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Air Transport Assoc View of '06 & Beyond

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chase

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Nov 27, 2001
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State of the Industry Q&A Feb. 3, 2006 – Vice President and Chief Economist John Heimlich
Related Link: “Are we there yet?”
When did the airline industry last report a profit?
In 2000, the airlines recorded a $2.5 billion net profit, good for a 1.9 percent margin. In the previous three years, 1997-1999, the industry enjoyed net margins ranging from 4.3 to 4.7 percent.

How much have the airlines lost since then?
Between 2001 and 2004, including one-time items, the industry posted $32.3 billion in cumulative net losses.
And what is projected for 2005?
While we do not expect the U.S. Department of Transportation (DOT) to release 2005 year-end financial results until mid-2006, we currently estimate a $10 billion net loss for the full year 2005 (this includes approximately $4 billion in interest expense, as well as some other non-operating items). Add that figure to the performance during the past four years and we are looking at more than $42 billion in post-2000 losses, which truly is staggering.
So are the airlines heavily indebted?
Many are, to say the least, although some have shed a significant amount of debt through the bankruptcy court process. Including off-balance-sheet debt (i.e., capitalized aircraft rents), U.S. airlines were carrying upwards of $100 billion in debt as of Sept. 30, 2005. That is up sharply from an estimated $71 billion at the end of 2000.
Why are we continuing to see such large losses?
In addition to the usual perennial suspects, such as a heavy special tax burden and growing security costs, 2005 can be summed up in two key words: fares and fuel. In isolation, neither one is a huge problem, but when you have the juxtaposition of historically low fares, which are at 1988 levels, and historically high fuel prices, every airline has a problem, albeit of differing magnitudes. You cannot fill half a plane, or even three-fourths of a plane with 1988 level fares and expect to cover the cost of $72-per-barrel jet fuel.
$72 a barrel? Really?
The 2005 average price for jet fuel – for Gulf Coast, New York Harbor and Los Angeles – was $72.32. During October 2005, following-Hurricanes Katrina and Rita, we actually witnessed a few days in which jet fuel exceeded $130 per barrel in the Gulf Coast region. In nominal terms (i.e., not adjusting for inflation), that is the highest fuel price ever recorded. At the 2005 consumption rate, every dollar increase in the price of a barrel of jet fuel adds nearly $1.3 million in daily industry operating expenses. So a $58-per-barrel spread ($130-$72), could add as much as $75 million a day.
How did that compare to 2004?
The average cost for a barrel of U.S.-based jet fuel in 2004 was $50.72, still significantly higher than prior years, but not as painful as $70 plus, to be sure. Apply that differential to our annual consumption and you can see why we spent $10 billion more on filling our tanks in 2005 than we did in 2004.
Is there anything the government can do to help bring down the price of fuel?
Unfortunately, very little in the short term. That is why it is so critically important to have as few non-market burdens imposed upon the industry while carriers grapple with fuel prices that are indisputably high. In the mid-to long-term future, however, the government should be encouraging conservation across all elements of the economy and exploring alternative sources of energy, a luxury that airplanes do not have. We also would like to see a streamlined permitting process for refineries in a variety of U.S. locations.
Are carriers hedged against jet fuel price volatility in 2006?
Unfortunately, only a handful of carriers have been in a position to hedge at prices ranging from $36 per barrel to the high $60s. The vast majority of airlines have no protection. The painful reality for passenger carriers is that the domestic market has been unwilling to accept fares that reflect high fuel prices. In contrast, on the cargo side of the house, and even in some international passenger markets, fuel surcharges have been relatively successful.
So what does all this mean for 2006?
Assuming that analysts’ projections for slightly lower fuel prices and higher domestic ticket prices materialize, the industry should be able to shave a few points off last year’s historically unparalleled 80-plus percent break-even load factor, perhaps down to 80 percent, or even the high 70s. The likely effect of still-high fuel prices is that it appears domestic capacity will remain relatively flat. Passenger revenue, according to public estimates of financial analysts is predicted to rise about five to six percent. Fuel efficiency will improve, though partially offset by continued airspace and airport congestion. Labor productivity will continue to improve. Airlines reorganizing under bankruptcy court supervision should be able to shed a material amount of debt and related interest expense, in addition to reducing payroll expense. Factor that together and we are looking, on a GAAP* basis, at up to $2 billion in net losses. Many carriers, “legacy” or Low Cost Carrier (LCC), should be able to turn a modest profit, but those results will be more than offset by heavy losses from a few competitors.
*Generally Accepted Accounting Principles
And what is the 2007 outlook?
I expect the industry to turn a profit in 2007, but how much remains to be seen.
So is the industry back on solid footing?
Far from it. While conditions are certainly improving, debt levels remain precariously high, leaving the airlines especially vulnerable to fuel spikes, recession or exogenous shocks (e.g., terrorism, pandemics, natural disasters). It will take several years of profits to dig our way out of this hole, repairing balance sheets to the point where we can invest adequately for the future. Compounding concerns is the fear that the government, on hearing the first relatively positive news about the industry finances in five years, will respond with additional tax and fee burdens.
So, in other words, one year of profits is not enough, right?
Precisely. What we are looking for is sustained financial health. Ultimately, that is good for not only the airlines and their customers, but for the remainder of the economy. U.S. airlines need to remain competitive globally to continue to help stimulate economic growth. Travel and tourism remains an initial part of the world economy. Unfortunately, the U.S. share of that market is on the decline and without a strong airline industry, there is every reason to expect that decline to continue.
What is happening with capacity right now?
Our latest analysis (Feb. 3, 2006) of airline schedules shows 3.1 percent year-over-year growth in available seat miles (ASMs) between the U.S. and foreign destinations for the first seven months of 2006, sharply contrasting with a 3.6 percent reduction domestically. [Note: The international number includes non-U.S. carriers and reflects only those flights departing the United States.] Not surprisingly, the domestic reduction is principally a function of capacity reductions by traditional network carriers and the cessation of Independence Air and others.
What is so attractive about the international markets?
Unit revenues have been quite strong, especially across the Atlantic and Pacific, but Latin markets and the Caribbean have been performing well, too.
Will these international markets see fares, and consequently profits, diminish as carriers add capacity?
That is always a risk, but for now, airlines are simply following the money. That is smart business, as long as they are putting the right number of seats in the right markets.
What else have carriers done to reduce costs?
All of the traditional network carriers have simplified and shrunk their fleets. Preliminary year-end 2005 figures show that American, Continental, Delta, Northwest, United, and US Airways have a combined mainline operating fleet that is 20 percent (700 plus airplanes) smaller than on June 30, 2001. With changes in long-standing work rules, labor productivity has surged 30 percent. As of October 2005 (the most recent DOT data), network carriers alone have shed over 160,000 jobs, a 37 percent reduction, and more cuts have been announced, not including the recent shutdown of Independence Air. Carriers also have reduced costs by improving fuel efficiency. Fuel efficiency has risen 18 percent since 2000. The airlines also have reduced distribution costs, closed facilities and automated a number of customer- service functions. By necessity, especially with fuel prices at historic highs, the changes are numerous and ongoing.
Do you see anything different for low-cost carriers? Are they making money?
Carriers of all shapes and sizes have struggled in this environment. Independence Air has just gone of out business, on the heels of Vanguard, National, Midway and others since 2000. ATA Airlines remains in Chapter 11. In fact, 19 LCCs and other non-“Big 6” carriers have filed for bankruptcy court protection, or liquidated since 2000. And through the first three quarters of 2005, America West and Spirit were in the red, with AirTran, Frontier and JetBlue posting profit margins in the low single digits. The interesting issue for LCCs in 2006 will be how they manage revenue as fuel hedges expire, which will leave them more exposed to the high price of jet fuel. In many markets, they also will be facing leaner network competitors than they have in the past few years.
 
