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Law360 (May 15, 2020, 5:51 PM EDT) --
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| Alan Hoffman |
The Airlines
For nearly 10 years, the U.S. airlines have enjoyed unprecedented prosperity. In 2015, the Federal Aviation Administration released a study that found that the restructuring and consolidation of the industry resulting from deregulation led to reduced seating capacity, rising fares and increasing ancillary fees.
"Since its deregulation in 1978, the U.S. commercial air carrier industry has been characterized by boom-to-bust cycles," said the FAA. (It could equally have said that of the industry prior to deregulation.) "Looking ahead there is optimism that the industry had been transformed from that of a boom-to-bust cycle to one of sustained profitability," it concluded.[1]
That prediction was amply borne out. In 2019, U.S. airlines reported after-tax profits totaling $14.8 billion, up from $11.8 billion in 2018, and the seventh consecutive year of growing industry profitability.[2] Much of this was used to fund stock buybacks and enhance executive compensation.
As soon as the effects of the pandemic became evident in March, the airlines petitioned Congress for financial assistance. In April, industry lobbying group Airlines For America reported that the airlines had idled more than 2,000 airliners, passenger volume was down by a staggering 90 percent over 2019, and there were predictions of bankruptcies.
The Coronavirus Aid, Relief, and Economic Security Act passed by Congress provides $25 billion for payroll support and another $25 billion in loans. Seventy percent of the payroll support funds are outright grants, and 30 percent is structured as 10-year loans.
In return for the payroll support funds, airlines are required to forego major staffing or pay cuts through September, refrain from stock buybacks and dividend payouts, and accept limits on executive pay until March 2022. Recipients of loans of over $100 million will also be required to grant the government stock warrants or other equity instruments equal to 10% of the loaned amounts. Some airlines have already indicated that they may begin layoffs as early as October, making the payroll support of limited effect and benefit to employees and the public.
Despite this governmental support, the outlook for the airlines is daunting. Air Transport World Editor Karen Walker says the pandemic "shattered the illusion that U.S. airline management had found the magic keys to sustained profitability and growth." Investor Warren Buffett announced in early May that he had liquidated his entire portfolio of airline stocks (Southwest Airlines Co., American Airlines Inc., United Airlines Inc. and Delta Air Lines Inc.), saying that the situation was "through absolutely no fault of the airlines themselves."
U.S. regional airlines, already battered by the congressionally mandated "1,500 hour rule" requiring all cockpit crew to possess an Airline Transport Pilot rating, pilot shortages and rising costs, are particularly vulnerable, and their business model may no longer be viable.
St. Louis-based regional Trans States Airlines, which previously lost its contract with American Airlines and terminated its order for 50 Mitsubishi regional jets, ceased operating at the end of April. Overseas, Walker predicts that the pandemic will speed airline consolidation in Europe and Asia.
The situation overseas may be even more dire than in the United States. International Air Transport Association Director General Alexandre de Juniac's appraisal is literally apocalyptic: "Travel restrictions and evaporating demand mean that there is almost no passenger business. For the airlines, it's apocalypse now." His solution? "We need governments to act fast with financial relief," in the absence of which almost half of the airlines will fail.[3]
But government aid is likely to come with strings attached. In return for loans worth €7 billion ($7.6 billion) France has ordered Air France-KLM to become more profitable and more competitive, while at the same time substantially reducing emissions for environmentally conscious Europe. The latter goal is likely to be more attainable than the former in the near term.
At this point, it is impossible to forecast when the pandemic will abate to the point that global economies begin to rebound and air travel demand begins to recover. Until it does, airlines will struggle to match costs to drastically reduced revenues.
Manufacturing
The effect on aircraft manufacturers has also been severe. The virus has ousted Boeing's 737 Max woes from the daily news cycle, but it has added to the challenges faced by the beleaguered program.
While testing the modifications needed to lift the Federal Aviation Administration's grounding order appears to be nearing completion, the aircraft will face returning to service with airlines whose financial resources have plummeted. Boeing's 4,000 Max order backlog has shrunk by nearly 10% since the start of 2020, and further cancellations and delivery deferrals are inevitable. Customers may be unable to take delivery of aircraft on order, and new orders have essentially dried up.
Boeing responded to this challenge by requesting $60 billion in assistance from the federal government. Politically ambitious former United Nations Ambassador Nikki Haley resigned her Boeing directorship in protest, saying that companies should not receive federal largesse. But Boeing is facing a liquidity crisis. Its commercial aircraft business is spending $4 million monthly with little cash influx, and by March it had already exhausted a $14 billion short-term line of credit issued in January.
With Boeing employing more than 150,000 workers and responsible for tens of thousands of jobs in its supply chain, some form of governmental support seems inevitable. But it will come at a price.
The same type of strictures applied to aid for the airlines — restrictions on dividends and stock buybacks, maintenance of employment levels, and possible public equity interest — are likely to be imposed. "The idea of governments in different companies, that's going to be the case because a lot of companies are going to have to be bailed out," says Mohamed El-Erian, chief economic adviser at Allianz.[4]
The Boeing-Embraer Deal
One of the casualties of Boeing's commercial woes has been its partnership with Brazilian manufacturer Embraer. Forged in response to archrival Airbus' acquisition of Bombardier's troubled CSeries small jetliner, rebranded as the Airbus A220, the agreement called for Boeing to pay $4.2 billion to take control of the manufacture and marketing of Embraer's E-Jet regional airliners.
