The latest profits performance from the US industry suggests that seat capacity is still out of line with demand despite optimism surrounding rising load factors, writes Chris Tarry of CTAIRA

At times it appears that some airline managements believe that the normal economic rules of supply and demand do not apply. In other words capacity is added into the system despite the equal and opposite impact on yields and ultimately profits. The US industry is a case in point.

A near common theme from the recent round of US results has been one of the pain brought about by excess capacity and what was generally referred to as aggressive pricing by competitors. The result was an underlying operating loss for the majors of some $1.8 billion in the final quarter of 2004 compared to just below breakeven a year earlier (see table page 75). The effects of the fuel price have been well documented and indeed its short-term influence over financial performance has been discussed before. However, the route to underlying financial improvement is dependent not simply on oil price but on structural change.

There are some observers who point to a modest rise in load factors as proof that demand is on the rise and indeed they edged up 1.5 points for US majors in the final quarter. But taken in isolation such excitement over higher loads is often misplaced. A load factor, after all, merely records the percentage of seats that were filled. It does not indicate whether the loads were achieved at sufficient yields to make a profit and indeed they may simply represent a success by the yield management system in hitting its predetermined targets. In short, the load factor achieved reflects the relationship between capacity, traffic and the market clearing price. The more important figure is the breakeven load factor which factors in the balance between fares and costs.

Ever rising load factors are not the route to salvation: it is the gap between the achieved and breakeven load factor that is the fundamental relationship and a simple corporate objective must be to maximise this gap.

In the December quarter the earnings release for Delta Air Lines suggests an underlying break even load factor of just under 87% compared with an achieved load factor of just under 74%. As we suggested last month Delta's Simplifares initiative may well result in a step change in the competitive landscape but the recognition by the company that despite higher traffic there will be a negative revenue impact indicates the true nature of the current stimulative effect of price on demand. Furthermore whilst the US airline industry overall was in loss Southwest for example continued to report profits; not only this but its load factor for the quarter was 65% which is some 10 points below that of American and 17 below Delta.

While the full data for 2004 is not yet available the US Department of Transportation has published the analysis for the September quarter and this is very revealing. That shows that while Southwest's load factor was nearly 10 points clear of breakeven, Delta's came in at 19 points below.

In the past we have argued that the demand for air travel is a function of economic growth and price. Furthermore price reflects competition and the degree of excess supply in the market place. When there is excess capacity at the previously prevailing market price, then fares fall. When there is excess demand against capacity then prices rise.

If it is as simple as adjusting capacity to likely and actual demand then why then does the industry not simply cut capacity and return to a sustainable profitable existence?

Unfortunately the real world is not a controlled laboratory experiment and the necessary adjustment is often expensive and difficult. Whilst reducing costs and shrinking are not recommended as sustainable strategies for profit growth it might be reasonable to expect that capacity growth, particularly in the US market, would be at best modest. However, there is little evidence of this on the basis of the statements so far made. Even now there is still too much capacity for the industry to generate the returns that it needs and given the pain of cutting back aircraft or labour, attention remains focused on trying to adjust demand rather than supply.

The need for meaningful structural capacity adjustment remains of paramount importance; but we expect that few are holding their breath for such an outcome.

Source: Airline Business