in Lessors & Asset managers , Capital Markets
Friday 15 July 2016
Brexit Part II: Weaker sterling impacts airline order books
Last week we analysed the impact of Brexit from a macro perspective, this week we look at its impact on UK airline order books. The most visible and immediate impact of Brexit so far has been the devaluation of sterling. As of 7th July, 2016, GBP was down 14% against the US$, reaching a 31-year low of 1.2798. The pound has suffered a similar fate against the euro. While the currency devaluation is expected to negatively impact outbound traffic as well as positively affect inbound traffic, a weaker pound also means that airlines would theoretically require to spend more sterling on their aircraft purchases. Our analysis suggests that among the airlines operating out of the UK, Jet2 appears to be more vulnerable to the impact of the weaker pound and if outbound traffic is weakened, could defer some of its planned deliveries. The other major airlines operating out of UK should be able to manage their fleet deliveries without any major deferrals or cancellations, however, subject to their revenue sources, they could also take a hit as a result of the increased cost of aircraft.
*Flybe stated in its 2015/16 annual report “Flybe has entered into a contract with Nordic Aviation Capital (NAC) to cancel obligations to lease nine used Bombardier Q400 turboprop aircraft, while taking ownership of 10 Q400 aircraft it was under contract to lease, for a cash consideration of c£86.0m, with delivery and consideration to take place over the next 12 months. The contract has a number of conditions that still remain to be satisfied as at 8th June 2016. This will leave 10 Q400 aircraft to be delivered in 2016/17”
The following table shows the estimated additional cash burden airlines might have to face on their aircraft purchases as a result of sterling’s devaluation. These values are computed using indicative delivery values in 2016 US$ terms. The analysis does not take into account the fact that PDPs have probably already been made on a significant proportion of the order backlog, or that airlines with high levels of revenue in US Dollars are to some extent shielded from the devaluation of Sterling, however it does provide a guide towards the overall quantum of impact that Brexit may create.
* tables exclude the 12 A350s ordered by Virgin Atlantic this week at the Farnborough Airshow.
Jet2 faces forex challenge
IAG’s CEO, Willie Walsh, in an interview post Brexit said that the principal impact of the UK leaving the European Union will be on currencies. As per the USD/GBP exchange rate post Brexit, the major UK airlines are collectively looking at an additional cash outflow of nearly GBP1.3 billion (USD1.7 billion) compared to a no-Brexit scenario (ignoring other factors impacting currency valuation). However, this figure assumes a constant devaluation ratio over an 8-10-year period. We would draw attention to a more immediate period, where our analysis suggests that the airline most vulnerable is Jet2. Jet2 has around 18 737-800s scheduled for delivery during the remainder of 2016 and 2017. Based on indicative delivery values, it could potentially face an additional cash outflow of around GBP50 million (USD65 million) on these aircraft purchases. Jet2 is a low-cost airline serving the British leisure market. Weaker sterling could discourage UK holidaymakers and may lead to the postponement of holidays which has the potential to negatively affect Jet2’s traffic. This situation is likely to continue for at least a year so long as sterling remains weak. The combination of falling traffic and potentially higher outflows for aircraft purchases could force Jet2 to re-schedule their orders. In the event it decides to take deliveries as scheduled, it would mean the bottom-line taking a hit.
Ishka anticipates Flybe may also feel the impact of the weakened sterling. The airline, which is focused on serving regional destinations within Europe using its fleet of Q400s, E175s, E195s and ATR72s has been restructuring since 2013. It only managed to post its first pre-tax profit in 6 years in FY 2015/16 on the back of restructuring efforts. As part of its restructuring, the airline entered into a deal with Embraer and the US based Republic Airlines (Republic) under which it cancelled its obligation to take delivery of 20 ERJ-175s and instead agreed to sublease 24 Q400s from Republic, 10 of which are scheduled for delivery in FY 2016/17. Separately, Flybe also entered into a deal to take ownership of 10 Q400s which are under lease from Nordic Aviation Capital (NAC) for a cash consideration of around £86 million. As of June 2016, the contract between NAC and Flybe was yet to be finalised and therefore it remains to be seen whether the cost of the acquisition is affected. It is also possible that the airline could tweak some of its deliveries from Republic considering the increase in lease costs in sterling terms.
While the bottom-line of other major airlines operating out of the UK is also estimated to be impacted, we do not see these airlines altering their fleet plans substantially. In reality, most of the major airlines should already have some currency hedging plans and that should help them to reduce the impact of a weaker sterling in addition to their strong fundamentals and/or significant dollar based revenues. Both British Airways’ and Virgin Atlantic’s fleet expansion in the next year or two is focused on long-haul traffic and since Brexit is expected to primarily impact outbound short-haul traffic from the UK, demand for long-haul travel and therefore aircraft should remain more or less unchanged compared to a no-Brexit scenario. Ryanair and easyJet are truly pan-European airlines which should allow them to adjust capacity across Europe depending on the market conditions. Even though Ryanair is not based in the UK, the country constitutes a substantial portion of its operations. However, since Ryanair reports its accounts in euros it has a natural hedge against sterling.
Monarch has recently undergone a successful transformation which saw it return to profit. As Monarch’s objective for fleet overhaul is more strategic rather than operational, it is unlikely to alter its fleet plans. Monarch’s deliveries start after 2017, which should give it sufficient time to reconsider its network plans, provided it is not acquired by either easyJet or Ryanair who could tweak Monarch’s order book to conform with their own.
While these are still early stages to pinpoint the effects of Brexit on UK’s aviation industry, the impact of currency devaluation following Brexit is more certain. Since aircraft purchases are all in US$, airlines based in the UK now have to pay more in sterling to buy aircraft. The Ishka view is that while increased aircraft prices will impact the bottom-line of all major airlines, Jet2 appears to be more vulnerable than others. To make matters more challenging, the airline is dependent on leisure travellers as its customer base and as result its outbound UK traffic could also be affected as a result of the weaker pound. This might require the airline to adjust its fleet plans for the next two years. The strength of fundamentals at BA, easyJet and Ryanair and their business models should help them manage the additional cost burden.
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