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How to Predict an Airline Financial Crisis

14 April 2016

Prepared for:

Aircraft Finance and Lease Russia & CIS Conference

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1. WHO WE ARE

2. THEORY

3. PRACTICE

20 min presentation 5 min Q&A

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One of the World’s Largest, Most Experienced Aviation Firms

53 years in air transport 100 aviation staff Covering the whole industry More than 150 airlines clients

WHO WE ARE

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ICF has End-to-end Aviation Industry Capability in 4 Specialized Practices

WHO WE ARE

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Andras Bognar - the Presenter

WHO WE ARE

Economist

Airline, Airport and MRO specialist

13 years in the industry

Speaks Russian

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1. WHO WE ARE

2. THEORY

3. PRACTICE

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Without a Turnaround Financiers are Likely to Lose Everything

THEORY

Airlines tend to be highly leveraged

The business is seasonal

–Little cash off season

Airline cash-flow is quickly disrupted at the hint of bankruptcy

Employees are paid before creditors –Airlines have many employees

Airline assets lose value quickly

Without Turnaround

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With a Turnaround Chances of Creditors Being Paid are Better

THEORY

Creditors may recover 40-70% of their money

Creditors may recover ~3% of their money

With Turnaround

Without Turnaround

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THEORY

Two Case Scenarios of Bankruptcies

American Airlines: –After bankruptcy announcement:

–Unsecured bonds dropped from 0.4 USD to 0.16 USD / 1 USD

–Secured bonds traded at 0.75 USD / 1 USD

– Eventually, all unsecured debt was converted to shares and shares recovered

–Airport bonds also suffered

–Airlines are likely to re-negotiate their rents during a bankruptcy

Malev: – Unsecured creditors expect less

than 2%

• VEB among them

With Turnaround

Without Turnaround

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Problems Tend to Build-up Over Time and can be of any Length

THEORY

denial

hidden

crisis

disintegration

collapse

Examples

• 7 years for Kingfisher

• 12 years for Malev

• 2-3 years for Transaero

Prediction is needed

to avoid the worst

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External factors Internal factors

Good Financial Results are Triggered by Many Factors

THEORY

Competitive advantage

Economic factors

Organi-sational factors

Legal and political factors

Absolute cost advantage

Relative cost advantage

Product differentiation

E.g. lower

fuel costs

E.g. bigger

aircraft

E.g. better

FFP

E.g. leaner

organisation

E.g. international

route rights

Macro economic factors

Competition

E.g. exchange

rate

E.g. capacity

addition

Good financial results

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So in Theory, Monitoring the Factors can Predict a Crisis

THEORY

For example “Altman Z-score” formula predicts the likelihood of bankruptcy:

–Where

–x1, x2, x3, etc. are different financial ratios of the company

–a, b, c, etc. are their weightings

–And if Z is below a certain value, then bankruptcy is threatening

Z = a*x1 + b*x2 + c*x3 + etc.

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A Similar Logic is Applied to Credit Rating

THEORY

Source: www.theairlineanalyst.com

Variables

Weighting

Combined

Score

Interpretation

Scores

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1. WHO WE ARE

2. THEORY

3. PRACTICE

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But Quantitative Prediction Doesn’t Always Work…

PRACTICE

Not all factors are possible to measure

– E.g. passenger loyalty

Not all factors are being disclosed by the airlines

– E.g. details of business plans

External factors are too many

– E.g. competitors increasing capacity, political events, etc.

Financial reports show highly aggregated information

– Hard to see behind them

Financial reports summarise the past

– But we want to see events in advance, not ex-post

Management tends to show a picture more favourable for themselves

– E.g. favourable leasing rates but unfavourable return conditions

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Formulas Need to be Supported by Judgment

PRACTICE

Sign Interpretation

1 Airline not making money in summer (high season)

• It will certainly lose money during the whole year

2 Airline expands into long-haul flights

• Long-haul represents a much higher financial risk than short-haul

• E.g. Norwegian suffered financially when long-haul expansion did not go according to plans at first

3 CEOs changing less than every 2 years

• Frequent changes of CEOs mean they can’t figure out the solutions to the problems

• New CEOs tend to change lower level management as well

• Industry outsider CEOs need min. 2 years to start to “feel the business”

4 High unit costs • High unit costs demand high unit revenues • But the airline business is cyclical and yields tend to fall

eventually • E.g. SAS

Suspicious Signs

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Suspicious Signs (Continued)

PRACTICE

Sign Interpretation

5 Too many aircraft types in the fleet

• Complexity drives higher costs • E.g. TAROM has 23 aircraft and 6 sub-fleets

6 Fleet renewal / expansion at all costs

• Buying aircraft during good years of the cycle means aircraft will be expensive

• Young aircraft mean less flexibility to decrease capacity when needed

• E.g. South East Asian airlines recently • E.g. Kingfisher ordering A380s

7 Capacity indiscipline • Adding capacity at the top of the cycle (or during the downturn) means overcapacity during the downturn

8 Building a transfer hub at all costs

• Usually happens because local market is small • But transfer traffic is very price sensitive

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Suspicious Signs (Continued)

PRACTICE

Sign Interpretation

9 “Everything” done in house

• E.g. in-house MRO, Catering, Ground Handling, Tour Agency, etc.

• Usually leads to many sub-scale businesses with uncompetitive cost levels.

• Distracts management attention from core business • Ties down capital

10 Turnaround “half done”

• E.g. financially restructured, but not operationally • E.g. salaries decreased, but nothing more • Temporary solutions will bring only temporary results

11 Acquisitions • Especially harmful is the acquisition of “losers” • E.g. Swissair’s “Hunter Strategy” buying Sabena, South African

Airways, etc. • E.g. Kingfisher buying Air Deccan

12 Organisational inertia

• Inability to take decisions in a highly competitive environment • Typical of government-owned airlines

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Suspicious Signs (Continued)

PRACTICE

Sign Interpretation

13 Schedule unreliability

• Schedule disruptions in many cases are symptoms of operational disintegration of the airline

• E.g. strikes over late payments of salaries • E.g. ground handlers demanding upfront payment

14 Glamourous headquarters

• In a very competitive transportation business office luxury is not sustainable

• E.g. Pan Am headquarters in the centre of Manhattan • E.g. Air India headquarters in the most expensive part of

Mumbai

15 Consuming the reserves

• This is suspicious when it happens contrary to previous practices

• E.g. selling slots (not exchanging them) • E.g. selling and leasing back aircraft

16 CEO / President denying the crisis

• If the airline has no cash reserves left the CEO / President needs to prevent a panic

• If the airline has cash the CEO / President can admit the problems and say they are working on a solution

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Conclusions

PRACTICE

1. The downward slope towards collapse can be of any length

2. A turnaround can save much of the unsecured debt

3. Predicting bankruptcies need a combination of quantitative and qualitative tools, and ideally supported with external viewpoints not encumbered by emotion or politics…

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Thank you! For questions regarding this presentation, please contact:

Andras Bognar Senior Manager – Airlines

+44-788-44-90-781 abognar@icfi.com