Commercial Aviation: Legacy Airlines Must Further Reduce Costs to Restore Profitability
Released: 2004-08-11T00:00:00

Letter

Background

In 1978, under the Airline Deregulation Act, the United States deregulated its domestic airline industry. The main purpose of deregulation was to remove government control and open the air transport industry to market forces. Prior to the Act, the Civil Aeronautics Board regulated all domestic air transport, controlling fares and setting routes. In this regulated market, airlines competed more through advertising and onboard services than through fares. Similar to other highly regulated industries, the airline industry was heavily unionized with a highly trained and stable workforce.

In the years since deregulation, many studies, including ours, have found that fares measured in real terms have fallen since 1978. For example, in 1999, we reported that overall airfares had fallen 21 percent in constant dollars between 1990 and the second quarter of 1998. However, while deregulation led to lower fares, it did not bring about the full measure of competition envisioned by its creators. Legacy airlines created unique hub- and-spoke networks that increased service for consumers but kept local market fares high at their dominated hubs. Generally, the legacy airlines earned a premium for operating their hub and acted in a highly competitive fashion (e.g. substantially increasing scheduled service and aggressive pricing) against intruders, including low cost new entrant airlines. In many ways, however, these legacy airlines continue to compete based on service rather than fares.

The U.S. commercial airline industry is capital-intensive, labor-intensive, and has high fixed costs with revenues and profits closely tied to the nation’s business cycle. Fixed costs, including labor union contracts that are in effect for several years at a time, comprise a large portion of airline expenses and airlines must anticipate their capacity needs several years in advance. As a result, airlines tend to place orders for aircraft during profitable years, but deliveries tend to occur during down years. This has contributed to the cyclic nature of industry profitability. For example, in the 1990s, the industry recorded historically high profits of $47.4 billion from 1993 through 1999, during which time several airlines signed new agreements with their contract work force and ordered new aircraft. However, the industry has also experienced downturns at the beginning of each decade since deregulation. The airline industry reported losses of $2.5 billion from 1980 through 1982, $7.7 billion from 1990 through 1992, and $23 billion from 2001 through 2003. It is during these lean times that legacy airlines such as Braniff and Eastern failed, and others—such as US Airways and United more recently—filed for bankruptcy protection. It is also during these lean times that new entrant low cost airlines emerged. In the past, many of those new airlines quickly disappeared. In response to the latest downturn, the Congress provided several forms of financial relief, including direct grants and a 4-month security fee holiday, and it set up the Air Transportation Stabilization Board to provide up to $10 billion in loan guarantees.

The U.S. airline industry is principally composed of legacy, low cost, and regional airlines; and while it is free of economic regulation, it remains regulated in other respects, most notably safety and operating standards. Legacy airlines are essentially those airlines that were in operation before deregulation 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. To enhance revenues without expending capital, legacy airlines have entered into domestic (and international) alliances that give them access to some portion of each other’s network. Legacy airlines contract with or separately operate regional airlines to provide service to smaller communities; regional airlines typically operate turboprop or regional jet aircraft with up to 100 seats. Low cost airlines entered the marketplace after deregulation and primarily operate point-to-point service from “focus cities” using fewer types of aircraft. These airlines typically offer a simplified fare structure that was originally aimed at leisure passengers, but is increasingly attractive to business passengers because they do not have restrictive ticketing rules that make it significantly more expensive to purchase tickets within 2 weeks of the flight or make changes to an existing itinerary. Low cost airlines do not yet offer service outside Canada, Central America, and the Caribbean. DOT oversees industry competition and safety, including the air traffic control system. The Department of Homeland Security’s Transportation Security Administration (TSA), which was formed after the September 11, 2001, terrorist attacks and was originally part of DOT, oversees industry security, including passenger and baggage screening.

Airline Industry Facing Serious Challenges

Although the airline industry was deregulated 26 years ago, during the last several years, airlines have been presented with a sweeping set of challenges. These challenges stem from the internal restructuring of the airline industry and from external factors affecting the demand for air travel. Internally, the impact of the Internet on how tickets are sold and how consumers can search for fares, the emergence of low cost airlines as a powerful market force, and the growth of regional airlines have had a major impact on the airline industry. Coincidently, a series of largely unforeseen events—among them the September 11, 2001, terrorist attacks, war in Iraq, and associated security concerns; the SARS crisis; economic downturn; and a steep decline in business travel have seriously disrupted the demand for air travel.

Structural Changes Have Altered Historical Industry Trends

Since 1998, the U.S. airline industry has faced internal changes that have fundamentally altered the domestic airline industry. Among the most significant factors affecting this change are the emergence of the Internet and a new breed of low cost airlines, and the growth of regional airlines have spurred the industry to reevaluate how it conducts business.

The Increased Use of the Internet Has Lowered Airline Distribution Costs but Created Price Transparency and Downward Pressure on Airfares

Since the mid-1990s, partly in response to increasing costs of global distribution systems, airlines have increasingly sold and processed tickets through Internet-based applications, such as airline Web sites, Orbitz, and other internet-based travel agencies. Through various incentives, airlines have encouraged some passengers to book a growing portion of tickets this way (see fig. 1). This distribution method is less expensive to airlines than traditional travel agencies, but it has also increased the ability of consumers to compare airline ticket pricing and scheduling and often gives consumers access to special low fares available only on the Internet. This increased price transparency has been a significant factor in the downward pressure on airfares, creating a real decline in airline passenger revenues at the same time that airlines are incurring cost savings.

