Airline Industry Outlook - April 2011 - Industry Outlook

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In a major turnaround, the airline industry recorded $16 billion in profits last year, after losing $16 billion in 2008 and $9.9 billion in 2009. But 2010 was most likely an earnings peak, as a host headwinds have come together to bring down industry profits.


The International Air Transport Association (IATA) expects 2011 profits softening to the level of $8.6 billion from its previous expectation of $9.1 billion. The factors weighing on earnings include the escalating fuel prices, weak traffic volumes and the March 11 catastrophe in Japan, which are expected to suppress demand for air travel.


Worldwide air freight volumes rebounded in 2010 to the 2008 peak level. This rebound was particularly apparent in Asia, where volumes were well above previous peak levels established in 2007. Air freight is expected to be unchanged in 2011 due to excess capacity and yield pressures as demand softens.


As stated by IATA, Asia-Pacific is expected to generate $3.7 billion in profits in 2011, the highest in the industry, outstripping other regions. However, the region's profits would be down substantially from the 2010 level of $7.6 billion. Despite the strong economic growth, aggressive inflation measures in China are weakening the demand for air travel in the country.


North American carriers are facing challenges from rising fuel prices. Profits in the region will likely fall to $3.2 billion from $4.7 billion reported in 2010. Growth in Europe is also lagging due to the ongoing banking and government debt crisis. European airlines' profits are expected to drop to $500 million in 2011 from $1.4 billion in 2010.


The African air carriers are expected to break even in 2011 compared to profits of $100 million made in the prior year. Strong economic growth and high demand for air travel will be offset fully by intense competition from Middle Eastern carriers. Middle East air carriers reported 2010 profits of $1.1 billion. The IATA expects this profit to slide to $700 million in 2011, owing to political instability in that region. Latin American carriers' profits are also expected to decline to $300 million from $1 billion in 2010.


Persistently rising fuel prices since last December have surfaced as a major headwind to the airlines industry. Crude oil prices are currently trading around $110 per barrel, representing the steepest rise in more than two years. Oil prices have already risen more than 21% this year due to the ongoing economic unrest in the Middle East.


Following the massive earthquake and Tsunami in Japan on March 11, air carriers introduced drastic cuts in their capacity. Fears of flying to Japan are increasing, owing to the still-unsettled nuclear situation, and the demand for air travel in the country is dropping, hurting the overall airline profitability.


However, the carriers will likely be able to handle this situation as conditions stabilize in Japan. In all probability, the capacity cuts are temporary, and should last only for the next two–three months. Also, the carriers are combating rising fuel prices with higher fares and extra fees.


OPPORTUNITIES

We believe industry consolidation and various ancillary revenues will boost profitability and cost performance of most air carriers going forward. This is an opportune moment for companies to consolidate in order to regain their lost profits post-recession and operate more effectively.


Ancillary Revenue:
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A number of supplementary revenue streams helped the airline industry gain ground in 2010 after two years of drought. The airline companies are enforcing fees on baggage, reservation change, pet travel, food and beverage to add to their revenue streams. These are expected to enhance revenues in 2011. The IATA projects total revenue of $594 billion for 2011, up slightly from $565 million reported in 2010.


Consolidation:
Airline companies are consolidating in order to restore profits. The first consolidation in the industry was
Delta Air Lines'
(
DAL
) successful acquisition of Northwest Airlines in 2008. The merger catapulted Delta to the position of the second largest airline in the world, generating significant cost savings for both.


In October 2010, United Airlines merged with Continental Airlines and formed a new company --
United Continental Holdings Inc.
(
UAL
). This merger created the world's largest airline, overtaking Delta Air Lines.


The third merger, between the discount leader
Southwest Airlines
(
LUV
) and fellow discounter
AirTran Holdings
(
AAI
) announced in September 2010, is underway. The acquisition of AirTran represents a unique opportunity for Southwest to expand its presence in key markets. Southwest will gain a valuable market presence in Atlanta, the busiest airport in the U.S. The transaction is expected to complete in the second quarter of this year.


