Changing Flight Path
Airline industry profits, particularly among North American carriers, are taking off. As IATA notes, low fuel costs are certainly contributing to lofty performance.
However, the industry has talked about structural realignment. Could a decades old trudge through regulatory easing, better customer targeting, and a healthy product pipeline be behind a structural shift? Consequently, the airlines are increasingly well-managed and profitable, benchmarking favorably against industrials.
Air Travel Reaches New Heights
In 2016, demand for air travel reached an all-time high. Recently, Airlines for America forecast 140 million people would fly on a U.S. carrier sometime this spring. Indeed, IATA forecasts demand for air travel will grow by 6.9% in 2016 y-o-y, with an average 9% ROI on equity.
Low fares and improved accessibility partly explain the surge in air travel. To cope with the increase in activity, airlines are expanding routes and deploying larger planes. In addition historically low fuel costs, better management, and wiser investment strategies are contributing to exceptionally strong profits.
Low Energy Costs Fuel Record Profits
What is responsible for the improved bottom line? Many analysts credit cheap oil prices as a significant boon to the airline industry over the last couple of years. However, they are only one factor in a larger story. As Brian Pearce, chief economist at the IATA notes, airline profits were, in fact, rising before the recent drop in fuel prices. He singles out capacity management, which entailed the elimination of marginal routes, as a key driver of profitability.
Structural Changes Have Realigned the Industry
Several considerations have contributed to a structural shift that has dramatically changed the aviation environment. First, deregulation initiated in 1978 fundamentally altered the competitive landscape, transforming air travel into a global commodity product. As a result, the industry became indispensable to transporting people, international commerce, and the world’s overall GDP. For example, air travel is a huge driver of economic development, generating $118 billion dollars in tax revenue and helping to sustain nearly. 63 million supply chain jobs.
Second, post-911 security measures radically altered the way airlines do business, creating significant barriers to entry, and greater gains on government approved consolidation.
Of course, increased security screening initially had an adverse impact on passenger volume, but over the long term, it has increased consumer confidence in the aviation system as a whole.
Greater emphasis on safety and security is paying dividends. Speaking in 2015, Tony Tyler, general director at the IATA noted, “With one jet hull loss for every 4.4 million flights last year, flying has never been safer.” This exceptional transportation track record has fostered positive brand awareness among air travelers, boosting the prospects of the entire industry.
Thirdly, industry consolidation — as evidenced by the recent American/US and perhaps lastly for the legacy networks Alaska/Virgin mergers — has engendered efficiencies to the industry. In particular, a trend towards more professional management has fostered greater financial discipline among carriers. While remaining price competitive, consolidation has led to vastly improved capacity management. This has reduced fragmentation in the industry as a whole. For now the airlines seem less apt to engage in significant fare wars.
Finally, new unbundled product lines — championed by ultra low-cost airlines like Spirit — have expanded the market for air travel as consumers now have the option of commodity flights or tiered service. Also, investment in infrastructure — such as airport lounges and frequent flyer programs — have created more lucrative and diversified ancillary revenue streams.
Consumers have been a huge beneficiary of these trends. Air travels costs are 50% lower than they were 30 years ago. Meanwhile, increased demand for air travel is encouraging carriers to expand routes, which is enabling the flow of good, services, and economic activity. The industry is capitalizing on being at the center of a virtuous cycle.
Takeaway
We have entered a new era in aviation. Recent profitability is not just the result of the peak in a business cycle. It is a result of major structural reforms.
However, sustained growth will depend on preserving competitive cost structures and overall. economic growth. The airlines are doing a far better job at managing the costs they can control.
Choosing to hedge fuel or not may remain a philosophical quandary on the optionality of an embedded put for the short to medium term, and longer term new aircraft deliveries should serve as at least a partial mitigant.✈️