Tailwinds 2013 airline industry trends

Spotlight: The 50-seater bubble: Boom to bust

We are pleased to introduce Tailwinds, a new publication for the airline industry. Each edition of Tailwinds will provide an overview of the state of the industry and highlight an important trend or challenge facing the industry. The first section looks at key metrics in the US airline industry, such as growth and operating income, as well as expense patterns since 2008. While the industry has become better at managing capacity and generating ancillary revenues, it faces rising costs for labor, maintenance, and fuel. Achieving profitability under these difficult conditions requires operating discipline and new ways of generating revenue. The second section examines two critical issues facing the regional airlines: the challenging economics of operating 50-seat regional jets and an impending pilot shortage. Our discussion looks at the immediate and longerterm impacts of these factors and how the regional airlines are dealing with them. We hope you will find our perspectives on the industry and its challenges to be interesting, informative, and enjoyable to read.

Table of contents

Part one: Current US domestic industry trends

Part two: The 50-seater bubble: Boom to bust

Contacts 10

Part one: Current US domestic industry trends

Revenue growth in the US airline industry has recovered to close to the pre-recession levels of 2008. Except for a dramatic dip in 2009, when the recession significantly decreased demand, airline revenue growth has exceeded real GDP (Figure 1). Load factors have increased by almost four percent since 2008, primarily due to better capacity discipline and reduced supply driven by industry consolidations.1 Since 2008, there has been an eight percent reduction in the number of flights, but only a one percent reduction in total passengers.2 Given these favorable metrics, expectations of slightly lower fuel prices, and continuing consumer confidence, the industry is expected to maintain profitability into 2013. The International Air Transport Association (IATA) supports this view, noting that airline share prices were up seven percent for the first two months of the year, despite a five percent rise in jet fuel prices.3

Figure 1: Real GDP and airline revenue growth (20082012)

20% 15% 10% 5% 0% -5% -10% -15% -20% 2008 US GDP growth 2009 2010 2011 2012

Airline revenue growth

Sources: US Bureau of Economic Analysis (2013), Company 10-Ks (20082012), PwC analysis (based on large US carriers with annual revenues greater than $4 billion in 2012)

Figure 2: Average domestic airfare and main ancillary fees (20082012) ($US)

$400 $390 $380 $370 $360 $350 $340 $330 $320 $310 $300
1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12

Looking at revenues: ticket prices and ancillary fees

The price of a domestic airline ticket has increased in line with inflation over the last five years, growing less than two percent in real terms (Figure 2). However, revenue was buoyed by charging customers fees and selling ancillary products. The increase was driven primarily by baggage, standby, and cancellation/change fees and, to a lesser extent, priority access and other miscellaneous charges.4

Average domestic airfare

Average domestic airfare with fees

Source: Bureau of transportation statistics (2013)

Tailwinds: 2013 airline industry trends

Figure 3: Crack spread (20082012) ($US)

$4.00 $3.50 $3.00 $2.50 $2.00 $1.50 $1.00

single greatest cost faced by airlines. In 2003, fuel was about 12 percent of costs, rising to 28 percent in 2012.9 Airlines have tried to mitigate this increase through hedging strategies and the use of newer, more efficient aircraft and improved operating procedures, such as reduced taxiing. In 2012, the price of jet fuel averaged $3.08 a gallon, greater than the record high of $3.00 in 2011. The crack spread, or gap between jet fuel and unrefined oil prices, has also increased to 25 percent of total jet fuel cost as refineries focus on higher-margin product, creating an additional cost challenge for airlines.10 Some carriers are taking aggressive steps to address the crack spread, even to the point of acquiring refining capability. Finally, some slight relief on fuel costs is anticipated: The US Energy Information Administration (EIA) forecasts lower petroleum prices in 2013, from an average of $94 per barrel in 2012 to $93 per barrel in 2013 and $92 in 2014. This moderation in fuel prices is expected to help drive improved margins for domestic airlines this year.

