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Industry Outlook

The global airline industry continues to face challenges in 2012, from rising costs -- fuel, in particular -- and economic uncertainties. The condition looks bleaker ahead with a weak outlook for Europe, given its financial problems.

The International Air Transport Association (IATA) projects overall airline profits of $3.0 billion for 2012. This is down from the $3.5 billion projected last December and $4.9 billion projected in September.

Moreover, the 2012 profit outlook is also below the estimated $7.9 billion in 2011 and $16 billion earned in 2010. This steep decline in the industry's profitability is a function of the overall unfavorable macro backdrop with which the industry must operate this year.

Regional Forecast

North America: North American airlines like United Continental Holdings Inc. ([url=http://www.zacks.com/stock/quote/ual]UAL[/url]), Delta Air Lines Inc. ([url=http://www.zacks.com/stock/quote/dal]DAL[/url]), Southwest Airlines Co. ([url=http://www.zacks.com/stock/quote/luv]LUV[/url]), JetBlue Airways Corporation ([url=http://www.zacks.com/stock/quote/jblu]JBLU[/url]) and US Airways Group Inc. ([url=http://www.zacks.com/stock/quote/lcc]LCC[/url]) have shown improvements thanks to higher ticket prices, capacity cuts and improved ancillary revenues. Together, these companies are expected to post profits of $900 million, down from the previous expectation of $1.7 billion in 2012.

Asia-Pacific: These carriers are expected to record a profit of $2.3 billion in 2012, up from the $2.1 billion forecast previously. Better-than-expected performance by the Chinese carriers will lead to the outperformance from the prior outlook. Notably, this is the highest profit-producing region in the industry outside the home market.

Middle East & Latin America: Per IATA, profits from the Middle East carriers are expected to grow to $500 million from the previous expectation of $300 million. Profit projection for Latin American carriers remains unchanged at $100 million.

Africa: African air carriers are expected to incur a loss of $100 million due to weaker yields after touching the break-even point in 2011.

Europe: As for the European airlines, the IATA projections show a loss of $600 million for 2012. Though major Eurozone woes have been averted to some extent, many of the companies are still experiencing a downturn due to the continued weakness in cargo and passenger businesses. Additionally, higher passenger taxes are largely responsible for the lackluster performance.

U.S. Airline 2011 Performance

Though the airlines have not yet released their global 2011 actual profit numbers, the IATA projects that the industry should earn profits of $7.9 billion. This is up from the previous projection of $6.9 billion, primarily attributable to better performance of the Chinese carriers.

However, U.S. airlines announced a profit of $390 million overall in 2011, which is much lower than $2 billion projected by the IATA. The 2011 profit also plunged 86% from $2.7 billion earned in 2010. This nevertheless marked the second consecutive year of profits after incurring cumulative losses of more than $50 billion in the past decade.

Fuel price volatility, the worst threat to the airline industry, represents about 35% of total expenses, up from 30% in 2010. North American airlines yielded 0.3% of the net margin, down from 2.2% in 2010. Revenue climbed 12.6% year over year with total expenses rising 15.5%, primarily due to a 36.1% rise in fuel costs.

Further, the U.S. air carriers are providing excellent services to their passengers. They are performing at record levels when it comes to arriving on-time, baggage handling, fewer customer complaints, lower cancellations and lower overbooked flights.

Underlying Factors for 2012 Profits

In the base-case scenario, there are several factors that will drive overall airline profits in 2012:

Cargo & Freight

With the U.S. economy now moving slowly, airfreight is recovering as major worries regarding Eurozone crisis have been abated. Airfreight in emerging markets, China in particular, is showing growth attributable to the booming e-commerce market, airport development plans and development in western China.

As travel demand is picking up, the IATA projects global airline passenger growth of 4.2% in 2012 versus 4% forecasted previously. The cargo market is expected to remain stable in the first half of 2012 and show considerable improvement in the second half.

