Business Policy Assignment

NOTE: This Industry overview is only a starting point for your analysis. Environment and industry issues can change rapidly and some of the information here may therefore be out-of-date.

You MUST supplement this information with additional research.

The Airline Industry

4940- Summer, 2014

Few inventions have changed how people live and experience the world as much as the invention of the airplane. During both World Wars, government subsidies and demands for new airplanes vastly improved techniques for their design and construction. Following World War II, the first commercial airplane routes were set up in Europe. Over time, air travel has become so commonplace that it would be hard to imagine life without it. The airline industry certainly has progressed. It has also altered the way in which people live and conduct business by shortening travel time and altering our concept of distance, making it possible for us to visit and conduct business in places once considered remote.

The airline industry exists in an intensely competitive market. In recent years, there has been an industry-wide shakedown, which will have far-reaching effects on the industry's trend towards expanding domestic and international services. In the past, the airline industry was at least partly government owned. This is still true in many countries, but in the U.S., all major airlines have come to be privately held. The U.S. airline industry has been in a chaotic state for a number of years. According to the Air Transport Association, the airline industry’s trade association, the loss from 1990 through 1994 was about $13 billion, while from 1995 through 2000, the airlines earned about $23 billion and then lost about $35 billion from 2001 through 2005. Against this backdrop of poor financial performance, dramatic changes in industry structure have occurred. Growth in air passenger traffic has outstripped growth in the overall economy and the U.S. airline industry remains in the midst of an historic restructuring. Over the last five years, U.S. network airlines have reduced their annualized mainline costs excluding fuel by more than 25%, or nearly $20 billion. While some of the cost savings realized in the industry were the product of identifying greater operational efficiencies, most of the savings were generated by renegotiation of existing contractual arrangements with creditors, aircraft lessors, suppliers and airline employees and achieved either through the bankruptcy process itself or under threat of bankruptcy. A portion of industry capacity still operates in bankruptcy. But, it is down from a high of 46 percent in 2005. As a result, several carriers that were near liquidation now have lower cost structures that should allow them to show improved performance.

Economic profile of the Air line industry: The airline industry has always exhibited cyclicality because travelers' demand is sensitive to the performance of the macro economy yet airlines must predict this demand accurately because of the lead time required to acquire aircraft. When airlines over predict demand, which can happen for any number of reasons, they suffer losses. The main components of demand for airline services are business travelers, tourism, freight transport, and mail transport. Flight schedules tend to be the crucial competitive issues for business travelers, while tourists and personal travel is much more price sensitive.

This industry note has been compiled by Dr. Derrick D’Souza, from various secondary sources (A list of sources is provided at the end of this note), and is intended for use as an instructional tool in the Business Policy (BUSI 4940) classroom at the University of North Texas. The use of this note for any other purpose, without the express permission of the author, is prohibited.

Freight and mail services account for about 15% of airlines total overall revenue, while international freight and mail is closer to one-third of airlines' international revenue. Airline services enable access to other goods, such as vacations, business meetings, or foreign-sourced products. Thus, the demand for airline services is closely linked to the demand for these goods.

