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Entries in Financial condition of US airline industry (4)

Sunday
Dec112011

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.

Wednesday
Jan282009

In Dallas/Ft. Worth: Compare and Contrast; Contrast and Compare

This blog has made no bones about its fascination with airlines in Texas generally and those in the Dallas Metroplex specifically. This past weekend’s post on Southwest Airlines ranks among the most widely read posts ever on Swelblog.com. Despite recording it 36th consecutive year of profitability, many are writing opinions on Southwest that are very different from those we have historically come to know.

I have been traveling or otherwise less connected this week and I am behind on my reading.

But I was glad I was sitting down when I read a Sunday column from Mitchell Schnurman of the Ft. Worth Star-Telegram on Southwest’s cross-town competitor, American Airlines. The title of Schnurman’s piece: Things are looking up at AMR. Schnurman takes a look back at the numerous management actions undertaken by the legacy carrier’s management absolutely necessary to position the high cost airline for a better tomorrow. For what seems like a very long time, there have not been many positive stories written about American, its prospects or its management.

Schnurman is correct that there has been a lot done at American. And there remains a lot more to do. If AA had not taken the actions it has since its 2003 restructuring, Schnurman would have written a very different story. A story that might have been reminiscing rather than thinking that tomorrow will be better.

The compare and contrast as we begin 2009 is very interesting. Particularly in the Dallas Metroplex where at least one or two of 2009's most impacting aviation stories will likely be written.

Sunday
Jan182009

Part Trap(ed); Part T.A.R.P.(ed)

This post is in part influenced by the seemingly infinite depth of government pockets for the banks as demonstrated by the inclusion of Bank of America under what I’m calling The US Nationalization Bank. And the de-leveraging effect – and the resulting need for even more government capital - continues to be a headline story as banks announce their quarterly losses. A constant reminder that we are far from out of the woods.

In addition, this post is influenced in part by the upcoming earnings season for US airlines. Wall Street’s best analysts already suggest that 2009 may be a very good year for the industry. But I’m uncomfortable about some of these predictions which are based on how far the revenue line would have to fall before it overwhelms the savings in fuel, without giving appropriate consideration to demand.

John Maynard Keynes and the Liquidity Trap

As the stimulus story unfolds, we are reminded that Keynesian economics are back in vogue and more important than monetarist policies in helping to pull the US out of this downturn.

For those who remember Economics 101, Keynes theory promotes that C (consumption) + I (investment) + G (government spending) + X (exports) – M (imports) = National Income. We have talked many times here about the virtuous circle of airline prosperity. Keynes also held that there was a virtuous circle: the flow of the money supply whereby one person’s spending becomes another person’s income, propagating a cycle where consumption drives incomes, drives more spending, and so on.

Keynes first made a name for himself during the Great Depression based on the other side of his theory in which he argued that savings or investment slows consumption, contributing to negative economic output, or a recessionary environment. According to Keynes, a depression occurs when a recession falls into a “liquidity trap”. A liquidity trap occurs when consumers curtail spending to conserve cash; banks do not loan or businesses do not see a need to borrow; and there is little investment because prospects are not promising.

From Keynes perspective, government intervention through increasing the money supply is the solution to the liquidity trap, allowing the virtuous circle to begin anew.

Fear and Greed; Greed and Fear

It is said that fear and greed are the two primary psychological drivers of investing and the markets. In the past I have referenced the concept of the velocity of the money supply, where greed has been at the epicenter for some time. Greed is bad in that it ultimately leads to asset bubbles as emotional buying supplants proven practices of smart buying. But just as devastating is fear which leads to emotional selling and unintended consequences for the macroeconomy.

Is T.A.R.P. a Trap?

There are many smart economists out there assessing not only the credit crisis and all things banks but also the policies and programs that may succeed in steering the country back onto the virtuous circle of economic prosperity. In this space, I’ve discussed the deleveraging of banks and the multipliers at work as banks do just that.

For simplicity’s sake, let’s think about in terms of a multiplier of 10. The banks have stepped up their timetables to announce their financials – in this case likely multi-billion dollar losses.

In the banking world, these losses should be multiplied by 10 to determine the effect on the money supply. Assume the banks announce pre-tax losses of $100 billion for the current quarter, a good starting point because the initial outlays from T.A.R.P. tranche #1 have been made. So, absent even more government intervention, a $100 billion loss would have another $1 trillion impact on the money supply. Bank of America is the most recent example. Having already announced losses greater than expected, the government hands over $20 billion more in T.A.R.P. funds and agrees to backstop even more.

The problem is that the U.S. government keeps writing checks we cannot afford. The question is whether we can afford to not write the checks? A supply of money with no velocity does no one any good. The unintended consequence is consumer fear. And cautious consumers may lead to a hoarding of disposable income except for items that are essential for day-to-day living - thus perpetuating a self-fulfilling prophecy.

What Does Any of This Have to Do With the Airline Industry?