Coming to demand-supply balances, demand (measured in traffic) will outpace capacity (combined passenger and cargo) as the year advances. Capacity is expected to show an increase of 3.2% while air travel demand is expected to see a 3.6% pickup. The combination of freight market stabilization, higher fuel costs and tighter capacity would lead to passenger yields of 2% this year.

Fuel Price Rise: Bane or Boon?

Airline profit outlook depends on fuel prices, the major variable component in the industry. Escalating fuel prices are making aircraft operations expensive and are changing the sector's overall dynamics. Airlines need to figure out ways to counter rising fuel expenses.

High crude oil prices, largely a function of geostrategic forces, are beyond the control of the airlines. We expect crude oil and jet fuel prices to increase this year because of the political tensions in the Persian Gulf, but forecasting this key variable with any level of accuracy has always been extremely challenging (hedging strategies discussed below).

While air carriers are contemplating a more effective and enduring way to counter the rising costs, passing on the increased cost to customers in the form of fare hikes seems an easy way out. Airlines imposed about 10 broad fare increases last year, which have all been successful with the rise in travel demand. If demand remains strong and the fuel price continues to rise, then carriers will be able to earn higher through-fare hikes in 2012.

Getting Rid of Unprofitable Jets

Air carriers believe capacity reduction is another way of countering rising fuel costs. The companies are scrapping or cutting flights in many small U.S. airports that are unprofitable.

According to the Airports Council International, 27 airports, including those in St. Cloud, Minnesota and Oxnard, California, lost services from the well-known airlines over the last two years. Instead, the carriers are adding long-distance flights. It is easy to charge more for traveling long distances rather than for shorter routes.

New Advertising Rule

The U.S. Department of Transportation (DOT) set new pricing rules for the air carriers effective January 26, 2012. Airline companies have to include all taxes and fees while advertising fares for their flights. Previously, the carriers were allowed to advertise ticket prices excluding taxes and fees, which could add up to 20% to the price of air travel.

We are apprehensive that the new advertising policy will look expensive to passengers and hit the stocks. As the passengers switch to lower fares, the new rules might hurt travel demand, thereby leading to lower industry profits.

Rightsizing

Passengers are demanding high quality services with proper security. Airlines are using obsolete, old and less-fuel efficient aircraft, flying which are no longer feasible in a fuel-expensive environment. Hence, air carriers are also focusing on fleet rightsizing.

Though initially expensive, the new aircraft are more fuel efficient than the existing ones and have helped in lowering operating and maintenance costs. Global airlines are expected to invest $3.5 trillion to buy 27,800 new airplanes, having seating capacity of more than 100, over the next 2 decades (2011-2030). New airlines business, advanced technology and dynamic growth of air travel in emerging markets throughout the world are boosting the demand for these airplanes.

About one-thirds of the demand is expected to come from Asia, which currently account for 28% of global air passengers. The demand in Europe and the U.S. is expected to fall to 23% and 20% by 2030, respectively, from the current 27% that each enjoy.

Airbus, the world's leading aircraft manufacturer, will deliver the largest number of aircraft to the airline companies, followed by The Boeing Co. ([url=http://www.zacks.com/stock/quote/ba]BA[/url]). The U.S. air carriers have started buying new planes from these manufacturers in order to provide good customer service. The progress thus attained would help these companies to regain their lost profits.

Hedging Strategies

Hedging strategies provide a cushion to the rising fuel prices and is being used extensively. The carriers use a combination of calls, swaps and collars at varying WTI crude-equivalent price levels to hedge.

U.S. Airlines - 20-Year Projection

The U.S. airline industry is expected to remain profitable over the next two decades given the improving worldwide trends in air travel. However, growth may be held back until 2015 due to surging fuel costs and economic uncertainties in the U.S. and Europe.

Although U.S. airlines will see a small dip this year, the demand for air travel will double over the next 20 years, as predicted by the U.S. Federal Aviation Administration (FAA). Passenger demand is expected to grow 2% to 746 million in 2013 and about 3% in the future years, reaching $1 billion by 2024 and $1.2 billion by 2032.

