Big Downside Risks on Weak Profitability
-European Losses Deepen-
11 June 2012 (Beijing) - The International Air Transport Association (IATA) released its revised industry outlook for 2012. Global industry profits are expected to be $3.0 billion, unchanged from the last update in March. A fall in oil prices, stronger than expected growth in passenger traffic and a bottoming out of the freight market are driving some improvements in the profitability outlook. However, this is offset by the continued and deepening European sovereign debt crisis, which has led markets to expect a further deterioration and damage to economic growth, the adverse impact of which has been built into this forecast.
This will be the second year of declining returns since airline profits peaked in 2010 at $15.8 billion with a net profit margin of 2.9%. In 2011, industry profits fell to $7.9 billion for a 1.3% net profit margin. This year’s projected $3.0 billion industry profit would yield a net profit margin of just 0.5%.
Compared with the previous forecast in March, North American and Latin American carriers are expected to see improved prospects. The outlook for African carriers is unchanged. But the outlook for European, Asia-Pacific and Middle Eastern carriers has been downgraded, with European losses now expected to be $1.1 billion (nearly double the previously forecast $600 million loss).
“The $3.0 billion industry profit forecast has not changed. But almost everything in the equation has. Demand has been better than expected, so far this year. And fuel prices are now lower than previously anticipated, but that’s on the expectation of economic weakness ahead. The Eurozone crisis is standing in the way of improved profitability and we continue to face the prospect of a net profit margin of just 0.5%,” said Tony Tyler, IATA’s Director General and CEO.
“Although airlines face the common challenges of high fuel prices and economic uncertainty, the regional picture is diverse. Carriers in the Americas are seeing improved prospects for 2012. The rest of the world is seeing reduced profitability. For European carriers, the business environment is deteriorating rapidly resulting in sizable losses,” said Tyler.
Economic Growth: As the Eurozone crisis deepens, the revised forecast is based on a weaker European economic environment than previously forecast in March. In this central forecast, we assume that:
· The worsening of the Eurozone situation is limited and does not deteriorate into a widespread banking crisis
· The US economy continues to recover, but at a mediocre pace
· Chinese economic growth slows, but a hard landing is avoided by policy stimulus
World GDP growth, a key driver of airline profitability, is expected to be 2.1% in 2012. That is slightly better than the anticipated 2.0% growth forecast in March. But this is still a slower growth environment than last year, and one in which airlines will struggle to recover cost increases. Historically, the airline industry has fallen into losses (at a global level) when world GDP growth drops below 2.0%.
Oil Prices: Oil prices have slipped below $100/barrel (Brent), as the Eurozone crisis generated fears of recession, having been above $120/barrel earlier this year. The forecast uses the latest consensus estimate for Brent, which has been revised down to $110/barrel (from the $115/barrel used in our March outlook). Even with this price softening, fuel is still expected to account for 33% of airline operating costs, the same as in 2008 when oil prices spiked.
Traffic: Given the actual slower economic growth environment it has been notable that up to April passenger demand, measured in revenue passenger kilometers, continued to expand at an above-trend rate of 6.0%. The strongest markets have been those linked with Asia, Latin America, and the Middle East, where economies have been more robust. However, a weaker second half of the year is expected as deepening problems in Europe damage confidence. Even so, the strength of travel demand in the first part of this year has caused an upward revision to the forecast for air travel growth to 4.8% from 4.2% in the previous forecast. Passenger numbers are expected to reach 2.966 billion this year, up from 2.835 billion in 2011.
Cargo demand has bottomed out, following a sharp fall in 2011, in line with the moderate improvement of business confidence in a number of economies outside Europe. But the upturn is weak and narrowly based, with only Middle Eastern airlines seeing significant volume gains. European economic weakness is expected to limit any further improvement. Overall 47.8 million tonnes of freight are expected to be shipped by air in 2012, basically unchanged from the 47.7 million tonnes carried in 2011.
Capacity: One of the notable features of this business cycle has been the limited expansion of capacity by airlines, and the resulting success in sustaining high levels of asset utilization. In any capital-intensive business this is a key factor behind profitability. On passenger markets, load factors reached record levels in the second quarter, and during the same period, freight load factors began to recover from their lows. Over the rest of the year the forecast anticipates that, although demand is slowing, airlines will add capacity at an even slower pace. Growth in available tonnes kilometers (a combined measure for the passenger and cargo capacity) is forecast to be limited to 3.3% this year, compared with growth in both passenger and cargo traffic of 3.5%. Load factors and aircraft utilization are expected to be kept close to current high levels, limiting the reduction in airline profitability.
Costs and Revenues: Limited capacity growth, high asset utilization and lower oil prices will help to contain cost increases in 2012 to 7.3%, down from a rise of 10.6% in 2011. However, revenue growth is expected to slow more significantly—from 9.3% last year to 5.7% this year. Air travel volume growth has been revised upward, but outside the United States this looks to have been partly achieved at the expense of yield. Both passenger and cargo yields have been revised down from the March forecast.
