June 3, 2002
Vol. 20
Iss. 22
Use the table of contents below to jump to the stories that interest you, or use the scroll bar to browse through the entire issue.
Wide Gap In Business, Leisure Fares Drawing Fire
  
Corporate Travel Execs Back Major Pricing Overhaul
The airline industry is coming under increasing pressure to narrow the gap between business and leisure fares, and some corporate travel executives want carriers to
dramatically restructure their pricing models. The executives reject the notion that when the economy strengthens, business travelers will come rushing back and the industry will
return to the pricing power of the 1990s.
The drumbeat from Wall Street to acknowledge new pricing realities is growing louder. For example, Sam Buttrick, an analyst at UBS Warburg, says he would be much more
impressed if the large network carriers focused on creating demand instead of constraining supply. He emphasizes that leisure travel is a terrific value in the United States while
business travel often is not, and that consumers are spending on air travel while businesses are not. "Does anybody see the connection here?" he asks in a May 23 analysis.
Another analyst, Brian Harris of Salomon Smith Barney, says the large gap between business and leisure fares is a key factor in the airline industry's poor revenue
performance. He notes in a May 28 analysis that business fares are five times more than leisure fares. This is due to business fare increases in the late 1990s and leisure fare
cuts this year and last year. The widening divide, he says, continues to drive the "business buydown phenomenon" evident since February 2001. In Harris' view, the solution is to
raise leisure fares and potentially lower business fares. Despite recent attempts to do this, no meaningful leisure fare increase has stuck.
Harris points out that over the past two months, airline stocks have declined by 29 percent thanks to a flow of bad news -- flattening revenue improvement, Street expectations
coming down, an America West Airlines [AWA] fare reduction, failed attempts to raise leisure fares and rising oil prices. Yet Harris is optimistic that
leisure fares will climb in the not-too-distant future. "While we cannot predict when a significant leisure fare increase will stick . . .we think it likely that one will occur
within the next four months, upon which time the stocks will likely surge leaving those investors on the sidelines having 'missed the move'," he says in the analysis.
Many corporate executives are not as optimistic. They are pressing the airline industry to completely overhaul the airfare structure. They do acknowledge, however, that
airlines have bona fide concerns about the risks associated with airfare reform. The response to "value pricing" in 1992 cost the industry some $300 million dollars.
Still, the executives say there is a growing recognition that the domestic U.S. airfare structure is no longer adding value for the airlines -- or for their very best corporate
customers - and that fundamental reform is urgently needed. This viewpoint was fleshed out in a white paper last month from the Association of Corporate Travel Executives
(ACTE). It said the objective of any reform should be to induce business travel demand at high enough yields to return the airline industry to "sustainable profitability" as soon
as possible. It said that while major airlines recently have experimented with new business airfare programs, few have attempted true reform.
Historically, airlines have been reluctant to pursue reform for several reasons. For one thing, some airline executives seem to believe that when the economy strengthens,
business travelers will come roaring back. In addition, most airline executives are concerned about taking a risk on a new approach to an airfare structure that would not have the
support of corporate customers and could be sabotaged by competitors.
According to the white paper, some major airlines acknowledge they have lost control over their pricing because business travelers are purchasing low-yield, restricted
airfares. Standard & Poor's, the credit rating agency, has compiled a report noting that U.S. business travelers are taking advantage of low leisure fares.
Even the Bush Administration is becoming sensitive to airline pricing policies. Norman Mineta, the head of the Department of Transportation, reportedly said in
May that leisure and business fares have to be more in line if the industry expects to climb out of its financial doldrums.
According to the ACTE white paper, major airlines face a conundrum. It notes that labor costs are too high for the current and foreseeable airline revenue environment, worker
productivity levels are too low and pilot scope clauses are too restrictive. As a result, a lower business airfare model is inextricably linked to reform of the labor model. Yet
there is a perception among some labor leaders that there is no need to move toward a more rational labor model. The white paper says that like some airline executives, labor
leaders seem to believe a rebound in business travel is nearly 100 percent tied to the economy.
