2012 marks beginning of next chapter in US airline industry

There are an increasing number of travel surveys concluding leisure travel will rise this year. Despite last summer's angst, when fears of a double dip recession were high, the economy picked up nicely in 2011 growing faster than expected each quarter, with the fastest growth expected in the fourth quarter.

Unemployment applications have been halved from the 650,000 in March 2009 although admittedly still too high to create a robust turnaround. Small businesses are hiring and consumer inventories at retailers are rising, up 8.7% in October year-on-year. Housing starts have also risen, up 9% in November compared to October.

Trans- and intercontinental bookings are already up for Asia, Australia and Europe, according to a travel agent survey which indicated clients plan to spend the same or more for travel in 2012.

The survey also supported suppositions that the advanced booking window will stretch as travellers try to squeeze every dollar out of their trips. Leisure travellers are already at eight weeks or more but business travel windows are expected to rise as well. United has already reported a 3.7% increase in advanced domestic bookings between mid-December and February.

Fares were up 22.4% domestically in 2Q2011 compared to 2009, according to the Bureau of Transportation Statistics (BTS). While this is good news, it comes as inflation-adjusted fares are still 15.8% lower than in 2Q1995. Expect fares to continue their upward trajectory and more fare increase attempts to stick this year.

2Q average fares: 1995 to 2011

Source: Bureau of Transportation Statistics

We have passed the time when airlines will be consistent money losers, as evidenced by the fact that they were profitable in 2011 despite higher fuel prices than in 2008, when losses were common. It is difficult to visualise a circumstance when that would change failing another travel-related terrorist attack.

Costs on the rise

It is a fact that no matter how much carriers cut costs, some new cost outside of their control will come in to swallow up whatever savings they have managed to eek out. That means, through mostly government regulations, they will face headwinds beyond fuel.

The inclusion of airlines in the European Union Emissions Trading Scheme (EU ETS) is one that is expected to cost airlines USD26 billion over eight years. Anticipate airlines to follow Lufthansa's lead in imposing emissions surcharges rather than try to recover the costs in fares alone. They are much more successful selling fuel surcharges than fare increases so they will likely follow that route with the emissions costs as well.

There is also the new pilot fatigue rules which are expected to increase costs between USD300 million and USD1.96 billion depending on whether you are talking to the Government or the airlines.

While not in effect for a few years, the new rules will only exacerbate the growing pilot shortage, especially at regional airlines and will result in not only increased operational pressure but costs as well. Regionals are already facing a shortage resulting in the new 1500-hour minimum requirement for hiring. That, in turn, threatens more small- and medium-sized community abandonment.

There is, of course, the threat of rising fuel from Iranian posturing on threatening fuel flow either from its own coffers or by blockading the Strait of Hormuz. That will be compounded with the growing volatility in Nigeria.

Some of that will be mitigated by the promise of increasing oil production from other oil states but other world events and continuing demand from emerging economies will keep everyone nervous this year.

Fares rising

Still, airlines in 2011 were able to make half of the 20 fare increases stick but they will probably do better in 2012. Southwest, the industry's fare-increase spoiler, has been very successful in achieving the revenue goals set out five years ago. However, it realised last year, and especially with the final legacy bankruptcy of American Airlines, that rising revenue is not enough. It needs higher productivity and lower costs to compete following its competitors consolidating and going through bankruptcy re-structuring. It has, so far, committed to not attacking pay rates in favour of productivity gains.

Southwest is behind the power curve on cost cutting given the actions taken by legacies which continue to chase cost savings. For Delta and United, the costs savings have compounded the revenue and cost synergies from their mergers, but given fuel volatility there is still more to be done.

This may signify Southwest's reticence to play the spoiler on fare increases than it has in the past. The result will be that more fare increases will stick this year as airlines continue to winnow away at the bargain basement prices that has been the 30-plus-year fare honeymoon following deregulation.

