Air travel industry hits profit turbulence

The past five years started with buoyant demand for air travel even as high fuel prices pressured airlines to increase airfares. However, domestic airlines faced major hurdles when the global economic downturn hit. High unemployment and low discretionary income growth slowed demand for air travel in Australia.

Demand weakened significantly for two years as Australians shelved their travel plans. On the other hand, strong price-based competition between the major domestic airlines increased demand for air travel.

Although the price-cutting helped maintain passenger numbers, industry revenue and profit margins suffered. Therefore, IBISWorld estimates that industry revenue will average growth of only 0.5% per annum over the five years through 2011-12 to reach $14.5 billion. Passenger traffic is expected to improve in 2011-12 due to low unemployment. Consequently, industry revenue will grow by approximately 5.1%.

Domestic airlines’ operating profit nosedived over the past five years as the global economic downturn reduced demand for air transport. Operating profit margins dropped from an estimated 9.2% in 2007-08 to a low 1.1% in 2008-09. Domestic airlines reduced capacity, cut underperforming routes and discounted prices to align supply with demand and attract more passengers.

As such, earnings remained above zero. Since then, operating profit margins have improved only slightly to an estimated 3.7% in 2011-12. Strong price competition and high fuel prices prevented a major recovery in profit margins. Profit margins are expected to remain weak over the next five years to reach an estimated 4.2% in 2016-17. Competition from low-cost airlines is expected to keep profit margins low over the five-year outlook.

Low unemployment and rising household disposable income will bolster air travel expenditure. However, slightly lower consumer sentiment due to interest rate rises will dampen the growth in air travel expenditure. Domestic airlines will expand capacity as demand for air travel returns. However, higher fuel prices will lift airfares and slow potential industry revenue growth. Furthermore, competition is expected to intensify over the next five years. The strong competition will lead to weak industry revenue of 0.5% per annum over the next five years, to reach $14.9 billion in 2016-17.

Industry outlook

New fuel-efficient planes and growth in domestic trips will provide a tailwind for domestic airlines over the next five years. Rising disposable incomes, tourism promotion, and a third low-cost domestic airline expanding capacity will assist industry revenue growth for most of the five-year period. Buoyant business confidence will lead to stronger business-related demand. Low unemployment and rising household disposable income will bolster air travel expenditure, while slightly lower consumer sentiment due to interest rate rises will dampen the growth in air travel expenditure.

Demand for air travel will strengthen as competition between airlines intensifies, leading to continued low airfares. Furthermore, the forecast larger number of international visitors over the next five years will aid domestic air travel demand. Although the value of the Australian dollar will remain high over the next five years, Australia being an expensive tourist destination will not restrain tourists from the fast-growing Asian region. However, industry revenue is expected to decline in the later part of the five-year period as competition between airlines intensifies. As such, industry revenue is expected to grow at a subdued rate of 0.5% per annum over the five years through 2016-17 to reach $14.9 billion. In 2012-13, revenue is forecast to grow 6.2%.

Domestic airlines will expand capacity over the next five years as demand for air travel returns, particularly as airlines arm themselves with the newest fuel-efficient aircraft. Airlines are also shifting towards propeller-driven aircraft on short routes. Propeller-driven planes use less fuel and do not have a significant time disadvantage to jet-powered planes when used over short routes. The resulting greater fleet efficiency will allow an increase in the number of routes.

Sky-high oil prices and pilot shortages

Crude oil prices are expected to remain high over the next five years. Elevated oil prices will keep the industry’s purchase costs and airfare high. The higher airfares will shift customer preferences towards other forms of transport, including road and rail. The resulting lower demand will affect industry revenue growth over the next five years. At the same time, the increased fuel costs will threaten industry profitability. Airlines are expected to implement fuel surcharges to minimise the effects of higher fuel costs on industry revenue and profit.

Despite higher fuel costs, domestic airline profitability will recover to an estimated 4.2% in 2016-17. The improved earnings will reflect the fuel efficiency of new aircraft and equipment as operators upgrade their fleets. Profit margins will also increase as airlines streamline their operating processes and remove all unnecessary costs. However, competition from low-cost airlines such as Tiger Airways will put downward pressure on margin gains.

