird flu epidemics, the credit crunch and recession, volcanic eruptions in Iceland and the “Arab spring.”

“It’s never going to be an easy business,” he said.

--With assistance from Louise Downing in London. Editors: Chris Jasper, Heather Harris.

To contact the reporters on this story: Steve Rothwell in London at srothwell@bloomberg.net; Mathew Carr in London at m.carr@bloomberg.net

To contact the editor responsible for this story: Chad Thomas at cthomas16@bloomberg.net Stephen Voss at sev@bloomberg.net


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