World Travel: Airlines Lining Up for Profits

FROM THE ECONOMIST

After losing $43 billion in five years, airlines are at the beginning of a massive boom

MENTION the airline industry in polite company and a few truisms invariably come trundling out: airlines are loss-making, inefficient, prone to extreme cycles and vulnerable to fickle consumers. Why, most of America's industry is currently bankrupt, flying on only thanks to that country's Chapter 11 cushion. Only an idiot would buy shares in British Airways (BA), which currently owes almost half its £3.5 billion ($6.1 billion) market value to its pension fund. And so on.

The trouble with truisms is that they can obscure big changes as they start to happen. In fact, the airline industry is poised for an almost unprecedented boom, as a new generation of planes is combining with better business models and huge volume growth in new markets. This year an industry with revenues of about $400 billion will end up paying $97 billion for its fuel. According to IATA (the International Air Transport Association), had the price of oil stayed where it was in 2003, at $30, instead of rising to the average $57 expected for the whole of this year, the world's airlines would have made more profit ($45.6 billion) than they have lost in the past five years. (This, says IATA, is also partly a result of a 34% improvement in labour productivity.)

But there is more to it than savage cost-cutting; traffic volumes are growing. International traffic has risen by 8.3% so far this year, compared with 2004. In America, total traffic is up by 5.4%; in Europe the rise is 6%. In Asia, IATA is forecasting continuing annual growth of 6.8% through to 2009: China and some east European countries will go on growing by around 10%.

But perhaps the most conclusive indication of brightening skies is the boom in aircraft orders that is stretching Boeing and Airbus production plants to the limit. Airbus is scouring Europe and farther afield for 1,000 engineers to push ahead with its new long-haul A350 250-300-seat plane and bring its super-jumbo A380 into service without adding to the six-month delay that has already pushed its first commercial flight for Singapore Airlines back to the end of next year. Boeing is booming even more, with about 650 orders under its belt already this year, compared with just over 400 for Airbus at the end of September. Some observers think Boeing could finish this year with almost 1,000 orders, while Airbus will net nearly 900. In a good year the two manufacturers usually share 800 orders between them. This year's numbers will be about a quarter higher than the record number of total orders set in 1989.

Because of the ongoing crisis among American carriers and the global worry over the high oil prices that have doubled jet-fuel costs to nearly $90 a barrel in two years, it is easy to forget the advances being made in many parts of the world. New no-frills airlines are springing up, not just in Europe (where there were around 50 at the last count), but in South Asia and the Middle East, too. India is liberalising its market, allowing foreign carriers such as Virgin Atlantic, bmi (formerly British Midland) and BA more flights. Passenger numbers have risen to 59.3m from 48.7m in the past year, thanks to the arrival of new local airlines such as Kingfisher and SpiceJet. In China consolidation has already taken place; seven small airlines have been folded into the big three--Air China, China Eastern and China Southern. Two and a half years ago Chinese carriers were zapped with the scare over the SARS disease, but their traffic recovered smartly within six months. China Eastern has just reported third-quarter results showing revenues up by 43% and profits more than doubling to 673m yuan ($83m), while China Southern reported net income quadrupling to 852m yuan in the past three months, compared with the same period in 2004.

In Europe, consolidation has started, led by the merger of Air France and KLM. Eastern Europe sports some of the fastest traffic growth in the world, with Poland set to grow even faster than China. BA is inching ever closer to Iberia, attracted by its profitability and its complementary network of routes to Latin America. South America itself has seen strong double-digit traffic growth in recent months, and some start-ups such as GOL in Brazil are prospering as low-cost carriers. Africa, which has had only three viable carriers (Kenya Airways, South African Airways and Ethiopian Airlines) now has a new Nigerian flag-carrier in the form of Virgin Nigeria, 49% owned by Sir Richard Branson's Virgin Atlantic. Sir Richard wants the venture to open up routes across Africa, which is notoriously deficient in air connections. He thinks that Lagos, in one of the biggest and richest countries and halfway up the continent, is a much more natural hub than Johannesburg or Cape Town.

A new chapter

Bad news continues to flood out of America. September saw two more big carriers, Delta Air Lines and Northwest, tumble into Chapter 11 bankruptcy protection. Delta says it will lose $2 billion this year. Northwest's losses have ballooned from $46m in the third quarter of 2004 to $475m in the same period this year.

Behind the headlines, things are looking less bad. After three years in Chapter 11, United Airlines has just reported a loss of $1.8 billion--its 21st consecutive quarterly loss. But that is all down to accounting charges related to its planned emergence from Chapter 11 in February, which is now looking more credible after several false dawns in the past. At an operating level United had an underlying profit for the July-September quarter of $165m. American Airlines (AA) cut its losses in the summer quarter from $214m last year to $153m, while Continental (with AA, the only network carrier to avoid bankruptcy) reported a profit of $61m compared with a loss of $18m last year in the third quarter. Southwest Airlines, the biggest of the no-frills airlines, reported a rise in third-quarter net profit from $119m to $227m, on the back of an 18.8% rise in revenues, helped by price increases.

But the really bright spot on the devastated landscape of America's big six airlines is that the three of them that went bust are at last doing something positive about solving the industry's problems. Ever since their troubles began emerging in the early summer of 2001, America's airline industry has been like a rabbit caught in the headlights. No consolidation took place for two reasons: no network carrier was strong enough to reduce capacity by swallowing the weaker ones; and none of the financially healthy no-frills airlines, such as Southwest, had any appetite for buying into the loss-making business model of the network airlines. But now that could be changing, and there is some hope that excess capacity in the American domestic market could be disappearing. For a start, US Airways has merged with America West to form a new carrier (called US Airways) and escape from Chapter 11. In the process they are shedding 59 planes and cutting their combined capacity by 15%. There is speculation that further mergers could take place, with Delta or Northwest tying up with Continental.

