All of the large US airlines delivered profits in 2014, with many achieving a return on invested capital well in excess of 10% including Delta Air Lines’ 20.7% return and Alaska Air Group’s 18.6% ROIC.
It is a far cry from a decade ago when Delta and Northwest were on the verge of entering Chapter 11 reorganisation and United was about to mark its third year of bankruptcy protection.
At that time, ROIC was not even on the radar of airline executive teams that were struggling to ensure the short term survival of their respective entities.
A big issue in this new environment is how labour will view the new profitability - and how the different airline managements are responding. CAPA's Americas Aviation Summit, Las Vegas, 27/28 April, includes a powerful panel looking at the role of pilots in the airline business.
Since those dark days, an industry is transformed
Delta absorbed Northwest, United and Continental merged to form the present iteration of United and the “new” American – the combination of American and US Airways – rounded out a wave of consolidation that started with America West’s pursuit of US Airways.
The dissolution of some iconic airline brands has arguably created a more healthy US industry with three large global network airlines, a large domestic airline – Southwest, the largest hybrid airlines Alaska, Hawaiian and JetBlue, ULCC Spirit and aspiring low-cost airline Frontier. “When you think about that tiering relationship, it creates very contestable markets, but it also creates a rational industrial structure,” Delta CEO Richard Anderson concluded in late 2014.
Airline executives now regularly mention structuring their companies to ensure their performance mirrors members of the S&P 500. Delta Air Lines, which re-entered the index in 2013, stated that its USD3.7 billion free cash flow in 2014 was better than 90% of the companies in the index’s industrial sector.
Delta joined Southwest as the only other airline in the S&P 500, but American believes it will join the ranks at some point. “If you look at our results, we produced a total shareholder return of 113% in 2014 and, had we been in the S&P 500, that would have been the second best amongst all the S&P 500, behind by the way only Southwest Airlines, our competitor,” American CEO Doug Parker recently declared.
Delivering shareholder returns is now also a mainstay in the US airline business
That was something reserved only for the likes of Southwest and Alaska Air Group until a couple of years ago. Southwest completed USD955 million in share repurchases in 2014 while issuing USD139 million in dividend payments. Delta touted its USD1.1 billion share buyback programme in 2014 and its dividend payout of USD251 million. American Airlines issued its first dividend since 1980 during 2014 and completed a USD1 billion stock repurchase programme a year early, while United estimated spending USD320 million for share repurchases in 2014.
The turnaround of the US airline industry is not just limited to the large US airlines that were no doubt aided in their restructuring by Chapter 11. Alaska Air Group, which has never sought bankruptcy protection, has been engaged in share repurchases since 2007, and delivered approximately USD410 million in share repurchases and dividends in 2014.
Its free cash flow as a percent of revenue for the 12M ending Sep-2014 was 6.1%, compared with 6.3% for industrial transport companies. Its position in that metric is far better than US network airlines and low-cost airlines. It is an impressive performance for an airline that represents just 2.5% of US domestic ASMs as of late Feb-2015, and also shows that smaller airlines have a viable place in the post consolidated US industry.
But underlying the widespread discussions about ROIC and shareholder returns are questions as to whether the US industry has truly transformed
Are market share grabs and irrational capacity expansion really are shadows of a bygone era? US airlines are all too aware that a certain level of scepticism remains about their long term viability.
An important test for the industry was the rapid decline in fuel prices that occurred in late 2014, which created some skittishness among investors that the capacity discipline that has driven much of the industry transformation would be abandoned, and that airlines would drop ticket prices rather than retain savings from falling energy prices.
US Airlines are working to allay those fears at every opportunity
“The US industry has transformed itself over the last several years through consolidation and capacity discipline, matching capacity with demand... and United will continue its discipline of growing capacity less than GDP regardless of the price of oil,” United CEO Jeff Smisek declared in early 2015.
