Middle East Airlines – Strategic Diversifiers or Serial Destroyers of Capital? (Part 2)

The below is Part 2 of the Middle East Airlines post. In Part 1, we covered most of the top-down dynamics of the industry. This section looks closely at the Middle East region in the context of the global sector and delves into the bottom-up side of the story.

The next few slides will look at MENA’s relative contributions to the global capacity growth picture.  We sourced most of the traffic and fleet capacity data from both IATA as well as Boeing’s Commercial Market Outlook 2018-2037.  The latter provides a plethora of data (historical and long-run forecasts) for the global airline industry, though with a somewhat Pollyanna-like perspective on secular growth trends (all of the past 5 outlook reports we studied have very bullish prognostications!).  This is unsurprising since Boeing (like Airbus) is in the business of selling as many planes as possible to as many airline operators.  For readers that want to read a more objective perspective on this subject, we would highly recommend reading a fantastic academic paper published by an MIT Master of Science in Transportation candidate (Karim Al-Sayeh) in 2014 titled “The Rise of the Emerging Middle East Carriers: Outlook and Implications for the Global Airline Industry”. It is a comprehensive and very detailed appraisal of the ME airline sector.  We draw on it heavily in our analysis and reach similar conclusions. 

Let’s start with the trend in share of industry-wide traffic measured by revenue passenger kilometers or ‘RPKs’ graphed in Chart 46 below (sourced from IATA).  The Middle East has been the overwhelming leader in RPK share growth for the better part of the last two decades.  This trend began in earnest in 2001, shortly after the sharp decline in traffic demand that ensued in the aftermath of the September 11, 2001 attacks on the World Trade Center and continued unabated until 2016 when share gains began to taper off. Note also the stagnant trends in European and Asia Pacific share growth, while North American share declines have followed a pretty consistent downward trend since the early 1990s.  ME traffic grew its share of global capacity and traffic from well under 3% in 2001 to just below 10% by 2016, roughly tripling both capacity (ASKs) and traffic (RPKs) in the interim.  

This giant leap in global share of traffic between 2000-2017 was propelled by world leading growth rates that were second only to China amongst major international route markets (i.e. excluding intra-country/intra-regional traffic; see Chart 47 below with data from Boeing).  Total routes to/from the Middle East excluding intra-regional traffic (orange bars) grew at a CAGR of 10.8% between 2000 and 2017, eclipsing even Chinese route traffic growth of 9.3% (again – excludes intra-regional Chinese traffic which grew at the fastest rate of 14% CAGR).  ME route traffic growth rates were even higher during the latter part of this period (2007-2017), commanding over half of the top 20 fastest growth markets.  

According to Boeing, the Gulf carriers were particularly aggressive in taking origin & destination (O&D) share from European network carriers between 2002-2017 (see Chart 48 below).  This involved taking a large portion of the traffic on key long-haul routes between Europe and Southeast Asia, Oceania and the Indian Subcontinent.  For example, Gulf carriers grew their share of the Europe-South Asia route from 16% in 2002 to 42% in 2017 and from 3% of the Europe-Southeast Asia market in 2002 to 34% in 2017.  Noteworthy here is that these two O&D markets witnessed very low growth rates during 2000-2017 (5.1% and 1.1% respectively – Chart 47), so most of the GCC share gains were made at the overwhelming expense of European carriers with little stimulation to growing the size of the overall pie. 

The same dynamic seems to have been at play in the US-South Asia O&D routes.  According to several white papers sponsored and published in 2015 by The Partnership for Open & Fair Skies (or ‘POFS’), a US airline industry group composed of American Airlines, Delta Airlines and United Airlines, along with several influential US airline labor unions, the GCC carriers also cannibalized several major US O&D routes.  Charts 49 and 50 below (sourced from one of several white papers published by POFS), illustrate this phenomenon during 2003-2015 on the major US-Indian Subcontinent route.  US and major European JV partners began to lose a meaningful share of daily seats to the GCC carriers beginning in 2009 (Chart 49) with the GCC market share (% of bookings) of Eastern US-Southeast Asia routes rising from just 1% in 2008 to 13% by 2014 (Chart 50).  

POFS contends that “The Gulf Carriers are taking share without meaningfully stimulating demand, a fact that can be seen most dramatically on traffic flows between the United States and the Gulf. For example, between the end of 2007 and 2014, Emirates increased its daily seats between Dubai and the United States (excluding JFK) from approximately 250 per day to approximately 5,000. Over that same period, however, the average daily bookings between the eight U.S. cities and Dubai decreased by eight passengers – from 746 in 2008 to 738 in 2014. Overall, nearly 11,000 daily seats have been added between the United States and Abu Dhabi, Dubai and Doha since 2008 – 95% of them by Gulf carriers – but over the same period, the average daily bookings between the United States and the three Gulf hubs has increased by only 85 passengers per day.”

