High-flying investments

It's easy to understand why sentiment towards airlines is often so poor. Planes cost millions, fuel is extortionate, competition is fierce and the industry is vulnerable to macro events, too. And there's little happening now to discourage the notion that airlines are money pits. High fuel prices, hefty airport taxes and low growth are taking their toll and carriers are stuck in a fight for survival. More will inevitably go bust and others face being shackled by painful restructuring efforts.

Growth in passenger demand fell to just 3.4 per cent in July from 6.3 per cent the previous month, according to International Air Transport Association (IATA) and the industry body's director general and chief executive Tony Tyler warns airlines to expect a "tough" second half.

But it's not all bad news. Demand for international flights to more prosperous far-flung destinations meant European carriers still grew a respectable 4.8 per cent. Numbers from UK budget carriers have been impressive, too. Indeed, easyJet flew 6 per cent more passengers last month than at the same time last year, and Ryanair had a record month following a 9 per cent increase in August. Even BA and Iberia owner International Consolidated Airlines (IAG) managed 5 per cent.

Given that more passengers are flying, you may ask why sentiment towards the sector is not more positive? Well, costs for one thing. A fall in the price of jet fuel during the spring was short-lived and carriers are paying nearly $1,100 per metric tonne again, about 25 per cent more than they were paying in June. IATA had already predicted the global airline industry's fuel bill would increase by $31bn (£19.4bn) this year to an eye-watering $207bn. That's nearly five times as much as in 2003 and means around one-third of an airline's operating expenses are fuel compared with 14 per cent nine years ago. And with passenger growth unable to compensate, industry net profits are tipped to plunge from $7.9bn to just $3bn in 2012.

"The eurozone crisis is standing in the way of improved profitability and we continue to face the prospect of a net profit margin of just 0.5 per cent," said Mr Tyler. It's worth bearing in mind that this forecast was made before the latest spike in fuel. The outlook is grim.

Efficiency is key

But as share price performances tell, nimble low-cost carriers, such as easyJet and Ryanair, have been far more successful than network airlines, such as Air France-KLM, Lufthansa and IAG's Iberia. That's largely down to these companies restructuring early and getting a grip on capacity by grounding planes in quiet winter months and diverting others to more profitable routes. Margins are improving and they don't have the structural issues that hamper rivals.

Indeed, easyJet is so efficient it has been able to increase forecasts twice this year. Costs have risen less than feared and a wet start to the summer meant business was brisk during the third quarter. Still, life is hard - the weak euro is unhelpful, easyJet will spend over £1bn on fuel this year, and it's unclear whether it has the leg-room to increase fares much more.

Ryanair certainly doubts whether higher fares can cover extra costs this year. It understands why consolidation is important and inevitable too. Fewer competing carriers mean less seats, higher fares and bigger profits for the survivors - owner Michael O'Leary reckons only Air France, British Airways (BA), easyJet, Lufthansa and Ryanair will be left standing.

Mr O'Leary was quick to exploit the demise of Hungary's Malév and Spanair, and it's the same thinking that's behind his latest attempt to buy Irish rival Aer Lingus, which Ryanair already owns a 30 per stake stake in. The deal is currently with the European Commission and Ryanair reckons a dramatic package of concessions could get it past the regulator. It may be third time lucky for the loudmouth Irishman. If not, Gulf carrier Etihad, keen to drive traffic through its Abu Dhabi hub, looks a likely buyer.

Cashing in on consolidation

Now, more than ever, it's critical that airlines establish alliances and code sharing agreements over flight schedules and other services. Indeed, Etihad has already struck 36 code-shares and taken a 29 per cent stake in Air Berlin, providing the German carrier with much-needed financing in the process. Other struggling carriers are looking towards the Middle East, with Quantus ditching a 17-year tie-up with IAG and agreeing a new 10-year alliance with Emirates, the Gulf's largest operator, which provides much better connections to the rest of Europe And there's far more logic to having a hub in the middle, rather than at the end of a long-haul route.

The huge restrictions on ownership of foreign airlines have made alliances more popular than mergers and acquisitions in the sector. Indeed, BA's tie-up with American Airlines on transatlantic routes is about as close to a merger as you can get without running into regulatory problems. Given the importance of US connections to BA, it's easy to see why IAG, its owner, is also mulling taking a stake in the bankrupt US operator, although it may not have to if a merger goes ahead between American and US Airways which would be supportive of the BA/American relationship.

That's the best possible outcome for IAG, which recently bought BMI for its Heathrow slots. Its balance sheet strength looks limited, especially as the carrier will be cash flow negative for the next few years. And there's a pressing need for it to address issues at Iberia. "Up to now it's been a disaster," said one analyst, slamming the acquisition of the Spanish airline as "structurally flawed" and citing the threat of low-cost carriers, an imploding Spanish economy and possible rivalry from Latin America.

It's the same for European peers. True, reining in capacity provides some downside protection but, like Iberia, that alone is not enough for Lufthansa, Air France-KLM. "While clearly there is potential for operating leverage, fuel is a headwind and the restructuring programmes are still in their early stages with labour posing obstacles to reforms," reckons Stephen Furlong, an analyst at Irish broker Davy.

IC VIEW

We've suspected for some time that increasingly price conscious consumers would favour low-cost carriers over the network airlines, and they have. That said, we didn't expect easyJet's share price to leap 80 per cent in a year. In the short term, there looks to be little opportunity for the pre-occupied legacy carriers. With easyJet trading on multiples in line with its three-year average, it's hard to see much upside there, either. Yes, airlines are highly geared to economic recovery, and rapid growth will come, just not yet.