©Copyright 2010 AirlineForecasts, LLC / All Rights Reserved
Revenues Are Strong, But Myriad Factors Continue
To Work Against Airline Industry
By Carol Ward / Airport Revenue News (ARN) / December 2010
Washington, D.C.-based AirlineForecasts is one of the nation’s foremost research and analysis
firms for the aviation industry. AirlineForecasts provides independent industry assessments,
forecasts, and airline valuations. The firm’s primary focus is to stay two steps ahead of the market
by forecasting and analyzing the fundamental factors and forces that shape the industry and drive
investment decision making.
Vaughn Cordle, managing partner and chief analyst for AirlineForecasts, conducts in-depth
analysis of the entire U.S. airline industry, including assessments of the latest mergers and
acquisitions, regulatory changes, individual airline balance sheets and myriad other factors that
contribute to the overall health of the industry. Cordle recently spoke with ARN’s Carol Ward to
discuss the airline industry’s plans and challenges for the coming year.
ARN: Let’s start with the political landscape, given that in 2011 we will have a much stronger
Republican presence in the U.S. government. Can you give me a broad-based look of how that will
impact consolidation efforts or other airline strategies, as well as aviation funding?
Cordle: One of the big issues is proposed sunset provisions that [Representative James] Oberstar
[of Minnesota] had made in terms of the international joint ventures and alliances for airlines.
Oberstar, an 18-term Democrat who just lost office, wanted alliances and joint ventures to sunset in
three years. It’s likely that’s dead now. I view alliances as positive -- they can benefit the consumer
because of cost synergies and ability to offer more flights around the world. Oberstar tried to block
mergers, limit foreign ownership of U.S. airlines, restrict maintenance outsourcing overseas, and
end global alliances with antitrust immunity. And, he attempted to facilitate the unionization of
FEDX. He will not be missed by the airlines.
With a Republican-controlled House and greater influence in the Senate, one of the regulatory
changes that makes perfect sense to me is a relaxation on crossed border investments. The
alliances simply divvy up the world’s market in a rational sense that better manages supply and
demand so these airlines and their investors can get a rate of return that sustains that investment
and keeps that capital coming. If they don’t, capital goes away.
Another big issue is the FAA reauthorization bill and funding for the trust fund. As fares have fallen
in real terms, the revenue for the FAA trust fund, which is a function of government fees on those
average fares, has gone down, but at the same time, government costs have gone up. About 90%
of the FAA’s cost and ATC costs are labor. You have a bloated bureaucracy with too high a
headcount and no political will to reduce the labor cost and improve productivity. It’s a problem that
may be resolved by a greater influence of the Republicans in the House and Senate.
ARN: Do you anticipate that Next Generation (NextGen) air navigation system will get funding to
move forward at a faster rate?
Cordle: It’s going to require tens and billions of dollars being spent over the next decade or so.
Just for aircraft alone, to upgrade the current U.S. fleet is probably in the $2B - $4B range. Who’s
going to pay for that? Is this government going to mandate it? There are two other potential costs
in the pipeline. Security right now costs the industry $2B a year. The White House budget has a
security cost going up an additional $240M by 2012 and its up by $2.7B in 2014. That has to be
imposed on the industry. If reauthorization is passed, airports will require the airlines to collect an
additional $2B in passenger facility charges. There is, potentially, much higher cost in terms of
higher user fees to fund the FAA trust fund, which has a huge and growing gap between cash
outlays and cash inlays.
ARN: There has also been discussion of taxing ancillary revenues for airlines, correct?
Cordle: Baggage fees amounted to $3.1 billion for the 20 U.S. airlines in the 4 quarters ending
June 2010 [Table 1]. The government could argue that any fees or charges that were associated
with travel from A to B should incur that same 7.5% segment fee that is charged on fares now.
Table 1:
ARN: What about Southwest Airlines’ position of not charging baggage fees? Is that hurting or
helping their competitive position?