Chart 46 – Regional Share of Industry-Wide Passenger Traffic – 1990-2018

Chart 47 – Airline Traffic Growth by Major Routes – 1985-2037F (Boeing)

Chart 48 – Gulf Carriers & O&D European Traffic – 2002-2017 (Boeing)

Chart 49 – Gulf Carriers & O&D US Traffic – 2003-2015 (POFS)

Chart 50 – Gulf Carriers Growing Share of US-Southeast Asia Routes – 2008-2014 (POFS)

Looking at global share of route traffic evolution since 1985 (Chart 51; data from Boeing) – similar conclusions can be made. The left panel plots the respective major route category shares of the delta in traffic (e.g. incremental traffic between 2007 & 1985 and 2017 & 2007), while the right panel gets more granular and breaks the major routes into minor ones.  From 1985-2007, intra-regional incremental traffic accounted for 61% of all traffic, of which China intra-regional (i.e. China-China) traffic accounted for 7.2% of the 61%.  While the overall share of intra-regional traffic remained stable (62.4% during 2007-2017), the Chinese component in this intra-regional traffic more than doubled to 16% (consistent with the world-beating growth data we shared in Chart 47 above).  

If you peel away China-China and all intra-regional traffic and just look at international routes, you start to see a pretty clear picture of the major shifts that have occurred in incremental market shares.  Routes originating or terminating in the Middle East (the light brown and dark brown bars) collectively grew from 5.4% in 1985-2007 to 15.4% in 2007-2017, while major competing international routes shrank materially (e.g. Major West-West routes: 13.5% to 6.9%, Major Asia-West routes 10.4% to 3.6%).  The big loser in incremental traffic share between 1985-2007 and 2007-2017 was overwhelmingly the intra-regional North American market routes, which shrank from 18.5% of incremental RPK additions to just 4.6% (dark green bars in the right panel columns).

Zooming in to the period of 2008-2017 and highlighting the major shifts in market share deltas in 2009, we start to see an even clearer picture of how the global traffic market ‘shook out’ post the global financial crisis (Chart 52 below).  For example, in 2009 vs. 2008, the overall global traffic market actually shrank in aggregate by 75 billion RPKs, almost entirely wiping out the incremental 77.3 billion RPKs added in 2007.  The violent shifts in route shares in 2009 were quite dramatic.  While the routes that contributed to the bulk of the gross decline in traffic were principally: Intra-North America -58.9, Major Asia-West (ex-China) -38.6, Intra-Europe -35.6 and Major West-West -26.5, those that grew positively during 2009 were concentrated in a small groups of routes: Intra-China +50.8, Middle East (ex-Intra, ex-China) +28.9 and Middle East-Asia & China +23.6.  So, the big net gainers in 2009 were overwhelmingly the domestic Chinese traffic and the Middle East long haul transit traffic.

Once the recovery began in earnest in 2010 and global traffic recovered back to trend growth, many of the ‘winners’ from the 2008-9 ‘wash-out’ managed to maintain their relative shares of incremental traffic additions (e.g. the major Middle East-Asia and Middle East-Non Asia routes and Intra-China) while some of the losers from the 2008/9 carnage took many years to fully recover their incremental shares (e.g. Intra-North America and Intra-Europe in particular).  Some routes, such as Major Asia-West routes (pink bars) never fully recovered their shares until as late as 2017.  By 2015, a ‘new market regime’ of sorts was established, with Middle Eastern international routes commanding almost 1.8x more in incremental share of traffic relative to the two major East-West O&D routes (72 vs. 41).  This, more than anything, sheds light on the timing of the POFS lobbying initiative that began in 2015 – it was the height of ‘pain’ for the US airlines' international business in particular.  Only by 2017 did the relative shares of the major US & European O&D routes recover back to a more balanced ratio relative to the new Middle Eastern entrants.

Chart 51 – Airline Traffic Annual Delta Share of Route Categories – 1985-2017

Chart 52 – Airline Traffic Change by Minor Route Categories – 2008-2017

Since 2010, the dominant ME carriers (which we include the Turkish airline carriers amongst them - a departure to how Boeing and IATA classify Turkey as being part of Europe) collectively grew both their traffic and capacity at record-beating rates (Chart 53 below plots YoY% capacity growth rates; ME is in brown).  According to Mr. Sayeh’s calculations, during the steepest part of their growth curve (2007-2012), the top 4 ME Carriers (Emirates Airlines, Qatar Airways, Turkish Airlines and Etihad Airways) on average grew their ASKs and RPKs by close to 18% annually, while growing their fleet sizes by just under 14%.  The IATA data shows slightly more subdued YoY growth rates, though confirming the relative growth premiums vs. other major regions during this general time frame. 

Chart 53 – Airline Passenger Traffic & Capacity Growth: Regional Trends – 2010-2019F

As a result of capacity growth (ASKs) outpacing traffic growth (RPKs) for most of this period for the Middle Eastern region, relative load factors over the past five years (Chart 54) have suffered.  ME markets faced the sharpest declines in overall load factors between 2014 and 2016, according to IATA data, only recovering in 2017 to 64% from as low as 59% in 2016 when capacity rationalization began in earnest.  In the meantime, load factor head-rooms (the difference between actual load factors and break-even load factors) fell from 1.2% in 2014 to as low as 0.8% in 2019, lower than any other region globally with the exception of Africa.  

The combination of bloated capacity levels, lower utilization and fierce price competition – especially on non-domestic international routes which began in 2016/17 as the industry recalibrated - all translated into deteriorating operating and net profit margins for the ME region (Chart 55 below).  With the exception of a blip in margin improvement in 2015 (due almost exclusively to sharply lower fuel costs which every region enjoyed the fruits of), the region experienced a persistently falling margin structure , with operating margins dropping from 3.7% in 2010 to 1.4% in 2019 (top panel in Chart 55).  This is in stark contrast to trends witnessed in the overall global industry and especially the incredible improvement witnessed by the North American market (operating margins rose from 5.7% in 2010 to as high as 14.4% in 2015, levelling off at a healthy 10% by 2019). We will drill down into some of the specific carrier-level dynamics in the next section when we look at franchise EVA, but they obviously mirror the regional trends described above.