Fare attempts will be helped by continuing tight capacity which should continue through 2012 if not into 2013. This is not only due to new aircraft deliveries replacing less fuel efficient aircraft but because it will take at least a few more years to make consumers understand that the days of irrational fare sales are over.

This essentially runs counter to their holiday experience in which if they did not see a high-percentage discount they did not buy. Airlines have long since learned to launch sales strategically and ultra-low-cost carriers such as Allegiant and Spirit do not have the network footprint to change that strategy, yet.

Lessors are still willing to help launch new entrants but it is doubtful with tight money and high fuel there will be many of those. Rising fuel will keep new entrants at bay since the available, cheap aircraft to be retired are less fuel efficient. Indeed, the catalyst for many startups was the availability of cheap aircraft and Allegiant is a perfect example of that. But those days are over as Allegiant is now finding with its rising fuel bills.

Confidence in the airline business model increasing

The yeoman work accomplished by airline management since the financial meltdown has not seeped much past analysts. While many have recognised that airline management practices have all changed for the good, it will likely take an entire business cycle to convince them that irrationality has left the industry for good. Still, the fact that they are profitable during a recessionary economy coupled with fuel hikes, speaks volumes.

United said that unit revenue will be up 9-10% for the year and Delta's expectations for USD800 million in profitability in 2011 adds a few chapters. While United's guidance may be historically significant, it still disappointed analysts who pegged United's 4Q2011 unit revenue at a 10% increase instead of the 8.5-9.5% the company expects.

Aircraft orders provide flexibility

There is a lot of flexibility built into recent aircraft orders from American and Southwest in case indicators call for a measured capacity increase. Responsible growth may take through 2013 to happen, however, when economic indicators are more clear.

Even so, recent months indicate that consumers are growing weary of austerity as evidenced by the travel over the holiday period. It proved they are saving for big ticket items that focus on travel. Both Disney World and Universal theme parks were at overcapacity, forcing them to metre entry. Thus it is likely that travel demand, which has yet to soften to previous levels, will continue.

Worries come from the economic situation in Europe for all trans-Atlantic carriers but that is expected to be balanced by the opportunities Delta and United will have in picking off routes cut or abandoned by American.

American could shave USD1 billion annually in costs just on shedding unprofitable routes during its bankruptcy. While CEO Tom Horton's statements post bankruptcy indicated the company will stay the course on its cornerstone strategy, that may change since it has been shown to be a failure to most observers. Thus actions by Mr Horton in 2012 will indicate the post-bankruptcy viability of the company.

US Airways and American are expected to tie the knot one way or the other in the final round of legacy consolidation but it is unlikely to happen in 2012 unless there is a move for takeover. That would be relatively easy since the stock is low enough that it will soon be delisted.

Even so, American has a grace period in its plans. The only thing certain here is that carriers are testing American's fortress at Dallas and will likely be making significant inroads this year, with moves by Spirit, JetBlue and Delta. For Dallas/Fort Worth, this new service is good news but it still faces a questionable future for its capital projects as long as American is in bankruptcy.

United is high risk

United faces two huge risks this year. First, merging the computer reservations systems of United Airlines and Continental Airlines. Changes in reservations systems have plagued other carriers including Virgin America, which is still suffering from the October cutover.

It is a highly complex maneuver even for non-merging carriers. It was no picnic for US Airways, which did the deed in 2007. WestJet also suffered from its change although JetBlue managed a much smoother transition.

As for United, the cutover is expected in the first quarter so look for impacts on its 1Q2012 financials and operating statistics. Currently, software in the disparate United and Continental systems is incompatible so United's data must migrate to the Continental booking suite, Hewlett Packard's SHARES. There is also the learning curve for United agents.

Southwest remains the single LCC that has not yet converted, placing the carrier at a competitive disadvantage. It is only the market share shift coming from its bags-fly-free policy that has saved the LCC since its IT issues were behind its inability to charge for bags in the first place.

