New Year, Same Old Airlines


By Philip Baggaley, CFA U.S. airlines are likely to face continued difficult conditions in 2006, though recent declines in oil prices and success in raising fares are positive developments. Five U.S. airlines, including three of the five largest, are in bankruptcy, with UAL and its United Air Lines subsidiary (both rated D by Standard & Poor's Ratings Services) hoping to emerge from Chapter 11 early in the year. A number of key factors -- including the cost of fuel, pricing and revenues, and cash commitments -- will determine the direction of credit trends in the industry as the year unfolds.

High jet-fuel prices had a severe impact on airline earnings and cash flow in the second half of 2005, and S&P's Ratings Services outlook is for crude oil figures of around $60 per barrel over the next several quarters. Although this is below the peaks reached after Hurricanes Katrina and Rita, it's nonetheless high by historical standards, and almost 50% above the price at the start of 2005. Added to those high prices are the effects of limited refining capacity, which widened dramatically the normal price difference between oil and jet fuel in the wake of the hurricanes.

At its peak, the difference between crude-oil and jet-fuel prices, referred to as the "crack spread," added the equivalent of $60 per barrel to the cost of crude. That produced jet-fuel prices of around $125 per barrel. Although the crack spread has diminished substantially -- to about $10 per barrel as of early December -- it's still well above the $5 typical of previous years.

PRICE EROSION. With refining capacity tight, any new disruptions could cause jet-fuel prices to spike again. A prolonged period of very high fuel prices (particularly if it occurred over the winter months, when airline travel is seasonally weak) could precipitate a cash crisis at Delta Air Lines (rated D) or Northwest Airlines (rated D), which entered Chapter 11 in September. It could also further delay UAL's planned emergence from bankruptcy and push the solvent large airlines, AMR (AMR

, rated B-) and Continental Airlines (CAL

, rated B), closer to the edge of insolvency.

The revenue side of the equation has also been problematic. U.S. airlines have faced a substantially more difficult revenue environment since 2001, particularly in the domestic market. Recession, terrorism, and the rapid spread of low-cost carriers have caused an erosion of pricing that several years of economic recovery haven't been able to correct.

Since February, the pressure of high fuel costs has prompted a series of fare increases. These are at last beginning to reverse the trend of the past several years, although pricing remains far below pre-2001 levels. Revenue performance on international routes has been more favorable, rebounding to pre-2001 levels, thanks to strong demand and a relative lack of low-cost airline competition.

For 2006, several positive and several negative factors will influence pricing and revenues:

Positive:

Delta and Northwest are reducing domestic seat capacity while in bankruptcy, following the example of United and US Airways Group (B-), and thereby improving somewhat the overall balance of supply and demand.

Southwest Airlines' (LUV

, A) proportion of fuel needs covered by hedges is gradually decreasing (from 85%, at $26 per barrel of oil in 2005, to 70%, at $36 per barrel in 2006, and less thereafter), which should increasingly place pressure on that airline to raise fares and thereby allow competitors to do likewise.

As the large hub-and-spoke airlines, the so-called legacy carriers, reduce their operating costs to levels that are closer to those of their low-cost brethren, the pricing strategies of the various airlines should become more similar, promoting greater price stability.

Negative:

Although some legacy carriers are withdrawing capacity from the domestic market, they are continuing to aggressively increase their capacity on international routes. At some point this will undermine heretofore favorable pricing in those markets.

Low-cost airlines continue to have fairly aggressive growth plans, which will offset much of the capacity withdrawn from the domestic market by legacy carriers, and will further expand their market share and pricing influence.

The recent fare increases in the domestic market have occurred within the context of solid U.S. economic growth; S&P's economic forecast calls for moderating, though still respectable, growth, which could make it somewhat more difficult to pass through fare increases.

DIMINISHING EDGE. The story of the post-2001 era has been financial tribulations for U.S. legacy carriers and rapid growth by low-cost airlines. However, the latter group face increasing challenges of their own. Sky-high fuel prices are hurting their results, with JetBlue Airways (JBLU

, B+), which had been highly profitable, now forecasting a 2005 net loss and Southwest Airlines acknowledging that its financial performance would be far worse were it not for the company's fuel hedges. Although the low-cost carriers tend to have newer (and thus more fuel-efficient) aircraft fleets than legacy carriers, their cost advantage in this respect is far narrower than their edge in labor, distribution, and certain other expense categories.

But low-cost carriers' edge, while still substantial, is diminishing. The huge concessions negotiated by legacy carriers with their unions, either in bankruptcy or with the implied threat of that eventuality, have narrowed the labor cost differential. For example, UAL projects that its labor costs in 2006 will be 44% lower than in 2002, when it filed for bankruptcy, due to a combination of shrinking the airline, labor concessions, and outsourcing some activities. As the legacy carriers reduce their cost structure, they're in a better position to offer lower and simpler fares in competition with low-cost airlines.

