Airline Woes Preceded Sept. 11 and Will Remain Long After

Sept. 11 didn't cause the crisis facing the airline industry -- it merely exacerbated existing systemic problems. Thanks in part to a massive federal lifeline, the events have also speeded up the much-needed overhaul of an industry resistant to change.

In the immediate aftermath of Sept. 11, no sector was as directly devastated as airlines. Fear of flying was pandemic. Even a year later, security questions remain.

But predictions that passengers would never return to the skies proved only half right. The bargain hunters returned. Only the business-fare travelers stayed away -- and that has more to do with the economy than terrorism.

The Reckoning

Industry losses are expected to top $6 billion in 2002 (that figure was the same as in 2001), and a return to profitability may not come until late 2003, at the earliest. Ticket prices are at 1988 levels, yet domestic traffic is still down. And business travel, once a gold mine, has dried up.

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Airline Woes Preceded Sept. 11 and Will Remain

Wall Street Shocked Into Exodus

Over the past year, airline stocks have been punished, with the American Stock Exchange Airline Index losing 62.3%. But the swoon doesn't mean these stocks are a good value. Heading into 2003, corporate losses are expected to continue; the current economic environment doesn't augur the strong return of business travel -- a fat-margin area for airlines. And war in Iraq could drive up oil prices and increase fuel costs for carriers.

"The industry as a whole had already begun to see high-yield fares start to collapse late last spring," says Holly Hegeman, Editor of PlaneBusiness.com. As early as July 2001, "top revenue-management folks at more than one major airline had told me the situation was the worst they had seen -- ever. The bottom was falling out of the industry's revenue model."

In summer 2001, industry losses were mounting due to the recession, and smaller regional carriers like Midway Airlines began filing for bankruptcy. Bigger carriers, save low-fare Southwest Airlines(LUV Quote), were battling issues that imperiled the long-term viability of the industry. Over the past 12 months, with the help of a massive federal lifeline, airlines have re-evaluated everything, from the hub-and-spoke system to code-sharing deals to a fare-pricing structure that many say is outdated.

"When companies make strategic changes, the main triggering factor is a crisis," said Briance Mascarenhas, professor of management at Rutgers University's business school. "Their back is against the wall now. They're cutting capacity overall, which should improve pricing power. They're lowering their cost structures, by renegotiating with labor and cutting less-efficient planes."

The result: Carriers are doing the things they've been avoiding for years, like slashing capacity, renegotiating cumbersome labor contracts and reconsidering the way business fares are priced. Instead of consolidating operations through mergers, which could be blocked by the Federal Trade Commission, many have opted to share passengers instead through code-sharing agreements.

Today, US Airways (UAWGQ Quote) is bankrupt, and United, a unit of UAL (UAL Quote), is on the verge. Only one major carrier, Southwest, is consistently profitable.

US Airways "was already in dire financial straits going into 2001, Hegeman says. "When the proposed merger with United was finally declared dead in June of last year -- a bankruptcy was inevitable, Sept. 11 or no ... the airline had no workable business strategy in place."

Airline Aftermath How the sector has performed since 9/11
Carrier	Stock % Change Since 9/11*	Earnings Comparison
		Q2 2001	Q2 2002
American	-69%	-$105 million	-$465 million
US Airways	-94	-24 million	-248 million
Delta	-55	-123 million	-162 million
Northwest	-55	-55 million	-93 million
Continental	-76	42 million	-35 million
Southwest	-18	176 million	85 million
United	-90	-292 million	-341 million
America West	-76	-15 million	-10 million
*As of Thursday, Sept. 5, 2002. **Excludes all charges. Source: Company reports, Baseline, TSC Research

Seeds of Change

As travel ground to a halt last fall, cash-strapped airlines came dangerously close to losing their ability to raise capital to pay bills. To avert a complete failure of the air-travel industry, the federal government passed the Air Transportation Safety and System Stabilization Act, which provided airlines with $5 billion in compensation grants and $10 billion in loan guarantees.

"Without this forceful response, there is little doubt that the aviation crisis would have slipped out of control quickly," wrote Christopher Besant, an expert on airline reorganization, in The Journal of Corporate Renewal's soon-to-be-released September 2002 issue. "The government became the debtor-in-possession lender of last resort to an entire industry."

The government pushed carriers to seek significant cost reductions in order to receive loans. This emboldened airline management to seek wage concessions from labor tackling a problem that has always plagued the industry -- extremely high operating costs. The battles are already heating up at US Airways and United and should continue at other carriers throughout 2003.

Airlines are also drastically reducing capacity and cutting back on services and perks. According to the Air Transport Association, an industry trade group, systemwide capacity was down 8.3% year-over-year in July and more cuts are on the way. By slashing capacity, the airlines hope to reduce supply enough to raise prices -- reversing years of capacity growth.

Since Sept. 11, airlines have stepped up cooperation in the form of code-sharing partnerships. Under these partnerships, carriers can sell tickets on other carriers' flights and honor their frequent-flier miles.

"We're seeing innovative new ways to utilize assets, like code sharing. By cross-listing flights they expand reach without adding any physical assets," said Mascarenhas. "And they probably wouldn't have done this unless Sept. 11 happened."

The end result is that carriers become individual partners in a consortium of merged, yet separate, operations. For the industry, this is a preferable method of consolidation -- where everyone can expand their reach without spending a dime on physical costs or assuming debt.

In July, the second- and seventh-largest carriers -- erstwhile merger partners US Airways and United -- announced a code-sharing agreement. This was followed in mid-August with a similar announcement by Delta (DAL Quote), Northwest (NWAC Quote) and Continental (CAL Quote) (the nation's third-, fourth- and fifth-largest airlines).

The Transportation and Justice departments, as well as company labor unions, will decide the fate of code-sharing agreements sometime in 2003. If it doesn't pass, then consolidation may become a more favorable option, especially with regional airlines like America West (AWA Quote) inching towards profitability.

"They will return to profitability in two or three years and then they'll get things back to normal -- if there hasn't been another catastrophe," said Mascarenhas. "In the meantime, the airlines won't do well, but they will have simplified operations so when the volume picks up, they'll be in pretty good shape."