Passenger airlines in the United States are benefitting from an improved economy. Despite crippling winter weather in the northeastern and midwestern United States during the first quarter of the year, 2014 is expected to be a strong year for passenger carriers. And commercial cargo, which has been very weak, is showing some modest improvement. However, certain other sectors are experiencing significant challenges. Airlines that specialize in flying for the U.S. Department of Defense and, in particular, transporting cargo for the U.S. military, are struggling. Regional airlines that fly smaller jets and turboprops are facing a severe pilot shortage, which in some cases is not only complicating operations but also adversely affecting profitability and perhaps viability. Here is an overview of the key market sectors:

U.S. PASSENGER AIRLINE INDUSTRY

• OUTLOOK  Strong
• OPPORTUNITIES Continued strong economic growth
• CHALLENGES Industry is susceptible to economic cycles and oil price fluctuations

Anyone who has flown recently has likely encountered long security lines, cramped overhead bin space, overcrowded airplanes and stressed employees. But for an industry that until recently was a true laggard on Wall Street, full airplanes and busy airports are welcome problems for air carriers. The U.S. airline industry is expected to post its fourth consecutive year of profitability in 2014. In 2013, the 10 largest airlines (measured by numbers of passengers flown) reported an aggregate net profit of $11.7 billion for the year. And 2014 is expected to be even better, notwithstanding the historically inclement weather in the first quarter of the year. Despite massive flight cancellations, more people flew in the first quarter of 2014 than the same period in 2013.

The key factor in airline profitability is a strong domestic economy. Even though corporate air fares are up approximately one percent year-over-year, revenues from business travel have been reported to be up two percent at United, six percent at Delta, and “mid-single digit” at American. Load factors in May 2014 were above 87 percent for American, United and Delta, while Southwest was at 84 percent. Other factors contributing to the favorable results are capacity discipline (i.e., limiting growth in available seats), greater availability of capital and the resulting lower borrowing costs, and the diminution in competition from industry consolidation as a result of the mergers and tie-ups between American and US Airways, Southwest and AirTran, United and Continental, and Delta and Northwest. These airlines now control over 85 percent of the U.S. domestic market, up from about 60 percent a decade ago.

Based upon projections from the Federal Aviation Administration (FAA), strong gross domestic product growth and increased passenger counts are expected to continue through 2022, with an annual growth rate of two to three percent during that time for domestic passengers and over four percent for international traffic.

However, historically, the passenger sector has been very cyclical, with periods of good times followed by very poor results as a result of micro- and macroeconomic factors, government regulation and world events. In a recent Standard and Poor’s research report, the credit rating agency noted that the “industry is still subject to U.S. and global economic cycles, oil price fluctuations, and unforeseen events such as global terrorist events and disease outbreaks.” And the traditionally powerful labor unions in the airline industry are expected to seek a greater share of profits during the next cycle of collective bargaining negotiations as they seek to recoup many of the “give backs” negotiated by airlines during the last wave of restructuring a few years ago. Southwest and AirTran, United and Continental, and Delta and Northwest. These airlines now control over 85 percent of the U.S. domestic market, up from about 60 percent a decade ago. Based upon projections from the Federal Aviation Administration (FAA), strong gross domestic product growth and increased passenger counts are expected to continue through 2022, with an annual growth rate of two to three percent during that time for domestic passengers and over four percent for international traffic.

However, historically, the passenger sector has been very cyclical, with periods of good times followed by very poor results as a result of micro- and macroeconomic factors, government regulation and world events. In a recent Standard and Poor’s research report, the credit rating agency noted that the “industry is still subject to U.S. and global economic cycles, oil price fluctuations, and unforeseen events such as global terrorist events and disease outbreaks.” And the traditionally powerful labor unions in the airline industry are expected to seek a greater share of profits during the next cycle of collective bargaining negotiations as they seek to recoup many of the “give backs” negotiated by airlines during the last wave of restructuring a few years ago.

COMMERCIAL AND MILITARY CARGO

• OUTLOOK Challenging
• OPPORTUNITIES Improving economy may increase commercial cargo
• CHALLENGES Reduction in U.S. troop deployment and budget cuts

Since the 1950s, U.S. airlines have provided passenger and cargo air services to the U.S. military in peacetime and during times of war when the Department of Defense (DoD) requires additional airlift. Participating airlines contractually pledge aircraft to the DoD to be ready for activation in a time of emergency or war. As an inducement to air carriers to participate in the Civil Reserve Air Fleet (CRAF) program, the DoD awards peacetime business to the CRAF air carriers and allows them to join teams and barter among themselves to optimize flying, so that specialty airlines do most of the flying and the “scheduled” passenger and cargo airlines (e.g., UPS and FedEx) trade their entitlements to the specialty airlines. The system was designed to encourage airlines to contingently pledge aircraft for major activations and to ensure the health and availability of specialty carriers to handle normal flying and routine overflow from the DoD.

However, as a result of DoD budget cuts and a sharp reduction in troop deployment in Afghanistan and Iraq, there have been significant cutbacks in flights awarded to cargo and passenger specialty military operators. Even though over 25,000 troops and 15,000 vehicles remain in Afghanistan, the amount of flying outsourced by the government to cargo carriers is approximately one-tenth of what it was a few years ago. To cut costs, the military has looked to alternative sources to meet its logistics needs, including “multi-modal” – the combined use of ships, rail, trucks and air. In testimony before Congress, the head of airline procurement for the DoD remarked that the use of commercial airlines will be further reduced because of severe budget constraints. So far in 2014, two historic military specialty air providers have shuttered their operations. World Airways, a military cargo and passenger airline in business since 1948 (and the operator of the very last flight out of Da Nang during the Vietnam War) and Evergreen International, a major operator of Boeing 747s around the globe, have liquidated in bankruptcy. A third, North American Airlines, is in the process of transferring its remaining aircraft to Omni Air (a larger competitor) in a bankruptcy- supervised sale. The prospects for those specialty airlines that remain could be very bumpy unless their revenue base is significantly diversified with non-DoD business. And this may likewise affect adversely the DoD’s ability to react swiftly if a global conflict arises.

REGIONAL AIRLINES

• OUTLOOK Challenging
• OPPORTUNITIES Weaker competitors may be forced to shut down or curtail operations
• CHALLENGES Shortage of available pilots; increase in crew costs

In February 2009, Colgan Air Flight 3407 crashed into a house outside of Buffalo, New York. Fifty people died. Although the turboprop aircraft was operating in bad weather, the crash has largely been blamed on pilot error and pilot fatigue. As a result of the air crash, Congress enacted legislation – The Airline Safety and Federal Aviation Administration Extension Act of 2010 – requiring commercial airline pilots to have significantly greater experience in flying time and training before obtaining a license to fly commercial airliners. The new “3407 Rules” also require greater rest time for airline crews between work days and more stringent hourly limits on pilot duty time. Most airlines expect to hire additional pilots to fulfill the needs created by the 3407 Rules.

In addition, a large number of pilots approaching the mandatory retirement age of 65 has led to a significant hiring surge at the major airlines, which in turn do most of their hiring from domestic regional airlines. Those pilots have experience flying in the U.S. domestic market and must meet the same federal standards for licensing. Generally, the major airlines pay more and have more generous benefits, so the pilots flee and the regionals have to find new pilots. But the available pool has shrunk sharply because the new 3407 Rules have significantly raised the minimum standards and far fewer pilots are available to backfill the regional jobs. Accordingly, a ”feeding frenzy” has been created, with more jobs than qualified pilots and regional airlines using inducements such as higher pay, signing bonuses, hotel stays for commuting pilots and less stringent work rules.

Even with the lure of additional compensation, regional airlines are struggling to fill their hiring quotas. One regional airline had 300 pilots a year ago and now has 80. Mesa Air closed its Hawaiian operation, while Republic Airways refused to fly 27 small jets citing safety concerns due to having too few pilots. Silver Airways gave up contracts with the U.S. government.

The regional industry has petitioned the FAA and Congress for relief but none is expected to be forthcoming, although industry insiders question whether the 3407 Rules meaningfully improve airline safety. Undoubtedly, crew costs are going up, but without assurance that the requisite numbers of pilots can be recruited. These higher costs are not likely reimbursable (or perhaps only partially so) by the mainline partners for whom the regionals fly. Higher costs cut into margins and, in the case of weaker carriers, threaten their viability. And if they are unable to fly the routes they are contractually committed to fly, the regionals are exposed to contractual indemnification claims and penalties for non-performance.

It is clear that the economic model upon which the regional airline industry is predicated is ripe for change as the risks of uncontrollable issues – pilot shortages, weather and other contingencies – fall squarely on the regionals, who are struggling at a time when the major airlines are enjoying significant profitability.