The Airline Industry’s Rising Crisis

The airline sector is facing unprecedented turbulence. According to analysts, airlines could suffer losses of US$9 billion this year. As recently as March, the red ink was estimated at US$4.7 billion for 2009, according to the International Air Transport Association (IATA). IATA has also adjusted its estimates for losses in 2008, from US$8.5 billion to US$10.4 billion. Giovanni Bisignani, director general of IATA, painted a gloomy picture for the industry at the association’s latest annual meeting in Kuala Lumpur, Malaysia, affirming that “there is no modern precedent for today’s economic meltdown. We are witnessing a cataclysm. Our industry is trembling.”

According to IATA, airline cargo revenues will drop 17%. Carriers will transport 33.3 million tons, in comparison with 40.1 million tons in 2008. Similarly, demand by passengers could drop 8% to 2.06 million travelers, in comparison with 2.24 million in 2008. Add to that reductions in profits of 11% for cargo and 7% for passengers. Overall, IATA estimates that revenues will drop by 15%, from US$528 billion in 2008 to US$448 billion in 2009 – numbers that are unprecedented.


According to Antonio López de Avila, director of the IE Business School’s master’s program in tourism management, the sector has not experienced such a crisis since the terrorist attacks of September 11, 2001. “September 11 was a scare -- a little pause to see what was happening. Above all, it was the U.S. airlines that suffered a lot. [After] 9-11, people weren’t flying because they couldn’t fly. Now, it’s because they don’t want to fly.”

IATA’s Bisignani noted in Malaysia that after 9-11, revenues fell by 7%, but “almost immediately, we returned to growth that was fueled by strong economies.” Now, the scenario is one of global recession.

Demand, Petroleum and Returns

Experts note that the epicenter of this earthquake is the collapse in demand that resulted from the economic crisis. According to López de Avila, as a result, “companies have been obliged to reduce capacity, reduce frequency and make very significant economic adjustments.” According to IATA, “this dramatic fall in demand can lead to a rise in unit costs that are not related to fuel, and which cannot be cut proportionally.”

Amid this flood of bad news, the good news is that fuel prices are lower than last year. The sector’s spending on fuel will drop by US$59 million to an estimated US$106 million this year. López de Avila says that such a strong drop in the price of fuel has enabled airlines to survive this year, mitigating the damage from the fall in revenues. Airlines have adjusted to a market in which there is very little demand by reducing supply. “The margins in the aviation sector are very small, about 1%, so the sector has to get by on volume. It has to squeeze a great deal of profitability out of each plane and each flight it makes. What has happened is that profitability has declined enormously, and this has led to a very significant drop in revenues, and in a very critical year.” Added to this are the extremely tough price wars the airlines are conducting against one another.

Last year, when petroleum rose above US$140 a barrel, many companies suffered a death blow. Those that survived the crisis, notes López de Avila, “made a tremendous adjustment in their costs by reducing their personnel and flight frequency. Now, they are trying to fill more seats on each flight in order to make it more profitable.” However, the trend in oil prices has become alarming again. Goldman Sachs has raised its forecasts for the end of the year to between US$65 and US$85 a barrel. López de Avila warns, “To the degree that it [oil] continues to rise from here through the end of the year, we are going to see some airlines close down because many airlines are overcoming the crisis as well as they can but they are running red ink.” In his view, “starting from US$70 to US$80 a barrel, airlines already have problems. They have already done all they can, especially because they have adjusted prices and demand has plummeted.” He notes, for example, that the business class segment has fallen by practically one-half, “and this is the class that makes airlines profitable.”

According to Josep Francesc Valls, professor of marketing at ESADE’s tourism management center, the airline sector has overcome the brutal increase in oil prices that happened last year, and now the price is about US$70 to US$80 per barrel so the sector is suffering less from this factor. Despite the fact that some airlines did not foresee these historic oil prices and were battered by difficulties, “today, there is no company that is counting on oil prices remaining at the levels we’re seeing today. Since the excessive [prices] of the past have ended, this factor is no longer critical. The problematical factor now is the fall in passenger seat sales, and there is a great opportunity to create new conglomerates with new market niches [that serve routes] between Europe and America,” he notes.

