Learning to fly

Ever since the first commercial airline started in Germany in 1910, airlines have been struggling to stay out of the red. From the end of World War II to 1994, the sum of the industry’s profits and losses was less than zero. From 1995 to 1999, the industry’s best years ever, airlines earned only three and half cents for every dollar of sales, according to New York Times magazine.

By nature, airlines are a cutthroat, highly regulated, manically cyclical business with labor relations and deregulation keeping many carriers in a constant state of negotiation. Major airlines have always been plagued by an impossible equation: rising costs and falling revenues. The price of planes – about $100 mn for a wide-body jet – and the costs of maintaining a skilled labor force have killed many airlines. When an airline carrier’s already enormous costs rise, it often finds it can’t charge competitive prices because if fares are too high, seats don’t get filled and the carrier ultimately fails, as seen recently with Belgium’s Sabena, Australia’s Ansett and Swissair.

Deregulation, beginning with the US in 1978, was supposed to improve the operating costs-to-earnings ratio for big carriers. But labor negotiations, fuel prices and low capacity kept them from turning steady profits. What deregulation did do, however, was allow for competition. Smaller start-up carriers like Texas-based Southwest, a discount carrier founded in 1971, were able to expand their market share by offering new short-haul routes on smaller planes at dramatically reduced prices. Full deregulation of European airlines was completed in 1997, allowing smaller discount carriers like Ireland’s Ryanair, launched in 1985, to follow the Southwest model of expansion. Today, these low-cost carriers are the only airlines making serious money and growing their businesses. The UK’s EasyJet announced a 39 percent year-on-year increase in traffic for March 2002.

‘The airline industry is now split into two separate industries: short haul and long haul,’ says Stephen Furlong, an airlines analyst with Davy Stockbrokers in Dublin. Traditionally, low-fare carriers only fly short-haul routes, and long-haul routes are dominated by major airlines that also fly smaller distances.

Low & sweet

For the last decade, low-fare carriers have been growing steadily and turning better profits than big carriers because they have been able to keep their costs down. ‘Low-cost, point-to-point carriers in the US and Europe are the only kind of airlines that build long-term shareholder value,’ suggests Furlong. ‘Major carriers only make money cyclically, and because they have very low net margins, they’re almost destroyers of shareholder value.’ Generally speaking, growth investors tend to gravitate to low-fare carriers and cyclical investors watch the highs and lows of the majors.

According to Furlong this divide in the airlines industry – between profit-making discount carriers focused on point-to-point service and debt-ridden large carriers that provide long-haul service – existed before September 11, but it was exaggerated by the public’s reaction to those events. Since 9/11, passenger traffic is down 15 percent among major European carriers, according to the Association of European Airlines. ‘At the same time, low-cost airlines are showing passenger traffic is up by 30 percent,’ Furlong compares. Among US carriers passenger traffic was down 10.7 percent during February 2002 compared to a year earlier, according to the Air Transport Association. The US major carriers, by far the worst hit by the events of September 11, suffered badly in 2001 while low-fare carriers continued to grow. Even after receiving a $15 bn bailout package from the government, major US airlines still reported record losses for the year. United Airlines suffered the worst blow with a historical $2.1 bn in losses for the year; and AMR Corporation, the company that owns American and TWA, reported a loss of $1.8 bn. Adding insult to injury, United has since been embroiled in a pay dispute with mechanics, only finally reaching a tentative agreement the day before the union was set to strike.

While major US airlines cut capacity by an average of 20 percent following the tragedy in September, discount carriers reduced capacity only slightly. Florida’s Spirit airlines dropped a handful of routes while Texas-based Southwest continued to operate at full capacity. By the end of 2001, Florida-based AirTran Airways had actually increased capacity by 3.3 percent. Some low-fare carriers like JetBlue had a landmark year. The New York-based airline recently announced plans to go public along with the purchase of 10 new A320 aircraft valued at $500 mn.

Asian airlines were not as badly hit by events in the US because their transpacific routes are not as well developed as their transatlantic routes, says an Asia-based airlines analyst. Among Asian carriers, passenger traffic is 30-40 percent higher on intra-Asia routes compared to transpacific routes, he adds.

Still, Asian airlines are not immune to the devastating effects that global economic recession and September 11 have had on the industry. ‘We have witnessed a huge drop in revenue across our network and our recent traffic figures show widespread market weakness in demand for both passenger and cargo services,’ reports May Lam, corporate communications manager at Cathay Pacific Airways. In January 2002, Cathay Pacific carried a total 960,967 passengers, 3.1 percent less than the same month the previous year.

Bums on seats

Cutting routes, laying-off thousands of employees (major US carriers furloughed over 100,000 employees in 2001), dropping fares and adopting new security measures are the strategies many of the world’s major airlines have been forced to adopt in what experts are calling the new world of air travel. In this environment, building shareholder value is secondary to mere survival for the big carriers while low-fare airlines continue to seek out new opportunities.

After major airlines reduced capacity following September 11, discount airlines expanded their market share by default.

For example, Ryanair picked up service to Montpellier, France after British Airways pulled out. And when Air Lingus dropped its Shannon to Paris route, Ryanair added service there. Primary airports also started offering new opportunities to low-fare carriers. ‘Desperately in need of traffic, airports that never even considered discount carriers started offering them slots,’ says Furlong.

