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THE WORLD ECONOMIC AND FINANCIAL OUTLOOK Federick W. Bradley, Jr. Senior Vice President Citibank, New York Thank you, Dr. Stever. It is certainly a great pleasure for me to participate in this workshop on the role of NASA in aeronautics. I have been asked to discuss the financial and economic outlook for the aviation industry as part of the background for your discussions this week. Before looking at the future, let us review the present status of the aviation industry. We are, unfortunately, in the middle of what probably will be the worst year in history for the U.S. airlines in terms of earnings. Although not as hard hit as the U.S. carriers, most airlines throughout the world are anticipating a substantially lower level of earnings for l980. Although the depressed U.S. economy and the slowing down of economic activity worldwide are the major contributors to these events, the changed regulatory environment has also been a factor. Clearly, the passage of the Airline Deregulation Act in October l978 has had and will have an important impact on the U.S. domestic carriers, while the philosophical underpinnings have already been widely felt on international routes. Any assessment of both domestic and worldwide industry must take into account the short- and long-term impacts of this significant legislation. Although dedicated to the concept of less government regulation of industry, many of us in the financial community were concerned about the impact of legislation that encouraged more competition and lower fares in a future environment of steady cost increases, continuing fluctuation of traffic levels with the economic cycle, and an inability to realize the dramatic productivity gains through improved technology that were achieved in the past. We are still concerned, and recent events seem to indicate that our skepticism was well founded. l5

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While L978 domestic traffic was up l6 percent, the combination of higher costs and lower yields (due to the heavy use of discount fares) caused break-even load factors to rise almost as fast as passenger load factors. There is no question that the proliferation of discount fares contributed to some of the traffic growth, but there are many in the industry who believe that traffic in l978 would have been robust without the discount fares and that, in fact, their bottom lines would have been better with less traffic growth and a higher yield. Although the industry fared well in l978, it is apparent that some of the seeds sown at that time have brought about the problems we are facing today. For the calendar year l979, the U.S. trunks earned $256 million, down 76 percent from l978. The fourth quarter was particularly devastating, with a loss of $l07 million compared with earnings of $66 million for the previous year. Clearly, l979 was an unusual year for the industry and one we hope will not be repeated. The total increase in fuel prices from 40 cents per gallon in the first quarter to approximately 74 cents at the end of the year was staggering. Also, the United Airlines strike and the grounding of the DC-l0 impacted performance. However, the high break-even load factors stimulated by the new regulatory environment heightened the industry's vulnerability to the dramatic escalation in the price of fuel. As you are all aware, the results of the first quarter of l980 show a further deterioration with a domestic trunk loss of $235 million compared with a $37 million profit in the first quarter of l979. Particularly disturbing is the continued escalation of fuel costs for the U.S. carriers; at 93 cents per gallon at the end of the first quarter compared with 74 cents at year end. Total losses for the last quarter of l979 and the first quarter of l980 were the highest in airline history, and it appears that the domestic trunks may experience a significant operating loss for the full year l980, the first such loss since l96l. Losses for the second quarter may exceed $l40 million. Traffic in the first half of the year was down 2.8 percent. Most carriers had hoped that there would be a substantial improvement in traffic in the third quarter that would wipe out or substantially reduce the losses of the first half of the year. However, the severity of the recession is having a devastating impact, with the prospect of far less traffic than normal for the third quarter and a very poor fourth quarter. For the full year traffic may drop 5 to l0 percent, which would be the first year-to-year decline in two decades. During the l974-l975 recession, traffic growth was less than l percent, but at least it was positive. The situation is complicated by the fact that under the new regulatory environment we have excess capacity, and although it is now possible to raise fares to cover increased costs, particularly fuel costs, many carriers are hesitant because of the negative impact on traffic. Also, overcapacity on routes with high traffic density, such as the transcontinental routes, has created an unstable competitive environment that makes price increases difficult to implement since all carriers will not follow. l6

