Views presented in this blog are the author’s own opinion and do not constitute financial research or advice.
The global airline industry suffered a terrific beating during COVID-19, accumulating some US$187 billion of pandemic-related losses. Fortunately, profitability is recovering.
Some groups, including Singapore Airlines and IAG, have reported record earnings. Notwithstanding the recovery, investors remain pessimistic. The MSCI World Airline Index is about half the all-time high set in 2018 and around 40% below its pre-pandemic level.
In late October, Air France-KLM fell to a record low after news of a record third quarter profit. Harsh medicine, and indicative of investor disdain for the industry. Investors clearly see lingering problems.
We agree, and decided to analyse how the poor business environment has impacted on airline accounting. The results weren't great: Our Manipulation Risk Analyzer (MRA) gives the global airline industry a Manipulation Risk Score of 53.7%.
This is one of the worst accounting manipulation scores among all industries, and exceeds 34.8% for the entire global market. The airline score is driven significantly by Chinese carriers struggling with sputtering demand for international travel.
Almost 70% of airline companies have a risk score above 50%. In other words, our risk engine assesses that many airlines are at risk of meaningful account manipulation and possible financial failure.
Figure 1: Net profit in the global airline industry
Source: IATA
Weakness among Asia-Pacific airlines
While the overall picture is troubling, there is considerable differentiation among the airlines. Virtually all of the profit recovery in the industry has occurred in North America, Europe and, to a much lesser extent, in the Middle East.
Asia Pacific, which was a key driver prior to the pandemic, is not expected to reach meaningful profitability in 2024.
Figure 2: Regional net profit in the global airline industry
Source: IATA
Within this mix, some airlines have performed well, such as Ryanair and US Airlines. The market has rewarded Singapore Airlines for its exceptional performance in poor overall Asian business conditions.
Figure 3: Chinese passenger numbers (per annum)
Source: Civil Aviation Administration of China
The main difficulty in the Asia-Pacific region has been the very slow turnaround among the Chinese carriers. Chinese passenger numbers did not bottom until 2022 and were 11% below the pre-COVID level in 2023.
Although domestic traffic is recovering, Chinese international passenger traffic remains mired. In 2023, international traffic was still down almost 70% from the pre-COVID level and on par with passenger numbers as far back as 2012. Since long-haul international flights are more profitable than short-haul domestic flights, the lack of recovery in international traffic is hitting the Chinese carriers.
Accounting manipulation analysis
When investors look at the airline industry, they see three problems:
- Current high profits are a function of a shortage of planes, which is keeping ticket prices high.
- The industry has some 13,900 aircraft on back order, which will surely impact pricing and expenses as these aircraft arrive.
- In a world of worsening geopolitical risk, and hence of potentially volatile fuel prices, many see the industry as excessively vulnerable to external shocks and too difficult to model.
Being focussed on account manipulation risk, we have a different take on the industry’s woes. We think the quality of accounting at the airlines is generally low, meaning there will likely be a payback for aggressive accounting in future years.
Some manipulation risk factors are a natural consequence of the volatility of the industry in the pandemic, and should be seen as largely unavoidable, while others reflect potentially more serious problems.
Figure 4 identifies the manipulation risk score for carriers in different domiciles:
- The mean (1) and median (2) Transparently Manipulation Risk Engine (TMRE) scores are calculated by country of domicile.
- The market capitalization weights (4) for each domicile are calculated by summing the market capitalization share of each airline in that domicile.
- The summed weighted scores (3) is calculated by multiplying the market capitalization weight of each airline by its risk score and summing the total for each country.
- Column (5) provides the proportion of the total weighted score contributed by each country.
- Column (6) provides the difference between the weighted score (5) and the portfolio weight (4).
Hence, a higher value of (5) compared with (4) indicates that the contribution to the manipulation risk score from the country exceeds that country’s weight in the airline industry. Column (7) ranks countries by the value in column (6).
Figure 4: Accounting manipulation risk scores by the domicile of airlines
Source: Transparently.AI
The countries at the top of the table represent the countries that have the largest contribution to the overall airline manipulation risk score, relative to their weight in the portfolio. They are the key sources of manipulation risk in the airlines.
Excluding the UAE, Ireland and Panama, one can see that most of the airlines have risk scores exceeding 40%.
These scores are higher than usual because airlines have experienced extreme volatility in sales and margins in recent years. Most have booked large abnormal losses, and all have had to significantly adjust their balance sheets as aircraft were mothballed in the pandemic. Cash quality and income quality have been poor, largely as a result of the pandemic, and the risk scores reflect this.
By the same token, airline risk numbers are typically high even without the pandemic because airlines usually have high gearing and the airline industry is highly cyclical and subject to frequent external shocks.
Moreover, airlines often have significant affiliate businesses, including other airlines and loyalty programs that generate significant non-operating income that can be highly discretionary in the way it is booked.
As a consequence, airlines have significant opportunities for income smoothing and aggressive use of accruals. In addition, airlines have significant discretion in the way that they fund their aircraft. Changes in financing and interest capitalization can significantly impact reported earnings.
Chinese carriers
From Figure 4, we can see that much of the industry’s problems are located in China. Chinese carriers are responsible for 35.6% of the weighted score. In part, this is because Chinese carriers have higher than average gearing and worse cash quality than other carriers.
On average, Chinese carriers have higher non-operating assets and non-operating income than global peers. They tend to have higher interest capitalization and affiliate income. In addition to lowering income quality, these factors are associated with signals of business manipulation risk such as production manipulation and abnormal cash generation.
Moreover, options issuance and compensation feature prominently as a risk for the Chinese airlines. Asset quality is flagged as a risk at two of the major Chinese airlines due to volatility in depreciation, high investment in associates and growth of long-term assets.
To be sure, all of these risk factors also feature to some degree in other global airlines. Airlines with a high risk score tend to exhibit several of the features in combination.
Airlines in developed markets with above average risk scores tend to exhibit risk due to excessive use of accruals or other types of smoothing activity. This may be because they have had greater access to funding and have stronger cash positions than the Chinese airlines, which appear to have exhausted scope for aggressive use of accruals.
Bottom line: Airlines have high accounting manipulation risk
The bottom line is that most airlines have relatively high manipulation risk scores in part because their finances are weak and they have been through a hellish business environment.
Airlines in developed markets with below average gearing typically show evidence of accruals management and other types of smoothing activity. Some show asset quality risk due to imaginative use of depreciation and factors that boost long term assets such as interest capitalization.
In general, the Chinese airlines and those carriers in other countries with risk scores above 60% typically show risk of manipulation that goes beyond simple use of accruals or income smoothing.
This is because cash quality is too weak to support such activity. In these higher risk domiciles, our risk engine finds concern with income quality, cash quality, asset quality and indicators of business manipulation.
Much of these concerns relate to the treatment of expenses, unusual non-operating income and other abnormalities that are related to investments in associates, and aggressive use of intangible assets and depreciation. Some of this likely relates to complex aircraft financing arrangements.
Although income is recovering, the relatively high manipulation risk score for airlines suggests that income could well be overstated. This could be an added reason why investors have been slow to warm to the industry.
Disclaimer: Both the author and Transparently Pte Ltd do not have trading positions in the companies it expresses a view of. In no event should the author or Transparently Pte Ltd be liable for any direct or indirect trading losses caused by any information contained in these views. All expressions of opinion are subject to change without notice, and we do not undertake to update or supplement this report or any of the information contained herein.
