Strength in numbers: US airlines see return to profitability in second quarter and look to strong 2006

Washington DC
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A year after Hurricane Katrina recast the US airline industry's route for recovery, another unpredictable force of nature has stormed onto the scene. But the London terror scare of mid-August 2006 does not necessarily mean that the basic path has been changed.

The surprising strength of the US second-quarter results, in which most airline executives were able to contain their surprise at the strength of their earnings, come after a genuinely surprising first quarter. Observers, analysts and stock pickers were slightly taken aback as the two carriers in bankruptcy, Delta and Northwest Airlines, posted operating profits. The carrier that is barely out of bankruptcy, United, came in "much better than expected", said Merrill Lynch analyst Mike Linenberg, who expected United earnings at about half their actual level.

Delta had an operating profit of $379 million, versus a $33 million deficit in the same quarter a year ago. But this time it still did not make enough to pay its bankruptcy lawyers or other restructuring costs. Its bottom line was $2.2 billion in the red, but this includes a $2.4 billion reorganisation charge. Similarly at Northwest, the quarter produced an operating profit of $295 million, up from a loss of $142 million a year before. Restructuring and the attorneys saw it post a $285 million net loss.

Behind the surprises lies a single major driver: strength in the economy and consumer willingness to pay what the airlines ask. At American, which has never been bankrupt and is proud of it, yield was up by 7.6%, its fifth consecutive quarter of increasing yields, and unit revenues rose by 11.7%, chairman Gerard Arpey told employees in a note. At the mainline carrier the 6.58¢ revenue per ASK actually surpassed the level reached six years ago during 2000's second quarter. In fact, the quarter was the best second quarter for American in eight years, Arpey said.

At US Airways, which has been bankrupt twice, and is not ashamed of it, the performance was about the strongest in the industry, according to JPMorgan's Jamie Baker. He calculates that the merged US Airways/America West showed a stronger improvement in mainline unit revenues, 20.9% year-over-year, than any other carrier including Southwest (at 17.9%) or even Continental (at 9.7%) in the ­second quarter. That strength, says US Airways chief executive Doug Parker, is the direct result of the synergies unleashed by their merger, which was effective in the fourth quarter of last year. The US Airways results, he says, "show what tremendous value can be created through consolidation".

That has led Parker to suggest it is time for more consolidation in the industry and that he would like to be part of it. Word emerged within days of the results that Parker had made a number of calls, including one to Delta chief executive Jerry Grinstein, to say US Airways wanted to be part of any other deals.

While no one immediately signed Parker's dance card, the word set off the latest series of merger and acquisition rumours and speculation - right up until the terror alert in London. That got people thinking, although after a few days they seem to have decided that the industry would not end this quarter with any major changes in the works.

Disposing of speculation that carriers would shift capacity from the North Atlantic to more secure domestic ­markets, Baker says: "Long term, travellers have shown remarkable tenacity when it comes to terror-related travel issues." Such a move would also reverse the trend of some, like Continental and Delta, which have been moving aircraft in the opposite direction. Lehman Brothers analyst Gary Chase does not "expect a long-term impact" from the terror scare and says the industry should focus only on the fundamentals: oil, consumer demand and capacity.

Oil prices keep going up but so does demand. By the end of the first quarter, the US government's Air Travel Price Index had risen more than 10%, the largest year-to-year increase since the Transportation Department's Bureau of Transportation Statistics began compiling the index in 1995. Since then, ­Continental, the leading indicator of unit revenues, has posted double-digit increases month after month of around 10% to almost 13%, with few signs of weakening even in months when comparisons were more difficult.

A late summer downward blip - slowing traffic growth at Southwest and others - drew attention as a possible precursor to consumer resistance as gasoline prices rises, inflation hovers in the wings and the domestic home-sales boom seems to have de-boomed, if not gone bust. At present this is a wobble, not a fall, with some seeing it as the economy's way of factoring in concern about the latest Middle Eastern wars.

At some point, people will just start to say "no" to more fare rises. The point now is that the industry is not yet at that point.

Fare hikes

At Southwest, where the quarterly earnings broke a record set six years ago, chief executive Gary Kelly is not known for wild-eyed optimism. Kelly does, however, concede: "Fares have been pushed about as far as they can be pushed, but that is in a very small number of our markets but admittedly in some." But he adds: "Our third-quarter revenue growth will exceed our first quarter 2006 year-over-year growth rate of 11.3% as trends have strengthened since the first quarter".

Then consider capacity. Parker of America West may have some grand notions of the shape of the industry, but he seems to have a firm grasp on fundamentals: the strong performance "isn't great management. It's because a bunch of seats went away," he says.

Analyst Susan Donofrio of Cathay Financial thinks that they will largely stay away, forecasting third-quarter domestic capacity to rise just 0.3%, followed by 1.2% growth in the year's final quarter. And the ever-restrained Kelly of Southwest says: "There is no evidence that suggests that the capacity picture is going to change anytime soonthere are announced reductions in flying for the fall already by the competition. We will continue to see a pretty benign capacity environment."

If these fundamentals are strong, the prospects for the autumn and winter perhaps come down to the tenacity of travellers in the face of their fears and their tolerance for the increased inconvenience of added security. ■