The airline industry was hit hard in 2011, by the unrelenting
market turmoil and rising fuel costs after a strong rebound in
2010. Major carriers experienced declining year-over-year earnings
and revenues. Unfortunately, we foresee a similar scenario in 2012.
Conditions could worsen in 2012, stemming from the weak outlook for
Europe given its financial problems. According to the International
Air Transport Association (IATA), airlines are expected to generate
overall profits of $3.5 billion in 2012, down from the estimated
$6.9 billion in 2011 and $16 billion in 2010. This steep decline in
the industry's profitability is a function of the overall
unfavorable macro backdrop in which the industry has to operate
North American airlines like
United Continental Holdings Inc.
Delta Air Lines
Southwest Airlines Co.
JetBlue Airways Corporation
US Airways Group Inc.
) that were untouched by the Euro-crisis will benefit the most in
2012. These carriers have also shown improvements thanks to higher
ticket prices, capacity cuts and improved ancillary revenues. These
firms together are expected to post profits of $1.7 billion in
The 2012 profit projection from the Asia-Pacific carriers is $2.1
billion. Notably, this is the highest profit-producing region in
the industry outside the home market, outstripping other areas.
Middle East & Latin America:
Per IATA, profits from the Middle East and Latin American carriers
are expected to plunge from 2011 levels to $300 million and $100
African air carriers are expected to incur a loss of $100 million
due to weaker yields after touching the break-even point in 2011.
As for the European airlines, the IATA projections show a loss of
$600 million for 2012, indicating a downswing from a profit of $1
billion in 2011. The weak economy and higher passenger taxes are
largely responsible for the downturn.
Airfreight is declining as world trade is deteriorating and
shippers are moving away from costlier air transport. The end of
2011 showed weak traffic growth in Europe and the other affected
markets, particularly in the Middle East/North Africa region.
Though Tunisia is showing signs of recovery, traffic to Egypt and
Libya are still disrupted. Hence, we believe the recovery of
airfreight depends on the overall health of the European economy.
Despite the weak economic growth, travel demand is picking up. The
IATA projects a slowdown in global airline passenger growth to 4%
in 2012 from 6% in 2011. The cargo market is expected to remain
stable in 2012.
In the worst-case scenario of a full-blown Euro-zone crisis, Europe
will likely drag the U.S. into a recession as well, pulling down
growth in China and other emerging economies. In that scenario,
losses in the global airline industry would be quite large, perhaps
the worst since the 2008 financial crisis. Every region of the
world would be affected, though Europe would be worst hit, followed
by North America and then the Asia-Pacific region.
In the base-case scenario, there are several factors that will
drive airline profits in 2012:
Fuel Price Rise: Bane or Boon?
Airline profit outlook depends on fuel prices, the major variable
component in the industry. Escalating fuel prices are making
aircraft operations expensive and are changing the sector's overall
dynamics. Airlines need to figure out ways to counter rising fuel
High crude oil prices, largely a function of geostrategic forces,
are outside of the control of the airlines. We expect crude oil and
jet fuel prices to remain largely stable this year, but forecasting
this key variable with any level of accuracy has always been
extremely challenging (Hedging strategies discussed below).
While air carries are contemplating a more effective and enduring
way to counter the rising costs, passing on the increased cost to
customers in the form of fare hikes seems an easy way out. Airlines
have already imposed about 10 broad fare increases in 2011, which
has been successful with the rise in travel demand. If demand
remains strong and the fuel price continues to rise, then carriers
will be able to earn higher through fare hikes in 2012.
Getting Rid of Unprofitable Jets
Air carriers believe capacity reduction is another way to counter
rising fuel costs. The companies are scrapping or cutting flights
in many small U.S. airports that are unprofitable.
According to the Airports Council International, 27 airports
including those at St. Cloud, Minnesota and Oxnard, California lost
services from the well-known airlines over the last two years.
Instead, the carriers are adding long-distance flights. It is easy
to charge more from passengers traveling long distance rather than
the shorter routes.
New Advertising Rule
The U.S. Department of Transportation (DOT) laid new pricing rules
for the air carriers effective January 26, 2012. Airline companies
have to include all taxes and fees while advertising fares for
their flights. Previously, the carriers were allowed to advertise
ticket prices excluding taxes and fees, which could add up to 20%
to the price of air travel.
We are apprehensive that the new advertising policy will look
expensive to passengers and hit the stocks. As the passengers are
switching to low fares, the new rules might hurt the travel demand,
thereby leading to lower industry profits.
Air carriers are also focusing on fleet rightsizing. Though
initially expensive, it seems the correct strategy to lower
non-fuel costs. Air carriers are replacing their older fleet with
new fuel-efficient aircraft, to optimize cost efficiency of their
Delta Air Lines, United Continental and Southwest would add new
) over the next few years. JetBlue will buy Pratt & Whitney
) to power its A320neo jetliners.
Hedging strategies provide a cushion to the rising fuel prices and
is being used extensively.
Delta Air Lines is 40% and 15% hedged of its expected consolidated
fuel consumption for the first half and the second half of 2012,
respectively, at current jet fuel prices. United Continental is
hedged 47% and 36% for the first two quarters of 2012 and JetBlue
has hedged approximately 21% for full 2012 using a combination of
calls, swaps and collars. Southwest is 50% hedged for 2012 through
fuel derivative contracts at varying WTI crude-equivalent price
We believe industry consolidation and various ancillary revenues
will boost profitability and cost performance of most air carriers
going forward. This is an opportune moment for companies to
consolidate in order to regain their lost profits and operational
Ancillary Revenue: A number of supplementary revenue streams helped
the airline industry gain ground in 2011 and 2010 after two years
of drought. Air carriers are adding new features to services as
well as expanding new products to improve passenger satisfaction
and experience. The IATA projects total revenue of $618 billion for
2012, up slightly from $596 million projected for 2011.
