By Luca Poeschl, Rayan Singh and Constantin Wells (University of St. Gallen)
Airlines have been able to overcome a wide variety of challenges over the past decade: cut-throat pricing in a highly competitive environment, hefty pressure on the industry for reductions in carbon-dioxide emissions, and fast-changing government regulation. Commercial airlines demonstrated their resilience by generating an approximated $838bn in revenue, up 11% in comparison to 2017, with profitability and constantly growing passenger numbers.
In the 21st century, the airline industry has proven to always bounce back sharply and drive economic recovery, demonstrated by the V-shaped returns after 9/11 and the second Gulf War. The ongoing pandemic, however, has caused an almost entire wipe-out of all commercial flights for months instead of days or weeks, leaving aviation in a state of crisis unseen before. The unprecedented nature of the circumstances suggests that a rapid bounce-back that we have historically experienced may not occur. The aviation sector plays a crucial role in the global economy, as seen in Europe, wherein 2019 it was responsible for the largest portion of its high-tech exports, a staggering $94bn. The effect on the rest of the economy, beyond the fuel industry which has been drastically affected by potential long-term drops of oil demand, remains to be seen.
The crisis may prove to have accelerated a potential paradigm shift in travel. Communication platforms like Zoom, which has a market cap of $48bn and is now worth more than the world’s 7 biggest airlines combined, have had time to establish their offerings in the global environment and are predicted to cause long-term disruption among air travel. Airlines may never reach the potential and heights they were predicted to reach in the pre-Covid-19 era.
Global travel restrictions have played an important part in the containment of the pandemic so far; many borders have been closed and government measures implemented have restrained people from traveling between countries. The government actions, which secured the well-being of its citizens have, however, had severely adverse effects on international travel. The measures have led to daily international flights plummeting 87% since January, leaving 60% of the world’s commercial aircraft grounded.
While many sectors are in the state of recovery, attributable to better control of the pandemic and further relaxation of safety measures being discussed, the airline industry’s situation has worsened in the past weeks, showing no clear signs of a recovery whatsoever. The S&P 500 Airlines Index has dropped 67% from its 2020 high in February. Compared to the S&P 500’s current 14% decrease from its all-time high in mid-February, the state of crisis many American airlines currently find themselves in is contextualised, with no substantial improvement in sight as long as the cash drought airlines are currently facing endures. The world’s largest carrier, Delta Airlines, is currently losing roughly $60m a day, attributable to 600 of its fleet’s aircraft not being able to depart. This cash drain prompted Berkshire Hathaway to sell all of its $6bn worth of airline-related stock, including Delta, with Warren Buffett directly criticising the airline fleet size.
Although governments are trying to rescue endangered airlines, the ongoing crisis has already seen various airlines fall such as Flybe, Virgin Australia and Avianca, South America’s second-largest carrier. With the Trump administration trying to prevent further bankruptcies in the U.S., the airlines Delta, Southwest, United and American Airlines have taken generous loan offers from the U.S. treasury, exchanging equity in return for grants and low-interest debt. However, this has come at the price of being forced to fly unprofitable routes whilst also not being able to lay off employees until October, a measure to prevent further unemployment filings in the U.S., which have risen to more than 36 million in the last eight weeks.
Meanwhile, European airlines have no such constraints, with British Airways laying off nearly 30% of its workforce and Ryanair dismissing 3000 employees in order to cut costs preparing for months of stasis. This doesn’t mean they are not involved in government bailouts however, with the German airline Lufthansa being in negotiations over a rescue deal worth up to $9.9bn.
“Out of the world’s nearly 1,000 airlines a lot are just bubbles of debt with wings.”
Brian Burridge, Chief Executive of the Royal Aeronautical Society
When shifting focus from the U.S. and Europe towards China, it is safe to say, that the air travel situation has its worst behind it. Weekly airline seat capacity on domestic routes, which was at almost 15 million seats pre-Covid-19, has climbed back to roughly 13 million, meaning a mere 10% downfall from the same period last year. This is extremely remarkable, especially compared to the current 73% drop in the U.S., highlighted by the CAPA Centre for Aviation. Revenues at the three largest Chinese carriers, Air China, China Southern, and China Eastern, plummeted 46% year-on-year to $7.7bn in Q1, whilst facing a combined net loss of $2bn. Their financial situation compared to American Airlines Q1 net loss of $2.2bn is again remarkable. These numbers, however, must be viewed with caution, as they were self-reported by the named airlines. In contrast to those figures, McKinsey forecasted a 48% fall in air traffic, implying no continuation of the seven years of constant global passenger growth rates of 4-8%. A recovery similar to China for Europe and the United States assumes travel-bans are lifted soon, Covid-19 cases decrease and strong economic interventions, like tax and regulation waivers, are successfully implemented.