Chart 54 – Regional Airline Load Factors & Headroom – 2014-2019

Chart 55 – Regional Airline Profitability Trends – 2010-2019

Finally, on the regional perspective front, the sharp variance in fleet growth between regions is also worth highlighting (Chart 56 below) as this explains the engine behind the incredible capacity growth additions made by these carriers in the last decade.  

According to data from Boeing’s Commercial Market Outlook 2018-2037, the Middle East accounted for 13.5% of total aircraft deliveries for the period 2006-2017, 2nd ranked only after China (39%).  When compared to an installed capacity share of under 3% in 2005 (in terms of ASKs – see Chart 57 below which aggregates regional shares based on the top 30 airlines globally from Flight Global) one can fully appreciate how large these incremental fleet additions were. Total fleet additions for the region grew at 17.3% CAGR from 2006 to 2017, ranking 3rd in terms of growth behind China and South Asia which grew their regional fleets by 20% CAGR each.

It is even more impressive if one looks at the share of widebody fleet additions made by the Middle East carriers during 2004-2017.  For reference, wide-body planes tend to have seat capacities ranging from 238-553 as opposed to single-aisle narrow-body planes than have seat capacities of 117-258 seats. The super-large widebody fleet category (A380 for instance) has a seat capacity of up to 868 passengers, so it offers just over 2x the seat capacity of an average wide-body aircraft.  As it has been widely reported and analyzed, the Gulf carriers (particularly Emirates Airlines) were the dominant buyers of A380s at inception (at $450 million list price per plane).  Currently Emirates owns and operates 111 A380s, representing 47% of the global installed base. With Etihad & Qatar operating 10 A380s each, the Gulf carriers collectively own 55% of this (now cancelled) aircraft category. Most of the carriers outside of the ME super-connectors have begun to abandon the A380, since it has proven to be uneconomical with falling load factors on long haul routes and unnecessary in light of expanding landing capacities in O&D airports.   

The Middle East’s overall wide-body fleet stood at 346 in 2004 (already as high as 9% of the world total installed base of 3,885). By the end of 2017, the region’s share of global wide-body airplanes grew to 16.7% of the total (or 710 planes out of 4,290).  We are not sure what share of gross additions this is as we are not privy to the widebody fleet that was retired during this period globally.  On a net addition basis, the ME share of widebody additions may have been as high as 75%-90% - a remarkable figure if in fact accurate.  In forecasting regional fleet growth going out to 2037, Boeing has not really tempered their enthusiastic expectations, with the ME region forecast to grow its total fleet by 4.9% (ahead of Asia Pacific and China), while accounting for 7% of overall unit delivery share, but a higher share of delivery value (10.4%) – suggesting a continued tilt towards higher priced wide-body airplanes (46% of gross additions and 19% share of wide-body net additions).

Chart 56 – Global Aircraft Fleet Growth & Share of Deliveries by Region – 2006-2037F

Chart 57 – Global Airline Capacity Share Evolution – Top 30 Carriers by Region-2005-2018

Now that we have fleshed out the top-down, sectoral and regional drivers and dynamics, we are now ready to focus on the bottom-up perspective (individual airline dynamics and profitability). Before we dive into the company/franchise analysis, we will first introduce the reader to our chosen framework of analysis – Economic Value Added (or ‘EVA’).

We chose to use the EVA lens for several important reasons.  We believe the EVA framework is the most comprehensive and effective lens for diagnosing the critical aspect of long-run sustainability of a business franchise. If an airline franchise cannot generate positive economic profit above its market-based cost of capital for sustained periods of time, one would question either the sustainability of its business model or the intent behind the sustenance of such a value destructive model. Since EVA is predicated on an economic spread between the return on capital employed (ROIC) and the cost of capital (WACC), it is a relatively straight-forward framework for decomposing the drivers of both returns on capital and the components of the cost of capital. 

EVA is also an elegant framework for comparing risk adjusted returns across different sectors and business models and thus allows us to look at airlines’ historical economic value-added in units of capital translated to a hard currency relative to other sectors in a somewhat standardized fashion.  In its purest form, the cumulative EVA that an airline franchise generates over an extended period of time embodies the true historical risk-adjusted economic value added.

In order to normalize the analysis for the spectrum of global airlines in the study, we made the following simplifying assumptions: 1) all miles are converted to kilometers for volume measurements (ASK, RPK, etc.) in order to enable a standardized unit comparison, 2) the ROIC numerator of NOPAT or (EBIT * (1-Tax rate)) assumes EBIT is strictly operating profits or losses before any extraordinary items, but assuming comprehensive operating revenues and costs (inclusive of non-scheduled revenues such as cargo and ancillaries and all direct operating expenses including operating lease rents); when the tax rate is negative (tax credit/rebates), we assume the tax rate is 0% for simplification purposes, 3) the ROIC denominator is based on the total capital employed in the business or the Book Value of Equity + Net Debt.  Net Debt is (Gross Debt – Cash & Equivalents), while Gross Debt includes the PV of all operating lease minimum payments annually since this effectively capitalizes the off-balance sheet operating leases as though they were on-balance sheet debt. 

