Failure To Adopt New Cost Structure Could Be ‘Lethal’

Failure To Adopt New Cost Structure Could Be ‘Lethal’

A $15 billion government aid package will likely give many carriers time to adjust to “radically changed” market conditions, but airlines will have to adopt more solid pricing policies and alter basic cost structures to survive, according to a new analysis that sends a chilling message to the industry. “The old cost structure was uneconomical before September 11 and in the new industry environment we believe it could be absolutely lethal,” financial analysts at ABN AMRO say in the report.

From now on, they say, everything about the airline industry will be subject to review -from fleet and route strategy to compensation, productivity and costs. “The world has changed since September 11, and in our view the existing airlines and their employees will have to adjust or perish, to be replaced by more efficient corporate entities.” The analysts stress that airlines will have to negotiate rapid and significant cost reductions with suppliers and employees, rein in capacity to prevent future deep discounting of ticket prices and correctly size the entire business to better meet future market demand.

Capacity already has been reduced to more manageable levels and costs have been cut through layoffs and the grounding of aircraft. But in the longer term, permanent changes will have to be made, especially on the labor front, the analysis says.

Because the mindset of the traveling public has permanently changed since Sept. 11, airlines will have to reduce capacity and major network carriers may have to sacrifice much of their low-yielding traffic. As soon as the industry stabilizes, according to ABN AMRO, airlines will have to price their product more rationally and forget about trying to fill every last seat at whatever price it takes.

This stark assessment meshes with the thinking of Fitch Inc., an international ratings agency. It makes the case that high-cost network carriers will need a much more dramatic improvement in fare prices to stop the outflow of cash.

The single biggest problem for the airline industry is the high cost of labor, according to ABN AMRO. Labor is the largest single operating cost, and in some cases accounts for up to 40 percent of all operating expenses. Set off by the “outsized” August 2000 contract settlement between United Airlines [UAL] and its pilots, the industry was going into a “death spiral” even before the Sept. 11 events, dragged down by a slowing economy and escalating costs resulting from “uneconomic labor settlements,” the analysis says.

The industry norm and airline employee expectations are that any contract settlements reached at any airline must always top the last contract signed by a competitor, no matter how uneconomic, according to the analysts. As a result, they say labor costs have been heading to levels at which it would have been difficult, if not impossible, for airlines to make profits over a large part of the economic cycle.

“In recent contract negotiations, the pendulum has swung entirely in labor’s favor, particularly in the case of pilots,” ABN AMRO contends. “Airline management has been held hostage by the threat of disruptions of service if pilots did not get everything they asked for. As a result, settlements reached were not economically sustainable.”

While this observation is sure to be contested by labor unions, a very similar sentiment was expressed earlier this year by the head of the Air Transport Association. In April, Carol Hallett told the Senate Commerce Committee that illegal work slowdowns by airline employees are a form of “anti- consumer, guerilla warfare” to gain concessions outside the bargaining process. Because it is hard to prove slowdowns are taking place, “it is a virtual certainty that major service disruptions and substantial economic losses will be experienced before any action can be taken to begin to deal with the situation,” she said.

The authors of the ABN AMRO analysis, Raymond Neidl and Erik Chiprich, argue that airline unions and much of their membership are in a state of denial that uneconomic contracts and unproductive work rules are not a major part of the problem. They also caution that while the $15 billion package of direct grants and loan guarantees will be a big help, a large portion of the industry could still end up in bankruptcy proceedings and that some of the carriers may not make it .

ABN AMRO does have some encouraging words. It says the airline industry should be back to somewhat normal levels of traffic by the second half of 2002, and if the economy recovers, the industry may be profitable again in 2003. But it is likely that the major network carriers will be slightly smaller as they accelerate retirement of older aircraft and defer new deliveries.

