Airline Position Report

State of the Industry

Jay A. Johnson Embry-Riddle Aeronautical University Dr. Larry Carlton

THE SETUP Over the past 50 years, the air transportation industry has become an increasingly important part of the U.S. economy. Aviation is the nations dominant interstate mode of transportation for those passengers and goods that must be transported quickly and efficiently. This report will take a look at the state of this vital industry, discuss the major factors that have led to its present condition, including the events and aftermath of September 11, 2001, and make a prediction for what the future holds for the industry. The beginning of the 21st century will forever be marked by the September 11 terrorist attacks on our country. An immediate and obvious economic result of the attacks was the complete grounding of the airlines for several days, followed by an unprecedented decline in traffic and sales. Aircraft values plummeted along with airline credit ratings and the capital markets threatened to retreat, further compounding the crisis. In order to fully understand the state of the industry we will take a look at traffic, capacity, fleet, revenues and expenses of the major airlines post September 11. It would be easy to blame the current state of the airline industry on the events of September 11, but they were only the catalyst that ignited an already volatile industry. Despite records in passenger enplanements and cargo ton-miles, the early 1990s proved damaging for the airline industry. The Iraqi invasion of Kuwait helped fuel losses of close to $4 billion. With rising fuel costs, recession and fear of terrorism looming carriers were stuck between imposing fuel-cost induced fare hikes and losing more passenger and cargo traffic. 1993 saw intense public, media, and government interest in the condition of the U.S. airline industry. Despite efforts by President Bill Clinton and his National Commission to Ensure a Strong Competitive Airline Industry, the industry

collectively lost $2.1 billion by 1993. With uprisings in the middle east tamed by 1994. fuel prices began to drop leading to shrinking losses for the airlines but much of the damage had already been done, the airlines had put themselves in a vulnerable situation. With carries postponing new aircraft order due to recent losses load factors began to increase and many airlines found themselves filling commuter aircraft routes with jet service. By mid 1995 the airline had turned the corner financially, the national economy was recovering, and the industry had one of the safest years in its history. Unfortunately, many carriers had accumulated a lot of new debt in the early 1990s and were not prepared for the capital intensive years to come. The costs would become enormous to the industry as carriers tried to replace their oldest jets. The late 1990s were characterized by an expanding economy, rising incomes for individuals and businesses, all of which led to record numbers of passengers and cargo carried, but nothing could have prepared the industry for the beating it would take in the next few years. TRAFFIC According to the 2001 Airline Industry Review, 2001 started what would be the greatest trough the cyclical airline industry could ever imagine. Revenue passenger miles declined 5.9 percent to 652 billion, the largest drop in U.S. history. Passenger enplanements declined 6.6 percent to 622 million. Though the industry started the first two quarters of 2002 with a 2.8 percent growth rate, the terrorist attacks in September would result in a 26.8 percent decline over the next two quarters. Along with the terrorist attacks a recession began in 2001 which hit business travel especially hard as corporate earnings fell. Based on information from a sampling of ATA member airlines, domestic business traffic fell 5.5 percent during the first eight months of the year, the decline of

business travel traffic quadrupled to 24.2 percent and personal and pleasure traffic reversed its course, falling 18.0 percent. For the full year, international passenger traffic fell 7.1 percent, reflecting post September 11 security concerns of air travelers and a worldwide economic slump. Cargo traffic declined 7.9 percent in 2001 and mail revenue ton miles declined 22.8 percent due largely to new security restrictions. CAPACITY Through August of 2001 seating capacity had made a modest increase, but after September 11, airlines made sharp cuts in capacity. Available seat miles declined 2.8 percent for the year. In the immediate aftermath, airlines cut their schedules by a fifth before adjusting those cuts to match the level of demand as traffic began to stabilize. As carriers struggled with a rapidly changing marketplace, regional jet service continued to grow rising 542 aircraft in 2000 to more than 700 in 2001. Smaller aircraft became much more in demand, as carriers downsized the aircraft used to serve many markets. The use of smaller aircraft has continued to benefit small and medium-size communities, allowing carriers to provide direct service even when traffic is declining, but they are simply a small bandage on a huge wound. According to the FAA, regional jets are expected to number over 1,000 by the end of 2003. Despite valiant efforts by the airlines scheduled flights declined from 9.0 million in 2000 to 8.8 million in 2001-down about 600 flights per day. However, the fourth quarter decline in 2001 was closer to 3,000 flights per day showing the affects of September 11. One of the hidden benefits with the significant cuts in flight operations was the vast reduction in air traffic control delays. Although almost all of the airlines made quick, unprecedented adjustments I capacity the average load factor fell 2.4 points to 70.0 percent in 2001-the first drop in

