Industry Surveys Jim Corridore, Industrials Sector Equity Analyst

DECEMBER 2014

Current Environment ...... 1

Industry Profile ...... 13

Industry Trends ...... 14

How the Industry Operates ...... 24

Key Industry Ratios and Statistics ...... 33

How to Analyze an ...... 35

Glossary ...... 41

Industry References ...... 43

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Topics Covered by Industry Surveys

Aerospace & Defense Electric Utilities Metals: Industrial Airlines Environmental & Waste Management Movies & Entertainment Alcoholic Beverages & Tobacco Financial Services: Diversified Natural Gas Distribution Apparel & Footwear: Foods & Nonalcoholic Beverages Oil & Gas: Equipment & Services Retailers & Brands Healthcare: Facilities Oil & Gas: Production & Marketing Autos & Auto Parts Healthcare: Managed Care Paper & Forest Products Banking Healthcare: Pharmaceuticals Publishing & Advertising Biotechnology Healthcare: Products & Supplies Real Estate Investment Trusts Broadcasting, Cable & Satellite Heavy Equipment & Trucks Restaurants Chemicals Homebuilding Retailing: General Communications Equipment Household Durables Retailing: Specialty Computers: Commercial Services Household Nondurables Semiconductors & Equipment Computers: Consumer Services & Industrial Machinery Supermarkets & Drugstores the Internet Insurance: Life & Health Telecommunications Computers: Hardware Insurance: Property-Casualty Thrifts & Mortgage Finance Computers: Software Investment Services Transportation: Commercial Lodging & Gaming

Global Industry Surveys

Airlines: Asia Foods & Beverages: Europe Pharmaceuticals: Europe Autos & Auto Parts: Europe Media: Europe Telecommunications: Asia Banking: Europe Oil & Gas: Europe Telecommunications: Europe Food Retail: Europe

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S&P CAPITAL IQ INDUSTRY SURVEYS (ISSN 0196-4666) is published weekly. Redistribution or reproduction in whole or in part (including inputting into a computer) is prohibited without written permission. To learn more about Industry Surveys and the S&P Capital IQ product offering, please contact our Product Specialist team at 1-877-219-1247 or visit getmarketscope.com. Executive and Editorial Office: S&P Capital IQ, 55 Water Street, New York, NY 10041. Officers of McGraw Hill Financial: Douglas L. Peterson, President, and CEO; Jack F. Callahan, Jr., Executive Vice President, Chief Financial Officer; John Berisford, Executive Vice President, Human Resources; D. Edward Smyth, Executive Vice President, Corporate Affairs; and Lucy Fato, Executive Vice President and General Counsel. Information has been obtained by S&P Capital IQ INDUSTRY SURVEYS from sources believed to be reliable. However, because of the possibility of human or mechanical error by our sources, INDUSTRY SURVEYS, or others, INDUSTRY SURVEYS does not guarantee the accuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information.

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CURRENT ENVIRONMENT

Sharp drop in oil prices bode well for profit outlook

Since September 2014, global oil prices have fallen dramatically, with West Texas Intermediate (WTI) crude reaching a level below $70 a barrel in early December. This sharp decline in oil prices is likely to drive significantly lower jet fuel costs for the industry for the fourth quarter of 2014 and into 2015, in our view.

The US airline industry has transformed itself over the past 10 years, through mergers and restructurings, bankruptcies, and dissolutions. During this time, airline executives have also changed their focus from a “market share at all costs” mentality to one based on obtaining and preserving profitability, along with a focus on improving return on invested capital. However, undercutting all their hard work is one variable they can do little to control: the price of oil. FUEL COSTS & CONSUMPTION Such prices were volatile in 2012 and 2013. In (Major US airlines, domestic operations) June 2014, the International Air Transport 1,400 420 Association (IATA), a coalition of some 260 airlines throughout the world, had forecast that 1,300 360 Brent crude oil prices would average $108 per 1,200 300 barrel in 2014, compared with the $108.80 per 1,100 240 barrel average in 2013. However, very few Chart H01: FUEL people could have predicted the sharp decline in 1,000 COSTS & 180 oil prices since that time. 900 CONSUMPTION 120 Sharp decline in prices 800 60 After peaking at a record high of $147.27 a 700 0 barrel on July 11, 2008, WTI oil prices receded 2004 05 06 07 08 09 10 11 12 13 2014* sharply. In 2009, oil averaged $61.95 a barrel, Consumption (millions of gallons; left scale) down 58% from the record high, and down Price per gallon (in cents; right scale) 39% from the average oil price of $99.67 a *Data through August. Source: U.S. Bureau of Transportation Statistics. barrel in 2008. In 2010, prices bounced back, averaging $79.48 a barrel for the year, up 28% from the 2009 average. The average for 2011 increased 19% to $94.88 a barrel. In 2012, oil prices were volatile, hitting a high of $109.39 a barrel on February 24, but then declining on worries about the economy; on June 28, prices hit a low of $77.72 a barrel. According to the US Energy Information Administration (EIA), the price for WTI oil averaged $97.91 a barrel in 2013, up 4% from the prior year. The EIA expects WTI oil prices to average $97.72 and $94.58 a barrel in 2014 and 2015, respectively.

Year to date through November 3, 2014, Brent crude oil prices averaged $104.40 a barrel, down 3.7% compared with the same period last year, according to the EIA. On November 4, Brent crude hit a four-year low, almost $82 a barrel, after Saudi Arabia cut the price of oil sold to the US, according to BBC News.

In our view, the sharp decline in prices will be a tailwind to 2015 earnings. In addition, marginal routes could become profitable, which could lead to extra capacity. However, reckless capacity additions could put industry recovery at risk, as overcapacity will limit potential fare increases.

The spot price of domestic jet fuel reached a record high of $4.32 a gallon on July 3, 2008, double the year- earlier level. According to the US Bureau of Transportation Statistics (BTS), a division of the US Department of Transportation (DOT), the price of domestic jet fuel averaged $1.90 a gallon in 2009, 56.0% below the record high. In 2010, domestic jet fuel averaged $2.27 a gallon, up 19.5% from the average for 2009; in 2011, it averaged $3.06 a gallon, up 34.8% from the average for 2010; and in 2012, jet fuel averaged $3.19 a gallon, up 4.2% year over year. In 2013, jet fuel averaged $3.05 a gallon, down 4.4% year over year. Through August 2014, jet fuel averaged $3.01 a gallon, down 1.6% year over year.

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 1

Domestic jet fuel usage has declined since 2009, based on airlines’ reduced overall capacity levels and the retirement of the oldest, least fuel-efficient aircraft in their fleets to facilitate the capacity reductions. Some of the financially stronger airlines restarted their hedging programs to protect themselves from any upward trajectory in oil prices. These programs should allow them to lock in recent lower prices for at least a portion of their intended fuel usage over the next couple of years. However, we think that most airlines are poorly hedged and are unprepared if oil prices spike sharply.

As oil prices have risen over the past four years, they have become increasingly volatile. Reasons for this increased volatility include geopolitical uncertainties; the Ukraine crisis; concerns about the nuclear ambitions of Iran and North Korea, and about how the US and the rest of the world will address those ambitions; high oil consumption in the US, India, and China; concerns about supply disruptions in Russia, Nigeria, Venezuela, and the Middle East; and fluctuations in the value of the US dollar versus other currencies. Though we think that the US has ample supplies of oil at present, and that prices have already factored in much of the geopolitical turmoil around the world, it is easy to make an argument to the contrary, considering the growing demand in Asia, and the ongoing risk of supply disruptions in the Middle East and elsewhere. For these reasons, we expect oil prices to remain extremely volatile and move in much larger swings than they have in the past.

US production has started to move the oil market According to the EIA, US crude oil production reached 2.7 billion barrels in 2013, up 12.5% from 2.4 billion barrels in 2012. For the first eight months of 2014, crude oil production totaled 2.0 billion barrels, an 11.1% increase from 1.8 billion barrels in the same period in 2013. In September 2014, total US crude oil production averaged an estimated 8.7 million barrels per day (bbl/d), the highest monthly production since July 1986. In October, the EIA projected that total crude oil production, which averaged 7.4 million bbl/d in 2013, would average 9.5 million bbl/d in 2015—the highest annual average crude oil production since 1970, if realized.

Paying Brent prices for crude oil, instead of WTI prices Other factors adding to the rising fuel problems for airlines are the increasing use of Brent pricing as a benchmark for crude oil and its higher cost vis-à-vis the price of WTI crude oil. Brent crude, which is a light sweet crude oil sourced from the North Sea, has increasingly gained popularity over WTI as an indicator of global oil prices. Though considered slightly inferior to WTI, Brent enjoys the advantages of better shipping flexibility and better access to international markets.

WTI’s role as an international oil benchmark came into question in 2011 after a backlog at its delivery point of Cushing, Oklahoma, caused it to disconnect from the global market, pushing the price difference between the two benchmarks up to a record $28.00 a barrel. Because of this difference in price, the number of Brent contracts traded rose, while the number of WTI contracts traded declined. In 2013, however, the difference narrowed, and the number of Brent contracts traded declined, and WTI contracts traded rose.

Since jet fuel prices are usually based on the Brent price plus the refining spread, fluctuations in Brent price matter. Since 2013, the average Brent premium has fluctuated, posing a threat to airlines. As of January 2013, the average monthly Brent premium over WTI crude oil stood at $18.2 a barrel, according to data from the EIA. By July, the spread between Brent and WTI had fallen to $3.26 a barrel. As of September 2014, the spread stood at $3.88 a barrel.

“Crack spread” has narrowed In addition to the price of oil, airlines have another factor to contend with when figuring the cost of fueling their planes: the “crack spread.” This measure—the cost difference between a barrel of oil and a barrel of refined jet fuel—has traditionally hovered somewhere between $5 and $10; that is, jet fuel costs $5–$10 a barrel more than crude oil. However, in the aftermath of Hurricanes Katrina and Rita in 2005 (which devastated oil and natural gas production in the Gulf of Mexico and shut down about a third of US refining capacity), that spread widened to about $60 a barrel, exacerbating the difficulties the industry was then facing, and it remained well above historical levels through 2008. In 2009, partly related to the decline in demand for jet fuel, the crack spread narrowed back toward its historical range, averaging $7.94 for the

2 AIRLINES / DECEMBER 2014 INDUSTRY SURVEYS year. The crack spread widened again in subsequent years, averaging $10.78 in 2010 (up 36% from 2009), $31.10 in 2011 (up 188% from 2010), and $34.30 in 2012 (up 10% from 2011). However, in 2013, the crack spread dropped to $24.68, according to Airlines for America (A4A). Should there be another major supply disruption, the crack spread could easily widen further.

Fuel costs could fall if oil prices stay stable According to a compilation by S&P, fuel costs absorbed about 33% of total airline revenues in 2013, up from 32% in both 2012 and 2011, 26% in 2010, and 25% in 2009, but down from 36% in 2008. In contrast, fuel costs totaled 15% in 2003. S&P expects fuel costs to account for about 32% of airline industry revenues in 2014.

According to the A4A, the airline industry’s trade group, each penny rise in the price of a gallon of jet fuel costs the industry $190 million to $200 million, assuming industry consumption of between 19 billion and 20 billion gallons a year. Airlines’ average jet fuel costs were 43% lower in 2009 than in 2008. In 2010, however, average jet fuel prices rose 18% from the average of 2009. In 2011, jet fuel prices rose 28% from the average of 2010, and in 2012, the average price rose by nearly 3% from the average of 2011. In 2013, the trend shifted, and the average jet fuel cost declined 4.4%. For 2014, we see jet fuel costs falling about 10%, largely on lower prices.

While there is little certainty in predicting the direction of future oil prices, and while the recent drop in oil has been dramatic and unexpected, S&P thinks it is highly unlikely that oil will recede to its historic trading range (near $30 per barrel). For US airlines to be successful, they must find ways to offset higher fuel costs, either with revenue increases (including the addition of new revenue sources), or by cutting costs in other areas. However, the latter may be difficult. After several years of industrywide cost cutting, much of the low-hanging fruit has already been plucked, and in our view, further meaningful cost cuts will be more difficult to attain.

US AIRLINES REPORT RECORD PROFITABILITY

At the end of the third quarter of 2014, some US airlines showed record-high earnings per share (EPS). For instance, Group Inc. reported third-quarter EPS of $1.28, an increase of 25.5% from the third quarter of 2013. Inc. reported EPS of $2.37 in the third quarter, a leap of 141.8% from the same quarter last year. For the first nine months of 2014, American Airline’s total EPS was $3.10 and United Airline’s total EPS was $2.84, up 76.9% and 147.0%, respectively, from the prior-year period.

US airlines also showed strong cash flow generation. For the first nine months of 2014, American Airlines generated $2.3 billion cash from operating activities, up 21.1% from $1.9 billion in the same period in 2013, while United Airlines generated $2.7 billion, up 50.0% from $1.8 billion. Similar to other companies, airlines use cash from operating activities to pay down debt, repurchase stock, and pay dividends. Year to date through the end of the third quarter, American Airlines spent $2.8 billion for payments of long-term debt and capital leases, $155.0 million for stock repurchases, and $72.0 million for dividend payments. United Airlines paid a long-term debt of $2.0 billion and repurchased $220.0 million worth of stock for the first nine months of 2014.

REFINING ISSUES

The jet fuel crack spread has widened because a number of refineries were idled or shut down on the East Coast for various reasons. For instance, the area hit by Hurricane Sandy has eight operating refineries, which have a combined refining capacity of around one million barrels of crude oil per day. The hurricane arrived at a time when inventories of oil products, such as gasoline, distillates, and jet fuel, were already quite low. According to the EIA, jet fuel supplies in the period right before the hurricane were 8% below the same period in 2011. The hurricane is estimated to have caused the idling of almost 70% of the oil refineries on the East Coast. Further, refineries in the Midwest, which account for some 20% of US refining capacity, also faced refinery shutdowns and oil pipeline ruptures.

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 3

Delta Air Lines acquires a refinery On April 30, 2012, purchased an oil refinery near Philadelphia from Phillips 66, an oil refining and marketing company that had been spun off from ConocoPhillips. Delta, which received $30 million in state government assistance as part of the deal, purchased the 185,000-barrels-per-day refinery for $150 million and planned to invest an additional $100 million to upgrade and maximize jet fuel production at the refinery. This marks the first time a refinery has been purchased by an airline. Delta expected the move to help bring down its fuel costs by $300 million annually and to ensure jet fuel availability for the company’s Northeast operations.

As part of the deal, Delta will trade the refinery’s non-jet fuel outputs for jet fuel from several energy companies under multiyear agreements. Further, the company entered into a three-year agreement with BP Products North America Inc., under which BP will supply crude oil for the refinery, but the agreement was terminated on July 1, 2014. The company estimated that the jet fuel production at the refinery, along with the jet fuel received in exchange for non-jet fuel produced, would meet 80% of its jet fuel needs. Jet fuel production at the refinery started in September 2012 and the company attained a production level of 40,000 barrels per day as of May 2013. This represented about 25% of Delta’s domestic jet fuel consumption and 22% of the refinery’s capacity. In a September 2012 presentation, the company noted that, given the large volume of fuel involved and the crack spread expansion partly due to the recent refinery closures on the East Coast, even a small saving on jet fuel costs would have a significant impact on the airline’s cost structure.

In our view, Delta added risk and complexity to its business model in purchasing the refinery, but given the low purchase price and Delta’s high cash balances, it represents a risk that the company could afford. It is notable that the East Coast refining business has been a money loser for a long time, and Delta’s purchase of a refinery is not likely to alter the economics of that business. In periods when the price of oil is falling, the refinery will be hurt by the cut, possibly eating away at the benefits of lower pricing that Delta might otherwise have realized. In 2013, the refinery business reported an operating loss of $116 million. Moreover, for the first nine months of 2014, the company reported an operating loss of $9 million. We think an effective hedging program could accomplish the same goals without these risks.

However, this is an innovative approach that has not been tried before, and it may be successful in cutting Delta’s fuel costs. In addition, just keeping the refinery running means an increased amount of refined product available in the marketplace, thus keeping prices lower than if the refinery had been shuttered. CHANGE IN PRICE OF AIR TRAVEL VS. OTHER GOODS AND SERVICES Further, with the jet fuel crack spreads widening, the refinery % CHG. might end up earning a ITEM 1978* 2000 2013 1978-2013 considerable return for the airline. Walt Disney World ($, one-day adult pass) 6.50 45.00 95.00 1,362 Only time will tell how this plan College tuition: public ($ per year) 688 3,508 8,893 1,193 works out for Delta, and if it will College tuition: private ($ per year) 2,958 16,072 30,094 917 National Football League game ticket 9.67 49.35 81.54 743 spur other such deals. Prescription drugs (index)Table B045 61.6 285.4 442.6 618 Major League Baseball game ticketCHANGE IN 3.98 16.22 27.48 590 AIRLINES ATTEMPT TO PUSH Gasoline ($ per gallon, unleaded)PRICE OF AIR 0.67 1.51 3.53 427 AIRFARE HIGHER New automobile ($)TRAVEL VS. 6,470 24,923 31,762 391 New single-family home ($)OTHER GOODS 55,700 169,000 265,900 377 Year to date through October 22, Consumer Price IndexAND SERVICES 65.2 172.2 233.0 257 2014, airlines have attempted 21 Movie ticket ($) 2.34 5.39 8.13 247 fare increases, but only five Postage stamp ($, one ounce, first-class) 0.15 0.33 0.46 207 succeeded, according to Whole milk (index) 81.0 156.9 214.7 165 farecompare.com, an online Air travel ($, round-trip domestic fare) 186.00 314.00 362.85 95 resource. In 2013, there were Apparel (clothing/footw ear/jew elry, index) 81.3 129.6 127.4 57 three successful fare hikes (out of Television (index) 101.8 49.9 4.6 (96) 12 attempts), while 2012 saw *Congress enacted legislation deregulating domestic airline passenger service seven successful fare hikes (out of in October 1978. 15 attempts). American Airlines Source: Airlines for America. and Delta Airlines have been

4 AIRLINES / DECEMBER 2014 INDUSTRY SURVEYS responsible for 14 of the attempted hikes in 2014 so far, with one successful attempt for American Airlines and two successful attempts for Delta Airlines.

The industry’s capacity restraint has aided airfare hikes because fewer seats are available. In addition, increased business travel demand has led to a more profitable mix of airfares on the plane, since business travelers tend to buy more expensive refundable tickets and sit in more expensive coach seats. Finally, the absence of major fare sales has also had an impact. Airlines have been doing much less discounting than in the past, waiting longer for seats to book up before starting a fare sale. All of these factors are driving healthy yield gains for US airlines.

Fare hikes have been of benefit for the industry. According to A4A, the average industry systemwide yield was 16.22 cents in 2013, up 2.0% from 2012. In 2012, systemwide yield averaged 15.90 cents, up 3.2% from 2011. Total passenger revenue was up 3.8% in 2013, after rising 3.8% in 2012 and 10.5% in 2011.

VOLATILE OIL PRICES AND ECONOMIC UNCERTAINTY MUTE CAPACITY INCREASES

In our view, although demand weakened significantly in 2009, the US airline industry was better positioned to handle that downturn than past industry down cycles, mainly due to the large capacity cuts the industry had already taken. In addition, both the network and discount airlines indicated intentions to practice continued capacity restraint. This was a change from the past, when carriers would typically abandon pricing discipline when demand weakened, leading to severe price cuts; then, when demand started to strengthen, the airlines would quickly add back capacity, leading to overcapacity and limiting potential fare increases. We think that capacity and behavioral changes clearly lessened the severity of the industry’s price declines, and should allow for greater price and revenue gains in an improving demand environment.

The first industry capacity cuts took place from DOM ESTIC AIRLINE YIELDS (Year-to-year % change) late 2008 through mid-2009 in response to a sharp spike in oil prices in the summer of 2008, 20 Table H06: which culminated with a record-high oil price of 15 DOMESTIC $147.27 a barrel on July 11, 2008. At that time, the industry was enduring billions of dollars in 10 AIRLINE YIELDS operating losses while burning through millions 5 of dollars a day in cash. 0 (5) In 2013, airlines held back on their capacity expansion plans. According to A4A, systemwide (10) capacity (as measured by , or (15) ASMs) was up only 1.3% and domestic (20) capacity up 1.5% from 2012. In 2012, 2004 05 06 07 08 09 10 11 12 13 2014* systemwide capacity declined 0.4% and *Data through September. domestic capacity declined 0.1%. Year to date Source: Airlines for America. through September 2014, systemwide capacity rose 1.8%, while domestic capacity was up 1.1% from the same period in 2013. For 2015, we expect capacity increases to grow at a rate slightly in excess of gross domestic product (GDP).

