The US Big Three: Contrasting priorities in 2013 - American/US Airways, United and Delta Jan/Feb 2013
US airlines’ recent round of fourth-quarter earnings calls showcased an industry that is doing amazingly well financially and has a promising earnings outlook for 2013, despite the tough global economic environment and fuel cost headwinds. US airlines may even, in the words of one analyst, have evolved from what once was a “boom-and-bust industry” into a “viable, long-term business where adequate returns on invested capital can confidently be anticipated”.
But 2013 will certainly not be boring in the US. There will be plenty of fireworks, dramas, dazzle and pop as the post-2001 Chapter 11 and consolidation cycles draw to a spectacular finish.
Also, there will be a variety of issues to follow and digest, because the top three US legacy carriers are currently in very different situations, each with different priorities in 2013.
2013 will be a pivotal year for American, which is looking to exit Chapter 11 and also has to focus on the challenging task of executing a merger with US Airways.
United, in turn, has to prove that the 2010 merger with Continental will work, following an operationally disastrous 2012. United’s priorities in 2013 are to win back business customers that it lost due to last year’s IT and other integration issues, achieve the promised merger synergies and to start narrowing the profit margin gap with competitors.
Delta, which has a two-year head-start over United on the merger front, with the integration of the successful 2008 merger with Northwest long behind it, and having achieved stellar financial results, has to keep costs in check, attain its debt reduction goal and keep its promise of returning capital to shareholders. It also has to manage new strategic investments, which have included an oil refinery and equity stakes
Healthy profits, promising outlook
2012 was the third consecutive year of healthy profitability for the US airline industry. According to JP Morgan data, the seven largest carriers earned an aggregate operating profit of $7.1bn (5.1% of revenues) last year. The combined net profit before special items was $3.4bn, 2.5% of revenues.
IATA noted late last year that North America-based airlines would see the greatest profit improvement among the major regions in 2012, even beating their Asian counterparts for the first time. IATA expected North American airlines to post an aggregate $1.9bn net profit for 2012, up from $1.3bn in 2011.
The reasons for the US legacies’ current financial strength are well documented: a decade of restructuring, many Chapter 11 visits, an intensive new consolidation phase, years of tight capacity discipline, repeated domestic fare increases, lucrative new ancillary revenue streams and smarter managements that are more profit and return oriented .
At this point all the indications are that 2013 will be another strong year for US airlines. US GDP is expected to grow at a modest rate, business travel bookings continue to rebound, domestic capacity remains tight and fuel costs are “behaving” (as one analyst put it). Analysts expect even bigger gains in profits in 2013.
A permanent structural revolution?
Two years ago industry visionaries like US Airways’ CEO Doug Parker began arguing, to a mostly sceptical audience, that US
JP Morgan’s Jamie Baker has argued in recent research notes that “things truly are different this time”. Factors such as cost convergence, consolidation, fare unbundling, lack of new entrants and return-oriented management teams are driving the “oligopolization of the sector” and have turned the US airline industry into a viable business where 6%-11% operating margins become the norm. Baker also suggested that, given that balance sheets are also being attended to, and assuming that oil prices decline in future economic downturns, the next US recession would not produce material losses or bankruptcies in the airline industry.
As a result, Baker foresees an eventual “broadening of the shareholder base and gradual expansion of multiples”. “Airline equities are sorely under-owned by larger institutional investors”, he observed, noting that about 25% of the aggregate equity of Alaska, Delta, JetBlue, US Airways and United is held by hedge funds, which is three times the hedge fund ownership of the Dow Jones Transportation Index and eight times that of Southwest (3.2%).
A broadening of the shareholder base would obviously be a healthy development for the industry. But Baker and others acknowledge that it could be a slow process. Investors in the US continue to worry about re-acceleration of capacity growth by large LCCs, such as Southwest or JetBlue, or future new entrants – something that could force an end to the profit cycle of the legacies.
Delta executives were asked in the airline’s fourth-quarter call: “How can investors be confident that your financials are more insulated from this threat than they have been in the past?” The executives thought that the combination of high fuel prices and poor availability of substantial start-up capital effectively barred new entrants from the market.
It must also be noted that, even though analysts have confidence in the industry’s ability to deleverage and Delta’s accomplishments on that front are encouraging, US airlines remain extremely highly leveraged. Even if deleveraging becomes a top priority, there is a long way to go.
