Aviation: Dark skies ahead for Flybe?

It seems almost certain that there’s more turbulence ahead for beleaguered UK carrier Flybe. A month ago the airline issued a profits warning, which it followed on November 14 with an announcement that it was open to takeover bids. The latest financial filing shows that it made a profit during the first half of 2018 which was lower than the equivalent last year. Passenger volumes were up slightly but yield (the margin made from each passenger) was down. This came despite changes already having taken place within the business and an acknowledgement that urgent improvements to its financial position were going to be necessary.

Difficult trading conditions

The airline’s 2018 H1 results included some interesting titbits that further explain why Flybe is in a precarious position. Average revenue per seat increased to just over £60 during the first half of 2018 but the firm was hit by a 5.9% increase in costs, mainly from currency fluctuations and hikes in fuel prices. As a result its shares, which were valued near £0.50 in March and have been as high as £1.50, dropped substantially. Although there was a rebound immediately after the interim results were posted, the stock price has since bumped along at near £0.12.

Clearly the business is in need of further reform. Looking forward, a significant proportion of its current major problems – future currency and fuel costs – are hedged (committed in advance at a pre-determined price). But securing those deals has been expensive – fuel is now booked at £663 per tonne rather than £518 previously. Taking into consideration staffing that costs Flybe an average of £10.09 per passenger, £16.03 going to acquisition and maintenance the fleet, and £30.83 required to operate the aircraft (fuel, airport and navigation charges), it becomes obvious that there’s slim pickings left from the £60-odd that it typically extracts from each customer.

The predicament

The fundamental problem is that the majority of Flybe’s business comes from short domestic flights. While lucrative business travel is part of the mix, it also competes with rail and road. Flybe’s lead-in fares are often competitive with – and sometimes lower than – surface transport, and even over shorter booking horizons it often betters flexible train fares. But the airfare paid by UK domestic travellers includes £13 Air Passenger Duty (APD) that goes directly to the government; on that basis alone the treasury makes more from every Flybe customer than the airline does itself.

On the other hand several train companies that Flybe competes against receive a subsidy (Cross Country - £0.051 per passenger per kilometre, Great Western - £0.048/pax/km, Virgin West Coast - £0.016/pax/km). On a 403 miles trip from London to Glasgow the direct tax take from an airline passenger is £13, while the railway receives £10.39 from the government for an equivalent journey. Another problem is that Flybe’s fuel and currency costs have also risen much faster than inflation. Flybe anticipates that these costs could increase further, and credit card issuers might demand additional cash to secure payments. And yet if it raises fares it risks losing customers, especially to rail where some ticket prices are regulated and can’t be increased by more than RPI + 1% each year.

It’s not all bad news though. Some aircraft that were expensive to operate have been removed from the fleet with more to follow over the next couple of years, while lease costs have been cut. Unprofitable routes have been abandoned, capacity is down and load factors are up – and that’s always a good mix. Managers are also seeking additional ‘code share’ partnerships with larger airlines, primarily on connections between long-haul routes and its plethora of links to smaller regional airports. These deals could be quite lucrative, as long as Flybe gets a reasonable share of the revenue (a failing that partly contributed to the demise of another UK airline, bmi, back in 2012). It’s obvious that progress is being made as future bookings are ahead of last year, but the business could be further weakened yet by the ongoing uncertainty over the Brexit outcome.

At the end of the first half, the comments of independent auditors PriceWaterhouseCoopers summed up the challenges succinctly: “Flybe's operating results vary significantly from quarter to quarter and the first half of the year is generally significantly stronger than the second half as the airline industry enjoys higher demand and yields during the Summer season…” and “[The possibility of card acquirers requiring more cash collateral] indicate the existence of a material uncertainty which may cast significant doubt over the Group’s ability to continue as a going concern.”

The implications seem fairly clear – the best part of the year is over, the results weren’t great, and further change will be needed if the business is to survive.

The road ahead

With all that in mind it’s fairly obvious why the board has decided to raise the prospect of the business being acquired by or merged with a rival. It spurned an approach by Stobart Air earlier in the year, a decision which with the benefit of hindsight could perhaps be regarded as misguided since the market value of Flybe has declined by two thirds since then. The Flybe Group includes a well-respected aircraft engineering business that manages lucrative third party contracts in addition to servicing the in-house fleet and that could be sold-off to raise capital – but it would do little to address the fundamental challenges faced by the airline. So who would be interested in Flybe, and why?

