We may not all enjoy the hustle of an airport or the turbulence of being 35,000 feet up, but aviation makes it easier for us to enjoy some much-needed holiday sun or attend an important business meeting. We take flying so much for granted that when planes are grounded it unleashes a huge level of frustration.

This was evident in December when an illegal drone flown over Gatwick Airport led to three days of flight delays and cancellations affecting 150,000 passengers.

Such events also quicken the heart rate of airline chief financial officers. Cancelled flights hit revenues, reputation and future demand. Passengers are also entitled to compensation running into the hundreds of pounds if the delay is the airline’s fault, such as late crews or technical issues.

“An airline CFO needs to be very good at risk management, governance and control,” says Robert Palmer, adviser to fast-growing regional airlines. He was previously interim CFO at CityJet and group finance director at Monarch Group. “Trying to identify all the risks and ensure you have a plan in place is important, as there is always a crisis in the airline industry.”

So exactly what issues – apart from mysterious drones – are on their agenda?

According to the latest Airlines Financial Monitor from the International Air Transport Association (IATA), airlines are experiencing a squeeze on profit margins from higher input costs as well as a decline in free cash flow.

Oil prices are higher and premium cabin prices, which IATA states have “provided a useful buffer for airline financial performance over the past year”, have seen “downward pressure on economy yields”.

Revenues remain volatile. The annual growth in industry-wide revenue passenger kilometres (RPKs) accelerated to 6.3% in October 2018, up from a weather-affected 5.5% in September.

CFOs also must deal with volatile crude oil and jet fuel prices. They have trended upwards in recent years but increased supply from Saudi Arabia and Russia has sent prices lower recently.

Air freight is performing well with available freight tonne kilometres (AFTKs) rising by 5.4% year-on-year in October. Another area of consideration for CFOs is labour costs, with IATA stating that wages will increase by 2.1% in 2019.

These key issues are also reflected in the most recent statements from CFOs of UK airlines.

In easyJet’s latest annual report, CFO Andrew Findlay outlined the airline’s main financial measures such as profit and revenue per seat, numbers of seats flown and load factors. Costs were taken from third-party industrial action, air traffic control restrictions and adverse weather conditions. It also reported charges for the sale and leaseback of aircraft and increase in ground handling costs and maintenance supply chain contracts.

Findlay highlighted a rise in crew costs after agreed inflationary increases in pay and employee bonuses and higher retention over winter to “build for peak summer growth”.

Cost benefits came from upgrading easyJet’s fleet to larger and more efficient aircraft.

At IAG, CFO Enrique Dupuy highlighted tackling rising fuel commodity levels in its most recent results through hedging on price and transaction exposures. It also noted higher handling and catering costs and landing fees, and has launched bond issues to fund aircraft deliveries.

Flybe recently launched a strategic review and is considering a potential sale after a series of profit warnings caused by the weak pound, high fuel prices and faltering consumer demand. Its CFO Ian Milne said the airline has increased the amount of owned aircraft following the return of end-of-lease aircraft and negotiated the extension of leases on other aircraft on reduced payment terms.

It operates a policy of managing fuel price volatility by entering into derivative contracts representing a portion of its aviation fuel requirements a minimum of 12 months forward from the current date. It is also required to purchase carbon allowances for all flights departing from and arriving into the EU in order to offset its carbon footprint. It manages its exposure by purchasing carbon emissions allowances through a forward purchase programme.

Palmer states that key risks for an airline CFO include fuel price volatility, foreign exchange and interest rates. “Most of the fuel and maintenance are purchased in US dollars,” he states. “Airlines don’t accrue the same amount in dollar revenue, so they are rarely in alignment and exposed to currency swings. Interest rates are another risk because you have a number of long-term assets such as planes on lease finance deals.”

With regards to fuel he says CFOs look to forward-hedging solutions to aid future budgeting: “Think carefully why you are hedging because if you get it wrong and your competitors benefit from lower prices then you will struggle.”

What of fluctuating passenger demand? “The demand curves don’t work the same way each year,” Palmer explains. Selling seats is the job of the commercial function but it is all linked to forward cash flow, so the CFO needs to be on top of it. “There may have been limited capacity at the peak summer period one year which leads to more people booking earlier the following year. You need to consider these demand shifts – including the state of the economy and consumer confidence – and what this means for your prices and forward revenue forecasts. Trying to judge how your sales are going to go is an art.”

He says there needs to be a lot of communication between the CFO and the commercial department to “ensure there is quality information such as regular sales data available”.

With regards to the main airline assets – the aeroplanes – he describes the industry as “very capital intensive”. He says: “You are making estimates about the value and maintenance conditions of your aircraft and how that relates to your profit and loss. If your aircraft are owned, then you need to consider residual value and if they are a mixture of owned and leased you need to factor in interest rates and the cost of maintenance. They are extremely material assumptions but if you underestimate or overestimate the value of your aircraft it might inflate short-term profits or under-declare.” So CFOs need to have a firm grasp over their accounting policies.

“If you lease aircraft for seven to 10 years and the contract says you need to give the aircraft back in a certain condition, then you need to work closely with the engineering team to ensure you meet the contract,” he says.

“Leasing is the most popular option the less capital you have. You don’t have to worry about the residual value as you are not carrying that risk on your balance sheet. Owned aircraft will be on the balance sheet and in times when the industry is in trouble it might be easier to get rid of them.