Capacity restraint has contributed to higher load factors. In 2013, systemwide passenger load factor (PLF)—the percentage of available capacity that is taken up by revenue-paying passenger traffic—averaged 83.1%, up 0.3 percentage point from 2012, which in turn had seen a gain of 0.8 percentage point. Domestic load factor averaged 84.0% in 2013, up by 0.1 percentage point from 2012, which had seen a gain of 0.4 percentage point. Through July 2014, PLF increased by 0.5 percentage point to 83.4%, while domestic load factor increased by 1.2 percentage points to 84.9%.

Over the longer term, it remains to be seen whether carriers will start to abandon the capacity restraint they have shown over the past five years if demand strengthens significantly or if oil prices decline sharply. On the other hand, sharp capacity growth could put pricing power at risk. In our view, such lack of restraint would serve carriers poorly in the next industry downturn, and would hurt the much-needed pricing power they have

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 5 only started to regain due to industrywide capacity reductions. The merger of American Airlines with US Airways (discussed earlier) is likely to help overall industry capacity levels decline modestly, in our view.

HIGH CASH BALANCES PROTECT AIRLINES FROM NEXT DOWNTURN

Most US airlines are sitting on high cash balances, which S&P believes should help protect them against the next cyclical downturn, when it occurs. The cash balances for the industry stand at an average of about 19% of trailing 12 months (TTM) revenues. For instance, American Airlines Group ended the third quarter of 2014 with cash and short-term investments worth $7.9 billion, while ended the third quarter with $3.6 billion, representing 19.8% and 19.6% of their TTM revenues, respectively. Companies are using their cash to pay down debt, buy back stock, and meet capital expenditure requirements. For instance, for the nine months ended September 30, 2014, Southwest Airlines had capital expenditures of $1.3 billion. Southwest Airlines repaid $517 million in debt, and repurchased common stock worth $755 million. Moreover, the company intends to repay an additional $395 million in debt in the fourth quarter of 2014.

In our view, airlines are repairing their balance sheets, which in turn can lead to increased access to capital markets and better rates due to better balance sheets.

However, while airlines currently seem to have ample liquidity, cash balances can burn up rapidly in a downturn. Because the airline industry is such a capital-intensive business and most carriers have high debt levels, reduced cash inflows during a downturn can quickly lead to depleted cash levels. For this reason, the airlines often keep on hand billions of dollars in undeployed cash.

STRONG PASSENGER DEMAND

In 2011 and 2012, US airlines showed improving demand and revenues, but encountered slower growth in these metrics in 2013. Travel demand has been strong during peak periods like holidays, though demand has been weaker during non-peak periods. Airlines have also seen a steady recovery in travel demand from the corporate segment, despite a still-tepid US economy. If the US economy shows meaningful growth, a recovery in air travel demand will likely follow. Conversely, if the economy starts to lose traction, air travel demand would slow, particularly in the areas of corporate and first-class travel.

Capitalizing on the periods of strength, US airlines have begun implementing surcharges to travel during “peak” travel periods, though the exact definition of what constitutes peak travel may vary. Most of the major carriers have added surcharges of up to $50 per flight segment above the published airfare on select dates. This action irritates passengers, since these surcharges may not show up in the posted airfares on many websites, only appearing in the total cost later in the booking process.

Year to date through September 2014, systemwide enplanements were up 2.1%, revenue passenger miles (RPMs, a measure of traffic volume) rose 2.3%, passenger revenues rose 4.8%, and yields were up 2.4%, according to the A4A trade group. In 2013, enplanements were up 0.5% (versus gains of 0.1% in 2012 and 1.1% in 2011), RPMs rose 1.8% (vs. 0.3% and 1.4% in 2012 and 2011, respectively), passenger revenues increased 3.8% (3.7%; 10.5%), and yields were up 2.0% (3.3%; 9.0%). We expect positive trends in industry revenues and profitability to continue through 2014.

ANCILLARY CHARGES

The big US airlines have increasingly relied on ancillary fees, such as baggage charges, to support their bottom lines. According to the BTS, the baggage fees and reservation change fees charged by 16 airlines in the US totaled $3.4 billion and $2.8 billion, respectively, in 2013. Delta topped the list with a total of $1.7 billion, followed by United ($1.4 billion) and American ($1.0 billion). In 2012, the baggage fees and reservation change fees charged by 16 airlines in the US amounted to $6.0 billion. Though unhappy with the recent trend, passengers have gradually become accustomed to paying higher fees for baggage and other services.

Some airlines also charge fees to passengers for window and aisle seat assignments. Certain other airlines reserve window and aisle seats for members of their own loyalty programs. Low-cost carriers Allegiant and

6 AIRLINES / DECEMBER 2014 INDUSTRY SURVEYS

Spirit Airlines charge in the range of $1 to $199 for seat reservations made prior to the check-in. In May 2012, baggage fee levels witnessed a new high when announced its carry-on bag fee of $100 per bag per trip. The fee, which could be lower depending on whether it is paid at a check-in kiosk or whether the reservation has been made online, is a sharp rise from the $45 baggage fee that the airline previously charged. In May 2013, said that it would charge $25 for carry-on bags that are put into the overhead bin (small bags that can be stowed under the seat remain free), and would charge $100 for those who pay at the check-in gate.

The bigger airlines such as Delta Airlines, JetBlue, and American have been increasing their fees on the second checked bags. United Airlines, for instance, increased its fee for second checked bags from $70 to $100 on some international flights in June 2013.

Baggage and other customer service statistics The 15 largest US airlines reported a mishandled baggage rate of 3.09 per 1,000 passengers in 2012, their lowest rate since 1987, when the DOT first reported this measure. Airlines also posted an 81.9% on-time arrival rate in 2012, the third highest annual performance in the last 18 years, according to the BTS. In 2013, United Continental Holdings said that its completion factor rose to 99.0%. We think that the lower baggage-mishandling rate is largely due to a decline in the number of checked bags caused by rising baggage fees, while the other statistics have gained support from overall capacity cuts in the industry.

In 2013, the 16 largest US airlines reported a mishandled baggage rate of 3.22 per 1,000 passengers and an on-time arrival rate of 78.3%, according to the Air Travel Consumer Report released by the DOT. In September 2014, the 12 largest airlines operating in the US recorded an 81.1% on-time arrival rate, and their cancellation rate was 1.4%. Their baggage-mishandling rate was 2.98 per 1,000 passengers (up from 2.71 in September 2013).

The improvement in flight delays could also be partly attributed to various rules pertaining to tarmac delays implemented by the US Federal Aviation Administration (FAA). In April 2010, a rule went into effect, whereby a domestic flight carrying passengers would not be allowed to sit on the tarmac for more than three hours, except for reasons concerning safety, security, or air traffic control problems. In 2013, there were 70 domestic tarmac delays of more than three hours, versus 42 in 2012. According to the Air Travel Consumer Report, a monthly publication of the DOT, there was one domestic tarmac delay over three hours in the month of September 2014.

GREEN INITIATIVES UNDER WAY

Airlines have listed all the ways that they have reduced jet fuel usage over the past 10 years in order to fight the perception that they are a major source of greenhouse gases (GHG): modernizing their fleets to more fuel-efficient planes, efforts to control fuel use, and modifications to existing planes to increase fuel efficiency, to name a few. Although the airlines may have undertaken these initiatives to cut costs in the wake of high oil prices, they are also using their FUEL EFFICIENCY accomplishments as a way to ease (Gallons consumed per available seat-mile) environmental concerns. In our view, this issue 0.025 is starting to gain attention in the industry, and we expect airlines to face increasing pressure on 0.020 this front over the next few years. Chart H04: 0.015 FUEL Airlines have conducted biofuel test flights at EFFICIENCY various times over the past five years. 0.010 Continental Airlines was the first US airline to

0.005 do so, in January 2009. In November 2009, a test flight conducted by KLM Royal Dutch 0.000 Airlines was the first to carry passengers. In 2003 04 05 06 07 08 09 10 11 12 13 2014* July 2011, ASTM International, a US technical *Data through July. standards group working in conjunction with Source: US Bureau of Transportation Statistics. the FAA, approved the use of biofuels in

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 7 commercial aviation. This approval allows the use of biofuels in commercial aviation outside of their prior use only for testing purposes. In November 2011, two airlines conducted demonstrations. United Airlines used 40% biofuel on one of its commercial domestic flights, and Alaska Air used 20% biofuel (made of cooking oil) on two of its flights. Alaska Air had plans to operate 75 commercial passenger flights using this biofuel mix. According to the airline, the use of a 20% biofuel blend in the flights will reduce GHG emissions by 134 metric tons.

So far, these tests have shown that biofuel can perform as well as traditional jet fuel, though the fuel is still much more expensive. While we think the full-scale deployment of biofuel is still likely to be several years away, there could be several benefits from the development of an alternative to fossil fuels. First would be a reduction in the reliance on oil. Second, airlines will greatly improve their image among environmental groups. In addition, studies have shown that some biofuels have a modest positive impact on fuel efficiency.

In June 2013, United Airlines executed a definitive purchase agreement with AltAir Fuels for competitive, sustainable, and advanced biofuels on a commercial scale. In partnership with United, AltAir Fuels will retrofit part of an existing petroleum refinery near to become a 30-million gallon, advanced biofuel refinery. United has agreed to buy 15 million gallons of lower-carbon, renewable jet fuel over a three-year period, with the option to purchase more. AltAir expects to deliver five million gallons of renewable jet fuel each year.

US and other airlines fight EU carbon emissions trading scheme The European Union Emissions Trading Scheme (EU ETS), which started in January 2012, applies to the entire global airline industry, including US airlines. Under the ETS, carriers operating flights to and from

(and within) the EU will have to surrender one carbon allowance per tonne of carbon dioxide (CO2) emitted on each such flight. Operators that do not comply, will face a penalty of €100 per missing allowance, along with an obligation to buy missing allowances and the possibility of being banned from operating in the EU.

Airlines get a certain amount of free allowances for the nine-year period between 2012 and 2020, based on data gathered for airline carbon emissions for 2010. Airlines across the globe have been extremely critical of various aspects of the scheme, and question the legality of the EU to impose the ETS on them. The US and several foreign nations have expressed strong objections to this unilateral decision by the EU to include international carriers in the scheme. According to an analysis by Thomson Reuters Point Carbon, an energy market research firm, the EU ETS cost airlines approximately $1.5 billion during the first year of its implementation.

While the EU has been trying to impose its scheme on airlines globally, airlines in the US, China, and India have protested paying for their carbon emissions.

NEW TAXES AHEAD

President Obama, in his fiscal 2014 budget request, proposed raising a number of taxes levied on the airlines. The administration noted that higher taxes would be used to help reduce the deficit, improve airports, and add new immigration and customs officers to reduce wait times for processing foreign visitors. The proposals included raising the security fee to $5 per one-way trip from $2.50 per flight segment, increasing taxes for customs inspections to $7.50 from $5.50 for an international flight, and increasing the tax for immigration services to $9 from $7. According to John Heimlich, chief economist at the A4A trade group, the tax on a $300 domestic ticket would rise 23%, to $75 from the current $61. Vaughn Jennings, managing director for government and regulatory communications at A4A, noted that the budget proposals would increase taxes on airline customers and airlines by 29%, leading to a $5.5 billion rise in their $19.0 billion annual tax burden.

In the fiscal 2015 budget request, a total of $15.4 billion is required to fund the FAA, compared with $15.7 billion in the fiscal 2014 budget. The passenger facility charge (PFC), which is collected from every boarded passenger by airports, is expected to increase to $8 from $4.50. According to the A4A trade group, the new budget would increase the per-person security fee to $6 per one-way trip from $5.60 and the customs fee to $7.50 from $5.50. A new departure tax of $100 would also be levied for each flight.

8 AIRLINES / DECEMBER 2014 INDUSTRY SURVEYS

Even without the proposed new taxes, the US airline industry already faces an extremely high tax burden. Current taxes and fees in place in aggregate constitute 20% of the average ticket price. The A4A points out that the industry is taxed at a higher rate than tobacco and alcohol, two “sins” that the government is trying to reduce usage of as part of its tax policy.

IS NEXTGEN ATC ON ITS WAY?

The FAA has been working on a completely new system of air traffic control (ATC), known as the Next Generation Air Transportation System (NextGen), which is supposed to be implemented in phases between 2012 and 2025. Using satellite surveillance, the new ATC system would be a complete overhaul from the current radar-based system. NextGen ATC would deploy new methods to route pilots, planes, and passengers, and implement landing procedures that would help reduce the time currently wasted by planes waiting at the airport for a clear runway. The new global positioning system (GPS)-based technology would allow planes to be spaced closer together, a major improvement over the current system.

Conversely, the FAA has been grappling with multiple problems, such as funding and management of the technology upgrade, and is finding it difficult to meet its deadlines. In June 2013, FAA Administrator Michael Huerta told the NextGen Advisory Committee (NAC) that the annual budget reductions under the sequestration process would make it difficult for the agency to complete the modernization programs on time. A Government Accountability Office (GAO) report on the progress of NextGen, submitted to Congress in April 2013, noted that the FAA has made progress in delivering some operational improvements, but to demonstrate those improvements sooner, it has made “trade-offs” that could limit their overall benefit to airlines in the coming years. Another case in point is the En Route Automatic Modernization (ERAM) system, which will help provide communications and create display data to be used by air traffic controllers. The development of this system is lagging behind the original deadline of 2014 by as much as two years and has exceeded its budget by $500 million.

Funding in recent FAA authorization President Obama signed the funding bill in February 2012—providing $63.4 billion to the FAA through 2015. This reauthorization of the long-term funding bill, which expired in 2007, could expedite the ongoing work on the NextGen ATC. Having received around 23 short-term funding extensions, the FAA had been dealing with an unstable funding plan.

In June 2013, the House Appropriations Subcommittee on Transportation, Housing and Urban Development approved a fiscal 2014 funding bill that would provide the FAA with $11.8 billion, $756 million below the current fiscal year and $103.3 million below the level from the automatic sequestration cuts. However, air traffic controllers’ salaries and the contract tower program would be protected. The bill provides $9.5 billion for operations and directs that “not less than” $140 million of that amount be spend on the contract tower program. The operations funding would be $200 million below the Obama Administration’s requested amount. As mentioned earlier, Congress failed to pass an appropriations bill for 2014, with an interim bill passed on October 16, 2013. The funding of $15.6 billion in fiscal 2014 was authorized after agreement between the Senate and the House in January 2014.

In March 2014, FAA made a budget request of $15.4 billion for fiscal 2015. However, it is expected to increase spending on NextGen to around $1 billion, which includes $836 million plus an additional $186 million on Opportunity, Growth, and Security initiative, compared with $901 million in fiscal 2014 and $883 million in fiscal 2013.

INDUSTRY REVIEW AND OUTLOOK

As of November 2014, we had a positive fundamental outlook for the airline sub-industry for the next 12 months. Traffic statistics showed improving demand and revenues in 2013, and we see that strength carrying on through 2014. We expect the US airline industry to see good demand, despite the tepid US economy. We think that since the industry has reduced capacity levels, it should be able to raise fares as passenger travel demand improves, and hold the line on fares if demand weakens. Oil and jet fuel prices, should they start to rise, represent a risk to the fragile industry recovery. In our view, the airlines are likely

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 9 to see tougher comparisons in 2014 after rising unit revenues in 2012 and 2013, but we expect demand for air travel to remain strong.

We think investor sentiment on airline stocks has improved, and we expect further improvement on signs that the US economy is recovering and if oil prices continue to retreat. The bankruptcy filing of AMR Corp., parent of American Airlines, led to some domestic and international capacity cuts as American restructured. The subsequent merger of American Airlines with US Airways was completed in December 2013, and is likely to lead to further capacity rationalization over time as the airlines combine operations and eliminate some overlap. The industry successfully instituted a number of fare hikes in 2011 and 2012, but was somewhat less successful in hiking fares in 2013. However, we think that fares are likely to continue to rise in 2014. Many of the shares warrant added risk premiums, in our view.

We estimate that the largest US carriers earned $6.0 billion in 2013, $4.0 billion in both 2011 and 2012, and $3.7 billion in 2010, after losing $5.0 billion in 2009 and $4.0 billion in 2008. Results in 2013 benefited from improved business travel and lower oil prices, while increases in ancillary fees such as baggage, change fees, and premium seating slowed. We think cuts to domestic and international supply over the past three years have improved airline pricing power.

Total RPMs rose 1.8% in 2013, versus a 0.6% increase in 2012. Yields rose 2.0%, after a 3.2% advance in 2012. Available seat miles rose 1.3%, after a 0.4% decline in 2012. The PLF rose by 0.3 percentage points to 83.1%, after a 0.8 percentage-point increase in 2012.

Year to date through October 31, 2014, the S&P Airlines Index rose 54.5%, versus an 8.6% increase for the S&P 1500 Composite Stock Index. In 2013, the S&P Airlines Index increased 67.0%, versus a 30.1% rise in the S&P 1500. The five-year compound annual growth rate (CAGR) for the S&P Airlines index through May 30 was 30.2%, versus 14.6% for the S&P 1500.

AIRLINES IN FOCUS

In general, S&P expects the airlines to see tougher comparisons in 2014 after rising unit revenues in 2013, but expects demand for air travel to remain strong. Traffic statistics showed improving demand and revenues in 2012 and 2013, which are continuing in 2014. We think the US airline industry is seeing good demand, despite the still-tepid US economy. In addition, we think that since the industry has reduced capacity levels, it should be able to raise fares as passenger travel demand improves, and hold the line on fares if demand weakens. Oil and jet fuel prices, should they rise, represent a risk to the fragile industry recovery. In the midst of bankruptcies, restructurings, recoveries, mergers, and growth among discounters, the changing shape of the airline industry is another dynamic variable that could sway results.

Delta’s strong cash flow growth In May 2014, Delta announced the next phase of its shareholder-return strategy that includes a dividend and stock buybacks. With these two programs, the company expects to return $2.75 billion to shareholders through 2016. In September 2014, the company paid a quarterly dividend of $0.09 per share. Additionally, in the same month, it completed $350 million of its $2 billion share repurchase target.

Delta also outlined a five-year financial plan that focuses on free cash flow generation through a disciplined capital investment approach and earnings improvements. The company plans to reinvest 50% of its operating cash flow (about $2.0 billion–$2.5 billion) annually in order to improve its fleet, facilities, products, and technology. The company will use the remaining free cash flow to return cash to shareholders, reduce the company’s net debt (debt minus cash) to a target level of $7 billion, and address longer-term pension funding needs.

In 2013, Delta Airlines was able to reduce debt to $9.4 billion after generating $5 billion in operating cash flows and $2.1 billion in free cash flows. Moreover, Delta also contributed $250 million more than required funding toward pension plans and generated returns for shareholders in the form of $100 million in dividends and $250 million in share repurchases.

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For the first nine months ended September 30, 2014, Delta Airlines generated $4.4 billion in operating cash flow, which helped to reduce debt and capital lease obligations by $1.5 billion, fund capital expenditures of $1.6 billion, contribute $905.0 million to its pension plans, and return $776.0 million to shareholders.

UAL starting to gain traction United Airlines received a single operating certificate from the FAA on November 1, 2011 after completing its merger with Continental Airlines on October 31, 2010. The merged company successfully implemented a single passenger service system, a single loyalty program, and a single website in the first quarter of 2012.

However, the merger process was not completely smooth for United Airlines. The company grappled with a number of operational challenges, including technology issues that arose after conversion to a new IT system. In its fourth-quarter 2013 earnings call in January 2014, the company noted solid improvement in earnings, and expects to provide further growth in financials in 2014. United, currently No. 2 after the newly formed American Airlines Group Inc., posted net operating income of about $1.1 billion in 2013, an 84% increase compared with 2012. At the end of the third quarter of 2014, the company reported a net income of $924.0 million on total revenue of $10.6 billion.