For most airlines, the difference between the asset-based ROIC (denominator is Net Fixed Assets + PV of Operating Leases + Net Working Capital) and the capital-based ROIC (see above) was found to be negligible.  We therefore used the capital-based ROIC as the denominator in the calculation as it is usually a cleaner number (less distortions resulting from NFA disposals, varying depreciation lives, etc.), 4) all annual financial data is converted to US Dollars at the fiscal year-end exchange rate, and 5) the WACC for each airline was derived from Bloomberg estimates of the annual market cost of equity plus the market cost of debt, each weighted according to the market weight of each in the capital stack and added to one another, or (WACC = CoE * ME% + CoD * MD%).  In the instances where the specific airline does not have marketable debt or equity, we utilized relevant proxies for the cost of equity and/or debt and used the relative weights of book equity and book debt as the weighting factors for the WACC calculation.

It is also important to note what the EVA framework does not capture.  On the cost side, EVA does not fully capture the individual country-specific subsidies that are bestowed upon each airline by the host country or majority sovereign stakeholder through direct or indirect subsidies (whether these are capital, operating expense or revenue subsidies).  Examples of these subsidies would include subsidized fuel, labor or landing costs, or subsidized marketing (e.g. sports team sponsorships, state sponsored promotions, etc.).  Subsidized capital categories would include subsidies for infrastructure (e.g. airports), loan guarantees, hedging subsidies, equity infusions or debt forgiveness.  

For a somewhat one-sided analysis of these state-sponsored subsidies, please refer to the white paper published by POFS referred to above.  As of the latest update (2017), the POFS estimates that “Since 2004, the governments of Qatar and the UAE have provided $52 billion in subsidies and other unfair benefits to Qatar Airways, Etihad Airways and Emirates Airlines.  This subsidized support includes interest-free government 'loans' with no repayment obligation, government grants and capital injections, free land, airport fee exemptions and more.  These subsidies are a clear violation of Open Skies policy, which is based on the principle of fair competition in a marketplace free of government distortion.” It is not only the magnitude of subsidies that is alarming, it is also their incredibly wide scope and open-ended nature.

Since EVA is a purely financial framework, it is very much a cold and sober appraisal of the financial performance of a business enterprise.  In this vein, EVA does not capture the full gamut of positive and negative externalities generated by the airline for the host country or countries that it connects or services.  These externalities would obviously include things such as employment of citizens and migrants, facilitation of inbound tourism flows, training of the labor force, high technology transfer or the creation of brand-new clusters of activity that in turn may grow to become engines of economic growth and prosperity. We tried to cover some of the positive externalities and their expected impact on diversification, labor productivity and enhancements to human capital stock in the top-down section earlier.  We would however stress here that one cannot overstate the achievements made by the Gulf countries in particular in the logistics space over the past 30 years. The economic and financial analysis undertaken in this post may only serve to show a distinct, yet important, aspect of the GCC development model, and is by no means a comprehensive assessment (positive or negative).   

So, with all that said up front, lets proceed with the company analysis.  

We looked in detail at 14 individual airline franchises: five in the Middle East (Emirates Airlines, Etihad Airways, Qatar Airways, Turkish Airlines and Royal Jordanian Airlines), three legacy European airlines (Air France-KLM, Lufthansa and IAG-the parent of British Airways), three legacy US airlines (Delta Airlines, American Airlines, United-Continental Airlines), one Asian airline (Singapore Airlines) and two low cost carriers or ‘LCCs’ (Ryanair in Europe and Southwest Airlines in the US).  These airlines collectively account for close to 40% of the global airline traffic in 2018, so a reasonably large sample to draw meaningful observations about the industry and regional dynamics, from a bottom-up perspective.

Instead of walking the reader through a drawn-out sequential financial analysis of each company, which may risk alienating those readers that are not financial analysts or so inclined, we decided to throw up the ultimate ‘punch line’ first – cumulative EVA earned by each airline from 2004-2018 in US dollars (Chart 58 below).  We prefer to look at a cumulative track record as it smooths out all annual aberrations and short-term idiosyncrasies.  At the end of the day, a cumulative tally of EVA should be one of the most important assessments that a stakeholder in an airline will look at to assess its financial and economic viability on a stand-alone basis.

A few broad observations: 

1) Only two of the 14 airlines analyzed had achieved positive EVA during the 12-year scope of analysis: the two LCCs – Southwest and Ryanair.  While Ryanair consistently generated a positive EVA track record, Southwest only turned positive EVA on a cumulative basis in 2016.  The fact that the only two positive performers on this metric are LCCs says volumes about which business models have proven to be the most scalable, profitable and value-creating for their shareholders while enhancing value for such a large and growing pool of travelers over the past 12 years.  This is a key take-away for us as investors since it has had big implications for the industry, not only for the ME super-carriers who are themselves trying to adapt to competition from LCCs in their own backyard, but all major airlines globally.  The LCCs are a force to be reckoned with.

