Articles & speeches

A Perfect Storm?
Keynote address to the 21st Annual Canadian Airline Investment Conference
Toronto, June 2o, 2008

Ladies and gentlemen:

Those of you who may have glanced at my biography have probably concluded that I have been in aviation a fairly long time.

Well to tell the truth, when I started in the airline – in those days Air Canada was called Trans-Canada Airlines – commercial jet travel had just become the latest novelty.

Over the many years that I have been in this crazy business, I have seldom experienced a dull day.

I feel quite confident that the airline executives participating in this event would support that observation.

I am thinking more specifically of Bob Deluce and Joe Randall. Indeed, I should thank them both for having done such a fine job some 25 years ago or more, in heading the two regional airlines which preceded Jazz.

In the case of Bob – Air Ontario; and Joe of course was heading Air Nova.

The creation of a number of regional airlines across our country was one of the important elements of my restructuring strategy which was required to make – what was at that time a Crown Corporation – privatize-able.

You will appreciate that setting up these regional airlines, each with a much lower operating cost structure than Air Canada, could provide good service with a fleet of Dash-8s to markets too expensive to serve with the DC9-30’s and Boeing 727-200s of the Air Canada fleet.

It was a sort of a win-win. Good and affordable air services were being provided at dozens of locations being abandoned by Air Canada, and the main airline was substantially lowering its domestic operating cost.

It is rather nice to see that the fledgling children we launched back then have become a solid and profitable airline, playing a very valuable role in this country.

By the way, another initiative launched at approximately the same time was Aeroplan!

But for this we have to blame American Airlines. My counterpart there, the famous Bob Crandall, had launched the American Advantage Bonus Plan.

Within weeks we had created our own response which was Aeroplan, but unfortunately, in the then highly regulated environment of the times, the Canadian Transport Commission turned down our proposal.

Following more than six months of frantic negotiations, we finally prevailed – but by then we had lost some 5% of our high-yield Transborder business class traffic.

Fortunately for us, Aeroplan became very successful very quickly, although no one would have ever imagined that it would become the important stand-alone business it is today.

Incidentally, I am not mentioning these two success stories merely for nostalgic reasons.

They are good examples of monetizing some of Air Canada’s hidden values, which is one of the important actions one should take, particularly in times of crisis.

And today the aviation world is certainly facing yet another crisis.

In Istanbul, at the IATA AGM a few weeks ago, some U.S. airline CEO’s were describing the current situation as a “Perfect Storm”.

This is because costs are going up while at the same time revenues are coming down.

This is most disappointing given the fact that we had recently experienced better than average traffic growth.

IATA reported that international traffic grew by 7.2% in 2007 – close to the 7.6% increases achieved in the previous year.

Most encouragingly, business travel was expanding at a fairly good pace during 2007, providing to the network airlines a great source of yield improvement.

Indeed, in the long haul markets travel in business and first class was growing faster than economy.

With capacity growing at a slower pace than traffic, load factors in both international and domestic markets reached the high 70s.

Airline revenues increased by some 7% in 2007 and profitability, although still very much insufficient, reached a 4.2% return on investment.

While this represented better results than the industry had been able to achieve for many years, this result is still far too low to attract capital and ensure financial sustainability in the long run.

In 2007, fuel started the year close to 50 USD a barrel, and then rose to hit 100 USD a barrel.

By the end of last year, it looked like many airlines were hoping that fuel had peaked and that – if the sub-prime crisis was contained – the economy would return to a reasonable rate of growth.

But the first half of this year has shown that this view was overly optimistic.

There is probably light at the end of the tunnel, but no one seems to be venturing a guess as to how long that tunnel may turn out to be.

With some markets undergoing rapid decompression, the likelihood of over-capacity at times of economic slowdown shows that once again we have not learned from the past.

Revenues of airlines are closely linked to economic cycles. Airlines tend to order airplanes at the top of the cycle…

All too often, unfortunately, the airplanes are delivered during a downturn.

Over the past two years, airlines have ordered an unprecedented number of airplanes.

With these airplanes about to be delivered at the time of decreasing traffic – and with the cost of fuel sky-rocketing – this amounts to a rather disastrous scenario.

I am told that at least one U.S. airline executive, totally bewildered by this situation and unable to decide what to do, finally turned to his local preacher for advice.

“Put your faith in the bible”, counseled his spiritual adviser, “and you should find an answer in there.”

Our airline executive, bible in hand, went walking on the beach, meditating.

Tired of walking, he sat down, placing the holy book at his feet.

Suddenly there was a strong gust of wind and the pages of the bible began to flip furiously. Then, just as suddenly, the wind dropped. Eagerly, our airline executive picked up the book and looked at where the pages had stopped flipping. It said “Chapter Eleven”.

Unfortunately, for many U.S. carriers it’s a case of “been there – done that”, and I am quite sure that they have no wish to go through that painful process again.

