Airlines switch on the warning lights

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Out of fuel

Clearly, the industry's rapid ascent had to end eventually. Between September last year and early August 2013, shares in Ryanair (RYA), easyJet (EZJ) and International Consolidated Airlines (IAG) had risen on average 127 per cent. Both low-cost carriers happily mopped up customers left behind by the numerous airlines that went bust during the recession, and an outbreak of capacity discipline elsewhere certainly justified a re-rating. Even British Airways-owner IAG defeated Spanish unions and is gradually repairing Iberia.

But all of a sudden, the future looks a little less rosy. The price of oil has topped $100 (£64) a barrel for the past two months and recently made a five-year high. Some analysts believe any direct western intervention in Syria could push the price through $120. That could be disastrous for the airline industry, particularly if the west gets bogged down in a lengthy conflict.

Refined from crude, the cost of jet fuel is pegged to oil prices and, after a period of relative stability, has risen back above $1,000 per metric tonne. That's significant because fuel accounts for about a third of an airline's operating costs, and the impact on margins can take time to offset. IAG spent over €6bn (£5bn) on it last year, and 45 per cent of Ryanair's budget will go on fuel in 2014, according to broker Investec Securities.

Capacity conundrum

Of course, volatility here is nothing new and carriers have already put in place plans to offset cost inflation. Hundreds of jets with more fuel-efficient engines are on order and airlines are flogging more lucrative extras - so-called ancillary revenue, such as allocated seating and insurance. Legacy airlines, meanwhile, are busy trimming bloated wage bills. That said, unless these extra planes are packed, yields will suffer.

While the era of extreme under-supply may be over, anticipated capacity growth, in the near term at least, appears relatively modest. Stephen Furlong, an analyst at Irish broker Davy, expects relatively low supply over the next year or two and a period of more managed growth thereafter. Air traffic experts at Eurocontrol believe supply will definitely pick up in 2014. They pencil in 2.8 per cent capacity growth next year, and an annual average of 2.3 per cent out to 2019.

Others, such as UBS, have recently raised concerns about large short-haul capacity additions in Germany and the UK, key markets for both Ryanair and easyJet. IAG faces possible headwinds, too. Global capacity growth will easily outstrip European performance, driven by rapid progress in emerging markets which might limit yield growth on long-haul routes.

Warning lights - on

Capacity issues will play out further down the road. Of more immediate concern, however, is Ryanair. Its boss Michael O'Leary, already spitting feathers after the UK Competition Commission essentially killed any hope he had of buying Aer Lingus (AERL), issued a shock profit warning. The usually ebullient Irishman guided down expectations for full-year net profit to the lower end of the forecast range of between €570m and €600m. If business doesn't improve, it could be worse.

Higher fuel costs, the timing of Easter and striking French air traffic controllers had already hit first-quarter profit. A summer heat wave and strong pound haven't helped since, although there will still be a small increase in first-half profit. Yet, it is the emerging trend that's disturbing here.

There's been a "perceptible dip in forward fares and yields into September, October and November", warns Mr O'Leary, blaming austerity, currencies, price competition and capacity increases in the UK, Scandinavia, Spain and Ireland. In response, Ryanair is selectively cutting winter capacity which will trim 500,000 off the annual traffic target. It is slashing fares in these markets, too. And that is, perhaps, the nub of it.

Canary in the mine?

"O'Leary is preparing the market for a price war in Europe, so is reining in yield expectations," reckons Rob Byde, transport analyst at Cantor Fitzgerald. "He's clearly concerned about analysts overcooking their numbers." If right, that's sensible, and perhaps justifies taking some money off the table. After all, Ryanair's share price has surged 83 per cent over the past year, and a correction at some point was inevitable.

But the City senses this could be just a pause. "Don't overplay the profit warning," urges Mr Furlong. "It's a readjustment of expectations, but we're not bearish. There isn't suddenly a wall of supply about to hit the market." Ryanair has, however, called things early in the past, which raises concerns that its problems are not isolated, but industry-wide.

Clearly, there are one-off factors such as austerity which impact all, but that is nothing new. And sterling strength hits Ryanair harder given it has to convert a lot of revenue back into euros, its reported currency. True, Aer Lingus also blamed good weather for a drop in short-haul traffic last month, but monthly statistics from easyJet reveal it basked in the glorious sunshine - both passenger numbers and load factor improved. Expect confirmation in next month's trading update, with more useful data on trends in November's full-year results.

IC VIEW:

Conditions within the European airline sector are difficult to judge. Much depends on whether carriers, both no-frills and network, maintain discipline around supply. But even analysts admit getting a clean number on capacity in the region is difficult given the aggressive restructuring of short-haul operations under way at legacy carriers. Admittedly, the magnitude of the sector re-rating took us by surprise, and we still have trouble reconciling current multiples with near-term headwinds of fuel and capacity. A pause for breath seems highly likely, at least until we have greater clarity on earnings over the next month or two.