I-S Comment 06-24-04
2 Pages
English
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I-S Comment 06-24-04

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2 Pages
English

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Information for Decisions Equity Market Sector & Industry Comments New York • London • Boston June 24, 2004 Airlines: Strong Economic Tailwinds Not Enough for Earnings Take-Off Certain industries that rely heavily on both consumer and business spending rely more heavily on the business side for their profitability. Businesses, though more price-sensitive than ever, are still less so than individuals. When business profits are strong, as they are today, and spending recovers, it leads to higher average prices and margins for hotels, restaurants, and airlines (and also advertising-driven industries, the subject of a separate report, could also be included in the list). With a modest lag, growth in corporate profits has the ability to slingshot performance at such industries, the beginning of which is being seen currently. Airlines should theoretically be a major beneficiary Airline Traffic Improving, Pricing Not of this key top-down fundamental, especially at a (seasonally adjusted) time when both business and consumer spending power are both strong. Traffic is indeed growing well 60 16 (see chart), after having been slammed down by 9/11 55 15 and then again by the Iraq war. Traffic levels are still 50 14 5% below the 2001 peak, but May traffic was up 45 13 15% over last year, and the most recent three-months 40 12 rose 6.5% at a seasonally adjusted annual rate 35 11 (compared against a long-run pre-9/11 average of 3.7%). Moreover, load ...

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Information for Decisions
New York • London • Boston
Equity Market
Sector & Industry Comments
June 24, 2004
1
Airlines: Strong Economic Tailwinds Not Enough for Earnings Take-Off
Certain industries that rely heavily on both consumer and business spending rely more heavily on the business
side for their profitability. Businesses, though more price-sensitive than ever, are still less so than individuals.
When business profits are strong, as they are today, and spending recovers, it leads to higher average prices
and margins for hotels, restaurants, and airlines (and also advertising-driven industries, the subject of
a
separate report, could also be included in the list). With a modest lag, growth in corporate profits has the
ability to slingshot performance at such industries, the beginning of which is being seen currently.
Airlines should theoretically be a major beneficiary
of this key top-down fundamental, especially at a
time when both business and consumer spending
power are
both
strong. Traffic is indeed growing well
(see chart), after having been slammed down by 9/11
and then again by the Iraq war. Traffic levels are still
5% below the 2001 peak, but May traffic was up
15% over last year, and the most recent three-months
rose 6.5% at a seasonally adjusted annual rate
(compared against a long-run pre-9/11 average of
3.7%). Moreover, load factors have been kept high as
airlines remained cautious about bringing capacity
back online.
However, factors unique to this industry are leading
instead to huge losses at many companies, current
and impending (and repeating) bankruptcies, and
almost certain consolidation to come. Following United’s recent apparent rebuff from the federal government
regarding further loan guarantees, and the onslaught of new low-cost competitors, restructuring appears
inevitable.
Some of these negative factors facing the airlines include:
Bloated labor cost structures for the older companies, inherited and preserved from the days of regulated
pricing;
Higher security costs after 9/11 (though some airlines undoubtedly overemphasize this aspect to veil more
fundamental cost problems);
Weak prices (see chart). The relative success at Southwest Airlines during this cycle, with its lower costs
and profitable routes, has spawned another wave of new low-cost airlines, preventing most recent
attempts to raise prices. Average prices (yields) started to strengthen as the recovery gained speed in late
2003, but have petered out since then;
Airline Traffic Improving, Pricing Not
(seasonally adjusted)
30
35
40
45
50
55
60
Jan-89
Jan-91
Jan-93
Jan-95
Jan-97
Jan-99
Jan-01
Jan-03
Billion
10
11
12
13
14
15
16
Cents/RPM
Rev. Passenger-Miles (L)
Yield (R)
2
High fuel prices, the largest airline cost after labor. Just as new entrants came in, oil prices spiked to $43
and are still above $37 per barrel (WTI). There is almost certainly a terrorism/Iraq/Middle East uncertainty
premium built into the price, but perhaps more important, a substantial upward turn in worldwide economies
has raised energy demand substantially, with China now a major factor in the equation. Jet fuel prices in May
were 42% above a year ago. Some large airlines were fully or partially hedged and still have oil at $20 to $25,
while others were not hedged at all. But hedging strategies cannot prevent problems in the longer run if oil
prices remain high, which is DE’s current stance. Global demand side is sustainably strong now (with the
possible exception of unexpectedly rapid slowing in China), while increases in supply are limited even after
the Saudi production increase—especially if Iraq oil supply is unable to surpass current levels.
The near-term earnings outlook is consequently bleak and highly uncertain for most of the larger U.S. air
carriers. This view may not be fully reflected in S&P500 Airline industry EPS, where almost all the market c
a
p
belongs to Southwest (the remainder to Delta), and as Southwest’s growth relative to the industry continues.
While a positive risk would be a rapid decline in oil prices, high labor costs and the competitive landscape (and
resulting pricing issues) will remain a challenge for the major carriers, one or two of which may not exist a
year from now. Airlines not as exposed to cost issues through short-term hedging or favorable labor
agreements (or post-bankruptcy restructuring) will be better able to take the improving demand environment to
the bottom line.
Larry Horwitz, DE Boston
617-994-0505