Delta Airlines Essay

A BRIEF ANALYSIS OF SELECTED AIRLINE¡¯S PROSPECTS

Table of Contents:

1. Introduction 3
2. Trends and Strategies in the Airline Industry: a Brief Overview 3
3. Airline Profiles 5
3.1 Southwest Airlines 5
3.2 United Airlines 5
3.3 American Airlines 5
4. The Impact of Acquisitions and Mergers 6
4.1 United Airlines/USAir 6
4.2 American Airlines/Trans World Airlines 7
4.3 Southwest Airlines/ATA 7
5. The Impact of Bankruptcy Proceedings on Untied Airlines 8
6. Effect of United Airlines Chapter 11 Proceedings on Other Airlines 9
7. External Factors Affecting the Airline Industry 9
7.1 Effects of September 11 on the Airline Industry 9
7.2 Effects of the Iraq War on the Airline Industry 10
7.3 Effects of SARS on the Airline Industry 10
7.4 The Impact of Oil Prices 11
7.4.1 Fuel Hedging 11
7.4.2 Jet Fuel Hedging Strategies 12
7.4.3 Airline Stock Prices Fall Due to Record Fuel Prices 13
8.
Conclusion 13

1. Introduction
This analysis focuses on the US airline industry and its companies¡¯ stocks during the last decade. Specifically, this analysis gives attention to two so-called legacy airlines which include UAL Corporation, holding company for United Air Lines, Inc. (¡°United Airlines¡±), AMR Corp., holding company of inter alia American Airlines, Inc. (¡°American Airlines¡±), and a low cost carrier, Southwest Airlines Co. ("Southwest Airlines"). These three airlines were chosen in particular as they each have very unique strategies on how they compete in this extremely competitive industry.

2. Trends and Strategies in the Airline Industry: a Brief Overview
Hurt by poor profits and scarred from likely terrorist attacks against the US due to the US involvement in the Iraq war, the airline industry finds itself on a bumpy course. In an effort to head off a drop in the number of passengers and rising costs for security , companies laid off staff and trimmed services. In an already intensely competitive market, the ¡°inevitable¡± industry wide shakedown will have far-reaching effects on the industry's trend towards expanding domestic and international
services.
International traffic is intricate for US Airlines. Many airlines are still partly owned by their respective nations, and treaties between nations determine which airlines can land where. To get around national laws and regulatory problems, US airlines have formed global alliances such as Star (United Airlines and Lufthansa) , Oneworld (American Airlines and British Airways) , and SkyTeam (Delta Air Lines, Air France, and AeroM¨¦xico) . Through such alliances, airlines benefit from each other's resources, which include additional routes and marketing strategies as well as code-sharing agreements, without incurring the high costs of expansion. The costs involved with increased security precautions and route changes will force the airlines to examine their agreements. For customers, airline alliances offer broader frequent flier programs, streamlined travel, and simplified systems for purchasing tickets, but those benefits may do little to allay passenger concerns regarding safety. Even as airlines stake out their positions in the global market, they are not immune to domestic competition. Regional airlines have gained new ground with the development of newer, smaller jets that are faster than turboprop (propeller) planes and have greater ranges. The new regional jets have also made operating in previously underserved markets more cost-efficient. Recognizing their potential, major US carriers Delta Air Lines (which owns regional carriers Delta Express, Atlantic Southeast, and Comair) and American Airlines (with its AMR Eagle) have sought to control all or part of the upstart regional airlines.
To confront such difficulties, major carriers were hoping to merge, such as United Airlines and US Airways. Yet, they were repudiated by regulators scrutinizing competition issues. As the world's airlines struggle to rise above regulators and each other in efforts to grow bigger and better, they are finding themselves in additional struggle on other fronts. Airport capacity, route structures, weather, technology, and, most significantly, rising fuel and labor costs have cut into airline profits. Carriers have sought refuge in higher prices, primarily for business customers, who during the thriving economic times of the late 1990s were willing to pay more in exchange for better services and, even more important, for scheduling freedom. The move worked until corporate belt-tightening became the norm in 2000 and 2001, and companies began to reevaluate their travel budgets. This slow-down of the US economy is echoed in a decrease of United Airlines and American Airlines share prices in that period (see Exhibit 1.2) as these Airlines traditionally cater to the business traveler . Increasingly, business travelers are looking to various alternatives to high ticket prices: using software to streamline travel expenses, scouring the internet for cheaper fares that leisure travelers enjoy, and relying increasingly on video and teleconferencing technologies. The results have left airlines struggling to come up with ways of attracting more premium passengers.
Exacerbating that struggle further were the tragedies at the World Trade Center in New York and the Pentagon in Washington, DC, where two American Airlines jets and two United Airlines jets were hijacked and crashed as part of apparent terrorist attacks in 2001. The catastrophe led to a first-time shutdown of all US air traffic by the Federal Aviation Administration (FAA). The shutdown not only halted all domestic traffic, it prevented all international traffic from entering the US. Effects from the shutdown were nearly instantaneous. Midway Airlines decided to permanently halt its operations, but later resumed limited operations with the help of $10 million in federal aid, only to go away for good. Of the major carriers, Continental Airlines and US Airways were the first to react by cutting back their flights and laying off workers (about 20% each) . Other carriers soon followed, which brought the number of layoffs to about 100,000 in the US. The immediate effect of these events on share prices, in particular on those of American Airlines and United Airlines, can be seen in Exhibit 2.3.
European carriers, such as British Airways and Lufthansa, also began cutting services and workers . In anxiety over anticipated financial losses, major US carriers requested government help and received $15 billion worth in direct aid and guaranteed loans . The EU successfully discouraged state bailouts. The forces buffeting the industry, however, have prevented any smooth take-offs back into profitability; most US carriers are still incurring heavy losses. This especially true for the legacy carriers American Airlines and United Airlines that are not profitable since 2001 (see Exhibit 7.2 and 8.2). Net Operating Income Margin has been negative even since mid 2000 (see Exhibit 4.4).
That trend has put the spotlight on another not necessarily new, but mostly disdained business model the low cost carrier.
One-time upstart Southwest Airlines pioneered it with peanuts, and newcomer JetBlue has given it satellite TV. Prior to September 11, there were only a handful of successful budget carriers in the US and Europe. Now those numbers are growing rapidly. Europe has seen the most growth with more than 50 budget carriers operating where there had only been four in 1999 . In the US Southwest Airlines reigns supreme over the low-fare realm. Southwest Airlines was not only profitable for the last decade (see Exhibit 6.2) but since its establishment 32 years ago . As a result, it has become a top-five carrier in the country . Likewise, since its inception in 1999, JetBlue has been growing almost exponentially. Others are taking note. Atlantic Coast Airlines, which had once relied on United Airlines for 85% of its revenue, waved good-bye to the major carrier, adopted a new look, and changed itself into a budget carrier called Independence Air
.
In response to the phenomenon United and Delta have created budget carriers of their own - Ted and Song, respectively . The moves have to work. United still hasn't emerged from bankruptcy and Delta has been threatening to go into bankruptcy if it can't get costs down . The only difference between Ted and Song and the more successful budget carriers is Ted and Song were created and are run by giant loss-making carriers.
No one knows how this new breed of airline will fare for sure, but it's clear the industry is changing and changing quickly.

