Commercial Aviation: Despite Industry Turmoil, Low-Cost Airlines Are Growing and Profitable
Published: 2004-06-03T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Since 2001, the U. S. airline industry has confronted financial losses of previously unseen proportions. From 2001 through 2003, the industry reported losses of about $23 billion, and two of the nation's largest airlines went into bankruptcy. Since September 11, 2001, the U.S. government has provided struggling airlines with $7.0 billion in direct assistance and many billions more in indirect assistance in the form of loan guarantees, a tax holiday, and pension relief. Under the 2003 Emergency Wartime Supplemental Appropriations Act (P.L. 108-11) and Vision 100--Century of Aviation Reauthorization Act (P.L. 108-176), Congress mandated that GAO review measures taken by air carriers to reduce costs, improve their revenues and profits, and strengthen their balance sheets. Later this year, GAO will provide a report to Congress in response to these mandates. This statement provides a preliminary summary of that work and focuses on three main questions: (1) what have been the major challenges to the airline industry since 1998; (2) what costcutting measures have airlines reported taking to remain financially viable; and (3) what is the financial condition of the airline industry?
section_title: What GAO Found
paragraphs: U.S. airlines, particularly major network or "legacy" airlines, have faced an unprecedented set of challenges since 1998 that have reshaped the industry and reduced the demand for air travel. Within the industry, the growth of the Internet as a means to sell and distribute tickets and the emergence of well-capitalized low-cost airlines as a powerful market force have created unprecedented pressures on how airlines operate and price their products. Coincidently, a series of largely unforeseen events--among them a steep decline in business travel, the September 11th terrorist attacks, war in the Middle East, and global recession--have combined to seriously disrupt the demand for air travel. To counter these challenges, airlines undertook very different strategies. Legacy airlines sought to cut costs, while low-cost airlines took advantage of legacy airlines' retrenchment and expanded. Legacy airlines collectively reported a reduction in operating costs of $12.7 billion (14.5 percent) between the October 1, 2001 (immediately after September 11th) and the end of 2003. The reductions occurred in nearly all areas of operations, but 43 percent of the savings came from labor. Legacy airlines reduced their seat capacity by 12.6 percent as they reduced operations and shifted service to their regional airline partners. Conversely, low-cost airlines increased seating capacity by 26.1 percent as they expanded their operations, and operating expenses actually increased by just over $1 billion (9.8 percent). Since 2000, the financial condition of legacy airlines, as a group, has deteriorated significantly. Despite their cost-cutting efforts, legacy airlines' unit costs have not declined, and low-cost airlines enjoy even a greater cost competitive advantage. Meanwhile, neither legacy nor lowcost airlines have been able to significantly improve their revenues owing to weak fare growth and overcapacity in the system. As a result, legacy airlines have recorded nearly $25 billion in operating losses since 2001, while low-cost airlines have remained profitable throughout. Two major legacy airlines have already declared bankruptcy; others may follow.

section_title: Letter
paragraphs: We appreciate the opportunity to participate in today’s hearing to discuss  the financial condition of U.S. airlines. Since 2001, the U. S. airline industry  has confronted financial losses of unprecedented proportions. From 2001  through 2003, the industry reported losses of $23 billion, and two of the  nation’s largest airlines went into bankruptcy. Following the tragic  terrorist attacks of September 11, 2001, the U.S. government has provided  struggling airlines with $7.0 billion in direct assistance and many billions  more in indirect assistance in the form of loan guarantees, a tax holiday,  and pension relief. The most recent assistance to airlines came in April  2003, under the 2003 Emergency Wartime Supplemental Appropriations  Act (P.L. 108-11). The federal government provided $2.4 billion to the  airline industry, and Congress mandated that the GAO review measures  taken by airlines to reduce costs, improve their revenues and profits, and  strengthen their balance sheets. Subsequent to P.L. 108-11, in December  2003, Congress provided a similar mandate under the Vision 100—Century  of Aviation Reauthorization Act for GAO to report on the financial  condition of the U.S. airline industry. Later this year GAO will provide a  report to Congress in response to these mandates. Although we are still  gathering and analyzing information in response to these mandates, my  statement today provides a preliminary look at some of our findings. My  remarks today address three main questions: (1) What have been the major  challenges to the airline industry since 1998? (2) What cost cutting  measures have airlines reported taking to remain financially viable? (3)  What is the financial condition of the airline industry?
