Airlines and Airports: Two Different 2012 (and Beyond) Stories

The links between the economy and the airline industry are well documented.  It used to be that when the U.S. sneezed, Europe caught a cold.  The interdependencies between the two economies are clear.  The question today is which side of the Atlantic is most prone to a bad economic cold?

Today’s economic indicators and the relative performance of the airline industry are a bit perplexing.  Real GDP remains below 2007 levels.  Household incomes are at 1996 levels.  Consumer confidence is an oxymoron as it recently hit the lowest non-recession reading in its history.  While manufacturing activity showed strength in the early half of 2011, it is now close to levels suggesting contraction of the sector might be around the corner.

Despite the negative signals surrounding the economic indicators we tend to rely upon for direction of U.S. airline revenues, the industry is performing admirably - albeit still not covering its weighted average cost of capital.  Maybe even incredibly given the economic headwinds it faces.  At the heart of the industry’s performance are the positive results being realized from consolidation and a religious adherence to capacity discipline.

An example of the industry’s improved financial performance can be found by comparing financial results in 2008 and expected results in 2011.  The U.S. airline industry yearns for its earnings to be relatively stable like those of corporate America; steady with minor ebbs and flows based on economic cycles. 

Instead, the airline industry follows a boom and bust pattern – mostly bust.  Look at 2008 and, as oil ran to $147 per barrel, the industry lost 17 cents on each dollar of revenue.  In 2011, the industry is paying more for oil on average than in 2008, yet is expected to earn one penny for each dollar of revenue.  This is a remarkable result particularly given the negative economic underpinnings, the price of crude oil and the price to refine a barrel of crude into jet fuel.  Ancillary fees have helped most airlines, but are still secondary to consolidation and capacity discipline.  

Truth is, without the high oil price trigger, it is unlikely the industry would have had the will or the necessary pressure to cut capacity.  The U.S. airline industry has too often expanded too much during the up cycles and kept unprofitable capacity in place in the down cycles - all in the name of market share.  The industry’s obsession with market share arguably created an airport system too big to be sustained as well.  Today, 97 percent of domestic demand can be found at 40 percent of the commercial air service airports comprising the system.

That brings us to the airport side of the equation that, arguably, has more capacity than is necessary to satisfy profitable demand.   Why should the infrastructure for a consolidating industry not consolidate itself around the strongest airport markets serving any number of regions within the U.S. air transportation grid?  Are all of the airport markets enveloped by larger airport market catchment areas necessary? 

Over the past three decades, aircraft technologies, airline marketing strategies, and one could even say, airport strategies (think Los Angeles with five airports serving one metropolitan area) have all been designed in some way to fragment markets.  Some argue this creates “healthy” competition, but I think it actually is destructive. Look at it this way, current fuel prices caused airlines to cut capacity and, in some cases, retrench in certain markets. Those same fuel prices – which are probably never returning to previous levels – are why examining what airport capacity can be removed from the system without disenfranchising significant amounts of the population is necessary.

2012 begins a period in which the U.S. air service map begins to redraw itself.  There is no way the government will do the right thing and study the nuances of airline service and determine whether one airport is more profitable, or more ”essential,” than another. Politics will not allow it.  The market, though, is already at work determining the survivors.  This is not a process that will happen in one year; I believe the 2012–2020 period will be a shakeout of profitable and unprofitable airport markets. 

Some will say a smaller regional airline network and fewer markets served will have a negative impact on overall demand.  I disagree.  True demand will find its way into the air transportation system even if the highway serves as the first access point.  Think back to the days when iconic airline names were lost and hubs were closed.  Are those hubs like Atlanta and New York smaller today?  No.  Is St. Louis?  Yes, because it does not have the same economic vitality as an Atlanta.  In most markets new capacity quickly replaced capacity lost.  Along the same lines, small market capacity will find its way to larger regional markets within a reasonable drive.

On the other hand, there are a significant number of markets that realized less traffic in 2010 than in 1990.  There are a number of factors why, including the location within the catchment area of a competing low-cost carriers and the fact jet service was replaced with regional carrier service.  This trend will continue as long as the price of jet fuel remains at the equivalent of $120 per barrel.  Don’t forget, Delta announced it was looking to pull out of 24 markets mid-2010.  They won’t be alone in 2012 – 2020 period.

