A number of people have conducted surveys in recent weeks on the intentions of consumers to take flights or travel more or less than before the crisis. What do they tell us about the likely level of demand over the next year?
I was triggered to take a look at this by this article in today’s FT (apologies if you are hit by the paywall). It references a survey conducted by UBS in mid May of 1,000 UK consumers, which showed that 31% of people were intending to fly less over the next year for travel to Europe, with 10% intending to fly more. That sounds quite alarming, but even if you assume a halving of the travel of the “fly less” group and only a 20% increase in those keen to make up for lost time, that would equate to a 14% drop in demand compared to pre-COVID levels. That is actually somewhat better than the 20% drop most airlines are expecting for next year.
Interestingly, the results for “worldwide” travel were no different from those for Europe. Many commentators have predicted that long haul travel will be hit harder. This might still be the case of course, if government restrictions are lifted on European travel but not on other long haul destinations.
BCG have also been posting the results of their consumer sentiment surveys on their incredibly useful Travel Recovery Insights portal. For UK consumers, they are a little more pessimistic, with 38% of consumers intending to travel “a lot less” and 24% “somewhat less”. Assigning a 50% drop to the “lot less” group, “20%” to the “somewhat less” and equivalent increases to those planning to spend more, gives a drop in demand of 21%, much closer to the current consensus. Maybe this tells us that airlines are more likely to believe consultants than investment bankers?
It should also be noted that the BCG survey asked people about their spending plans for travel over the next 6 months, rather than intention to fly in the next year. You would expect people to be more cautious nearer term and the two sets of figures could be consistent with a 21% drop over the next 6 months followed by a 7% drop in the 6-12 month timeframe. A much rosier view for the level of demand next year than most commentators are expecting.
What is also clear is that there are going to be some fantastic deals on offer once the travel industry is allowed to get going again. So even the 62% of consumers who expect to spend less on travel may be able to achieve that objective without reducing the actual number or duration of their trips. Whilst that won’t be good for airline yields, maybe the volumes will recover faster than people are thinking.
One final caveat: all this is based on consumer intentions. It all relies on people being allowed to travel and on the flights being there for them. Which fits with the current focus of the industry on getting governments to lift restrictions on travel and to get on with allowing travel to resume where this can be done safely. The survey evidence suggests that the consumer demand for travel will be there if they do.
The contrasting stories of two of Europe’s biggest airline groups
Air France-KLM (AF-KL) entered the COVID crisis in decent shape from a balance sheet point of view. Even before the injection of funds from the French government, the March 2020 cash position was €6.4 billion, equivalent to 23% of 2019 revenues, almost matching the 26% ratio at well capitalised IAG. Net debt of €6.6 billion was actually lower than IAG’s €7.5 billion.
However, it was much less profitable than IAG, with operating margins in 2019 of 4.4% compared to IAG’s 14.8%. This meant that as a ratio to EBITDA, a standard measure of debt affordability, net debt levels were a little higher at 1.6x compared to 1.4x at IAG. But still pretty solid and much better than Lufthansa which had cash levels of only 9% of revenue and net debt / EBITDA of 3.3x.
AF-KL’s profitability had lagged behind IAG’s for many years. So how did it come to be in such a relatively solid position from a balance sheet perspective? To answer that, we need to look back at the last few years of history, because the two companies have been on very different tracks.
The back story
Since 2015, IAG has returned €4.1 billion of cash to shareholders in the form of dividends and share buybacks. It also spent €1.4 billion buying Aer Lingus and had to put €3.3 billion into plugging the historic pension fund deficit at BA, totalling over €8 billion of cash outflows.
AF-KL is almost a complete mirror image. It hasn’t paid a dividend since 2008 and since 2015 has raised €1.3 billion of new equity (€751m from industry partners Delta and China Eastern plus the conversion of bonds into €523m of equity). It generated €1.3 billion from disposals (mostly €884m of Amadeus shares and a €246m sale of LHR slots to Delta), giving total cash inflows of €2.6 billions.
So IAG has been buying things and returning money to shareholders whilst AF-KL has been selling things and raising new capital. The result is that despite the fact that AF-KL was slightly bigger than IAG in revenue terms, prior to the COVID induced sell off in all airline shares, IAG’s market capitalisation stood at 3.5 times that of its less shareholder-friendly and profitable rival. If it hadn’t been for the drag of BA’s historic pension fund deficit, the difference would have been even starker.
