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THE SKY GODS CAN SMILE (FOR NOW)
By Joe Brancatelli
August 4, 2010 -- This is honest-to-goodness, once-in-a-decade good news: The nine largest U.S. airlines collectively racked up about $1.9 billion in second-quarter profits before special items. That missed being the industry's best financial performance in a decade by $8 million, essentially a rounding error.

Now the not-so-good news: The profits came on $31.7 billion in revenue, the airlines' second-best performance in the history of U.S. commercial aviation. That makes the average second-quarter margin less than 6 percent, an uninspired performance for an industry that has destroyed perhaps $100 billion in capital since the September 11 terror attacks in 2001.

And now the bad news: History suggests there's nowhere to go but down. The seeds of the next crisis in the airline industry are always planted during the putative good times. This cycle doesn't look much different and, in some ways, may be the beginning of the endgame for the legacy airlines that were the Masters of the Sky when the industry was deregulated a generation ago.

But let's give the Sky Gods their due before we burst their bubble. Thanks to fanatical restraint on their seat capacity, comparatively modest oil prices, a tentative recovery of leisure travel, and the first signs of a rebound in business travel, eight of the nine carriers reported black digits in the second quarter. In an industry accustomed to explaining away a blizzard of crooked red numbers for years at a time, that alone is a remarkable achievement.

Delta Air Lines, which gobbled up Northwest Airlines last year and is now the world's largest carrier, reported its best quarterly result in a decade. It earned $549 million. United Airlines reported its first quarterly profit ($430 million) since 2007. Continental Airlines, United's soon-to-be merger partner, reported its best second-quarter profit ($257 million) since 2000. US Airways, the smallest of the legacy lines, turned in its second-best profit ($265 million) since its 2005 merger with America West. American Airlines, the only legacy carrier from the pre-1978 regulated era that has never been in bankruptcy, brought up the rear. It lost $10.7 million.

So much for the unalloyed good news. Now for a reality check. The industry's best second-quarter performer, according to Robert Herbst of Airline Financials, was not one of the old-line carriers. It was Alaska Airlines. Its second-quarter profit of $84 million on revenue of $976 million gave it a net income margin performance of 8.6 percent. Unlike its larger, publicity-hungry competitors, Alaska toils out of the media spotlight. Its headquarters (Seattle) and route network (largely in the West) make it a corporate outlier.

Moreover, Alaska does things differently than the legacy carriers. It isn't a member of a global alliance, which legacy competitors claim is the key to the future. It doesn't offer much international service, the opiate of the legacy lines since the middle of the last decade. Alaska continues to own and operate its commuter carrier (Horizon Air) while competitors rush to sell off theirs. It pours a disproportionately large percentage of its service into leisure markets such as Hawaii and Mexico, areas that many of its competitors ignore because of the supposedly low margins. Alaska and Horizon operate just three aircraft types (the Boeing 737 series, one regional jet, and one turboprop) while competitors grapple with the cost and complexity of managing three times as many. It has a comparatively good reputation for customer service and has not gone wild with a la carte pricing, two more areas where Alaska diverges with legacy lines.

The rest of the nine largest carriers--Southwest, JetBlue, and AirTran--are also threats to the legacy lines. Southwest Airlines, which has churned out profits for 37 consecutive years, turned in its second-best second quarter in history, with a $216 million profit on record operating revenue ($3.2 billion). JetBlue Airways had record second-quarter sales ($939 million) and profit ($30 million). AirTran Airways also booked record revenue ($701 million) and a second-quarter profit of $39 million.

How big of a threat do these four smaller carriers pose to the five legacy lines? For the six months ending in June, they controlled a combined 22 percent share of the nation's passenger traffic. That's more than double their 9.5 percent market share in September 2001. Southwest alone gained a point of market share in 2009 and Southwest's executives are convinced that its policy of allowing all flyers to check two free bags is fueling its ability to steal passengers from the legacy carriers.

It gets worse for the legacy carriers. Although oil costs rose substantially year over year in the second quarter, jet-fuel prices remain dramatically lower than their 2008 highs. Any sharp price spike will surely wipe out any potential future profit since the hedging programs of the big airlines have proven feeble.

Moreover, the second-quarter profits are suspect because they are based on abnormally low labor costs. In the last decade, labor dropped to 23.6 percent of total airline expenditures, compared with 36.2 percent at the beginning of the 21st century. But legacy carriers have a plethora of unresolved labor-union contracts--in the highly unionized airline industry, contracts never technically expire, but become "amendable"--and rank-and-filers believe their decade of givebacks should end. No strikes are imminent, but it is unrealistic to expect that the big lines can continue to keep bending the labor-cost curve downward.

The rebound in traffic is also suspect. This year's uptick in leisure flyers may be an expression of pent-up demand after last year’s "staycation" trend. Besides, leisure demand is extremely price sensitive. Based on historical patterns, any fast rise in prices will kill off the nascent recovery.

Nor has business travel has not bounced back as fast as you've been led to believe. That's especially true for international premium-class business travel, where most of the profit lies for legacy airlines. According to the latest figures from IATA, the global trade group, premium-class international traffic remains 10 percent below its pre-recession levels. Worse, the yield the airlines generate from upscale flyers is 15 percent below the pre-recession peaks. In other words, business flyers are coming back, but very slowly and at prices far below their previous levels.

A last bit of historical precedent that should make you wary of expecting the airlines' second-quarter bounty to last too long. The bosses of the legacy carriers all stressed their nearly religious conversion to "capacity restraint" (that's airline speak for flying fewer flights) as one of the keys to their nascent profit. And that's true: The U.S. industry shrank faster last year than at any time since World War II, and the airlines' collective load factor (the percentage of seats filled) reached a record-high 81 percent during the first six months of 2010. But that kind of discipline won't last long. It never does. OAG, the industry's schedule keeper, says seat capacity in North America will grow 1 percent this month. That's the first rise since 2007, and even by the most cynical reading, that's a very modest increase. It is, however, indicative of the industry's actions: As fares inch up and capacity fills up, some smarter-than-the-room airline executive thinks he's found a new niche and expands. That provokes a competitive response, and the destructive cycle of capacity growth and fare wars resumes.

And that's just how the existing airline players react. For the first time in years, conditions seem right for some new competitors to enter the marketplace.

"Fares going up and sold-out flights are what attracts startups," a longtime industry executive told me last month. "There are plenty of planes [in storage] available too. You can always find some investor who sees gold where no one else does. No matter how shaky the [financial] realities, there's always someone who wants to start an airline."

The Fine Print…
Most industry analysts are expecting a profitable third quarter. Many are bullish on the fourth quarter. Preliminary reports released this week by Continental Airlines and AirTran Airways are encouraging, too Continental's load factor in July increased to 88 percent and per-passenger revenue jumped 20 percent compared with the dire days of July 2009. AirTran's load factor reached 88.6 percent.
ABOUT JOE BRANCATELLI Joe Brancatelli is a publication consultant, which means that he helps media companies start, fix and reposition newspapers, magazines and Web sites. He's also the former executive editor of Frequent Flyer and has been a consultant to or columnist for more business-travel and leisure-travel publishing operations than he can remember. He started his career as a business journalist and created JoeSentMe in the dark days after 9/11 while he was stranded in a hotel room in San Francisco. He lives on the Hudson River in the tourist town of Cold Spring.

THE FINE PRINT This column is Copyright © 2010 American City Business Journals. All rights reserved. Reprinted with permission. JoeSentMe.com is Copyright © 2010 by Joe Brancatelli. All rights reserved.