3. Airline Profiles
3.1 Southwest Airlines
Southwest Airlines is a major domestic airline that provides primarily shorthaul, high-frequency, point-to-point, low-fare service. Southwest Airlines was incorporated in Texas and commenced customer service on June 18, 1971 with three Boeing 737 aircraft serving three Texas cities - Dallas, Houston, and San Antonio. Today Southwest operates over 400 Boeing 737 aircraft in 60 cities . Southwest has the lowest operating cost structure in the domestic airline industry and consistently offers the lowest and simplest fares. Southwest also has one of the best overall customer service records. LUV is their stock exchange symbol (selected to represent their home at Dallas Love Field, as well as ¡°the theme of their employee and customer relationships¡±) .

3.2 United Airlines
UAL Corporation operates as the holding company for United Airlines that provides transportation of persons, property, and mail. It also engages in travel distribution and customer loyalty e-commerce activities. As of December 31, 2003, the company operated 1,600 daily departures to approximately 110 destinations in 23 countries and 2 U.S. territories. Its operating aircraft fleet totaled 532 jet aircraft, of which 252 were owned and 280 were leased. It primarily operates in North America, the Pacific, the Atlantic, and Latin America. The company was incorporated under the laws of the state of Delaware in 1968. UAL is headquartered in Elk Grove Township, Illinois. UAL, United, and 26 of its subsidiaries filed voluntary petitions for reorganization under Chapter 11 of Title 11 of the United States Bankruptcy Code in December 2002. The company and its subsidiaries operate their business as debtors-in-possession .

3.3 American Airlines
AMR Corporation, through its principal subsidiary, American Airlines, Inc., operates as a scheduled passenger airline. The company operates scheduled air freight carriers, as well as provides freight and mail services to shippers. AMR, through its AMR Eagle Holding Corporation subsidiary, also owns two regional airlines, which do business as the American Eagle carriers. It also contracts with three independently owned regional airlines that do business as the American Connection. The company provides connecting service primarily in the United States, Canada, Mexico, and the Caribbean. AMR¡¯s another wholly owned subsidiary, AMR Investment Services, Inc., serves as the investment manager of the American AAdvantage Funds, a family of mutual funds with both institutional and retail shareholders, as well as provides customized fixed income portfolio management services. The company provided scheduled jet service to approximately 150 destinations throughout North America, the Caribbean, Latin America, Europe, and the Pacific, as of December 31, 2004. It served approximately 250 cities in approximately 40 countries with approximately 3,800 daily flights with a combined network fleet of approximately 1,000 aircraft, as of March 1, 2005. AMR Corporation was founded in 1982 and is headquartered in Fort Worth, Texas . American Airlines is the largest airline in the world in terms of revenue-passenger-kilometers .