Cordle: The network airlines have been losing share to Southwest. It’s a small loss to each but
when you aggregate it up, it’s brought in $1B [in the first half of 2010] for Southwest. [With the
baggage fees] the fare differential is quite substantial. The average fare for the industry is $340,
but that is a high fare average relative to what Southwest, JetBlue, Spirit, and AirTran charge. They
account for about 25% of the market share. In Southwest dominated markets – Baltimore, [Chicago]
Midway and five or six others – I find that those fare levels are 25% lower than the average
industry fare which is close to the average fair in Atlanta. With the AirTran deal, if Southwest goes
into Atlanta, for example, and offers a fare in new markets that’s roughly 25% lower than Delta’s,
over time I think it’s reasonable to assume they’ll pick up traffic. The consumer benefits as Delta
fights to maintain its dominate share in Atlanta
ARN: Average fares have risen significantly this year. Do you expect that to continue?
Cordle: Yes, but it’s an eye-opener to see these in inflation-adjusted terms. Remember, $1 in
2000 is worth $1.25 in 2010 dollars. The average fare in the second quarter was $340, according
to BTS [Bureau of Transportation Statistics, a division of the U.S. Department of Transportation].
That’s up almost 14% from last year, but still more than 20% lower than a decade ago in inflation
adjusted terms. There’s a reason airlines reported $68 billion in losses over the last decade. There
has been an alarming and massive amount of wealth destruction in this industry. Airlines are also
facing higher costs. When we go into next year, I’m projecting a revenue increase over 2010 that’s
only going to be 3%- 4%.
ARN: Those higher costs are mainly for labor, correct? And possibly fuel cost increases?
Cordle: Fuel and labor cost account for 50% to 60% of the total cost of an airline. If you look at the
wage increases that labor currently expects at each one of the network airlines, those higher
expected labor cost would reduce those earnings anywhere from 50% to over 100%. And oil prices
are expected to rise. So, every ten-dollar swing in the price of oil costs the industry $3.2 billion for
the top 13 airlines [Table 2]. These airlines are expected to earn a [mid-point estimate] of $5
billion in 2011, so a $10 swing in oil price completely wipes out 60% of the profits, all else held
constant. Now, add labor cost to that, another $3 billion dollars. Airlines will have no choice but to
pass these costs along to the consumer. Luckily, the mergers allow the airlines to consolidate
operations and accommodate the drop off in demand as fares increase.
Table 2:
ARN: Let’s talk about the mergers. Delta Air Lines and Northwest Airlines started it all, at least the
latest round, and then Continental Airlines and United Airlines and now Southwest and AirTran.
How do you expect those to play out?
Cordle: With mergers come a higher concentration and better management of supply [seat
capacity] and passenger demand. We measure the market power with a methodology called the
Herfindahl Index (HHI). In the U.S. airline industry only, excluding international segments, that
market power as measured by the HHI more than doubles with all the mergers that have occurred
over the last two years. In the U.S. market there were too many airlines competing away their
profitability. The industry lost $68 billion in inflation-adjusted terms over the last decade, about
5.5% of revenue, due to excess capacity.
We estimated that excess capacity to be around 7.8% for the six (6) network airlines, but only about
1.6% for the seven low cost airlines. Network carriers had a load factor for the ten years of 78% on
average, but they needed a load factor of 85% just to break even. When you keep too much supply
in the system, you don’t have the pricing power to cover your true cost of capital. With the mergers
and consolidations the industry is able squeeze out that excess capacity. The year before the
credit bubble popped in early 2008, the industry had a HHI of less than 900. Anything below 2,000
means there is no pricing power. With the Delta-Northwest merger, the Continental-United merger,
and now the Southwest-AirTran merger, we have a HHI that’s over 2,000. It’s still not high enough
to stop fare competition so consumers will still enjoy competitive fares.
ARN: Going forward, is it now a matter of constraining capacity as demand continues to increase?
Cordle: That and taking advantage of the cost synergies that come with the mergers. This year
alone Delta’s on track to produce $1.5 billion in additional revenue which they would not have
produced without the merger, and $2 billion by next year. They just announced a $300 million profit
share for labor. Part of the savings can go into lower fares. We’re seeing that Delta is taking their
cost synergies and translating that out into a little more capacity. So cost synergies, because of the
mergers, can translate into lower average fares and/or additional capacity. That being said, I think
that the revenue synergies that the airlines are estimating for the mergers is overstated. Some of it
will be competed away overtime as airlines like Delta focus on market share gain as opposed to
higher profits.
ARN: But then there is the danger of adding too much capacity, and losing pricing power….
