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Turbulent headwinds

The past year has been a turbulent one for the European airline industry with the demise of several airlines. Keith Mwanalushi speaks to aviation analysts to discuss what has happened
 
By all measures the European aviation industry is performing strongly. However, as witnessed during 2018, airlines in the region, or at least some, face unprecedented pressures. On 29 August 2018, heavily indebted SkyWork Airlines based in Bern, Switzerland ceased its flight operations. Just two days later VLM Airlines, a Belgian airline offering scheduled, charter and ACMI services, also shut its engines permanently and went into liquidation. 
 
Azur Air of Germany, a leisure airline headquartered in Düsseldorf, went bust in September, and more recently, in October, the two-year-old Cypriot carrier Cobalt Air stopped flying when Chinese investors pulled the plug on their financing. All very dramatic – and fingers point to saturation and overcapacity in the market. Brian Rynott, Managing Director at Alton Aviation Consultancy, thinks there is no doubt that the European airline market continues to need further consolidation. 
 
“The European market is very different to the US market, where consolidation has improved the financial health of the industry and also the product for passengers, as airlines have reinvested in their cabins, fleets, and customer service training, amongst others,” he observes. Analysts at global aviation consultancy firm ICF have been closely monitoring the European market, and say significant capacity has been added across the board, more than compensating for the ‘lost’ capacity arising through the major insolvencies of Monarch and airberlin in 2017.  ICF data shows that European first-half traffic growth was just under 7%, which is significantly above longer-term averages, and builds on an already impressive growth of 8.5% in 2017.
 
“These growth rates should be seen in the context of relatively languid European economic performance implying a strong elasticity between traffic growth and economic performance, we would not expect these multipliers to continue to be sustained in a relatively mature aviation market such as Europe,” suggests Rob Walker, Principal at ICF. Looking ahead, Walker says strong capacity growth is again expected through the weaker winter season, which is likely to put further pressure on yields, at 
a time when carriers’ cost bases are being impacted by rising fuel prices. 
 
Walker adds: “This capacity growth from the main players (such as Ryanair, easyJet and Wizz) is expected to continue, they have been able to grow profitably, but given their increasing overlap with competitors [and each other], this naturally takes its toll on the wider market.  Given the growth plans of these and other major carriers, overcapacity trends are likely to continue, which may well play into their hands by driving further consolidation as weaker players continue to drop out.”
 
The rising cost of fuel is another critical element. Fuel will have an outsize impact, especially for smaller airlines that may not have the capacity to hedge fuel or pass along price increases to customers, Rynott notes. “For example, this could be particularly evident in leisure and holiday markets, where there is a longer time lapse between when 
a passenger buys a ticket, and when that passenger actually flies.”
 
Additionally, the strength of the US dollar clearly has had an impact, which has broadly strengthened against other currencies, in part driven by higher interest rates. Rynott further reminds that a strengthened dollar will increase an airline’s cost base – the price of fuel and other costs, such as aircraft, maintenance, insurance, amongst others, are almost all denominated in US dollars. The impact of the dollar increase can be exacerbated when an airline has largely non-dollar denominated revenues to offset the corresponding cost increase.
 
And more broadly from a macro level, a strengthened dollar can be ominous in emerging markets where both business and government have undertaken large dollar-denominated borrowings, which can pressure the local economy and currency.
 
“So, if you have these factors against a market with excess capacity, facing competition by mature, established airlines, as well as geopolitical issues, any one of these can significantly impact the financial health of an airline. “There has long been an ebb and flow of airlines that start and go bust, the latter especially happening during the low off-peak season. What we’re witnessing now, with airlines collapsing or restructuring so soon after the summer season, is an indication of how precarious the operating environments and markets are proving to be for airlines,” Rynott states. 
 
Cobalt Air, as well Skyworks to a degree, were quite dramatic scenarios. Low Cost & Regional Airline Business visited the Cypriot airline offices in Larnaca just two weeks prior to the suspension of services, and at the time, there was no obvious indication of financial trouble brewing. There is probably a comment about the general timing of these insolvencies, after the summer peak airlines often become loss making, and positive cash flow can quickly switch to an operating loss.“I suspect that in the case of Cobalt with a very seasonal market, they would have run into issues as the Cyprus market is highly seasonal and demand would have been dropping off,” suggests Walker. 
 