My statement today focuses on the seven legacy and seven low-cost  airlines that accounted for 90 percent of all domestic airline industry seat  capacity in 2003. Legacy airlines are essentially those airlines that were in  operation before airline deregulation in 1978 and whose goal is to provide  service from “anywhere to everywhere.” To meet this goal, these airlines  support large, complex hub-and-spoke operations with thousands of  employees and hundreds of aircraft (of various types) with service to  domestic communities of all sizes as well as international points at  numerous fare levels. Legacy airlines contract with, or separately operate,  smaller regional airlines to provide service to smaller communities. Low- cost airlines, except Southwest, entered the market after deregulation and  generally operate point-to-point service using fewer types of aircraft.  These airlines typically offer a simplified fare structure and generally do  not offer international service outside of Canada, Central America, and the  Caribbean. Although there is variation among the airlines in each of these  groups, there are far more similarities than differences. Most importantly,  the seven low-cost airlines consistently had lower unit costs than the  seven legacy airlines between 1998 and 2003. To determine the major  challenges that airlines have faced, we examined prior GAO work and  research by various industry experts. To determine the cost-cutting  measures airlines took and to assess the industry’s financial condition, we  analyzed financial and operating data reported by airlines to the  Department of Transportation (DOT). To assess the reliability of those  data, we reviewed the quality control procedures that DOT applies and  subsequently determined that the data were sufficiently reliable for our  purposes. We performed our work in accordance with generally accepted  government auditing standards.
U.S. airlines, particularly legacy airlines, have faced a sweeping set of  challenges since 1998. These challenges are both internal factors reshaping  the airline industry and external events that sharply reduced the demand  for air travel. Within the airline industry, even before September 11th, the  growth of the Internet as a means to sell and distribute tickets and the  emergence of well-capitalized low-cost airlines as a powerful market force  created tremendous competitive pressures on airlines. At the same time, a  series of largely unforeseen events—among them the September 11th  terrorist attacks and associated security concerns, war in the Middle East,  the SARs epidemic, global economic downturn, and a decline in business  travel—-seriously disrupted the demand for air travel.
To overcome the many challenges of the last several years, the two groups  of airlines undertook very different strategies. Legacy airlines sought to  cut costs, while low-cost airlines took advantage of legacy airlines’  retrenchment and expanded. Legacy airlines collectively reported a  reduction in operating costs of $12.7 billion (14.5 percent) between the  October 1, 2001 (immediately after September 11th) and the end of 2003.  The reductions occurred in nearly all areas of operations, with the single  largest reduction coming from labor costs that were reduced $5.5 billion.  During this time period, legacy airlines reduced their seat capacity by 12.6  percent by shifting traffic to regional airline partners and grounding  aircraft. Conversely, low-cost airlines’ operating expenses increased by  just over $1 billion (9.8 percent); and their seat capacity increased by 26.1  percent as they expanded their operations.
Since 2000, the financial performance and viability of legacy airlines has  deteriorated significantly compared with low-cost airlines. Legacy airlines  have collectively lost $24.3 billion over the last 3 years, while low-cost  airlines made $1.3 billion in profits. Despite the cost-cutting efforts of  legacy airlines over the last couple of years, legacy airlines are even less  cost competitive relative to low-cost airlines than in 2000. Low-cost  airlines still maintain a significant unit cost advantage over legacy airlines  despite legacy airline cost cutting. Meanwhile, neither legacy nor low-cost  airlines have been able to significantly improve their revenues owing to  weak fare growth. As a result of their weak performance and mounting  losses, legacy airlines’ financial condition has also deteriorated, and they  face considerable debt and pension obligations in the next few years. At  least one other legacy airline has announced that, like USAirways and  United Airlines in 2002, it may enter bankruptcy this year.
subsections: section_title: U.S. Airline Industry Is Facing Significant Challenges
paragraphs: A series of significant changes and unforeseen events during the last  several years has presented the airline industry with its most significant  challenges since it was deregulated 25 years ago. These challenges have  come from within the industry as well as from external factors affecting  the demand for air travel.
