Navigating the Storm: The Future of the Airline Industry
The global airline industry has been one of the hardest-hit sectors by the ongoing coronavirus pandemic. Government restrictions on international flights, the reduction in business travel as corporations switch to videoconferencing, the collapse in consumer confidence due to health concerns and decreasing disposable incomes have greatly hit the willingness and ability of consumers to travel on board aircraft. As a result, air travel demand has dropped by more than 90% within weeks of the onset of the crisis and remains at historically low levels.
Despite an already-bad first quarter, the second quarter of 2020 was by far the worst quarter for airlines in modern history, with virtually all major airlines posting record losses. Of 26 leading airlines analysed by Flight Global, 25 were loss-making. In total, the 26 major airlines’ Q2 net losses were $26.3 billion, compared to a net profit of $6.6 billion during the same period last year. Airline stocks around the world have responded accordingly: as of August 19, the Arca Global Airline Index, which tracks the share prices of airlines around the globe, is down 51% year-to-date, with US airlines performing slightly worse than Asia Pacific and European airlines. The performance of the Global Airline Index is particularly bad compared to the benchmark MSCI World Index, which has already recovered from its coronavirus-induced lows and is now flat at 0% growth YTD. On a positive note, most airlines have managed to survive what appears to have been the worst months of the downturn. Airlines managed to stay afloat despite collapsing revenues primarily by imposing aggressive cost cutting measures. These include laying off thousands of employees, delaying the delivery of new aircraft, postponing any unessential investments, and parking approximately two-thirds of the global aircraft fleet.
Some airlines resorted to more desperate measures such as sale-leaseback agreements, wherein airlines sell a portion of their fleet and lease them back immediately, which bolsters their balance sheet while ensuring they can still use the planes when demand recovers. Delta Air Lines and Southwest Airlines raised $815 million and $1 billion in this way, respectively. Nonetheless, cash flows remain negative. Airlines heavily rely on debt and equity markets for financing, as well as on government bailouts such as the Cares Act, which provided US airlines with more than $50 billion in loans and grants. A second stimulus package is currently being negotiated in the US but the Republicans and Democrats remain at loggerheads. For some airlines, however, the options described above were not enough to enable them to withstand the prolonged collapse in revenues. Notable airlines that have started bankruptcy proceedings include two of the largest carriers in Latin America, i.e. LATAM and Avianca Holdings, as well as Virgin Atlantic in the US, Virgin Australia and Flybe. The crucial question now is what lies ahead for the airline industry. Stakeholders are particularly interested in estimating how much time it will take for air traffic to return to pre-pandemic levels, as measured by revenue passenger kilometres (RPKs, a key demand metric obtained by multiplying the number of airline customers by distance travelled). Most optimistically, Moody’s analysts anticipate a recovery of RPKs “by the end of 2023,” although they caution that increasing infection rates may force governments to reinstate quarantine protocols, which would hurt travel demand.
The International Air Transport Association (IATA) forecasts that RPKs will not return to pre-pandemic levels until 2024 – a year later than their previous estimate due to the recovery so far being “slower than expected.” Finally, McKinsey’s model is the most pessimistic, estimating that it may take until after 2025 for the broader transportation industry to recover from the coronavirus shock. It is important to note that the best and worst-case scenarios presented by analysts wildly differ due to the uncertainties surrounding the progression of the pandemic. Nonetheless, we can identify the factors that will be most important in determining the medium-term future of the airline industry. Not all is bleak for the beleaguered airline industry; there are developments that have noteworthy upside potential. Firstly, while international RPKs have barely shown any signs of recovery (down 96.8% year-on-year in June compared to 98.3% in May), domestic flights are experiencing a surprisingly strong rebound. According to IATA, global domestic RPKs in June were 67.6% lower than normal, which is significantly better than the 78.4% registered in May. If restrictions continue to be loosened within the largest economies, i.e. the US, China, and the Eurozone, an increase in domestic flights may recover some of the lost revenues for airlines. Local airlines that mainly offer domestic flights may expect to return to profits earlier than large airlines that focus on international flights.
