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A race to the bottom: overcapacity in Asian airlines

A race to the bottom: overcapacity in Asian airlines

[Note that the draft of this blog was written last week, before Qantas came out and downgraded its profit forecast so this isn’t a blog in response to that! Rather, the Qantas downgrade can be seen as providing more supporting evidence, particularly as they cited the International segment as the weakest. Ed]

Tuesday was the “race that stops a nation”. One of the oddities of Melbourne Cup day is that people proceed to plough a lot of money into a race in which there are a lot contenders about which most people know very little, with most people ending up losing money. Which can represent only one sector within investing: airlines!

Want a small fortune? Start with a large one and buy an airline

It’s generally well known that airlines as a sector have not been great stocks to own for the long run. Rather they have been stocks to “rent from time to time but not own”. Or as the great man put it:

“[...] if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.” Warren Buffett

Globally, airlines have done well over the past two to three years as lower oil prices and, particularly in the USA, a reduction in the number of players, led to better profits and higher share prices as they outperformed global markets by nearly 20%.

Figure 1 - Bloomberg Global Airlines Index versus MSCI World Index (since October 2014)

Relative and normalised Source: Bloomberg, Team analysis

Relative and normalised
Source: Bloomberg, Team analysis

The downside that is emerging is that, flush with cashflow, airlines have ordered a large book of new aircrafts, with Asian carriers in particular ordering a lot of new aircrafts.

Figure 2 - Ratio of Aircraft Orders to Operating fleet

Source: Airbus

Source: Airbus

Introducing Hubs and Spokes (planes, not bikes)

A brief background to understanding hub and spoke models. There are two basic models to run a fleet of aircraft. The first is called “point to point” and the title is fairly self-explanatory. Most passengers would prefer this option.

Often there isn’t enough demand from a point to another point, so airlines introduce “hubs” to concentrate traffic and increase frequency. This is more common in the USA, as they have such a large number of cities, that the permutation of direct routes is nearly limitless.

Outside the USA, Emirates is now one of the world’s largest hub providers and has, over the last few years, taken away firstly the Qantas traffic and more recently, supplanted airlines such as Singapore Airlines who run their hub out of Singapore.

But now there is a bigger threat in Asia and it is Chinese carriers either dumping capacity and/or taking hubs out of the equation for business travellers that want to go to the USA/Europe from China. The biggest losers from this are Korea, Japan. Taiwan and most importantly – Hong Kong (Figure 3 below).

Figure 3 – Asian airports’ share of transit traffic

Source: UBS evidence Lab

Source: UBS evidence Lab

The expansion of Chinese carriers is simply huge. The Chart below (Figure 4) outlines routes on which a Chinese carrier has expanded versus Cathay Pacific routes, but to use an example closer to home, in Australia, this week China Eastern announced that they would fly Sydney-Kunming (which we’d wager most Australians had never heard of) direct from next month, making it the 13th route from Sydney to China. Travellers on these routes were previously hubbed through one of the Asian hubs above to get to Sydney.

Figure 4 – Planned new routes by the Chinese airlines versus Cathay Pacific’s existing routes

Source: Civil Aviation Authority of China, UBS

Why small losses matter so much to Hub models

Hub business models rely on passenger density (i.e. lots of travellers) to sell frequency to high yielding business travellers. Take away the “grind” of economy class and you risk frequency. Lose frequency and you lose business travellers. Lose business travellers and your profit evaporates (business travellers represent nearly all the profit for airlines).

Since people would prefer to fly direct, the only way you can keep them is to offer them larger discounts for the inconvenience of breaking their flight up.

So this is why we see load factors (the percentage of the plane full) remaining high for airlines like Cathay Pacific, yet them announcing profit warnings continuously, such as the other week.

Given the Chinese carriers order books, it is hard to see the above situation improving any time soon. Further, given Chinese airlines seem to focus more on market share and regional government diktats, losing money is less of a concern than for listed companies such as Qantas or Cathay Pacific.

How to make money out of this?

We hold a collection of short positions in these airlines. Having been in this now for a few months, we think the market (as represented by earnings forecasts) has now lost its “oil price momentum” (Figure 5 below).

In this case we hold a view on a regional sector, so it makes little sense to short one stock in particular – this is a war in which no-one wins.

Figure 5 – Normalised 1 year forward EPS for Bloomberg Asian Pacific Airlines Index

Source: Bloomberg, Team Analysis

Source: Bloomberg, Team Analysis