Booming Cargo Demand Helps Airlines Stanch Red Ink

Madhu Unnikrishnan
August 16th, 2020 at 6:20 PM EDT

  • It describes itself as the world’s third-largest cargo airline. But even at a time of surging cargo yields, this didn’t help Hong Kong’s Cathay Pacific avoid a mammoth $1.3b net loss for the first half of 2020 (it didn’t disclose Q2 figures alone; it reports only semiannually). Excluding special items like aircraft value impairments, Cathay’s H1 net loss was more like $891m, still a gruesome result. And that included about $130m in government grants. Operating margin was negative 23%.

    In 2019, the airline surprisingly managed a small profit, with cheaper fuel and internal cost cutting an offset to terrible demand conditions in both the passenger and cargo realms. Cargo, typically a quarter of total revenues, suffered from U.S.-China trade tensions last year. Passenger traffic suffered from civil unrest that began last August. Going further back, Cathay was a money-losing airline in 2016 and 2017, a testament to its longterm problems. The hope was that 2020 would mark a turnaround. Could demand really get any worse than it was late last year? We all know the answer to that now. On January 24, Cathay suspended all flights to Wuhan, China, in response to a mysterious virus. The rest is history.

    Today, the airline’s passenger business is serving just 22 destinations with bare minimum capacity. HK Express, a low-cost carrier it bought last year, was completely shut down through the start of this month. Total H1 ASK capacity was down 66% y/y across the group, which also includes Cathay Dragon. The decline between April and June was 97%. Thanks to the freight boom — H1 cargo revenues rose 9% despite 31% less capacity — total groupwide revenues in the half thus only declined 48% y/y.

    Operating costs, meanwhile, declined 34%. Cathay got a head start on aggressive cost-cutting given the problems it faced before the Covid crisis. But it’s also a notoriously clumsy fuel hedger, losing another $206m from hedges in the last half. Additional losses came from ancillary businesses like catering. Also generating losses was Cathay’s 18% ownership stake in Air China, which had an extremely rough first quarter (Cathay’s results incorporate Air China’s contributions three months in arrears, in this case from October 2019 through March 2020).

    On the other hand, profits increased at Air China Cargo, a separate venture in which Cathay owns a 35% stake. Air Hong Kong, a wholly-owned all-cargo subsidiary, likewise saw profits increase. Management expects the cargo strength to continue through the remainder of 2020. In fact, most of the passenger flights it’s currently operating are earning positive cash returns only thanks to belly cargo. Still, only about a tenth of its normal passenger schedule is currently flying. It’s getting a bit of a passenger demand boost from the recent removal of a ban on transit passengers through Hong Kong airport. Mainland citizens will now be able to use the hub for connections. Sixth-freedom transit traffic between the Philippines and Vietnam to and from North America is picking up. Cathay is also seeing some demand from Hong Kong residents studying overseas. Connecting passengers currently account for about a third of total volumes.

    None of this, however—not even the thriving cargo business—absolved the need for lots of new capital to sustain liquidity while the Covid crisis rages. Hence a $3.5b government rescue, in the form of share purchases and loans. Swire Pacific, Air China, and Qatar Airways, Cathay’s three top shareholders, remain so after the bailout, contributing $1.5b in new share purchases. Cathay will further preserve liquidity by deferring A350 and A320/21 NEO deliveries. It’s in advanced discussions with Boeing about deferring B777-9 deliveries as well. Much of its workforce is on unpaid leave. But there’s more cutting to do as executives ponder just how much flying future demand will be able to support. A new business plan is under development.