Another major factor in the internal restructuring of the U.S. commercial aviation industry is the growth of low cost airlines. Low cost airlines have increased their share of available seat miles (ASM)—an industry measure of supply—from 10.8 percent in 1998 to 17.5 percent in 2003 (see fig. 2). Low cost airlines typically rely upon fewer types of aircraft and offer simpler fare structures than legacy airlines. Unlike earlier low cost airlines, many of which quickly disappeared, these airlines are well-capitalized and offer a good overall product. As relative newcomers in the industry, these airlines do not yet suffer from what is commonly know as “legacy costs,” costs that older airlines incur simply due to their longevity. These include the labor costs of a more senior workforce as well as retirees, aircraft costs from maintaining several fleet types as well as older aircraft, and the costs of maintaining networks.

During this period of turmoil for the legacy airlines, their regional affiliates have increased capacity and maintained profitability. Regional airlines, which operate in affiliation with one or more legacy airlines, may be wholly or partially owned by the partner airline or completely independent. Regional airlines primarily serve smaller communities with regional jet or turboprop aircraft through contractual arrangements with legacy carriers. Many of these contracts are risk free for the regional airline because the legacy partner pays a fee for the regional airline’s service. From 1998 through 2003, the 16 largest regional airlines included in our study earned an operating profit of $3.3 billion. At the same time, regional airlines increased seat capacity 140.6 percent between 1998 and 2003 (see fig. 3). This growth and profitability of the regional airlines came about because legacy airlines transferred routes to them. Recently, two low cost carriers—AirTran and Frontier—also partnered with regional airlines for regional jet service. In contrast, JetBlue plans to introduce 100-seat Embraer 190 regional jets into its own fleet for service in late 2005. However, changes are looming for regional airlines. Legacy airlines are seeking less expensive contracts with their regional partners. In the case of one of United Airline’s former regional partners, Atlantic Coast Airlines decided to reinvent itself as a low cost carrier, Independence Air, instead of operating under a new contract with United or another airline. This may be the first of several shake-ups in the legacy-regional airline partnerships, as Delta Air Lines contemplates a bankruptcy filing and US Airways struggles to avoid a second bankruptcy. (App. III contains additional financial information on the regional airlines.)

External Shocks Have Depressed Demand for Air Travel

Demand for air travel began weakening in 2000 due to a number of external changes in the aviation environment. An economic downturn that began in 2000 precipitated a decrease in demand for air travel, while the terrorist attacks of September 11, the Iraq War, and the outbreak of SARS have compounded this trend. These events have accelerated the structural changes in the demand for air travel that is likely to suppress revenue for the foreseeable future, including the inability of airlines to charge premium business fares.

Airlines’ financial problems of the past 4 years began with an economic downturn in 2000. As illustrated in figure 4 below, industry experts have long recognized a relationship between the nation’s economic performance and the demand for air travel. The growth in the nation’s gross domestic product (GDP) most recently peaked in 1999 before falling to 0.5 percent in 2001, and then rebounding in 2002. This coincided with a drop in demand for air travel from a high of 691 billion revenue passenger miles (RPM) in 2000 to a low of 641 billion RPMs in 2002. While this time period includes September 11, quarterly year-over-year data reveals a clear downward trend in RPM growth prior to September 11; RPM growth reached a peak of 8.9 percent in the second quarter of 2000, with a recession in air travel beginning in the second quarter of 2001.

The terrorist events of September 11 compounded the decline in demand for air travel in the United States. Compared to the Federal Aviation Administration’s (FAA) June 11, 2001, forecast of passenger demand (the last forecast made before the terrorist attack of September 11): actual full year 2001 demand, as measured in RPMS, turned out to be about 4 percent less; and actual demand for 2002 was about 17 percent less compared with FAA’s June 2001 forecast.

After September 11, FAA revised its forecasted demand downward considerably relative to its June 11, 2001, estimates. FAA’s March 2002 demand forecast predicted RPMS would be an average of 11.5 percent per year less from 2002 through 2012. FAA’s March 2003 forecast (prior to the Iraq War and SARS), predicted demand would be an average of nearly 19 percent per year less from 2003 through 2012, compared with FAA’s estimates of June 2001. Figure 5 presents FAA forecasts of RPMS for June of 2001 through March of 2004, and actual RPMS for 1998 through 2003.

The effects of the war in Iraq and the outbreak of SARS on demand for air travel were relatively minimal compared with the effects of September 11. Actual demand in 2003 was about the same as it was in 2002. FAA’s demand forecast after the Iraq War began and the SARS outbreak was revised upward an average of 8 percent for 2004 through 2012. FAA staff we interviewed thought that the SARS effect, while significant, was limited to Pacific air travel; year-over-year RPMs dropped 33 percent for the second quarter of 2003 in the Pacific sector.

The Iraq War and unrest in the Middle East also contributed to rising fuel costs for airlines. From the first quarter of 2002 through the first quarter of 2004, the price of oil per barrel increased from $20.98 to $32.97; an increase of 57 percent. However, oil prices are volatile by nature, and many airlines hedge some portion of their oil and fuel costs to lock in these costs. Figure 6 presents the cost of oil per barrel from 1998 through the first quarter of 2004.

The decline in business fares is another factor that has contributed to the financial problems of the industry. During the late 1990s, legacy airlines’ profitability became increasingly reliant on a very small percentage of last minute business travelers that paid fares much higher than the average leisure fare. As the economy soured in 2001, business travelers became less willing to pay premium fares. According to Air Transport Association (ATA) data reported by the DOT Inspector General, the number of business travelers declined 26 percent from December 2001 through December 2002. Moreover, the average one-way business fare also declined nearly 10 percent, from $672 in the first quarter of 2001 to $607, in the first quarter of 2004 (see fig. 7).

