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Airline Woes: It's Just Math

While most airlines have money in the bank, the industry still struggles with rising fuel costs and the lingering threat of recession

As crude oil tops $110 per barrel, a worried hum heard in the U.S. airline industry in recent months is now building into a shrill alarm. The latest alert came Mar. 12 when JPMorgan Chase (JPM) downgraded seven large U.S. airlines and suggested the "best-case" scenario for the industry is a $4 billion loss for the year. "And if demand trends mirror prior recessions, a $9 billion loss can't be ruled out," JPMorgan analyst Jamie Baker wrote.

That report came a day after a similar Credit Suisse (CS) warning and a notice from Standard & Poor's Ratings Services that it will review its ratings on 10 U.S. airlines, citing "cost pressures of rapidly increasing fuel prices and a weaker domestic economy."

That was about all investors needed to hear. Alaska Air Group (ALK) plunged 18%, to 18.36; American parent AMR (AMR) tumbled 13%, to 9.31; Delta (DAL) fell 16%, to 10.13; Northwest (NWA) dipped 16%, to 10.25; and US Airways Group (LCC) dropped 10%, to 9.02. All of those stocks set 52-week lows on Mar. 12. UAL's (UAUA) United dropped 10%, to 24.29, and Continental (CAL) was off 10%, to 20.46.

The selling came on a day when a barrel of West Texas Intermediate crude oil rose to a record of $110.20 on the New York Mercantile Exchange (NMX). Jet fuel has soared nearly 80% over the past year, from $1.85 per gallon a year ago to a record $3.21 on Mar. 11 on the spot New York Harbor exchange. That's far above the forecast of $2.50 to $3 per gallon most airlines had expected for the current quarter.

The only good news in all the gloom is that the airlines' balance sheets can withstand the current price, for a while. The two largest U.S. airlines, American and United, had $5 billion and $3.6 billion on hand, respectively, at the end of 2007. The bad news is they are heading into a period of likely malaise for the U.S. economy and reduced travel spending.

An Uncomplicated Equation

The immediate problem for all the airlines comes down to a simple equation they've been able to do very little about: a high and rising fixed cost—jet fuel—combined with weak sales that may soon drop. As Baker puts it: "The math is not complicated." Across the industry, he says, airlines are staring at a fuel bill that is $25 billion more than in 2002, the second year of the industry's last significant downturn. That swamps the $7 billion airlines squeezed out in labor costs during the wave of bankruptcy reorganizations that followed.

On Mar. 10, Northwest Chief Executive Doug Steenland said oil above $100 will cost the company $1.7 billion more than it had budgeted in 2008. "For us, this is a serious budget-breaker. Every $1 increase in fuel equates to $42 million per year in added costs," Steenland told employees on a Mar. 10 weekly telephone message. "If fuel remains where it is today, our increased fuel costs will again create a difficult financial challenge for the airline." Delta Chief Executive Richard Anderson also complained about high fuel prices this week at a conference in Washington, D.C. Both airlines have reportedly been talking about merging.

Some Good News

On the brighter side, the JPMorgan report noted several reasons customer demand may be off 6% to 7% instead of the 10% to 15% decline seen in previous recessions. Among the factors it cited: a "decoupling" of domestic and international travel, a smaller spread between the cheapest and most expensive tickets than in 2001, and a shift of more of the industry's overall capacity to low-cost players such as Southwest (LUV), JetBlue (JBLU), and AirTran (AAI) than during the 2001-02 downturn. Also, pricey crude is hurting everyone. "[September 11] proved a crisis for a certain subset of the industry (those with bloated labor costs) whereas airlines like Southwest and JetBlue hardly skipped a beat," Baker wrote. "This is different. Everyone feels the current reality."

A potentially more significant issue arises when a U.S. recession strikes and customer demand wanes. S&P projects a 70% chance of recession this year, with negative gross-domestic-product growth in the first half. In that scenario, airlines could be forced to cut prices while still paying a higher fuel price than their business model factors in. "I think demand will remain. What will happen though is that airlines…may have to discount to fill seats," Calyon Securities analyst Ray Neidl says. "It's your yield rather than your demand that I would be more concerned about." Moreover, most airlines have been building piggy banks for lean times and have cash and short-term investments equal to 15% to 25% of annual revenue, according to S&P.

All of which means that, cash-wise, airlines are fine for now but could face liquidity problems if a U.S. downturn proves severe. "Most of the big carriers could get through the next two years," Neidl says, given their more profitable international routes. Notable exceptions would be US Airways and JetBlue, which do not have much exposure to international revenues and don't have the deep cash reserves of Southwest.

Sizing Up

One partial fix would be to reduce fleet sizes. Baker says JPMorgan calculates 400 planes—about 17% of the domestic fleet total—"could be fairly easily shed." Another option would be combining carriers and reducing capacity to the most profitable flying. That scenario, however, faces a thorny course of regulatory, political, consumer, and labor opposition, and pushing through any deal may require the kinds of concessions that don't fix the underlying economics.

"Consolidation may help longer-term assuming labor doesn't intercept most of the benefit, but getting there may prove scary," Baker wrote. Deep capacity cuts later in 2008 "may offset part of the expected pain," but not enough to greatly curb the expected losses. While he still expects the industry to begin consolidating, Baker is telling clients to play any resulting rally as a time to head for the exit.

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