This report analyses different options for airlines to hedge their risks. "Airlines face substantial strategic, financial, operational and hazard risks" (Loudon, 2004, pg. 296). This report will describe strategic, organisational, financial risks and hedging options. This report will further analyse the hedging strategies used by Air New Zealand (referred to AirNZ).
1. Key risks hedging options on strategic, operational and financial level
It is key to understand what the different corporate methods of hedging risk are. Hedging can be used to generate profit, but this report is focussing on hedging to avoid severe disruptions to normal operations. According to Weiss and Maher's analysis based on the 'September 11' attacks "a higher rank of total hedging level is positively and significantly correlated with increase cash flow from operations and less depressed stock returns" for major US airlines ( 2009).
Changes in the economic environment create financial risk associated with uncertainty in future revenues, operating and financing cost, and future cash flows (Loudon, 2004).
Active corporate hedging is also a signal to investors that the management is risk aware and is mitigating it actively, which should positively impact the stock price.
1.1 Strategic hedging
Strategic risks mostly arise from changes in supply and demand or the competitive landscape. Mitigating these risks is difficult, but can also become a sustainable competitive advantage. Strategies include customer orientation, low-cost focus, Lean/6Sigma and innovation activities. Some airlines, e.g. Lufthansa, extend the service activities to become more independent from the pure airline business, other aim for absolute low cost (Southwest Airlines and Ryan air)
1.2 Operational hedging
Operational hedging is an important component of the overall corporate risk management.
Hedging vehicles that we will analyse are e.g. higher fleet standardisation to enable more flexible operations as planes, crews, etc. can easily be used on different routes and redirected; passenger load, higher capacity (seat miles) utilisation; aircraft ownership policies impacting options when downsizing is required; cancelling plane leasing contracts drains cash (cancelation fee); selling planes to reduce overcapacity has a positive cash flow stream; international business activities is mitigating local risk; increased cash holdings provide more room for action and increase the independence from debtors.
"The findings indicate that operating hedging vehicles are more powerful in protecting airlines than using financial instruments" (Weiss and Maher, 2009).
1.4 Financial hedging
Airlines hedge to stabilise cash flows and costs implying that "the market will respond to reduce volatility in profits, with a higher price for the airline's stock" (Morrell and Swan, 2006). An issue with this is that according to the CAPM model investors can almost for free average company specific risk away so are not willing to pay a premium for a company hedging their specific risk on the contrary it might reduce the stock valuation. But variable levels of hedging can be used to transfer profits from one quarter to the next to provide stable forecasts.
AirNZ is exposed to the following financial risks which can be classified into five categories:
Foreign Currency Risk: Exchange rate risk is important to manage because it is related to AirNZ profitability (Loudon, 2004). Exchange rates influence the tourist numbers both internationally and domestically, it also influences the revenue and expenses incurred by AirNZ denominated in different currencies (Loudon, 2004). Aviation fuel is mostly traded in US$; fuel costs make up about 15% of the overall costs, so managing exchange rate risk becomes very important. Moreover, borrowings of AirNZ are also denominated in different currencies (Loudon, 2004).
Interest Rate Risks: Interest rate changes directly affect the borrowing costs. Interest rates changes are of significance to AirNZ because debt financing is extensively used. Moreover, direct and indirect costs of borrowing are directly related to interest rates (Loudon, 2004).
Fuel prices risk: A Major component of the operating cost to AirNZ is the price of fuel (15% of the overall costs). According to Carter, Rogers and Simkins (2002) as cited Loudon (2004), fuel price changes are negatively correlated to cash flows and stock returns of Airlines and AirNZ is no exception to this. An increase in fuel costs eats significantly into the profit as most other cost are long term fixed (planes, personal, etc.). Airlines have only a few options: Increase fuel efficiency of their fleet, pass on the increase to their customers or use hedging tools. A Complication is that when airlines need fuel price hedge the most - on the edge of bankruptcy - they do not have the liquidity to buy oil futures as they can't provide the margin requirements; they could by options though, but again this costs cash, increasing today's cash flow risk to avoid potential future risk. But Weiss and Maher (2009) disagree "financial leverage and derivatives used to protect from fuel price volatility are insignificantly associated with the hedging rank". The industry is divided: since August 2008 US Airways has been completely un-hedged; in comparison American Airlines hedged a quarter of its full year fuel demands.
