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Optimism, uncertainty and cost pressures offer an unpredictable mix for 2017

Airline Leader

A sense of optimism prevailed among North American airlines as 2016 draws to a close. It is driven by the beginning of stabilised pricing in the US domestic market and an improved outlook for Western Canada after a marked drop in oil prices triggered a collapse in demand.

After two years of recession triggered plummeting demand to Latin America, the largest North American airlines serving the market started reporting positive revenue trends at the end of 2016; but the outlook for trans-Atlantic and trans-Pacific markets remains far more subdued.

Uncertainty over the UK Brexit vote, heightened competition and overcapacity were weakening airline performance in the trans-Atlantic and excess supply was also creating pressure in trans-Pacific markets.

And, as profitability and labour pressures provoke significant wage growth, the groundwork is being laid for another cycle of cost increases.

North America Capacity Seats per week, week starting 05-DEC-2016

North America airlines with more than 50 upcoming deliveries on order till 2031

North America projected delivery dates for aircraft as at 08-DEC-2016

Early projections for both the US and Canada show approximately 2% GDP growth for each country in 2017, which is a slight improvement from 2016. Prior to the Nov-2016 US presidential election, the general consensus was the selection of Donald Trump would send markets into a tailspin, yet...

US markets were gaining ground after his election but uncertainty reigns, particularly over whether Mr Trump's protectionist campaign rhetoric will upset global trade balances and, consequently, affect demand for travel. Even before his installation, a regular flurry of tweeting suggests that policy uncertainty will prevail for at least several months to come.

The profitability streak North American airlines have enjoyed for several years had been expected to continue into 2016. Similar to 2015, lower oil prices helped lift profits at those airlines, but overcapacity and a lack of pricing traction caused unit revenues for most North American operators to remain stubbornly negative in 2016. It was the second year in a row that the majority of North American airlines posted negative unit revenue performance.

Several North American airlines, including American, Delta and Southwest, and Canadian low cost operator WestJet, believe they can achieve a positive unit revenue performance in 1H2017. The pillars of those forecasts include lower capacity growth, higher oil prices and the promise of pricing traction, particularly for close-in bookings, that began to take hold in late 2016.

All of those airlines, along with rival United, will face marked cost pressure during the next couple of years, mainly driven by new and necessary labour agreements forged in 2015 and 2016. United's unit costs excluding fuel, profit sharing, special items and third party expenses during 2016 grew 2.75% to 3.25%, and roughly 2.3ppts of the increase was driven by new labour contracts ratified in 2016.

For 2017, the company's unit costs are forecast to grow 3.5% to 4.5%. Beginning in 2018 and continuing through 2020, United aims to cap its annual unit costs growth at 1% or lower, based on aspirational annual capacity growth of 1.5% during that time period.

Southwest's unit costs excluding fuel, profit share and special items grew 2% to 3% in 2016, and will trend at those levels or higher in 2017 after the airline's pilots and flight attendants ratified new labour deals in late 2016. WestJet's projected unit cost inflation excluding fuel of 2.5% to 3.5% for 2017 is largely attributed to a higher number of smaller gauge 78-seat Bombardier Q400s entering its fleet. WestJet is taking delivery of eight Q400s in 2017 and six mainline Boeing 737 narrowbodies. The Q400s have a higher unit costs, but also generate higher unit revenues.

All North American airlines face the daunting task of ensuring their unit revenue growth outpaces the marked cost inflation they project for 2017. During the past couple of years, investors have been shaken by the negative unit revenue performance of North American operators, and have been waiting for an inflection point. With fuel costs rising, industry dynamics are increasing the urgency for all North American airlines to turn a corner in their unit revenue performance. Meeting their latest deadlines for positive unit revenue growth could be more important than ever.

One way North American airlines are working to meet their declarations of positive unit revenue performance in 1H2017 is adjusting their capacity growth targets to create a more stable pricing environment. The three large US global network airlines - American, Delta and United - appear to be growing their ASMs below GDP. United is planning capacity growth of 1% to 2% for 2017, and American and Delta should also increase their supply within that range.