American: Chapter 11 exit and merger with US Airways
About a year ago, a few months after filing for Chapter 11 in November 2011, AMR’s management put forward a standalone business plan that was widely criticised as weak and uninspiring. That misstep gave US Airways’ ambitious CEO Doug Parker an opportunity to win support from AMR’s deeply unhappy workforce and many of AMR’s unsecured creditors for a potential merger between the two carriers.
Despite that rather inauspicious beginning, the all-stock merger that AMR and US Airways announced on February 14 and hope to complete in 3Q does look reasonably promising. The deal, which is subject to regulatory approvals and customary conditions, will retain American’s name, brand and DFW headquarters. At this stage the airlines expect to maintain their eight hubs and service to all destinations. But there will be upheaval in the form of a leadership change: Parker will take over as CEO, while AMR’s CEO Tom Horton is demoted to chairman – a temporary role he will relinquish in 2014.
The merger will restore American to a roughly equal size with United and Delta and will strengthen its East Coast presence – all important for recapturing the corporate market share lost in recent years. As US Airways will leave Star and join oneworld, the merger will be a major boost to oneworld.
Describing the merger as “extremely complementary”, Parker said that there are only 12 overlapping routes out of the total of 900. American serves 130 cities that US Airways does not, while US Airways flies to 62 unique cities. Nevertheless, while regulatory approval is likely, antitrust experts say that the airlines will probably be required to concede slots at Washington Reagan, Charlotte and DFW.
The new American will be well positioned on the fleet front, given its massive firm orderbook of more than 600 aircraft (517 narrowbodies and 90 widebodies), resulting in large part from AMR’s large Boeing and Airbus orders in 2011. AMR also has much flexibility to rationalise its older fleet while in Chapter 11.
The airlines expect annual synergies of “more than $1bn” in 2015, mostly on the revenue side. S&P suggested that even though the combine’s pro forma revenues and RPKs would make it the largest US airline, the network would not be “quite as strong or balanced” as UAL’s or Delta’s. This is because the merger will not help American in Asia, where it is relatively weak, and it will only “mitigate somewhat” American’s disadvantage to UAL at Chicago O’Hare.
The deal is highly unusual in that it has the support of both airlines’ unions. Many of the contracts are signed and ratified. This means significantly lower labour risk (though the pilot groups must still agree on seniority list integration).
However, the downside is a risk of much higher labour costs. US Airways reportedly suggested to AMR’s unions that the labour concessions under the merger plan need not be as steep as under the standalone plan. Also, US Airways’ labour cost advantage could narrow significantly as its workers’ pay is brought up to AMR’s levels.
Of course, the new American’s biggest challenge is to integrate operations smoothly in the next couple of years. The terrible IT/technology integration glitches experienced by United and others do not offer much hope on this front.
The merger deal is expected to take AMR out of Chapter 11. Significantly, AMR won the support of major unsecured creditors holding some $1.2bn of unsecured claims, helping ensure the deal’s approval in bankruptcy court.
Creditors liked the deal because it offers “enhanced recoveries” for stakeholders. Many unsecured creditors will be made whole on their claims in the form of stock in the merged company. Even existing shareholders, who usually recover nothing in Chapter 11 cases, will get at least a 3.5% ownership stake.
Importantly, the AMR-US Airways merger would be done from positions of relative financial strength. US Airways is now one of the nation’s most profitable carriers. AMR, too, is now profitable, having accomplished what by all accounts has been a very effective restructuring. AMR has not only slashed costs but has significantly improved its RASM performance.
United: Recovery from 2012 issues
Although UAL remained profitable on an ex-item basis in 2012, its margins lagged those of its peers. Its pretax margin was only 1.6%. United also disappointed by posting bigger losses for the fourth quarter. Hefty special charges pushed 4Q and full-year net losses to $620m and $723m, respectively.
United’s underperformance was due to the extensive and prolonged operational and service issues it suffered as a result of an over-ambitious IT/reservations systems switchover in March 2012. Dubbed the largest-ever aviation technology migration, it was a critical integration milestone that was supposed to drive significant merger synergies; instead, when things went wrong, UAL lost valuable premium market share, weakening its revenue performance. Fixing the woes (increasing airport and maintenance staffing levels, making more spare aircraft available, etc.) then caused costs to soar. UAL was already feeling CASM pressures because of the harmonisation of labour costs and the lack of ASM growth.