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In consequence, we have very soft traffic, inadequate yields, and increasing costs, which is the formula for substantial losses and which the U.S. carriers are now experiencing and probably will experience for the balance of the year. The regional carriers have fared somewhat better than the domestic trunks under the new regulatory environment. They have been able to drop some unprofitable routes that have been turned over to commuter carriers and enter some trunk markets, successfully utilizing traffic fed from their regional systems. In addition, since a significant percentage of their traffic is business oriented and the trunks have not been interested in competing on the regional's relatively short route segments, their yield has been higher and less susceptible to the proliferation of discount fares. However, even though some of these carriers have done fairly well individually, the regionals as a group report a moderate loss for the first half of l980. Perhaps the most sweeping impact of the present aviation policy of the Carter Administration is on the international carriers serving the United States. Even though foreign carriers are not directly affected by the Airline Deregulation Act of l978, by means of bilateral negotiations, the Civil Aeronautics Board (CAB) is seeking to impose its philosophy of more competition and lower fares on the rest of the world. This has had the effect already of substantially diluting the yields of many international routes. On most routes throughout the world the International Air Transport Association has been able to agree on fuel-related fare increases. However, on routes to the U.S. many of these increases, until recently, were rejected by the CAB, resulting in a far greater lag in adjusting fares to cover increases in the cost of fuel on international routes serving the U.S. than on domestic routes. This has been particularly devastating for U.S. flag carriers. Even though the international carriers serving the U.S. have more upward flexibility under the recent legislation relating to foreign routes, the policy of encouraging more competition and additional capacity on international routes serving the United States will continue to have a depressing impact on yields. The present policy of the CAB has the effect of narrowing the profit margins of the non-U.S. carriers as well as the U.S. international carriers at a time when most governments are pushing their air carriers toward financial independence. The non-U.S. carriers are also experiencing the same scenario; i.e., a softening of traffic, increasing fuel and labor costs, and pressure on yields as indicated earlier. In consequence, the earnings performance of the carriers outside the United States in almost all geographic areas will undergo a substantial deterioration in earnings this year. Looking ahead from the discouraging situation of the present, what do we foresee beyond l980? Although some of the carriers are cutting back in order to more realistically match capacity with travel, others are not. Likewise, although some carriers are working toward using their new flexibility relative to fare increases to increase yield, l7

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others are being more cautious. All carriers are working very hard to cut costs, but, unfortunately, a large percentgage of an airline's costs, particularly fuel, are really outside management's control. Some of the carriers, as they cut back, are selling or grounding some of their older aircraf.t. Fortunately, because of the inflationary environment, there is a market for the more efficient models of the present generation of aircraft. However, some of the less fuel-efficient aircraft have a very small market and it is anticipated that many of these aircraft will be grounded. As we look at the present environment, those carriers with the most efficient cost and capital structure will do much better than the less efficient and more highly leveraged carriers. In fact, some of the stronger carriers are using their new route and flare flexibility to improve their market position vis-a-vis the less efficient airlines. In consequence it can be anticipated that, as we look toward the future in the new deregulated environment, some of the weaker U.S. airlines will be acquired by the stronger carriers. Not only in terms of cost structure and capital structure, but also in terms of route structures, some of the small U.S. domestic trunks will be more vulnerable with respect to survival in the anticipated future environment. As we look at the future all indications are that the economy will improve early in l98l, which should lead to improved traffic growth by the second quarter of next year. Although this anticipated traffic growth will help pull the domestic industry out of the doldrums and improve operating performance, we have to recognize the fact that the l5 percent annual rates of traffic growth we have enjoyed in the past will probably not be with us. In addition, the cost of fuel and labor will continue to escalate, while yields will continue to be under pressure both from the political aspect of consumer pressure and as a possible deterrent to traffic growth. In summary, the outlook for the U.S. airline industry is not all that rosy. The outlook for the non-U.S. carriers is less severe. In the first place, they have a long history, through bilateral agreements, of attempting to match capacity to anticipated traffic growth through capacity control agreements or pooling arrangements. In addition, on scheduled routes the fares are related to cost, with low-cost vacation travel relegated to charter carriers on a plane-load basis. Although, as indicated, the profit margins of foreign airlines have been narrowed due to the U.S. policy of encouraging competition and lower fares on routes to the United States, most non-U.S. carriers operate on routes within their continent where competition is restricted and economic fares are maintained. In addition, traffic on these regional routes is more sustained over time than in the U.S., particularly now when the economies of many countries are not as depressed as that of the United States. In consequence, these carriers can often partially or wholly offset losses on routes to the U.S., whereas American international flag carriers do not have as much flexibility in this regard. In addition, when the chips are down the foreign flag carriers may well receive government support, whereas no l8