Airport markets with relatively strong local economics and demographics will survive the war of attrition.  Markets with three or more choices of a larger regional airport with a more diverse menu of services within a 2 hour drive may find it hard to keep service.  A look at any airport map shows there is too much duplication of service in the Northeast, Upper Midwest and parts of the Southeast.

The regional airport of tomorrow will offer a mix of networks, low-cost carriers, as well as some “traditional” regional service.  It will not be dependent on the 50 seat jet.  It will also have competition from carriers representing each of the three global alliances.  It may have service from a carrier like Allegiant, but if its traffic makeup is comprised of a majority of ultra-low cost service, it is unlikely to be the airport of choice within a region.

Most airlines are expected to report a profit in 2012 because they have consolidated and adhered to capacity constraints.  But there is still more to do.  Today’s industry only cares about profitable flying, not flying for the sake of pretending to be something for everyone. The regional airport of tomorrow, though, will need to be everything to everyone. 

My outlook is not all doom and gloom.  I see it as the next phase of restructuring being undertaken by an industry badly in need of a fix.  The industry is inextricably tied to its infrastructure and what has become a necessity for airlines might soon become reality for airports.  That is to regionalize, the airport vernacular for consolidate.

A Recent Swelbar Interview

The ANALYST is the flagship publication of ICFAI University Press* which caters to a niche segment comprising finance professionals, bankers, academicians, economists, corporate executives and students. Just published.

The ANALYST: Delta Air Lines and Northwest Airlines have recently agreed to merge in a $3.1 billion deal. How do you see the deal?

Swelbar: I see the deal as the real beginning of the second phase of the restructuring of the US airline industry. The first phase began with the bankruptcy filings in 2002 and concluded with the emergence from bankruptcy of Delta and Northwest in early 2007. The industry (largely the legacy carriers) shed nearly $20 billion of cost during this period with nearly 60% of that being reductions in employees, rates of pay and benefit reductions. But the necessary cost reductions were designed to address a revenue environment that was increasingly influenced by the low cost carrier sector of the industry that had grown to nearly 30% of industry capacity. This created more competition with an industry that was producing $30 billion less in revenue as the relationship of revenue to GDP fundamentally shifted beginning in early 2001. The restructuring cuts were not made with the idea that oil would increase from $45 per barrel to $117 per barrel today. And it is the cost of oil today that is the catalyst underscoring that the restructuring work to make the industry sustainably profitable is far from done.

The ANALYST: What are the parameters considered at arriving at the deal?

Swelbar: I will answer this as the catalysts to consolidation: high oil; a softening economy both domestically and globally; increased global competition; and tightening credit conditions to name a few. The US domestic market, where all US carriers have the strong majority of their capacity deployed, remains a highly fragmented and hypercompetitive market. Therefore it is a most difficult space to realize higher fares absent the push from higher fuel. Today fares are on the increase domestically but not near enough to offset the cost of higher commodity prices. Therefore the industry is exploring two different paths: 1) consolidation of industry capacity through merger and acquisition activity; 2) consolidation through liquidation of airlines; and 3) consolidation of industry capacity by removing uneconomic capacity. Both strategies are being employed simultaneously and can be expected.

The ANALYST: What are the expected synergies of this deal?

Swelbar: Delta and Northwest, while announcing some capacity cuts prior to announcement of the deal, are betting that the linking of two end-to-end networks is the way to drive increased revenues without increasing flying expense. This is possible through a larger network providing for an increased number of new city pairs to sell. On the cost side, the combined carriers see that the ability to best match aircraft size to city pair markets will provide a cost savings going forward. As to other benefits, the North Atlantic alliance with Air France, KLM, Alitalia and CSA will remain and can only become more robust. Obviously Northwest's delivery position for new transoceanic equipment is a benefit. But most of all this is a step, among many, to continue to work toward finding a more stable platform for employees, communities and stockholders that stand alone plans cannot begin to guarantee. Is there risk? Yes. But there is arguably more risk with a stand-alone plan.

The ANALYST: What could be the challenges to this merged entity?