2008

2009

2010

2011

2012

Average jet fuel price (per gallon)

Average unrefined oil price (per gallon)

Source: US Energy Information Administration (2013), PwC analysis

The average customer paid $9.66 for bag and change fees on top of base airfare in the first quarter of 2012.5 Even more strikingly, the largest US carriers collected more than $3.5 billion in baggage fees in 2012,6 adding nearly three percent to the average airfare. When other fees and revenues are added and averaged across all passengers, the average base airfare increased by almost nine percent.7 In the past three years, the actual average airfare has rebounded, while bag and change fees have reached a plateau. Since the third quarter of 2009, the average fare has increased $60, or 11.6 percent after inflation adjustment.8 On the other hand,

since 2009, revenue generated from bag and change fees has remained relatively stable on a per customer basis. Faced with higher baggage feesranging up to $45 for the first bagmany passengers have opted to travel light or not check baggage at all. Consequently, baggage fee revenue is flat. Therefore, airlines are looking for ways to generate ancillary revenue by strategically charging fees and bundling services that are aimed at enhancing the travel experience.

Looking at expenses: labor

The second-highest expense for airlines is labor. Labor expenses, primarily flight and ground crew salaries, accounted for 23 percent of US airline expenses in 2012.11 Over

Looking at expenses: fuel

Over the last decade, fuel costs have more than doubled as a percentage of operating expenses to become the

Tailwinds: 2013 airline industry trends

the last five years, labor expense for airline employees has been increasing, as shown in Figure 4, in part as a result of merger and consolidation activity in the airline industry. When airlines negotiate merger terms, they often agree to higher salaries and better terms of employment in order to gain union buy-in. This overall increase in salaries has reversed some of the reductions implemented during past bankruptcies. An impending pilot shortage is likely to result in pushing pilot salaries higher. Starting in August, new US commercial copilots will need a minimum of 1,500 hours flight experience, six times the current requirement. Beginning in 2014, the FAA will also require more rest time between flights. These changes are coming at a time when baby boomer pilots are reaching the mandatory retirement age, military pilots are staying in the military longer, and foreign airlines are competing for pilots.

Figure 4: Labor expense per average seat mile (20082012)

4.0 3.49 3.0 3.08

3.68

3.63

3.76

2.0

1.0

0.0

2008

2009

2010

2011

2012

Labor expense: cents per ASM

Source: Company 10-Ks (20082012), PwC analysis (based on large US carriers with annual revenues greater than $4 billion in 2012)

Figure 5: Maintenance expense per average seat mile and airline fleet age (20082012)

0.95 0.90 0.85 0.80 0.75 0.70 0.65 2008 2009 2010 2011 2012 0.77 0.79 0.76 0.83 0.89

13

Looking at expenses: maintenance costs

Aircraft maintenance expenses are a significant cost for airlines as they manage balance sheets by deferring aircraft replacement. Maintenance costs per seat mile increased from 0.77 cents in 2008 to 0.89 cents in 2012, as shown in Figure 5. This increase of over 16 percent was driven by an aging fleet and above-inflation increases in engine maintenance

12

11

10

Maintenance expense: cents per ASM

Average fleet age in years

Source: Company 10-Ks (20082012), PwC analysis (based on large US carriers with annual revenues greater than $4 billion in 2012)

Tailwinds: 2013 airline industry trends

Figure 6: Operating income per available seat mile (20082012)

Airlines continue to fight for profitability

Airlines continue to be challenged by high expenses, especially the cost of jet fuel, and unplanned disruptions, such as bad weather. Tony Tyler, IATA CEO, called the industry fragile.13 However, there are several positive trends operating in the industry. During 2013, 155 new and more efficient aircraft will be added to North American fleets.14 The 14 percent reduction in domestic flights from 2005 to 2011 allowed airlines to manage a smaller network more efficiently.15 According to Airlines for America (A4A), an industry trade group, US airlines are expected to scale back capacity in 2013 to offset fuel prices, projecting a 2.4 percent reduction in scheduled domestic flights.16 A4A also said that last year, domestic airlines achieved an 82.8 percent load factor, the highest since 1945.17 Fleet age is expected to decline over the next decade as airlines use deliveries of new technology aircraft to replace less fuel efficient aircraft, reducing both maintenance and fuel costs.

