A Quarter Awash in Red Ink

Madhu Unnikrishnan

July 26th, 2020

  • Don’t even think about the “B” word. Bankruptcy is not something American Airlines has to worry about in 2020. Not with a massive $16b in liquidity, more than enough to cover even a lengthy worst-case scenario of near-zero revenues. This figure includes nearly $5b it’s borrowing through a government-backed program, as well as another $1.2b it arranged to borrow via bond issuance just last week. Costs are down sharply. Some 150 planes were forever removed. And big job cuts are coming this fall.

    So no, American won’t be filing for bankruptcy, even as it loses monstrous sums of money. How monstrous? From April through June, its net loss adjusted for special items was almost $3.4b. More worryingly as it looks ahead to eventually coming out of this mess, balance sheet liabilities are growing enormously, to nearly $50b at the start of Q3. American, remember, entered the crisis with considerably more debt than its peers, mostly because it renewed its fleet more aggressively. It wasn’t just an inferior balance sheet though. American’s income statement was weaker too, its pre-crisis profit margins depressed by labor tensions, B737 MAX disruptions, and outsized exposure to difficult South American markets. Once the airline starts generating positive cash flow again, hopefully by the start of next year, debt repayment will be a top priority. That surely means less money allocated to product and service improvement, never mind shareholder rewards like dividends and stock buybacks (banned in any case as a condition of taking federal credit aid).

    But underinvestment will be a challenge for the whole U.S. airline sector — all carriers will be smaller, more indebted, and less able to invest their product. After a promising jump in domestic leisure demand in May and early June, with fuel prices extremely low, and with uncle Sam footing about three-quarters of its wage bill, American decided to restore capacity more aggressively than its peers. The fact that it’s a more domestic airline than either Delta or United helped. So did its large Florida footprint (it has a hub in Miami) and its domestic-heavy mid-continent hubs Dallas DFW and Charlotte. Management downplayed the long-term significance of this more aggressive capacity approach, calling it a mere summertime tactic that helped generate more revenues and cash, even if the extra flying was loss-making in a strict accounting sense. More meaningful is American’s long-term effort to address chronic weakness from New York, Boston, and along the west coast. These markets account for roughly a quarter of its total capacity, dragging down margins. In Dallas-Fort Worth and Charlotte, by contrast, American outperforms the industry on unit revenues and profit margins.

    What to do? American’s West Coast solution is a partnership with Alaska, announced just before the crisis. And its New York/Boston solution is a partnership with JetBlue, announced earlier this month. With Alaska as an ally, American will dismantle much of its intercontinental flying from Los Angeles and launch routes to Europe, China, and India from Seattle. With JetBlue as an ally, American will launch new service to Israel, Greece, and Brazil from New York JFK, while ending some 50-seat regional jet routes that waste precious JFK and LaGuardia airport slots. Philadelphia, though, will remain American’s leading transatlantic gateway, with excellent connectivity from most of the U.S.

    Also still crucial is a joint venture with British Airways and Iberia, as well as separate JVs with Japan Airlines and Qantas. Other key international partners include China Southern, which is building a major hub in Beijing, and Brazil’s Gol, which replaces former partner Latam. Other partners like Royal Air Maroc were to facilitate new routes like Casablanca, though that’s on hold for now. Also for now, international markets remain largely dormant, with recovery unlikely before mid-2021 at the earliest.

    Domestically, net bookings are now down 75% to 80% y/y, after a period in which the decline was more like 50%, and even less than that in certain sunshine markets. The momentum reversal, however, stems from worsening Covid spread in the Sunbelt and newly imposed quarantines by states like New York.

    As it looks beyond the crisis, to a point after which a vaccine helps normalize demand conditions, American will have the opportunity to renegotiate its credit card agreements with Citi and Barclays in 2022. In the past, airlines have been able to cash in on such opportunities. Will banks be so eager to pay for the privilege two years from now? The answer will partly depend on business travel habits, which some say will snap back and others say will change forever.

    For now, the name of the game is burning as little cash as possible, until vaccines come to the rescue, probably sometime in the next six-to-nine months. Things could be tough this fall, when airlines like American typically depend on business traffic for nearly half of their revenue. Executives say they’re biased toward flying less rather than more this fall. Q3 capacity, at the moment, is expected to be down about 60% y/y. American, by the way, is still selling middle seats unlike rivals Delta, Southwest, Alaska, and JetBlue.
  • United is still selling middle seats as well but flew considerably less capacity than American last quarter. Even so, its domestic load factor was just 36%, compared to American’s 44%. It’s also more of an international airline than American, though this presented some valuable overseas cargo opportunities. The distinctions don’t matter much when comparing losses of such grand magnitude, but for what it’s worth, United’s Q2 operating margin (negative 209%) was the least awful among America’s Big Three. Delta, keep in mind, paid significantly more for fuel when factoring in losses from its oil refinery: $2.16 a gallon, compared to United’s price of just $1.18 (American paid $1.13).

