US legacy carriers: shakeout to begin this autumn? June 2004

Crude oil prices averaging mid–to–high 30s (dollars per barrel) would mean another heavy $2–4bn aggregate net loss for the US major carriers in 2004 — the year when many of them had expected to return to modest profitability at long last

. The industry is now scrambling to find ways to cut non fuel costs further, but can anything meaningful be achieved outside bankruptcy? And what about the heavy debt burden? It has to be noted, first of all, that the large US carriers are clearly worse affected by the high fuel prices than their European and Asian counterparts — many of the latter are still likely to turn in profits this year.

US airlines are suffering because, unlike carriers like BA and Singapore Airlines, they have not been able to deploy the standard tactic used by most industries to mitigate external cost increases: raising prices.

In other words, they have not been able to introduce fuel surcharges in the domestic market.

It has not been for the lack of trying. One US major airline or another (mostly Continental in recent weeks) has tried to raise fares in response to fuel costs nearly every Friday, but the attempts have always collapsed after the weekend when not all carriers participated.

The competitive dynamics in the US domestic market are such that no airline with a sizeable presence on a route dares charge higher fares than competitors for risk of losing market share.

It has been difficult to get fare increases to stick for many years, but the problem has been exacerbated by the increased presence of LCCs and excess capacity (which Continental’s CEO estimates at 25%).

To further illustrate how the legacy carriers have effectively lost pricing power in the US domestic market (even though they still account for 70%-plus of the capacity), only LCCs like Southwest and AirTran have been successful in raising fares in response to fuel in recent weeks. However, those increases (such as Southwest’s $1–2 per segment) have been too small to have any real beneficial impact.

The start of the summer travel season has brought no improvement to the pricing environment. However, several airlines have indicated that they are reassessing their schedules for the leaner autumn months. This could mean elimination of some of the excess capacity, though nobody is expecting much positive revenue impact.

In his recent testimony to Congress (as part of hearings on aviation taxes and security costs), S&P analyst Philip Baggaley made the point that lower inflation–adjusted fares, rather than higher real fuel prices, are the airlines' main problem. According to Baggaley, current real fuel prices are only modestly higher than the averages of the last 15 years.

Real domestic yields and RASM collapsed in 2001–2003 (after declining steadily since deregulation) and have recovered only modestly over the past year.

The big problem regarding fuel, acknowledged by Baggaley and others, is that we are not talking about a temporary spike. Oil prices are expected to remain high for an extended period. Many analysts feel that the prices will settle in the low–to–mid 30s, at best. AirTran’s CEO Joe Leonard said recently that he doubted oil would ever fall below $30 again.

This has significant financial implications for an industry used to oil prices in the $24- 26 range. According to Merrill Lynch analyst Michael Linenberg, for every $1 change in the price, the US majors' aggregate pretax profit swings by about $450m.

In the longer term, the higher fuel prices are likely to lead to a revision of fleet strategies, namely accelerated disposal of older fleets in favour of more fuel–efficient aircraft.

In the short term, with little improvement in sight on the revenue side, cost cutting remains the only option open for the legacy carriers.

Before the May spike in fuel prices, Delta, Northwest and US Airways were the only major carriers seeking labour cost savings (the first two because their pilot costs were totally out of line with competitors', US Airways to avert another Chapter 11 filing).

Now even the strongest legacy carriers may find it necessary to seek labour cost savings later this year. Continental has already warned of potential furloughs, wage concessions and reduced pension funding in the autumn, while many airlines have said that they will consider layoffs.

Although at first glance it is hard to see how Continental and American could extract new concessions from their workers, the more airlines join the process, the easier it is likely to get for everyone. United is widely expected to need another round of labour concessions in Chapter 11; if it succeeds it would make American’s wage levels look uncompetitive.

While Delta may now find it easier to get the concessions it needs from its pilots, some analysts are questioning whether that will be enough to avert Chapter 11.

JP Morgan analyst Jamie Baker suggests that, in addition to $800m annual pilot concessions, Delta would need aircraft ownership cost savings significantly greater than the $175m achieved by AMR, possibly $300m.

The airline is likely to focus on its $2.5bn of non–EETC secured debt, but the problem is that it is extremely difficult to restructure secured debt outside bankruptcy. There is speculation that Delta may need Chapter 11 by the winter to restructure debt.

Of course, after borrowing heavily in recent years to maintain adequate liquidity, all of the legacy carriers have significant debt burdens. According to Baggaley, fixed charges (interest, rentals and scheduled debt maturities) now represent 15–20% of revenues — higher than fuel’s 12–14% share.

Baggaley calculated that each of the legacy carriers would take more than 30 years to pay off its debt and leases at the current rate of cash generation. "The debt burden is so heavy for these airlines that they have little prospect of reducing it materially by issuing stock.

Even bankruptcy can help only to a degree: US Airways went through bankruptcy but still has a fairly heavy fixed financial burden, and United’s proposed reorganisation would reduce their debt and leases by about one quarter."

Baggaley argued that the legacy carriers would not be able to restore their financial strength as they did in the 1990s.

"This lack of backup financial resources and the breadth of the financial weakness across the industry mean that a wave of bankruptcies is possible in the next aviation downturn." Because of the threat of terrorism, "the next industry downturn could happen tomorrow", and it could cause some of the weaker carriers to cease operations and liquidate.

Many in the industry doubt that US Airways will succeed in transforming itself into an LCC (see Aviation Strategy, May 2004). The airline has an incredibly ambitious schedule of completing all labour concessions talks this month (June).

It is also becoming harder and harder to see how United could possibly emerge from Chapter 11 in this environment. In early June it was still waiting to hear about the $1.6bn loan guarantee application — one possibility is that (given that it is election year) the approval might be conditional.