Sunday, August 03, 2008

Aviation Industry: Flying into a storm

Consolidation could be the only way for the airline industry to recover from its current mess, writes William Lyons
WHEN Giovanni Bisignani, the director-general and chief executive of the International Air Transport Association, prophesied the present crisis engulfing the airline industry hetalked about a "perfect storm" that was potentially more destructive "the Horsemen of the Apocalypse combined."

Those waiting for the prophesy to be fulfilled need look no further than Willie Walsh, the cheerful Irishman in charge of British Airways, who must feel his airline has flown right into the middle of it.

For Walsh, who in May unveiled a stunning set of results with record profits, the widest-ever profit margin, and the first dividend since the 9/11 terror attacks on New York and Washington, the outlook couldn't be darker.

But last week as he announced first half results crippled by high fuel prices, Walsh admitted he will have to raise fares and axe routes as he grapples with a 90% fall in profits and a £8m a day fuel bill.

Among the routes affected will be the daily services from Glasgow, Edinburgh and Aberdeen to Heathrow and Gatwick. From the end of October to the beginning of March nearly 1,000 Anglo-Scottish flights will be dropped as the airline seeks to manage its capacity reductions, a move industry chiefs have already warned will damage Scotland's domestic tourism industry.

Speaking to analysts, Walsh indulged in his own hyperbole. "This is the worst trading environment the industry has ever faced and fares are likely to go up as we reduce some winter capacity and cope with unprecedented oil prices, but we won't be grounding any aircraft," he said.

His view was an echo of the earlier warning from chairman Martin Broughton that the airline was "up to its neck in perhaps the biggest crisis the aviation industry has ever known".

Walsh can take some comfort from the fact that he is not alone. Earlier in the week Ryanair lost more than a fifth of its value after the airline predicted a £47m loss due to rocketing fuel bills. In true Ryanair style its headline-seeking chief executive Michael O'Leary vowed to fight back by slashing fares to the bone.

He said: "We will respond as always – with lower fares and aggressive pricing. We now believe our average fares for the year may fall by as much as 5% if European air fares plunge this winter." Meanwhile, the International Air Transport Association forecasts the world's leading airlines face a £3bn loss this year unless oil prices fall from their current record levels.

"We are in for a very shaky ride," says one aviation analyst, who asked to remain anonymous. "There are going to be airlines that come under an awful lot of pressure. Ultimately, the quality carriers such as easyJet and Ryanair will win out but there will be casualties along the way.

"Gradually, some of the more marginal routes will go and those that have bought a holiday home in Europe may well be struggling to get there."

Just a year ago the mood was very different. Back then, Walsh, after an aborted takeover of Iberia with private equity group Texas Pacific, played down his interest in the Spanish airline, saying it was "very interesting to us but the deal is not transformational".

But this week, as the City digests BA's catastrophic fall in profits, Walsh will get on with the business of pursuing a merger with Iberia in the first tentative steps towards creating the world's first genuine 'world airline'.

"We are starting to see the emergence of the first wave of global consolidation," says Wyn Ellis, aviation analyst at Numis Securities. "Already we have seen tie-ups with Air France and KLM as well as Lufthansa with the Swiss. The next stage will be major European carriers hooking up with large American and Far Eastern airlines."

How, in just a year, can everything change? In short, airline economics have been transformed by the high oil price. Fuel accounts for between 30% and 50% of airlines' operational costs and in the past year the price of jet kerosene has more than doubled. British Airways' fuel bill has risen from 10% of its cost base in 2000 to 40% today. It estimates that its fuel bill will rise to £2.5bn by 2009 a 20% hike on the previous year.

Some airlines have managed to escape the rising costs by hedging or buying fuel in advance but this has just delayed the inevitable.

As the airline industry squares up for some of the most dramatic structural changes in its 100-year history, many are now asking who will survive the shake-up. With at least 25 carriers grounded already this year as sky high oil prices and the weak economic climate decimate sales, many analysts are now openly speculating about who will fall next.