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such support is available to the U.S. international carriers. In consequence, the deregulation policy of the United States could hurt U.S. international carriers ,nore than the overseas carriers. In summary, although the foreign carriers will probably have a few lean years as the recession in the U.S. spreads abroad, the regulatory environment in which they operate gives them greater ability to bridge the period to the return of traffic growth than is presently available to the U.S. airlines. The future environment for the industry as a whole of more moderate traffic growth, higher fuel and labor costs, and pressure on yields means that there will be continued pressure on airline earnings, which can only be alleviated by productivity gains resulting from further technological improvement in aircraft design and performance. During the past 20 years the carriers offset cost escalation by the tremendous productivity gains of jet aircraft and more recently the wide-body aircraft, as well as substantial traffic growth as air transportation reached more and more people at reasonable fares. However, in the future the cost picture will be worse. During the past 20 years, except for the last 5, fuel cost escalations were moderate, which is not the case at the present and unlikely in the future. Also, a leveling off of labor cost increases is not anticipated. As indicated, traffic growth will probably be more moderate, thereby limiting airline options in maintaining profitability through improvements in aircraft productivity or increasing of the price of their product. If the productivity gains are not there, then the only alternative is to increase fares, which at some point adversely affects traffic and will eventually halt the steady growth of the air transportation industry and may even lead to some contraction. The big concern of many of us involved in the air transport industry is due to the unfavorable outlook relative to operating costs, especially fuel, and the escalating cost of aircraft. The productivity gains of the new generation of aircraft—that is, the Boeing 757, the 767, and the A-3l0, and other contemplated advanced aircraft—could be eaten up before they are delivered in quantity in the mid-to-late l980s. Clearly, the productivity gains in aircraft performance contempla- ted for the l980s and l990s fall far short of those experienced in the l960s and l970s. This outlook represents a challenge to the aerospace industry. In the economic environment we contemplate over the next 20 years, further technological breakthroughs must be forthcoming in order to have a vibrant, worldwide air transport industry that can serve the public at a reasonable price. As a nontechnical person looking in from the outside, the new generation of aircraft will be most helpful on top of the more up-to-date versions of the present generation of aircraft, particularly the wide bodies, such as the Boeing 747, DC-l0, L-l0ll, and A-300. But, as we look toward the year 2000 and the economic environment that we foresee, the presently contemplated new generation l9

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of aircraft will not be enough to ensure that we will have a viable air transport industry capable of transportating an increasing number of passengers at a reasonable cost. This can only be accomplished by a substantial investment of money and talent by both government and industry in the l980s and l990s, leading to substantial technological breakthroughs that will result in substantial productivity gains in aircraft performance. Assuming that this will be accomplished, it is vital that the air transport industry have access to sufficient capital to modernize and expand its fleets with the most modern and efficient aircraft available in the l980s and beyond. In order to access this capital it is essential that the carriers generate sufficient profits to earn an adequate return on their investments. As indicated, in an environment of continued increases in fuel and labor costs, political pressure on yields, and a lower rate of traffic growth, it is vital that the airlines operate the most cost-efficient aircraft to ensure profitable operations. Failure to achieve sufficient earnings to attract capital for fleet modernization will eventually lead to losses and financial instability as the high-cost environment accelerates the economic obsolescence of older aircraft—aircraft that the airlines cannot replace because of insufficient financial capacity. The end result of such a scenario is less service and higher fares for the traveling public, which would in turn impede traffic growth. The ability to generate earnings is particularly important to the domestic and international carriers in the United States that do not have access to government support. In addition, there is an increasing number of carriers throughout the world that must stand on their own feet and do not have support from their respective governments. Even in the case of government-owned or -supported airlines there has been a distinct trend in recent years toward insisting that their flag carriers attain financial viability. Furthermore, many more government airlines must raise their funds to finance equipment purchases without government guarantees or other support, as was the case in the past. This will allow those governments to divert resources formally expended on their flag airlines to meet other pressing national needs. However, it should be noted that if the international regulatory environment does not create a climate that permits the flag carriers to realize financial independence, they will not be allowed to fail and will receive the support necessary to pursue their equipment programs from their respective governments. In summary, then, it is clearly in everyone's interest that the airline industry maintain a sufficient degree of financial strength and stability to access capital. It might be useful at this point to review briefly where this capital comes from. For the U.S. domestic and international carriers there are three primary sources of funds: commercial banks, the long-term institutional market—primarily insurance companies and the public markets for equity-type securities. These sources are supplemented by long-term leases of aircraft. Banks usually provide revolving credit facilities with full 20