    What matters most at this stage of the recovery is cash burn, and on this score United outperformed. Daily burn (adjusted for one-off items like government payroll support) amounted to $40m on average last quarter, compared to $43m for Delta and $55m for American. United began cutting capacity early on in the crisis, while at the same time acting less aggressively in terms of permanently retiring aircraft. It’s no less cash rich than its peers right now, following round after round of bank borrowing, bond issuance, stock selling, and aircraft sale-leaseback deals. One creative bond offering, in fact, was tied to its United Mileage Plus loyalty plan. This quarter, cash burn should drop to $25m a day on average, before hopefully turning positive by year end.

    Like others, United saw a promising domestic recovery began to wane in late June, with more fluctuations expected before a vaccine solution arrives, by late 2021 in United’s worst-case scenario. It won’t be able to avoid mass layoffs this fall, even with more than 6k employees accepting voluntary severance. Because of the recent stalled recovery, it’s now paring back some planned autumn capacity. It recognizes the highly unpredictable nature of current trends but seems confident that pre-vaccine, demand will plateau after reaching about 50% of normal levels. Certain types of business travel — in-house company sales events, for example — simply won’t return while Covid is still a major health risk.

    In the meantime, the airline is adapting its network to chase family-visit traffic in particular. Leisure travel could regain some momentum if Covid infection rates slow. Said CEO Scott Kirby: “The country has learned some lessons about things like wearing masks.” Denver is arguably its best-positioned hub at the moment, given its heavy leisure component, its limited international offerings, and its mid-continent geography. Intercontinentally, United is taking advantage of partner hubs abroad to serve customers with urgent travel needs around the globe. When intercontinental demand does ultimately normalize, it will likely do so first from big coastal gateways where United is strong, like Newark and San Francisco. Signing a more favorable credit card deal with JPMorgan Chase just before the crisis was a stroke of good timing.

    Less well-timed was a 2019 decision to outfit planes with more premium seats. Lots of B737 MAXs are still due to come, eventually. Will corporate travelers return? Yes, eventually — Kirby described a likely re-appreciation for flying the first time an executive loses a big sale because he or she elected to do a Zoom call instead of a face-to-face meeting. The carrier thinks an increase in working from home might even drive more air travel demand as people still periodically visit their offices from remote locations. For now, though, with corporate travelers grounded, United will proceed with re-sizing the airline appropriately, while retaining as much flexibility as possible to react to what could be a quick post-vaccine recovery. One key task right now is further variablizing the airline’s cost structure. Slowly but surely, management is getting better about forecasting demand under crisis-like conditions. It’s certainly not interested in chasing traffic just to win market share. 
  • Even with barely any international flying, Southwest burned through $23m a day in Q2, as it did something it almost never does: Lose money. Net even the mighty Southwest could escape the ravages of Covid’s demand destruction, leaving it with a $1.5b net loss ex items. Revenues dropped 83% y/y, while operating costs (ignoring federal payroll support) only fell by 36%. Southwest was the most aggressive U.S. airline in terms of capacity, with ASMs down only 55% from last year’s levels. Load factor was just 31%, in part because it blocked middle seats, something it will continue to do through at least September. In situations where demand for flights exceeded its seats available for sale, it simply added flights, which 80% of the time covered their costs.

    Cheap fuel made that easier to achieve, even while paying a bit more than the industry average ($1.33 per gallon) given fuel hedge premiums. Even with oil prices up somewhat from their springtime lows, Southwest sees hundreds of millions of dollars in fuel savings this year (of course it’s flying a lot less). It’s separately cutting costs in just about every other area, including labor. But thanks to good take-up of early retirement and other generous separation and extended leave packages, Southwest was proudly able to say that not a single employee will be involuntarily furloughed, for the remainder of this year anyway. Nor will anyone have to swallow a pay cut. Beyond this year, management won’t make any promises. But demand will hopefully be back in recovery mode by then.

    It’s looking more likely that breakeven cash flow won’t happen until Q1 of next year. But liquidity is certainly not a problem, with billions raised, and billions more available if necessary, thanks to investment grade credit ratings and lots of valuable assets to use as collateral. It would rather avoid taking a government loan, given the ownership warrants it would have to surrender, and the prohibitions on dividends and stock buybacks its shareholders would have to accept.

