Higher fuel prices saw airlines' profits evaporate in 2000. Worse times were expected but considered survivable. But following the events of 11 September, no-one knows

The events of last Tuesday could scarcely have come at a worse time for the airline industry. There had been hopes that better supply chain management could help soften the landing for the industry if the US economy slips into recession.

Analysts for the sector were hitherto pointing to a much smoother ride than in the early nineties "barring a disaster".

But disaster has struck. No-one can start to predict the long-term effect the four terrorist attacks will have on the industry. Increased security and fuel prices soaring ever higher will damage the business superficially, but nervous passengers deserting the skies will hit the airlines even harder.

The last recession was particularly harsh on airlines because a worsening financial situation was coupled with massive public shunning of commercial flights for fear of terrorist attack in the wake of the Gulf War in 1991. The fear now is that a similar mass rejection of air travel will force airlines to cancel aircraft orders.

Between 1986 and 1990, for example, there was massive over-ordering of aircraft, says a report by Commerzbank.

Leasing companies were guilty too. Total orders were equal to about half the installed fleet. Most were based on early 1980s growth forecasts, judged now as being hopelessly over-optimistic. The consequences of this became clear in 1992 when capacity rose by 14%. The airlines responded by stimulating the market with discounted fares, reducing yields. The industry lost $8 billion.

The state of the US economy is not yet recessionary. Growth is merely slowing. Even before the terrorist attacks, many analysts believed that the US economy had all the hallmarks of a recession. Now, the state of the industry hangs in limbo. Chris Tarry, an aviation analyst at Commerzbank says "the outlook is extremely uncertain and unquantifiable". No one knows just how badly affected traffic will be in the next few months.

Even before last week's events, the situation, for airlines, was recessionary, according to Edmund Greenslet from ESG Aviation Services, who cites terrible earnings, bad traffic, awful yields and higher costs. Of these, traffic falling rapidly and fuel costs rising are likely to endanger an already precarious position.

There are signs too that by the knock-on effect of the devastation caused to the world's main financial district will hasten a general recession in the USA and possibly the global economy.

A recession is the last thing that any industry wants, but airlines are especially vulnerable to customers' cost-cutting drives. Michael Linenberg, an analyst at Merrill Lynch says: "Our work has shown that airline revenue is closely correlated to changes in corporate profits with a lag of about three months".

The situation in Asia is even more worrying. Many carriers suffered a major downturn four years ago and only returned to profitability in the second half of 1999. They had hoped that their financial successes of last year would continue.

Not that 2000 was a jewel year. The tables overleaf detail the top 50 airlines' performance by revenue and by passenger figures. The tables were compiled by analysts at Air Transport Intelligence, based on data produced by Flight International's sister publication, Airline Business.

At first glance, the figures appear to show little change from the previous year. American Airlines and United Airlines may have swapped positions at the top of the revenue table, but in terms of passengers carried, Delta Air Lines is still the world's largest airline. Rankings for most other airlines have changed little too.

Revenues for the combined top 150 airlines rose steadily from $293.2 billion to $346.4 billion. AMR, the holding company for American Airlines, grew by 11.1% last year to $19.7 billion and United's parent UAL was up 7.4%. Some of the largest revenue growths came from European operators, with Lufthansa up 18.8% and Swissair, at 24.8%, benefiting from some acquisitions that it would later regret. Compared with earlier predictions, however, this performance looks bad.

In 1998, indicators pointed towards a turning point in the cycle. Traffic was rising steadily, sophisticated yield management had led to load factors approaching 80% and costs were falling.

Artificial boost

At an operating level, 1999's figures may have been artificially boosted by a series of large premiums from divestments, but a closer look shows the net results flattening out. Equally, last year's operating results are not as bad as they initially appear, with several airlines including large exceptional items in their balance sheets, but nevertheless, the net figures were still falling slightly. Net margins for the top 150 airlines, as defined by Airline Business, have fallen from 3.2% in 1997 to only 1.1% last year. Most North American carriers worry that 2000 will be their last profitable year.

So where's the profit? Up in smoke, basically. The cost of aviation-grade kerosene rose by over 50% during the year, which is a huge cost to bear on such slim margins. Fuel could now rocket further if instability hits the Middle East and the Gulf.

