2008 Business Travel Survey: Domestic Carrier Profits Undercut By Fuel Costs

In 2007, so much looked so right for domestic airlines: Their planes were the most full in history, passenger demand blossomed to its highest levels and revenues rose throughout the year. Those positive operating fundamentals nurtured net incomes that doubled, or in some cases tripled, the baseline profits established by most carriers in 2006—making 2007 the second profitable year for the domestic industry since 2000. However, last year's profits are likely to be the last for some time as the operating environment grows bleaker with every trip airlines take to the fuel pump.

That single expense item—the current growth of which was unfathomable to airline executives five years ago—is spurring airlines to segment traveler populations, raise fares, add surcharges and a plethora of ancillary fees, and slash domestic capacity. It helped bring together Delta Air Lines and Northwest Airlines in a merger pursuit to create the largest airline, while forcing others into operational oblivion or bankruptcy. In the past six months, Air Midwest, Aloha, ATA, Big Sky, Champion, Eos, Maxjet, Silverjet and Skybus ceased operations, while Frontier Airlines filed for Chapter 11 bankruptcy protection. Despite carriers' best efforts to offset rising fuel costs through capacity cuts, new revenues and higher fares, analysts said the bleeding has just begun.

Echoing a sentiment penned by JP Morgan airline analyst Jamie Baker in a research note earlier this year, Air Transport Association president and CEO James May last month said the surge in fuel expenses is generating "the worst economic shock since 9/11, and, possibly, one that is worse."

Add to the mix a slowing domestic economy, a weak U.S. dollar, increasing regulatory involvement in carrier operations and forecasts of softening air travel demand, and it becomes evident that the airlines are facing a crisis of survival.

The Air Transport Association last month projected the domestic industry's fuel bill this year will be 72 percent higher this year than in 2007, while JP Morgan's Baker last month projected the cost of fuel to bleed industry profits dry in the next two years, forecasting a "an all-time record" $7.2 billion operating loss this year and a 2009 operating loss of $8.1 billion.

"Certain more modest forecasts are difficult to reconcile absent heroic fuel declines or unprecedented demand growth," Baker said. "A war of attrition appears to be underway. One belief is that airlines will act collectively to massively reduce capacity, leading to near-record fare improvement, but management may instead engage in value destructive behavior as they attempt to merely outlast one another—after all, capacity cuts thus far fall meaningfully short of what we and most executives deem necessary. At current fuel prices, legacy bankruptcies and/or merge-at-all-cost attempts are a question of when, not if."

UBS airline analyst Kevin Crissey in a research note last month said fuel at its current levels "likely results in multiple bankruptcies."

To cope, most of the largest airlines continue to take capacity out of the domestic system and focus growth on higher-yielding international routes. Examining OAG monthly data for May 2008, year-over-year North American capacity declined 2 percent while international capacity grew 5 percent. Though airlines hope the decline in supply will give them an edge in pricing power in light of forecasted demand softness, Baker said carriers would have to take 20 percent out of domestic capacity "in order to recalibrate for current fuel prices." Baker said current capacity forecasts don't even come close to approaching that figure, though airlines say they are willing to further cut capacity this year, and in many cases continue to revise growth plans downward.

Merrill Lynch airline analyst Michael Linenberg said, "The industry can attempt to pass on its higher fuel costs in the form of multiple fare increases, but given the elasticity of demand, only so much can be done without substantially reducing domestic capacity." Linenberg expects another large round of domestic capacity cuts in the second half of the year "if the industry does not see any relief from record high fuel prices."

The Air Transport Association in a statement last month said, "Industry analysts say that since ticket price increases aren't enough to overcome soaring fuel costs, major capacity cuts could be next. What's clear is that if high oil prices persist, then the very nature of air travel as we know it will be forced to change: If airlines cut service as much as some industry analysts have indicated is necessary, passengers will see fewer daily flights to many cities, more crowded planes and more inconvenience overall."

The U.S. Bureau of Transportation Statistics showed declines for much of 2007 in average airfares compared with 2006: They fell 0.6 percent in the first quarter, 4.5 percent in the second quarter and 0.8 percent in the third quarter. However, carriers in the fourth quarter grew fares 4 percent.