Until now the conventional wisdom (borne out by facts since the early 1990s) has been that the bankruptcy law in America, by allowing an airline to stay in the air with lower costs because it does not have to pay some of its creditors, served perversely to make matters worse. Airlines in Chapter 11 tend to be run purely for cash and therefore cut fares to attract more customers. This perpetuates surplus capacity and depresses revenues and profitability across the industry. But bankruptcy also has the potential to improve things for the better if only airline bosses grasp the opportunity. As Keith McMullan of Aviation Economics, a consultancy, points out, "Chapter 11 enables them to get rid of unwanted aircraft, thus facilitating a sizeable capacity reduction if desired."

Without Chapter 11, airlines hang on to planes and even expand their networks to create more revenue to cover their high fixed costs. But Chapter 11 leaves them free to walk away from aircraft leases or allow redundant planes to be re-possessed. Fewer planes means lower fixed costs. Although many airlines cut capacity after the recession that began in 2001, another round of drastic cuts is under way. Delta has pulled out of the Dallas-Fort Worth hub as it cuts one-fifth of its capacity. Already it has got rid of 40 aircraft and has another 80 to go. Northwest will trim capacity by over 10%. Nor are these the only tough decisions airlines are taking.

Northwest has said that it will outsource cabin service if it does not get further wage concessions from employees. Delta is seeking overall cuts of $3 billion out of annual running costs of $18.3 billion. When its pilots, who agreed to cuts that saved the airline $1 billion last year and staved off bankruptcy for a while, refused to agree to a further $325m in reductions, Delta went to the bankruptcy court last week to get approval to tear up its contract with its pilots union. Similarly United won approval, upheld also last week on appeal, to close its flight attendants' pension plan. Some carriers are trying to improve their product even as they struggle for survival. One of the problems for the mainstream network carriers in recent years has been the downgrading of their service on board and on the ground, even as the no-frills carriers added features, such as seat-back live television, that made them more like full-service airlines. In effect, the network airlines were moving downmarket, while the no-frills carriers, such as JetBlue and Southwest, were moving up. A year ago United reacted to this by introducing a premium service on its East Coast-West Coast flights, with upgraded service levels in coach (economy) class and in business seats.

Un-American behaviour

Faced with tough competition at home from no-frills airlines, big American carriers are all seeking to boost their international services. Delta wants a 25% increase in its international capacity. United, which last week signed a flight codesharing (joint marketing and air miles) deal with Swiss International Air Lines on top of its central role in the global Star Alliance, has long identified international routes as one of its best sources of profits. Northwest, with an important hub in Tokyo, is also counting on international services to help it get back on its feet.

Although some of the international push will be towards South American markets and Asia, the main thrust will be across the Atlantic to European cities. Transatlantic travel by Americans has still not recovered fully from the decline caused by terrorist attacks on both sides of the ocean since 2001: in particular, the July bombings in London have depressed traffic. The temptation for the American carriers is to drop prices to lure back both holiday-makers and business passengers. Virgin Atlantic, which relies on transatlantic routes for about two-thirds of its traffic, notes that American carriers are offering corporate customers discounts approaching 50% of published fares. Sir Rod Eddington, who retired as chief executive of BA at the end of September, used his farewell address to London's Aviation Club to lambast the injustice of the way America, in effect, subsidises its airlines by allowing them to keep flying without paying their bills, so offering unfair competition to European airlines, which (with the exceptions of Olympic and Alitalia) no longer enjoy state subsidies.

A fares war should add spice to the negotiations on transatlantic air travel that open in Washington, DC, on November 14th, when representatives of the United States and the European Union sit down to try to negotiate a comprehensive deal liberalising air travel between Europe and America. Similar talks started two years ago, when power to negotiate such deals passed from EU member states to the European Commission, but broke down in disagreement in June last year. After a preliminary meeting in Brussels last month, there are fresh hopes for some progress at the Washington talks next week.

The Americans are in no mood to concede much. Even if a few voices in the administration would like a true free-market approach, this is unlikely to be offered. Apart from anything else, any substantial change would have to be ratified by Congress. Transatlantic trade relations are already soured by the row over subsidies to Airbus and Boeing, so any concessions to the Europeans would face a tough time on Capitol Hill, even if the result was that Continental, Delta and Northwest would finally gain access to Heathrow.

Instead, the only hope for progress is a relaxation of how some of the existing rules are applied. The foreign-ownership rules even preclude foreigners from holding the top executive positions in American airlines in which foreign capital owns as much as a 49% stake. If these were relaxed, as now seems likely, this would not need congressional approval. Virgin Group, which has been frustrated in trying to set up Virgin America for the past two years, might find it easier to raise the capital it needs. But some industry figures think Virgin's problem is a dodgy business plan, not protectionist rules.

The shape of things to come

Were America and Europe to surprise sceptics and agree a sort of common market across the Atlantic, it would unleash a revolution in global air travel. With full liberalisation of the two markets that account for more than half of air travel, the rest of the world would follow. Instead of the present trend toward a creeping liberalisation, bilateral deals would do away with all restrictions, allowing airlines to behave like normal businesses, with consolidation and cross-border mergers.

But there is the suspicion that the status quo suits the club of the Heathrow Four (BA, Virgin, United and AA) more than they admit, and that they enjoy the moral high ground knowing that they will never have to admit outsiders. A different aviation trade row is brewing in the Middle East, and illustrates a new trend in long-haul travel.

** NOTE: This story has been truncated from its original size in order to facilitate transmission. If you need more information about this story, please contact NewsEdge Corporation at 1-800-766-4224. **

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