Bankruptcies are nothing new to the airline industry, which has seen hundreds of carriers become defunct since the infancy of the business. But a recent spate of bankruptcies by several prominent carriers--including Frontier Airlines (Other OTC:FRNTQ.PK - News), Aloha Airlines, ATA Airlines, and Skybus--has spooked the industry and investors. While the demise of these carriers was preceded by cutthroat competitive dynamics and faltering liquidity, it seems that escalating oil prices (and in Frontier's case, nervous counterparties) finally pushed them over the edge.Deteriorating Industry Fundamentals With oil prices topping more than $130 per barrel, more carriers are in danger than ever before. A lethal combination of high oil prices, falling domestic demand, and unwieldy debt loads makes for treacherous terrain in this notoriously cyclical industry. Fuel now represents the single largest expense item at more than 30% of costs (exceeding labor costs), and inflation-adjusted fuel prices now exceed all-time highs reached back in the 1970s.
Domestic carriers are slashing capacity, seeking ancillary revenue streams, selling noncore assets, and pursuing consolidation to mitigate rising crude, but in our opinion, these steps may not go far enough to ensure survival for all participants. Even the current merger plans of Delta (NYSE:DAL - News) and Northwest (NYSE:NWA - News) are somewhat disappointing, as the combined entity has not targeted sufficient capacity cuts beyond what the stand-alone carriers had originally planned. And though American Airlines (NYSE:AMR - News) will be flying 11%-12% fewer mainline domestic seats by the end of this year, we estimate that airlines would need nationwide capacity cuts to the tune of 15%-20%, coupled with double-digit price increases, in order to show accounting profits at current oil prices.
Record-high oil prices couldn't come at a worse time because the U.S. economy is beginning to show signs of weakening. Year-over-year gross domestic product growth rates have slowed to an anemic 1% level, and consumer sentiment is at its lowest reading since 1980. To top off the bleak picture, airline debt levels are still too high for most carriers (despite bankruptcy restructuring in some cases) because of a legacy of low-cost debt financing to fund airline fleets. The cash hoard that airlines built up during the last several years as a cushion against a downturn will almost certainly be tapped to meet near-term debt obligations as operating losses mount.
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