    On the competitive landscape, rival Hong Kong Airlines is deeply troubled. But a new startup LCC called Greater Bay Airlines, with links to Shenzhen’s Donghai Airlines, is hoping to fly in the next couple of years, the South China Morning News reports. The Greater Bay name refers to the Pearl River Delta region which incorporates Hong Kong, Shenzhen, and Guangzhou, and which Beijing hopes to develop into a leading global economic center. At the same time, however, Beijing’s recent efforts to exert greater political control over Hong Kong adds uncertainty about the city’s future role in the global economy. Under any circumstances, Cathay doesn’t expect demand to normalize for several years.
  • Istanbul opened a giant new airport for a reason. For the last two years, Turkey’s largest city was among an elite group that handled more than 100m annual passengers. The Turkish airline market, more generally, was for much of last decade one of the world’s busiest and fastest growing. Riding the wave was Turkish Airlines, greatly relieved to leave the hyper-congested old airport, cheaper to serve though it was. Now, nobody’s talking about congestion. Even the tiniest of airports would have sufficed last quarter, when Turkish operated a mere 4% of its normal ASK capacity. Only in mid-March did scheduled passenger flights resume, after roughly three months of suspension due to Covid-19.

    Thankfully though, cargo is a major and growing part of the airline’s business, which went a long way toward mitigating Q2 losses. In fact, Turkish posted the same net loss of $327m in both the first and second quarters. With revenues down much more in Q2, operating margin was worse. But at negative 26%, the loss was among the least bad industry wide. Cargo revenues ballooned by 90% y/y on skyrocketing yields, producing $747m in revenue. That compares to just $115m from passengers. Include all revenues and cargo was 83% of the total. Cargo profit margins were in the double digits. The airline said selling its cargo unit could be an attractive option in the future, especially after Istanbul’s new airport opens a new cargo terminal. Cargo super-yields won’t last forever though, and Turkish will need passenger demand to revive if it ever hopes to be profitable again.

    On a positive note, demand for domestic and shorthaul international travel is showing “mild” signs of recovery since the June reopening. It pointed to Berlin, Paris, and London as three critical routes while rebuilding the shorthaul business. Longhaul though, is a big question mark, not just for this year but into 2021 and beyond. Though Turkish depends more on narrowbody planes than its Gulf rivals, for example, it does have more than 100 B777s, A330s, B787-9s, and A350-900s essential for serving the Americas and East Asia (it smartly never ordered any A380s or B747s, nor B777-Xs for that matter, though these might yet be a useful plane for Turkish one day). Widebodies are also important in lowering the carrier’s unit costs, which management doesn’t see retuning to 2019 levels until 2022.

    That of course depends on getting aircraft utilization back to productive levels. For the second half of 2020, ASK capacity will likely be less than half (about 45%) what it was in the same six months last year. Next year, a lot depends on the status of Turkey’s tourist market, one of the world’s largest. Turkish is a big provider of flights to migrant workers and their families around Europe and elsewhere, most importantly Germany. It’s also positioned Istanbul as a leading gateway in and out of Africa, and a leading hub for niche markets like Israel and Armenia. Tel Aviv is a particularly important market, though one now threatened by the likelihood of Emirates entering the scene (see Routes section).

    Turkish, like all airlines, is taking steps to cut costs and improve liquidity. But two key negotiations are still underway, one with aircraft manufacturers about deferring deliveries and pre-delivery payments, and the other with labor unions. It says it hopes to have new labor savings secured in the coming weeks, with a goal of cutting labor costs by 30% to 40%. It thinks it can do so while avoiding layoffs. Cash burn is sufficient through the end of the year at least, though burn rates will be higher this quarter than last as it puts more planes back in the sky, which requires working capital. Depreciation, by the way, accounted for more than a third of Q2 operating costs. The government is helping in some ways, with partial wage subsidies and laws to facilitate reduced-time working, for example. Ankara also temporarily lowered taxes on domestic air travel. The airline, remember, is 49% government owned, with the rest publicly traded.

    At the moment, shorthaul demand for August looks better than July, and September looks “O.K.” The airline’s best guess for 2021 is ASK capacity down about 15% to 20% from 2019 levels.  
  • Tourism is even more important to Thailand and Thai Airways than it is to Turkey and Turkish Airlines. With passenger air service closed the entire second quarter, Thai incurred a monstrous $437m Q2 net loss ex special items, joined by a negative 361% operating margin. The airline does fly some cargo. And cargo yields sure enough went through the roof. But it didn’t make a material difference in terms of y/y revenue decline, which was 94%. Operating costs, by contrast, declined by only 72%.