In Response to Challenges, Legacy Airlines Reduced Costs and Cut Capacity, While Low Cost Airlines’ Total Costs Increased Due to Capacity Expansion

To meet the many challenges of the last several years, airlines have sought to cut costs, enhance revenues, and obtain the assistance of the federal government. Legacy and low-cost airlines collectively reported to us $20.3 billion in cost-saving initiatives from October 1, 2001, through December 31, 2003. For the nine-quarter period ending December 31, 2003, legacy airlines collectively reported to us about $19.5 billion in cost-saving initiatives; actual operating costs decreased by about $12.7 billion dollars, or 14.5 percent, during that time. Collectively, legacy airlines cut their capacity by about 12.6 percent during the same period. Conversely, low cost airlines reported relatively little cost-cutting and their total operating expenses as a group actually increased 9.8 percent; however, their capacity increased even faster at 26.1 percent. Both legacy and low cost airlines reported relatively modest amounts of revenue enhancement initiatives in recognition of the weak demand for air travel during the period. From October 1, 2001, through December 31, 2003, legacy airlines revenues actually declined about 14.5 percent, while low cost airlines revenues increased 9.4 percent. Airlines used the $2.3 billion in security assistance provided under the 2003 Emergency Wartime Supplemental Appropriations Act to fund their security and operating costs, with 75 percent of the assistance going to the seven legacy airlines.

Legacy Airlines Sought 20 Percent Cost Reductions to Restore Profitability

Legacy airlines accounted for the vast majority of all cost-savings reported to us. The 14 legacy and low cost airlines in our study reported that they expected to cut a total of $20.3 billion from October 1, 2001, through 2003. Legacy airlines reported that they expected to reduce operating costs by about $19.5 billion through December 31, 2003, or 96 percent of this total. If achieved this would have amounted to a 22 percent reduction in costs for the legacy airlines. Low cost airlines, in contrast, reported $803 million in anticipated cost-savings through December 31, 2003, or just 4 percent of the combined total. Figure 8 presents expected cost-savings for each year by airline group.

It is difficult to disaggregate the cost-savings reported to us into cost categories because airlines lacked uniformity in their reporting. However, based on these reports, discussions with airlines and industry experts, airlines generally sought cost-savings from cuts in capacity, changes in salary and benefits, vendor concessions, and productivity improvements. In particular, United Airlines and US Airways were able to obtain concessions from their unions through the bankruptcy process or, in the case of American Airlines, through the threat of bankruptcy. Immediately following September 11, legacy airlines parked planes in the desert in an effort to reduce capacity and save costs. In recent months, some of these planes have been returned to service.

Actual Cost Cutting by Airlines Differed

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. Unlike the plans submitted to us, actual financial results reported to DOT can be disaggregated. Notably, legacy airline labor costs were reduced $5.5 billion annually, or about 16 percent during this time period (see fig. 9). Legacy airlines also achieved $2.1 billion in annual 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 likely 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 annually. Increases in transport-related expenses for legacy airlines are largely due to fees being paid to regional airline partners for providing regional air service. In the aftermath of September 11, legacy airlines shifted some of their capacity over to regional airlines in an attempt to reduce seat capacity and costs 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 annually, or 21 percent (see fig. 10). 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.

Revenue Enhancement Measures Reported to Us Were Far More Modest Than Cost Savings

The revenue enhancement measures that were reported to us were small compared with the cost-savings reported by airlines. Legacy airlines reported $2.3 billion in expected revenue enhancement benefits for the period October 1, 2001, through December 31, 2004, with most of this amount ($1.6 billion) expected in 2004. Legacy airlines reported benefits from changes in ticketing policies and fare structures, schedule changes, and new code-sharing arrangements. From October 1, 2001, through December 31, 2003, legacy airlines actually saw a decline of about $11.9 billion (14.5 percent) in operating revenue. Meanwhile, low cost airlines reported even less revenue enhancement, only $189 million for the same period, but actually increased their revenue for the period by about $1.1 billion (9.4 percent), thanks to greatly increased volume. Airline officials and analysts indicated that fares have remained very weak during the period limiting revenue options for airlines.

Government Assistance Stemmed Airline Losses

Airlines also depended on federal assistance in 2001 and 2003 to counter their losses during the period. For example, in 2001 airlines received nearly $5 billion in assistance, and the industry was authorized up to $10 billion in loan guarantees under the Air Transportation Safety and System Stabilization Act, of which loans totaling $1.56 billion were extended to 9 airlines. In 2003, the federal government provided another $2.4 billion in assistance, of which $100 million was reserved for reimbursement of cockpit door reinforcements and the remainder provided to help U.S. airlines with their security costs. Of the $2.3 billion, three-quarters went to legacy airlines, as shown in figure 11.

The law did not establish how airlines were to use the assistance, but it did require TSA to certify that the 64 airlines that ultimately received assistance allocated the funds for security-related expenses or revenues foregone as a result of meeting federal security mandates. By accepting the funds, the airlines agreed to this certification requirement. As shown in table 1, most airlines reported to TSA that they used the funds for their ongoing security costs and core operations.

Legacy Airlines’ Financial Condition Has Deteriorated Relative to Low Cost Airlines

The financial condition 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 11 levels, legacy airlines continue to lose money. Legacy airlines’ unit costs (cost to fly one seat 1 mile) have not decreased 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.