Adding further pressure to the major airlines' yields, the low-fare segment of the industry is resurgent with its highly productive workforces and attractive business airfare
structures. Some 73 percent of those who responded to an ACTE survey reported using low-fare airlines more in 2001 than in 2000. Some 69 percent said they will further increase
their use of low-fare carriers in 2002. Moreover, charter and fractional jet ownership programs are growing at double-digit rates, and corporations are intervening in the supply
side of the market to implement competitive alternatives, such as low-fare airline revenue guarantee programs and air charter networks. In short-haul markets, business travelers
are more often choosing a relatively hassle free, five-hour, door-to-door trip in their cars for $75, compared to a six-hour, $750 hassle-prone airport experience, according to
the white paper. The survey results indicate that 77 percent of travel and purchasing managers are observing greater use of rental cars and trains in airline markets with a
distance of less than 500 miles. Some 16 percent of companies now require employees to drive in short-haul markets, and 9 percent are considering such a policy.
Meanwhile, Harris of Salomon Smith Barney says that Frequent Flyer Partnership (FFP) programs are becoming increasingly important profit centers for the airlines and eventually
could be spun off as separate entities. He notes that Air Canada has made it known that it is considering a spin-off of its frequent flyer program, Aeroplan. The
sale of miles helps the airlines generate substantial incremental revenue through a host of different partnerships, including credit card companies, hotels and car rental
agencies. FFPs are in essence fast-growing, highly profitable distribution companies, generating above-average returns, according to Harris.
Industry Dragged Down By 'Unaffordable' Business Fares
Overly complex airfare structures, unpredictable prices and "unaffordable" business airfares are some of the factors dragging down the airline industry, according to the
Association of Corporate Travel Executives. A proposal by the group offers several suggestions for reforming airline pricing policies, including:
- Overly Complex Airfare Structure. Complexity is expensive and can breed mistrust among customers. Up to 1 million airfare changes are made each day to some 30
thousand posted airfares. In the view of many, shopping and buying an airline ticket has turned into a sort of shell game that can alienate business travelers. Expensive travel
technologies cannot be deployed for optimum benefit in a complex airfare environment, and resources are often misallocated to managing complexity instead of improving productivity
or reducing cost.
- Unpredictable Prices. Airfares are not generally guaranteed for the term of a contract, as with virtually all other products that corporations purchase. Many corporate
discount programs are, in a sense, counterfactual in that discounts are tied to a floating airfare that has generally trended up during the terms of contracts.
- Unaffordable Business Airfares. Many organizations, large and small, that fund business travel activities perceive current airfare levels to be too high for the value
received, and too high in comparison with currently available substitutes to the commercial airline product. Often travelers, especially small business owners, simply find
airfares unaffordable.
- Reverse Customer Segmentation. The airline industry seems to pursue customer segmentation differently than most other industries. The airline industry tends to focus on
building fences around the products a business traveler actually desires, versus building a product around what a customer wants and needs. Some airlines have recently responded
to this specific issue by providing affordable airfares, without a Saturday night stay requirement, for business people planning travel well in advance.
The group's proposal also says the myth remains alive and well that business travelers almost always plan flights at the last minute and that seats must be priced high to keep
them available. Many corporations have average advance purchasing times for air travel of 15 days or more, according to the group. And it says this average time could be pushed
higher if a major incentive were in place for corporations to aggressively promote such programs.
Senate New Battleground For US Airways' Restructuring
Following a defeat in the U.S. House of Representatives, US Airways [U] is fighting to convince the Senate to reject a provision in a
supplemental spending bill that would postpone the loan guarantee program until Oct. 1 -- and then whittle it down from $10 billion to $4 billion.