4. The Impact of Acquisitions and Mergers
What has been described as the ¡°inevitable¡± shake-out in the airline industry soon to come, might be in progress already.
4.1 United Airlines/USAir
In late May 2000, UAL Corp.'s United Airlines made a surprising announcement that the company had reached an agreement to purchase US Airways Group Inc. for $4.3 billion in cash, and the assumption of $7.3 billion of debt and lease obligations. Many industry experts were surprised by the news, as for several months prior to the announcement it had been rumored that United was planning on buying America West, a much smaller airline. United Airlines strategy, which was the world¡¯s largest airline at the time, was to fill a gap on its north-south routes in the eastern United States. Combined the two companies accounted for approximately $25.0 billion in annual sales and 145,000 workers, 980 aircraft and 4,400 flights a day for their core airlines, as well as thousands of commuter flights. The deal however drew opposition from Congress, airline labor unions and consumer groups almost from the start, and US Airways and United shares overall declined during the merger negotiations, suggesting that investors doubted the deal would be approved (see Exhibit 1.2). After the announcement some analysts believed the offer would spark a bidding war for US Airways, or a move for other carriers. Speculation sent the stock of UAL's two largest competitors, number two, American Airlines, and number three, Delta Air Lines, falling (see Exhibit 1.2 for American Airlines). At the same time values of some of the less successful carriers such as Trans World Airlines, Northwest and America West, saw their shares rise, as investors seemingly tried to guess which airline might see the next offer. In an attempt to address the department of Justice¡¯s monopoly concerns, United proposed to sell some of the combined companies' assets at the congested Reagan National Airport in Washington. The company also promised to limit fare hikes for two years except to keep up with rises in inflation or fuels costs.
Unfortunately, United Airlines¡¯ efforts were not successful and in July 2001 United Airlines parent UAL Corp. and US Airways Group Inc. announced that they had decided to terminated their merger agreement, which would have been the largest in the industry after the U.S. Justice Department said it would move to block the deal. The Justice Department explained that the proposed $4.3 billion deal, would hurt competition and raise airfares as on more than 30 routes, the combined airline would have a monopoly or duopoly on nonstop service, and that it would substantially limit competition on other routes. The department estimated that fliers spent $5.6 billion annually flying on those routes, an amount equal to about 20 percent of the two carriers' combined revenue in 2000. After the announcement of the termination the share of United Airline lost even more, however this was also the case for shares of American Airlines, which should have stayed unaffected or were even likely to benefit from the blocked merger. So, the decline of the share price (see Exhibit 1.2) may be attributed to the weak economy in this period and the worsening balance sheets (see Exhibit 5.2, 5.3). In particular, the steeply increasing ratio of Equity Turnover is not a sign of growing revenue but of rapidly declining total equity and, thus, increasing total debt.

4.2 American Airlines/Trans World Airlines
On January 10, 2001 American Airlines announced that the company had agreed to purchase Trans World Airlines Inc. for approximately $500.0 million in cash and the assumption of aircraft operating leases. As part of the transaction, American agreed to acquire up to 190 aircraft, 175 gates and 173 slots. The integration of TWA with American Airlines was designed of course to give American Airlines a strategic advantage, however many airline-industry watchers also suggested that AMR may have had another motive for acquiring TWA. Many analysts felt that American's principal purpose was to try to derail the above mentioned United Airlines/USAir merger which would have combined the two airlines into the world's largest carrier.
In 2001, TWA, was the nation's eighth-largest carrier and had been struggling financially under its current regime. It had lost $353.0 million in 1999 on sales of $3.3 billion and was expected to do even worse in 2001 . The airline had last earned a profit during the Reagan Administration. In order to make the acquisition more feasible, American agreed to acquire TWA only after the airline filed for bankruptcy. TWA subsequently voluntarily filed petitions in the U.S. District Court in Wilmington, Delaware for protection under Chapter 11 of the U.S. Bankruptcy code. In conjunction with the Chapter 11 filing, American Airlines agreed to provide TWA with $200.0 million in debtor-in-possession financing to ensure the airlines ability to maintain its operations throughout the completion of the transaction. The proposed merger spelled the end for another airline, which had a long and colorful history (dating back to Charles Lindbergh and Howard Hughes). At the same time the merger gave American Airlines the distinguished position as the world's largest air carrier. The merger did not significantly influence the share price of American Airlines (see Exhibit 1.2).

