A soaring success? Or a crash landing?

Martyn Cornell

If there is any industry that acts for the world economy like a canary in a coal mine, then it would be the airline sector. When the going gets tough, both leisure and business travellers cut back, and airlines see bookings, and profits, fall. Martyn Cornell finds out more

Analysts believe that premium business travel, in particular, will be cut sharply this year because of the chaos in world financial markets and a possible recession in the US.

In addition, the airline business is vulnerable to outside factors such as rising fuel costs, and it needs a confident banking and financial services sector to loan it the money to buy new aircraft, or to put up the guarantees on lease agreements.

Right now, therefore, it is no surprise to see the industry suffering what most observers agree is its worst crisis since the awful times that followed the terrorist attacks of September 11, 2001. Oil prices are at their highest ever, after more than doubling in the past year, and while most smart airline companies saw that coming and hedged their fuel bills, many of those hedging deals are coming to the ends of their lives, with no sign of the cost of a barrel of oil dipping back down to less painful levels. Even with hedging, however, the cost of fuel alone for a transatlantic flight for a company such as British Airways has quadrupled since 2000 to €28,000 a time.

Money becomes more expensive
The credit crunch that has badly affected the United States in the wake of the sub-prime loans disaster is making money more expensive. Labour costs are rising. Customers are flying less, on business or pleasure, because they are suffering themselves as the economies of the West hit turbulence. That not only cuts revenues, it makes it harder to raise ticket prices to cover higher costs.

The US Department of Transportation show that the airline industry made profits of €2.4bn in 2007, up from €1.1bn in 2006, which was the first year the industry was profitable since the events of September 2001. However, record fuel prices, with crude oil passing €82 a barrel, saw the industry make an estimated loss of €1.1bn in the first quarter of 2008.

The result is thousands of airline job cuts, airline closures, a rush of airline mergers and attempted mergers, and joint ventures on competitive routes, to try to save costs, and, in Europe, national governments suddenly breaking the rules and rushing to give their state-owned carriers subsidies to prevent them from crashing into the ground.

One of the problems airlines are facing is simple cashflow. Philip Baggaley, chief credit analyst at Standard & Poor's, issued a report in mid-May which said that if the 10 largest airlines in the US do not boost their revenue and restructure their loans, their total cash could fall by as much as two thirds, to around €5.4bn, by the end of this year. That sum, although it may look large, would not cover one month's expenses for the 10 airlines. "In other words, in this simplified example, the airlines, as a group, would be at risk of bankruptcy," Baggaley said.

Will the cash flow continue
Already in the United States, United Airlines, American Airlines and Northwest Airlines have all renegotiated covenants that would probably have meant they defaulted on loans later this year if their cash flows continue to decline. United also renegotiated an agreement with its largest credit-card processor to improve its cash flow, while one discount airline, Southwest Airlines of Texas, mortgaged 21 aircraft to raise €380m in cash to add to the €1.9bn it has on reserve. Southwest said it made the deal to "take advantage of attractive financing" and the cash would go to "general corporate use."

Airlines are also taking unpopular steps to try to raise more money from customers, such as fuel surcharges of €63 or more on tickets, and charging €16 to check in a second bag. Qantas, the Australian flag carrier, suspended its share buy-back programme to conserve cash “in light of the fuel price volatility", and announced drastic measures to boost its revenues, cut costs and conserve cash, including higher ticket prices. Geoff Dixon, Qantas's chief executive, said the airline had hedged 34 percent of its fuel requirements for the 12 months to June 2009 at an equivalent crude oil price of €57 a barrel, but the majority of the hedges were in the first half of its financial year. “If high fuel prices persist beyond this point, it would be of increasing concern,” he said.

Now Northwest and Delta Airlines, which both came out of Chapter 11 bankruptcy protection earlier this year, are looking for US government approval to merge to create a €1.9bn giant that would be the world's largest carrier, as their answer to the problems besetting the industry. The merged operation, which would fly under the Delta name, would have €22bn in combined sales, run more than 800 airplanes and employ 75,000 workers. The proposed deal was described by Congressman James Oberstar, chairman of the House Subcommittee on Transportation and Infrastructure in Washington, as not "a standalone, individual transaction but rather as the trigger of what will surely be a cascade of subsequent mergers that will consolidate aviation in the United States and around the world into global, mega carriers."

