1 Beyond the crisis
Trends and challenges
1.1 A cyclical and marginal industry
For the then Chairman of Air France, 1993 was an unhappy time. Every evening, as he left his office to go home, his airline had lost another US$4 million! This went on, day in day out, for a year or so. Of course, it was not quite like that. By the end of that financial year, his airline had lost almost $1.5 billion. Such figures graphically illustrate the depth of the crisis faced by the worldâs airlines in the early 1990s. This was a bad time for the airline business.
Worse was to come. Ten years later, in 2003, the Chairman of United Airlines might have been heard telling his wife every evening that his company had lost another $7.7 million that day. One wonders what her response might have been! Unitedâs losses added up to a total of $2.8 billion for the full year. (Throughout this book, $ refers to United States dollars unless otherwise stated.) The United Airlines Chairman was not alone. Many other airlines around the world reported substantial annual losses not only for 2003 but, like United, for the previous two years as well.
The results of Air France and United Airlines ten years apart are symptomatic of the airline industry and raise serious questions about its longer-term viability. It is an industry which as a whole is both cyclical in nature and very marginal in terms of profitability. Yet it is one in which a handful of airlines do manage to be consistently profitable over many years.
The fifteen years to 2003 typify the cyclical nature of the industry. In the four years 1990 to 1993 the net losses of the member airlines of the International Air Transport Association (IATA) amounted to about $15 billion. After 1994, as demand growth began to accelerate again and the cost-cutting measures launched during the crisis years began to have an impact, many airlines returned to profitability. The improving trend continued till 2000. The years 1997 to 1999 were particularly good for many airlines. Then a new downturn hit the industry. In the three years 2001 to 2003 IATA collective losses reached nearly $26 billion (this after a $5 billion aid package for US airlines from the US Government). This cyclical pattern of three to four years of losses followed by five to six years of profits is clearly illustrated in Figure 1.1. This refers to the total annual profit or loss of all the airlines of the member states of the International Civil Aviation Organisation (ICAO), not just those belonging to IATA. The operating results are before inclusion of interest, and other non-operating items such as tax, and the net results are after. While the diagram covers the period 1988 to 2003, the earlier years repeat this cyclical pattern. There were downturns in the early 1980s and again in 1974â5, which were each followed by several years of profits.
Figure 1.1 Profit or loss of the worldâs airlines, 1988 to 2003 (in US$).
This was the global pattern. Nevertheless a few airlines bucked the trend. Some continued to be profitable even during the cyclical downturns. For instance, British Airways, Singapore Airlines, Swissair and Cathay Pacific all continued to operate profitably throughout the downturn of the early 1990s. Southwest Airlines did the same in the period 2001 to 2004. On the other hand many airlines have been unable to generate profits even in some of the years when the industry as a whole has operated profitably. Most of the state-owned airlines belong to this latter group (Chapter 8).
The airline industryâs cycles appear to be closely linked to the world economic climate. When growth in the world economy slows down, the growth in demand for air traffic and for air freight also slows down, though there may be a time lag. A lower-than-anticipated growth in demand for air transport means over-capacity and lower yields as fares and tariffs are slashed to try to fill empty seats or cargo space. If the economic downturn is accompanied by â or caused by â external factors that can in turn adversely impact on the airline sector, then the latterâs downturn is even deeper or longer-lasting. Thus the world economy went into recession in the early 1980s partly because fuel prices and energy costs soared as a result of the IranâIraq war, which began in 1980. The airline industry was then hit both by a collapse in demand and a doubling in the real cost of fuel. Similarly, the airline crises of the early 1990s and early 2000s were made worse by the Gulf and Iraq wars respectively.
It is also the case that factors affecting the airlinesâ financial performance may vary between different regions or markets. As a result, the performance of airlines in a particular region may, at times, fail to correspond with the prevailing economic climate for the industry as a whole. The period 1997 to 1999 was one of the best for most airlines. Yet by early 1998 it was apparent that many Asian carriers were in dire straits. The crisis and meltdown that began to affect East Asian economies in the second half of 1997 hit Asian carriers hard. The economic downturn choked off the anticipated traffic growth. At the same time, the dramatic devaluation of many airlinesâ home currencies significantly increased those costs denominated in hard currencies, such as fuel costs, interest charges and debt repayments. By mid-1998 many East Asian airlines were posting large losses for the financial year 1997. Japan Airlines led the way with a net loss of US$513 million. Othersâ losses were not as high, but were still substantial. For the East Asian airlines, 1998 was even worse than 1997. While Japan Airlines and Korean managed to move from loss into profit, most carriersâ financial performance deteriorated. Cathay Pacific nose-dived into loss, its first ever. Philippine Airlines virtually collapsed in July 1998 after a disastrous pilotsâ strike. A very slimmed-down operation had to be resurrected twice through capital injections in the months that followed. In Indonesia two large domestic operators ceased flying, while Garuda teetered on the verge of collapse.
