Airlines - Magical Thinking

Pin-insights

Magical thinking is an update of recently documented information about the airline industry

• the current response of general management and the somber outlook of airlines is discussed in 'Airports and Airlines - for the long haul'
• a dire warning, meant to be a wake-up call for young investors lured by the deep discount on airline stocks, is published in the Robinhood Series on US airlines

The present note has benefitted largely from the interview of Hubert Horan, posted on the Financial Times, Sept. 11, '20

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Not one to entertain any illusion about the dramatic consequences of the pandemic on the airline industry, Mr. Horan, on the strength of 40 years of transportation expertise, tells it as it really is …

…and then the industry hit an iceberg

The sinking may not be a swift as was the demise of the Titanic but the consequences will be as lethal

The chain of causation is plain for everyone to see

• Airline companies are involved in a very capital-intensive industry – the planes themselves (owned or in long-term leases) and the fixed service costs represent a massive deadweight if – as today – companies need to downsize
• The collapse in revenue has wrought havoc – to put the current revenue fall of 75% in the US (in Q2-20) in context, the previous crisis in 2000 precipitated 75% of the industry in bankruptcy with a crippling 6% drop in revenue
• In March, as the pandemic started to bite, the hope that a V-shaped recovery would put everything right soon enough took hold
• By April, the industry was staring at abysmal losses – but still stuck to the recovery story line

What was left unsaid, is how the twin engines of profitability simply had ceased to exist: both business travel and international flights fell to zero, with extreme consequences on the delicate balance of the industry’s business model

This is where the industry stands, and though the focus is on US carriers, the same holds true around the world

• US losses in Q2-20 have been of $13 billion and cash drain $15 billion
• There is absolutely no recovery of the industry’s main drivers in sight – and scenarios were corporate business travel and international travel will never recover to pre-COVID levels, at least not in a medium 6-year term, appear credible
• In a best case scenario, costs could be brought down by 25% - which offers no comfort when revenue is falling by half (or more)

Mr. Horan’s recipe holds in three words – bankruptcy and industry-wide restructuring

Magical thinking

Shockingly, in this expert’s view, bankruptcy proceedings do not seem to enter general management's considerations and the financial media have remained mum

Clearly, no business can survive with its engine of profitability down and out, very large fixed costs and shallow cash reserves, the later depleted by $50 billion stock buybacks over the past few years, as if there was no tomorrow and no potential downturn to anticipate…ever

Stockholders, bondholders and general management may be intent on maintaining control, a stance which only a swift recovery makes plausible….

In other words, reality can be suspended only for so long…public support and furlough programs have kept the industry alive, pushing the day of reckoning back to October

There may be a calculation in waiting for the weakest competitor to fail – in our evaluation, American  – but in Mr. Horan’s telling all three large US airlines have to contend with a loss of up to 50% of revenue and the collapse of American does not resolve the drying-up of international travel on which all rely…

Only Southwest , essentially a domestic airline, may find some reprieve…

For the record, as discussed previously ...

Berkshire  had sold part of its Delta and Southwest Airlines shares by April 3 and the firm's entire holding in the US airline industry by May 2

The reversal of fortune of a finally tuned business model combining profitable lines with mass ‘economy’ transport has been dramatic, but economic realities will confront the airlines very soon if two assumptions prove correct

• Corporate business and international travel are impaired and will not recover before an extended period of time (if at all…)
• The industry cannot downsize by some 40% by letting market forces play out, simply because these key profitability drivers have vanished

External economic benefits

If industry restructuring involves the public purse in the near future, it is because airline services are essential cogs of flourishing economies by making trade and travel possible

It is true that national carriers retain an aura the world over, securing a new lease on life time and again for bad performers, such as Alitalia, the Italian flag carrier

But apart from emotional loyalty, the external benefits for national economies of a domestic airline network and international connection are the real deal

All of which points to continent-wide restructuring of the industry

• in North-America (South American companies already are in bankruptcy proceedings, simply because neither Mexico, nor Chile, nor Argentina could afford the support needed)
• in Europe
• in Asia

The benefits will compel governments to take charge in a process that will reverberate down the entire supply chain of the industry, with brutal consequences on employment and sustainability of a whole range of dependent activities

Blandly stated, none of this will be easy and creeping forms of nationalization tend to produce unintended consequences

• restructuring may be inevitable but is not sufficient to deliver a viable business model (which remains to be invented)
• outsized fixed costs will force ticket prices into much higher ranges, with predictable consequences on demand

The fact that the crisis – and the complexity of its resolution – are not recognized to their full extent by public officials has been uniquely demonstrated lately by the French Parliament

This legislative body is blithely preparing to discuss an ‘ecology’ tax on airline tickets of between €30 and €60 depending on the distance

The yield of the French tax on air travel – expected to reach €4.2 billion in 2021 – may belong to fantasy land because air travel will simply evaporate, but the tragedy is binary by revealing complete misjudgment

• of the transformative nature of the airline crisis
• of the essential contribution of the industry to a healthy domestic economy

Another fight for another day ?