Turbulent times for U.S. aviation industry

To say that the U.S. aviation industry has hit a patch of turbulence is a 747-sized understatement.

The price of fuel, now airlines' single greatest cost, increased 66 per centsince 2007, according to the Air Transport Association, the industry's trade group. Merger negotiations falter almost weekly, evidenced most recently by the collapse of discussions between UAL'sUnited Airlines and US Airways Group.

Seven U.S. airlines have shut down since Christmas, and one, Frontier Airlines, filed for Chapter 11 bankruptcy in April. Making matters worse, the Federal Aviation Administration can't seem to obtain government funding to overhaul the nation's aging air traffic control system--even as congested skies and flight delays abound.

Airlines are scrambling to conserve fuel and cut their overhead. The easiest way to do it? Cut capacity, which AMR's American Airlines recently announced it would do by as much as 12 per centby the end of the year.

According to Calyon Securities airline analyst Ray Neidl, "The sooner capacity cuts can be made, the faster cost benefits will be realized." That's likely to anger customers: Fewer planes means higher ticket prices.

Despite the gloom, there are a few glimmering bright spots in the industry. For example, Southwest Airlines posted a 30 per cent increase in first-quarter earnings in April. The carrier took a 63per centhit on profits for the year, but the carrier's profit margin (profit as a percentage of revenue) was still 1.34 per centthrough the first three months of 2008. Small beer, but they'll take it most U.S. airlines lose money these days.

Then there's Allegiant Air, owned by Allegiant Travel, which sends travelers to leisure destinations like Las Vegas and Florida. It's trimmed some of its flights lately due to fuel costs, but the company's revenues increased by 58 per cent, and its profit margin has jumped by nearly 8 per centon the year. Apparently, it pays to focus on customers who are ready and willing to spend money.

Open skies

Another development that might give a boost to some of the big network carriers is the new "open skies" agreement between the U.S. and the European Union. Effective as of March, it allows carriers to fly from any point in the European Union and U.S. Continental Airlines, Delta Air Lines and Northwest Airlines have already begun adding flights to London's Heathrow International Airport.

And on the horizon, there are discussions under way between U.S. and E.U. officials to relax airline ownership rules. If carriers could be internationally owned, there would likely be further consolidation in the industry. Not necessarily good for consumers, but it would help airlines regain some financial footing.

For now, however, the big picture for U.S. carriers is mostly bleak. Just rewind the events of the last few months for evidence. In March, a whistle blower investigation revealed that a cozy relationship between the FAA and Southwest Airlines allowed the carrier to fly dozens of its planes without adequate safety checks. Soon afterward, the agency forced American, Delta and others to ground hundreds of flights for maintenance checks on wheel wells in MD-80 planes.

In April, Delta and Northwest Airlines announced plans to merge, setting off speculation about a wave of airline consolidation. However, in recent weeks talks between United and Continental and now United and US Airways soured for various reasons, including financial performance and labor disputes. Aside from the Delta-Northwest marriage, no mergers of U.S. carriers are likely to take place until 2009.

If that weren't enough, sources on Capitol Hill now say Congress won't pass a bill to bulk up the FAA's funding this year, meaning the industry is stuck with a creaky air traffic control network until lawmakers can agree on a plan to fund a more efficient satellite-based system. In other words, 2009 at the earliest.

"The price of fuel is just an exclamation point" to the industry's woes, says Roger King, senior transportation analyst at research firm CreditSights. It's such an exclamation that American Airlines will start charging some passengers for checked bags as early as next week.

None of this provides much consolation for investors (or passengers) in commercial airlines. But in other corners of the aviation industry, there's better news. Three examples:

Defense

Aviation encompasses far more than just commercial airlines, and defense spending is not likely to decline in the near future. Shares of Northrop Grumman, which was recently the co-winner of a major Air Force contract, have soared by 72 per centin the last five years. Boeing, which was jilted in the deal, has seen its stock price fall by 20 per centin the last eight months, but the company is still relatively healthy, posting a $1.2 billion USprofit on $16 billion in revenues during the first quarter.

Suppliers

Unlike airlines, suppliers don't have to worry so much about rising fuel costs. Precision Castparts and Ducommun, which both make components for the aerospace industry, have done quite well financially in recent years. Precision's profit margin for the first quarter was 14.85 per cent; Ducommun's was 5.32 per cent.

Biofuels

General Electric and Honeywell are two companies working to develop a biofuel for jet engines. Boeing also has partnerships with Virgin Atlantic and Air New Zealand to make alternative jet fuel commercially available. Because of regulatory and technical hurdles, that day is probably five years away. The Commercial Aviation Alternative Fuels Initiative sponsored by several trade groups and the FAA is brokering the research effort between the private and public sector.

So buckle in. It's going to be a bumpy few years yet for U.S. aviation. But as long as there's a desire to fly, there's money to be made.