It will be different next time. How familiar that message must sound to the Wall Street analysts who track the financial ups and downs of the US airlines. But in 20 years of deregulation, the majors - with the one notable exception of Southwest Airlines - have yet to prove they can ride out a recession without plunging into a mayhem of price wars and red ink.
Rono Dutta, senior vice president of planning at United Airlines, sums up the recurring situation most honestly when he says:" Every recession we have gone through has been a traumatic experience. Every time we have been forced to go in and trash the product. Then we come out of recession and try to put the product back together again." But Dutta is just as quick to stress that this time it will indeed be different. "For the first time, we will make money in the next recession," he says.
Investors appear not yet to be quite so concerned. But then the yo-yoing of the stock market in 1998 showed their uncertainties to be general and not specific to the airline industry. Analysts and consultants are also cautious of accepting overblown promises from the airlines. But they do agree with airline management that proper preparation will go a long way towards lessening the severity of the effect of the next downturn. And there are signs that those managers are putting such preparations in place. As one New York analyst puts it: "I have never seen an industry so well prepared for a recession. It's like putting snow chains on your car in August."
The key to United's argument, that its preparations will see the company through the next recession relatively unscathed is that it will manage capacity better than it has ever done before. "Capacity is what drives our destiny," says Dutta. So the airline is holding on to its older fleet of 75 Boeing 727s and 25 737-200s, which will be used as a buffer that will allow management the flexibility to restrain growth quickly if necessary. In particular, the 18-year-old 727s, which are now being hushkitted, would permit United to drop its current growth plan of about 3% per annum to 1% or even negative growth. "It's just as bad to be caught short of capacity as it is to be caught long," points out Dutta. "So we will keep planning on conservative growth, but if the recession comes in we will have the flexibility to use our 727s to bring down capacity. One of the lessons we have learned is not to wait for a recession. You have to prepare. In any downturn, we will get hurt. Our challenge is to manage it so it doesn't hurt too much. We are just as sensitive to the capacity cycle as we were last time, but in the last recession we were growing into the recession - that's what made it so horrendous. This time, we are saying that if we manage unit revenue growth and unit expenditure growth, we can still make a profit," he says.
To this end, United's management team intends to use three additional reinforcements on top of its 727s in its defence against a recession. They are route diversification, customer loyalty and yield management, and cost management.
Route diversification means reaching out to more regions - something Dutta argues is made easier for United because of the Star Alliance. But United wants the focus to be on hub traffic, which it argues has a tendency to stay safe through a recession whereas point-to-point routes tend to shrink. The airline is also working to define its core product so that it can retain key customers and yields. "In a recession you are under so much pressure to cut costs that you cut them indiscriminately. You have to cut costs, but you have to do it discriminately," says Dutta.
United's goal is to make a net profit margin in excess of 5% during the next recession and to achieve this without any layoffs. The airline believes that with between 2,000 and 3,000 employees retiring each year, plus 400 pilot retirements, then any shrinkage can be handled through natural attrition provided a downturn is identified in time.
Dutta knows there is a wall of scepticism in New York. "Investors want proof that we can make money in a recession. But we need to go into one, handle it well and put it behind us. I'm not saying we actually welcome a recession, but there is an opportunity here to prove we have learned the lessons," says Dutta.
American Airlines chairman Donald Carty has been taking a similar message of "we are prepared" to the financial community in recent weeks. In November, American revised its 1999 plans so that growth will be cut from 6% to 4%. The airline will bring forward the retirements of eight McDonnell Douglas DC-10s and two Boeing 727-200s so that a total of 16 aircraft will be retired this year, saving the airline $40 million in heavy maintenance and modification costs. "We think that knocking our seat milegrowth down a bit is the prudent way to ensure that we don't get caught, as we were in the early 1990s, with too many seats chasing too few customers," says Carty.