    Back on the critical topic of cash flows, Southwest will have burned about $18m a day in July, which is up from $16m in June. The reason for the backsliding, as others have documented well, is the abrupt reversal in demand momentum that began in mid-June, with the Sunbelt spike in Covid cases, along with corresponding quarantines and business closures. Demand to Florida and Southwest’s home state of Texas slowed “very dramatically.” Trip cancellations are now increasing “modestly.” July bookings for all subsequent months have softened. Demand is now “much softer than we anticipated.” In response, the LCC is reevaluating August and September schedules, with an eye on beating its current Q3 daily cash burn forecast of about $23m. The fall, remember, is typically an offpeak period.

    And springtime hopes of some early bounce back in business travel now appear misplaced. August, according to company forecasts, will see a 20% reduction in y/y ASM capacity, but a 70% to 80% drop in revenues. Load factor for the month will likely be just 30% to 40%. Getting through the next half-year or so will be a “game of tactics and iterations,” said CEO Gary Kelly. “We’re prepared for a prolonged war against this pandemic.” Cost cutting will be essential, and even with promised severance payouts to departing staff, labor costs are expected to decline by $400m by Q4. With 17k people electing to leave the company though, its ability to respond to a sudden resurgence in demand will be somewhat limited. Kelly also expressed some concern about having cut investment spending to the bone.

    The carrier remains bullish on the B737 MAX, still the most efficient plane it’s ever flown. The plane could return to service by late December, though an early 2021 ungrounding wouldn’t surprise anyone. Southwest is still talking with Boeing about future delivery schedules. Would Southwest consider a second fleet type, like the A220? It’s not anything Kelly is thinking about currently.

    One thing that does remain a focus, as it was pre-crisis, is winning more managed corporate demand when the segment revives. To that end, it will offer its flights through the Travelport and Amadeus distribution platforms used by corporate travel agencies and company travel managers. The airline could not, however, reach a deal with the largest U.S. flight distributor Sabre — the two will terminate their existing relationship, however limited. (Recall that Southwest rebuffed its hometown neighbor Sabre for Amadeus when choosing a new reservation system last decade).

    On a final note, the world’s largest low-cost carrier says customer feedback has never been better, aided by its own efforts to make travelers feel safe, and thanks to much less crowded planes, airports, and airspace.
  • Of the six U.S. airlines that have thus far reported Q2 results, Alaska’s were least dreadful. To be clear, it reported a negative 139% operating margin. No putting lipstick on that. But an 82% y/y drop in revenues was less than what some rivals suffered. It cut a lot — ASMs were down 75%. But its hometown Seattle, with its leisure appeal and strong pandemic-era companies like Amazon and Microsoft, wasn’t a bad place to be. Operating costs, meanwhile, declined 48%.

    The big news for Alaska last week was its formal invitation to join the oneworld alliance, ideally before the end of this year. Its regional affiliate Horizon and even its regional partner SkyWest will join too, as affiliate members. Alaska itself will be the alliance’s 14th member, adding 34 unique destinations. Members British Airways, Cathay Pacific, and Japan Airlines all fly to Seattle, not to mention Los Angeles and San Francisco where Alaska also has a major presence. It’s most important partner, however, is American, which will rely on Alaska’s help to launch new London, Shanghai, and Bangalore service from Seattle, as mentioned in American’s earnings review above.

    Make no mistake: Seattle and the greater Pacific Northwest, including Portland, will be the chief focus of Alaska’s network strategy. The state of Alaska will always have an important place too. So will Hawaii, a market that was getting very competitive pre-crisis as Southwest began service. The giant California market by contrast, is no longer an expansion target, having realized that it’s simply too competitive. It’s still a vital market for the airline to be sure. But lots of the new routes it added from San Francisco after buying Virgin America were rolled back in the past year or so. It did announce 12 new routes from Los Angeles this month, but mostly to either its Pacific Northwest strongholds, or in a bid to generate leisure demand to Florida.

    Like other U.S. airlines, Alaska is greatly disappointed that the virus got so out of control in the Sunbelt, crushing what was becoming a robust rebound in domestic leisure travel. For a while, the carrier saw leisure demand back to about 50% of normal levels. Now, despair is building as many schools across the country delay their reopening, making it harder for parents to engage in normal business activities like travel. Companies also have duty-of-care obligations to protect the health of their workers. Hawaii, meanwhile, keeps extending its two-week quarantine rule for all visitors.