In the short-term, due to remaining ground operations and cut profits by higher airfares, many airlines will remain struggling financially, being heavily dependent on government aid. Ground maintenance and parking are significant cost factors, which could prove fatal to some airlines. While the operation of ghost flights in the U.S. was carried out to keep supply chains stable, the E.U. has adopted slot waivers to support airlines’ financial positioning. Moreover, many airlines recently supplemented their fleet with wet-leased machines in preparation for a summer of high travel volume. Whilst only a few carriers will manage to get out of the surplus of capacity by terminating their leasing contracts comfortably, the majority will have to pay either huge compensations or will sit on an armada of leased machines up until the contracts expire. Additionally, safety precautions such as social distancing measures or emergency healthcare services could increase airfares by 54%, according to IATA, leaving only limited options for the airline industry to recover from the consequences Covid-19 has entailed. As a result, airlines will likely suffer from liquidity droughts, relying on raising new cash by selling assets, taking new loans, or asking for repayment holidays. As airlines encounter a cash-intensive, highly leveraged business model, creditors understandably fear their positions. If financiers and carriers are not working closely together, we can expect more bankruptcies to come. This was recently shown by airlines Flybe and Virgin Australia collapsing into administration.
The gap between individual liquidity balances together with the varying government support will result in some airlines emerging out of the crisis stronger compared to some of their competitors, resulting in shifting competitive advantages. As few airlines are set out to sustain the downturn by themselves, most carriers rely on financial governmental aid in the form of grants, loans, and waivers to ensure debt repayments and supplement cash flow. In contrast to most Western upper-class airlines, low-cost airlines and Chinese carriers are well-positioned, due to a significant amount of sold ticket revenue. This will result in fundamental shifts in the aviation landscape – bearing in mind Ryanair, having cash to survive for two entire years, are competing against Lufthansa, with only four months of liquidity available, post-Covid-19.
Image: Liquidity Balance of Major Airlines as of 23/03/2020 (Statista)
The future winners and losers in aviation will be determined by either the level of governmental support received or by successful individual strategies’ implementation. With massive uncertainty ominously clouding over the sector, a thorough and robust reopening strategy has to be assured. An unpredictable reopening could drive costs for airlines even further. The almost negligible decrease in seat capacity of Chinese carriers came as a faster-reopening strategy, but if the health risks from the strategy are realised, a rebound of Covid-19 cases could brutally burden Asian airlines, especially compared to foreign competitors. In the long-run, fleet reduction imposed by cost-cutting measures will strengthen the focus on core routes and will discard unsuccessful ones. This opens new doors for more efficiencies within individual flight-networks. Additionally, companies will be forced to reassess their global orientation. This will add another trigger for the industry’s downturn and foster the redefinition of air travel.
The initial lock-down of Chinese industrial cities has questioned and undermined the previous utilisation of the cheapest production methods available and reinforced the importance of local supply chains in produced goods. New alternatives will have to be considered whilst assessing strategic options for the future. The pandemic will not only change how we do business but also have a fierce influence on leisure travel, which will be dented due to infection fears and global travel bans next to the growth of alternatives such as videoconferencing tools. These uncertainties and underlying changes in air travel demand will lead to strategic, operational, and financial hurdles, and will significantly influence the sector.
Effects on M&A
Short-Run Effects on M&A:
The aviation industry was plagued with uncertainty in Q1; massive due diligence concerns arose from unpredictable governmental and consumer responses to Covid-19, which led to severely decreased M&A activity in the industry. The value of a targets geographic positioning, both financially and strategically, is heavily influenced by when regions are able to resume air travel and in what capacity. Domestic travel may be in line for a V-Shape recovery, exhibited by China’s return to only a 33% year-on-year drop in domestic capacity as of April 22nd from a peak drop of 71% on February 14th. However, international travel has almost halted globally, and due to its uncertain recovery modeling the recovery of international travel and its effect on the financial and strategic position of a target airline is extremely difficult for due diligence purposes.