Carriers were able to up revenue last year on generally lower fares thanks to passenger growth and some of the highest load factors in history. "Obviously, the way we generated more revenue is the 10 or so percent pick-up in load factor the industry has traded over that period of time. So we continue to be frustrated by the inability of the industry to take this enormous fuel burden and put it where it belongs, which is on our customers, because that's ultimately where every cost has got to go," American Airlines CEO Gerard Arpey said during the carrier's fourth-quarter earnings call.

Those upward pricing patterns established at the end of 2007 continued into 2008. Air Transport Association data show that yields—the average amount passengers paid per mile flown—on domestic routes grew 6.4 percent for the first three months of this year compared with the same period last year. Carriers increasingly included fuel surcharges and other ancillary fees—such as charges for a second checked piece of luggage—to further boost revenues.

However, it doesn't appear to be enough to offset fuel prices. "The legacy airlines have grown passenger revenue 7 percent so far this year," Crissey said last month. "This is a good result by historical standards during a period of weak economic growth, but not remotely close to what's needed."

Air Transport Association chief economist John Heimlich said the portion of a ticket used to pay for fuel expenses is approaching 40 percent, up from 15 percent in 2000. "The rapid increase in jet fuel prices will add substantially to airline costs at a time when a weakening U.S. economy will make it more difficult to offset those costs with higher fares," said Standard & Poor's airline analyst Phil Baggaley.

Though most legacy carriers said the first quarter of this year showed little evidence of a grand pullback, with some claiming booking levels were steadily progressing and others disclosing signs of slowdowns only in certain pockets, a growing portion of corporations are scaling back air travel plans and the International Air Transport Association said domestic traffic growth is becoming stagnant.

Fuel's impact on carriers' balance sheets became most evident toward the end of last year, as profit margins slipped into the negative and pricing efforts left fuel costs unrecoverable. Those trends have continued into 2008 with airlines reverting to survival mode.

AirTran Airways managed a profit in 2007, netting $52.7 million, which was more than triple its $15.5 million 2006 profit. AirTran, however, ended the year with a fourth-quarter loss of $2.2 million and an even greater $34.8 million loss for the first quarter of 2008.

The carrier said it set records in its load factors, passenger counts and revenues last year. AirTran in the past year has remained one of the few domestic airlines in growth mode, though it is beginning to scale back its capacity plans. It grew capacity in the first quarter this year by nearly 11 percent and witnessed its highest quarterly load factors and robust passenger growth. However, in light of fuel costs that represented 43 percent of its total costs in the first quarter and suggestions of bearish demand, even this growth carrier is scaling back. AirTran expects to grow at similar pace through the third quarter this year, but it will begin scaling back in the last quarter and through 2009.

"Our growth rate for the September through December of 2008 period will be flat, year over year, as will our growth rate for all of 2009," said AirTran vice president of finance Arne Haak. "This represents a 10 percent reduction in our capacity plans for the fourth quarter and a 10 percent reduction in capacity for 2009."

Alaska Air Group last year dug itself out of 2006's annual loss of more than $50 million with a $125 million net profit, but ended the year on a sour note with a fourth-quarter adjusted loss, "driven primarily by skyrocketing fuel costs combined with fares that have not kept pace," according to CEO Bill Ayer.

CFO Bradley Tilden announced a $35.9 million first-quarter loss and outlined a number of initiatives to grow revenue, including reductions in schedule, introductions of new fees—from charges for overweight baggage and unaccompanied minors to fees for reservation center bookings—and fare growth. The carrier expects to grow capacity by 2 percent this year, a downward revision from its previously planned 6 percent growth.

American Airlines parent AMR Corp. in 2007 pulled in its second annual profit in the past five years, netting $504 million for the full year and more than doubling its $231 million profit for 2006. However, the carrier reported a $69 million fourth-quarter 2007 loss—its first following six profitable quarters. The carrier this year followed that with a loss of $328 million in the first quarter.

Though AA in 2008 posted its highest first-quarter load factor ever, with 78 percent of its seats full, and made gains in pricing with a 5.1 percent increase in average fare paid, the growing cost of fuel was the largest contributor to the carrier's cost growth of 15.8 percent.

AA last month revised its capacity outlook to cut mainline domestic capacity by up to 12 percent in the fourth quarter this year, as it plans to retire "at least 75 mainline and regional aircraft." The revised capacity reductions build upon the carrier's previous outlook, detailed in April, that forecast a fourth-quarter decline in available seat miles of 4.6 percent, compared with the same period last year. American now expects domestic mainline capacity to drop by 6 percent for the full year, compared with 2007.