Southwest, which faced some pushback from investors in late 2016 for keeping its 5% to 6% growth targets for the year intact, plans to lower its capacity expansion for 2017 to approximately 3.5%. WestJet, whose 9% capacity growth in 2016 also spurred investor trepidation, is slowing 2017's growth to 3.5% to 5.5%.

Both Alaska and jetBlue are forecasting higher capacity growth for 2017 than larger US airlines, but below 2016's expansion. On a stand alone basis Alaska, (which received conditioned US government approval for its merger with Virgin America in Dec-2016) plans 7% capacity growth in 2017 compared with expansion of 8.5% the year prior. JetBlue's preliminary guidance showed capacity growth for 2017 about 2ppts below the 8% to 9.5% increase it recorded in 2016.

Even the 15% to 20% annual ASM growth planned by US ultra LCC Spirit Airlines in 2016 and for the foreseeable future is a significant drop from the 30% growth it recorded in 2015.

At the beginning of 2016, Canada's largest airline Air Canada stopped offering capacity, unit revenue and yield guidance, but the airline is scheduled to take delivery of nine Boeing 787-9 widebodies and two 737 narrowbodies, which should result in 2017 capacity growth mirroring the approximately 10.5% expansion it recorded in 2016. During the last few years the bulk of Air Canada's capacity expansion has been dedicated to international markets, and 2017 will be no different.

In order to keep capacity growth flexible during coming years and keep a check on capital expenditures, some of North America's largest airlines United, Southwest and American outlined aircraft deferrals during 2016. United opted to defer 61 Boeing 737-700s originally scheduled to begin delivery in 2017, and stated it would likely convert those orders to next generation MAX aircraft.

United has concluded it can meet its capacity needs with its existing fleet, and estimates cutting USD1.6 billion in capex for the 2017-2018 time period. Meanwhile, Southwest has deferred 67 737 MAX deliveries from 2019-2022 to 2023. The deferrals result in the pushback of USD1.9 billion in capital spending.

American Airlines has decided to defer 22 Airbus A350 widebody deliveries from 2017 to late 2018, which should save USD500 million in 2017 and USD700 million in 2018. American is in the midst of a significant narrowbody fleet revamp to replace its ageing MD-80s. According to the CAPA Fleet Database, the airline's orders for 245 Airbus and Boeing narrowbodies represented roughly 81% of American's total 303 aircraft order book as of late Nov-2016. American is the top North American airline measured by deliveries scheduled through 2031. The CAPA Fleet Database shows 2017 is the peak delivery year for North American airlines between 2016 and 2022.

One of the most important developments in Canada during 2016 was a decision by the government to grant an exemption from foreign ownership restrictions to two upstart ULCCs. Now foreign backers can hold up to 49% of Enerjet and Jetlines instead of 25%. Influential ultra low cost airline investor Indigo is partnering with Enerjet, which aims to launch FlyToo in 2017. Enerjet is a charter company operating 737 narrowbodies, and believes its existing operating certificate could shrink its launch process by a year.

Jetlines had warned its low cost opportunity would be lost unless the Canadian government granted the foreign ownership exemption, and it aspires to launch operations in 2017. The company has previously placed an order for five 737 MAX aircraft scheduled for delivery in 2021. The company will launch with six current generation 737s and aspires to operate 40 aircraft over the first eight years of operation.

Canada's third startup ULCC NewLeaf Travel launched operations in 2016, opting to use idle charter capacity freed up by declining demand in the oil and gas sector. NewLeaf has also attracted ULCC star power. Former Spirit CEO Ben Baldanza is chairman of the company's board.

Inevitably both WestJet and Air Canada intend to compete vigorously with the ULCC upstarts. But WestJet has adopted a more aggressive stance against the new competitors. "We have the cost structure and the balance sheet and the loyal traffic base that we will defend our franchise, and so we're going to match whatever prices our competitors put in the market", WestJet CEO Gregg Saretsky declared. Both Air Canada and WestJet have the scale to match prices of ULCC competitors for quite some time, and WestJet has warned there has never been a time in Canadian airline history when more than two airlines could operate profitably.

