ANALYSIS: US airlines see firmer footing for profits

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Rewind to the end of 2002. United Airlines and US Airways - two of the largest US carriers - are operating under chapter 11 bankruptcy, while three of the smaller carriers, Midway Airlines, National Airlines and Vanguard Airlines, are either on the brink or have shut down in the course of six months.

"When I first got in the business [18 years ago], it was a highly fragmented business with market share-focused management," said Jeff Smisek, chairman and chief executive of United. "[Management] who didn't focus on the bottom line basically sold furniture to keep warm in tough times." Not a good time to be in the industry.

Fast forward a decade and things look a lot better. The number of large carriers has halved to five - American Airlines, Delta Air Lines, Southwest Airlines, United and US Airways - with four slated to emerge once the proposed American-US Airways merger is approved.

US majors' traffic evolution: 2002-12

 north america rankings graphic 640
Source: Airline Business World Airline Rankings (2002-12)

This year's World Airline Rankings show North American revenues up 3% to $210 billion compared with $120 billion a decade ago. Operating profits were also on the up last year to $8 billion. Compare that with the $6 billion losses racked up in 2002.

US carrier financial result evolution: 2002-12

Source: Airline Business World Airline Rankings 2002-12

"The parts of the world that are doing best are North America, where clearly restructuring and consolidation is having a very positive impact," said Tony Tyler, director general of IATA, in a speech on airline financials in June. The industry body predicts $4.4 billion in net profits this year from North American carriers.

Most industry financial metrics prove his point. Return on invested capital (ROIC) was in double digits at Alaska Airlines, American, Delta and Hawaiian Airlines, and pre-tax margins were positive at all except American last year, according to individual airline releases.

Wall Street analysts agree that the US industry's strict adherence to capacity discipline and reduced competitor numbers, which has increased the pricing power of remaining airlines, are driving, in part, the turnaround.

"It removes a decision maker," Helane Becker, an airline analyst at Cowen Securities, told Airline Business earlier this year. "Even if you don't take capacity out of the system specifically, what you really do is remove another layer of somebody who could lower fares and mess up the pricing structure."

Optimism in the financial future of airlines is nowhere more evident than at Delta. The Atlanta-based carrier announced in May plans to generate more than $1 billion in shareholder value over the next three years through a $500 million share buyback and a $0.06 per share dividend this September.

The programme includes up to $12.5 billion in capital expenditure or investment in the airline; more than $3 billion reduction in net debt to $7 billion; and $1 billion in incremental contributions to defined benefit pension plans for the next five years. "As we look towards our future, we see a lot of room for continued optimism," said Delta president Ed Bastian of the plan.

Opinion on the initiative is mixed. Moody's Investors Service gave the dividend and buyback programme a credit negative, citing the possibility of deteriorating demand, yields and operating profits in the volatile airline industry. However, it left Delta's rating unchanged at B2.

Fitch Ratings and Standard & Poor's (S&P) took more positive tracks on the shareholder measures. The former adjusted its outlook on Delta to positive from stable and maintained its B+ rating, while the latter upgraded the carrier to B+ stable. Both, however, said the shareholder initiatives do raise some concerns.

Southwest is the only other US carrier that pays regular dividends to shareholders. The other three majors are not expected to make similar moves in the near to medium term.

Despite the mixed reviews, the willingness of Delta's board to approve a dividend is a positive sign for the industry. "I think we're still at the relatively early innings of the benefits of consolidation," Bastian told investors in June. "These deals still have a couple of years before their [operations are] fully integrated, fleets are rationalised, new labour rates are set and benefits for those across the entire industry landscape begin to be seen."

Philip Baggaley, a credit analyst at S&P who tracks US airlines, says: "[Their financial health] is fairly good if you compare it to history, which is a depressing record. The fact remains that these are pretty highly-leveraged companies. The trend is positive [but] you have to restrain your enthusiasm."

All major carriers in the USA had debt-to-earnings before interest, taxes, depreciation and amortisation (EBITDA) ratios of more than 5.0x - which generally raises debt coverage concern - at end-2012, according to Airline Business research. Alaska Airlines is the exception, with a ratio of 3.0x for the year.

Despite the high rates, the trend is mostly positive. Debt-to-EBITDA at Delta fell to 6.5x in 2012 from 7.0x in 2011 and at Southwest to 5.1x from 5.4x. United's ratio rose to 15.4x from 6.8x, largely due to a revenue decline related to its Continental Airlines integration.

In spite of high debt-to-EBITDA ratios, major US airlines are not considered at risk of defaulting on debt and the ratings agencies almost unanimously agree that their metrics are slowly improving.

However, US carriers remain far from blue chip status.

"[Airlines'] financial health is better, but it's still not brilliant," says George Dimitroff, vice-president for advisory for the Americas at Flightglobal consultants Ascend. "We're not at a stage where carriers make clear and consistently defined profits easily. They're still very sensitive to external factors, such as weather and oil."

True to point, Delta's Bastian said in June that the carrier's anticipated margin expansion during the quarter was attributable to declines in the price of oil, while revenues held steady. The carrier anticipated a margin of 10-11% in the second quarter at the time, after reporting a 1.5 percentage point expansion year on year to 4.5% in the first quarter.

The average price for jet fuel stood at $2.93 per gallon year-to-date at the end of June, according to industry body Airlines for America. This is down from $3.06 and $3 per gallon in 2012 and 2011.

In 2002, the solution was a race to the lowest air fare and the steady rise of ancillary fees. Average fares are still down by 6%, at $375 after adjustments for inflation, from a decade ago while ancillaries, defined as luggage and change fees, are up by 7.5 times to $3.5 billion from $464 million in 2007, the oldest available DoT data shows. This excludes the ubiquitous "preferred" or "premium" seat charges, priority security and boarding queues, or onboard food and wi-fi.

Service is the next anticipated battlefield in the USA. American and JetBlue are upgrading their product on transcontinental flights between New York's JFK and both Los Angeles and San Francisco in order to compete with United's premium service. Delta offers its international product on the routes.

Delta will begin investing $2-$2.5 billion in its fleet, facilities, product and technology as part of its capital deployment programme this year, while United is two years into its $550 million investment in onboard products. Even costconscious Southwest is spending more than $60 million on new seats and wi-fi across its fleet.

However, US airlines' new-found ability to invest in product and services - even with the declining value of air fares - is the result of the near universal adherence to capacity discipline, debt reduction and ROIC.

"Since consolidation has begun, we have really as an industry changed both the conduct and the structure of the business," says Smisek. "We now have professional management teams who are focused on returns on invested capital [and] making sure we're running the airlines as a business instead of as an airline."