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The troubled airline industry: impacts on plane makers and the U.S. economy.

SINCE 1970, the number of passengers handled by the world's airlines has risen more than three-fold, from 383 million in 1970 to more than 1.2 billion in 1992. When the length of each trip is taken into account, the growth in passenger miles flown has been even greater, rising from 286 billion in 1970 to more than 1,200 billion in 1992, a four-fold increase.

To meet this growing volume of air travel, airlines added to their fleets of planes and increased the average size and usage of their planes. Available seat-miles rose from 522 billion in 1970 to over 1,700 billion in 1991, a three-fold increase, while the average occupancy rate or "load factor" for all airlines rose from 55 percent in 1970 to 68 percent in 1991.

Not surprisingly, the rate and nature of this growth has not been uniform everywhere in the world. The U.S., which has the largest and most established air travel system, has grown somewhat less rapidly than areas that until recently have had less-developed air travel systems or have had above-average economic growth, such as Europe and Asia. Other areas, with relatively slower economic growth, have also had less rapid growth in their volume of air travel. The size and prosperity of the U.S., along with its pioneering role in air travel and aircraft manufacturing, have led to its position as the world leader in air travel, with much greater shares of world air travel than either world GNP or population. Its leading airlines, American, United, and Delta, are among the largest and financially strongest in the world. The largest U.S. airline, American, has about as many planes -- about 660 -- as the combined total of the three largest European airlines: Lufthansa, British Air, and Air France. Data compiled by the International Air Transport Association (IATA) indicates that U.S. airlines accounted for approximately 37 percent of world air passenger travel in 1991, little changed from the 38 percent they accounted for in 1970. Domestic air travel within the U.S. accounted for about 35 percent of total world air travel in both 1970 and 1991. The remaining 2 to 3 percent of the U.S. share is due to U.S. airlines' international routes. Some estimates show an even larger share for U.S. airlines.

Improved efficiency, service, and economies of scale, along with deregulation of domestic air fares and a growing U.S. economy, helped reduce the cost and increase the volume of air travel within the U.S. during most of the 1980s. Between 1980 and 1990, U.S. air travel (measured in passenger miles) rose at an average annual rate of about 7 percent. However, affected by the slowing in the U.S. economy, domestic air travel has been sluggish since late 1987. International travel on U.S. airlines declined in 1990 and 1991, affected by economic slowing around the world and by heightened security concerns associated with the conflict with Iraq, but began to recover in 1992.

Europe ranks next after the U.S. as a major air travel market, accounting for about one-fourth the world total in 1990, followed by Asia (including China, India, and Japan) with roughly 15 percent. From 1970 to 1990, passenger-miles on European airlines grew at an average annual rate of about 8 percent, as did those on Japanese airlines, reflecting the strong growth of the major economies of Europe and Japan. However, several areas with lower initial levels of air travel grew even more rapidly during the same period. Airlines in China and the rest of Asia excluding India grew at an annual rate of roughly 20 percent, while airlines in the Middle East grew an estimated 11 percent, and those in Latin America and India grew about 9 percent each. Non-U.S. airlines have been affected by the Persian Gulf conflict and by the world-wide economic slowing in 1991 and 1992 much the same as U.S. airlines.

Historically, air travel has been adversely affected by economic slowing as businesses and consumers tighten their purse strings until economic conditions improve. The pace of air travel then resumes once the economy returns to its normal growth path. Estimates differ about how soon and how much economic conditions in various countries will improve. However, most analysts generally agree that growth in worldwide air travel averages somewhere in the neighborhood of 2-1/2 to 3 percent above the average rate of economic growth. Thus, if the average economic growth rate in the 1990s is on the order of 2 to 2-1/2 percent, the average growth in air travel will be somewhere in the vicinity of 4 to 5 percent. That would be slower than the average rate between 1970 and 1990 but still substantial, requiring more and larger aircraft to be put in service as the decade proceeds.

The greatest increase in air travel is predicted for the Asian region and for air routes linking Asia with Europe and the U.S. Air travel in or linked to Asia is projected to grow an average of 12 percent or more annually in the 1990s and beyond. Transatlantic air travel between North America and Europe is projected to grow on average about 8 percent annually during the same period, while domestic air travel growth within the countries of North America and Europe is projected to be near the world average of 4 to 5 percent. Air travel growth in Latin America and Africa is similarly linked to economic growth rates in those regions.

The current slowing and the prospects for future growth create a "good news - bad news" situation for airlines and plane makers alike. How to pay for needed future aircraft when airline books are currently awash in red ink?

