The Airline Industry Has Its Ups and Downs

So far this year both demand for seats and for cargo space is up as the economic recovery, fragile and weak though it is, has businessmen traveling again and goods shipments rising. Business travel, of course, is the key to airline profits, since executive rear ends generally settle into profitable business- and first-class seats. Which is why the industry’s chiefs lose sleep after they hear talk of a double-dip recession that would ground business high flyers. For now, they are comforted by the fact that American consumers’ spending on travel is increasing at about twice the rate at which the overall economy is growing.

The industry’s current good fortune is due in part to the carriers’ willingness to keep the inventory of available seats from rising so that increased demand translates into higher fares. Orbitz, the travel web site, estimates that domestic fares in the U.S. are up about 20 percent compared with last year, and fares for international travel have jumped by 30 percent. And the Air Transport Association, an industry group, reckons that the cost per mile of air travel in July was the second-highest in a decade for that summer month.

The industry has also figured out a way to supplement fare- and cargo-income with a host of charges that, at least initially, had travelers more than a little annoyed. Which troubles major U.S. carriers not very much, since extra charges for food, drinks, baggage, flight changes, standby arrangements are generating millions in income. One of these charges — change-of-reservation fees — netted carriers about $600 million in the second quarter.  Want to change tickets: $50-$250, depending on the airline; board first, $9; sit in the first two rows of economy-class, $19-$39; a pillow and a blanket, $7. In Europe, Ryanair, the Irish low-fare airline, is phasing in a £1 ($1.50) charge for access to the toilets on 168 of its planes, and reducing the number of toilets to one-per-189 passengers.  Economists would say that this pay-for-what-you-get — we call it unbundling of charges — is efficient, just as Apple’s unbundling of individual songs from CDs gives consumers an option they have until now been denied. So long as most airlines play follow-the-leader and impose these charges, consumers can’t avoid them. Unless they fly on  Southwest, which trumpets in its television ads, “We love bags.”

So the industry has good reason for joy at its present circumstance, which it is attempting to maintain in three ways. First, keep costs down: Ryanair CEO Michael O’Leary, preparing to order 300 new aircraft, even asks, “Why does every plane have two pilots?” Second, there has been an industry-wide tacit agreement (after being sued for agreeing to fix cargo rates one hopes the industry is avoiding more explicit coordination) not to bring laid-up aircraft back into service. I say “has been” rather than “is” because this week British Airways announced that it is bringing two of its eight mothballed 747s back into service to meet rising demand on the London-New York route. It is impossible to tell at this early date whether that is a measured response to a recovering market, or the first step down the return road to overcapacity and unremunerative fares.

Third, the industry is engaged in significant restructuring. When United and Continental complete their merger, the resulting carrier will be America’s largest. It estimates cost savings of over $1 billion, which prompted Standard & Poor’s, apparently unaware of the history of over-estimates of savings from mergers, to raise its rating on UAL Corp., the airlines’ parent. BA chief Willie Walsh claims that his merger with Iberia will produce €400 million in savings within five years, and establish a launching pad for several other acquisitions, with perennially profitable Qantas believed to be in his sights, even though the Aussie carrier is having a less profitable run this year. And low-fare carrier Southwest, now serving 66 cities and finding its growth limited by the unavailability of slots at some airports, has thrown past conservatism to the winds and, if the competition authorities approve, will acquire AirTran, another discounter, for $1.4 billion. Cost savings are estimated to reach $400 million by 2013, but one-time integration costs could be as high as $500 million, especially if the pilots’ unions — separate ones for each of the merger partners — have difficulty solving the knotty question of seniority. After all, Southwest pilots have always insisted that they take precedence over pilots of acquired companies, which might strip AirTran pilots of some of the scheduling and other perks they now enjoy.         

Unfortunately, in this industry the present is never prologue. Even if cost savings and restructurings do work out as claimed, there are always those random events: volcanic ash, terror threats, environmentalists’ antipathy to air travel that can result in new regulations or, in the case of Britain, the coalition government’s scuppering of a third runway at over-used Heathrow airport.      

Then there are the ever-present factors that can cut into profits, or even turn black ink to red. IATA is already predicting profits will fall by 40 percent next year. Fuel accounts for about 25 percent of the industry’s total cost, and with profit margins of under 2 percent even in a good year, it won’t take much of a rise to wipe out margins, even if most airlines are hedging their bets. Unions are always poised to strike, as BA has learned, and with national austerity programs reducing government benefits, workers are likely to feel more hard-pressed than ever, which is why Spain’s workers marched off the job earlier this week, closing down air travel to and from that country. This inevitably affects air travel here, as delays at any major airport quickly cascade into system-wide delays. European airlines, which even this year will lose over $1 billion, face increasing competition from Dubai’s Emirates, Abu Dhabi’s Etihad, and Qatar Airways, all of which benefit from European export credits when they buy Airbus-built aircraft, a source of some irritation to Walsh who feels that Europe’s decision to grant his Middle Eastern competitors this special advantage is like shooting yourself in the foot. Workers at Airbus, of course, disagree.

In short, boom and bust probably will be with the airline industry for the foreseeable future, if not forever more. So investors who accept Frank Sinatra’s invitation to “come fly with me”, should decline to “glide starry-eyed.” When analyzing this industry, gimlet-eyed is safer.