Swelbar: The obvious challenges are the age old challenges that present themselves when the US airline industry looks to consolidate: the regulators and organized labor. Change is difficult but an industry that took $20 billion of cost out of their combined operations and produced only two years of industry profitability underscores that the current industry structure is far from healthy. In addition the Congress is sure to raise consumer issues. But concerns that consolidation will raise prices are muted by the industry's fuel bill increasing by nearly $20 billion in 2008 versus 2007. Fares have to go up, otherwise we will have a bankrupt industry rather than a few bankrupt carriers. And the US market under deregulation has proven time and time again that if one carrier tries to gouge consumers in certain markets, there will be a lower cost provider ready and willing to exploit that market opportunity.

The ANALYST: How do you see the future of US airlines industry?

Swelbar: Honestly, I am concerned. Our market remains the most regulated, deregulated market in the world – or so it seems to me. And some of that regulation stems from parochial interests on Capitol Hill that somehow believes that if there is a runway, a terminal building and security that the airport is somehow entitled to air service – not whether the economics make sense. Consolidation along the lines of Delta and Northwest and others that might follow is but one step along the way. Globalization is an economic force that cannot be ignored. Recognition that the airline industry is a global industry would be a good start for the US policy makers. Recognition that US airlines need to be freed of the shackles that largely tie them to the US market need to be unlocked. Unless labor and policy makers can move their mindset away from believing that the US airline industry can support jobs and remain US-centric will only ensure that we continue to experience the boom and bust cycles that have been the rule for the industry over the last 30 years. And that has not proven to benefit anyone.

The ANALYST: Any other comments?

Swelbar: Unless something changes along the way that paves the path for a more globally focused US industry, I am afraid that we will see another icon like Pan Am or TWA disappear from the US landscape. Thank you for the opportunity to talk with you.

*this interview was done $20 per barrel ago.

Rambling, Musing and Pondering on Airline Industry Issues

In past years, the industry’s trade associations have not always been strong voices for issues, particularly economic issues, impacting the industry, whether it is the global industry or the US industry. In recent years that has changed. Each respective organization is fortunate to have two very capable Chief Economists: Bryan Pierce with the International Air Transport Association; and John Heimlich with the (US) Air Transport Association. The data and analysis provided by each should be a link on every serious industry watchers favorite list. And watch them daily, as meaningful insight is provided by each man.

The IATA Annual General Meeting opened today in Istanbul and IATA CEO Giovanni Bisignani warned that the global industry is on course to lose $2.3 billion if oil should average $107 per barrel and $6.1 billion if oil should average $135 per barrel. Less than a year ago, IATA was forecasting a global industry profit in excess of $10 billion. Bisignani has been a loud voice on the need for consolidation in the global industry citing important facts regarding this industry’s unhealthy and fragmented state. I really like this guy and I particularly like his call for a clean whiteboard as this blogger has wanted the UPS whiteboard guy to redraw the global map for some time.

United; United-US Airways; American; and Jim “Hell NO”berstar

I don’t know about you, but I am very happy that United said “NO” to walking down a road toward a formal combination with US Airways last week. Something just did not feel right about that one. Yes the labor issues were significant. The IT issues were significant. The combined networks left a bit to be desired from my perspective as the regulators would surely have required some auctioning off of valuable airline real estate. United has more than its share of problems to be sure, but the deal was far better for US Airways’ stakeholders from my perspective as there is little the Phoenix-based carrier could offer in terms of route portfolio diversification.

It took us 30 years to get into this mess and it will take time to get us out.

Despite industry consensus, Tilton did not pursue a deal for deal’s sake. Instead he said "NO" – at least from public reports. The historic US industry leaders – American and United – both began the process of battening down the hatches last week. Each carrier began to make announcements and pronouncements that their respective businesses would be managed in the near-term as stand-alone entities. So Jim “Hell NO”berstar looks less like a soothsayer as the wave of industry deals he suggested has come to a halt.

I like the decisions. I particularly like United’s decision because Tilton has been saying that the industry needs to restructure. Consolidation is part of the restructuring he has suggested. Consolidation has been the operative word used for mergers in the industry – but mergers rarely consolidate much if anything. Consolidation has been the scare word used by the naysayers to signal that consumers will get hurt. Consolidation has been used by labor to extract monopoly rent only to return to the bargaining table to give most of the rent won back to the respective company. Consolidation has been used by those on Capitol Hill to suggest that service will be lost.

