US industry outlook has brightened February 2002

Despite continued heavy financial losses, the outlook for US major airlines has brightened. While existing bank credit facilities and the government cash grants averted the initial post–September 11 cash crunch, aggressive capacity cuts, cost reductions and success in raising modest amounts of secured debt or equity have given the carriers more than adequate liquidity for the near term. With the possible exception of United (which may face labour troubles), the industry seems well positioned to take advantage of economic recovery in the coming months.

However, the dismal financial results released in recent weeks indicate that there is a long way to go. The nine major airlines posted an aggregate net loss of $3.2bn for the fourth quarter — the largest loss since the $3.6bn recorded in the fourth quarter of 1990. This brought the annual net loss to $7.3bn, which contrasts with a $2.6bn net profit earned in 2000.

Only Southwest was profitable in the fourth quarter and in 2001, though Continental stood apart from the network carriers for its relatively modest $149m and $95m net losses in those periods — the result of successful capacity management and cost controls. Alaska Airlines also escaped the worst effects because of its high leisure traffic content and West Coast focus. While low–fare and regional airlines generally performed better than the majors, only two — Atlantic Coast and Mesa — were profitable in the fourth quarter.

The losses would have been much worse without the benefit of significantly lower fuel prices. The major airlines typically paid 25- 33% less for fuel in the fourth quarter. The industry faces further significant losses in the current (seasonally weak) quarter. The latest estimate from Merrill Lynch analyst Michael Linenberg is an aggregate net loss of $2.1bn for the major airlines in the first quarter.

Unlike the fluctuations experienced in some other parts of the world, the post- September 11 recovery trends in industry fundamentals have been slow but remarkably steady in the US. Based on the month to- month sequential improvements in traffic, load factors and unit revenues, as well as continued strict cost controls, most of the airlines now expect to start generating cash at some point during this spring or summer.

Continental is expected to lead the way, posting net profits for March and for the second quarter (after burning through $3–4m of cash daily in January–February). US Airways, which has already more than halved its daily cash burn to $3m from $7m in the fourth quarter, expects to turn cash positive for April and the second quarter.

Among the largest carriers, American hopes to start generating cash in the second or third quarter and Delta sometime in the second half of the year.

Of course, the major carriers are still expected to post losses for 2002 as a whole.

But a solid financial recovery in 2003 now seems more likely than it did a couple of months ago.

While the current recovery trends in industry fundamentals seem well–established, airlines advise caution of the many unknowns. What happens if there are further adverse developments or if economic recovery falters? What will be the full extent of the increase in security and insurance costs, and to what extent will lower fuel prices offset those costs?

Traffic and load factor trends

While demand may well take a full year to recover to pre–September 11 levels, in the US this has been less of an issue than in other parts of the world because of the sharp capacity cuts implemented by airlines. In the fourth quarter, industry capacity (ASMs) fell by 13.9% and traffic (RPMs) by 18.8%, resulting in a 4.1–point decline in passenger load factor to 66.2%.

However, over the past month or two demand appears to have stabilised.

Many airlines reported a surge in total bookings and load factors over the year–end holiday period, and Continental actually experienced a year–over–year load factor improvement in December. January saw a 0.6–point increase in the industry’s domestic load factor to 63% — the first monthly year–over–year improvement since the terrorist attacks.

For most airlines, load factors are currently running slightly above last year’s levels. Exceptions include Southwest, whose load factors are still several points below last year’s — Southwest did not reduce capacity after the terrorist attacks. Also, US Airways will take a little longer to close the gap as it has arguably been hit harder by the slump than any other carrier — its heavy East Coast exposure, focus on short haul, the closure and gradual opening of Washington National and loss of passengers to competitors' regional jets are all to blame.

Several airlines reported that recovery in international markets is lagging behind domestic recovery. American, for example, disclosed that its international load factors are still four points down whereas domestic load factors are three points above last year’s levels.

Yield recovery prospects

The biggest problems in the US have been extremely depressed yields and unit revenues, reflecting both aggressive discounting and a sharp fall in business passengers using full fares. Before September 11, unit revenues were already down in double- digits due to economic downturn, so the dramatic fall precipitated by the terrorist attacks added to already depressed levels.

In the fourth quarter, yields typically fell by 15–18% and unit revenues by 17–21%.

While Alaska and Northwest escaped with much lesser declines, United was hit especially hard because of its high business traffic content (including a strong presence in international business markets like London and Tokyo), as well as uncertainty on the labour front.

The recovery trend in industry unit revenues has been gradual and steady, with the decline in domestic RASM tapering off from 30% in September to 24% in October, 19% in November and 16.5% in December.

However, this trend was expected to come to a halt temporarily in the seasonally weak month of January (figures were not yet available at press time).

