Flying The Unfriendly Skies
Brian Deagon , On Friday January 29, 2010, 7:53 pm EST

Buffeted by a decade of terrorism, endemic influenza, volatile fuel prices and two economic downturns, the airline industry is hoping for smoother skies in 2010.

The International Air Transport Association last Wednesday said airlines suffered the largest-ever decline in passenger demand in 2009, down 3.5% despite a 4.5% year-over-year jump in December traffic.

Passenger revenue among leading U.S. airlines fell 4% in December vs. the same month a year ago, the 14th consecutive monthly decline, according to the Air Transport Association of America. For the year, U.S. passenger revenue declined 18%, the biggest drop on record, exceeding the 14% decline in 2001.

That plunge stemmed from a 6% decline in passengers and a 13% decline in the average price paid to fly one mile.

Airlines aren't out of the clouds just yet, but the outlook is brighter. Carriers have reduced capacity and cut jobs over the past two years to offset declining travel because of the recession. They also got some relief from lower fuel prices in the second half of 2009.
Vaughn Cordle, an analyst with AirlineForecasts, said U.S. airline revenue declined about 17% in 2009 from 2008 but should grow 7% to 9% in 2010.

"Business travel is coming back and with capacity coming out of the system, the industry has the opportunity to get load factors and yields up," which will boost profit, Cordle said.

1. Business
Simply put, the airline industry is all about filling enough seats to fly planes at 80% capacity or better.

To reach that level in a depressed economy, airline companies have been reducing the number of planes in their inventory and the frequency of flights. Globally in 2009, airlines cut the frequency of flights 3% and routes flown 8%.

As a sign of growing confidence, airlines worldwide have been adding more flights and seat capacity in recent months.

Globally, available seats rose 3% to 294.6 million in January from a year ago, with 2.37 million flights scheduled, up 2%, according to OAG Aviation Solutions. It was the fifth consecutive month in which airline capacity has shown growth. For low-cost airlines such as Southwest Airlines (NYSE:LUV - News) and JetBlue Airlines (NasdaqGS:JBLU - News), frequency and capacity rose 10% in January from a year ago.

"It's a sign that demand is increasing," said Mario Hardy, OAG analyst and vice president of UBM Aviation.

Unlike recoveries of times past, though, airlines have been more cautious in the amount and pace of capacity increases.

"During any sign of recovery in the past they put back a greater amount of capacity than they have this time," said Hardy. "Now they're very cautious, adding capacity gradually and slowly, and are really watching the market. It is a wise strategy, which should help them manage better yields as the economy recovers."

In January, U.S. airlines actually trimmed total flights 2.7% and seat capacity 2.8%, boosting profits.

In December, Continental Air-lines (NYSE:CAL - News) increased its load factor to 83%, up 3.1% from a year ago. In its most recently reported quarter, Continental earned 3 cents per share, or $4 million, the second straight quarterly net profit after six quarters of losses.
"We are a long way from being out of the woods, (but) we are seeing some signs that business travel is beginning to head in the right direction," said Jeff Smisek, chairman, president and CEO, in a conference call on Jan. 21 after earnings were posted.

American Airlines parent AMR (NYSE:AMR - News) reduced its available seat miles 5% in the fourth quarter and boosted its load factor to 81% from 78% a year ago. Delta Air Lines (NYSE:DAL - News) increased its load factor to 81.7% from 80.6% as capacity fell 8.2%.
Name Of The Game: Match airline capacity to passenger demand to keep flights full and squeeze out as much cost as possible to deal with swings in jet fuel and other sudden unexpected costs.

2. Market
An average of 2.5 billion passengers and 50 million tons of freight are flown annually, according to a report by Oxford Economics, published in June 2009. The industry employs about 5.5 million workers and has annual revenue of about $1 trillion.