Changes in federal rules requiring airlines to advertise bottom-line fares including all government taxes and fees as well as all airline-imposed fees, have forced its IT change out to 2013. Even so its merger with AirTran has mitigated some the issues that was preventing Southwest from going international, among other things. Expect a positive hit to Southwest's financials as a result. Hawaii is also on its radar but that, too, has been pushed back.

Finally, United launches the 787 in the US, from which it will begin benefiting an expected 20% better fuel efficiency and passenger comfort. It is set to enter service in the second half when United is scheduled to take six of the type. However, Boeing has failed to deliver the seven promised aircraft for 2011 and has been mum on what is happening on the production line.

If United does get its 787s this year, it will be alone in operating the 787 for some time giving it a competitive advantage both on costs and comfort. The 787 has the potential of earlier twin-engine widebodies that shattered the monopoly of historical international gateways and ushered in service between city pairs that could otherwise not be served without them. Expect it to be deployed from United's existing hubs like Houston and Chicago.

Critical year for labour issues

2012 will also likely be the year we find out how labour rates will begin settling out. American's bankruptcy sent a chilling signal to labour which has mostly ignored all the other signals that the new normal in the industry means lowered expectations. Compounding this is the fact that there are little or no growth plans in the next couple of years to sweeten any deal.

Labour issues are expected to pepper 2012 with a lot of angst on both sides. Overshadowing all is the American bankruptcy during which American will likely establish a new pay base. By not accepting a deal to stave off bankruptcy, American pilots essentially reset the market.

That was not lost on Air Canada CEO Colin Rovenescu, who immediately after the American bankruptcy filing, sent word out that the company faces many of the same issues as American. Air Canada has been able to achieve all its cost-cutting targets early but it still must cut labour when its competition is the feisty, more nimble WestJet to which it is losing market share as well as international giants such as Emirates .

The biggest impact of American's bankruptcy will likely be at United and Southwest. Southwest CEO Gary Kelly already placed a shot across labour's bow in citing the narrowing gap between low-cost and legacy costs.

The bottom line is simple. Legacies can no longer afford past labour rates on its domestic service. The quest for labour peace at all costs is a thing of the past as are the 29% raises achieved in the United pilots' 2000 contract. Bankruptcy resulted in 40% concessions two years later which the union is still trying to recoup.

Legacies have tried to balance more international than domestic but they need to become far more competitive on purely domestic flights if they are to compete with low-cost carriers.

United is not only facing a new contract but a seniority agreement, which, again, put it at risk. It may be labour that will regret not going along with the last reset of market rates when Delta and Northwest merged. CEO Jeff Smisek's early, pre-merger offer of Delta rates plus one seemed a good offer to gain early acceptance of merger and contract. Key to unlocking all merger synergies will not only be the seniority agreement but gaining scope relief which has become one of the largest hurdles in the negotiations.

United faces contests with pilots, flight attendants and maintenance personnel as well as passenger service and reservations agents. Pilots have been in negotiations for more than a year focussing on recouping losses. It has been ugly, with pilots, much like their counterparts at US Airways, playing the safety card. Also, as with their US Airways counterparts, they lost their suit against the airline.

Until these contracts are done, the full USD1.2 billion in synergies promised by the United/Continental merger will remain locked, just as they have been six years after the US Airways/America West merger.

United had targeted settling contracts in 2011 but will be lucky to get it in 2012, given the fact pilots and management are USD1.3 billion apart on the contract. It is said to be making progress with flight attendants and has cut a tentative agreement with mechanics.

Southwest has been more successful in hammering out integrated contracts. Flight attendants, the largest labour group at the company have a contract which followed a similar deal between Southwest and AirTran pilots and mechanics.

Change in voting rules a non event

As for the much ballyhooed 2010 change in labour law imposed by the National Mediation Board, the impact has really been very little.

That means that House of Representatives attempts to turn back the new voting methods should be dropped. It has been holding up Federal Aviation Administration (FAA) reauthorisation legislation for more than a year to the point it is on the 22nd continuing resolution which now expires 31-Jan-2012.