The U.S. aircraft industry is the leading international supplier of commercial transport aircraft, and has been since the emergence of commercial air travel in the 1930s. In the first three years of the 1990s, U.S. plane makers Boeing and McDonnell-Douglas built 71 percent of the commercial jet transports delivered to world airlines. Airbus, the European aircraft consortium, built most of the remaining jet transports. A small percentage was built by other planemakers in Europe and Asia. Just over 75 percent of U.S.-made jet transports are sold to non-U.S. airlines, with the balance sold within the U.S. U.S. airlines purchased about 12 percent of the planes built by Airbus and other non-U.S. builders. U.S. builders of jet engines similarly lead the world in providing state-of-the-art powerplants that produce increased fuel efficiency and lower noise levels. More than 60 percent of the jet engines produced in the first three years of the 1990s were built by U.S. builders or a consortium in which a U.S. firm plays a leading role.

Jet transports, engines, and parts are the leading manufactured exports of the U.S., totaling $34 billion in 1992, nearly 10 percent of U.S. manufactured exports. Net exports of jet transports and engines, after subtracting all non-U.S.-made parts and imported transports and engines, totaled $17 billion. Jet transport- and engine-manufactures in 1992 directly employed approximately 296,000 U.S. workers, plus thousands of additional workers employed by vendors and subcontractors throughout the country.

The projected growth in air travel in Asia and other areas outside the U.S. suggests that an increasing share of U.S. jet transport sales will be aimed at routes outside the U.S., whether served by U.S.-based or non-U.S.-based airlines. However, the airlines industry is currently going through a global structural transition as well as the current economic slowing, both of which affect the pace of aircraft purchases and production.

TRANSITION TO A GLOBAL AIRLINES INDUSTRY

The world's airline industry includes both privately owned and state-owned carriers. U.S. carriers are privately owned but most non-U.S. carriers are owned and controlled by their national governments. International flights and passengers are subject to a complex network of agreements between national governments, intended to provide uniform standards for international air travel and to protect national interests.

In the U.S., airlines have always been privately owned and operated. Until 1979 federal regulation controlled their schedules, routes, and prices, as well as various aspects of aircraft and crew safety, flight operations, licensing, and other forms of passenger protection. The "deregulation" of U.S. carriers in 1979 discontinued federal control over routes, schedules, and prices, and eliminated federal subsidies for service to smaller airports. The result has been a dramatic increase in price- and schedule-driven competition among U.S. air carriers on both domestic and international routes. Price competition has benefited air passengers with generally lower air fares but has also created serious financial strains on many U.S. airlines. A number of new carriers were started in the 1980s, offering significantly lower fares (and often, reduced amenities) than the established airlines. To preserve their markets, the established carriers had to reduce their fares. The result of these fare wars, in combination with market fluctuations in fuel costs, has been a drop in airline profits and a high rate of attrition among both the startups and the established airlines. Few of the startups have managed to survive, and all but a handful of the largest existing U.S. airlines have been consolidated into larger carriers, have ceased operations, or have sought Chapter 11 bankruptcy protection.

Plane makers have responded to these changes by designing and building a new generation of jet transports offering greater fuel efficiency, reduced maintenance, larger capacity, and other improvements to lower operating costs, reduce noise and pollution, and improve safety.

Increased competition among U.S. carriers and technical progress in jet transports is creating ripple effects around the world. State-owned "flag" or "sovereign" carriers are increasingly pressed to reduce costs and fares and upgrade aircraft to satisfy rising passenger expectations and technical requirements for improved safety, noise, and pollution controls. At the same time, they are often held back by policies and traditions that treat employment with the national airline as a guaranteed lifetime government job, and by rising government deficits. Maintaining a world-class national airline has also been seen by many countries as an essential element in demonstrating their "membership" in the modern industrial world. The larger international carriers, using the advantages of economies of scale and bargaining power based on their size, are able to achieve lower costs than are smaller carriers, including many "flag" carriers from smaller or less-developed nations. Faced with rising operating deficits and capital investment requirements to maintain the competitiveness of their "flag" carriers, a growing number of nations are deciding to reduce their airline operations or to "privatize" all or part of their airlines. This has led to numerous mergers and changes in ownership. For example, the Australian government recently sold a major share of its Qantas Airlines to British Airways; and Sabena, the Belgian "flag" carrier, sold a major interest to Air France. The Argentine government earlier sold a major share of its Aerolineas Argentinas to Iberia, the Spanish carrier. Similar consolidations and strategic alliances involving privately owned carriers are also occurring in the drive to cut costs and raise load factors. For example, American Airlines recently announced it will provide administrative operations for Canadian Air and buy one-third of its stock; and British Airways recently received U.S. government approval for purchase of one-fourth of the stock of USAir and limited sharing of flights. Air Canada has been exploring various potential teaming arrangements with U.S. and European carriers to help fund its recent losses and provide better future revenues. The results of all this restructuring include an increase in the "global" nature of international air carriers and a reduction in the total number of carriers. Though it is far from clear exactly what the new industry structure will ultimately be, or who the future industry leaders will be, it is increasingly evident that changes in markets, prices, and profits in one area of the world lead to changes and adjustments on a global basis. It is not possible today to isolate air carriers in one part of the world from changes in other parts of the world; similarly, U.S. aircraft manufacturers and their suppliers are affected by developments throughout this global economy.

