U.S. airlines may stabilise in 2006
U.S. airlines are assessing the impact of another year of financial turmoil and multiple bankruptcies, improved domestic pricing and capacity reduction are establishing a stronger foundation for modest improvements in liquidity and balance sheet health in 2006, according to Fitch ratings.
With no clear signs of softening air travel demand on the horizon, the outlook for industry revenue is strong for the next several quarters, and average fares are likely to trend higher again next year.
However, the future direction of crude oil and jet fuel prices remains the greatest unknown that will likely determine whether 2006 is a year of modest balance sheet repair or simply another year of weak cash flow generation and ongoing liquidity pressure.
The recent spike in refined product prices caused by Hurricanes Katrina and Rita exposed U.S. airlines to extreme fuel cost pressure at a time when significant gains in revenue per available seat mile (RASM) would otherwise have supported stronger operating margins and respectable cash flow generation.
Unfortunately, the surge in 2005 energy costs (largely unhedged at the major carriers) has kept pressure on cash balances and prevented U.S. airlines from beginning the process of delevering badly damaged balance sheets. Indeed, the post-Katrina jet fuel price spike helped accelerate the timing of chapter 11 filings by Delta and Northwest on Sept. 14 and Independence air on Nov. 7.
While no other large carriers face the risk of an imminent liquidity crisis moving into 2006, it is clear that a similar energy supply shock could lead to another year of unsustainable operating results-even if such a shock did not result in weaker economic growth or diminished air travel demand.
With fuel now accounting for 22-25 percent of U.S. airline operating budgets, the need to keep tight controls on nonfuel unit costs is even more pressing. With the exception of Southwest Airlines, none of the major carriers has a substantial energy hedge in place for 2006, and weak balance sheets make entry into large-scale hedging programs difficult.
It is safe to assume that a major pull-back in crude oil and refined product prices next year would spur a big increase in the level of hedging activity. While the solvent majors and many of the better capitalized LCCs could be in a position to cap some fuel exposure next year, the bankrupt carriers (notably Delta and Northwest) will be forced to focus on cash conservation and may not be in a position to hedge effectively.
Should energy prices remain at or near current levels, a significant increase in passenger RASM will be decisive in determining whether the big carriers can report stronger cash flow and liquidity. Based on Summer 2005 demand levels and a favorable macroeconomic outlook, the foundation for strong domestic and international traffic patterns in 2006 appears solid. The unit revenue outlook is strengthened further by the improved domestic available seat mile (ASM) capacity picture.
Chapter 11 restructuring plans at Delta and Northwest call for deep cuts in domestic ASMs at both carriers next year. Furthermore, the likely liquidation of at least part of the Independence Air operation at Washington-Dulles should ease competitive capacity pressures on the East Coast next year. Fitch believes that domestic system capacity for the industry could fall by as much as 5% in 2006, with much of the supply relief occurring in the East.
To some degree, the positive impact of better domestic supply-demand fundamentals will be offset by the redeployment of ASM capacity to international markets, where 2005 yield trends have been quite strong. Plans to grow Trans-Atlantic and Latin American scheduled capacity at high rates in 2006 may begin to undermine pricing in some key markets.
Delta, in particular, seems to be at risk of unit revenue underperformance over the next several months as it moves aggressively to redeploy unprofitable domestic capacity to Europe and Latin America. For all of the U.S. majors, but especially for United and Northwest with their extensive Pacific route networks, the potential for emerging public health crises tied to avian flu outbreaks in Asia continues to pose some risk of international travel demand shocks and corresponding revenue weakness through the winter months.
The Delta and Northwest bankruptcies have set in motion another round of labor cost restructuring efforts at those carriers that will likely drive their pay and benefit levels closer to those seen at Southwest and the other LCCs by mid-2006. Wage cuts, whether reached consensually or through the direction of bankruptcy courts, will almost certainly be accompanied by the distressed termination of the two carriers’ defined benefit pension plans.
The cash funding burden required to meet unfunded pension liabilities will likely be too large for Delta and Northwest to attract exit financing following a Chapter 11 reorganization. Fitch believes that termination of the plans will be required, even if the U.S. House of Representatives follows the Senate in passing a pension reform bill that provides a 20-year amortization period for the repayment of unfunded airline pension liabilities. Pressures are intense to achieve benefit parity with United and reorganized US Airways, both of which have terminated all of their defined benefit plans in bankruptcy.
With most traditional airline pension plans likely terminated by late 2006, American and Continental will find themselves the only major carriers still facing the need to fund defined benefit plans. For both of these carriers to manage pension funding obligations and heavy debt maturities effectively, consideration of plan freezes will be required.
Continental has already contained part of its pension problem by freezing its pilot plan earlier this year. Absent a plan-freeze agreement with labor, American may be forced to seek offsetting productivity concessions from unionized employee groups to maintain a competitive cost position versus the other legacy carriers in an industry now largely devoid of traditional pensions.
For all of the highly leveraged legacy carriers, even United in the wake of its three-year Chapter 11 reorganization effort, substantial debt reduction and balance sheet repair will only be possible if earnings and operating cash flow levels recover dramatically in 2006 and beyond.
At a time when more classic midcycle revenue trends should be supporting a surge in free cash flow generation and debt reduction, high fuel costs and intense fare competition have delayed the process of financial reconstruction and have exposed the industry to the risk of even more structural turmoil when unit-revenue trends take a turn for the worse.
The bankruptcy filings of four major carriers over the past four years have failed to deliver the type of industry consolidation that could lay the foundation for corrective capacity adjustments and pricing stability during the next period of air travel demand weakness.
Prospects for industry consolidation appear somewhat better moving into 2006, given the surprisingly strong availability of equity capital (witness the recapitalization of new US Airways) and some indications that the opposition of antitrust regulators to big mergers may have waned during a period of industry financial crisis.
However, the willingness of better-positioned carriers (Continental and American in particular) to drive consolidation remains very much in question-particularly given the weak character of those airlines’ balance sheets. Still, improving access to private equity capital may well result in increased discussion of M&A activity and industry consolidation next year.