Structural Causes of Airline Cyclicality: Are We Sowing the Seeds for the Next
Downturn?
What is Wrong with the Airline Industry, and How Can We Fix It?
Kevin NeelsJanuary 14, 2008
2
The Industry Today
The industry is emerging slowly from a severe and extended downturn marked by a substantial number of bankruptcies
• US Airways• United• Northwest• Delta
The Air Transport Association projects substantial profits for the industry over the year ahead
• US airlines will post a collective $3.5-$4.5 billion net profit in 2008, which would mark the US industry's third consecutive profitable year (excluding bankruptcy restructuring-related losses in 2006), a feat not achieved since 1998-2000.
Whether these good fortunes will last is anybody’s guess
3
Have we been here before?
4
Eternal recurrence is a concept which posits that the universe has been recurring, and will continue to recur in the exact same form an incomprehensible and unfathomable number of times.
Eternal Recurrence
5
Sources of Cyclicality
Underlying industry structure
The compensation cycle
The order cycle
6
Sources of Cyclicality
Underlying industry structure
The compensation cycle
The order cycle
7
Some Industries are Characterized by High Fixed Costs, Low Variable Costs and Cyclical Demand
0
0.5
1
1.5
2
2.5
1 2 3 4 5 6 7 8 9 10 11 12Time
$
Revenues
Costs
8
Such Industries Can Fluctuate between Profit and Loss
0
0.5
1
1.5
2
2.5
1 2 3 4 5 6 7 8 9 10 11 12Time
$
Profits
Losses
9
Does this describe the airline industry?
10
US Airline Industry Profits
Source: ATA annual reports
US Airline Industry Profits
$(15,000)
$(10,000)
$(5,000)
$-
$5,000
$10,000
$15,000
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Year
Dol
lars
(in
mill
ions
)
Operating Profits Net Profits
11
But there are some differences…
Generally even a cyclical industry will be profitable over the long term.
Cumulative profitability has eluded the airline industry, however.
• The good times are not good enough• The bad times are terrible
Several aspects of the airline cycle amplify downturn losses
12
Sources of Cyclicality
Underlying industry structure
The compensation cycle
The order cycle
13
Pilot Costs per Air Hour(in 2007 dollars)
0
200
400
600
800
1,000
1,200
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
AmericanJetBlueContinentalDeltaAirTranAmerica WestNorthwestUnitedUSAirwaysSouthwest
Source: Form 41, T-100 data
14
Flight Attendant Costs per Air Hour(in 2007 dollars)
0
200
400
600
800
1,000
1,200
1,400
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Cos
t per
Air
Hou
r
AmericanJetBlueContinentalDeltaAirTranAmerica WestNorthwestUnitedUSAirwaysSouthwest
Source: Form 41, T-100 data
15
Delta Profits and Crew Costs (in 2007 dollars)
-2,000,000
-1,500,000
-1,000,000
-500,000
0
500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Pro
fits
('000
s)
0
200
400
600
800
1,000
1,200
Exp
ense
per
Air
Hou
r
Profit Pilot Cost per Air Hour Flight Attendant Cost per Air Hour
1996: New Pilots Contract (2% salary reduction rescinded after 4yrs)
June 1, 2006: Pilots ratify new contract providing cost savings
Sept 2005: DL files for bankruptcy
Nov 2004: Pilots agree to pay cuts that will save DL $1BN/yr
April 2001: 4-yr agreement makes up for concessions made by pilots in 1996
Source: Form 41, T-100 data, and news reports
16-1,500,000
-1,000,000
-500,000
0
500,000
1,000,000
1,500,000
2,000,000
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007Prof
its (i
n '0
00s)
0
100
200
300
400
500
600
700
800
900
1,000
Expe
nse
per A
ir H
our
Profit Pilot Cost per Air Hour Flight Attendant Cost per Air Hour
NorthwestProfits and Crew Costs(in 2007 dollars)
May 2006: Pilots approve $358M giveback
1993: Flight Attendants, Pilots, Mechanics, ground crew take 15% pay cut
1998: Pilots win pay increase after lockout followed by strike
May 2007: NW emerges from bankruptcy
2004: Pilots take pay cut
Source: Form 41, T-100 data, and news reports
17
UnitedProfits and Crew Costs(in 2007 dollars)
-5,000,000
-4,000,000
-3,000,000
-2,000,000
-1,000,000
0
1,000,000
2,000,000
3,000,000
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Prof
its ('
000s
)
0
200
400
600
800
1,000
1,200
1,400
Expe
nse
per A
ir H
our
Profit Pilot Cost per Air Hour Flight Attendant Cost per Air Hour
Oct. 2000: Pilots ratify contract with large pay increases
Nov/Dec 2002: UAL files for bankruptcy Pilots and Flt Atts agree to recovery plans involving paycuts
2005: Pilots and Flt Attsign contracts with pay reductions
1994: Employee buy-out
1997: Pilots sign agreement with raisesFlt Attssign 10 year deal. 2003: Pilots
and Flt Attssign contracts with pay cuts
2006: UAL exits bankruptcy
Source: Form 41, T-100 data, and news reports
18
US AirwaysProfits and Crew Costs(in 2007 dollars)
-2,000,000
-1,500,000
-1,000,000
-500,000
0
500,000
1,000,000
1,500,000
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Prof
its ('
000s
)
0
100
200
300
400
500
600
700
800
900
Expe
nse
per A
ir H
our
Profit Pilot Cost per Air Hour Flight Attendant Cost per Air Hour
Sept 2004: US re-enters bankruptcyOct 2004: Pilots accept 18% pay decrease through 2009.
