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US airlines see demand slump leveling off?

Written by editor

When you have been underwater for as long as the U.S. major airlines, touching bottom can be a relief.

When you have been underwater for as long as the U.S. major airlines, touching bottom can be a relief. Carriers are seeing signs that the steep demand drops of recent months are finally leveling off, although actual recovery still appears a distant prospect.

There is no disguising the fact that the first quarter was grim for the industry, with airlines reporting losses across the board. Revenue trends – bad enough in January and February – worsened dramatically in March. Unit revenue dropped by double digits, and yield declines of almost 10% were common. Load factors were also down, indicating the traffic fall has outpaced even the deepest capacity cuts.

Against this backdrop, any good news is welcome – and there is industry consensus that demand has not dropped further in April, or in advance bookings beyond that. Precisely what this means, though, is open to interpretation.

“We’ve seen some signs of stabilization as the revenue environment appears to have bottomed out,” says Delta Air Lines CEO Richard Anderson. The airline’s president, Ed Bastian, notes that while “things aren’t good . . . they also aren’t getting worse.” He stresses that there are not yet any indications of improvement.

Delta has generally been more bullish than the other majors in its predictions for this year, but its competitors are seeing similar patterns emerge. American Airlines CEO Gerard Arpey says the glass can be seen as half full or half empty at the moment, although “the fact that we’re not seeing further deterioration” is a positive sign. March actually turned out to be not quite as dire as expected for American.

While acknowledging that the revenue decline appears to have slowed since March, Southwest CEO Gary Kelly says he is not ready to declare that demand has reached its lowest point. Numbers for May will provide more clarity, but Kelly has “a hard time believing the second quarter will be better than the first.”

United CEO Glenn Tilton is also taking a more cautious approach. He says the outlook is “too difficult to call,” and he is seeing “no conclusive evidence” that demand has in fact hit its nadir. Tilton notes that several airlines have seen their forecast change dramatically in the short space of time since their last guidance in mid-March, proving how volatile the market is.

Looking farther ahead, Continental Airlines President Jeff Smisek believes it is impossible to tell “whether or not we’ve hit bottom, how long we will bump along the bottom once we’ve hit it, and what our rate of climb will [eventually] be.” Smisek notes the only thing that can be said for the current situation is that the rate of unit revenue decline seems to be decreasing.

Analysts generally see the same trends the airlines are reporting. Before the earnings season began, Michael Derchin, of FTN Equity, observed that March was “likely to mark the trough in this cycle.” He expects unit revenue declines to slow down as airlines move into the stronger April-August period. And after American reported, Derchin observed that the carrier’s bookings and yields firmed in the last week of March “and appear to have stabilized.”

Jamie Baker, of JPMorgan, says the March unit revenue drop was worse than any on record, except for the post-9/11 fall and the effect of United’s 1985 strike. American’s Arpey believes the second quarter of 2002 was the last time revenue dropped this much year-on-year.

Baker acknowledges the recent “stabilization rhetoric” in the industry, but he warns against overconfidence: The April relief for unit revenue could “yield to May disappointment.” For example, Delta is relying on demand patterns behaving as they have in the past, and its assumptions leave little room for further declines in travel.

While “stabilization is the precursor to recovery,” Baker notes that some estimates are too optimistic. If demand does level out but fails to recover, more capital injections will be needed by year-end. This will be less of a problem for a carrier such as American, but could be a strain for US Airways and United, he says.

Delving deeper into the first-quarter reports shows some of the challenges facing the U.S. airline industry. International routes are particularly weak, and after boosting their presence in their markets in recent years, airlines are now suffering from overcapacity. The transatlantic market has been the hardest hit: Continental estimates its average ticket price is running about 35% less than at this time last year.

Load factor decline is much less steep than the revenue drops, and this trend looks set to continue in the second quarter. However, load factors are being buoyed by ticket discounts, which in turn are helping to keep yields down. Fare sales have been “broader and deeper” than typically seen at this time of year, says Thomas Horton, American’s chief financial officer. The few attempts at fare increases have not been successful.

To a large extent, the falloff in demand was expected, and the major carriers were well prepared, thanks to double-digit capacity cuts that streamlined their networks. Oil prices have also plummeted, and the cost relief has almost canceled out the revenue pressure in some cases.

There is still a chance that the U.S. industry as a whole could be profitable this year, although analysts and airline executives are not as optimistic about this as they were at the end of last year. Some smaller airlines, such as AirTran and JetBlue Airways, are already there, having had profitable first quarters helped by their lack of exposure to international markets.

While the general demand and fuel-cost trends are affecting them all, airlines are confronting their challenges in a variety of ways. There have been no significant additional capacity cuts yet, but carriers are looking at new avenues to boost revenues and slash costs further.

For Southwest, reducing employee numbers is a necessity. The airline has taken the rare step of offering a voluntary retirement program for virtually all employees except senior management. While the carrier’s capacity has declined 4% year-on-year, head count is up about 2%, notes Kelly. “We need to get that in sync because certainly the first-quarter result suggests we are not going to be increasing our flying anytime soon,” he says.

United is using capacity cuts as a way to rid itself of its entire fleet of older Boeing 737s, which are its most fuel-inefficient aircraft. The carrier had nearly 100 737-300s and -500s when it began this effort last year, and has so far removed about half. The airline says it’s on track to retire the remainder by the end of this year.

American hinted that it will consider a further international capacity cut, although it will wait to see how summer demand shapes up. Arpey notes that American has shown more international capacity discipline than most of its competitors in recent years, and there is “a lot of capacity out there that is more marginal that what we’re operating.”

Delta, meanwhile, revealed more details of its previously announced capacity-cut plans. It will shed 40-50 mainline aircraft this year, including all of its 14 Boeing 747-200 freighters. This will mark the end of Delta’s unprofitable dedicated freighter services.

On the revenue side, Delta instituted a $50 fee for a second checked bag on international flights, its first such fee in these markets. The airline expects to make about $100 million a year from this initiative, adding to the $160 million per quarter it already collects from domestic bag fees. But what Delta – as well as its competitors – really needs is for more people to fly, and to pay more for the privilege.