As he was reporting the highest third-quarter profit in the
carrier's history, US Airways CEO Doug Parker last month called the moment a "watershed
event," not just for the carrier, "but for the U.S. airline industry."
In the course of two days, the nine largest carriers, one by one, followed suit
in detailing a profitable—in many cases, record-breaking—quarter. All told,
those nine carriers pulled in more than $1.9 billion for the quarter, when just
a year ago during the same quarter they were posting more than a half-billion
dollars in losses.
It begs the question: How are the airlines, the laggards of
U.S. industry and runts of the corporate American litter, scoring record
profits when, as Parker pointed out, oil continued to hover at $80 a barrel and
the economy only was "begrudgingly pulling out of recession?" How
have the airlines—the airlines?—been
beating the average growth rate of S&P 500 stocks through 2010? How is this
industry, as Parker said, "reporting record or near-record profits, while
the rest of U.S. industry is not"? He reminded investors and media tuning
into the earnings call: "That hadn't happened before, and we believe it's
concrete evidence that a fundamental restructuring really has taken place."
No doubt helped by broader economic trends and built upon a
decade of strife, airline management and aviation analysts pointed to a number
of factors that make this recovery different—one more structural than cyclical.
Among those, they say, a wave of consolidation has
rationalized the number of players, a new breed of airline CEOs has exhibited
renewed "discipline," new pricing models have emerged, capacity has
been vastly reduced and new entrants—who have played the role of spoiler to
legacy profits in the past—have yet to re-enter the market and flood it with
capacity the industry can't fill at a profit.
These forces combined, some airline executives and aviation
analysts contend, are not just the markers of yet another boom in the
boom-and-bust cycle airlines have been spinning in since deregulation.
"It's different this time," said JP Morgan
aviation analyst Jamie Baker. "There, we said it, and we expect you to
hold us to it. The steepest downturn in airline history failed to claim any
casualties. The industry is generating record profits despite anemic U.S.
growth. The industry shed three managements along the way, with a fourth expected
to depart soon given Southwest's pending acquisition of AirTran Airways.
Balance sheet repair implies reduced bankruptcy risk going forward."
Calling the past 10 years the "lost decade" for
U.S. airlines, Morgan Stanley airline analyst William Greene said the carriers
enter this upturn better positioned than in "any prior cycle."
Though rhetoric of a structural change in the airline
industry has swirled since the post-bankruptcy era a few years ago, UBS
aviation analyst Kevin Crissey, pointing to the rally in airline stock prices
that followed earnings reports last month, wrote in a research note that
airline executives' "positive commentary on the 'new look' of the industry
won over those that had been on the sidelines."
The "new look" also has translated to airline
stocks: According to data compiled by Dahlman Rose & Co. in the last week
of October, airline stock performance—comprising 15 large and small airlines in
the United States—has outperformed the S&P 500 year-to-date, growing nearly
28 percent compared with the S&P 500's average growth of 6 percent.
"There are legs to this business right now," said
Dahlman Rose aviation analyst Helane Becker. "As one CEO put it, in the
middle of a slow growth, sluggish U.S. economic environment, airlines reported
record results. This is atypical of what would be considered normal: Normally,
the airlines report losses when the economy does not show growth, so this year
is truly an anomaly."
It starts at the top
Scanning the leadership landscape, Parker noted that the
CEOs running the five largest airlines have backgrounds as either CFOs or
general counsels, representing a shift from marketing-led organizations to
finance-led organizations. "Those aren't guys who have made their careers
trying to be big," he said. "Those are guys who have made their
careers trying to get returns."
It would seem elemental that any business aims for returns,
but that has not been the history of the airline industry, UBS' Crissey pointed
out during a presentation at the Business Travel News/National Business Travel
Association Strategic Travel Symposium in March this year. Similarly noting a
more return-minded leadership structure, he said: "In the past, you had so
many aircraft coming that airlines had to be marketing machines to fill their
planes." Now, as US Airways' Parker said, "We have management teams
that are focused on returns instead of marketshare."
The end of empire
building?
The shift from a marketing-led industry to a returns-driven
one has manifested itself in the route network and capacity discipline of the
domestic airlines. Managements have touted their refined approach to network
building: Among the tenets of its renewed business plan, dubbed Flight Plan
2020, American Airlines is realigning its network around its cornerstone hubs;
United's merger with Continental, sealed early last month, now is leading the
two carriers on a path toward hub rationalization, an exercise Delta has
continued to refine following its merger with Northwest Airlines; and US
Airways has redefined its route network to center around its strengths.
"We now have 99 percent of our capacity deployed in
markets where we have a significant presence, either in Phoenix, Charlotte, the
D.C. area or Philadelphia," US Airways president Scott Kirby said last
month, "and, so, in all of those markets where we're competing with
someone, because we can carry more connecting traffic than they can, we have a
competitive advantage. In the long run, that competitive advantage wins."
Executives from all the major carriers have touched on this
theme during earnings calls, claiming they are building networks from a
position of strength, entering only markets where they can make money and
planning routes only where there is real demand.