The two airlines' chief executives, Richard Anderson for Delta and Douglas Steenland for Northwest, agreed with Oberstar that they "Would not be surprised" if other airlines considered a merger to compete with their merged airline. That is already happening: United Airlines of Chicago, having been rebuffed by Continental Airlines of Houston in April, is considering a merger with US Airways, which itself had failed to interest Delta in a move. Continental has held talks with American Airlines.

As part of the Delta/Northwest deal, Air France-KLM has offered to inject €475m in fresh equity capital into the merged entity in return for a joint venture covering transatlantic routes, particularly those into London Heathrow.

Recent Alitalia developments
Meanwhile, at the end of April, Air France-KLM pulled out of a deal to buy the struggling Italian state-run airline Alitalia, saying it no longer considered its offer "valid", and forcing the Italian government to give Alitalia an emergency loan of €300m to stop it immediately becoming bankrupt. Alitalia has been hit by competition from low-cost carriers (one of which, Ryanair, immediately complained to the European Commission over what it said was an illegal subsidy) and is reckoned to be losing €1m a day. Ryanair itself is suffering: has virtually no hedging protection in place for its fuel requirements for the 12 months to March 2009, and has warned investors that there is a “significant chance” its profits would fall by as much as 50 percent this year. Some are predicting rising fuel costs could fatally undermine the business viability of cheap flight firms such as Ryanair and EasyJet.

One operator that has already hit the floor this year is Eos, which operated twice daily business class only flights between John F Kennedy International Airport in New York and London Stansted Airport. It began with €54m in start-up financing in June 2004, running a small fleet of Boeing 757s originally meant for 220 passengers that had been reconfigured with 48 seats, each of which would extend into a full flat bed. Tickets cost from €2,220 to €5,710 for the round trip, and passengers were served champagne, cocktails and gourmet foods. However, Eos filed for Chapter 11 bankruptcy on April 26, blaming the current "challenging economic and credit environment" and saying it planned to "eliminate" most of its 450 employees.

The company was negotiating for €32m in additional financing from an undisclosed investor, but  "unfortunately, just as we were working toward closing on an investment that would have carried us to corporate profitability in 2009, some issues arose that we could not overcome," according to Eos's chief executive, Jack Williams. He went on to say: "It is regrettable that, even though investors continue to be enthusiastic about our business model, and even though we had a term sheet in hand, we were unable to close on the financing we needed."

Eos's troubles follow the collapse of Manxjet Airways late last year, while another small UK-based business carrier, Silverjet, has had to turn to an investor from the United Arab Emirates for an emergency injection of €16m in debt and equity.

Shares buyout
At British Airways the company has attempted to put behind it the fiasco of the recent opening of Terminal 5 at Heathrow Airport, London behind it, when thousands of passengers had heir flights delayed or cancelled after the baggage handling system collapsed, by declaring its first dividend since 2001. However, despite the five pence-a-share payout, analysts were unimpressed with the company's prospects, predicting that the company's earnings will drop from €870m this year to €290m next year. The company has hedged about two thirds of its fuel requirement for its current financial year, but it announced that its fuel bill will still rise by all of €1.25bn, which will be difficult to claw back through a customer fuel surcharge. Industry observers expect BA may have to use at least some of its cash reserves to get through the coming financial year, which makes paying a dividend now look more like PR than good economic sense.

The picture is not entirely gloomy, however. Global air traffic continues to grow. At Boeing Capital, part of the giant Seattle-based aircraft manufacturer, Kostya Zolotusky, the division's director of capital markets development, says aircraft financing conditions worldwide remain strong, even though capital markets and private-equity firms in the United States have largely stopped new aircraft financing projects since the beginning of April. The reason is that banks and sovereign funds in China and the Middle East are picking up the slack from American funds, while European banks are still lending on aircraft, at historically favourable rates, Zolotusky says.