Southwest adds international routes and completes its integration of AirTran On July 1, 2014, Southwest Airlines Co., the largest domestic US airline in terms of RPMs, launched its international service by offering routes to three Caribbean destinations—Aruba, Jamaica, and The Bahamas—from three of its gateway cities—Baltimore, Atlanta, and Orlando. The first of Southwest’s international departures, Flight 1804 from Baltimore/Washington to Oranjestad, Aruba, departed on time at 8:30am EDT, followed by Southwest’s Flight 906 to Montego Bay, Jamaica, and a midday flight from Baltimore/Washington to Nassau/Paradise Island in The Bahamas. On November 2, the airline completed the integration of its wholly owned subsidiary, AirTran Airways, and launched its first Southwest-branded flights to Mexico and The Dominican Republic.

Southwest acquired AirTran Holdings Inc. for $1.4 billion in cash and stock on May 2, 2011. The acquisition gave Southwest a large-scale presence in Atlanta, an important business travel market. It also allowed Southwest to grow about 20% without adding a single seat to overall industry capacity. The company received its single operating certificate from the FAA in March 2012, and took significant steps toward full integration in 2012. In April 2013, the company noted that integration of the separate route networks of Southwest and AirTran were complete, and was producing significant incremental bookings for future travel. The company expects to complete the AirTran integration by the end of 2014.

The acquisition of AirTran has allowed Southwest to continue to gain traction with business travelers, while enabling AirTran customers to take advantage of Southwest’s large domestic route network. Southwest reported a net profit of $754 million in 2013, compared with a net profit of $420 million in 2012. In its fourth-quarter 2013 earnings news release in January 2014, Southwest Airlines announced that it had achieved approximately $400 million in annual net pretax synergies, and at the end of the third quarter of 2014, the company reported a net profit of $382 million. The company has converted 34 of the 52 AirTran Boeing 737-700s to Southwest’s route network, and plans to convert most of the remaining 18 by the end of 2014.

JetBlue to get new CEO: Could they make revenue enhancement changes? On September 18, 2014, JetBlue announced that effective February 16, 2015, Robin Hayes, its current President, will succeed Dave Barger as Chief Executive Officer (CEO), when the latter’s contract expires. Industry analysts see this change as an opportunity for JetBlue to try to boost revenues. In addition, the company should benefit from lower oil prices, as it has had large profit swings on oil prices.

On November 19, 2014, JetBlue outlined its long-term plan to drive shareholder return through different product and service initiatives. Starting in the first half of 2015, JetBlue will also offer three branded fare bundle options. The first fare bundle will be for customers who do not plan to check a bag, while the other two fare bundles will offer one and two free checked bags. Another initiative is the Airbus A320 cabin refresh. JetBlue will reconfigure its A320 aircraft with a refreshed cabin similar to its A321 aircraft. The airline will use lighter and more comfortable seats, which will help increase the number of seats on its planes while still offering the most legroom in coach. JetBlue expects to start the retrofitting of the Airbus A320 fleet in mid-2016. The company expects

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 11 these revenue initiatives to generate more than $400 million in annual operating income on a run-rate basis, starting in 2017. Moreover, JetBlue announced the deferral of 18 Airbus aircraft, which is scheduled for delivery between 2016 and 2023. The company expects the deferral to reduce capital expenditures by more than $900 million through 2017 and to allow the airline to optimize its fleet to better match capacity with demand.

JetBlue recorded a net profit of $168 million in 2013 (up from $128 million in 2012). The company also reported a year-over-year increase in revenues of 6.9%. In the third quarter of 2014, the company reported a net profit of $79 million (up from $71 million in the third quarter of 2013). Amid the high level of consolidation activity in the aviation industry over the past few years, JetBlue has preferred to stay independent.

In 2014, JetBlue is expected to pursue various expansion activities. This includes its Mint service that offers customers a premium in-flight experience at affordable prices. Moreover, the company will add some new routes, and enhance capacity to 4%–6% by adding four new airbus A321 aircraft through the remainder of the year. 

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INDUSTRY PROFILE

Airlines still face extreme challenges

According to the Federal Aviation Administration (FAA), at the end of 2013, the US commercial aviation industry consisted of 15 scheduled mainline air carriers that used large passenger jets (over 90 seats) and 63 regional carriers that used smaller piston, turboprop, and regional jet aircraft (up to 90 seats) to provide connecting passengers to the larger carriers. US AIRL INE OV ERV IEW In addition, 30 all-cargo carriers were (For the 10 largest US passenger carriers, providing domestic and/or international air in billions of dollars except as noted) cargo service. 2012 2013 E2014 E2015 Passenger revenues 127.0 140.0 150.0 160.0 The number of aircraft in the US commercial Cargo revenuesTable B04 3.1 US 3.5 5.0 6.0 fleet, including regional carriers, totaled Other revenuesAIRLINE 13.9 15.0 16.0 16.0 6,727 at the end of 2013, a decrease of 184 Total revenuesOVERVIEW 144.0 158.5 171.0 182.0 aircraft from the end of 2012, according to % change 6.0 10.1 7.9 6.4 FAA estimates. The 2013 number included Operating income 11.5 14.0 18.0 21.0 3,774 mainline air carrier passenger aircraft Revenue passenger-miles (bil.) 794.0 774.2 793.6 833.3 (jets with more than 90 seats), 740 all-cargo % change 5.4 (2.5) 2.5 5.0 aircraft, and 2,213 regional aircraft (smaller Available seat-miles (bil.) 958.0 931.0 949.6 1,006.6 jets, turboprops, and pistons). % change 5.5 (2.8) 2.0 6.0 Passenger load factor (%) 82.9 82.9 83.6 82.8 United Continental Holdings was the largest E-Estimated. US airline based on carrier revenues in 2013, Sources: US Department of Transportation; Airlines for America; with reported revenues of about $38.3 S&P Capital IQ estimates. billion. Delta Air Lines, which reported revenues of $37.7 billion in 2013, was the AIRL INE M ARKET SHARE L EADERS second largest player. American Airlines Group placed third, with (Based on revenue passenger-miles; revenues of $26.7 billion, and Southwest Airlines was ranked fourth, 12 months ended July 2014) with revenues of $17.6 billion in 2013. % MARKET According to the Research and Innovative Technology Administration RANK COMPANY SHARE (RITA), the US airline industry (the majors, nationals, and regionals) 1. Delta 16.6 generated total revenues of $101.9 billion as of the second quarter of Table B03 2. Southw est 16.3 2014, up 4.1% from $97.9 billion in the same period last year. In terms 3. UnitedAirline market 15.4 of traffic, US Department of Transportation (DOT) statistics show that in 4. Americanshare leaders 12.6 2013, the total US airline industry logged 834.7 billion revenue passenger 5. US Airw ays 8.4 miles (RPMs)—the number of passengers multiplied by the number of 6. JetBlue 5.1 miles flown—up 2% from 817.6 billion in 2012. Also rising in 2013 7. Alaska 4.2 were enplanements (the total number of passengers), up 0.8% to 740.7 8. ExpressJet 2.5 million, and available seat miles (ASMs)—the number of seats in the 9. SkyWest 2.3 active fleet multiplied by the number of miles flown—up 1.6% to more 10. AirTran Corp. 2.0 than one trillion. Industrywide passenger load factor (PLF)—the Others 14.6 percentage of seats filled—increased by 0.3 percentage points to 83.1%. Source: US Bureau of Transportaion Statistics. Airlines around the world have experienced a difficult operating climate over the past 10 years. The global airline industry lost an estimated $9.9 billion in 2009, according to the International Air Transport Association (IATA), a coalition of some 260 airlines throughout the world. However, as in the US, the global environment has also improved. According to the IATA, global industry profits were $18.0 billion in 2010, $8.4 billion in 2011, and $7.6 billion in 2012. In 2013, the industry profits were estimated at $10.6 billion. For 2014, it projected profits of around $18.0 billion, with a net margin yield of 2.4%.

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 13

INDUSTRY TRENDS

The history of the airline industry in recent years has been one of shrinkage, fueled by consolidation and bankruptcies. The legacy of the first decade of the new millennium includes mergers, capacity cuts, bankruptcy filings, large-scale losses, and high debt levels, which represent challenges that are likely to persist for some time. On the positive side, the industry has been raising baggage and other “ancillary” fees that generate additional revenues and have other benefits, and on-time and other measures have improved.

THE AIRLINE INDUSTRY’S NEW LANDSCAPE

S&P Capital IQ (S&P) thinks that the largest of a spate of mergers that completely changed the competitive landscape of the US airline industry occurred on October 31, 2010, when UAL Corp., parent of United Airlines, and Continental Airlines Inc. completed their merger, creating a global airline with revenues of $37 billion in 2011. Other important deals include the merger of Delta Air Lines and Northwest Airlines Corp. in 2008, and the acquisition of AirTran Holdings Inc. by Southwest Airlines Co., the largest domestic US airline in terms of revenue passenger miles (RPMs), for $1.4 billion in cash and stock in May 2011.

After United and Continental merged in 2010, the number of major US network carriers was reduced to four (Delta, United, American, and US Airways), plus Southwest Airlines (which does not have a significant international network), and a few smaller carriers such as JetBlue and Alaska Air. Moreover, the reductions may not be over. In December 2013, AMR Corp., the parent company of American Airlines, merged with US Airways, with the surviving entity to operate under the American Airlines name. The merger created the world’s largest airline and further reduced the number of big players—American Airlines, Delta Airlines, Southwest Airlines, and United Continental Holdings Inc. together account for 80% of US domestic capacity. (See the “Current Environment” section of this Survey for a detailed discussion.)

Size and scale have become more important than ever in the wake of these deals. The US airline industry has fewer competitors and less capacity chasing customers, which should help the industry to be more disciplined on capacity, so airlines can price their product in a way that generates a sustainable return on invested capital. Recent capacity cuts and capacity restraint, even in the face of improving demand, are positive trends that the elimination of several competitors should only improve.

As a result, S&P expects the supply-demand equation to continue to shift in favor of the airlines. We think US consumers are likely to face higher airfares over the next couple of years, though fare sales during periods of seasonal weakness will probably continue. On an inflation-adjusted basis, air travel is still extremely cheap, particularly when accounting for the increase in oil prices over the past five years. However, we think airfares are likely to continue to head higher.

A shrinking industry Following this period of consolidation, we think that the changes the industry has undergone will have a far-reaching, long-term, and competitive impact. The shrinking number of competitors should allow for continued capacity restraint and potential fare increases, due to a combination of less competition and improving industry demand. In addition, while the airlines are integrating their mergers, they will be able to redeploy and right-size their capacity to where it is most profitable. The capacity reduction that S&P thinks is a likely result of merger integration (where redundant routes are likely to be streamlined) should lead to customers chasing fewer seats. Moreover, with fewer airlines out there, capacity additions during future up cycles could be more muted than in the past.

We also see a shift in strategy among airline executives, who have become much more focused on managing their businesses for sustainable profitability, rather than market share gains. This is a significant change. S&P thinks that the US airline industry, after years of suffering multibillion-dollar losses, may have finally learned a key lesson: although size and scale are important, the industry must be disciplined on capacity, so that airlines can price their product in a way that generates a sustainable return on invested capital. Recent capacity cuts and restraints, even in the face of improving demand, are positive trends that should only improve with the elimination of a competitor through the United-Continental merger.

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 AMR-US Airways merger completed after DOJ drops objections. On December 9, 2013, nearly 10 months after signing a merger agreement, American Airlines’ parent company AMR Corp. with US Airways Group Inc. finalized and closed their merger. In the all-stock deal, AMR shareholders and creditors received 72% of the combined entity, and US Airways’ shareholders received the remaining 28% interest. US Airways’ Chief Executive Officer (CEO) Doug Parker became the CEO of the new company, with AMR’s CEO Tom Horton serving as non-executive board chairperson through 2014. The new publicly traded company operates under the name American Airlines Group (NYSE: AAL) and is part of the OneWorld global airline alliance.

The two airlines secured the approval of the European Union (EU) on August 5, 2013, on condition that they surrender some slots at ’s Heathrow Airport and Philadelphia International Airport. However, on August 13, the US Department of Justice (DOJ), joined by the attorney generals of several states, filed a lawsuit in the US District Court (District of Columbia) to block the merger, claiming that it would violate anti-trust laws, and would lead to less competition and higher prices for consumers.

The US District Court scheduled the trial on November 25, 2013. However, on November 12, the DOJ announced that it had settled its case with the two airlines. As part of the settlement, the two airlines agreed to give up gate slots and takeoffs at several major airports across the US. They also agreed to maintain hubs in seven cities for a period of three years. Most notably, US Airways agreed to give up 52 slot-pairs at Reagan National Airport in Washington, D.C., and 17 slot-pairs at New York’s LaGuardia Airport, along with smaller divestitures at ’s Logan Airport, Dallas Love Field, Los Angeles International Airport, and Miami International. S&P thinks that the real power of the merger lies in the combination of American’s global route network with US Airways’ low-cost culture and strong management. We think these concessions will not prevent the economics and synergies of the merger from being realized.

The merger created the world’s largest airline (as measured by either revenues or RPMs), surpassing United Airlines, which became the largest after its merger with Continental Airlines in 2010. The new American Airlines offers 6,700 daily flights to almost 340 destinations in 56 countries. It has hubs at seven of the nine busiest US airports and a strong presence in Europe and Latin America. The merger reduced the number of major US airline companies to four—the new American Airlines, United Continental Airlines, Delta Air Lines, and Southwest Airlines. Together, these four carriers control more than 70% of the US market.

S&P thinks that the networks of American Airlines and US Airways are complementary. While the merger gave US Airways access to American Airlines’ bigger international network, it also strengthened American Airlines’ weak passenger feed in some domestic markets. American has a large presence at Heathrow Airport in London, one of the world’s major financial capitals, and on key routes throughout Europe. It is also the dominant US player in Latin America.

AMR Corp. and American Airlines had filed for Chapter 11 bankruptcy protection on November 29, 2011, in the US Bankruptcy Court (Southern District of New York). In September 2013, the court approved American Airlines’ bankruptcy plan, but ruled that the decision was contingent upon the DOJ’s approval of the carrier’s merger with US Airways. The airline asked the judge to allow American/AMR to consummate its merger with US Airways. On November 27, the judge gave her approval, and AMR emerged from bankruptcy on closing of the merger on December 9.

While AMR was in bankruptcy, it reported profits, largely on the back of concessions made by employees, leaseholders, debt, and other cost cuts made through the bankruptcy process. For 2013, American Airlines reported a net loss of $1.8 billion, compared with a $1.9 billion loss in 2012. For the fourth quarter of 2013, American reported a net loss of $2 billion compared with a $262 million profit in the same quarter of 2012. In the fourth quarter of 2013, revenues rose 7.6%, year over year, while labor costs fell 12.2%. The airline had cash and short-term investments of $10.3 billion at the end of 2013, compared with $4.7 billion in 2012.

AMR and American have started planning the integration process, which we expect will be a highly complex and lengthy exercise. The companies plan to move to a single computer system and website, combine their operations centers, and align employee procedures and manuals within a year after the completion of the deal. However, the two airlines must wait for receipt of a single operating certificate from

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 15 the US Federal Aviation Administration (FAA) before they can join their workforces, mix and match aircraft and crews, and offer a single passenger experience.

 United Airlines. United Airlines became the largest passenger airline in the world in terms of passenger revenues after its merger with Continental Airlines in 2010. Under terms of the deal, United was the acquirer, with each Continental share getting 1.05 UAL shares. The new company adopted the name United Continental Holdings Inc., but is flying under the United name, using Continental’s logo, livery, and colors. The new company’s headquarters is in Chicago, United’s headquarters, but Houston, Continental’s main hub, is the combined company’s largest hub.

S&P thinks the deal made strategic sense because there was not much overlap between the carriers. Internationally, United had a strong market presence in Europe and flew out of hubs that included Chicago and Los Angeles, while Continental flew internationally out of its hubs at Newark’s Liberty International Airport and Houston. For this reason, we think the two airlines complement each other in getting passengers to and from Europe. Continental also adds its strong Latin America network to the combination, while United has strength in the Pacific region, including China. We think the combined carrier is a truly global airline, allowing its passengers to travel throughout the world.

As to the composition of the fleet, both carriers primarily fly Boeing planes, which should help keep expense items like training, maintenance, and spare parts from becoming an issue. With several kinds of Boeing jets in use, United should be able to put the right-sized airplane into the right market, driving revenue synergy opportunities. The deal also gives the combined airline flexibility in streamlining the fleet and eliminating older, less fuel-efficient planes. As of December 31, 2013, the combined carrier had an average aircraft age of 13.5 years (13.3 years in 2012), among the youngest in the industry. United said that over the next few years, it could fly as few as 550 to as many as 700 planes, depending on industry conditions, which we think should afford it remarkable opportunities to capitalize on improving demand, with the ability to scale back if the industry does not recover.

 Southwest has gained foothold in Atlanta. The acquisition of AirTran by Southwest Airlines also made a great deal of strategic sense, in our view. AirTran was too small to compete against the larger network carriers effectively, but had a large market presence in Atlanta, a city that is highly attractive to business travelers and one in which Southwest did not have a major presence. Following the acquisition, we think Southwest is more attractive to business travelers. Moreover, the acquisition allowed Southwest to grow its capacity about 20% without adding a single extra seat to industry capacity.

We note, however, that Southwest has taken on additional risk in the acquisition by adding its first new fleet type. While AirTran and Southwest both fly the Boeing 737, AirTran also flies the 717, a smaller aircraft discontinued by Boeing in May 2006. However, in its third-quarter 2012 earnings call in October 2012, the company said that despite a spike in its engine cost component, its long-term cost outlook for maintenance materials and repairs is quite positive with the company undertaking fleet modernization. By the end of the third quarter of 2014, all Southwest Boeing 737-700s and 78 Boeing 737-300s, and 34 AirTran Boeing 737-700s were converted to the Southwest livery and had been retrofitted with the Evolve interior. The company plans to convert most of the remaining 18 AirTran Boeing 737-700s by the end of the year. We think that the acquisition of AirTran has resulted in huge benefits for the combined airline in terms of adding Atlanta and other attractive cities.

Can we expect more deals? We think that the AMR-US Airways and United-Continental deals were spurred by the perception that the merger of Delta Air Lines and Northwest Airlines Corp. in 2008 has been a success. In our view, the Delta- Northwest merger was very similar to United-Continental in that it combined a carrier very strong in Europe (Delta) with a carrier strong in Asia (Northwest). We think the smooth integration of that merger and the apparent benefits of the size and scale of the new Delta convinced United and Continental executives that the potential benefits of a larger, more integrated network would outweigh the headaches of a merger. In addition, we think that the Southwest-AirTran merger agreement was also a result of the more positive view on mergers in the US airline industry. However, United is currently facing a number of integration issues with respect to its merger with Continental that have hurt the airline’s operational statistics.

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S&P has been skeptical about the possibility of more consolidation activities in the future, mainly because so few players are left. However, given the merger of AMR Corp.’s American Airlines and US Airways, it appears that US airline industry consolidation is not yet complete.

ANCILLARY FEES

The US airline industry has been cultivating a new multibillion-dollar revenue stream. According to the Bureau of Transportation Statistics (BTS), a division of the US Department of Transportation (DOT), US airlines collected $2.8 billion in reservation cancellation/change fees in 2013, up from $2.6 billion in 2012, while baggage fees were down 0.4% to $3.4 billion. In 2011, US airlines’ reservation cancellation/change fees totaled $2.4 billion, up 3.6% from 2010. That year, however, although the number of passengers rose 1.3%, baggage fees declined by 1.0% to $3.4 billion.

In addition to baggage fees, most airlines have added or otherwise increased fees to book reservations over the phone, to cancel or change a reservation, and for overweight checked bags. Many airlines have started charging passengers for onboard snacks or meals.

According to a November 2014 press release from IdeaWorksCompany, a consultant specializing in the area of airline ancillary revenues, total ancillary revenues were projected to reach $49.9 billion in 2014, a 17.1% increase from $42.6 billion in 2013 and a 121.0% increase from the $22.6 billion in ancillary fees in 2010. In 2013, five US airlines placed in the top 10 list for collecting ancillary revenues.

It is clear that customers do not like the changes. Nevertheless, the air traveling public has largely been willing to endure low-frills service for low fares; those airlines that have tried to differentiate themselves as high service have not succeeded in gaining customer loyalty. First-class and business-class passengers, however, continue to be treated well—most airlines waive many of these fees in order to maintain the happiness of these much more profitable customer groups. S&P expects that this new model will endure largely out of necessity, but also because customers have shown that they are willing to absorb these fees.