The immediate COVID response
The other big difference has been the two companies’ response to the COVID crisis. At the end of March 2020, IAG still had access to €2.6 billion of undrawn facilities, whilst AF-KL had drawn all of its remaining facilities and still had less cash than IAG. AF-KL went straight to the French and Dutch governments of course and was rapidly granted €7 billion of state or state backed loans by the ever helpful French government, with the potential for another €2 to €4 billion to come from the somewhat more reluctant Dutch state. IAG got €1 billion of loans backed by the Spanish government and €300m from the UK, giving it €10 billion of liquidity at the end of April. At the same date, I estimate AF-KL had secured €12.9 billion of liquidity and were looking to raise another €2-4 billion from the Dutch government.
So why does AF-KL need €5-7 billion more liquidity than IAG says it does? That is a question that I am sure the Dutch state is also trying to get answered.
The next few months
The answer doesn’t seem to lie in the cash requirements of the next few months. With revenue effectively wiped out for both companies, the cash requirements are driven by 1) the level of cash costs during lock-down 2) any immediate loan repayments required and 3) working capital effects. Let’s take them in turn.
For IAG, as I outlined in this article, I think the monthly cash burn is in the €800 – €900m range, quite similar to the figure given by Lufthansa. In their Q1 results announcement, AF-KL quoted a monthly cash burn of €400m, which seems oddly small for a company with slightly higher “normal” cash operating costs (€1.9 billion a month versus €1.7 billion at IAG). One factor will be the better fuel hedging position, with AF-KL disclosing a €455m “ineffective fuel hedge” loss compared to over €1.3 billion at IAG. That will turn into cash over the remainder of 2020. Another factor is undoubtedly the €570m of tax and social charges payments which were disclosed to have been “deferred beyond 2020”, once again thanks to the largesse of the French government. There is something of a pattern developing here.
When it comes to loan repayments, at the end of March AF-KL showed €900m of debt repayments due for the remainder of 2020. IAG don’t give a figure for this, but at the end of December 2019, the current portion of their long term debt (which means it was due in 2020) was shown as €1.8 billion, so perhaps €1.4 billion for the April – December period. So on the face of it, that doesn’t seem to explain it either. Much of these “loan repayments” are actually lease obligations and I’m guessing that IAG, with its much better financial track record, will have been able to secure deferrals on much of this. That won’t have been the case I think for AF-KL, in large part because the lessors will have known that the French state would step in.
Finally, working capital requirements. One of the biggest items here is deferred revenue on ticket sales. This is money that airlines have received from customers for future travel. With much of those bookings on flights that have been cancelled, there is a potentially big cash outflow from refunds during a period when no new bookings are coming in. These are big numbers. For IAG at the end of December 2019, this item stood at €5.5 billion. Perhaps there is a difference here which might explain why AF-KL needs more liquidity? In fact, the corresponding figure for them was only €3.3 billion. Maybe they are being more helpful in allowing cash refunds, rather than insisting on vouchers? Nope. In response to questioning from UK politicians during a Select Committee hearing, Willie Walsh said that IAG had already made refunds totalling €1.1 billion by early May. In contrast, AF-KL were singled out by consumer watchdog Which? for “… not just delaying refunds but flatly refusing them”.
Beyond the immediate crisis
So what is the real reason that AF-KL has secured so much extra liquidity at the taxpayer’s expense? I think that IAG is determined to take the necessary steps to get back to profitability quickly and is being vilified by UK politicians for doing so. In contrast, AF-KL knows that it cannot do so (it was barely profitable even before the crisis) and isn’t going to rock the boat with its political paymasters by even trying.
One final thought. Shareholders in AF-KL should take note that almost all of the largesse from the French state has come in the form of loans and tax deferrals, which will need to be repaid or refinanced with equity at some point. Given the awful track record of the company when it comes to how it treats shareholders, I would suggest that the 3:1 ratio of the current market capitalisations of the two companies might not be representative of the proper relative valuations.
By way of fair disclosure, I am a shareholder in IAG and do not own any AF-KL shares. I’m not that stupid.
