Counting The Cost

Counting The Cost – Grim Financial Outlook For Airlines

The following essay was written and supplied to World Airline News by Vaughn Cordle, a Senior Captain with United and a financial analyst. Many of these views have already been discussed in Internet forums by leading industry figures, but have been revised and updated. Of particular interest are the financial tables on pages 8-10. Cordle points out that these tables include “roughed out” estimates, and are for illustrative purposes only.

On September 11, 2001 the world turned upside down for the airline industry when four aircraft were hijacked and used as weapons of mass destruction. In the blink of an eye, everything changed.

Two days later I did a ‘first look’ analysis that examined the cash, earnings and equity burn rates for the major US airlines. The objective was to quickly assess the relative liquidity, earnings and financial wherewithal of the airlines; the picture that emerged was absolutely ugly. Two weeks have passed and the consensus is that the industry is on the brink of collapse.

It is readily apparent that America West, US Airways, AirTran, and several of the smaller airlines are particularly vulnerable to bankruptcy and would be the most likely to file first. United and American faced massive liabilities that dwarf the equity of the firms; both would have benefited under a bankruptcy administration – if Congress had not resolved the legal liability issues very quickly. United employees are in for a double whammy if there is a bankruptcy filing, with massive layoffs and employee stock ownership program (ESOP) equity wiped out.

There is no doubt that the government bailout package is needed to prevent serious and long-lasting damage to the airline industry. The Air Transport Association is forecasting US$5 billion in losses from Sept. 11-30. Analysts’ reports are estimating industry losses in the $10 billion range through the June quarter 2002.

Based on the actual losses for the first six months of 2001 and the 12.8 percent drop in industry revenues reported in August, the industry was already in a recession prior to the hijackings and headed for a restructuring. The industry simply had too much capacity and costs were too high to be sustained.

The air-traffic congestion and labor problems of last summer were more than anyone could bear. These problems contributed to the yield-killing reduction in business travel and exacerbated the industry downturn.

Poor service problems, a rapidly decelerating economy, high fuel prices and expensive new labor contracts developed into the “perfect storm” and are the reasons losses were forecast to be approximately $2.5 billion in 2001.

The terrorist attacks could not have happened at a worse time. The industry has taken a near fatal hit and several airlines are on the verge of filing bankruptcy. By way of contrast, the industry had operating revenues of $129 billion and net profits of $2.6 billion in 2000.

Economic Boom Inflated Airline Profits

A strong case can be made that traffic levels, yields and industry profits were inflated during the latter half of the 1990s. This phenomenon led to over-investment in aircraft and recent labor contracts that are arguably above free-market derived compensation levels. Labor costs appear unsustainable at many airlines when current and forecast industry economics are considered.

Individual financial assets grew at 4.5 times the rate of disposable income – the S&P500 index returned on average 24 percent per year from 1995 through 1999, while disposable income grew 5-6 percent. This is evidence of a bubble in the broader market that inflated the equity and spending levels of the consumer.

The link to the airline industry is that it is a demand-derived sector that responded naturally to the strong economic environment with large investments in assets and growth. As of Dec. 31, 2000, airlines had firm orders of 1,083 aircraft (plus 1,581 options) with 383 aircraft scheduled for delivery in 2001. Of course that was before the terrorist attacks on the World Trade Center and the Pentagon, and the U.S. government’s subsequent declaration of war on terrorists.

The bubble in traffic and airline profits was inflated, in large measure, by the aggressive accounting policies of corporate America. These accounting practices exaggerated earnings per share and stock prices during the 1995 to 2000 period. Wall street cheerleaders, in the guise of sell-side analysts, over- hyped companies that had (in many cases) banking relationships with the firms the analysts themselves were employed by.

In the longer-run, economic profits – as reflected in the difference or spread between return on invested capital (ROIC) and weighted average cost of capital (WACC) — are positively correlated with stock prices and provide the correct measure of real profitability of a firm. The airline industry’s spreads were positive in the years between 1996 and 2000 but negative over the length of the last business cycle. Cumulatively, the industry destroyed capital (negative 15 percent) from 1991 to the end of 2000. Needless to say, very large sums of capital are currently being destroyed with no foreseeable positive economic spreads in sight. Southwest is the exception, as usual.