There is also a massive divide between the policies that governments intend to roll out and what the industry advocates for, creating more uncertainty about what international travel will really look like. Ryanair’s chief executive Michael O’Leary recently slammed the U.K government’s 14-day quarantine plan on international arrivals at an FT Conference. He described the plan as “nonsense” and lacking a scientific basis, reaffirming his pledge to resume 40% of Ryanair flights from July. In the immediate short-run, the lack of clarity in due diligence arising from uncertainty in how governments and consumers will respond to the crisis, and the divide between industry expectations and legislation have been the main determinants in the low M&A activity in Q1 within the industry.
“If it’s a nine-inning baseball game, we’re in Inning 1 or 2 with how Covid-19 is ultimately going to impact the way we do deals and the way the diligence process unfolds.”
Eric Swedenburg, M&A Partner, Simpson Thacher
Ongoing M&A Deals:
M&A deals which have been announced but not concluded in the airline industry, such as Air Canada’s acquisition of Transat, exist in a completely different market setting to the one in which negotiations had been entered in. Ongoing M&A transactions may potentially want to be renegotiated from the acquirer’s perspective, but the stage at which negotiations are at affects the ability of an acquirer to renegotiate. Chris Murray, an analyst at AltaCorp, argues that in the Air Canada deal, negotiations may have reached too advanced of a stage to have discussions re-opened. Restructurings of other deals may include more performance-based pricing considerations which would preserve the value of the deal if the aviation industry returns to levels pre-Covid-19.
The ability of a firm to exercise a Material Adverse Change (MAC) clause heavily depends on the wording of the clause in the agreement between the parties. In the case of the acquisition of Transat, the wording in the clause is unfavourable towards Air Canada if they wanted to trigger the MAC clause. Dan Fong, an analyst at Veritas Investment Research, said in an email that “the language in the agreement effectively states that material adverse effect must disproportionately affect Transat relative other companies operating in the same space” for a MAC clause to be viable. Since travel agencies and airlines have all been severely affected by the pandemic, this argument would be hard to make in the majority of MAC clauses worded in similar fashions in the aviation industry, as further shown in the sale of Asiana Airlines, where similarly a MAC clause is unlikely to let the buyer walk away from the deal.
The new M&A deals that have arisen post-pandemic have been pushed forward from the target rather than the acquirer’s side of the negotiating table since large airlines interested in acquisitions are cash strapped. A current case example is Virgin Atlantic’s hiring of investment bank Houlihan Lokey to look at funding options for its £750 million funding requirement. This follows Virgin Atlantic’s rejected $500 million-pound state aid request from the U.K. Government. Companies that do not receive enough support from governments to meet their forecasted liquidity requirements may look to private markets, particularly as a target in M&A activity, to fill its reserves and ensure its stability through the crisis.
Due to the lack of short-term acquirer-side demand in M&A, the majority of able and interested acquirers look to be private equity (PE) and distressed debt specialists. The American-based PE group Apollo Global Management looks to be an interested party in Virgin Atlantic’s funding efforts but has been quoted as saying there is no certainty that they will invest. The firm, who bought budget airline Sun Country Airlines, was interested in Thomas Cook’s German carrier Condor and has the cash necessary to fund an acquisition bid. However, PE firms like Apollo may not be attracted to funding the airlines that want to be acquired, since the airlines that are in most need of financing at the moment tend to have high debt and leverage profiles. If the PE firms aim to acquire an airline using a leveraged buyout, the collateral that the PE firm has to put up itself due to the debt and leverage profile of the airline may make the cost of acquisition too high and risky, possibly justifying why no PE firm has stepped in to save debt-ridden Avianca yet.
Long-Term M&A Effect: Consolidation
The long-run effect of Covid-19, once travel resumes, will be consolidation by the biggest airlines, most notably in Asia and South America, but the process will be slowed down by anti-trust regulators.
Coming out of the Covid-19 crisis, airline carriers will need scale to survive, implying consolidation being key for the industry, similar to in the automotive industry. Ronojay Gupta, CEO of IndiGo, the largest carrier in India in terms of fleet size and passengers in 2019, discussed aviation’s future in an interview with the IATA. He argued that “more consolidation is inevitable”. Gupta believes that the airline industry is already extremely consolidated in Europe and the United States at this point, but he highlighted that “Asia has not seen any consolidation at all, and it is in Asia that we will see a lot of merger activity”. Europe already had a round of consolidation post 9/11 with British Airways, Air France, and Lufthansa all involved in massive M&A transactions, and it is unlikely that the United States’ big-three will be allowed to get any bigger.
