Flying on empty

Aviation in America

May 19th 2005
From The Economist print edition

America's airlines have managed to keep flying with the help of some unusual friends. But for how much longer?

EVERYONE else in aviation makes money while airlines just do the flying. So says Giovanni Bisignani, boss of the International Air Transport Association. His point is that airports, component-makers, aircraft-makers, banks and so on make a nice living, while most airlines chronically fail to turn a steady profit. Nowhere is this more true than in America, roughly half of the world's aviation market.

America's six big traditional carriers have lost a total of $27 billion since 2000, yet they are all still flying. One of the top six, US Airways, is enjoying Chapter 11 bankruptcy protection (which keeps creditors at bay while the business goes on) for the second time in recent years: its latest wheeze is to merge with America West, another troubled airline. United Airlines, the country's second largest airline, has been stuck, battling the unions and creditors, in Chapter 11 for 30 months.

The terrorist attacks of September 11th 2001 coincided, roughly, with the collapse of profits from business travel, which had been at inflated fares during the dotcom bubble. It also coincided with strong growth by low-cost carriers such as Southwest and JetBlue. In the previous industry downturn in 1990, low-cost carriers had only a 7% market share; this time they were approaching one-third of the market, and had wrested pricing power from the traditional carriers on all but a few routes.

So how have America's traditional carriers (the big six with their hub-and-spoke networks and a legacy of unionisation and high labour costs) managed to keep aloft?

A federal hand-out of $2.5 billion in compensation for shutting airspace for four days after September 11th stopped them all going into Chapter 11 then. That might have been a better way to go. The government could have stepped in later to allow only those airlines with credible business plans to fly again.

Lessor of two evils?

Arguably, however, the most significant change in the industry since the early 1990s has been the growing role of aircraft lessors. They are led by General Electric's Commercial Aviation Services (known as GECAS) and International Lease Finance Corporation (ILFC), owned by AIG, the biggest American insurer. The GE business offers a panoply of services to airlines: not only is it the leading maker of jet engines, but also it offers aircraft finance, aircraft leases, servicing and even pilot training. “No organisation envelops airlines quite like GE,” wrote Robert Ashcroft, an analyst at UBS, in a recent research note.

Moreover, GE is the leading lessor within America. Over half of its roughly 1,350 planes are with American carriers. In contrast, ILFC leases nearly 90% of its planes to non-American carriers. At the end of 2004, GE had 150 aircraft, financed to a value of $2.6 billion, with US Airways alone.

This explains why GE has been so supportive since September 11th of stricken airlines. A nightmare for GE would be another carrier flying into Chapter 11, or one of those already there being liquidated, as either would release a flight of planes on to the market, thereby further depressing second-hand values and leasing rates.

Many of GE's leases to American carriers are so-called leveraged leases. These let the owner of an aircraft (ie, GE) defer its tax bills by writing off the cost against tax over seven years. Add in the interest on money borrowed to finance the plane and the effect is to reduce the lessor's tax payments in the early years of the lease.

Companies from beyond the usual bounds of aviation have become involved in this scheme over the years, to defer tax. A firm could, through a special-purpose entity (SPE), stump up, say, only 20% of the cost of an aircraft and yet claim 100% in tax relief—all without putting the relevant debt on to its balance sheet. When an airline goes bust, however, the deferred tax could become payable sooner than expected, and the money in the SPE could be at risk. Firms such as EDS and Walt Disney that, surprisingly, are involved in financing aircraft leases, took write-downs when US Airways and United went into Chapter 11. Whirlpool, a maker of white goods, faced accelerated tax payments. For GE, another airline bankruptcy could be a double whammy: lost or lower lease revenues and large tax payments.

A glance at GE's exposure to American carriers explains its willingness to intervene to help airlines stave off Chapter 11 and liquidation. GE was quick to help United with short-term loans when it entered Chapter 11. It has also led a syndicate that lent up to $630m on a secured basis to Delta. It is to take 24 regional jets back from Independence Air and defer the troubled fledgling carrier's lease or loan payments on other aircraft. It has agreed to contribute $140m to US Airways through loans and deferrals on lease or loan payments, and to take back 25 Boeing and Airbus planes. Counting only US Airways, ATA (a smaller carrier in Chapter 11), Aloha Airlines and United, GE's exposure is $5.4 billion. Given that GE has a further 255 aircraft placed with Continental Airlines, Northwest Airlines and America West, it could soon have to dip its hand into its deep pockets again to fend off the effects of leases going bad as another of these operating airlines goes bust. As Eric Jones of GECAS says: “We're in the business of helping our customers if we can; we do it if it makes sense for us.”

GE does hold some advantages, even as oil at around $50 a barrel threatens to push the rest of the American airline industry over the cliff in the second half of this year. A special provision of Chapter 11 gives aircraft lessors a privileged position over other creditors: they can re-possess aircraft if an airline cannot pay its outstanding lease charges within 60 days.

With air travel and airline profits recovering outside America, GE may be able to ease its troubles by placing some of its now unwanted Boeing 737s and Airbus A320s elsewhere, particularly Asia. In the first quarter of this year, GE re-deployed 18 Boeing planes in China, India and Brazil that ATA returned when it went bust. But this was a small deal. The collapse of one of the big American carriers into Chapter 11 would have far more troubling consequences for lessors.

GE is not alone in seeking to preserve the status quo by keeping airlines on life support, whether in or outside Chapter 11. A $250m loan from Airbus may have sealed the merger of US Airways and America West. Banks with credit cards tied to air miles also have a vested interest, as they do not want their customers to lose their miles. One industry estimate links 40% of Citigroup's credit-card revenues just to American Airlines' frequent-flyer programme. Tellingly, American Express has paid a $500m advance to Delta. Even so, banks are tempted to hold back some payments due to airlines, to cover the credit risk of paid-for flights that never take off. Delta and United face the prospect of tougher terms in August and January respectively, when their credit-card contracts with the banks are up for renewal.

Beyond the support of interested and profitable parts of the aviation food-chain, and the difficulty of revising labour contracts and pension promises, there is another huge obstacle to a general shake-out that would slash capacity. For consolidation to occur in any industry, at a national or global level, there must usually be at least one strong firm able to pick up the pieces. For instance, in airlines in the early 1990s, American Airlines and United picked up the lucrative international routes of distressed PanAm and TWA.

No big airline is currently strong enough to want to pick up the scraps of bust carriers. And the industry's outlook is too bleak to attract outside investors to take on the challenge—even cash-rich private-equity investors are steering clear. The healthy low-cost airlines have no interest in assuming the legacy business model of the hub-and-spoke carriers.

Hence the miserable stalemate in which lessors and banks prop up ailing carriers in or near Chapter 11, while armies of lawyers and consultants earn huge fees working on rescue plans that never succeed. Creative destruction may be essential to healthy capitalism, but in America's air travel business the wrecker's ball has not even started to swing, yet.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.