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This page intentionally left blank
Airline Finance
Third Edition

PETER S. MORRELL
Cranfield University, UK
© Peter S. Morrell 2007

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system
or transmitted in any form or by any means, electronic, mechanical, photocopying, recording
or otherwise without the prior permission of the publisher.

Peter S. Morrell has asserted his right under the Copyright, Designs and Patents Act, 1988, to
be identified as the author of this work.

Published by
Ashgate Publishing Limited Ashgate Publishing Company
Gower House Suite 420
Croft Road 101 Cherry Street
Aldershot Burlington, VT 05401-4405
Hampshire GU11 3HR USA
England

Ashgate website: http://www.ashgate.com

British Library Cataloguing in Publication Data

Morrell, Peter S., 1946-
Airline finance
1. Airlines - Finance
I. Title
387.7'1

Library of Congress Cataloging-in-Publication Data

Morrell, Peter S., 1946-
Airline finance / by Peter S. Morrell. -- [3rd ed.].
p. cm.
Includes bibliographical references and index.
ISBN 978-0-7546-7000-1
1. Airlines--Finance. I. Title.

HE9782.M67 2007
387.7'1--dc21
2006034812

ISBN 13: 978 0 7546 7000 1 (Hbk)

ISBN 13: 978 0 7546 7134 3 (Pbk)

Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire.
 Contents

List of Figures viii

List of Tables ix
Preface xiii

1 Industry Financial Performance 1

1.1 World Airline Financial Results 1
1.2 Factors Affecting Financial Results 8
1.3 Asset Utilisation 10
1.4 Key Financial Issues 12

2 Airline Financial Statements 15

2.1 Introduction 15
2.2 Profit and Loss Account (Income Statement) 17
2.3 Balance Sheet 26
2.4 Balance Sheet Comparison: BA vs AMR 36
2.5 Cash Flow Statement 38
2.6 Value Added Statement 42
2.7 Cash Value Added 43
2.8 Progress Towards Greater Accounting Standardisation 44
Appendix 2.1 Frequent Flyer Programme Award Accounting 47
Appendix 2.2 Accounting for Finance and Operating Leases 51

3 Airline Financial Ratios 55

3.1 Performance/Earnings Ratios 56
3.2 Risk or Solvency Ratios 59
3.3 Liquidity Ratios 62
3.4 Stock Market Ratios 64
3.5 Inter-airline Comparison of Financial Ratios 69
3.6 Interpretation Problems 72

4 Airline Valuation 75
4.1 The Valuation of Intangible Assets 75
4.2 The Valuation of Tangible Assets 83
4.3 The Valuation of the Airline as a Whole 84
4.4 Ratings Agencies 88

5 Sources of Finance 91
5.1 Sources of Internal Finance 92
5.2 Sources of External Finance 93
5.3 Institutions Involved in Aircraft Finance 100
vi Airline Finance
Appendix 5.1 Term Loan Repayment, Book Profit and Manufacturers’
Pre-payments 109

6 Equity Finance 113

6.1 Share Issues 113
6.2 Equity Finance for Start-up Airline 115
6.3 Foreign Ownership Limits 117
6.4 Share Trading and Stock Market Listings 119
6.5 Initial Public Offering (IPO) 124
6.6 Mergers and Cross-Investment 126

7 Airline Privatisation 129

7.1 Full Privatisation through Flotation – British Airways 131
7.2 Full Privatisation through Trade Sale and Flotation – Qantas 135
7.3 Gradual Privatisation – Lufthansa 137
7.4 Partial Privatisation – Kenya Airways 139
7.5 Full Privatisation and Trade Sale – Iberia 142
7.6 Gradual Privatisation and Acquisition – Air France 142
7.7 The Results so Far 145

8 Airline Financial Planning and Appraisal 151

8.1 Budget Preparation and Control 151
8.2 Working Capital Management 156
8.3 Financial Planning 160
8.4 Start-up Airline Business Plan 171

9 Risk Management: Foreign Currency and Fuel Price 175

9.1 Exchange Rate Volatility 175
9.2 Airline Trading Exposure to Currency Movements 178
9.3 Airline Balance Sheet Exposure to Currency Movements 183
9.4 Airline Foreign Exchange Risk Management 184
9.5 Fuel Price Exposure 189

10 Aircraft Leasing 195

10.1 Finance Lease 197
10.2 Operating Lease 200
10.3 Japanese Operating Lease (JOL) 203
10.4 Wet Lease 204
10.5 Sale and Leaseback 204
Appendix 10.1 Lease Rental Calculations 206
Appendix 10.2 Lease vs Buy Decision 207

