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The boom bust cycle of airlines

Historically airlines have gone insolvent on a regular basis (Ansett, and more recently, Virgin!). The airline business involves a large upfront cost to buy aircraft and build networks. They then compete fiercely on price. Downturns (or pandemics) happen and the reduction in travel volumes is unable to sustain the high-cost base of airlines, particularly challenger airlines. There are also times when airlines earn outsized profits, particularly at the start of the cycle when capacity is constrained and revenues grows faster than costs.

Since the dark days of Covid, and the temporary shutdown of the airline industry, Qantas has incurred cumulative losses of about $4 billion. They also received $2 billion in assistance from the Federal Government to stay afloat. From a consumer perspective (and personal experience) the airline industry seems to be generating outsized profits with higher ticket prices and a low-quality customer service experience (particularly at Qantas). What exactly is happening?

When the airline industry shut down the first response was to lay off large numbers of staff and to put aircraft in long term storage until the pandemic ended. Over time passenger numbers have normalised, although we are still at domestic passenger levels that are 75-85% pre Covid. However, whilst demand surged as Covid restrictions lifted, staffing levels were far below needed to service the 75% demand and some airlines asked executives to show up for baggage services.

With the new normal of working from home and corporate meetings on Teams/Zoom, this may be a new structurally lower base – domestic passenger numbers have flat lined over the last six months.

For international travel numbers, there has been a steady growth in passengers as airlines have lifted international capacity. Unlike domestic passenger numbers, growth has not flatlined yet and we are at about 65-75% of the pre-Covid numbers.

Overall though, the return of demand has outpaced the growth in supply (capacity). That is, airlines have been slow to restore/reinstate fleet sizes and the frequency of services and, hence, the number of people looking to book flights has rebounded significantly more quickly than the number of seats available. For the airlines, some of this is probably intentional and some is co-incidental (the fact that Covid shutdowns ran much longer in China than in other countries and that Chinese airlines used to provide a substantial share of international capacity – particularly at lower prices). This has led to higher air ticket prices.

How are the airlines fairing in this environment? The following is a chart of Qantas’ pre-tax earnings and its operating margin.

Historically, Qantas has had an operating margin of 7-8% – in its last reported earnings it was 16%. Demand is relatively inelastic at the moment with many people keen to travel after years of lockdowns. We would expect margins to converge to the long run averages as consumers respond to the higher prices over time (and perhaps with a slowdown in travel demand due to a central bank induced recession to contain inflation!), or more capacity enters the market in response to high prices. Either way, the cycle will eventually turn the other way with revenues falling faster than operating costs.

Alan Joyce has certainly timed his exit well – whilst profit margins (and customer complaints) are high!

For our readership (infrastructure investors), in contrast to airlines, airports have historically earned very high operating margins of 50-75%. Like airlines, airports have high upfront capital costs. But unlike airlines they do not compete on pricing, being in general monopoly assets. What does effect airports is passenger volumes, and as noted above, we’re yet to return to pre-covid volumes.

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