Following another year of financial turmoil in which persistently high jet fuel prices and domestic overcapacity undermined the operating performance of major U.S. airlines, Fitch Ratings believes prospects for a long-awaited rationalization of capacity and a modest recovery in pricing now appear stronger for 2005. While uncertainties over the future direction of jet fuel prices remain, some moderation of capacity pressures, particularly in East Coast markets, seems likely next year. A slowdown in the destructive multiyear collapse of passenger yields may therefore be possible in 2005. However, even in a domestic capacity rationalization scenario, debt reduction will likely take a back seat to liquidity conservation as carriers seek to maintain financial flexibility in an industry that remains vulnerable to ongoing event risk.

Going in to 2005, the major U.S. legacy carriers and some of the rapidly growing low-cost carriers (LCCs), find themselves in a more precarious financial position than at any time since the weeks immediately following the September 2001 demand shock. Despite guarded optimism early in the year that a turnaround in 2004 operating performance could be supported by more robust air travel demand patterns and steady pricing, the combined impact of high fuel prices and a worsening domestic overcapacity problem once again drove all legacy carriers and many of the LCCs to report significant losses this year. For full-year 2004, the combined net loss for U.S. airlines should top $5 billion, and cash flow generation has once again lagged to the point where no significant progress toward balance sheet repair has occurred. With two of the seven largest U.S. carriers (United and US Airways) already operating under Chapter 11 bankruptcy protection and a third (Delta) still in financial distress, some form of structural change now appears far more likely in 2005.

The price of jet fuel, expected to average more than $1.50 per gallon during the fourth quarter of 2004, remains the biggest unknown for U.S. carriers as they plan for 2005. Despite hopes in mid-2003 that easing global supply pressures would keep crude oil prices near the $25 to $30 per barrel range, in which most airlines can operate comfortably, high demand for crude oil and refined products such as heating oil and jet fuel kept 2004 spot prices well above historical norms. In this difficult pricing environment, few U.S. carriers had adequate hedging positions in place, and the industry reported approximately $4 billion in foregone cash flow as a result of the swing in 2004 jet fuel prices alone. After labor, fuel represents the single largest expense item in airline operating budgets, accounting for 15%-18% of total operating expenses. Fitch believes that the average price of West Texas Intermediate crude oil could potentially exceed $40 per barrel in 2005, translating into jet fuel prices of more than $1.20 per gallon.

The absence of meaningful hedging positions among all of the U.S. legacy carriers means that sustained fuel price pressures in 2005 will offset any improvements in the revenue line related to capacity constraint and a modest rebound in passenger yields. Among the top 10 U.S. carriers, only Southwest Airlines, with approximately 80% of anticipated 2005 jet fuel deliveries hedged at an equivalent crude oil price of $28 per barrel, has the capacity to generate acceptable cash flow next year in a $40-plus crude oil scenario. Fitch believes that another year of fuel price pressure similar to that seen in 2004 will expose all of the solvent majors (AMR, Delta, Northwest, and Continental) to extreme liquidity pressures that could force more severe restructuring actions prior to the winter of 2005-2006. The combination of heavy maturing debt obligations, increasing levels of required pension plan funding, and scaled-down aircraft capital spending commitments could put heavy pressure on unrestricted cash balances and cause even the better positioned U.S. legacy carriers to consider reorganization under bankruptcy protection.

However, interestingly, a sustained fuel price shock in 2005 could accelerate the arrival of domestic capacity corrections by bringing about the liquidations of bankrupt US Airways and, potentially, Independence Air, a Washington-based regional jet operator now facing an urgent need for financial restructuring to preserve liquidity. Should US Airways cease operations prior to the seasonal swing to positive cash flow in March, approximately 6% of domestic available seat mile (ASM) capacity would exit the system, at least temporarily. This would offer surviving carriers the opportunity to gain more fare traction in many of the East Coast markets in which the glut of low-cost seats has forced traditional revenue premiums to collapse. While the risk remains that displaced US Airways or Independence Air service would quickly be replaced, effectively negating the favorable capacity change, a reduction in domestic ASM growth would almost certainly have a positive impact on critical revenue metrics such as passenger yield and revenue per ASM. Without such a rebound in industry unit revenue, deeper cuts in labor costs will become necessary as another year of unacceptably weak cash flow generation and eroding liquidity unfolds.