    As a noxiously unhealthy airline even before the crisis, Thai was unsurprisingly forced to file for bankruptcy in May. At the same time, Thailand’s government brought its ownership stake below 50%, relinquishing control. The associated low-cost carrier Nok Air, in which Thai started and still holds a stake, also filed for bankruptcy in late July. For much of Thai’s long existence, mass tourism was enough to deliver consistent profits. But the 2010s brought trouble, in the form of much greater competition both domestically and internationally. Thai itself, to paraphrase the often-cited Warren Buffett line, was quickly revealed as a swimmer without trunks. Overstaffing, political interference, excess fleet complexity, and low yields were all problems.

    Can it successfully restructure in bankruptcy? Thailand’s airline market is screaming for consolidation, with Thai AirAsia, Bangkok Airways, VietJet, and Lion Air all competing with Thai and Nok. But barring that, Thai will need to become more productive in terms of labor and fleet. The airline will spend the next few months preparing a new business plan, which could be implemented late next year if all goes smoothly. This week, in fact, it will propose some initiatives before the bankruptcy court. But nothing will work without a return of tourists, from China in particular.

    By the way, if you’re wondering why you never saw Thai’s Q1 results, it’s because they only reported them last week, concurrent with the Q2 results. The takeaway: a negative 12% operating margin despite Q1 being the peak for Thai tourism. Another “by the way” fact: the airline’s auditors did not sign off on the financial results, concerned about its ability to sustain itself given liquidity concerns. 
  • As Korean Air and Asiana showed, it’s not impossible to make money during a global pandemic. By now it’s clear: Cargo is the key. And that’s good news for Taiwan’s two major airlines. China Airlines (CAL), which got 30% of its revenues from cargo last year, and more like a third in a typical year, saw cargo yields roughly double last quarter. That was good enough to catapult CAL into the Q2 winner’s circle with Korean and Asiana. Not only did it earn a profit ($75m net). But its operating margin was a double-digit 10%. That’s how strong cargo was last quarter, with so much belly-hold capacity grounded, and with health care and e-commerce demands soaring. The passenger business basically didn’t exist, as is clear from CAL’s 96% y/y decline in ASK capacity. Actual passenger volumes were down 98%. But thanks to cargo, total revenues fell only 39%. Even better, operating costs fell 44%, which means margins were up y/y. Indeed, during last year’s Q2, CAL’s operating margin was a mere 1%.

    Taiwan is arguably the champion of the world in terms of containing Covid-19, with just seven recorded deaths—Bermuda and Malta have had more. No surprise then, that its economy is actually expected to grow this year, by about 1% or 2% after shrinking slightly last quarter. Longterm, Taiwan’s economy will be greatly influenced by developments in relations with mainland China, which claims the island as its own. Beijing’s more assertive actions of late, in fact, make Taiwan a major geopolitical flashpoint, and a key tension point between Beijing and Washington. For the island’s airlines, both the China and U.S. markets are large, for both passengers and cargo in normal times.

    On a quirkier note, with overseas markets largely closed now, Taiwanese carriers have offered travel junkies much-publicized flights to nowhere, taking off and landing at Taipei’s Songshan airport.
  • CAL’s rival EVA is a big cargo player too, but not quite as big. It typically gets not a third of its revenue from cargo like CAL, but closer to a fifth. Sure enough, it did earn an operating profit last quarter. But operating margin was just 1%. And EVA’s net result was a $24m loss. Operating revenues fell 56% y/y, but operating costs fell only 55%. It kept passenger flights a bit more active than CAL, with ASKs down only 87%. But passenger volumes nevertheless saw a similar 98% decline. EVA has a more North America-centric passenger network than CAL, carrying many nonstop travelers in normal times, but also connecting traffic between North America and the ASEAN region. Restrictions on such transit traffic were lifted in June. Unlike Seoul, Taipei is not a major hub for North America-mainland China traffic, with mainland citizens barred by Beijing from using the airport to connect, for political not health reasons.

