Fitch Ratings: War's Impact On Major U.S. Airlines Far-Reaching.

Business Editors

CHICAGO--(BUSINESS WIRE)--March 28, 2003

Following the start of the war in Iraq, U.S. airlines are again facing a period of heightened uncertainty regarding future revenues, volatile fuel costs and accelerating cash losses. Based on the initial responses of the U.S. major carriers to a rapidly changing operating environment and information gathered regarding booking trends, Fitch Ratings is providing this preliminary assessment of the near-term financial impact of the Iraq war on the top seven U.S. airlines and an opinion on the possible make-up of a government assistance package now being debated in Washington. An accompanying press release ('Fitch Ratings: Airline Credit Concerns Compounded by War') provides airline-specific summaries of the financial condition of each of these seven carriers and a review of the war's impact on each individual credit profile.

The largest single risk related to the war in Iraq is the dramatic fall-off in passenger traffic - particularly on international routes - that is currently clouding the airlines' short-term revenue and cash flow forecasts. Initial reports from the major carriers suggest that system-wide bookings and traffic in the first four to six weeks of the war are likely to fall by 15% or more in comparison to year-earlier levels. On the international side, traffic declines of more than 30% can be expected to persist through at least the end of April, mirroring a trend seen after the start of the Gulf War in 1991. Both Atlantic and Pacific demand appears to have quickly weakened in response to the war, and a perceived heightening of terrorism risk among international passengers. Of the international destinations served by U.S. network carriers, Latin American markets may hold up somewhat better. However, traffic in this region has already been eroded badly as a result of macroeconomic weakness in South America. In domestic markets, early reports indicate that bookings and traffic could fall by 10% or more in the first few weeks of the war.

Particularly on international routes, where demand has fallen the most, the U.S. network carriers have announced plans to adjust capacity levels in the coming weeks in an effort to re-balance supply with demand. Most of the schedule changes are occurring in the form of reduced international frequencies rather than outright cancellation of city pair service. This will provide opportunities to add back capacity more effectively should demand patterns firm somewhat in the summer. In addition, capacity adjustments are being optimized through cooperation between the U.S. majors and their international code-share alliance partners. Announced reductions in April available seat mile capacity for the major international carriers are in the range of 6% to 12% on a year-over-year basis.

Based on expected traffic patterns in April and the implementation of announced industry capacity cuts, Fitch estimates that the April cash flow impact of the war on the seven largest U.S. carriers will be in the range of $600 million to $700 million. A gradual recovery in demand in May and beyond is likely, but the timing of any rebound will be highly sensitive to the pace of the military campaign in Iraq and the appearance of any war-related terrorism.

Beyond war-related demand effects, jet fuel prices remain highly volatile as a result of uncertainty over the course of the war in Iraq. While early progress in securing Iraq's Ramallah oil fields quickly pushed crude oil and jet fuel prices down from their high pre-war levels, the airlines continue to face the risk of rapid price spikes until the security of Iraqi crude oil supplies is ensured. Fuel hedging policies have assumed greater importance in recent weeks as jet fuel prices soared prior to the start of the war. The hedging approaches of the major carriers vary widely, ranging from complete or near-complete 2003 hedges (Southwest and Northwest) to a total absence of hedging (United).

For all of the major U.S. network carriers the demand and fuel price shocks tied to the war complicate the task of returning to positive operating cash flow and better liquidity positions in 2003. Even before the risk of war and spin-off terrorism grew in February and early March, the U.S. majors were facing a sluggish revenue environment characterized by persistent weakness in passenger yields, a poor business/leisure fare mix and lingering overcapacity--particularly in the domestic network. In addition, the growth of low-cost carrier competition has prompted each of the network majors to initiate aggressive cost-cutting efforts aimed at realigning bloated operating costs with a sharply diminished revenue base. As the degree of overlap with low-cost carriers has grown, so too has the intensity of efforts to lower unit labor costs to levels much closer to those seen at low-cost airlines like JetBlue, AirTran and Southwest.

The dim outlook for a meaningful recovery in industry unit revenue during 2003 comes at a time when all of the major airlines (excluding Southwest) have excessive levels of leverage in their capital structures and generally lack the cash flow generation capacity to service fixed financing obligations (principal and interest payments, aircraft and facilities rents and required cash contributions to defined benefit pension plans). In the absence of industry restructuring, perhaps precipitated by the liquidation of United, major network airlines are unlikely to return to profitability and strong cash flow without deep cuts in operating expenses.

For all of the network carriers, liquidity preservation is the single most important financial objective in 2003. The need to focus on cash balances has been reinforced by the absence of significant unencumbered assets (particularly late-model aircraft) that could be pledged as collateral in future debt transactions. Without access to the capital markets, all of the network majors (with the possible exception of Delta) are wholly reliant upon improvements in operating cash flow to sustain acceptable cash levels on their balance sheets.

The heightened uncertainty over the impact of the war has once again pushed the airline industry to the front of the public policy agenda in Washington. Concerns over the potential impact of a Chapter 7 liquidation of United Airlines and a near-term Chapter 11 filing by American Airlines have led to discussions over the size and scope of a new industry relief package in the Bush administration and on Capitol Hill. Although industry relief funding was excluded from the supplemental war appropriations measure submitted by the White House this week, it appears likely that some limited form of government assistance for the airlines will gain congressional and administration approval over the next few weeks. This package would probably include a roll-back of certain taxes, fees and unfunded federal security mandates that the U.S. airlines regard as an unfair financial burden at a time of industry crisis. An extension of government backstop support on terrorism insurance also seems likely at this time.

The larger question for the industry is whether or not a broader program of government cash support - possibly in the form of a re-opened federal loan guarantee program or a funding of fuel cost rebates as envisioned in legislation now being considered in the House of Representatives - has sufficient support in Washington. Given the industry's recent public statements on this issue (articulated by the Air Transport Association on March 11 and 26), most major carriers seem to be opposed to a re-opening of the loan guarantee program. Senior management at both American and Delta has expressed concerns about adding more debt to their balance sheets in the form of government-guaranteed loans. More critically, however, solvent airlines can be expected to oppose any form of government assistance that would provide immediate cash to United, thereby delaying a Chapter 7 liquidation that could occur as early as June. The fuel rebate plan envisioned in the legislation proposed by Rep. James Oberstar (D-MN) would represent the type of across-the-board cash support that might benefit United disproportionately in light of that airline's inability to hedge against fuel price swings.

Any government assistance measures targeted at easing the fuel cost burden on the major airlines may in fact be misplaced now, as much of the war risk premium built into pre-war oil prices has evaporated. A tapping of the Strategic Petroleum Reserve, for example, appears unlikely with crude oil prices below $30 per barrel and diminishing risks of long-term disruption in Iraqi crude supplies.

Fitch believes that a more limited industry assistance plan, aimed primarily at easing the burden of security on the major airlines, stands the best chance of receiving bipartisan support in Washington. Absent the impact of a major federal liquidity infusion that might provide a cash buffer for United in its effort to restructure under Chapter 11 protection, it is difficult to see how a more modest assistance package could offset the impact of a new airline operating environment that appears to be pushing the industry inexorably toward restructuring and consolidation. Reflecting upon the ineffectiveness of the September 2001 government assistance package in establishing a solid foundation for financial recovery, the approval of a similarly ambitious war relief package in 2003 appears highly unlikely.

For company-specific assessments of the war's impact on the seven largest U.S. airlines, see the accompanying press release, 'Fitch Ratings: Airline Credit Concerns Compounded by War', available on the Fitch Ratings web site at 'www.fitchratings.com'.