“But owned gives you more flexibility and you can sell them on the marketplace quickly and upgrade to better and more cost-efficient models. It is often best to have a mix of owned and leased if your capital ratios are not an issue.”

Duncan Batchelor, aviation partner at Norton Rose Fulbright, says CFOs are much more focused on fleet management than in the past. “When you don’t get it right it becomes expensive quickly. When, where and what is flying?” he states.

He adds that leasing – either wet, where the crew, insurance and maintenance comes with the aircraft, or dry – can help CFOs when they want to scale their fleet up quickly to increase capacity in comparison with the “several years’ lead time” when ordering a new aircraft.

“Sale and leaseback can also be a way of generating cash. Airlines can negotiate a good purchase price with a manufacturer – as you can get a better deal buying 50 instead of five – and then sell the aircraft on to a leasing company,” he explains. “You then lease back the planes and amortise the cost of the aircraft. You save on the depreciation costs.”

Batchelor adds that CFOs need to be forensic in their capacity forecasting, something which can prove difficult when faced with industry challenges. “Some routes are susceptible to economic growth, some can be attacked by your competition increasing traffic and lowering prices and some routes may see passenger numbers drop off as happened after the recent terrorist attack in Egypt. This can cause huge operational problems.

Cost reductions are another vital concern for CFOs. In his time at Monarch, Palmer delivered £30m of cost savings.

“One area I looked at was maintenance. A supplier was making too many full aircraft cleans,” Palmer states. “So, we renegotiated the contracts and made savings. You also need to be aware of the very strong seasonal fluctuations in the sector. In the northern hemisphere you go as hard as possible in the summer with revenues and investment while looking at maintenance contracts more during the quieter winters. You need to have decent cash flow systems in place to manage this.”

A Frost & Sullivan report highlighted revenue leakage as a major issue for airlines, costing them about 3% of revenues. It can come from credit card fraud, identity and frequent flyer fraud.

Frost & Sullivan added that revenues received post-sale – from flight-related services such as baggage and seat upgrades – are difficult to tie back to the actual passenger revenue from the airfare. A key solution is to integrate revenue accounting systems with revenue management and revenue integrity systems as well as having more real-time information.

This is an area of focus for Rob Morgan, CFO of aviation tech firm Vistair, which supplies software to airlines such as Delta, to help manage operational documents, safety reporting, risk management, benchmarking, analytics and audit/compliance.

“Companies want to get their planes into the sky with as little delay and as much efficiency as possible,” he states. “We can help reduce their cost base and improve performance.”

He mentions one client case study where safety reporting increased by 71%, audit findings decreased by a quarter and insurance premiums fell 3% a year after demonstrating that safety had improved. There was also a 50% reduction in de-icing charges after safety reports showed it was taking place too early before take-off in Scandinavia.

“We help airlines with a number of global bases collate performance data more efficiently,” Morgan says, “getting information into the right hands at the right time.” He also extolls the virtues of one CFO working with another. “We work very closely to work out what value we can unlock. It is a partnership, building a relationship and looking for those CFOs who want to make a difference and improve profits,” Morgan explains.

At present the UK is part of a liberal common aviation agreement where airlines have the freedom to fly to and within EU countries. It is also part of the European Aviation Safety Agency (EASA) which sets regulation and certification. The UK is keen to remain in EASA post-Brexit, to secure an Air Transport Agreement that ensures liberalised aviation access to EU member states.

However, without an agreement, all UK Civil Aviation Authority-issued approvals, certificates and licences will cease to be valid in the EU – meaning UK planes won’t be able to fly in the EU.

The International Air Transport Association says a soft Brexit will see a 55% increase in UK passenger numbers by 2035, but even a hard Brexit will see growth of 45%. Nevertheless, to alleviate risk airlines have taken preventative action.

EasyJet has set up – at a cost of about £10m – an EU-based business with an air operator certificate (AOC) in Austria. It hopes that its residence and majority EU ownership status will keep it within the European Common Aviation Area. Ireland’s Ryanair has been granted a UK AOC to secure UK access after Brexit, as has Hungary’s Wizz Air.

Just before Christmas there was a hint that these bases might not be needed. In its own no-deal plans, the EU stated that UKowned airlines would be able to fly between Britain and Europe but not internally for a set 12-month period. Other conditions included UK airlines not being able to expand their number of routes to Europe or signing any bilateral agreements with individual member states.

Barry Humphreys, aviation consultant, says: “The EU has open and liberal agreements with third parties such as the US, so if they are consistent we can expect the same with the UK. An airline services agreement between the UK and EU should not take too long to secure after Brexit. In the meantime, I doubt that the EU will stop any UK air services travelling internally in Europe because they don’t want to disrupt tourism.”

Emma Giddings, aviation partner at Norton Rose Fulbright, adds: “If an EU carrier wishes to lease an aircraft from a third country, they have to show they can’t obtain that capacity from within the EU. The UK will be treated as a third country although it will be able to lease airlines from the EU. There are also questions over pilot and engineering licences and qualifications – would a UK engineer be allowed to maintain an EU aircraft?”

Parts manufacturers will also face challenges in a no-deal Brexit from increased customs delays and tariff barriers. Firms such as Rolls-Royce are reportedly in talks with manufacturer Airbus to use planes to deliver its engines to final assembly sites on the Continent and avoid sea ports.

• In-depth look at the airline industry: Flying by numbers
  Business & Management Magazine, February 2019

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