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Airlines is a highly cyclical industry. The industry has a history of seeing bankruptcies and M&A activity every ten years. This piece, which is the first-part of a two-part series, will deal with the main drivers of the Airline Industry.

The U.S. Airline Industry is currently standing at a point where its future does not seem clear. Although the International Air Transport Association (IATA) and the Federal Aviation Administration ((NYSEARCA:FAA)) have forecast a rise in passenger and cargo traffic, and a decline in profits; a lot more needs to be sorted out regarding the profits that the industry will be making in 2012, especially after the Fed announced plans to inject $40 billion in the economy, each month, as a part of its third phase of quantitative easing. The European debt crisis has also added to the woes of the industry.

The biggest challenge for the airline industry remains high volatility in oil prices. Fuel costs, currently 34% of operating costs on average, form a large chunk of airlines' input costs.

Oil, GDP and Airlines

Oil prices were on a decline till August, after which they have risen to $97 (still -3% YTD). Oil prices impact the profitability of airlines as they are one of the largest costs in the industry. Also, airlines often move closely with growth in global GDP. According to the IMF, global GDP is expected to grow by 2%, which means that a rise in airline stocks is expected. This is because countries rely on one another for different products and services, and therefore a rise in global GDP means a rise in international trade, and a rise in the frequency of people moving across borders.

Critics often comment that a rise in GDP often leads to a rise in oil prices, which can reduce the gains that airlines make when GDP is growing. This is true to a certain extent, but there are certain times when oil prices and GDP growth may not move closely at all. There can be cases where the economy may not be moving at all, but oil prices may be rising. In these cases, there is a supply-side problem, rather than demand causing a spike in oil prices. The shooting up of oil prices after sanctions on Iran is a prime example of such a case.

QE3

QE3 can be one such example, where the U.S. GDP may not move, but oil prices are certainly expected to rise, giving a hit to airlines. QE1 and QE2 did not work according to plan, and only caused a surge in prices. Therefore, they brought no real boost to the economy, as Jims Roger, a veteran U.S. investor, said about the Fed:

"They are a little bit embarrassed because they announced QE1 and QE2, and it did not work."

Oil prices, along with most commodities like gold and silver, surged after the QE3 announcement.

Airline Tactics against Fuel Prices

In order to address the problem of high exposure to oil prices, airlines have been using different techniques. Fare hikes, replacement of old fuel-inefficient planes and fuel hedging strategies have been employed to combat this problem.

For the last two years, various airlines have been slashing capacities and getting rid of old fleets. For instance, Delta Air Lines Inc (NYSE:DAL), US Airways Group (LCC), United Continental Holdings (NYSE:UAL), and American Airlines, a subsidiary of AMR Corp. (AAMRQ.PK), made the following cuts to their capacities:

In the context of hedging fuel prices, carriers use a combination of calls, swaps and collars, at varying crude oil prices, to hedge the fuel price hike.

Industry Overview and Future Outlook

The global Airline Industry is expected to earn $3 billion this year with a margin of 0.5%, according to the IATA. This is $500 million less than the earlier forecast given at the end of 2011. The reduction was made due to rising oil prices. The $3 billion is almost 62% less than the $7.9 billion in profits enjoyed by the industry in 2011, and down 82% from the $16 billion in profits in 2010. This shows the deterioration of profits in the industry.

US Airlines

September Outlook

September is considered to be a month of weak sales, as leisure trips fall sharply after summer vacations come to an end. As mentioned earlier, oil prices have made most analysts bearish on these stocks, and Wall Street has trimmed earnings for the rest of 2012, as well as the first half of 2013.

The growth rates in revenue have been declining. DAL reported that its increased revenue, which was up 15% YoY in January, shrunk to 5% in July. Similarly, a 9% rise in revenue for United Continental Holdings in January shrunk to zero in July.

According to Airlines for America, the U.S. trade association for the industry, traffic declined by more than 16% for seven big U.S. airlines in September, compared with August.

According to the analyst at the Bank of America Merrill Lynch, passenger revenue is expected to show a growth of less than 2% in the third quarter of the year compared with 9% and 6% for the first and second quarters.

Margins in August declined to negative 1.5% from 0.4% in the prior period. This happened because of an 8.2% rise in revenue, which had to cover a 9.4% rise in expenses, brought about by a 13% rise in fuel prices.

Future Outlook till 2030

U.S. airlines are expected to remain profitable in the next two decades, even though severe headwinds are expected to put pressure on margins till 2015. The FAA predicted that traffic will double by 2030, with small rises along the way. The demand is expected to rise by 2% to 746 million in 2013, and by 3% annually till 2024, eventually reaching $1 billion-$1.2 billion in 2032. In order to cater to this increase, North American airlines are expected to raise capacity (availability of seat miles) at an annual rate of 3.1%, reaching 1.89 trillion by 2032.

Revenue per available seat mile i.e. RASM, is expected to grow by an average of 3.2% each year till 2030. Total revenue passenger miles were 815 billion in 2011, and are expected to rise to 1.57 trillion by 2032.

According to the FAA, a technology by the name of Next Gen is being developed, which will make air traveling much more efficient in the future. Next Gen is an advanced satellite navigation system.

The prevalent average load factor of 78% is expected to remain stable over the years. However, it is highly variable through the course of a year, and can reach 86% in busy months like August.

Conclusion

The Airline Industry is an evergreen industry. People will always travel across borders, be it for leisure or for work purposes. However, it is fuel prices that can cause significant damage to the industry and can force companies like AMR to file for bankruptcy. There are certain opportunities that airlines can avail in order to grow more than the industry.

Ancillary revenues - Southwest Airlines (NYSE:LUV) is benefiting from unaccompanied minor programs, full fledge in-flight entertainment systems, and interior modernization. JetBlue Airways Corp. (NASDAQ:JBLU) is also making money through its "Even more Space" product.

Consolidation - American Airline is looking to merge with Alaska Air Group (NYSE:ALK), Frontier Airlines (a subsidiary of Republic Airways Holding (NASDAQ:RJET)), or LCC, in a bid to restore its profits

Expansion - Airlines can look to expand their international flights. Delta's deal with China Eastern Airlines is a prime example of such a scenario.

Technology up-gradation - This will lead to improved ticketing systems, which will reduce operating costs.

The final part of this series will include an analysis of different airline stocks.

Source: Drivers Of The U.S Airline Industry