subsections: section_title: Internal Challenges Lead to Structural Changes
paragraphs: Since the late 1990s, the U.S. airline industry, especially legacy airlines, has  faced several internal challenges that have altered the way it operates.  Foremost among these challenges is addressing declining yields brought  on by price transparency and competition. The airlines’ increased use of  the Internet to reduce ticket distribution costs. However, the price  transparency the Internet provides has empowered consumers searching  for the lowest fares and depressed fare levels. The emergence of well- capitalized low-cost airlines has also been a significant challenge.  Although earlier new entrant airlines quickly disappeared, this recent  group is better capitalized and offers a good overall product. Between  1998 and 2003, these low-cost airlines increased their presence in the 5,000  largest city pair markets (e.g., New York – Boston) from 32 to 46 percent  and increased overall market share of passenger enplanements from 23 to  33 percent.
section_title: External Shocks Have Depressed Demand for Air Travel
paragraphs: Demand for air travel began weakening in 2000, well before the September  11th terrorist attacks. An economic downturn that began in 2000  depressed airline revenues, and the terrorist attacks of September 11th,  the Iraq war, and the outbreak of Severe Acute Respiratory Syndrome  (SARS) have compounded this trend. These events have contributed to a  change in the demand for air travel that is likely to suppress revenues for  the foreseeable future, including the inability of airlines to charge  premium business fares. Although it is impossible to isolate the effect of  various events, demand as measured by revenue passenger miles (RPMs),  was down 6.5 percent and 11.4 percent for 2001 and 2002, respectively,  from the Federal Aviation Administration’s (FAA) June of 2001 forecasts.
section_title: In Response to Challenges, Legacy Airlines Reduced Costs and Cut Capacity, While Low- Cost Airlines Grew
paragraphs: Airlines responded very differently to the challenges of the last few years.  Legacy airlines faced with mounting losses and curtailed demand for air  travel sought to reduce capacity and along with it their operating  expenses. Low-cost airlines, already enjoying a cost advantage over legacy  airlines, used their competitive cost advantage to grow.
Legacy airlines cut operating expenses by $12.7 billion between October 1,  2001, and December 31, 2003. This 14.5 percent reduction in operating  expenses exceeds the percentage reduction in seat capacity of 12.6  percent during the same period. According to airline financial reports to  DOT, legacy airline labor costs were reduced $5.5 billion annually, or  about 16 percent during this time period (see fig. 1). Both USAirways and  United signed new labor agreements while in bankruptcy, and American  Airlines also achieved new agreements while on the verge of bankruptcy.  Legacy airlines also achieved $2.1 billion savings from a 59 percent  reduction in the commissions paid to travel agents, because those  commissions were sharply reduced. Finally, legacy airlines reduced fuel  costs by 18.7 percent during the period, although the recent upsurge in  fuel prices has reversed these savings. The only cost category to increase  for legacy airlines was transport-related expenses, which doubled during  the period, an increase of $3.9 billion. Increases in transport-related  expenses for legacy airlines are largely because of fees paid to regional  airline partners for providing regional air service. In the aftermath of  September 11th, legacy airlines shifted some of their routes over to  regional airlines in an attempt to reduce seat capacity on these routes.
Meanwhile, low-cost airlines used legacy airlines retrenchment as an  opportunity to expand. The seven low-cost airlines increased seat capacity  by 26.1 percent during the same period that legacy airlines cut capacity by  12.6 percent, but total operating costs for low-cost airlines increased by a  more modest 9.8 percent, or a little more than $1 billion. Low-cost airlines’  labor costs, these airlines’ largest single cost component increased over  $750 million, or 21 percent (see fig. 2). Despite their growth, low-cost  airlines were able to achieve small reductions in some of their other costs,  including commissions, passenger food, depreciation and amortization,  and transportation related expenses.
section_title: Legacy Airlines’ Financial Performance Trails Low-cost Airlines
paragraphs: The financial performance of U.S. airlines since 2000 has followed two  very different paths. Despite significant cost-saving initiatives and  industry-wide traffic volumes approaching pre-September 11th levels,  legacy airlines continue to lose money. Legacy airlines’ unit costs (cost to  fly one seat 1 mile) have increased since 2000 while fares have declined; as  a result, these airlines have yet to regain profitability. Meanwhile, low-cost  airlines continue to expand market share, enjoy a greater unit cost  advantage over legacy airlines than they did in 2000, and in all but one  quarter have collectively earned a profit. The weak performance of the  legacy airlines over the last 3 years has significantly diminished their  financial condition; as a result, some of these airlines are vulnerable to  bankruptcy, especially if there are additional shocks to the industry.