When presenting the below-par 4Q/2012 results, the management sought to reassure the financial community that UAL had addressed the issues and was ready to recapture premium market share and start closing the profit margin gap. However, UAL is still predicting a sizable loss for 1Q. The management sees recovery accelerating as the year progresses, culminating in a healthy full-year 2013 profit.
With much of the merger integration accomplished, the management believes that UAL is now in a position to “go forward as a single carrier and compete effectively on a global scale”. CFO John Rainey stated: “2013 will be an important year for us as we take the necessary steps to create economic value and achieve a sufficient level of profitability.”
United’s operational performance indeed improved dramatically in the fourth quarter (triggering two on-time bonus awards for employees). The combine’s January on-time performance was the best in 10 years. To ensure that things stay that way, United will maintain the higher than normal airport staffing and spare aircraft levels for the next few quarters.
Customer satisfaction scores apparently continue to improve, as does feedback from corporate customers. UAL is investing heavily in the “tools, training, equipment, inventory and procedures” that will help maintain consistent operational performance and service. Many product improvements are rolling out. United claims to be ahead of its peers in terms of the number of flatbeds offered in international premium cabins, and 90%-plus of its mainline aircraft now offer the popular “Economy Plus” seating.
UAL is likely to recapture its premium traffic share eventually because, as its executives noted, while operational reliability, customer service and a competitive product all mattered, route network and schedule convenience may be the most important factors when business customers choose an airline. UAL’s industry-leading global network and hubs at six of the eight largest metropolitan areas in the US position it well to win back corporate customers and attract new accounts.
United certainly hopes to close the gap in revenue performance with competitors this year. That gap accounted for the bulk of the profit margin underperformance in 2012. As one analyst noted, it is just a matter of execution; there is nothing structurally wrong with UAL’s franchise.
Reducing costs will be harder, though the management sees opportunity to increase efficiency. A number of initiatives are planned for 2013 that aim to mitigate some of the cost pressures, including a 7% officer headcount reduction and 6% cut in the management ranks. Later this year UAL hopes to start removing the temporary costs associated with fixing last year’s operational woes.
United expects its system capacity to decline by 0.5% in 2013 – something that will maintain pressure on unit costs. Ex-fuel CASM is projected to rise by up to 5.5%, of which about half will be the result of new labour agreements.
In December UAL’s two ALPA-represented pilot groups (ex-United and ex-Continental aviators) finally ratified a joint contract — an important step forward on the integration front. The next goal, which UAL hopes to accomplish this year, is a deal on seniority list integration – a contentious subject, but the two pilot groups have agreed to binding arbitration if they cannot agree on a list. The flight attendant and IAM-represented groups, in turn, have made good progress in their talks in recent months. UAL is committed to reaching joint contracts with all of its work groups.
Getting a single pilot seniority list is crucial, because United will then be able to freely allocate aircraft and crews across the combined network – important for achieving the full anticipated $1.1bn merger synergies. Because of the revenue shortfall, United did not achieve the projected 75% of the synergies last year, and attaining the full synergies may now slip into 2014.
United’s strategy in all the labour talks has been to agree to restore pay to industry standards in return for meaningful productivity improvements and increased flexibility. JP Morgan analysts described the pilot deal as “expensive, but in line”. The four-year deal, which came in the wake of Delta’s industry-leading contract last summer, compensates for the concessions that both pilot groups made in the last decade and is believed to be “on par with Delta from a pay-rate perspective”. But the deal includes important productivity enhancements and a significant relaxation of the pilot scope clause; among other things, it will allow United to increase its large-RJ fleet to 255 by 2016 (subject to certain conditions) and to add new small narrowbody aircraft.
UAL is actively renewing and rationalising its fleet. Last year it took delivery of 25 aircraft, including its first six 787-8s and 19 737-900ERs, while disposing of 23 older types and 37 parked aircraft. This year’s schedule includes 26 deliveries — 24 737-900ERs and two more 787s in the second half of the year. The mainline fleet is expected to shrink by ten units to 692 by year-end.
UAL placed a long-awaited $14.5bn, 150-aircraft narrowbody order last year. The 50 737-900ERs (plus 60 options) are due for delivery from late 2013 and the 100 737 MAX9s (plus 100 options) from 2018. The airline’s 270-plus firm orders also include 44 787s and 25 A350XWBs.
