Airlines may have finally shaken the monkey off their back, with a recent report suggesting they are set to achieve a return on capital above the cost of capital. That would be the first time in history, should it occur. Other industries are expected to do that year in, year out.
According to the International Air Transport Association (IATA), global airlines in aggregate are expected to generate a return on capital of 7.5% in 2015 – above the current cost of capital, which has fallen to 6.8%, thanks to lower interest rates on debt.
However, the industry average is dominated by US airlines, which are benefitting from a strong local economy, US dollar-denominated fuel prices, which have shrunk and industry restructuring. Outside the US, the average airline is still unable to generate a return above the cost of capital and struggles with a huge debt load.
"The industry's fortunes are far from uniform. Many airlines still face huge challenges", said Tony Tyler, IATA's director general and CEO.
Simple economics suggests that unless a company can generate higher returns than costs, it will need to constantly raise capital, either equity or debt. The airline sector has consistently had one of the lowest levels of return on capital of any industry, according to research by McKinsey & Company.
Of the US$29.3 billion expected to be generated in airline profits, North American airlines will account for more than half with $15.7 billion. North American airlines also boast the strongest earnings before interest and tax (EBIT) margins of 12.1%, compared to the average of 6.9% globally, and more than double that of the next-best performing regions of Asia-Pacific and Europe.
The main drivers of that profit is the 36% fall in average oil prices, more passengers and cargo, and a significant rise in the US dollar against other currencies.
Domestically, Qantas Airways Limited (ASX: QAN) and Virgin Australia Holdings Ltd (ASX: VAH) should be headed for a good result this financial year, with the former flagging the potential to even pay dividends. The end of a major capacity war between the two has meant airline ticket prices have recovered to more 'normal' levels and more passengers on each flight.
Qantas is expected to report a pre-tax profit of near $1 billion this financial year, although profit has been boosted to the tune of around $200 million annually, mainly due to a one-off write-down in the value of the Qantas International fleet of more than $2.5 billion.
Foolish takeaway
Unfortunately, this is unlikely to be the start of a new trend. It's impossible to compete against a competitor who acts or can act irrationally when it wants to.
Many state airlines are still majority-owned by their respective governments and can price their fares irrationally when competing against the likes of Qantas and Virgin. They are not answerable to shareholders and the like, and among other things, don't have to be profitable. It would also be quite easy for either Virgin or Qantas to act irrationally again in future – as they did in 2013 and 2014.