The deal had to overcome Brazilian political opposition as well as a European Union inquiry into possible anti-competitive effects. (The real EU concern seemed to be that it would allow Boeing to compete too effectively with Airbus).
Nevertheless, the merger seemed to be on track until Boeing unexpectedly announced its termination on April 25, ostensibly because Embraer failed to satisfy conditions to closing the agreement — even though Boeing had already begun the logistics of moving the Embraer commercial business under its control. It's unclear why Boeing and Embraer could not have negotiated to postpone closing while addressing outstanding issues and keeping the potential benefits of the deal for both parties alive for the future,
The announcement triggered outrage at Embraer. It issued a statement claiming that Boeing had manufactured "false claims as a pretext to seek to avoid its commitment to close the transaction," which it attributed to Boeing's "own financial condition and 737 Max and other business and reputational problems." And it vowed to collect a $100 million wrongful termination fee, which Boeing predictably promised to resist, leading to another legal battle that neither company needs at this time.
Industry observers have tended to side with Embraer's view, citing Boeing's financial situation and the bad optics of spending $4 billion to acquire a foreign enterprise while asking for $60 billion in assistance from the United States. Boeing unquestionably needs cash in the short term, but the long-term implications of termination are serious. It wanted Embraer's E-Jet line to compete with the Airbus A220 at the low end of the single-aisle market, and it also stood to benefit from acquiring Embraer's engineering expertise. It has now chosen to abandon both.
Teal Group analyst Richard Aboulafia says that Boeing is being "boxed in" by Airbus. It has forfeited the small airliner market by terminating the Embraer deal, and it is losing badly to the Airbus A321neo at the other end. Its only single-aisle offering is the troubled 737 Max, and it has nothing to compete with the long-range Airbus A321XLR for international routes.
"Boeing is rapidly becoming a niche company in the single-aisle market," says Aboulafia. Boeing's 787 is beating the Airbus A350 in the wide body twin-aisle sweepstakes, but this segment is stagnant as airlines look for lower acquisition and operating cost alternatives.
The outlook for Airbus is also far from rosy. In April, Airbus CEO Guillaume Faury issued a dramatic warning that the company was "bleeding cash at an unprecedented speed," and "in just a couple of weeks we have lost roughly one-third of our business." He added, "The survival of Airbus is in question if we don't act now."
His remarks came soon after the company decided to reduce production rates for its entire airliner family by one-third. However, Airbus can likely count on support from its European host nations to weather the current storm, and its prospects for recovery look brighter than Boeing's in the aftermath of the latter's latest self-inflicted wound.
The Military
Beyond the commercial sector the picture is considerably less dire. Military orders and production have been little affected by the pandemic so far and are less vulnerable to economic trends than commercial aviation. Boeing's military business continues to hum along filling domestic and international orders for F-15, FA-18 and EA-18 combat jets at its St. Louis plant, and for KC-46 tankers and P-8 Poseidon patrol planes from its Everett and Renton production lines.
Indeed, the latter programs, based on the commercial 767 and 737, may help keep those lines active during the commercial drought. Lockheed Martin Corp.'s too-big-to-fail F-35 program also shows no sign of weakness due to the virus. In Europe, Airbus' military activity is limited and plays little role in the company's total performance.
General Aviation
One phase of aviation that has particularly suffered is general aviation. The airlines' growing pilot shortage led to an increase in training activity in recent years, but that has come to a standstill during the outbreak.
While ground classes and individual study can be carried on remotely, there is no way to practice social distancing during flight instruction, where the instructor's observation of and interaction with the student is vital. The pilot shortage has quickly turned into a surplus, which is likely to persist even while airline activity slowly increases once a general recovery begins. Demand for new pilots will surely lag while that is the case.
Conclusion
Commercial aviation historically has closely followed the overall business cycle. After enjoying the fruits of an extended expansion following the 2008 recession and industry consolidation resulting from deregulation, it has borne the brunt of the COVID-19 crisis. The result will likely be an acceleration of existing trends toward smaller, more economical planes, and continued decline in wide-body operations.
Military aviation has been relatively unaffected, and the outflow of military pilots to the civilian sector is likely to abate while the lack of demand for pilots continues. And general aviation has taken a body blow from which recovery is uncertain — as with so much in this time of global uncertainty.
Alan Hoffman was a product liability attorney for 43 years, until his retirement from Husch Blackwell LLP in 2017. He is an aviation historian, a private pilot, and a member of the Experimental Aircraft Association and the Missouri Aviation Historical Society.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] Federal Aviation Administration, FAA Aerospace Forecast: Fiscal Years 2015 – 2035, p. 1
[2] United States Department of Transportation Bureau of Transportation Statistics, 2019 Annual and 4th Quarter U.S. Airline Financial Data, Release Number:BTS 26-20, Monday, May 4, 2020, https://www.bts.gov/newsroom/2019-annual-and-4th-quarter-us-airline-financial-data
[3] Lewis Harper, "IATA issues airline 'apocalypse' warning," Flight International 31 March – 6 April 2020, p. 8.
[4] Michael Bruno, "Bail out Boeing?" Aviation Week & Space Technology, April 6 – 19, 2020, p. 10.
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