Credit risk: - "Credit risk is the potential loss from a transaction in the event of default by a counter party during the term of the transaction or on settlement of the transaction" (AirNZ, 2010). In AirNZ's context this risk arises from trade receivable and other financial instruments.
Liquidity risk: - AirNZ holds significant cash reserves to enable it to meet its liabilities in normal course of its business and as protection from unexpected external events (AirNZ, 2010).
2 AirNZ risk hedging analysis
2.1 Strategic: To survive as one of the smaller airlines AirNZ follows a low-cost combined with customer orientation strategy - providing good service at a competitive price. AirNZ is also constantly innovating, even in the midst of the recession they introduce world-first check-in innovations; installed entertainment systems and fuel saving winglets on their Boeing 767 fleet. AirNZ also invest in research for jet fuel replacement options (bio-fuel) and started tests in Dec. 2008. In 2010 AirNZ designed an innovative lie-flat seat that gained world-wide attention.
2.2 Operational: The fleet standardisation is difficult given the differences of the domestic operations between small airports, mid range to Australia and long haul flights to Asia, US and Europe. AirNZ (2010) has 8 types of planes in operation. Fleet standardisation is low, but AirNZ is investing in modern fuel efficient Turbo-Prop engine planes for short flights. For mid-range mainly two planes are used (12 type Airbus 320 and 15 Boeing 737); for long-range three types of planes (7 type 747, 8 type 777, and 5 type 767) are used. AirNZ is gradually retiring the older 767 planes. End of 2009 AirNZ used their strong financial position to order 14 Airbus 320 at a discount price due to the downturn. In 2010 they introduced the new more efficient Boeing 777 airplanes. AirNZ (2010) is committed to make its fleet more efficient and standardised.
The Passenger load factor has increased from 75% in 2006 to79% in 2008 and is in 2010 at 82% a very good trend of hedging the capacity, creating an operational buffer (AirNZ, 2010).
AirNZ (2010) aircraft ownership policies are split between leasing and owning airplanes (56% owned in 2010). This well balanced hedge gives AirNZ the financial leverage in good times (leasing) as well as cash-flow positive options in downturns (sale of planes).
AirNZ (2010) international business activities are well hedged. 50% of the revenue comes from New Zealand operations; the other 50% derives almost equally from Australia/Pacific, North America, UK/Europe, and Asia. If international downturns or disruptions occur; New Zealand's markets are mostly decoupled or at least show delayed reaction to international events; the domestic market on the other hand is too small to impact the rest of the world.
AirNZ has a high level of cash holding with short term Total Current Assets of $1,688M in 2010 representing 42% of operational revenue or 105% of current liabilities (AirNZ, 2010).
2.3 Financial: To mitigate the financial risks mentioned in section 1.3 of this report, AirNZ has used the following financial instruments:
Foreign Currency Risk Management: Foreign currency operating cash inflows are denominated in Australian Dollars, European Community Euro, Japanese Yen, United Kingdom Pounds and United States Dollars and outflows are primarily denominated in United States Dollars (AirNZ, 2010). AirNZ's " treasury risk management policy is to hedge between 75% to 95% of forecast net operating cash flows for the first 6 months, with progressive reductions in percentages hedged in subsequent months out to 2 years" (AirNZ, 2010). AirNZ (2010) foreign operations assets are exposed to foreign currency translation risk; this risk is managed through borrowings denominated in the relevant currency of the country where the operations are based.