1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 -2.51 2008 2009 0.15

0.79

0.53

0.28

2010

2011

2012

Operating income: cents per ASM

Source: Company 10-Ks (20082012), PwC analysis (based on large US carriers with annual revenues greater than $4 billion in 2012)

costs.12 The average age of the US fleet has increased from 11.8 years in 2008 to almost 13 years in 2012. Lower-cost carriers (LCCs) have helped hold down average fleet age through their aggressive fleet expansion, but now LCC growth has slowed. Engine maintenance costs have increased because of aging and reduced competition as engine original equipment manufacturers control an increasing share of the engine maintenance, repair, and overhaul market. Airlines are looking to leverage advanced analytics and predictive maintenance to control these increases, but they are hampered by legacy IT platforms, which generally lack the ability to capture and consolidate the large amounts of data created by newerfleets.

A decline in operatingincome
Operating income per available seat mile continued to decline after a rebound in 2010, and in 2012 it fell to an average of 0.28 cents, compared with -2.51 cents in 2008 (Figure 6), during the worst recession since the 1930s. High fuel costs were a significant driver of lower operating income in 2008, 2011, and 2012, and merger and bankruptcy issues put further pressure on earnings in 2011 and 2012. The overall net result is an industry that continues to struggle to achieve consistent profitability.

Tailwinds: 2013 airline industry trends

Part two: The 50-seater bubble: Boom to bust

Despite global economic challenges, the airline industry has returned to profitability through operational improvements, consolidation, and ancillary revenues. Passenger demand is up, airlines are more efficiently managing capacity, and load factors are at a record high. Last year, US airlines achieved their second-best performance in more than twenty years, as measured by the number of on-time arrivals, mishandled bags, consumer complaints, and overbookings.18 Yet the industry as a whole is still operating on very thin margins and looking for additional ways to control costs and increase profitability in a time of high fuel prices. This struggle is clearly manifest in the story of the 50-seat jet, the workhorse of the regional sector, which has become unprofitableto fly.

Figure 7: Fleet growth forecast World 20-to-59 seat 60-to-99 seat 100-to-149 seat Total 2011 eet 3,600 2,500 5,100 11,200 Deliveries 300 5,600 6,900 12,800 Retirements 2,700 1,300 3,000 7,000 2031 eet 1,200 6,800 9,000 17,000

Bombardier Commercial Aircraft Market Forecast 20122031

shorter than 1,000 miles. The demand for the 50-seat jets understandably exploded, creating the conditions for the development of a market bubble.

Bigger regional jets takingflight

The logical replacement for a 50-seat jet is a larger, more economical jet. A larger jet can spread its fuel costs and overhead over more seats, reducing unit costs. The move to larger jets is already underway, as evidenced by some recent moves by Delta. Delta closed down its wholly owned subsidiary, Comair, and has renegotiated its deal with Pinnacle Airlines that will nearly double the number of large planes it flies for Delta and phase out its smaller planes.20 Delta has limited 50-seat flights to trips shorter than 700 miles and has indicated it will phase out these planes over the next few years. It is purchasing 90-seat and leasing 100-seat jets and has already replaced some regional jet flights with mainline flights.21 Bombardier, one of the two principal manufacturers of the 50-seat jet, maintains that the 60- to 90-seaters have started to take hold, with more than 200 aircraft delivered in 2011. It projects that by the end of 2031, the total fleet of 60- to 90-seaters will expand to 6,800 aircraft. (Figure 7 ) A little more than half of the new delivery aircraft will be regional jets, and the