The trend Gupta predicted is illustrated by IndiGo’s parent company’s interest in bidding for Virgin Australia, an airline which entered voluntary administration last month and is one of the largest airlines operating in Australia (not to be confused with Virgin Atlantic). IndiGo’s acquisition of Virgin Australia would follow the international consolidation strategy of Lufthansa in Europe, which aimed to acquire non-German national airlines to strengthen the company’s continental positioning. However, according to Reuters, IndiGo will face competition from the “eight non-binding indicative offers from potential buyers, including Brookfield, Bain Capital, and BGH Capital”.
Much of the consolidation of Asian airlines may occur in China, both by regional and international acquisitions. An HSBC Global Report found that consolidation in the Chinese market will likely occur post-Covid-19, led by China’s “big three” airlines. Consolidation would shore up the financial positions of China’s three biggest airlines due to fewer competitors and economies of scale, achieved through acquisitions of regional airlines that share central hubs with the acquirer, and allowing support processes and operations to be integrated and provide cost synergies. Moreover, the regional consolidation effort would likely be supported through cheap financing from the Chinese government, which aims to ensure the stability and competitive positioning of its largest carriers.
China’s Comac, a state-sponsored entrant into the commercial aerospace industry, can provide critical supply advantages in China compared to other Asian airlines, positioning China’s big-three for international acquisitions. An FT article highlighted that Comac is building the new narrow-body C919, which can strengthen Chinese airlines’ advantages in regional travel. Regional travel looks to be bouncing back to pre-Covid-19 levels in a V-shaped manner, which suggests that design advantages for planes created for regional, short-to-medium distance travel may be key to an airlines’ competitive advantage. Chinese airlines may have competitive airline advantages over their Asian peers, and their dominance could lead to them consolidating smaller Asian players. In the crisis, Comac and its China-focused supply chain seem to be closing the gap to aerospace companies Boeing and Airbus, as “Chinese companies, with strong backing from the state, have already acquired a number of small to medium-sized aerospace suppliers in Europe and the U.S.” China may, therefore, lead the process of consolidation through M&A in the Asian market, supported by its advancing aerospace suppliers.
While consolidation efforts in Europe and North America will most likely be minimal post-Covid-19, the bankruptcy of Latin America’s two largest airlines Avianca and Latam Airlines has opened up a lot of market share for new players in the region. The Latin American market is heavily fragmented, with an array of national airlines competing for market share. Delta Air previously owned 20% of LATAM Airlines Group, and the airline group seemed well-positioned to take Avianca’s market share in Colombia due to its scale and Delta’s backing post-Covid-19. However, Latam’s filing for bankruptcy on the 25th of May closed this pathway. According to CAPA, in 2019, Avianca had 56% of Colombia’s domestic passenger share, followed by LATAM Airlines Colombia with 18%. LATAM Airlines Group and other big, resilient Latin American carriers like Volaris and Gol seemed best positioned to come out of Covid-19 with stronger balance sheets than the majority of competing regional and national airlines. This could have fueled a future round of consolidation within the Latin American aviation market. However, more likely the case, the hesitance and/or inability of South American governments to bailout even their biggest airlines may fuel consolidation from stronger, government-supported North American rivals of any Latin American carriers that survive the pandemic, rather than solely consolidation within regional players themselves.
Consolidation, however, will be slowed down by government intervention. Ronojay Gupta argued that “the biggest obstacle to consolidation is government objection to foreign ownership.” Deals such as Air Canada’s acquisition of Transat are still being scrutinised by antitrust regulators, the Competition Bureau in Air Canada’s case, for fears of unfair market monopolization. An objection for the acquisition of Virgin Australia comes from regional governments in Australia, which question the influence that an Indian parent company should have on one of its influential national carriers. Moreover, with the influence that the Chinese state has on its airlines, governments may intervene with Chinese airlines attempting to acquire their national carriers out of fear for the influence that the Chinese state would have in its country, which could be manipulated and abused in times of geopolitical tension.