2) All of the legacy carriers based in Europe, the USA and Singapore have produced negative cumulative EVA with varying magnitudes of losses and trends.  Most (the exception is Singapore) have improved their EVA track records of late, especially since their respective profitability troughs in 2013-16, with several reversing this trend of improvement in the past 1-2 years – a concerning trend.  The worst performer (Lufthansa) has lost a cumulative EVA of $13.2 billion while the best performer (IAG) has lost (only) $473 million in economic value since 2004.  Singapore has consistently leaked EVA on a cumulative basis since 2008 and has shown an accelerating trend of deterioration in the past 3 years.  

3) The Middle East carrier group (bottom panel; we used the same scale as the top panel for comparison purposes) also shows a consistent pattern of a deteriorating cumulative EVA loss trend.  The big under-performer of the bunch is Etihad, which has lost a cumulative EVA of close to $20 billion since 2004.  Emirates is a distant runner up to Etihad, with $8.3 billion in cumulative EVA losses, while Qatar and Turkish follow with cumulative EVA losses of $8 billion and $7 billion, respectively.  RJ which is the sole legacy ME airline we threw into the analysis for context, has a scale of franchise that is a factor smaller than the others (only 10% of Etihad’s seat capacity, 16% of revenues).  Despite this relatively small size, RJ has consistently leaked economic value since 2007, cumulatively losing over $600 million in EVA by 2018, more than IAG which is 31 times RJ’s size in revenues.  Emirates is a bit of an outlier in the group as it remained very profitable on a cumulative EVA basis until 2011, after which, the trend began to decline precipitously.  We recall reading a McKinsey note, titled “Between ROIC and a Hard Place: The Puzzle of Airline Economics” in early 2017 which highlighted Emirates’ superior 2005-2015 ROIC performance relative to global peers at the time.  We will show later on in the post and in the exhibits (see Appendix) that most of this superior performance was in fact leaked away in the ensuing three years (2016-2018) as margins contracted while capital intensity remained stubbornly high.

Chart 58 – Cumulative Economic Value Added – Select Airlines & Middle East Carriers (2004-2018)

Now that the ‘bottom-line’ assessment is out of the way, let’s try to unpack most of the big bottom-up drivers of the EVA framework.  We will start with a side-by-side ROIC decomposition and then look at the other key parts of EVA for select carriers – the cost of capital and the magnitude of capital employed.  

Before we do that, it is helpful to look at how these 14 airlines are positioned on two important axes – 1) returns on investment vs. growth (Chart 59) and 2) returns on investment vs. capital intensity (or ‘CI’, Chart 60).  At the end of the day, growth and capital efficiency are the two major drivers of EVA, particularly since growth tends to be a key driver of underlying profitability, many times outweighing margins when it comes to scalable businesses that are capital intensive.  On the capital side of things, the efficiency of capital deployed is the pivotal driver for the resultant cost of capital since you can be burdened with high capital costs, but if you use less capital in your business, you can still earn very high returns.  We use capital employed/revenues to normalize the capital intensity of a business to the size of revenues it generates for every dollar of capital deployed.

Ryanair, the top-ranked and most consistent EVA generator is unsurprisingly a real outlier in both ROIC/Growth and ROIC/CI. Ryanair has earned one of the highest rates of capacity growth (the ASK growth axis is in log scale to fit all airlines that span a wide range of growth rates) while generating the highest average ROIC of the peer group (by a wide measure and almost double that of runner-up Southwest).  On the ROIC/CI side, Ryanair is able to generate this superior ROIC with a similar capital intensity ratio of the peer group (0.86x) and roughly half of the capital intensity of Emirates (1.45x) and Qatar (1.82x).  Most of the other airlines on the ROIC side cluster between ROICs of -1% (Lufthansa) to 7% (IAG).  

The ME carriers (with the exception of Etihad who is an extreme outlier on the negative-end of the ROIC spectrum with -15%) cluster in the 3.5%-6% range, while generating 4 of the top 5 capacity growth rates (Ryanair is one of the five high-growth businesses).  However, when it comes to capital efficiency, the profitable ME carriers diverge considerably with Qatar and Etihad choosing to adopt a very high capital intensity model relative to the rest of the peer group (1.82x for Qatar, 1.91x for Etihad).  Emirates is less capital intensive than both GCC peers (1.45x) but is meaningfully more capital intensive than the legacy US and European airlines of similar size (the size of the diamond represents the relative size of ASK capacity).  Etihad again resides in an extreme quadrant on its own (top left) – adopting the highest capital intensity model of the group (1.91x capital to revenues) while generating the lowest ROIC.  

It is also worth mentioning Turkish Airlines here, which generates decent albeit mediocre ROICs of 5%, but is able to do so while generating one of the highest capacity growth rates in the Middle East peer group (in-line with Ryanair and Emirates) while utilizing a relatively capital efficient model (1.07x). Turkish Airlines however does not have the luxury of low cost of capital (very high inflation and thus risk-free interest rates in Turkey since 2016) and therefore needs to generate much higher ROICs than it does currently in order to produce positive EVA.  It is a classic example of a mediocre business that is stuck in a high capital cost environment.  

Chart 59 – Returns on Invested Capital vs. Capacity Growth – Average 2004-2018

Chart 60 – Returns on Invested Capital vs. Capital Intensity – Average 2004-2018

So that’s broadly how the average 12-year picture looks like for these 14 airlines.  The evolution of this picture however is also worth studying.  Recall the ROIC/WACC chart we presented (Chart 42) in the overall airline sector analysis section above and how ROICs for the global airline industry rose upwards in a ‘hockey-stick’ fashion in the 2013-2015 period, eclipsing the cost of capital for the first time in decades?  This improvement trend broadly excluded the Middle East region. 