Capacity of airline industry is influenced by the number of aircrafts, frequency, availability of routes, number of airports, etc. While industry analysts expect continued long-term growth in the demand for air travel, airline industry profitability has been volatile. High airline fixed costs, significant operating cost sensitivity to fuel prices, and the sensitivity of international travel to business and political conditions make airline profitability depend significantly on macroeconomic factors. Airlines have responded to competitive pressures in a variety of ways: liquidating, seeking government subsidies, improving operating efficiency, privatization, and forming alliances with other airlines. The growth of low cost carriers (LCCs) in the U.S. and elsewhere is arguably the single most important factor currently shaping the airline industry. The rapid growth of LCCs has been commonly cited as one of the primary causes of the financial crisis currently facing the large hub-and-spoke carriers. The evolving market structure – and the resulting impact on both fares and service – will depend critically on the direction of the competitive clash between LCCs and the major network carriers. At the same time, the percentage of business travelers willing to pay much higher “walk up” or unrestricted fares has steadily fallen. These trends were enhanced by the growth of the Internet as a mainstream marketing and distribution channel, creating an environment of nearly perfect price information for both leisure and business travelers, further curtailing the ability of network carriers to charge significantly higher prices to the most time-sensitive passengers. The influence of the economic cycle on domestic traffic is apparent. The high-risk nature of the airline industry tends to discourage entry. Because airlines have high fixed costs relative to revenues, a small change in load factors or fare levels can have a large impact on profits. The industry is therefore highly vulnerable to an economic slowdown. Besides, the airline industry is one of the most heavily taxed in the U.S., with taxes and fees accounting for approximately 20% of the total fare charged to a customer. Competition in Airline industry: It is important to examine the substantive effect that mergers and alliances may have on competition in general and on consumers in particular. International alliances may have a somewhat different form than domestic mergers, but may have the same substantive effect on competition and thus appear to merit similar review and oversight. Pricing is highly competitive. Deregulation and increasing competition, while bringing considerable benefits to consumers, have put additional pressure on airline companies’ profits. Several international markets still have unnecessary constraints on competition including the United Kingdom, China, Japan, and several countries in Latin America – that effectively protect foreign airlines and raise costs for U.S. carriers and consumers. Decentralization & deregulation were the two major insights to boost the competition in the airline industry.

The airline industry is separated into four categories by the U.S. Department of Transportation (DOT):

· International - 130+ seat planes that have the ability to take passengers just about anywhere in the world. Companies in this category typically have annual revenue of $1 billion or more.

· National - Usually these airlines seat 100-150 people and have revenues between $100 million and $1 billion.

· Regional - Companies with revenues less than $100 million that focus on short-haul flights.

· Cargo - These are airlines that generally transport goods.

Airport capacity, route structures, technology and costs to lease or buy the physical aircraft are significant in the airline industry. Other large issues are:

· Weather - Weather is variable and unpredictable. Extreme heat, cold, fog and snow can shut down airports and cancel flights, which costs anairline money.

· Fuel Cost - According to the Air Transportation Association (ATA), fuel is an airline's second largest expense. Fuel makes up a significant portion of an airline's total costs, although efficiency among different carriers can vary widely. Short haul airlines typically get lower fuel efficiency because take-offs and landings consume high amounts of jet fuel.

· Labor - According to the ATA, labor is the an airline's No.1 cost; airlines must pay pilots, flight attendants, baggage handlers, dispatchers, customer service and others.

Ratios/Terms that bear close monitoring in the airline industry

· Available Seat Mile – (Total number of seats available for transporting passengers) X (# of miles flown during period)

· Revenue Passenger Mile - (Number of revenue-paying passengers) X (# of miles flown during the period)

· Revenue Per Available Seat Mile - (Revenue) / (number of seats available)

· Air Traffic Liability - An estimate of the amount of money already received for passenger ticket sales and cargo transportation that is yet to be provided. It is important to find out this figure so you can remove it from quoted revenue figures (unless they specifically state that ATL was excluded).

· Load Factor - An indicator, compiled monthly by the Air Transport Association (ATA), that measures the percentage of available seating capacity that is filled with passengers. Analysts state that once the airline load factor exceeds its break-even point, then more and more revenue will trickle down to the bottom line. Keep in mind that during holidays and summer vacations load factor can be significantly higher, therefore, it is important to compare the figures against the same period from the previous year.

Airlines can earn revenue from transporting cargo, selling frequent flier miles to other companies and up-selling in flight services. However, the largest portion of airline revenue is derived from regular and business passengers. Business travelers are important to airlines because they are more likely to travel several times throughout the year and they tend to purchase the upgraded services that have higher margins for the airline. On the other hand, leisure travelers are less likely to purchase these premium services and are typically very price sensitive, and are less likely to travel in times of economic uncertainty or sharp decline in consumer confidence.

