Demand-supply dynamics are favoring aviation-related sectors in Asia-Pacific. Positive momentum in airline passenger traffic will ensue over the next 12-18 months, especially as more Chinese travelers take to the skies. Meanwhile, S&P Global Ratings believes industrywide capacity constraints, due to supply-chain issues, should support load factors and ticket fares.

Our expectation of a progressive credit recovery at India airports is reflected in our recent upgrade of Delhi International Airport Ltd. and positive outlook revision on GMR Hyderabad International Airport Ltd. This follows several negative rating actions during the COVID-19 pandemic, where lower traffic and tariffs collectively weakened the entities' cash flow profile. We also recently affirmed the ratings on Australia and New Zealand (Pacific) airports, given a strong recovery in passenger traffic volumes has been in line with or better than our expectations.

Our ratings on the aircraft lessors have remained relatively stable over the past year as lease collections from airline customers continue to improve.

Lessons from the pandemic will sharpen the risk management and resilience of the sector, in our opinion. Nevertheless, airports and lessors depend on airlines--a sector exposed to high cash-flow cyclicality and capital-intensity. Airlines' pricing power could gradually diminish as reopening benefits recede. Meanwhile, with fundamentals improving, the sector will likely refocus on investing in future growth and sustainability. This is one reason that leverage could weaken or remain elevated.

Asia-Pacific Air Traffic Rides On Robust Demand

Passenger air traffic in Asia-Pacific should return to pre-pandemic levels over the next 12-18 months.  As of August 2023, the region's revenue passenger kilometers, or RPK, reached 93% of pre-pandemic levels. This is more than 35% above levels in December 2022, and in our view largely attributable to the relaxation of Chinese border restrictions since the beginning of the year.

Asia-Pacific is now rapidly catching up with recoveries elsewhere in the world, highlighting the region's reliance on the Chinese market. We believe the recovery momentum will keep pace through 2024, given strong pent-up demand, and increasing airline capacity.

According to IATA, Asia-Pacific held all top-10 city routes by passenger traffic as of June 2023--an indication of the sturdy underlying domestic demand within the region. We see similar traffic recovery for Asia-Pacific airports and expect rated airports' cash flows to benefit from a solid rebound.

Chart 1

We expect an uneven recovery, with India and Pacific leading the way.  This is because the size of domestic traffic, return of seat capacity, airline entrants, fare levels, propensity to travel as well as timing of easing of borders, vary across different countries. For example, India's domestic and international air traffic has surpassed pre-pandemic levels. Australia and New Zealand are not far behind in domestic but need more inbound tourism for international to reach pre-pandemic by 2024-2025.

Revivals in North Asia (excluding China) remain well below others in the region partly due to the slower easing of restrictions in Japan and Hong Kong. China's domestic market has also surpassed pre-pandemic levels, although international traffic still has some way to go. We estimate that the average international RPK for the big three state-owned Chinese airlines was about 56% of pre-pandemic levels as of September 2023, while that of domestic RPK was close to 120% over the same period. This indicates still substantial room for the region's international air traffic recovery. Airports in India and Pacific with greater exposure to domestic traffic are also rebounding quickly.

Chart 2a

Chart 2b

Economic Downside And Other Risks Weigh On The Sector's Recovery

Macroeconomic uncertainties loom.  While Asia-Pacific's growth has so far remained resilient on domestic demand, a few factors are weighing. These include slowing global consumption as well as the potential for substantial setbacks to China's recovery. If downside risk materializes, it could derail the pace of recovery for Asia-Pacific aviation. Airlines are especially susceptible to geopolitical risks, which inevitably have a direct and/or indirect impact on the sector. We have seen this in the Russia-Ukraine conflict. Along with the unfolding Israel-Hamas war, escalation of conflicts may increase the volatility in oil prices.

Labor inflation, high interest rates and oil prices may keep airfares up should airlines protect their margins, yields and liquidity. Persistently high airfares can deter travel. The outlook on the sector is subject to uncertainty and prevailing market conditions, given low visibility on future bookings (with the majority placed about three to four months in advance). Strength in the greenback and higher U.S. interest rates are still pressuring regional currencies, amplifying depreciation strains.

