Why Europe may never follow the US airline industry’s path
The market is still highly fragmented but governments are often unwilling to let national carriers disappear
Until not too long ago, investing in the airline industry was viewed by many as not much better than setting fire to money.
Such has been the pain suffered by generations of operators and their shareholders that rueful observations by several high-profile investors have almost become business clichés.
How do you become a millionaire, quipped Richard Branson? Start as a billionaire and buy an airline. Warren Buffett wrote in Berkshire Hathaway’s 2007 letter to shareholders that “if a farsighted capitalist had been present at Kitty Hawk [the site of the Wright Brothers' first flight], he would have done his successors a huge favour by shooting Orville [Wright] down”.
Indeed from 1960 to 2000, the aggregate profits of the US airline industry would have been enough to pay for the delivery of just two 747 jumbo jets. Then, after the 2008 financial crisis, things changed. A wave of mergers between US airlines resulted in rapid consolidation.
As the market became less fragmented and operating models leaner, it started to appear that the US airline industry would become reliably profitable for the first time in its history.
Operating margins moved from negative to positive. Shares in Delta Air Lines rose fourfold from the start of 2009 to the start of 2015. United rose by more than 5.5 times. The “Great Consolidation” had occurred, and even Mr Buffett came to decide that — this time — things would be different. In 2016, in a move that shocked his acolytes, he bought stakes in the four largest US airlines.
Investors came to believe that a more consolidated industry would behave in a more predictable fashion and that the remaining operators would refrain from brutal price wars that flooded the market with seats and cheap tickets. If they all kept in line, all would benefit.
Over recent years, investors and analysts in European airlines have eyed the transformation in the US and started to dream that, maybe, the same Great Consolidation could be possible across the Atlantic.
Unlike in the US, market share in Europe is still highly fragmented, with incumbent formerly state-owned airlines competing with big low-cost carriers such as Ryanair and easyJet, and other smaller ones.
Mark Manduca, an analyst at Citi who has long believed that European airline consolidation is inevitable, noted at the start of this year — before the pandemic hit — that there was increasing evidence of capacity growth slowing in European short-haul, and a widening gap between stronger airlines and weaker ones, which would end up failing or being merged.
“Simply put,” he wrote at the start of the year, “in European aviation history we have yet to see a period (such as now) when four airlines control so much of the profits of the industry”. These “Big Four”, Air France-KLM, IAG, Lufthansa and Ryanair, would increasingly take market share from a “subscale tail” of lossmaking airlines, and the industry would start over the next five years to follow what happened in the US.
The industry crisis caused by the pandemic has reminded investors of all the most ugly things about the European airline sector. So-called “barriers to exit” in airlines have always been very high, with operators having to make such huge capital outlays that they are often compelled to run flights even if they are lossmaking, just to keep cash flowing though the business in the short term.
In Europe the situation is worse, because governments are often unwilling to countenance their national carrier disappearing. No matter how much money Alitalia loses, for example, no Italian government has considered it acceptable simply to let it fail.
The frustrations of Ryanair’s Michael O’Leary, who last month accused German rival Lufthansa of “hoovering up state aid like a drunken uncle at a wedding” is a pained acknowledgment that European government cash is vastly distorting for the sector. It also makes further mergers complicated.
In the wake of the crisis, as Mr Manduca of Citi has noted, short-haul capacity will contract. Some weaker airlines are in difficulties. The strong, such as the “Big Four”, and some others will survive and likely, in time, become stronger. The problem in the short term, is the likely price war that will break out as people start flying again this summer.
This is good for consumers, obviously. But for investors, Europe’s Great Consolidation looks likely to be postponed for many years, while the more profitable future they have been dreaming of remains elusively over the horizon.