Tuesday, 12 June 2012

Air Traffic is a leading deflationary indicator

"He who rejects restructuring is the architect of default." - Macronomics.

Following on the theme of deflationary indicators (see our conversations "Shipping is a leading credit indicator" - "Shipping is a leading deflationary indicator"), we thought this time around we would venture towards Air Cargo and Airlines, given that on June 5 the Lex Column in the Financial Times asked an interesting question in relation to Europe and Airlines: "How many airlines does Europe need? Certainly not 40, providing 8.5 per cent more seat  capacity in 2011 compared with 2007. One theory says that the region could live with three flag carriers (Lufthansa, International Airlines Group and Air France-KLM), a couple of budget airlines (Ryanair and easyJet) and perhaps, a few niche players. But while consolidation talk is plentiful, the actual pace of airline rationalisation remains fairly stately."

As we posited in our "Shipping" conversations, as far as Airlines are concerned, in similar fashion, it is as well a global game of survival of the fittest.

In fact Lex Column concluded their 5th of June EU consolidation conversation by the following:
"Ultimately, though, credit withdrawal pressures may be required to achieve rationalisation. Last year, these pushed Malev and Spanair out of the skies. It could be an even tougher winter ahead."

We already know from our various credit conversations relating to 2011 issues, namely access to dollar funding, that many European banks have in fact scaled back from dollar-funded businesses such as aircraft financing. In similar fashion to shipping we believe credit withdrawal will accelerate the pace of rationalisation in the European skies.
As a reminder:
Last year issues surrounding liquidity issues and difficulties in accessing dollar funding mean most European banks are paring back on their Structured Finance Operations: Definition of Structured Finance business - source Credit Agricole CIB:
"The Structured Finance business consists in originating, structuring, and financing operations involving large-scale exports and investments in France and abroad, often backed by collateral security (e.g. aircraft, ships, corporate real estate, or commodities), as well as complex and structured loans.
The Structured Finance division comprises nine finance segments: aviation and rail / shipping finance / tax-based leases / natural resources, infrastructure and power / real estate and lodging / export and trade finance / acquisition finance / transactional commodity finance / structured finance advisory."
So in our Air Traffic conversation we will first look at Air Cargo as a leading deflationary indicator then at the ongoing issues plaguing Airlines which will lead to consolidation.
According to a note by Nomura published on the 12th of June, Air Cargo is a leading indicator of chemical volume growth and economic activity:
"Our air cargo indicator of industrial activity came in at -7.6% (y-o-y) in May, following -7.8% in April and -4.3% in March. As a readily available barometer of global industrial activity, air cargo volume growth is a useful indicator for chemical volume growth."

It has also been a very reliable indicator in relation to industrial production according to Nomura:
"Over the past nine years' monthly data, there has been an 85% correlation between air cargo volume growth and global industrial production (IP) growth, with an air cargo lead of one to two months. In turn, this has translated into a clear relationship between air cargo growth and chemical industry volume growth."

Nomura’s proprietary air cargo indicator shows a high correlation (85%) with global industrial production:

Moving on to the ongoing issues plaguing the Airlines industry, as recently as yesterday IATA (the International Air Transport Association) has almost doubled its 2012 loss forecast for European airlines and said the continent's debt crisis could wipe out an expected global profit according to Bloomberg - IATA Doubles Loss Forecast for Europe Airlines on Crisis:
"Carriers in Europe may lose $1.1 billion this year, compared with a March forecast for a $600 million loss, the airline body said today at its annual meeting in Beijing. It reiterated a forecast for a $3 billion global profit. The worldwide estimate could be reduced if the European economy worsens more than expected, the group said. “If there’s a full-blown crisis, all bets are off,” Tony Tyler, head of IATA, which represents about 240 carriers, said in a Bloomberg TV interview yesterday. “It will have a big impact on the world economy and a huge impact on airlines.”
Global profits are already set to fall from $7.9 billion last year, as recessions in the U.K., Spain and other European countries damp demand and erode gains from lower fuel prices. Deutsche Lufthansa AG (LHA), Air France-KLM (AF) Group and International Consolidated Airlines Group SA (IAG), Europe’s three biggest full- service carriers, have all announced plans to cut staff or restructure operations following first-quarter losses."

Although the recent fall in fuel costs could been seen as good news for Airlines, in the 1st quarter of 2012, soft pricing and high fuel costs had already meant losses for European airlines due to weak price elasticity for European carriers as indicated by Bloomberg on the 26th of April:
"Most European airlines will record losses in 1Q, according to consensus expectations. Load factors improved on depressed air fares, which rose 6% on average during the period, barely enough to cover the 400 bps to 500 bps of margin loss due to higher fuel costs. Substantial hedging should alleviate some, not all, of the pain." - source Bloomberg

In fact given that many carriers hedge more than 70% of fuel consumption, it is highly unlikely that the recent fall in fuel prices will make a big difference to their difficult situation:
"European airline fuel hedges could alleviate the effects of a 1Q fuel price increase. Jet fuel prices rose 16% yoy and 9% sequentially. The effect of high fuel prices could be damped as many carriers hedged more than 70% of fuel consumption for the period. Hedges are typically most effective when prices rise significantly sequentially." - source Bloomberg, 26th of April.

