European Airlines: Reasons Why Brexit Is Credit Negative (English)


I have been following the airline industry for more than fifteen years now and therefore,  would like to share my thoughts with respect to the Brexis impact on European Airlines with you.

  • First of all, it seems clear to me that the Brexit for the airline industry by no means will be an event of such magnitude like say 9/11
  • That said, I believe that the Brexit will have negative credit implications for the European Airline Industry.
  • Hardest hit will be airlines with major hubs in the UK and the low cost carriers which have a business model that relies on the possibilitiy to fly passengers around Europe in the most cost efficient and cheapest way.
  • However, other European carriers are likely to feel the impact, too.


The devaluation of the GBP versus EUR and USD will result in lower demand for passenger air travels

Immediately following the referendum the value of the GBP deteriorated sharply which will have the effect of a price increase for tickets from the UK to Europe, the US etc. This will make business and holiday trips to anyplace outside the UK more expensive and thereby reduce the demand for passenger travels going forward.

For passengers visiting the UK the weakness of the GBP has the opposite effect, so that inbound travel will increase and thereby, to some extent, mitigate this currency effect. However, on balance the number of outbound trips (i.e. from the UK to destinations overseas) is two times higher than the number of inbound trips which means that the net currency impact going forward will be negative for UK based airlines.

While I expect a certain recovery in the GBP/EUR and GBP/USD currency exchange ratios over the medium to long term the International Air Transport Association (“IATA”) expects the net currency related impact (inbound and outbound from the UK) to be a reduction on UK air passenger numbers of between 1.7% and 2.9% over the next two years. I believe that the degree of a currency related decrease in demand for air traffic will rely on the performance of the GBP versus  the local currencies of preferred UK holiday destinations going forward.

(Photo: Guido Billstein)

As the business of most airlines is to operate on a scheduled services basis, any deterioration in the number of passengers (as measured in “Revenue Passenger Kilometers” or “RPK”) and revenues on a sustained basis will weaken the companies‘ cash flow generation abilities going forward (if everything else stays the same). This will weaken the debt protection measurements.

The negative impact of a medium to long term GBP weakness will mostly hurt airlines with major hubs in the UK such as British Airways / IAG (senior unsecured ratings of Baa3/BBB- by Moody’s/S&P’s), Easyjet (Baa1/BBB+) and Ryanair (BBB+ by S&P’s and Fitch).

For Europe’s major Low Cost Carriers Ryanair and Easyjet this may in particular be negative, as 36% of Ryanair’s and 46% of Easyjet’s capacity are currently used in the UK air travel segment.

Long Term Outlook for lower GDP growth or economic stagnation in the UK and in Europe will further reduce the demand for air travel 

Historically, there has been a strong correlation between (expected) economic growth rates and the demand for passenger air transportation.

According to OECD, for the UK a Brexit will have a negative GDP impact of 1.3% by 2018 compared to baseline (i.e. no Brexit) which leads to the expectation that the UK economy is likely to have a very slow or zero growth outlook for 2017 /2018. For the EURO zone OECD expects a negative impact of 1.1% (compared to a non-Brexit scenario) which leads to the expectation of a slow down of GDP growth to around 1.0% p.a. in 2017 and 2018.

Source: OECD, „Economic  Outlook“, June 2016

While economic forecasts often turn out to be inaccurate in hindsight I believe that the outlook for a downswing in the European economy will lead to a reduction in the demand for air travel, both in the business and economy segments. In rather gloomy times, companies tend to reduce the number of business trips. In my view, the airlines‘ yields will come under pressure which, given the high fixed cost basis, will weaken the cash flow / debt ratios.

Again, airlines with major hubs in the UK will be impacted the most. However, given that the EURO zone is likely to face a reduction in economic growth as well, I believe that the continental European airlines (such as Lufthansa and Air France/KLM) also will see a reduction in demand for tickets and passenger numbers.

Medium to long term outlook for air cargo operations will suffer from uncertainties regarding trade and air traffic agreements but also from the negative economic outlook and decreasing trade volumes

In Europe major ‚legacy‘ airlines derive on average between 5% and 10% of total revenues from their cargo operations.

Trade flows and volumes historically have been closely related to GDP. Therefore, the medium term outlook for air based shipments is negative, too.

In addition to that the uncertainties around the future trading arrangements between the UK and Europe make it difficult at this stage to project the flow of inbound and outbound trade volumes to be transported by aircraft. According to OECD estimates, trade volumes in and out of the UK could shrink by 10% to 20% over the next ten to fifteen years.

