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City Insider: Airlines flying high but beware a credit squeeze and wage inflation

City Insider - FT journalist David Stevenson on the travel industry



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Our regular City analyst, David Stevenson, warns a tightening of liquidity by banks and increasing wage demands will see prices continue to rise in the global travel sector

It’s been an interesting period for the UK based airline sector, with a string of trading updates suggesting that the pace of profits growth is expanding pretty much across the board.

Ryanair’s recent results were hugely impressive and FlyBe has made steady progress in taming its cost problems. In the meantime we’ve had an impressive update from BA parent IAG, via its third quarter numbers.

Net profit up 3% year on year to €580 million, although a better measure is to look at profits before exceptionals where profit rose 30%.

Crucially full year guidance for 2014 was marked up – profits are now likely to hit €1.3 billion for the year, a big improvement on last years €770 million.

Many investors reacted very positively to news that Iberia seems to have turned a corner, with third quarter operating profits doubling, revenues up 3.4% and margins increased to 13%.

BA, and especially its long haul routes to North America, were the standouts

Compare these results to Lufthansa and Air France KLM and its clear which airline is best positioned but I’d be a tiny bit more cautious than the investing mainstream.

BA is riding high on its lucrative North American routes (how long have we heard that story?) which is in turn a reflection of the resurgent US economy.

But I’d wager that the US economy will struggle to grow at its current clip over the next 18 months.

I wouldn’t argue we will see a big slowdown but I do think that a resurgent dollar and the US Federal Reserve moderating its monetary intervention will cause the pace of growth to moderate stateside.

Back in Europe a resurgent Ryanair will have low cost airline Vueling firmly in its sights and overall I’d observe that despite IAGs heroic achievements, it’s still not properly covering the cost of its own capital.

One other thought – Latin America is looking very weak at the moment (with Brazil especially vulnerable) and that will have a big impact on any rebound at Iberia.

That point about IAG failing to produce a high enough return on its capital employed brings me nicely to a set of broader observations about unexpected trends within the travel sector.

Most analysts and investors have been focused on the big, broad brush trends – lower oil prices, Eurozone troubles and the strong rebound within the US economy.

But I think the travel sector should also keep a beady eye on some smaller trends that might just catch the whole sector by surprise.

In particular I’d watch out for the cost of capital which is going to be the elephant in the board room for many big travel companies.

Put simply the UK and the US are now moving – very slowly to be sure – to a tightening of liquidity within the global wholesale capital markets.

That means there’ll be less credit available from the central banks. Interest rates might rise a tiny bit but I’d watch out for bond investors demanding a higher return on their investments in big and medium sized corporates.

Put all this together and we have a situation where big corporates will have to pay more for their capital which will in turn have an impact on both new investment and the rates of return required by business units. Crucially there’ll be less liquid capital sloshing around the system.

So although the likes of IAG will benefit hugely from lower oil prices they’ll also be hit by higher financing costs. If I were a supplier to major travel giants as a precaution I’d look carefully at the amount of debt any big listed travel giant has to refinance in the next two years.

If they have a big lump of money to cope with, I’d be very cautious about extending too generous credit terms.

This increasing cost of capital will have another knock on factor – rising prices for those travellers most able to afford them ie business travellers.

The constant drum beat from economists across the developed world at the moment is that we should fear deflation.

But I’d suggest that this isn’t a uniform trend across the globe and that especially in business travel the bigger issue will be increased product prices.

Only recently Carlson Wagonlit Travel (CWT) released its 2015 Global Travel Price Outlook report with the GBTA Foundation.

One highlight for me was: “The study reveals that travel managers expect price increases next year across the board on travel categories including airfares, hotel room rates and rental car rates,” according to Joseph Bates from the GBTA Foundation.

The report suggests that “airfares are expected to rise gradually through 2015, by as much as 2.2%, although low-cost carriers are limiting price increases in some regions…. Hotel suppliers will be in a better negotiating position than they have been for some time in 2015, due in part to stronger demand and investor interest, and favourable capital costs.”

This analysis is important as it reminds us that although some costs are steadily declining, back in the real world inflation is far from conquered especially in the Anglo Saxon economies and a large part of the emerging world.

I’ve been talking to a number of City-based execs who regularly fly with the major airlines around the world and stay at the nicer hotels owned by the bigger chains.

To a man and woman they tell me that the big challenge is that they’re facing noticeable price increases, ranging from 2% to 10% in the last six months.

And talking of costs, one input that is definitely going to go up in price in the future is labour.

Over in the US one of the most interesting aspects of the recent midterm political elections was that a raft of big states voted in favour of increased minimum wage rates.

Adding to this discussion there’s already there’s talk of a minimum wage of $15 an hour for many Democrat friendly states – although the actual net cost of labour may end up being even higher as health costs carry on increasing and big travel groups scramble to attract and keep good employees.

I think we’ll find an echo of these trends here in the UK, with a big impact on the travel sector which has traditionally figured as a lower cost employer.

Demands from some politicians (Labour and Tory) for a ‘living wage’ are likely to feed through into a national debate that’ll see minimum wages hit at least £8 an hour by the end of the decade, if not much higher (my guess is that that number might end up being above £10 an hour).

In reality this will all be excellent news for the UK economy, as one of the reasons why we’re all feeling so jaded as an electorate is that wages are subdued.

This has fed through into fairly subdued aggregate consumer demand – with some suggesting that the only reason consumer demand is as strong as it is because we’re all cutting back on saving and borrowing at historically low interest rates.

As wages start to rise, consumer demand will increase but my guess is that the main casualty will be corporate margins which are likely to be squeezed.

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