4.3 Southwest Airlines/ATA
On December 16, 2000, ATA Holdings Corp., the nation's 10th largest passenger carrier, announced that it had selected the bid from Southwest Airlines for acquisition of certain of the airlines Midway Airport lease rights. The bid of Southwest Airlines was selected by ATA upon conclusion of an auction, which took place pursuant to the authorization from the U.S. Bankruptcy Court, in which ATA¡¯s Chapter 11 reorganization case was pending. Bidding at the auction was Southwest Airlines and AirTran Airways, Inc., another low-cost-carrier. The final bid presented by Southwest Airlines included a total of $117 million in commitments to ATA, with the transfer to Southwest Airlines of lease rights to six gates and a maintenance hangar at Chicago Midway Airport for $40.0 million, $47.1 million in financing and an investment of $30.2 million into ATA once it emerges from bankruptcy, representing 27.5% of equity in a reorganized ATA . ATA Holdings Corp. filed for protection under Chapter 11 of the U.S. Bankruptcy on October 26, 2004. The proposed transactions also marked the first significant code-share agreements for both airlines. The code share agreement was launch in early February on Chicago Midway flights and over the following six months at five other airports. Code sharing allowed each airline to transfer passengers to the other airline on a single ticket. The investment of Southwest Airlines, which is mainly targeted at ATA¡¯s gates at Chicago Midway Airport, at which Southwest already enjoys a strong position. The investment of Southwest had no significant impact in Southwest¡¯s share price.

5. The Impact of Bankruptcy Proceedings on Untied Airlines
In 2001 United Airlines lost $2,145 million on revenues of $16,138 million (see Exhibit 8.2) and applied for a $1.5 billion loan guarantee from the federal Air Transportation Stabilization Board (¡°ATSB¡±) established in the wake of September 11. Competing airlines such as American Airlines, Continental Airlines and Delta Airlines lobbied the ATSB to deny the loan guarantees. They hoped to capitalize on United¡¯s bankruptcy by snatching up market share and taking over some of the airline¡¯s choice routes, particularly its lucrative trans-Pacific flights . When the application was rejected in late 2002, the company was forced to seek debtor-in-possession financing from commercial sources to cover the expected future loses. Unable to secure additional capital, UAL Corporation filed for Chapter 11 protection against bankruptcy on December 9, 2003. The Employee Stock Ownership Plan (¡°ESOP¡±) was terminated, as but by then its shares had become virtually worthless. Blame for the bankruptcy had fallen on the events of September 11, which triggered financial crisis in all the major North American airlines. However the rise of low-cost carriers, labor disputes, and problems within the management structure of the company also contributed significantly. United Airlines¡¯ bankruptcy was the largest in airline history as the airline was the second largest air carrier both in the US and globally, and at the time of the filing had 85,000 employees worldwide and service in more than 120 cities. The company lost close to $4 billion in the two years prior to the filing and was ¡°burning¡± more than $7 million in cash a day .
The Chapter 11 filing allowed United to petition bankruptcy judges to not honor existing labor agreements and impose major concessions on its workforce, including changes in wages, scheduling and benefits for current employees, and cuts in health coverage and other benefits for retirees. However, as United continued it operations during its bankruptcy, it was forced to reorganize under delicate terms. Tens of thousands of workers were furloughed, as well as all many city ticket offices in the US were closed. Despite its drastic cost cutting measures the airline did continue to invest in new projects. On November 12, 2003, it launched a new low-cost carrier, named Ted, to compete with other low-cost airlines. In 2004 it launched its luxury "p.s." (for "premium service") service on reconfigured 757s from JFK Airport in New York City to Los Angeles and San Francisco. The service was designed to targeted and attract business customers and high-end leisure customers in the coast-to-coast market. Through its hard cost cutting techniques and through its renegotiation of employee contracts as well as the shelving of its pension plans the company is, however, determined to exit bankruptcy in the third quarter of 2005. Through the words of its CEO, Glenn Tilton, United is poised to enter into a merger agreement once it becomes financially stable . However, as with everything in the unstable industry, whether these predictions actually happen has yet to be determined.

6. Effect of United Airlines Chapter 11 Proceedings on Other Airlines
If airlines are unable to match United¡¯s cost cuts outside of Chapter 11, then they may well take the bankruptcy route themselves. Airline executives from the large airlines are hoping to achieve much needed saving through collective bargaining agreements in order to avoid a Chapter 11 filing. Nevertheless, several CEO¡¯s recently told the Senate Finance Committee that pensions covering 150,000 workers and retirees are unmanageable and could force their airlines into bankruptcy . According to United's Chief Financial Officer Peter McDonald, however, UAL's cost cuts during bankruptcy merely leveled the playing field with other carriers . But bankruptcy is not a guaranteed remedy for what's ailing airlines. With a relatively low rate of successful restructuring, some industry leaders consider it strictly a last resort. Furthermore, airlines contemplating bankruptcy as part of a business plan must consider the unintended consequences that could derail future success. As an example, bankrupt companies often pay higher borrowing costs. Also in many cases, a bankrupt airline sees a decline in advance bookings as potential passengers begin to question the carrier.

