"Airlines' Fundamentals are Deteriorating"

So says S&P's Philip Baggaley, who also thinks the deal by American Airlines' parent to buy troubled TWA could pose big labor problems for the carrier

After soaring for most of 2000, the U.S. airline industry has hit some rough weather in recent months. And that's not just a figure of speech. A harsh winter, combined with rising labor and fuel costs -- and a deteriorating economic environment -- are striking at the major carriers' bottom lines.

Want proof? On Jan. 17, AMR Corp. (AMR ), parent of American Airlines, reported an 83% drop in fourth quarter net income from a year earlier. But at least they posted a profit. Rivals U.S. Airways (U ) and America West (AWA ) each reported large losses for the period.

Amid all the turbulence, shares of some of the top players in the industry remain well below the highs recorded in early 2000. And the industry appears headed for another wave of consolidation. The latest, and most eye-catching deal, was announced Jan. 10: AMR agreed to buy most of the assets of bankrupt Trans World Airlines (TWA ). In a separate deal, AMR agreed to buy about 20% of US Airways. UAL Corp. (UAL ), which owns United Air Lines, has a deal to acquire the rest of US Airways.

Will there be more mega-deals on the order of AMR-TWA? And what's the prognosis for the industry? BusinessWeek Online correspondent Alan Hughes sat down with Philip Baggaley, managing director and airline bond analyst at Standard & Poor's. Edited excerpts from their conversation follow.

Q: What do you think of the airline industry's current fundamentals?


The airline industry's current fundamentals are deteriorating. Obviously a slowing economy will hurt most of them. The fuel price situation is improving but a larger and longer-term problem is rising labor costs. And so just as their revenues are beginning to weaken from strong levels, their largest single cost category is escalating significantly.

Q: Wall Street gets nervous about airlines every time there's a hint of recession in the air. What kind of impact could the current economic slowdown have on the airlines? What segment of the industry is feeling the greatest impact?


So far the airlines have not actually seen any impact from the slowdown. Indeed, they seem to be so much surprised by it. Now they're going to be releasing earnings in about two weeks and perhaps in some of those calls some airlines will begin to disclose weaker bookings. But up until now they have said that traffic and bookings and the pricing in particular because of the fare increases, have remained strong. I wouldn't expect that to continue.

The one airline that will probably continue to do quite well, however, is Southwest (LUV ). They offer a lower fare product and people sometimes switch down in a recession. The other thing is that because the big airlines are seeing increasing costs and potentially with the [industry consolidation], they might have more pricing power. Southwest's cost advantage is going to widen even further so I think they'll continue to do quite well. But certainly the larger, more traditional airlines will be hurt by slowing traffic.

Q: Will the current lower interest rate environment help the airlines financially?


That won't help them much because most of their debt and leases are fixed rate.

Q: One of the larger expenses for airlines is fuel. Aren't these prices locked in, or hedged, as well?


Obviously to the extent that they're buying it on the spot market and they're unhedged, [the airlines] will benefit. On the other hand, their original lower cost hedges that were put in place awhile ago have been running off. And so the hedges they have in place now in most cases were put in place after fuel costs had begun to rise so they're at higher levels. In other words, they're not as protected as they might have been before.

Q: Aside from the economy, what is the most pressing concern facing airlines?


Well, labor is the largest cost item, it's over a third of total costs. And it's also the biggest problem for them. Because there is a pattern bargaining increase in wages going around the industry, big increases. Wages were already moving up somewhat and then when United's pilots got their very generous contract, that just raised expectations. Not only for other pilot unions but also for other employee groups like mechanics and flight attendants. And the fact that we're going into a slowing economy isn't going to temper their interest in getting higher wages.

The trend of labor costs in the airline industry tends to lag the business cycle. So if you go into a slowdown it'll be a while before the unions can be persuaded that they need to either make concessions or restrain increases. And conversely when the economy is improving, for awhile they don't get the benefit of it and after a couple of good years, these contracts roll off and labor gets impatient and they want big increases to catch up. And that's what's happening currently.

Q: What kind of a financial impact do you think this winter's harsh weather conditions will have on the airlines?


It's not a long term concern and it's not really on the same scale as some of the other issues. In fact, labor disruption probably has a bigger impact. United had a loss in the third quarter, which is the summer quarter and normally very strong. Delta (DAL ) has already disclosed they've been hurt badly by the pilots not flying overtime.

Q: AMR Corp., which owns American Airlines, recently agreed to acquire bankrupt Trans World Airlines Inc. and some assets from US Airways. Is this a sound strategic move for AMR? What are the chances that other buyers could step in?


I think it's unlikely that other serious buyers will come in. TWA has effectively been for sale for over a decade and there have been no takers. American was moved to finally make an offer mainly because UAL was trying to proceed with their acquisition of US Airways and also because TWA had gotten to the point where they could try to buy it out of bankruptcy. AMR didn't want to buy it as a going concern because then they'd have to accept all the existing financial contracts, labor contracts and so forth. So I don't think it's likely that anyone would step forward with a serious offer.

Q: Do you think it's a good deal for AMR?


Well, we did place our ratings on AMR and American on credit watch with negative implications being that they'll be reviewed for a possible downgrade if this goes through. The risk that American is taking is one that they're taking on more financial obligations. But perhaps more important, they face a difficulty of integrating various labor groups in a merger and labor is often the biggest problem in airline mergers. It's a heavily unionized industry and the pay of employees, especially the pilots, is determined mostly by their seniority. So when you put two employee groups together, you have to determine where they stand in the seniority ranking and that means big dollars for the employees.

The other thing that happens is that the unions of the company which the acquisition, in this case American, use the need for their cooperation as bargaining leverage to get more generous contracts. That's what United did and that's what American pilots are making noises about.

Now, the alternatives facing American, however, weren't necessarily good either. If UAL's acquisition of US Airways was approved in its original form, it would have put American at a competitive disadvantage. As it is, under this proposal, they'd be able to buy about a fifth of US Airways' assets, including some that American find very attractive. So I think American was faced with two somewhat unappetizing choices and they felt that this was the best of the two.

Q: Do you see more consolidation ahead for the industry? Is there a chance that the Justice Department might step in?


It's possible but not certain. Delta, Northwest (NWAC ) and Continental (CAL ) are the remaining three big players. From an antitrust point of view, probably Delta could get permission to combine with either Northwest or Continental -- but not both, certainly. However, there are a couple of problems. One is that Northwest was asking such a high price when American looked at them that American choked on it and didn't proceed and probably Delta would too.

Also, Delta has only one major union, their pilots union, and they tried to keep their other major groups like the mechanics and flight attendants non-union. If they were to acquire Northwest, which is heavily unionized and has been for a long time, they'd have to have representation elections and unions could well be voted in. So those are two deterrents.

In the case of Continental, which Delta looked at before and very seriously, the main deterrent is that Northwest still has a veto power over Continental selling out to anyone. So Delta would have to somehow buy off Northwest to get permission to buy Continental.

Q: You said the airline industry's fundamentals are deteriorating. Are there any bright spots here at all?


Well, the one silver lining in the clouds for the big airlines -- if not for the flying public -- is that if these various mergers go through, in many markets there will be more pricing stability and less tendency to discount. So after you go through all these disruptions and through whatever slowdown our economy is going through, they'd benefit from higher pricing.

Edited by Will Andrews

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