Can_better_management_save_the_old_line

Vaughn Cordle, CFA / September 9, 2005

The spike in fuel costs and crack spreads is expected to drive additional bankruptcies. Delta
Airlines, Independence Air, and NWAC are bankruptcy candidates; US Airways, United, and ATA
Holdings are already in bankruptcy.

There is a widely-held belief that if these airlines simply had better management they would not
fail. The assumption is that management is all-powerful and can turn around any company in
trouble. This is a flawed assumption, in my view, because it ignores the differences in capital
structure, age of the airline, labor cost differentials, plunge in yields, and spike in fuel costs. These
are the real drivers of airline financial performance.

Even Herb Kelleher of Southwest Airlines, arguably the best airline manager, cannot save these
airlines from financial failure. All of the airlines are performing adequately in terms of providing
customers safe and on-time air transportation.

The older and slow-growing airlines have higher costs. In addition, it is the cost of capital and
labor that separates today's potential winners and losers. I say “potential” winners because only a
few airlines will be reporting a profit this year and next.

The potential to earn superior results has everything to do with the number of competitors, the
price of fuel, the cost of labor, the level of taxes, and the price elasticity of demand . The elasticity
will reflect air travel substitutes, travel alternatives, and the strength of the economy. The number
of competitors and capacity in the system will affect the intensity of rivalry and drive fare levels.

Management competency is critical in terms of how the company positions itself competitively, and
manages human and physical capital. Managing company culture, marketing, scheduling, pricing,
and providing a competitive product is what management is all about in the airline industry.

However, not even Jack Welch, the greatest CEO of all time, could earn a normal profit in the
airline industry, given today's conditions.

Historically, the airlines have always lost money when GDP growth was below 2.5 percent, and
made money when it was greater than 4 percent . The difference between $20 oil and $5 crack
spreads, and $68 oil and $17 crack spreads is $22 billion.
The price of a barrel of jet fuel rose to $100 during the second week of September because of
Hurricane Katrina’s impact on refinery production. It averaged $25 during the 1990 to 2004 period.

AirlineForecasts is estimating industry revenue for the top 13 major airlines to be $104 billion in
2005. Moreover, if the industry had the same yields today that it had in 2000; revenue would be
$23 billion higher. Load factors and traffic will fall with higher fares, so this figure is somewhat
inflated. Yields are a proxy for average fares.

The point is that yields and unit revenue are more than 20 percent lower this year than they were
five years ago. There are plenty of reasons for this, most of which have nothing to do with
management's ability to run an airline. Management and a coherent strategy are critical; however,
plunging yields and spiking fuel costs are, for the most part, outside of management’s control.
Management can raise fares and hedge fuel, but not to the degree required, given the current
industry fundamentals.

The industry is on track to lose close to $6 billion this year, and if oil and crack spreads were the
same as they averaged over the 1985–2004 period, the industry would be highly profitable—$17
billion in profits and 9.6 percent net margins. USAir, UAL, NWAC, and DAL would be making
money, and bankruptcy would not be an issue. Moreover, if 9-11 had not happened, we would not
have security travel hassles and their negative impact on demand and earnings.

It is easy to say that JetBlue and Southwest have superior management. Yet neither is earning
their true cost of capital . Take away the benefits of fuel hedging, and factor in stock option
expenses, and Southwest is losing money. If fuel costs stay as high as the NYMEX forward curve
implies, JetBlue will also lose money in 2006.

The macroeconomic forces and industry fundamentals have overwhelmed management's ability
to earn a normal rate of return in the airline industry. The vast majority of these factors and forces
have nothing to do with management capability.

In the case of half of the industry's capacity, bankruptcy is best place for the workouts, because it is
the only way to shed debt and lower costs. The capital structure of the industry is not sustainable,
given the revenue environment and its cost. This cost and structure is a function of past earnings
retention, past growth decisions, and the age of the company. Earnings retention has primarily
been a function of union power and labor costs. Moreover, it is a function of the industry's tendency
to grow capacity too fast for its own good.

In terms of magnitude and priority, spiking fuel costs, bad industry fundamentals, and the low fare
environment are more than management can handle. The best management can do is
restructure in a way that gives the airline a chance to survive if and when fuel costs come down
and industry capacity is reduced.Simply reducing one's own capacity is a poor long-term strategy
and an inadequate solution. Pulling down capacity is a forced response to industry fundamentals
that overwhelm the company's resources and management's ability to raise capital at acceptable
costs.

Can management save the airlines, given a low-yield and high-fuel-cost world? A reasonable
answer is that it depends on how successful they are in terms of shedding debt, restructuring
costs, and dealing with unions. For most of our old-line airlines, this is exceptionally difficult to do
outside of bankruptcy.

In a war of attrition, the airlines with the deepest pockets and lowest costs win. Southwest Airlines
has the deepest pockets of all.