A supplemental appropriations bill approved by the House on May 24 put the loan guarantee program on hold until Oct. 1, the beginning of the new fiscal year. As expected,
efforts by Rep. James Moran (D-VA) to strike this provision through an amendment failed (AFN, May 27). Now that the House has voted, US Airways is shifting its focus to the
Senate, which will return from the Memorial Day break the first week of June.
A congressional source said the Senate may take up the appropriations bill (S. 2551) on June 3 or June 4. It is hard to say whether an amendment will be offered on the Senate
floor to delete the provision curbing the loan guarantee program. The bill - including the loan guarantee provision - was approved by a unanimous vote in the Senate Appropriations
Committee. But the source noted that sometimes senators introduce amendments on the floor instead of challenging bills in committee.
According to a source with US Airways, the carrier is working with senators from several states - including Pennsylvania, Virginia and North Carolina - in an attempt to kill
the provision.
The language to postpone and dramatically cut the loan guarantee program was approved by the Senate committee on May 22. If the provision is not deleted from the Senate bill,
it would be virtually impossible to keep the loan guarantee program alive over the summer. Both the House and Senate bills would call for the loan guarantee moratorium until Oct.
1, and there would be nothing to work out in a House-Senate conference. The two chambers would, however, have to decide whether and by how much the loan guarantee program should
be reduced.
US Airways hopes to file an application with the Air Transportation Stabilization Board within a few weeks for a $1 billion loan guarantee. The application deadline is
June 28, but the new de facto deadline will be the day the supplemental appropriations legislation is signed into law. US Airways wants to get the loan guarantees over the summer,
and the legislation could complicate efforts to gain concessions from labor, lenders and others. "It significantly impacts our ability to put forward our restructuring plan," the
source with the carrier said. "We feel it is patently unfair to change the rules at this hour. We are still going forward with the process of filing. The issue is when we will get
the assurances [loan guarantees]."
Meanwhile, the Stabilization Board rejected a loan guarantee application from Vanguard Airlines [VNGD] on May 28. A source with the company said the
application will be re-filed "as soon as possible." Vanguard is quite aware that the legislation working its way through Congress could shorten the June 28 filing deadline. "We
certainly feel optimistic, but we are not the ostrich with its head in the sand," she said. Vanguard is trying to get a $13.5 million loan guarantee to support a $15 million loan.
But the board said the carrier's proposal did not provide a "reasonable assurance" that Vanguard will be able to repay the loan.
Credit Quality Dragged Down By Low-Fare Carriers
The credit quality of established U.S. and European airlines is being dragged down by a number of factors, including the spread of low-fare carriers and an inability to climb
back to profitability following the Sept. 11 attacks, according to an analysis by Standard & Poor's.
The May 20 analysis, titled Transportation Report Card, also breaks down the corporate credit rating for 21 airlines. S&P notes that the spread of low-cost, low-fare
airlines has accelerated in Europe and continues in the United States, posing another long-term challenge to established air carriers. It points out that British
Airways [BAB] has been particularly affected so far. Airline revenues are recovering at varying rates from the effects of Sept. 11 and global economic weakness. North
American and European domestic leisure traffic and intra-Asia routes have recovered relatively quickly. However, U.S. business traffic is lagging, with weak pricing a particular
problem due to less business traffic and business travelers taking advantage of low leisure fares.
In addition, despite rapid and drastic capacity and cost reductions, most large U.S. and European airlines remain unprofitable or only modestly profitable. Efforts to maintain
liquidity have been mostly successful, but are requiring substantial debt and leases.
Availability of capital for airlines has partially recovered, with secured borrowing available to most, according to the analysis. But labor costs, which have escalated in
recent years, particularly for large U.S. airlines, remain a long-term concern. Efforts to negotiate concessions have made little progress, despite widespread layoffs and the
obvious financial distress of the industry.
Fuel prices are volatile, but are not likely to be as serious an issue as revenues and labor costs. However, a Middle Eastern crisis that disrupts supplies would cause a more
substantial problem for airlines.
