US airlines: Can they now make profits across the cycles? Jan/Feb 2012

Recent weeks’ robust fourth-quarter earnings reports and optimistic 2012 outlook commentary from US airline managements have stood in stark contrast with the dire warnings from the World Bank, the IMF and others about Europe and the global economy. Is corporate travel really on the uptick for US carriers? Have the airlines found a way to be profitable in any kind of environment?

The macroeconomic doom and gloom has intensified around the world in recent weeks as fears have grown about escalation of Europe’s sovereign-debt crisis. In late January the World Bank and the IMF both cut their estimates of global growth in 2012 (IMF’s new figure is 3.25%, down from 4% in September 2011). The organisations also warned of other risks that could help trigger a new global recession, including a new oil shock or a “hard landing” in one of the larger emerging economies. Even without such added calamities or the escalation of Europe’s problems, the euro-zone economies are expected to go into a recession and other regions to see a slowdown in 2012. Moreover, there are fears that Europe’s crisis could trigger more serious disruptions in the financial markets and spread to the financial systems on other continents.

Yet, except for modest weakness in advance leisure bookings in some international markets, US airlines have not seen adverse effects. They reported healthy earnings for both 2011 and the December quarter, despite significantly higher fuel prices. And in early 2012 they have continued to see robust demand and strong RASM growth across their networks.

US airlines have not detected any slowdown in corporate travel, even in the transatlantic market. Delta, United and US Airways have all reported continued strong premium cabin bookings to Europe (especially for US-originating travel).

Given all the dire headlines, one might have expected US corporations to show considerable caution in their 2012 travel budgets. But United reported in late January that the majority of its global corporate accounts expected their 2012 travel volumes to be “flat-to-up” and travel spending “moderately increased”.

These trends may reflect the modest economic upturn seen recently in the US, which has offered hope that the US could weather the European crisis relatively unscathed. Late-January data from the Commerce Department indicated that US GDP growth accelerated to an annualised rate of 2.8% in the fourth quarter, up from 1.8% in the third quarter. Consumer spending rose by 2%, a slightly higher rate than in the previous quarter.

Subsequently, employment data for January provided further evidence of a recovery: the US economy added 243,000 payroll jobs and unemployment fell to 8.3%, a three-year low. This followed several months of positive trends in the labour market.

Notably, the IMF did not reduce its growth forecast for the US, because it considered that the “self-sustaining” nature of economic growth in the US would offset the negative effects of a European recession and slowdown in emerging markets. As a net importer, the US would suffer less in a global recession than countries that rely heavily on exports, such as Japan, Germany and China.

IATA, in a February 1 commentary, also noted the “improving business confidence

Compared to global carriers in other regions, US airlines may be somewhat protected in times like these by their lesser international exposure. They still earn more than 60% of their revenues domestically. Their exposure to the transatlantic market is still very limited (just 17% of system revenue at both United and Delta).

In interesting contrast, Singapore Airlines, which is 100% international (and despite being in the dynamic Asia region), seemed much more concerned about its outlook when posting its December quarter results. SIA warned on February 1 that forward bookings “continue to show signs of weakness” due to “uncertainty in the global economy and the protracted euro zone debt crisis”.

Of course, the US airline industry is performing well financially these days because it has gone through a thorough transformation since the mid-2000s. Fewer airlines, a domestic shrinkage, tight capacity, strict cost controls and lucrative new ancillary revenue streams have all played a part. JP Morgan analysts suggested in a research note last month that the US industry is evolving into one “increasingly in control of its own destiny, and exhibiting diminished cyclicality with every passing year and curveball thrown its way”.

US airlines plan to tackle the 2012 challenges (including potentially rising fuel costs and weakening global demand) by sticking to the past two years’ successful formula: fare increases, capacity discipline and non-fuel cost controls. As a result, barring major disasters, most analysts expect US airlines to produce a third consecutive year of respectable profitability in 2012.

Besides air travel demand, this year’s main topic of interest will be American’s restructuring and future. AMR filed for Chapter 11 bankruptcy protection in late November and over the next 18-24 months will, among other things, be downsizing modestly and seeking to renegotiate labour agreements. This is likely to result in both new market opportunities and reduced labour cost pressures for competitors.

