CIBC: an airlines industry analysis Note: This analysis have many graph and exibits that I can't copy; so, only texts have been shown. Canadian Airline Industry: Can The Sector Return To Pre-pandemic Profitability?
A Look At The U.S. Airline Industry Over The Last 40 Years
Our Conclusion
While the near-term focus on the Canadian airline sector remains on the weak demand environment with questions around what the recovery looks like, in this report we look to address another question we often get – can Air Canada (and the Canadian airline industry overall) ever return to prepandemic profitability?
To answer this question, we take a look at how the U.S. airline industry fared through previous crises and we do see a silver lining. We believe airlines that survive this ordeal without taking on too much debt or accepting onerous government conditions are in a better position when the industry recovers.
This bodes well for Air Canada given the strength of its balance sheet heading into this crisis, its cost-cutting initiatives, and its operational adjustments. These factors should allow the company to recover faster than its domestic peers. As Air Canada’s financial performance begins to benefit from a recovery in air traffic, this is also a positive for Chorus Aviation as it reduces the risk around its Capacity Purchase Agreement (CPA) with Air Canada.
Canadian Airline Industry: Can The Sector Return To Prepandemic Profitability?
There is a saying that what doesn’t kill you makes you stronger. For the Canadian airline sector, which is facing an unprecedented decline in air traffic, that is the hope as it looks past this pandemic. While the near-term focus remains on the weak demand environment with questions around what the recovery looks like and timing of a vaccine, in this report we look to address another question we often get – can Air Canada (and the Canadian airline industry overall) ever return to pre-pandemic profitability? To answer this question, we take a look at how the U.S. airline industry fared through previous crises and we do see a silver lining.
While at this juncture we do not have a clear sense of what air traffic demand looks like in a post-pandemic world, looking at the U.S. airline industry, we see a sector that has come out of every crisis over the last 40 years stronger than it was going into each downturn. This culminated in the U.S. airlines industry entering 2020 as the strongest financially versus other major markets, which reflects the significant restructuring that has occurred, especially post 9/11 and the Great Financial Crisis.
We believe airlines that survive this ordeal without taking on too much debt or accepting onerous government conditions are in a better position when the industry recovers. With the Canadian airlines benefiting from a more favorable outlook for jet fuel and in the midst of aggressive cost cutting, the sector is shrinking in the anticipation that air traffic may not return to 2019 levels until some time closer to the middle of this decade. In other words, the Canadian airlines are reducing their cost structure in anticipation of lower volumes for the next few years. As well, significant macro shocks should result in less rational competitors being forced out of the market. All of the above bodes well for airlines that survive the downturn. This suggests that, in turn, the industry could see a rebound in profits faster than a rebound in traffic.
A Look Back At The U.S. Airline Industry – A More Profitable Industry After Each Crisis
Since deregulation of the U.S. airline industry in the late 1970s, the industry has exhibited a high level of volatility, but a key observation is that after each crisis, the sector exhibited a higher structural level of profitability. If we look back to the early 1980s, the U.S. economy has experienced five recessionary periods (excluding the current downturn), but we group these into three economic shocks to the airline industry. We see that exiting these downturns the sector saw a material improvement in profitability. We would also note that, until this year, the U.S. airlines had experienced the longest streak of positive profits since deregulation. Higher margins help reduce volatility in that they create a greater buffer to manage through unexpected events.
Below are a few observations we would like to point out as we look back over the last 40 years of the U.S. airline industry, highlighting how the industry became more profitable.
First, looking at fuel, this is a line item that experiences the greatest volatility for any airline. Prior to 2010, we saw a strong relationship between U.S. airline revenue and fuel – this makes sense as airlines looked to offset rising input costs but were also quick to give back any savings from fuel due to the competitive nature of the industry. The correlation between U.S. airline RASM and fuel cost per ASM was 62% from 1977 to 2009
But if we look over the last decade, we see that the jet fuel price and RASM relationship weakened, with carriers able to keep the gains from lower fuel costs. This highlights a sector exhibiting more rational behavior as airlines look to structurally improve their historically weak margin and ROIC profile versus just “giving back” the savings from falling jet fuel prices.