He also stressed that any cash United generates as a result of lower fuel prices would be used towards reducing the airline’s financial leverage and continuing to return cash to shareholders through stock buybacks.
Mr Smisek’s sentiments were echoed among most airline executives at the beginning of 2015, who stressed that the drop in oil prices – jet fuel had fallen to USD65 per barrel in Jan-2015 – would not deter their companies from continuing balance sheet repair or create lapses in shareholder rewards.
But despite those pledges there does appear to be industry discounting on marginal capacity. Spirit Airlines cited some of that discounting as a partial driver for its projected 9% to 11% fall in passenger unit revenues during 1Q2015. Delta has not outlined any specific pricing pressure, but its president Ed Bastian has concluded that “there’s no question there is a correlation as fuel prices come down there’s an industry supply macro that you need to think about”.
United Airlines also highlighted some softening of domestic demand in late 2014 that was continuing into 2015
Generally, US airlines were anticipating tepid passenger unit revenue growth for 1Q2015 driven in part by the strengthening of the USD against other weaker currencies, increased aircraft gauge (which also creates unit cost tailwinds) and weakness in other global regions. Not one of the large four major US airlines was forecasting passenger unit revenue growth above 1%, and American was forecasting a 2% to 4% decline. The first quarter is typically a weaker period for North American airlines, so some of the revenue drag is also likely driven by seasonality.
Despite the revenue headwinds US airlines were facing in 1Q2015, the outlook on their overall performance for 2015 remains favourable. Delta anticipated a 1Q2015 operating margin of 11% to 13%. American, meanwhile, believes that its financial results will exceed 2014, which included USD2.8 billion in profits. “We also expect our pre-tax earnings margins will be the best of our global network peers. It will be only our second year post-merger,” declared Mr Parker.
US airlines overall seem to believe that demand will remain solid, especially in the all-important corporate sector. During early 2015 Delta cited a survey in which 88% of its customers anticipated maintaining or increasing travel spend in 1Q2015 and over the course of the year after corporate sales grew 7% in 2014.
Both United and Southwest are keeping an eye on corporate travel within the energy sector as falling fuel prices could potentially soften demand in that business segment. United’s second largest base measured by ASMs as of late Feb-2015 was its hub in Houston, a region where the oil industry is a significant driver of the economy.
The airline said it was working with its corporate clients within the energy sector as travel planning for 2015 gets underway. Southwest, headquartered in Dallas, has concluded: “The change in energy prices is no doubt going to ripple through the oil and gas economy, and we serve Texas [which is dependent on that sector] in a big way,” stated CEO Gary Kelly.
Southwest’s largest domestic route measured by seat deployment in late Feb-2015 was Dallas Love Field to Houston Hobby.
It is encouraging that US airlines have retained a bullish outlook for 2015 despite some pockets of weakness
These have created revenue headwinds in 1Q2015. The outlook is underpinned by the significant progress airlines have made to transform the industry into a sector that warrants a second glance from investors that would have turned a blind eye to the business just a few short years ago. But those same airlines admit there is still much to accomplish before their transformation is complete.
US Airline trade group Airlines for America (A4A) estimates that the 5.7% net profit margin recorded by US airlines (Alaska, Allegiant, American, Delta, Hawaiian, JetBlue, Southwest, Spirit and United) for the nine months ending in 3Q2014 was 2.3ppt below the 9% of S&P 500 companies and far below the 21.6% posted by tech giant Apple, the 17.5% recorded by McDonalds and CSX’s 15.2% margin. A4A calculated that for every dollar of revenue collected, US airlines were keeping roughly USD6 cents as profit.
In late 2014 Mr Anderson stated that Delta had the second lowest P/E among the S&P 500 industrial companies. “I think that is where our work lies for you [shareholders], in continuing to build a very durable company that manages well through every cycle.”