The FAA projects air traffic, customarily measured in billions of revenue passenger miles -- implying a unit of one mile flown by one passenger -- to grow by more than 90% over the same period. Revenue passenger miles would jump from 815 billion reported last year to 1.57 trillion by 2032 at an average annual rate of 3.2%.

International traffic is expected to grow 4.2% per year, in contrast to domestic travel that will growth at a more modest clip of 2.7% annually through 2032. This projection assumes a steady economic recovery with no major calamities like a large rise in oil price, swings in macroeconomic policy or financial meltdowns. Further, major North American airlines would raise capacity (available seat miles) at an annual rate of 3.1%, reaching 1.89 trillion by 2032.

The 20-year airline growth is expected to stem from the implementation of NextGen, the satellite-based navigation system that aims to make air travel more efficient. The carriers are taking numerous steps to improve their profitability as described in the above sections.

Moreover, the growing demand for air travel and a relatively lesser number of planes will make future fare hikes possible over the next two decades. Airline mergers and consolidation will bring down the number of flights and reduce the number of cities served.

OPPORTUNITIES

We believe industry consolidation and various ancillary revenues will boost profitability and cost performance of most air carriers going forward. This is an opportune moment for companies to consolidate in order to regain their lost profits and operational efficiency.

Ancillary Revenue: A number of supplementary revenue streams helped the airline industry gain ground in 2011 and 2010 after two years of drought. Air carriers are adding new features to services as well as expanding new products to improve passenger satisfaction and experience. The IATA projects total revenue of $633 billion for 2012, up slightly from $596 million projected for 2011.

Carriers are going wireless with the in-flight entertainment systems such as American Airlines' Gogo "Vision" wireless video-on-demand, Delta Air Lines' "Delta Connect" and Lufthansa's "BoardConnect." Other carriers such as Virgin America, Qantas and Virgin Australia will soon launch their in-flight entertainment systems.

Cathay Pacific, Malaysia Airlines, KLM, Delta, Qantas and British Airways have also made Apple Inc.'s ([url=http://www.zacks.com/stock/quote/aapl]AAPL[/url]) iPad available to passengers in their lounges, rent them out in the air as well as use them as a self-service kiosk, customer survey tool and food ordering tool.

Further, major U.S. carriers remain focused on expanding their product and service offerings on board and on the ground for higher ancillary revenues. Delta Air Lines ([url=http://www.zacks.com/stock/quote/dal]DAL[/url]) and United Continental ([url=http://www.zacks.com/stock/quote/ual]UAL[/url]) are installing winglets, WiFi and flat-bed seats apart from expanding Economy Comfort or Economy Plus seats to their fleet. United Continental is also introducing streaming wireless video in its aircraft.

Southwest Airlines ([url=http://www.zacks.com/stock/quote/luv]LUV[/url]) is benefiting from EarlyBird check-in, unaccompanied minor travel and pet fees. The company is renovating in-flight cabins and redesigning interiors, and has labeled the new appearance as Evolve: the New Southwest Experience. These fleet modernization plans and the All-New Rapid Rewards program is contributing to revenue growth.

JetBlue ([url=http://www.zacks.com/stock/quote/jblu]JBLU[/url]) is experiencing solid growth given continued success in the Getaway Vacations Division, as well as the Even More Space product.

Consolidation: Airline companies are consolidating in order to restore profits. The first in this grouping was Delta Air Lines' successful acquisition of Northwest Airlines in 2008. The merger catapulted Delta at the time to the position of largest airline in the world, generating significant cost savings for both.

In 2010, United Airlines merged with Continental Airlines and formed a new company, United Continental Holdings. This merger created the world's largest airline, overtaking Delta. The third merger was between Southwest Airlines and fellow discounter AirTran Holdings, which was completed in May 2011.

Another airline consolidation is seemingly underway. The rumors about American Airlines, a subsidiary of AMR Corp., merging with another airline have been heating up since the company filed for bankruptcy protection in November last year. The three labor unions of American Airlines are, in fact, supporting a plan for the bankrupt carrier's merger with rival US Airways ([url=http://www.zacks.com/stock/quote/ulcc]LCC[/url]), the fifth largest U.S. airline. This move represents a first step toward consolidation -- though creditors, directors and management have yet to give the green light.