Consumer costs increase due to ever-evolving baggage fees… The first US carrier to charge fees to check luggage was American Airlines. In April 2008, it adopted a $25 fee for the second bag checked. This action was a move toward what the carrier described as an “à la carte” pricing model—an attempt to get passengers to pay more for the services they use. All major airlines (with the exception of Southwest) eventually followed suit. In May 2008, American again led the way by implementing a fee to check first bags, which most of the industry also matched. Today, while most US airlines charge bag fees on domestic flights, ranging from $15 to $35 for a first bag and $25 to $50 for a second bag, Southwest continues to market its “Bags Fly Free” program as a way to differentiate its service and gain market share.

Spirit Airlines, a small low-cost carrier based in Fort Lauderdale, Florida, announced in April 2010 that it would start charging passengers a fee of up to $45 for a carry-on bag that is put into the overhead bin, thus becoming the first US airline to initiate such a fee (carry-ons that fit under the seat are exempt). Spirit justified the fee by stating that its fares are $100 lower, on average, than other airlines’ fares. In May 2012, Spirit announced that it would raise its baggage fee to $100, effective November 6, 2012.

On April 4, 2012, , a Las Vegas-based carrier, announced fees for luggage placed in overhead bins. The fee is $35 per flight when the luggage is checked at the airport, but a lower $15–$30 if the baggage is checked in online. Bigger airlines such as Delta, United, and others have also raised their baggage fees, citing increased fuel and handling costs as the reason. In January 2012, Delta Airlines announced that it had raised its fees on a second checked bag from $75 to $100 on international flights. In June 2012, United Airlines matched the increase by raising its fee on a second checked bag to $100 on flights from the US to Europe and a few other routes. In April 2014, Frontier Airlines said that it would charge from $20 to $50 for a carry-on bag placed in the overhead bin, depending on whether the passenger pays online or at the gate, while allowing free small bags under the seat. While airlines are likely to be watching customer reactions closely, the fees demonstrate just how far US airlines are willing to go to raise revenues.

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…with numerous benefits for airlines… The first (and most obvious) aim of these fees is the attempt to boost revenues in any way possible. Since baggage fees are generally paid at the airport when the bags are checked (although there is an online check- in option), many passengers do not consider them until they arrive for their flight; as a result, the airlines have not seen a large reduction in travel demand attributable to baggage fees. Indeed, airlines like Continental, that waited to see what customers would do before adopting bag fees, found that customers were not “booking away” from airlines with fees, so they eventually joined the crowd on this issue.

Since each airline has different fee structures for baggage, ticket changes, and other ancillary fees, these fees make it difficult for passengers to compare airfares on an apples-to-apples basis. While that information is available on the airlines’ websites, it is generally separate from the actual airfare the customer sees, and requires further investigation to discover what the fees are. S&P thinks that legislation will eventually be enacted requiring all fees to be reported to the passenger upfront on the booking page to allow for transparency of costs and the ability to compare fares with other carriers. In September 2011, the DOT proposed collecting more detailed revenue information aimed at giving consumers more transparency on airline pricing. However, the proposal has generated resistance from the airlines.

…including fuel savings and improved baggage performance The second, less obvious reason for fees is that they help reduce operating costs. Providing fewer meals onboard reduces both expenses and weight to the extent that the airline is able to eliminate heavy metal carts and kitchen galleys; in some cases, this opens up space for additional seats. Fewer phone reservations means less staffing needed in this area.

The increased baggage fees, which have reduced the number of bags being shipped, have resulted in a better performance for the airlines. First, fewer bags reduce the weight on planes and result in fuel savings. Second, fewer bags reduce the pressure on the baggage handling system and can improve customer service metrics like lost baggage, since the system is less overloaded. According to SITA, an information technology company that works with airlines, 99.1% of bags checked in 2012 were delivered on time to passengers—a record. Furthermore, the number of mishandled bags has decreased 21.2% year over year, to 6.96 bags per 1,000 passengers in 2013. Moreover, the cost of mishandled bags has decreased 50% compared with 2007, when the number of mishandled bags was 18.88 per 1,000 passengers. Though these figures are reported on a worldwide basis, they do reflect an improvement in the US airlines baggage handling services.

CAPACITY CUTS HAVE EASED CHRONIC DELAYS SOMEWHAT…

The improvement in on-time statistics has been a bright spot from the sharp capacity reductions announced by US airlines over the past two years. For 2012, airlines posted an 81.9% on-time arrival rate, the third highest annual performance in the last 18 years, according to the BTS, a division of the DOT. However, the on-time arrival rate was 78.3% in 2013, and 81.1% in September 2014.

…but the underlying problem remains S&P thinks that although on-time and other statistics have improved, once demand and capacity strengthens in a meaningful way, the US air travel industry will return to the chronic delays and passenger inconvenience that have been more the rule than the exception at airports. The main contributor to the delays is the antiquated air traffic control (ATC) system that uses radar rather than the more sophisticated satellite-based global positioning system (GPS) technology largely available in passenger vehicles. In other words, the plane in which you fly has less tracking sophistication than you have in your car. Though better technology is available, it will take many years and billions of dollars to implement a new system, so we think that flight delays will be here for some time to come. (For more details on the ATC upgrade, see the “Current Environment” section of this Survey.)

In the long term, the replacement of the outdated ATC system will be necessary to ease congestion. In the short term, however, there are several fixes that we think could alleviate the pressure on the system and that would go a long way toward easing airport delays and congestion until a new ATC system can be deployed. Among the possible short-term solutions include the following:

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. Peak period flight restrictions. The FAA could impose restrictions on US carriers to fly fewer flights during peak periods, which would force airlines to shift more flights to off-peak periods. In addition, we think that smaller regional and corporate jets could be given less priority for takeoff than bigger legacy planes carrying more passengers. . Flight path changes. The FAA has already implemented changes to flight paths in some major markets, including the New York metropolitan area, that are intended to allow air traffic controllers to spread flights out over a greater geographic area and thus increase air traffic density. . Curbs on regional jets. Restrictions on the number of regional jets flown in congested markets could also be a partial solution, since regional jets carry far fewer passengers than large jets, yet take up just as much time taxiing, taking off, and landing as other planes. Forcing airlines to “upgauge” their fleets (flying bigger jets rather than smaller planes that necessitate more takeoffs) could also help cut delays, in our view. . Congestion pricing. The FAA is also reportedly trying to implement a congestion-pricing plan, in which it would charge higher airport fees during peak hours in an effort to encourage the spreading out of flights throughout the day.

We think the US government could step in and force some corrective action, if the carriers themselves are unable or unwilling to take some steps.

FAA rules on stranded passengers may have unintended consequences A DOT rule prohibiting airlines from keeping passengers stuck on domestic flights for more than three hours took effect on April 29, 2010. The rule allows for fines of up to $27,500 per passenger per incident; the three-hour period is measured from the time the cabin doors close to when the flight takes off. Exceptions include a situation in which airport operators decide it would be too disruptive to return a plane to the gate, or a situation in which a pilot decides that there is a security or safety reason for the delay. At first, the rule applied only to domestic flights. On August 19, 2011, the DOT expanded this protection to international flights, where the delay was more than four hours.

The DOT has issued two fines concerning tarmac delays. On November 7, 2011, the DOT issued the first fine under the new rule, fining American Airlines’ American Eagle regional subsidiary $900,000 for several lengthy tarmac delays where the DOT determined that Eagle had the opportunity to avoid the delays. In August 2012, the second fine of $90,000 was charged to JetBlue Airways Corp. due to a delay at the John F. Kennedy Airport in New York.

The rules are intended to protect passengers from those occasions, admittedly rare, when planes sit on the tarmac for hours, and are a response to past incidents where passengers were stuck without working toilets or food in some cases. Nevertheless, these rules have the potential unintended consequence of leading to flight cancellations should a three-hour delay be a possibility.

A domestic cross-country flight carrying 250 passengers may generate revenues of between $80,000 and $100,000; if such a flight ran afoul of the new stranded-passenger rules, however, the fine could potentially exceed $6.8 million. Airlines cannot afford to bear such a risk, and are likely to choose to cancel a flight if they think that there is a possibility the plane will not depart within three hours. Passengers would then presumably be returned to the terminal and would need to be rebooked on a future flight, turning a potential three-hour delay into a much longer ordeal. We think the American Eagle fine is likely to lead to many more flight cancellations, particularly in the winter or during severe weather.

Delays of over three hours have been cut sharply since the new domestic rule has been implemented. According to the BTS, in 2013, there were 70 domestic tarmac delays of more than three hours, as against 42 in 2012, and 50 in 2011. Between May 2009 and April 2010, the final 12 months before the rule took effect, the carriers reported 693 tarmac delays of more than three hours. Since August 2011, US and foreign airlines operating international flights at US airports have been subject to a four-hour tarmac delay limit. In addition, there has been a decline in the flight cancellation rate. According to the BTS, in September 2014, the flight cancellation rate stood at 1.4%. In 2013, the cancellation rate increased to 1.9% compared with

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1.29% in 2012, the second-lowest annual rate for the past 18 years (the lowest was 1.24% in 2002). However, according to RITA, the cancellation rate is projected to increase further to 6.05% in 2014.

AIRLINE BANKRUPTCIES CONSOLIDATION AND BANKRUPTCIES EVER-PRESENT AIRLINE DATE* CHAPTER Evergreen Int'l Airlines 12/31/13 7 The US airline industry has a long list of bankruptcies. Most 9/28/12 11 recently, on December 31, 2013, a US-based , Comair 9/12/12 7 Evergreen International Airlines filed for bankruptcy as Pinnacle Airlines 4/1/12 11 creditors forced the company to pay off its debt. The company Ryan Int'l Airlines 3/6/12 11 had a total debt of $500 million and assets worth $100 million. Global Aviation Holdings 2/6/12 11 On September 28, 2012, Southern Air Inc., a US cargo carrier, American Airlines 11/29/11 11 filed for bankruptcy owing to defense budget cuts and a troop Gulfstream Int'l Airlines 11/4/10 11 contraction in Afghanistan. On April 1, 2012, Pinnacle Airlines Arrow Air 6/30/10 11 Corp., parent company of Pinnacle Airlines and Colgan Air, Table B07: Mesa Air 1/5/10 11 filed for bankruptcy as it succumbed to rising oil prices and Primaris AIRLINEAirlines 10/15/08 11 weak travel demand. On March 6, 2012, Ryan International Sun CountryBANKRUPTCIES 10/6/08 11 Airlines, an airlift provider for the US military, filed for Gemini Air Cargo 8/12/08 7 bankruptcy protection. On February 6, 2012, Global Aviation Vintage Props & Jets 7/18/08 11 Champion Air 5/31/08 7 Airlines, the leading commercial provider of aircraft to the US Air Midw est 5/14/08 7 military, filed for bankruptcy owing to reduced government Eos Airlines 4/26/08 11 spending and high labor costs. American Airlines and its parent Frontier Airlines 4/12/08 11 company AMR Corp. filed for Chapter 11 reorganization on 4/7/08 11 November 29, 2011. ATA Airlines 4/2/08 11 Aloha Airlines 3/20/08 11 On November 4, 2010, Gulfstream International Airlines, a Big Sky 1/7/08 7 small based in Florida with $105 million in MAXjet Airw ays 12/24/07 11 annual revenues, filed for Chapter 11 protection. Also in 2010, Kitty Haw k Aircargo 10/15/07 11 both Arrow Air Inc. (a Miami-based cargo carrier) and Mesa Florida Coastal Airlines 2/21/06 11 Airlines filed for Chapter 11 protection. Independence Air 1/6/06 7 Era Aviation 12/28/05 11 On April 12, 2008, Frontier Airlines Holdings Inc. (parent of Independence Air 11/7/05 11 Frontier Airlines) filed for Chapter 11 protection. The company Mesaba Airlines 10/13/05 11 was acquired by Holdings and came out of TransMeridian Airlines 9/29/05 7 bankruptcy on October 1, 2009. According to a compilation of Delta Air Lines 9/14/05 11 bankruptcies in the US by Airlines for America (A4A), 13 US Northw est Airlines 9/14/05 11 airlines filed for bankruptcy in 2008, of which Frontier was by Aloha Airlines 12/30/04 11 far the largest. Despite the sharp industry downturn in 2009, Southeast Airlines 12/1/04 7 there were no bankruptcy filings in that year. ATA Airlines 10/26/04 11 US Airw ays 9/12/04 11 In today’s environment, the legacy major carriers face intense / 1/30/04 11 pressure to change cost structures and operational strategies. In Great Plains Airlines 1/23/04 11 December 2002, UAL Corp., the parent company of United Midw ay Airlines 10/30/03 7 Airlines, filed for bankruptcy, marking the largest bankruptcy Haw aiian Airlines 3/21/03 11 filing in the history of the US aviation industry. United Airlines 12/9/02 11 US Airw ays 8/11/02 11 United’s bankruptcy was a monumental event in the industry, Vanguard Airlines 7/30/02 11 given that United accounted for about 25% of all RPMs flown 1/2/02 7 by US scheduled airlines in 2002 and about 24% of the US * Chapter 11: date filed; Chapter 7: date operations airline industry’s capacity, as measured in available seat miles ceased. (ASMs). On February 1, 2006, the bankruptcy court confirmed Source: Airlines for America. UAL’s reorganization plan, and the company emerged from Chapter 11 after operating for more than three years under bankruptcy protection. UAL emerged with sharply lower operating costs and lower debt levels, and without the burden of a hugely underfunded pension plan, which was passed on to the US Pension Benefit Guarantee Corp. (PBGC), a government agency that insures the pensions of US corporations. In bankruptcy, United cut annual costs by $7.0 billion, cut capacity by about 20%, and sharply reduced debt and other obligations.

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UAL was the second major US airline company to file for Chapter 11 protection in 2002, following US Airways Group Inc. US Airways subsequently emerged from bankruptcy, reentered it, and finally emerged again in September 2005, after merging with America West Holdings Corp. ATA Holdings Corp., parent of ATA Airlines (the 10th largest US airline at that time), filed for bankruptcy protection in October 2004. The company emerged from bankruptcy in February 2006, but filed again on April 2, 2008, and ceased all operations.

The rest of the industry seems stable, with most of the airlines sitting in a comfortable cash position, despite the continued spate of bankruptcies. However, bankruptcies have been a part of this business owing to the large investments and the high operating costs involved. Most of the major US airlines, except Southwest Airlines, have opted for bankruptcy at some point in their life.

AIRLINES STILL HIGHLY LEVERAGED

With many swings of boom and bust years, the US airline industry has always been a highly cyclical industry. However, since the events of 9/11, the industry has mostly been in a bust cycle, one it briefly broke out of to record modest profits in 2006 and 2007, before again reporting losses in 2008 and 2009. While no longer appropriate to blame the events of 9/11 for the industry’s woes, given that 13 years have passed since the attacks, it is important to remember that the severity of the downturn the industry faced at that time led to some of the high debt levels and weakened balance sheets that persist today. Interest expense related to high debt levels weakens airlines’ earnings power considerably. In addition, weakened balance sheets limit carriers’ ability to increase capital expenditures, add to their networks, survive another downturn, and find a willing lender to add to liquidity in a toughened credit market.

After the collapse of such companies as Lehman Brothers, Bear Stearns, and AIG, investors became increasingly worried about balance sheet stability, as many airlines have extremely high debt levels, though with the majority of the airlines having high cash balances, the net debt on their balance sheets might appear lower. For example, AMR Corp., parent company of American Airlines, reported $29.6 billion in debt when it filed for bankruptcy in November 2011. Delta Air Lines Inc. ended 2004 with debt of $13.9 billion and a negative stockholders’ equity of $5.8 billion. The company subsequently filed for bankruptcy on September 14, 2005. Before it filed for bankruptcy, Northwest Airlines Corp. also had negative stockholders’ equity. In contrast, Southwest Airlines Co., which had a healthier balance sheet than the other major airlines, such as United, US Airways, Delta, and JetBlue, had over $2.7 billion in long-term debt (including current maturities) and $7.4 billion in stockholders’ equity at the end of the third quarter of 2014, for a debt-to-total capital ratio of 36.5%. However, this represented a worsening from a debt-to-total capital ratio of 23.0% at the end of 2007, reflecting fuel-hedging losses that sapped cash and an increase in debt levels.

SECURITY RULES MAKE THE PROCESS LESS ONEROUS

A number of federally mandated security measures have been put into effect since the terrorist strikes in 2001—both to reassure the flying public and to prevent future occurrences. Airlines are now required to either screen all bags for explosives or make sure each bag is matched to a passenger seated on that flight— time-consuming and expensive initiatives.

These security measures have also made flying less convenient for travelers, and have led to customer anger and major delays. On November 1, 2010, the US Transportation Security Administration (TSA) initiated another two security procedures. The first requires passengers to submit their full name as written on their government identification; the reaction to this change was minimal. The second, the implementation of relatively invasive pat-downs for passengers who refuse to go through certain security lanes, generated a nationwide uproar and could wind up hurting air travel demand if passengers decide that the invasive new procedures make flying too much of a hassle.

The TSA has been deploying backscatter X-ray machines at airports throughout the US, with the intention of deploying up to 1,400 of the machines nationwide by 2014. The machines, which are designed to detect any object attached to a human body, including weapons and explosives, project low-level X-ray beams onto an individual to create a reflection of the body as displayed on a monitor. Some object that the new technology is overly intrusive, since the images are highly revealing—the passenger’s full body image is

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 21 shown to a security screener who sits alone in a closed-off area. Others are concerned that the low-level radiation emitted by the machines may constitute a health risk.

The increased security measures and new baggage checking requirements mean longer lines at airports, both to check in and to pass through security. Most airlines, though, have been adding security lanes, but such lines can, and do, back up, making air travel more difficult, frustrating, and time consuming for passengers.

In October 2012, the TSA started replacing the backscatter X-ray machines with a new security technology known as millimeter-wave scanners, which it completed by June 1, 2013. The TSA made this move only in an effort to speed up the screening process at the busier airports, not in response to the privacy and health concerns raised by passengers. Further, the TSA has decided to employ the backscatter machines at the smaller airports, keeping in mind the processing time and staffing requirements. However, based on tests conducted in Europe and Australia, the millimeter-wave scanners have been found to have a high false- alarm rate at 23%–54%, as even folds in clothing or sweat can set off the security alarm.

We think that the majority of passengers will have a “grin and bear it” approach toward the stricter security procedures, and that it will be impossible to quantify the number of passengers that choose not to travel solely due to these procedures. Still, these new intrusive procedures add another layer of unpleasantness to an air travel experience that much of the traveling public already views as difficult and disagreeable.

In October 2011, the TSA launched PreCheck, a new security program that covers frequent flyers at two of the top airlines and trusted-traveler program enrollees. The program works by storing a passenger’s security information contained in a bar code on the passenger’s boarding pass, and allows passengers who have been pre-approved to go through a dedicated PreCheck security check lane. Eligible travelers are not required to remove shoes and jackets or remove laptops from their bags. According to the TSA, passengers who are eligible for PreCheck include US citizens of frequent traveler programs or who are members of a US Customs and Border Protection (CBP) Trusted Traveler Program, and Canadian citizens who are members of CBP Nexus Programs. In September 2013, the TSA announced that the PreCheck program would be expanded to 60 airports.

STRUGGLING REGIONAL INDUSTRY

Regional jets (RJs)—small jet planes that fly shorter distances and have fewer seats than do large mainline jets—were first introduced in the late 1980s. The first airline to embrace the regional jet was Comair Inc. (now wholly owned by Delta). Demand for these planes began to take off about 1995, when Brazil’s Embraer SA and Canada’s Bombardier Inc. introduced low-cost jet planes, with 50 to 70 seats, for $15 million to $20 million each.

Regional jets open new markets RJs have stimulated air travel over shorter segments by getting people out of cars, buses, and trains and onto planes. With its low purchase price and operating costs, RJs have transformed short-haul markets, previously abandoned by major airlines, into viable destinations. Compared with turboprop planes, RJs also offer greater passenger comfort and increased range. RJs can handle routes of 1,300 miles—up to 2,300 nautical miles, in some cases—while most propeller planes are confined to flights of 350 miles or less.

