Are airlines nearing capacity?

While cheap airfares are a blessing for travellers, the root cause of such deals could put investors on edge – and rightly so. The European short-haul market is a saturated space and overcapacity has forced several airlines to cut prices to stay competitive against peers. Mr O’Leary said short-haul overcapacity had plagued the European market this winter, although he thinks this lower fare environment will "shake out more lossmaking competitors, with WOW, Flybe (FLYB), and reportedly Germania, for example, all currently for sale". 

But even without the rampant capacity issues in the European airline industry, the sector has been a difficult place to be, both for operators and investors. Air traffic control strikes – mainly in France – resulted in months of delays for all the major operators in 2018, while related compensation added significantly to costs. Ryanair was also affected by its own pilot strikes, while oil prices have been on the rise too, further adding to the cost base.

All aboard

Managing capacity is a delicate business. On the one hand, adding more planes and seats can provide a timely boost to revenues – but only if additional tickets are sold. Adding capacity doesn't do a company any good if those seats aren't filled – and certainly not if fuel is wasted by flying half-empty planes.

Flybe has learned this the hard way. The airline has struggled to undo costly mistakes of the past – namely expanding too quickly by overordering new planes, while operating lossmaking routes. While some progress had been made in cutting down routes and flying fuller planes, its load factor continued to trail that of rivals. Unfavourable currency movements and rising fuel prices exacerbated these issues, prompting the airline to put itself up for sale in November 2018.

But in light of recent developments, Flybe might not be up for sale much longer. The airline’s management has recommended that shareholders accept an offer from Connect Airways – a newly formed joint venture between Stobart Group (STOB), Virgin Atlantic and US-based Cyprus Capital Partners via DLP Holdings. But the 1p a share or £2.8m valuation prompted some shareholders to question whether this truly reflected the company's worth. If it is determined to be fair, it’s a demonstration of how poorly managed expansion can damage shareholder value. 

The deal aims to combine Virgin Atlantic’s branding with Stobart’s aviation business, which will then become part of Connect Airways. The idea is that short-haul Connect Airways flights could operate in harmony with Virgin’s longer routes: when a long-haul flight arrives at a destination in the UK or Ireland, Connect can fly the passengers to their final location. The clue, it seems, is in the name.

An interesting idea in theory, but it’s difficult to gauge what would set Connect apart from other existing short-haul operators. It’s also worth noting that Virgin’s previous UK short-haul operator Little Red – whose purpose was to help long-haul Virgin customers connect with other parts of the UK – was wound down after only a couple of years of operation.

In short, Connect will have to contend with more established operators. Ryanair and easyJet (EZJ) have traditionally led the way, particularly in terms of load factor. Even smaller operator Wizz Air (WIZZ) has steadily improved its load factor despite pushing ahead with expansion plans. Over the rolling 12 months to December 2018, Wizz increased capacity by 18.4 per cent to more than 36.6m seats, with a 19.6 per cent increase in passengers pushing the load factor up 1 percentage point to 92.4 per cent. 

Despite being in a rapid expansion phase, the group has clearly been managing added capacity well to date. Case in point: rising oil prices prompted Wizz to scale back capacity plans from an 18 per cent increase to just 14 per cent during the second half of this financial year – a prudent step to keep expansion plans rolling without pushing the dial too far. 

Of course, even with the best intentions, managing capacity can sometimes fall out of an airline’s control. In a recent first-quarter update, easyJet reported an 18.2 per cent increase in capacity to 24.1m seats, but load factor fell 2 percentage points to 89.7 per cent, in part due to the "dilutive impact" from the Berlin Tegel airport slots bought after Air Berlin’s collapse. This also weighed on revenue per available seat – a figure expected to decline more in the wake of IFRS reporting changes and a later Easter.

Brexit beware

Meanwhile, Brexit has been the looming spectre over the travel industry. Both Mr O’Leary and International Consolidated Airlines (IAG) chief Willie Walsh are clearly concerned that the UK will leave the European Union (EU) without sufficient legislation to allow UK airlines to fly to and from European destinations. The European Commission (EC) addressed these concerns in November with the publication of a contingency document, which proposed measures to ensure that UK operators can continue to fly to and from EU destinations – but only if the UK offers reciprocal arrangements. The document also said the UK would be added to the visa-free travel list post-Brexit, implying short-stay travel would avoid disruption. 

While this sounds promising, possible restrictions on new routes and frequencies could make growing operations difficult. Routes currently offered by UK airlines to the EU could be frozen from 29 March 2019 for 12 months if a Brexit deal is not agreed, according to the Airports Council International’s (ACI) analysis of the statement. The Commission’s contingency proposals include a stipulation where UK airlines wouldn't be allowed to add new routes or increase frequencies on current routes during that 12-month post-Brexit period.

The ACI’s director general, Olivier Jankovec, estimated this would result in the loss of around 140,000 new flights and nearly 20m passengers. On the other hand, the currently tabled Brexit deal would allow such operations to carry on business-as-usual.