So as we posited in our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid...", same apply to US Airlines versus European Airlines, its the credit conditions stupid given, as indicated by Bloomberg in their article - IATA Doubles Loss Forecast for Europe Airlines on Crisis:
"IATA raised its profit forecast for North American carriers to $1.4 billion from $900 million. The airlines will boost earnings from $1.3 billion last year as they refrain from adding many flights amid a 0.5 percent growth in demand, the slowest pace worldwide, the group said."

As far as traffic is concerned, in similar fashion to shipping (see our previous posts), traffic to the Americas have been the biggest beneficiary as indicated by Bloomberg in April:
"Lower airfares boosted international demand and improved load factors for European carriers in 1Q. Traffic to the Americas saw the best improvement, probably aided by depressed U.S.-to-Europe air fares. Asia-Pacific region traffic, the second-biggest market, also improved during the period on lower fares." - source Bloomberg, 26th of April.

As far as Europe consolidation is concerned, the game of survival of the fittest is truly on. For instance, Air France-KLM in the first quarter of 2012 took market shares to its rival IAG (the British Airways and Iberia company formed in January 2011) as reported by Bloomberg on the 26th of April:
"Domestic load factors improved in 1Q for the top full-service European airlines, though they remained weak at about 67 on average, on a 3.6% traffic gain and with capacity unchanged. Air France added capacity and increased traffic, improving load factors and gaining market share from IAG, which cut capacity during the quarter." - source Bloomberg.

Europe has already seen some airlines collapse this year, including Hungary’s Malev and Spain’s Spanair as a matter of fact.

When it comes to low cost airlines, the fight is as well truly on, in a weak pricing environment where Ryanair's loss in the 1st quarter was, as reported by Bloomberg, EasyJet's treasure:
 "Ryanair's 2.3% capacity cuts weighed on low-cost European airlines' domestic capacity growth (3.4%) in 1Q amid weakness in pricing. EasyJet countered Ryanair's contraction by adding 7% capacity during the period, increasing market share. Domestic load factors were unchanged for European low-cost carriers on a 1% increase in traffic." - source Bloomberg 26th of April.

Although US Airlines have been benefiting from European woes, according to Bloomberg, American, United Airlines are most exposed to a potential fall in Latin America Airfaires:
"Non-premium airfares for U.S. to Latin America travel fell for the second straight month in May, by 3%, while premium fares fell sharply by 28%, indicating Latin America passenger yields may slow. American Airlines and United are the most exposed to demand changes to the region because they are the biggest carriers to Latin America by traffic." - source Bloomberg, 17th of May.

But in this global deflationary environment, it is not only affecting American and European carriers facing potential headwinds such as pricing issues, weak earnings and consolidation threats. Australian airline Qantas predicted a 91% drop on the 5th of June 2012 leading to an 18% slump in its share price on the day:
"Qantas Airways Ltd., Australia’s largest carrier, plunged to a record low in Sydney trading after
saying annual profit may fall as much as 91 percent because of losses on overseas routes and higher fuel costs.
The carrier, which listed in 1995, slumped as much as 18 percent, the biggest drop since February 2009, to as low as A$1.16 at 1:52 p.m. in Sydney as the benchmark S&P/ASX 200 Index
rose 1 percent. Credit-default swaps rose to an eight-month high.
Underlying profit before tax may be A$50 million ($49 million) to A$100 million in the year ending June because of a A$700 million increase in fuel bills and a doubling of losses at Qantas International, the airline said today. The Sydney-based carrier could also lose its investment-grade credit rating at Standard & Poor’s following the profit warning, said National Australia Bank Ltd."
- source Bloomberg

On the 5th of June Qantas 5 year CDS  jumped 15 bps to 365, their highest since October 2011,
according to CMA data. S and P downgrading the carrier from BBB is likely and a two-grade two-grade cut to a non-investment level is an “outside possibility,”  according to National Australia Bank said in a research note as reported by Bloomberg.

In similar fashion to Wilbur Ross planning shipping expansion as industry distress grows for shipping (which we discuss in our recent shipping conversation), the sharks are circling the stricken airline industry as well, with Qantas shares jumping 11% today, their biggest gain in more than 5 years as reported by Bloomberg. This jump has led Qantas to hire Australian bank Macquarie Group Ltd to ward-off the predators - "Qantas Hires Macquarie for Takeover Defense After Slump":
"Qantas may be more attractive to bidders after its stock slumped to its lowest levels on record last week after forecasting the first annual net loss since a 1995 initial public offering. The airline, which can only legally be controlled by Australian investors, is battling rising losses on international services as rivals from the Middle East and Asia lure passengers."

Similar to the shipping industry, consolidation, defaults and restructuring are going to happen no matter what, in the Airline industry in our on-going deflationary game of survival of the fittest.

"The first thing you have to do is accept that decay sets in and there's nothing you can do about it."
Francesca Annis

Stay tuned!

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