"The next wave of airline bankruptcies"

Friday, July 9, 2004

Jubak's Journal
The next wave of airline bankruptcies
Competition with low-cost carriers is only going to get fiercer. US
Airways and Delta look vulnerable, Continental is on the bubble and even
Southwest may not be safe.
By Jim Jubak
CNBC-TV


There's a dogfight in the skies over Europe, and the outcome of the
battle very well could foretell the future of the airline industry in
the United States. The continent is now home to more than 50 low-cost
carriers, including Wizz Air, Snowflake, VolareWeb, Air Polonia, Now and
SkyEurope. And, of course, Easyjet and Ryanair Holdings, the most
successful of the bunch.

With so many players, no one is surprised that five newcomers have gone
bust recently. And airline analysts expect more to exit the business
this winter.

What surprised analysts, however, was the Jan. 28 earnings warning from
Ryanair. Earnings for the fiscal year ending in March 2004 would be 10%
below earnings for fiscal 2003 and 20% below earlier projections for
fiscal 2004, management said.

Investors, reeling in shock, asked "How is this possible?" and drove
down Ryanair's share price by 30% in just one day. After all, Ryanair
and its neck-and-neck competitor Easyjet together dominate the
intra-Europe low-cost market with a joint share of 58%, according to
Credit Swiss First Boston. And the number of passengers flying low-cost
airlines intra-Europe has grown at a compounded 38% annually over the
last eight years.

The problem was that all that competition, even the competition from
failing competitors, was forcing fares lower faster than even Ryanair
could cut costs. The company estimated that the average fare would fall
by 20% to 30% in the March quarter of 2004.

Informed consumers and too many seats

Things have become both better and worse since Ryanair warned. Fares and
profit didn't drop as much as the company predicted in January. But the
price war that began last winter has extended into the summer season
when airlines earn most of their profit and will extend into the winter.
Ryanair is now predicting a 20% drop in fares for fiscal 2005 from the
fiscal 2004 level.Check out your options.

The problem is too much supply of a commodity that, thanks to the
Internet, is driven by price-sensitive customers.

No one expects supply to drop much, even if more low-cost carriers go
broke this winter. In the current aviation market, planes are just so
cheap and money so easy to raise either from equity investors or from
airplane-leasing companies that it seems that just about any management
group with some airline experience can start a new carrier. 

Europe's high-cost majors are fighting back, too, giving ground in the
short-haul market only grudgingly. Many are in fact trying to build
traffic in advance of the delivery of the new Airbus 380 with its higher
passenger capacity.

5 rules for a free-for-all

So here are the five characteristics which, from the evidence of the
European example, define the dynamics of the low-cost airline industry:

   Average fares will continue to fall under the pressure of continued
surplus supply.

   Since air travel is a commodity, airlines have no ability to raise
prices based on quality or brand.

   Continued revenue growth depends on the continued ability of low
prices to attract new travelers and on taking share from higher-cost,
established competitors.

   Profit growth depends on revenue growth outrunning price declines.

   Profit margin growth depends on the ability of carriers to increase
the percentage of seats they fill on each flight (tough in times of
excess supply and further price cuts) and to cut costs further.

This kind of free-for-all will lead ultimately to the demise of many of
the established high-cost majors. There is simply no way that a mature
company can cut its costs to match those of a startup. 

Why the majors can't compete

Sure, the European majors can match Ryanair by removing the seatback
pockets in its planes because they increase cleaning time, but they
can't lower the wages of experienced pilots and maintenance workers to
match the entry-level salaries at low-cost carriers. They operate at a
serious cost disadvantage to the low-cost carriers on benefits as well.
A startup doesn't have to pay any retirement costs because it doesn't
have any workers with enough seniority to retire. Contrast that with an
established carrier that has to wage a bloody battle just to reduce
pension costs. 

But winning this free-for-all doesn't offer the survivors any security.
Since entering the business is so easy, the survivors constantly face
new competitors. Some of these drop by the wayside relatively quickly
because they are underfinanced or incompetently run. But others gain at
least initial success and threaten to devour older survivors. 

