The airline industry turned around in 2010, recording $16 billion in profits after losing $16 billion in 2008 and $9.9 billion in 2009. The rebound was faster than expected, driven by higher traffic and air travel demand. But this year, the ongoing market turmoil, natural calamities as well as rising fuel prices have stalled the recovery and hit hard the industry’s profitability.

In June, the International Air Transport Association (IATA) cut its 2011 overall profit outlook by a drastic 54% to $4 billion. This was the second IATA profit projection cut in the last six months, the first one being from $9.1 billion to $8.6 billion in March. The latest profit outlook represents a 75% decline from the 2010 industry profit.

Tougher conditions are unlikely to go away given the high fuel prices as well as the ongoing problems in Japan, North Africa and the Middle East. These could end up suppressing demand for air travel.

Fuel will account for 30% of the industry costs this year compared with 13% a decade ago. Persistently rising fuel prices since last December have become a major industry headwind. Jet fuel price averaged $3.08 per gallon in mid-August, 45% higher than the prior year. Since 50% of the industry’s fuel requirement was hedged at 2010 price levels, IATA estimates fuel expenses to increase by $10 billion to $176 billion this year. The recent pullback in crude oil prices is helpful, but it has yet to fully translate into lower jet fuel prices.

Worldwide air freight volumes bounced up to the 2008 peak level in 2010. This rebound was particularly apparent in Asia, where volumes were well above previous peak levels established in 2007. Air freight is expected to remain unchanged in 2011 due to increased capacity (from the year-ago level) and yield pressure as demand softens.

Regional Forecasts

According to IATA, the Asia-Pacific region is expected to generate $2.1 billion in profits in 2011, the highest in the industry, outstripping other regions. However, profit would decline substantially from the 2010 level of $10 billion. Despite strong economic growth in India and China, the Japan disaster and high fuel prices remain the key headwinds for the region’s profitability.

North American carriers are being challenged by steep fuel prices as well as old and less-fuel efficient aircraft. Regional profits will likely fall to $1.2 billion from $4.1 billion reported in 2010. Growth in Europe is also lagging due to the ongoing sovereign-debt crisis. European airlines’ profits are expected to reduce to $500 million in 2011 from $1.9 billion in 2010.

Profits from the Middle Eastern air carriers are expected to plummet to $100 million from $900 million earned in the prior year, owing to political instability in some parts. Latin American carriers would benefit from increased traffic, innovation and consolidation but would end up with a likely profit of $100 million, down from $900 million last year.

Only the African air carriers will likely generate a loss of $100 million in 2011. Political unrest, particularly in Egypt and Tunisia, is the major drag to the region’s profitability.

Fare Hikes & Capacity Cuts

Airline companies are raising fares and reducing capacity to control increased costs, weak demand and consequences of the massive earthquake and landslides in Japan.

The carriers have already raised their fares at least eight times this year. The increased ticket prices have so long been well adopted by travelers. So, the companies have been able to pass on higher fuel costs to its customers.

With respect to capacity cuts, second largest U.S. airline, Delta Air Lines (DAL) announced plans to trim its capacity by 5% post Labor Day and offered worker buyouts for the first time since 2009. The largest U.S. airline United Continental Holdings Inc. (UAL) has scrapped plans to boost capacity by 2% this year to keep it similar to 2010.

The low-cost carrier Southwest Airlines Co. (LUV) cut its capacity growth projection in the range of 4–5% from 6% while the discount U.S. carrier JetBlue Airways Corporation (JBLU) reaffirmed its capacity growth in the range of 6–8% for 2011.

According to IATA, overall capacity will expand 5.8% in 2011 compared with 4.4% in 2010. However, this capacity growth is lower than what was initially expected.

Hedging Strategies

Hedging strategies provide a cushion to the rising fuel prices.

Delta Air Lines is 45% and 55% hedged for the third and fourth quarters, respectively. United Continental hedged 51% of its expected consolidated fuel consumption for the remainder of the year using a combination of calls, swaps and collars.

JetBlue has hedged approximately 48% of the projected fuel requirement for the third quarter and 43% for fiscal 2011, with a combination of crude call options and collars, jet fuel swaps and heating oil collars. Southwest is 50% hedged for the remainder of the year through fuel derivative contracts at varying WTI crude-equivalent price levels.

OPPORTUNITIES

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 efficiency.

Ancillary Revenue: A number of supplementary revenue streams helped the airline industry gain ground in 2010 after two years of drought. The airline companies are enforcing fees on baggage, reservation change, pet travel, food and beverage to add further revenue streams in 2011. The IATA projects total revenue of $598 billion for 2011, up slightly from $565 million reported in 2010.

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 October 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 on May 2. The combination represents a unique opportunity for Southwest Airlines to expand its presence in key markets. Southwest gained a valuable market presence in Atlanta, the busiest airport in the U.S., post merger.

Technology Upgrades: 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 service.

WEAKNESSES

Overall, we expect the industry to post strong growth in the upcoming years. However, near-term risks remain. These include volatile fuel prices, economic weakness, the disaster in Japan, government regulation, unionization, airport infrastructure constraints and safety concerns. Some of the major risks are discussed below.

Oil Price Volatility: Airline operations are geared toward aviation fuel prices, a major variable cost. Oil prices have pulled back in recent days as concerns about the health of the U.S. economic recovery have increased. But they nevertheless remain high. More importantly, the recent pullback has not yet fully seeped down into lower prices for most refined products, including jet fuel.

Since airline companies have limited ability to pass on increased costs of fuel to their customers, they must ensure that their profits absorb the impact. In order to offset the loss from high oil prices, airlines are levying additional fees and charges on customers. Hedging strategies could also be profit protection tools, and will be used extensively.

Unionization: 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, hampering operations.

Federal Regulations: The airline industry is highly regulated, particularly by the federal government. All airlines engaged in air transportation in the U.S. are subject to regulations implemented by the Department of Transportation (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.

Capacity Creep: The airline industry has a lousy record of capacity discipline, though they have largely been mindful of this issue in this cycle. It remains to be seen how long 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.
 
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