Issued by Xuemin Jia, Msc, Seahawk Investments GmbH
Executive summary:
COVID-19 has thrown the global airline industry into the darkest period in history – due to the rapid, massive spread of the virus, almost all countries have imposed lockdown and travel restrictions starting from end of January in China, to mid-March in the U.S. and Europe, until mid-May. As a result, over 80% of global fleets have been grounded in March, airlines have been burning cash every day, airline stocks have been slashed to half of pre-crisis level since then. This pandemic brought a drastic short-term impact on air traffic demand. At present, flight bookings are slowly recovering as the virus spread is fairly under control by now, but it could alter people’s travel behaviour and public health policies – social distancing will become a new normal.
Looking back, airlines have experienced some good years as a result of the fast globalization development, the rapidly growing Asian aviation market growth and increasing global GDP growth. Global commercial airline revenue has grown at a compound annual growth rate (CAGR) of 5.8% after the global financial crisis. As compared to previous years, airlines in general had lower debt levels and stronger liquidity positions in 2019 which enabled a softer landing during the crisis. We expect low cost carriers (LCC) to get through this crisis in better shape. LCCs are able to operate more efficiently due to their competitive cost structure, smaller scale, lower exposure to international routes and stronger balance sheets. Once travel demand starts to pick up, we expect them to recover at a faster speed to the pre-crisis level. In contrast, many full-service carriers (FSC) had to rely on government aid to survive, which translates into elevated debt and equity dilution. Some flagship carriers have to experience a costly recapitalization before they start to generate profit again. Strings attached to government rescue packages are normally associated with suspended share buybacks, suspended dividends which make their stocks less lucrative.
Empirically, airlines needed at least one year after material disruptions to reach operational profitability. Examples are the 2008 financial crisis or the 2003 SARS pandemic.
When the lockdown has ended and economies have slowly reopened, domestic air traffic in the US has initially picked up quicker than expected. Market sentiment has suddenly turned very optimistic. However, evaluating the fundamentals of the airline equity market, we believe that further caution is required.
On the other hand, the airline fixed income side looks quite attractive. The central banks’ asset purchase programs are giving general support to the corporate investment grade and high yield market. Moreover, most airlines are expected to deleverage their balance sheets by raising equity. In addition to that, current credit spreads are showing significant mark-ups vs. their rating peers.
1. Demand shock & revenue loss on an unprecedented level
As the COVID-19 outbreak has been spreading across the whole world since February, the global economy has experienced turmoil across almost all sectors. According to the latest I.M.F estimation, the global economy is expected to contract by -4.9% during 2020, the worst downturn since the Great Depression. The COVID-19 outbreak is undoubtably a fatal demand shock to the airline industry. Starting from January, the emergence of the corona virus in Wuhan, China, daily international flights have on average been reduced by 87% until mid-April, according to the statistics from major airports worldwide. The majority of airlines have reduced their flights by more than 90% and a handful of airlines such as Air Asia, easyJet, Emirates, have grounded all fleets. Travel restrictions have extensively impacted both domestic and international flights but to a more severe extent international traffic.
The corona virus has brought at least three important aspects that affect the airlines revenue outlook:
a. Major economies have implemented policies such as quarantine, border control and further travel restrictions to control the virus spread. This directly hits the airlines revenue and this ongoing demand shock is most likely expected to persist until the end of this year. The revision of public health policies in different countries owing to the pandemic imposes capacity restrictions as another contributing factor further reducing the airlines revenue. However, the travel demand plunge may be a short-term effect if the virus fades away during the summer period which could be a typical pandemic pattern. However, whether there will be a second or third wave of infections still remains unknown.
b. The uncertainty of virus recovery patterns leads to various probabilities of economic growth recovery scenarios in the short to mid-term. However, the virus pattern is expected to vary in different economies as it depends on the effectiveness of government policy intervention on virus spread control and the effectiveness and timeliness of response to the virus resurgence. This knock-on effect, therefore, is having a direct impact on the airline industry due to the high correlation between GDP growth and airline industry revenue. Empirically, airlines get back to operating profitability after at least one year when material disruptions occur, such as the 2008 financial crisis or the 2003 SARS pandemic. This indicates a relatively slow medium-term recovery of the whole industry.
c. Another factor that should not be neglected is how people’s travel behaviour change as a result of the pandemic. Reduced travel demand could also be one of the personal lifestyle changes, such as the booming demand for video conferencing, home office solutions and gaming markets during the great lock down. For business and VFR (Visiting friends and relatives) travellers travel demand is expected to bounce back rapidly whereas leisure travellers demand is related closely to personal lifestyles, state of the economy and public health issues. Airlines exposed to different customer groups are expected to experience different speeds of revenue recovery.