Profitability: Keeping revenues ahead of costs is the constant challenge in the airline industry. In 2012, operating revenues are expected to reach $631 billion, while operating costs will grow to $623 billion. The resulting operating profit or EBIT of $8.6 billion reflects the narrowness of the gap between revenues and costs. It doesn’t take much to eliminate the 1.4% operating profit margin. Moreover, these earnings are just sufficient to pay for debt interest, taxes, and other financial transactions. We forecast this will leave airline shareholders with a net profit of just $3 billion in 2012.
The Outlook by Region
North America: North American carriers are expected to post a profit of $1.4 billion. That is up from the March projection of $0.9 billion and a slight improvement on the $1.3 billion that the region’s carriers made in 2011. The main driver of this performance is a significant improvement in yields on the back of tight capacity management. Capacity growth for North American carriers is basically flat (0.1%), against demand growth of 0.5% (which, notably, is the slowest among all regions).
Europe: European carriers are expected to post the industry’s largest aggregate losses of $1.1 billion as the Eurozone crisis continues. This is a $0.5 billion downgrade from the March forecast. Demand growth is expected to slow to 2.3%, which is significantly down on the 6.7% expansion of 2011. Some major European economies are already in recession (Spain and the United Kingdom) and it is anticipated that economic weakness will spread further during the course of the year as the Eurozone crisis deepens. Concurrently, European carriers continue to be hit by high and rising tax regimes, inefficiencies in air traffic management, and the high cost of complying with poorly thought-out regulations.
Asia-Pacific: Asia-Pacific carriers are expected to make the largest contribution to industry profits ($2.0 billion), even with a $0.3 billion downgrade from the previous outlook, due to the weak first quarter performance. This is less than half the $4.9 billion profit that the region delivered in 2011 and a quarter of the $8.0 billion achieved in 2010. Asian carriers make up about 40% of the global air cargo business and the weakness of this market in 2011 was the reason why there was a large decline in the region’s profits. There has been little sign of the region’s airlines benefiting from the modest upturn in cargo markets this year. The slowdown in the Chinese and Indian economies is another factor in the slow growth environment. Nevertheless, the region will benefit from stronger growth in aggregate passenger and cargo traffic this year, as a result of the rebound in demand in the Japan market following the tsunami and earthquake last year. Regional demand is expected to grow at 3.9%, above the anticipated 3.3% growth in capacity, providing some protection to airline profits.
Middle East: The Middle East carriers are expected to post profits of $0.4 billion, down from the March projection of $0.5 billion. This is a significant drop compared with 2011, when the region’s carriers returned a profit of $1.0 billion. The weakness of European originating traffic will damage long-haul markets, but Middle East airlines continue to lead the industry on growth. Along with capturing long-haul passenger traffic through the Gulf hubs, they have been the beneficiary of 80% of the improvement in cargo markets during the past six months. Overall, capacity by the region’s carriers is expected to expand by 13.3%, behind the 14.1% growth in demand.
Latin America: Latin American carriers are expected to post profits of $0.4 billion. This is a $0.3 billion improvement compared with the March projections. Like their counterparts in North America, Latin America-based airlines are forecast to show a modest improvement on 2011 performance ($0.3 billion). The main driver is a turnaround in the previously loss-making Brazilian market, as capacity growth is reduced and yields improve.
Africa: The outlook for African carriers is unchanged with an expected loss of $0.1 billion. This is a downgrade on the break-even performance in 2011. Weakness in originating traffic from the key European market is expected to adversely affect international passenger markets in the region. Moreover, load factors are already low and capacity is expected to grow 5.2% this year, ahead of demand growth of 4.2%. The region’s carriers continue to face stiff competition on long-haul routes.
The risks to the forecast are primarily on the downside. While the forecast is built on the market’s expectation that the sovereign debt crisis in the Eurozone will intensify, the risk of more severe economic weakness in the event of a broader Eurozone banking crisis could easily wipe out industry profits. Similarly, the recent softening in oil prices could easily reverse should the ongoing dispute with Iran deteriorate, causing fears of a disruption in oil supply to resurface.
The main upside risk would be a calming of the Eurozone crisis. There is no scenario for an immediate solution to the crisis, but actions to provide further liquidity on a large scale and steps towards closer integration for Europe would give a modest boost to industry profitability.
“There has been no let-up in the volatility of the economic environment. A few months ago, an oil price crisis was the biggest risk. Now all eyes are back on Europe. Markets are expecting the Eurozone sovereign debt crisis to intensify and economic damage to follow. But with little clarity on how European governments will manage the situation beyond providing further liquidity, the risk of a major downward shift in economic prospects is very real. The next months are critical and the implications are big,” said Tyler.