The beleaguered U.S. airline industry is struggling to make a 'safe landing' in a turbulent air of financial and operational crisis. Fleet cancellations, grounding of planes, massive workforce reduction and bankruptcy filings are among the problems that are compounded by the skyrocketing of fuel prices. Adding oil to the fire, consumer confidence and travel demand have been receding, reflecting the slowdown in the overall economy.
Fuel expenses of major airlines, which control 71% of the U.S. market share, have increased 128% since 2000 to $27.6 billion in 2007. During this seven-year period, capacity as measured by Available Seat Miles decreased 7% and operating revenue remained nearly the same at about $95 billion. The industry has laid off nearly four out of 10 of its employees over the years. The carriers have also defaulted on about $20 billion worth of pension payments.
Airline Industry - Evolution
The U.S. airline industry was deregulated in 1978 following the Congress passing the Airlines Deregulation Act. Prior to the deregulation, the Civil Aeronautics Board controlled the routes the airlines flew as well as the ticket prices they charged.
Following the deregulation, the industry flourished with the number of passengers carried rising manifolds. In the early years of deregulation, there was intense competition among the established airlines and from new entrants as well as from carriers formerly confined to intra-state markets. In the mid-to-late 1980s, there was a wave of industry consolidation. The major carriers developed a powerful hub-and-spoke networks system that secured them monopoly over certain airports and regions.
However, coinciding with the Gulf War and the economic recession in the early 1990s, the industry went into a slump, when airlines like Pan American and Eastern disappeared. A few gusty players like Continental Airlines Inc. (CAL) and TWA, meanwhile, sought protection under Chapter 11 bankruptcy.
Although low cost carriers operated without much success and were assimilated by the bigger carriers, the emergence of Southwest Airlines Co. (LUV) as a discount carrier in the late 1990s sent tremors down the spine of the major operators. Southwest's success rested on its strategy of averting a head-to-head showdown with the major carriers and the usage of second tier airports near the biggest cities. It also hedged most of its fuel requirements and purchased fuel options years in advance to smooth out fluctuations in fuel costs. In the years 2001, 2002 and 2003, Southwest reduced its annual fuel expense by $171 million, $45 million, and $80 million, respectively, through its fuel hedging operations. The company hedged 95% of its fuel usage at $50 a barrel last year and nearly 70% of its fuel requirement at about $51 per barrel this year.
When the industry was emerging from a slowdown, it entered into another downturn in 2001. In the period between 2001 and 2004, the industry turned in net losses of $32.1 billion, pressured by an economic slowdown in 2001, the SAARs epidemic, intense competition, the aftermath of the September 11 attacks and a rise in oil prices. During this period, the average crude oil price rose about 60%.
Fuel Price Impact
Of late, jet fuel prices are hovering near new record highs due to higher prices of crude oil, which in turn is driven higher by speculation and fears of supply disruptions. The airline industry purchases about 80% to 95% of its jet fuel requirements directly from refiners on a formula pricing basis.
In the week ended May 30, the price of jet fuel was $160.7 a barrel, a 12.6% rise from April and a 90% increase from the same period last year. Nevertheless, the price represented a 6.5% decline from the week ended May 23rd.
Meanwhile, July crude rose $3.90 to $135.83 a barrel on the New York Mercantile Exchange on Friday amid supply jitters following news that Israel practiced an attack on Iran's nuclear sites. Last Monday, crude for July delivery had settled at a record $139.89 a barrel.
According to the International Air Transport Association, or IATA, which represents about 230 airlines globally comprising 94% of the scheduled international air traffic, jet fuel price would average around $131.5 per barrel in 2008, adding $74 billion more to the 2008 fuel bill of airlines.
In 2007, worldwide airline operators' fuel expenses were $136 billion, roughly 29% of their total operating expenses. In 2006, the fuel bill reached $111 billion, accounting for 26% of the industry's total operating expenses. In 2005, fuel expenses, representing 22% of operating expenses, rose to $90 billion from $61 billion a year ago.
