Earlier this year US carriers touted their ability to turn profits in 2011 despite the fact that fuel expenses mirrored the record highs of 2008. But growing uncertainty of where the price of fuel would settle in 2012 belied such celebrations.
A choppy economic recovery is increasing uneasiness over the ability of airlines to remain profitable. The pricing power they enjoyed through numerous fare hikes in 2011 to offset rising fuel costs remains questionable.
But while US airlines turn over every rock on their expense line items to lower non-fuel expense in their battle to master energy price volatility, their investments in improving the customer experience remain intact as they conclude the returns on that spend will be favourable over the long-term.
Data from US airline trade group Airlines For America (A4A) show that 11 US passenger airlines recorded a razor-thin 0.3 per cent margin on a collective profit of USD 390 million in 2011. US carrier profitability plummeted a whopping 86 per cent last year compared with the USD 2.7 billion profit recorded in 2010.
Despite posting healthy revenue growth during 2011 of 12.6 per cent to USD 15.7 billion, the USD 18.3 billion those airlines recorded clipped the gains those airlines made in boosting revenue. Not surprisingly, fuel was the culprit. Fuel expense accounted for roughly 35 per cent of airlines’ total operating costs compared with 30 per cent in 2010.
Even as carriers highlighted positive demand trends that were prominent in 2011 and were continuing into the early part of this year, they cautioned that as 2012 unfolds comparisons would become increasingly difficult as fare increases pushed through during the first half of 2011 would distort year-on-year unit revenue comparisons.
For the first quarter the second largest US domestic carrier in passenger share, Southwest Airlines, recorded average passenger revenue per available seat mile (PRASM) growth of 5 per cent, dragged down by February’s weak growth of 4 per cent. During the first quarter of 2011, Southwest recorded 8.1 per cent PRASM growth.
US Airways, which eked out a USD 111 million profit on an USD 1.3 billion rise in consolidated fuel costs, concludes the outlook for 2012 is uncertain as president Scott Kirby warns volatility in fuel can change profitability forecasts by several million dollars in a single day.
The fuel costs conundrum is an industry-wide phenomenon as Southwest CEO Gary Kelly concludes: “We fully admit that energy prices are something we just can’t predict.”
But most carriers have accepted fuel costs volatility as a permanent fixture in the airline industry and are building their business models around oil prices per barrel in the triple digits.
Delta Air Lines CEO Richard Anderson has declared that high fuel costs are the new norm for the industry, and the carrier in 2012 would pass along those higher input costs as it worked to manage the volatility of higher fuel expenses.
Massachusetts Institute of Technology airline industry analyst William Swelbar notes that while the industry has no control over oil prices or geopolitical events, the airline business has mechanisms in place to respond to higher energy costs. He believes the industry remains in a price band for jet fuel that allows carriers to comfortably price their product at a level that does not erode demand.
However, if fuel prices reach USD 150 per barrel, Swelbar says the industry will need to hunker down and begin to cut additional capacity to withstand the increase.
One major reason that demand is holding up as airlines increase fares to cover the costs of fuel is that rising costs at low-cost carriers are levelling out the playing field among all carriers, which means that one sector of the industry does not dictate economic prices for another, says Swelbar. “You don’t have an industry where one carrier has a significant cost advantage,” he says. All carriers are dealing with an uncontrollable cost as their largest expense. To illustrate his point he highlights that Southwest Airlines has led a couple of the fare increases instituted by the industry this year.
Part of Delta’s strategy in mitigating unpredictable fuel prices is reining in its non-fuel costs. Delta has embarked on a plan to shave 40 cents off its unit costs per available seat mile (CASM) excluding fuel during the next couple of years that would translate into overall savings of USD 600-750 million. The scheme has three tiers – improved maintenance efficiency, an increase in employee productivity and fleet simplification largely driven by Delta’s unwavering desire to shrink its fleet of smaller, inefficient 50-seat jets.
For US Airways producing lower unit costs than its legacy peers is a matter of survival as the carrier’s management stresses its hubs in Charlotte, Phoenix and Philadelphia produce less revenue than the mega hubs of its peers located in Atlanta, Chicago and Dallas. The airline predicts a mainline CASM increase of 1 per cent to 3 per cent in 2012 after the carrier had flat unit costs excluding fuel and special items during 2011.
Even so-called low-cost carriers find themselves battling cost creep. Southwest Airlines now has some of the highest costs in the industry, and its chief Gary Kelly has warned that staff productivity needs to be sustained and improved in order for the carrier to remain competitive.
“I just challenge the premise that there are no opportunities to left to improve productivity or improve our efficiencies or to eliminate waste because there are,” says Kelly.
Fellow low-cost carrier JetBlue Airways admits its cost advantage over legacy carriers is narrowing, driven somewhat by maintenance costs spikes in 2011 that are carrying over into 2012 as the airline completes heavy checks on a significant number of its Airbus A320s and Embraer E-190s this year.