Technology Upgrades:
Air carriers are involved in numerous technology upgrades and system automation for various activities such as airline reservation system, flight operations system, website, maintenance and in-flight entertainment systems. These upgrades enable companies to perform better, lower costs and enhance customer service.


WEAKNESSES

While the long-term outlook for the industry has improved, near-term risks remain. These include volatile fuel prices, economic weakness, the disaster in Japan, government regulation, unionization, airport infrastructure constraints and safety concerns. Some of the major risks are discussed below:


Oil Price Volatility:
Airline operations are geared toward aviation fuel prices, a major variable cost. Oil prices, though high currently, remain well below the 2008 levels of over $140 per barrel that had ravaged the airlines industry. Since, airline companies have limited ability to pass on increased costs of fuel to their customers, they have to absorb the impact on their profits.


In order to offset the increased burden of high oil prices, airlines are levying additional fees and charges on customers. Hedging strategies could also be profit protection tools, and will be used extensively. We believe the overall airline industry fuel expenses will increase by $10 billion to $166 billion including the impact of fuel hedging (50% of expected consumption).


Japan Disaster:
The March 11 catastrophe interrupted air traffic at most Japanese airports. The disaster not impacts the near-term air travel growth outlook for Japan, but also has negative effects on other countries as well. Japan's domestic airline market, which according to IATA generates about $19 billion in annual revenue, has been hit the hardest.


Outside Japan, air travel in China has suffered drastically as 23% of its international revenue is generated from Japan. Taiwan and South Korea were also affected as these generate about 20% of their international revenues from Japan flights, followed by Thailand (15%), the U.S. (12%), Hong Kong (11%) and Singapore (9%).


The major U.S. carriers cancelled most flights to and from Japan following the calamity and rerouted their flight structures. The airline companies had offered several alternatives to exchange or refund of ticket and also waived fees for passengers rebooking flights to Japan. These moves have raised operating costs of the carriers even more.


Further, in a move to control the situation, major U.S. airlines are cutting their Japan capacity owing to the demand slump. Delta announced its intention to cut capacity by 15% to 20% and suspend services to Tokyo's Haneda airport through May. United Continental is expected to slash 10% of its capacity in April and 14% in May for the flights operating between Tokyo and U.S. cities like New Jersey, Los Angeles, Seattle and Washington. Additionally, the company is planning a 4% reduction in capacity by September.


The natural disaster also took a toll on American Airlines, a wholly owned subsidiary of
AMR Corporation
(
AMR
). The airline has suspended two of its six daily flights to Japan between April 6 and April 25. Further, Asian carriers were also affected. Japan Airlines reduced its weekly flights to 14 from 21 round-trips between Tokyo Narita and Honolulu.


Unionization:
The airline business is labor intensive. Most of the employees are unionized and depend on various U.S. labor organizations. The relation between airlines and labor unions are governed by the Railway Labor Act, which states that a collective bargaining agreement between an airline and a labor union does not expire, instead it becomes amendable as of a stated date. Failure to amend terms and conditions suitably may lead to work stoppages or strikes, hampering operations.


Federal Regulations:
The airline industry is highly regulated, particularly by the federal government. All airlines engaged in air transportation in the U.S. are subject to regulations implemented by the Department of Transportation (DOT). Further, airlines are also regulated by the Federal Aviation Administration, a division of the DOT, primarily in areas of flight operations, maintenance and other safety and technical matters.


Currently, we have a long-term Neutral rating on Delta Airlines and Southwest Airlines. However, we have an Underperform rating for United Continental Holdings as it is cutting its capacity more than its rivals to combat the difficult situation arising from the Japan crisis as well as high fuel prices. We believe the reduced capacity will lower down the United Continental's profitability going forward.


AIRTRAN HLDGS (AAI): Free Stock Analysis Report

AMR CORP (AMR): Free Stock Analysis Report

DELTA AIR LINES (DAL): Free Stock Analysis Report

SOUTHWEST AIR (LUV): Free Stock Analysis Report

UNITED CONT HLD (UAL): Free Stock Analysis Report

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