Industrials

Chris Bryant is a Bloomberg Gadfly columnist covering industrial companies. He previously worked for the Financial Times.

Is the civil aircraft market becoming over-inflated? Airbus's annual report card captures a company in rude health: full-year net profit jumped 15 percent, cash flow was strong and its backlog of orders for commercial aircraft stands at a record high. Even the long-suffering Airbus A380 is at break-even.

But investors holding Airbus on the seeming strength of its order book could yet be disappointed.

There’s no guarantee all those bookings will lead to deliveries to customers, which is when most of the cash flows to the manufacturer. That's a problem because Airbus is planning to increase production output, which means adding fixed cost.

Delta Air Line's CEO caused a stir in October when he warned there was already a “huge bubble” in the market for some second-hand wide-body aircraft, meaning there were bargains available. Investors have taken note:

Air Pocket
Investor enthusiasm for aircraft-maker shares has waned this year

It’s hard to square Anderson's assertion with still-rising passenger numbers and growing demand for new planes. But in a world where cheap credit has helped fuel widespread industrial overcapacity, there's no reason it couldn't happen in aircraft too. If so, it would spell trouble for margins and pricing.

There are two main concerns. First, many of Airbus's more than 6,800 civil aircraft orders were placed when fuel prices were high. That made buying new fuel-efficient jets seem astute. Now, plunging fuel prices threaten to encourage some airlines to defer orders because it's more cost-efficient to operate older aircraft.

Second, airlines in Asia Pacific may have gotten ahead of themselves ordering new planes. Some have ordered up to four times as many aircraft as they operate now.

Budget Boom
Low-cost Asian airlines have about four times as many planes on order as they have in their existing fleets
Source: Ascend Flightglobal, Bloomberg Intelligence
Nb. Passenger aircraft only

Chloe Lemarie, a Mainfirst analyst, notes that Airbus is more exposed than Boeing to airlines with “aggressive” fleet plans and highlights Lion Air and AirAsia as being at risk of deferrals. Overall, Asia Pacific accounts for 31 percent of the group's order book, Airbus said in a presentation Wednesday.

Asia-Pacific Exposure
Airbus has a much higher percentage of orders from Asia-Pacific than its big rival
Source: Bloomberg Intelligence, Ascend Flightglobal

So far passenger traffic in Asia Pacific has continued to grow strongly, supporting demand for new planes. But things can change fast: after the 1997 Asian financial crisis Boeing had to cut production and thousands of jobs.

For once, China isn’t the biggest worry. According to UBS, it represents only 3 percent of Airbus orders due for delivery in 2016-2018. But if China's forced to further devalue the yuan, other regional economies could be vulnerable. Low-cost airlines from Indonesia and Malaysia are a big chunk of the Airbus backlog.

That's a worry because airlines from those countries don’t generate the margins enjoyed by European budget carriers such as Ryanair. Operating margins for Southeast Asian carriers average about 0.3 percent, compared to 5.9 percent in Europe and 13.8 percent in the consolidated North American market, according to IATA.

Thin Cushion
Airbus' order book is exposed to south-east Asian airlines whose profitability is very weak
Source: IATA

Why? Competition is tough and having to buy fuel priced in US dollars with depreciating emerging market currencies lessens the boost from falling oil prices. AirAsia reported a $111 million net loss in the third quarter because of foreign exchange losses.

Investors are not blind to these risks: aerospace valuations have fallen in recent weeks. Yet Airbus still trades on 15.5 times forward earnings, a premium to Boeing's 13.5 times. Given its weaker operating margin, Airbus investors need a lot of confidence in future profit growth to justify that.

For now, the sheer depth of the Airbus order backlog ($1 trillion at list prices) gives it a plump cushion. It could withstand a few deferrals and cancellations and still cover production for several years. Nevertheless, investors would be wise to keep an eye on the fortunes of its client airlines. Often in business, the quality of your customer matters at least as much as the quantity.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Chris Bryant in Frankfurt at cbryant32@bloomberg.net

To contact the editor responsible for this story:
James Boxell at jboxell@bloomberg.net