Major airlines’ regional affiliates use these small jets to feed their hubs from smaller metropolitan areas that do not have a large enough population or travel demand to warrant larger jet service. They also use RJs to provide off-peak service when demand is insufficient to warrant a standard 100-plus seat aircraft. RJs can be profitable for such service because their break-even can approach a 50% level, versus a much higher load factor—historically about 65%, but in the past few years, closer to 85%—needed for large jets in a normal industry environment. By offering round-the-clock service, an airline gains appeal among business travelers, who account for some 70% of RJ passengers. With RJs gaining in range, they are increasingly being used not only to feed passengers into hub airports, but also to provide point-to-point competition against carriers employing full-sized jets.

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Regional airlines, majors in symbiotic relationship The major and regional airlines have a reciprocal relationship. The majors cannot rely solely on their own expensive aircraft and crews to gather passengers to feed into their hubs. The regionals depend on major carriers to provide connecting flights at central hub airports for up to 60% of their passengers. The major airlines also provide credibility, worldwide marketing power, and the all-important designator code in the computer reservation system (CRS). To be successful, regional and major airlines must work as a seamless operation using a single system for booking and boarding.

However, despite the obvious contributions regional airlines make to feed the major carriers’ hub-and-spoke networks, the major airlines are looking to their regional partners as a potential source for cost relief. The majors have been losing billions of dollars over the past 10 years and are turning over every stone to look for potential cost improvements. The regionals, which have largely remained profitable over the past 10 years due to contracts that reimburse them for fixed costs plus a guaranteed operating margin, have been pressured by the major airlines to cut rates. In addition, major carriers have been cutting regional routes where possible, and have not been adding new ones, leaving the industry without a source of new growth. S&P thinks this is likely to remain an issue for the regional industry for years to come, and major airlines continue to view regional costs as too high and an attainable target for their own cost improvement efforts.

According to the 2014 Annual Report by the Regional Airline Association, a trade group representing smaller airlines, the top 50 regional airlines in operation in the US enplaned 157.0 million passengers in 2013, versus 82.5 million in 2000 and 14.7 million in 1980. The FAA predicts that the US regional aircraft fleet (jets and turboprops) will reach 2,141 by 2034, as it is predicted to decrease by an average of three aircraft per year after 2014. Although many of the new regional jets on order are intended to replace older turboprops, they are projected to grow from 1,642 in 2013 to 1,953 in 2034. At the same time, the turboprop fleet is expected to decline from 571 units in 2013 to 188 units in 2034.

Use of regional jets restricted by labor contracts All pilot contracts have “scope” clauses, which establish the definition (or scope) of pilots’ jobs, and dictate who may perform those jobs. Scope clauses in many existing labor contracts severely limit the ability of some airlines to participate in the regional jet market boom.

WEAK GLOBAL ECONOMY CHALLENGES INTERNATIONAL MARKETS

Many US airlines see international markets as an avenue for profitable growth. These flights, which are longer haul in nature, tend to have higher average fares and lower unit costs, and are generally much more profitable than US domestic flights. During the global economic slowdown, international travel demand fell sharply, leading many US carriers to cut international capacity. In response to some economic improvement and partly due to relatively easy prior-year comparisons, international markets rebounded sharply in 2010.

International enplanements for US-based airlines rose 3.3% in 2013, after rising 2.0% in 2012, 1.7% in 2011, and 7.0% in 2010. International RPMs rose 3.1% in 2013, after increasing 1.1% in 2012 and 1.7% in 2011. Year to date through January 2014, international enplanements were up 4.6% and international RPMs were up 2.6%.

Airlines need a level playing field to compete effectively for international traffic. This requires the enactment of “open skies” aviation treaties—bilateral agreements that reduce economic regulation of airlines and allow code sharing, alliances, and partial ownership deals among international carriers. However, domestic routes in the US and overseas remain closed to foreign competition. “Cabotage”—the transport of passengers by a foreign carrier on purely domestic flights—is illegal in all nations.

The US government has favored deregulation of international aviation markets since the late 1970s. Because domestic carriers suffered heavy losses following US deregulation, the government did not pursue open skies policies until the early 1990s. The world’s first open skies pact was reached in 1992 between the US and the Netherlands. By July 2012, over 100 nations had signed agreements with the US, the most recent being agreements with Sierra Leone and Montenegro. Not all of these aviation pacts provided for unfettered competition, but all moved strongly in that direction, providing for phased-in deregulation.

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Open skies for US carriers The US government has been pursuing open skies treaties aggressively over the past decade. Most notably, on March 23, 2007, the US signed an open skies agreement with the EU that supersedes individual open skies treaties with individual European nations. This deal, which became effective on March 28, 2008, opened up restricted trans-Atlantic routes and allows US airlines to fly anywhere in the 27-nation EU to any point in the US.

Without giving up similar domestic rights to international carriers, US carriers are now able to fly within Europe. In particular, the deal has opened up the London market to more competition, as several new carriers, including Continental Airlines and Delta Air Lines, were awarded landing slots at extremely desirable Heathrow airport. We think the deal increased competition in some European markets. US carriers that did not previously enjoy landing slots at Heathrow, including Continental Airlines and Delta Air Lines, have launched new routes from that airport. Carriers such as United, American, and , though, saw increased competition.

Global partnering International alliances are crucial to achieving profits on many international routes. Having a global partner that feeds traffic through a hub generates numerous benefits. By facilitating smoother connections and stimulating traffic, an alliance can help a carrier to lower its costs dramatically, cut fares, and increase flight frequency, without requiring substantial investment in additional aircraft, airport facilities, or route authority.

Alliance partners realize cost savings in several ways: by sharing cargo and passenger terminal facilities; integrating frequent-flyer programs; consolidating sales, maintenance, and administrative operations; combining information technologies; coordinating advertising; and engaging in joint procurement where feasible. Alliances are currently structured so that partners remain independent entities, but with coordinated schedules and combined frequent-flyer programs.

Alliances aid airlines abroad Star Alliance, SkyTeam, and OneWorld are the three major global airline alliances. Each alliance includes large US and European airlines, as well as numerous secondary carriers.

 Star Alliance. Anchored by United Airlines, Lufthansa, Scandinavian Airlines, Thai Airways International, and Air Canada to name a few, Star Alliance had 27 members, with more than 18,500 daily departures to 1,316 airports in 192 countries, as of November 2014.

 SkyTeam. Anchored by Delta, Air France, and KLM, SkyTeam had 20 members, with nearly 16,323 daily flights to 1,052 airports in 177 countries, as of November 2014.

 OneWorld. Anchored by American Airlines and British Airways, this alliance had 15 members, with more than 14,000 daily flights to more than 900 destinations in 150 countries, as of November 2014. The new American Airlines Group, formed in December 2013 on the merger of AMR Corp. and US Airways Group, is now part of the OneWorld global airline alliance.

HOW THE INDUSTRY OPERATES

Few inventions have had as profound an influence on the way people live, work, and experience the world as the airplane. By shortening travel time from weeks to hours, air travel has altered our concept of distance. The world has become smaller, as people can visit and conduct business in places once considered far-flung.

The transformation of the Wright brothers’ early twentieth-century invention from a novelty to a commercial industry required considerable technological refinements and government assistance. Until the 1920s, the airplane was envisioned principally as a military tool. That view broadened in 1925, when airplanes began carrying mail. With the passage of the Air Commerce Act of 1926, the US airport and air traffic control (ATC) infrastructure began to take shape.

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To promote the then-fledgling passenger travel industry, the Watres Act of 1930 changed the airmail fee structure: fees paid to air carriers to move mail were increased expressly to subsidize passenger service. Furthering the cause of air travel was the introduction in the US of the jet aircraft for passenger service in 1958. With greater seating capacity and faster speeds, the jet dramatically cut operating costs and thus facilitated lower fares.

The industry was deregulated in 1978, freeing it from government control of fares, routes, merger and acquisition activity, and alliances. This step helped to complete the transformation of air travel from a luxury to a mass-market service. Government involvement is still evident in controls over international routes, however, and the US Department of Justice (DOJ) has halted some merger attempts, as discussed in the “Industry Trends” section of this Survey.

PROVIDING TRANSPORTATION

Airlines today derive most of their revenues from the fares charged to passengers, but they also generate revenues by carrying mail and cargo, selling alcoholic beverages, and offering in-flight entertainment and services to passengers. Additionally, airlines sell frequent-flyer credits to hotels, auto rental agencies, credit card issuers, and other organizations, which in turn offer these credits as premiums or as a way to build goodwill. Some airlines have begun selling food to coach customers onboard the plane, replacing the long- time custom of supplying it free. Many airlines have started charging to check baggage onboard the plane and some also charge extra fees for window and aisle seats or exit row seats with extra legroom.

Business travelers: less willing to pay up The airline industry has promoted the globalization of commerce, making the world into one big marketplace. Many business people use air travel to conduct sales trips, visit remote factories, and attend industry conventions. Business trips are often scheduled within seven days of the flight, so business fares have historically been the highest, whether for coach or first-class seats. Because their firms pick up the tab, business travelers long tended to be relatively price-insensitive.

Business fares climbed significantly faster than leisure fares; however, corporations became more cost- conscious. The economic slowdown that began in 2001 led to significant cuts in corporate travel budgets. In addition, corporate downsizing made organizations leaner, with fewer managers and executives authorized to travel. As part of their cost-cutting efforts, some companies are directing employees to travel coach or to patronize low-fare carriers. To reduce travel costs further, many companies negotiate travel deals, under which they promise to do most of their travel with a certain airline in exchange for sharp fare discounts. In addition, the rising prominence of online ticket distribution has made it far easier to obtain a lower fare for travel—even on short notice.

Airlines actively solicit the business traveler. Many larger aircraft contain designated business sections, which offer roomier seats and premium food service. Recently, some airlines have expanded their business- class sections. Airlines compete for business passengers by offering priority check-in, expedited baggage handling, luxurious airport lounges, and in-flight amenities such as faxes, telephones, and power outlets for recharging laptop computers. To appeal to this class of traveler, airlines must provide frequent flights, reliable on-time performance, and top safety records.

Leisure travelers look for price breaks Compared with the business traveler, the leisure traveler is highly price-sensitive. The cheaper fares resulting from deregulation have allowed people from all walks of life to travel by air to visit distant friends and relatives or take vacations more frequently.

Leisure travelers can secure discount fares in two ways. First, low fares are available to individuals who book flights at least 14 days in advance. Second, deeply discounted fares are also available, mainly via the Internet, a few days before departure. Many leisure travelers defer making trip arrangements until a fare sale is offered. The upshot of these patterns is that over short periods, leisure travel can be erratic. Over the longer term, leisure travel is more cyclical than business travel; it waxes and wanes together with consumer sentiment and disposable income levels.

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International travel International travel (defined here as flights between the US and a second nation) encompasses both business and leisure travel. In 2013, international travel accounted for 12.8% of enplanements for US airlines, similar to enplanements in 2012, but up from 12.7% in 2011, according to the US Department of Transportation (DOT). Because the average stage (or flight) length is nearly four times longer for international than for domestic flights, international travel generates a disproportionately high level of revenue passenger miles: 30.8% of total revenue passenger miles in 2013 (up from 30.4% in both 2012 and 2011).

Freight and other revenues All passenger aircraft are capable of carrying cargo, but most freight moves on wide-body jets on long stage lengths. Major airlines carry significantly more mail and cargo in the belly space under the passenger cabin than do regional and commuter airlines.

Passenger airlines view freight transport as a sideline to their main business. They garner freight business by offering discounted rates compared with those charged by specialized air freight carriers, and do not rely on large sales forces to pursue this business. Airlines often accept freight from only a few air forwarders.

Among passenger airlines, Delta Airlines generated the most revenues from cargo in 2013: $937 million (or 2.5% of its revenues) for that year. United Continental Holdings was second, with $882 million (2.3%), while American Airlines was third, with $685 million (2.5%). For the 10 largest US airlines, cargo and mail together accounted for 2.2% of total revenues in 2013. In addition, airlines generate revenues from the sale of in-flight alcoholic beverages and various amenities and services, accounted for as “other revenue.” This category may also include income from international code-sharing programs. On long-haul flights, most carriers provide telephone, ATM, fax, and TV and entertainment services for a fee. Some international flights even offer video gambling. Although such supplementary sales carry high margins, they account for a relatively small portion of industry revenues.

Most airlines have added various fees to check bags, change tickets, make phone reservations, and for just about any other service involving air travel. These fees have become an important part of the overall revenue makeup for the US airline industry. While not specifically broken out on the airlines’ income statements, the majority of these revenues fall into the “other revenue” category.

INDUSTRY STRUCTURE

The airline industry is an imperfect oligopoly. A few carriers dominate long-haul passenger traffic, while several dozen small carriers compete for short-haul flights.

Size categories The DOT classifies airlines as major, national, or regional carriers, according to revenue base.

 Major airlines. To be classified as a major airline, a carrier must have annual revenues of more than $1 billion. Major airlines typically operate jet aircraft that have 130 to 450 seats and average stage lengths of about 1,000 miles. The large aircraft used for international flights can travel 5,000 miles before refueling.

. These are carriers with revenues between $100 million and $1 billion. Despite this designation, some of these carriers limit their service to regional markets, while others offer international service. Their aircraft are usually smaller (about 100 to 150 seats) than those of the majors. National carriers may operate more short-haul flights than the majors do; they typically specialize in point-to-point service.

 Regional airlines. Regional airlines (those with revenues of less than $100 million) comprise two distinct types of carrier: short-haul/commuter airlines and start-ups. . Commuter airlines primarily serve low-density, short-haul markets that are, strictly speaking, regional in scope. Their average stage length is about 245 miles, but they often provide point-to-point service for flights of up to 400 miles. Most commuter airlines are partners with major airlines, sharing the majors’ gate space at hub airports and their computer reservation system (CRS) codes. They shuttle passengers

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to and from the secondary cities on major airlines’ hub-and-spoke systems, sometimes using turboprop aircraft that seat 20 to 50 persons (though they have recently begun using jets with 90–100 seats). A few small commuter airlines, however, operate independently of the majors and provide service on low- density rural routes.

. Start-up carriers often are classified as regional airlines based on their revenues. With an average stage length of 400–600 miles, they may initially serve a single region, though their goal is typically to offer broad coverage. Indeed, few start-ups stay in the regional category for long; either they quickly grow into the national and/or major classification, as did AirTran Holdings Inc. and JetBlue Airways Corp., or they fail. Start-up airlines often either cannot obtain or cannot afford gate space during peak business travel hours at the major airlines’ hub airports—a significant disadvantage. Moreover, even if they do get the space, the big carriers frequently match their discounted fares. Consequently, successful start-up airlines have chosen to fill niche markets overlooked by the larger carriers.

Charter airlines Charter or unscheduled service is another form of airline operation. It consists of transporting passengers on call—an irregular service like that of a taxicab. Charter service is popular with tour operators, the military, and professional sports teams. Major airlines sometimes book charter space on other airlines when they have a capacity shortfall. Most airlines provide some charter service, but only a few specialize in this line; those that do may be classified as major, national, or regional carriers. Charters’ aircraft types and stage lengths are similar to those of other airlines.

Two-tier operators A relatively new breed of airline is the two-tier operator. Typically, these carriers are major airlines that service long-haul markets via a hub-and-spoke system, but which also operate a fully independent, point-to-point air service in the discount excursion market. Most routes served by low-fare affiliates are shorter haul and consequently use smaller capacity aircraft. These affiliates also typically operate with separate wage scales.

One example is AMR Corp.’s American Eagle. Delta Air Lines Inc. discontinued its own Delta Express service and now operates through a network of regional affiliates operating under the Delta Express name.

COMPETITORS ON ALL SIDES

Airlines confront a variety of competitors. In some markets, major airlines face competition from other majors and from national and regional airlines as well. All airlines compete with other transportation modes, such as automobiles, railroads, and buses.

Before 1978, the Civil Aeronautics Board regulated the fares that airlines could charge and which routes they could fly, severely limiting new entrants into the industry. Following deregulation in 1978, competition in the airline industry intensified. As regulatory barriers to entry were dismantled and risk capital poured in, established carriers faced an unending parade of aggressive start-up airlines that targeted the larger carriers’ high-margin business. However, competitive pressures have eased, as risk capital has become scarcer for start-ups and as established carriers have limited their geographic horizons.

The automobile is the airline industry’s chief competitor. For short trips, airline travel is neither practical nor economical. For long distances, however, travelers prefer flying to driving. Airlines also face competition from intercity railroads (specifically Amtrak), which have fares that have been partly subsidized by the US government. While Amtrak operates some long-distance routes, its passengers use it for an average journey length of about 280 miles. Intercity bus travel, although much more popular than railroads, rarely competes directly with air travel, because the typical bus journey is just 140 miles.

Airlines compete with each other on both service and price. For business travelers, the frequency and reliability of flights are critical factors; frequent-flyer programs, cuisine, and other amenities are also influential. Small airlines that cannot obtain gate space during peak travel periods have difficulty attracting business travelers.

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Service information is disseminated by the DOT’s Office of Consumer Affairs, which each month reports the on-time performance for the larger airlines. The DOT also collects and disseminates information about airlines’ performance in baggage handling, passenger bumping, and overall complaint record statistics that can influence business travelers’ carrier selection. Such reports have less effect on leisure travelers; aside from the few first-class non-business passengers, price is the leisure traveler’s main criterion for carrier selection, in our opinion.

To differentiate themselves from their competitors, airlines may strive to build brand loyalty through frequent-flyer programs. Targeting mainly business travelers, frequent-flyer programs let travelers chalk up bonus miles by booking flights or by conducting business with other organizations that have tie-ins with the airlines. Bonus miles can be redeemed for free air tickets or service upgrades. Frequent-flyer programs are designed to promote repeat business for an airline; members tend not to defect to other carriers to reap minor price savings.

AIRLINE FARES: VARIABLE PRICING

Price competition is a fundamental weapon that carriers commonly use to seek a greater share of the market. Fare differentials of just a few dollars can persuade leisure travelers to select one airline over another or to make their journey by a different mode. Business travelers are also becoming more price-sensitive.

To attract leisure travelers, airlines advertise deeply discounted fares. However, most passengers do not get these fares: by law, carriers do not have to offer more than 10% of the seats on a flight at the discounted rate. On a given flight, passengers who fly coach may have booked fares at as many as a dozen different prices. Fares differ in part according to how far ahead of time the seat is booked. Walk-up fares, paid by passengers at the airport gate at departure time, tend to be high. Since the advent of online sales, however, last-minute discounts have become increasingly prevalent.

Consumers’ level of price sensitivity varies. At one extreme are passengers willing to make several connections and book “red eye” flights through online ticket auctioneers such as priceline.com Inc. Other travelers are willing to pay somewhat higher fares for direct flights at convenient times.

Perishable inventory Airline seats are perishable inventory: once a plane is aloft, its empty seats can no longer be sold. To minimize such losses, the industry has developed sophisticated computer programs to help determine how much demand there will be for each route at different times of the day, days of the week, and seasons of the year.

Airlines attempt to calculate how much of a flight should be booked by a given point in time through a practice known as yield management. Yield management alerts the carrier to abnormal booking patterns, to which it can react by either cutting or raising fares well before a flight is scheduled to depart. By offering deeply discounted last-minute fares via the Internet, airlines can now fill seats that otherwise would have gone empty. The down side is that the Internet is making consumers even more price-conscious, which is exerting downward pressure on yields.

Yield management also helps carriers estimate the number of passengers who will cancel their flights and how many seats can be overbooked without the risk of having to bump customers (deny them seating on an overcrowded flight). Only 0.92 passengers per 10,000 were bumped in 2013, down from 0.99 passengers per 10,000 in 2012. The industry tries to avoid bumping, since by law they must pay $400 to passengers involuntarily denied boarding. Carriers use computer programs to redeploy smaller aircraft to routes where sales are slower than anticipated and put their larger-capacity jets into markets that are more popular.

Igniting fare wars Since deregulation, the airline industry has been prone to periodic bursts of destructive fare wars. Much of the blame lies in the aggressive pricing tactics of start-up carriers, which operate with substantially lower costs than the major airlines and are eager to gain a foothold in the market. Southwest Airlines Co. and JetBlue (though no longer start-ups) have been the source of much fare pressure.

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Generally, the industry is susceptible to fare wars when capacity levels far exceed demand. Because airlines have high fixed costs (for equipment and maintenance facilities) relative to their marginal costs (the cost of flying one additional passenger), fare wars can reach extremes before order is restored.

THE INTERNET CREATES OPPORTUNITIES, BUT ALSO POSES THREATS FOR AIRLINES

The Internet has profoundly changed the way in which airlines price and distribute their product. By selling tickets online, airlines have dramatically cut distribution costs by eliminating paper shuffling, bypassing agents, and reducing airline staff. On the other hand, the Internet has led to more competitive pricing.