The grounding of the 787s for safety reasons since January 16 is an unfortunate development for the type’s North American launch customer. As of late January, analysts did not believe the impact to be financially material in the short term. This is the low season for United, so re-accommodating traffic with other aircraft is less of a problem. According to JP Morgan, at the end of March 787s will account for at most 2% of UAL’s mainline capacity.
Whether United will be able to add all the new international service it was planning in 2013 will obviously depend on how long the 787s remain grounded. As of January 23, the list included Taipei, Shannon, Paris, Denver-Tokyo and three cities in Canada.
Analysts have been somewhat divided on United’s prospects this year. Many responded to the 4Q/2012 results by downgrading their recommendations on the stock. BofA Merrill Lynch noted that United had had five consecutive quarters of margin underperformance, that the PRASM guidance suggested that it was not recapturing market share quickly and that labour costs would pressure CASM – reasons why “UAL’s recovery will continue to disappoint”. But others were more optimistic. “We expect big things from UAL this year, including industry-topping margin improvement (ex-AMR)”, wrote JP Morgan, which projects UAL’s per-share earnings to almost triple this year.
UAL has actually been meeting its ROIC targets. In the past three years, its average ROIC was 10.7%, above the company’s goal of a 10% return over the business cycle. Last year’s ROIC was 8%.
United’s capital spending has been running at a relatively high level since the merger, because fluctuating earnings and liquidity issues in earlier years resulted in chronic underinvestment. Almost half of the $1.4bn net capex planned for 2013 is for items that are more one-time in nature, such as a new data centre and new maintenance hangars. Once merger integration is completed, the airline will adopt a more balanced approach to cash flow allocation.
United executives feel that one of the best immediate opportunities to provide value to shareholders is to pay down debt, especially higher-interest non-aircraft debt. Efforts in that area have already produced tangible benefits: interest costs fell by $122m in 2012. Last year UAL paid off around $340m of debt that had an average coupon of over 11%, while tapping the capital markets for low-interest funding for aircraft and other long-term investments. There is potential for further savings, because a significant amount of high-interest debt is coming due in the next few years.
In summary, United’s cash flow priorities are to get operational integrity firmly restored, fully complete merger integration, catch up with necessary long-term investments in the business and pay down higher-interest debt. Only after that will United be ready to have a “healthy discussion about returning cash to shareholders”.
Delta: “Balanced” capital deployment
By contrast, Delta has been under growing pressure to start returning capital to shareholders. At its December investor day the airline finally announced that it intended to disclose new plans for capital deployment in June 2013, with any new programmes commencing in early 2014.
Delta is under such pressure because it has posted solid profits for three years, is earning significant free cash flow and because it is on the verge of reaching its debt reduction goal.
Delta’s 5.5% and 7.1% operating margins in 4Q and 2012, respectively, were among the best in the industry. In 2012 Delta earned a very impressive $1.6bn net profit before special items (up 30%), which included $372m in profit sharing. Including special items, the net profit was $1bn. In the fourth quarter, despite a $100m negative impact from Superstorm Sandy and refinery operations, Delta still managed a $238m ex-item net profit.
Since 2010 Delta has generated $4bn of free cash flow and earned a 10% ROIC – within its targeted return of “10-12% over the long run”. Last year’s ROIC was 11%. In the past three years Delta has also reduced its lease-adjusted net debt by $5.3bn, from $17bn at year-end 2009 to $11.7bn at the end of 2012. The airline is now on the home stretch in reaching its $10bn goal by mid-2013.
The strong profits reflect unit revenue outperformance for seven consecutive quarters. In 4Q Delta outperformed its peers in all regions except the Pacific, which was weighed down by the Japanese routes, which have suffered from rising capacity, a weaker yen and Japan’s economic slowdown (Delta is trying to diversify into non-Japan markets, particularly China).
The PRASM outperformance has been the result of customer-focused initiatives, corporate share gains and capacity actions. A prime example of the latter was Delta’s bold 7% capacity reduction on the transatlantic in 4Q, which resulted in an 8% increase in unit revenues for the region.
In recent years Delta has made many investments that it believes have driven its PRASM gains or are critical for maintaining the long-term PRASM premium. It has launched Economy Comfort, invested in flatbeds (over 85% of the international fleet by end-2013), revamped two terminals at LaGuardia, opened a new international terminal at Atlanta, launched a new website, bought equity stakes in three foreign carriers and invested heavily in pricing, yield management and business intelligence tools.