IMPACT OF GLOBAL RECESSION ON TRAVEL AND AIRLINES

Since 1987, the world economy has been affected by a series of major changes that have reduced output and employment in several key regions, with corresponding adverse impacts on air travel, airline economics, and aircraft sales. In the U.S., an extended period of slow growth and economic restructuring has caused businesses and consumers to reduce both domestic and international air travel. In addition, in 1990-91 fear of terrorism associated with the conflict with Iraq prompted a virtual halt in international air travel between the U.S., Europe, and the Middle East, and to a lesser extent between these areas and some southeast Asian countries.

The political and economic liberation of the former Soviet bloc countries resulted in some rise in air travel between those countries and the West, but that has been offset by worsening economic conditions in those countries and, more recently, in Europe and Japan.

These slowdowns in growth -- in some cases actual reductions -- in passenger demand placed additional financial stress on both U.S. and foreign air carriers. U.S. carriers have sustained the largest and longest period of industry losses since World War II. Pan Am and Eastern, long-time major U.S. carriers, closed their doors after making major efforts to restructure. TWA and Continental, also long-time and well-known U.S. carriers, now operate under Chapter 11 protection and are struggling to restructure and survive.

In a weak market, financial difficulties are contagious. Per unit costs and cash flow depend on passenger volume, which depends largely on price. Weaker carriers try to protect their short-term cash flow and volume by setting their fares below their competitors, even if the fares don't fully cover their overhead costs. To protect their share of passenger volume, other carriers respond with fare cuts, which in turn weakens their profitability and cash position. As a result, losses of U.S. air carriers since 1990 have totaled over $10 billion, and bond ratings for even the leading carriers have recently been downgraded, further raising their costs of borrowing.

TIGHTER CREDIT FOR LEASE/PURCHASE OF AIRCRAFT

The slowdown in airlines industry growth comes at the same time that financial institutions are undergoing their own readjustments. World money center banks, which have been major lenders to airlines and leasing organizations, have tightened their purses as a result of major losses in real estate and other assets. Although loans for jet transports have traditionally been among the most solid financial investments, weakening airline profitability and the failure of several weak carriers has caused banks and other large investors to look more skeptically at new aircraft financing deals.

Credit has played a key role in the growth of the airlines and, consequently, in the sale of jet transports. Banks, lessors, plane makers, and investors have used a wide range of innovative methods for meeting the needs of the airlines industry, including various kinds of leases, equipment trust arrangements, manufacturer financing, foreign sales corporations, government export credit, and bank debt.

Financially stronger airlines rely more on bank borrowing and equipment trust arrangements, where they can generally obtain funds more advantageously because of their stronger credit rating. Smaller airlines, and those with less strong financial positions, generally must rely more on operating leases, which are more expensive than debt arrangements but don't appear as long-term debt on the firm's balance sheet. Government export credit, and credit provided by plane manufacturers, are parts of virtually every international plane sale, often playing a decisive competitive role in determining which manufacturer gets the order. Purchase and lease deals are typically complex, custom-tailored combinations of bank debt, manufacturer credit, third-party investors, lessors, and other elements included to minimize taxes and borrowing costs. The increase in jet transport orders and deliveries in recent years has been accompanied by a corresponding rise in the debt and lease service level of the air carriers. The mix of borrowing and leasing makes it difficult to measure the actual level at any point in time, especially for non-U.S. carriers. However, industry analysts note that for U.S. carriers, which are among the world's strongest, the ratio of total debt to total capital rose from below 60 percent in the mid 1980s to more than 85 percent at the end of 1990, and it has continued to rise since then as operating losses have grown.

The International Air Transport Association estimates that interest charges of all airlines have more than doubled since the mid 1980s and total $3.4 billion in 1992. To cover this amount of interest, carriers must achieve an average operating profit of 4 percent, far above the recent level. Other industry analysts estimate airlines capital outlays totaled more than $190 billion during the period from 1980-90 while airlines net cash flow was nearer $75 billion, resulting in a $115 billion gap covered through a combination of debt and lease arrangements. Based on current projections for world passenger growth from 1991-99, some analysts project airlines' capital needs in excess of $460 billion compared to projected net cash flow of roughly $200 billion during the period, leaving a "funding gap" on the order of $260 billion.