Since 1995, carriers have had a presence on the Internet. Initially, their websites displayed schedule and fleet information, as well as promotional material. Today, travelers can use these sites to check the status of their frequent-flyer accounts, to book flights and select seats, and, increasingly, to book hotels and other non- airline-related travel.

Online travel agencies, such as Expedia Inc., Travelocity.com LP, and Orbitz Worldwide Inc., have taken significant market share from traditional travel agents, a trend that S&P Capital IQ (S&P) expects to continue, as consumers become even more comfortable with e-commerce and as Internet purchases become an increasingly everyday part of people’s lives.

Helping to cut costs, but increasing competition In 1995, (a unit of Alaska Air Group Inc.) became the first airline to allow tickets to be booked via the Internet. Alaska booked about 51% of its tickets on its own website in 2011. The company has since been surpassed by many of its competitors, particularly discounters like JetBlue, whose strategy is to keep costs low through extensive use of its own website and reservation agents. In September 2012, Alaska Airlines launched its mobile booking facility and started a “Flight Status On the Go” service, which would allow passengers to get details about the airline’s current flight schedules through their mobile devices. In 2012, Southwest Airlines (excluding AirTran) led all major airlines in bookings over the Internet, getting 84% of its sales over its own website.

The Internet’s appeal for airlines is apparent. A commercial website can be kept open for business 24 hours a day, seven days a week. It allows an airline to reduce the number of customer service agents, since fewer are needed to answer flight information questions. Southwest Airlines reported in 2002 that its Internet bookings cost about one dollar to make, while its cost to book with a travel agent was between $6 and $8. According to the International Air Transport Association (IATA), e-ticketing saves up to $3 billion per year for the global airline industry.

Indeed, a big incentive for airlines to distribute tickets via the Internet is to reduce travel agent commissions. In 2002, US airlines cut base commission rates entirely on domestic flights (as discussed in the “How the Industry Operates” section of this Survey). Cuts in commission rates and increased Internet sales have been the major reasons for the trend toward lower commission costs.

On the down side, however, the Internet may ultimately hurt airline profitability by making travelers too price-sensitive. With airfares changing at lightning speed and the Internet keeping customers apprised of these changes, airlines must respond quickly to match rivals’ fare cuts. Consequently, the range of fares that competing airlines can charge on a point-to-point route will tend to be extremely compressed. In addition, the premium charged for travel booked on short notice has eroded. Airlines cannot use business travel as effectively to subsidize discounted pleasure travel, now that business travelers can make low-price, near- term travel arrangements online.

E-tickets reduce costs Ever on the lookout to cut costs, airlines have enthusiastically embraced “ticketless travel”—the practice of issuing electronic tickets (e-tickets) to customers. E-tickets are booked in the usual manner—online, through a travel agent, or directly through the airline—but no paper ticket is issued. Instead, passengers are issued an e-ticket number. They can print boarding passes at home, obtain boarding passes at the airport check-in

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 29 counter, or get them from an automated dispensing machine, which is activated with a credit card, frequent- flyer card, or e-ticket number.

According to United Airlines, electronic ticketing eliminates 14 accounting and processing procedures and thus costs just 50 cents per ticket, versus $8 for paper. Much of the savings come from not having to mail actual tickets. Travelers can get a receipt and itinerary via fax or e-mail, or at the airport. E-tickets are now the norm: S&P estimates that they accounted for over 99% of tickets sold in 2013.

Improving service Many travelers appreciate the speed of air travel. However, the process leaves much to be desired, with long lines to check in and obtain boarding passes, and frequent delays or cancellations of flights. Conditions worsened when the airlines had to institute heightened security measures.

Technology has helped with some of these problems. For example, many airlines’ passengers can skip the boarding pass counter by printing their own documents through their personal computers. In addition, a growing number of airlines have installed hundreds of self-service kiosks that allow passengers to check in luggage, obtain boarding passes, and check their frequent-flyer credits. Such kiosks have been around in one form or another since 1995.

AIRLINE COSTS

The airline industry is both labor- and capital-intensive. Additionally, fuel costs have absorbed a growing portion of revenues in recent periods.

Fuel Airlines are energy-intensive operations; for the 10 largest US carriers, fuel accounted for 30.7% of total revenues in 2013, down from 32.1% in 2012, and compared with 31.6% in 2011, 26.5% in 2010, and 25.0% in 2009. How much a carrier spends on fuel depends not only on fuel prices but also on consumption, which varies with the age of its aircraft and its average flight length. The fuel efficiency of different aircraft varies widely, with the number of engines a major determinant. Takeoffs and landings (which are more frequent for short-haul carriers) consume a lot of fuel.

Some carriers attempt to hedge their fuel costs by striking deals with suppliers or by buying and selling futures on the commodities market. Because the jet fuel futures market is thin, carriers sometimes hedge with crude oil or heating oil—an imperfect process, since neither moves in exact harmony with jet fuel prices.

Labor Labor is the second largest airline expense. Labor accounted for 22.0% of total revenues in 2013, versus 22.5% of total revenues in both 2012 and 2011, 24.1% in 2010, and 26.2% in 2009. Employment can be divided into several broad positions: flight crews (pilots and engineers), flight attendants, ground service (including baggage handlers and ramp workers), dispatchers, maintenance, and customer service (bookings and boardings).

Most airline workers belong to one of a dozen major unions. The larger unions include the Association of Flight Attendants, the Air Line Pilots Association, and the International Association of Machinists and Aerospace Workers. At any given time, an airline might be in negotiations for half dozen or more labor contracts. Union contract talks tend to be protracted, often lasting two years or more before settlement, largely because the industry follows procedures laid out by the Railway Labor Act of 1926 (RLA). Strikes occur infrequently because under the RLA, airline contracts do not expire, but become amendable. Before a strike can occur, labor disputes must be submitted to the National Mediation Board, an impasse must be declared, and a cooling-off period served.

Equipment Airline equipment costs, excluding fuel and maintenance, are equal to about 10% of total expenses. Aircraft may be obtained new or secondhand, or they may be leased.

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For carriers with balance sheets that are stretched, leasing is the most affordable method of obtaining equipment. Many major airlines lease the bulk of their aircraft (about 55% of their fleets) from intermediary companies known as lessors. Lessors often can finance the purchase of new aircraft more cheaply than airlines can because of their superior credit rating. They then pass on some of the savings to the airlines, reducing carriers’ equipment costs while earning a profit for themselves. For financially strong carriers, however, it is cheaper to buy aircraft outright than to lease them.

Carriers incur the costs of maintaining their fleets, whether leased or owned. Most carriers perform routine maintenance, but many outsource heavier repairs to firms that specialize in such work. Even if they contract out the maintenance work, though, airlines are still responsible for the airworthiness of their aircraft.

The high cost of bad weather Weather is another unpredictable variable that can have a profound short-term effect on airline costs and operations. Wind speeds and air temperatures influence how much fuel an aircraft will require to reach its destination. Floods, fog, ice, and snow can shut airports and force the cancellation of flights. Weather is the second largest cause of airline accidents, after pilot error.

The industry must obtain detailed weather forecasts that include cloud height, horizontal visibility, and wind speed and direction. Some airlines have their own meteorology departments to provide this information, although most rely on government agencies and pilot reports.

OPERATIONS OVERVIEW

Airline flights are either nonstop or connecting. A nonstop flight has a “point-to-point” itinerary, in which the aircraft flies from origin to destination without interruption. A connecting flight is one that involves at least two legs and passes through at least one hub.

Short flights typically have no intermediate stops, while flights covering longer distances tend to be routed through a hub. The hub-and-spoke system lets airlines gather passengers from lightly traveled markets to a single point to build up densities for the longer leg of a flight. To bring passengers to the hub, the hub carrier will use either its own smaller capacity aircraft or the services of a regional airline, which the major airline often owns wholly or in part. Until recently, the regionals typically employed only turboprop aircraft, but they are aggressively phasing out these small, noisy aircraft in favor of comparatively larger jets. On the longer leg of the route, larger-capacity jets are used.

To connect flights from central hubs to low-density destinations or vice versa, large airlines and small regional carriers often complete different portions of a trip—a practice known as “interlining” passengers. Such joint flights are typically scheduled through a code-sharing arrangement.

Through code sharing, a carrier sells seats for flights on joint routes. Although two carriers are to provide the service, the customer receives a single ticket. In these arrangements, the regional airline typically operates under the major airline’s code, and flights are booked as such in computer reservation systems (CRS). Federal regulations require airlines to inform passengers when they are booking a flight that involves code sharing.

Another technique, used mainly for short duration, is a “wet lease” arrangement, in use both in the US and overseas. A larger airline leases an aircraft accompanied by a full crew to provide service on a route that it cannot or chooses not to operate directly. Once traffic on the new route reaches a level where the carrier can use its own aircraft and crew, it often drops the wet lease.

DISTRIBUTION CHANGING WITH TECHNOLOGY

The airline industry historically distributed tickets primarily through travel agents, but it also books flights directly through company clerks and on the web. In addition, online travel sites are gaining market share.

According to the US Bureau of Labor Statistics (BLS), approximately 64,250 travel agents operated in the US as of May 2013, down from 64,680 travel agents in May 2012 and around 105,300 travel agents in

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May 2008. Also, nearly 20,000 accredited points of sale were using transaction settlement services offered by Airlines Reporting Corp. (ARC), a provider of technology, data, and financial services to the airline industry. These numbers have been declining due to a more difficult operating environment, in which airlines are reducing commissions, and growing Internet competition.

In April 2002, most of the major US airlines eliminated the payment of base commissions to travel agents on domestic tickets. Many airlines substituted incentive commissions to travel agents that booked a predetermined volume of tickets for that airline. Many travel agents have responded to these cuts by charging customers a service fee to book air travel, which means that the airlines have essentially passed much of the cost of booking tickets on to the consumer.

Airlines try to encourage travel agents to steer customers their way by offering “commission overrides.” A commission override is an incentive whereby an airline agrees to compensate an agent at a higher-than- customary rate once the agent’s bookings exceed a predetermined level.

Computer reservation systems To book a flight, the travel agent harnesses one of several major CRS. Nearly all airlines now supply their flight and fare information to CRS operators, though most carriers hold back special fares for their own Internet sites. When a flight is booked, the airline pays the CRS operator a fee of between $2.50 and $3.00 per ticket. In addition to offering real-time airfare and route information, the CRS can be used to book hotels and cruises and to rent cars.

The leading CRS is Sabre Holdings Corp., which began as the internal reservations system for American Airlines before it was opened to other airlines in 1976. Air carriers have sold or spun off controlling stakes in Sabre and other CRS operators such as Amadeus IT Group SA, Galileo International LLC., and Worldspan LP (the latter two are affiliated with Travelport). In March 2007, private equity groups Silver Lake Partners and Texas Pacific Group acquired Sabre.

After deregulation, the CRS became indispensable, as air carriers began offering a multitude of fares per flight and making frequent changes in their fare offerings. These systems contribute to a more efficient market in airfare pricing, because they provide customers and carriers with full knowledge of existing fares.

Air travelers can book flights and secure fare information via the Internet. Airlines allow flights to be booked through their Internet home pages. Another option for passengers is to book flights via the Internet by utilizing cyber travel agents—intermediaries that pull together all airline schedules into a synthetic variant of a CRS. The Internet version of the CRS is accessible to all PC owners and is in a format that is more user-friendly than a traditional CRS.

REGULATION UNDER DEREGULATION

Federal regulation of domestic airline fares and markets ended with the Airline Deregulation Act of 1978. However, the DOT and its affiliated agency, the Federal Aviation Administration (FAA), continue to regulate the industry with regard to safety, labor, operating procedures, aircraft fitness, and emission levels. The International Civil Aviation Organization (ICAO), an entity affiliated with the United Nations, proposes noise standards, though the standards are not legally binding in a given country unless the country has formally agreed to them.

The FAA, established in 1958, primarily promotes safe air travel. It does this by monitoring the industry’s maintenance and operating practices. The FAA certifies aircraft and airlines and establishes age and medical requirements for pilots. One of the agency’s chief functions is to operate the nation’s air traffic control (ATC) system at some 288 airports. Another 161 airports are operated under contract from the FAA.

The DOT levies civil penalties against airlines that engage in fraudulent marketing practices or that violate code-sharing rules. It also oversees compliance with denied boarding (bumping) compensation rules and renders decisions on airline ownership and control issues. The DOT plays an important role in negotiating bilateral aviation treaties with foreign nations.

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When US airlines operate in international markets, they are subject to economic regulation by individual foreign governments and collective organizations such as the European Commission. The degree of regulation varies from country to country, and the rules are laid out through formal bilateral aviation treaties. These accords govern reciprocal landing rights and typically limit the number of carriers that can operate in a country, the level of rates, the type of aircraft, and the frequency of flights.

Feds take jurisdiction over airport security In response to public worries about air travel security following the terrorist attacks of September 2001, President George W. Bush signed the Aviation and Transportation Security Act in November 2001. The law federalized the airport security industry and created the Transportation Security Administration (TSA). As of May 2013, there were 45,790 federal screeners, who were deployed at all 429 US commercial airports.

Federal control of airport security is aided by the use of information from the Federal Bureau of Investigation and other agencies in the screening process. The government pays workers’ salaries; the airlines are responsible for some costs, including equipment expenditures and airport charges. In addition, airlines pay a federal tax of $5 per passenger per segment to cover a portion of the government’s added security costs. This fee is passed along to passengers.

The 2001 law also required that all bags be checked for explosives. At present, this is done by passing bags through a bomb detector or by assuring that each bag is matched to a passenger who actually boards the same plane. Ultimately, all checked baggage must pass through scanning equipment.

The Federal Air Marshal Program, operated by the FAA, deploys specially trained, armed teams of security specialists on domestic and international flights. While the number of total marshals in place and their itineraries are secret, the FAA says it has taken steps to sharply increase the number of marshals in the sky.

KEY INDUSTRY RATIOS AND STATISTICS

 Revenue passenger miles (RPMs). This measure of airline traffic is calculated by multiplying the total number of passengers carried by the number of miles flown. The most frequently reported aggregate figure is RPMs for the 10 largest carriers, a group for which data are available on a timely basis. Accounting for over 90% of total US traffic in 2013, the 10 largest airlines are a good proxy for the entire industry.

Industrywide RPM numbers are available on a monthly basis from Airlines for America (A4A), an industry trade group representing larger passenger airlines and leading air cargo companies. Examining this indicator’s year-over-year change for AIRLINE TRAFFIC STATISTICS each month shows the pace at which the (System operations, twelve-month moving total) industry is growing or contracting. (An 1100 84 examination of month-to-month changes 1025 82 is irrelevant, however, because the 950 80 indicator is not adjusted for seasonal factors.) For the US industry as a whole, 875 78 RPMs (including domestic and 800 76 CHART H02 Airline international flights and express carriers) 725 74 Traffic Statistics rose 2.0% in 2013 to 834.7 billion. Year 650 72 to date through September 2014, RPMs 575 70 were up 2.3%, year over year, reaching 500 68 609.1 billion. 2000 01 02 03 04 05 06 07 08 09 10 11 12 13 2014*

ASM (in billions, left scale)  Available seat miles (ASMs). This RPM (in billions, left scale) capacity indicator measures the total PLF (in percent, right scale) number of seats in the active fleet, ASM-Available seat-miles. RPM-Revenue passenger-miles. multiplied by the number of miles flown; PLF-Passenger load factor. it can be calculated for an individual *Data through July. Source: US Bureau of Transportation Statistics. airline or for the entire industry. The

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A4A compiles an industrywide figure on a monthly basis. Changes in ASMs are influenced by net additions of aircraft to the fleet, by the pitch and mix of aircraft seats (number of first-class seats versus business and economy), the average length of flights, and by how quickly the airline (or industry) turns around its aircraft between flights.

For the US industry as a whole (including domestic and international flights), ASMs totaled 1004.1 billion in 2013, an increase of 1.6% over 2012. Through September 2014, ASMs were up 1.8%, year over year, reaching 725.7 billion.

 Load factor. This indicator, compiled monthly by the A4A, measures the percentage of available capacity (as measured in ASMs) that is taken up by revenue-paying passenger traffic. It may be calculated as a single airline’s capacity utilization, or for the entire industry.

Once the industry’s load factor exceeds the break-even point (which is a moving target), profit margins can expand dramatically as incremental revenues flow to the bottom line. Because seasonal elements influence the load factor, year-over-year comparisons are more meaningful than month-to-month changes. As deregulation has forced down fares and helped fill aircraft cabins, the direction of the industry’s load factor has generally been upward. In the early 1970s, the average flight was half-empty. The load factor was 82.0% in 2011, 82.8% in 2012, and 83.1% in 2013. Through September 2014, the load factor was 83.9%.

 Consumer confidence. The Conference Board, a private research firm, compiles this index monthly. Consumers from every US geographic region are surveyed about their near-term spending plans and overall economic expectations. The index peaked at 144.7 (1985=100) in January 2000, surpassing the record high that had stood since October 1968. Subsequently, however, consumer confidence AIR TRAVEL PLANS (Percentage of consumers planning a vacation in the next six months) fell sharply, reflecting the economic slowdown. As of July 2014, the index stood at 90.9, up 70 from 86.4 in June. 60 Chart H03 Air 50 Travel Plans One component of consumer confidence that has direct relevance for airlines is consumers’ 40 plans for vacation travel, along with the 30 percentage of consumers planning to travel by air. According to the Conference Board, as of 20 October 2014, 52.4% of consumers were 10 planning a vacation in the next six months, and 0 21.1% planned to fly. 03 04 05 06 07 08 09 10 11 12 13 2014* Planning a vacation Traveling by air  Disposable personal income. Reported each *Data through October. month by the US Department of Commerce, Source: The Conference Board. this measure calculates aggregate consumer income (in dollars) after taxes. Changes in disposable income have a bearing on leisure travel. Although growth in nominal disposable income (unadjusted for inflation) tends to be positive, real (inflation-adjusted) disposable income rises and falls with the economic cycle. It was up 3.8% in 2011, 3.9% in 2012, and 1.9% in 2013. S&P Economics (which operates separately from S&P Capital IQ) was projecting disposable personal income to rise 4.7% in 2014.

 Corporate profits. Reported quarterly by the US Department of Commerce, this figure is a measure of aggregate business profits, in dollars. Although corporate profits are reported both before and after taxes, the pretax number is more useful. Changes in corporate profits, unless extremely minor, have major bearing on business travel. For example, the sharp drop in corporate earnings that often accompanies a recession will ultimately lead to a curtailment in business travel. Pretax corporate profits rose 2.1% in 2011, 18.5% in 2012, and 3.4% in 2013. For 2014, pretax corporate profits were projected to rise 12.0%.

 Jet fuel prices. The spot price for jet fuel (at New York Harbor) can be found on the Bloomberg Terminal, which tracks transactions with a 15-minute delay. Changes in jet fuel prices are often the swing

34 AIRLINES / DECEMBER 2014 INDUSTRY SURVEYS factor in airline profits. It’s important to remember, however, that because of purchase contracts and hedging strategies, airlines buy very little of their fuel at the spot market price.

The highest price for jet fuel was reached in July 2008, when it averaged $3.70 a gallon for the month. For 2013, jet fuel averaged $3.03 a gallon, down 4.5% from the average for 2012. Year to date through August 2014, the cost of jet fuel averaged $3.01 a gallon, down 1.6% from the average for the same period in 2013.

HOW TO ANALYZE AN AIRLINE

Factors to examine when analyzing an airline include its traffic and pricing, market share, costs, profitability and load factor, balance sheet stability, service and safety record, and equity valuation, as discussed following. Other important factors are managerial strength and employee morale. Although difficult to quantify, these characteristics are typically reflected in an airline’s cost and asset performance measures.

