My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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Flybe: The U.K. Government should not support this airline (unless it supports others)

Updated: Jul 19, 2020

On January 14th, the precarious financial position of UK domestic airline Flybe was disclosed by several news services, including the BBC, which highlighted that this U.K. airline was teetering on the edge, about to collapse unless a rescue financing was arranged quickly. The press articles were also fairly transparent in saying that the U.K. government was prepared to play a role in the rescue of Flybe to ensure that the airline could continue to operate. If you would like more context and history on the difficult past of Flybe, this article from the FT is one of the more informative.

Of course, history is littered with the failure of airlines, and even the ones that have received state assistance have often remained on long-term life support, becoming financial sinkholes for taxpayers. In the U.K., we have seen the failures of three airlines in the last three years: Monarch Airlines (2017), Thomas Cook (2019) and Flybmi (2019). And many other perhaps less-familiar airlines have also gone bust globally, including in 2019: Germania (Germany), WOW (Iceland), Jet Airways (India), Aigle Airlines (France), Adria (Slovenia), Peruvian Airlines (Peru) and California Pacific (USA), amongst others.

You might ask why the airline business is so difficult? I am far from an expert, but there are obvious characteristics that make an airline very difficult to operate profitability over the long term. Firstly, there is high operating leverage. This means that the cost base is dominated by fixed (rather than variable) operating expenses, including the cost of the aircraft themselves (expensive to purchase or lease, on-going maintenance, insurance, etc), most labour costs, landing fees, taxes, marketing/ticketing costs, etc. Secondly, certain of the variable costs are difficult to project with confidence, especially fuel, which can account for around 20% of an airlines’ operating expenses with a volatile range based on the price/bbl. of oil in the world market. This short-term rather inflexible cost base means that airlines need to fly at the highest possible capacity to address their fixed costs, which in the industry is known as the passenger load factor, essentially a measure of capacity utilisation. Fortunately, capacity load factors have generally been improving for many years, but they are correlated with GDP growth and are obviously cyclical.

High and ideally improving passenger load factors are essential since industry EBIT margins are generally only 5%-6%, pre-tax margins are 3%-4%, and leverage (debt-to-EBITDA) is on average around 4.5x. Throw in fickle consumer demand and a highly competitive environment and you have the recipe for a notoriously difficult business to run. If you want to dig deeper regarding the industry, the International Air Transport Association (IATA), an industry trade group, has a good, concise report on recent trends and outlook.

Let’s turn back to Flybe, now that there is some (amateur) context. What is Flybe? Flybe is a U.K. (Exeter-based) airline that was started in 1979, did its IPO in 2010, and was taken private again in 2019 by Connect Airways, a consortium consisting of Virgin Atlantic (itself owned 49% by Delta Airlines), Cyprus Capital Partners and Stobart Aviation. The airline was taken private after a tumultuous decade of volatile and generally poor operating performance. Flybe carries circa 8 million passengers a year on 189 different routes, operating out of 28 airports in the U.K. and 43 international airports in Europe. It is the largest carrier of air passengers in the U.K. as far as domestic routes. Its latest media pack (dated July 2019) is here. The map below illustrates the company’s route coverage.

The table below, extracted from the FT article mentioned in the first paragraph, shows the company’s profitability since its listing in 2010. The article also covers one of the reasons for this poor track record - the company’s rather abysmal average passenger load factor, a death-nail for an airline. Compared to the upward trend towards 82%+ by the industry overall, this FT article says that Flybe’s load factor “has typically hovered between 61 per cent and 75 per cent over the past decade, much lower than that achieved at its larger low-cost rivals easyJet and Ryanair.”

What should be done? My personal economic philosophy is this: poorly managed businesses operating in the private sector should not be given new leases on life from the government except in rare circumstances, because - more often than not – this turns into an exercise in “throwing good (taxpayer) money after bad”. And obviously, state aid gives an ailing competitor a potential leg-up on other industry players that are profitable without such support. My economic compass does not believe that Flybe is an airline that should be given yet another opportunity since the management and shareholders alike, past and present, have yet to unlock the formula for making Flybe consistently profitable and keeping the airline afloat.

Even though I am not in favour of a rescue of Flybe with government involvement, I am not blind to the social, political and economic arguments that favour government assistance in this case. Here are three arguments that favour a rescue involving the U.K. government, and a fourth argument – the most important to me – against such a rescue using taxpayer money.

