How Standard & Poor's Rates The Global Airline Industry

Summary

This video discusses the key credit factors comprising Standard & Poor's ratings of the airline industry, highlighting its inherent risks and potential positives. Phil Baggley, a managing director in the manufacturing and transportation area, is interviewed by Mike Skbo from the corporate ratings group. Despite airlines being a cyclical and capital-intensive business heavily affected by oil prices, they show long-term growth potential due to globalization and limited competition in long-haul flights. Market position, revenue potential, and operating cost structure are key competitive factors. The financial overview reveals extensive use of off-balance-sheet leasing and generally weak financial ratios due to high leverage. Liquidity is crucial, and airlines usually maintain substantial cash reserves. Future trends such as regulatory changes and potential industry consolidation could significantly impact credit factors.

Highlights

• Airlines operate in a cyclical industry affected by consumer spending and oil prices, making it riskier than many other sectors. 💼
• The industry's capital-intensive nature and high fixed costs mean greater operating leverage. 🚀
• Globalization and limited competition in certain routes present growth opportunities for airlines. 🌎
• Market position and operating costs influence a carrier's competitive edge. 📊
• Leasing practices hide the full extent of airlines' financial liabilities, impacting credit assessments. 📊
• Future consolidation and environmental regulations could bring major changes to the industry's dynamics. 🌱

Key Takeaways

• The airline industry is highly cyclical and sensitive to changes in consumer spending and oil prices. ⛽️
• Despite high risks, there are positives like long-term growth, globalization benefits, and limited competition on long-haul flights. 🌍
• Competitive position relies on market share, route network coverage, revenue capabilities, and cost structures. 🛫
• Financial health is undermined by high leverage and reliance on off-balance-sheet leasing, affecting credit ratings. 📉
• Maintaining liquidity is crucial; airlines typically hold a significant portion of their revenues in cash reserves. 💰
• Future trends such as environmental regulations and consolidation could reshape the industry. 🔄

Overview

Airlines, as discussed in this video, are part of a high-risk industry deeply intertwined with consumer spending patterns and volatile oil prices. Their cyclical nature combined with the substantial capital necessary for operations leads to a dynamic yet precarious business environment. Despite these challenges, there are promising growth prospects owing to globalization trends and minimal competition on longer routes.

Competitive positioning within the airline sector is determined by several factors, including market share, route coverage, revenue-generating ability, and cost efficiency. Significant players leverage their widespread networks and operational strengths to maintain an advantageous market position. However, persistent financial issues, notably high leverage through off-balance-sheet leasing, remain an obstacle.

The conversation also sheds light on critical financial considerations, particularly concerning liquidity. Airlines' reliance on keeping a significant portion of their revenues as cash underscores their vulnerability to economic shifts. Looking forward, regulatory changes and sector consolidation are potential game-changers that might significantly influence the credit ratings landscape for airlines.

Chapters

• 00:00 - 00:30: Introduction and Guest Introduction In this introductory chapter, Mike Skbo, Senior Director at Standard and Poor's Corporate Ratings Group, welcomes listeners to the 'Credit Matters' series. He introduces the topic of key credit factors in the airline industry, featuring a conversation with Phil Baggley, Managing Director in Manufacturing and Transportation. Phil recently published an article on related criteria which will be discussed.
• 00:30 - 02:00: Key Credit Factors in the Airline Industry This chapter explores the key credit factors within the airline industry, focusing on the higher level of risk compared to other sectors. The industry's cyclical nature, with revenues closely tied to fluctuations in consumer spending and corporate profits, is a primary concern. Additionally, airlines face significant vulnerability due to changes in oil prices, as fuel costs comprise the largest expense for most airlines. This vulnerability becomes pronounced during fuel price spikes.
• 02:00 - 04:00: Competitive Positioning in the Airline Industry The airline industry, despite being heavily impacted by various challenges, including high costs, remains a long-term growth sector. The industry benefits from globalization and increasing global income, and there is limited competition from other transportation modes.
• 04:00 - 06:00: Examples of Industry Risk and Competitive Position In this chapter titled 'Examples of Industry Risk and Competitive Position', the focus is on the transportation industry, emphasizing its dependency on certain routes, especially long oceanic ones, where alternatives are limited. This situation benefits the industry due to limited competition. The chapter further explores competitive factors in the industry, identifying market position, revenue generation, and operating efficiency as key components that define a company's competitive standing.
• 06:00 - 08:30: Financial Factors in the Airline Industry The chapter 'Financial Factors in the Airline Industry' delves into the various financial components that impact airlines. It highlights their cost structure, market position such as market share, and revenue potential in major markets. The chapter discusses the importance of a broad route network for attracting travelers, as well as the significance of pricing strategies and seat occupancy rates. It also emphasizes the differentiation in operating cost structures among airlines.
• 08:30 - 10:00: Liquidity in the Airline Industry The chapter discusses various aspects of liquidity in the airline industry, focusing on factors such as relative labor costs, industry risk, and competitive positions. It references specific examples like United Continental, which emerged from the merger of United and Continental Airlines. The chapter aims to provide detailed insights into the strengths and weaknesses of different players within the industry.
• 10:00 - 11:30: Long-term Trends in the Airline Industry The chapter explores long-term trends in the airline industry, focusing on market positioning and revenue strategies. It discusses how some airlines maintain strong market positioning by being rooted in major markets across the Pacific, Atlantic, and United States, which generates profitable business traffic. Additionally, Southwest Airlines is highlighted as an example of achieving a good market position through low operational costs, which often drives competitors out, leading to a high market share on the routes it serves. The chapter emphasizes that these strategies contribute to revenue generation within the industry.
• 11:30 - 12:30: Conclusion and Farewell The chapter discusses different airline strategies for revenue generation and cost management. It highlights British Airways' revenue success through their service to business and first-class passengers on international routes. Operational efficiency is exemplified by Southwest Airlines, known for its lean operation, paying employees well while maintaining high productivity. The chapter concludes with a reference to these examples as models of effective airline management.