11 Aircraft Securitisation 211

11.1 Equipment Trust Certificates 212
11.2 ALPS 92-1 Securitisation 213
11.3 ALPS 94-1 Securitisation 215
 Contents vii
11.4 Airplanes 96 Securitisation 215
11.5 ALPS 96-1 Securitisation 216
11.6 More Recent Securitisations (2005/2006) 217
11.7 Conclusions 217

12 Airline Bankruptcy 219

12.1 North America 219
12.2 Latin America 223
12.3 Europe 224
12.4 Australasia 226
12.5 Summary 227

13 Industry Financial Prospects 229

13.1 World Airline Traffic and Financial Forecasts 229
13.2 World Airline Capital Expenditure Projections 231
13.3 World Airline Financial Requirement Forecasts 232

Bibliography 235
Glossary of Terms 239
Index 251
 List of Figures

Figure 1.1 ICAO scheduled airline traffic growth vs world GDP growth 2
Figure 1.2 ICAO scheduled airline financial results 3
Figure 1.3 ICAO scheduled airline financial results as per cent revenues 4
Figure 1.4 Operating result as per cent revenues by region of airline 5
Figure 1.5 Net/operating margins by type of carrier (average of
2003/2004/2005) 7
Figure 1.6 Passenger load factor trends by major world region 7
Figure 1.7 Airline return on invested capital (ROIC) 8
Figure 1.8 Actual and break even load factors for ICAO scheduled airlines 9
Figure 1.9 World airline stock index vs top share indices, 1995–2006 13

Figure 2.1 Aircraft lease classification guidelines 55

Figure 4.1 Income statement valuation ratios for selected airlines by region 88
Figure 4.2 Balance sheet valuation ratios for selected airlines by region 89

Figure 6.1 Ryanair (Dublin) vs Nasdaq (ADR) share price 120

Figure 7.1 British Airways’ share price trend vs UK market 137

Figure 7.2 Qantas Airways’ share price trend vs Australian market 139
Figure 7.3 Lufthansa share price trend vs the German market 140
Figure 7.4 Air France share price trend vs the French market 145
Figure 7.5 Air France-KLM post merger interim structure 146

Figure 8.1 NPV vs discount rate: A330-300 vs B777-200 170

Figure 9.1 Key currency exchange rates vs US dollar, 1983−2005 179

Figure 9.2 Selected Asian exchange rates vs US dollar, 1997/1998 184
Figure 9.3 Cost of hedging vs eventual spot rate 189

Figure 10.1 Number of airlines owning and leasing aircraft 198

Figure 11.1 Aircraft financing spectrum 214

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 List of Tables

Table 1.1 World airline productivity 11

Table 2.1 British Airways’ Group consolidated income account 22

Table 2.2 British Airways’ operating accounts 23
Table 2.3 British Airways’ turnover/profit by area of sales 23
Table 2.4 American Airlines’ consolidated statement of operation 24
Table 2.5 Lufthansa Group consolidated income statement 25
Table 2.6 British Airways’ Group balance sheet 30
Table 2.7 British Airways’ Group non-current assets 31
Table 2.8 Airline depreciation example 32
Table 2.9 Depreciation rate comparison for 2005/2006:
Short/medium-haul aircraft 33
Table 2.10 British Airways’ Group current assets 34
Table 2.11 British Airways’ Group current liabilities 35
Table 2.12 British Airways’ Group non-current liabilities 36
Table 2.13 British Airways’ Group capital and reserves 37
Table 2.14 Balance sheet comparison: Assets, 2005/2006 39
Table 2.15 Balance sheet comparison: Liabilities, 2005/2006 40
Table 2.16 British Airways’ group cash flow statement 41
Table 2.17 Summary cash flow statement comparison, 2005/2006 43
Table 2.18 Value added statement for British Airways Group 44
Table 2.19 Cash value added statement for British Airways Group 45
Table 2.20 AAdvantage award distribution in 2005 52