Given the marked cyclical swings in the economic fortunes of the airline industry, a key question is whether profits have been sufficiently high in the good years to compensate for losses when times were bad. For some airlines this has been so, but for the industry as a whole it is doubtful if this is the case. This is because even in the best years the industryâs overall profit margins, expressed as a percentage of total revenue, have been relatively low. This is evident from Figure 1.2 which shows, for the airlines of ICAO member states, the operating and net profit margins for each year from 1988 to 2003. Even during the three most profitable years, 1997 to 1999, the net profit was only 2.5 to 3 per cent. This was low by the standards of most other industries including aviation-related sectors such as oil supply, airports or global distribution systems. Such poor margins are unlikely to be sufficient both to cover past losses and provide sufficient internal capital for future growth and development. The airline industry as a whole is rather marginal even though several individual airlines have performed well over long periods. But even in the good years the most profitable airlines have rarely achieved net profit margins equivalent to more than 10 per cent of their revenues. This too appears low when compared to the best-performing companies in other sectors. While there are many individual exceptions, the airline industry in general is not very profitable compared to other sectors.
Further proof of the industryâs marginal overall performance is provided by the fact that, during the last two crisis periods, huge injections of external capital, mainly from governments, were needed to keep several of the major airlines afloat. In the early 1990s a number of airlines required massive injections of capital to survive, particularly Europeâs state-owned airlines such as Air France. Those from member states of the European Union received $9.6 billion in âstate aidâ in the period up to 1995. This was government funding provided after approval by the European Commission. If one adds this to the stated losses for the worldâs airlines, $15 billion, for the four years 1990â93, then the true loss was close to $25 billion. Later in 1997 Alitalia was given a further $1.7 billion of state aid. In addition, several airlines received government funds of various kinds totalling nearly $1.3 billion but not categorised by the European Commission as âstate aidâ. Even privatised European airlines received capital injections from their shareholders through rights issues during this period (Chapter 8, Table 8.4). Outside Europe most state-owned airlines needed direct or indirect government subsidies to keep going.
Figure 1.2 Profit or loss as percentage of revenues â world airlines, 1988 to 2003.
In the more recent crisis after 2000 it was primarily the United States airlines that needed to be bailed out by government support and aid. The US Government provided $5 billion of direct grants to US carriers to mitigate the disastrous impact of the 11 September 2001 terrorist attacks, on both domestic and international passenger traffic. This was supplemented by the provision of up to $10 billion in loans guaranteed by the federal government. This would be made available to airlines to help them implement a viable recovery plan, which had to be approved by the Air Transportation Stabilization Board (ATSB). While all airlines received some part of the $5 billion compensation grant, only a few were able to, or wished to, obtain loan guarantees since these were conditional and came with strings attached.
United Airlines, despite being in Chapter 11 bankruptcy protection, failed three times to get its loan requests approved by the ATSB, largely because the latter did not feel the United recovery plan was viable. Unitedâs third request for a $1.1 billion loan guarantee was rejected in June 2004. In addition to all the above, a further $2.8 billion of federal funds was paid to airlines to cover the cost of the new security measures required by the government. But support went even further. US airlines, in order to keep flying, began to reduce or postpone contributions into their employeesâ pension plans. For example, in mid-September 2004, when it entered Chapter 11 for the second time, US Airways told the bankruptcy judge it would terminate its defined benefit pension plans and would not make a $110 million pension payment then due. Of course, all this was happening while some airlines, notably United and US Airways, were also being protected from their creditors after entering Chapter 11. This also enabled them to exact major concessions from both their creditors and their unions.
Elsewhere in the world too, governments were having to intervene to prop up their collapsing airlines. Thus in December 2000 the Malaysian Government bought back almost 30 per cent of Malaysian Airlines in order to set about saving it. A year later, in October 2001, the New Zealand Government injected NZ$885 million to buy back and rescue Air New Zealand. In Europe, despite the large losses being suffered by Europeâs airlines, state aid was really very limited by comparison to what had been handed out by governments in the mid-1990s, largely because it was now banned by the European Commission. Nevertheless, a few airlines such as Olympic Airways managed to bypass the rules. In the early 2000s the most blatant example of government support for the airline sector was in the United States â all the more surprising as it was in the pantheon of competitive and freemarket economies.