2. Airline industry prospered in the past years
The global airline industry has experienced some good earning years prior to COVID-19 thanks to the increased global travel activity and large declines in the price of crude oil. Over the last 10 years, the global airline industry revenue has grown at a CAGR of 5.8% as a result of globalization and stronger interconnectedness of value chains. Moreover, the technological evolution supports ancillary revenue and automated ticketing. The ongoing deregulation of civil aviation in multiple markets has spurred the rapid revenue growth of low-cost carriers such as Ryanair and Southwest Airlines. In terms of profitability across different regions, North American and European airlines achieved the highest return on invested capital while Asian Pacific and Latin American airlines were lagging.
Source: Statista, IATA 2019 End-year report
Below is an estimated passenger revenue loss in 2020 assuming a three-months lock down until the end of Q2 by IATA. The entire industry will suffer an aggregate loss of $314 billion and the Asia Pacific region accounts for more than one third. By now, most countries have lifted the quarantine restrictions, domestic air traffic is recovering gradually and the incoming summer holiday period could boost demand to some extent. But international air travel recovery is expected to be more muted.
Source: IATA COVID-19 Updated Impact Assessment, April 14, 2020
3. Pre-crisis liquidity and leverage level of airlines
Most airlines entered into the COVID-19 crisis in a sound financial position: low debt levels and strong liquidity positions, compared to prior years. Looking at the fiscal year 2019 financial positions, U.S. and European airlines in general have shown better solvency and liquidity, in contrast to Asian and Middle Eastern airlines. Many airlines in the Asian and Middle Eastern market are either fully state-owned or the government is an influential shareholder. In this case, substantial government support is more likely. The significantly higher leverage level in Asian markets is mainly driven by three airlines, China Eastern, China Southern and Thai Airways (Thai Airways has already filed for bankruptcy in May 2020). Therefore, overall debt levels are much higher compared to international peers.
Source: company FY2019 financial reports, Bloomberg
Source: company FY2019 financial reports, Bloomberg
The graph above compares the firm’s solvency and liquidity position at the end of fiscal year 2019, before COVID-19 had a significant impact on the financial position of global airlines. It is quite noticeable that in general LCCs (Low Cost Carrier) came into the COVID-19 crisis in a much better financial position, with higher cash reserves and less leveraged balance sheets. As LCCs are quickly able to lower operating costs, it allows them to make up for the ticket revenue loss and to cushion the travel demand shock in a better fashion than FSCs.
Source: CAPA March,2020; company FY2019 financial reports
In terms of liquidity equivalent to days of revenue, measured by cash and cash equivalents, Wizz Air and Ryanair, two fast growing LCCs in the European airline market, are able to self-sustain a longer time even without government’s aid. Although it needs to be mentioned that Ireland based Ryanair has received GBP 600mn (about $ 730 million) from the UK Covid Corporate Financing Facility (CCFF).
Flag carriers, however, like Lufthansa and Norwegian Air Shuttle are trapped in deep trouble amid the pandemic crisis. In late May Norwegian Air Shuttle has finally managed to unlock a state rescue deal through a large debt-for-equity swap which has pushed its equity ratio to 15-17 per cent, to exceed the threshold requested (8%) for the state-backed loan guarantee of NKr 3 billion (€ 277 million). As a result, two of the world’s largest aircraft leasing companies, AerCap from Ireland and BOC Aviation, which is indirectly controlled by Chinese government have become the largest shareholder of Norwegian Air Shuttle. The CEO of Norwegian Air Shuttle also signalled further bailout request might come later.
The German government. Lufthansa and the European have agreed to a € 9 billion bailout package: The German government will obtain 20% of Lufthansa shares to become its biggest shareholder. This bail-out deal was only able to get approval by the European Commission with certain concessions attached to it. Lufthansa will be forced to surrender airport slots at the Frankfurt and Munich airports. The government participation at a discounted share price dilutes common shareholders equity.