Cordle: Correct. For the month of October, Delta had a load factor that went negative year over
year. But a problem going forward -- and one of the reasons capacity discipline will be maintained
-- is that the airlines have a capital structure that’s worse than at the end of any major business
cycle since World War II. In 2000, when we had a recession after that NASDAQ bubble popped, the
top 12 airlines had about 28% of [book] equity on their balance sheet. As of the latest quarter
[Q3], equity only represents 1.1% of those total assets. Not all airlines are created equal.
Southwest has excess equity on the balance sheet, close to 40% of total assets. At the other end of
the spectrum is American Airlines. They have a negative 27% of their total assets. They’re going
to lose $300 - $400M this year, in an industry that we project will earn about $2.9B this year and
about $5B next year.
ARN: American then would seem ripe for some sort of merger. Do you anticipate that happening?
Cordle: American Airlines probably needs to go through the carwash of a bankruptcy, but that may
not occur until the next downturn in the economy or a spike in fuel. If these airlines start losing
money again, that provides great incentive for American and US Airways to merge or to look
around for a partner so they too can gain $1B-$2B in synergies. Also, if the government relaxed
restrictions on cross border investments then American Airlines has a beautiful domestic operation,
although it’s a very high-cost operation. American has a cost structure that’s 10% higher than the
groups of high-cost network airlines. They’ve got huge pension deficits, huge liabilities for
healthcare cost, and a labor cost disadvantage that’s over $600 million. If they tried to compete on
fares to not lose market share, they lose a lot of money. If they raise fares to cover the true cost,
they tighten the downward spiral in market share loss. They lose either way. But if the government
allows cross border investment, guess what? A strong foreign entity would like to tap in to the U.S.
domestic market and American is in a great position to take advantage.
ARN: What about mergers among low-cost carriers?
Cordle: I believe there will be more mergers in the low cost sector and the commuter sector. There
are 25 regional commuters that feed the network airlines. The regional sector accounts for about
13.5% of the total capacity in the U.S. and there are too many players. It’s already occurred, and it’
s continuing. There is more to come, much more. I also expect a further consolidation in the low-
cost sector because many of these airlines are simply too small [on their own]. Virgin America,
JetBlue, Spirit, Frontier -- these are small entities. I think they need to be rolled up if they are to
sustain shareholder support for the longer-term. All should be profitable next year if fuel costs do
not spike and the economy continues to expand.
To Work Against Airline Industry
By Carol Ward / Airport Revenue News (ARN) / December 2010
Washington, D.C.-based AirlineForecasts is one of the nation’s foremost research and analysis
firms for the aviation industry. AirlineForecasts provides independent industry assessments,
forecasts, and airline valuations. The firm’s primary focus is to stay two steps ahead of the market
by forecasting and analyzing the fundamental factors and forces that shape the industry and drive
investment decision making.
Vaughn Cordle, managing partner and chief analyst for AirlineForecasts, conducts in-depth
analysis of the entire U.S. airline industry, including assessments of the latest mergers and
acquisitions, regulatory changes, individual airline balance sheets and myriad other factors that
contribute to the overall health of the industry. Cordle recently spoke with ARN’s Carol Ward to
discuss the airline industry’s plans and challenges for the coming year.
ARN: Let’s start with the political landscape, given that in 2011 we will have a much stronger
Republican presence in the U.S. government. Can you give me a broad-based look of how that will
impact consolidation efforts or other airline strategies, as well as aviation funding?
Cordle: One of the big issues is proposed sunset provisions that [Representative James] Oberstar
[of Minnesota] had made in terms of the international joint ventures and alliances for airlines.
Oberstar, an 18-term Democrat who just lost office, wanted alliances and joint ventures to sunset in
three years. It’s likely that’s dead now. I view alliances as positive -- they can benefit the consumer
because of cost synergies and ability to offer more flights around the world. Oberstar tried to block
mergers, limit foreign ownership of U.S. airlines, restrict maintenance outsourcing overseas, and
end global alliances with antitrust immunity. And, he attempted to facilitate the unionization of
FEDX. He will not be missed by the airlines.
With a Republican-controlled House and greater influence in the Senate, one of the regulatory
changes that makes perfect sense to me is a relaxation on crossed border investments. The
alliances simply divvy up the world’s market in a rational sense that better manages supply and
demand so these airlines and their investors can get a rate of return that sustains that investment
and keeps that capital coming. If they don’t, capital goes away.