It is not necessary to accept the accuracy of these estimates to recognize that airlines will have to overcome serious financial hurdles if they are to position themselves to survive and compete effectively in the world travel markets of the 1990s.

While the capital and credit needs of the air carriers continue to rise, the sources that principally satisfied those needs in recent years offer dimmer prospects for the future. Major world money center banks, many of which actively supported aircraft deals in the 1980s, are contending with their own needs to increase capital to satisfy rising regulatory standards. Some have also been stung by losses tied to airline failures, aircraft lease cancellations, real estate deflation, and generally weak economic conditions. The failures of Eastern, PanAm, and Midway Airlines in 1990 affected loans and leases on some 390 aircraft operated by those carriers. In addition, the market for previously owned transports has been weakened by a rise in the number of aircraft sidelined due to age, obsolescence, or industry cutbacks. While most of these used aircraft are not economically competitive with newer models, their existence does make potential investors nervous about accepting aircraft as collateral on loans and adversely affects the market rental value of leased planes. The major Asian banks, notably those in Japan, have been a major source of financing for both loans and leases. However, Japanese banks have been especially hard hit by losses related to the rapid decline in real estate values in that country; and the prospects of their continuing as major participants in aircraft finance for non-Japanese firms are greatly curtailed for the next several years.

The attractiveness of investments in aircraft leasing has also been diminished by highly publicized financial difficulties of GPA Group, the leading international lessor, based in Ireland. Although several other major aircraft leasing organizations have not had similar problems -- for example, another leading lessor, ILFC, is apparently doing well and has placed sizable orders for new planes from Boeing and Airbus -- the large number of airlines, financial institutions, and investors affected by GPA's difficulties has added yet another cloud to the financial horizon for airlines and plane makers. Government tax and export credit provisions have often played a pivotal role in the cost and availability of aircraft financing arrangements. Export credits and guarantees provided by the Export-Import Bank often make the difference between whether a sale is made and whether the sale goes to a U.S. or non-U.S. firm, especially where airlines from less industrialized nations are involved. Other tax-related incentives, including foreign sales corporations, largely depend on the availability of corporate profits that can be partially shielded from taxation by special handling. With both corporate profits and government revenues in more limited supply than in the 1980s, the financial significance of such provisions is likely to be reduced.

Financial assistance from U.S. and European plane makers is also a critical competitive factor in deciding which builder makes a sale, but the slowing in both commercial and military sales and the overall reduction in credit availability puts added constraints on plane makers' ability to offer more credit.

IMPACTS ON U.S. PLANE MAKERS, SUPPLIERS, AND COMPETITORS

Faced with sluggish passenger growth, continued losses, and tighter credit conditions, air carriers have cut all but immediately essential outlays. The result has been a decline in the number of orders for new planes placed in 1991 and 1992 and an increase in the number of delivery delays and deferrals negotiated on existing plane orders by both carriers and leasing firms. Sales of parts and spares have also declined sharply, especially impacting engine manufacturers. For the most part, the delays on previously ordered U.S.-built planes affect deliveries planned in 1994 and future years. However, because of the impact on parts and spares consumption and the lead time involved in producing large aircraft, the effects of the slowdown already are apparent in the form of reductions in production employment and orders from suppliers.

Though the pace of aircraft orders is affected by many factors, in this case by a weak economy and special factors in the airlines and finance sectors, much of the current slowing in new plane orders has been anticipated for several years by the manufacturers and by industry analysts. The jet aircraft business, like other capital goods businesses, has cyclical ups and downs. A similar cycle in commercial jet sales occurred in the early 1980s but was somewhat masked by a concurrent rise in military purchases. It was followed by a record-setting surge in jet transport sales and production in the late 1980s. The current cycle is occurring at a time when military purchases are declining, so the effects on workers and suppliers are even more apparent.

Orders being placed now for new planes will not be delivered until 1995 and beyond. As a result of this long lead time required for building jet transports, a significant upturn in jet transport production before 1996 seems unlikely at this point. If the global economy recovers soon with a strong surge in air travel, aircraft production could begin accelerating again by 1996. If the global economy recovers more slowly, with slower growth in air travel, acceleration in aircraft production will take longer.