Even before September 11, economic recession and surging fuel prices were challenging major airlines to stay afloat. ‘The fact that business travelers were avoiding high fares was the biggest problem facing large carriers before September 11,’ notes Brian Harris, an airlines analyst with Salomon Smith Barney in New York.

As companies slashed their travel budgets, business travelers started using low-fare carriers for intra-European trips.

On some European routes now, 50 percent of low-fare carriers’ passengers are business travelers, says Furlong. This increase in demand for low-fare flights made it even more difficult for large carriers to fill planes on short-haul routes. And low-fare carriers seized the opportunity to expand their routes, offering cheap, no-frills flights that take off and touch down at secondary airports.

In-flight IR

There are several factors that make investor relations in the airline industry unique.

The fact that this capital-intensive industry has a lot of fixed costs makes it easier for investors to understand the business. ‘Once we have our flight schedule in place, it’s really a matter of whether we can fill the seats,’ says Tammy Romo, director of investor relations at Southwest Airlines. However, because airlines are cyclical – meaning they follow the highs and lows of the global economy – they are very vulnerable to recession. As Romo describes, the industry has to contend with energy risks in addition to risks associated with the impact of economic cycles.

For IROs, investor targeting is secondary to keeping an airline profitable. ‘This doesn’t mean we don’t do all the normal things you would expect from an IRO, but at the end of the day we need to post results,’ explains Romo. So while roadshows, face-to-face meetings, traffic-figure updates, quarterly conference calls, industry conferences, annual reports and SEC filings are all part of Romo’s busy schedule, building shareholder value is mostly about keeping planes full and costs down. ‘Building credibility with the Street is about reporting consistent results, and if you do that everything else sort of falls into place.’

Despite the fact that the airlines business is intensely competitive, building market share is also secondary to maintaining profitability. The fact that analysts report that WestJet has grown its market share from 14 to 18 percent over the last year is somewhat irrelevant to IR, says Siobhan Vinish, director of public relations and communications at Calgary-based WestJet. ‘We don’t look at our business from the market share perspective. Our goal is to be profitable and continue to grow by 40-50 percent a year,’ she says. WestJet is the second largest airline in Canada with an 18 percent slice of the pie, while Air Canada, the country’s single major airline since swallowing Canadian Airlines in 2000, has 81 percent.

IROs in the airline industry must communicate their company’s message to the usual constituencies – analysts, investors, retail shareholders and employees – with the standard tools of the trade. ‘We use our web site to communicate regular industry information and have an open book policy when it comes to investor queries,’ says Sean Coyle, head of IR for Ryanair.

What’s different with investor relations in the airline industry is that passengers are often shareholders. ‘When a customer has a positive experience on a flight they might decide to become a stockholder,’ notes Romo. ‘So our customers are also a very important audience for IROs to take care of.’

Reaching altitude

Low-fare carriers have a huge cost advantage because they fly shorter routes, pay lower airport fees and normally buy only one type of plane, thus saving considerably on labor costs.

Major airlines have tried to compete with low-fare carriers by establishing their own discount service, but this approach has been largely unsuccessful. United Airlines recently announced plans to do away with United Shuttle, a low-fare carrier in direct competition with Southwest, while Delta Airlines cut its Delta Express by 43 percent. And in the UK British Airways sold off its budget subsidiary, Go, in a management buyout. Still, for big carriers this may be the only way to hold on to short-haul domestic routes. Following terrorist attacks in the US and the failure of Canada 3000, Air Canada introduced Tango, a low-fare carrier with domestic routes.

In the short term, it will be difficult for the major airlines in North America and Europe to return to profitability. ‘Big European carriers will continue to report losses over the medium term and there will be some sort of consolidation in the future,’ predicts Furlong. ‘The big three airlines – British Airways, Air France and Lufthansa – will grow despite their balance sheet concerns and continue to focus on their main hub airports.’

Major US carriers will probably also continue to struggle in coming months before returning to profitability. Despite record losses in 2001, United will survive, says SSB’s Harris. ‘The airline is a little further along on the risk/return horizon, but I am still favorable on the stock,’ he says.

In Canada, meanwhile, ‘Not much will change from the current environment,’ suggests Jack Kavafian, an airlines analyst with Yorkton Securities. ‘Air Canada will be limping along for a long time and WestJet will continue growing.’

Due to tight regulation in Asia, especially in the north, there are relatively few regional and low-fare carriers. Hong Kong-based Dragonair is one of the only profitable Asian regional carriers because of its home base, says an Asia-based airlines analyst. And while many of the region’s airlines went through major restructurings following the Asian economic crisis in 1997, only Malaysia Airlines took the step of splitting its long-haul and regional operations. Air China has been talking about an IPO for some months now but, as one analyst says, ‘It’s pretty tough to have a look at their books, so it’s hard to say when it will happen and who will invest in the airline.’

So what can major carriers do to avoid becoming the dinosaurs of the airline industry? According to Furlong, ‘They have to realize that there are two separate markets now and that there is no sense in competing with discount airlines.’ That’s not to say they should cut out their short-haul routes altogether, ‘but they need to focus on long-haul routes and hub airports.’

British Airways was the first of the large carriers to announce a major restructuring, assessing each route to see if it makes money and possibly cutting some of its short-haul routes. BA may be the first, but it surely won’t be the last of the major carriers to take a cold hard look at its strategy in coming months.

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Andy White, Freelance WordPress Developer London