structural causes of airline cyclicality final · us airline industry profits. source: ata annual...

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

jenna curto

Text Box

Copyright © 2008 The Brattle Group, Inc.

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




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




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


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


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


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


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


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


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


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


20

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




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

24

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…

structural causes of airline cyclicality final · us airline industry profits. source: ata annual...

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