Therefore, I believe that the cargo segments of European airlines will face a downturn in demand and volumes. However, the negative impact on the carriers‘ cash flow generation abilities will be limited by the moderate share of air cargo in the airlines‘ total revenues.

European legacy airlines (i.e. ‚flag carriers‘) will struggle to timely adjust capacity, network and workforce to a continued reduction in the demand for passenger and cargo air traffic

Given the high fixed cost basis of the airline industry (around 75% of operating costs are of fixed nature or outside management influence) in particular legacy carriers in the past have mostly been unable to adjust their cost basis to timely react to changes on the demand side.

In my view major obstacles for the airlines industry in this respect are

Aircraft fleets: It may take years to downsize capacity based on the aircraft types currently used in the airlines‘ fleets

Medium or long term nature of financial or operational contracts like lease arrangements, supply contracts etc

Unionization of critical parts of labor-force (pilots, flight attendants and check-in / ground-handling personnel)

(Photo: Guido Billstein)

The airlines‘ operating profits have reached peak levels in 2015 and 2016, mainly due to the continued low fuel cost environment. I believe that it may be quite difficult at this stage to enter into negotiations with unions in order to achieve further cost reductions and lower personnel expenditures by way of staff reductions or pay / compensation reductions. That said, I believe it to be likely that any such action taken by managements will result in strikes and thereby might lead to major disruptions of operations.

I believe that low cost carriers such as Easyjet and Ryanair will  be more quickly when it comes to taking and executing business decisions such as moving the HQ / place of incorporation outside the UK or adjusting capacity and network or reducing staff.

Uncertainties about the UK’s continued access to the European Single Market and US/Europe Open-Sky agreement

This is actually a minor concern for me at this stage as it will be highly unlikely that the UK at the end of the day (i.e. post Brexit) will be excluded from the single European and the US aviation market.

As of today, the UK is still a part of the European aviation market and the EU’s bilateral air travel agreements with all countries around the world (including the US). Upon formally giving notice by the UK government to leave the UK under article 50 of the Lisbon Treaty the process of Brexit will begin and this will take up to two years or more.

I believe it will be most likely that the UK will join the European Common Aviation Area (“ECAA”) post Brexit. The ECAA extends the European liberalized aviation market to European countries that have no EU-member status such as Norway, Iceland and most of the Balkan states. This would also allow the UK to be part of the EU-US air travel agreement going forward.

However, the UK’s ECAA participation may require the acceptance of certain EU rules like the freedom of movement for people (which was one of the major topics for the ‚Leave‘ campaign). Therefore, the UK participation in the ECAA while being the most likely and easiest way to go from here is by no means a done deal or a foregone conclusion at this stage.

(Photo: Guido Billstein)

Alternatively the UK could enter into bilateral air traffic negotiations with the EU, the US and all other countries around the world (like Switzerland has done before). I believe this to be a rather unlikely (but certainly not impossible) scenario as it would be a very time consuming negociations procedure and require interim arrangements.

The worst case scenario would be a clean divorce with the absence of formal agreements post Brexit. At this stage I believe this scenario to be unlikely as it could lead to the loss of access to the European aviation market.

Things and financial ratios to look at in order to determine the potential negative credit implications for any specific airline credit / rating

  • Strategic position of the respective airline and exposure to the UK travel market
  • Management ability and willingness to take decision and execute action in a timely way
  • Gross adjusted leverage ratio (as measured by EBITDA / gross debt, adjusted for leases and pension funds deficits): This should be lower than 3.0 times on a sustained basis to maintain investment grade status
  • EBIT / Interest Coverage (adj.): Should not sustain-ably fall below 2.0 times for investment grade credits
  • Liquidity policy and status (OK. This is one of the must-do things at all times, when you look at airline industry credits)

Guido Billstein, Hamburg / July 2016

Sources used for this article
CAPA Centre for Aviation, “Brexit and aviation” Part 1 &2, June 2016
IATA International Air Transport Association, “The impact of ‚BREXIT‘ on UK Air Transport”, June 2016
Moody’s Investors Service
OECD, “Economic Outlook”, June 2016
I do not have a business or personal relationship to any of the companies mentioned in this opinion.
I will not receive any compensation for my credit opinion.
I do not own shares or other securities issued by any of the companies mentioned in this opinion.
My opinion is based on public domain information only.
My opinion is expressed to the best of my knowledge. But it is an opinion, which may turn out to be inaccurate or wrong. Investors, therefore, should before taking an investment decision get hold of all information available and form their own opinion about this issue.

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