Airlines are in Serious Trouble

The airline industry has announced a 20 percent reduction in capacity and 100,000 employee layoffs. The pain and restructuring of the industry has begun and the bubble has popped. Over-leveraged balance sheets and deflated stock portfolios – combined with the prospect of war – suggest that consumer confidence and corporate capital spending will plunge along with traffic levels. The good news is that monetary and fiscal policies are pumping up the money supply and the industry is restructuring to better match supply with demand. It will be a gut-wrenching and painful experience.

The hope is that the government bailout and loan guarantees will stabilize the industry long enough for it to regain its footing. Unfortunately, several airlines will fail – even with the government infusion of cash and loan guarantees. The reality is that many have inadequate cash flows and lack the financial wherewithal to sustain a prolonged slowdown in traffic levels and lower yields. The cash infusion will only cover the immediate and short-term losses attributed to last week’s tragedy, and will not solve the intermediate and longer-term problem of negative economic spreads for many. Loan guarantees will help but will only prolong the agony and eventual demise of the weaker competitors. This is the ugly reality and it implies that the taxpayer will ultimately pay the (loan) tab for the propped-up walking dead.

The industry must restructure because there is simply too much capacity and too many fragile airlines in the post-Sept. 11 world. Moreover, It appears that we are in for a long and painfully drawn out recovery. Perhaps in rebuilding the industry, managers can focus on repairing the broken confidence of its most valuable constituency, the business traveler. Refocusing attention on servicing the needs of the passenger – and actually delivering on that promise – would go along way toward rebuilding traffic levels, consumer goodwill and eventually profitability. – Vaughn Cordle.

Table # 1

(In millions) Post-Sept. 11 daily cash burn

21-Sep-01 Cash burn Revenue Net Monthly

Airline per day per day cash burn burn

Southwest 13.2 9.2 -3.9 -118

Delta 31.6 23.7 -7.9 -238

United 41.1 29.4 -11.7 -350

American 47.2 35.1 -12 -361

Continental 20.5 15.6 -4.9 -146

Northwest 23.3 17.7 -5.6 -168

USAir 21.1 15.6 -5.5 -166

Alaska 4.8 3.7 -1 -31

America West 5.2 3.9 -1.3 -39

AirTran 1.6 1.3 -0.3 -8

Composite $210 $155 ($54) ($1,626)

(In millions) Pre-Sept. 11 daily cash burn

21-Sep-01 Cash burn Revenue Net Monthly

Airline per day per day cash burn rate

Southwest 13.2 14.2 1 31

Delta 39.5 36.5 -3.1 -92

United 51.4 45.3 -6.1 -183

American 59 54.1 -4.9 -147

Continental 25.6 24.1 -1.6 -47

Northwest 29.1 27.2 -1.9 -57

USAir 26.4 23.9 -2.4 -73

Alaska 6 5.7 -0.2 -7

America West 6.5 6 -0.5 -16

AirTran 1.9 2 0 1

Composite $259 $239 ($20) ($590)

Source: SEC filings and V.Cordle

1) Cash burn per day rates are based on 80% capacity levels (Southwest is at

100%).

2) Revenue for the rest of the year based on 65% of pre-Sept. 11 levels.

3) Pre-Sept. 11 cash burn per day and revenue per day based on June 30, 2001

numbers.