Changing the voting regulations and forcing everyone to actually cast a vote has done very little for union success. Engineers at United rejected Continental's efforts to bring them into their union.

It did not help Air Line Pilots Association, International (ALPA) gain the membership of JetBlue or Virgin America pilots and it has not been able to change Delta's near total rejection of unionisation efforts, with the singular exception of its pilots.

The Northwest flight attendant union was not even able to capture equal pay to Delta flight attendants for their members. Even tests of election interference at Delta have not been fruitful for unions who are losing more often than they are winning at airlines across the US.

Union failures in election after election really signals that union excuses of why they are not gaining a greater foothold are running out. Clearly, they must look to themselves to figure out why they are being rejected wholesale.

Labour, management in transition

Labour management relations are now undergoing a transition that will narrow the cost gap between legacies and low-cost carriers further. These contracts will have to toss the idea of being made whole from past concessions. Labour is still being stubborn on that, especially in light of management pay scales, so it could mean we see more labour actions in 2012, especially since management is rejecting labour peace at any cost.

New contracts will likely reflect the new realities of today's airline economics. It will also mean regional pilot pay could rise at a time when regionals are facing mainline pressures to cut costs. That pressure has already cost them dearly and may push Pinnacle into bankruptcy this year.

It is well known that regional pilots subsidise mainline employment packages and that has to change. With the cost of becoming a pilot now over USD100,000, future regional pilots will have to be compensated at better levels if they are to pay off those loans. They cannot be expected to be satisfied for paying upwards of USD120,000 for a job that only pays USD20,000. Regionals already have a pilot shortage because minimum hours have now been Congressionally set at 1500. They are now competing with a growing business sector for those pilots.

Scope restrictions are already forcing regional carriers, such as SkyWest, to look to the Q400 and ATR 72 to push the current cap and provide more lift for less money. This year will likely give us hints on how scope will unfold between the 50-seat jet cap at Continental and the higher cap at United. Large turbroprops have worked successfully at Continental and with rising fuel they are making increasing sense. That could mean more work for turboprop manufacturers, especially if scope cannot be resolved in this round of pilot contracts.

Scope restrictions are ostensibly about saving mainline jobs but, given the layoffs and furloughs of the 2000-2010 period, the restrictions have proven a failure. A more promising strategy would be to develop markets as airlines were supposed to have done with regionals when they first began teaming up in the 1980s. Airlines would then be smart to revisit regional routes with an eye toward developing them to be taken over by mainline pilots. It has worked in the past and can work in the future if we adopt a different mindset about regional-mainline-labour relations.

Ancillaries to grow on new, non-fee products

Delta is likely to break the current ceiling for non-cargo ancillaries and perhaps earn over USD1 billion annually from ancillary revenue in 2012. It has rolled out a sophisticated merchandising programme that links retailers and passengers, which will be the future of ancillaries. Like Southwest, Delta rolled out its programme for holiday shopping but new programmes for vacation packaging as well as retail sales will increase ancillaries exponentially.

While airlines could increase the fees now charged, most believe the fee-based game is reaching its limits. Thus the importance of Delta and Southwest moves on the ancillary front.

Ancillaries will shift to adding options that enhance the passenger experience rather than just charge for what used to be free, like bags, meals and pillows.

This will also be the year in which rebundling goes beyond low-fare carriers such as Frontier and Southwest. Legacies are already rebundling for the top tier customers but that will be extended to steerage. Airlines know they can increase the take rate for certain fee-based items if they bundle them during the booking process, or, as Virgin America does, offer them on-demand through the in-flight entertainment system once on board.

Route abandonments

There will be increasing route abandonment as costs outpace any revenues to be had from local communities. More 50-seaters will be retired prompting such abandonment.

These abandonments could mean an opportunity for enterprising small airlines like SeaPort or CapeAir to create the next generation commuter airline. They only lack an aircraft now but interest is rising in addressing the low end of the aircraft market, thanks to Cape Air's developing prototype for a Cessna 402 replacement.