The success of the airline industry is unequivocally tied to the health of the macroeconomy.

I cringe at recent media reports that Delta Air Lines expects industry revenue to shrink 10 percent in 2009. For Delta alone, that implies a revenue loss as high as $2.5 billion. The reports then go on to paint a rosier picture based on fuel costs that, at current prices, could save Delta as much as $5 billion this year. Does that mean a $2.5 billion profit for Delta and windfalls across the industry?

Ain’t gonna happen.

Time will tell. But I’m not ready to jump on the bandwagon that is predicting airline profitability just yet. Yes, the industry’s efforts to cut costs and control capacity have impressed analysts and that could be a boon for airline shareholders who have been on a wild ride in recent years.

But a closer analysis through a Keynesian lens tells a more cautious tale. History provides a prism to make learned predictions. Keynes would say that a Depression is the result of a recession that fell into a liquidity trap. We may not be there yet, but I fail to see how the other tools in Keynesian Theory could be used to stimulate economic activity today. Unless consumers begin to feel, and act, more optimistic, airlines should not count on a stronger demand for their product. As the industry continues its remake in response to an ever changing economic environment – and capacity likely to shrink further – it is increasingly difficult to predict what 2009 will bring for U.S. airlines.

I am not confident that we really understand the true demand for air travel because, historically, the numbers include a large component of emotional, non-core demand. A fair question is whether yesterday's emotionally purchased air travel should be included in today's demand calculus or not? Therefore, until we can fully understand the true demand for air travel, predicting widespread profitability for an industry subject to the every ebb and flow of the economy seems to be walking into a trap. A trap that sets off a series of others - I fear.

And we have not even started discussing what all of this might mean for some of the credit card issuers. The enabler of the consumer-led expansion. That too is for another time - I fear.

Sunday
Apr132008

This Week’s Conversation Will Be In Words that Start With “C”

It is Sunday afternoon and before I sit down to watch the Masters and what appears to be a five player chase for the green jacket, will the week ahead produce any eagles and birdies for the US airline industry? Or will bogeys or worse continue to dominate the headlines? Earnings season kicks off this week. And with earnings season, there will be a theme or two that will emerge as airlines talk about the business going forward.

As I ponder the week ahead, I am thinking the conversation about the business will be dominated by a lot of words that start with C. Yes CONSOLIDATION will remain top of mind. But that C word will be joined by others like: CREDIT CARD holdbacks and who might be next; COVENANT COMPLIANCE that might trigger a CREDIT CARD event; CREDIT CONDITIONS generally; CASH and more importantly, unrestricted cash; CAPITAL expenditure plans, whether aircraft or non-aircraft, and what adjustments to those plans are likely; COMPLIANCE with airworthiness directives and maintenance requirements; COMPENSATION and yes that will be executive compensation; CHAPTER and you pick the number; CAPACITY reductions and how much more can be expected or gaining more insight into plans; and CASH BURN rates are likely to be the new concern and hot topic.

Talk in oil denominated terms will likely continue. Something like: that was $20 a barrel or so ago. Assuming that Delta and Northwest finally announce something this week as is widely expected, then I am sure that changes to the deal structure will be discussed in those terms. But come to think about it, we never ever really knew what the structure of the deal that wasn’t really was. But while all the original CATALYSTS for CONSOLIDATION remain, at what point do we begin to hear that CAPITAL is emerging as the real CATALYST driving CONSOLIDATION as the industry searches for a more stable operating platform – or as capital makes it clear that a bigger platform is necessary in the new world of high oil prices for the US industry.

But if the conversation does turn to CASH BURN, then talking in oil denominated terms is right. Based on what we know about expected capacity reductions largely taking place after the peak summer season, it is important to remember that while bookings for the summer are strong, those tickets were purchased some $20 per barrel ago. So while fare increases have been put in place, only some of those increases will be realized over the coming months. Simply, the industry will be carrying those passengers throughout the summer that purchased tickets earlier in the year at fuel prices that are much higher today. This is a primary reason for citing CASH BURN and liquidity as the hot topic.

So while there are lots of interesting topics that start with C that we could write about, I am going to end with the situation at Frontier. I read a news story that had a title something like: Frontier Pointing Its Finger at First Data. Yes the credit card company may have been the catalyst that caused the filing with very little notice, but is Frontier’s filing really a surprise? It just seems to me that this underscores the fragility of the industry today at nearly every corner.

If I am a credit card company and am concerned about customers defaulting on obligations, and I have a lot of exposure to a very risky industry I am probably going to make some very hard decisions. Do I think that this chapter filing will go the way of the others we have seen thus far. No. But then again, if we have not yet seen the bottom then maybe there will finally be a capital aversion for this industry or at least for business plans that just do not make sense or offer promise of solid returns for investors. A couple of posts ago we talked about how the historical barriers to exit just might not be the safety nets that they once were.

Well I think the Frontier story is the first test of those traditional barriers to exit. And not the last.