Valls notes that aviation is undergoing a very rapid globalization in its mindset. “The approval of the Open Skies Agreement last March means that companies in the U.S. and Europe, with some restrictions, can already make international flights between the U.S. and Europe -- a great market that is very attractive. This, along with the process of mergers and alliances, and the creation of great Euro-American groups, led by Europe, presents an excellent opportunity for globalization.”

The creation of these conglomerates “will empower some traditional companies (Iberia/BA, where negotiations are making progress), and some low-cost airlines (Clickair/Vueling), as well as the American airlines, with which we were already associated,” says Valls, referring to the alliance in which Iberia participates. “But you can say the same thing about the alliance of Air France and KLM; and about the Lufthansa consortium. In this sense, we have a great opportunity, because this should permit a higher professionalization of airport services, and the remodeling of the great global airports, as well as a rapid process toward decentralization and privatization” which are an obstacle to modernization in the case of Spain.

On the other hand, Valls points out that nowadays you also have to take environmental costs into account. In order to save fuel and be cleaner in that regard, he says, airlines are using technology so they can lighten their equipment and have less environmental impact. “The global requirements for governmental measures are going to raise air travel-related production costs a bit. A factor that is going to mitigate this a little is the economic crisis.” In his view, this means that air travelers will pay more in order to fly, but on the other hand, societies everywhere around the world will benefit from the lower environmental impact.

LAN and Copa, the Exceptions

When it comes to regions, the airlines that are suffering most are the Asian, European, African and North American carriers. This year, IATA estimates that the companies of the Asia-Pacific region could record the greatest losses, since Japan, the largest market in the region, is immersed in a deep recession, while airlines in China and India accumulate great losses because of the slowdown in demand for those countries’ exports.

European airlines could lose some US$1.8 billion because of the collapse in demand for premium services in all of their major markets (intra-European, Europe-North Atlantic, and Europe-Asia). African airlines will lose some US$500 million, while Near Eastern airlines will suffer US$1.5 billion in losses. In the U.S., the losses will amount to US$1 billion, a better number than the US$5.1 billion in losses recorded in 2008. The explanation for this recovery, says IATA, is that “their inability to invest in covering their risks from fuel prices left the aviation sector in the U.S. at the mercy of a rising spiral in the price of fuel in 2008. This wound up being an advantage in 2009 because the same companies could take advantage of the better spot prices once the price of fuel began to drop.”

IATA estimates that Latin American airlines will lose some US$900 million because of the impact of the recession in the U.S., and the fact that Chinese demand for the region’s raw materials and products will weaken. But it’s not all bad news for the region. Amidst this bleak landscape, two Latin American airlines have managed to avoid recording red ink, says López de Ávila: “Chile’s LAN Airlines and Panama’s Copa Airlines. In 2008, LAN recorded a net profit of US$336 million, and it expects that figure to grow by 12% in 2009. Copa recorded a net profit of US$152 million last year”.

López de Avila notes that these two airlines have survived so far because the economy of the region in which they operate has not deteriorated as much as the rest of the world. “The economies of countries like Colombia, Argentina, Chile and Panama have not suffered so much from the crisis, and they have even managed to grow.” This fact becomes clear with LAN’s creation “of a ‘Premium Economy Class,’ a sort of business class that is nevertheless economy. LAN is still banking on its business class because demand for it has yet to drop,” he says.

In addition, both airlines have done very well when it comes to controlling costs and achieving operational profitability, “which is 12% in the case of LAN and 17% in the case of Copa,” notes López de Avila. “LAN and Copa are engaged in lean processes, which involve eliminating any waste that does not bring value to the customer, and which reduce corporate costs as a result. They are continually reviewing their operational business practices.” Valls believes that this progress didn’t come overnight in the case of LAN. “LAN depends on very good service policies. It has not moved toward a low cost structure, but it has lowered its costs below the levels of the flagship carriers. In addition, LAN has established alliances with other Latin American companies, in some cases through mergers; in other cases, it has done this simply through alliances, which have converted it into an airline that serves [all of the Americas].”