Hedging and capital management should mitigate some of the risks.  Most airlines in our sample and rated lessors hold fixed-rate debt, after taking into account interest-rate swaps. Nearly half of the sampled airlines hold fuel-hedging instruments. While such instruments can raise operating costs, they also reduce risk from fluctuations in fuel prices and debt costs.

Indian airports have largely relied on fixed-rate U.S. dollar bond funding, mitigating rising interest rates. Recent tender offers to repurchase U.S. dollar debt with cheaper domestic funding will also cut interest costs. Forex exposure is manageable due to currency-hedging policies and they benefit from some U.S.-dollar-denominated revenues such as duty-free income. Pacific airports have limited forex exposure and typically adopt high interest rate hedging and average debt maturities of five years or longer.

Profitability Should Trend Toward Pre-Pandemic Levels

Asia-Pacific airlines' margins could gradually ease to below 20%.  Median EBITDA margins for our selected Asia-Pacific airlines stood at 22% for the 12 months to June 2023, compared with 16% for the same period ending June 2019. This is on the back of our estimated 17% median increase in EBITDA, although revenues were still about 5% lower over the period.

Apart from a better ability to pass through costs with higher ticket prices, leaner operations through pandemic-related downsizing have contributed to this improvement. For instance, Thai Airways, Garuda Indonesia, and Philippine Airlines improved margins by over 15 percentage points over the period. Singapore Airlines reported a record net profit in the recent fiscal year of S$2.2 billion, resulting in significant margin uplift as well. This is in contrast to the marked deterioration in margins for Chinese airlines that have been burdened by the delayed border reopening.

While we expect airlines to continue generating higher EBITDA in 2023 and 2024, their ability to sustain fare hikes proportionate to input cost increases will be key to preserving their profit margins.

As pent-up travel demand eases, airlines' margins will likely weaken, on the back of moderating load factors and yields, and as airlines restore crew and previously grounded fleet.

Demand could ease for upper class cabins, which typically fetch higher margins, once consumers has had their fill of splurging on more expensive tickets for their first few trips post reopening. While the resilience of business travel has exceeded expectations, we believe remote working and virtual meetings has become an important aspect of work culture. This could diminish demand for business travel, especially when companies seek to reduce costs.

Chart 3

Airports' margins should restore at least by 2025, if not earlier  (see chart 4). Stable and steady property income reduced the impact of lower profitability on Pacific airports during the pandemic, while some level of domestic travel in India cushioned the impact. Still, rated airports faced lower margins during the pandemic due to paying fixed operating costs and concession fees. Improving earnings and margins will hinge largely on traffic volumes, given airports cannot frequently vary their pricing either due to regulation or negotiated agreements with airlines.

Higher traffic footfall and a rebound in international traffic will significantly lift non-aeronautical revenues over the next two years. Passengers spend rates are higher among international travelers, particularly in the retail and duty-free segments.

Rated Indian airports will also benefit from an increase in retail space and offerings following the completion of terminal expansions this year, while Pacific airports reap benefits from their strong property inflation-linked rentals and car-parking facilities.

Chart 4

Aggregate EBIT margins of rated aircraft lessors should continue recovering above 50% through 2025.  This is on the back of our expectation of a gradual recovery in lease yields, after bottoming out in 2022. Tight aircraft supply, along with robust travel demand, will facilitate this trend, and mitigate lessors' ability to absorb higher costs. Lower impairment on aircraft and lease receivables will also improve margins. This is given the current strong aircraft valuations as well as improving lease collections from airline customers as they continue to recover arrears built up in the pandemic.

Nonetheless, we expect aggregate margins to remain below levels in 2019, which were close to 60%. We attribute this to lease yields languishing below pre-pandemic levels due to new leases signed during the pandemic at lower rates. Ongoing aircraft and engine-supply disruptions are also impeding deliveries of new aircraft that should fetch higher lease rates.

Will The Sector's Recovery In Leverage Sustain?

