Airline Financial Strategies, Application Essay Example

Introduction

In the current recession and after long years of struggle to create profits, airlines need funding to re-organize their operations. Many authors have confirmed that the future of the aviation industry is bleak, due to the recession, insecurity of the fuel prices, the rise of operational costs and different fees imposed on the airlines based on their environmental impact. However, it is still possible to find airline companies that are able to set up a financial and operational strategy that is going to be proven to create better results and success. The responsibility is the financial and investment banking industry’s to carefully evaluate the specific airline’s risks, assets and profitability before providing finance for their plans. Reviewing the capital structures of the airline applying for funding would help banks reduce risks and negotiate deals according to the possible outcomes.

According to a recent study published by Boyd Group (2013), the airline capacity is not going to grow in 2013. Air passenger traffic is likely to be declining. The long term analysis is also predicting lower traffic and the replacement of the 50-seat regional jets. Based on those assumptions, the below analysis of funding and financial planning in US Airline industry is needed to determine whether it is possible to secure returns for investments.

Evaluation of Finance Strategies

There are different financing strategies airlines use today, and Boeing (2013) has recently published a report on aircraft financing environment, which is providing a full picture of the market and equity situation of different companies. The evaluation table is attached below, taken from the report would certainly provide a clear picture of the situation and an analysis of aircraft financing.

According to the table, the most caution should be taken regarding financing methods provided by export credit agencies and airframe and engine manufacturers. Commercial banks should also be hard to obtain, while leasing is a clear option. Below the study will focus on the main funding options for airline companies in the next few years.

Gibson and Morrell (2010, p. 49.) confirm that in the US all major airlines are listed on public share markets. None of the airlines are government owned in the United States.

Raising Additional Equity

One of the options for airlines is raising additional equity for finances. (Morrell, 2011) It is a model that helps the company secure future borrowing and balance the existing debt and equity. Using share issues is a low risk financing method, used by European airlines, like Lufthansa.

Airline Privatization

Gibson and Morrell (2010) examines airways privatization. Bringing up the examples of British Airways, Lufthansa and Air France, as the trigger for better financial performance. Obtaining the shares or bonds at a lower cost and maintaining efficiency of operation can result in growth and equity.

Commercial Loans

Aircraft financing through commercial loans can be obtained through manufacturers and secured loan companies. The two main financing options for obtaining the aircraft directly from the manufacturers are a commercial loan secured using a mortgage and a finance lease. The advance rate provided ranges between 70 and 90 percent of the value. The interest rates can be fixed or floating, with floating rates carrying more risk for the airline. The benefit of this financing model include the fact that the company gains equity in the asset over time, and this can be used as a source of cash. (security). There are also some tax benefits associated with financing and purchase. The disadvantages include residual value risk, restrictions set by the financing companies and reduced fleet flexibility.
Market Capitalization

Financing based on market capitalization carries risk and uncertainty. Looking at the example of Ryanair, it is evident that while the share price of the company does reflect market position and the company has a market capitalization of 8.24 billion Euros, the figures do not reflect debt, the economic risks of the industry climate, and only consider future perceived prospects. As an example, the 9/11 shock has affected the share price and market capitalization of many American airlines. Therefore, uncertainty is the major risk of raising funds through market capitalization.
Aircraft Leasing

Today, over 30 percent of the world’s aircraft fleet are leased. (Mann) There are different benefits for financing companies and airlines associated with this model. It is flexible, easy to adjust to the company’s needs and strategies, reduces the risk for both the lessor and airline and can supports innovation. When a company’s operations management goal is to increase efficiency or provide shorter journeys, become greener, newer models can be obtained fast and with a low risk using this model. Also, it is important to consider that leasing is a financial agreement that can help the company manipulate balance sheets and get a better debt-asset ratio. However, the conditions of return can impose risks on both the lessor and the company. The air crafts need to be returned in a condition specified by the agreement, non-compliance can result in penalties. Early return penalties are also often applied. Some leasing companies also have operation restrictions to protect their interest. From the taxation perspective, leasing can impose higher tax burden on the company initially. There are different leasing agreements used by companies: Wet lease, dry lease, damp lease and operating lease. The most popular type of leasing among aviation companies is operating lease, as they are able to share risks with the finance provider.