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availability for 2, 3, or 4 years during the period of aircraft delivery, then funding over periods ranging from 6 to 8 years with a normal door-to-door term of l0 years. The commercial banks have been the source of last resort of the U.S. airline industry during past periods of adversity and by and large have stuck with the airlines through thick and thin. However, since bank money is usually limited to a l0-year term at most, it is vital for the industry to have access to the institutional market that could offer terms of l5 to 20 years. With the continuing escalation of the cost of aircraft, the payback period to the airline grows longer and it is most important that the financing more closely matches the useful economic life of the aircraft. In addition, due to the cyclical nature of the industry, cash-flow considerations dictate that a significant portion of a carrier's financing must have a repayment term in excess of that available from commercial banks; hence, the importance of the institutional lenders. With the difficulties experienced by the U.S. industry in the early and mid-l970s, the institutional lenders largely closed their doors to the airlines. Fortunately, during the last several years this group of lenders has returned, but on a somewhat different basis than previously. Instead of lending on an unsecured basis for 20 or even 25 years in some cases, they have limited themselves to l5 to l8 years on a basis whereby they are secured by specific aircraft. This takes the form of an equipment trust financing with the airline or lessor taking a 20 to 30 percent equity position on the aircraft. It is very important to the industry that this class of lenders is not scared away again. The third source of funds is the public market for common stock, preferred stock, and subordinated debt issues. This is a vitally important ingredient because the leverage ratio—that is, the relationship of debt to equity—has an important impact on the ability of a carrier to access senior debt from institutional lendings and commercial banks. Again, during the early and mid-l970s this source was closed to the industry, but in recent years some carriers have been able to raise a modest amount of junior funds from the public market to supplement their retained earnings and reduce leverage. As indicated earlier, a supplemental source of capital is leasing that usually utilizes banks as well as other sources for equity and institutions for long-term debt on a basis similar to an equipment trust issue. These leases usually range from l5 to l9 years. A portion of the benefits of the l0 percent investment tax credit and accelerated depreciation captured by the owner-lessor are passed onto the airline, resulting in a lower equivalent interest cost. However, since the owner-lessor is in a junior position relative to the senior lender he is particularly sensitive to the financial well being of the lessee. In recent years, primarily as the result of competition among airframe and engine manufacturers both in the U.S. and abroad, a significant portion of both senior and junior funds have been secured by the airlines from aircraft and engine suppliers. For most of the airlines of the world other than U.S. carriers, the sources of funds 2l

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are somewhat different. However, some of the techniques developed for the American carriers, particularly those extending the term of financing to meet the useful life of the equipment, are becoming available to non-U.S. carriers. Most aircraft manufactured in the U.S. and sold abroad are financed on a basis involving a participation or guarantee on the part of the Export-Import Bank of the United States. Usually this financing involves a l0 to 20 percent down payment by the airline, which can be financed, with the balance split equally between commercial banks and the Export-Import Bank over a l0-year term with the commercial banks taking the early maturities and the Export-Import Bank the latter maturities. In the case of an Export-Import Bank guarantee, funds are raised through the Private Export Funiing Corporation at market rates for U.S. government guaranteed paper, which Ls somewhat more expensive than the Export-Import Bank's direct lending rate. However, due to an informal agreement between the various countries' export agencies, the Export-Import Bank's financing has been limited to l0 years from delivery, which falls considerably short of the estimated economic life of the new aircraft and today puts a substantial squeeze on cash flow. In consequence, some carriers have utilized the leasing technique or the private placement of long-term debt in order to achieve a l2- to l5-year financing instead of utilizing the Export-Import Bank's financing. In recent /ears, the institutional market has opened up for a number of non-U.S. airlines, which gives them access to term funds originally available only to U.S. carriers. In addition to the above sources of funds, some foreign carriers have secured their funds in the Eurodollar or other foreign currency markets with and without the Export-Import Bank's participation. Most such financing has been limited to a term of l0 years. In connection with aircraft built outside the U.S., particularly the A-300, financing has been secured through the use of guarantees of the export agencies of France, Germany, and more recently the United Kingdom, to finance a very substantial portion of the aircraft. The balance has been raised unguaranteed from the commercial sources. It is hoped that the export agencies of the aircraft manufacturing countries will eventually extend their lending term to l5 years, which is more in line with the useful life of the newer aircraft. In essence, in looking at airlines worldwide, all classes of len- ders are interested in the ability of carriers to generate sufficient cash to pay back their loans over the useful life of the equipment. Also, profits ensure that a larger percentage of requirements can be met from internal cash sources, thereby limiting the amount of debt required. Lenders also want to see a sound capital structure with moderate leverage to gain confidence that the airline can ride through the normal economic cycles that historically have affected airline traffic and earnings. In conclusion, the same sources of capital utilized in the past will be available in the l980s and beyond to assist the airlines in modernizing their fleets as long as they can demonstrate sufficient earnings and cash flow to meet their obligations. However, in our 22

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view this will only be possible if the aviation industry has at its disposal cost-efficient aircraft that will permit them to operate profitably in the anticipated economic environment where costs will be higher, fares tailored to the ability of the public to pay, and traffic growth less robust than in the past. I hope that your deliberations this week will bring us closer to that goal. Thank you very much. 23

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