How Northwest Surprised Wall Street - TheStreet

How did

Northwest Airlines

(NWAC)

manage to surprise Wall Street with its return to profitability this week? And can it keep up the momentum?

By and large, Northwest surprised the analysts, because it controlled costs better than they expected while keeping revenue steady with the year-ago quarter, at $2.5 billion. The lesson? Even without top-line growth and a return to boom levels seen in 1999 and 2000, airlines can and will show solid bottom-line improvement, provided they keep costs down, keep prices firm and keep planes full.

After three years of hefty losses, airline management teams have finally pared down operations to meet the reduced travel demand, parking thousands of planes in the desert, axing employees and scaling back schedules. Northwest's profit of 49 cents a share in the third quarter,

announced on Thursday, serves as a good example of how much leverage airlines will have if and when business improves.

"If you go to 1999, Northwest had $10.3 billion in revenue. In 2000 they had $11 billion, which was the peak. In 2001 they had $9.9 billion,

which fell to $9.5 billion in 2002, and this year we're looking at $9.5 billion again," said Helane Becker, airline analyst at The Benchmark Company, a brokerage firm. "

Northwest is down $1.5 billion in revenue from the peak and

has had to do everything

it can to get costs down to that level. The industry lost three years of growth."

As airline employees are well aware, reducing costs is a must for any airline hoping to get in the black, while protecting market share from low-cost competitors such as

JetBlue

(JBLU) - Get Report

. While cost cuts usually come hand in hand with layoffs, the unusual part of Northwest's quarter was that the carrier cut operating costs by 5.7% -- without the help of wage concessions.

This is a different take on the story told by

AMR

(AMR)

, parent of American Airlines, which managed to avert a Chapter 11 filing only after all of its labor unions agreed to $1.8 billion in concessions. But the narrative is the same. With AMR's cuts in place -- along with another $2.2 billion in annual savings from nonlabor sources, such as maintenance costs -- some analysts think that American could post a profitable quarter sometime in 2004.

Lucy, You Got Some 'Splaining to Do
One day after Northwest beat Wall Street estimates, analysts were torn on why the company surprised to the upside.

"Northwest's earnings were driven mainly by stronger-than-expected revenue." -- Michael Linenberg, Merrill Lynch

"Nonlabor cost discipline was the major driver of the surprise." -- Gary Chase, Lehman Brothers

"Seasonal strength, declining costs, high capacity utilization and strong cargo related traffic all contributed positively to earnings results in the quarter." -- Daniel Hemme, Prudential

"The upside from our model was almost entirely in passenger revenue, which was $100 million more than our forecast." -- William Green, Morgan Stanley

"Cost surprises were the biggest driver, with Northwest's continued revenue premium driving the company into the black." -- Glenn Engel, Goldman Sachs

"The primary reason for the difference between our estimates and the actual results was our overly conservative unit revenue assumption." -- David Strine, Bear Stearns

"Northwest exceeded our 40-cent loss estimate by an embarrassing degree, with costs per available seat mile, excluding fuel, rising just 0.6% vs. our 3.3% estimate." -- Jamie Baker, J.P. Morgan

"The big story was on the cost side. Costs were down 5.7%, with maintenance and landing fees showing the largest decreases." -- Susan Donofrio, Deutsche Bank

Source: Analyst Reports

Northwest management reached profitability without this wage help by targeting the costs that it could control, renegotiating cheaper landing fees at its major Detroit hub, reducing marketing expenses and moving away from older airplanes that use more fuel and require more maintenance. Northwest cut costs in every single line item except two -- depreciation and amortization, and aircraft rentals.

"The older planes are out of the fleet. All the airlines have idled the older, less efficient planes, but certainly for Northwest it was more than that," said Jim Corridore, airline analyst at Standard & Poor's. "Maintenance costs were much better than we were expecting, and the company indicated that's a run rate we can see in the future."

With nonlabor costs under tight control, Northwest plans to push forward with a plan to reduce labor costs by $1 billion annually. Company management has already begun talks with pilots, represented by the Air Line Pilots Association, and ground personnel, represented by the International Association of Machinists and Aerospace Workers.

But with a profit in the third quarter, some analysts fear the company could be a victim of its recent success. From a negotiation standpoint, management may have a harder time convincing employees that wage cuts and new work rules are necessary, especially as it posts a profit. These cuts may be a bitter pill to swallow, but analysts say Northwest needs to take its medicine or run the risk of losing business to rivals.

"The long-term erosion of network airline market share will continue as long as costs remain at extremely high levels relative to the best low-fare carriers," said Gary Chase, airline analyst at Lehman Brothers, in a research note. "Northwest has done its share by reducing nonlabor expense significantly, cutting management ranks and, more importantly, outperforming the industry on the revenue front."

If Northwest can get cost savings from labor, which accounted for 40% of expenses in the third quarter, then the company will recover even faster than analysts expect. But with the revenue picture improving and management at other airlines talking more optimistically, Chase said Northwest won't be able to employ some of the arguments American employed to get cost cuts from unions.

"First, Northwest has a lot of cash, which makes the company unable to credibly threaten bankruptcy in the near term. Second, a profitable third quarter and a growing -- and false, in our view -- sense the industry is out of the woods makes us even more skeptical," said Chase. "Convincing labor that concessions are necessary will prove a significantly tougher task."

Such a scenario would put Northwest in an impossible position, unable to get cost concessions it needs at a time when the industry is improving, but still posting losses and vulnerable to an external shock, like a terrorist attack or SARS. Barring a devastating attack, the gradual economic improvement should support the carriers, which will continue to nip at costs, increase efficiencies and lead the way to strong profits. Northwest didn't return a call seeking comment.

While the airline industry remains five quarters away from profitability, Northwest's results are an example of how management decisions made during three years of deep losses, and seismic change have set carriers up for success down the road.

"Northwest's management team is one of the best in the industry and one of the least noticed," said Becker of The Benchmark Company. "They attacked every cost that they could control."