Airlines face lower yields amidst falling costs

epa05128697 Passengers look at model of aircrafts flown by different air carriers at Kuala Lumpur International Airport (KLIA) in Kuala Lumpur, Malaysia, 27 January 2016. KLIA, the home of Malaysia Airlines, is the largest airport in the country, and world wide rates among the top 13 airports handling the most international passenger traffic. EPA/BARBARA WALTON

STRONG signs are pointing to a recovering airline industry helped largely by lower crude oil prices. However, at the same time, airline yields are also dropping due to rising competition, which is a cause for concern.

Yields, which are a measure of revenue multiplied by revenue per kilometre (RPK), has been on a downtrend since the fourth quarter of 2014, according to Maybank Kim Eng. Revenue per average seat kilometres (RASK), often described as the sweet spot to profitability for any airline, has also been on a similar downtrend over that time period.

In fact, 2015 yields in absolute terms are close to the levels achieved by the industry back in 2004.

So, exactly how much lower can yields go? And does this mean that the airline industry will eventually be unprofitable again despite falling costs?

There are several reasons why both cost and yields are going down.

Firstly, airfares have been steadily going down over the last three years both for the full-service and low-cost carriers, making it more affordable than ever for people to travel. Falling airfares translate into falling yields.

As for the falling cost, not surprisingly, this is predominantly driven by lower jet fuel prices.

This has, in turn, enabled airlines to reduce their fares. The reduction in fares has pushed up passenger demand, which has, in turn, pushed up airline utilisation rates.

“The most accurate measure of airline performance is to observe the RASK-to-CASK (cost per average seat kilometres) spread. Airlines dropping yields is not necessarily a bad thing or signs of distress, as long as they are able to lower CASK and achieve a good spread,” says Maybank Kim Eng in its report entitled “The Cockpit View”. Maybank Kim Eng is of the view that 2016 is looking better and better for airlines.

It notes that Asian-based airlines delivered the highest year-on-year profit growth for 2015, followed by those in Europe and the United States. The synopsis of Asian airlines’ 2015 strong performance is as follows – capacity (available seat-kilometre or ASK) grew by 5.2%, but traffic rose at a faster rate of 8.6% on higher load factors achieved (80.5% in 2015 versus 78.0% in 2014).

RASK fell 10.9%, but this was more than offset by a 15.1% decline in CASK, thus widening the RASK-CASK margin and propelling net profits.

“The RASK-to-CASK spread has been in firm positive territory since the third quarter of 2014. This means an airline’s business health is exceptionally good, and investors should not be overly obsessed with the lower-yield environment, as the industry is able to manage it well,” says Maybank Kim Eng.

The other point to note is that the margin between yields (RASK) and cost (CASK) is also widening, a strong indicator pointing to airlines making more money now.

Furthermore, demand has outstripped supply since early 2015 and this trend has continued into January and February.

This is the first time since 2005 that the industry is enjoying a supply deficit and an unbridled growth streak for over a year, says Maybank Kim Eng.

The 2015 load factor of 79.1% is the highest level since 2005, which is a direct function of demand exceeding supply, thus boosting the load factor.

“Virtually, all the listed Asia-Pacific airlines have recorded year-on-year gains in load factor, and many have achieved record load factors in 2015 and on a year-to-date basis in 2016,” says the research house.

The rise of low-cost carriers

One of the biggest gainers on Bursa Malaysia this year are the low-cost carrier stocks.

The share prices of both AirAsia Bhd and AirAsia X Bhd (AAX) have staged strong recoveries on a year-to-date basis. Fuelled mainly by a turnaround in their financials, AirAsia and AAX are up 65.89% and 111.11%, respectively, on a year-to-date basis.

AirAsia has risen close to 145% from its five-year low of 87 sen on Aug 28 last year. AAX, meanwhile, has also risen 153% from its low of 15 sen on Aug 25.