There is no doubt that Delta has been capturing corporate market share (also because of United’s and American’s operational problems last year). The gains have apparently been the largest in the financial services and banking sectors; in the past six months Delta signed a “very big bank corporate deal” out of New York, which contributed to a 31% increase in revenues from the banking sector in 4Q.
Delta continues to enjoy strong revenue momentum in 2013, as it further strengthens its position in New York. Its new terminal at JFK will open in May, which the executives suggested will address “one of the largest drivers of our traditional underperformance in New York”. The planned cooperation with Virgin Atlantic will further enhance Delta’s position in New York, especially in the JFK-LHR market where the banks travel the most.
The price paid for the investments in the business has been a steady erosion of Delta’s CASM advantage. According to BofA Merrill Lynch, Delta’s 2012 non-fuel costs were about 10% higher than in 2010, a six-point greater increase than the industry’s. To reverse that trend, Delta is targeting $1bn of structural cost savings in 2013-2014. Key measures include a domestic fleet restructuring , which will see a dramatic reduction in 50-seat RJs in favour of operating more cost-effective and customer-preferred 717s, MD-90s, 737-900s and CRJ-900s. Delta is also redesigning its maintenance programme and buying 23 MD-80s “at very low prices” to use as spare parts for MD-88s and MD-90s.
Delta expects to start benefiting from the $1bn programme in the second half of 2013, with continued ramp-up through 2014. Although non-fuel CASM is still projected to rise by 4-6% in 2013, the worst will be in the current quarter and cost pressures will ease as the year progresses.
So, strong revenue momentum should enable Delta to improve its profit margins in the current quarter, and later on cost savings will kick in to maintain healthy earnings growth in 2013 and 2014. All of that is making Wall Street very happy, and Delta continues to be analysts’ favourite by a wide margin.
But Delta will have to keeps its promise of returning capital to shareholders. Investing in the business and deleveraging the balance sheet are great uses for cash flow, but shareholders have felt left out and have called for a more balanced approach. Delta is in the process of evaluating the options and expects to announce something before its annual meeting in June. BofA ML expects Delta to implement a $500m share buyback programme.
Some investors have wondered if Delta might be “under-investing” in aircraft and living on borrowed time, given its relatively old fleet and a much smaller orderbook than its peers. Delta executives explained in the 4Q call that the strategy is to get returns on day one on fleet investment. The airline is always working to calibrate the right mix of new and used deliveries and believes that it has the right mix going forward. The average age of the widebody fleet is 13-14 years. The domestic fleet will see significant new deliveries beginning this year. Delta is taking advantage of the current glut in narrowbody aircraft and believes that there are significant further opportunities as residual values on 8-10 year old aircraft are on a downward slide. Besides, Delta’s operational performance is at the very top of the industry.
Delta takes pride in “being the most creative at deploying business strategies”. In addition to the interesting fleet strategy, this has so far meant buying an oil refinery and minority equity stakes in three foreign airlines.
The Trainer refinery (see Aviation Strategy, October 2012) did not become profitable in 4Q as expected, because of production issues caused by Sandy (damage to regional pipelines), but Delta expects a “modest profit” from that investment in 1Q.
The Aeromexico and Gol stakes are long-term strategic investments aimed at strengthening Delta’s position in Latin America, as well as facilitating cost reductions (in the first place, through joint MRO facilities).
Delta’s purchase of SIA’s 49% stake in Virgin Atlantic (for $360m in December) was grudgingly approved by Wall Street, amid concerns that there might be less capital available for share buybacks or dividends. But the financial community appreciates that the deal will fix Delta’s Heathrow access problem and make it a credible player in the important New York-London market. Delta and Virgin Atlantic target at least €150m in synergies by FY15. The airlines hope to win the necessary regulatory approvals within a six-month timeframe and have FFP reciprocity and codesharing in place by the start of the next winter season.
|revenue||result||margin||Net result n||Net margin|
|$ (m)||$ (m)||%||$ (m)||%|
|Total top 7 airlines||139,236||7,129||5.1||3,436||2.5|
|Note: Spirit Airlines results announced Feb 19|
|Source: JP Morgan and individual airlines|