The largest U.S. airlines in 2013 collectively are poised to
post a fourth consecutive year of profits, the longest such run since the late
1990s. Analysts have called the intervening years a "lost decade" in
which airlines lost billions grappling with the shock of Sept. 11, the highest
jet fuel costs in history and the worst recession in a generation. Financially
cleansed by a series of bankruptcies, emboldened by mega-mergers and steered by
execs who many describe as more prudent leaders, the largest U.S. carriers are
slowing their growth and tinkering with new pricing models as they navigate a
path toward sustained profitability.
That's not to say this year will be without challenges or
that profits are a lock. Amid tepid macroeconomic growth, airlines face
softening demand and ever-volatile fuel prices.
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Alaska Airlines, Allegiant Air, American, Delta, Hawaiian,
JetBlue, Southwest, Spirit, United and US Airways combined "eked out
another year of meager profitability," with a modest $152 million in
aggregate 2012 profits, according to Airlines For America vice president and
chief economist John Heimlich. Combined performance by those members of the
trade association was dragged down by a significant loss at American, which
incurred big expenses related to its ongoing bankruptcy reorganization. The
company expects to complete Chapter 11 proceedings in the third quarter this
year and begin merging with US Airways.
"We've had three profitable years in a row, but with
margin suppression each year," Heimlich said during a February conference
call. Airline industry profit margins, or earnings as a percentage of revenue,
since the last economic recession peaked at 2.2 percent in 2010, fell to 0.3
percent in 2011 and stayed a hair above break-even last year at 0.1 percent.
"As Herb Kelleher used to say, the price of a Happy
Meal at McDonald's is my profit margin," said Heimlich, paraphrasing
Southwest Airlines' co-founder. Last year, carriers would have coveted Happy
Meal margins, as Airlines For America reported that its member airlines netted
about 21 cents per passenger.
Demand Drag
A glance at a U.S. Bureau of Transportation Statistics chart
on U.S. passenger enplanements shows that demand slowly but steadily has
crawled out of the mid-2009 trough. A positive, if tentative, trend line is
clear. Yet, passenger volume last year grew a scant 1 percent from 2011,
according to BTS, and traffic levels so far this year have been anemic, partly
due to government cutbacks.
Delta, for example, entered 2013 with corporate demand
growth intact. But following a "strong January and February," the
airline in mid-March "saw a drop in close-in bookings," CEO Richard
Anderson said in April. Others, including United and US Airways, indicated
similar trends and cited the U.S. federal government sequester as a chief
culprit. Those automatic spending cuts impacted government demand as well as
travel patterns at large federal contractors, notably those in the defense
industry. Still, Cowen Securities airline analyst Helane Becker noted that "government
and government-related travel ... is less than 3 percent of total traffic."
United reported that first-quarter contracted government
travel declined 25 percent year over year. US Airways saw first-quarter
government revenue fall by 37 percent. Delta indicated that corporate clients
in the defense sector from late March through mid April spent up to 20 percent
less on Delta tickets.
U.S. airlines during the first quarter, however, pointed to
healthy business travel demand that is producing increasing revenue from
corporate clients and based on advance bookings should remain strong in the
summer. Wolfe Trahan airline analyst Hunter Keay in a May research note wrote
that his own predictive model "shows solid demand that is not tapering off
as some have feared recently."
Keeping Supply In
Check
Airlines have been quick to mitigate the ebb and flow of
demand by adjusting capacity. In general, airline executives at major carriers
use gross domestic product growth as a gauge for capacity levels. Simply put,
when airlines grow capacity at or below GDP growth, they're poised for profits.
Capacity growth in excess of GDP is perilous for carriers.
The U.S. Bureau of Economic Analysis in late April estimated
that first-quarter real U.S. GDP grew by 2.5 percent year over year. The
International Monetary Fund also in April projected full-year U.S. GDP to be up
by 1.7 percent year over year. By comparison, U.S. airlines this year are
expected to grow capacity more slowly, at 1.3 percent.
"Capacity has come out of the industry and is mostly
staying out," according to The Buckingham Research Group airline analyst
Daniel McKenzie.
While this year will see some modest capacity gains, the
industry remains significantly smaller than it was before the last recession. "Versus
in 2007, the last year of industry profitability in the last cycle, the
industry is still 9 percent smaller this summer," according to McKenzie.
As the largest network carriers keep supply tight, there are
pockets of growth. Allegiant, JetBlue, Southwest and Spirit as a group are
expected to grow capacity this year by nearly 5 percent from 2012 levels,
according to Morgan Stanley projections.
"Despite aggressive growth" by such carriers, "there
are still 21 million fewer seats available for sale in global distribution
systems domestically versus in 2007," according to McKenzie.
Revenue Growth
Moderates
Driven by higher average fares and growing pools of
ancillary revenue, the largest U.S. carriers last year generated more total
revenue than in 2011, up 5 percent among members of Airlines For America.
Faced with a number of challenges that diverted some
business last year, United experienced the lowest revenue growth rate among
major players, up 0.2 percent from the prior year. On the other end of the
spectrum, JetBlue grew passenger revenue last year by nearly 12 percent versus
2011. Delta and American were more in line with the average growth rate, with
US Airways slightly above.