Fuel Hedging and Foreign Currency.

Fuel Hedging is one of the methods used by airlines to reduce operational costs and create stability in fuel costs, increase the airline’s competitiveness and create lower volatility. As a form of investment, this method can reduce the profit swings of the company, influenced by fuel costs. Morrell and Swan (2006, p. 4.) confirm that the expected value of the fuel hedge is zero. Therefore, the authors confirm that investors should not value companies’ fuel hedges and consider them as assets. The study also concludes that a ten percent rise of fuel costs can account for a 1.7 percent operating margin reduction in the case of American Airlines.

Delta Airlines Financial Strategies

Looking at the volatility of the aviation industry, the insecurity of the markets, according to Morrell (2011), it is evident that the company needs flexibility provided by financing options. Therefore, market capitalization due to the high insecurity of bond and share prices would not be a good option. Financial agreements purchase does not allow the airline to quickly respond to the changes of the market and demand, change the operations strategy and reduce costs, either. Therefore, the most suitable finance strategy in the case of Delta Airlines should be operating lease. While it does not provide the company with the benefit of gaining equity, it is a low risk agreement that is able to help the company gain a competitive advantage on the market, gain market share and reduce financial risks. Below, the different risks, benefits and financial data will be analyzed based on Delta Airlines’ reports to provide prediction for the benefits of the financial agreement, namely operating lease.

Operational Risk

There are five different high risk areas associated with aviation, namely:

1. Demand volatility

The demand for passenger travel and air carrier services is based on the economy and external factors, including regulations, taxes, costs, recession. Therefore, there is no security provided by constant demand for services.

2. Input cost volatility

Fuel costs can change any time, based on the markets, therefore, without fuel hedging, the operations costs can change in the aviation industry significantly. Taxes imposed on fuel might also vary according to government regulations, airport costs would also increase as a result of tightened state supervision.

3. Sales price volatility

In the highly competitive market of the airline industry, with many companies struggling with bankruptcy (Delta filing Charter 11 bankruptcy in 2007) and Pan Am in liquidation, it is hard to gain consumer trust and compete with companies trying to use price promotions for gaining more profit.

4. Ability to match price to input costs

As input costs are rising, demand is being reduced, according to the Boyd Group report (2013), it is challenging to match the price to input costs, attract customers, when market predictions for operations costs are not reliable or accurate.

5. Timely new product development

In times of recession, new product development and innovation costs increase, while the demand of the market declines. While financing through mortgage or secured loans would require a high level of investment, the initial cost of a leasing agreement would be lower, the risks associated with innovation being reduced as well.

Debt-asset ratio

The debt-to-equity ratio of Delta is currently 1,195.8%, according to latest NYS reports. It is still lower than US Airways, but it imposes a high risk on investors. However, financial reports also show that the debt is slowly falling, therefore, operating lease seems to be a profitable and well thought through financing option. (Delta Financial Report 2012)

Financial Reports

The 2012 financial report of Delta Airlines shows an increase in fuel consumption in the past three years. Fuel accounted for 36 percent of the company’s operation expense in the past two years, compared to 30 percent in 2010. The company also launched a fuel hedging program in order to eliminate fuel price volatility.

The operating revenue of the company rose alongside with the operating expenses in 2012. The total operating income for 2012 was 2,175 M Dollars, net income rose and the company made earnings on shares, too. However, the operating cost per available seat mile rose from 2011 to 2012, and this confirms the validity of the company’s decision to replace smaller aircrafts with B-737-s. The total assets rose, while the total debts declined in 2012, compared to data from 2011.

• Funding and investment profile

The company has recently acquired investment in oil refinery operations and has bilateral and multilateral alliances throughout the world. It has sharing agreements and joint operations with different airlines with the aim to strengthen market position and reduce cost of operation. According to the financial report, the company has made agreements to acquire 49 percent of shares of Virgin Atlantic, subject to regulatory approval.