U.S. airlines' recent quarterly results reflect the impact of soaring fuel prices on their earnings. Continental, JetBlue Airways Corp. (JBLU), Delta Air Lines Inc. (DAL), United Airlines (UAUA) and U.S. Airways Group, Inc. (LCC) were the major companies that reported losses for the first quarter, primarily due to high fuel costs. Revenue growth and cost control measures did not help United and JetBlue to weather the weakness induced by higher fuel costs. Delta, which emerged from bankruptcy in 2007, incurred a goodwill impairment charge of $6.1 billion relating to a decline in the company's market value due to a surge in crude prices to fresh records. Southwest was the only airline to post a profit, though lower than the year-ago period, reaping the benefit of its fuel-price hedging.
Other Costs and Bottlenecks
Other than fuel costs, the airline sector is paying several charges and fees relating to airport, Air Traffic Control and taxation, all of which are increasing. These infrastructure charges form the second largest external cost to airlines after fuel. Worldwide, airlines pay at least $43.5 billion a year to airports and Air Navigation Service Providers, or ANSPs, or about 11% of the airline revenues. The aviation industry is also highly taxed in comparison to other transport modes.
Further, the industry is facing pressure from Government agencies and policy makers to harness technology to meet new environmental challenges, as technological improvements can play a major part in reducing the "carbon footprint" of the aviation industry. Aviation is under the spotlight of environmental groups because it is one of the most rapidly growing sources of greenhouse gases.
Also, the sector has recently witnessed several unexpected groundings and flight cancellations due to safety issues and functional checks following a crackdown by the Federal Aviation Administration, or FAA. The agency has been auditing airline maintenance records following the discovery of fuselage cracks in four planes of Southwest in mid-March. FAA directive has ordered the nation's airlines to inspect their older Boeing 737 jets for problems.
The latest in a series of grounding of aircraft was by United Airlines, the subsidiary of UAL Corp., which in April delayed or cancelled flights due to a functional check on all 52 of the company's Boeing 777 aircraft.
Prior to that, American Airlines, a unit of AMR Corp. (AMR), canceled most of its flights that use the Boeing MD-80 aircraft. About 171 of the airline's 2,200 daily flights were canceled, while about two-thirds of its 300-plane MD-80 fleet was temporarily grounded.
Delta had revealed the cancellation of about 275 flights for a voluntary safety review. Meanwhile, the National Transportation Safety Board, or NTSB, has been investigating the separation of a composite panel from the wing of a Boeing 757 aircraft of U.S. Airways on the route from Orlando, Florida, to Philadelphia, Pennsylvania.
While airlines are negligent of regular safety checks and maintenance, the U.S. economy lost $26.5 billion in the past year, as air travelers made about 41 million fewer trips due to frustrations stemming from unexpected cancellations and delays and inefficient security screening, according to a survey by the Travel Industry Association, or TIA. This is not a small amount for the aviation sector and the economy, especially when both are trying to find equilibrium in a tough time. The survey also showed that nearly 50% of the air travelers felt the air travel system was not likely to improve in the near future. Monthly load factor and traffic data reported by many airlines reveal the impact of this decline in passenger numbers.
According to Roger Dow, the president and chief executive officer of TIA, the air travel crisis has hit a tipping point with more than 100,000 travelers each day voting with their wallets by choosing to avoid trips. He also said that the time is up for a meaningful reform in the airline sector.
Hard Steps
With rising fuel costs, the market recession in the U.S, and intensified competition, the only way for airline operators to limit the damage to profitability would be capacity reduction and maximum efficiency gains. Many have already turned into running lean operations.
A recent statement by Continental's chairman and chief executive Larry Kellner clearly defines the situation. "The airline industry is in a crisis. Its business model doesn't work with the current price of fuel and the existing level of capacity in the marketplace. We need to make changes in response," Kellner said in a message to the company's 45,000 employees. The company has decided to cut 3,000 jobs and pull 67 older, less fuel-efficient jets out of service. In the first six months of 2008, Continental has removed six older aircraft from service.
Just a day before Continental's announcement, United said that it is planning to cut as many as 1,600 workers and ground 100 airplanes in its struggle for viability. United has also hiked domestic fares up to $60 round trip to mitigate the impact of higher fuel prices.