There is already much talk of possible future bids for AMR by one of its competitors. US Airways and Delta have both retained advisors to help assess a possible AMR bid, while private equity firm TPG is also looking at AMR and has reportedly already reached out to AMR’s European partner IAG for support.

Even though any bid would be quite a long way off and could come up against insurmountable regulatory hurdles, the implications would be so monumental — in terms of additional industry restructuring and shaking up the Atlantic and Pacific alliance/JV line-ups — that it is easy to understand why this has become a hot topic so early.

Impressive 4Q and 2011 profits

2011 was a second consecutive profitable year for the US airline industry. It was not quite as good as 2010 because of the high fuel prices. The eight largest carriers (excluding AMR) reported an aggregate operating profit of $6.5bn for 2011, down slightly from the $7.9bn earned in 2010. Operating margin was 5.8%, compared to the previous year’s 7.7%. Net profit before special items was $3.4bn, down from $4.6bn but still a respectable 3% of revenues. Industry operating revenues were $113.1bn, up 10.8%.

American, the third largest US carrier, is not included in these totals because it has not yet reported for the year (as of February 3). AMR’s results may be distorted by huge restructuring charges, but even without those it is looking at a sizable loss. In the first nine months of 2011, AMR incurred operating and net losses of $270m and $884m, respectively.

The US industry’s financial performance in the fourth quarter was particularly impressive. Typically most of the carriers incur losses in what is one of their seasonally weakest periods, but this time all eight were profitable when special items were excluded. The airlines had a combined $1.5bn operating profit and a $662m ex-item net profit in 4Q (5.4% and 2.4% of revenues), both up slightly on the year-earlier result despite a near-40% increase in fuel prices.

United Continental, now the largest US carrier, posted an impressive $1.3bn net profit before special items (or $840m including items) for 2011, its first year as a merged entity, despite a $3.4bn hike in fuel expenses. Return on invested capital (ROIC) was 11%. UAL achieved more than 25% of the anticipated merger synergies in 2011 and will be distributing $265m in profit sharing to employees in February.

Delta had a similar $1.2bn ex-item net profit in 2011, despite $3bn higher fuel expenses, and will distribute $264m to employees. The airline generated $1.6bn of free cash flow and a ROIC of 9.1%. In the fourth quarter, Delta’s extremely strong revenue performance covered fully the $500m-plus hike in fuel costs. It was the most profitable December quarter in Delta’s history. The airline earned operating and ex-item net margins of 7.7% and 4.5%, respectively.

While US Airways also reported its second consecutive 4Q and 2011 profits, full-year earnings were down sharply because of fuel. The 3.3% operating margin was the industry’s lowest. However, while fuel costs were up by $1.2bn, profits were down by only $330m, indicating strong revenue growth and good cost controls. US Airways generated $286m of free cash flow in 2011.

Southwest reported its 39th consecutive year of profitability, though its operating margin (5%) continues to be below the industry average. The low-cost leader’s revenue performance was strong but not quite sufficient to offset a $1.7bn hike in fuel costs in 2011, so profits declined. Southwest earned a modest 7% ROIC (including AirTran) and generated over $400m in free cash flow in 2011.

AirTran became Southwest’s wholly-owned subsidiary in May 2011, though integration efforts will take several years. So far the merger has not affected operational performance and in November the two pilot groups ratified a seniority list integration agreement — a crucial step in the integration process. Southwest realised $80m of the anticipated $400m net annual pretax synergies from the merger in 2011 and estimated that, excluding special items, the merger was modestly accretive to 2011 earnings.

JetBlue had another solid year characterised by record revenue performance – reflecting its successful expansion in Boston and the Caribbean – and good cost controls. The airline’s 2011 operating profit ($322m, 7.1% of revenues) was similar to 2010’s despite a $500m-plus higher fuel expense. The $23m net profit in the fourth quarter was a new record for JetBlue in that period. The airline produced positive free cash flow for the third consecutive year.

Alaska Air Group was the operating margin leader last year, achieving 10.9% in 4Q and 11.3% in 2011. Its 12% ROIC in 2011 was also the highest among the US major carriers. Alaska has a very successful niche along the US West Coast.

Allegiant, a niche carrier with an unusual strategy of operating old MD-80s (and soon 757s), was the runner-up in the operating margin league, achieving 10.4% and 11% margins in 4Q and 2011, respectively. In 4Q Allegiant was able to successfully raise its average scheduled fare by $10, offsetting a $9-per-passenger increase in fuel costs.

