When financial Accountants talk of "Quality of Earnings," they are referring to an analytically-intensive process by which they assess sustainabilityof earnings – not just whether corporate earnings adhere
to acceptable accounting practices in a particular period but whether reported earnings include one-time events or whether competitive or market factors are likely to erode earnings over time.Acquisition targets and potential acquiring companies need to understand more than "audited" financials; purchase prices depend on sustainable value. So accountants have developed a disciplined process for analysis of financials based on sustainability.
Of course, for airlines – subject to cyclical demand and to sudden market entry or price cuts by competitors, it’s hard to defend any sustainability notion. Most U.S. airlines have a history of extraordinary financial losses, many airlines disappear each year, and most of those that have "survived" have relied on bankruptcy restructuring at least once. Historically, one would not characterize airline earnings as sustainable.
However now, U.S. airlines have a few years of profitability under their belts as they just achieved record profitability. Do the notions of sustainable profits now apply? Although sustainability relates to both revenue and cost performance, let's focus on the factors used to assess sustainable revenue performance used in other industries. These factors are of particular interest to airline revenue accounting departments as they support analysis and decisions across the revenue production process. In fact, QOE is highly dependent on highly granular revenue and customer accounting.
"Quality of Earnings" is typically associated with a highly diversified customer base; dependence on one customer or one small customer segment entails risk to sustainable earnings. For airlines, this can mean too much reliance on a few corporate customers, or to full fare business travelers, or to a particular industry. Many carriers suffered during the various tech crashes, reliant as they were on business travel by the technology industry. Some also linked their revenue weakness to falling fuel surcharges and declining travel by oil and energy sector customers and corporate accounts.
QOE is also normally associated with diversification across markets. How dependent are airlines on a few markets? The big four in the U.S. are truly national carriers; the large mergers have allowed each carrier to fill in gaps in their network and achieve true national coverage and diversification. Each of the larger carriers now have major hubs, or focus cities, in every region of the country. Each hub in turn has hundreds of daily departures serving dozens of cities and perhaps over 100 city-pairs.
This is much less true for the remaining smaller niche airlines: JetBlue, Alaska, and Hawaiian. Despite its heavy dependence on Seattle, however, Alaska’s hub has so far been able to withstand intensified competition from Delta.
Frontier Airlines, prior to its ULCC restructuring, focused its operations on Denver. This was not viewed as sustainable given intense competitive pressures from United and Southwest. The company sought a merger partner that could help diversify its market coverage. As a ULCC today, it has become much less dependent on Denver.
Although each of the larger carriers is now national, they dominate certain airports. In fact, they each rely on a half dozen or so key hubs. In general, such concentration is not viewed negatively since airport dominance offers advantageous pricing and marketing opportunities.
Nevertheless, American Airlines pointed to Dallas Fort-Worth and Chicago-O’Hare as significant contributors to its revenue weakness last year. Growth by ultra low-cost carriers at these airports drove yield weakness.
Spirit, the leader in the U.S. in ancillary, argues that ancillary fees, a relatively new pricing strategy for airlines, makes airline revenue more sustainable and less subject to the historic cyclicality of airline revenue streams. If Spirit is gaining 45% of its revenue from ancillary offerings, fluctuations in its base fare have proportionately less impact on its total revenue. Also of course, if the base fare is lower due to ancillary, the airline can tap into more price sensitive segments, further diversifying its customer base. All airlines have diversified their product line into ancillary revenue streams – even if they haven’t gone so far as Spirit.
Only recently could the "Quality of Earnings" of airlines even be considered. Applying accounting standards to airline revenue with regard to QOE reveals many positive trends (greater customer and market diversification, beneficial concentration, greater product/fee diversity).
Despite the individual progress of airlines in improving QOE on various traditional metrics, the financial performance of all airlines still relies heavily on external factors. Yes, the industry is cyclical and is subject to macro-economic factors, but still equally important are competitive actions, including industry capacity and pricing. Many analysts attribute improved U.S. airline financial performance to recent industry capacity discipline.
Industry capacity discipline is, of course, not as relevant for companies that enjoy more differentiated products, where each firm can individually match supply with demand. Despite all of the progress in the factors above, unfortunately, demand/supply trends on an industry basis will continue to drive airline revenue performance and therefore each airline’s bottom line.
Sensitivity to industry factors – independent of airline-specific decisions – remains the most important factor for sustainable airline financial performance.