Due to the downturn in the number of passengers flying in the past two years, airlines began cutting passenger and freight capacity in early 2008. But in the first half of 2009, demand fell much faster than airlines were able to cut capacity, causing a severe slump in load factors.
In the second half of 2008 and the first half of 2009 combined, the top 10 U.S. airlines lost $10 billion, Cordle says.

Additional capacity cuts and growing demand in the second half of 2009 allowed airlines to restore load factors back to 2007 highs, resulting in most major airlines earning a profit.
Demand for first- and business-class tickets, which account for nearly a third of most airlines' revenue, improved in November from October but remained weak by historical standards.
The IATA noted that more business travelers flew on economy seats, especially on short routes.
Economy travel accounts for 91% of total international passengers and is showing signs of growth, up 2.4% from a year ago.

Across the board, industry executives have voiced growing confidence.

"We've seen clear evidence that the revenue environment is improving," said Delta President Edward Bastian in a conference call after the company's Jan. 26 earnings report. "While the comps have certainly become easier as we closed out the year, we have seen tangible evidence of sequential demand improvement, which indicates the recovery has begun."

Emerging economies such as Brazil and China represent a new growth driver. The best-rated stocks in IBD's airlines Industry Group include the likes of Brazil's Gol Intelligent Airlines (NYSE:GOL - News) and Tam (NYSE:TAM - News), China's China Eastern Airlines (NYSE:CEA - News) and Chile's Lan Airlines (NYSE:LFL - News). On Friday, a Brazilian magazine reported that Tam is looking to take a stake in Lan; Lan shares rose nearly 4%, while Tam fell about 5%.

3. Climate
Labor and fuel have consistently ranked as airlines' top two costs, forming about half of operating expenses. During the recession, U.S. airlines cut employment for 17 straight months. Full- and part-time employment totaled 379,400 in November, down 3.3% from a year ago, according to the U.S. Department of Transportation.

Fuel costs can be much more volatile and may hinder recovery efforts.

Fuel prices surged in 2008 and peaked at about $3.50 a gallon in the third quarter. By the second quarter of 2009, prices dropped 50%, helping airlines return to profitability in the second half.

Though airline executives sound optimistic, a number of issues could trip them up.
One is airline security. U.S. airlines spend $2 billion a year on security technology such as baggage scanners and personnel -- money that comes from fees tagged onto ticket prices.
That cost, already expected to grow to $5 billion by 2014, may rise faster than airlines can hike prices.

4. Technology
Breakthroughs in aircraft body design and materials have made planes lighter and more fuel efficient.

And while airlines have focused more on cutting costs than beefing up entertainment technology, more offer in-flight wireless Internet access.

Delta said in January that it plans to spend $1 billion over the next three-and-a-half years to boost fuel efficiency, remodel existing aircraft and improve customer service. It will add in-seat audio and video-on-demand on more planes.

At the same time it plans to install "winglets," curved wingtip extensions that reduce drag, on more than 170 aircraft to boost fuel efficiency as much as 5%.

5. Outlook
"We are cautiously optimistic on the airline space entering 2010," wrote Stifel Nicolaus airline analyst Hunter Keay in a mid-January research note.

But given the fragility of pricing and the industry's mixed track record of capacity, caution is the order of the day, he adds.

Among his concerns: airlines adding capacity too quickly and price fragility, which might make increasing fares difficult if fuel prices rise.

Fuel prices, as always, will play a big role in the financial performance of airlines.
Cordle projects the top 10 airlines will earn a net profit in the range of $1.5 billion to $2 billion in 2010, based on his estimate that the price of a barrel of oil will average $78.

A $10-per-barrel swing in oil prices would have a $3.5 billion hit on profit. Depending on the direction, it's possible that the top 10 airlines could earn more than $5 billion for the year or show a loss of as much as $4 billion.

Upside: The airline industry has downsized to a level that's matching demand and has seen relief in fuel prices.

Risks: A high-profile terrorist attack, a surge in fuel prices or continued high unemployment could thwart the airlines' best efforts at running a profitable business.