Can Capacity Cuts Ensure Airline Profits?

There are signs 2008 could be another profitable year, but fuel costs will remain a concern.
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CHARLOTTE, N.C. - The stock market may not think so, but many airline executives believe capacity discipline will enable the industry to show a profit in 2008 despite a slowing economy.

The first step to profits, of course, would be increased revenue per available seat mile. Want to know the 2008 RASM outlook? Just ask Scott Kirby, president of

US Airways

(LCC)

, who says he uses a "back of the envelope" formula to determine this key industry measure.

The formula: Take the year-over-year change in gross domestic product, subtract the year-over-year change in capacity as measured by available seat miles, and double what you find.

For example, if GDP is flat and ASMs rise by 2%, then RASM declines by 4%. If GDP is down 2%, and ASMs are up 2%, then RASM declines by 8%.

Now, let's use projected numbers to look at the coming year. For 2008, the Air Transport Association sees overall capacity rising between 0.5% and 1.5%. Meanwhile, the

Federal Reserve projects

2008 GDP growth of 1.8% to 2.5%. So let's take the middle numbers to get an estimate -- 2.2% GDP growth, capacity growth of 1%, and using Kirby's formula, and you have 2.4% RASM growth next year.

"There is evidence of a slowdown in other industries

and it's hard to see how that doesn't eventually hit airline demand at some time," Kirby said, at a recent investor conference. But "as long as we have capacity discipline, I think we can keep unit revenue growing pretty robustly."

Airlines reported strong results in October, and some of the November RASM data has been encouraging. And last week, three carriers disclosed additional capacity cuts. They cited rising fuel costs and, in the words of Gary Kelly, CEO of

Southwest

(LUV) - Get Report

"growing evidence of slowing economic growth that would inevitably affect passenger demand."

Continental

(CAL) - Get Report

, the fastest-growing legacy carrier, lowered its capacity expansion estimate for next year to between 2% and 3%, down from its previous forecast of the 3% to 4%. Southwest said it will grow 4% to 5% in 2008, down from the 6% it projected previously.

Delta

(DAL) - Get Report

said it will scale back domestic capacity by 4% to 5% next year.

The ATA projects that the industry will earn $5 billion in 2007, marking the first time since 1999-2000 that it has recorded two consecutive profitable years. Another profit is likely in 2008, which would be the first time the industry has had three straight profitable years since 1998-2000.

"I put my money on a three-peat," says John Heimlich, ATA economist. "I think that the increase in revenue next year, combined with their nonfuel cost performance and their capacity control, will be sufficient to enable airlines to maintain their profitability."

If he's right, then airline stocks may have a better future than Wall Street anticipates. So far this year, the Amex Airline Index is down about 33% and hovering near a 52-week low.

Meanwhile, a separate group from the ATA, the International Air Transport Association, is looking for global industry profits of $5.6 billion this year, and another profit next year, but a decline to $5 billion. That's well below the previous expectation for earnings of $7.8 billion in 2008.

Giovanni Bisignani, IATA's director general and CEO, blamed fuel costs, the turmoil in the credit markets and the prospects for more capacity.

"The challenges get tougher in 2008," he said in a statement. "A favorable economic environment and effective efficiency measures helped mitigate the impact of high fuel prices and underpinned profitability improvements. With the credit crunch, that is changing. The peak of the business cycle is over, and we are still $190 billion in debt. So we could be heading for a downturn with little cash in the bank to cushion the fall."