A cautionary example can be found north of the border. Air Canada (B) lowered its operating and capital costs significantly in bankruptcy and overhauled its fare structure to be much simpler and more transparent to passengers. The lowest fare offered now always matches that of WestJet (not rated), the principal low-cost carrier in Canada, which has therefore mostly given up trying to underprice Air Canada. WestJet, which has expanded rapidly and, until recently, profitably, now faces a much more difficult battle for market share.

FLIGHT TREATY. All of the U.S. airlines, with the exception of Southwest Airlines, are highly leveraged and most face significant debt and lease payments. Several low-cost airlines have substantial debt and lease obligations, mostly incurred to finance growth of their aircraft fleets. JetBlue and AirTran face greater fixed financial obligations (as a percentage of revenues) than do AMR or Continental Airlines over the next year, though the latter two airlines have pension-funding commitments in addition to debt maturities and lease payments.

The European Union and the U.S on Nov. 18 announced agreement on a draft "Open Skies" aviation treaty that would allow airlines to operate routes from any European city to any U.S. city and vice versa, give them freedom to set prices and forge alliances with other airlines, and remove barriers limiting the number of carriers that can fly between the U.S and London's Heathrow airport.

The Open Skies agreement is expected to be contingent on implementation of a new interpretation by the U.S. Department of Transportation (DOT) of existing limits on ownership of U.S. airlines by non-U.S. citizens. The interpretation, unveiled in early November, 2005, would allow a substantially increased amount of management control over U.S. airlines by non-Americans (including, potentially, non-U.S. airlines), but doesn't raise the current 25% ownership cap, which would require congressional legislation. However, the DOT interpretation immediately attracted strong opposition from U.S. unions, some airlines, and by various members of Congress, which could block implementation of the new interpretation.

SHOCK-SENSITIVE. If implemented, the treaty would take effect as early as October, 2006, and increase the likelihood of an investment in a U.S. airline by a European partner. However, because the EU airline could still acquire no more than 25% of the U.S. airline, any such arrangement would presumably be mutually agreed upon. The benefit for the U.S. airline would be additional equity capital. While such an arrangement could help the affected U.S. airline, it isn't clear to what extent it would provide a more general solution to the difficulties facing the industry.

Although large U.S. legacy carriers are highly leveraged, their most pressing problem has been a cost disadvantage to low-cost carriers in the domestic market. Airlines have generally been able to attract capital in the form of secured debt and leases to finance aircraft or to continue operations in bankruptcy, which has enabled them to survive and slowed what otherwise might be a more rapid trend toward industry consolidation.

The airline industry has been beset by a seemingly endless series of external shocks and remains vulnerable to event risk. Terrorism is an ongoing concern, though its form may change from that of September 11, 2001. Shoulder-fired antiaircraft missiles, bombings at crowded airports, or other attacks could replace hijackings as the next threat. Although passengers have become more accustomed to some degree of risk, a successful attack within the U.S. would nonetheless hurt revenues and prompt additional expenditures for countermeasures.

FOR THE BIRDS. Potentially more damaging than terrorism would be a global outbreak of avian flu. A deadly and communicable respiratory disease of this sort could well prompt travel restrictions by businesses and governments -- a possibility raised in the Bush Administration's description of plans to prepare for and deal with such an outbreak -- and frighten away many other travelers. The relatively limited severe acute respiratory syndrome (SARS) outbreak in 2003 caused a brief but severe plunge in revenues for many Asian airlines, including a steep quarterly loss for the otherwise very profitable Hong Kong-based Cathay Pacific (not rated).

A global avian-flu pandemic would most likely have more severe and widespread effects and cause additional disruption through illness among flight crews and their families. Legacy carriers, which rely more heavily on international routes, would likely be affected first, but even domestic-focused low-cost carriers would be hurt eventually. Given the vulnerable financial condition of many large U.S. airlines, such a scenario could trigger Chapter 11 filings or even liquidation of already bankrupt carriers. The only hopeful factor is that previous flu pandemics, including the catastrophic 1918 Spanish flu, spread and then subsided fairly rapidly.

The U.S. airline industry remains under financial pressure, though recent declines in fuel prices and rising fares provide some reason for hope. S&P's Ratings Services doesn't see any of the remaining solvent airlines at near-term risk of default (all are rated B- or higher), but most of those companies are financially vulnerable and face the need to continue efforts to reduce costs and raise liquidity.

Baggaley is a credit analyst who follows the airline industry for Standard & Poor's Ratings Services


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