Chart 61 below (from the same source as Chart 42– IATA) charts the progression of ROICs by region from 2010-2017 relative to an average global WACC.  The Middle East region stands out as the extreme laggard, not only in the sharp recovery period (2013-15), but throughout the entire 7-year period.  The region was only able to generate a positive EVA in a single year (2011) before resuming a sharp downward trend in profitability in 2012 and a sideways trend since then.  This is a major departure from virtually all other global regions which have maintained ROICs comfortably above their cost of capital since 2015. Once again, North America is the big positive outlier since 2012, reaping the dividends of dramatically better capacity utilization and capital efficiency.

Chart 61 - Returns on Invested Capital by Region vs. WACC – 2010-2017

The next six charts unpack ROIC, capital intensity, the cost of capital and leverage by stacking each of the 14 profiled airlines side-by-side.  We utilized an analysis framework that is similar to the DuPont framework in decomposing ROIC into its main component factors: profitability, capital productivity and leverage.  The decomposition of profitability is nuanced in order to account for some of the major components of an airline’s cost structure (fuel, labor, rents, maintenance, etc.).  The capital side was also nuanced by splitting up capital productivity into net fixed asset turnover and net working capital turnover in order to highlight the important effects of negative working capital, a dynamic that is quite pronounced in any airline’s business model (the receivables cycle tends to be much faster than the time they have to pay suppliers like aircraft vendors – an inherent subsidy in the form of cheap and patient vendor financing).

We will not go through each of the charts below, but instead will highlight a few key observations by focusing on a few outliers. 

Ryanair is an interesting case in point. It generates the highest NOPAT/Sales ratio (15.8%), a factor higher than the rest of the airlines we analyzed.  Looking at its operating cost structure, it achieves this high profitability principally through the labor channel (wages/revenues are one of the lowest at 10%) while fuel intensity (32%) is the highest and rent intensity (operating lease expense and other equipment) is also highest of the pack (22%).  Apart from these three chunky cost components, Ryanair is very disciplined in keeping ‘other expenses’ to a minimum (only 8% of opex, relative to a group average that is north of 20%).  The ‘other expense’ category includes marketing and promotion, amongst other 'non-core' spending items.  Ryanair’s yield per kilometer is the lowest of the group (USc 4.83/RTKM), but the airline is able to generate the highest margins (EBITDAR, Operating and Net) by keeping its unit costs (excluding fuel, 2.64 USc/RTKM) at a level that is second best only to Emirates (2.62).  Since it is a high grower (traffic growth is #4 ranked at 15.9% behind Etihad, Qatar & Turkish) it is able to translate this high scale volume into high revenue growth, despite its lowest-in-class yields. 

On the capital efficiency side, Ryanair boasts the highest load factor (86%), meaningfully above its break-even load factor of 77% (huge cushion), but does not necessarily shoot the lights out on investment capital turnover (the inverse of capital intensity) which at 1.2x is ‘middle of the pack’.  Its fixed asset turnover (0.81x) is also average while it scores very low on the NWC turns (-3.9x; it prefers to pay vendors in cash to extract the biggest discounts). Ryanair is therefore very capital intensive from a capital expenditure angle (capex/sales of 23% - 3rd highest, most likely because they prefer to buy rather than lease on balance; operating leases are also only 31% of total leases.  

On the cost of capital side, it obviously helps to be based in Europe where the cost of debt and equity are low, but Ryanair does not enjoy even close to the same level of capital cost that the big European legacy airlines take for granted (Ryanair’s WACC of 10.5% is more than double Air France-KLM’s WACC of 5%).  It’s WACC is also somewhat inflated (on a normalized basis) due to its extreme conservatism on gearing (2nd lowest net debt/EBITDAR of 0.55x, and 2nd lowest net debt/equity of 0.16x) – a factor lower relative to European legacy peers.

But whatever shortcomings Ryanair faces on the capital side, it makes up for it (and quite a bit more) on the profitability side. The high level of discipline inherent in the LCC model and the religiously narrow focus allow it to execute more consistently than any of its peers. Ryanair does this by only buying narrow body planes and only from one vendor so that it can squeeze as much savings through higher negotiating leverage.  It focuses exclusively on tertiary airports in order to minimize landing fees.  It offers a no-frills product to minimize non-core expense while being better able to lower prices and thus penetrate far bigger pools of new travelers.  It does this while maintaining overall yields by charging extra for incidental services that passengers prefer to have optionality for, rather than be forced to cross-subsidize luxury for everyone.  The list goes on and on.  

As a result of its far superior profitability track record and high growth profile, Ryanair commands the highest equity rating (via stock trading multiples) relative to its global peers and has maintained this premium status for over a decade.  In short, Ryanair is an amazingly well-run business, positioned in the ‘sweet spot’ of penetration growth while operating in a very tough and competitive global sector.

