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Airlines will be challenged to meet forecast demand growth, reveals study


July 3, 2013 12:19 by

The International Air Transport Association (IATA) has called for new thinking regarding the relationships between partners in the air transport value chain. The call was made in order to attract the $4 trillion to $5trn needed over the coming 20 years to meet the growing demand for aviation-enabled connectivity.

An IATA study, entitled “Profitability and the Air Transport Value Chain”, supported by analysis from McKinsey & Company identified the problem between the partners. The report shows that although the returns on capital invested in airlines have improved in recent years, they are still far below what investors would normally expect to earn.

“Aviation supports some 57 million jobs globally and we make a possible $2.2trn worth of economic activity. By value, more than 35 per cent of the goods traded internationally are transported by air,” says Tony Tyler, IATA’s director general and CEO. “But, in the 2004 to 2011 period, investors would have earned $17 billion more annually, by taking their capital and investing in bonds and equities of similar risk. Unless we find ways to improve returns for our investors, it may prove difficult to attract the $4trn to $5trn of capital needed to serve the expansion in connectivity over the next two decades, of which, the vast majority will support the growth of developing economies.”

During the 2004 to 2011 period, returns on capital invested in the airline industry worldwide averaged at 4.1 per cent. Although it is an improvement considering the average of 3.8 per cent generated in the previous business cycle between 1996 and 2004, it is nowhere near the average cost of capital of 7.5 per cent, which represents the return on capital that investors would expect to earn by investing in assets of similar risk outside the airline industry. While some airlines have consistently created value for equity investors, they are a small majority. On average, returns were only sufficient for the industry to service its debt, with nothing left to reward equity investors for risking their capital.

The study showed that over the past 40 years, virtually all industries have generated higher returns on invested capital (ROIC) than the airline industry. Moreover, airlines are the least profitable segment of the air transport value chain, while other segments consistently generate good returns for their investors. The biggest cost for airlines today is fuel and companies in this sector benefited from an estimated $16bn to $48bn from their annual net profits generated by air transport. The most profitable part of the rest of the value chain is in distribution, with the computer reservation system businesses generating an average ROIC of 20 per cent, followed by freight forwarders, with 15 per cent.  

However, high profits and inefficient costs in the value chain are only part of the explanation for persistently poor airline profitability. In fact, over the past 40 years, the airline industry has more than halved the cost of air transport in real terms, owing to better fuel efficiency, asset utilization and input productivity. Yet, these efficiency gains have ended up in lower air transport yields, rather than improved investor returns. Although this has created tremendous value for customers and the wider economy, it has left equity investors in the airline industry unrewarded. The study reveals that this aspect of the airlines’ performance lies more in the industry’s highly fragmented and unconsolidated structure and the nature of competition, rather than in the supply chain, although distribution is a key part of the puzzle.

An agenda for governments is also outlined in the study. “Smart regulation is needed from governments around the world to maximize the economic benefits of connectivity i.e. jobs and growth. Unfortunately, high taxation and poorly designed regulation in many jurisdictions make it difficult for airlines to develop connectivity.  On top of cost issues, airlines also face a hyper-fragmented industry structure, owing to government policies that discourage cross-border consolidation. But, there is plenty of room for some fresh thinking on all accounts,” says Tyler.

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