Deregulation of the airline industry: US airline deregulation was a very significant and successful step to the development of commercial airlines. Airlines can now develop their own policies and standards; they can add new routes, which are expected to be profitable, and remove old routes which are considered unprofitable. Airlines received the opportunity to vary the amount of airplanes on each route, to set fares by themselves without government interference and to make managerial decisions themselves. Airlines deregulation attracted many new competitors; some of them bankrupted, some merged and some prospered. Government policies: An increasing number of governments are moving to eliminate economic regulation of domestic airline services under policies known as "open skies" policies. However, even states that have deregulated the airline industry have been reluctant to allow foreign airlines to provide domestic services. In 1992, Congress established the National Commission to Promote a Strong and Competitive Airline Industry. The commission made recommendations concerning FAA's structure, the airline industry's financial health, and foreign ownership limits. The events of 9/11 accelerated and aggravated negative financial trends already evident in the airline industry. In order for the industry to return to profitability, several steps must be taken to increase consumer demand for air travel, especially business travel, control costs, and address certain pricing issues. Congress has enacted several measures aimed at helping the airline industry to recover and respond to terrorist attacks. Over the long term, however, the outlook for the U.S. airline industry is more uncertain. The industry faces persistent structural problems that must be addressed if we are to avoid facing another wave of bankruptcies in the next economic downtown, and if the industry is to take full advantage of the very substantial progress made in lowering unit costs. When the Federal Reserve increases the interest rate, then investments in airline industry become costlier. Similarly, if government follows contractionary fiscal policies by increasing the tax rates, the profits of the airline industry will be affected. Thus, economic policies & changes in the structure of the economy highly influence the structure of the airline industry as the industry is highly sensitive & dynamic to the policy changes.

At first glance, you might think that the airline industry is pretty tough to break into, but don't be fooled. You'll need to look at whether there are substantial costs to access bank loans and credit. If borrowing is cheap, then the likelihood of more airliners entering the industry is higher. The more new airlines that enter the market, the more saturated it becomes for everyone. Brand name recognition and frequent fliers point also play a role in the airline industry. An airline with a strong brand name and incentives can often lure a customer even if its prices are higher.

The airline supply business is mainly dominated by Boeing and Airbus. For this reason, there isn't a lot of cutthroat competition among suppliers. Also, the likelihood of a supplier integrating vertically isn't very likely. In other words, you probably will not see suppliers starting to offer flight service on top of building airlines.

What about the bargaining power of buyers in the airline industry? While a single buyer may not be able to demand a specific price for a given flight, consider the ability of a consumer to switch from one airline to another. What, if anything, can an airline company do to make their flights different from any other? (e.g., Is the seat in one airline more comfortable than another? Probably not unless you are analyzing a luxury liner like the Concord Jet).

What is the likelihood that someone will drive or take a train to his or her destination? For regional airlines, the threat might be a little higher than international carriers. When determining this you should consider time, money, personal preference and convenience in the air travel industry.

Highly competitive industries generally earn low returns because the cost of competition is high. This can spell disaster when times get tough in the economy. The airlines constitute one such industry.

Sources:

1. Investopedia, http://www.investopedia.com/features/industryhandbook/airline.asp#axzz1WGsHM2KY

2. AirlineFinancials.com: http://www.airlinefinancials.com/Airline_Data_Analysis_.php

3. http://www.mbacasestudysolutions.com/Blog/US_Airline_Industry_7-11-2008.html

Supplemental Information on the Industry from major airline annual reports. (Major airline annual reports are often good sources of environmental/industry information).

Industry Conditions

Domestic Competition. The domestic airline industry is highly competitive and dynamic. Currently, any U.S. carrier deemed fit by the DOT is free to operate scheduled passenger service between any two points within the United States. The Company’s competitors consist primarily of other airlines and, to a lesser extent, other forms of transportation. Competition can be direct, in the form of another carrier flying the exact non-stop route, or indirect, where a carrier serves the same two cities non-stop from an alternative airport in that city or via an itinerary requiring a connection at another airport.

Air carriers’ cost structures are not uniform and there are numerous factors influencing cost structure. Carriers with lower costs may deliver lower fares to passengers, which could have a potential negative impact on the Company’s revenues. In addition, future airline mergers, acquisitions or reorganizations pursuant to Chapter 11 of the United States Bankruptcy Code may enable airlines to improve their revenue and cost performance relative to peers and thus enhance their competitive position within the industry.