The bursting bubble

Less than 20 years since its introduction, the 50-seat jet is once again having a game-changing effect on the airlinesonly this time, the aircraft is being viewed as a liability. Small size limits the jets profitability at a time of consistently high fuel prices and less attractive capacity purchase agreements (CPAs). In the last several years, with the restructuring of the major airlines through bankruptcy proceedings, the majors altered their CPAs with regional partners, leading to less favorable terms for the regionals. Bankruptcy proceedings changed the duration of contracts and reimbursement rates, creating a mismatch between the lease terms for 50-seat aircraft and the duration of the capacity purchase agreements between US regionals and their network partners.19

The 50-seater bubble

Introduced in the mid-90s based on new engine designs, the 50-seater was an economical replacement for turboprops and larger jets that enabled airlines to better match capacity with demand. Airlines could serve smaller cities and markets and provide more connections between the major airports and secondary and tertiary airports, feeding into long-haul and international routes. The regional jets were also more comfortable, quieter, and faster than the older turbojets, creating better flying conditions for commuters. Given their attractive attributes, these jets very quickly became the aircraft of choice for most domestic routes
6 Tailwinds: 2013 airline industry trends

rest will be modern turbojets, which are more economical to operate on short flights and provide a natural hedging tool for air carriers against high and volatile fuel prices.22 In addition to being more fuel efficient, the larger jets offer an opportunity to increase fares. With 20 or more additional seats, airlines can offer first class and premium economy sections, an advantage for both the airlines and their customers.

Issues in transitioning tolarger jets

Scope clauses Scope clauses, provisions in a pilots contract that define the number and size of aircraft a regional can fly on behalf of a carrier, may have slowed the transition to larger aircraft. The 50-seat jet is still the dominant regional jet and constitutes 43 percent of the entire regional airline fleet, according to the Regional Airline Association.23 However, as contracts expire and are renegotiated, the scope clauses that held airlines to 50-seaters are falling by the wayside as airlines attempt to increase the size of their regional jets. One major carrier has gained the ability to increase its 70-plus-seat aircraft by 27 percent, while reducing the number of 50-seaters. Another major US carrier negotiated to gradually shift 60 percent of 70-seaters to 76-seaters.24 With the handwriting on the wall, what will happen to the 50-seaters? Given their past ubiquity and scope

clauses limiting the number of larger regional jets, its a safe bet that 50-seaters will be part of the regional fleet for some time. But how many will continue to fly depends on whether the economics of the aircraft can be changed. A key variable in this calculation is the renegotiation of terms with lessors to lower lease rates. Typically, lease rates are reduced to a market clearing rate that offsets inefficiency. However, it remains to be seen whether even very low rates can turn the 50-seater into a profit maker in todays environment. Retired planes Historically, most retired planes were repurposed. Some went to other parts of the world, such as Russia, Africa, and Latin America. Others were reconfigured as business jets or cargo planes. However, the resale market for 50-seaters does not look very promising, since jet fuel is an expensive commodity globally. Their size makes them potential business or private jets, but even during the best of times, the resale market for private and business jets is relatively small. Perhaps some cargo companies could deploy some 50-seaters to replace turboprops for short-haul flying, but even this usage will be limited because of fuel considerations and the planes limited payload, only one-third that of a 737 aircraft.25 Ownership With the supply of retired 50-seaters outstripping demand, many planes may sit in storage, leaving open

the question of who will suffer the financial consequences. To a large extent, the answer depends on who owns the aircraft. In the case of the 50-seaters, some aircraft are owned by network carriers that sublease them to their regional partners. Some manufacturers have backstop agreements with residual value guarantees that leave them with some liability and provide them with an incentive to help the airlines find buyers. Less impacted by the issues surrounding the 50-seat jets are most of the leading airplane lessors, who have focused more on ownership of mainline aircraft. A notable exception is GE Capital Aviation Services, which owns nearly 70 percent of all leased regional jets.26

Longer-term impact onairlines

At the start of the growth of the 50-seater market, many mainline carriers owned their regional subsidiaries to gain greater control over their schedules, routes, and brand. It also provided a direct feed of pilot talent from the regional to the mainline owner. Today, this ownership model is being re-examined, especially in light of the challenging economics of the 50-seat jets. If mainline carriers own regionals, they may continue to incur losses because of the number of 50-seat jets still flying. Also, ownership constrains a mainline carrier from competitive negotiations with different regionals.