Carty's mood is also one of optimism for the state of the industry through the next downturn. "While the industry remains intensely competitive, each of the major carriers today has a route system well suited to its individual strengths," he says. "Also, we have fewer carriers today in the kind of financial disarray we saw in the 1980s and early 1990s. We're seeing fewer carrier on the verge of bankruptcy - they are operating with a more long-term focus. And while the industry has a number of new aircraft on the way, there has not been excessive commitments for new capacity. We've built a lot of flexibility into our aircraft deals and we have a lot of older, fully depreciated aircraft we can either hold on to or retire."
Carty acknowledges that not everyone will be convinced, however. "Some in the financial community have obviously already made up their own minds - and not in our favour," he says. "But from our perspective, we believe there have been some fundamental changes in the industry since the last down cycle and those changes argue for less volatility in our financial performance."
Management at Delta Air Lines, too, has some persuasive messages for Wall Street. First, the company has an almost totally new top-level management since the last recession and the new team, recruited largely from outside the airline industry, has been receiving mostly high marks from analysts. The numbers are also looking healthy. Load factors are up to more than 76% and at the end of the 1998 third quarter the company's cash balance was $1.1 billion and its debt to capital stood at 69%. Delta believes it is in a "strong position" to face any possible recession in 1999 and has left its fleet plan flexible for such an event. "We are cautious about general economic conditions," says Delta president Leo Mullin. "However, we remain confident that Delta is better positioned today than at any time in its history to deal with economic uncertainty."
Some - though not all - of the analysts are listening to the US carriers and agreeing that what they say makes sense. Raymond Neidl, an analyst at ING Barings in New York, has taken a close look at where the North American airlines appear to be heading based on their 1998 third quarter results and his conclusion is that he is "cautiously optimistic" even if, as he expects, the Asian flu spreads with a resulting likelihood of a US recession beginning in 1999 increases. "The economic slowdown may happen this year, but no airline manager has seen that going into the first quarter," says Neidl.
They are in a much better situation now to weather the next recession for a number of reasons. But the real big story is that their yield-management systems will help them to navigate through the next recession. "All carriers are now using much stronger yield management systems which allow them to offer discounts without giving away their product through ruinous price wars" he says.
Barings believes that record or near-record results will continue in the short-term, with the exceptions of Northwest Airlines and TWA, both with unique problems. Neidl points out that Northwest has some 30% of its system in the Asia-Pacific region and lost $224 million in the 1998 third quarter following a strike by its pilots. But while weakness in Asia continues to plague Northwest, Barings adds that advance bookings look strong and "-if there is an economic downturn, Northwest management believes it has greater flexibility than its competitors to adjust with its older aircraft that could be retired."
TWA is more problematic. Barings points out that the recent contract signed with TWA pilots was a "catch-up" agreement to bring them in line with other carriers since employees took major salary hits during the airline's two bankruptcy proceedings. It was, therefore, an expensive agreement for TWA, which reported a "disappointing" net loss of $0.9 million in the 1998 third quarter and saw its cash levels drop from $374 million in the 1998 second quarter to $315 million. "TWA is still trying to recover from years of mismanagement and neglect," says Barings.
For all its general optimism, however, Barings highlights labour demands as a potential hot spot that will need to be monitored across the US industry in 1999. " Pressure is building for labour cost increases," warns Barings. "These would raise unit labour operating costs, which could cut into earnings if the increases could not be passed on to the consumer. The biggest remaining threat to major carriers' earnings, long term, is that they may be forced to enter into outsized labour agreements."
Another lesser threat comes from possible new regulatory moves that could be introduced by the US Depart-
ment of Transportation in 1999 following last year DoT's sharp political focus on competition and the lack of new startups. The Air Transport Association has been campaigning fiercely in recent months against the introduction of new competition and anti-predatory behaviour guidelines. But the small low-costs and startups are expected to launch a new and equally determined campaign this year to make sure that the DoT's guidelines are not diluted.
And while international strategic alliances may help the North American carriers to diversify their route structures, Barings points out that the US domestic alliances may be in trouble after the Justice Department decided to sue the proposed Northwest-Continental deal on ownership grounds. "This move by the government could signal strong opposition to anything beyond sharing of frequent flying programmes. It could be the death knell for large domestic alliances," concludes Barings.