Oct 1997: Pilots agree to 5 yr concessionary contract
May 2000: Flt Att. get 5 yr contract with 11% pay increases
2002: US enters Chapt 11. Pilots and Flt Atts agree to concessionary contracts Jan 2005:
Flt Attsaccept 9% pay decrease
Source: Form 41, T-100 data, and news reports
19
SouthwestProfits and Crew Costs(in real 2007 dollars)
0
200,000
400,000
600,000
800,000
1,000,000
1,200,000
1,400,000
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Prof
its ('
000s
)
0
100
200
300
400
500
600
Expe
nse
per A
ir H
our
Profit Pilot Cost per Air Hour Flight Attendant Cost per Air Hour
Jan 1995: Pilots ratify 10 yr contract with stock options rather than raises
2002: Pilot Contract Agreement extended thru 2006
Dec 1997: Flt Atts approve new contract with raises
2004: Flt Attssign 6 yr deal with raises
2006: Pilots reject offer to extend agreement by 1 year
Source: Form 41, T-100 data, and news reports
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The Dynamics of the Compensation Cycle
The legacy of regulation
• Under regulation workers were well compensated, setting expectations for “what we deserve.”
• Competition created pressures to reduce labor costs.
• Memories are long, however, and expectations slow to adjust.
21
The Dynamics of the Compensation Cycle
Eternal recurrence…• Losses during downturns pressure carriers to demand wage
concessions.• A return to profitability prompts workers to demand a return to
pre-concession compensation levels.• Increased labor costs erode upturn profits and amplify
downturn losses.
• New entrant carriers have been less subject to this cycle.
22
Sources of Cyclicality
Underlying industry structure
The compensation cycle
The order cycle
23
Profits, Aircraft Orders, and Aircraft Shipments
$(12,000)
$(10,000)
$(8,000)
$(6,000)
$(4,000)
$(2,000)
$-
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
-1,000
-800
-600
-400
-200
0
200
400
600
800
1,000
Net ProfitsNet New OrdersShipments
Sources: Aerospace Industries Association and ATA annual reports
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Dynamics of the Order Cycle
• New orders increase during upturns.• As orders accumulate, delivery schedules lengthen.• The slow pace of deliveries limits carriers’ ability to
exploit the upturn.• New aircraft deliveries spill over into the downturn,
worsening an already unfavorable supply demand balance and amplifying downturn losses.
25
What to do? Some Potential Ideas for Change
• Bankruptcy, and possibilities for “culling the herd”
• Indexing labor compensation
• Leasing
• Congestion pricing
26
Should Bankrupt Carriers be Forced to Shut Down?
Some have advocated putting an end to the “living dead.”
However there are potential problems…• Would a shutdown really eliminate excess capacity?• Would market concentration increase?• Do we really want to liquidate firms in response to
cyclical downturns?
27
Indexing Labor Compensation
• Labor compensation has varied over the industry cycle, changing in a series of acrimonious confrontations.
• Could unions and management agree to a formula-based adjustment mechanism?
• The positive example of state rainy-day funds.• The negative example of the United ESOP.
28
Leasing Comes in Many Forms
0% 100%
Lease Term / Asset Lifetime
Aircraft
Aircraft & Maintenance
Aircraft, Maintenance,
& Crew
Cos
ts In
clud
ed
Charter
Ownership
Can we move toward a charter model?
29
If We Move toward the Charter Model…
Costs become more variable.Profits become less variable.Expansion incentives during upturns weaken.Transfer of excess capacity to other markets becomes easier.
However,
Lessors are forced to absorb cyclical risks.
30
Congestion Pricing Could Dampen Industry Cycles
• Congestion worsens dramatically during upturns.• Proceeds from slot auctions would rise during
upturns.• Incentives for expansion during upturns would
weaken• Funneling auction proceeds into the Aviation Trust
Fund could permit reductions in other user fees.• The Trust Fund as industry shock absorber.• The Federal Reserve, the party and the punch bowl.
31
What Are the Prospects for Real Change?
Lessors have already assumed a larger role, and will likely continue to do so
Can the labor compensation cycle be broken? Good labor relations as a strategic advantage.
The futures of the Trust Fund and of congestion pricing remain unclear.
32
Is There a Will to Change?
Do we face Eternal Recurrence, or
A series of unfortunate events…