Tailwinds: 2013 airline industry trends

Consequently, most mainline carriers have chosen to sell their regionalbusinesses. Going forward, airlines will also have to decide whether they want to own or lease the 7090-seat jets that are supplanting the 50-seaters. If an airline thinks these jets will lose their value as quickly as the 50-seaters, then it is unlikely to choose an ownership model.

commercial pilots to have 1,500 hours of prior flight experiencesix times the current minimum. The Federal Aviation Administration has proposed some exceptions, reducing the requirement for military pilots to 750 hours and graduates of accredited university training programs to 1,000 hours.27 But the military exception is not likely to change the dynamic; military pilots have been staying in the military for longer periods of time.28 Severely aggravating the expected shortage is the impending retirement of thousands of pilots at major airlines who are reaching the mandatory retirement age of 65.29 Approximately 3,000 pilots a year have retired in recent times, and that number may jump to 10,000 a year over the next ten years.30 These retirements will begin at about the same time that a second new regulation is set to take effect early in 2014, mandating more daily rest time for pilots. It is estimated that this regulatory change will require an additional five percent increase in the number of commercial pilots, further intensifying the pilotshortage.31 Regional airlines are likely to feel the greatest impact of this pilot shortage because new pilots typically start their commercial careers flying for regionals. Many people now in pilot training programs will find it difficult to log enough hours before the deadline. In addition, many new pilots choose to start their careers overseas, where the pay is often better.32

Combating the pilotshortage

In the short term, the pilot shortage may cause some regional airlines to curtail flight schedules, eliminate lower-trafficked routes, and raise airfares. In the long term, the regionals may have to be more engaged in filling the pilot pipeline by funding training and subsidizing pre-certification flying time. They may also have to increase compensation packages in order to attract more potential pilots, particularly given that the regulation requiring additional flying experience will increase the investment required to become a commercial pilot. In anticipation of a pilot shortage, one mainline-owned regional carrier said it would offer a $5,000 signing bonus at the start of training in exchange for a two-year commitment.33 The regionals may also look to strike deals with the mainline airlines to help them with funding and compensation, since mainline carriers rely on regionals to provide experienced pilots. For mainline airlines that owned regionals, this pipeline was a natural progression. But now, with many regional airlines spun off from their mainline parent, carriers may have to look for other means to ensure they have enough pilots. One example is the agreement between Delta and Pinnacle Airlines, an independent regional airline that filed for bankruptcy protection last year. As part of that deal, Pinnacle pilots will be hired by Delta, allowing for career progression.34

Impact on manufacturers
Even when the demand for 50-seaters was at its peak, the two primary manufacturers of these planes, Embraer and Bombardier, anticipated that the growth of airline travel would create the need for larger planes on many routes. Before fuel prices began to climb, Embraer and Bombardier stopped making 50-seaters for the US market and refocused their resources on building bigger jets. Embraer is concentrating on jets in the 7090 seat range and is now facing competition from Mitsubishi Aircraft for that segment of the market. Bombardier is betting on 120-seaters, putting it in direct competition with Boeing and Airbus.

Impending pilot shortage

Less than a year after a commuter plane crash in 2009, Congress, in an attempt to improve airline safety, passed legislation mandating more training time for new pilots. The ruling, which is set to take effect in August 2013, will require most