Decisions on domestic pricing are based on intense competitive pressure exerted on the Company by other U.S. airlines. In order to remain competitive and maintain passenger traffic levels, we often find it necessary to match competitors’ discounted fares. Since we compete in a dynamic marketplace, attempts to generate additional revenue through increased fares oftentimes fail.

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The airline industry is highly competitive, marked by significant competition with respect to routes, fares, schedules (both timing and frequency), services, products, customer service and frequent flyer programs. The industry is going through a period of transformation through consolidation, both domestically and internationally, and changes in international alliances. Consolidation in the airline industry and changes in international alliances have altered and will continue to alter the competitive landscape in the industry by resulting in the formation of airlines and alliances with increased financial resources, more extensive global networks and altered cost structures. In addition, other network carriers have also significantly reduced their costs over the last several years including through restructuring and bankruptcy reorganization. American Airlines is nearing the end of its bankruptcy restructuring, which is enabling it to reduce its costs. Our ability to compete effectively depends, in part, on our ability to maintain a competitive cost structure.

Industry Regulation

Domestic Regulation

General. All carriers engaged in air transportation in the United States are subject to regulation by the DOT. Absent an exemption, no air carrier may provide air transportation of passengers or property without first being issued a DOT certificate of public convenience and necessity. The DOT also grants international route authority, approves international codeshare arrangements, and regulates methods of competition. The DOT regulates consumer protection and maintains jurisdiction over advertising, denied boarding compensation, tarmac delays, baggage liability and other areas, and may add additional expensive regulatory burdens in the future. The DOT’s series of rules to enhance airline passenger protections have required U.S. air carriers to adopt contingency plans and procedures for tarmac delays exceeding three hours for domestic flights and four hours for international flights and to charge the same baggage fee throughout a passenger’s entire itinerary (even if on multiple carriers).

Airlines are also regulated by the Federal Aviation Administration (the “FAA”), an agency within the DOT, primarily in the areas of flight safety, air carrier operations, and aircraft maintenance and airworthiness. The FAA issues air carrier operating certificates and aircraft airworthiness certificates, prescribes maintenance procedures, oversees airport operations, and regulates pilot and other employee training. The 2011 FAA final rule amending existing flight, duty and rest regulations applicable to U.S. air carriers under Part 117 of the Federal Aviation Regulations, which took effect on January 4, 2014, mandates extensive changes to the way the Company schedules crews and deploys aircraft. (See attached article for more information on new pilot regulations) . From time to time, the FAA issues directives that require air carriers to inspect or modify aircraft and other equipment, potentially causing the Company to incur substantial, unplanned expenses. The airline industry is also subject to numerous other federal laws and regulations. The U.S. Department of Homeland Security has jurisdiction over virtually every aspect of civil aviation security. Beginning in March 2014, the Occupation Safety and Health Administration (“OSHA”) will extend its regulatory programs for hazard communication, hearing conservation and blood borne pathogens to areas of cabin crewmember safety and health. The Antitrust Division of the U.S. Department of Justice (“DOJ”) has jurisdiction

over certain airline competition matters. The U.S. Postal Service has authority over certain aspects of the transportation of mail by airlines. Labor relations in the airline industry are generally governed by the Railway Labor Act (“RLA”), a federal statute.

The Company is also subject to investigation inquiries by the DOT, FAA, DOJ and other U.S. and international regulatory bodies.

Airport Access. Access to landing and take-off rights, or “slots,” at several major U.S. airports and many foreign airports served by the Company are, or recently have been, subject to government regulation. Federally mandated domestic slot restrictions currently apply at Reagan National Airport in Washington D.C., John F. Kennedy International Airport (“JFK”), LaGuardia Airport (“LaGuardia”) and Newark Liberty. In addition, to address concerns about airport congestion, the FAA has designated certain airports, including Newark Liberty, JFK, and LaGuardia as “high density traffic airports” and has imposed operating restrictions at these three airports, which may include capacity reductions. Additional restrictions on airline routes and takeoff and landing slots at these and other airports may be proposed in the future that could affect the Company’s rights of

ownership and transfer.