Table 3.1 British Airways Group – Operating ratio/margin 58

Table 3.2 British Airways Group – Net profit margin 59
Table 3.3 Return on Invested Capital (ROIC) 60
Table 3.4 Return on Equity (RoE) 61
Table 3.5 British Airways Group – Interest cover 62
Table 3.6 British Airways Group – Debt/equity ratio 62
Table 3.7 Effect of gearing on ratios 64
Table 3.8 British Airways Group – Current ratio 65
Table 3.9 British Airways Group – Quick ratio 66
Table 3.10 British Airways Group – Dividend cover 66
Table 3.11 British Airways Group – Market capitalisation 67
Table 3.12 British Airways Group – Earnings per share (EPS) 67
Table 3.13 British Airways Group − Price/earnings ratio 68
Table 3.14 British Airways Group – Net asset value per share 69
Table 3.15 British Airways Group – Equity value/EBITDAR 69
Table 3.16 Key financial ratios for major airlines, 2004/2005 72
x Airline Finance
Table 4.1 British Airways’ valuation criteria 89
Table 4.2 Selected airline debt ratings, June 2001 and December 2004 90

Table 5.1 Scheduled world airlines balance sheet long-term financing 94

Table 5.2 Hypothetical example of manufacturer’s support for aircraft
finance 102
Table 5.3 Top 10 operating lessors and their fleets − end 2005 108
Table 5.4 Examples of European Investment Bank lending to airlines 109

Table 6.1 Venture capital interests in LCC/start-up airlines, early 2000s 118
Table 6.2 International passenger airlines with stock market listings 122
Table 6.3 Major world stock indices 123
Table 6.4 AMEX Airline Index (XAL), July 2006 124
Table 6.5 Constituent airlines of the MSCI world airline index (July 2006) 125
Table 6.6 British Airways’ Performance Share Plan comparator airlines 125
Table 6.7 Airline IPOs taking place between 2000 and 2006 127
Table 6.8 Major airline cross-border investments in other airlines
(June 2006) 129

Table 7.1 Government shareholdings (per cent) in top 20 international

airlines, 2005 132
Table 7.2 British Airways’ and Laker Airways’ liabilities 134
Table 7.3 British Airways’ privatisation factsheet (1987) 135
Table 7.4 Initial post-privatisation British Airways share distribution 136
Table 7.5 Qantas Airways’ post-offer share distribution 138
Table 7.6 Qantas Airways’ privatisation factsheet (1995) 138
Table 7.7 Lufthansa shareholding − 1996 and 1997 141
Table 7.8 Kenya Airways’ pre-privatisation financial data 142
Table 7.9 Kenya Airways’ post-privatisation results 143

Table 8.1 Route profitability analysis 155

Table 8.2 Typical airline management accounts − Budget 2006 156
Table 8.3 Example of airline cash budget 157
Table 8.4 Aircraft investment appraisal cash flow forecasts (US$ million) 163
Table 8.5 Example of accounting rate of return 164
Table 8.6 Example of payback period 165
Table 8.7 Financial evaluation of alternatives 169
Table 8.8 Start-up airline business plan 172

Table 9.1 Effect of exchange rate depreciation on profits of exporter airline 181
Table 9.2 Effect of exchange rate depreciation on profits of importer airline 182
Table 9.3 SAS revenue and cost currency breakdown in 2005 (per cent) 182
Table 9.4 Impact of currency changes on Qantas after-tax profit for
1995/1996 183
Table 9.5 Asian airline US dollar mismatch 184
Table 9.6 Fuel surcharges announced by major airlines in 2004 191
 List of Tables xi
Table 9.7 Percentage of 2004 fuel needs hedged at 31 December 2003:
US majors 194
Table 9.8 FY2004/2005 fuel needs hedged at YE2003/2004:
Largest non-US carriers 195

Table 10.1 Leased aircraft shares by region for selected airlines 199
Table 10.2 Typical operating lease terms 204

Table 11.1 ALPS 92-1 aircraft portfolio 216

Table 11.2 ALPS 92-1 bond amounts and interest rates 216
Table 11.3 Airplanes securitisation − Aircraft numbers and values 217
Table 11.4 Airplanes securitisation − Bond amounts and interest rates 218

Table 12.1 Key US airline Chapter 11 entry and exit 222

Table 13.1 World air traffic and GDP forecasts 232

Table 13.2 Air traffic forecasts by region: Airbus vs Boeing 232
Table 13.3 IATA short/medium-term forecasts 233
Table 13.4 Commercial jet aircraft delivery/retirement forecasts 234
Table 13.5 Boeing airplane demand by region (2004−2023) 235
This page intentionally left blank
 Preface