The hard steps taken by Continental and United were followed by American Airlines, which said last month that it will reduce domestic capacity by 11% to 12% in the fourth quarter and retire about 75 airplanes, while cutting several thousand jobs. The company has also begun charging $15 for the first piece of checked luggage on domestic flights. Meanwhile, Delta plans to reduce capacity by about 10% and slash 3,000 jobs.
Last week, U.S. Airways revealed its decision to make additional domestic capacity reductions, eliminate about 1700 positions and implement several new revenue initiatives in an attempt to tackle the challenges raised by surging fuel costs and a weak economy. The company's domestic mainline capacity for 2009 is proposed to be reduced by 7% to 9% from the previous year. Additionally, U.S. Airways plans to introduce a first-checked-bag service fee of $15 and a new in-flight beverage purchase program.
The latest in this series is from Northwest Airlines Corp. (NWA), which for the second time this year, has announced a series of capacity reductions. The company will reduce its consolidated capacity by 3% to 4%, mainline capacity by 8.5% to 9.5% and domestic capacity by 7% to 8%. Earlier, in April, the airline had indicated a 5% reduction in its scheduled domestic system capacity over the 2008 business plan. Northwest has not yet finalized the specific employee impacts resulting from the capacity reduction. In May, the company started collecting fees for two or more checked bags.
Additionally, many carriers have cancelled orders for new aircraft. JetBlue said it will delay buying 21 new Airbus jets for four to five years. Qantas Airways also has cancelled an order for a new Airbus jet. Airbus said recently that it expects more cancellations and postponements for aircraft orders as carriers lower capacity.
Meanwhile, beginning June 1, the world's leading airlines have switched to e-ticketing, which translates into major cost savings in terms of paper. According to industry observers, airline should emulate e-commerce companies and increase the number of services they offer online, such as travel insurance, hotel reservations and rental cars, all services available to passengers after booking a ticket. It broadens the revenue base.
Further, in an effort to tackle fuel price costs, Continental and United have announced a framework agreement that would link their networks and services worldwide to create revenue opportunities and cost savings. Additionally, Continental plans to join the Star Alliance that will allow the airline to cooperate with other airlines in international regions.
Mergers and Bankruptcy Filings
As the global aviation sector is waging a war for survival, more mergers and bankruptcies are likely, according to Willie Walsh, the chief executive officer of British Airways.
"I suspect that many airlines out there that struggled when fuel was less than $100 a barrel are not going to be able to take the required actions and we will see further failures," Walsh said.
Seven airlines have failed in the last five months, including Oasis Hong Kong Airlines Ltd., Skybus Airlines Inc., Frontier Airlines Holdings Inc., Silverjet Plc and Aloha Airlines. Frontier Airlines and ATA Airlines filed for bankruptcy in April.
A Chapter 11 bankruptcy filing, which is considered as a painless bailout strategy, would mean the unsecured bond holders of the company are likely to lose about 90% of the value of the security. Ironically, the fact is that none of the airlines had filed for bankruptcy before the deregulation.
Also, the recent $17.7 billion merger agreement between Delta and Northwest reflect the aviation industry's proclivity for combinations that deliver effective cost synergies and additional profit. The merger combines Delta's strengths in the South, Mountain West, Northeast, Europe and Latin America with Northwest's leading positions in the Midwest, Canada and Asia.
Just a day after the Delta-Northwest merger deal announcement, Continental Airlines said that it is looking at strategic alternatives. As per reports that came in mid-May, United and Continental have held discussions about forming an alliance to secure some benefits of working together without actually going into a merger. There were also media speculations that United was pursuing talks with U.S. Airways. However, a report by the New York Times on May 30 suggested that United's officials have decided not to continue the negotiations.
Industry experts believe that, apart from the Delta-Northwest deal, no mergers among U.S. carriers are likely to take place until 2009. However, days of some sort of 'combined action', including a strategic amalgamation or sharing of common amenities are not very far.