Legislation. The airline industry is subject to legislative activity that may have an impact on operations and costs. In addition to significant federal, state and local taxes and fees that the Company is currently subject to, proposed taxes and fees are currently pending that may increase the Company’s operating costs if imposed on the Company. Congress may pass legislation that could increase labor and operating costs. The Airline Safety and Federal Aviation Extension Act of 2010 and the FAA Modernization and Reform Act of 2012 have increased regulation and are likely to cause increased costs in the areas of airline safety, pilot training, and consumer protection. Climate change legislation is also likely to be a significant area of legislative and regulatory focus and could adversely impact the Company’s costs.

Emissions . The U.S. Environmental Protection Agency (the “EPA”) is authorized to regulate aircraft emissions and has historically implemented emissions control standards previously adopted by the International Civil Aviation Organization (“ICAO”). Our aircraft comply with existing EPA standards as applicable by engine design date. The ICAO has adopted two additional aircraft engine emissions standards, the first of which is applicable to engines certified after December 31, 2007, and the second of which is applicable to engines certified after December 31, 2013. In June 2012, the EPA published a final rulemaking for new emission standards for oxides of nitrogen (NOx), adopting ICAO's additional standards. Included in the rule are two new tiers of more stringent emission standards for NOx. These standards, referred to as the Tier 6 standards, become effective for newly-manufactured aircraft engines beginning in 2013.

Concern about aviation environmental issues, including climate change and greenhouse gases, has led to taxes on our operations in the United Kingdom and in Germany, both of which have levied taxes directly on our customers. We may face additional regulation of aircraft emissions in the United States and abroad and become subject to further taxes, charges or additional requirements to obtain permits or purchase allowances or emission credits for greenhouse gas emissions in various jurisdictions. This could result in taxation or permitting requirements from multiple jurisdictions for the same operations. Ongoing bilateral discussions between the United States and other nations as well as discussions at the ICAO Assembly and Conference of the Parties, most recently in Doha, Qatar in December 2012, may lead to international treaties or other actions focusing on reducing greenhouse gas emissions from aviation.

Cap and trade restrictions have also been proposed in the United States. In addition, other legislative or regulatory action, including by the EPA, to regulate greenhouse gas emissions is possible. In particular, the EPA has found that greenhouse gases threaten the public health and welfare, which could result in regulation of greenhouse gas emissions from aircraft. In the event that legislation or regulation is enacted in the U.S. or in the event similar legislation or regulation is enacted in jurisdictions other than the European Union where we operate or where we may operate in the future, it could result in significant costs for us and the airline industry. In addition to direct costs, such regulation may have a greater effect on the airline industry through increases in fuel costs that could result from fuel suppliers passing on increased costs that they incur under such a system. We are monitoring and evaluating the potential impact of such legislative and regulatory developments.

We seek to minimize the impact of greenhouse gas emissions from our operations through reductions in our fuel consumption and other efforts and have realized reductions in our greenhouse gas emission levels since 2005. We have reduced the fuel needs of our aircraft fleet through the retirement and replacement of certain elements of our fleet and with newer, more fuel efficient aircraft. In addition, we have implemented fuel saving procedures in our flight and ground support operations that further reduce carbon emissions. We are also supporting efforts to develop alternative fuels and efforts to modernize the air traffic control system in the U.S., as part of our efforts to reduce our emissions and minimize our impact on the environment.

Noise . The Airport Noise and Capacity Act of 1990 recognizes the rights of operators of airports with noise problems to implement local noise abatement programs so long as such programs do not interfere unreasonably with interstate or foreign commerce or the national air transportation system. This statute generally provides that local noise restrictions on Stage 3 aircraft first effective after October 1, 1990, require FAA approval. While we have had sufficient scheduling flexibility to accommodate local noise restrictions in the past, our operations could be adversely impacted if locally-imposed regulations become more restrictive or widespread

Finally, aviation security continues to be the subject of frequent legislative and regulatory action, requiring changes to the Company’s security processes, frequently increasing the cost of its security procedures, and adversely affecting its operations.