• Market share

The company is present in different areas of aviation, travel and hospitality. Currently trying to strengthen its position using shared operations, agreements, Air Miles programs and cargo operations through SkyTeam. Delta Tech Ops and Private Jets are also adding up to the total revenue of the company. Passenger revenue accounted for 31,807 M dollars revenue in 2012, while cargo operations and other subsidiaries around 4500 M.

Delta has also managed to reduce net interest expenses, while it made a loss on extinguishment of debt in 2012.

• Operations management goals

According to recent reports (Boyd Group), the airline is focusing on replacing its 50-seat crafts to replace them with B-717-s. It is confirmed that the larger the aircraft the higher the associated cost is, however, the cost per passenger is lower in case of a B-717 than a smaller aircraft. Therefore, the decision to replace the smaller air crafts is supported by the idea of reducing operational costs, creating a competitive advantage based on price. However, a larger aircraft would have aerodynamic benefits, lower maintenance costs, higher speed and the air crew cost per passenger would also be reduced.

• Fleet Planning

The company is working towards a more fuel-efficient operation. Obtaining B-737 aircraft models and moving towards narrow body fleet, while reducing the number of 50-seat passenger carriers with high operational costs is a decision that can improve the company’s profitability outlook.

• Profitability Ratios

Currently, Delta’s return on assets is 3.58 percent, while the return on capital is 13.30 percent. (Bloomberg, 2013). After the report of registered profits, the stocks values have increased in the past six month.

• Sources of liquidity

The primary source of liquidity was operating activities cash flow. Advance ticket sales have increased the liquidity of the company in 2012, and fuel and hedge margins also added more security to operations.

• Regulatory environment risks

There are various risks associated with taxes and fees associated with aviation that need to be taken into consideration before creating an operating lease agreement. Increased government regulation, the insecurity of markets worldwide can affect the revenues and expenses of the company.

Conclusion

According to the latest financial report (2012), the company has a 1.8 billion dollar undrawn line of credit available. The revolving credit facilities and the expiry of different agreements in 2016 indicate that the company is in a favorable position of acquiring operating lease agreements. The risks analyzed above are addressed by the operations management team in the 2012 financial report. In the aviation industry, the largest risk is the volatility of operational costs, which has been eliminated using fuel hedge funds. This has positively affected the share price of the company, the cash flow, liquidity and the profits. However, the introduction of new, more fuel-efficient aircrafts would help Delta Airlines reduce the cost of operation in the next few years, providing the carrier with a competitive advantage. While the debt-asset ratio still remains high, in the aviation industry, the figures are not abnormal, and in times of expansion there is a need for acquiring higher level of debts. Investments into fuel hedge funds and subsidiary operations are well laid out and planned, aimed at higher profits, lower operational costs.

References:

Boeing Capital Corporation. Current Aircraft Finance Market Outlook. Web. http://www.boeingcapital.com/cafmo/brochure.pdf [Accessed: Date (fixed)]

Boyd Group International. Snapshots: US Airline Industry 2013 Review Of Key Changes. Challenges. Evolution. Web. http://www.aviationplanning.com/Images/BoydGroup2013Predictions.pdf [Accessed: Date (fixed)]

Morrell, P. (2011) Trading, Legal and Air Finance. AFM Issue 74. July-August 2011

Morrell, P., Swan, D. (2006) Airline Jet Fuel Hedging: Theory and practice. Transport Reviews, Vol. 26. Issue 6 November 2006, p. 713-730.

Delta Airlines Financial Reports. Web. http://www.delta.com/content/dam/delta-www/pdfs/about-financial/DeltaAirLines_10K_2012.pdf [Accessed: Date (fixed)]

Morrel, P., Gibson, W. (2010) Global airline equity ownership and Aircraft investment valuation. Conference Paper. Web. http://www.airbusiness- academy.com/files/aba/Publications/William-Gibson-Global-airline-equity-ownership-and-aircraft-investment-valuation-2010-ATRS-conference.pdf [Accessed: Date (fixed)]

Bloomberg Business Week. Delta Airlines Report. http://investing.businessweek.com/research/stocks/news/news.asp?ticker=DAL[Accessed: Date (fixed)]