nine years. Load factor has long been an industry norm for measuring the efficiency of the industry. Unfortunately, post-September 11 it has become a less appropriate indicator of asset utilization due to the large number of aircraft that have been grounded and labeled with zero utilization. FLEET With a decline in demand the airlines have reduced the frequency of departures and began shrinking their aircraft fleets. Airlines are targeting less fuel-efficient and more maintenance-intensive aircraft when deciding which aircraft to ground. In addition to ground aircraft, many airlines have also postponed delivery dates for new aircraft. For deliveries in 2002 and 2003, there are only 202 and 137 firm orders, compared to 283 and 186 as of December 2000. In combination with fleet reductions due to declining traffic carriers have limited ability to purchase new aircraft due to heavy financial losses. REVENUES In the aftermath of the events in September 2001 airline revenues fell 11.8 percent to $115.4 billion-only the second annual decline in airline history. This last occurred in 1991 following the outbreak of war in the Middle East, and the subsequent U.S. economy recession which dropped demand even further. The events of September 11, however, have had a more pronounced impact on airline revenues, which have yet to recover despite signs of a slowly improving economy. By the end of 2001 passenger revenue, which accounts for 70.1 percent of total operating revenues, had fallen 13.5 percent to $80.9 billion. Every sector of the industry saw a decline in passenger revenue in including Pacific travel, where revenue fell 16.2 percent. These reductions were driven by decreases in both volume and price. As traffic declined, airlines began to offer lower

prices in an attempt to stimulate more volume. The average price of air travel, measured by passenger yield, the amount collected by airlines to fly one passenger on mile, decreased 8.1 percent. After the terrorist attacks and the consequent drop in demand, airlines reduced prices to levels not seen in more than a decade. When adjusted for inflation, airline prices have fallen 25.0 percent since 1991. The Consumer Price Index estimates inflation to have increased 30 percent over the last 11 years. Consumers continue to benefit from the intense competition and improved efficiency unleashed by airline deregulation. Since passenger deregulation in 1978, airline prices have fallen 44.9 percent. These tremendous declines in price are unmatched by any other industry, and in combination with sharply rising labor costs, decreased load factors, and a drop in demand for services overall, explain why airlines are falling short of covering unit costs. These price reductions have driven the industrys breakeven load factor to record levels. Traditionally around 65 percent, the breakeven load factor for passenger operations now sits in the high 70s. Basic economics tells us that as prices fall, more seats need to be filled to generate the same amount of revenue. The industrys hope is that demand returns to normal, upward pressure on prices and load factors are going to be needed to help restore economic stability across the industry. EXPENSES With current market conditions preventing carriers from raising prices to cover higher costs, airlines are faced with finding a way to fill the cost gap that ticket prices are not covering. With labor costs continuing to rise sharply since 2001 and labor productivity rates stagnate since 1996, the terrorist attacks of September 11 forced the

industry into layoffs and furloughs. Airlines initially announced layoffs and furloughs of roughly 100,000 employees. Fortunately, by using voluntary programs and worksharing, this number was reduced to about 80,000 employees, or about 11 percent of the workforce. As traffic has begun to recover, airlines have been able to recall some of these employees, mostly support services employees. However, because of a slower than anticipated recovery, it is expected that it will take some time to return to a full workforce. Following labor costs, jet fuel is their second largest expense item. With a worldwide decline in energy demand by the end of 2001 jet fuel prices had fallen from 92 to 60 cents per gallon. Normally over 20 billion gallons per year, the post-September 11 reduction in flying lowered fuel consumption about 300 million gallons per month. For the full year (2001), fuel expenses declined $1.6 billion. Due to plunging fuel prices and consumption in the fourth quarter of 2001, flying-operations costs, composed of cockpit crew, fuel, and insurance costs, decreased $0.6 billion. These savings were all offset by the $1 billion annual increase in insurance costs after September 11. Airlines have been aggressively pursuing self-insurance plans to help contain these terrorism-related costs but have not yet significantly reduced these costs. Security costs are also increasing sharply, especially since the Transportation Security Administrations assumption of security functions. These expenses in the form of everything from bullet proof cockpit doors to more training for cabin crews, have a negative impact on the airlines bottom line. Rapid increases in security costs, with little or not support from the federal government, are resulting in an increase in the cost of air travel and further reducing the long-term growth rate of the industry.

BALANCE SHEET

EARNINGS