He said that Delta aims to run its business on investment-grade metrics. “If you think about 20 years ago, the industry was focussed on EBITDA margins...EBITDA margins are not a good metric for our business.” Delta no longer uses that metric, said Mr Anderson, yet he understands why the industry in the past had to rely on EBITDA. “You couldn’t use a P/E multiple...because there weren’t any Es to go with the P, but we’re pretty well past that now.”
Delta’s CEO explained that a de-risked company is a major attraction for long equity investors, “so the risk has to come off the balance sheet to protect the equity very long term”.
The new low risk philosophy is not unique to Delta
US airlines across all business models are looking to clean up their balance sheets by cutting debt, starting with debt carrying the highest interest. JetBlue’s adjusted net debt to capital ratio at the end of 2014 was 53%, a 6.5% improvement year-on-year. Its cash and short term investments as a percentage of trailing 12 months revenue was 12%. “Strengthening the balance sheet remains an ongoing priority, to the extent fuel prices stay low thereby increasing your cash from operations we’d expect even faster balance sheet improvement by making opportunistic debt prepayments,” said company CFO Mark Powers.
United’s total debt has fallen from USD22 billion in 2010 to USD18.3 billion as it works towards a goal of USD15 billion. “We continue to take steps to strengthen our balance sheet,” concluded company CFO John Rainey. At the end of 2014 he highlighted attractive rates on some of the company’s pre-payable debt.
Given that balance sheet repair is in full force, US airlines are perhaps crossing the mid-point of their transformation
The aim would be to achieve a viable industry similar to the railroad industry. “Think about how the railroads have evolved before the Staggers Act and what we have now in terms of the industrial organization of the railroad industry in the US,” Mr Anderson told investors in late 2014. “And I would submit to you, and we have to keep proving it to you, that this industry is going down a very similar path.”
But are those messages of de-risking and sustained shareholder returns reaching the long-term investors airlines are targeting? Only two US airlines are considered investment grade after Alaska Air Group joined Southwest in achieving that status in 2014.
Delta, Allegiant, United, JetBlue, American and Hawaiian all have varying levels of speculative credit grades, according to A4A. “Airline creditworthiness remains far from stellar,” the association has stated. “Airline margins at this point in the business cycle remain subpar, well below the S&P 500 average”.
As airline profits reach a certain level of sustainability, employees obviously want to share in those gains
There are at least two ways to do this - through better wages or profit sharing. For now it seems airlines are recognising the need to reward their employees, and are willing to ensure that wages are competitive across the industry.
A driver of Virgin America’s estimated 4% to 6% rise in unit costs excluding fuel for 2015 is an increase in wages to align compensation with current industry averages. During Apr-2015 the airline is introducing an average increase of 15% for pilots and 5% for most of its other work groups with the exception of flight attendants that have unionised. Negotiations between representatives from the Transport Workers Union and management are scheduled to commence in late 2015.
Alaska Air Group is projecting flat unit costs growth in 2015 after posting a 1.3% decline for 2014. During 2015 a new flight attendant contract is adding roughly USD25 million in structural expense for the company, and approximately USD15 million in incremental expense after 2015. However, Alaska stressed the new pact includes important work productivity enhancements.
American is incurring USD200 million in additional costs in 2015 from a new joint collective bargaining agreement with its flight attendants and roughly USD650 million from a new pilot contract.
The outcome was tough to predict, as some pilots had strong feelings about work rule provisions of the deal. But the agreement was ultimately approved, although news outlet Reuters has reported that pilots stated the contract still lags behind Delta due to a lack of profit sharing.
Profit sharing provisions are absent from the deals American has struck with labour groups. Management at American, largely populated by former US Airways executives, has been criticised for abandoning profit sharing while rival Delta constantly promotes its profit sharing programme, which included approximately USD1 billion for 2014.
But American’s management is not relenting on its profit sharing stance. In an interview with Reuters, CEO Doug Parker concluded that airlines offered profit sharing during the last decade to make up for wage cuts. “We should move back to what normal industrial companies do, which is pay people [what] they earn,” he concluded.