“We expect the major network carriers will have fewer seats to offer for the foreseeable future, possibly enabling them to gain slightly firmer control over pricing,” the analysis says. “There is also the possibility that there may be fewer airlines, further reducing seat inventory.”

On Nov. 7, Neidl pointed to some immediate problems confronting the airline industry. He found that nine major carriers plus AirTran Holdings [AAI] had significantly lower traffic levels in October compared to last year because of the Sept. 11 attacks. As a result of the fall-off in traffic and lost revenues, many carriers have announced significant decreases in capacity to help reduce costs to slow cash burn.

The airlines had a cumulative decrease in revenue per available seat miles (RPMs) of 24.6 percent, while available seat miles (ASMs) decreased for the month of October by 15.3 percent. The larger percentage decrease in RPMs as compared to ASMs caused the load factor for the universe to fall 7.7 points to 62.8 percent for the month of October.

Neidl noted that the load factor had a slight improvement when compared to September when it was 58.9 percent but said he suspects that any traffic gains were generated by deep discounting. He therefore expects to see a sharp erosion of yields in October and the fourth quarter.

“The airline industry is in a crisis and how quickly traffic returns to the airlines will depend on economic improvement, the magnitude of ticket discounts, how fast security changes are made, and when travelers begin to feel confident in their safety when flying,” he said. “Traffic has begun to see some improvement, but we do not believe that normal traffic patterns will return until at least the middle of 2002.”

Some Carriers Move Aggressively To Survive

Despite the enormous disruption caused by the Sept. 11 attacks, there is some good news. While still sizeable, ABN AMRO’s 2002 loss estimates were sharply reduced for American Airlines [AMR], America West Holdings [AWA], Delta Air Lines [DAL], Continental Airlines [CAL] and Northwest Airlines [NWAC] since these carriers have taken aggressive steps to cut costs.

In fact, ABN-AMRO says that with stock prices relatively low, investing could be attractive and the prospect for a sharp long-term appreciation in values is good if carriers can get through the current crisis.

The carriers expected to do the best will have stronger balance sheets, greatest liquidity, the most experienced and flexible management and the broadest systems.

Widespread Chapter 11 Filings Likely Despite Bailout

Even with layoffs and a $15 billion government aid package, there is a “distinct possibility” that a large portion of the airline industry could end up in Chapter 11 bankruptcy proceedings, with some carriers not surviving, according to ABN AMRO. And if they don’t pull through, the investment house says the government would be hard pressed to give them more money. “If airlines cannot make it with the current aid package, they should not look for a second rescue attempt,” it says.

An author of the analysis, Raymond Neidl, has testified in favor of the airline aid package. But he also says that the industry might be better off in bankruptcy if reforms are not made in the basic way carriers operate and in their cost structures. “The benefits of bankruptcy reorganization would be that reform would be forced on the airlines; those unwilling or unable to make fundamental changes would perish to be replaced by more efficient entities.”

One downside to the government aid package is that excess capacity could remain in the market as marginal airlines continue to operate using government loans. “Even after recovery under a best case scenario, airline balance sheets will likely be in a shambles,” the analysis says. “Given the expected high losses over the next four to six quarters, and the need for additional loans – whether government guaranteed or not – to boost liquidity, airlines are expected to become more highly leveraged than is prudent.”

With government loans there would be equity dilution, and any type of loan would require additional debt servicing, putting a further strain on profits and future cash flow. While carriers could issue new equity, that also would be “dilutive” at the currently very low stock prices.

For airlines to survive, they will have to lower unit labor costs, whether by reduced compensation levels, a change in work rules, or a combination, ABN AMRO argues. “Balance sheets are being devastated and all carriers will have to borrow to keep themselves liquid. Those carriers that make it through the current crisis will be facing a new crisis down the road when the debt has to be serviced.”

Moreover, carriers will have to convince powerful pilot unions that the use of a greater number of regional jets to service smaller markets is no longer a luxury but a necessity if network carriers are to remain competitive. >TK

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