Legacy Airlines Have Significantly Higher Unit Costs Than Low Cost Airlines

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 3 years, capacity reductions have made it difficult for legacy airlines to achieve meaningful unit cost 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.

Equity and credit analysts suggested that one of the best measures for examining airline unit cost performance is to compare airline unit cost curves. These curves illustrate the relationship between airlines’ unit costs and the distance flown (“stage length”). Figure 12 shows legacy and low cost airlines’ unit cost curves for 2000 and 2003 and suggests that the gap between legacy and low cost airlines’ 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 (ASM) (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 ASM to 3.8 cents at the end of 2003. The size of this gap may be somewhat overstated because of a change in the financial reporting requirements for airlines during this time. Beginning in 2003, airlines were required to report the cost of buying additional capacity from regional airlines under transport-related expenses. To calculate the legacy airlines’ unit costs correctly under this new reporting requirement, the ASMs that the legacy airlines buy from the regional airlines should also be included in calculating their unit costs. We could not incorporate this into our calculation because the exact amount of capacity purchased by legacy airlines and the amount of money spent on capacity purchased from regional airlines are not reported in sufficient detail to do so. However, to indicate legacy airlines’ minimum unit costs, we calculated legacy airlines unit costs excluding transport-related expenses (low cost airlines reported very little transport- related expenses). Accordingly, the unit cost difference between legacy and low cost airlines grew from 1.6 cents per ASM in 2000 to 2.5 cents in 2003.

Figure 13 shows the gap between legacy and low cost airlines’ unit costs, including and excluding transport-related expenses.

The two primary cost components that comprise the unit cost differential 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. Low cost airlines are able to suppress unit costs 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 different fleet structures than low cost airlines. Additionally, because legacy airlines generally operate hub-and-spoke business models in comparison to the point-to-point model generally operated by low cost airlines, legacy airlines are not able to achieve the same level of asset utilization as low cost airlines. Other costs that currently comprise the remaining unit cost difference between legacy airlines and low cost airlines include expenses for items such as fuel, passenger ticketing commissions, and passenger food.

Labor costs accounted for over 40 percent of the unit cost difference between legacy airlines and low cost airlines in 2003. Legacy airlines’ high labor costs are the result of a highly tenured workforce, higher pension costs, and work rules that differ from their low cost competitors. Low cost airlines have been effective at keeping unit labor costs down by achieving higher labor productivity and paying less. Legacy airlines have made progress in improving labor productivity since 2001, but they continue to trail low cost airlines, which have steadily improved labor productivity since 1998. As Figure 14 illustrates, in 2003 legacy airlines had improved labor productivity 8.3 percent, compared with 1998, by increasing the number of ASMs produced per employee. However, in 2003 they still produced 7 percent fewer ASMs per employee than low cost airlines.

Legacy airlines encounter higher asset-related unit costs than low cost airlines because legacy airlines have older fleets and more types of aircraft in their fleets than low cost airlines, and legacy airlines put their planes in the air fewer hours per day than low cost airlines. Legacy airlines own older aircraft than many low cost airlines; and older aircraft can be expensive to operate because they are less fuel-efficient than newer aircraft, and they have higher maintenance costs. Additionally, legacy airlines usually have more types of aircraft in their fleets, adding to maintenance costs and pilot training costs. Moreover, because legacy airlines generally operate a hub-and-spoke business model, they are not able to operate their aircraft for as many block hours per day as low cost airlines. Low cost airlines typically operate a point-to-point business model that allows them to limit the amount of time a plane must spend on the ground from the time it lands until it is ready to take off again. Figure 15 demonstrates the asset utilization differential that exists between legacy airlines and low cost airlines when measured in block hours per day per aircraft in service. Legacy airlines have improved asset utilization since the events of September 11; however, despite these improvements, they continue to trail low cost airlines with respect to asset utilization trends.

Other operating expenses that explain the unit cost difference between legacy airlines and low cost airlines include items such as aircraft fuel and oil, passenger food, and passenger commissions related to ticketing. Together these items comprise approximately 20 percent of the unit cost difference between legacy airlines and low cost airlines.

Depressed Fares and Declining Traffic Have Weakened Revenues for Legacy Airlines

Overall industry revenues have not returned to pre-September 11 levels despite a return in demand for air travel. In 2003, passenger demand for air travel (as measured in miles flown by paying passengers) returned to 95 percent of the 2000 level. However, industry revenues only totaled $77 billion in 2003, which represents just under 80 percent of the 2000 level. The revenue picture is significantly different when comparing legacy airlines with low cost airlines. Legacy airline passenger revenues are down 28 percent from 2000 through 2003, while low cost airlines have increased passenger revenues over 12 percent. Figure 16 below presents the changes in total industry revenues from 1998 through 2003, as well as changes by the legacy and low cost groups.

Low airfares constrained revenues for both legacy and low cost airlines. Yields, the amount of revenue airlines collect for every mile a passenger travels, have fallen 19 percent industry-wide from the first quarter of 2000 through the fourth quarter of 2003 for the 30 airlines examined in this study. Figure 17 presents the trends in yields for both legacy airlines and low cost airlines from 1998 through 2003. The trends are similar for both the legacy airlines and low cost airlines; legacy yields dropped about 19 percent, while low cost airline yields dropped about 17 percent.

In addition, the gap between the legacy airline yields and the low cost airline yields has narrowed. Legacy carriers are often able to command a higher fare—or “revenue premium”—compared with low cost airlines because passengers will often pay more for the benefits of a network structure. Accordingly, legacy airline officials have stated that they do not need to lower their costs to the same levels as low cost airlines because they can command a revenue premium. This ability to command a revenue premium, however, appears to be eroding. The revenue premium commanded by the legacy airlines has fallen from 9.8 percent to 6.4 percent from 1998 to 2003—a 45 percent decrease. Moreover, this revenue premium is less than half of the 15 percent to 16 percent revenue premium one legacy airline stated that they expected to be able to command.