The last of the legacy carriers this year to deploy a fee for checking a second bag, American built upon that initiative by introducing a $15 fee for customers to check their first bag.

American expects to achieve "several hundred million dollars in incremental annual revenue" from that and other fees on traveling with pets, oversized baggage and reservation services, including a $20 fee for AA call center reservations and $30 for airport ticket counter reservations.

American CEO Arpey in announcing the capacity cuts and new fees said, "The airline industry as it is constituted today was not built to withstand oil prices at $125 a barrel, and certainly not when record fuel expenses are coupled with a weak U.S. economy. Our company and industry simply cannot afford to sit by hoping for industry and market conditions to improve."

Arpey said American is further attempting to reduce costs through a hiring freeze for management and support staff. "We're clamping down on all of our capital spending moving forward," he said.

Continental Airlines netted $459 million last year, an improvement upon its $343 million 2006 profit, but the carrier began the year with an $85 million first-quarter loss.

CEO Larry Kellner said international trends remain strong, though he expects year-over-year mainline domestic capacity to decline by 16 percent in the fourth quarter.

While president Jeff Smisek detailed strong revenue growth into this year, surging by $391 million to a total $3.6 billion in the first quarter, the carrier is witnessing the same trends as the rest of its domestic peers as costs, anchored by fuel expenses, continue to outpace passenger income. "We currently expect demand will remain solid throughout the summer, but unless the economic indicators improve dramatically, we think things are likely to get pretty tough after we get past the peak summer travel season," he said.

Although declining to engage in merger activity, Continental said it is exploring new alliance opportunities as its SkyTeam partners, Delta and Northwest, link up.

After spurning a US Airways takeover in early 2007, Delta Air Lines emerged from Chapter 11 bankruptcy protection in the spring, found a new CEO in former Northwest CEO Richard Anderson in the summer, entered into a transatlantic joint venture partnership with Air France in the fall, scored its first annual profit in years and then this year announced a merger agreement with Northwest.

The carrier reported a net loss of $274 million for the first quarter this year, though Anderson outlined hopes to weather the harsh industry environment and unprecedented fuel costs through capacity discipline, cost containment, fare increases and its merger with Northwest, which it expects to complete by year-end.

The carrier has continued to grow international capacity, which now generates nearly 50 percent of its revenue. It expects to shrink domestic capacity by up to 10 percent this year, while growing internationally up to 16 percent.

"With our capacity reductions, we're trying to stay ahead of the curve and anticipating a significant decline in business travel towards the back half of the year and getting ahead of that," said executive vice president of network planning and revenue management Glen Hauenstein. "Hopefully, we'll be pleasantly surprised and the economy will start to rebound, but I think we are really well positioned with the 10 percent year-over-year domestic capacity reduction to produce very nice unit revenue growth through the fourth quarter."

JetBlue Airways last year achieved its first annual profit since 2004, but even though it grew operating revenue by 34 percent in the first quarter and claimed to charge its highest average monthly fare in March, it wasn't enough for quarterly profitability as it posted a net loss of $8 million, largely due to fuel expenses that were $180 million higher than in the first quarter of 2007.

The carrier in the past year has attempted to grow its relevance to the corporate market, with increased flexibility to structure deals and participate in global distribution systems and fare products aimed at the business traveler, including refundable fares and preferred seating schemes.

Though the carrier continues to grow, it has reduced its capacity plans for this year to a maximum of 5 percent growth, from its previous growth forecast of up to 8 percent. "Most of this 2008 growth is driven by the run rate of aircraft which were added to the fleet in 2007," said CEO Dave Barger, who replaced former CEO and founder David Neeleman at the helm last year.

Like merger partner Delta, Northwest Airlines last year freed itself of the Chapter 11 yoke to return to solvency and end with an annual profit. The carrier last year maintained its load factor on modestly raised capacity, but this year is joining the industry in reducing its domestic footprint to cope with the growing fuel burden. Northwest plans to shed domestic capacity by up to 8.5 percent, while growing internationally by up to 9 percent, and CEO Doug Steenland said the carrier is further attempting to grow its revenues through fuel surcharge and fare increases and such restrictions as minimum-stay requirements to "better segment passenger demand."

Steenland, who plans to step down from the CEO post upon a final merger, said the deal with Delta allows the carrier to "better utilize Northwest's valuable Pacific franchise, better develop both carriers' domestic hubs and better match the right airplanes with the right routes."