7. External Factors Affecting the Airline Industry
An important external factor for the airline industry is the price of fuel and the underlying price of crude oil, which will, therefore, be discussed in some detail. Apart from the rising fuel prices, particular three events in the past have affected passenger behavior and, as a result, the airline industry in a manner unprecedented for the airline industry or any other industry so far.
7.1 Effects of September 11 on the Airline Industry
September 11, 2001 was the darkest day for air travel worldwide. Passengers abandoned the airports in the weeks following the tragedy. The attacks in New York City and Washington D.C. extended beyond US borders with grave ramifications for many airlines. Soon after, a number of airlines collapsed. The September 11 catastrophe was obviously an unprecedented shock to the airline industry. But many airlines misconstrued the resulting plunge in business as an anomaly whose effects would eventually dissipate. They cut capacity and trimmed costs but quickly reversed those moves when the economy showed signs of a rebound in mid-2002. As a result two years after the September 11 terror attacks the airlines found themselves in a more precarious shape than ever. September 11 permanently resized the U.S. airline industry. As a percentage of GDP, airline revenues fell 20 percent to 30 percent from levels of the past 25 years . And instead of bouncing back during an economic recovery, as airline executives clearly hope would happen, revenues remained depressed. Meanwhile the only airlines that really rebounded quickly after the events of September 11, were low-cost carriers like Southwest, AirTran, Frontier, and JetBlue which began taking market share away from the large network airlines and were, partly, growing at rates that seem more typical of an Internet startup than an airline.

7.2 Effects of the Iraq War on the Airline Industry
The start of the Iraq war was another devastating blow to a industry which was already in a economic turmoil after the events of September 11. In a report released on March 11, 2003 by the Air Transport Association (ATA) , airlines predicted that the pending war with Iraq would markedly accelerate the already precarious economic situation confronting the industry. According to the report, Airlines In Crisis: The Perfect Economic Storm, economic damage could be so severe that ¡°there is serious risk of chaotic industry bankruptcies and liquidations¡± and ¡°the prospect of a forced nationalization of the industry is not unrealistic.¡± As it become apparent that the Iraq war was unlikely to end in a matter of days, many airlines (and presumably business and discretionary travelers) began moving to a second phase of risk management. This involved further substantial cutbacks in capacity. North American carriers were badly affected by the conflict, causing capacity reductions of around 10% or more across the board. During the war North Atlantic and Pacific traffic levels decreased by up to 30-40% .
7.3 Effects of SARS on the Airline Industry
Intra-Asian traffic had been only relatively lightly affected by the Iraq conflict, but the outbreak of an illness referred to as Severe Acute Respiratory Syndrome or ¡°SARS¡± in March, 2003 became a real threat to traveler confidence in specific markets. Hong Kong's authorities declared that the SARS outbreak had reached epidemic proportions. The Chinese government reported that 34 people had died and almost 800 were ill. The number of people infected globally had reached 1,200 with more than 50 people were reported to have died. Some governments issued travel advisories against travel to Hong Kong. Service cancellations, staff cuts and other contingency plans were once again implemented by carriers in response to falling demand, which was up to 25% or more in some markets .
The combination of the Iraq war together with SARS influencing the share prices can be seen in Exhibit 1.2 for American and United, whereas Southwest as domestic carrier remained not affected.