    Prior to the global Covid pandemic, Taiwan’s two major airlines had other concerns, including tough foreign LCC competition, trade wars, occasional labor unrest, and the birth of an ambitious new carrier called StarLux, with an order book of NEOs and A350s. Looking ahead, EVA said last month that it expects some Asian carriers including LCCs to perish or merge as a result of the crisis. It also noted how pre-crisis concerns about airport slots and pilot shortages are now “less urgent.” It added that an uncertain cross-Strait relationship with Beijing will complicate and lengthen the recovery period. As for cargo, transporting vaccines as they emerge should be a major area of activity in 2021.

A Less-Rosy Picture in Latin America

  • Forget about finding any airlines earning profits in In Latin America. Instead you’ll find a wave of bankruptcies affecting even the region’s largest and strongest carriers. Avianca is one. It undertook a successful out-of-bankruptcy restructuring process just before the crisis. All the work proved insufficient however, after Colombia suspended all air travel to contain the Covid pandemic. Now restructuring again within the confines of a U.S. bankruptcy court, Avianca last week disclosed a $232m net loss for Q2. Operating margin was a relatively not-so-awful 64% but this included some one-off revenue gains from asset sales; without these gains, operating margin would have been negative 138%. In last year’s Q2, a slow season in South America, Avianca’s operating margin in Q2, 2019, was negative 3%. The airline is now using its bankruptcy rights to renegotiate or walk away from old contracts, with aircraft lessors and bondholders, for example.

    A big priority is finalizing a new deal for $2b in debtor-in-possession (DIP) financing to cover its liquidity needs through the crisis. It’s also planning to use DIP cash to buy back most and potentially all of the 30% stake in its LifeMiles loyalty plan that it sold to investors a few years ago. One earlier move was closing its Peruvian airline operation. Cargo by the way, accounted for 60% of total Q2 revenue, with most of the rest from other business units like LifeMiles. Passenger revenue was less than 2%.

    Colombia’s airline market is still closed as the country and South America in general suffer greatly from the virus, medically and economically. But the intention remains: To transform Avianca into a “highly competitive, right-sized, solidly profitable airline.”
  • The Brazilian carrier Azul echoed the sentiments of most airlines by calling the Covid crisis “the most challenging time in aviation history.” It’s so far managed to avoid the bankruptcy plight of other South American carriers including rival Latam. But it’s fervently restructuring its balance sheet and slashing costs outside of bankruptcy after a $544m net drubbing last quarter. Exclude special items and the net loss was more like $278m. Operating margin was negative 204%.

    But you get the point: Azul like the rest of the airline industry needs to become smaller and leaner. It already has agreements to defer 82 aircraft deliveries. It cut wages by 40%. It more generally variabalized much of its labor obligations, so that costs drop when flying less, and vice versa. Latin governments have been notoriously unhelpful in supporting their airlines financially during these dire times, hence the multitude of bankruptcies. But Brazil did undertake some helpful reforms, including a relaxation of costly consumer protection laws. The government’s development bank is also providing credit support, but it’s hardly a sweet deal and not something Azul currently plans on using. It might not need to after successfully lowering its near-term cash obligations, giving it about two years of liquidity. It also has a wholly-owned loyalty plan to collateralize if necessary. And though it’s selling its ownership position in TAP Air Portugal, money it lent to the carrier won’t be at risk with Lisbon providing TAP a big bailout. With aircraft lessors, Azul negotiated a deal whereby lease obligations for the remainder of 2020 will decline by 77%. In exchange, the carrier will pay slightly higher lease rates starting in 2023, or in some cases agree to extend existing lease terms at market rates.

    Despite Brazil’s terrible experience with the virus, domestic airline demand is recovering at a faster pace than in other parts of the world. Azul aims to be flying about 60% of its normal ASK capacity by December, which is higher than the 40% it envisioned earlier in the crisis. The economy began reopening from lockdown last month, and leisure demand already exceeds 50% of last year’s levels. Azul says business demand is starting to show some green shoots too. Average fares, indeed, have increased in the past few weeks. The airline is also a significant cargo player, with e-commerce shipments announcing for about a fifth of its freight revenues. Management emphasized the advantage of having a diverse fleet, including smaller planes with low trip costs.