The primary factor differentiating legacy and low cost airline revenue performance is the change in demand. Demand (as measured in RPMs) is down 11 percent for legacy airlines from 2000 through 2003, while demand for low cost airlines has risen nearly 37 percent (see fig. 18). Low cost airlines have expanded their operations and market share enough to increase revenues in a lower yield environment and can do so profitably because of their lower cost structure. Legacy airlines are simply flying fewer people at lower fares, which represent decreases in both factors of the revenue equation. Although nearly as many passengers are flying as before September 11, they are paying less to do so and choosing to fly on low cost airlines more often.

It appears low fares will continue to depress revenues during 2004 since airlines continue to add capacity. A year-over-year comparison of ASMs for the first quarter of 2004 indicates capacity is up over 7 percent from 2003. Airlines generally add capacity to compete for or defend market share. Legacy airlines are adding capacity because they possess excess capacity that can be added at relatively low marginal costs. Collectively, however, this strategy is problematic because the additional capacity depresses fares further. Credit and equity analysts we interviewed stated that the increase in capacity is likely to outweigh the increase in demand for air travel and continue to depress fare prices.

High Unit Costs and Depressed Fares Have Combined to Eliminate Profitability at Legacy Airlines

Weak revenues and the inability to realize greater cost-savings have combined to create unprecedented losses for legacy ailrines. At the same time, low cost airlines have been able to continue producing modest profits as the result of significantly improved cost performance. As figure 19 demonstrates, the unit-operating margin (or difference between unit revenues and costs) for legacy airlines turned negative during the second half of 2000 and reached its trough shortly after September 11. While the operating margin for legacy airlines recovered in 2003 from its post- September 11 low, and losses in 2003 are not as great as in 2002, these airlines have experienced operating losses in all quarters but one since September 11, 2001.Meanwhile, low cost airlines maintained a positive operating margin between 2001 and 2003, with the exception of the fourth quarter of 2001—the immediate aftermath of September 11. Further, an expected return to moderate profitability in 2004 for legacy airlines has not materialized due, in large part, to historically high oil prices.

As a result of the difference in operating margin, legacy airlines have lost $24.3 billion since the end of 2000, while low cost airlines have made a profit of $1.3 billion. Figure 20 presents airline profits and losses from 1998 through 2003. One industry estimate indicates the airline industry, as a whole, will again be unprofitable in 2004, losing in excess of $3 billion.

Legacy Airlines’ Financial Condition Has Weakened Since 2000

Since 2000, the financial condition of legacy airlines has deteriorated. Both legacy airlines and low cost airlines built cash balances following the events of September 11; legacy airlines did so primarily through borrowing, while low cost airlines increased liquidity through borrowing and generating cash from operations. Since 2001, legacy airlines have taken on more debt, relying on creditors for more of their capital needs than in the past. Higher debt levels leads to greater interest expenses and can make raising additional capital more difficult. Low cost airlines also increased their debt levels, but not as much, and their solvency (or long-term prospects of repaying the debt) has not deteriorated to the same extent as 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’ liquidity has deteriorated overall and relative to low cost airlines. Liquidity is a measure of a firm’s ability to meet short-term liabilities with cash or marketable securities. Both groups of airlines built cash balances immediately following September 11—for example, comparing cash and marketable securities to current liabilities, known as the cash ratio, rose for both types of airlines (see fig. 21). However, low cost airlines have built proportionally larger cash balances and did it primarily by generating cash from operations, as well as modest borrowing. In contrast, legacy airlines built cash balances after September 11, principally by borrowing. More recently, losses have depleted cash balances and legacy airlines’ ability to meet current obligations has not improved. During 2002 and 2003, low cost airlines built cash balances by generating cash from operations, while legacy airlines continued to lose cash from operations and compensated for operating losses by taking on additional debt. In 2003, low cost airlines generated approximately $2.2 million in cash per day while legacy airlines depleted their cash reserves at a rate of approximately $682,000 per day. Low cost airlines maintain more favorable liquidity measures than legacy airlines, and the differential between the two groups of airlines is widening.

Since legacy airlines have issued debt to cover operating losses, they continue to be more highly leveraged than low cost airlines, indicating that low cost airlines are more likely to be able to fulfill their long-term financial obligations than legacy airlines, and the gap between the airline groups is growing. Both legacy airlines’ and low cost airlines’ debt have increased since 1998. As figure 22 demonstrates, legacy airlines have financed 92 percent of their assets by issuing debt (priced at book value), while low cost airlines have only financed approximately 50 percent of their assets by issuing debt. However, as the graph also illustrates, low cost airlines’ debt ratios have fallen since the end of 2002, and the gap between the two groups of airlines appears to be widening. 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. In addition, as legacy airlines’ financial condition has deteriorated, credit rating agencies have generally downgraded airline debt, further limiting their access to capital markets.