7.4 The Impact of Oil Prices
Jet fuel prices have climbed dramatically. And most major airlines have been left so vulnerable to the higher prices that profitability is unlikely. Because fuel is the second most significant operating cost for carriers (after labor costs), the high price of fuel is the latest hurdle for the struggling airline industry. According to industry analysts, each dollar per barrel rise in crude oil prices, equates to a $425 million increase in the industry¡¯s jet fuel expenses. Accordingly, the shares of both United and American Airlines show a negative correlation to crude oil prices (see Exhibit 9: -0.45 for American airlines and -0.71 for United Airlines). The airline unaffected by oil prices is Southwest Airlines (see Exhibit 9: +0.48). This may be the result of Southwest Airlines¡¯ effectively using a practice known as ¡°fuel hedging¡± to help minimize the impact of rising fuel costs.
7.4.1 Fuel Hedging ¡°Hedging¡± is the practice of using investments in the commodities futures markets to ¡°lock in¡± or ¡°cap¡± the price that eventually will be paid for future purchases. The effect is similar to purchasing insurance.
Hedging allows airlines a measure of protection against major fuel price swings. Nevertheless hedging is an investment, and there is always risk associated with investing. The practice of hedging requires an airline make an informed forecast about future trends in fuel prices. If the forecast ultimately proves incorrect, a ¡°hedging¡± airline could find itself effectively forced to pay more for fuel than the actual market price. This is where the ¡°insurance¡± analogy is not always applicable. In other words: there is a downside risk that the practice of hedging could cost an airline money if there is an unforeseen drop in the market price of fuel. This can occur when prices are ¡°locked in¡± at a fixed price rather than ¡°capped¡± at a particular price. Most airlines assumed oil prices would remain at the $24 to $25 per barrel price forecast for late 2003. However, an unforeseen 40 percent jump in the last 12 months has hit the industry hard, leaving many carriers with the likelihood of an unprofitable 2004. Fuel prices are at their highest level since the Persian Gulf War, almost surely delaying any hoped for industry turnaround. One industry analyst predicts that if the cost of jet fuel averages $34 per barrel for this year, none of the major ¡°legacy¡± airlines are likely to be profitable . Most of the ¡°legacy¡± airlines have been focused not on hedging, but on restructuring and finding ways to compete more effectively with low fare carriers such as Southwest. According to industry analysts, three of the eight largest airlines are not hedged for 2004. One was hedged only through the first half of the year. Three others are hedged for less than one-third of their fuel needs.
As for Southwest Airlines, it is more than 80 percent hedged for 2004, a tactic which resulted in offsetting savings of roughly $350.0 million at current market prices. In addition, they are approximately 85 percent hedged for 2005 . In the first quarter of 2004, Southwest claimed $63.0 million in ¡°hedging gains.¡± Had they not hedged, the company would have failed to report a profit in the first quarter and, instead, would have realized a net loss of $8 million . Though hedging has not entirely shielded Southwest Airlines from the impact of rising fuel costs. As they are approximately 85 percent hedged, it also means that they are 15 percent unhedged for the more than 1.3 billion gallons in 2005 the airline will use. 7.4.2 Jet Fuel Hedging Strategies
While fuel costs are hedgable, there is not a perfect hedge available in either the over-the-counter or exchange traded derivatives markets. Over-the counter derivatives on jet fuel are very illiquid which makes them rather expensive and not available in quantities sufficient to hedge all of an airlines jet fuel consumption. Exchange-traded derivatives are not available in the United States for jet fuel, so airlines must use futures contracts on commodities that are highly correlated with jet fuel, such as crude and heating oil. Southwest, for example, states that the majority of the company¡¯s hedges are effectively heating oil-based positions in form of option contracts . As such, airlines employ a variety of strategies ranging from not hedging to fully hedging or using a combination of products. These include using both over-the-counter and exchange-traded derivatives and remaining unhedged.
Options, including collar structures, and swaps are the primary derivatives used by airlines. Many airlines, including Southwest, have stated that they prefer over-the-counter derivatives to exchange traded futures because they are more customizable, however Southwest uses all three instruments . Jet fuel costs have substantially risen over the past several years putting consistent pressure on airlines to maintain positive cash flows. Therefore, most airlines prefer to trade with three or four different banks to diversify this risk and also to get the best pricing possible. The ability to customize these contracts greatly facilitates the implementation of what is called a ¡°dynamic hedging strategy¡±, which is successfully used by Southwest, and, to a lesser degree, JetBlue. This strategy is based on the presumption that the oil price cycle is a mean-reverting process, or that it moves in cycles rather than consistently in one direction. Given this characteristic, it is possible to implement a hedging strategy that enables airlines to lock in prices at the low point in the cycle while capping prices at the high end to take advantage of eventual price declines. To implement such a dynamic hedging strategy, a firm needs to vary the products over the oil price cycle. When oil is at the low point in the cycle, receive-fixed swaps are used, because the likelihood of further price declines is not considered as probable as price increases, and the swap contract allows the airline to lock in the relatively low price. In the mid-range of the cycle, collars are used to lock in a specified range of prices, giving up potential savings from price depreciation while hedging against further increases. When oil prices are at the top of the price cycle, caps are used to prevent losses from further appreciation while allowing the company to take advantage of price decreases. This somewhat sophisticated strategy requires a substantial amount of monitoring, but it has been rather successful for Southwest: 85% of their fuel costs are currently (for the year 2005) locked in at the equivalent of $26 per barrel of oil (65% of jet fuel requirements at $32/bbl for 2006, and 45% at $31/bbl for 2007) , while the majority of its competition is paying market of approximately $40 per barrel.
By not hedging, airlines are taking on the risk of rising commodity prices into their business model because when fuel prices rise, airlines cannot pass all of the cost on to their customers. Other fuel-dependant companies, such as FedEx, are able to force their customers to accept fuel surcharges, however, in the airline industry the success of such programs is very unpredictable. So far both legacy airlines, mostly unhedged, were not able to pass on increased fuel cost to the customer and were suffering declining Operating Income Margins (see Exhibit 4.4).