On the other side of the spectrum we could spend hours discussing the European and US legacy carriers and the laundry list of dys-functionality that has plagued them for the past 3-4 decades.  Consolidation over the last decade has in fact helped several to stay afloat and begin to generate respectable profitability and returns (IAG is a leader in this regard with 3rd ranked ROICs of close to 7%).  The legacy carriers have also become much more productive on the capital side of late, with some of the highest asset turnover ratios of the peer group (Lufthansa is a positive outlier in this regard).  However, their Achilles heel has continued to be anemic volume growth (3%-4%), weak pricing power (probably due in large part to the intensifying LCC competitive pressures in both regions) and stubbornly high cost structures (the top three highest unit cost carriers are all legacy European airlines). Compounding these issues are still very high financial leverage ratios, particularly among the US legacy names (albeit improving of late).

Chart 62 – Returns on Capital Summary & ROIC Decomposition – Average 2004-2018

Chart 63 – Capacity & Volume Growth (CAGR) & Capacity Utilization – Avg 2004-2018

Chart 64 – Yields & Unit Economics – Average 2004-2018

Chart 65 – Margins & Operating Expense Intensity – Average 2004-2018

Chart 66 – Capital Intensity Decomposition & Cost of Capital – Average 2004-2018

Chart 67 – Leverage Summary (Average 2004-18) & Gearing Trend (2015-2018)

Finally, we will conclude with a summary appraisal of the Middle Eastern carriers by contrasting how they are positioned financially relative to their strategic positioning in the context of the current tenuous global environment.

First, let us summarize our perspective on the strategic side.

One of the key differences that sets the four large ME carriers apart from the rest of the airlines in our analysis is the inherent vulnerability in the ‘super-connector’ business model.  Our concern here is principally based on three main threats:  

1)   The aggressive capacity additions made in the past 10 years are so large that they may in turn not only become a disproportionately large fixed-cost burden on the four ME airlines, but may also swamp the overall industry and cause severe overcapacity in certain fleet segments (widebody in particular) and route segments (East-West long-haul especially) as a result. The recent decision by Airbus to cancel the A380 program and Emirates’ decision to defer and/or cancel its remaining A380 deliveries are ominous developments.  To quote from Mr. Sayeh's report – 

“The business models of the emerging [Middle Eastern] carriers are based on them providing one-stop connecting service between long haul destinations.  In order for them to continue growing they must expand their networks to offer convenient service between East and West.  Though there is growing demand for travel to/from the Middle East, especially by lucrative business passengers, it is not sufficient to sustain four carriers of this size.  They therefore cannot focus solely on the traffic emanating from the Middle East. This is coupled with the fact that they face competitive pressure from both legacy and low-cost carriers in the region.”

2)   The balance of influence vis-a-vis the host countries of the primary aircraft vendors (US-Boeing and Europe-Airbus) has begun to tilt negatively to the detriment of the Middle Eastern carriers as the US and Europe become far more protectionist towards their home legacy airlines (we believe POFS is the proverbial ‘canary in the coal mine’).  This is also compounded by the fact that the outlook for global aircraft fleet order backlogs to 2037 are now tilted much more in favor of sales to large O&D markets in Asia (China/India) than the Middle East with over two-thirds of future fleet sales directed towards Asian airlines. These airlines and their eager domestic travelers are only too keen to avoid an unnecessary stop at a transit hub, and if given the choice to fly directly (all else being equal on price, safety and service quality), they will obviously prefer to fly with a point-to-point carrier. 

3)   One of the key enabling factors behind the super-connector model’s flourishing in the past decade has been the dearth of airport capacity globally, but especially at large destination urban cities in emerging markets.  In the past several years alone, this bottleneck has begun to ease materially. The new Beijing Daxing International Airport (expected to be the world’s largest when it opens this year), is the latest step in the Chinese strategy to expand airport capacity by close to 30% by 2020.  In the meantime, competing connector hub airports like Turkey’s newly opened Istanbul New Airport, promise to also challenge the Gulf’s super-connector business on European routes, by offering a closer and cheaper alternative to flying through Dubai, Doha or Abu Dhabi (Turkey is closer to Europe and has the scale benefits of a large captive domestic market).

With impending overcapacity, a virtual certainty for all of the Middle Eastern super-connector carriers, the context of an extended and mature economic and traffic demand cycle (10+ years from the last trough) coming to an end, paint a very daunting yet probable scenario.  Add to this: a) higher restrictions from key origin markets like Europe and the US that are restricting 5th freedom routes (like those destined for Milan and Athens which originate from major US cities), b) competitive intensity rising significantly in the form of legacy destination country airlines dis-intermediating the super-connector hubs as they vie for a larger share of their own O&D traffic which is being enabled by much higher airport and wide-body/long-haul airplane capacity in these countries, c) rising competitive intensity from regional transit hubs like Turkey and d) intensifying pricing pressure from regional LCCs. This has all the ingredients of a 'perfect storm' for the super-connector carriers.

When one overlays this clear strategic vulnerability on top of the current weak financial posture of many Middle Eastern airlines, the picture begins to look even more ominous. 

We will focus principally on Emirates Airlines to flesh this out in a summarized fashion since Emirates is the best-of-breed amongst the ME carrier group on most metrics.  In the Appendix, please refer to the list of charts (A1-A17) that summarize most of the key financial metrics and drivers for Emirates on a stand-alone basis, looking at the trend in dynamics since 2004. The first set of charts in the Appendix are ratios, while the latter are the raw metric data we compiled from Emirates' audited annual reports.

Emirates’ ROIC profile over the past 14 years tells most of the story.  ROICs have declined from a high of 10.4% in 2004 (at the time, one of the highest ROICs globally) to a mere 1.6% in 2018, and meaningfully below the 14-year average of 5.5%.  This is mirrored by trends in ROA, ROE and ROCE, all of which sit at a fraction of the 14-year average.  