US regionals are expected to continue their decline in 2012. Pinnacle is now in the most trouble, thanks to Delta, which convinced Pinnacle to buy Mesaba only to drop much of the service once the deal was done. Newly installed president Sean Menke has hired restructuring experts.

Other regionals will continue to suffer with the service cutbacks and 50-seat RJ retirements. It will be a few years before we know the ultimate impact of regional restructuring. It is clear there are too many regional aircraft for the consolidated US legacy industry. It will be interesting to see whether there will be consolidation at the regional level or whether some will just fail outright.

We only have a real view of the top three holding companies including SkyWest, Republic and Pinnacle since the rest are closely held.

The availability of American Eagle, despite its historical profitability, does not now present much of an opportunity while American remains in bankruptcy.

We already know that Republic Airways Holdings wants out of Frontier. It has yet to raise the USD70 million in additional financing it requires, although it may have achieved the USD120 million in cost savings.

This year will likely tell whether Frontier will survive. It is already exiting Milwaukee and fighting in Denver even as it puts a focus on Kansas City. Developing new hubs has never been that successful in the long term as evidenced by Milwaukee.

An interesting future may be in a Frontier takeover by another LCC. Virgin America has already been mentioned but it has struggles of its own considering its lack of profitability, and Virgin America has a very strong brand and focus that does not mesh well with Frontier. Additionally, the track record of putting two unprofitable airlines together is not good. JetBlue could be a candidate but it is now focussing on completing its expansion at Boston and in the Latin/Caribbean markets. And for its part, Southwest is otherwise engaged with AirTran and considering how quickly it can shed AirTran's 717s, let alone ponder taking Frontier's Airbus fleet.

Consolidation at airports possible

With rising pilot requirements and fatigue rules, many small and mid-sized communities will likely suffer significant service losses. But consolidation and capacity cuts will force others, particularly since the post-deregulation era forced a US airport system that is too big. The current system contributes to fragmentation as can be seen by the fact Los Angeles has five airports.

Airlines have been dehubbing for years with Pittsburgh and St Louis the largest examples, but Cincinnati and Memphis more current victims. This may ultimately lead to something that has been talked about for decades: the regionalisation of air service.

Long ago, the US Department of Transportation (DoT) wanted to consolidate essential air service around regional airports. The idea was to provide air service from the regional airport rather than from many small-town USAs. While that may have worked in the East where airports and metropolitan areas are closer together, it would not have worked in the West.

Now suggestions are rising that all airports should be consolidated around the strongest airports, as offered by MIT research analyst Bill Swelbar. But the time may be at hand when the impacts of passengers who drive to low-cost-carrier airports can be coupled with airline service changes to create a much more efficient and cost-effective domestic transportation network.

Mr Swelbar argues airports should be consolidated around the strongest markets which would then serve various regions. This tallies with US Airways CEO Doug Parker's admonitions that the US has too much airport infrastructure for the size of today's carriers. He seriously questions airport capital projects, saying they will probably not be filled as the industry shrinks. We certainly saw this with both Pittsburgh and St Louis, the latter of which moved an entire town to accommodate a new runway.

After all, fuel prices have forced capacity cuts and it may be worth examining where airport capacity can be cut to develop a more efficient system, Mr Swelbar suggested. The trick is to ensure that huge swaths of population are not disenfranchised from air transportation.

We have already seen the airline service map change over the last decade. Delta, alone, is adding 24 more markets to the abandoned landscape. That means the next decade will continue to show us how market changes will redraw infrastructure requirements.

Conclusion

This year will be only the beginning of the next chapter in the US airline industry. Much remains to be done with labour and other cost centres. Much also remains to be done in developing new revenue centres.

It is clear that 2012 will be a transition year between the industry we have watched for the last decade and the industry we will have in the future. We know that more and deeper changes are needed, but by the end of this decade we are likely to see an industry that is far healthier and bigger than it is today. And it just may have far fewer players.