However, wider problems were likely at play, Walker reckons: “For example, Cobalt was a small sub-scale operator, working across many competed markets with limited sales presence to benefit from. No doubt trying to grow [to achieve scale], with relatively low capitalisation in face of increasing costs and competition was just too much.”
Having a quick look at schedule data shows many competitors, including Ryanair, are growing strongly in the Cyprus market through 2018. As Walker affirms, “that would have put increased pressure on them [Cobalt].” 
 
As for Skyworks, Walker feels that whilst having the Bern market virtually to itself, it no doubt leaked a lot of demand to surrounding airports, served by much more efficient/lower cost operators. “No doubt market factors, including fuel and over capacity, would have only contributed to its recent decline.” Rynott highlights that Cobalt and SkyWorks had a completely different business model,  but at the same time, each were influenced by both macro and micro factors impacting their respective business. “At the macro level, factors that would have impacted each of them include the increase in fuel expense and strengthening dollar. Meanwhile, both were unable 
to secure shareholder funding to keep operating and had to suspend operations.”
 
It’s worth noting that most of the airlines that have collapsed in 2018 had relatively small fleets. Others, such as the German and Polish units of Small Planet Airlines, are restructuring. Rynott notes that except for Primera, all these airlines had fewer than 10 aircraft. “So, these airlines have a smaller scale from which to spread costs and are more exposed when issues do arise in the business. Thus, if an airline didn’t have a strong summer season allowing it to hoard cash reserves for the lean winter months ahead, and don’t have the shareholder means to provide for the same, it is far more exposed to a potential restructuring or existential event,” he says.
 
 
However, at the time of going to press, it seemed as though Virgin Atlantic was attempting to extend a lifeline to Cobalt Air. The UK carrier owns Cobalt’s expensive daily slots at London Heathrow, and reportedly a Cypriot court injunction had been granted overruling the transport minister’s decision to revoke Cobalt's licences. At the time of this writing, a skeleton staff was still in the Larnaca office, following supposed interest from new investors to bring the airline back in the air. 
 
Following the demise of another carrier, Primera Air, the spotlight is back on the sustainability of the low cost long haul (LCLH) model. Further, Icelandair's purchase of its low cost Icelandic competitor WOW air comes a surprise, but this follows indications that WOW was dropping several of its LCLH routes over the Atlantic. Norwegian too has dropped some of its recently introduced services from the UK. 
 
Walker feels this model is yet to be fully proven, and recent reported troubles for the likes of Primera, Norwegian, WOW and more only serve to underline this sentiment – “they’ve only been around for a few years, and have not yet shown the staying power through a typical industry cycle. Whilst I can certainly see a place for them in the European market, there are also significant challenges they face.”
 
Since Jet Star started operations in 2006, the number of LCLH airlines has steadily increased.  However, the market faces challenges that highlight the uncertainty around LCLH business models. Paul Lyons, Head of Advisory at IBA said a key differentiator for these operators is the network strategy that they deploy, often focusing on locating in airports which provide access to the passengers of other operators, or taking advantage of a feed of passengers from their parent legacy operator.  
 
“Most commonly, the airlines have a high commonality of aircraft, ensuring that there is flexibility across the fleet and staff, as well as minimising costs from maintenance and training,” Lyons stated. Lyons stressed there was need for consolidation in this market, or growth from the current operators. He said recent moves by IAG, owner of LCLH operator LEVEL, to acquire a 5.5% minority stake in Norwegian, could be a prelude to a merger or takeover, which would create Europe’s leading airline group by 
seat capacity.  
 
“Whilst global expansion of LCLH has been huge, we don’t see any reason for this to change. What must happen is that the operating and business models can cope with external cost influences, at the same time as managing costs within the business. We expect the introduction of the long haul narrowbody to drive growth in this sector and it will be interesting to see how the LCLH airlines transition to new aircraft. This is a fascinating market for operators and investors alike.  There are going to be successes, 
but we shouldn’t underestimate the risks, which all make for exciting times ahead.”
 
Rynott indicates that there are challenges manifesting in the business model. “It’s a confluence of factors, not just difficulties with the long haul low cost business model itself, though there are challenges with the model too.” Clearly, higher fuel expenses will have an impact on the economics of this model. The jury is still out, but with a greater pinch of optimism. 

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