Moreover, the consumers who bought second homes on the back of the low-cost airline boom, are wondering whether they will be left stranded on the runway?

More than 15 airlines have ceased flying this year, including business-class carrier Silverjet, the Isle of Man airline EuroManx and the no-frills long-haul player Oasis Hong Kong Airlines. More could follow. Virgin's Sir Richard Branson predicts that one major US carrier will go out of business this year while the normally bullish O'Leary says only five can survive the present European downturn: Air France, BA, easyJet, Lufthansa and Ryanair.

In the States it isn't much better, with Continental already confirming 6,000 job losses and the grounding of 60 planes.

"There are three factors hanging over the airline industry at the moment," says Evans. "A very high oil price which doesn't look like going away; an economic slowdown; and thirdly the airlines' response to that slowdown. Any one of these can act as a lever which could lead to a particularly nasty conclusion."

Despite cost cutting, most airlines are at a loss over what to do. After a wave of reducing capacity and capital expenditure, the aviation industry has realised that consolidation is perhaps the only solution.

Hence Walsh's new-found desire to complete a merger with Iberia. Despite BA having a larger market capitalisation – £2.9bn compared with Iberia's £1.2bn – the deal is being sold as a merger of equals, with both airlines retaining their brand identities and their separate managements for day-to-day operations. Under the proposals a single holding company will list on both the London and Madrid stock exchanges.

Many analysts say the deal makes a lot more sense for BA than last year's takeover approach. The two airlines see cost savings from combining IT systems and procurement but it is the expansion of the geographical route base which most appeals. BA is strong in North America, the Middle East and the Far East, while Iberia has a wide network of routes in South America and Africa.

There is also the attraction of Madrid, which has more potential for expansion than Heathrow, and the creation of two European super hubs.

Any deal will have to be carefully planned to secure the existing landing slots and routes that both have acquired in many parts of the world. International air transport is still defined by bilateral agreements between governments that determine which airlines will fly between which countries while most countries outside the EU still demand reciprocal landing rights.

When Air France merged with KLM, the deal was structured in a way that left it short of a full merger in order to maintain the flying rights of both nations. Walsh has already publicly stated he wants a similar deal.

But others speculate that Walsh is already plotting his next move, with a three-way tie-up with Oneworld Alliance partner American Airlines already on the cards. They say Walsh's main goal is the merger or takeover of American Airlines.

As Walsh, who admitted to discussing the deal with American Airlines chief Gerard Arpey, said: "This (the merger with Iberia] creates a very strong third European airline, which will give us a platform for further consolidation. I see this as the start, not the end, of consolidation."

As the major airlines consolidate, the low-cost operators are ironically best placed to ride out the economic downturn. In previous market downturns budget airlines have benefited as travellers moved from the major carriers. While fuel costs have risen, so have passenger numbers, while other revenue generating streams have come online.

British Airways has been careful not to axe any routes to Scotland, preferring instead to reduce the frequency of existing services. This, says one insider, stops them losing valuable slots to carriers such as easyJet. But the reduced frequency will still be felt north of the border.

Colin Borland, from the Federation of Small Businesses in Scotland, has warned that it is putting the country at a disadvantage.

"How can we compete for contracts with companies based in, say, London, if we can't get to a meeting without leaving the night before?" he said. "Not only that, given that many flights to international destinations route through London, it will take longer and cost more to do business in Europe and beyond.

"Reducing the frequency of flights is also bound to have a knock-on effect on the price we'll pay for those flights which do remain available. It's a lose-lose situation – fewer flights at higher cost.

"Perhaps it's now time for Government at all levels to safeguard Scotland's long-term transport and business links and make a commitment to a proper high speed rail link between Scotland and the rest of the UK."

Flying into a storm
Scotsman, United Kingdom