Another big issue is the FAA reauthorization bill and funding for the trust fund. As fares have fallen
in real terms, the revenue for the FAA trust fund, which is a function of government fees on those
average fares, has gone down, but at the same time, government costs have gone up. About 90%
of the FAA’s cost and ATC costs are labor. You have a bloated bureaucracy with too high a
headcount and no political will to reduce the labor cost and improve productivity. It’s a problem that
may be resolved by a greater influence of the Republicans in the House and Senate.
ARN: Do you anticipate that Next Generation (NextGen) air navigation system will get funding to
move forward at a faster rate?
Cordle: It’s going to require tens and billions of dollars being spent over the next decade or so.
Just for aircraft alone, to upgrade the current U.S. fleet is probably in the $2B - $4B range. Who’s
going to pay for that? Is this government going to mandate it? There are two other potential costs
in the pipeline. Security right now costs the industry $2B a year. The White House budget has a
security cost going up an additional $240M by 2012 and its up by $2.7B in 2014. That has to be
imposed on the industry. If reauthorization is passed, airports will require the airlines to collect an
additional $2B in passenger facility charges. There is, potentially, much higher cost in terms of
higher user fees to fund the FAA trust fund, which has a huge and growing gap between cash
outlays and cash inlays.
ARN: There has also been discussion of taxing ancillary revenues for airlines, correct?
Cordle: Baggage fees amounted to $3.1 billion for the 20 U.S. airlines in the 4 quarters ending
June 2010 [Table 1]. The government could argue that any fees or charges that were associated
with travel from A to B should incur that same 7.5% segment fee that is charged on fares now.
Table 1:
ARN: What about Southwest Airlines’ position of not charging baggage fees? Is that hurting or
helping their competitive position?
Cordle: The network airlines have been losing share to Southwest. It’s a small loss to each but
when you aggregate it up, it’s brought in $1B [in the first half of 2010] for Southwest. [With the
baggage fees] the fare differential is quite substantial. The average fare for the industry is $340,
but that is a high fare average relative to what Southwest, JetBlue, Spirit, and AirTran charge. They
account for about 25% of the market share. In Southwest dominated markets – Baltimore, [Chicago]
Midway and five or six others – I find that those fare levels are 25% lower than the average
industry fare which is close to the average fair in Atlanta. With the AirTran deal, if Southwest goes
into Atlanta, for example, and offers a fare in new markets that’s roughly 25% lower than Delta’s,
over time I think it’s reasonable to assume they’ll pick up traffic. The consumer benefits as Delta
fights to maintain its dominate share in Atlanta
ARN: Average fares have risen significantly this year. Do you expect that to continue?
Cordle: Yes, but it’s an eye-opener to see these in inflation-adjusted terms. Remember, $1 in
2000 is worth $1.25 in 2010 dollars. The average fare in the second quarter was $340, according
to BTS [Bureau of Transportation Statistics, a division of the U.S. Department of Transportation].
That’s up almost 14% from last year, but still more than 20% lower than a decade ago in inflation
adjusted terms. There’s a reason airlines reported $68 billion in losses over the last decade. There
has been an alarming and massive amount of wealth destruction in this industry. Airlines are also
facing higher costs. When we go into next year, I’m projecting a revenue increase over 2010 that’s
only going to be 3%- 4%.
ARN: Those higher costs are mainly for labor, correct? And possibly fuel cost increases?
Cordle: Fuel and labor cost account for 50% to 60% of the total cost of an airline. If you look at the
wage increases that labor currently expects at each one of the network airlines, those higher
expected labor cost would reduce those earnings anywhere from 50% to over 100%. And oil prices
are expected to rise. So, every ten-dollar swing in the price of oil costs the industry $3.2 billion for
the top 13 airlines [Table 2]. These airlines are expected to earn a [mid-point estimate] of $5
billion in 2011, so a $10 swing in oil price completely wipes out 60% of the profits, all else held
constant. Now, add labor cost to that, another $3 billion dollars. Airlines will have no choice but to
pass these costs along to the consumer. Luckily, the mergers allow the airlines to consolidate
operations and accommodate the drop off in demand as fares increase.
Table 2:
ARN: Let’s talk about the mergers. Delta Air Lines and Northwest Airlines started it all, at least the
latest round, and then Continental Airlines and United Airlines and now Southwest and AirTran.
How do you expect those to play out?