Legacy airlines face large debt repayment obligations and pension plan contributions during the next 4 years. Figure 23 illustrates the looming long-term debt and capital lease (a fixed obligation similar to long-term debt) payments that legacy airlines face in comparison with their low cost competitors. While legacy airlines had approximately $6.8 billion in cash at the end of 2003, they face a total of $19.2 billion in long-term debt and capital lease obligations during the next 4 years. In contrast, low cost airlines had a collective cash balance of approximately $3.5 billion at the end of 2003 versus long-term debt and capital lease obligations of $2.1 billion coming due through 2007. A recently passed law postpones a portion of legacy airlines’ requirements to make payments to their defined benefit pension plans in 2004 and 2005, but these airlines are still required to fully fund these plans in future years. Current estimates indicate that legacy airlines’ defined benefit pension plans are underfunded by approximately $20.5 billion. 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.

Low Cost Airline Growth Has Created Greater Competition in Many Domestic Markets

Airline competition has increased in domestic markets since 1998 because of the growth and expansion of low cost airlines. Between 1998 and 2003, the number of effective competitors in many of the 5,000 largest domestic markets increased, even as the overall number of passengers remained about the same. Low cost airlines entered more of these markets and increased their share of total passengers, particularly in longer distance markets. Legacy carriers continued to serve nearly all of these markets, but they carried fewer passengers in 2003 than in 1998, and their overall share decreased. Legacy airlines continued to dominate many of the largest 5,000 domestic markets in 2003, but most of those were relatively small markets to or from their hubs.

The top 5,000 city-pair markets we analyzed accounted for about 92 percent of all domestic passenger traffic in 2003. Within this group, markets differ greatly in size, with passenger traffic concentrated in relatively few of them. In 2003, almost 23 percent of all domestic passengers flew in the 52 largest markets. Each of these large markets had at least 840,000 passengers annually and on average, over 1.5 million passengers flew in each. The largest market in 2003 was Los Angeles—San Francisco, in which 5.1 million passengers flew. Throughout the remainder of this report, we define “large” markets as those 52 markets. Conversely, relatively few passengers flew in each of the smaller markets. At the opposite end of the spectrum from the 52 largest markets are the 4,157 small markets, in which 24 percent of domestic passengers flew. Each of those markets had less than 85,000 passengers annually and had an average of 20,569 passengers annually. The smallest markets in this group, which includes Oklahoma City to Savannah, had 4,840 passengers (about 13 passengers per day) in 2003.

Competition Has Increased Most in Larger Markets as Low Cost Airlines Have Expanded Service Beyond Their Traditional Markets

Although most of the top 5,000 largest domestic markets were already competitive in 1998, many had become more competitive by 2003 as low cost carriers ventured into new markets, more directly challenging legacy carriers and taking a larger share of passengers. The number of monopoly markets decreased, and the number of markets with three or more airlines providing service grew by 8.9 percent. Overall, the average number of effective competitors in the top 5,000 markets rose from 2.20 in 1998 to 2.36 in 2003. Figure 24 illustrates the number of effective competitors in 1998 and 2003 by market size.

Increased competition in domestic air service is largely attributable to the growth of low cost airlines, which increased the number of markets served from 1,594 in 1998 to 2,304 in 2003, an increase of 44.5 percent (see fig. 25). In 1998, low cost airlines were generally serving large, short-haul markets such as Dallas to Houston or Atlanta to Orlando. By 2003, as they opened operations in new cities, low cost airlines expanded into smaller markets by making connections available that did not exist before. In addition, low cost airlines evolved from serving mostly short-haul markets to flying transcontinental (e.g., in 2003 JetBlue began service from Fort Lauderdale to Long Beach and Southwest began service between Baltimore and California). DOT has also observed that low cost airlines have been spreading service to smaller and longer-haul markets as well as competing more aggressively for business passengers. According to DOT, low cost airlines generate lower fares and an increase in passengers in the markets they enter. Although legacy airlines have made large cuts in operating costs over the past few years, they were present in nearly all of the top 5,000 markets each year.

Low cost airlines’ addition of more routes expanded the extent to which they competed directly with legacy airlines. In 1998, low cost airlines operated in 31.5 percent of the markets served by legacy airlines, and provided a low-cost alternative to 72.5 percent of passengers. By 2003, low- cost airlines competed directly with legacy airlines in an additional 698 markets. They operated in 45.5 percent of the markets served by legacy airlines and provided a low cost alternative to 84.6 percent of passengers in the top 5,000 markets.

The entry of low cost airlines into new markets contributed to the shift in market share for legacy and low cost airlines. Overall, low cost airlines’ share of total passenger traffic increased from 23 percent in 1998 to 33 percent in 2003, while legacy airlines lost market share, falling from 69 to 65 percent (see fig. 26). Low cost airline total passenger traffic increased from 79.8 million in 1998 to 117.1 million in 2003. Low cost airline passengers also increased in all markets sizes and market distances over 250 miles, with the largest increases in long haul markets. Legacy carrier passengers decreased from 242.2 million in 1998 to 231.6 million in 2003.

With the increase in overall competition, the number of dominated markets declined by 279 between 1998 and 2003 (7.7 percent). However, during the financially difficult years of 2001 through 2003, the number of dominated markets increased by 63 (see fig. 27). And although a single airline may have carried more than half of the total passenger traffic in those dominated markets, 31.2 percent of those markets had service from three or more airlines in 2003.

As a group, dominated markets enplaned the majority of passengers from 1998 to 2003, but individually they tended to be smaller than non- dominated markets. In 2003, dominated markets enplaned an average of 64,217 passengers each, while nondominated markets enplaned an average of 85,730 passengers each, a difference of 34 percent (see fig. 28).