The purpose of the book is to provide, as far as possible, a broad understanding of

all areas of airline finance. To do this, it has been necessary to sacrifice some detail,
but sometimes accountants and industry specialists will be directed to other texts
to explore more complex topics further. In many cases, however, these other texts
do not exist, at least in an air transport industry context. This significant gap, at
least at the level of the non-specialist, is the main reason for this book. While there
are obviously numerous financial management, corporate finance and related texts
available, none of these provide explanations, as this book does, for some of the
quirks of the airline industry (for example, the accounting treatment of frequent flyer
programmes or the various aircraft leasing options available). Furthermore, none of
them provide worked examples based solely on the air transport industry.
It is hoped that each area of airline financial management will be discussed in
sufficient depth to satisfy both those in the industry without any financial background,
and newcomers to the industry perhaps with some knowledge of finance. No prior
knowledge is required of, for example, accounting, economics or statistics to gain
considerable benefit from the book. In a few cases, notably in the chapters on
investment appraisal and aircraft leasing, mathematical formulae have been used,
but in such cases they are based on relatively simple compound interest concepts,
and generally confined to a separate appendix at the end of the chapter.
The opening chapter describes the financial trends for the airline industry as a
whole, with developments for the major regions and airlines also contrasted. This
is followed by a step by step analysis of an airline’s financial statements. British
Airways has been chosen as an example because of the way it presents its published
financial statements with sufficient clarity and detail for the reader to obtain a good
understanding. Other airlines’ accounts are also introduced to contrast different
approaches, especially the AMR Corporation (the parent of American Airlines) and
in the following chapter to compare financial performance and ratios.
The valuation of an airline as a whole, its route rights and airport take-off and
landing slots are dealt with next, covering the techniques applied both in equity
IPOs (Chapter 6) and airline privatisation (Chapter 7). First sources of finance are
discussed and the institutions that specialise in airline financing. This is followed
by a new chapter on equity finance that looks at way start-up airlines are financed.
The application of some the key techniques in financial analysis are then explained
and applied to the airline industry, supported by practical examples faced by airline
planners. The role played by hedging and derivatives in the airline industry is
introduced in the next chapter, again supported by actual airline examples. Fuel price
hedging has been expanded in this third edition, both because of its close relationship
with currency hedging, also because of its more widespread use by airlines and
greater relevance. Leasing is examined in some detail, and aircraft securitisation is
explained, as well as a new chapter on airline bankruptcy before concluding with
xiv Airline Finance
an evaluation of the financial prospects of the industry. Wherever possible, the
links between the various elements of airline finance will be highlighted, although
the textbook nature of the book will ensure that each chapter and topic could be
consulted separately.
Finally, it would be impossible to mention all those who have contributed,
knowingly or otherwise, to the book. Over the past years, MSc students of air transport
management at Cranfield University have made numerous valuable comments,
pointed out errors, and generally provided the motivation for the development of
much of the material presented here. Over the same period, airline industry executives
attending one week airline finance short courses at Cranfield University have done
the same, albeit from a different perspective. Special thanks must also be extended
to senior airline industry experts who have given up their precious time to contribute
to those courses (and my understanding of the industry), in particular more recently:
Ian Milne of British Airways; Alan Robinson of ALM; John Ludden and colleagues
from GECAS; Kevin Jones of ECGD; Alan Meldrum and colleagues from KPMG,
and Andrew Lobbenberg, a former colleague now with ABN Amro.
I am also grateful to all my colleagues in the Department of Air Transport at
Cranfield’s College of Aeronautics for their help in discussing both industry trends
and the more specific concepts included in this book.
 Chapter 1

Industry Financial Performance

1.1 World Airline Financial Results

The airline industry has over the years been buffeted by both economic cycles and
threats from terrorism and epidemics. Following seven years of good profitability
that stemmed from a relatively long world economic upswing between 1994 and
2000, it suffered a severe setback in the 2000s with the post ‘year 2000’ downturn
and the aftermath of 9/11. Cumulative net losses of the world’s scheduled airlines
amounted to US$20.3 billion between 1990 and 1993, but this was followed by
almost $40 billion in net profits between 1995 and 2000. This highlights the cyclical
nature of the industry, and the need to treat with caution comments after the Gulf War
recession and 9/11 about the continued ability of the industry to finance expansion.
Since the end of the early 1990s recession, the airlines’ balance sheets have been
considerably strengthened, even allowing for the replacement of large numbers of
noisier aircraft that did not meet the current Chapter 3 standards. ICAO figures show
the debt/equity ratio for the world’s scheduled airlines declining from a high of
2.90:1 at the end of 1993 to 1.42:1 at the end of 1999. This had deteriorated to 2.46:1
in 2003, before improving somewhat to 2.41:1 in 2004.1
Clouds appeared on the horizon in 1999, with the price of jet fuel jumping from
40 cents per US gallon a barrel to 75 cents in January 2000. This led to a drop
in operating profits, although net profits were maintained largely due to the sale
of aircraft and non-core investments such as holdings in IT and communications
companies. The dollar price of fuel in 2001 was still well below its high in 1981.
At that time fuel expenses rose to just under 30 per cent of total airline operating
expenses. In 2000, they were still only 12 per cent of the total, even after recent
sharp increases. This has been helped by substantial advances in fuel efficiency.
For example, British Airways has reduced its average fuel consumption in terms of
grams per revenue tonne-km from around 440 in 1990/1991 to 345 in 1999/2000
(or by an average of 2.6 per cent a year), and is on track to meet its target of 306 g
in 2010.2
As stated above, the fuel price started increasing alarmingly in early 1999; a
further advance occurred at the end of summer 2000 to a high of 107 cents, before the
price fell back to around 75 cents by the end of 2000.3 The next period of instability
was in 2004, when prices ranged from a low of 92 to a high of 157 cents per US

