Airline investors should assume crash position

A UK Times reports says that the airline industry has a funny way of coping with risk.

Passenger safety is paramount; shareholder safety is not.

It is almost as if airline executives sweat so much to make sure their aircraft and safety systems are close to risk-free that when it comes to the business model and balance sheet, they say: “Sod it, we’ll take a bit of a flyer here – the investors and creditors will just have to chance it.”

Thus it was last week that yet another travel and aviation group – XL – came to a messy standstill at the end of the runway, never to get airborne again. The casualties are not only the customers stranded abroad or those forced to make alternative travel arrangements, nor the 1,700 staff.

They are also the banks, investors and other creditors who are owed more than $200 million (£112 million), according to one source, who will be lucky to get any money back.

Airlines and travel operators are failing by the squadron. Silverjet, Zoom and MAXjet have gone to the great hangar in the sky and Willie Walsh, of British Airways, reckons that another 30 will join them soon.

Sir Richard Branson, when asked how to become a millionaire, replied: “Start out as a billionaire and launch an airline.” Warren Buffett quipped that Western capitalism would have been immensely better off if the Wright brothers had been shot at Kitty Hawk.  The headwinds facing the industry are notoriously fierce. There’s the strict regulation and the vulnerability to outside factors, such as strikes and terrorist attacks.  There’s the overcapacity caused by the need for every nation state to boast its own carrier, sometimes indecently propped up by subsidy and airport slot favouritism.

But this time it is the soaring price of aviation fuel that is blamed for the industry’s troubles. This is a huge expense for most airlines, especially budget operators that can scrimp on most things, but not on kerosene. EasyJet reckons that it will spend £800 million on fuel this year, four times as much as its entire wage bill.

But the doubling in the fuel price of the past year is not that freakish an outcome.  The crude oil price is notoriously volatile. Any sensible board should have run just such an eventuality through its stress-testing models. A prudent board would assure itself that it had sufficient margin headroom to cope with such a price increase or put in place the necessary hedging arrangements.

Ironically, XL did hedge, but the transaction appears to have been imperfectly structured.  It was not simply an insurance policy against a rising oil price. It was a two-way bet.  When fuel prices fell, XL apparently started to lose money to Barclays, its counterparty, which then started to call in the debts last month.

XL was created by a management buyout two years ago, bought out from Avion Group, of Iceland, for $450 million. There are no details on the balance sheet structure, but one pertinent question for the management is whether the company was loaded up with too much debt at that time. It would have been a rare buyout not to have taken on additional leverage in those carefree times.

The industry takes customers’ money far in advance of travel.  That is a tremendous cashflow advantage and should give it an extra financial cushion to withstand shocks.  The least it should do is to set its fares and hedge its costs and manage its gearing to ensure that it is still around to meet its side of the bargain.

The Civil Aviation Authority’s new Atol arrangement to charge an additional £1 on every package holiday fare means that it is the responsible, low-geared, sensibly hedged tour operators – and their passengers – who end up subsiding the likes of XL.

A Report by The Mole