AirAsia is trading at a historical price-earnings (PE) ratio of 11.03 times, while AAX, which doesn’t have a historical PE, is projected to trade at a 2015 PE of 34.55 times.

The catalyst for the run in their share prices has been their fourth-quarter results, which they announced back in March.

AirAsia’s stock was further boosted when its founders and major shareholders – Tan Sri Tony Fernandes and Datuk Kamarudin Meranun – announced that they were planning to raise their stake in the company from 18.9% to 32.4%, a signal of their confidence in the airline.

While AirAsia returned to the black with a net profit of RM554.2mil in the fourth quarter of financial year 2015, AAX posted a net profit of RM201.58mil in the fourth quarter ended Dec 31, 2015.

This was AAX’s first profit after eight quarters of losses.

AirAsia’s net profit of RM554.2mil in its fourth quarter ended Dec 31, 2015, was in comparison to a net loss of RM428.51mil a year ago.

This was on the back of a 47% increase in revenue to RM2.17bil and a 21% reduction in the average fuel price from US$95 per barrel to US$75 per barrel.

Its main operating indicators of revenue passenger kilometres and load factors are on the rise.

“In the fourth quarter, demand growth of 12% exceeded capacity growth of 5%, thus resulting in a higher load factor of 85%. We believe that some of this demand could have resulted from MAS’ capacity cuts,” says MIDF analyst Tan Yow Ken in his earnings report for AirAsia.

For the financial year ended Dec 31, 2015 (FY15), AirAsia’s net profit grew more than six-fold to RM540.96mil from RM82.8mil in FY14. Revenue was up 16.3% to RM6.3bil for the period.

Tan, who initially had a “buy” call on AirAsia, has now revised his call to “neutral” with an unchanged target price of RM1.94, thanks to the huge run-up in its share price.

The revision is partially due to AirAsia’s share placement exercise, which will see a potential 15.3% dilution in its share price.

Meanwhile, the better results by AAX, the long-haul arm of AirAsia, was due to better operating performance, other income, forex gains and deferred taxation.

On a full-year basis, its net loss reduced to RM360.23mil from a previous loss of RM519.44mil. Revenue increased 4.28% to RM3.06bil.

AAX’s turnaround in the fourth quarter was boosted by RM450mil in maintenance reserves transferred from the balance sheet into the revenue line during the fourth quarter of 2015. However, even if this were removed, the group’s profits still exceeded expectations.

CIMB Research says that AirAsia used the opportunity afforded by the RM450mil boost to revenue by kitchen-sinking various items, hence reported net profit was lower at RM554mil.

“The kitchen sinking means that the FY16 numbers will not be burdened by write-offs and provisions.”

CIMB Research analyst Raymond Yap feels that AAX’s business model of medium and long-haul flights is a lot more riskier compared to AirAsia’s short-haul flights.

“The AAX group’s core net loss rose from RM38mil in FY13 to a staggering RM704mil in FY14, before shrinking to a still-significant loss of RM512mil in FY15,” said Yap in a March 24 report.

The FY15 improvement was due to lower oil prices, route cuts and capacity reductions by AAX, and a better competitive environment after MAS cut capacity to Taipei, Shanghai and Australia from August 2015. Despite this, AAX still lost more than RM100mil in the third and fourth quarters of 2015 at the core level, so it is not yet out of the woods.

Yap forecasts AAX group’s losses to decline further to RM175mil in FY16, due to even lower oil prices, the beneficial full-year impact of the MAS capacity cuts, and the improving flow of Chinese tourists into Malaysia.

Among others, Yap is worried about Malindo Air’s planned expansion into medium-haul routes.

“AAX is also planning ASK expansion in excess of 20% this year, including the recently launched Gold Coast-Auckland route and a possible Osaka-Hawaii route from the second quarter, which will likely require promotional fares in the 12-to-18-month gestation period,” says Yap.

Yap views AAX’s aggressive ASK growth this year with some trepidation.

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