The US' largest ULCC Spirit also battled weak unit revenue performance in 2015 and 2016 as lower oil prices allowed larger airlines to discount on the margins. Now American, Delta and United are in various phases of developing fare families in which the lowest tier is a bare bones offering designed to permanently compete with ULCCs.

Throughout 2016 Spirit, which came under the leadership of a new CEO earlier in the year, has talked about pivoting its network from larger markets to smaller and medium sized regions in order to minimise competition with larger rivals. The company opted to keep smaller gauge A319 aircraft in its fleet, and also reached an agreement with Airbus to convert 10 A321neos scheduled for delivery in 2019 to smaller gauge A320neos.

Near the end of 2016 Spirit had not outlined major plans to penetrate smaller markets other than announcing a handful of new routes from Akron-Canton, Ohio. More network changes could be in store for 2017 as Spirit continues to move towards a higher mix of small and medium sized markets.

Large North American airlines are attributing part of capacity pressure in the trans-Atlantic from new low cost competitors in the market including WOW Air and Norwegian Air Shuttle. WestJet also debuted nonstop trans-Atlantic flights to London Gatwick in the summer of 2016. More competitors are poised to enter the market in the not too distant future, most notably jetBlue. The airline has included options for the A321LR in an order for A321s that could be used to launch service across the Atlantic.

JetBlue has concluded members of immunised trans-Atlantic joint ventures hold a high concentration of seats in the market, which results in a lack of low fare options. Members of immunised joint ventures created by the oneworld, SkyTeam and Star alliances represented approximately 74% of the seats deployed between the US and Western Europe in late Nov-2016.

North American global network airlines looking to broaden their network reach with new joint ventures hit roadblocks in late 2016 as the US DoT tentatively rejected the proposed JV between oneworld partners American and Qantas and required slot divestitures at Mexico City Juarez and New York JFK for SkyTeam airlines Delta and Aeromexico to move forward with their transborder joint venture. Additionally, US regulators limited Aeromexico and Delta's antitrust immunity to five years, a stipulation absent from previous approvals of joint ventures.

JetBlue and other smaller airlines during 2016 voiced concern about the power that the joint ventures wield, and requested regular regulatory reviews of the tie-ups. The Obama administration appeared to take those concerns seriously; but Mr Trump offered little insight into his views of the aviation industry on the campaign trail, other than identifying Los Angeles and New York LaGuardia as "third world airports". Given his populist protectionist bent that emerged during the campaign, Mr Trump's administration could cast a more watchful eye over joint ventures between US and foreign airlines.

The power of international JVs already appears to be becoming a concern under the Obama administration; a proposed American-Qantas expansion of its JV was rejected in Dec-2016.

Most of the capacity pressure in the trans-Pacific is centred on routes from North America to China as airlines work to ensure a strong presence in one of the world's most important aviation markets. But United Airlines, which has started serving secondary Chinese markets from its hub in San Francisco, concludes that service thresholds in the China-US bilateral are close to being met, which will slow down capacity growth in 2017 and beyond.

Although North American airlines were seeing an uptick in fortunes on Latin American routes at the end of 2016, after Mr Trump's election the Mexican peso plummeted against the USD, and threats to erect a border wall are casting a shadow over the benefits of a newly minted liberalised bilateral agreement between Mexico and the US that lifts restrictions on the number of airlines operating on certain routes. Mr Trump's pledges to dissolve NAFTA and carry out mass deportations are a toxic combination for demand between the two countries.

North American airlines ended 2016 on a generally positive note after seeing encouraging signs of modest economic growth and some positive pricing trends. But the pressure to deliver on their forecasts of attaining positive unit revenue performance in 1H2017 is becoming more acute due to rising oil prices and marked cost inflation many of those airlines face in the short term.

It remains unclear how a government administered by Mr Trump will affect the North American airline industry, and for now those airlines have to wait and see how much of his campaign rhetoric crystallises into actual policy. At this stage no-one knows, not even seemingly Mr Trump.