4. Government aid summary
The aviation industry is a key driver to global economic development contributing to around 3% of global GDP and therefore this industry pays an important portion of government tax revenues. Since the beginning of the COVID-19 outbreak flying activities were abruptly halted, governments have offered support in various forms to help airlines weather this crisis.
U.S. Congress has passed an over $2 trillion economic relief package (Coronavirus Aid, Relief, and Economic Security – CARES Act) which has been signed into law by President Trump at the end of March, of which $25 billion in grants are obtained by U.S. passenger airlines for the payroll support. In addition, another $25 billion in low interest federal loans are also made available to airlines to mitigate refinancing difficulties. The 10 largest U.S. airlines including American (ticker: AAL), Delta (ticker: DAL), United (ticker: UAL), JetBlue (ticker: JBLU), Alaska (ticker: ALK), Southwest (ticker: LUV), Allegiant Travel (ticker: ALGT) all participated in the program. However, the state aid comes with strings attached: stock warrants equal to 10% of the loan amount are awarded to the government, share buybacks and dividend programs are suspended, further there is limitation to layoffs and involuntary furloughs through September 30, 2020.
The largest U.S. airline, American Airlines has accepted a $5.8 billion package including $4.1 billion grants and $1.7 billion loan. In addition, American Airlines is in the process of closing a separate $4.75 billion federal loan and most recently it revealed another $3.5 billion refinancing plan in the capital market. American Airlines issued $1.5 billion in shares and convertible senior notes plus a $2.5 billion junk bond offering at a yield of 12%. American Airlines’ debt level will be pushed up to $40 billion which further deepens its leverage level.
Source: Company 2020 Q1 Reports
European airlines are able to tap into an aggregate support package of €32.9 billion whereby local governments have already firmly agreed to 80% of this support. Apart from the aforementioned, Lufthansa’s bailout package is the highest with an aggregate volume of €9 billion. Air France-KLM also obtained a €7 billion loan package from French government (a €4 billion loan guarantee issued by the state and a €3 billion loan direct from the state). These loans were tied to certain conditions including environmental aspects and future orders with French aircraft maker Airbus.
In general, large, national flagship carriers demanded and obtained more liquidity support from local governments due to their economic importance, unlike in the U.S., most European governments offered support in the form of either direct loans or credit guarantees, thereby adding more debt to their balance sheets. This should push shareholder earnings further away.
Source: Transport& Environment Airline Bailout Tracker updated to June 19, 2020; company media releases
5. Equity market outlook
The current equity market of airlines is highly distorted – in the past few months, almost all airline stocks across all regions have been slashed to half of the pre-crisis market capitalization due to the expected negative earnings in the foreseeable future, although the market recently rebounded in response to a better than expected summer flight capacity utilization. This was to a large extent a sentiment driven market movement. We therefore evaluate the longer-term earnings perspectives under the assumption, that in 2021 COVID-19 will be fairly under control. Moreover, we are assuming that global travel demand will be slowly recovering with possibly new travel policies addressing social distancing requirements.
Below we analyse a few key factors that affect the valuation results:
Revenue:
According to the latest semi-annual report from IATA, the RPK in 2021 (revenue passenger kilometre), an important indicator of the market travel demand, is expected to recover to only 70% of 2019 level and the average return fare (before surcharges and tax) is forecasted to be $257 in 2021, 68% lower than in 1998 when adjusted for inflation. As a result, the airline revenues are likely to stay at a low level even when travel demand slowly recovers, since airlines will face an intensive price war to attract customers and stimulate travel interests under a recessionary economic environment.
Operating costs:
Cost management and liquidity preservation are the most crucial challenges for all airlines during 2020, we expect it to be the same for 2021 due to weakened revenues. Jet fuel cost and labour cost are the top two operating expenses, accounting for nearly 25% and 20% of the total operating expenses for airlines. The difference in cost structure between LCCs and FSCs can substantiate our view that LCCs could get through the crisis in better shape. Additionally, LCC’s costs are more driven by jet fuel prices, which are variable costs, whereas the main operating cost driver for FSCs are labour costs. These are fixed costs component with high operating leverage.
Source: Bloomberg, retrieved on Jun 3, 2020
Source: Bloomberg, retrieved on Jun 3, 2020
The high jet fuel costs in the past two years has limited the airlines profitability. Since the beginning of the pandemic, the jet fuel price has decreased abruptly, driven by a sharp demand reduction and the oil price war between Russia and Saudi Arabia in March.
