 |  |  |  |  |
US Airlines: The weak and feeble must either fail or be absorbed before
the industry is ready for renewed investments
Vaughn Cordle, CFA / April 7, 2008
The failure of ATA, Skybus, Aloha, Maxjet and Champion is sad news for the employees and investors
of these weak airlines, but welcome news for a feeble industry that has been infected with the "excess
capacity" disease for much too long. Excess capacity is a function of excess domestic competition,
and this explains why the US airline industry is unfit for long-term investment.
These airlines were forced to shut down because industry fundamentals and macroeconomics have
deteriorated significantly over the last three months. Indeed, there is nothing on the horizon that
suggests things will get better anytime soon. The airlines could not raise capital (or raise it at an
acceptable cost), and their balance sheets could not absorb the losses. The airlines simply could not
make a successful business case for continuing operations after it became obvious that they would
run out of cash in the sooner rather than later.
Without prospects for growth and the resultant lower relative cost effect, many of these smaller players
were unable to attract the capital required to offset their losses. And without an adequate cushion of
equity and the lack of profitable growth opportunities, the risk of bankruptcy is simply too great for even
the dumbest airline investor. The wealth destroyers tend to use depreciation expense-enhanced
cash flow (recall that deprecation is a noncash expense) to fund operations and growth, and this sets
them up for failure later when times get tough and the lack of proper investment finally catches up with
them. Clearly, this strategy only works as long as the funding of growth does not over-leverage the
balance sheet.
Most airlines exceed an optimal (i.e., sustainable) rate of growth for too long, and this is the primary
reason most of them get into trouble. Executives have a strong desire to grow because doing so
lowers costs and expands valuation multiples. This tendency to grow too fast for their own and the
collective good is what I call the "destructive growth prerogative."
The best outcome for the wealth-destroying US airline industry is one in which the market is allowed to
weed out the most weak and feeble competitors. Less competition will reduce the yield-destroying
intensity of rivalry and benefit the airlines that have the financial wherewithal to survive both a
recession and higher fuel costs.
Our base-case is that the industry will pull down 5% or so domestic capacity with the anticipation of an
economic recovery in a year or so. The bigger airlines have greater financial flexibility to weather a
recession than the smaller ones, and it is those smaller airlines that have a greater exposure to the
weak US economic environment. Big network airlines have resources and supplier-provided relief
that smaller airlines lack. This provides them with a significant advantage in terms of keeping the
doors open for business when times are tough.
The US airline industry is mature—and in decline—and it simply cannot absorb more "low-cost"
airlines that finance fast growth via dumb investors rolling the dice, too easy financing and low labor
costs. The industry is in desperate need of consolidation, and the recent bankruptcies and grounding
of the weakest airlines is a good place to start. The combined capacity represented by these five
small airlines is only 1.12 percent of over one trillion ASMs systemwide, so the weeding out of the
most uneconomic and excess capacity must continue. However, even a small reduction in capacity
has an outsized and positive impact on the remaining competitors. When all things are held constant,
a 1.12 percent reduction in total capacity results in a .90 percent increase in industry load factors and a
1.13 percent increase in unit revenue.
Industry passenger revenue remains the same if yields and revenue passenger miles do not change
as capacity leaves the system. However, the benefit is that the competitor's lost traffic and revenue is
shared by the remaining competitors. Moreover, there is a positive correlation between load factors
and yields, especially when average load factors are near 80 percent or higher. Yields and unit
revenue increase at a much greater rate at high load factors [in proportional terms] relative to the
reduction in capacity.
Of course, things are never held constant and the biggest impact on load factors and yields will occur
in the specific markets where capacity has been reduced. Obviously, this is a case of the survival of
the fittest, and the biggest winners will be those airlines that previously competed with ATA and Aloha.
United and American will be the biggest beneficiaries given their large share of the Hawaiian market.
All of the major airlines fly to Hawaii and all will benefit from the shutdowns.
Without a merger or three, it's a war of attrition in an industry that still has 15 percent too much
capacity, given $100-plus oil and a weak economic environment. The industry would certainly benefit if
at least one big airline or a handful of smaller companies failed. Consolidation works best since
mergers reduce redundant and overlapping functions and enhance scope economies. Those
economies are further enhanced when the merged airline better coordinates its capacity with a foreign
airline (alliance partner) that is willing to invest equity.
the industry is ready for renewed investments
Vaughn Cordle, CFA / April 7, 2008
The failure of ATA, Skybus, Aloha, Maxjet and Champion is sad news for the employees and investors
of these weak airlines, but welcome news for a feeble industry that has been infected with the "excess
capacity" disease for much too long. Excess capacity is a function of excess domestic competition,
and this explains why the US airline industry is unfit for long-term investment.