In contrast, low-cost Brazilian companies, such as Gol Linhas Aereas Inteligentes and TAM, whose country of origin was growing until recently, have been suffering. López de Avila explains that at TAM, “they are already tightening their costs, but not their capacity for 2009. They wanted to grow by 8% in the domestic market and by 20% in the international market, but they still need to do some homework. They estimate that part of their US$311 million in profits comes from the depreciation of both petroleum and the Brazilian currency, the Real. Last year, Gol lost 1.39 million reales, and its operational lost was 89 million reales (or US$45 million). They eliminated long distance flights in 2008 and they are trying to lower their costs in 2009, so they can try to improve their position.”

López de Avila stresses that IATA is seeing a stop in the decline of air cargo traffic. “This figure has remained steady … something that analysts consider a positive sign. Historically, once air cargo starts to recover, passenger traffic also begins to recover. There could be a light at the end of the tunnel, so long as the price of a barrel of oil does not rise above US$80.”

On the governmental level, initiatives are already taking place to restrain the impact of the crisis on the sector. In France, for example, air fares have already been reduced. In Spain, fare prices for 2010 have been frozen, and the rules for the sector have become more flexible. Thus, those air carriers in Spain that increase the number of passengers they carry during the second half of 2009 will be provided with a bonus worth 100% of the extra passenger fares that result from that growth in traffic. According to López de Avila, however, this measure is futile because “practically no company is going to improve its numbers from last year, which was a record year. In addition, we were starting from air traffic control tariffs that were the highest in Europe. If AENA (the Spanish state owned company that owns and manages all Spanish airports) records a deficit next year or the year after, despite the fact that it has sustained itself until now, the most important thing to do may be to cut costs [for carriers] so that companies do better -- not to subsidize something.”

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Stressed Out?

Call it the great cap rac(is)e; 10 banks, 6 months and $75 billion in capital to raise.

As the news of the stress test on top banks of US trickles down Wall Street there is mixed reaction among investors and analysts alike, but the bottom line is; it is not that harsh as everyone once imagined.

The stress test was carried out for 2 months by the Treasury department with the help of 150 regulatory officials pouring over the books of 19 largest banks in US, to clearly draw a line between weak and strong and to exactly quantify the amount of capital injection required to bail out the banks. They were measured against two scenarios 1. A 'baseline' assumption that recession continues along the estimates of analysts and 2. A more adverse circumstances where recession dives deeper with greater unemployment and large credit problems etc., The results were made public on Thursday which shows that out of 19 banks, 9 are in good health and the other ten need to quickly sketch out their course of action to raise additional capital (course of action should be submitted to treasury department within the next 2 months). This was carried out to restore faith in the biggest financial system and to assure that there is a way to move forward in a worst case scenario. As far as it goes for the big 19 it was an acid test to prove that they should be granted right to continue business.

However there was mixed reaction to the parameters considered for the stress test. Some said that the treasury department has painted a very gloomy picture and some analysts voiced that the test was not rigorous enough. Consider this as an example from the pessimists, government considered unemployment to reach 8.9% in a worst case scenario, but the data from US labor department very recently pointed unemployment rate at 8.9% in April 2009.

Bank of America (BoA) emerged as the weakest with almost $34 billion required to fill the hole, next was Wells Fargo with $13.7 billion requirement, GMAC was third with $11.5 billion, followed by Citi group ($5.5 billion) and Regional finance with $2.5 billion (See table for complete details). GMAC will have the hardest time of all not because of its loan performance but due to its exposure in Mortgage market through its ResCap unit and also due to its heavy reliance on a single customer, the troubled carmaker GM.