Looking ahead, the jet fuel price is expected to recover in the post crisis environment. Given all remaining uncertainties, we still expect it to be lower than previous year’s level. To airlines, a low jet fuel environment is definitely a tailwind factor, which could partially alleviate lower revenues in the following year. Following the above analysis, LCCs could essentially benefit more under this case. At the operational level, the willingness to take new aircraft deliveries and orders will be lower than expected. On the one hand airlines will speed up old aircraft retirement to save maintenance costs and to adjust their fleet structure to meet future travel demand (very likely to be short haul, reduced load factor, reduced aggregate demand). On the other hand, the low fuel cost environment provides airlines less incentive to do so. Therefore, it adds more uncertainty to the overall operating performance.
Source: U.S. Energy Information Administration, retrieved on June 8, 2020
Thus, in an effort to evaluate the airlines earnings perspectives in the long run, our assumption is based on the average historical EBITDAR margin of the past ten years. As a key valuation multiple, historical averages of forward enterprise value / NTM EBITDAR are utilized. Our positive scenario assumes an 80% revenue recovery in 2021 compared to the revenue level of 2019, while the negative scenario considers only a 70% revenue recovery.
Although there is still high uncertainty regarding the further development of the pandemic development for the rest of the year, we still think the big picture is clear – COVID-19 did bring a devastating, far-reaching damage to the airline industry. Given the fact that during 2020 most airlines need debt as well as equity recapitalization, their enterprise valuation (EV) looks ambitious compared to the expected operating profit (EBITDAR) in 2021. The current pricing of the equity side suggests that unless there is clear visibility that airlines can return to the pre-crisis 2019 revenue level soon, a cautious build-up of equity exposure is advisable. The valuation result brings another message which consistently corresponds to our view on low cost airlines. Thanks to their operation and cost-efficient business model, low exposure to international routes, strong balance sheet, not only can they navigate the existing challenges, but their recovery after the crisis will be much sooner as well.
Source: Bloomberg, company 2020 Q1 earnings call, past years financial reports, current market value updated to 19/06/2020
6. Fixed Income market outlook
Airlines have been quite active in the credit market to shore up liquidity in the past few months since the Fed cut the federal funds rate to nearly zero and announced the corporate bonds buying plan including high yield bonds up to BB- rating (issues had to be rated BBB- as of March 22nd). The announcement effectively soothed the credit market especially for high yield bonds and reopened refinancing access for corporates in a bearish market environment triggered by COVID-19.
While for airlines equity holders, it might take years to see positive earnings, the return on the airline corporate bonds could be attractive. Credit rating agency Fitch has downgraded all major north American airlines in April, given the negative outlook of the entire industry in the near term with regard to the debt level and liquidity. When comparing US airlines bonds to similarly rated corporate and high yield bonds, the yield pick-up is quite significant and reflects the negative momentum in the airlines market. As most of the airlines are in the process of significant equity and debt recapitalization, most of the short-term liquidity risk will be eliminated. Moreover, they are expected to become free-cash-flow positive again during 2021, solvency risks should improve over the course of the next 12 months. As one recent example, after Delta airline sold a $3.5 bn 5-year secured bonds with airport slots in New York and Heathrow pledged as collateral in April, Delta shortly returned to the bond market again planning to issue another $1.25 unsecured debt with an 8% coupon rate and 5-years maturity. This illustrates that bond-holders are receptive to new bond issues in the airlines sector.
Source: Bloomberg, retrieved on 17/06/2020
Monetary policy in Europe is similar. At the end of April, the European Central Bank (ECB) has loosened its Pandemic Emergency Purchase Program (PEPP) collateral rules to include “fallen angel” bonds which have been downgraded from an investment grade credit rating during the pandemic.
Given the overall accommodative monetary environment, we do believe that the credit market is well supported. Moreover, improving credit fundamentals in the airline segment should be positive for airline fixed income investors in the US and Europe.
Source: Bloomberg, retrieved on 17/06/2020
June 25th, 2020
Xuemin Jia, Seahawk Investments GmbH
Notes:
* Due to difference in financial reporting cycle and to give a common ground for valuation comparison, Ryanair and Wizz Air are forecast to their FY22 which corresponds to 2021 Apr. – 2022 Apr.
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