As expected, the US majors emerged from last year showing signs of a slow progress toward recovery but it is not yet there
The year-end numbers tell their own tale: the US majors did much better in 2003, if only because they had to, given the awful year before. From the outset it was never going to be easy, starting with the invasion of Iraq and the fears it raised over terrorism, then moving on to the SARS epidemic. Nevertheless, carriers performed progressively better as the year unwound, until by the fourth quarter they were collectively within sight of breaking even at operating level.
American Airlines returned to investor and analyst favour after it managed to get its operating costs down to levels competitive with the recent legacy darlings, Continental and Northwest airlines. JP Morgan's Jamie Baker went so far as to call American "the new low-cost leader among network carriers" after its fourth quarter performance. It surpassed Continental for the first time in a decade, down from an earlier 16% cost disadvantage, he notes, adding that its costs are only about 20% over those of the overall leader, Southwest Airlines, down from a 60% gap two years ago.
At Continental, which has long held the lowest costs among the big network players, results were so strong that Michael Linenberg, the Merrill Lynch analyst, said the carrier was "on the foothills of recovery". Reflecting a growing consensus, Deutsche Bank's Susan Donofrio says that Northwest, American, and Continental are favourites for a return to profitability.
But a view of the distant shore is far different from reaching a safe harbour, and 2004 has seen rocks and shoals appear as well. Fuel has emerged as a major unpredictable factor and low-cost carriers have stretched their wings even more deeply into traditional network carrier territory. Lehman Brothers analyst Gary Chase says that, indeed "the worst is likely over", but he is not yet confident that the up cycle has arrived. Despite substantial cuts in costs and capacity in the worst of the crisis, "major structural issues facing the industry have been unaddressed in this down cycle", he believes.
One way of addressing basic structural issues has traditionally been reform by way of the bankruptcy code, where carriers can reject aircraft, real-estate and even labour contracts and force creditors to grant them new and more favourable terms. But the experience of bankruptcy in 2003 suggests that even here the process has its limits and that to escape from structural problems is going to be no easy achievement.
As the threat of bankruptcy has re-entered the vocabulary of airline executives in this year's debate, it may be worthwhile to consider the two major bankrupt actors: the United Airlines and US Airways groups. United continued to post the airline industry's worst losses, even if they kept shrinking. Its fourth quarter 2003 net loss of $476 million after exceptionals (or $251 million before)is down from the $1.5 billion deficit of a year ago - its worst quarterly result on record. Costs were cut by 16%, helped by steep labour concessions and lower aircraft payments. Revenues rose 4% to $3.6 billion, reflecting improving demand for air travel.
Airline consultant Stuart Klaskin, however, says that if the results are extrapolated, at best it could take another nine months to a year before United starts making money. And by its own admission, the group has plenty to do before it finally gets ready to make its formal exit from bankruptcy, a step it has already rescheduled three times.
Similarly, at US Airways, which formally exited reorganisation on 31 March 2003, bankruptcy still remains a major issue, as the consensus emerges that the carrier's seven-month reorganisation was possibly too rapid. Observers do not suggest that bankruptcy court is a good venue from which to manage an airline, but that US Airways could possibly have extracted deeper cost costs. Even if it could have done so, its re-entry into the ranks of the unprotected came just as the low-cost onslaught was making its strongest inroads.
Like most observers, US Airways executives had expected Southwest to add an East Coast city, but did not imagine that it would be one of their major hubs. Yet Southwest, the king of the discounters, will indeed start service to Philadelphia in May. US Airways also faces the jetBlue plan to begin service at New York LaGuardia airport, another of its strongholds. Then there is jetBlue's plan to add regional jets of about 100 seats to its fleet to fly head-to-head against US Airways in secondary East Coast cities starting in 2005.
In a message preparing US Airways workers for a third round of cost cuts, chief executive Dave Siegel said they may be "victims" of the new reality of airline economics and have to make a long-term adjustment to the "lower pay, fewer benefits, and more efficient work rules" of the low-cost carriers. Siegel rules out another bankruptcy filing in "any kind of relevant time horizon", but most analysts say the early spring and summer are crucial, with a federal requirement to meet financial covenants set in its $900 million government federal loan guarantee.
The US Airways plan to fight back against the discounters has been to rely on regional jets flown at attractive pay rates; United's has been to develop a low-cost in-house brand, Ted, which began service in February. But the task is huge. The low-fare sector took a 28% share of passengers in the USdomestic market and 19%of revenues, according to latest figures released by the Department of Transportation for the 2003 second quarter.
Although it is fair to say that the traditional carriers are now fighting back - through the likes of Ted and Song, as well as through focused fare promotions that target low-cost rivals - they now face a new wrinkle in the shape of the growth of long-haul, low-cost service. In particular, there is the emergence of the low-cost carriers as a major presence in the transcontinental market.
Historical strength
Lehman Brothers analyst Gary Chase says America West, ATA Airlines and jetBlue are making inroads into non-hub transcontinental routes. "Historically, these have been bastions of strength for the majors, especially American and United," he argues, calculating that they made annual profits respectively of between $100 million and $200 million on these routes between 1998 and 2002. Furthermore, almost half of their total revenue generation in the cross-country markets came from fares of $1,000 or above.
The low-fares attack on these routes, says Chase, "speaks volumes about the shape of things to come". If low-fare carriers continue to make inroads in these markets, Chase warns, "the majors will have to rely increasingly on their hubs".
However, that turns back to the start of the vicious and as-yet-unbroken circle: the structural reliance on hubs and the concomitant issues of labour costs, productivity and revenue enhancement. The same challenge as in 2001: sluggish demand that is unlikely to return to robust levels, creeping and in some cases trotting capacity increases, rising fuel prices and the unaddressed issue of corporate debt. Of these, capacity is the most important. Industry capacity for the majors, including Southwest, fell by 4% in 2003 (see table left), after a 10% drop in 2002. But Deutsche Bank's Susan Donofrio estimates that a rise of almost 6% looms for 2004.
Capacity may be controllable. Jet fuel prices are not, and these were edging up past ¢90 a gallon early in the year. Fuel is an airline's second-largest expense after labour and each penny rise in the price of jet fuel costs the US industry $180 million over a year. Blaylock and Partners analyst Ray Neidl says that even with oil at $35 a barrel, "that's going to be crushing for earnings".
So it is back to the past, and back to labour costs. UBS Warburg's Sam Buttrick sees 2004 industry losses shrinking to the $500 million level. And, perhaps far more the optimist than others, he expects that for labour "it will eventually become rational to consider compromise deals. Just don't expect it anytime soon."
It is Buttrick's view that Northwest has a chance of agreeing a pilot deal this year or early next. If Northwest can bring down its labour costs, it will end a marathon that reflects the industry's long-running labour dilemma. Since 2001, the airline has managed to perform eight rounds of non-labour cost cuts, getting about $1.6 billion a year in savings, but it has not reached its goal of getting as much as $1 billion a year, or nearly 25%, out of labour expenses despite nearly a year of union talks.
But Buttrick has a rationale for his belief that some unions will break the cycle this year: "All roads lead to the market and, ultimately, it's up to labour to decide how to take its medicine: smaller doses sooner or larger doses later."
DAVID FIELD WASHINGON/DATA ANALYSIS FABRICE TACOUN ATI
Source: Airline Business