Carriers are going wireless with the in-flight entertainment
systems such as American Airlines' Gogo "Vision" wireless
video-on-demand, Delta Air Lines' "Delta Connect" and Lufthansa
"BoardConnect." Other carriers such as Virgin America, Qantas and
Virgin Australia will soon launch their in-flight entertainment
Cathay Pacific, Malaysia Airlines, KLM, Delta, Qantas and British
Airways have also made
) iPad available to passengers in their lounges, rent them out in
the air as well as use them as a self-service kiosk, customer
survey tool and food ordering tool.
Further, major U.S. carriers remain focused on expanding their
product and service offerings on board and on the ground to aid
growth in ancillary revenues. Delta Air Lines and United
Continental are installing winglets, WiFi and flat-bed seats apart
from expanding Economy Comfort or Economy Plus seats to their
fleet. Southwest Airlines is benefiting from EarlyBird check-in,
unaccompanied minor travel and pet fees. The company is upgrading
its fleet with the new Boeing Sky Interior and the All-New Rapid
Rewards program is contributing to revenue growth. JetBlue is
experiencing solid growth given continued success in the Getaway
Vacations Division as well as the Even More Space product.
Consolidation: Airline companies are consolidating in order to
restore profits. The first in this grouping was Delta Air Lines'
successful acquisition of Northwest Airlines in 2008. The merger
catapulted Delta to the position of the second largest airline in
the world, generating significant cost savings for both.
In 2010, United Airlines merged with Continental Airlines and
formed a new company, United Continental Holdings. This merger
created the world's largest airline, overtaking Delta Air Lines.
The third merger was between Southwest Airlines and fellow
discounter AirTran Holdings, which was completed in May 2011.
Another airline consolidation is seemingly underway. American
Airlines, a wholly owned subsidiary of
), filed for bankruptcy protection in November, which would help it
to cut down expenses and position it for consolidation. Looking
back, bankruptcies in the airline industry pave the way for mergers
and acquisitions. This is because carriers seek protection to
emerge as a low cost provider with a strong competitive position in
the industry. There is a good chance of American Airlines merging
with US Airways.
The merger of American Airlines and US Airways, if successful,
would be the fourth in the last three years. Though the deal is not
yet official, we believe it could change the competitive dynamics
of the airline industry. US Airways has been looking for a merger
candidate following its bankruptcy protection filing in 2002 and
has long-standing problems with its pilot union. The company failed
to acquire Delta when it went bankrupt in 2006. As a result, US
Airways might take American Airlines' bankruptcy as a great
opportunity to take over its larger rival.
Carriers are making continuous efforts to increase their domestic
and international flights. Delta Air Lines is focusing on adding
flights in Latin America, Mexico and Brazil. Delta Air Lines is
progressing well on the $1.2 billion expansion at New York-JFK,
scheduled to open in 2013, and the new Maynard H. Jackson Jr.
International in Atlanta, slated to open in 2012. Internationally,
Delta's deal with a Chinese international airline China Eastern in
early June should prove profitable.
United Continental is benefiting and enhancing its access from each
other's hubs and networks. Southwest gained a valuable market
presence in Atlanta, the busiest airport in the U.S, post the Air
Tran acquisition in May 2011. The company is introducing services
to new and unexplored domestic markets and expanding services in
New York LaGuardia, Boston Logan, Milwaukee, Baltimore/Washington
and many smaller domestic cities. The company will also debut in
the Caribbean and Mexican markets in mid-2012.
JetBlue continues to successfully expand its network in two major
growth regions: Boston to New
York and the Caribbean.
Air carriers are involved in numerous technology upgrades and
system automation for various activities such as airline
reservation system, flight operations system, website, maintenance
and in-flight entertainment systems. These upgrades enable
companies to perform better, lower costs and enhance customer
Of the many challenges facing the industry, the most important ones
include volatile fuel prices, economic weakness, natural
calamities, government regulation, unionization, airport
infrastructure constraints and safety concerns.
Oil Price Volatility:
Fuel price volatility continues to be one of the significant
challenges, as the cost of fuel is largely unpredictable. Fuel
prices, though high currently, remain well below the 2008 level of
over $140 per barrel that had ravaged the airlines industry. The
company's ability to pass along the increased costs of fuel to its
customers is limited by the competitive nature of the airline
industry. Thus, even a small change in fuel prices can
significantly affect profitability.
The airline business is labor intensive. Most of the employees are
unionized and depend on various U.S. labor organizations. The
relation between airlines and labor unions are governed by the
Railway Labor Act, which states that a collective bargaining
agreement between an airline and a labor union does not expire,
instead it becomes amendable as of a stated date. Failure to amend
terms and conditions suitably may lead to work stoppages or
strikes, and thereby hamper operations.
The airline industry is highly regulated, in particular by the
federal government. All airlines engaged in air transportation in
the U.S. are subject to the regulations implemented by the DOT.
Further, airlines are also regulated by the Federal Aviation
Administration, a division of the DOT, primarily in areas of flight
operations, maintenance and other safety and technical matters.
The airline industry has a lousy record of capacity discipline,
though it has largely been mindful of this issue in this cycle. It
remains to be seen how long the current trends remain in place
before old habits return.
Currently, we have a long-term Neutral rating on Delta Airlines,
United Continental Holdings, Southwest Airlines and JetBlue
supported by a Zacks #3 Rank (Hold).
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