Nearly 85 percent of the markets dominated in 2003 were dominated by legacy airlines. Additionally, a large percentage of the total number of dominated markets were “hub markets” of legacy airlines (i.e., travel originated or terminated in one of the legacy airline’s hubs). In 2003, the 2,854 markets that were dominated by legacy carrier. Each had an average of 48,375 passengers. Low cost airlines dominated 458 markets in 2003, and those markets tended to be significantly larger. On average, 158,378 passengers flew annually in markets dominated by low cost airlines. This difference reflects the low cost carriers’ targeting of high-density markets and the nature of hub-and-spoke networks operated by legacy airlines.

Concluding Observations

While the airline industry was deregulated more than 25 years ago, some of the most significant competitive changes are only now occurring, brought about by the unprecedented challenges of 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 onboard amenities as well as fares; profits were earned by maximizing revenues from high-value business travelers. While low cost airlines competed in some markets, as a whole, they never accounted for a significant segment of the industry and rarely took on a legacy airline directly. In the past, new entrant low cost airlines rarely survived an entire business cycle. 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 restore profitability. The scale of cost- cutting reported to us by legacy airlines was not fully achieved and, most importantly, legacy airlines were no more cost competitive with low cost airlines in 2003 than they were in 2000.

Meanwhile, low cost airlines are using their cost advantage to expand their market share and challenge legacy airlines like never before. While industry traffic has recovered to pre-September 11 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 condition with large debt and pension obligations looming in the next few years. The potential for airlines to earn large profits during up-cycles to cover losses during down-cycles, as they did during the 1990s, appears to have come undone this decade. Whether legacy airlines can effectively compete with low cost airlines and regain profitability will depend on their ability to further reduce their unit costs and gain a revenue premium associated with network service that connects smaller U.S. communities with international destinations—a service that low cost airlines do not now offer. The survivability of legacy carriers may well depend on their ability to do so— certainly, they cannot continue to sustain losses like those incurred over the past few years. The growth of low cost airlines in recent years has benefited most consumers through increased competition, but the structure of the U.S. domestic airline industry remains very much in flux.

Comments

We provided a draft of this report to DOT for its review and comment. DOT officials provided some clarifying and technical comments that we incorporated where appropriate. We also provided selected portions of a draft of this report to the ATA to verify the presentation of factual material. We incorporated their technical clarifications as appropriate.

We provided copies of this report to the Secretary of Transportation and other interested parties and will make copies available to others upon request. In addition, this report will be available at no charge on our Web site at http://www.gao.gov. If you have any questions about this report, please contact me or Steve Martin at 202-512-2834. Other major contributors are listed in appendix V.

Airline Cover Letter

1. Post-Enactment Implementation Period In completing this section, list only the initiatives that were or are expected to be implemented after the enactment of the Act, i.e.,April 1, 2003 through December 31, 2003. Initiatives that were begun in this time period but have not yet been completed are considered implemented in this time period.

Using your best judgment, (1) report only the most significant initiatives such as those that result in large dollar benefits or large operational impacts and (2) categorize initiatives into Cost Reduction and Revenue Enhancement categories for the Financial Improvement Initiatives and into Liquidity, Debt Management, and Other categories for the Balance Sheet Initiatives.

Name of the Most Significant (Net, rounded to the nearest dollar)

Initiative (Net, rounded to the nearest dollar)

Resulting From Each Initiative, applicable)

I. Cost Reduction Initiatives

Significant Operational Impacts Resulting From rounded to the nearest dollar) dates if applicable)

This section might include initiatives relating to the following areas:

2. Pre-Enactment Implementation Period In completing this section, list only the initiatives that were implemented after the terrorist attacks and before the enactment of the Act (October 1, 2001 through March 31, 2003). Initiatives that were begun in this time period but have not yet been completed are considered implemented in this time period.

Using your best judgment, (1) report only the most significant initiatives such as those that result in large dollar benefits or large operational impacts and (2) categorize initiatives into Cost Reduction and Revenue Enhancement categories for the Financial Improvement Initiatives and into Liquidity, Debt Management, and Other categories for the Balance Sheet Initiatives.

Initiative (Net, rounded to the nearest dollar)

Initiative (Net, rounded to the nearest dollar)

Initiative (Net, rounded to the nearest dollar)

I. Cost Reduction Initiatives

Significant Operational Impacts Resulting From rounded to the nearest dollar)

This section might include initiatives relating to the following areas:

3. Net Effect of All Initiatives In completing this section, record the following operating statistics, financial data, and economic assumptions for the specified time periods. This overall carrier performance will provide a context in which we will evaluate the reasonableness and feasibility of the initiatives listed in this plan. This information is similar to that which is provided to the Department of Transportation's Bureau of Transportion Statistics on the Form 41.

Average Fare, Int’l Revenue Passenger Load Factor (%)

Average Passenger Trip Length (miles)

Average Number Aircraft in Service Avg. Number of Departures per Aircraft Average Stage Length (miles)

Employees (avg. FTEs)

Aircraft rentals and landing fees Long term debt and capital leases Other income and expenses (net)

Net Income (Loss) Before Taxes Net Income (Loss)

GDP (% change)

CPI (% change)

Avg. Fuel Price ($/gallon)

List the amount of airline relief payments you received on May 15, 2003 from the Transportation Security Administration under the Emergency Wartime Supplemental Appropriations Act, 2003, (P.L. 108-11). If you distributed any portion of these funds to another carrier or entity, provide a listing of such payments.

Describe how the funds received from TSA were or are expected to be used.

Discuss here any other relevant information that you wish to highlight regarding financial improvement initiatives such as uncontrollable events or factors.