Hawaiian, too, has been posting solid results. Its 4Q operating margin of 7.9% was the third strongest among the US carriers. It had the industry’s fastest revenue growth in 2011 – 26% — as it, amazingly, found a way to expand profitably in the Honolulu-Japan market despite the devastating effects of the March 2011 disasters in Japan.

The common theme for US airlines in 2011 was a strong revenue environment, which has continued into 2012. Virtually all of the carriers witnessed PRASM growth in the low-double or high-single digits in the fourth quarter, with similar rates seen in January and February.

The domestic revenue environment has been strong for a couple of years now and is the result of the US industry’s significant shrinkage and capacity discipline. Since 2005 the number of (mainland-based) major carriers has been reduced from 11 to seven. But mergers are only a part of the story; just as crucial have been the cutbacks by individual carriers and the slowing of growth by LCCs.

The combination of tight domestic capacity and robust demand created a strong pricing environment, facilitating a steady stream of fare increases over the past year. Just as important was the more muted fare sale activity. US airlines have thus been able to pass on a fair chunk of the historically high fuel prices to consumers.

Capacity discipline has also improved the viability of international routes. Delta’s dramatic 10% capacity reduction on the transatlantic in the autumn boosted its European RASM growth to 11% in the fourth quarter, despite Europe’s economic weakness. Delta was expecting its transatlantic RASM to surge by 17% in January. And, by keeping its capacity flat on the transpacific, Delta boosted its RASM growth there to 14% in 4Q.

In 2011 the three largest US carriers’ combined system capacity was roughly flat – a result of a 1.8% reduction in domestic ASMs (including regional operations) and 3.3% growth in international ASMs.

UAL’s plans for this year are similar: system capacity down 0-1% (domestic down 2-3% and international up 2-3%). Delta, too, intends to remain disciplined, though so far it has only disclosed that its system capacity will fall by 3-5% in the current quarter.

American’s downsizing in bankruptcy, which by most estimates could be in the region of 5-10%, will be an added bonus, helping maintain a healthy domestic pricing environment.

To everyone’s relief, Southwest confirmed that it will maintain flat capacity in 2012. It has no plans to grow its fleet this year – or even in subsequent years until it hits its profit targets. In fact, Southwest expects to end this year with fewer aircraft, after retiring 40 older 737s and bringing in 33 (larger) 737-800s.

JetBlue is the only one of the top six carriers that has stepped up growth. Its ASM growth accelerated to 7.2% in 2011, including a worrying 10.5% spike in 4Q, and this year’s plans call for 5.5-7.5% growth. But JetBlue does have unusually good growth opportunities.

So, with flat industry capacity in 2012, the stage is set for a continued healthy revenue environment. Delta is particularly well positioned for strong RASM and margin gains. The larger route network resulting from the merger, dominant market shares at all of its hubs and solid positions in New York and on transatlantic and transpacific routes have given Delta strong momentum for attracting business traffic and gaining corporate market share.

Delta and US Airways should also reap benefits from the unique slot swap that they are finally able to implement this year. Delta secured more New York LaGuardia slots and US Airways more Washington National slots, enabling each airline to focus their assets on areas where they have some competitive advantage. US Airways will be adding 11 new cities and boosting flights on existing routes from National in March, with another expansion phase following in July. Delta is implementing a summer schedule that will give it 50% of daily departures at LGA, making it well-positioned to increase corporate share in the New York area.

JetBlue is also poised for continued strong PRASM gains as it increases its business traffic share in Boston and also grows in the Caribbean where competitors are retreating. Boston is highly lucrative for JetBlue, because nearly 30% of its customers there are travelling on business, compared to 20% in the rest of its network.

Southwest should start reaping more benefits from the AirTran merger after it secures a single operating certificate (expected this quarter), which will mark the start of deeper integration and network optimisation. Service changes at Atlanta, AirTran’s withdrawal from unprofitable markets, new service to the Caribbean, a revamped FFP, the larger 737-800s and new 737-700 interiors will all boost Southwest’s revenue and earnings in the next couple of years.

For United Continental, the IT/reservations systems switchover planned for early March will be a critical integration milestone, driving significant further merger synergies in 2012. Among other things, it will facilitate the free flow of aircraft across the network and the launch of a combined FFP. There is always risk of a potential disruption, but United seems to be well prepared. The other major remaining challenge is to secure a pilot seniority integration agreement.