OPERATING STATISTICS OF THE MAJOR US AIRLINES CONTI- NORTH- SOUTH- US TOTAL YEAR AIRTRAN† ALASKA AMERICAN NENTAL‡ DELTA JETBLUE WEST § WEST UNITED AIRWAYS£ MAJORS AVAILABLE SEAT- MILES (MILLIONS) 2014ʬ NA 26,922 200,604 NA 181,647 33,558 NA 98,357 185,808 NA 726,896 2013 NA 33,672 154,499 NA 232,740 42,824 NA 130,344 245,354 91,574 931,007 2012 NA 31,428 166,223 NA 230,415 40,075 NA 128,137 248,860 88,425 933,563 2011 NA 29,627 167,828 NA 234,656 37,232 NA 120,579 252,528 86,673 929,123 2010 24,062 27,669 165,420 NA 232,684 34,744 NA 98,437 169,565 85,818 838,400 2009 23,294 26,436 163,340 97,407 230,331 32,558 NA 98,002 140,716 85,092 897,176 2008 23,809 24,218 163,491 102,527 128,979 32,442 83,882 103,271 152,025 89,104 903,749 2007 22,692 24,210 169,862 103,139 127,749 31,904 86,142 99,636 158,191 90,001 883,002 2006 19,007 23,278 173,945 97,666 125,480 28,594 85,603 92,663 158,835 76,983 866,000 REVENUE PASSENGER-MILES FLOWN (MILLIONS) 2014ʬ NA 23,078 Table 165,730 B01 Operating NA 154,897 28,421 NA 81,267 156,348 NA 609,741 2013 NA 28,833 statistics 128,413 of major NA US 194,988 35,836 NA 104,348 205,167 76,663 774,248 2012 NA 27,007 airlines 136,620 NA 192,974 33,563 NA 102,875 205,485 73,318 771,842 2011 NA 25,032 136,386 NA 192,767 30,698 NA 97,583 207,531 71,321 761,318 2010 19,578 22,800 134,298 NA 193,169 28,279 NA 78,047 140,857 69,593 686,621 2009 18,588 20,770 130,672 79,824 188,943 25,955 NA 74,457 114,245 68,459 721,913 2008 18,956 18,711 131,730 82,807 105,700 26,071 71,216 73,492 122,216 71,425 722,323 2007 17,298 18,452 138,421 84,310 103,452 25,737 72,924 72,319 130,048 71,594 734,554 2006 13,836 17,822 139,396 79,189 98,911 23,320 72,606 67,691 129,727 60,689 703,187 PASSENGER LOAD FACTOR (PERCENT) 2014ʬ NA 85.7 NA NA 85.3 84.7 NA 82.6 84.1 NA 83.9 2013 NA 85.6 NA NA 83.8 83.7 NA 80.1 83.6 NA 83.2 2012 NA 85.9 82.2 NA 83.8 83.8 NA 80.3 82.6 82.9 82.7 2011 NA 84.5 81.3 NA 82.1 82.5 NA 80.9 82.2 82.3 81.9 2010 81.4 82.4 81.2 NA 83.0 81.4 NA 79.3 83.1 81.1 81.9 2009 79.8 78.6 80.0 81.9 82.0 79.7 NA 76.0 81.2 80.5 80.5 2008 79.6 77.3 80.6 80.8 82.0 80.4 84.9 71.2 80.4 80.2 79.9 2007 76.2 76.2 81.5 81.7 81.0 80.7 84.7 72.6 82.2 79.5 83.2 2006 72.8 76.6 80.1 81.1 78.8 81.6 84.8 73.1 81.7 78.8 81.2 *For comparison only; not included in total. Company w as not classified as a major airline until 2004. NA-Not available. £Merged w ith American Airlines in December 2013. †Acquired by Southw est Airlines in May 2011. ‡Merged w ith United in May 2010. §Acquired by Delta Airlines in 2008. ʬData through September. Sources: Aviation Daily; US Department of Transportation. REVENUE-RELATED FACTORS

Traffic is the starting point in analyzing a passenger airline. It can be measured in terms of revenue passenger miles (RPMs) or enplanements (the total number of people carried). Both provide useful measures of a carrier’s market share. Traffic levels and yield, a measure of pricing trends, are the two determinants of revenues.

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 35

Traffic: revenue passenger miles For any given period, RPMs equal the total number of passengers enplaned, multiplied by the average distance flown. This measure is superior to enplanements as an analytical tool, because airline revenues closely correspond to RPM levels. Short-haul carriers sometimes rank high based on total enplanements, but appear smaller when measured by RPMs or revenues.

Changes in RPMs should be compared with industry averages to determine whether a carrier is gaining or losing market share. Traffic performance must be viewed in conjunction with yield analysis to determine whether a carrier is “buying” market share at the cost of profits. Each month, scheduled airlines report their traffic data to the US Department of Transportation (DOT). Start-up carriers and regional and charter airlines typically outperform the majors in RPM growth because their traffic base is much smaller. Again, growth rates should not be confused with profitability.

A comparative analysis of different carriers’ RPM performance over a short period can yield a distorted picture. Vacation travel tends to be concentrated during the summer months, creating uneven seasonal traffic patterns. For small regional airlines with a high proportion of business travelers, these seasonal swings may be largely absent. Consequently, using data for the off-season winter travel period might lead one to conclude erroneously that small, business-oriented airlines were outperforming their larger competitors.

Yield: a look at pricing trends The other component of revenues is pricing, or fare levels. The passenger revenue generated per RPM is commonly referred to as the yield. It is useful to compare the trend in a carrier’s yield with the trend in yield for other airlines; however, comparing the yield levels for different carriers is useful only if the carriers provide a similar mix of flights.

Although international flights have yields that tend to be lower than those on domestic routes, they may be more profitable. Thus, one should take into consideration the percentage of domestic versus international travel in a carrier’s mix. In addition, airlines that have a larger mix of business or first-class seats will report yields that are higher than carriers flying the leisure trade on identical routes. While short-haul flights tend to have higher yields, their costs are also higher and their load factors tend to be lower.

MARKET SHARE AND GEOGRAPHIC MIX

The best method for determining a carrier’s relative market performance is to look at the specific city pairs that it serves—its share of total enplanements at the airports where it operates. An analysis of city-pair traffic can pinpoint exactly where a carrier is facing the greatest degree of competitive pressure. In today’s environment, it is not unusual to find major airports where a single airline accounts for 75% or more of total enplanements. Carriers that have low market share—or that serve cities where no single airline dominates—will face greater competitive pressure on fares.

An airline’s geographic mix is also important. Economic growth and the level of discretionary spending— and, hence, air travel—vary from region to region and nation to nation. Airlines that serve a limited market can see their traffic diverge from overall national trends. A carrier that primarily serves Hawaii, the Florida tourist market, or the oil-patch states could beat or underperform other carriers at times. Likewise, carriers that derive a high percentage of their total RPMs from international travel may see their traffic occasionally out of step with those that serve domestic markets exclusively.

Whatever markets an airline serves, however, it is not locked into them in the same way that a railroad is because airlines can reposition their assets depending on where the best growth opportunities lie. Airlines can shift resources out of weaker international locations and into stronger ones, or out of weak, underperforming, or money-losing domestic markets into those with better growth potential. There are limits to this strategy, however, since not all aircraft types can be operated in every market. For example, jumbo jets need dense, long-haul routes for profitable operation and require airports with long runways.

36 AIRLINES / DECEMBER 2014 INDUSTRY SURVEYS

COSTS

When evaluating an airline, it is often more important to analyze its cost performance than its traffic. Among start-up airlines, the aggressive, high-growth carrier is frequently the one to suffer defeat. In contrast, carriers that pursue a manageable level of growth while controlling costs tend to thrive.

Labor Labor has historically been the industry’s largest cost item, though from 2005–2008, and again in 2010, fuel was the largest cost category for most carriers. According to data compiled by S&P Capital IQ (S&P), labor costs at the 10 major US airlines averaged 22.0% of total revenues in 2013, versus 22.5% of total revenues in both 2012 and 2011, ranging in 2012 from 16.0% (Spirit Airlines) to 28.4% (Southwest Airlines Co., surprisingly to many).

How much an airline spends on labor depends on its efficiency and the labor-intensity of its routes. For example, short routes on which meals are not served have lower personnel and cleaning costs than those that require meal service. They also have lower gate rental fees. Aircraft can be turned around quickly because they do not require catering entrances and other facilities needed by long-haul flights; also, they do not need to refuel as often. Thus, short-haul operators typically incur lower labor costs than do the major national airlines.

Outsourcing certain functions, such as maintenance or reservation services, reduces labor costs as a percentage of the total and can cut total costs as well. Similarly, a technology-intensive airline—one with a high percentage of sales booked over the Internet, for example, and/or electronic ticketing and self-service check-in kiosks—will enjoy high labor productivity.

While most airline employees are union members, wages and work rules differ from carrier to carrier. Aircraft type and design will determine the size of the flight crew: some aircraft require two copilots, while others need only one. Nonunion airlines instruct flight attendants to perform tasks that are restricted to fleet service operators in union airlines. Some airlines offer sizable profit-sharing programs or may have employee stock ownership programs (ESOPs) in addition to salaries and benefits. Although these may not be recognized as an expense category on the income statement, such airlines will record a charge to earnings to cover distributions under the ESOP plan—equaling as much as 5.0% of revenues.

Labor efficiency should be measured relative to output; in the airline industry, this translates into RPMs per worker. Labor productivity averages about 1.4 million RPMs annually per worker, with major carriers recording between 1.1 million and 1.6 million RPMs per worker per year.

Fuel Airlines are energy-intensive operations, but carriers have different levels of exposure to changes in fuel prices. In the past, fuel costs at the major airlines averaged as little as 10.0% of their revenues. Rising oil prices have hit all the major carriers, however. In 2013, fuel costs averaged about 30.7% of total revenues among the 10 largest US airlines, versus 32.1% in 2012, and 31.6% in 2011. Costs in 2013 ranged from a low of 29.0% (Alaska Air Group) to a high of 34.6% (JetBlue) of revenues. Along with the number of engines, the age of a carrier’s aircraft greatly influences fuel consumption rates, as newer planes are more fuel-efficient than older models.

Carriers specializing in short hauls, which involve frequent departures, consume more fuel than do long- haul airlines, because a disproportionate amount of fuel is burned during takeoff and landing. However, short-haul carriers operating turboprop aircraft consume less fuel than those employing jets. Meanwhile, carriers based in the western US typically pay more per gallon than do other US airlines.

Most airline managers now see the value of using futures and swaps to hedge a majority of their fuel price exposure. Thus, under normal conditions, the average price per gallon of jet fuel may vary by 10% to 15% from carrier to carrier, as airlines engage in fuel hedging to varying degrees. Given the recent weakness in many airlines’ balance sheets, however, many carriers have been unable to hedge against rising oil prices to the extent that they would like. In addition, with oil prices recently near record highs, many carriers have

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 37 been unwilling to enter into new hedge positions as older ones expire; they are afraid to lock in high oil prices, which could lead to hedging losses if oil prices recede.

Maintenance The average carrier spent about 5.5% of its revenues on maintenance in 2013 and 2012, versus 5.2% in 2011. Maintenance spending per carrier varies materially with the amount of work outsourced.

Aircraft age greatly influences the level of maintenance required. Just as important, however, is the spacing of fleet ages. Every six to eight years (or 20,000 flight hours), each aircraft must undergo an intensive maintenance program known as the D-check. Airlines that fail to space orders evenly, or that buy secondhand aircraft of the same age, will face a bunched-up maintenance program at some point. If this happens, it will distort the results of a comparative analysis.

Financing aircraft purchases For the major airlines, interest expense (net of interest income and capitalized interest) averaged about 2.0% of revenues in 2013, versus 2.1% of revenues in 2012, and 2.6% in 2011.

Many airlines lease some portion of their fleets from equipment lessors. Aircraft rental costs averaged about 2.3% of revenues in 2013, versus 2.4% of revenues in 2012 and 3.0% in 2011.

PROFITABILITY AND LOAD FACTOR

A key determinant of profitability is capacity utilization, as measured by load factor: a carrier’s RPMs divided by its available seat miles (ASMs). ASMs are calculated as aircraft miles flown, multiplied by the number of seats available for revenue passenger use. Given airlines’ high fixed costs, the more passengers that can be boarded before each departure, the more profitable the flight will be, provided variable costs are covered.

Immediately after September 11, 2001, load factors dropped sharply—to well below 50%—but they have since risen above historical averages as low fares have spurred demand, albeit at the cost of lower industry yields. It is important to realize, however, that rising load factors show only that capacity utilization is increasing, not necessarily that passenger volumes or profitability are improving.

Carriers’ load factors are always highest during the peak summer travel season, as approaching or exceeding 80.0%. (In July 2010, mainline passenger load factor averaged 87.6%, which is a record for any month.) During the off-season, load factors may be closer to 75.0%. Short-haul commuter airlines, which typically operate small turboprop aircraft, often sustain load factors well below those of the majors, but can operate profitably at load factors of 50% or less, because they turn their planes around more frequently. For longer- haul flights, break-even load factors would likely be above 70.0% under normal conditions. For the legacy majors, they have been much higher in recent periods due to reductions in capacity and sharp discounting, which has filled planes but at below break-even revenue levels. A carrier’s break-even load factor depends on its revenue per passenger mile and the cost of providing each available seat-mile.

RASM versus CASM Comparing passenger revenues per ASM (RASM) with costs per ASM (CASM) is a common way of measuring airline profitability. RASM is the indicator most closely watched by financial analysts, but both measures are crucial. In the past, United Airlines and American Airlines demonstrated that simply removing seats could increase RASM. This increase, however, clearly was not enough to make them profitable.

Since airlines often earn an additional 10% of their income from other sources, S&P also likes to consider a total RASM measure that includes cargo operations, sales of frequent-flyer miles, in-flight liquor, entertainment, or telephone services and other amenities. These non-passenger revenue sources can make the difference between an operating loss and a profit.

38 AIRLINES / DECEMBER 2014 INDUSTRY SURVEYS

BALANCE SHEET STABILITY AND CASH BURN

Given the high debt levels carried by many airlines and the frequency of large operating losses, it is important to assess the strength of an airline’s balance sheet. Metrics such as debt-to-equity and debt-to- total-capitalization should be examined, as should cash on hand to cover interest payments and other liquidity needs.

During times of industry losses, it is important to determine how quickly an airline may be using its available cash (its cash burn rate). For example, UAL Corp. (before its bankruptcy filing in December 2002) and Delta Air Lines (which was in a precarious financial state in late September 2004 and again in March 2005) burned through millions of dollars in cash each day. In such cases, it is important to gauge how long an airline can withstand a downturn and remain solvent.

SERVICE AND SAFETY RECORD

One way to measure an airline’s service performance is by the percentage of its flights that arrive on time, as published in the DOT’s “Air Travel Consumer Report.” Typically, 75%–80% of all flights arrive within 15 minutes of their scheduled time. Carriers that route passengers through hubs into connecting flights are more likely to have a lower on-time performance than those offering direct point-to-point flights.

On-time performance is generally worse during the winter, when weather can wreak havoc with schedules. This is especially vexing for carriers that serve more northern than southern states in the US. In addition, airlines serving congested metropolitan markets often suffer from poor on-time performance caused by air traffic control-related delays. The on-time numbers are not an infallible measure, though, because some airlines lengthen their estimated flight times to allow for delays.

The DOT collects and disseminates information about consumer complaints, which is usually a relatively reliable indicator of service levels. Sometimes a poor service performance reflects low employee morale, particularly if a carrier’s labor talks have reached a stalemate.

Another way to assess service is to look at the bumping ratio—the percentage of passengers denied boarding. Airlines that overbook flights will have high bumping ratios. Some 0.2% of all passengers are bumped; of that total, however, only 5.0% are bumped involuntarily—the rest take an offer from the airline to be “voluntarily” bumped. Bumped passengers are compensated for their inconvenience, often with as much as $400 in cash, vouchers, or frequent-flyer credits. Consequently, airlines with high levels of overbooking still may have high levels of consumer satisfaction. A case could even be made that high bumping ratios coincide with wider profit margins, because it indicates that flights are fully loaded with passengers.

A carrier’s safety performance can sometimes play an important role in determining consumers’ choice of airline. The Federal Aviation Administration (FAA) measures carriers’ accident rates per 100,000 departures. Most carriers have low accident rates, and their safety records tend not to vary significantly. In general, airline safety has been on the rise. The National Transportation Safety Board reported one fatal accident (the first in three years) in more than 9 million scheduled departures in 2013, resulting in two fatalities.

Fleet planning and management An analysis of an airline’s asset performance determines how well it manages its fleet. The faster a carrier can get its aircraft back into revenue service, the more profitable it will be. Jet utilization is measured by the number of hours the average aircraft is in service. The most efficient (and usually the most profitable) carriers tend to have their aircraft in service for 11 to 12 hours per day.

Fleet age is an important statistic because it provides an early warning of when a carrier’s capital spending may have to be ramped up to replace equipment. The age of an aircraft is less important than the number of takeoff and landing cycles, which puts stress on the fuselage. In addition, the age of the aircraft’s engines and number of hours flown is a better gauge for the condition of the aircraft. While many start-up airlines operate with older planes, established regional and commuter airlines, even those operating primarily with turboprops, tend to own fairly new fleets.

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 39

EQUITY VALUATION

Airline stocks are among the most volatile shares on the market: investors tend to bid up shares of airlines when they are incurring substantial losses and things look bleakest. Once profits are fat, investors normally move on, racing to lighten their airline holdings before the next downturn. However, the industry downturn that began after September 11, 2001, and persisted through 2005 seems to have shaken that historical pattern due to the sheer size of the losses and the extreme difficulties the carriers were facing. In light of this volatility, many airline stocks have historically been viewed as trading vehicles.

Speculators tend to trade airlines as plays on falling oil prices or the expectation of falling prices. The stock movements can exaggerate the effect that changes in fuel costs have on an airline company’s bottom line. For example, while a 10% jump in crude oil may increase airline fuel costs 10%, total costs might rise only 3%, affecting profits somewhere in between. Yet, driven by speculators’ response to the change in oil prices, an airline’s shares may rise or fall 40% or more.

Furthermore, the “best” airlines may not have the richest valuations. A strong service performance and a young fleet are of secondary consideration in this regard; investors tend to favor growth airlines with wide profit margins. During a rally in airline equities, however, the biggest percentage gain in stock price may go to the “worst” airline, because investors anticipate a greater gain (off a depressed base) in that carrier’s bottom line. Thus, in the perverse logic of Wall Street, an airline’s quality may have an inverse relationship with its stock performance—at least during a bull market. In a bear market, however, quality usually shines through.

S&P typically focuses on Enterprise Value-to-EBITDAR (earnings before interest, taxes, depreciation, amortization, and aircraft rent), or EV/EBITDAR, as a way to compare airlines on an apples-to-apples basis. Since so many airlines have lost money over the last 10 years, it’s hard to use price-to-earnings (P/E) as a valuation metric when there are no earnings. In addition, since some airlines choose to mortgage their planes, while some choose to lease them, it’s hard to use EV/EBITDAR, which would skew the results of those who lease planes and have high aircraft rent. EV/EBITDAR adds back aircraft rent as well as interest, taxes, depreciation and amortization, which allows you to compare those airlines that mortgage planes and have high interest expense and depreciation, with those that lease them and have high aircraft rent and low depreciation.

US airlines over the past 10 years have tended to trade at an EV/EBITDAR multiple of anywhere from 3X– 8X trailing EBITDAR, depending on investor interest and where in the industry cycle the airlines were. S&P feels that the better-run airlines, in our highly qualitative view, can enjoy a multiple on the higher end of the EV/EBITDAR spectrum, while those with high debt levels and uncertain future prospects tend to trade at the lower end. 

40 AIRLINES / DECEMBER 2014 INDUSTRY SURVEYS

GLOSSARY

Available seat miles (ASMs)—A measure of airline capacity; calculated as aircraft miles flown multiplied by the number of seats available for revenue passenger use.

Blended winglets—Modified wings that are intended to lessen drag and, therefore, increase fuel efficiency. They can be factory installed or added to planes through wing modification kits.

Bumping—The practice of denying ticketed passengers the right to board an overbooked flight. Bumped passengers may receive compensation of up to $400.

Cabotage—The transport of passengers by a foreign carrier for purely domestic flights; illegal in all nations.

Charter—Nonscheduled service in which all seats are booked by a single entity such as a tour operator.

Code sharing—An agreement in which one carrier’s flight schedules are listed under another airline’s code on a computer reservation system (CRS).

Commercial air carrier—An air carrier that is certified to carry passengers for a fee.

Commuter airline—An airline that operates short-haul flights using small-capacity aircraft, typically turboprop planes.

Computer reservation system (CRS)—One of a number of centralized databases listing fare and flight information used to book flights.

Cost per available seat-mile (CASM)—A commonly used measure of unit operating costs, calculated as total operating costs divided by available seat miles.