Once the plan is completed, submit it and any other supporting analysis or other documentation via overnight mail, postmarked no later than July 16, 2003 to: Phil McIntyre Room 5V21 U.S. General Accounting Office 441 G Street, NW Washington, DC 20548 We are expecting that we will be provided sufficient information to evaluate the reasonableness or feasibility of the initiative and underlying assumptions. During our review, we may follow-up with the contact person listed on page 1 to ask for additional supporting information or clarification of the information provided. If you have any questions or concerns, please call Phil McIntyre (202) 512-4373 or Steve Martin (202) 512-3389.

Airline Enplanements and Government Assistance Received Pursuant to P.L. 108-11

(Incl. in AA) (Incl. in AA) (Returned aid)

Aid to American Eagle and Executive Airlines was included with American Airlines.

Mesa was awarded aid, but did not accept the aid.

The total number of enplanements in the U.S. airline industry during 2003 was 647,761,545.

Scope and Methodology

To identify challenges facing U.S. airlines since 1998, we relied on a variety of sources. We conducted interviews with airline officials from legacy airlines, low cost airlines, regional airlines, and representatives from airline trade associations. We also interviewed government experts from the Department of Transportation (DOT) and its agencies—the Federal Aviation Administration (FAA) and the Bureau of Transportation Statistics—and the Department of Homeland Security’s Transportation Security Administration (TSA). Using DOT Form 41 and SC-298 financial and traffic data, FAA aviation forecasts, and business fare data from Harrell Associates, we examined the effects of various events and time frames on airline traffic and finances. In addition, we interviewed credit and equity analysts, academic experts, and private consultants to gather their opinions and relevant studies.

To assess the measures taken by airlines to remain financially viable, we relied on a variety of sources. First, we used submissions provided by 64 U.S. commercial airlines that received assistance under the Emergency Wartime Supplemental Appropriations Act of 2003. The Act and its accompanying conference report tasked airlines with providing us with a plan demonstrating how they would reduce their operating expenses by 10 percent. Working with airlines and airline trade associations, we devised a data collection template for airlines to submit their financial plans (see app. I). Because of the proprietary nature of these plans, and for the purposes of this report, we aggregated the financial information contained in these plans into one of three airline categories—legacy airlines, low cost airlines, and regional airlines. We then compared the plans with actual financial results as reported to the DOT on Form 41 filing for the same period to determine to what extent these plans were realized. We also interviewed airline trade associations and representatives of five legacy, two low cost, and two regional airlines to discuss their plans. Finally, we met with airline equity and credit analysts to discuss airline measures.

To review the financial condition of the U.S. airline industry, we conducted interviews with airlines and their trade associations, credit and equity analysts, government experts, and academics. We also reviewed DOT Form 41 and SC-298 financial and traffic data submitted by the carriers in our study. We obtained these data from BACK Aviation Solutions, a private contractor that provides DOT Form 41 data to interested parties. To determine airline stage-length adjusted cost curves, we contracted with Roberts Roach Associates, a consulting group that specializes in airline economics. We also reviewed airline cash flow data that DOT supplied directly to us in order to determine how airlines’ cash balances have fluctuated in recent years and what airlines’ main sources of cash have been in recent years. Finally, we used airlines’ publicly reported Securities and Exchange Commission filings to determine airlines future financial obligations. To assess the reliability of these data, we reviewed the quality control procedures that BACK Aviation Solutions, DOT, and Roberts Roach Associates apply and subsequently determined that the data were sufficiently reliable for our purposes.

To determine how the competitiveness of the U.S. airline industry has changed since 1998, we obtained and stratified DOT quarterly data on the top 5,000 city-pair markets for calendar years 1998 through 2003 and then determined shifts in competitive factors overall and for markets with and without low cost airlines as well as for legacy and low cost airlines. These data are collected by DOT based on a 10-percent sampling of tickets and identify the origin and destination airport, which we converted to city-pair markets for cities with multiple airports. Since only the issuing carrier is identified, regional airline traffic is counted under the legacy parent or partner airline. To assess the reliability of these data, we reviewed the quality control procedures DOT applies and subsequently determined that the data were sufficiently reliable for our purposes. According to DOT, these markets accounted for about 92 percent of all passengers and about 11 percent of domestic city-pairs in 2003. The smallest markets in this group ticketed 4,840 passengers while the largest ticketed 5.1 million passengers in 2003. To analyze changes in competition based on the size of the passenger markets, we divided the markets into four groupings based on 1998 passenger traffic: less than 85,000 passengers; 85,000 to 289,999 passengers; 290,000 to 839,999 passengers; and 840,000 and more passengers. Each group comprised one-quarter of the total passenger traffic in 1998. To stratify these markets by the number of carriers operating, we used the following categories: 1, 2, 3, 4, and 5 or more carriers. To stratify the data by market distance, we obtained the great circle distance for each market using the BACK Aviation Solutions database and then grouped the markets into five distance categories: up to 250 miles; 251-500 miles; 501-750 miles; 751-1,000 miles; and 1,001 miles and over. To assess changes in competition in these markets, we analyzed changes in passenger traffic by market type and airline type, changes in the number of markets according the various stratifications we developed, determined the number of dominated markets, and calculated the average number of effective competitors in each market for each year as well as the average annual number of effective competitors per market grouping.

We had access to sufficient information to make informed judgments on the matters covered by this report. We performed our work between December 2003 and August 2004 in accordance with generally accepted government auditing standards.

GAO Contacts and Staff Acknowledgments

GAO Contacts

Acknowledgments

In addition to those named above, Paul Aussendorf, Tom Gilbert, David Hooper, Ron La Due Lake, Grant Mallie, Richard Swayze, and Pamela Vines made key contributions to this report.

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