Founder: Turnaround Talk
One of the industries that has faced the biggest disruption since the beginning of the Covid-19 Pandemic has been the airline industry. Not only were airlines forced to ground their fleets for the better part of 2 years, but airlines are also now coming to terms with rising fuel costs and the fact that discretionary spending means that people will simply travel less.
South African airlines experienced major volatility. South African Airways still remains the country’s biggest business rescue after the company became financially distressed in 2020. While this process has most been completed, there are still major concerns regarding the future funding of the airline. SA Express has been placed into business rescue and had to negotiate numerous run-ins with the Civil Aviation Authority over the past two years. And who can forget Comair’s short stint in business rescue before the airline filled for voluntary liquidation?
It is clear that the challenges faced by international airlines are global challenges. Comair said that one of the major reasons why the company was forced to consider liquidation was the rising cost of airline fuel that became a risk that was to great for the company’s lenders. When Turnaround Talk spoke to Dr Joachim Vermooten in July 2022, he pointed out that the global airline industry should return back to normal by the end of 2024. A projection by the Gordan Brothers points out that this timeline could be a little shorter.
The article points out that the COVID-19 pandemic caused a severe decline in global air travel and negatively affected demand for industry products. Demand has slowly rebounded since 2021, and net jet orders trended up for the first half of 2022 as travel rates have steadily improved. Major manufacturers Boeing and Airbus expect air traffic to recover to 2019 levels between 2023 and 2025.
Travel demand rises as disruptions challenge recovery
Although COVID-19 variants remain a concern for travellers worldwide, air travel demand soared in this year with the increasing availability of vaccines. Although U.S. passenger airline operating revenue totalled a net loss of approximately $3.5 billion for the first half of 2022.
The article adds that, despite a pre-tax loss in the first half of this year, operating revenues are in line with pre-pandemic levels from the first half of 2019. However, major US carriers reported a 13% increase in operating expenses for 2022 compared with the same period in 2019. Although commercial airlines continue to incur net losses, loosening of travel restrictions and greater vaccine availability are driving expectations for a potential return to profitability by 2023.
Commercial air travel, specifically domestic travel, shows signs of recovery from pandemic lows. Global airline capacity hit 98 million seats at the end of September 2022, which is consistent with travel in the last week of August, but capacity had retreated to just over 90 million by early November, 15.4% below the same period in 2019.
The Gordan Brothers article points out that the International Air Transport Association expects travel to and from North America to recover ahead of other regions with demand reaching 94% of 2019 levels by the end of the year and exceeding them in 2023. North American original equipment manufacturers (OEMs) have ramped up production of narrow-body aircrafts among other products as air travel demand continues to rebound.
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Global seat capacity
The article points out that amid rising demand, airlines continue to grapple with higher fuel and labor expenses that are hampering their ability to rebound to full capacity. American Airlines and other major U.S. carriers limited flying this year to confront cost increases, ongoing flight disruptions, air traffic congestion and economic volatility, which combined have restricted their ability to take full advantage of improving travel demand.
In July, American Airlines reported its expected flight capacity to be down 9.5% for the year from pre-pandemic levels. Similarly, United limited flying to 13% below pre-pandemic levels for the year and cut its growth expectations for 2023. Delta is also curtailing capacity for the remainder of the year, with its third-quarter capacity to decrease as much as 17% from 2019.
Russia-Ukraine War compounds global supply chain disruption
The Gordon Brothers article adds that the Russia-Ukraine war continues to affect the global supply chain by obstructing the flow of goods and driving dramatic cost increases for a range of commodities, including oil.
Trade war disruptions in 2018 and 2019 escalated during the Pandemic and were compounded by Russia’s invasion of Ukraine. Ensuing trade sanctions and other obstacles have obstructed logistics and trade route operations. Approximately 600,000 businesses worldwide rely on suppliers from Russia and Ukraine, with over 90% based in the US.
The aerospace and defence industry’s complex yet fragmented supply chain consists of over 1,000 small- and medium-sized suppliers serving an extremely limited number of major OEMs, which causes difficulties and can result in various cost overruns for manufacturers.
Supply shortages stemming from the pandemic and compounded by the Russia-Ukraine war have upended the global marketplace, impeded supply chains and increased time costs as manufacturers wait for delayed parts to arrive. This has made it more difficult for companies to keep up with demand and resulted in a struggle to meet production needs.
Emerging technologies expected to grow through mergers and acquisitions
The article points out that the aerospace and defence industry experienced significant merger and acquisition (M&A) activity in 2021 with overall deal volume increasing more than 26% over 2020. 2022 M&A activity has cantered among smaller defence companies with megamergers unlikely as government approval for a merger of two already highly concentrated OEMs is improbable.
Additionally, increases in defence spending and fewer available large military contracts have increased M&A activity. This could result in some subsegments not having enough contracts for the same product lines and potentially lead operators to leave certain fields or acquire companies to diversify and break into the civil sector or other defence segments.
The article adds that although industry analysts expect continued consolidation among supplier and defence contractors, smaller operators may enter the market to fill niche positions in the supply chain. As a result, experts project the number of companies engaged in aircraft, engine and parts manufacturing to increase at an annualized rate of 3.3% through 2027.
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Valuation considerations
Forecasts indicate the aircraft, engine and parts manufacturing industry revenue in the U.S. will increase at an annualized rate of 2.5% to over $238.8 billion through 2027 because of the increase in military hardware exports and an anticipated short-term increase in the defence budget.
The article points out that additionally, industry experts anticipate defence sector growth as the production of aircrafts, such as the F-35, begin to ramp up. However, even with the increased demand for commercial aircraft and the defence market picking up, profit for the industry will most likely remain constrained because of volatile purchase costs. Rising inflation, interest rates, and environmental and government regulations for fuel efficiency have the potential to negatively affect the industry over the next several years.
In the short term, Gordon Brothers recommends monitoring costs as any deterioration in margin would have a negative effect on appraisal values. In the long-term, our firm recommends monitoring inventory levels, specifically slower moving inventory, as an accumulation can occur over time rendering the inventory undesirable or obsolete.