The carriers that stand to benefit most from a US Airways liquidation scenario are those with substantial East Coast route networks and a high degree of overlap with the distressed airlines. These include Delta, AirTran, American, and Continental. A shutdown of US Airways' hub at Philadelphia would open up new and attractive market opportunities for low-cost leader Southwest to grow more aggressively in the East. This would parallel the growth that Southwest and the ultimate winner of the bidding war for Chicago-Midway gates will enjoy in the wake of ATA Airlines' bankruptcy and subsequent exit from the Chicago market.

For United Airlines, now entering its third-year under Chapter 11 bankruptcy protection, ongoing operating losses, constrained liquidity, and the need to attract an equity sponsor to ensure a viable post-exit capital structure have led to a renewed cost-cutting strategy involving as much as $725 million in incremental annual labor cost savings. Ultimately, United's future depends heavily on the willingness of the bankruptcy judge and the airline's creditors to support United's restructuring initiatives in the face of stiffening union opposition. Like US Airways, United faces heightened risks of labor actions that could complicate the reorganization process by undermining operational integrity and contributing to a 'booking away' effect by passengers. At the same time, United's debtor-in-possession (DIP) financing facility contains covenants that will provide lenders an opportunity to trigger a liquidity crisis in 2005 should progress toward restructuring objectives falter.

While a liquidity squeeze is not imminent at United, delays in the roll-out of cost reduction could jeopardize the arrangement of an exit financing package in a year when new debt and equity capital may not be readily available. United has already tripped cash flow covenants in its $1 billion DIP credit facility and will likely require more cooperation from lenders in 2005 if it is to stay on track to reorganize successfully in Chapter 11. United has already announced plans to scale back domestic ASM capacity next year and may be forced to shrink further if a legacy carrier-leading cost position cannot be achieved via either consensual or court-imposed labor contracts. Termination of the carriers' four defined benefit pension plans now appears likely in early 2005, assuming the bankruptcy court judge agrees with management that United's proposed pension overhaul is essential for reorganization and exit from bankruptcy.

At Delta and the other solvent legacy carriers, the outcome of the United and US Airways bankruptcy cases, in addition to the fuel and revenue environment, will be critical in determining whether another round of labor cost cuts and an outright termination of defined benefit pension plans must be pursued in bankruptcy. While American achieved comprehensive labor cost reduction deals in 2003, the carrier may well discover that its unit cost position relative to the other restructuring carriers is no longer sustainable in 2005. American must also refinance its maturing $834 million secured credit facility to safeguard liquidity. At both Northwest and Continental, further progress on wage, work rule, and benefit improvements will be required in 2005 to ensure a competitive relative cost position. Ultimately, a protracted delay in industry capacity rationalization and a continuation of extreme fuel price pressures may force those carriers to consider more sweeping contract and pension plan changes that position them for long-term competitiveness versus the LCCs.

New pension reform legislation will likely be addressed in the next session of Congress, and this could have broad cash flow implications for the large nonbankrupt carriers with substantially underfunded defined benefit plans, notably Delta, Northwest, and American. Heightened pressure from the Pension Benefit Guaranty Corporation (PBGC) to address the build-up of unfunded liabilities and terminated plans could result in generally tighter funding requirements. However, any provisions specific to airlines that would permit the 'terming out' of unfunded liabilities over a number of years would have a large impact on the required cash contributions of the legacy carriers at a time when free cash flow generation is expected to remain weak. Pension legislation will be a key area to monitor in 2005.

For all of the highly leveraged legacy carriers, meaningful debt reduction and balance sheet repair will have to wait another year. Until operating performance stabilizes and liquidity pressures ease, all of the restructuring airlines will remain focused on cash conservation and continuing efforts to bring unit labor costs in line with diminished long-term revenue expectations.