Source: IATA Economics, FlightRadar24 Second, crude oil prices have only partially recovered since they collapsed in early 2020 (see below). Lower oil prices lead to lower prices of jet fuel, which benefits airlines since fuel is their largest expense. But there’s a twist: some airlines hedge on fuel, i.e. they agree to buy fuel in the future at a pre-arranged price to ensure that fuel price volatility doesn’t affect their business too much. For instance, Ryanair has hedged 90% of its fuel requirement at $77 a barrel for the remainder of the year (almost double the current price). Meanwhile, US and Chinese airlines tend not to hedge on fuel at all and will therefore benefit more than their European counterparts from the relatively low cost of jet fuel in 2020. If prices remain low in the medium run, airlines should have an easier time returning to profitability once demand recovers.
Source: Platts, Datastream Third, cargo shipping is emerging as a lucrative alternative to passenger travel. As a result of the pandemic, air cargo rates have more than doubled (see below) and IATA expects global cargo revenues to increase by almost 10% in 2020. This has enabled Korean Air, which has been heavily investing in its cargo network, to benefit from a 95% increase in cargo sales and become the only major airline to post a Q2 profit. Airlines are now attempting to profit from the high cargo rates by repurposing some of their idle passenger aircraft into cargo aircraft, which could prove crucial in allowing them to weather the pandemic.
Source: Bloomberg However, there are also developments which pose significant downside risks to the recovery of the airline industry. First and foremost, consumer confidence is stagnant despite rising business confidence, which may cause customers to delay air travel even as the rest of the economy recovers. According to a survey carried out by IATA, 55% of passengers are not planning to fly again in 2020.
One of the main drivers of low consumer confidence is the unpredictability of government policy in light of repeated waves of coronavirus infections. On 14 August, for instance, the UK announced that it would impose a 14-day quarantine requirement for British travellers returning from France almost overnight, causing British airline stocks to tank. Flight and train tickets quickly sold out as some of the 140,000 British holidaymakers in France scrambled to return home before the quarantine came into force. Such “stop and go” changes to travel regulations impair the ability of consumers and airlines alike to plan ahead, thereby slowing down the recovery in the short run. In the medium to long run, however, it is the availability of a coronavirus vaccine or treatment that will be crucial in raising consumer confidence and reassuring travellers that air travel is safe again. Second, several non-obvious risks to the balance sheets of airlines are now starting to surface. When airlines had to cancel flights in the early stages of the pandemic, they often resorted to offering coupons for future flights instead of giving passengers refunds. Now that flights are beginning to restart, many customers will be redeeming the coupons they received, depriving airlines of much needed cash flow.
Another hit to the airlines’ balance sheets is the rapid deterioration of the value of their fleets as aircraft demand plummets and excess supply is expected to reach 4,000 aircraft in 18 months’ time. The Economist reports that an A380 may soon be worth between $10m and $15m, which is an order of magnitude less than the original sale price of $250m to $300m. This is particularly unfortunate for airlines with the weakest balance sheets, which may have hoped to improve their liquidity by selling off a portion of their fleet. Third, there are fears that the reduction in corporate travel may be here to stay. Even once travel restrictions are lifted, IATA expects corporate travel budgets to be very constrained compared to pre-pandemic levels. What is even more worrying is the fear that video conferencing has made a permanent inroad as a substitute for physical meetings. The pressure from consumers for corporations to appear more eco-friendly as well as the recent evidence that videoconferencing on a large scale can indeed be done may encourage firms to rethink whether business travel is as necessary as it was previously considered to be. In conclusion, while the road ahead of the airline industry is wildly uncertain, it appears that there will not be another quarter as bad as 2Q2020. Key developments with upside potential include low oil prices, the rise in freight rates, and continued growth of domestic air travel. Downside risks include surges in coronavirus infections decreasing consumer confidence, a surplus of aircraft driving down the value of airlines’ fleets, and a potentially permanent reduction in business travel.
One thing that is certain is that passenger traffic will recover to pre-pandemic levels eventually, regardless of whether that occurs in 2022 or 2025. When that happens, airlines will be able to return to the long-run growth trajectory the sector has been experiencing over its 100-year-long history. And even if more major airlines fail, bankruptcies will leave room in the market for more cost-efficient entrants to join. Airplanes are now cheaper than ever, airports have spare slots, and pilots are plentiful – all of which pose a perfect opportunity for new airlines to enter the industry.