    Another advantage is its hub network that funnels passengers from all over Brazil through airports like Campinas near São Paulo. One example of its flexibility is a shift from high-frequency E-Jet service between Rio’s downtown airport and Campinas (catering to business travelers) to lower-frequency A320 service (catering to leisure and family-visit travelers, many of whom are connecting in Campinas to someplace else). During normal times, roughly 65% of Azul’s traffic is flying for business.

    Strategically, Azul last week implemented a new codeshare and loyalty partnership with Latam, something unthinkable from a regulatory point of view pre-crisis. It’s also selling some older E1 E-Jets to David Neeleman’s new U.S. startup, Breeze.

    “Crisis brings opportunities,” Azul insists, promising to emerge as a lower-cost and more efficient airline by 2022.

Cebu Pacific Frustrated by Government Restrictions

  • Cebu Pacific of the Philippines was a profitable airline before the crisis, and one that planned to expand more aggressively with new planes after several years of stagnation. But Covid-19 caused a rough Q2 loss, captured by a negative 442% operating margin. Revenues plummeted 94% y/y but operating costs declined only 59%. Cebu was essentially non-operational in the quarter, with ASK capacity down 99%. The only exception was cargo, which was ramped up in the quarter.

    Cebu expressed frustration with travel policies within the Philippines, which can vary greatly by local government. Some localities only permit Philippine residents to travel. Some have limits on even domestic flight frequencies. Required documentation varies. Cebu contrasts this with Indonesia, Thailand, Vietnam, and Malaysia, which all now at least permit domestic leisure travel. As a result, Cebu’s capacity will be just a tenth of normal next month. Forward bookings look terrible.

    The LCC is negotiating with Airbus for delivery deferrals of its A321 NEOs and A330 NEOs. It continues to add more cargo flights. And it’s using the downturn to devise new ways to increase efficiency in operations, maintenance, passenger services, payments, crew scheduling, and so on. The efforts, along with more incoming A321 NEOs, should reduce unit costs 21% from 2022 (when demand hopefully normalizes) to 2025.
  • After a profitable first quarter, Air Arabia suffered a $65m net loss in the second quarter. Q2 operating margin was negative 173%. The low-cost carrier is based in the Emirate of Sharjah, where it stations 37 planes. It has another nine flying for a joint venture it operates in Morocco. It has a four-plane joint venture in Egypt. And just last month, it launched its latest joint venture: Air Arabia Abu Dhabi in cooperation with Etihad.

    Across the group, Q2 revenues declined 90% y/y, having flown just 40k passengers. In the same quarter a year ago, it flew 2.3m passengers. Operating costs, meanwhile, fell 65%. Air Arabia runs a number of other businesses, offering maintenance, hotel rooms, training, tour packages, etc. That diversification normally offers a hedge against the ups and downs of air travel. Not now though. Everything travel- and aviation-related is suffering. Well, except cargo, which offers Air Arabia a bit of relief. It also made some money with charter flying, mostly for repatriation purposes. The airline, controlled by Sharjah’s government, feels conformable with its liquidity position. But more cost cutting is necessary.

    Unfortunately, it signed a contract to by 120 NEO jets from Airbus in November—if only it had waited until the market crashed. It’s now even questionable whether it needs all those planes, with travel demand likely depressed for the next few years. Then again, maybe traffic will revive faster than expected. It does help to be a low-cost shorthaul carrier. Dubai, for which Sharjah is a convenient gateway, reopened to tourists last month. Air Arabia is already flying NEO LRs, which enables longer routes like Sharjah-Kuala Lumpur. It will take a fifth LR before year end. In its 120-plane order last fall, included were 20 XLRs with even greater range.     
  • Back in Turkey, Pegasus is a quiet competitor to Turkish Airlines, less well known abroad but often more profitable. Last year, it was the world’s fourth-most profitable airline with a 19% operating margin. During summers, its margins can be stratospheric. So how is it dealing with the greatest industry crisis ever? It didn’t operate any scheduled flights during April and May, reviving domestic service only on June 1, and international service on June 13. Without any cargo to soften the blow, operating margin for the quarter was negative 356% on a mere $24m in revenue. Revenues and operating costs declined 95% and 75% y/y, respectively. Labor costs, more specifically, dropped 63% with help from unpaid leave schemes and government wage subsidies.