subsections: section_title: Low-Cost Airlines Have Significantly Lower Unit Costs Than Legacy Airlines
paragraphs: Legacy airlines, as a group, have been unsuccessful in sufficiently reducing  their costs to make them more competitive with low-cost airlines. Unit  cost competitiveness is key to profitability for airlines because airlines  have found it extremely difficult to increase their revenues in the current  environment. While legacy carriers reduced their overall operating  expenses over the last three years, these cuts largely paralleled legacy  airlines’ capacity reductions. Conversely, low-cost airlines have been able  to reduce their unit costs through expansion. Low-cost airlines’ ability to  maintain lower labor costs and lower asset-related costs accounts for the  majority of the unit cost differences between low-cost airlines and legacy  airlines.
Wall Street analysts suggested that one of the best measure for examining  airline unit cost performance is to compare airline unit cost curves. These  curves relate airlines’ unit costs to the stage length (distance) flown.  Figure 3 shows legacy and low-cost airline unit cost curves for 2000 and  2003 and shows that the gap between legacy and low-cost airline unit costs  has widened across all distances. For example, in 2000, at a 1,000-mile  stage length legacy airlines’ unit costs were 45 percent higher than low- cost airlines; by 2003, legacy airlines’ unit costs were 67 percent higher.  Some of the legacy airline unit cost increase is due to the capacity  purchased from regional airlines—an increase in operating expenses (the  numerator) but without a corresponding increase in available seat miles  (the denominator) in the unit cost calculation. However, this does not  account for all or even most of the gap between legacy and low-cost  airlines’ unit costs.
To account for this unit cost difference between legacy and low-cost  airlines, we also examined legacy and low-cost airline unit costs over time  and the various cost items that comprise total operating expenses. Overall,  we found that the gap in aggregated (for all stage lengths) unit costs for  legacy and low-cost airlines has widened since 2000, from 2.1 cents per  available seat mile to 3.8 cents at the end of 2003. Figure 4 shows this  widening gap and the cost components that account for the difference.
The two primary cost components that comprise the unit cost difference  between legacy airlines and low-cost airlines are labor costs and asset- related costs.
Legacy airlines have high labor costs owing to a highly tenured, unionized  workforce, while low-cost airlines are able to keep labor costs down  because of a younger and lower paid work force but also by achieving  higher levels of labor productivity than legacy airlines.
Legacy airlines have higher asset-related costs than low-cost airlines  because legacy airlines generally have older fleets and more types of  aircraft in their fleets than low-cost airlines. Legacy airlines also put their  planes in the air fewer hours per day than low-cost airlines. Finally, some  portion of this difference is due to legacy airlines’ purchase of regional  airline capacity during the period.
Other costs that currently are part of the remaining unit cost difference  between legacy airlines and low-cost airlines include expenses for fuel,  passenger ticketing commissions, and passenger food.
section_title: Depressed Fares Have Impeded Revenue Growth For Legacy Airlines
paragraphs: Both legacy and low-cost airlines have encountered weak revenues over  last several years. The internal and external factors cited earlier have  depressed fares and demand for air travel. Overall, industry-wide demand  has nearly returned to pre-September 11th levels, but fares have not. Unit  revenue, or yield, the amount of revenue airlines collect for every mile a  passenger travels, has fallen 19 percent from the first quarter of 2000  through the fourth quarter of 2003, for the airlines examined in this study.  The trends are similar for both the legacy airlines and low-cost airlines;  legacy yields dropped about 19 percent, and low-cost airline yields  dropped about 18 percent (see Figure 5). Although nearly as many  passengers are flying as before September 11th, they are paying less to do  so. In addition, legacy airlines are losing market share to the low-cost  airlines. Demand, as measured in the number of miles paying passengers  were transported, is down over 10 percent for the legacy airlines since  2000; demand for low-cost airlines has risen nearly 40 percent. Not only  are legacy airlines collecting less fare revenue from the passengers they  fly, they are also flying fewer passengers than they used to. Low-cost  airlines are flying more passengers at lower prices.
section_title: Low-Cost Airlines Are Profitable Owing to Lower Costs
paragraphs: Low-cost airlines have been able to use their relative cost advantage to  remain profitable at a time when fares are down throughout the industry.  As figure 6 demonstrates, legacy airlines have lost money in each of the  last 3 years, for a total of $24.3 billion; low-cost airlines have made money  in every year.