4) Cash burns are based on daily expenditures minus amortization and

depreciation and unusual expenses

Table # 2

($ In millions, ASM in 000,000) Est. 9/20/01 9/10/01

% Of total Cash Cash

Airline ASM capacity infusion position

American 50,724 0.2041 $919 872

United 44,691 0.1798 $809 2295

Delta 39,071 0.1572 $708 2351

Northwest 26,233 0.1056 $475 1302

Continental 22,813 0.0918 $413 813

USAir 18,275 0.0735 $331 1075

Southwest 16,444 0.0662 $298 1048

America West 6,896 0.0277 $125 326

Alaska 5,259 0.0212 $95 124

AirTran 1,699 0.0068 $31 98

Composite 232,105 0.934 $4,203 $10,306

($ In millions, ASM in 000,000) Shutdown (Total)

Pre-Sept. 11 Cash burn 4 days of

Airline cash per day shutdown

American 969 11.6 -46

United 2553 34.8 -139

Delta 2747 45.2 -181

Northwest 1752 51.9 -208

Continental 1008 22.6 -90

USAir 1296 25.6 -103

Southwest 1250 23.2 -93

America West 371 5.2 -21

Alaska 174 5.7 -23

AirTran 112 1.7 -7

Composite $12,232 $228 ($910)

Source: SEC filings and V.Cordle

1) ASMs based on the 3 months ending June 2001.

2) Cash infusion from $5 billion bailout, minus $500,000 for cargo

3) Share based on top 10 only.

4) AMR: includes TWA and Eagle’s ASMs.

5) DAL: June 2000 ASMs used due to Comair strike in June 2001.

6) ALK: includes Horizon’s ASMs

Table # 3

($million) 9/20/01 June Q 2001

Tangible Goodwill & Reported

Airline equity intangibles equity

Southwest 3717 0 3822

Delta 2519 2217 5030

United 3636 655 4716

American 4840 1411 6740

Continental -12 1056 1251

Northwest -842 646 40

USAir -1584 829 -542

Alaska 734 52 835

America West 277 283 612

AirTran 5 33 53

Composite $13,289 $7,182 $22,557

($million) Shutdown Reduced

Tangible equity burn equity burn

Airline equity 4 days 6 days

Southwest 3822 50 56

Delta 2813 154 140

United 4061 193 232

American 5329 223 266

Continental 195 95 112

Northwest -606 108 127

USAir -1371 97 115

Alaska 782 22 26

America West 329 24 28

AirTran 20 7 8

Composite $15,374 ($974) ($1,111)

Source: SEC filings and V. Cordle

Notes:

1) Tangible equity is based on June 30, 2001 reported equity minus goodwill and

intangibles.

2) Sept 20, 2001 tangible equity is based on June 30 equity minus shutdown and

6 days equity burns.

3) Daily equity burn rate based on cash burn rate plus amortization and

depreciation.

Table # 4

(Figures in $million) 20-Sep-01 June 30, 2001

Tangible Equity as Total Total

Current

Airline equity % of assets assets liabilities

assets

Southwest 3717 49.80% 7469 3647 1329

Delta 2519 11.00% 22881 17851 3256

United 3636 14.60% 24914 20198 4465

American 4840 16.70% 29002 22262 5174

Continental -12 -0.10% 9496 8245 2216

Northwest -842 -7.20% 11630 11590 2579

USAir -1584 -16.60% 9564 10106 2561

Alaska 734 27.10% 2707 1872 749

America West 277 17.00% 1632 1020 447

AirTran 5 0.90% 524 471 172

Composite $13,289 14% $119,819 $97,262

$22,949

(Figures in $million)

Current Working CL as Current wtd avg

Airline liabilities capital % of equity ratio Current

ratio

Southwest 1629 -300 44% 0.82 0.05

Delta 6421 -3165 255% 0.51 0.1

United 8122 -3657 223% 0.55 0.11

American 7894 -2720 163% 0.66 0.16

Continental 3217 -1001 -26812% 0.69 0.05

Northwest 3924 -1345 -466% 0.66 0.06

USAir 2930 -369 -185% 0.87 0.07

Alaska 768 -18 105% 0.98 0.02

America West 680 -234 246% 0.66 0.01

AirTran 210 -38 4354% 0.82 0

Composite $35,795 ($12,846) 269% 0.72 0.64

Source: SEC filings and V. Cordle

COPYRIGHT 2001 PBI Media, LLC

COPYRIGHT 2001 Gale Group