The analysis also looks at key trends affecting credit quality in the airfreight industry. Weak global economic conditions are continuing to adversely affect demand for all
industry participants. Although the impact on express operators has been fairly modest, the impact on heavyweight cargo operators has been significant, and has been exacerbated by
excess capacity.
Heavyweight cargo carriers that are already financially weaker than their more integrated counterparts in the express business have seen a significant deterioration in
financial performance.
To offset industry pressures, heavyweight carriers have slashed lift capacity, cut costs, reduced headcount, shifted substantial volumes to ground transport, and have focused
on increasing prices. In addition, increased military charter flying has helped pick up some of the slack in traditional demand. Even so, financial results remain under pressure,
and little material improvement in financial performance is expected in 2002. An improvement in financial results will depend mainly on the timing and extent of recovery in
various markets.
Meanwhile, S&P says that aircraft lessors continue to face weak, although stabilizing, lease rates and increased aircraft returns from failing airlines. Those with a
globally diverse customer base and modern, widely used aircraft are at less of a risk. The majority of such companies is owned by strong financial institutions, supporting access
to liquidity and capital.
Revenues within all sectors of the transportation equipment leasing industry continue to be negatively affected by the recession, although to a lesser extent than the
transportation sectors they serve. Most lessors have reduced capital spending, which has allowed them to preserve free cash flow and maintain fairly stable debt levels, and in
some cases, debt to capital has actually declined, according to S&P.
Atlas Hit Hard By Sharp Drop In Global Air Cargo
A sharp decline in global air cargo demand is taking a toll on Atlas Air Inc., which suffered lowered credit ratings in May from both Fitch Ratings and
Standard & Poor's (S&P). According to Fitch, Atlas' recent operating results demonstrate how a poor demand environment can affect the performance of a company with
very high levels of financial and operating leverage. International commercial airfreight demand weakened sharply last year, and according to S&P, no "material improvement" is
expected in 2002.
Fitch downgraded the unsecured debt of Atlas Air to B from B+. The rating change affects all of Atlas' outstanding senior unsecured notes. The rating outlook is negative.
The downgrade reflects the ongoing impact of a sharp decline in global air cargo demand on Atlas' ability to generate strong operating cash flow from its core contract business
of aircraft, crew, maintenance and insurance, known as ACMI. Relative to its high level of fixed financing obligations (both debt service and aircraft lease payments), Atlas' cash
flow generation outlook remains uncertain, according to Fitch.
After enduring the effects of a yearlong downturn in global air cargo demand -- particularly in trans-Pacific markets that Atlas aircraft have served extensively -- the company
is looking ahead to a gradual build-up in demand during the seasonally strong second half of the year. Still, Fitch believes that uncertainties related to a significant change in
Atlas' product mix, together with the need to finance three new Boeing 747-400 freighters in late 2002, will weaken the company's credit profile over the next several
quarters. Atlas has made it clear in recent months that high levels of aircraft utilization and revenue growth can only be realized if the company embarks upon a strategy to
supplement its traditional ACMI product. Responding to the changing needs of major airline customers for a more flexible cargo lift product, Atlas is rolling out so-called
fractional and partial ACMI contracts that allow customers to fill only part of a contracted aircraft, or use an entire aircraft on a less regular basis. Along with Polar Air
Cargo, Atlas' sister company acquired by Atlas Air Worldwide Holdings [CGO] last November, Atlas has also developed a network of hubs (Miami, Liege,
Belgium and a future hub in Anchorage) to optimize service levels and aircraft utilization.
While Fitch believes this strategy opens up new opportunities for Atlas to grow its customer base and diversify revenue sources over the long term, Fitch also recognizes the
short-term risks associated with the transition to a new product and a possible shortfall in block hour utilization as the program ramps up.