What's more, since fuel is bought in dollars, non-US airlines are particularly hard hit. Korean Air and Asiana Airlines, for example, have both reported hefty losses on the back of the depreciation of the South Korean won, while Thai Airways International has seen its profits fall sharply in part as a result of the depreciation of the baht. Since both the Hong Kong dollar and Malaysian ringgit are pegged to the US dollar, Cathay Pacific and Malaysian Airlines respectively have seen their dollar-denominated costs exceed their dollar revenues. "If the US dollar weakens," says Singapore-based HSBC analyst Mark Webb, "that would be pretty positive from an earnings perspective."

Yet, airlines have contingency plans, such as hedging, in place to cope with the vagaries of fuel pricing. Furthermore, as fuel prices shot up last year, the stronger economy held traffic, particularly business traffic, at healthy levels through much of the year. More worrying to those studying bottom lines, will be other rising costs, such as wages.

Labour pains

Striking pilots at US giant United last year were soon joined by colleagues from other airlines as long-pent up salary expectations were unleased just as airlines began to run out of cash. The negative impact of these labour costs is plain to see. According to New York-based Brian Harris at Salomon Smith Barney, industry unit costs in the USA rose more than 11% in the second quarter of this year. Fuel prices, even with hedging, rose by 12%. Worse still, both United and Delta posted double-digit declines in unit revenue, as passengers stopped travelling.

This double whammy of rising costs and falling revenue will produce poor yields this year after strong figures last year, reflecting a still-booming US economy. US carriers still hold the top seven places on the passenger table, but yields have declined steadily for domestic US traffic in the first six months of this year, forcing many major airlines to abandon careful growth strategies that were laid out inlast year's annual reports.

Given these black clouds, should the aerospace industry be worried? Tarry thinks not. Conditions are different this time around and airlines are better prepared for a small slowdown. A full recession triggered by the terror attacks would be considerably worse, but either way, the industry should come out the other side leaner than it is now.

If it is just a slowdown, outright cancellation of jet orders will be rare, reckons Klaus Heinemann, an aviation analyst at DVB Bank. Airlines will rather stretch orders for new aircraft. This time, "airlines are acting sensibly by cutting capacity early on", says Heinemann.

Airline options

Of the options open to airlines, reconfiguring cabins and downsizing aircraft are being sold to customers as improvements in comfort, while retiring older aircraft early pleases the cost-cutting demands of shareholders. So far, Lufthansa has led the way in offering its premier passengers an "improved" business class on many European routes, which, says Heinemann, will give extra leg room for each passenger, reducing available overall seats.

For Lufthansa, at least, this is prudent forethought, since its passenger figures are still rising. The German carrier's main concern has been cargo; shipments of high-tech products from Asia have slumped, reducing yields dramatically. Likewise, many Asian carriers suffered traffic declines in the first half, mainly on the cargo side, which saw volume drops some had never seen before, on the back of falling IT-related exports to the USA and the weak Japanese economy.

Other airlines in Europe are downsizing aircraft, not least since it is easy to sell the benefits of a quiet regional jet over a narrowbody to customers, while the economics of greater fuel efficiency speak volumes in the boardroom. These kinds of capacity cuts should hasten fleet improvements that would otherwise have taken longer.

But capacity in Europe is still rising, albeit more slowly than the modest predictions of last year, says David Henderson from the Association of European Airlines.

His organisation has measured a 4.7% capacity growth for the first six months of this year for intra-European travel, but more worryingly, he says, traffic to destinations outside Europe is now only growing by 1.7% so far this year, with Asian and African destinations taking up the fewest seats. He says this has not yet led to the heavy discounting of the early 1990s, as airlines look set to sit it out.

US market expansion

In the USA, where traffic growth has outpaced capacity growth for the past three years, carriers stuck to planned market expansion over capricious growth last year, says ESG Aviation Services' Greenslet. This year, even small capacity growth has outpaced traffic. Witness the dismal revenue and yields reported in recent quarters.

Almost every US carrier announced capacity cuts this year, despite many resorting to across-the-board fare discounting to stimulate traffic. Once regular services are resumed after last week's suspension of flights over US airspace, more capacity cuts are likely as traffic slumps.

So far, most carriers have placed the emphasis on retiring older aircraft to reduce capacity. In fact, United is the only airline so far to even announce a delivery deferral (of Airbus narrow-bodies in 2003).