We anticipate that over the next 12-18 months, catch-up spending that had been deferred during the pandemic will weigh on the leverage of some entities in each sector. This could undo some of varying leverage recoveries in airlines, airports, and lessors.

Strong air traffic uplift and leaner operations have supported airlines' leverage.  The leverage of airlines deteriorated sharply during the pandemic, but recovered more quickly than that of the airports. We attribute this to the airlines' better pricing power, enabling a larger relative improvement in earnings, compared with airports.

We estimate the median gross debt-to-EBITDA ratio of Asia-Pacific airlines improved to 4.0x as of June 2023, compared with close to 5.0x in June 2019. This is in spite of a 22% rise in median gross debt over the period as airlines raised liquidity to support operations when passenger travel demand came to a halt. Net median debt-to-EBITDA ratio improved by two turns.

Chart 5a

Chart 5b

Airlines within Southeast Asia in our sample deleveraged the most significantly. We attribute this to their unsustainably high leverage pre-pandemic, and aggressive organizational downsizing, fleet rationalization, network optimization during and post-pandemic. For instance, both Thai Airways and Garuda Indonesia slimmed down their workforces and reduced their fleets by more than 40%. Some airlines also shut unprofitable domestic and long-haul routes, as well as underperforming subsidiaries. Unsurprisingly, airlines in the Chinese market lagged the recovery the most.

But debt will likely grow to fund expansion.  This deleveraging trend, however, may not be sustainable. Improving industry prospects could encourage airlines to resume investing plans to capture potential growth. Relentless delays faced by aircraft manufacturers could also spur airlines to quickly place their orders in the queue, given long waiting times.

Indian airlines have already ordered more than 1,800 aircraft this year, with Air India and IndiGo topping the list of orders. According to the Center for Aviation, Asia-Pacific airlines have a collective 4,430 commercial aircraft on order, accounting for almost 40% of identified outstanding orders globally. These fleet investments could reverse the meaningful deleveraging in recent quarters.

Asia-Pacific airlines could continue generating positive annual free operating cash flow (FOCF) over the next two years (consistent with our expectations for the globally rated airlines). But FOCF won't likely keep pace with growing investments, especially if industry conditions start to normalize. Higher capex could increase potential funding needs, particularly if cash generation falls short. Airlines will also likely face higher funding costs and lease payments for future aircraft deliveries or leases, given the elevated interest rate environment.

Chart 6

Airports could take the next one to two years to stage a full recovery in leverage.  Rated airports' financial health will improve with higher passenger traffic, tariffs, and cash flow. Nevertheless, leverage in fiscal 2025 (see chart 7 for fiscal-year ends) will by our estimates still be higher than pre-pandemic levels. This is due to debt accumulation during the pandemic, as some airports incurred high capital spending on committed expansion projects. The big uptick in capex among Asian airports is driven by Hong Kong Airport (for its three-runway system project) and Incheon airport (for capacity expansion). We expect capex to taper off after completion of heavy expansion works, supporting leverage recovery from fiscal 2026.

The leverage of the Indian airports we rate should steadily improve over the next two years, in our view, but remain higher than pre-pandemic levels. We believe the key credit drivers are timely tariff implementation that incorporates investment on expansion capex (watch point for Delhi International Airport, which will benefit from higher tariffs in the next control period 4), and dividend payout in light of stronger cash flow.

Pacific-based airports are already seeing a lift in their leverage profile. This is attributable to higher aeronautical charges and strong cash flows from non-aero activities. This together with cautious capex and dividends should see only a modest increase in debt levels for the next two to three years.

Chart 7

Chart 8

Most rated Asia-Pacific aircraft lessors' leverage could weaken through fiscal 2024, before improving.  This is due to a combination of higher interest expenses, and debt drawn either for aircraft spending or cash flow needs.

Liquidity Should Be Mostly Manageable

More Asia-Pacific airlines have adequate cash to service upcoming debt maturities.  We estimate close to 60% of the Asia-Pacific airlines in our sample will have sufficient cash balances to cover their current debt maturities. This is about double the proportion in 2019, and is consistent with our expectation that airlines are inclined to hold a higher amount of cash to buffer against future potential industry downturns, compared to pre-COVID.