7.4.3 Airline Stock Prices Fall Due to Record Fuel Prices
As if to support the suggested correlation of airlines with oil crude prices, shares of major airlines, weakened broadly on Jun 24, 2005, impacted by skyrocketing oil prices, an expense that carriers are finding difficult to pass along to travelers. Some airlines have mitigated the impact of high oil prices by raising fares during the peak summer travel season. But bookings may taper off in the fall and fares may decline as well. U.S. crude oil futures traded at $59.65 a barrel on June 24, 2005, down from a record $60 a barrel the day before. Shares of Northwest Airlines posted the biggest percentage decline, off 5.5 percent, or $0.28, to trade at $4.77 on the Nasdaq, while shares of American Airlines shed $0.42 cents, or 3.3 percent, to $12.15 on the New York Stock Exchange .

8. Conclusion
An investment in airline shares is mainly seen nowadays as a bet on the development of oil prices as fuel accounts for about a third of the operating cost second only to labor. Thus, despite several rounds of expense reductions and labor concessions, the legacy airlines shall continue to post losses. At $50 plus per barrel oil prices, it is believed that also low cost carriers, such as Southwest Airlines, are not operating profitable, unless their fuel positions are comprehensively hedged. Although, in principle, all U.S. airlines have faced many of the same challenges, there are significant differences in the way airlines master these challenges.
Southwest has managed to remain profitable since its launch about 30 years ago, although its margins have suffered lately. In fact, shares of Southwest have indicated over time to more or less represent the industry risk over the last ten years (see Exhibit 10, p. 2: ¦Â .92 relative to Dow Jones Industrial Transportation Index and 1.0 to the S& P 500). Southwest Airlines, as a purely domestic player, has been less exposed to turbulence in international markets during the period following September 11 and lower cost structure has helped to outperform the legacy carriers. Accordingly, Southwest has the strongest balance sheet of the airlines analyzed which shall keep its capital cost lower than those of its competitors. That being said, the Southwest shares are relatively expensive with a price/earnings ratio of 30.78 , they exceed the S&P 500 level of about 20.5 . However, Southwest has still room to grow in the USA without changing its business model of using aircraft of the type 737, only. Though the investment in ATA that opened up international opportunities, may point into another direction, Southwest stays focused on growing domestically. With its strong balance sheet Southwest is likely to profit significantly from an industry shake-out if it occurs. Shares of Southwest are a buy if one wants to invest in the airline industry.
With United Airlines the worst seems to be over by now. The airline should benefit from revived travel to Asia, where it had been traditionally strong having taking over the routes from PanAm, and had, hence, suffered from decreasing travel due to SARS above average. Under Chapter 11 proceedings the airline secured significant concessions by its personnel and considerable pension savings. In addition it will be able to renegotiate its lease contracts and restructure its fleet to cut further cost thereby. Chapter 11 gives United Airlines a crucial cost advantage other airlines do not have, and which makes them even contemplating of joining Untied Airlines in bankruptcy. Yet, under Chapter 11 proceedings the appointed judge will be likely to oppose any fuel hedging strategies that are traditionally perceived as risky. So, as with the entire airlines industry, the future of United Airlines depends heavily on the oil price development. If the oil price will come back down, the chances that United Airlines will find its way out of bankruptcy are highly likely. That might soon be the case as it is assumed that above an oil price of $55/bbl the exploration of new sources, in particular the exploitation of Canadian oil sand becomes profitable. Canadian oil sand is believed to hold more reserves than Saudi Arabia. In case of a successful turn-around the leverage will be, indeed, alluring. The share is a buy if an investor is prepared to take substantial risk: out of 147 airlines in bankruptcy only three made it so far (America West, US Air, Continental).
American Airlines is the world¡¯s largest airline and has thus most to gain from any recovery in the industry. Yet, American Airlines faces competition at both ends of the market: form the low-cost-carriers on the one hand and the other legacy carriers, in particular those under Chapter 11 on the other. Unsurprisingly, American Airlines thinks about seeking the Chapter 11 as a safe haven to renegotiate its expensive contracts with unions and suppliers. The reason for American Airlines that it has not gone down that route by now, is probably that it has a bet on the doom of United Airlines which would strengthen its position in an disproportionate fashion. So far, this strategy has not worked as United is more likely to survive than to fail. Though, American Airlines has one of strongest route networks in the industry and shall benefit from large corporation contracts, the share of American Airlines merely represents the industry risk plus a significant premium (see the high amplitude in returns in comparison to the market and competitors in Exhibit 3, and also Exhibit 10, p. 2: ¦Â to Dow Jones Transportation Index 1.9 and 2.45 to the S&P 500) without having the up-side potential of its competitors if the airline industry starts to thoroughly recover. Buying shares of American Airlines may be interesting, though, as a hedge on the failure of United Airlines.