Because air travel has become a commodity, carriers can't use their
brands to defend market share. Because pricing information is so readily
available, increasing market visibility isn't an effective way to defend
market share. Any company with enough financing can offer prices low
enough to win market share almost instantly. And as the survivors age,
they gradually become vulnerable on the cost front to startups which,
again, don't pay the higher salaries that workers with seniority command
or face the higher benefit costs that come with worker seniority.

Same forces at play in the United States

You can see this at work right now in the U.S. low-cost air industry,
where newcomer JetBlue Airways (JBLU, news, msgs) has taken the
lowest-cost trophy away from the older Southwest Airlines (LUV, news,
msgs). In 2003, the cost per seat mile at JetBlue was just 6.1 cents
versus 7.5 cents at Southwest, according to Merrill Lynch.

But both show a huge edge over the established carriers. In 2003,
despite heroic efforts, cost per seat mile at American Airlines was
still 10.1 cents, lower than the 11.1 cents in 2001 but still badly
trailing Southwest and JetBlue. Continental Airlines (CAL, news, msgs)
costs stood at 9.7 cents, making it the lowest-cost airline among the
major established carriers. Delta Air Lines' (DAL, news, msgs) costs
stood at 10.6 cents, and US Airways' at 11.5 cents.

Add this to another number and you can see the true extent of the
trouble that the established carriers face. Not only is JetBlue's cost
lower, but its planes are fuller. The load factor -- that's the
percentage of seats filled with passengers -- at JetBlue in 2003 was a
whopping 84.5%. At Delta, it was just 74.3% and just 73.3% at US Airways
Group.

Low prices create unit sales in a commodity business, and low unit costs
turn those sales into profits.

Which U.S. airlines are now at risk, according to this model? US
Airways, with its declining market share and high costs, is under direct
assault by low-cost carriers who smell blood. The company is in its
third round of labor negotiations in two years in an effort to cut
costs. Delta will probably go into bankruptcy to cut costs if it can't
win major concessions from its pilots in negotiations. Continental
should be OK if air travel continues to recover, but the airline has
very few unencumbered assets that it can use to secure additional
financing if something does go wrong.

United Airlines' costs are still way, way too high. Although cost per
seat miles declined to 10.5 cents in 2003 from 11.4 cents in 2002,
thanks to cost-cutting, that's at the high end for the established
carriers. In addition, United parent UAL Corp. faces a huge $4 billion
in unfunded pension liabilities due by 2008. With its market share and
route network, United is almost certain to get the funding it needs to
emerge from bankruptcy, but don't be surprised to see the airline back
in bankruptcy protection within a few years. 

The American Airlines unit of AMR Corp. has made the most progress in
lowering costs of any of the majors, although it also had some of the
highest costs before the cuts. Cost per seat mile fell to 10.1 cents in
2003 from 11.1 cents in 2001. If air traffic continues to pick up, AMR
could run in the black in the June and September quarters and for all of
2005.

The most interesting case is Southwest. The company has managed to keep
costs per seat mile steady since 2001 at 7.5 cents. But thanks to recent
expansion into new markets, the carrier's load factor was just 66.8% in
2003. That should rebound as new markets build traffic. But if it
doesn't, it will show that the challenge from the newer low-cost
carriers may be more serious than anyone now thinks. 

It's clear the new low-cost carriers are taking share from the
established airlines. The jury is still out on what effect they are
having on Southwest.

Challenging the establishment

The five characteristics that I used to define the dynamics of the
European low-cost air travel market apply to the future of other
industries that sell commodity products as well. In an industry like
that, companies must run as fast as they can just to stay in place.
Price pressure from new entrants to the industry with lower costs are a
constant threat. 

Since part of those lower costs is simply a result of newness, investors
in these sectors need to reverse the conventional wisdom that gives the
edge to the established companies in that market. 

The established nature of these companies may put them at a cost
disadvantage, and the Internet-enabled price sensitivity of these
commodity industries may minimize any advantage that comes with
longevity.


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