Part 2

Was America West/US Airways the tip of the consolidation iceberg?
I think consolidation, in some form, is a reality in adapting to an increasingly global (and increasingly high-fuel price) marketplace. It simply is one mechanism by which many, if not most, deregulated industries, adapt in a changing marketplace. Keep in mind that we have seen Air France and KLM link up in Europe, along with Lufthansa and Swiss. And global alliances seem to be gravitating toward three major players. Consolidation is also a means (but not the only means) of reconciling an environment in which there are not enough revenues to go around to cover everyone’s expenses. Whether people realize it or not, we have seen assets exit the U.S. marketplace in the last 12 months. I would expect at least one major merger proposal in 2006. I also expect to see continued new-entry competition, although perhaps on more rational terms given the reality of fuel prices. Can government help restore the industry to profitability?
Returning to financial health first is in the hands of the airlines. While the airlines have done a yeoman’s job in a remarkably difficult environment, there only is so much cleaning you can do in your own house. The government could help by lessening some of the financial burdens or operating inefficiencies it imposes upon the industry. Restructuring the air traffic system, including both how it operates and is funded, is a critical step. Today, airlines constitute about two-thirds of FAA-controlled flights but foot over 90 percent of the bill. And in return, airlines and their customers too often take unnecessary delays or consume more fuel, crew time and other resources than they ought to this far into the 21st century, while non-airline users of the system, growing at a healthy clip, consumer more and more of system capacity. Airlines should cover the costs they impose on the air traffic system, but they should not be expected to subsidize the competition. Current FAA leadership is committed to turning things around, and has made important strides, but much work remains to be done in transitioning to the future air traffic management system and determining how it is to be funded.
Then consider the Department of Homeland Security (DHS), to which airlines contribute $3 plus billion annually in special taxes/fees to protect travelers from harm. Every year since 2001, the airlines have been pressured to pay more and more, effectively to subsidize the defense of the United States against terrorist attacks, while more and more unfunded security mandates are imposed with insufficient prioritization based on risk management or cost-benefit analysis. ATA endorsed the creation of DHS partly because it was an opportunity to improve homeland security while simultaneously eliminating inefficient agency governmental redundancies that had crept into the system over time. So why do airlines continue to pay six separate DHS fees whose total has risen rather than fallen?
An effective public-private partnership in passenger- and cargo-related aviation should facilitate economic activity while maintaining safety and security. Remember, we are in a global economy. A healthy U.S. airline industry, operating in an efficient commercial aviation system, is among the key ingredients of U.S. economic growth and competitiveness on the world stage. Early evidence suggests that commercial aviation ultimately drives 11 million U.S. jobs, or nine percent of the nation’s employment. If aviation markets are allowed to work, other U.S. markets will work better, too.
So, are we there yet?
Whenever I hear someone say, “demand is back,” I wonder, “back to what?” Traffic volumes we should have seen years ago? 1988 fare levels? When we add it up, passenger revenue is actually about $25 billion per year below where it ought to be based on the historical relationship between spending on air travel and the nation’s gross domestic product. Having said that, industry fundamentals have improved and if fuel prices moderate, we could be talking about record profitability rather than multibillion dollar losses. Airlines are far from being out of the woods, but few can deny that they have turned the corner. Staying on course to recovery and sustaining financial health is the key, but airlines cannot do it alone. Ideally, airlines should be thriving, not just surviving.
 

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