Cordle: With mergers come a higher concentration and better management of supply [seat
capacity] and passenger demand. We measure the market power with a methodology called the
Herfindahl Index (HHI). In the U.S. airline industry only, excluding international segments, that
market power as measured by the HHI more than doubles with all the mergers that have occurred
over the last two years. In the U.S. market there were too many airlines competing away their
profitability. The industry lost $68 billion in inflation-adjusted terms over the last decade, about
5.5% of revenue, due to excess capacity.
We estimated that excess capacity to be around 7.8% for the six (6) network airlines, but only about
1.6% for the seven low cost airlines. Network carriers had a load factor for the ten years of 78% on
average, but they needed a load factor of 85% just to break even. When you keep too much supply
in the system, you don’t have the pricing power to cover your true cost of capital. With the mergers
and consolidations the industry is able squeeze out that excess capacity. The year before the
credit bubble popped in early 2008, the industry had a HHI of less than 900. Anything below 2,000
means there is no pricing power. With the Delta-Northwest merger, the Continental-United merger,
and now the Southwest-AirTran merger, we have a HHI that’s over 2,000. It’s still not high enough
to stop fare competition so consumers will still enjoy competitive fares.
ARN: Going forward, is it now a matter of constraining capacity as demand continues to increase?
Cordle: That and taking advantage of the cost synergies that come with the mergers. This year
alone Delta’s on track to produce $1.5 billion in additional revenue which they would not have
produced without the merger, and $2 billion by next year. They just announced a $300 million profit
share for labor. Part of the savings can go into lower fares. We’re seeing that Delta is taking their
cost synergies and translating that out into a little more capacity. So cost synergies, because of the
mergers, can translate into lower average fares and/or additional capacity. That being said, I think
that the revenue synergies that the airlines are estimating for the mergers is overstated. Some of it
will be competed away overtime as airlines like Delta focus on market share gain as opposed to
higher profits.
ARN: But then there is the danger of adding too much capacity, and losing pricing power….
Cordle: Correct. For the month of October, Delta had a load factor that went negative year over
year. But a problem going forward -- and one of the reasons capacity discipline will be maintained
-- is that the airlines have a capital structure that’s worse than at the end of any major business
cycle since World War II. In 2000, when we had a recession after that NASDAQ bubble popped, the
top 12 airlines had about 28% of [book] equity on their balance sheet. As of the latest quarter
[Q3], equity only represents 1.1% of those total assets. Not all airlines are created equal.
Southwest has excess equity on the balance sheet, close to 40% of total assets. At the other end of
the spectrum is American Airlines. They have a negative 27% of their total assets. They’re going
to lose $300 - $400M this year, in an industry that we project will earn about $2.9B this year and
about $5B next year.
ARN: American then would seem ripe for some sort of merger. Do you anticipate that happening?
Cordle: American Airlines probably needs to go through the carwash of a bankruptcy, but that may
not occur until the next downturn in the economy or a spike in fuel. If these airlines start losing
money again, that provides great incentive for American and US Airways to merge or to look
around for a partner so they too can gain $1B-$2B in synergies. Also, if the government relaxed
restrictions on cross border investments then American Airlines has a beautiful domestic operation,
although it’s a very high-cost operation. American has a cost structure that’s 10% higher than the
groups of high-cost network airlines. They’ve got huge pension deficits, huge liabilities for
healthcare cost, and a labor cost disadvantage that’s over $600 million. If they tried to compete on
fares to not lose market share, they lose a lot of money. If they raise fares to cover the true cost,
they tighten the downward spiral in market share loss. They lose either way. But if the government
allows cross border investment, guess what? A strong foreign entity would like to tap in to the U.S.
domestic market and American is in a great position to take advantage.
ARN: What about mergers among low-cost carriers?
Cordle: I believe there will be more mergers in the low cost sector and the commuter sector. There
are 25 regional commuters that feed the network airlines. The regional sector accounts for about
13.5% of the total capacity in the U.S. and there are too many players. It’s already occurred, and it’
s continuing. There is more to come, much more. I also expect a further consolidation in the low-
cost sector because many of these airlines are simply too small [on their own]. Virgin America,
JetBlue, Spirit, Frontier -- these are small entities. I think they need to be rolled up if they are to
sustain shareholder support for the longer-term. All should be profitable next year if fuel costs do
not spike and the economy continues to expand.
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