Despite having some reservations about certain elements of the contract, American’s pilots ultimately approved the deal, which is a huge win for arguably labour and management. It shows that perhaps some of the virulent relationships between airline managements and labour are also beginning to change, albeit slowly.
CAPA's Americas Aviation Summit, Las Vegas 27/28 April, includes a panel:
"Pilot Unions and Their Future Role in the Airline Industry"
The airline industry, containing as it does so many varied activities, has a proliferation of unions. But pilots tend to be the most powerful – and nowhere are pilots more powerful as a voice than in the US. Their influence on airline management has been enhanced by consolidation and the quest for higher returns
- What role have pilots played in creating a new framework for airline profitability?
- What role can they play to sustain future profitability?
- What are the new dynamics between regional and mainline pilots now that scope clauses are fading?
- What are pilots’ views of the competitive dynamics in the international marketplace?
Moderator: Cranky Concierge, President, Brett Snyder
- Allied Pilots Association, Chairman Government Affairs Committee, Bob Coffman
- ALPA, President, Tim Canoll
- Flightpath Economics, Aviation Economist, Dan Akins
- SWAPA, President, Paul Jackson
Southwest Airlines is seemingly heading in the opposite direction
Just as greater civility emerges in labour relations at some airlines, cracks are appearing in the historically positive relationship Southwest has maintained with its employee groups, particularly pilots. As American’s stance on profit sharing garners headlines, one of the most important negotiations to monitor in 2015 is Southwest’s contract talks with its pilots.
In late 2014 the airline’s pilots filed for mediation with the US National Mediation Board, the third labour group at the airline to seek government intervention during the latest round of negotiations.
“This is certainly not a step either side wants to take during negotiations, and certainly not a typical step in the pilot and management relationship at Southwest Airlines,” said the Southwest Airlines Pilots’ Association. “But times have certainly changed.”
The union cited sacrifices pilots had made during the last four years, which has allowed Southwest to achieve its financial goals, including a 15% ROIC (its 2014 ROIC was 21%). As Southwest continues to post gains in profitability, beats its return goals and expands shareholder returns, the rifts with employees will only grow deeper as management aims to preserve the shrinking cost gap it has with major airlines and the widening gap with ULCCs.
“We must keep Southwest Airlines competitive and this is now an evolved environment where our legacy competitors are stronger than ever and it’s more important for us than ever to maintain our low cost position and preserve our low fare brand. So that has been under attack as the other airlines have gone through bankruptcy,” Southwest CEO Gary Kelly declared at the beginning of 2015.
Southwest also has the added challenge of American’s pilot contract – which included a 23% raise for 2015 and annual 3% increases for the next five years – setting a benchmark as it works to reach a new agreement with pilots.
It is not just pilots that are a concern. Other work groups are also vocalising their discord with management
Baggage handlers recently highlighted that Southwest has earned USD3 billion in profits since 2011, and continues to benefit from a steep drop in jet fuel prices. “Breaking from the Southwest tradition of rewarding employees as important stakeholders in the company, current management has held down wages despite healthy profits,” the Transport Workers Union has declared.
Southwest’s labour challenges show that even in a revitalised operating environment, significant challenges loom for US airlines.
US airlines have made significant strides in their attempts to transform their businesses into investment grade vehicles, but much work is left undone, of particular concern is changing the mindset of labour to work collaboratively with management to ensure airlines can continue to de-risk and de-lever attracting equity investors committed to sticking with those airlines over the long term.
The timing in which US airlines will fully complete their transition to a viable industrial-grade industry is impossible to predict, but for now they appear to be passing the first real test by sticking to capacity discipline in a lower fuel cost environment and trumpeting their intentions to continue balance sheet repair and increase shareholder returns.
Those companies deserve some level of recognition for the significant progress that has been made, but the journey is far from complete, and many major challenges remain before they can declare victory.