How Standard & Poor's Rates The Global Airline Industry Transcription

• 00:00 - 00:30 welcome to credit matters I'm Mike skbo senior director standard and pors corporate ratings group today we're going to talk a little bit about the key credit factors in the airline industry uh joining me is Phil baggley he's a managing director in our manufacturing and transportation area Phil thanks my pleasure first uh so you recently published an article uh criter
• 00:30 - 01:00 article that talked about the key credit factors in the airline industry let's first start with industry risk you noted it's a bit riskier than other Industries maybe you can provide some color for us yeah a couple reasons there first of all airlines are a very cyclical business their revenues are correlated with changes in consumer spending corporate profits second of all um they're vulnerable to changes in uh oil prices uh fuel is the largest expense category for most Airlines and certainly when you have a fuel price spike as we did in 200
• 01:00 - 01:30 n that hit all the airlines very hard uh also um it's a very Capital intensive industry aircraft are expensive and they spend a lot of money then they have high fixed cost and therefore High operating leverage sure all right a lot of negatives there any positives uh believe it or not there actually are some uh first off airlines are a long-term growth business I mean they're benefiting from the trends of globalization Rising Global income second of all there's not really a lot of uh competition for from other modes
• 01:30 - 02:00 of transportation on most of their routes on short routes yeah there could be trains or cars but on a lot of their long rots over the ocean certainly there's not really a lot of Alternatives uh so that benefits them as well you also talked about uh competitive position uh as as we think about an industry what in this industry are the competitive factors that we consider yeah we consider the most important competitive factors to be Market position re generation and operating
• 02:00 - 02:30 cost structure so by market position I mean things like their market share in major markets and how attractive how what's the revenue potential in those major markets uh also the breadth of their root Network are they covering a lot of the globe which is attractive for travelers uh on the revenue side it's a matter of um how much are they able to charge and are they able to fill up the planes uh operating cost structure it's mainly a difference based on their uh
• 02:30 - 03:00 relative labor costs uh some have much higher labor costs than others can you provide some examples about what we just talked about industry risk competitive position whether it be strong or weak for different players in the industry just provide some color more specifically yeah I mean if we look at uh that market position there are a couple of good ways to get to a good answer one example might be um United Continental that's the result of the merger between United in Continental you put them together you
• 03:00 - 03:30 have a very good root system they're strong in the Pacific the Atlantic throughout most parts of the United States uh they're serving major markets that generate business traffic which is generally more profitable that's one way to do it another way to get to a good Market position is the Way Southwest Airlines has done it which is they have very low costs and they've often driven their competitors out they have a very high market share on the particular routs they serve so that's an example on the market position Revenue uh an
• 03:30 - 04:00 example of strong Revenue generation British Airways carries a lot of business class first class passengers um on their International routes so that's an example of good Revenue generation on the operating cost side I'd go back to Southwest Airlines and some of the other lowcost airlines uh Southwest runs a very simple lean operation they pay their employees well but they're also very productive so they get a lot out of their airplanes and out of their people sure okay I want to go back to you
• 04:00 - 04:30 mentioned diversity of Revenue when we think about diversity and competitive position you mentioned revenue and earnings maybe can you talk a little bit about uh diversity here and what we're kind of what you kind of mean well when we're looking at Airlines the way we think about diversity is first off geographical diversity are they getting their revenues from different regions different countries so that not all of them will be in a recession at the same time perhaps um another source of diversity although it's not as significant of one is there are