Southwest Airlines in 2007 achieved its 35th consecutive annual profit with a $645 million net income, thanks in large part to its enviable fuel hedges.

"Our fuel hedging program has consistently mitigated such price increases dating back to year 2000," the carrier said in its annual earnings statement. "Since then, in each year, we have striven to hedge at least 70 percent of our consumption. In 2007, we were approximately 90 percent protected at approximately $51 a barrel. That protection saved us $727 million last year and limited us to an 11.3 percent increase in the economic cost per gallon, year over year."

The carrier's fuel hedge gains have not stopped it from seeking new forms of revenue—particularly from the corporate market. Southwest last year reinvented itself for the business travel buyer by entering into long-term—though limited—global distribution system deals, bulking up its sales force, changing its boarding process, upgrading its frequent flyer program and adding new fare tiers. The carrier for the first quarter of this year posted a record load factor and record revenues.

"Fuel is obviously the biggest challenge that we have going forward, even with a great hedge," Southwest CFO Laura Wright said. "We're pleased with our revenue momentum and we're going to continue pressing our revenue initiatives. We'll also continue our efforts to improve our productivity and maintain our disciplined cost control. Fortunately, we have a very strong balance sheet which will allow us to weather the economic climate and also allow us to take advantage of any market opportunities should they arise."

Though the carrier remains in growth mode, Southwest has scaled back its capacity growth forecast for this year from 8 percent to 6 percent, though CEO Gary Kelly during the carrier's first quarter earnings call said Southwest is open to cutting capacity further this year. The carrier also has scaled back plans to grow its fleet next year and plans for 2009 capacity growth of no more than 3 percent.

UAL Corp., parent company of United Airlines, last year generated its largest profit since 1999 and first annual profit since 2000, excluding reorganization items due to its emergence from bankruptcy protection in early 2006. The company grew passenger revenue by 7 percent last year with a sharp revenue uptick in the fourth quarter. However, that growth was not enough to offset the rising cost of fuel in the last three months of the year, for which the carrier posted a $53 million net loss.

For the first quarter this year, the company reported a $618 million increase in fuel expenses, widening its first-quarter loss to $537 million. CEO Glenn Tilton during the carrier's first-quarter earnings call in April announced measures to help combat the unbridled growth in jet fuel costs.

"We are further reducing our fleet, cutting capacity and eliminating marginal flying," he said. "We will be grounding a total of 30 of our most inefficient aircraft and are slimming down our operation accordingly by reducing our workforce by some 1,100 people, including 500 salaried and management employees. We're also cutting our capital spending and other costs in a focused manner."

The carrier expects mainline domestic capacity to be down by nearly 14.5 percent year over year in the fourth quarter, which is on top of declines witnessed in the last part of 2007.

Tilton said the carrier further plans to merchandize its product—"charging customers for services they use"—by unbundling and upselling initiatives. "All told, we expect that merchandising opportunities will generate $1 billion in revenue annually over the next few years," Tilton said.

United chief revenue officer John Tague during the carrier's first-quarter earnings call outlined the carrier's plan to gain passenger revenue in any way it can. "We need to pull every lever that is available to us, be it capacity discipline, fare increases, fuel surcharges, ancillary revenue generation or something as basic as returning pricing segmentation to the marketplace," he said.

Despite a fourth-quarter loss of $79 million, US Airways managed to net a profit of $427 million for full-year 2007. However, like its legacy brethren, the fourth quarter set the tone for 2008, as the carrier posted a $236 million loss for the first three months.

The carrier said it expects to cut mainline capacity by up to 4 percent in the second half of the year.

President Scott Kirby, during the carrier's first-quarter earnings call, said, "I doubt that the current levels of industry capacity cuts will be enough to return the industry to sustained profitability in the face of $115 to $120 a barrel fuel."

As such, the carrier, like its Star Alliance partner United, has embarked on a number of revenue-generating initiatives. Kirby said the carrier would "significantly increase" a la carte pricing "that lets customers pay for the services that they desire."

Kirby added, "In addition to the a la carte initiative, fares simply must go up to cover the cost of jet fuel. The numerous fare increases that make headlines on legacy carrier fares are helpful in that regard, but they only apply to a small percentage of the tickets purchased by customers."

CEO Doug Parker during the call added, "We are looking to modify our pricing structure and reduce our capital expenditures."