These airlines were forced to shut down because industry fundamentals and macroeconomics have
deteriorated significantly over the last three months. Indeed, there is nothing on the horizon that
suggests things will get better anytime soon. The airlines could not raise capital (or raise it at an
acceptable cost), and their balance sheets could not absorb the losses. The airlines simply could not
make a successful business case for continuing operations after it became obvious that they would
run out of cash in the sooner rather than later.
Without prospects for growth and the resultant lower relative cost effect, many of these smaller players
were unable to attract the capital required to offset their losses. And without an adequate cushion of
equity and the lack of profitable growth opportunities, the risk of bankruptcy is simply too great for even
the dumbest airline investor. The wealth destroyers tend to use depreciation expense-enhanced
cash flow (recall that deprecation is a noncash expense) to fund operations and growth, and this sets
them up for failure later when times get tough and the lack of proper investment finally catches up with
them. Clearly, this strategy only works as long as the funding of growth does not over-leverage the
balance sheet.
Most airlines exceed an optimal (i.e., sustainable) rate of growth for too long, and this is the primary
reason most of them get into trouble. Executives have a strong desire to grow because doing so
lowers costs and expands valuation multiples. This tendency to grow too fast for their own and the
collective good is what I call the "destructive growth prerogative."
The best outcome for the wealth-destroying US airline industry is one in which the market is allowed to
weed out the most weak and feeble competitors. Less competition will reduce the yield-destroying
intensity of rivalry and benefit the airlines that have the financial wherewithal to survive both a
recession and higher fuel costs.
Our base-case is that the industry will pull down 5% or so domestic capacity with the anticipation of an
economic recovery in a year or so. The bigger airlines have greater financial flexibility to weather a
recession than the smaller ones, and it is those smaller airlines that have a greater exposure to the
weak US economic environment. Big network airlines have resources and supplier-provided relief
that smaller airlines lack. This provides them with a significant advantage in terms of keeping the
doors open for business when times are tough.
The US airline industry is mature—and in decline—and it simply cannot absorb more "low-cost"
airlines that finance fast growth via dumb investors rolling the dice, too easy financing and low labor
costs. The industry is in desperate need of consolidation, and the recent bankruptcies and grounding
of the weakest airlines is a good place to start. The combined capacity represented by these five
small airlines is only 1.12 percent of over one trillion ASMs systemwide, so the weeding out of the
most uneconomic and excess capacity must continue. However, even a small reduction in capacity
has an outsized and positive impact on the remaining competitors. When all things are held constant,
a 1.12 percent reduction in total capacity results in a .90 percent increase in industry load factors and a
1.13 percent increase in unit revenue.
Industry passenger revenue remains the same if yields and revenue passenger miles do not change
as capacity leaves the system. However, the benefit is that the competitor's lost traffic and revenue is
shared by the remaining competitors. Moreover, there is a positive correlation between load factors
and yields, especially when average load factors are near 80 percent or higher. Yields and unit
revenue increase at a much greater rate at high load factors [in proportional terms] relative to the
reduction in capacity.
Of course, things are never held constant and the biggest impact on load factors and yields will occur
in the specific markets where capacity has been reduced. Obviously, this is a case of the survival of
the fittest, and the biggest winners will be those airlines that previously competed with ATA and Aloha.
United and American will be the biggest beneficiaries given their large share of the Hawaiian market.
All of the major airlines fly to Hawaii and all will benefit from the shutdowns.
Without a merger or three, it's a war of attrition in an industry that still has 15 percent too much
capacity, given $100-plus oil and a weak economic environment. The industry would certainly benefit if
at least one big airline or a handful of smaller companies failed. Consolidation works best since
mergers reduce redundant and overlapping functions and enhance scope economies. Those
economies are further enhanced when the merged airline better coordinates its capacity with a foreign
airline (alliance partner) that is willing to invest equity.
©Copyright 2008 AirlineForecasts, LLC All Rights Reserved