One of the key issues in 2002 is how quickly and to what extent business travel will recover. None of the airlines have detected any sign of recovery, based on discussions with their corporate customers, but most believe that, as always in the past, business travel will pick up when the economy strengthens.

Analysts like UBS Warburg’s Sam Buttrick have argued in recent months that business travel may actually never recover to the earlier levels, because business fares have risen by 15% in the past 18 months and are no longer considered value for money. Buttrick suggests that a substantial reduction in fares might be necessary to get business customers flying again.

However, the airlines have refuted such arguments, pointing out that the main problem is that domestic business travellers are now finding access to extremely low fares (rather than not flying at all). United, for example, reports that its business mix in November and December was very similar to those in the previous two years, but the yield was down by 20%.

Southwest has reported that its current full fare passenger mix of 35%, which is down from a peak of low–40s in 2000, is actually very similar to the one in the early 1990s recession. Since its load factors are still depressed, the airline plans to continue discounting "very aggressively" for the foreseeable future.

By contrast, the network carriers, whose load factors have already recovered (on sharply lower capacity levels), are clearly hoping that they might be able to start raising fares from the current 12–year lows once the economy and demand growth pick up.

Will capacity come back?

One particularly critical issue this year, affecting US airlines' ability to raise fares, is whether or not the sharp post–September 11 capacity cuts will be restored. Initially, airlines like American went out of their way to stress the importance of everyone keeping capacity cuts in place. After all, if one airline adds capacity, others will have to follow suit so as not to lose market share. However, American is now one of several carriers that have already added back capacity or announced plans to do so this spring.

All indications point to capacity being added back in an extremely cautious fashion.

American, which began adding flights at its main hubs and key cities in early February, says that the strategy is to "gradually and thoughtfully restore capacity as demand increases" so as not to cede share in key markets to key competitors. The airline still expects its capacity to decline by 7% in 2002.

United has decided to restore 127 daily flights in key markets in April for the same reason. It may have serious labour and cost problems, but it also has a great network and does not want to lose market share to competitors.

Southwest took the first two of its previously deferred 737–700s in early February and will take four more in March–April, to cautiously resume growth in key East Coast markets. The airline says that it will remain extremely conservative until there is more clarity in the earnings picture. Based on the current schedule to take 11 new aircraft in 2002, this year’s capacity growth would be only 3.5–4% and no new cities would be added. However, there is flexibility to take up to 19 new aircraft this year, and Southwest has been hinting recently that it is likely to pass the 11 aircraft mark.

The network carriers' cutbacks, including the elimination of MetroJet and halving of Delta Express' operations, have given Southwest many exciting growth opportunities.

However, the airline believes that there is no long–term strategic advantage to be gained by rushing into those markets before profitability is assured. As CFO Gary Kelly expressed it, "we think that those opportunities will be there for us later, as opposed to having to make those decisions right now".

US Airways, of course, is contracting in size quite dramatically, reducing its mainline fleet from the pre–attack 417 to 306 by this spring. The airline expects its capacity to decline by 10–12% this year. There will be no mainline growth for several years, as the airline has deferred all of its 2003 and 2004 aircraft deliveries and will take only three aircraft in 2005.

Significantly, US Airways took its 23% capacity cut as an opportunity to implement substantial permanent structural changes to its network, which, it hopes, will improve future earnings performance. The move involved eliminating unprofitable flying and focusing efforts on East Coast hubs and key cities.

There are several reasons why the post–September 11 capacity cuts are unlikely to be restored in the near term.

First, the extensive fleet retirements involved typically old aircraft, which are extremely unlikely to be brought back. Second, many of the airlines took the drastic capacity cuts as an opportunity to simplify their fleets by retiring entire fleet types, thus achieving more meaningful cost savings.

Over the past year, American has shed five aircraft types from its fleet — DC–10s, MD–11s, MD–90s, MD–87s and DC–9s — and will retire its remaining 727s and return TWA’s 717s in the second quarter. United has retired two fleet types early, while US Airways will have shed four by this spring — DC–9s, 737- 200s, MD–80s and Fokker 100s.

Whatever capacity is restored will be done mainly through increased utilisation and planned new aircraft deliveries.

However, US airlines have also drastically scaled back this year’s aircraft purchases. Of the largest carriers, American is taking only nine of the 45 aircraft that had been scheduled prior to September 11, while United is taking just 24 of the 67 aircraft that it previously expected to receive in 2002–2003.

At the same time, the major airlines are increasingly using their lower–cost regional partners to help rebuild service. In recent months United has used its partners' regional jets extensively to replace mainline narrowbody aircraft, to rightsize operations in markets where demand has declined. A similar trend is evident at Delta and American.

Most recently, American, having greatly expanded Eagle operations at Raleigh/Durham, announced that it would also bring RJs to the West Coast in the current quarter. US Airways is now pinning its longer–term survival hopes on securing pilot approval for its regional partners to operate large numbers of RJs.