Worst Yet to Come for Airlines?

A new report predicts the commercial flight industry will be hit harder than expected. Morgan Stanley cuts earnings forecasts

The airline industry will be hit by a downturn far worse than even the most tumultuous periods in recent memory — the post- 9/11 years and the early Nineties recession — new research predicts.

Morgan Stanley slashed its earnings forecasts yesterday for several major European carriers, including British Airways and easyJet, in the latest of a flurry of gloomy assessments of the industry. Penelope Butcher, the analyst who authored the report, warned that although the record oil price has already led to two dozen bankruptcies worldwide in the first half of this year, the worst is yet to come.

"The unprecedented move in crude and jet fuel prices over the last 12 months means that fundamental valuation methods are no longer valid for the airline sector," she said. "Industry returns are likely to be the lowest we have seen in recent history (including the last global recession and even September 11) and carriers could well break previous lows on [valuation] multiples". Several carriers will be plunged into loss, she added.

The news is arguably much worse for consumers. Assuming a level of $136 for a barrel of oil for the foreseeable future, Ms Butcher said airlines will have to hike fares by between 30 and 40 per cent to cover the increased cost.

The bearish view echoes those of several other industry figures, including Giovanni Bisignani, head of the IATA, the industry trade body, and Glenn Tilton, chief executive of United Airlines, the American carrier.

Last week Mr Tilton admitted that "the magnitude of the current economic reality requires action far greater than anyone in the industry could have anticipated just a few months ago... fuel at more than $130 a barrel is a 'game changer' for the aviation sector."

British Airways shares, which have already shed 50 per cent of their value in the last year, dropped 5 per cent yesterday to 225.75p after Ms Butcher cut her price target for the UK flag carrier from 160p per share to 149p, with a worst-case scenario — $180 per barrel of oil — to just 79p.

It is not an idle musing. Goldman Sachs said oil could spike to as much as $200 per barrel, as has the chief executive of Gazprom, the world's largest gas producer.

The bank was even harsher on easyJet, slashing the low-cost carrier's price target by 16 per cent to 259p, with a worst-case prediction also at 79p. The stock closed at 301.25p yesterday.

Airlines are all facing varying degrees — depending on their hedging position — of the same challenges. In order to cover soaring jet fuel bills, they are ramping up fares. That will in turn lead to less people travelling, cutting into revenue.

Most carriers, including BA, have said they will also reduce the number of routes, especially those flown by older, less fuel-efficient planes, further reducing cash flow. Against a background of rising inflation, the industry's heavily unionised workforces have meanwhile begun pushing harder for above-inflation pay rises, adding further pressure to airline balance sheets.

Ms Butcher said: "Market prices are not yet discounting $136 per barrel fuel into perpetuity, or are assuming double-digit annual price increases can be implemented without demand destruction."