• 04:30 - 05:00 non-passenger revenues Airlines carry cargo uh some outside the US actually operate cargo aircraft dedicated cargo aircraft uh they also sell frequent fly miles which is actually a pretty profitable business for Airlines so those are some of the ways that we think about diversity sure let's switch gears a bit what we've talked about provided great color for us is is business let's switch a little bit to financial some of the key financial factors we take into consideration let's start with accounting any specific accounting ISS isues here in the space yeah there are a
• 05:00 - 05:30 couple of big issues uh for airlines that we keep an eye on one is that Airlines use a lot of Leasing and usually it's off balance sheet leasing this could be for the aircraft it's also for uh their airport facilities uh we capitalize leases as we do for other companies and it can make a big difference in fact for most of the US Airlines the present value of their leases is larger than their balance sheet debt so clearly it makes a big difference in their ratios the other one
• 05:30 - 06:00 which is uh important although it's not necessarily the case for all the airlines is what what how do we stack these up or
• 06:00 - 06:30 how do these financial ratios for this industry fall into other industrial I I guess uh Industries uh throughout the world uh generally the airline ratios look pretty poor that's perhaps not surprising if you look at their ratings um airlines are mostly highly leveraged all that money to buy new planes and also because of their generally poor profitability track record not a lot of retained earnings built up so the ratios are mostly weak not not not always there are some
• 06:30 - 07:00 investment grade rated Airlines LT hanza Quant Southwest Airlines but by and large the uh credit ratios look relatively poor okay so overleveraged unprofitable how how do they afford to buy aircraft that could be a few hundred million dollars yeah well I mean that that's a good question and the answer is that the aircraft themselves are valuable uh the planes are usually financed with either secured debt or leases and if the line defaults uh the
• 07:00 - 07:30 creditors can take the planes back and these can be redeployed in a global market these planes are used all around the world so even weak Airlines can usually get some sort of aircraft financing now the downside to that is that that tends to encourage over capacity there's not as much capacity discipline at least historically uh but those are major factors great let's switch gears liquidity obviously as you get lower down the the rating Spectrum becomes much more important um what do what do we think here what factors do we
• 07:30 - 08:00 think about in liquidity in the industry yeah certainly when you're down at this end of the rating scale in most cases liquidity is very important uh Airlines don't have in most cases large uh committed Bank facilities at least large relative to the size of their balance sheet however almost all of them carry a fair amount of cash and that's really their last line of defense um Airlines uh in the US typically would carry between 10 and 30 30% of their
• 08:00 - 08:30 annualized revenues in the form of unrestricted cash and short-term Investments and that's something we actually track we calculate a credit measure which Compares unrestricted cash and short-term Investments to annual revenues uh currently most of them are in a somewhat better place they're up mostly in the 20% area which is really pretty comfortable sure one last question um I want to talk a little bit about longer term what are some of the significant longer term Trends in the industry that could affect uh the key
• 08:30 - 09:00 credit factors here mostly we don't see big changes coming but there are some things which could have material effects one is uh regulatory really long-term environmental regulations the European Union is certainly very interested in that they're bringing Airlines there into their cap and trade system and that could be fairly expensive what it tends to do is it pushes Airlines to replace their planes sooner with newer more fuel efficient models but of course they are
• 09:00 - 09:30 very expensive so the airlines have to try to raise fairs to offset that so that's one thing another thing is uh consolidation now we've seen certainly some consolidation both inside the United States and in Europe um longer term if some of the rules change about ownership you could see more crossb mergers there have been crossb mergers in um the European Union um km and Air France British Airways in Iberia now um but we haven't seen that involving US
• 09:30 - 10:00 Airlines because there's a law that says that non- US citizens can't own more than 25% at the moment there's not a prospect of that changing really but longer term there could be pressure and change that and I think that could be something which would change the Dynamics of the industry well this has been great Phil it's always a pleasure having you on the program appreciate your thoughts thank you we'll see you again next time
• 10:00 - 10:30 oh