Headwinds Blasting Airlines

Without cheaper fuel or pension reform, the major players will keep nose-diving into red ink.
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Those giant skidding sounds you heard last week were airlines sliding off the runway into a sea of red ink.

Five major airlines reported first-quarter losses totaling almost $2 billion as record high fuel costs eroded bottom lines. Simultaneously, the industry's capacity glut left individual carriers unable to lift fares enough to fully offset fuel bills. For some airlines, labor costs remain stubbornly high.

That environment has created a war of attrition, where airlines with the strongest balance sheets and lowest costs will hold on until either fuel prices moderate or weaker rivals shut their hangars first.

Looking ahead, fuel costs are likely to remain punishing. American Airlines' parent

AMR

(AMR)

expects fuel to cost it $1.3 billion more this year than last -- that's on top of a $1.1 billion increase from 2003 to 2004.

Capacity also will remain a problem, with carriers adding seats. For example,

Delta Air Lines

(DAL) - Get Report

expects to increase domestic capacity 4% to 6% during the remainder of the year.

There are some variables that could help some troubled names, though.

Northwest's

(NWAC)

and

Alaska Air's

fortunes could improve if they are able to convince labor to accept concessions. Meanwhile, pension reform floated in Congress last week could give large network carriers -- particularly Delta -- extra time to fill yawning pension deficits.

The first quarter's money losers were Alaska, AMR,

Continental

(CAL) - Get Report

, Delta and Northwest. Delta's losses were the worst, breaching the $1 billion mark.

The profit makers were

Southwest Airlines

(LUV) - Get Report

, with its aggressive fuel hedging;

JetBlue Airways

(JBLU) - Get Report

, flying a young fleet and enjoying low unit costs; and

America West

(AWA)

, which got into the black via a noncash accounting gain from fuel hedges.

Looking ahead, Southwest is well-positioned to weather continued turbulence, with fuel hedges stretching out until 2010 (although the percentage of fuel needs covered by hedges decreases over that period) and an enviable balance sheet. The airline ended the first quarter with $1.9 billion in cash and an available unsecured credit line of $575 million. The first quarter was the 56th consecutive one where Southwest earned a profit.

Some analysts are also applauding JetBlue for being able to turn a better-than-expected profit in the latest quarter, even though its first-quarter fuel hedges sheltered it less from high crude oil prices than Southwest's.

"JetBlue is the only airline that consistently makes money without major fuel hedges," writes Roger King and Glenn Reynolds, analysts at CreditSights, a New York-based independent research company that does no investment banking. "Listening to their conference call is like being in another industry. Domestic growth is strong, new market launches work like a champ, price raises do not stunt demand and guidance is for more of the same. What's wrong with this picture? Nothing -- young fleet, lowest unit costs, entrepreneurial culture and a unique product offering."

Still, some observers have cautioned things may get more difficult for JetBlue over the long haul, as its planes and workforce age and become more costly.

Among the traditional network carriers, AMR is the favorite of some handicappers. During the first quarter it managed to reduce nonfuel unit costs by 3.2%, while unit revenue in its mainline operations rose by 3.7%.

AMR even managed to generate positive cash flow, ending the quarter with $3.5 billion in cash vs. $3.4 billion at the end of 2004, and that was after it made a $138 million pension plan contribution. It also has several options left for raising additional cash, including preselling frequent-flier miles. "Among the legacy airlines, we believe AMR has the greatest staying power," writes Goldman Sachs' Glenn Engel. Goldman does and seeks to do business with companies covered in its research reports.

Other majors, notably Northwest and Delta, may not be so well-positioned. The former does have a strong cash position and finished the quarter with $2.3 billion, of which $2.1 billion was unrestricted. But Northwest has been unable to persuade most of its workers to accept deep concessions, even as Delta and Continental have wrangled concessions from workers, and

US Airways

(UAIRQ)

and United Airlines' parent

UAL

(UALAQ)

have used the bankruptcy process to hack at wages and benefits. On Friday, UAL got additional relief, when

federal pension insurers said they would take over the company's traditional pension plans.

Doug Steenland, Northwest's CEO, said "increasingly noncompetitive labor costs" contributed to the company's $458 million, or $5.28-a-share, loss. Late last month, the airline was forced to increase its annual labor savings target to $1.1 billion from $950 million. Having achieved only about $300 million of that goal, Northwest remains in federal mediation with three unions and continues to negotiate with other work groups.

Although some money-losing rivals -- AMR, Continental and Alaska -- still managed unit revenue growth in the latest quarter, Northwest did not. Unit revenue slid 0.6% on a sharp 4.7% drop in yields, which gauge average fares. Some analysts believe Northwest has taken an unusually hard hit from industrywide fare reform prompted by Delta's Simplifares, which capped maximum fares and simplified pricing. That's because Northwest had less exposure to low-cost competitors and had to ratchet more of its fares lower to match Delta's move than other rivals did.

Delta faces more immediate straits, with its gaping first-quarter loss. The airline has warned of a liquidity crisis if fuel remains at high levels, and CEO Gerald Grinstein acknowledged last week the company was pursuing additional opportunities to cuts costs and ensure adequate liquidity levels.

Raising capital could be tough, though, as almost all of Delta's assets already back up various debt obligations. Two exceptions are its Comair and Atlantic Southeast regional airlines, and Delta may have to resort to putting them on the auction block.

Delta's mainline unit revenue declined 2.9% in the first quarter from a year before, as harsh East Coast competition from discounters like JetBlue and

AirTran

(AAI)

pressured fares.

The poor price environment and high fuel costs masked some of the strides the airline has made in cutting costs. Excluding fuel and special items, mainline unit costs fell 12.7% from a year before. But its efforts may be too late.

"Delta is in a race against time," write the CreditSights analysts. "Can its liquidity hold out until all the cost cuts are effective, fuel prices retreat and pension reform is enacted? CEO Grinstein has done an amazing job ramrodding a comprehensive re-engineering program, but key factors are out of his control. Fuel prices are too high, and yield declines too deep to allow a high probability of success."

However, AMR, Delta and Northwest could get big breaks if lawmakers push through pension reform. Last week, U.S. Sen. Johnny Isakson, a Republican from Delta's home state of Georgia, introduced a bill that would give airlines 25 years to meet pension obligations. It would also allow them to freeze defined-benefit pension plans and switch to less-burdensome 401(k)-type plans.

Analysts have said it's hard to gauge potential support for such a bill. While it could help airlines avoid dumping pension obligations on the federal government, some lawmakers may be reluctant to stick up for anything the public might view as another handout for airlines.

Perhaps the only sure thing is that the industry will remain wild and woolly.