1 ICAO: Tables A−4 from Financial data.

2 British Airways, (2000), Social and Environmental Report 2000.
3 Lufthansa Cargo Website, (2001). Retrieved from www.lufthansa.com average of spot
jet fuel prices for Rotterdam, Mediterranean, Far East Singapore, US Gulf and West Coast.
2 Airline Finance
gallon. In the following year the range rocketed up to 119−223 cents, and the 2005
high of 223 cents was again reached in August 2006.

Figure 1.1 ICAO scheduled airline traffic growth vs world GDP growth

Some economists link any sudden and substantial rise in fuel prices to an economic
recession about 18 months later. This appeared to be happening in 2001, as the downturn
in the US economy began to have a serious effect on Asian exports, especially for
countries such as Taiwan and Federation of Malaysia. The impact of declining GDP
for the major world economies such as the US, EU and Japan has in the past led to a
downturn in traffic (Figure 1.1). The first ever decline (as opposed to large reduction in
growth rate) in world air traffic growth in 1991 was due to the combined effects of the
Gulf War and the world economic recession, with a second in 2001.
Figure 1.2 shows the cyclical nature of past financial results for the world’s
scheduled airlines. As mentioned above, the impact of rising fuel prices on costs
resulted in a deterioration in operating results for 1999 and 2000, and a slowing of
the recovery in 2004/2005. Other cost items such as flight crew salaries also rose
sharply for some airlines in 2000/2001, but this has been cushioned to some extent
by lower distribution costs. The Asian financial crisis of 1997/1998 can be seen to
have had little effect on the fortunes of the world’s airlines, but a significant impact
on a number of Asian carriers (see Figure 1.4). The SARS health threat of 2003 was
more local, affecting carriers such as Cathay Pacific most severely.
The difference between the operating and net profit is caused by net interest paid,
gains or losses on asset sales, taxes and subsidies, and provisions for restructuring.
Interest paid is the largest of these items, and this has declined in the second half
of the 1990s due to the combined effects of falling interest rates and lower debt
outstanding. Profits from asset sales also make a good contribution in some years,
generating over $2 billion in both 1998 and 2003.
 Industry Financial Performance 3
Preliminary estimates for 2005 suggest that the recovery is continuing, and in
2006 even some of the ailing US legacy carriers reported profits. However, the
cyclical pattern looks like recurring once higher oil prices start to affect consumer
and business spending. Their impact on airlines in 2005−2006 could be mitigated by
passing on some of fuel cost increases to consumers, against a background of strong
demand. The danger is the combined impact of weak demand and continued high oil
prices. The other difference this time is that more airlines are privately owned, and
subsidies might be not be forthcoming. However, the re-nationalisation of Malaysian
Airlines and Air New Zealand (see Chapter 7) suggests that air transport may still
receive special treatment.

Figure 1.2 ICAO scheduled airline financial results

Subsidies approved by the European Commission for payment to just five European
airlines (Olympic Airways, TAP Air Portugal, Iberia, Air France and Aer Lingus)
between 1992 and 1997 totalled US$8.94 billion, or almost 17 per cent of the sum of
the airlines’ three previous years’ revenues.4 On the basis that they were paid in equal
instalments over the 5 years, 1992−1997, this would have amounted to $1.8 billion
a year. By 2006, two of these airlines had been successfully privatised, and a third
radically transformed into a profitable airline expected to be privatised by 2007. The
last two, TAP and Olympic, are still loss-making and defy efforts to privatisation.5

4 Cranfield University (1997), Single Market Review, 1996: Impact on Services – Air
Transport, Kogan Page for the European Commission.
5 Unable to sell the airline, they both split off ground handling services with the intention
of privatising that separately.
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