First up, Stobart Air could come back to the table. Success now would come as a moral victory and at a much lower price than before. However, Stobart's aviation business faces its own internal boardroom problems at the moment. It also seems to be reshaping and downsizing its airline operations after successfully providing a platform on which much-needed business was brought to London Southend Airport, another part of the Stobart empire. Low-cost carriers including easyJet and Ryanair have also been touted as potential suitors. But this seems unlikely as the former has well-established operations on most of the UK’s major domestic air routes, while the latter has largely forsaken the UK market and would probably not want to return – at least until the ramifications of Brexit become clearer. In any case low-cost airlines specialise in volume and simplification (especially in fleet and operations), and Flybe offers little of that.

Newly resurgent Loganair and flybmi (formerly bmiRegional), both held by parent Airline Investments Limited (AIL) are cut from the same cloth as Flybe and understand the regional airline business. But with a combined fleet numbering little more than half of that flown by Flybe (and revenues largely in line with that differentiation) do they have the gravitas to take on more business and make it profitable in fairly short order? Flybe is cheap enough so an attempt might be made, but it’d be a big ask for AIL to turn round Flybe without overtaxing resources that it relies on to keep an eye on its existing businesses. Perhaps CityFlyer Express would have more of an appetite? It has a substantial operation at London City Airport where Flybe has recently been building a presence, and the two carriers share a common[-ish] fleet of Embraer regional jets. But thus far, and despite it being headquartered in Manchester, CityFlyer has displayed little interest in the UK regions other than dipping a toe in the weekend holiday market. Would it want to take on the complexity of Flybe’s network, when it has traditionally focused on a single ‘hub’ at London City?

The elephant in the room is British Airways (BA) and its parent International Airlines Group (IAG). But it’s hard to see what BA would get out of a deal. The ‘national carrier’ has largely forsaken the UK regions with the exception of trunk routes to London. Flybe could channel more passengers into BA’s long-haul operations, but that needs slots at Heathrow and the few held by Flybe are remedies from bmi and cannot easily be switched to other routes. Besides, IAG has been strengthening its hub in Dublin and Aer Lingus is doing a good job of connecting the UK regions to the rest of the world via the Republic of Ireland.

Aside from venture capital firms – which haven’t got a great reputation for rescuing UK airlines after the Monarch debacle – the only other opportunity to keep things intact appears to be a foreign carrier taking on Flybe. But do any of them actually want it at the moment, with Brexit looming? Flybe could be a cheap way to obtain an UK air operators certificate, but only if an overseas airline sees a future in what could be a segregated European market. It may be that Britain’s impending departure from the EU has little or no impact on aviation, but would anyone take a punt until the path forward becomes clearer?

Something is better than nothing

The bottom line is that Flybe has been struggling for quite some time now, with successive management teams failing to turn it around. At the same time, each has spent time publicly pointing to the challenges inherent in the operation – increasing costs, unpredictable demand and complexity. Flybe plays in small markets, and any future success (i.e. profits) seems likely to be similarly limited. None of its likely suitors have a magic wand that will enable them to turn things around quickly. So it will take patience and deep pockets.

The other alternative is that the business could be shuttered or broken up with the profitable bits being retained or cherry-picked by other airlines, and the rest dumped. The demise of Flybe - or a substantial reduction in its size - would come as a major blow to UK regional airports; Cardiff, Doncaster, Exeter, Guernsey, Jersey, Newquay, Norwich and Southampton to name a few. It would also have a significant impact at Birmingham and Manchester where the carrier accounts for a notable amount of business, especially UK connecting traffic. It would also affect travellers who prefer flying, rather than face a slow and expensive train journey or a tedious and congested road trip. But if Flybe disappears in its current form, which now seems quite possible, not all of its routes are likely to be filled by other carriers such as flybmi and Loganair, or even by easyJet or Stobart Air - plenty of gaps will be left and the UK transport market will be much the worst for it.

No doubt this subject will run for a while. The Aviation Oracle will keep an eye on it and report back as developments unfold.