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Will airline capacity be cut in wake of Brexit?

Many airlines have been on the front foot where expansion is concerned but the engines of growth may have to be dialled down
July 15, 2016

Airlines have literally been hurtling down the runway when it comes to plans for expanding the number of planes in their respective fleets. Despite a wave of terrorism-related events, chief executives have continued to view it as sensible to increase what the industry calls 'capacity' based on the belief that UK tourism is a robust beast.

But will Britain's vote to leave the European Union (EU) weigh heavily on demand for an extended period and should airlines be moderating capacity in the coming months?

Answering the first question is difficult, but there seems to be a logical conclusion with regards to the second. It may well be prudent to extend the timeframe during which additional aircraft were scheduled to be added - especially as unwarranted capacity growth is considered by some to be the industry's 'original sin' and share prices are baking in weak demand post-referendum.

One airline that curbed capacity growth just prior to the vote was the domestically-skewed Flybe (FLYB). On the day of its results the shares oscillated wildly as the market digested a decision taken by management to cool near-term expansion. It had already announced plans to lower seat capacity growth from 17 per cent to 15 per cent in FY2017 and from 10 per cent to 6 per cent in FY2018, but went further in negotiating a 12-month postponement for the delivery of four Embraer jet aircraft it had on order. These will now arrive in FY2019.

Low-cost carrier easyJet (EZJ) has capacity growth of 6.5 per cent pencilled in this year, although British Airways owner International Consolidated Airlines (IAG) recently announced it had "moderated" its short-term capacity growth plans. The reasons incited in April included the fallout from the Brussels terrorist attacks and softer demand from premium customers, but it may have been a prescient move given the outcome of the referendum. IAG grew capacity, excluding Aer Lingus, by 5 per cent in FY2016. Elsewhere, Irish carrier Ryanair (RYA) is thought to be expanding capacity by 9 per cent this financial year.

Anand Date, equity research analyst at Deutsche Bank, has highlighted three things that could curtail capacity growth. There's the demand side first, then the issue that most capital expenditure in the airline industry is in US dollars, which makes it more expensive on a translational basis and specific cases whereby companies have tied capital expenditure to something like operating cash flow. The general environment had encouraged reasonably high capacity growth but he thinks it is safe to say "the numbers will come back". He added that since Brexit, weaker demand levels are "clearly worrying", and while the exact reasons for poor demand remain unclear, all else being equal he expects capacity "to be cut if demand deteriorates further".

Finally, Mr Date said capacity discipline should be a key factor when assessing airline stocks. In the past, the industry "added too much capacity when times were good" but if a company says the demand picture had become more uncertain and the cost of capacity growth had gone up, and so orders will be deferred by a couple of years, investors should see that as "positive because it's sensible". In conclusion, it's Mr Date's opinion that capacity discipline is positive and rational.

Rob Byde, a transport analyst at Cantor Fitzgerald, said he had seen some "quite aggressive growth plans" pre-referendum. In the European short-haul market, he expected roughly 6 per cent growth in seats running to the summer, although he now expects "a bit of a pullback on that". That will be partly due to an anticipated downturn post-vote but also factors such as air control strikes in France.

It's Mr Byde's belief that many capacity plans often struggle to "survive exposure to the real world" and so changes by airlines are not necessarily uncommon. However, such decisions could be more warranted in light of the referendum result. "Until now we have been seeing a reasonable recovery in leisure travel across Europe," he said. "European short-haul has been experiencing a Goldilocks scenario - demand was starting to recover, prices were holding up, fuel costs were low and crew and airport charges were under control. I would not say the outlook is sharply negative but I think there will be a bit more caution exercised."

Traditionally, low-cost carriers usually win the day when the demand is soft. But given the pound has fallen so much against the US dollar in recent weeks, it's feasible that inbound tourism from the US could get a boost and thus support operators of transatlantic routes.

 

IC VIEW

The major airline stocks are still down between a fifth and a third in the past month, with those falls highly correlated with the EU vote. But we support the view that outbound tourism is robust and that while the short term will be challenging, the desire of Brits to go abroad will not be completely snuffed out. Those operators with solid business travel traffic could also hold up well in the near term as businesses may need to travel in order to assess how they might operate if the UK fails to secure access to the single market. The pound's fall also has the potential to encourage overseas tourists to the UK.

 

Favourites

We're most bullish on budget carrier easyJet given management's ability to manage costs, its growing appeal within the business community, and the fact it's been proactive post-Brexit. The group has a Swiss operating licence already but is reported to have jump-started a contingency plan which includes establishing an EU-domiciled legal entity to help it navigate any difficult conditions, such as trade barriers, which could emerge amid Britain's extraction from the bloc. We also like British Airways owner IAG, particularly as it recently declared its first final dividend since 2011. Having both stocks in a portfolio balances exposure to legacy and short-haul market trends.

 

Outsiders

While we're not hugely bearish on Ryanair, its share buyback scheme is coming to an end and it may have been this that supported the shares recently. We're also relatively neutral on domestic-skewed Flybe, as the business has undergone a lot of change in recent years.