Why European aviation won’t and shouldn’t be the same after Covid

While in our previous article we discussed to what extent fear of flying, travel restrictions and the economic downturn may have contributed to the substantial drop in demand for aviation, in this article we will discuss why the European airline industry will be and should be different post recovery.

Europe’s large population, yet fragmented political boundaries have sustained a financially inefficient airline industry as a whole. The decades long market-share focused approach started to be slowly ushered out by the arrival of low cost carriers. While low cost carriers have pushed network carriers and regional airlines towards consolidation and forced substantial efficiency improvements both operationally and financially, room for improvement remains.

While in Europe we have seen consolidation over the last 15 years, the market is nowhere near the scale of the US. The combined market share of IAG, Lufthansa Group and AF/KL and Ryanair in 2019 was circa 50%, compared to 58% of the four largest carriers in North America (IATA & airline reports). Although consumers benefit from the increased competition in Europe, the industry is running at sub-optimum.

The “capacity dumping” approach to competition won’t stand post Covid, when penny clinching and strict ROI targets are going to be on the top of every CFO’s agenda.

We take a look at IATA’s latest industry factsheets to take a look at how the European competition has led to overcapacity and system wide inefficiencies when compared with North America.

Source: IATA

While the faster rate of growth in passenger numbers indicates an overall positive picture for the European industry, there may be some less obvious drivers behind this growth. The growth in passenger number may bring joy to suppliers and the wider aviation supply chain we need to understand the sustainability of the growth. Is it driven by lower fares or is it growth at a consistent revenue?

Source: IATA

The evolution of yield over the last 7 years shows that European traffic growth to some extent is likely to have been the product of lower yields. More importantly however, the increase in fuel price between 2017 and 2019 didn’t show as much in Europe as it did in North America, where cost per pax and yield both moved in line with this increase.

The above chart also shows how much more incentive European airlines have to lower their costs compared to their North American counterparts. Remember, even though the metric is per passenger (distance not factored in) the graph itself is an indexed graph, still highlighting the noteworthy evolution between the two markets. Most of the cost decline in Europe is spearheaded by low cost carriers through their own cost base, but also in turn putting pressure on network carriers to reduce their production costs.

Profit margin North America vs. Europe
Source: IATA

If we consider how the profit margin of the North American industry consistently outperforming that of the European (even during years where increased costs are passed onto the passenger) it is an illustration of the extent to which Europe is hindered by an underlying issue.

Source: IATA
Load factor
Source: IATA

If we take a look at the break-even load factor (and this is ATK i.e. cargo also included) it’s a consistent picture with our graph above on profit margin. For some reason European airlines need a higher load factor to make money. Potential culprits:

Lower yields:

Yields are lower in Europe and while the average distance flown is also lower, it isn’t proportional with the extent to which yields are lower.

Overcapacity:

This is both a symptom and a driver of the above point. Competition results in increased need for capacity, which in turn drives yields down. But the easiest way of reducing unit costs is larger planes, which have a detrimental effect on yield, resulting in a vicious cycle.

Higher costs:

Aviation has been surprisingly good at sustainably reducing its costs in Europe (goes to show how bad the starting point was), however room for improvement remains in overheads. In addition, the larger planes required to ensure low unit costs also need higher load factors to ensure profitable operations, contributing to higher break-even load factors.

profit share traffic share
Source: Airline reports & IATA

However, while we can blame overcapacity and cost structures, if we look at the profit share and market share of the largest 4 groups by continent, in Europe the top 4 carry circa 50% of traffic, but are responsible for almost 80% of profit. In North America on the other hand the top 4 carry almost 60% of traffic but are responsible for less than 50% of revenues. Therefore depending on where and how consolidation in Europe happens going forward could in fact do more damage to the industry than good.

The top 4 in Europe seems to have a more solidified  financial position compared to the US, meaning the inefficiencies in Europe stem from the “best of the rest” and the rest…

In conclusion, the mindset with which airlines tend to compete in Europe favours consumers, but not so much their shareholders beyond the top 4. Capacity rationalisation and network tailoring will be essential post recovery to ensure a sustainable European industry. Smaller aircraft offering better schedules, lower break-even load factors and higher yields could be the answer much of Europe’s efficiency problems. At a corporate level strategic consolidation between smaller players will further drive efficiencies and make smaller players better equipped to compete with the major groups of the continent.

While our free market weeds out weaker carriers through failures, mergers and acquisitions those solutions at times can come with much more abrupt and drastic measures for both customers and staff alike than an industry aiming to become more (not only environmentally but also) financially sustainable

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