A looming pilot shortage may curb any ambitious fleet expansions and renewals. Pilots qualified to fly new aircraft will become increasingly scarce. The pilot shortage will develop as demand for qualified pilots continues to be buoyant while training schools struggle to attract enough students. The pilot shortage means airlines will bid up pilot wages as competition for their qualifications increases. Service cancellations threaten firms that cannot attract or maintain sufficient pilot numbers.

Sustainability and regional opportunities

Domestic airlines will continue to implement sustainability programs aimed to reduce greenhouse gas emissions. Qantas and Virgin Australia currently offer their customers the opportunity to pay extra for the company to offset the gas emissions generated by their contribution to the flight. Qantas also plans to become more environmentally friendly through the introduction of new fuel-efficient planes. Such planes include the A380, which burns about 10% less fuel per passenger and emits less noise, while the Boeing 787 consumes 20% less fuel than similar-size aircraft. The Q400 on regional routes burns 35% less fuel than similar-size jet aircraft.

Airlines can expect to face tougher regulation on greenhouse gas emissions over the next five years. The government will target the airline industries because they are significant fuel users. The tougher regulations will put pressure on industry profit. However, the regulations fit well with the industry’s efforts to reduce costs through fuel efficiency.

Regional airlines have potential opportunities operating as specialist airlines that fly niche tourist routes between major population areas and popular tourist destinations. By flying specialist routes, regional airlines avoid encroaching upon prime routes where they face direct competition from major airlines. In the long term, regional airlines may benefit from subcontracting arrangements with major airlines, while the major airlines concentrate on competing on trunk routes. Regional commuter operators may move further into regional services previously operated by the major airlines or their subsidiaries. Lower capacity commuter aircraft could offer services better suited to the needs of the public in small- to medium-size communities.

Tiger Airways earns its stripes

The expansion of Tiger Airways will change the competitive landscape of the Domestic Airlines industry. Tiger Airways enjoys financial backing from Singapore Airlines, the Singaporean Government and other investors. With strong financial backing, Tiger Airways will stir industry competition and threaten the market share of low-cost airlines Jetstar and Virgin Blue. Tiger Airways is expected to expand its fleet substantially over the next five years, increasing its number of serviced routes and service frequency.

Unlike previous domestic airline providers, IBISWorld estimates that the three major low-cost airlines will be able to maintain their industry presence over the next five years. This is because all three lower costs and have strong financial support from their parent companies, which have the expertise and capital to sustain long-term operations. In any case, a new entrant will cause volatility in prices and services in the market. Fare wars are inevitable because airlines will prefer to sell a seat at any price then take off with the seat empty.

Any customer gains from lower fares will be short lived unless airlines can sustain the low fares through new operational methods involving lower overheads and better yield management. The airlines’ low-cost structure will help sustain their position. For example, low-cost airlines will use only one aircraft type to reduce maintenance and training costs.

Key success factors

• Links with travel agents and other suppliers: Airlines are required to have good relations with travel agents and other suppliers. Travel agents are important in attracting high-margin business and encouraging repeat customers.
• Optimum aircraft capacity utilisation: Airlines need to select appropriate aircraft to match various routes. This enables airlines to regulate capacity on specific routes and enhance profitability across their network.
• Having an integrated operation: To operate effectively in this industry, companies need to have the infrastructure to support engineering requirements, sales distribution and website to sell tickets.
• Ability to expand and curtail aircraft capacity rapidly in line with air travel demand: It is imperative for an airline to be able to expand and contract capacity in line with market demand to maximise revenue and profitability. This is important in ensuring load factors remain high on all domestic routes.
• Economies of scale: Larger airlines are able to capitalise on the benefits of size by leveraging cost efficiencies available in labour, purchases, infrastructure and other aspects of the airline.
• Well-developed internal processes: Links to a national or international central reservation system are vital for the ticketing process.
• Access to the latest available and most efficient technology and techniques: The use of technology such as the internet and loading facilities will help improve airline efficiency. The internet is also one of the primary booking methods in the industry.
• Use of high-volume/low-margin strategy: This strategy is critical for low-cost carriers, who seek high volumes to maximise capacity. They operate with a single passenger class, a single type of aeroplane, simplified routes and direct ticket sales to reduce operating costs.