In other words, we saw more rational pricing post the Great Financial Crisis (and arguably after every downturn) as RASM looked to have structurally increased as the airline industry recovered.
Second, we also saw better asset utilization post every crisis, which is key given airlines have a high fixed-cost structure. We saw load factors continue to increase, reaching a peak of ~85% in 2019 and averaging over 83% in the last decade. This compares to an average load factor of 76% from 2000 to 2009.
What Drove The U.S. Airline Industry To Be More Profitable After Every Downturn?
While the path towards the airline sector recovering from COVID-19 still faces a lot of uncertainty, we see that the U.S. airline industry was structurally better after each crisis when looking back the last 40 years. Below we discuss what we view as the key factors that drove this improvement.
1. Increasing Industry Concentration; Less Rational Competition Exits Market
In 2019, the top four U.S. airlines accounted for over 60% of the U.S. airline domestic market share as measured by passengers versus ~50% from 1990 to 2010. As well, the difference in market share for UAL, the fourth largest domestic carrier by passenger count in 2019, is over double the next carrier. Looking back from 1990-2010, we saw a number of carriers with midsingle-digit percentage share. In other words, the U.S. airlines that survived the Great Financial Crisis and other downturns were able to concentrate their market position.
We also saw less rational airlines entering a downturn being forced to exit the industry. As noted below, and not surprisingly, U.S. airline bankruptcies significantly spiked during periods of industry downturn
As the airline industry consolidated, especially after 9/11 and the Great Financial Crisis, the surviving airlines created a more rational competitive environment. With fewer players, the industry as a whole saw improved profitability and ROIC.
2. Size Matters
The concentration of market share gravitated towards the bigger U.S. airlines. We can see that the top four U.S. carriers by domestic passenger count have stayed relatively constant in the last 40 years despite all the turmoil with the industry. While the larger carriers were not the most profitable, coming out of a downturn they benefited from having the network size to accommodate the recovery in demand. We would also note that while U.S. Airways cracked the top four in 2010, it was acquired by American Airlines in 2013.
As airlines reduced their point-to-point routes and pushed more passengers through their hubs or operating bases, especially during downturns, this benefited the large carriers. When looking at the hubs/operating bases from the current top four U.S. airlines in 2019, these airports now account for ~68% of total passenger enplanements in the U.S. versus ~65% in 2008. Over this period, while total passenger enplanements were up ~25% in the U.S., they were up over 34% in the top 10 U.S. airports
It was not just that the U.S. carriers benefited from an increase in market share from their home market, we also saw them siphon share away from foreign carriers coming out of the last downturn. As the U.S. carriers leveraged their hubs and offered improved scheduling, this increased their competitive advantage over foreign carriers, especially as the latter group likely retrenched. In 2000, the U.S. carriers had 43% market share of international capacity (as measured in number of seats) and in 2010, post 9/11 and the Great Financial Crisis, that market share rose to ~53%.
3. Becoming More Nimble
The U.S. airline industry used previous downturns to reduce their cost structure, making the industry more nimble. While we recognize fuel plays a significant role in determining an airline’s profitability, we note that coming out of the Great Financial Crisis earnings recovered faster than traffic (i.e., the sector did not need to return to the same size to generate “normalized” profitability) while margins were structurally higher the last decade than any other time since deregulation of the U.S. airline sector. If we use 2007 as the baseline, U.S. airline operating income returned to pre-crisis levels by 2010, while traffic took another two to three years to recover.
We recognize the pushback here is the fear that COVID-19 will structurally reduce business travel, which is highly lucrative to the airline industry. We do expect business travel to lag in the recovery, as it does coming out of every downturn. That said, exiting the Great Financial Crisis, leisure travel took two years to recover versus five years for corporate travel. Even with this headwind, profitability rebounded faster than the recovery in business travel for the U.S. airline industry
What Could This Mean For The Canadian Airline Industry Post Pandemic?