In 2011, the average domestic airfare in nominal terms was "the
highest on record," and through three quarters in 2012 it was up another
3.5 percent, according to BTS data.
Fourth-quarter figures weren't available at press time, but
there is evidence of the revenue environment softening this year.
While first-quarter revenue increased year over year at the
largest U.S. carriers, "growth slowed," according to Cowen Securities'
Becker. In a May research note, she added that the industry's average
first-quarter fare dropped 3 percent.
"Forward bookings for May and June are trending higher,
although pricing is remaining relatively flat with current levels," Becker
wrote.
As carriers reap cash from bag fees, seat assignments,
change fees and other ancillary products and services, they have become less
reliant on fares as their sole revenue driver. According to BTS, last year's
third-quarter airfare accounted for 71 percent of U.S. airlines' total revenue.
In 1990, the first year BTS reported this metric, airlines realized 88 percent
of their revenue from fares.
Publicly traded U.S. airlines last year collected around
$3.5 billion in bag fees alone, according to Wolfe Trahan projections. Those
airlines also collected an estimated $2.5 billion in change fees. Some airlines
have indicated that fees for seat assignments represent an area for significant
potential revenue growth. Delta and United are among those increasingly
applying sophisticated revenue management techniques to price preferred seats,
including premium-economy products.
Meanwhile, airlines likely will see growth this year in
change-fee revenue; American, Delta, United and US Airways in April raised such
fees, lifting the industry standard for a domestic flight change to $200 from
$150.
Pain At The Pump
Eases
As revenue growth hits a soft patch, airlines are finding
some relief in their largest expense: fuel. Airlines For America reported that
U.S. carriers spent $50.4 billion on fuel last year, down marginally from 2011.
The lower fuel bill, however, was due to less consumption, as the average cost
per gallon of jet fuel in 2012 increased six cents year over year to $3.06.
Jet fuel prices have moderated this year, according to
Airlines For America, which in May reported a year-to-date per-gallon average
of $3.02. The U.S. Energy Information Administration expects jet fuel
consumption to be flat this year at an average price per gallon of $3.03,
according to a May forecast.
The same trends that have driven recent "passenger
revenue softness also pushed down oil prices," said Delta's Anderson. Recent
drops in fuel costs represent more than $1 billion in annual cost savings at
Delta alone. "We anticipate the lower fuel costs, combined with prudent
capacity management, will more than offset any revenue softness," said
Anderson.
Even so, to combat fuel price volatility, some airlines
continue to hedge a portion of their fuel consumption. While US Airways has
shunned hedging on principle, likening it to gambling, others see it as an
insurance policy. However, airlines in recent years generally have de-emphasized
hedging or stopped doing it altogether.
Meanwhile, Delta last year made a move to manage fuel
expenses by buying from Phillips 66 a Pennsylvania oil refinery. Delta posted a
$22 million first-quarter loss on the business, due in part to supply
disruptions from Hurricane Sandy. Delta CFO Paul Jacobson expects a "modest"
profit from the business this quarter.
The Last Merger?
In February, US Airways CEO Doug Parker called his carrier's
proposed merger with American "the last major piece needed to fully
rationalize the industry, enabling airlines to be intensely competitive but
also sustainably profitable."
American and US Airways are the fourth- and fifth-largest
U.S. carriers, respectively. The combined entity would be the largest U.S.
airline, with more than 20 percent market share, according to data from BTS.
The deal follows recent industry-concentrating moves including mergers between
Delta and Northwest, United and Continental, and Southwest and AirTran.
JP Morgan analyst Jamie Baker noted that should AA and US
Airways secure the requisite approvals to tie the knot—as the carriers expect
in the third quarter—the four largest U.S. airline companies would control 88
percent of the domestic market, up from 60 percent in 2005.
Some consumer advocates, as well as big-spending
corporations, are concerned that this next piece of M&A will push fares up
and pull capacity down.
Airline For America's Heimlich said there is "no
credible evidence that mergers have led to increases in fares." Indeed,
there are so many factors in airline pricing—the cost of fuel and the
supply-demand equation chief among them—that it is difficult to prove mergers
alone affect pricing. Parker has dismissed the notion that the AA-US Airways
merger is built on raising prices.
Yet, some analysts suspect M&A does help solidify
pricing power.
J.P. Morgan's Baker in a late March research note indicated
that "yes, we believe this transaction in particular may lead to firmer
domestic pricing," but he was skeptical of the extent.
In an exchange with Delta executive vice president of
revenue management and network planning Glen Hauenstein during an earnings call
this year, Baker said that if he had been "in a coma for the last seven
years and I woke up to find America West, Northwest and Continental to no
longer be part of the landscape, I'd expect a truly firm pricing environment."
But, he said, "We just don't seem to be seeing it."
Hauenstein replied that the industry has had "a lot of
consolidation that has been announced but really hasn't happened yet."
Even among merged carriers, "you still have airlines looking to figure out
what their new combined network strategy is."
Hauenstein's conclusion: "All the pieces are in play,
and I think we will see a much more robust environment in the future."
This report
originally appeared in the May 27, 2013, edition of Business Travel News.