The frequent need for state aid emphasises the marginal nature of the airline industry but is also one of the causes of the industryâs very low overall financial returns. The direct or indirect protection by governments of their airlines may well be justified in political or social terms and, in some countries, in economic terms as well. But while such protection may be beneficial, at least in the short term, for individual airlines, for the industry as a whole the effect is malign. It means that the industry has an inherent trend to over-capacity, because airlines which should exit their markets because they are loss-making and technically insolvent do not do so; or do not do so until after several years of losses. The result is that in many markets there are too many seats or too much freight capacity sloshing around in relation to the demand. This in turn creates strong downward pressure on yields as airlines drop tariffs to fill up empty capacity.
1.2 Crisis turns to disaster
It is sometimes assumed that the events of 11 September 2001 marked the start of the economic crisis facing the airline industry in the early years of the twenty-first century or were even the cause of it. Nothing could be further from the truth. The airline crisis pre-dates the horrific events of that day. As is evident from Figures 1.1 and 1.2 the industryâs profit margins dropped in 2000 compared to the three previous years. In fact many airlines which had been profitable in 1999 found themselves with heavy losses a year later in 2000. The biggest loss-makers included Swissair, which had a net loss of $1.7 billion in that year, Korean ($409 million loss), Malaysian ($351 million), Sabena ($298 million), TWA ($267 million), US Airways ($255 million) and Alitalia ($236 million). Several of these, Swissair, Sabena and TWA, would not survive much more than a year or so; and Malaysian, as previously mentioned, had to be rescued by its government.
The industry as a whole was profitable in 2000. But the warning signs were there. A new cyclical downturn appeared to be imminent. As in previous cycles the root cause was a slowing down in some major economies at the turn of the century, notably those of Japan, Germany and the USA, but elsewhere too. This meant that traffic growth for both passengers and freight was lower than anticipated. Business travel was also adversely hit by the collapse in 2000 of the dot.com boom which had been such a stimulus to business travel. But several other factors worsened the climate for the worldâs airlines.
There was over-capacity in many markets, especially on longer-haul international routes, partly as a result of further deregulation and partly because of the growth of global alliances. By linking together different airlinesâ networks, these alliances offered medium- and long-haul passengers many more alternative routings. Over-capacity in turn created downward pressure on yields as airlines fought for market share. This trend was exacerbated in Europe and the United States by the expansion of low-cost, no-frills carriers. The latter were not only capturing a growing market share, but were also forcing the traditional legacy airlines to reduce fares. While yields were going down, costs were starting to climb in real terms. Prices for jet fuel doubled between October 1998 and October 2000. Airlines which had not hedged their future fuel purchases were badly hit. The strengthening of the US dollar against many currencies, including the Euro, made matters worse. Labour costs also rose sharply, especially in the United States. There the three- to five-year wage agreements between airlines and unions â entered into during or at the end of the crisis years of the early to mid-1990s â began to unwind. In the good years of the late 1990s employees wanted to recoup some of the sacrifices and concessions they had made in the earlier agreements. In the period 1998 to 2000 several US airlines were forced to grant major wage increases to their employees. This pressure for substantial wage increases spilled over to some European carriers such as Lufthansa.
By mid-2001 profits at many airlines were beginning to evaporate as traffic growth rates in many key markets fell well below expectations. It was evident that the airline industry was at the top of a new downturn in its fortunes. Then the events of 11 September 2001 turned impending crisis into disaster.
The impact on demand and traffic was immediate and catastrophic for the airlines. For three days all flights to, from or within the United States were banned. But the impact on traffic levels was felt much longer as shock, fear and uncertainty stopped many people from flying in the months that followed. Passengers, especially in the USA, were also put off by the long delays at check-in resulting from the enhanced security measures. While the impact on US airlines was much more severe and longer-lasting than on most others, airlines in most regions of the world were adversely affected. According to the Association of European Airlines, between 11 September and the end of 2001, traffic on the North Atlantic routes dropped by 30 per cent, translating to a loss of almost 3 million passengers for European airlines. US carriers lost another 3 million or so passengers. In the same period traffic on the trans-Pacific routes from the USA dropped by over 35 per cent.
The impact was even wider than just on international routes to the United States. Traffic between Europe and the Far East dropped by 17 per cent in the four months after the attack and traffic within Europe by 12 per cent. While the collapse of traffic on US domestic routes in the first four months was not so steep as on many US international routes, it averaged 20 to 25 per cent, and it took much longer to recover.
During 2002 United States airlines saw little growth. Within North America domestic traffic for the year was down 4.5 per cent, while trans-Atlantic traffic was down 12.5 per cent and trans-Pacific fell by 1.0 per cent. Their European counterparts did slightly...