Well, we are about to begin a real consolidation of the industry and it cannot be laid at the feet of a merger and acquisition proposal/era. Capacity will be cut because it is not economic to run individual networks of the scope that are operated today. Prices will go up, but not because of a merger and acquisition proposal but rather because a business that needs to pass on the costs of providing the service. Labor will negotiate their next contracts just as they have before, except for the Delta pilots that recognize that certain scope restrictions standing between revenue and principal are not in anyone’s interest. And the condition of the economic environment will be taken into account in either direct or mediated talks or whether the case lands in front of a Presidential Emergency Board.

American and United are, and will be making some tough decisions. Delta and Northwest have made a tough decision to join hands. But that decision is in the best interest of two companies that are so dependent on network scope to maintain service to a maximum number of points. Northwest would be particularly hard-pressed to maintain all of the service it provides. Continental is blessed by geography but still has fragility in its financial position. And the question becomes for the remaining legacy carrier, is US Airways’ cursed?

As for the sectors incorrectly referred to as Low Cost and Other Carriers: Southwest is blessed with capital and well all that is-Southwest; Alaska, jetBlue and Virgin America are arguably blessed with a brand; and AirTran is blessed – in the near-term with flexibility of selling off delivery positions to help it today - but could hinder it tomorrow when the market does make a turn for the positive.

This really is a cool time in the industry’s history. A time that will be embraced by the survivors. The "oil era" will be sure to have its place in history. And for some the slippery slope caused by the commodity will land some in airline oblivion; for others it will end on a path toward something much better than today.

The Price of Oil and Attributes of a “Bubble”

Over the weekend, a number of articles appeared suggesting that the oil chart replicates some of the stock – or shall we call them commodities’ – charts of the late 90’s. One thing I have learned from years in this industry is not to second guess the markets and not to try and predict the price of oil. Do today’s oil prices have “bubble” attributes in the traditional sense – yes. Does history suggest that anything that is market influenced will remain on this trajectory – no. And this is yet another reason why, if I am labor, I would be putting some chips with insurance on the come line. Leverage with the business is the only hope of coming close to replacing a majority of what was given up during the restructuring period. Only it will be in a one-time payment and not a legacy payment embedded in a contract.

CEOs, Policy Makers and Shareholders

I like to refer to today’s CEOs as “Agents of Change”. Popular? – no. Hell bent on change – yes. Standing in the way of preventing the past practice of doing business – yes. Concerned about their place in history – yes. Afraid to get dirt thrown their way in the process – no. Bringing the shareholder into the “virtuous circle” of airline industry prosperity – yes.

With the exception of Delta-Northwest, the litmus test is underway. Each of the legacy carriers is on a path toward restructuring their respective businesses. The naysayers should be happy. Of the six legacy names, the current construct will preserve five. Yet service will be cut and prices will go up – and it will not be because of consolidation in its historic definition. It will be of business decisions necessary to preserve the capital of the day’s stakeholders. Not all of them. But….. Today’s CEOs will do that as their fiduciary duties begin and end with that fundamental charge.

Labor will be tested and will probably say on some Monday morning: “Man, that merger proposal may have been better than riding out a business that has to make these decisions to cut, cut, cut”. Congress will ask: “Maybe this business is not a utility that serves my region’s airport? Some sort of rethinking the emotional issues may have provided my constituents with something better?” Regulators will say: “I knew if we kept our hands off the US market would be better served”. And hopefully the Executive Branch policy makers will say: “this boom and bust is good for no one, so let’s give them a clean whiteboard and if it gets out of hand will step up. But the way we are doing this just does not work”.

And the shareholders will finally say: “the barriers – oh I mean excuses – have been removed and if this guy cannot do it now then let’s find another guy”.

Now This Is A Little More About What I Have Been Talkin' About

Reuters reports today on US position as Phase II of US-EU liberalization talks set to begin in Slovenia later this week: UPDATE 2-US suprises EU with global airline ownership plan.

More to come.