The near future will require tight control and tough choices by U.S. plane makers. Cut back too little and face serious losses now. Cut back too much and face higher future costs for rebuilding workforce and supply lines when orders improve, plus raise the risk of missing future sales. Since early 1992, Boeing and McDonnell-Douglas have made or announced significant cutbacks in production and employment, as has engine builder Pratt & Whitney, amounting to over 40,000 production jobs. Further cutbacks may yet be required if the situation does not soon begin to improve.

Suppliers are widely spread throughout the economy and therefore their job losses are difficult to measure; however, based on industry data compiled by the Census Bureau and the U.S. Department of Commerce, about 51 cents of every dollar from U.S. aircraft sales goes to pay outside suppliers and 39 cents goes to pay workers within the industry. Thus, job losses among suppliers probably equal or exceed job losses within the industry. Electronics, communications, instruments, and fabricated metals are the leading vendor-supplied hardware items, collectively accounting for about 20 percent of outlays to suppliers; however, business and professional services are the largest single vendor-supplied item, amounting to roughly 8 percent of total outlays to suppliers.

The impact of airline losses and reduced aircraft orders has been reflected in the decline in share prices for airlines and plane makers. As future prospects are constantly reevaluated by the market and by industry analysts, share prices will respond accordingly. Investors have a widely recognized tendency to overreact to changes in industry fundamentals, often turning overly pessimistic in a slowdown and overly optimistic in an upturn. While the current situation in the airline and aircraft industries requires changes in plans and adjustments in spending and employment, it is important to recognize that the longer term outlook for world air travel, which undergirds them both, indicates continuing solid growth well into the next century.

The decline in aircraft orders further intensifies competitive pressures among plane makers. Not only are price and financial terms key elements in the competition among plane makers, but also technological and design enhancements that help raise the operating efficiency and productivity of the airlines which buy them. Among the most important design enhancements are those that lower fuel consumption, reduce maintenance time and costs and raise the productivity of air and ground personnel. The three leading plane makers -- Boeing and McDonnell-Douglas in the U.S. and Airbus in Europe -- are continually seeking to develop new and improved design enhancements to strengthen their individual competitive positions.

International sales to government-owned airlines often depend in addition on the value of various "tie-in" arrangements of special interest to the buyer-government, which the competing sellers may be encouraged to offer. These vary widely in nature, depending on the needs and interests of the buyers. Tie-ins that assist the government with its domestic economic development through the purchase of local products and services or through local investments are among those most frequently sought. However, regardless of their specific nature, these tie-ins reflect the intense level of competition for aircraft sales in the international marketplace.

The competition for continuing technological improvements and design enhancements highlights the importance of strong, strategic, market-driven R&D in the jet aircraft industry. U.S. plane makers have captured and held their present world leadership position in market share because they have continually maintained a high level of investment in strategic R&D. Corporate R&D has been bolstered -- and sometimes preceded -- by fundamental research at U.S. universities and pioneering R&D at government-funded U.S. research centers. It is important that this public-private R&D collaboration be maintained, particularly during this period when both corporate and government budgets are under severe stress, to provide a continuing foundation for U.S. competitive leadership in the aircraft industry.

U.S. plane makers also face increased pressures from foreign buyers for substantial coproduction and subcontracting arrangements, well beyond the level of traditional tie-ins. The challenge, both for U.S. planemakers and policymakers, is to find and maintain the right balance between long-term technological and strategic advantage and shorter-term competitive and cooperative realities.

In the short run, the slowdown in U.S. aircraft exports will complicate U.S. efforts to trim the trade deficit and create jobs. If sound policy choices emerge during this transition period, the prospects for continued U.S. leadership in aircraft manufacturing will be excellent, with major benefits for the U.S. economy. On the other hand, if U.S. government and industry leaders act as adversaries rather than partners in this matter, the potential of the U.S. aircraft industry to create jobs and boost international trade is likely to be greatly impaired.

In April 1992 a National Commission to Ensure a Strong Competitive Airline Industry was appointed by President Clinton and instructed to hold hearings and make recommendations by mid-August 1993. Witnesses appearing before the Commission -- including industry leaders, consultants, consumer and labor leaders, and legislators -- urged a wide range of measures from domestic airline reregulation to federal tax roll-backs, but no clear-cut consensus emerged from the hearings and the Commission was still working on its recommendations when this article went to press.

FOOTNOTE

1 This article is condensed from a lengthier policy study with the same title published by the Aerospace Industries Association in June 1992.

Robert D. Shriner is Managing Partner of Shriner-Midland Co., Falls Church. VA.
COPYRIGHT 1994 The National Association for Business Economists
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Author:Shriner, Robert D.
Publication:Business Economics
Date:Jan 1, 1994
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