    Alaska fortunately entered the crisis with an extremely strong balance sheet. And it joined the rest of the industry in piling mountains of cash to ensure liquidity far into the future. It did say, like others, that demand needs to improve before cash flow turns positive. A true recovery to pre-crisis levels could take about two years, management believes. It’s a smaller management team to be sure, after already-enacted job cuts. Front-line jobs could be next on the cutting board, after Oct. 1. As things stand now, October capacity will be down 35% y/y. And even by next summer, capacity will likely still be down by something like 20%. Hence the likely need for job cuts.

    Alaska sees Americans falling into one of three buckets: those who will travel, those who might travel, and those who won’t travel. A vaccine or effective Covid treatments of course could change the way many people feel. Ideally, Alaska can start generating cash again in 2021, so it doesn’t have to burn through all the cash it borrowed. It can instead use the cash to repay those borrowings, and ultimately return to profitability and growth. Will oneworld membership and its new American partnership help in that regard? CEO Brad Tilden did remind Wall Street that “you’ve seen us make some of our boldest bets when things are down.” 
  • Spirit was another carrier heartened by the springtime pickup in demand, prompting it to restore more summer capacity. The move largely worked in June (for which load factor was 79%), and even as late as the July 4 holiday weekend, which the airline described as relatively strong. The second quarter ended in June though, and much of the period was sullied by Covid’s early devastation of demand. Operating margin, at negative 247%, was high compared to others that reported. One reason for that was Spirit’s workforce expansion designed to accommodate what was supposed to be another year of zealous growth. Instead, Q2 ASM capacity sank 83% but total labor costs barely budged.

    Another thing Spirit did just before the crisis was order lots of new Airbus planes. Little did it know the market for new aircraft would soon collapse. It’s arranged with Airbus to take just 12 new planes this year rather than 16, and 16 next year rather than 25. It does have 25 A319s that it fully owns, and thus economically sensible to ground if demand doesn’t pick up. A lot will depend on Florida, the epicenter of both the springtime demand revival and the subsequent summertime Covid spike. About half of Spirit’s network touches Florida, which also happens to be its home state (it’s based near Fort Lauderdale). Myrtle Beach is another major Spirit market that initially surged before a sharp slowdown.

    The misleading demand signals, in fact, caused Spirit to reduce capacity just 18% in July, a plan too bullish in retrospect. Learning the lesson, ASMs will be down 35% in August, and 45% in September. Then again, with conditions so volatile, maybe that will prove to bearish. The winter holidays (Thanksgiving and Christmas) will be an important period to watch.  What June showed in any case, was that when leisure demand to places like Florida does come back, Spirit is well positioned to benefit. It insists its cost advantage is “here to stay,” even if forced to reduce aircraft utilization. Rivals, after all, will be reducing their utilization too. And besides, most of Spirit’s cost advantage is derived from other attributes like high seating density, efficient fuel burn, and low overheads.

    How about its labor costs? Will it furlough workers? Spirit hasn’t yet made a decision.
  • Europe was different than the U.S., in that most airlines largely stopped flying early in the crisis, and in many cases didn’t really start again until July. This was the case for Finnair, which only few 3% of its normal capacity during the second quarter. In ASK terms, capacity was down 97% y/y; no U.S. airline declined more than United’s 88%. Finnair’s losses were no less severe, embodied in its negative 254% operating margin. Cargo was a bright spot, especially during May and especially on routes to Asia. This held the decline in Q2 revenues to 91%, even while barely flying passengers at all.

    Operating costs dropped a lot too, by 67%. Companies in Finland can temporarily idle workers without pay, which is exactly what Finnair did. Just as importantly, it was able to raise ample new funds via debt and equity, with the backing of Finland’s government. Helsinki thus remains the airline’s controlling shareholder. The new capital puts Finnair in a resilient position as it awaits recovery. With European countries gradually if inconsistently opening their borders, Finnair will operate about 25% of its flights this month, and 75% by September. This reactivation of flying though, will increase cash burn in the near term.

    Europe isn’t Covid free. But its spread is much better contained than in the U.S. Demand is thus returning quickly, at least to shorthaul leisure markets free of onerous travel restrictions. Finnair is also gradually restoring service to East Asia, the backbone of its network. Flights there are supported by cargo, as well as European expats returning home for the summer, and Asian residents of Europe (especially from China) going back to visit family. Overall July load factor should be about 60%. Bookings are coming in later than usual amid all the uncertainty. Finnair, meanwhile, is still working through its backlog of processing cash refunds.

    Management is now undertaking the difficult task of convincing unions to surrender permanent pay and productivity concessions. The carrier still needs to order new narrowbody jets and luckily didn’t buy too soon, before Covid crashed the market. Longterm, Finnair still aims to earn annual operating margins of 8%. By its own admission though, achieving that will now take longer than originally hoped.  

Madhu Unnikrishnan

July 26th, 2020