In a private presentation to aircraft investors and analysts in New York in May, Zolotusky said orders for new commercial aircraft have been at record levels for the past two years, with financing readily available. Both Boeing in the United States and Airbus in Europe, the world's only two makers of large aircraft, have strong order books, powered by the increasing growth in air travel in emerging markets and the demand from established airlines for more modern, fuel-efficient planes, he said. Even airline mergers are good for business, since merged airlines need to switch some of their aircraft to harmonise their fleets and cut maintenance costs.

Positive future
Boeing will deliver new aircraft worth €21bn this year, all financed by lessors, banks and other lenders. Boeing Capital acts as a "third-party helper" in loan deals, rather than lending to customers itself, and even in the credit crunch it sees no need to do direct financing. "We've looked at the aircraft orders we have on the books through 2010 (and) we don't see any sales where we would have to step in," Zolotusky said.

Both Boeing and Airbus benefit from the fact that purchases by airlines outside the manufacturers' home countries - the United States for Boeing, the United Kingdom, France and Spain for Airbus - can be facilitated through government credit export agencies in the US and the European Union respectively. For Boeing, this means four fifths of its current order book backlog is eligible for US export-import bank financing, according to the company.

Currently nearly half of aircraft are owned by leasing firms, a proportion which is expected to grow for this year's new aircraft sales as leasing becomes increasingly popular. It gives start-up airlines a chance to build their fleets with less outlay of expensive capital outlay and allows the established carriers more flexibility to change aircraft as business conditions change.

The two largest lessors are GE Commercial Aviation Services, known as Gecas, and International Lease Finance Corporation (ILFC), part of General Electric and AIG respectively. However, AIG recently suffered a credit rating cut, which has adversely affected its subsidiary ILFC's cost of borrowing, and in a tight market that could make the company's business uneconomic. Smaller companies are entering the market: the Dutch firm Aercap Holdings which became a public company a year ago, leases a fleet of more than 300 aircraft and is in the process of securing an additional €1.9bn of credit from banks in Europe. But when Boeing conducted a poll of 150 aircraft finance executives in New York in May, more than two thirds said they expected to see mergers and consolidation among the recently formed leasing companies, who currently take around 10 per cent of the global aircraft leasing market.

To underline the brightness of the silver lining around the cloud of gloom the airline business is currently flying through, on May 19 the business aviation company Xojet, which launched in January 2006, announced financing agreements for up to €1.56bn to fund its North American operations and its global expansion strategy, the largest publicly-announced business aircraft financing package ever. The deal was put together by David Bonderman, founding partner of the airline financing specialist TPG, which has done business in the past for Ryanair, US Airways and Continental, and it involves the global investment company Tasameem, Export Development Canada, White Oak Global Advisor and Xojet's founder, Paul Touw.

Joint ventures
Almost €1.25bn will be made immediately available to Xojet, which currently has 127 aircraft and aircraft orders valued at more than €1.9bn. The remaining €1bn will be made available later this year for a joint venture between Xojet and Tasameem in Abu Dhabi that is looking to take advantage of the rising demand, worldwide and particularly in the Middle East, for business jet travel.

It is a picture that is actively encouraging new entrants to the airline market: Bahrain Air, for example, made its inaugural flight, from Bahrain International Airport to Dubai, only on February 3 this year. Already Bahrain Air is negotiating with two aircraft manufacturers to purchase six new aircraft for around €170m to enable it to add more services and expand its network in and outside the Gulf region. Finance for the aircraft is coming from a fund set up by shareholders of Bahrain Air to pay the deposits, with the remainder borrowed from international banks.

There are also completely new markets opening up in countries such as India, where the number of business jets in operation is expected to soar: Embraer, the Brazilian business jet maker, for example, says it expects to deliver 250 planes, worth €2.4bn, to Asian countries in the next 10 years, with market growth expected to average 9.1 percent a year until 2015. Many of these new aircraft will be for charter, but a growing number will be in "fractional" ownership – deals that see, say, six different people put up €320,000 each for a €1.9m jet, and then share the airtime and running costs.