US revenue and cost trends: surprisingly upbeat May 2000
Sharply reduced earnings or losses reported by the US major carriers for the quarter ended March 31 give a rather misleading picture of the state of the industry and its prospects. This is because traffic, capacity, yield and non–fuel unit cost trends continue to be favourable — and fuel prices, too, are now moderating.
Unit revenue recovery
One Wall Street analyst described the $354m industry aggregate net profit in the first quarter as an "amazing achievement" in light of a 61% average rise in fuel prices. The hike meant an additional $1.2bn of fuel expenses. Excluding fuel, the industry’s pre–tax profit margin rose by about three percentage points. The first–quarter results were essentially rescued by a solid 4.3% increase in domestic unit revenues (RASM) in March, after just 0.9% growth in February and 2–3% declines in December and January. In fact, this was only the fourth time RASM has risen in the past 18 months.
There was a sudden dramatic surge in the last two weeks of March, driven by a rebound in leisure demand (partly representing a recovery from the Y2K effects), industry–wide fare increases and a fuel surcharge introduced in February. Another factor was coach class seat removals at American and United which, according to an estimate by PaineWebber, have reduced industry capacity by about 0.75%.
While some of those factors obviously have little lasting impact, there are signs that the unit revenue trend has turned positive at long last. This is because a combination of robust demand, moderating capacity expansion and continued fuel and labour cost pressures is likely to keep fares at a healthy level.
The US economy continues to grow strongly, but new worries about inflation are expected to lead to another hike in interest rates (this year’s third) by June, which will slow the economy and traffic growth. But ATA, the industry association, still expects 3.2% RPM growth in 2000, compared to 5% last year.
The chances of the fare hike labelled as "fuel surcharge" being reversed as fuel prices decline seem pretty remote at present. As Continental’s CEO Gordon Bethune put it, "planes are full, so prices are not too high". In ATA’s estimates, fares will increase by about 2.5% this year, after a 1.6% decline in 1999.
Analysts believe that April saw another strong 4.5–5% increase in domestic RASM but that growth will moderate to 3–4% in May and June, still leading to an improvement in industry unit revenues this year.
Moderate capacity growth
American’s and United’s respective "More Room Throughout Coach" and "Economy Plus" initiatives are expected to boost their RASM growth by as much as 2–3 percentage points in the current quarter and beyond. However, seat removals are not likely to become a trend as other carriers focus on alternative ways to improve passenger comfort. ATA currently projects that industry capacity growth will decelerate from last year’s 4.8% to 4- 4.5% in 2000, reflecting recent downward adjustments by a number of carriers. This is very good news, though growth would still exceed the 3.2% projected increase in traffic, which could put some downward pressure on fares.
While capacity management continues to be the key concern of airline investors, substantial capacity addition is, of course, tolerated if the airline is Southwest or if growth takes place from underdeveloped hubs.
Southwest is now exceeding its earlier long term planned growth rate of 10%. Its ASMs rose by 14.2% in the March quarter, which was amply exceeded by traffic growth. Despite some aircraft delivery delays, the airline believes that it can achieve 14% ASM growth in the current quarter and "at least 12%" for the year.
Continental’s major growth phase is now winding down and has recently decelerated further. After 9% ASM growth in the first quarter, the carrier now expects 5% growth for the year and just 2–3% in 2001. The past few years' rapid expansion has been so profitable that Wall Street analysts sound rather disappointed that it is over. Salomon Smith Barney’s Brian Harris wonders if Continental may have gone a little too far with the slow–down "given its underdeveloped hubs".
US Airways' immediate plans sound promising — four new transatlantic routes out of underutilised hubs this spring and some smart restructuring of MetroJet flying, which is expected to add up to an 11% ASM increase in the current quarter. But there are concerns about the 2001 growth rate, which Harris estimates at 6–8% based on current fleet plans and considers aggressive in light of the major carriers' projected average rate of around 4% and intensifying competitive pressure from low–cost operators on the East Coast.
Impact of fuel prices
The worries also reflect dented management credibility. While there is unanimous agreement that US Airways' fleet renewal and growth strategy could be instrumental in reducing its extremely high unit costs and ensuring longer–term survival, the management’s record in implementing the strategic plan has been dismal so far. The US industry’s unit costs rose by on average about 6% in the first quarter, which was almost entirely due to higher fuel prices as non fuel unit costs inched up by a fraction of a percent. But there was considerable variation between carriers depending on their hedging policies.
At one extreme, Delta, which was extremely well–hedged, paid only 23% higher fuel prices (59.5 cents per gallon). At the other extreme, US Airways, Southwest, Continental and Alaska, which had no effective hedges in place, saw prices more than double to well over 80 cents per gallon.
Labour vs. distribution costs
In recent months just about all the previously unhedged carriers have hedged themselves to varying degrees, but in many cases there are no immediate benefits while the longer–term benefits are questionable now that fuel prices are on a downward track. The flat first–quarter non–fuel unit costs were the result of substantial labour cost increases and impressive commissions savings more or less offsetting one another. The indications are that these trends will continue, with labour cost increases possibly gaining a slight edge.
The worst–positioned carrier in that respect is United, which will see a significant rise in labour costs this year and next as its ESOP comes to a close. The process, which began in April, will account for the bulk of the 10% rise in unit costs projected for the current quarter (some is due to the seat removals). The ESOP cost impact for 2000 is estimated at $750m (or $1.3bn on a full 12–month basis, according to Merrill Lynch) and it is the main reason why UAL’s earnings are expected to fall this year.
American also faces tricky labour issues, following the rejection of a tentative flight attendant contract last autumn (talks continue) and the recent breakdown of negotiations with its pilots over the use of RJs. And the issue of the $45m sickout fine has still not been resolved with the pilots.
Labour cost pressures also continue at Delta, whose pilots are demanding industry–leading pay rates in talks on a contract that becomes amendable later this year. And the new flight attendant deals at US Airways (ratified May 1) and Northwest (tentative) both include big pay increases.
On the positive side, the hefty pay increases granted particularly by Delta and Continental in recent years are to a large extent offset by productivity gains. And at least Continental, US Airways and Alaska now have no new contracts coming up for renewal until 2002 or 2003.
The resolution of labour issues will enable US Airways at long last to focus properly on implementing its strategic plan. Some analysts believe that the current quarter will be the first to show a decline in unit costs stemming from past restructuring efforts.
One of the positive surprises this year is that commission expenses have continued to fall at a rapid rate. According to a research note from Merrill Lynch, the major carriers' commission costs declined by 12% in aggregate and by 16% per ASM in the March quarter.
This reflected a cut in travel agency commission rates from 8% to 5% and more direct sales — factors that will produce benefits also for the remainder of the year. In addition, American is now reaping extra benefits from a recent reduction in Latin America commission rates from 9- 11% to 6%.