Many people have commented on the difference between the the amount of money which Germany has put behind their main airline group Lufthansa, compared to what has been done by the governments of the UK and Spain for IAG. I thought I would have a look at the figures to explain why Lufthansa needed the support and IAG could avoid going “cap in hand” to the government for a bailout, and also to look at where the huge bailout for Lufthansa leaves IAG from a competitive point of view.
In the case of Lufthansa, a bespoke €9 billion “stabilisation package” has been assembled, all backed by the German government, About 55% of this is in the form of equity from the government, with 45% in the form of government backed debt. For IAG, they have had access to the government guaranteed COVID loan schemes in the UK and in Spain which were available to all companies, adding up to “only” €1.3 billion.
Given the huge disparity, where does that leave the two companies in relative liquidity terms? IAG started from a much healthier position, with liquidity of €9.5 billion at the end of March compared to €4.25 billion at the larger Lufthansa. However, despite being smaller than Lufthansa, IAG seems to me to be burning cash at a somewhat higher rate currently.
It is difficult to compare the companies as they quote figures on a different basis. In their Q1 2020 releases, Lufthansa gave a cash burn figure of €800m a month, whilst IAG cited “normal run-rate cash operating costs” of €200m a week, or €857m a month. To put the IAG number onto a more comparable basis to Lufthansa’s figure, you need to make two main adjustments. Lufthansa’s number includes fuel hedging losses, whereas I believe that IAG’s does not. IAG declared “ineffective fuel hedging” losses of €1.3 billion, versus €950m for Lufthansa. This seems to reflect IAG being more highly hedged in the near term than Lufthansa was. In any case, a large part of the hedging losses will materialise in cash terms in Q2, which will increases IAG’s cash burn in Q2 by around €270m a month based on my estimates. The other adjustment needed is to include the revenue that is being earned. With flights operating at around 10% of normal capacity in Q2, that will be a fraction of the usual €2 billion a month that IAG would normally generate in Q2. However it probably adds about €165m a month, taking IAG’s monthly cash burn to €962m on the same basis as Lufthansa.
So let us do a crude calculation of the predicted liquidity position of IAG and Lufthansa at the end of Q2, by which time both companies are expected to have recommenced “a meaningful operation”. Lufthansa will have liquidity of €4.25 billion (the March position), plus the €9 billion stabilisation package, less three months of cash burn at €800m a month giving €10.9 billion. IAG gave a figure of €10 billion for their liquidity at the end of April, which I think went up from up €0.5 billion from the position at the end of March due to €1.3 billion raised from the UK and Spanish governments, offset by cash burn for April. That suggests a cash burn in April of €836m, slightly below the figure I calculated above. By the end of Q2, they will have burned another €1.9 billion, giving them €8.1 billion. Expressed in terms of their “normal” cash operating expenses when operating at full capacity (where Lufthansa is 1.7x the size of IAG), this gives Lufthansa 115 days of liquidity compared to IAG’s 147 days. Of course they both have many more days of liquidity than this, as this metric assumes zero revenue and full operating costs, but it is a good basis on which to compare the two companies.
Given the amount of assumptions that have gone into these calculations, my conclusion is that both companies will start the third quarter with similar levels of liquidity compared to the size of their pre COVID cost bases, with IAG in a somewhat better position (c 25% better). The big difference, of course, is how much backing it will have required from governments to get to that position. For Germany, it took €9 billion, compared to €1.3 billion for IAG, of which the UK government has only provided €0.3 billion.
I think that UK Government MPs, who have been very critical of British Airways and IAG, would do well to reflect on these differences, As well as being thankful for their good fortune in having such well capitalised airlines based in the UK, I would suggest that they could consider being more helpful going forward if they don’t want to see the lead that UK airlines had over their European rivals going into this crisis being squandered as a result of COVID and the different policy responses.
It should be the case that as the lower cost and more profitable operator pre COVID, IAG should be able to get back to profitability and cash generation at a faster rate than Lufthansa. However, the UK government seems to be doing its best to offset this advantage by the inept way in which it is dealing with the resumption of air travel. The ill thought through introduction of quarantine requirements for arrivals into the UK, just as other countries are relaxing theirs, is the current prime case in point.
I hope this won’t be another example of the UK failing to realise that “You don’t know what you’ve got till it’s gone”. We no longer have a car industry to speak of due to government neglect. Let’s not let the UK’s previously strong global position in the airline and aerospace industries be casualties of this dreadful crisis.