But sprinkled through the general, if cautious, optimism is a liberal dose of salty scepticism. A study by Gemini Consulting of London to try and assess the vulnerability of US airlines to recession concludes that even if those airlines plan to manage capacity through a recession, any fall in load factor will damage operating profit considerably (see charts). Load factors, points out Gemini, improved by an average of 7.1 points for the majors between 1992 and 1997 (and hit new records during 1998), and this has been the primary driver of revenue growth, hand-in-hand with a 9% increase in customer demand. But corresponding break-even load factors have reduced by an average of only 1.7 points during the same period. Break-even load factors range from Southwest Airlines' 56.4% to TWA's 75%, with the remainder falling between 64% and 69%. In 1998, according to ATA figures, load factors averaged 70.9% - up 0.4 points on 1997, while break-even averaged 62.5%, down just 0.1 points.
The safety margin is a dangerously narrow line, points out Kieron Brennan, a vice-president at Gemini Consulting. "If load factors come down by just 3% - and in the last recession they went down more than that - then the next recession will not hit so badly. But that does not mean to say it won't hurt. Our figures demonstrate the sensitivity to load factors without price wars and without companies downgrading personnel from business to economy class. This is simple volume. And a 3% drop would come as no surprise," says Brennan.
Brennan does not dismiss the majors' argument that they will be able to manage capacity better through their flexible fleets, but his confidence is tempered. "They are planning to manage capacity so it stands still. They will assume it stands still. But if demand drops faster than stand still, then the load factors will go down," he says. "Then there is the swing factor which would give that load factors drop by 5%, which would be bad news. It would seriously hit the bottom line of all the majors. On top of that, you have to consider price competition. Although they say they won't enter a price war, it will take a lot of discipline to resist it once load factors drop."
While Gemini believes that load factors, and more specifically the correlation between differential load factor and industry operating profit, will be the critical issue for the airlines, Brennan adds that other problems potentially lurk in a recession that could result in a "double whammy", making the effect of a drop in load factors even worse. These include fuel prices - although Brennan and others believe these will remain stable for the foreseeable future - and labour pressures. "There are a number of combinations and sensitivities out there that could combine to make the effect of each worse."
The ATA, meanwhile, is cautious but not overly fearful about 1999. It expects to see an economic slowdown in the USA, but also continued growth. The ATA also anticipates that its members will turn in a net profit of between $6 billion and $6.5 billion for 1999, compared with 1998's $5.4 billion.
There are two new weapons available to many of the North American majors that they did not possess during the last downturn. The first is the regional jet, which has played a large part in the revival of the regional airline industry and for which continued strong growth in 1999 is predicted by the airlines and analysts. In particular, the regional jet is flooding the east coast. "Regional jet growth is good and healthy because it's almost a new market," says United's Dutta. "We would like to grow our regional jets fast as well."
The other weapon - and one that is helping to keep startups at bay - are the low-cost airline-within-airline operations such as Delta Express and US Airways' new MetroJet. For the first time, the majors have their own answer to Southwest, which can ride out a recession in style because of its unerring eye on keeping costs down and knowing its markets.
The impending Category 3 noise regulations might also help the majors as they head towards the end of the century. If they do need to retire ageing aircraft fast because of a downturn, then there is a stronger possibility than ever before that those aircraft will be scrapped or go overseas - rather than be picked up by US startups - because many of the aircraft would require an expensive investment in hushkitting to keep them viable in the USA through the year 2000. On the other hand, the going is likely to continue to be tough in 1999 for small low-costs and startups, with or without any assistance from the DoT.
There remains the one all-important question that draws a different answer from each analyst and each airline manager. Everyone agrees there will be a recession in the USA. The question is when? And perhaps the answer that is closest to the mark comes from United's Dutta. "I don't have a clue," he admits candidly."
Source: Airline Business
