Airline CFO: Plenty of Chop

Post 9/11, some airline finance chiefs wonder whether the industry's business model has changed forever.
Craig SchneiderJuly 9, 2002

If you want to see what’s happening to the airline industry, look at the phone business. Following deregulation, the telecommunications sector was flooded with new players — players who were quite willing to lose money to gain market share. That undivided focus on market share, plus concerns about unused assets, forced service providers to lower costs again and again and again. Ultimately, the price war led to ridiculously low phone rates, with long-distance rates plummeting to ridiculously low rates. It’s hard to make money at three cents per minute.

Airline CFOs know the feeling. “It’s a tough industry in the best of times,” grants Jeff Misner, finance chief at Continental Airlines.

The last year hardly qualifies as the best of times for airline CFOs. Misner himself boarded Continental as finance chief just a few months after the disastrous events of Sept. 11. With airports shut down for four days, Misner says, “the whole focus shifted from shareholder return to liquidity.”

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To be sure, finance chiefs at major airlines have always faced daunting challenges — challenges unrelated to terrorism in the skies. Since jets tend to cost a lot of money, CFOs must work to keep cost of capital as low as possible. Finance chiefs must also negotiate with well-organized and powerful labor unions. Further, they must ensure that flight and safety rules are met (and those rules have become more onerous post 9/11).

For many carriers, running an airline has become a decidedly low-margin, high-volume business. “It’s like an accounting business with wings,” says one industry observer. “Shaving a few pennies off every mile flown can make the difference between profit and loss.”

Skies Not So Friendly

Of late, it’s been mostly losses for airlines. UBS Warburg airline analyst Samuel Buttrick predicts the industry will lose $5 billion this year, followed by a $1 billion loss in 2003, with profits unlikely until 2004. In his report, he cites a “less robust revenue environment” amid industry cost cutting.

Airline shareholders have taken a beating, too. The AMEX Stock Exchange Airline Index is off 45 percent from its March highs and is now below post-Sept. 11 lows.

Things may not get much better next year, either. Deregulation has substantially lowered the barriers to getting into the flight game. And with a lot of spare equipment on the market — spare equipment that doesn’t hold its value — Misner says just about anyone with the financial means could come in, “buy a couple 727s, and mess up the revenue side of the equation.”

Not surprisingly, finance chiefs at major carriers are paying closer attention these days to competitors looking to encroach on their turf. Consider the growing market share of Southwest Airlines, an upstart just a few years back. This year, JetBlue Airways hit the runway.

In fact, low-cost carriers account for 20 percent of the U.S. domestic marketplace. “Before, when they accounted for five percent or 10 percent, they would be in two or three of markets,” Misner notes. “Because of the competitive industry, they would set the pricing. As they continue to get a larger presence, you have to address those markets.”

Such initiatives may be easier said than done. Typically, low-cost carriers operate under different cost structures than established airlines. Southwest and JetBlue, for example, don’t provide seat reservations, transfer luggage from one carrier to another, or serve meals. With a reduced overhead, the carriers are able to set lower prices than major carriers.

For his part, Misner still insists there are customers out there willing to pay a premium for a higher level of service. But with U.S. airlines struggling just to fill seats, he’s left with some tough questions. “How do we effectively price that?” he asks. “How do I restructure my ledger to realign with the revenue out there?”

Continental’s competitors may provide the answer. With the advent of online booking and electronic reservation systems, an airline CFO knows immediately when a competitor lowers the price of a flight. Lagging behind on lower fares can translate into a whole lot of empty seats. “You’re limited in your ability to set prices,” Misner concedes. “The industry moves together or not at all.”

Flying Lazy Circles

Right now, what the industry seems to be moving toward is a new business model: that of low-cost, low-fare service. Even major carriers have gone that route. Several airlines, including Continental, Delta and American, have launched no-frills regional service.

Whether major carriers expand their regional operations remains to be seen. A big financial commitment to the low-fare model — including smaller, more fuel-efficient planes — could bomb if the economy picks up unexpectedly. “Which of those two directions are we going to have to head?” Misner wonders. “You don’t want to make a decision one way if the economy turns out to be going another.”

In the meantime, airline CFOs will continue to hoard capital. Misner’s new liquidity goal is to carry a $1.5 billion cash balance by the end of 2002.

He’s getting there. In December, the company raised $175 million in a shelf offering, then another $200 million in a convertible debt deal in February. Then, in April, Continental sold 47 percent of its Express Jet regional subsidiary. Minus banking fees, the initial public offering raked in about $450 for the company.

The U.S. government has kicked in as well, funneling about $400 million to the nation’s fifth-largest carrier following the Sept. 11 terrorist attacks. Indeed, the government’s airline industry aid package consisted of $5 billion in cash and $10 billion in loan guarantees.

To date, America West is the only carrier to apply for and receive loans from the U.S. loan guarantee program. Why so few takers? The program is essentially a debt-for-equity swap, and America West had to give up about a third of the company’s equity (in options) to Uncle Sam.

Continental’s CFO says he will be looking to avoid the loan guarantee program. “It’s almost to some extent like a bankruptcy filing,” he explains. “You put everything out there, and everyone divvies it up.”