We believe the Canadian airline industry has a lot of the same attributes as the U.S. airline industry, and if history repeats itself, this suggests that the sector should come out stronger post COVID-19. A number of reasons we see this being the case are: 1. The Canadian airline industry is even more concentrated than in the U.S. The larger Canadian carriers should benefit from their strong market position as smaller players face a more challenging financial situation that limits their competitiveness, including upstart airlines. For example, Canada Jetlines has abandoned its strategy of becoming a ULCC, Flair exited the U.S. market back in 2019, Porter has suspended its service to October 7, and Transat has exited the Western Canadian market. While Air Canada and WestJet have also significantly curtailed capacity, they have an advantage over the smaller carriers given their existing market share and network reach. It also points to a market that should be more rational as we get past the early innings of the recovery.
2. In Europe, Asia-Pacific, Latin America, Africa, and the Middle East, we see a large number of national carriers. Given governments typically provide financial support to their “flag carriers”, this capacity is stickier. In other words, it is more difficult in these continents for larger carriers to consolidate market share as each country looks to maintain their airline industry. As such, these regions have not benefitted from the same amount of capacity exiting the market during previous downturns, which is a key reason we believe the airline sector outside of North America has not seen the same stepfunction improvement in profitability. Looking at North America, if we exclude the Caribbean airlines that do not typically offer a robust global network, Air Canada is arguably the only “flag carrier.” While the U.S. does not have a “flag carrier”, one could argue that Delta, United Airlines, and American Airlines serve this function. Nonetheless, the number of national carriers in North America pales in comparison to other major jurisdictions, as noted in the exhibit below. So as we come out of this downturn, Canadian airlines face less foreign airline competition (just like the U.S. carriers).
3. Air Canada’s position as Canada’s leading global carrier remains intact. Prior to the pandemic, WestJet’s strategy was to expand its international network. We suspect this strategy has been pushed out as the airline looks to conserve liquidity and given expectations that international travel will lag in the recovery. WestJet noted back in May that it is considering whether to defer or cancel future scheduled deliveries of the Dreamliner. So while Air Canada will be a smaller carrier versus what it was heading into this pandemic, it will still reman significantly bigger than its domestic competitors. We believe bigger airlines are better able to manage how demand evolves post COVID-19 given their more diverse product offering and geographic reach. As well, as airlines reduce point-to-point routes given the demand destruction we have seen due to COVID19, Air Canada is well positioned given its hubs are in Canada’s three largest cities (Toronto, Montreal, Vancouver). Arguably, Air Canada’s hub positioning may be more advantageous than its U.S. peers, as seen in Exhibit 16.
4. The Canadian airlines have taken aggressive steps to reduce their cost structure. Air Canada has specifically noted that it has expanded its cost reduction, capital reduction and deferral program as a result of COVID-19 to ~$1.3 billion, up from an initial target of $500 million, and that its daily cash burn in Q3/20 will be ~$15 million-$17 million ($4 million per day is capex) versus $22 million in March. This suggests that it will be a more nimble airline as traffic returns. This should allow for earnings to potentially recover faster than traffic, especially in a weaker jet fuel price environment.
While air traffic will take years to recover (IATA assumes it will take four years for traffic to normalize, with international and business travel lagging in the recovery), we do see an opportunity for the Canadian airline industry to come out of this in a stronger position. The evolution of the U.S. airline industry over the last four decades gives us this hope. While there are questions today around what happens to the highly lucrative business travel as companies have become accustomed to “Zoom meetings” or do fears of the next pandemic impact leisure travel, we would argue that during every downturn the airline industry faces questions about a structural impairment to demand. But in every instance, air travel has proven to be resilient and the airline sector has shown it can adapt.
As such, we believe Air Canada is in a good position given its market position, the strength of its balance sheet heading into this crisis, its cost-cutting initiatives, and its operational adjustments. All of these factors should allow it to recover faster than its domestic peers. The recent launch of its revamped loyalty program also provides an additional earnings lever for Air Canada. In addition, as its financial performance begins to benefit from a recovery in air traffic, this also bodes well for Chorus Aviation as it reduces the risk around its Capacity Purchase Agreement (CPA) with Air Canada.