During 2001, Atlas was able to downsize its operations through crew furloughs and the parking of six older Boeing 747 freighters. However, given its relatively fixed-cost
structure, Atlas swung to a net loss of $68.5 million, compared to net income of $85.3 million in 2000. Total Atlas operating revenues (excluding Polar) fell by 13 percent in 2001
to $687.3 million. Weak demand has carried over into first quarter 2002 results. Atlas' revenues declined by 16 percent to $151.0 million in the first quarter, and the company
reported a net loss of $11.1 million. This compares with a net profit of $1.6 million in the first quarter of 2001. Poor operating performance and scheduled aircraft lease
payments translated into a net use of $47.5 million in cash for operating activities in the first quarter.
Some of the weakness in ACMI contract services has been offset by strong demand for military charter cargo lift in support of more extensive military operations overseas.
Participation in the U.S. Air Force's Air Mobility Command contract program will provide support for Atlas in its effort to rebuild the revenue base through the remainder of this
year. Charter revenue grew to $40.1 million, or 27 percent of total Atlas revenue, in the quarter that ended March 31.
Under its aircraft purchase agreement with Boeing, Atlas is currently required to take delivery of three new B747-400 freighters in the second half of this year. A fourth
freighter will be delivered in late 2003. Although the company is pursuing alternative sources of financing for these new aircraft, it appears likely that Atlas will negotiate
operating leases with the manufacturer, according to Fitch. As part of this financing deal, some of the new aircraft delivery dates may be extended. In light of the weak revenue
environment and the incremental ownership costs associated with the new aircraft, Fitch says that any extension of the delivery dates could limit operating cash outflow and
improve the company's credit outlook.
Atlas Air is a wholly owned subsidiary of Atlas Air Worldwide Holdings and is a provider of cargo capacity to major passenger airlines worldwide. Together with Polar Air Cargo,
the holding company's other subsidiary, Atlas offers a range of ACMI contract services, charter, and scheduled freighter operations through a global route network. Atlas is based
in Purchase, N.Y.
New Obligations Came At Bad Time For Atlas
The purchase of Polar Air Cargo late last year by Atlas Air Worldwide Holding [CGO] increased Atlas' fleet and lease obligations just when the
airfreight market came under significant pressure, according to an analysis by Standard & Poor's.
Polar Air Cargo provides scheduled airport-to-airport cargo services as well as other nonscheduled services. But Polar's scheduled service is a different type of business and
serves different customers than Atlas' existing freighter services, and it carries a higher fixed-cost component.
Adding to risks in the near term is Atlas' preexisting commitment to acquire four new Boeing 747 aircraft despite existing over capacity. Financial risk is also
heightened by substantial debt maturity requirements over the next few years.
"Because of its high operating leverage, substantial debt burden, and reduced industry demand over the past year, Atlas has experienced a deterioration in financial measures,
and liquidity has become constrained," said S&P credit analyst Lisa Jenkins. "Industry conditions are expected to remain challenging this year and, as a result, no material
improvement in financial performance is expected over the near term."
Over the longer term, Atlas should benefit from a rebound in air cargo demand. However, because of its changing business mix, Atlas will likely experience more volatility in
operating results, according to S&P.
Until last year, Atlas' primary business was providing aircraft, crew, maintenance and insurance (ACMI) services for airlines, a business in which it is a market leader. But in
2001, Atlas expanded its product line to include charters, fractional ACMI, partial ACMI and dry leases (aircraft, maintenance, and insurance but no crew) for aircraft.
S&P lowered its corporate credit rating on Atlas Air Worldwide Holdings to B+ from BB-. The move reflects increased risk in both the company's financial and business
profiles, stemming from current industry pressures and an increasing focus on new, more risky service offerings. The outlook is negative.
New York-based Atlas -- which provides heavyweight air cargo services through its Atlas subsidiary and scheduled, high-frequency airport-to-airport cargo services through its
Polar subsidiary -- has about $2.5 billion of debt, including off-balance sheet leases.