Further, the "Open Skies" agreement between the U.S. and the European Union is expected to open new thresholds in the aviation sector. The new deal allows flights from Europe to fly directly to their U.S. destinations, whereas, governments on both sides of the Atlantic had to negotiate access for airlines to airports on a city-by-city basis under the old agreement. Continental, Delta and Northwest have already begun adding flights to London's Heathrow International Airport.
Also, changes in rules limiting foreign ownership of U.S. airlines is a major agenda in the "Open Skies" agreement. Liberalizing the cap of 25% would give carriers another source of potential capital. German carrier Lufthansa's purchase of 19% stake in JetBlue earlier this year is seen as a movement in this direction. As per reports, Air France-KLM has contemplated the possibility of making an investment in Delta.
Stale 2008 Outlook
Yet, under changed circumstances, IATA expects the airline industry to report lower profit in 2008. IATA estimates net profits of just $4.5 billion in 2008, down from $5.6 billion in 2007. This year's operating profit is expected to be $12.1 billion, compared to $16.3 billion in 2007 and $12.9 billion in 2006.
IATA also forecasts 2008 industry-wide revenue of $508 billion, of which $403 billion would be from passengers and $56 billion would be from cargo. This compares to revenues of $485 billion in 2007 and $452 billion in 2006.
Further, IATA has cut its profit forecast for U.S. airlines in light of the risks in the business environment, and warned that the U.S. sector could easily turn into a net loss if the current economic environment worsens further. IATA now expects a net profit of $1.8 billion for U.S. airlines.
The Association also believes that assets owned by airlines in other sectors, which have provided a cushion, would not act as a savior this year. This source of cash may diminish in 2008 as the crisis in the financial market makes asset sales more difficult, the firm noted.
Stock Performance
Reflecting the turmoil in the sector, airline stocks have declined more than 22% in the last three-month period. UAL, U.S. Airways and AirTran Holdings Inc. (AAI) are the biggest losers, with their stocks plunging 69.10%, 63.92% and 57.47%, respectively. Meanwhile, shares of Southwest gained over 15% during the period. For the 30-day period also, Southwest is the top performer in the sector, with shares rising 15.09%.
Tough Time Ahead?
While the aviation sector is facing a debacle, even analysts are not very optimistic about its future, as they fear that the massive job cuts and layoffs will make the coming years the worst for the industry since 2001.
"Nobody right now has a viable long-term business plan," said Darryl Jenkins, a Virginia-based airline industry observer. According to him, the cuts should have been made years ago. The capacity reductions, job cuts and fee increases announced by the U.S. airlines may not be enough to counter the impact of the billions of dollars of fuel price increases, Jenkins noted. Meanwhile, he highlighted the deal between Delta and Northwest as the future business model for legacy carriers.
Certain industry experts are of the view that if the work force reduction continues in the same pace, the airline industry will lose more than 60,000 jobs in 2008. Additionally, with fuel prices showing no signs of budging, the passengers are likely to be burdened by the pass through effect, which in turn could further reduce air travel demand.
However, recently, brokerage Lehman Brothers upgraded the U.S. airline sector to "positive" from "neutral," saying the industry restructuring was coming at an accelerated pace. "We see real value in the capacity reductions now under way and believe it is time for investors to revisit the airline space," analyst Gary Chase said in a note to clients.
"We believe a compelling survivor play is developing within the airline sector," Chase said. "What's clear to us is that if nothing changes, bankruptcy risk is significant for the entire industry. It is for that very reason, however, that we believe significant changes must, and ultimately will, happen." Chase is of the view that the industry may need to access almost $3 billion in new equity in the coming 12 to 18 months to stabilize its liquidity positions.
Comments from analyst Michael Derchin of FTN Midwest Securities in New York also suggest that there is still a ray of hope. If the strategies are effective, 2009 will possibly be a turnaround year and 2010 a solidly profitable one as actions start to bear fruit, assuming oil stabilizes at high levels, Derchin said.
Southwest's new Chairman Gary Kelly is also optimistic that the industry will rebound. "As they have in past downturns, the best airlines, large or small, legacy or low-cost, will adjust," Kelly said. He believes there is a very high demand for air travel, and if improvements can be made, demand will be even higher. However, "there is not going to be instant gratification," Kelly added.
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