The latest downturn in the aviation industry has dealt a fatal blow to many of the domestic airlines and has severely wounded many of the remaining survivors. Since the recession began. three major airlines, namely Pan Am. Eastern and Midway have liquidated. TWA, Continental and America West struggle to reorganize and losses for the "healthier" survivors have, and continue to be, substantial. The length and severity of the economic recession are much to blame for the industry's problems, but the Persian Gulf War, higher oil prices and price-cutting by weaker competitors are also at fault. The only way the megacarriers appear to be able to fill their seats is by giving them away at ridiculously low prices. In response to their dismal earnings, airlines have been carefully analyzing their route systems, eliminating or reducing service at those airports with marginal returns and adding flights at those airports with market potential.

At the same time, the U.S. economy is at a standstill. One day the economic indicators show signs of a recovery and the next day a different indicator will show it weakening. This stagnant economy has resulted in discretionary and even business travel being lower than projections made by airports during the booming 1980's.

Almost every airport in the country has been affected by the recession and the consolidation of the airline industry. The airport sector used to be one in which many of the credits had "A" ratings. This year, there have been a few, such as Miami and San Francisco, that weathered the storm so well that they were upgraded to the "Aa" category. But, airports such as Tampa and Phoenix proved to be vulnerable and have weakened in credit quality.

The Airlines

For the nine-months ended September 30, 1992, all of the major carriers except Southwest Airlines reported sizable, if not record breaking losses: American Airlines' losses doubled from the previous year to $231 million; Delta reported another sizable loss of $680 million for the first 9 months of 1992; United Airlines made $21.5 million in the quarter. but is losing $166 million so far this year; Continental's losses narrowed to $1 million for the first nine-months of the year, but widened for the quarter; and US Air showed signs of improvement with a loss of $203 million. Southwest Airlines has been the only airline to continuously make money. For the nine-months ended September 30, 1992, Southwest's net income increased 75% to $76 million. The last time any of the other airlines even made a profit was in 1989.

What is Southwest doing that the other airlines are not? Southwest operates under a low-cost, no-frills policy 365-days a year, and does not use a traditional hub-and-spoke network. Southwest operates under a different concept in hubbing called continuous hubbing.

This last point is extremely important. Since deregulation the traditional hub-and spoke network was believed to be the most efficient means of transporting passengers from point A to B. The traditional hub involves the airline purposely scheduling aircraft, ground crews etc. to all converge at a hub to transfer passengers at a specific time period. The congestion in most of our nation's airport system is during those peak connecting times. At other times of the day, the hub site is relatively dormant. What is happening is that the staffing, higher fuel costs and equipment needed for this form of hubbing is becoming too expensive and inefficiently used.

Under the continuous hub concept, point-to-point flights are scheduled into and out of a hub at a higher frequency basis with no regard for connecting flights. Planes used in such an operation are typically smaller, lower costing 737's instead of the $40 million jumbo jets used in the traditional hub and spoke network. Fewer gates and support facilities are needed since flights are scheduled at frequent intervals with no peak connecting times.

Southwest is the only airline currently using the continuous hub concept, and their outstanding earnings, combined with a low fare structure, proves that it works. As Southwest expands into other cities (and self-inflicted congestion increases at other airports), it may be the standard that the megacarriers will have to meet in order to survive.

We do not believe that the traditional hub and spoke network popular in the 1980's is dead. What we are saying is that as Southwest expands their market and the fare-wars continue, the other megacarriers will not survive lower pricing structures. In some cases, their fares are up to 72% lower. It may take years for this new concept to catch on, but the megacarriers can no longer afford the higher costs and operating inefficiencies of the traditional hub-and-spoke network. What we would expect to see is a transition into a form of hubbing that is a combination of continuous and traditional. Airlines are already beginning to make the shift to the smaller, more efficient aircraft needed.

Many airports have not caught on yet and are over-sizing their facilities for hubbing traffic that may not be there. Airports can no longer be assured that if an airline reduces or eliminates service in their area that another carrier will move in and take its place. Most of our airports existing facilities are large enough to meet our nation's transportation needs. We should learn to utilize them more efficiently.

Open Skies

Weaker carriers, are now looking to form alliances with foreign carriers to compete with United, Delta and American (the "Big Three"). Recently, British Airways proposed an injection of $750 million in return for a minority stake in USAir Should the Department of Transportation approve this deal, it would certainly help USAir's financial position, yet the "Big Three" are threatening to sue the federal government if approval is made without granting U.S. carriers an equal "Open Skies" policy to British cities and beyond. The "Big Three" claim that the USAir Agreement is one-sided and would erode their revenue base by an additional. $500 million per year (losses that would certainly lead to further downgrading of the megacarriers). Bill Clinton has indicated that he is against the proposed alliance. Follow these negotiations closely for they could have both positive and negative implications for the domestic airline's credit quality and may lead to an increased presence of foreign carriers in our markets.

KLM was also proposing to form an alliance with Northwest, but KLM recently withdrew their offer due to its own financial problems. Nevertheless, the Department of Transportation did approved the alliance.

Let's look at the credit quality of the other carriers: TWA has sold most of its valuable assets and will have a difficult time surviving; United, Delta and American are longer-term survivors but their earnings will not necessarily improve with the economy. Their operations have become too expensive and they need to adapt to their new environment for their credit quality to substantially Improve. Until then, the "Big Three" and the Speciality Bonds that they Issue are marginal "Air Partners Ltd." Once approved by the U.S. Bankruptcy Court and the department of Transportation, the deal should enhance airline to profitability.

O&D Airports

During this period of turmoil in the airline industry and heavy airport debt issuance, investors need to stick with the fundamentals. Heavy scrutiny of an airport's capital improvement program will provide an investor with a better understanding regarding whether the proposed improvements or expansions truly reflect the needs of the 1990's and not the potentially outdated ways of the 1980s Investors should invest in origination and destination (O&D) airports of large cities with large catchment basins. When compared to hub airports, O&Ds are not as vulnerable to the corporate decision-making of domestic airlines looking to maximize their profits Miami is a good example of a large O&D airport that survived the bankruptcies of two major carriers (PanAm and Eastern) over a one year period. This was primarily due to American Airlines Increasing their presence in that market to meet local needs.

Hubbing facilities or airports dominated by one carrier can be stable investments but require more in depth knowledge of the carriers credit quality and specific terms of their operating agreement. Investors can no longer be assured that should an airline liquidate or dramatically reduce service, that another carrier will pickup where they left off. Exclusive gate agreements can also make It difficult for an airport to evict an airline under utilizing terminal gates Hartsfield Atlanta International was the most notable example of an airport that was held hostage to the bankruptcy of Eastern Airlines, but survived due to the strength of the airport's finances.

We don't mean to sound pessimistic about the airport sector In fact, it has been and continues to be a relatively secure sector with a lot of "A" credits. But the airline industry is going through tough times and our prediction is that their fourth quarter earnings will be disappointing. As municipal analysts, we can not close our eyes to the troubles facing the airlines since they have and will continue to shape the credit quality of the Airport Revenue and Special Facility Bonds.

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