section_title: Legacy Airlines’ Financial Condition Has Deteriorated Since 2000
paragraphs: Since 2000, the financial condition of legacy airlines has deteriorated. Both  legacy airlines and low-cost airlines increased their cash balances  following the events of September 11th; legacy airlines did so primarily  through borrowing, while low-cost airlines increased theirs by generating  profits as well as borrowing. Since 2001, legacy airlines have taken on  more debt, relying on creditors for more of their capital needs than they  have in the past. Increased debt increases interest expenses and can make  raising additional capital more expensive. Low-cost airlines have acquired  some debt, but their solvency (or ability to repay the debt) has not  deteriorated to the same extent as it has for legacy airlines. In the process  of taking on additional debt, several legacy airlines have used all, or nearly  all, of their assets as collateral, limiting their access to capital markets.
Legacy airlines face large debt repayment and pension funding obligations  during the next 4 years. These fixed obligations greatly exceed the current  cash balances for many of the legacy airlines. For example, legacy airlines  had a collective cash balance of $6.8 billion at the close of 2003 versus  $19.2 billion of long-term debt and capital leases (a fixed obligation similar  to long- term debt) coming due through 2007. In contrast, low-cost airlines  had a collective cash balance of $3.5 billion versus long-term debt and  capital lease obligations of $2.1 billion coming due through 2007. If legacy  airlines’ debt cannot be refinanced, some legacy airlines might be forced  to enter bankruptcy. In addition, legacy airlines have significant defined  benefit pension funding obligations that low-cost airlines do not. Recent  pension reform legislation postpones a portion of legacy airlines’  requirements to make payments to their defined benefit pension plans in  2004 and 2005, but are still required to fully fund these plans in the years  beyond. Because legacy airlines’ future access to capital markets appears  to be limited, these airlines will need to begin generating cash from  operations if they intend to fulfill their future financial obligations and  avoid bankruptcy.
section_title: Concluding Observations
paragraphs: Although the airline industry was deregulated more than 25 years ago,  some of the most significant competitive changes are only now occurring  brought about by a myriad of challenges over the last 4 years. Before 2000,  large legacy airlines, all of which predated deregulation, dominated the  domestic airline industry. These airlines competed on the basis of their  networks and in-flight amenities as well as fares; they earned profits by  maximizing revenues from high value business travelers. Low-cost airlines  competed in some markets, but as a whole did not account for much more  than 10 percent of the market, and they rarely took on a legacy airline  directly. However, in recent years, this pattern has changed, perhaps  permanently. Significant structural change combined with severe demand  shocks has presented unprecedented challenges to the airline industry,  especially for legacy airlines. Legacy airlines, burdened by significant costs  of labor contracts and pension plans negotiated during profitable years  and an extensive and costly network infrastructure, have found it difficult  to reduce costs quickly enough to become cost competitive and restore  profitability. Meanwhile, low-cost airlines are using their cost advantage to  expand their market share and challenge legacy airlines like never before.
Although airline industry traffic has recovered to pre-September 11th  levels, profitability for legacy airlines has not, owing to higher costs and  weak fare growth. Three years of losses have left legacy airlines in a  weakened financial position with large debt and pension obligations  looming in the next few years. The potential for airlines to earn the large  profits of 1995-2000 does not appear possible. Instead, the airline industry  is being transformed into two industries, profitable low-cost point-to-point  airlines that continue to grow and extend their reach into ever more  markets and the major network legacy airlines that account for the vast  majority of the industry’s losses. Although legacy airlines still control two- thirds of all domestic traffic, possess profitable overseas routes, and have  a valuable domestic route structure, until these airlines are able to bring  their unit costs closer to those of low-cost airlines and align their services  with fares that passengers are willing to pay for “anywhere to everywhere”  networks, they are unlikely to be able improve their financial condition.
This concludes my statement. I would be pleased to respond to any  questions that you or other Members of the Subcommittee may have at  this time.
For further information on this testimony, please contact JayEtta Hecker  at (202) 512-2834 or by e-mail at heckerj@gao.gov. Individuals making key  contributions to this testimony include Paul Aussendorf, Tom Gilbert,  Grant Mallie, Steve Martin, Richard Swayze, and Pamela Vines.
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