And thus the aviation world is facing yet another crisis, partly caused by the recent rapid rise in the price of a barrel of fuel and, to some extent, the sub-prime financial crisis which has started to undermine the confidence of consumers, primarily in North America.

On the basis of an average oil price of 120 to 130 USD per barrel for the current year, IATA is now forecasting an industry loss of $2.3 billion.

This is a major swing from their initial forecast of a profit of $6.8 billion based on last year’s expectations.

We are told that some 24 airlines have suspended operation, or gone out of business, in the past six months.

These include the three “business class only” airlines which emerged in the last three years, attempting to create a new niche across the Atlantic.

Year over year, in the first quarter of this year, global passenger traffic slowed down markedly, although the worldwide average has remained, for international traffic, at +5%.

At the same time, domestic traffic fell everywhere compared to last year over the first four months of this year.

The largest domestic market, the North American market, is definitely on a decreasing slope.

As a result of the worsening U.S. situation, “legacy” carriers have once again launched some major capacity reduction, taking the opportunity to ground many of their older airplanes.

United Airlines has announced that it will retire 100 mainline jets. This would include ninety-four of its B737s and six B747s. The cumulative mainline domestic capacity will shrink by 17-18%.

Continental Airlines plans to retire twenty-four B737-300s out of a fleet of forty-seven and thirteen B737-500s out of a fleet of fifty-five.

Some further reductions are planned for 2009, which will amount to a mainline capacity reduction of 14-16% in total.

Continental has announced that 3000 jobs will be eliminated.

American Airlines plans to retire forty to forty-five mainline aircraft, mainly MD80s and some A300s. This amounts to approximately 11-12% of capacity reduction.

The so-called “low costs” are also affected, slowing down their expansion.

Jet Blue Airways is deferring delivery of twenty-one A320s from 2009-2011 to 2014-2015.

Air Tran Airways is deferring the delivery of eighteen B737-700s from 2009-2011 to 2013-2014.

Southwest, while still taking delivery of twenty-nine new B.737-N.G. airplanes, is now planning to retire sixteen older B737s this year.

The price of fuel represents the largest percentage of operating costs for low cost airlines, in some cases in excess of 40%. This makes them more fragile and could lead to more failures and/or consolidation.

Although less affected at this point, the European low costs are responding as well to the cost challenge.

Ryan Air achieved a hefty profit at the year ending March 31, but it has announced plans to ground about 10% of its fleet during the winter schedule.

Air Berlin reported a net loss of close to 60 million euros in the first quarter of this year, and has embarked on a major cost reduction program.

Although the general weakening of the global economy is worrisome to all airlines, the impact of high fuel increases is somewhat less for European airlines because of the strength of the euro.

As well, most E.U. airlines have hedged a large proportion of their anticipated fuel needs for 2008.

As such, the main European international carriers – although continuing to look at ways of reducing cost – have not decided to dramatically reduce capacity as have their U.S. counterparts.

The structure of the world economy has changed considerably since the last financial crisis.

The rapidly growing Asian economies have increased their internal and intra-Asia trade, and are much less dependent on the U.S. economy.

China, India, and other Asian nations, as well as the Middle East, more particularly the Gulf States, are set to continue their expansion aggressively – at least for the time being.

But the outlook remains very much uncertain, with several unanswered questions.

Will the weakening of the U.S. economy cause serious damage to the economy of its trading partners?

Is the full extent of the sub-prime financial crisis now fully known – and contained – in the U.S. as well as elsewhere, given the fact that some of that sub-prime debacle was exported through the international financial network?

Is another bubble about to burst?

The Gulf airlines such as Emirates and Etihad have remained very optimistic in terms of their projected growth, and have not modified or delayed the delivery dates for their fleet acquisitions.

More particularly, Emirates recently stated rather clearly that it intends to continue to take delivery of fifty-eight A380s currently on order.

The Chinese airlines, led by Cathay Pacific, are enjoying participating in the growth of the Asian economy, and thus far have not felt threatened by the so called “slow-down” in international markets.

However, we should expect that there will be further losses and consolidations… in Southeast Asia and India, as a result of the recent proliferation of low cost airlines and the price wars that have resulted from the ensuing excess capacity. This current excess capacity situation is, of course, unsustainable and within the next year or two will lead to a rationalization of the situation.

The consolidation process which has been ongoing in Europe for some time is continuing.

The case of Alitalia would have been settled by now if it had not been become a political football during the last Italian election and temporarily stopped.

I would expect that even Prime Minister Berlusconi cannot escape the inevitable.

Shopping for a buyer for Iberia is continuing, and Lufthansa is now in a position to exercise its right to take control of British Midland International – and its very valuable London Heathrow slots.

In the U.S., we are all too familiar with the regrouping underway.

Delta and Northwest should soon be a “fait-accompli”, although there may still be substantial discontent by the Northwest Pilots which should be resolved as soon as possible if the integration is to be harmonious.

And then there is the question of whether or not United Airlines will be able to merge with Continental, now that getting together with U.S. Airways has proved to be impractical.

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