    Like its fellow LCCs Ryanair and Wizz Air, Pegasus will be fine once leisure traffic volumes return to something akin to normal. It doesn’t need high-yield traffic given its low-cost structure. The recovery will take time though, with the carrier’s domestic ASK capacity back to just three quarters of normal last month, and passenger volumes only 58% of normal. The July international figures are lower (22% of normal ASKs and 15% of normal traffic). Pegasus is still taking A320 and A321 NEOs this year, planning for a near all-NEO fleet by 2024, with CEOs and B737s on the way out.
  • Air Arabia’s LCC rival Jazeera Airways, based in Kuwait, posted a $13m Q2 net loss, with a negative 54% operating margin, according to financial statements published with the Kuwaiti stock exchange. Its balance sheet, meanwhile, showed a big increase in both its cash balances and liabilities, consistent with various fundraising efforts. Jazeera didn’t provide any commentary about Q2.

    But before the pandemic, it was starting to adopt a more ambitious growth strategy after many years of keeping its fleet and network small. A number of new NEOs entered service. It began serving more Indian subcontinent routes. And it even launched an A320 NEO flight from Kuwait to London Gatwick. It also operates its own terminal at Kuwait’s main airport. Another change in strategy was a decision to adopt a new pricing model and abandon business class seating on all but its London Cairo flights. It was supposed to add five new NEOs and five new routes this year.
  • Chorus, which operates much of Air Canada’s regional operation, managed a $20m net profit last quarter thanks to part of its revenue coming from fixed margin contracts with its partner that don’t vary with aircraft activity. But the net result excluding special items was negative, as was its operating margin (-11%). Canada’s extremely stringent travel restrictions meant Chorus could only operate about 5k flights last quarter, compared to 56k typically. It flew just 9% of it Q2, 2019 block hours. It was also forced to cut more than 65% of its workforce and raise new funds.

    Chorus complained no less loudly than Air Canada about Ottawa’s aviation and travel policies, citing the absence of financial aid and higher costs. Nav Canada, responsible for air traffic control, is actually increasing charges 30% next month, Chorus said. Air Canada, meanwhile, is closing regional airports and shuttering routes. 
  • U.S. regional airlines are certainly not immune to the Covid catastrophe. But their business model protects them from some of the short-term pain. Fortunately for them, the four U.S. airlines that outsource a major portion of their flying—United, American, Delta, and Alaska—have sturdy enough liquidity positions to pay their bills. According to a typical capacity purchase agreement between two carriers, the mainline partner provides a guaranteed monthly fee per aircraft under contract, plus a fixed fee for each block hour and flight actually flown. They’ll also cover the regional carrier’s direct operating expenses, i.e. for fuel.

    Mesa Air—which flies CRJ-900s for American and E175s and CRJ-700s for United—collected its fees and earned a $3m calendar Q2 net profit. But that included the payroll support it received from Washington. Assuming Mesa had paid for labor itself, the company’s actual net result would have been a $40m loss, accompanied by a negative 38% operating margin. The big issue was a heavy reduction in flying with American and United cancelling so many flights. Mesa’s block hours, a measure of capacity flown, declined 70% y/y, meaning woefully low utilization of aircraft, workers, and other resources.

    That said, flying should be up considerably this month and next, and Mesa won’t have to furlough any workers if current schedules more or less hold firm. After payroll support expires on Oct. 1, assuming no extension, the airline will however implement reduced hours and continue voluntary leave programs. Competing with the regional giant SkyWest isn’t easy. But Mesa’s low costs are an advantage, and one it intends to preserve.

    The radically altered pilot market will certainly help on the cost side—no more big hiring bonuses and frequent turnover. On the revenue side, Mesa is talking to American about a contract extension. More E175s are coming for United, though financing the new jets is a challenge. More unorthodox is a new contract to fly B737-400s for the cargo carrier DHL. This will among other things help keep pilots gainfully flying, keeping them around for what could one day be another regional pilot shortage. As for liquidity, Mesa intends to take advantage of Washington’s CARES Act loan program. 
Madhu Unnikrishnan
August 16th, 2020 at 6:20 PM EDT

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