On the profitability side, margins have generally also trended lower since 2004, with the exception of the 2015 aberrant spike in operating margins (reaching close to 10%) due principally to a drop-in fuel intensity to 23%, a big departure from the average of 30%.  In 2016, operating margins plummeted to 3% and have yet to recover since then.  EBITDAR margins on the other hand show a consistent improvement since 2011, but mask the significant rise in rent intensity (mainly operating lease payments that the EBITDAR figure ignores).  Keep in mind that Emirates is one of the most aggressive users of operating leases in the large airline peer group with OL/TL ratio of 70%.  

Labor intensity, which has been very stable at around 12.5%-13.5%, has continued to drive Emirates’ biggest comparative advantage relative to peers, with labor costs as a proportion of total operating costs running at less than half that of legacy US and European airlines.  Employee headcount growth has slowed markedly since the peak in 2016, driving labor productivity to a new 14-year high of 560 in 2018 (capacity/employee also mirrors this trend).  The other big comparative advantage for Emirates, which manifested itself in an optical (accounting) manner was its very young fleet and the low depreciation intensity it was been endowed with from 2004-2012.  As the fleet ages, depreciation intensity tends to rise (6.5% in 2011 to 10% in 2018).  This young fleet however is also more fuel efficient relative to older fleets, thus also giving Emirates an edge on fuel intensity.

On the growth side, traffic growth began to decelerate meaningfully as recently as 2014, with 5-year CAGR RPK growth falling to under 5%, a big drop from the 2004-2010 CAGR of 19% and the 2004-2014 CAGR of 16.4%.  With capacity growth still trending higher than traffic growth (5.7% ASK growth from 2014-2018), utilization began to weaken in 2015, with passenger load factors dropping to 75% in 2016 before recovering slightly to 77% in 2018.  

With growth, utilization and margins all under pressure of late, it is not surprising that the key headline profitability metric of NOPAT/Sales has hit a 14-year low of 2.5% in 2018.  Finally, from a unit economic standpoint, a concerning trend since 2015 has begun to take hold – falling unit revenues (8.2 US$c in 2014 dropping to 6.8 in 2018) and rising unit operating costs (3.6 in 2015 and 4.0 in 2018), thereby squeezing unit profitability (unit EBIT) to 14-year lows of US$c 0.18.  This is a dangerous trend, especially as unit growth continues to slow, while unit capital intensity (invested capital per ASK) remains elevated at US$c 10.8 – in line with the 14-year high investment average of 11.0.

On the capital productivity side, the dynamics since 2014 have also deteriorated at an alarming pace.  Net fixed asset turnover, once one of the highest in the peer group (e.g. 2011 it was as high as 0.77x) has fallen to 0.56x by 2018, in turn driving down overall invested capital turnover from 0.9x in 2011 to 0.62x in 2018.  Large net additions to Emirates’ fleet in the past 4 years (with higher leased aircraft via operating leases relative to on-balance sheet capital leases or purchases) has driven this deterioration in asset productivity and is masked by the falling capex/revenue ratio.  

On the cost of capital side, despite marginally higher cost of debt (3.2% in 2014 rising to 4.4% in 2018), overall WACC remains anchored below the 14-year average of 6.3% (5.5% in 2018) due to the large implied weight of debt financing in the mix (77%) and a falling cost of equity (proxied by large-capitalization listed UAE stocks since Emirates Airlines is not listed).  Finally, Emirates’ financial leverage ratios have remained broadly stable over the past five years, with both net debt/equity and net debt/EBITDAR well below the 2012 peak levels.  Even with a normalization of off-balance sheet financing due to IAS 16 accounting changes in 2019, we do not expect Emirates’ leverage ratios to deteriorate meaningfully as a result since our calculated ratios have adjusted for this (grossing up debt with the NPV of operating lease payments and substituting EBITDAR for EBITDA).   

So, the big question for us having undertaken this analysis is the following:

How do the Gulf carriers like Emirates, that are already fighting strong endogenous profitability pressures, survive such a painful systemic storm?  

Regardless of the carrier’s balance sheet strength or deep pocketed sovereign backing, airlines like Emirates obviously need to hunker down, aggressively cut costs and expenditures, and try to shrink their fleet in the coming months.  In light of the current cloudy industry backdrop, we would not be surprised to see Emirates and the rest of the super-connector carriers being forced to cut prices aggressively in order to maintain break-even load factors in a vastly oversupplied market.  The structurally high fixed cost profile of the airline industry (and the high negative operating leverage that comes with it) make this reaction almost a certainty and a key for survival. Otherwise, a scenario where shareholder equity may be completely wiped out over several years becomes highly probable (just ask Etihad, which has recapitalized itself several times in the past 5 years to make up for chronically large serial losses). 

Are the Middle East carriers (the Gulf carriers in particular) capable of weathering a storm of this magnitude based on how their business models, cost structures and fixed asset profiles are positioned? With decelerating global trade, cyclically weakening global GDP growth and intensifying competition in most regions depressing overall yields, the challenges are indeed formidable.  

Note to readers: The charts in the post are much better viewed enlarged in a separate window. To do so, please right click the chart and open image in a new panel or window.

Appendix Charts - Emirates Airlines: