OVERCAPACITY: ITS SIGNS AND SOLUTIONS

OVERCAPACITY: ITS SIGNS AND SOLUTIONS

Much has been written about the capacity predicament in the industry and there is no carrier unaffected by this problem.

The issue is not only the airline's problem, it has become the manufacturer's as carriers cancel their orders to bring capacity in line with demand.It has also become the lessor's predicament as aircraft are returned or as airlines begin demanding lower rates reflecting the excess supply of aircraft.

It has become the lender's predicament as customers become enmeshed in

financial problems, have been liquidated in Europe and Canada or have filed for protection from creditors under Chapter 11 of the Bankruptcy Code.

Excess capaci- ty gives out clear early warning signals so that everybody - the lenders, the manufacturers, the lessors and the airlines - should have known it was coming well in advance.

We know, for instance, that the industry is highly sensitive to recessions influenced by outside events. In the 1970s, we had the 1970 recession and OPEC embargo. Then in the 1980s there was the Iranian oil crisis preceding the 1982 recession. The most recent, of course, was the Persian Gulf War and the 1990-91 downturn. When the Mideast events, which drove up one of the prime costs in aviation - fuel - were combined with a recession, the economic condition of the industry quickly deteriorated, with resulting operational cutbacks.

OVERSUPPLY OF NEW JETS

The predictability of the present airline crisis was due to the build-up in deliveries of new jets above the level of 400 aircraft a year. In the mid-'80s, Boeing, Douglas and Airbus were delivering a total of 400 new jets a year. In the 1991-92 period, deliveries peaked at twice that much - at about 800 a year.

This was a clear signal of other problems to come. If you look back to 1987, traffic grew by 19 percent while aircraft deliveries by 1990 increased by 60 percent. In 1991 and 1992, they averaged over 90 percent higher than what they had been five years before.

This growth in deliveries from 400 aircraft to 800 aircraft a year caused the dilemma the manufacturers, lenders, lessors and airlines are facing now. Everyone blames the airlines for over-ordering, but when manufacturers and lessors combined to provide a "walk away" lease, this is like telling a 7- year-old that the candy store is giving away the M&Ms.

Another sign in mid-1990 that we were getting into trouble was that aircraft were being parked or offered at lower lease rates. I'm not talking about older Stage 2 aircraft, I'm talking about new-generation Stage 3 equipment delivered in spring 1990 that couldn't be used. The world inventory of commercial jets for all airlines is a little under 10,000 aircraft. For the past two years there have been over 900 aircraft available for sale or lease in the supply of old and new aircraft.

Out of the 700-plus aircraft grounded and parked in the Southwest desert, well over 100 during the past two years have been new Stage 3 equipment overhanging the market. This overhanging supply made the secondhand market non-functioning.

You can understand how predictable was the excess in aircraft production between 1989 and 1993. In May 1990, before the Kuwait invasion, before the spike in the oil prices and before economists found that there was a recession, SH&E tracked the anticipated deliveries, based on the peak orders placed in 1988 and 1989. We caught the build-up in Stage 2 aircraft as we were facing the gun to sell the Braniff I 727-200s. We sensed the sharp drop in Stage 2 prices and the first of the Stage 3 oversupply in late spring 1990.

An existing small oversupply, combined with future excess deliveries, caused us to forecast that there was going to be an excess of aircraft beginning in 1990 which would become substantial by 1991 and would be at peak levels from 1992 through 1994. We predicted it would wind down in 1995. We showed our clients in May 1990 - three months before the August invasion of Kuwait - what we thought was going to occur.

A doubling of deliveries from 400 to 800 doesn't happen overnight. The orders peak two years earlier. If SH&E could predict the numbers three years ago, everyone else could have done it and acted upon what was coming. Simply

put, the cutbacks in orders took too long to occur. Instead, orders kept coming in even after this was apparent. Boeing's forecasters, during this period, kept saying these mega orders could not go on forever, but in the next quarter there was another set of mega orders. It got to the point when they began wondering out loud during their forecast announcements about all these orders and when they would slow down.

We think it will take until at least 1995 to get aircraft supply and passenger demand at profitable yields in balance. Too many aircraft are still being added to the world's fleets. For the 1993-1996 period, Boeing is forecasting over 600 deliveries a year, down from 1992's deliveries of 784. Airbus is forecasting about the same. McDonnell Douglas is forecasting a lesser number at 472. You must keep these figures in context with earlier delivery spikes. Four hundred excess aircraft from the last two years is a lot to absorb.

Cutbacks have occurred and even more cutbacks are to come. Cancellations of commercial jet orders increased abruptly in 1991 from the 39 in 1990 to 144 in 1991. This continued with a further cutback of 134 orders in 1992. This year obviously will see a peak in aircraft order cancellations and serious postponements that will exceed the last two years by 40 percent to 50 percent. These rising cancellations will force deliveries down to, and probably below, the 400 a year level by 1994. And a lot of those will be delivery to the new Chinese airlines.

CYCLICAL BUSINESS

This cycle is similar to other cycles in several ways. Aircraft use is declining at the rate of about 7 percent between the peak year and the trough years. In 1980, use was at 8.2 hours daily and then declined by 1982 to 7.6 hours. Similarly, from the peak in 1988 until 1991, it had dropped by six- tenths of an hour. This obviously is a response to excess capacity, because only when airlines are very troubled do they increase costs by reducing efficient use.

Another similarity is that the peak for orders leads the peak in deliveries by about two years. In 1966 the order peak was two years ahead of the 1968 peak for deliveries. Similarly, 1988 was the peak for orders and 1991 was the peak for deliveries. This two-year lead is an early warning signal of what is going to happen and when the excess capacity is going to hit.

It is what is different in this cycle that is interesting. In the past, carriers always recognized that demand was falling and got caught temporarily operating the planes with more empty seats as load factors declined. But it was temporary. Today, in this cycle, U.S. carriers maintained load factors by sacrificing yields. This is something the U.S. airlines had never before done to this extent, because sophisticated revenue control methods became widespread only in recent years. What we have all learned in the past decade is that we can produce any load factor the chief executive wants. "Sixty-five percent, boss? Sure, here it is." The problem is we can't achieve the yield he wants to produce profits.

Yield management systems can be used to control the load factor. We can pump up the traffic with extremely low fares, and 1992's fare war was the peak of that exercise in Nintendo gamesmanship. However, it was an artificial growth in traffic and the airlines lost their collective shirts because their

revenues per available seat mile did not equal the cost per seat mile.

The U.S. carriers have achieved a higher level in yield management and the cycle made it obvious. The rest of the world reacted as it had 10 years ago, while the U.S. carriers had a change of less than 1 percent in load factor. During the 1970s trough, the load factor in the United States dropped about 8 percent from the peak, while the rest of the world - with more controlled and restricted markets - dropped only about 6 percent. In the 1980s cycle, the load factor dropped 5 percent in the United States and only 2 percent in the rest of the world. Now, you see the difference in the 1990 cycle. The rest of the world again dropped about the same 2 percent as it did 10 years ago. The U.S. carriers, in contrast, kept up their load factor within a point of the 1989 peak.

The U.S. carriers are ahead in revenue management methods. They can reduce yields to maintain load factors or vice versa. Their predicament is what they can't do, i.e., maintain yields at the same time there is pressure on load factors. They have a choice, not a solution, as to how to respond to access capacity.

We want to look at the experiences of the U.S domestic market, because in some respects it seems to be leading the rest of the world. What happened in the 1987-1992 periods demonstrates the predicament carriers are in. Up through 1988, almost 40 percent of aircraft deliveries came to U.S. carriers. Airline seat miles (ASM) were growing at a fast rate. But during the latter period, after 1988, ASM growth slowed. RPM growth slowed still more. Consequently, there was little of the growth after 1988 as there had been in the 1981-1987 period.

For a four-year period, we have had a flat gross domestic product, which led to flat domestic revenue passenger miles and surprisingly flat available seat miles. Experts may argue that U.S. air transportation is a mature business because we no longer get high growth rates. They may turn out to be correct, but I don't know how you can prove it based on the past four years.

The revenue per available seat mile is the revenue per passenger mile yield multiplied by the load factor. Because modern yield management systems enable carriers to trade RPM yields for load factor, I'm going to switch from RPM yields to revenue per ASM (RASM). More and more of our clients realize that this is the figure they must forecast accurately because it is the RASM which must exceed the cost per ASM. Due to the trade-offs, it hasn't declined as much, percentage wise, as did the RPM yield. For the U.S. majors - domestic RASM has dropped 2 percent per year since 1988.

We have arrived at the crossroads that will determine the future health of the industry. The predicament here is how to curtail capacity so that growth in demand due to resumed GDP growth can push up the RASM. Everyone - lenders, manufacturers, airlines and lessors - has a stake in higher revenue per ASM.

Increases in the load factor result in improved passenger revenues. If we have only a 1 percent increase in U.S. domestic capacity during this year and can get a 1.6 percent increase in the load factor, passenger revenues will increase to $45 billion in 1993. In 1994, assuming a slower 3 percent growth rate in GDP in 1994 and a continuation of the capacity growth restriction to 1 percent, passenger revenue will rise to $46.8 billion.

While the 1993 results won't be sufficient to wipe out all the losses, it should put carriers close to break-even on the domestic front so that the question of whether an airline makes gains or losses rests on its international operations and its control of costs. This will continue into 1994, and at that point U.S. airlines will be in recovery and should lead the world's airlines toward profitability. The non-U.S. airlines probably will take a year longer to recover.

In addition, the airport has five surplus gates. It lost three major carriers to bankruptcy in 1991 as the new terminal was rising.