United CEO Jeff Smisek outlined such an approach as he
embarks on blending United and Continental networks, planning "to better
match supply and demand and take advantage of the opportunities provided by the
scale of the combined company. We will not grow for growth's sake, but only if
we can maximize our profitability by doing so."
Still, analysts are quick to point out warning signs of the
old empire-building ways. Citing route announcements made last month by
American, JP Morgan's Baker questioned new services from Los Angeles, including
expansion to Phoenix, a market he perceived as mature. Dahlman Rose's Becker,
meanwhile, questioned United's plan to enter the Los Angeles-Shanghai route,
announced a week after American gained its approval to launch the same service.
She wondered whether the move "is a backhanded way of a marketshare grab,
or is it still a position of strength?"
Finding some
discipline
As airlines navigated the oil spikes of 2008 and the
downturn that dominated 2009, their salvation was an unprecedented cut in
industry capacity. Despite plans to add capacity this quarter and overall
expectations of year-over-year growth in 2011, carriers maintain they are
growing responsibly.
CRT Capital Group principal and aviation analyst Michael
Derchin in a research note last month questioned whether capacity discipline
was "beginning to erode," as carriers add supply, but other analysts
agreed that growth forecasts remain in line with demand.
Morgan Stanley analyst William Greene last month said, "less
capacity is preferred to more," but he noted that capacity guidance for
2011 is in line with the demand outlook and falls below the expected growth in
gross domestic product—a rule of thumb for "disciplined" growth (see
graph, right).
That has been a key marker of capacity discipline, analysts
contend: not shrinking capacity, but adding only what can be consumed at a
revenue premium.
"Airlines adding capacity now are adding capacity at a
point when demand is strong, so the capacity will be absorbed," Becker
said. "Later in 2011, if the economy continues to be sluggish or if
business travel growth falters, we expect the airlines would respond in typical
fashion."
MIA: New entrants
Further hindering capacity additions is the motion toward
consolidation and the lack of new entrants, which had emerged by this point in
other up-cycles, but are nowhere to be found on the horizon. Even the so-called
low-cost carriers have recognized fewer growth opportunities than in the past,
though they are growing at a faster pace than their legacy counterparts.
For example, JetBlue Airways plans to grow full-year 2010
capacity by 7 percent and AirTran plans to grow full-year capacity by nearly 4
percent, but their smaller footprints compared to legacy carriers make the additions
a drop in the bucket. Southwest, meanwhile, has kept capacity flat this year,
but sees growth opportunities in the first half of 2011.
US Airways' Parker said the carrier's proposed acquisition
of AirTran is telling. "It clearly shows we're reaching a state whereby
the players in the domestic industry acknowledge that it's largely mature. Even
Southwest, giving the acknowledgment that their ability to continue to expand
required them to go do a transaction with AirTran, is a big statement."
That, of course, has hardly been the only motion toward
consolidation, which Delta CEO Richard Anderson last month called "good
for the industry," a sentiment echoed by all major airline CEOs at some
point during this past year (see sidebar).
US Airways' Kirby last month said, "Part of the way
that the industry has made it through the crises of 2008 and 2009 has been
because of consolidation and because of a more rational, less fragmented
industry. So we think it's a positive."
New pricing models
emerge
The world's airlines are poised to collect nearly $23
billion in ancillary revenue in 2010, up from $13.5 billion last year, and
U.S.-based carriers lead the industry in ancillary services as a percentage of
revenue, at more than 7 percent, according to estimates released last month by
Amadeus and IdeaWorks.
U.S. airlines continue to diversify their sources of revenue
through a la carte fees, new service charges and other ancillary fees. What
started a couple of years ago as a charge to check a second bag has snowballed
into a fundamental shift in how airlines price their products and generate revenues.
Such ancillary fees, management and analysts claim, are structural changes to
pricing that are less likely to ebb and flow, as base fares do, if a low-cost carrier
undercuts them or if load factors necessitate fare sales to stimulate demand.
Though 7 percent of revenue right now, ancillary revenues
are doing nothing but growing at the largest U.S. airlines. For example, during
the third quarter, United and Continental's ancillary revenues respectively
grew nearly 16 percent and 21 percent year over year. Delta reported "other
revenue," representing ancillary opportunities, increased $75 million, a 9
percent increase from the third quarter of 2009, "due primarily to an
increase in bag fees," president Ed Bastian said.
Echoing the opportunity for new sources of revenue, American
CFO Bella Goren summed up the airline stance: "We are focused on growing
our revenues by increasing the variety of customized product options we offer."
Spoiler alert
The "new recovery," like everything in the airline
business, remains tenuous, and airline CEOs are rightfully wary of what the
future holds, knowing that all it takes to spoil the recovery is a spike in
fuel costs, a new entrant that foists unsustainable pricing on them, a second
dip into recession or some other unforeseen event.
"The history of our industry has been [that] crises
forced discipline upon us," US Airways' Parker said. "That's
certainly been the case for the past three years, and then, unfortunately, when
the crisis subsides we tend to, at least sometimes, succumb to temptation. I
think that's what everybody's worried about right now. Is this industry going
to do what it's done in the past?"
This report appears in
the Nov. 8 issue of Business Travel News.