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Airlines

Sizing up

Budget airlines are encroaching on the traditional territory of full service carriers while getting cheaper funding from banks. David Carruthers, Head of Research at Credit Benchmark, analyses the implications
 

The global airline industry had its most lucrative year in 2016, with recorded profits of nearly $40 billion according to IATA. This was driven by a combination of growing passenger numbers, cheaper oil and greater capacity utilisation. 

 

With the International Monetary Fund projecting global GDP growth will reach 3.4% in 2017, the eight-year uptrend in aggregate sector profits is expected to continue. Despite these positive figures, airlines have traditionally been high-risk investments due to high operation leverage, subsidised national flag carriers, oil price volatility and environmental constraints on growth. It’s no secret that low cost carriers (LCCs) have significantly changed the dynamics of the airlines sector over recent years, disrupting business models and taking market share from their full service counterparts.

 

As newcomers to the market, budget airlines have been largely unencumbered by many legacy issues faced by full service carriers such as unprofitable routes, sunk infrastructure costs, supplier power, poor labour relations and unaffordable pension promises, and this has translated directly into higher profitability, stronger balance sheets, and some of the best credit ratings in the sector.

 

One of the biggest threats to profitability for airlines, both budget and full service, is jet fuel prices. The graph (page 31) shows that since January 2016, jet fuel prices have been rising above their recent lows. If this uptrend continues, it would be negative for profit margins in 2017.

 

The cost of oil is one of the biggest costs for airlines and the sector as a whole has benefited from the recent decline in the price of crude oil. This has significantly helped to improve margins and given many airlines the opportunity to restructure their fleets, buy back stocks, and expand into new routes, as well as invest in new more fuel-efficient aircraft to prepare for the inevitable rise in oil prices when it happens. The generally positive outlook for the sector depends on the strength of the global economy, and the continued financial discipline of the global carriers, who have been reinvesting in newer planes and other efficiency improvements to reduce overall break-even load factors.

 

In this uncertain environment, full service carriers have recognised the threats posed by budget airlines and have been keen to win back market share.

 

Earlier this year, American Airlines and United Airlines unveiled plans to offer ‘basic economy’ fares on US domestic routes. Over the last year, other airlines, including Virgin, IAG and Air France-KLM have also unveiled plans to enter the budget market. British Airways is also now adopting more pay-per-use options, including most recently charging passengers for onboard snacks from Marks & Spencer, the UK retailer. However, the incumbents are not the only ones trying to claw back market share – LCCs are also amending their business models to target a greater section of the airline market. Ryanair for example is expected to announce a series of feeder and shared connection deals with long haul carriers this year.

 

The European market


Looking at Europe, the success of budget airlines has greatly affected full service carriers. LCCs have had a huge impact on the full service market for short haul flights offering cut-price, no-frills tickets, and importantly, a greater choice of departure airports. European airline carriers face an uncertain regulatory environment, labour disputes, and intense competition in a fragmented market. The top three full service carriers in the European Union control just 29% of the market. This fragmented European market is another reason why LCCs have been so successful in taking market share away from flag carriers.

 

Italy’s flag carrier, Alitalia, has long admitted that it has struggled to compete against low cost rivals, and announced it was going into administration earlier this month.

 

If we compare the sheer number of bases operated by the likes of Ryanair and easyJet in Italy, to the traditional hub and spoke approach of Alitalia, it’s clear to see why the competition is so tough. They struggled to compete on both price and on convenience for passengers. With Alitalia, for example, a passenger from southern Italy might have needed to travel to Rome to catch a flight to Spain, but with Ryanair, there is a much greater choice of both departure and arrival airports. >>


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