NEWSWIRE - MARCH 20, 1998

Topic: Financial Forecasting

Source:"Airlines Pocket Huge Savings on Fuel Costs," by Susan Warren, Wall Street Journal, Wednesday, March 20, 1998, page B1.

Synopsis of Article: The airline industry is receiving a major boost in its net profits this year due to a significant decline in the price of one of its most important and most volatile cost items: fuel. The strong domestic economy also means that demand for airline services is robust. The result: revenues are up, costs are down and many industry analysts are revising their estimates of EPS upward.

Specifically, fuel costs have declined from their 1996 level of $0.70 per gallon to a current level of $0.39. For United Air Lines, this translates into a $30 million increase in operating profit and a $0.17 increase in EPS. But why haven't airlines reduced fares? Because they don't have to! The average flight is 70% full and robust demand, particularly from business travelers has allowed those fares to rise by 16% since 1996. While fare increases have slowed down in recent months, some analysts expect another increase of 6% for business fares during 1998. The only "winners" are leisure travelers who are expected to find their fares essentially unchanged in 1998.

Beyond the analysis provided in the article, this is a good vehicle for considering other critical factors affecting profitability in the airline industry. Here is an industry with enormous fixed cost components associated with the financing of equipment. As a result, a small downturn in demand or a modest reduction in variable costs (such as fuel) will provide a disproportionate bump in profits and EPS. This underscores the importance of the sales and financial forecasting for the airline industry as well as the impact of leverage.

Note: Perhaps airline executives showed prudence in resisting a cut in fares. The Tuesday, March 23, 1998 Wall Street Journal carried several articles describing the one day crude oil price increase of 13%. OPEC producers have agreed to curtail production of crude oil in order to raise the market price. Clearly, this will take some of the optimism out of airline earnings estimates.

Questions:

1. Why haven't fares dropped although fuel costs are down significantly for the airline industry?

2. Although not mentioned directly in the article, what are the major cost factors for an airline? Which of these are fixed and which are variable? Does this industry have a high degree of operating or financial leverage?

3. If you were forecasting revenues for an airline using the linear regression approach on pages 598 and 599, what would be good choices for explanatory variables?

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