The airlines may be better prepared this time around as Asia effectively acted as an early warning for the rest of the world. As the region overheated three years ago, carriers like Garuda Indonesia and Philippine Airlines only just survived by drastically cutting capacity, dropping unprofitable routes and renegotiating debt repayment schedules. Their debt loads, as well as that of Malaysia Airlines, remain high, however, and it will be years before they can say the tough times are behind them.

What the Asian downturn showed many is how to be more prepared for trouble, primarily in terms of aircraft capacity. Some, like Hong Kong's Cathay Pacific, have increasingly focused on leasing aircraft, rather than purchasing, to enable flexibility in making shifts when necessary.

This capacity cutting strategy may have already helped Asian airlines come close to the bottom of the cycle. Hong Kong-based JP Morgan regional airline analyst Peter Negline believes so. He points to China Eastern Airlines, Korean Air and Taiwan's China Airlines as three that have returned wet-leased freighters to Atlas Air in the past year, and are focusing on boosting passenger capacity over freight capacity.

With these kinds of minor tweakings, airlines' capacities should remain flat in the short term. If more aircraft are retired, it should even be enough to accommodate a shrinkage this year and next. In any eventuality, there should be no need to cancel orders. Boeing says that, despite some deferments, it is still optimistic that it will meet its 2001 order intake of 611 aircraft, but Airbus, which has seen confirmed deferred deliveries of 50 aircraft already this year, is adjusting its long term production schedule.

Budget carriers also differentiate 2001 from 1990. According to Airline Business figures, last year UK low-fares airline EasyJet had the fastest traffic growth of any airline in its Top 150, with a 79.4% change in revenue passenger kilometres on 1999. Canada's WestJet Airlines was just behind with 61% with a host of other budget carriers in the top 10 growers. Market pioneer Southwest Airlines may have joined the major league some time ago, but its behaviour still differentiates it; Southwest saw its revenue per passenger kilometre continue to rise almost in line with its available seat kilometres last year, like American Trans Air, but unlike most of the other majors.

Insulated regionals

Regional airlines in North America, similarly, remained relatively healthy in both the last cycle and today due to a change in operating strategy over the past year. Most have turned to contract flying over the traditional per-departure fee structure. This ensures a steady stream of revenues even in an uncertain economic climate. While many will not see the huge profit gains of previous years, the switch to contract flying keeps regionals insulated from an economic downturn. Delta Connection, Atlantic Southeast and Continental Express, for example, all experienced dramatic growth in the last cycle and remain in good shape as the industry declines.

Paradoxically, Heinemann sees the next few years as decisive for budget carriers as weaker majors fight back. Because leisure travel is surprisingly recession-resistant, once mainline airlines are starved of business travellers they will target leisure travellers, crowding out the budget market. Heinemann forecasts a couple of less well-established European budget carriers being forced out of their own market.

In Asia-Pacific, airlines and analysts are cautiously optimistic about the second half of this year and 2002, saying there are signs the region may be at the bottom end of a short-lived but worrying downturn. In Europe and the USA, however, all signs point towards the fourth quarter being what Heinemann describes as "an ugly one".

Following a mediocre first half, whatever happens in the second half will make the real difference to 2001's figures, since passenger traffic tends to fall later than cargo traffic. Unfortunately, next month, when last week's events will still be fresh in people's minds, most US companies will refine their budgets for the year ahead. Analysts at Merril Lynch expect another tough year for the airlines in 2002, even if the year turns out to be good economically in other respects.

A major component of recovery hinges on the return of business traffic - the industry's most revenue-lucrative segment, says analyst Michael Linenberg at Merrill Lynch. He believes airline revenues will remain depressed until the return of the business traveller.

Likely to be less affected by the fallout of the terrorist attacks, Webb believes benchmark Asian airlines' traffic and load factor growth rates will start to improve during the next three months. This could trigger an almost immediate recovery in share prices as investors tend to take traffic and load factors as their key indicators. A recovery in Asia could help to spur on their North American and European counterparts.

Looking forward, most analysts are as yet unwilling to even try to second guess market conditions. Merrill Lynch says that unit revenues will decline, but cannot put a figure on it. Earlier forecasts for a recovery in industry earnings for 2002 will also have to be revised.

The events of last Tuesday have changed the global playing field. Airlines may find themselves at the receiving end of some very brutal blows.

Source: Flight International