Chart 9a

Chart 9b

Shareholder returns should resume prudently.  Many airlines have significantly cut back on dividends in the past three years to conserve cash. While we expect most airlines to gradually resume dividend distributions, they have demonstrated the flexibility to reduce payouts when liquidity tightens. We believe such risk management should continue if required.

Most Asia-Pacific airlines have moderate access to funding, with a larger reliance on aircraft lessors.  Based on our sample of Asia-Pacific airlines, an average of close to 50% of funding obligations are comprised of aircraft leases. The rest of the capital structure is mostly secured term loans and domestic bank loans or bonds, with just slightly over 10% exposures to international capital markets. Airlines that have some direct or indirect government ownership have a higher likelihood of receiving liquidity support, as seen during the pandemic. This ranged from a mix of rights issuance, sovereign guarantees, and debt.

Watch out for negative equity.  Some airlines are still reporting negative equity due to accumulated losses through the pandemic. These airlines include Thai Airways, IndiGo, AirAsia and Garuda Indonesia in our sample. We see potential implications for the airlines' access to funding and liquidity should banks or investors impose covenants with equity threshold. Such airlines could also find themselves needing to continually borrow more to maintain their assets and competitiveness, resulting in higher leverage, in our opinion.

All our rated Asia-Pacific airports have adequate or strong liquidity, by our assessments.  Airports are increasingly tapping the domestic banking system and onshore bond market for funding needs and benefit from competitive interest rates relative to offshore funding. We believe funding will continue to be available at attractive rates for airports due to solid traffic growth and the strategic importance of airports as an infrastructure asset. The low-risk nature of the asset class is further supported by the fact that none of the airports breached covenants during COVID, although some airports had taken the precaution of getting their covenants waived for about 18-24 months period.

Overall, airports benefit from debt maturities that are well spread out and long-dated, matching their long-term cash flow profile.

Chart 10

Rated Asia-Pacific lessors' liquidity will continue to be supported by good funding access.  Banking relationships with lessors are generally robust and have stayed in place even in tough periods. This is manifested through syndicated term loans as well as covenant waivers during the pandemic, particularly for the lower-rated entities. Lessors can tap on secured debt, by collateralizing its aircraft or raise proceeds from aircraft disposals, if required. For rated Chinese lessors, they have the additional benefit of parental support in the form of credit facilities, amounting to US$3 billion-US$4 billion, as well as better access to capital markets to raise unsecured bonds.

The liquidity of each lessor, however, also largely hinges on their respective debt maturity profiles. For instance, we expect large short-term debt maturities to weigh on CDB Aviation's liquidity over the next 12 months. For BOC Aviation and Avation however, their maturity profiles are more well-staggered.

Asia-Pacific Still The World's Fastest Growing Aviation Market

Global aviation has been significantly tested over the past three years by COVID, the Russia-Ukraine conflict, supply-chain problems, inflation, and other challenges. Yet, passenger air travel is proving to be resilient, and the sector is taking off once again.

Asia-Pacific has good potential, given China's international traffic still lags. This should fuel air traffic momentum into 2024 and benefit the sector as a whole.

We expect the aviation industry's center to gravitate toward Asia-Pacific in the coming decades. India and China, the world's two most populous nations, are increasingly affluent. The regions' potential growth will propel significant investments to support traffic expansion.

Furthermore, compared with Europe or the U.S., this region lacks an integrated network of convenient sea, road and rail. This accentuates the need for air travel and creates more opportunities for the rise of low-cost carriers in particular, to fill this gap. We therefore expect regulations and infrastructure to evolve around this prospect, and airports in the region will also need to continually develop and ramp up capacity to keep pace.

Editor: Cathy Holcombe

Digital design: Evy Cheung

Appendix

Table 1

Glossary: Terms and sectors associations and consultancies

RPK--Revenue passenger kilometers

IATA--International Air Transport Association

DGCA--Directorate General of Civil Aviation

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