Enplanements—The total number of passengers, both originating and connecting, who board an aircraft.

Hub-and-spoke system—An air carrier route structure providing broad coverage across the US, though not point-to-point service between every small airport. “Feeder” flights connect passengers from outlying cities with a “hub” airport, where they may continue on the same plane or transfer to another flight to reach their destination.

Hush kit—A device used to modify an aircraft engine to reduce noise levels.

Interlining—The process of transferring passengers between two carriers’ flights, typically through a code-sharing arrangement.

Jet—An engine that creates propulsive thrust by expelling air at a much higher velocity than it has taken it in; introduced to US passenger aircraft in 1958.

Load factor—A measurement of the total aircraft seating capacity sold; it is calculated as revenue passenger miles divided by available seat miles on flights offering revenue passenger services.

Major airline—An air carrier with annual operating revenues greater than $1 billion.

National airline—An air carrier with annual operating revenues between $100 million and $1 billion.

Open skies pact—An aviation accord between two nations giving their respective air carriers greater access to each other’s markets and the freedom to set fares.

Outsourcing—Contracting certain tasks, such as maintenance, to an outside vendor to reduce operating costs.

Overrides—Bonus commission paid by airlines to travel agents for exceeding a sales target.

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 41

Oversales—Practice of booking more passengers than available seats; results in bumping.

Pitch—Passenger legroom; the distance between seats in an airline cabin. Recently, carriers eager to differentiate their service have touted expanded pitch as a selling strategy.

Regional airline—An air carrier with annual operating revenues less than $100 million.

Revenue passenger mile (RPM)—A measurement representing one passenger transported one mile in revenue service.

Revenue per available seat-mile (RASM)—A measure of unit operating revenue, computed by dividing total passenger revenues by available seat miles.

Slot—A rationed position in an airport’s schedule for takeoff or landing. Only a handful of airports—those that are at designed capacity—use a slot system.

Stage length—The distance of a flight in miles. It is frequently shorter than trip length, since a flight may consist of more than one stage (or “leg”).

Turboprop—An engine that uses propellers to develop its thrust; generally found in smaller regional or commuter aircraft.

Yield—A measure of unit revenues, computed by dividing passenger revenues by revenue passenger miles. 

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INDUSTRY REFERENCES

PERIODICALS Plane Business http://www.planebusiness.com Air Carrier Financial Statistics Airline news; site contains free sections and parts Air Carrier Traffic Statistics restricted to paid subscribers. http://www.rita.dot.gov/bts Cover Form 41 carriers; the first has quarterly financial CONSULTING FIRMS statistics; the second, monthly traffic statistics. OAG Aviation Air Transport World http://www.oag.com http://www.atwonline.com Independent provider of consulting and data information Monthly; articles on all aspects of the airline industry. services to the aviation industry.

Annual Report of the Regional Airline Association TRADE ASSOCIATIONS http://www.raa.org A comprehensive annual review of issues concerning Airlines for America (A4A) regional airlines; contains a statistical summary of carriers’ http://www.airlines.org operating performance. Primarily represents larger passenger airlines and leading air cargo companies; produces the Air Transport Annual Aviation Daily Report, a detailed annual summary of operating and Aviation Week & Space Technology financial statistics of leading carriers and the monthly http://www.aviationweek.com Scheduled Passenger Traffic Statistics. Formerly the Air The first is a daily, with current news on the air transport Transport Association of America Inc. (ATA). industry and useful statistics; the second is a weekly, with complete coverage of the aviation and space industries. International Air Transport Association (IATA) http://www.iata.org FAA Aerospace Forecasts Global trade organization; its members (some 230 airlines http://www.faa.gov/about/office_org/headquarters_offices/apl/avi throughout the world) account for approximately 93% of ation_forecasts scheduled international air travel. Annual forecasts of aviation activity at FAA facilities. Regional Airline Association (RAA) Travel Weekly http://www.raa.org http://www.travelweekly.com Trade group representing smaller airlines. Semiweekly; news about travel and tourism. US Travel Association BOOKS http://www.ustravel.org Representing all components of the US travel industry; Handbook of Airline Economics promotes US travel and tourism and is an authoritative Darryl Jenkins, Editor source for travel industry research, analysis, and forecasts. Essays providing a thorough review of all major aviation- related financial, operational, and regulatory issues, with REGULATORY AGENCIES contributions from leading industry executives. Energy Information Administration (EIA) ONLINE RESOURCES http://www.eia.gov A statistical agency of the US Department of Energy; Aviation Safety Network provides independent data, forecasts, and analysis http://aviation-safety.net regarding energy and its interaction with the economy and Comprehensive statistics related to airliner accidents and the environment. safety records.

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 43

Federal Aviation Administration (FAA) http://www.faa.gov Agency within the DOT that monitors commercial and general aviation safety, records and investigates complaints filed against airlines, certifies carriers, compiles statistics, promotes aviation education, and crafts regulations governing aviation safety.

National Transportation Safety Board (NTSB) http://www.ntsb.gov Independent federal agency (not part of the DOT) charged with investigating accidents involving all transportation modes; it makes recommendations, but cannot write regulations.

Transportation Security Administration (TSA) http://www.tsa.gov Agency within the DOT formed on November 19, 2001, in the aftermath of the attacks of 9/11. The TSA is charged with protecting the US transportation system and ensuring free movement of people and commerce.

US Department of Transportation (DOT) http://www.dot.gov Federal agency responsible for the regulation of all transport modes, including airlines. The DOT produces various performance, budget, and planning reports that summarize the agency’s activities during the past fiscal year.

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COMPARATIVE COMPANY ANALYSIS

Operating Revenues

Million $ CAGR (%) Index Basis (2003 = 100) Ticker Company Yr. End 2013 2012 2011 2010 2009 2008 2003 10-Yr. 5-Yr. 1-Yr. 2013 2012 2011 2010 2009 AIRLINES‡ ALK † ALASKA AIR GROUP INC DEC 4,964.0 4,657.0 4,317.8 3,832.3 3,399.8 3,620.3 2,444.8 7.3 6.5 6.6 203 190 177 157 139 ALGT § ALLEGIANT TRAVEL CO DEC 996.2 908.7 779.1 663.6 557.9 504.0 NA NA 14.6 9.6 ** ** ** ** NA DAL [] DELTA AIR LINES INC DEC 37,773.0 36,670.0 35,115.0 31,755.0 28,063.0 22,697.0 A 13,303.0 11.0 10.7 3.0 284 276 264 239 211 JBLU † JETBLUE AIRWAYS CORP DEC 5,441.0 4,982.0 4,504.0 3,779.0 3,292.0 3,388.0 998.4 18.5 9.9 9.2 545 499 451 379 330 SKYW § SKYWEST INC DEC 3,297.7 3,534.4 3,654.9 2,747.9 A 2,609.6 3,496.2 888.0 14.0 (1.2) (6.7) 371 398 412 309 294

LUV [] SOUTHWEST AIRLINES DEC 17,699.0 17,088.0 15,658.0 A 12,104.0 10,350.0 11,023.0 5,937.0 11.5 9.9 3.6 298 288 264 204 174

OTHER AIRLINE OPERATORS AAL AMERICAN AIRLINES GROUP INC DEC 26,712.0 A 24,855.0 24,022.0 22,170.0 19,917.0 23,766.0 17,440.0 4.4 2.4 7.5 153 143 138 127 114 RJET REPUBLIC AIRWAYS HLDGS INC DEC 1,346.5 D 2,801.1 2,876.2 2,653.7 1,642.2 A 1,479.8 415.1 12.5 (1.9) (51.9) 324 675 693 639 396 LCC US AIRWAYS GROUP INC DEC NA 13,831.0 13,055.0 11,908.0 10,458.0 12,118.0 2,254.5 NA NA NA NA 613 579 528 464

Note: Data as originally reported. CA GR-Compound annual grow th rate. ‡S&P 1500 index group. []Company included in the S&P 500. †Company included in the S&P MidCap 400. §Company included in the S&P SmallCap 600. #Of the follow ing calendar year. **Not calculated; data for base year or end year not available. A - This year's data reflect an acquisition or merger. B - This year's data reflect a major merger resulting in the formation of a new company. C - This year's data reflect an accounting change. D - Data exclude discontinued operations. E - Includes excise taxes. F - Includes other (nonoperating) income. G - Includes sale of leased depts. H - Some or all data are not available, due to a fiscal year change.

Net Income

Million $ CAGR (%) Index Basis (2003 = 100) Ticker Company Yr. End 2013 2012 2011 2010 2009 2008 2003 10-Yr. 5-Yr. 1-Yr. 2013 2012 2011 2010 2009 AIRLINES‡ ALK † ALASKA AIR GROUP INC DEC 508.0 316.0 244.5 251.1 121.6 (135.9) 13.5 43.7 NM 60.8 3,763 2,341 1,811 1,860 901 ALGT § ALLEGIANT TRAVEL CO DEC 92.3 78.6 49.4 65.7 76.3 35.4 NA NA 21.1 17.4 ** ** ** ** NA DAL [] DELTA AIR LINES INC DEC 10,540.0 1,009.0 854.0 593.0 (1,237.0) (8,922.0) (773.0) NM NM 944.6 NM NM NM NM NM JBLU † JETBLUE AIRWAYS CORP DEC 168.0 128.0 86.0 97.0 61.0 (76.0) 103.9 4.9 NM 31.3 162 123 83 93 59 SKYW § SKYWEST INC DEC 59.0 51.2 (27.3) 96.3 83.7 112.9 66.8 (1.2) (12.2) 15.2 88 77 (41) 144 125

LUV [] SOUTHWEST AIRLINES DEC 754.0 421.0 178.0 459.0 99.0 178.0 442.0 5.5 33.5 79.1 171 95 40 104 22

OTHER AIRLINE OPERATORS AAL AMERICAN AIRLINES GROUP INC DEC (1,834.0) (1,876.0) (1,979.0) (471.0) (1,468.0) (2,071.0) (1,228.0) NM NM NM NM NM NM NM NM RJET REPUBLIC AIRWAYS HLDGS INC DEC 48.3 51.3 (151.8) (13.8) 39.7 84.6 34.0 3.6 (10.6) (5.8) 142 151 (446) (41) 116 LCC US AIRWAYS GROUP INC DEC NA 637.0 71.0 502.0 (205.0) (2,210.0) 57.4 NA NA NA ** 1,109 124 874 (357)

Note: Data as originally reported. CAGR-Compound annual grow th rate. ‡S&P 1500 index group. []Company included in the S&P 500. †Company included in the S&P MidCap 400. §Company included in the S&P SmallCap 600. #Of the follow ing calendar year. **Not calculated; data for base year or end year not available.

INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 45

Return on Revenues (%) Return on Assets (%) Return on Equity (%) Ticker Company Yr. End 2013 2012 2011 2010 2009 2013 2012 2011 2010 2009 2013 2012 2011 2010 2009 AIRLINES‡ ALK † ALASKA AIR GROUP INC DEC 10.2 6.8 5.7 6.6 3.6 9.0 5.9 4.8 5.0 2.5 29.4 24.4 21.5 25.4 15.9 ALGT § ALLEGIANT TRAVEL CO DEC 9.3 8.6 6.3 9.9 13.7 10.7 10.4 8.2 13.1 16.5 23.8 20.9 15.2 22.3 29.0 DAL [] DELTA AIR LINES INC DEC 27.9 2.8 2.4 1.9 NM 21.8 2.3 2.0 1.4 NM 221.6 NA NA 103.9 NM JBLU † JETBLUE AIRWAYS CORP DEC 3.1 2.6 1.9 2.6 1.9 2.3 1.8 1.3 1.5 1.0 8.4 7.0 5.0 6.1 4.3 SKYW § SKYWEST INC DEC 1.8 1.4 NM 3.5 3.2 1.4 1.2 NM 2.2 2.0 4.2 3.8 NM 6.9 6.4

LUV [] SOUTHWEST AIRLINES DEC 4.3 2.5 1.1 3.8 1.0 4.0 2.3 1.1 3.1 0.7 10.5 6.1 2.7 7.8 1.9

OTHER AIRLINE OPERATORS A A L A MERICA N A IRLINES GROUP INC DEC NM NM NM NM NM NM NM NM NM NM NA NA NA NA NA RJET REPUBLIC A IRWA Y S HLDGS INC DEC 3.6 1.8 NM NM 2.4 1.4 1.4 NM NM 1.0 9.1 10.5 NM NM 8.0 LCC US AIRWAYS GROUP INC DEC NA 4.6 0.5 4.2 NM NA 7.2 0.9 6.6 NM NA 135.5 60.7 NA NA Note: Data as originally reported. ‡S&P 1500 index group. []Company included in the S&P 500. †Company included in the S&P MidCap 400. §Company included in the S&P SmallCap 600. #Of the follow ing calendar year.

Debt as a % of Current Ratio Debt / Capital Ratio (%) Net Working Capital Ticker Company Yr. End 2013 2012 2011 2010 2009 2013 2012 2011 2010 2009 2013 2012 2011 2010 2009 AIRLINES‡ ALK † ALASKA AIR GROUP INC DEC 1.1 1.2 1.1 1.2 1.3 21.6 31.8 41.7 48.7 62.4 414.3 369.1 NM 553.3 451.9 ALGT § ALLEGIANT TRAVEL CO DEC 1.5 2.0 2.1 1.3 1.8 33.6 23.7 26.1 3.5 6.6 153.7 68.0 69.5 22.0 17.1 DAL [] DELTA AIR LINES INC DEC 0.7 0.6 0.6 0.6 0.8 45.7 100.8 94.9 82.4 89.1 NM NM NM NM NM JBLU † JETBLUE AIRWAYS CORP DEC 0.6 0.7 1.2 1.3 1.3 43.6 50.9 57.0 59.0 61.8 NM NM NM NM 774.5 SKYW § SKYWEST INC DEC 2.4 2.4 2.1 2.4 2.8 37.4 41.8 45.8 46.6 49.0 153.2 174.5 244.9 215.5 225.8

LUV [] SOUTHWEST AIRLINES DEC 0.8 0.9 1.0 1.3 1.3 17.6 22.6 24.8 24.8 30.2 NM NM NM 295.2 487.5

OTHER AIRLINE OPERATORS AAL AMERICAN AIRLINES GROUP INC DEC 1.0 0.8 0.8 0.8 0.9 121.6 -817.0 -1,638.6 174.3 149.2 NM NM NM NM NM RJET REPUBLIC AIRWAYS HLDGS INC DEC 1.0 0.9 0.8 0.9 0.8 70.0 67.2 71.8 68.9 72.8 NM NM NM NM NM LCC US AIRWAYS GROUP INC DEC NA 1.1 1.0 1.0 0.8 NA 84.7 96.5 97.9 109.7 NA NM NM NM NM Note: Data as originally reported. ‡S&P 1500 index group. []Company included in the S&P 500. †Company included in the S&P MidCap 400. §Company included in the S&P SmallCap 600. #Of the follow ing calendar year.

46 AIRLINES / DECEMBER 2014 INDUSTRY SURVEYS

Price / Earnings Ratio (High-Low) Dividend Payout Ratio (%) Dividend Yield (High-Low, %) Ticker Company Yr. End 2013 2012 2011 2010 2009 2013 2012 2011 2010 2009 2013 2012 2011 2010 2009 AIRLINES‡ ALK † ALASKA AIR GROUP INC DEC 11 - 610- 711- 89- 411- 4 60000 0.9- 0.5 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 ALGT § ALLEGIANT TRAVEL CO DEC 24- 15 19 - 12 21 - 15 18 - 11 15 - 8464902203.1- 2.0 4.2 - 2.6 0.0 - 0.0 2.0 - 1.3 0.0 - 0.0 DA L [] DELTA A IR LINES INC DEC 2- 110- 713- 621- 14 NM- NM 1000NM1.0- 0.4 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 JBLU † JETBLUE A IRWA Y S CORP DEC 16- 10 14 - 923- 11 21 - 13 32 - 12 00000 0.0- 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 SKYW § SKYWEST INC DEC 15- 11 14 - 6NM- NM 10 - 713- 51416NM9111.3- 0.9 2.6 - 1.1 1.5 - 0.9 1.4 - 0.9 2.0 - 0.8

LUV [] SOUTHWEST AIRLINES DEC 18- 10 19 - 14 59 - 31 23 - 17 91 - 38 12 6 8 3 14 1.3 - 0.7 0.4 - 0.3 0.3 - 0.1 0.2 - 0.1 0.4 - 0.2

OTHER AIRLINE OPERATORS A A L A MERICA N A IRLINES GROUP INC DEC NM- NM NM - NM NM - NM NM - NM NM - NM NM NM NM NM NM 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 RJET REPUBLIC A IRWA Y S HLDGS INC DEC 14- 66- 3NM- NM NM - NM 10 - 400NMNM00.0- 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 LCC US AIRWAYS GROUP INC DEC NA- NA 4 - 126- 94- 1NM- NM NA 0 0 0 NM 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 0.0 - 0.0 Note: Data as originally reported. ‡S&P 1500 index group. []Company included in the S&P 500. †Company included in the S&P MidCap 400. §Company included in the S&P SmallCap 600. #Of the follow ing calendar year.

Earnings per Share ($) Tangible Book Value per Share ($) Share Price (High-Low, $) Ticker Company Yr. End 2013 2012 2011 2010 2009 2013 2012 2011 2010 2009 2013 2012 2011 2010 2009 AIRLINES‡ ALK † ALASKA AIR GROUP INC DEC 7.26 4.47 3.40 3.51 1.70 29.51 20.19 16.54 15.39 12.25 78.53 - 43.32 45.15 - 31.29 38.57 - 25.55 29.80 - 15.62 18.24 - 6.80 ALGT § ALLEGIANT TRAVEL CO DEC 4.85 4.10 2.59 3.36 3.82 20.26 20.71 18.42 15.67 14.71 114.77- 72.17 77.97 - 47.32 55.36 - 38.95 59.04 - 37.05 57.52 - 32.07 DAL [] DELTA AIR LINES INC DEC 12.41 1.20 1.02 0.71 (1.50) (3.30) (19.50) (18.86) (16.35) (18.33) 29.43- 11.97 12.25 - 7.83 13.21 - 6.41 14.94 - 9.60 12.65 - 3.51 JBLU † JETBLUE AIRWAYS CORP DEC 0.59 0.45 0.31 0.36 0.24 6.76 6.27 5.79 5.45 5.20 9.20- 5.70 6.32 - 4.06 7.13 - 3.40 7.60 - 4.64 7.74 - 2.81 SKYW § SKYWEST INC DEC 1.14 1.00 (0.52) 1.73 1.50 27.72 26.64 25.98 25.83 23.89 17.29- 12.25 14.32 - 6.25 17.28 - 10.47 17.45 - 11.38 19.25 - 8.17

LUV [] SOUTHWEST AIRLINES DEC 1.06 0.56 0.23 0.62 0.13 8.85 8.06 7.45 8.34 J 7.36 J 19.00- 10.36 10.61 - 7.76 13.59 - 7.15 14.32 - 10.42 11.78 - 4.95

OTHER AIRLINE OPERATORS AAL AMERICAN AIRLINES GROUP INC DEC (11.25) (5.60) (5.91) (1.41) (4.99) (34.96) (26.41) (23.88) (14.63) (13.46) 27.20- 0.80 0.99 - 0.24 8.89 - 0.20 10.50 - 5.86 12.48 - 2.40 RJET REPUBLIC AIRWAYS HLDGS INC DEC 0.98 1.06 (3.14) (0.38) 1.15 10.94 9.24 7.73 9.68 10.17 13.92- 6.05 6.33 - 3.39 7.79 - 2.47 9.58 - 4.48 10.94 - 4.10 LCC US AIRWAYS GROUP INC DEC NA 3.92 0.44 3.11 (1.54) NA 1.54 (2.42) (2.43) (5.33) 25.49- 12.70 14.51 - 4.97 11.56 - 3.96 12.26 - 4.47 9.70 - 1.88

Note: Data as originally reported. ‡S&P 1500 index group. []Company included in the S&P 500. †Company included in the S&P MidCap 400. §Company included in the S&P SmallCap 600. #Of the follow ing calendar year. J-This amount includes intangibles that cannot be identified.

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INDUSTRY SURVEYS AIRLINES / DECEMBER 2014 47

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48 AIRLINES / DECEMBER 2014 INDUSTRY SURVEYS