Interest Rate risk management: "AIRNZ group policy is to fix between 70% and 100% of its exposure to interest rates, including fixed interest operating leases, in the next 12 months" (AirNZ, 2010). AirNZ uses Interest Rate Swaps to achieve a right mix of fixed and floating rate exposure (AirNZ, 2010). According to the 2010 annual report no interest rate derivatives are outstanding and there was no impact on earnings as of 30 June 2010.
Fuel price risk management: Compared to other Airlines, AirNZ has hedged significant portion of its fuel cost. AirNZ (2010) has entered into option agreements and fuel swaps. "Between 75% and 95% of estimated fuel costs for the first 6 months are hedged, with progressive reductions in percentages hedged in subsequent months out to 1 year". 90% of the fuel is hedged for the second half of financial year 2010 and nearly 53% is hedged for the first half of financial year 2011. This aligns to the findings of Airguide Business (2010): "after huge oil price swings over the past two years, airlines are taking a variety of approaches to hedging".
Credit Risk Management: To manage Credit Risk, AirNZ (2010) has invested money in short-term deposits and derivatives. To limit exposure to one institute money is invested in many institutes. Only financial institutions with a Standards & Poor rating of A and above are chosen. AirNZ also conducts credit evaluations on customers requiring direct credit (AirNZ, 2010).
Liquidity risk: AirNZ holds significant cash reserves enabling it to meet its liabilities in normal course of its business and also to protect it from unexpected external events. In 2010 Total Current Assets were $1,688M that represents 42% of operational revenue or 105% of current liabilities; this was even higher in 2009 at $2,275M representing 50% of operational revenue and 129% of current liabilities (AirNZ, 2010).
3. Conclusion
According to Moody's, the outlook for Airlines in 2010 looks bleak, facing declining demand, operating losses and expensive fuel hedging costs, liquidity remains a major concern for all operators including AirNZ (Moody's. 2009). Giesel (2008) says that, "Companies engaging in enterprise risk management will do more harm than good, if they set out to identify every potential risk". Therefore, in order to survive through these tough times all airlines need to engage in effective risk management with focus on prioritizing their risks.
AirNZ strategic risk management works successfully and differentiation through innovation is starting to show results and work for fuel alternatives is underway. On an operational level AirNZ has used the downturn to acquire new airplanes to rejuvenate the fleet for long term efficiencies. The ownership model provides the leverage for good times as well as the positive cash-flow options for difficult times; the passenger load factor is improving and the cash holdings are high.
Financially AirNZ has, in addition to high levels of short term assets, hedged not only significant levels of currencies, interests, credit risk and fuel costs to reduce variability and, if needed, time to pull operational levers.
AirNZ has put itself into a very good position to weather the storm that might come and to participate from the long term trend of increasing air travel and cargo levels.
A. References
Morrell, Peter and Swan, William (2006), Airline Jet Fuel Hedging: Theory and Practise, Transport Reviews, 26(6), 713-730. doi: 10.1080/01441640600679524
Weiss, Dan and Maher, Michael W. (2009), Operational Hedging against adverse circumstances, Journal of Operations Management, 27, 362-373. doi: 10.1016/j.jom.2008.10.003
(2009). Moody's: outlook for airlines is negative. Airfinance Journal, 22. Retrieved from Business Source Complete database.
(2010). Airlines Split On Hedging Strategy For 2010. AirGuide Business, 1. Retrieved from Business Source Complete database.
Geisel, R. (2008). Airline tackles board, management 'worries'. Business Insurance, 42(13), 17. Retrieved from Business Source Complete database.
Loudon, G. (2004). Financial Risk Exposures in the Airline Industry: Evidence from Australia and New Zealand. Australian Journal of Management, 29(2), 295-316. Retrieved from Business Source Complete database.
AirNZ, (2010). AIR NEW ZEALAND ANNUAL REPORT 2010. Retrieved from http://www.airnewzealand.co.nz/2010-annual-results