Tailwinds: 2013 airline industry trends

A view of the future

The 50-seat jets are being replaced by 70-to 90-seaters principally because larger jets make more economic sense in an era of high fuel prices. Yet many 50-seaters may remain to provide service to small cities, as larger jets may not be the best choice for less populated areas. Another factor affecting the number of 50-seaters is the scope clause. While three of the largest mainline carriers have negotiated the addition of 70-plus-seat jets to their fleets, restrictions still exist. Deltas deal with its pilots, for example, reduces

the number of its 50-seaters to 125, but also caps the number of 70-seaters at 102.35 Practically, though, the move to 70-seaters may also be delayed by the inability of manufacturers to fill orders quickly enough. This shortage could result in new partnerships among the airlines, as those that were first to order the larger planes will have a competitive advantage. Will the 70-seater go the way of the 50-seater and be replaced as quickly by the 90-seater? Probably not. The story of the 50-seaters may be an exception rather than a change

in the normative retirement age of aircraft. The next generation of aircraft is more likely to be a 30-year asset, with manufacturers looking to make incremental improvements. The 70-seater, built with a focus on creating more efficient fuel burn, offers room for engine optimization that will help to lower maintenance costs and extend the life of theaircraft. But if the mainline airlines fall into bankruptcy again and scope clauses are further loosened, we may yet see a second bubbleonly this time with the 70-seaters.

Endnotes 1, 4, 5, 11, 12, 24, 25 PwC analysis 2 Sources: US Bureau of Economic Analysis (2013), Company 10-Ks (20082012), PwC analysis (based on large US carriers with annual revenues greater than $4 billion in 2012) 3 IATA.org, Financial Forecast, Mar. 2013 6, 8, 9, 16 Bureau of Transportation Statistics 7 PwC, Aviation perspectives: Airline mega-merger impact on the US domestic airline industry, Dec. 12, 2012 10 US Energy Information Administration (2013), PwC analysis 13 SITA Air Transport IT Summit, Brussels, Jun. 2012.Quoted in Airline Leader, Aug.-Sep. 2012,p. 21 14 Bloomberg Industries, "Airline Prots Rise on Lower Fuel, Tighter Capacity: Outlook," Nov. 27, 2012 15 Bureau of Transportation Statistics, Flights: All U.S. Carriers - All Airports 16 ainonline.com, Air Transport Perspective, U.S. airlines will reduce capacity next year to help offset high jet fuel prices, according to Airlines for America, Nov. 12, 2012 17 airlines.org, A4A announces U.S. airlines achieve 83 percent passenger load factor, highest level since 1945, 18 March 26, 2013 19 USA Today, U.S. airline quality has second best year in 20 years, Apr. 8, 2013 19 CAPA, Aviation Analysis, Republic works to restructure loss-making 50-seat operations at its subsidiary Chautauqua, May 3, 2012 20, 23, 34 online.wsj.com, Judge Approves Deals Between Pinnacle, Delta Air, Jan. 16, 2013 21 online.wsj.com, Are These Model Airplanes? Feb. 27, 2013 22 Bombardier Commercial Aircraft Market Forecast 20122031 26 ightglobal.com, Aircraft Finance Report 2012 27 Federal Aviation Administration, RIN 2120AJ67, Pilot Certication and Qualication Requirements for Air Carrier Operations 28, 30 chicagotribune.com, Arrival time for a pilot shortage?" Jan. 26, 2013 29 USA Today, "Pilot shortage looms for airline," Jan. 6, 2013 31 online.wsj.com, Airlines Face Acute Shortage of Pilots, Nov. 12, 2012 32 npr.org, Airlines Fear Pilot Shortage Amid New Federal Safety Rules, Dec. 26, 2012 33 examiner.com, [Carrier] offers signing bonus as pilot shortage looms, Jan. 12, 2013 35 ainonline.com, U.S. Scope Clause Relief a Double-Edged Sword, June 11, 2012

Tailwinds: 2013 airline industry trends

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Contacts

To have a deeper conversation about this subject or other related airline/transportation matters, please contact:
Jonathan Kletzel US Transportation & Logistics Leader +1 (312) 298 6869 [email protected] Richard Wysong US Transportation & Logistics Director, Advisory +1 (415) 498 5353 [email protected] Alexander T. Stillman US Transportation & Logistics Director, Advisory +1 (202) 487 8086 [email protected]

For general inquiries, contact: Diana Garsia US Transportation & Logistics Sr. Marketing Manager +1 (973) 236 7264 [email protected]

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