Fitch: European Airline Cuts Reflect Tough Demand, Cost Outlook

Fitch Ratings expects 2012 to be a year of significant retrenchment for the largest European network airlines, as a poor demand environment and persistent cost pressures threaten to drive operating losses higher. This month's roll out of a major cost and capacity restructuring plan by Air France-KLM may signal broader industry rationalization later in the year, particularly for carriers facing bloated cost structures and heavy exposure to quickly softening short-haul air travel demand across Europe.

Air France-KLM's decision to scale back projected capacity growth rates through 2014, with a stated goal of EUR1 billion in annualized operating cost savings, reflects a sharpened focus on cash flow and liquidity, with near-term revenue trends likely to weaken significantly. The carrier's restructuring efforts will focus on labor cost management, as loss-making short-haul routes (particularly in the Air France segment of the network) are pruned.

A return to positive free cash flow, as well as progress toward the goal of EUR2 billion in net debt reduction by year-end 2014, will force Air France-KLM to cut aircraft capex sharply, likely leading to consideration of aircraft delivery deferrals.

The company's decision to freeze wages and hiring will help limit operating losses this year, but strident opposition from labor unions could slow any attempts to reduce unit labor costs further. Management signalled its desire to revisit work rules and productivity in its labor contracts, setting up a potential showdown with the unions.

Despite slowing global economic growth, energy cost pressure is not abating, with Brent crude prices remaining near $110 per barrel and jet fuel costs for European carriers still substantially higher than a year ago. Persistent fuel cost pressure in 2012 will continue to erode the profitability of short-haul flights where unit fuel costs are significantly higher. As a group, European airlines will likely pay nearly 30% of total operating expenses for jet fuel in 2012.

Industry capacity grew sharply last year, even as economic conditions in the euro zone worsened and jet fuel prices rose sharply. The Association of European Airlines (AEA) reported last week that total seat-kilometer capacity grew by 9% in 2011, with traffic growth of 8% leading to a decline in European load factors. Across the board, air travel demand conditions began to worsen materially in the fourth quarter.

Unlike the U.S., where industry consolidation and a multiyear restructuring wave has kept a lid on fleet and capacity expansion, the European industry still faces a difficult adjustment period as fleet capex is curtailed, unprofitable routes are abandoned, and employment levels are reduced in response to the more difficult operating environment.

The AEA's December forecast of EUR1 billion to EUR2 billion in industry operating losses for 2012 may ultimately be tested as traffic and yields come under increasing pressure. Against a back drop of macroeconomic weakness and unrelenting fuel cost pressure, we expect European network carriers to remain focused on free cash flow improvement and liquidity preservation this year, with growth clearly taking a back seat.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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