The carrier has forecasted a 2 per cent to 5 per cent rise in unit costs this year, and to mitigate some of the cost increase JetBlue is instituting a management hiring and salary freeze in 2012.
One tactic adopted by carriers beginning in full force during 2008 to combat unruly fuel costs was product unbundling that has become a staple in nearly every airline’s business plan. United Airlines estimates it generated more than USD 2 billion in ancillary revenues last year. American and Delta have recently started to mimic United’s popular premium economy seating that helps to generate some of the Chicago-based carrier’s ancillary revenues.
Delta last year opted to offer a 34in seat pitch in its ‘Economy Comfort’ product featured on 550 mainline aircraft and 250 two-class regional jets with 70-plus seats including the Bombardier CRJ700s/900s and Embraer E-170s/175s.
American Airlines this year is debuting its ‘Main Cabin Extra’ product, which will be line-fit on its new-delivery Boeing 777-300ERs and Airbus and Boeing narrowbodies. American plans to retrofit its older 737-800s with the premium economy product that offers an additional six inches of legroom.
The premium economy offering introduced by Delta is part of an overall push by the carrier to increase its ancillary revenues between 2011 and 2013 from USD 200 million to USD 1 billion. Delta estimates recording USD 600 million in ancillary revenues during 2012, supported by a new e-commerce platform the carrier is introducing this year. The airline believes it has great promise for merchandising and direct marketing efforts to the estimated 160 million passengers it carriers annually.
JetBlue also enjoyed a steady increase in its ancillary revenues between 2007 and 2012. It recorded just USD 190 million from those revenue streams in 2007 compared with USD 535 million last year.
In 2012 JetBlue predicts its ancillary revenue should reach USD 590 million, which is USD 53 million higher than the USD 537 million US Airways recorded from its ancillary sales in 2011.
This year JetBlue is considering tests of unbundling the ‘Even More Speed’ element that is included in its added legroom product ‘Even More Space’. The overall product allows for expedited security screening and more space in the cabin.
JetBlue chief commercial officer Robin Hayes explains that the carrier needs to run the numbers on unbundling the priority security lane offering from the legroom product, “but I think it is trial that we probably need to do”. JetBlue netted roughly USD 120 million from the ‘Even More’ offering in 2011, and now offers expedited security at roughly 30 airports.
Despite the uncertainty fuel prices usher in regarding airline profitability, carriers’ pledges to invest in improving the passenger experience are not in jeopardy.
United admits to facing cost pressure last year due to its decision to make investments in the business, including increasing staff at airports to improve the customer experience, deploying ‘Economy Plus’ across the Continental mainline fleet (after finalising its merger with Continental in March) and improving food offerings in the premium cabin.
The carrier is also refreshing the interiors of many United clubs around its system and it’s building a new club in Terminal 2 at its Chicago O’Hare hub. United expects to have all of its international aircraft reconfigured with lie-flat seats by year-end. It is unapologetic for the spend it is undertaking as CEO Jeff Smisek declares: “We are making significant investments in our onboard product, airport experience and our industry-leading loyalty programme.”
Delta is also investing in significant product upgrades, and plans to spend more than USD 2 billion by 2013 on a myriad of projects with focus on increasing passenger comfort. The upgrades include offering lie-flat seats on all international aircraft, more first-class seating options on its domestic fleet, introducing Wi-Fi on all domestic two-class aircraft, building new terminals in New York and Atlanta and upgrading Sky Clubs across its system.
Swelbar of MIT says these product upgrade are necessary given the lack of capital expenditure by airlines for nearly a decade. Now those carriers need to address “tired” lounges and interiors. But those investments should generate revenue, and making these investments during the bottom of an economic cycle, “bodes well for the industry”, says Swelbar.
Southwest expects to record roughly USD 50 million in maintenance expense this year associated with the “Evolve” product refresh on its Boeing 737-700s that entails installation of new seats that create more passenger space and the addition of six extra seats on the aircraft for a total of 143. But the carrier calculates netting roughly USD 200 million annually in additional revenue from the 737-700 refresh, and stresses the 78 larger-capacity 737-800s scheduled for delivery from 2012 through 2014 “provides the opportunity for hundreds of millions of additional revenue”, says carrier CFO Laura Wright.
Overall, US carriers feel reasonably confident in their ability to weather the challenges posed by unpredictable fuel prices. Fundamental changes in the industry that include capacity discipline and consolidation also put the industry on firmer footing to better withstand current fuel price shocks than in 2008. US Airways CEO drives that point home as he stresses the carrier’s fuel costs in 2008 and 2011 were pennies apart, yet the carrier made a profit last year while losing USD 800 million in 2008.
He concludes that the US airline business has transformed itself “over a relatively short period of time. I think you’d be hard pressed to find a business that has its highest costs component exactly the same as three years ago but are producing margins that are 10 points higher. The economy hasn’t driven that. We have transformed this business.”