No Lull in the Airlines' Headwinds

The industry isn't doing as badly as it was, but that's not saying much, according to S&P's Philip Baggaley

Airlines are the Penelope Pitstop of U.S. industry -- always in need of rescue, just like the heroine of the 1960s animated TV series. And the last few years have been particularly perilous.

Just as the industry was beginning to shake-off the downturn that followed 9/11, oil prices began to soar. The rise of low-cost carriers has put the industry permanently on edge, and bankruptcy seems to be the order of the day.

BusinessWeek Online Senior Writer Steve Rosenbush spoke with Philip Baggaley, Standard & Poor's managing director and airline analyst, about the fate of the sector. Here are edited highlights of their conversation:

Q: Can you give us a snapshot of how the airline business is doing?


The industry is doing badly despite a strong economy. Broadly speaking, the revenue environment has been improving. It has been strong on international routes for a while. The domestic market, where pricing has been very competitive, has seen some improvement as airlines agree on fair increases.

However, the increases are not nearly enough to offset rising and very high fuel prices. And fuel is the largest problem at this point for airlines. Underfunded pensions are another problem. United (UALAQ.OB ) and US Airways (UAIRQ.OB ) terminated their plans in bankruptcy court. Delta (DAL ) and Northwest (NWAC ) have severe pension-funding problems.

Q: Will pension problems push Delta and Northwest into bankruptcy?


Not coincidentally, Delta and Northwest face a near-term risk of bankruptcy, particularly Delta. If Congress doesn't amend the current pension laws, Delta and Northwest have to make substantial payments over the next several years, in amounts they probably can't afford. One precondition for remaining solvent is new pension legislation. The bill is in the Senate. It could change shape.

Q: What else must big airlines do if they hope to remain out of bankruptcy?


The legacy carriers are trying to cut costs in response to 9/11. And they are responding to competition from low-cost carriers. Most have in fact negotiated concessions from labor. Northwest is the last one that hasn't.

Q: Are the industry's problems cyclical, or is something changing at a deeper level?


By far, 9/11 was the worst shock the airlines ever faced. Then there was the Iraq war and SARS and a huge run-up in fuel prices. They have cut costs and losses have narrowed, but they are flying into a headwind.

The Internet has made pricing much more transparent and tilted the field in favor of low-cost carriers that offer low and simpler faces. Low-cost airlines' market share is 25% now or 30% if you include US Airways. Their share has doubled over the past decade. But that really understates their power.

Legacy airlines face competition from low-cost rivals on 70%-75% of domestic routes. What's driving lower pricing is not so much overcapacity, but the growing market share of low-cost carriers, who are setting prices for the entire industry.

Q: What's the outlook for consolidation and the industry overall?


United and US Airways are in Chapter 11, but both remain unprofitable, although both will probably survive and come out of bankruptcy. So it appears there will still be [the same number of] legacy carriers although US Airways is merging with low-cost America West (AWA ).

It appears likely there will be more bankruptcy and that legacy carriers will get control over operating costs one way or another. But the industry will remain highly leveraged.

Q: In retrospect, how well has deregulation worked out?


There was less price competition and the industry was more profitable, although it was not particularly profitable. Deregulation has helped passengers obtain lower prices, greater value, and more choice. Business travel is a mixed bag. That market also faces more crowded planes and a lower level of onboard service. Deregulation has made life more difficult for organized labor. So it really depends upon who you talk to.

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