British Airways - Further turbulence ahead

In the iconic 1987 film Wall Street, stock broker Bud Fox once remarked to the ruthless Gordon Gekko that Blue-Star Airlines was one of his best buys. Gekko immediately replied to Fox's sales pitch that airlines made lousy investments because of high fixed costs, volatile fuel prices and problematic unions.  Looking at British Airways (LSE: BAY), Gekko has more than a point. 

Earlier this month, BA reported a record pre-tax loss of £292 million for a 6 month period which covered the traditionally profitable summer.  With the global financial crisis reducing the appeal of premium business travel, BA’s cost base was simply not flexible enough to handle the shift in consumer trends and a 14% fall in revenue.  

Gekko’s view on unions seems spot on also… as having recently agreed a £4.3 billion tie up with Spanish airline Iberia, the possibility of further job cuts is set to cause further upheaval with union Unite currently preparing staff for possible strike action over the busy christmas period.   

Like their respective domestic economies BA and Iberia have suffered more than most during the economic downturn and the joining of forces (which Ryanair chief Michael O’ Leary has described as as “….two drunks holding each other up on the way home…) will create the world's third largest airline measured by revenue.  

From where we sit the synergies look promising and the two airlines have very few overlapping routes. The combined entity will possess greater financial muscle and will be able to compete with European giants Air France-KLM and Lufthansa.  Crucially cost savings are expected to amount to around £357 million annually by 2015.   

Results elsewhere have been more positive.   Michael O’ Leary can afford to be smug right now as over the same period Ryanair saw passenger numbers shoot up by 15 per cent, posting profits of £350 million.  Fellow discount airline easyjet went about capturing the value driven business traveler, increasing its revenue per seat by over 4%.  No mean feat considering Ryanair’s average fare fell 17pc over the summer, British Airways - 18pc and Lufthansa, 19pc. 

Whilst the discounters have fared relatively well of late, the rising cost of fuel will continue to challenge industry profits long after the global economy has recovered.  Should BA’s huge pension deficit not scupper the deal, BA/Iberia will be a lean and mean machine however margins will remain under pressure from an increasing cost base. 

Jet fuel is one such cost.  Supported by a structurally impaired US dollar, the price of crude oil (from which jet fuel is derived) has ticked up in the absence of any real demand improvement from the US.  Looking ahead with oil becoming more difficult and more expensive to extract, further industry consolidation (which BA has suggested) could be the only form of survival. 

Overall we remain skeptical of the ability of airlines in general to pass increases in fuel costs onto the consumer without negatively impacting demand.  As we approach the end of a decade which has seen the September 11 attacks, SARS, Swine flu and the credit crunch restrict industry earnings, the post credit crunch frugal consumer and rising oil prices will make the next 10 years just as challenging.