Demand Past Peak: Airlines Increasingly Receptive To Domestic Corporate Discounting

Several airlines and industry analysts expect domestic airline demand to soften in the next year, and the anticipation of the descent from the domestic seller's market peak already is manifesting itself in deeper discounts for corporate travel buyers, even though airlines have remained aggressive in published fare increases, attempting a few in recent weeks.

First-quarter airline earnings from major carriers, including American, Continental, JetBlue and Southwest, and subsequent analyst commentary pointed to an approaching decline in domestic demand. Analysts said some softening in the economy and a lack of relief from fuel pricing are driving the trend.

J.P. Morgan air analyst Jamie Baker, even before all the domestic airlines released earnings, commented on the demand environment in a research note. "Let's not stick our heads in the sand," he noted last month. "There is a growing body of evidence that domestic demand is deteriorating, further calling into question the likelihood of 2008 results anywhere near the level implied by consensus."

UBS airline analyst Kevin Crissey in a research note last week downgraded ratings for most domestic carriers amid softening demand, high fuel costs and the general economic outlook. Crissey said the shift in demand began three quarters ago. "As a whole, U.S. airlines have been guiding earnings per share down since August 2006, despite modest industry seat growth," UBS' Crissey said. "There have been reasons to explain it—new security measures, lapping Delta/Northwest capacity cuts, etc.—and since fuel prices were falling and the sector was rallying, few cared. Q1, however, highlights the risk of relying on fuel prices to offset softening demand."

Crissey said modest capacity growth and a "significantly weaker" economy are resulting in "a lackluster fare environment" for airlines. "With fuel prices looking like a headwind instead of a tailwind, we suspect airlines will have difficulty passing on fares and we find meaningful margin expansion unlikely," he said.

Calyon Securities analyst Ray Neidl said, "Given concerns regarding the economy, fuel prices and demand, the airline sector has been considerably weakened in the past two weeks. We believe that the sector has been over-hit on demand and revenue worries, which we believe will be strong through the summer, though we have major concerns on ever-increasing oil prices that the airlines will not be able to pass through to travelers."

United Airlines last week raised by $25 to $50 per way, the "majority of its fares typically favored by business travelers," J.P. Morgan's Baker said in a research note. "Maybe we're too cynical," Baker noted, "but the last time United raised business-oriented fares by a similar magnitude was November 2000, shortly before domestic demand took a material turn for the worse. While we consider domestic demand trends today to be less vulnerable, the impact of repeated fare increases remains debatable. To wit, following 11 legacy and seven Southwest increases since January 2006, the cumulative impact by March 2007 was a mere 1.2 percent increase in what domestic passengers actually paid. Given continued sluggish domestic yield trends in general, we believe rising domestic capacity will offset any value of future fare efforts."

Scott Gillespie, TRX's Travel Analytics vice president and general manager, said corporate airline negotiations are yielding deeper-than-expected discounts for corporate clients—perhaps an indicator of airline internal demand forecasts. "We're seeing the airlines exceed our expected discounts in a number of cases," Gillespie said. "I think the airlines are getting a little more concerned about locking in the blue-chip corporate business."

Likewise, while the airlines have continued attempts to push through published fare increases throughout this year, Gillespie said he has not recently seen similar attempts in corporate pricing.

"The airlines' published fare pricing groups—the guys who are in a war room and watching monitors like stock traders—are setting fares almost minute by minute," Gillespie said. "At the other end of the spectrum, the corporate pricing folks are setting what really should be two-year contracts. They really do have a longer time horizon and they have to struggle with the medium-term or long-term view."

Gillespie noted that when traffic is forecasted to fall and demand is trending downward, "the pricing folks will probably end up giving a little more leeway to corporate sales folks to price a little more aggressively—this is happening."

Southwest CEO Gary Kelly was among the first airline CEOs to suggest a softening of demand during the carrier's first-quarter earnings. JetBlue CEO David Neeleman said soft demand would impact in the short term.

As carriers that primarily are focused on the domestic market, JetBlue and Southwest likely would be the hardest hit by downward shifts in domestic demand—but also would be the best suited to deal with such changes, said Robert Mann, an independent airline analyst and principal of R.W. Mann & Co.

"The exposure to domestic is mostly an LCC phenomenon," said Mann, "but you've got to remember that they are the price leaders and, more importantly, they're the cost leaders. They can make money at lower prices, while the others cannot. That's ultimately what causes them to continue to grow—even during an economic downturn—as the others pull back."

International business, an area where many of the legacy carriers in recent years have allocated resources and attention, is not expected to be hit like domestic, analysts and consultants said.

The International Air Transport Association, citing March traffic results, said international passenger traffic rose 7.8 percent year over year. "This is the largest year-on-year single month increase recorded in a year," IATA noted. North American carriers witnessed a 5 percent increase in international traffic, IATA noted.

According to data provided by the Air Transport Association, capacity still is expected to grow among U.S. carriers in both the domestic and international front. As measured by available seat miles, international will grow 5.6 percent this year, outpacing the 2.1 percent domestic growth. "Generally speaking, the industry is enjoying year-over-year growth, but at a slower place than from 2005 to 2006," ATA chief economist John Heimlich said last week.

"International will continue to do OK, because there's a large slice of foreign origin demand," said Mann. "Corporate profits are still pretty high, so outbound business travel is still strong. What's really missing is the non-international point-to-point domestic, which is a business cycle phenomenon. We are probably beyond the peak of this cycle."

J.P. Morgan's Baker said, "International trends remain robust," but said strong international performance "is unlikely to carry airlines to the finish line currently implied by consensus." Baker said, "$50 crude or healthy consolidation could potentially keep the equity dream alive, though we're not modeling for either."

The approaching summer travel season still is expected to be busy. "I think we'll see a very busy summer: highest load factors ever and everyone will be sharing an armrest," Mann said.