International commercial airfreight demand weakened sharply in 2001. No material improvement is expected this year, but S&P say that over the longer term, growth prospects
are still considered positive. The cyclical and price-competitive nature of the industry will remain a challenge for Atlas as will the matching of additional aircraft with
contracts and the renewal and pricing of expiring contracts.
Ratings assume that Atlas will maintain current levels of liquidity over the near term and generate a gradual improvement in financial measures as industry fundamentals begin
to strengthen. A protracted downturn in industry demand or difficulties in executing the new business strategy could lead to further financial pressures and could result in
further downgrades.
Analyst Says Airlines Can't Blame Everything On Labor
Hub and spoke airlines cannot blame labor unions for a high-cost, inefficient business model that only works in a high-revenue environment, according to Sam Buttrick of UBS
Warburg. "Labor can't be blamed for bad management decisions anymore than management should be held responsible for the unproductive deadweight in labor contracts," he says in
a May 23 analysis. "If it's broke, fix it - and that goes for both management and labor."
Buttrick does say, however, that airline industry labor costs are too high.
According to the analysis, airline executives should not expect to return to profitability on the backs of labor. It says that labor can be blamed for the sixth or seventh week
of vacation, but not for the six or seven fleet types and associated training costs.
Buttrick's analysis puts it this way: "Blame labor for excessive scheduling flexibility (canceling/trading trips) - but don't blame labor for sitting around in dingy crew
lounges waiting to make connections because you choose to operate an inefficient hub and spoke structure. Blame labor for engaging in periodic expensive counterproductive
slowdowns - but don't blame labor for lost productivity associated with headquarters staff checking load factors for their weekend trip home (and complex pass programs). Put blame
where blame is due."
A few years ago, United Airlines [UAL] defended its pilot contract with a chart showing that over the long-term, industry revenues and industry labor
costs reasonably tracked each other. And broadly speaking, according to Buttrick, that is true. "The explicit message to analysts was - Don't worry about higher labor costs
because other carriers will have to match over time (which they have been) and we'll raise fares (which they have done) and (eventually) revenues will rise (which hasn't exactly
panned out)," Buttrick says. "Of course, with enough effort, anything in life can be rationalized. UAL Corp hasn't posted a quarterly profit since then. It is certainly the case,
that in the current revenue environment, industry labor costs are too high."
Pilot compensation expense could be cut 75 percent in 2002 and the industry would be still be unprofitable. Buttrick says it is undeniable that recently negotiated contracts
reflect the comparative boom years of the late 1990s. "It is highly debatable when such a free-spending business travel environment will recur - though it's a fair bet that it
won't be anytime soon," the analysis says. "It is mathematically unequivocal that lower unit labor costs would improve industry results."
For the most part, the airline business is not a particularly good one, and 70 years of mostly desultory returns eloquently bespeak this fact, according to the analysis. It
also true that carriers achieving better results - Southwest Airlines [LUV], Ryanair [RYAAY] and Singapore Airlines for
example - have lower unit labor costs. Since unit labor costs are the product of wage level (wage rate, seniority, equipment, benefit, and pension) and productivity (structural
and contractual impediments), therefore, the quest for labor efficiency has multiple paths.
The analysis says that airline industry fundamentals are better but not good enough. U.S. airline unit revenue for April fell 9.9 percent. With the calendar shift in Easter
revenue from April to March, April's revenue per available seat mile (RASM) decline marked the first reversal in monthly RASM gains in the post-attack environment. (March RASM was
down 8.4 percent.). However, taken collectively, RASM for the two-month period fell 9.2 percent -- at least somewhat better than February's 9.6 percent decline.
International RASM (down 1.3 percent) substantially outpaced a 12.8 percent decline in domestic RASM. With this large differential, carrier relative performance generally fell
in line with geographic exposure. Buttrick estimates that Northwest Airlines [NWAC], United Airlines [UAL] and
Delta Air Lines [DAL] outperformed the industry while Continental Airlines [CAL], Southwest Airlines (not in this data set),
and US Airways [U] under-performed.
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