NOTES:

Aviation and Transportation Security Act of 2001. G. Engel, Sh. Wong, Bookman A., Goldman Sachs, ¡°A Wing and a Prayer¡± , Conference Wrap-up, April 2005, p. 2. Cf www.staralliance.com. Cf www.oneworld.com. Cf www.skyteam.com. Marshall Krantz, ¡°Airsickness, Legacy Carriers Deep In A Fight For Survival¡±, http://www.meetingnews.com/meetingnews/magazine/article_display.jsp?vnu_content_id=1000954839. www.cnn.com/2001/TRAVEL/NEWS/09/18/rec.mineta.airlines. news.bbc.co.uk/hi/english/ business/newsid_1667000/1667102.stm. Air Transportation Safety and System Stabilization Act ("ATSSA"), Pub. L. No. 107-42, September 23, 2001. Defined here as ; cf Frank K. Reilly, Keith C. Brown, Investment Analysis, 1997, 5th ed., p. 391. http://www.nationmaster.com/encyclopedia/Low_cost-carrier. Southwest Airlines¡¯ 2004 Report to Shareholders, Letter to the Shareholders, Jan 19, 2004, p. 1 No author, ¡°Southwest Keeps It Simple¡±, Air Transport World, April 2005, Vol. 42, No. 4, p. 26. http://www.flyi.com/company/default.aspx. http://en.wikipedia.org/wiki/Ted_(airline); http://en.wikipedia.org/wiki/Song_(airline). G. Engel, Sh. Wong, Bookman A., Goldman Sachs, ¡°A Wing and a Prayer¡± , Conference Wrap-up, April 2005, p. 20. Southwest Airlines¡¯ 2004 Report to Shareholders, Jan 31, 2005, p. A-2. No author, ¡°Southwest Keeps It Simple¡±, Air Transport World, April 2005, Vol. 42, No. 4, p. 26, 31. United Airlines Annual Report for the Fiscal Year ended Dec 31, 2004, p. 3. AMR Corp. Annual Report for the Fiscal Year ended Dec 31, 2004, p. 1. Air Transport World, April 2005, Vol. 42, No. 4, p. 1. See above p. 2. See above p. 1. Defined here as http://www.forbes.com/2001/02/08/0208topnews.html. Southwest Airlines¡¯ 2004 Report to Shareholders, Jan 31, 2005, p. A-14; Note 2 to the Consolidated Financial Statements, Dec 31, 2004. G. Engel, Sh. Wong, Bookman A., Goldman Sachs, ¡°A Wing and a Prayer¡±, Conference Wrap-up, April 2005, p. 16. www.economist.com/displaystory.cfm?story_id=874633; G. Engel, Sh. Wong, Bookman A., Goldman Sachs, ¡°A Wing and a Prayer¡±, Conference Wrap-up, April 2005, p. 2., Exhibit 2. http://www.airportbusiness.com/article/article.jsp?siteSection=3&id=1795. biz.yahoo.com/rb/050608/congress_pensions.html?.v=2. biz.yahoo.com/rb/050608/congress_pensions.html?.v=2. www.economist.com/displaystory.cfm?story_id=874633. http://www.bizjournals.com/phoenix/stories/2003/03/10/daily27.html. http://www.tia.org/press/IR03_impact.asp. http://207.44.203.245/infobank/publish/printer_370.shtml. G. Engel, Sh. Wong, Bookman A., Goldman Sachs, ¡°A Wing and a Prayer¡±, Conference Wrap-up, April 2005, p. 1. No author, ¡°Southwest Keeps It Simple¡±, Air Transport World, April 2005, Vol. 42, No. 4, p. 26, 32. Southwest Airlines¡¯ 2004 Report to Shareholders, Jan 31, 2005, p. A-30. Southwest Airlines¡¯ 2004 Report to Shareholders, Jan 31, 2005, p. A-45; Note 10 to the Consolidated Financial Statements, Dec 31, 2004. Southwest Airlines¡¯ 2004 Report to Shareholders, Jan 31, 2005, p. A-45; Note 10 to the Consolidated Financial Statements, Dec 31, 2004. Southwest Airlines¡¯ 2004 Report to Shareholders, Jan 31, 2005, p. A-45; Note 10 to the Consolidated Financial Statements, Dec 31, 2004. Southwest Airlines¡¯ 2004 Report to Shareholders, Jan 31, 2005, p. A-45; Note 10 to the Consolidated Financial Statements, Dec 31, 2004. http://biz.yahoo.com/cbsmb/050627/d33527036e0749baaf82a109ffebfc8d.html?.v=1; http://www.marketwatch.com/news/yhoo/story.asp?source=blq/yhoo&siteid=yhoo&dist=yhoo&guid=%7B9A00F44C%2DEE00%2D4A54%2DA849%2D0D4D7E0C39B3%7D Defined here as . http://finance.yahoo.com/q?s=luv. Source: Federal Reserve Board.