The troubled banks are already on course to raise additional capital. BoA is planning to sell assets, issue $17 billion in common stock and other steps to fill the gaps in the hole. Morgan Stanley has already sold $3.5 billion in stock as has Wells Fargo with $7.5 billion. Though the shares were sold on heavy discounts of around 11% it was better than expected price for both deals. The bank shares traded higher than expected on Friday morning, Morgan Stanley shares slid 6.4% to $25.39 after the news that it had sold 146 million shares at $24.00 each. Wells Fargo took the same course at $24.89 after it said, it had sold 341 million shares at $22.00 each. The banks like Morgan Stanley and others who have a lot less capital hole to be filled are already thinking of repaying the $10 billion capital it received last fall under treasury's TARP (Troubled Asset Relief Program). While other banks are still orienting themselves to devise a course of action to raise capital. Banks like Morgan Stanley can quickly plan strategies to pay back the TARP funds and attract customers out of the troubled banks.

Even if all of them manage to raise the required $75 billion, the question would be, will it be enough? No says Bert Ely, an independent banking analyst; since the government also says there could be close to $600 billion in bank losses, so in simple terms; they need more than what they are really looking for. Also Dan Alpert, Managing director of Westwood capital points out that the numbers have been artificially bolstered due to assumption of near zero cost of funds, a residential mortgage re-financing boom and government guarantee against losses from nearly every activity inherent in banking. If Q1 results are anything to go by then we are recovering sharply, but the real problem lies in the remaining 3 quarters. Analysts predict that slow growth will kick in and banks will be more concerned about preserving their capital than lending it out, a blow for those who are praying for speedy recovery. There is also a simple fundamental question: how can a bank perform better if non performing loans get continually worse?

Having said that, all is not grey and gory. There are many reasons to believe an optimist's point of view. Federal Reserve chairman Ben Bernanke has said in a statement that Fed has the tools to soak up more than $1 trillion in liquidity that the US bank has pumped into the banking system under TARP. The test results also won applause for the relatively small hole that the banks need to fill. This can be tracked in-line with the upward movement of banking stocks since the release of stress test result, not only that the DJ (Dow Jones) banking sector rose 2.2% and the index has doubled in the past two months. Even after the result, a large number of banking stocks were sold in the market at a premium indicating that the market has already absorbed the results which was better than expected. One major boost is that analysts have predicted there are no new threats for banks in the near future. The market went on a rampage, in fact BoA rose 4% when Kenneth Lewis, CEO, BoA, announced that it is better able to raise the capital than the government estimated in its stress test.

The road ahead

So all in all we will have to wait and see what course the market takes in the near future and it will be interesting to see if the banks are be able to raise new capital to keep them in business. One thing is for sure the banks who are better off with the capitals will now concentrate on repaying the TARP capital injection to avoid the strings that are attached to it in case of repayment failure and the management of the troubled banks will spend most of their time cleaning up the mess and raise additional capital.

After the long and hard battle the government expects to place new regulations to reduce excessive leverage and try to prevent all of this from happening again. Having said that innovative financiers will no doubt come up with products to hedge risk and disperse capital. So you can be sure of one more slump in the not so near future. As far as the Treasury and Fed go they will spend most of their time tweaking the policies. Ben Bernanke has already said that portions of banking law stand in the effective supervision and has urged the Congress to revise the Gramm-Leach-Bliley to ensure supervisors have necessary tools and authorities to monitor and address safety and soundness concerns in the banking system.

P.S., Just as I finish writing this article I have received a feed stating that Wells Fargo has raised $8.6 billion through a stock offering on Friday. Morgan Stanley has also found willing investors on Friday, raising almost $8 billion through debt and equity offerings beating the goal by billions. WF had only planned to raise $6 billion but heavy over-subscription saw them raise $8.6 billion at the top end range of $22/share. Not only that, Wells shares closed at $28.18 on Friday, up nearly 14 percent. Phew, finally much to rejoice and stay positive.