We believe the potential American Airlines-US Airways combination would be strong enough in scope and size to compete with larger rivals. In fact, the combination would create an airline identical to United Continental in terms of revenue and traffic, and would be better than Delta. Further, the new carrier would leapfrog other airlines in the U.S. East Coast and Midwest. The potential combination would have fewer overlapping routes.

The consolidation of American Airlines, if successful, would be the fourth in the last three years. As United and Delta will be long-term beneficiaries following the merger actions on both capacity and cost fronts, we believe American Airlines will also emerge as a successful candidate by balancing its debt level and lowering costs. Nevertheless, any potential merger with AMR will take several months or a year to materialize, as American Airlines has yet to complete its court restructuring process and will undergo antitrust scrutiny.

Expansion: Carriers are making continuous efforts to increase their domestic and international flights. Delta Air Lines is focusing on adding flights in New York, Latin America, Mexico and Brazil. Delta Air Lines is progressing well on the $1.2 billion expansion at New York-JFK, scheduled to open in 2013, and the new Maynard H. Jackson Jr. International in Atlanta, slated to open this year. Internationally, Delta's deal with a Chinese international airline, China Eastern, should prove profitable.

United Continental is benefiting and enhancing its access from each other's hubs and networks. Southwest gained a valuable market presence in Atlanta, the busiest airport in the U.S, post the Air Tran acquisition in May 2011. The company is introducing services to new and unexplored domestic markets and expanding services at New York LaGuardia, Boston Logan, Milwaukee, Baltimore/Washington and many smaller domestic cities. The company will also debut in the Caribbean and Mexican markets in mid-2012.

JetBlue continues to successfully expand its network in two major growth regions: Boston to New York and the Caribbean.

Technology Upgrades: Air carriers are involved in numerous technology upgrades and system automation for various activities such as airline reservation system, flight operations system, website maintenance and in-flight entertainment systems. These upgrades enable companies to perform better, lower costs and enhance customer service.

Major U.S. carriers, Delta, United Continental and Southwest, have a long-term Neutral recommendation supported by the Zacks #3 (Hold) Rank for the short term (1-3 months). Additionally, U.S. Airways also retain a Zacks #3 (Hold) Rank for the short term.

WEAKNESSES

Of the many challenges facing the industry, the most important ones include volatile fuel prices, economic weakness, natural calamities, government regulation, unionization, airport infrastructure constraints and safety concerns.

Oil Price Volatility: Fuel price volatility continues to be one of the significant challenges, as the cost of fuel is largely unpredictable. Fuel prices, though high currently, remain well below the 2008 level of over $140 per barrel that had ravaged the airlines industry. The company's ability to pass along the increased costs of fuel to its customers is limited by the competitive nature of the airline industry. Thus, even a small change in fuel prices can significantly affect profitability.

Unionization: The airline business is labor intensive. Most of the employees are unionized and depend on various U.S. labor organizations. The relation between airlines and labor unions are governed by the Railway Labor Act, which states that a collective bargaining agreement between an airline and a labor union does not expire -- instead it becomes amendable as of a stated date. Failure to amend terms and conditions suitably may lead to work stoppages or strikes, and thereby hamper operations.

Federal Regulations: The airline industry is highly regulated, in particular by the federal government. All companies engaged in air transportation in the U.S. are subject to the regulations implemented by the DOT. Further, airlines are also regulated by the Federal Aviation Administration (FAA), a division of the DOT, primarily in areas of flight operations, maintenance and other safety and technical matters.

Capacity Creep: The airline industry has a lousy record of capacity discipline, though it has largely been mindful of this issue in this cycle. It remains to be seen how long the current trends remain in place before old habits return.

JetBlue ([url=http://www.zacks.com/stock/quote/jblu]JBLU[/url]) is expected to underperform the broader market in the long term, with the Zacks #4 (Sell) Rank.

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