Airline Industry Outlook - Sept. 2010 - Industry Outlook

Overall Outlook is Positive

The economic downturn and the oil price spike before it had negatively affected the airline industry over the past two years. Now, with the economy on the mend, albeit at a slower-than-expected pace, demand for air travel is increasing from last year's depressed levels.

To combat the recessionary effects, the airlines cut costs, slashed capacity and increased load factor. This momentum also prompted the industry into the current ongoing consolidation phase. Currently, airlines are benefiting from the rebound in traffic, including an increase in business travel and premium service demand.

While the industry has thus far been fairly disciplined in managing capacity, it is bound to creep up going forward. This would help to keep fares in check, besides making it easier for travelers to book last-minute seats. Despite the overall air of economic uncertainty, we expect the rebound in air travel demand to continue in 2011.

With signs of sustainable economic growth, the International Air Transport Association (IATA) has more than tripled its full year 2010 profit outlook to $8.9 billion for the overall industry compared with the earlier outlook of $2.5 billion. The U.S. airline industry is on track to be profitable this year after a very long period of drought.

Despite the rising uncertainties about the economic outlook with expectation of a ‘double-dip,' current conditions in the cargo markets remain positive. Air freight has entered into a slower phase of expansion, but the pace of growth in both volumes and yields exceeds expectation. Revenues are growing strongly, and cargo profitability is expected to be back to pre-recession levels in many regions.

The improved demand for air freight in Asia and South America is now slowing, while trade across the Atlantic and from Europe to Asia is catching up. Consumer demand for electronics and other common air cargo products has not recovered in Europe and North America yet.

Thus, demand for air cargo is expected to slow in the remainder of 2010 and for full year 2011 following the surge post-recession. We expect fewer goods to travel by air as many technology products are being shipped by sea.

IATA expects full-year 2011 to be tough and profits to soften to the level of $5.3 billion. Industry earnings are expected to decline by 40% in 2011 as we believe excess capacity will outpace the demand and customers are checking their spending abilities. The outlook for 2011 remains uncertain, particularly in Europe and North America, as the effects of government economic stimulus begins to wane. However, travel and freight markets will remain strong in Asia, the Middle East and South America.

Airline companies are improving their revenue structure while paring costs. IATA projects revenue to be $560 billion for 2010. The companies are implementing various ways to enhance their profitability through add-on revenue streams, low fares, network expansion, optimizing routes, partnership alliances, etc.

We think the worst is over for the industry as overall economic conditions continue to show signs of improvement albeit at a slow pace. There is continued and sustainable demand for air travel. We expect faster growth in the next four years as the economy gathers momentum, consumers and business sentiments recover and spending increases.

OPPORTUNITIES

We believe consolidation is a major opportunity for most air carriers to enhance their revenues, cost performance relative to peers and competitive position going forward. This is an opportune moment for companies to consolidate in order to regain lost profit post-recession and operate efficiently and effectively.

Delta Air Lines' (DAL) acquisition of Northwest Airlines in 2008 has proved to be fruitful. The merger catapulted Delta to the position of the largest airline in the world, generating significant cost savings for both the airlines.

Currently, the merger of United Airlines, a wholly-owned subsidiary of UAL Corp. (UAUA), and Continental Airlines (CAL) remains on track for completion in the coming days. This merger was announced in May 2010.

The UAUA-CAL merger will create the world's largest airline with enhanced capacity and improved services, overtaking Delta. This will enable United Airlines to enjoy a favorable position in an increasingly competitive global and domestic aviation industry and help it perform better than any stand-alone airline. Even the discount leader, Southwest (LUV) has jumped into the consolidation drive, announcing a deal earlier this week to acquire fellow discounter AirTran Holdings (AAI).

Further, air carriers are involved in a lot of technology upgrades and automated systems for various activities such as airline reservation system, flight operations system, website, maintenance systems and in-flight entertainment systems. These systems upgrades enable the companies to perform better, lower costs and enhance customer service.

Currently, we have a positive view on all the major airlines – Delta Airlines, United Airlines, AMR Corp. (AMR), Jetblue Airways (JBLU) and Southwest Airlines.

WEAKNESSES

While we expect the industry to post strong growth in the upcoming years, near-term risks remain. They pertain to volatile fuel prices, economic weakness, government regulation, maintaining good labor relations, airport infrastructure constraints and safety concerns. A perennial problem for the industry has been lack of discipline in capacity additions. While they have shown admirable discipline thus far, it remains to be seen if the same can be sustained as the cycle stabilizes.

Some of the major risks are discussed below:

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

Oil prices are expected to rise slowly in 2011 as global economic growth leads to higher global oil demand. However, in order to offset the loss from high oil prices, the airlines are considering levying additional fees and charges on customers. Hedging strategies are another profit protection tool, and will be more extensively used.

Unionized: 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, but instead becomes amendable as of a stated date. Failure to amend the terms and conditions suitably may lead to work stoppages or strikes, hampering operations.

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

We think most of the airline stocks have potential upside as the economic recovery is in progress. We expect carriers to post better-than-expected results in the upcoming quarters. Hence, we do not think that airline stocks will underperform the broader market in the near future.
 
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