US airlines have benefitted enormously from the new ancillary revenue streams (checked bag fees, etc.) developed since mid-2008. The lowest-hanging fruit have been picked, but airlines such as JetBlue, Delta and United still see good growth potential. Delta expects to generate $400m in incremental ancillary revenues in 2012. UAL, which earned more than $2bn in ancillary revenues in 2011, is looking to relaunch its website after the IT switchover as a “platform for innovation” for developing new ancillary products.

But non-fuel cost pressures have also been building for US airlines, especially in labour, maintenance and airport costs, aggravated by the lack of ASM growth. Consequently, many of the airlines plan fresh attempts to tackle costs and improve productivity in 2012.

The US industry’s cash balances remain healthy and some of the airlines continue to make progress in deleveraging their balance sheets. Delta, which is leading the way in that area, is more than half-way through in reducing adjusted net debt from $17bn at year-end 2009 to $10bn by mid-2013. While United has much higher capital spending planned for the near-term (both aircraft and product investments) and has not set a debt reduction target, analysts expect it to prepay some of its higher-interest debt this year.

With continued profitability and generally no significant aircraft deliveries scheduled in the near-term, free cash flow generation is expected to remain strong at most US airlines in 2012.

Commentary from the airline executives indicated that the carriers are taking financial targets and shareholder returns more seriously. This may be because, for the first time ever, sustained profitability seems within reach for many US airlines (other than just Southwest).

AMR: a difficult and

lengthy restructuring?

AMR’s management outlined its proposals for cost cuts and other Chapter 11 moves on February 1. The company is targeting $3bn in annual financial improvements by 2017, including $2bn in cost savings and $1bn in revenue enhancements. AMR is looking for $1.25bn of annual labour cost savings, with the $750m balance coming from debt and lease restructuring, grounding of older aircraft, improved supplier contracts and suchlike.

The employee cost cuts would be across the board. Each work group would be required to reduce their total costs by 20%. This is expected to mean a total reduction of 13,000 employees, about 15% of the workforce. AMR is also looking for work rule changes to increase productivity and the removal of restrictions on codesharing and regional flying. And it wants to outsource a portion of maintenance work.

Most controversially, AMR has decided to seek court approval to terminate all four of its underfunded defined-benefit pension plans.

To appease the workforce, AMR stressed that the labour cost cuts would be “fair and equitable”, also including a 15% reduction in management. And AMR wants to put in place a profit-sharing plan that would pay 15% of all pre-tax income to employees.

The key elements of the proposed business plan are to renew and optimise the fleet, build network scale and alliances, and modernise brand, products and services. AMR wants to invest an average of $2bn annually in new aircraft. The “cornerstone” strategy would continue, with the five key markets seeing a 20% increase in departures over the next five years. There would be more international flying.

The verdict on these proposals: probably exactly what AMR needs to do to make its costs broadly competitive with those of Delta and United. The $1.25bn labour cost cuts, when added to the $1.8bn of labour concessions American secured in 2003, are roughly in line with the cuts implemented by competitors in Chapter 11.

However, it is also clear that AMR faces extremely tough hurdles in getting the proposals approved. Consensual labour agreements may not be possible and AMR may have to ask the court to terminate the existing contracts – a potentially disastrous scenario from the morale viewpoint.

Terminating the pension plans could be even more difficult. PBGC, the US agency that protects corporate pensions, has made it clear that it will fight the moves. It has stated that AMR has yet to show that defaulting on the plans is necessary. When AMR last month paid only a fraction of the $100m pension contribution that was due, PBGC filed liens against many of the airline’s international assets, citing AMR’s very healthy $4bn cash reserves.

AMR’s proposals also will not solve the problems on the revenue side, arising from a network that is smaller and less attractive than United’s and Delta’s. That is where Delta, US Airways and other potential suitors will come in at some future point. Currently, however, AMR’s management can use the takeover speculation to pressure the unions to cooperate. CEO Tom Horton wrote in a February 1 letter to employees: “You have likely read or heard reports that there are those who wish to shrink our airline, close hubs or acquire our company or assets” and that “the best way for us to assure that we are in control of our future is to make the necessary changes (and) complete our restructuring quickly”.