Brexit threatens Flybe’s first profit for six years

UK regional carrier, Flybe, has recorded its first full year profit since its stock market floatation in 2010. Overall, the airline recorded a pre-tax profit of £2.7 million for the period 2015/16, a 107.6% increase on the £35.6 million loss from 2014/15.

The carrier does not expect the Brexit vote to have a long-term impact its business, but in the short term it anticipates a £2.5 million hit to profits this year. Flybe’s profit, while encouraging, remains slim. The result of the UK referendum to leave the EU threatens to reverse the gains it has made in the last 12 months. In the near term profitability depends on keeping costs down. 

Fleet management has been key to driving down losses, although it is committed to increasing capacity. It launched 52 new routes in 2015/16.  The Ishka view is that the airline’s future profitability is by no means certain.

Unit costs continue to exceed unit revenues

The airline’s revenue for 2015/16 was up 8.7% to £623.8 million, from £574.1 million the previous financial year. Flybe’s balance sheet has improved, it had £163.6 million in free cash at the end of March 2016.

Capacity was up 9.7% to 11.3 million seats.  Passenger numbers also rose to 8.2 million, from 7.7 million the previous year. However, load factor dipped slightly by 2.6% to 72.6%.

The carrier’s recovery is predominantly the result of its fleet management strategy, which is covered in the section below. Operating costs actually rose by 4.8% to £586.8 million on the back of capacity expansion.

A major weakness for the airline is the gap between revenue per passenger and costs per passenger -  which is negative. In the year ended 31 March 2016, average cost per seat was down 2.3% to £52.67.  However, revenue per seat was also down by 1.4% to £50.64. Consequently, Flybe is not breaking even on its core business. Flybe attributes depressed revenues to terrorism in Europe and Brexit, but costs per seat were also higher than revenue per seat in the 2014/15 period.

In 2015/16 an operating profit of £8.7 million was only possible with other flying revenues (see pie chart below). Flybe has seven aircraft flying on its ‘White Label’ operation. These are operated by Flybe on behalf of SAS and Brussels Airlines and carry their livery. While the income from charter flying is welcome, the airline does need to shore up its underling passenger revenue or it will risk becoming too dependent on a couple of contracts.

Brexit, terrorism and taxes weigh on slim profits.

Flybe has warned that it will take a £2.5 million full-year profit hit because of short-term uncertainty following the Brexit vote.

 “The current outlook is very uncertain and we have limited forward visibility due to our late booking profile,” Flybe’s CEO, Saad Hammad. “We are yet to see the full impact on demand of the devaluation of sterling and the heightened consumer uncertainty after the Brexit vote.”

Since Flybe has no meaningful dollar income and a third of its costs are dollar denominated – including fuel, operating leases and loan repayments – the carrier has hedged 90% of its anticipated dollar requirements for the year to 31 March 2017, at an average exchange rate of USD1.5079.  Taking into account its hedged position, each $0.05 reduction or improvement in the dollar exchange rate has the effect of reducing or increasing Flybe UK’s profits in 2016/17 by approximately £0.7m. Nonetheless, the airline has bought itself time for the pound to recover.

Hammad also singled out France as a special concern due industrial unrest and worries about depressed tourist demand as a result of terrorism. France accounts for 12% of Flybe’s seat capacity.

In its home market, high passenger duty also remains a fetter on future growth as it is disproportionately levied on regional airlines. Flybe has stated that the UK government’s Air Passenger Duty (APD) is typically around 19 times the tax per mile compared to a long haul flight.

Rising fleet ownership is key to long term savings

For a regional airline Flybe is atypical in owning only 20% of its fleet. The ambition is to increase this to 50% in the medium term.

Flybe relies heavily on the Bombardier Q400.  In February 2016, they took ownership of three previously leased Q400s for £24.4 million.  The carrier is also taking another ten used Q400s from Nordic Aviation Capital for £86 million, which it is committed to sub-lease from Republic. The transaction on all 13 aircraft will deliver a net cost saving of £4 million in the 2016-17 year and £8 million thereafter. Oveall, the percentage of the fleet that is owned by Flybe is set to rise to 34%.

In order to maintain capacity growth discipline, Flybe has deferred the delivery of four Embraer E175 aircraft by an extra year to between January and April 2019.  Financing is in place for all acquired aircraft.

The airline also successfully negotiated itself out of a $485 million order for 20 E175 jets at no extra cost. Moreover, Flybe have also managed to find a partial solution to its unwanted fleet of  Embraer 195 aircraft which it has on lease. This has cut an estimated £120 million obligation from to around £40 million.  After absorbing £20 million in E195 related costs in 2014/15, the airline returned five aircraft to lessors and deployed the other nine aircraft on UK regional routes.  Flybe’s total aircraft rent expense fell by 1.6% last year to £79.3 million.

Scenarios

What if Flybe fails to bring down unit costs?

Flybe may be facing structural market barriers that keep operating costs high for regional carriers in the UK. These include high passenger duty, disproportionate financial penalties for delays, and a shortage of available landing slots at hub airports, like Heathrow and Gatwick, which keeps slot prices high. 

Flybe argues that UK passenger duty can be 19 times higher for regional airlines than for long-haul operators. It also says that compensation for delays hit regional carriers harder as they are not proportionate to the original ticket price and can often be three times higher on average than those levied on long-haul airlines. Flybe has also suspended plans to take up slots at London Heathrow due to high costs, despite an offer of £10 per passenger discount from Heathrow which the airline says is not enough.

The carrier is lobbying the Government for reduced passenger duty and potential access to RAF Northolt - a nearby air force base which already hosts executive jets.  There are both considerable hurdles to overcome for both, but do make sense commercially.

In the shorter term, if Flybe cannot bring its costs down it will become increasingly reliant on non-passenger revenues to compensate for unit costs exceeding ticket income. Currently, ticket revenues account for 91.6% of total revenues, but this could be pushed down. In 2015, Flybe Aviation Services (FAS) turned a £2.5 million profit. Further, the charter contract with Brussels Airlines was extended for a further two years in October 2015. Though this is no substitute for strong revenue growth and falling costs.

The Ishka View

Flybe retains a strong position in the UK regional market. It accounts for one in every two UK regional flights with a 55.1% market share.  On the other hand, Flybe is one of the least profitable listed airlines in Europe and its current cost structure is not sustainable in the long run.  Its fleet management plan has brought welcome efficiencies which will help relieve the short term fallout from Brexit.

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