The Social Argument: Cities and towns (and islands) that are considered desirable places to live and / or to work often benefit from - and depend on - vital transportation links that provide broader domestic or international access for the people living there.  These transportation links can of course be in the form of motorways, rail service, ferries and / or air service. Although there are some people that might enjoy being “cut off” from links to the broader world, the fact is that the more difficult a town or city is to access, the more likely its inhabitants will “experience” less than maximum happiness, or that the community will even be able to survive. The costs of isolation are both tangible (access to fewer goods & services, higher prices, etc.) and intangible (access to entertainment, cinemas, cultural events, etc.)  In many countries, including the U.K., there are smaller cities and - in some cases, islands - that inevitably benefit from links to other U.K. towns and cities, as well as to larger international airports like Manchester, London Heathrow and London Gatwick, which in turn provide citizens and businesses with easy and generally affordable access abroad.   Some of these routes are likely to be marginally economic or even unprofitable, but the social argument for providing such service is that such flights are a quasi-public service that a country’s government must provide (or subsidise in the private sector). For reference, this chart shows how significant Flybe is to certain U.K. destinations:

As you can see, Flybe represents 70% or more of the flight capacity at five U.K. airports: Anglesey (island off northwest coast of Wales), Southampton (south coast), Newquay (Cornwall coast), Exeter (Devon) and Belfast George Best City (Northern Ireland, one of two airports serving Belfast). You can see that Anglesey, Southampton and Newquay would be particularly adversely affected if Flybe stopped serving these communities, although I believe that the latter two are served by other airlines as well.

The Political Argument: This is the argument getting the most attention at the moment, because it is in fact driving the government’s involvement in the rescue. The political argument is this - a key contributor to the Conservative landslide victory in the early December election came from voters located outside of the capital. And perhaps not surprisingly, these Conservative voters overlap strongly with those that voted for the U.K. to leave the E.U. in 2016. Because of this, Boris Johnson and the Conservative Party at large feels indebted to these pockets of constituents, many of which are located in or around smaller cities in more remote parts of the U.K. And this, in turn, means that the Conservative Party will want to make sure that air service to these locations is maintained, even though it is clearly contrary to normal Conservative ideology of laissez-faire, favouring non-interference in failing businesses.   Whilst this might sound rather far-fetched at first consideration, it is clearly the main driver behind the government signalling that it will provide support to Flybe so that the airline can continue to operate, in spite of its poor financial performance over a rather protracted period of time.

The First Economic Argument (collateral or “knock-on” effects) - One direct cost of a business failing is obviously that employees lose their jobs.   But this is the case no matter what the business is, and unfortunately, such failures do happen regularly.   However, there are collateral or knock-on effects beyond just the business itself, and these can vary depending on the nature of the failed business.  You can think about it this way - the more removed a town or city it from a major hub or access point, the more likely it is to have its own micro-economy with many interrelated businesses.  And when an airline serving a remote location fails, it means - for example - that other airport services dependent on the airline are also likely to fail, and this is turn, leads to further knock-on effects throughout the micro-economy.  There is little doubt that the failure of an airline, especially if it is the only one serving a particular airport, will likely cause collateral economic damage that will ripple throughout the community. These affects might be short-term or long-term, and this will depend on how long it takes for the resources to be reallocated in an economically favourable way to re-establish some semblance of equilibrium. Having said this, the U.K. is a flexible economy, and it has “digested” the failure of three airlines in the last 2.5 years.

The Second Economic Argument (unfair competition): why Flybe should not be bailed out with government involvement - The hard reality is that any sort of government support for a failing entity tilts the playing field in favour of the player receiving such support at the expense of those that do not receive support.  This is the reason that the discussion of government involvement in the rescue of Flybe has competitors like EasyJet, Ryanair and British Airways jumping up and down.  And rightfully so, because these players are not receiving similar assistance even though they might also fly some break-even to money-losing domestic routes. In essence, the poor operator is being rewarded, whilst the airlines playing by the rules are being punished. This is an economic distortion that no matter how you might look at it makes little sense.  And it is one of the principal reasons in my mind that trumps all of the proceeding arguments that might favour a bail-out using public money.

The final chapter on Flybe has not been written, but the company’s shareholders and the present Conservative government clearly floated the trial balloon last week. Let’s see what the coming days have in store, as Flybe is on life support whilst its future is being sorted. It will be interesting to see how the government, should it play a role in the rescue (which appears likely), respond to the very valid complaints of competitors like Easyjet, Ryanair and British Airways. At the very least, unprofitable routes – not airlines – should be subsidised if they are considered to be in the public interest, so any government support for Flybe should extend to other airlines flying the same route. But let's face it - the track record of Flybe shows it needs not only additional capital and funding, but a management overall.

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