Airlines in most parts of the world are overcoming the impact of high fuel prices but in North America red ink is the norm.

That cliche about the three most important things in real estate being location, location, location is equally true for the airline industry these days.

If you are a carrier based in Europe or Asia, or you are a new-model airline in Latin America or the Middle East, odds are you're operating in the black in spite of today's record nominal fuel prices. If, on the other hand, you reside in North America, you're probably settling for smaller victories: Reducing the size of the annual loss, keeping CASM flat or near flat in the face of $70 oil, building the cash balance, paying down debt.

ICAO preliminary results for 2005 show that the scheduled airlines of the 189 member states achieved an aggregate operating profit of approximately $4.3 billion last year, up 30% over an operating profit of $3.3 billion in 2004, on a 9% rise in revenues to $413 billion. Passenger revenue growth was particularly strong, rising 11% to $325 billion (see tables, p. 28). But the organization noted that the profit was driven by airlines in Europe, Asia/Pacific, Middle East and Latin America/Caribbean while those in Africa and the US experienced in aggregate an operating loss. ICAO estimated the 2005 world net loss at $3.2 billion, which was narrowed from $5.6 billion in 2004. Figures exclude reorganization costs of US carriers (United Airlines had around $21 billion in mostly noncash reorganization expenses last year).

IATA tells the same story. If the North America region is excluded, carriers in Europe, Asia/Pacific and Middle East earned a combined $3.9 billion while those in Latin America and Africa lost $500 million. Parsing the results further reveals that US carriers operated at breakeven on their international services but lost $6.9 billion in their domestic business, Asia/Pacific airlines earned $2.1 billion and European carriers pocketed $1.6 billion.

A review of the individual airline results contained in the detailed financial table beginning on p. 39 supports the IATA and ICAO estimates. Excluding the fee-per-departure segment of the Regional airline industry, nearly every North American passenger carrier of any size lost money last year, the most notable exceptions being Air Canada, AirTran and Southwest Airlines. The first successfully reorganized under bankruptcy protection and changed its business model (ATW, 4/06, p. 24) while the latter two are low-cost carriers. Being an LCC is no guarantor of profits, however, the prime example being JetBlue, which in 2005 suffered its first annual loss since its Y2K startup year.

Meanwhile, across Asia and Europe, most large network airlines and LCCs were in the black, albeit at widely differing levels of profitability. Aer Lingus, AirAsia, Air China, Air France/KLM, Air New Zealand, ANA, British Airways, Cathay Pacific, China Airlines, easyJet, EVA, Finnair, Iberia, Jet Airways, Korean, Lufthansa, Qantas, Ryanair, SAS, Singapore Airlines, Thai Airways and Virgin Blue are among those that managed to overcome the challenges of soaring fuel prices, rapacious government tax masters and natural disasters to report profits in 2005. In Latin America, Copa, Gol, LAN and TAM were standouts.

The differing outcomes can be explained (or rationalized) in any number of ways, some less obvious than others. Just as US consumers tend to carry personal debt levels that surprise citizens in the rest of the world, US airlines historically tended to make more sporty use of their balance sheets and off-balance-sheet financing than their counterparts elsewhere in order to finance fleet growth that could not be sustained through earnings and operating cash flow. Over time, this has left them more exposed to the economic cycle and temporary disruptions and with notably higher ownership and lease expense than airlines outside the US.

The series of events since 2000 has amplified this situation greatly. According to the Air Transport Assn., US airlines carried approximately $100 billion in debt as of Sept. 30, 2005 (total industry revenues in 2005 were probably around $150 billion). That is up 41% from an estimated $71 billion at the end of 2000. As a result, they must achieve relatively high operating margins (for airlines) to carry anything through to the bottom line. American Airlines parent AMR Corp., for example, paid $957 million in interest expense last year, representing close to 5% of sales.

One certainly can argue that US carriers could have done a better job of managing their debt and cash flow during the seven fat years 1994-2000 so that they were better prepared for the lean years that followed. On the other hand, they have no control over the general economy or currency movements, and the weakness of the dollar over the past few years has left them more exposed to the run-up in oil prices. Airlines that buy fuel in other currencies have not experienced the hit as heavily as those in the US. Also, as IATA DG and CEO Giovanni Bisignani has pointed out, market penetration by LCCs is greater in the US. Using data from OAG, IATA figures that LCCs had a 29% seat share in the US domestic market in January versus 23% in Europe short-haul markets and 5% in Asia. The largest domestic airline in the US in terms of enplanements is Southwest, which carried 88.5 million passengers last year. The nearest competitor, Delta Air Lines, carried 78 million.

Bisignani also has cited the difference in labor costs among the regions, with the US having the highest although the gap has narrowed dramatically owing to the financial restructurings carried out by US carriers. ATA's cost index for the third quarter of 2005 showed unit labor cost for the Major and National passenger airlines was 2.95 cents per ASM, down from 3.99 cents just two years earlier and the lowest figure in 15 years. Labor's share of operating expenses was 24.7%, down from 38% at the same point in 2002.

ACE Aviation Chairman and CEO Robert Milton, who cut his teeth in the US airline industry before moving north in the 1990s, presented a penetrating analysis in a speech to the UK Aviation Club earlier this year. He was contrasting the US and European competitive environments, but he also could have included the Asia/Pacific region: "Despite the low-cost invasion now present on both sides of the Atlantic, there are some important differences to the challenges faced by airlines in Europe and North America. Most European legacy airlines have longstanding and expansive international route networks and operate out of well-established hub airports. To a degree, these international networks and hubs at airports like [London] Heathrow and Paris Charles de Gaulle have proven to be an effective insulator against the advent of low-cost competition, economic pressures and high oil prices. While intra-Europe business may be a cutthroat nightmare, international long-haul revenues can still help mitigate the low-cost revolution.

"In North America, there's no place to hide. The financial bloodbath has been mostly on the domestic stage. No US carrier has the advantage of operating in an airport hub environment such as Heathrowthe greatest airport franchise in the world and a major contributor to British Airways' ability to continue holding its own despite the aggressive assaults of Ryanair and other carriers in their intra-Europe market."

US airlines' strategy in light of these challenges has been twofold: Bring costs down to a level at which they can compete with the homegrown LCCs, and expand internationally, where with the exception of a few pockets, low-fare competition does not really exist. Alas, their success in lowering costs, through the Chapter 11 process or outside bankruptcy as in the case of American and Continental, has been overwhelmed by fuel prices.

Elsewhere, of course, carriers have mitigated much of the impact of higher fuel prices through fare surcharges (Ryanair excepted). US airlines by and large did not follow this path until Hurricanes Katrina and Rita and the mid-September bankruptcies of Delta and Northwest created a situation in which they had no choice but to raise fareselasticity be damnedwhile Delta and NWA now could legally stop paying rent on aircraft they could not afford to fly. The resulting domestic capacity reductions by these two as well as US Airways, and the disappearance of Independence Air, permitted US carriers to regain some pricing power (ATW, 6/06, p. 56). Through mid-June they had raised fares at least 10 times in 2006, according to JP Morgan. Second-quarter results will give a better indication, but it is certainly within the realm of possibility that excluding reorganization costs, the US industry will post its first annual operating profit since 2000, although ATA estimates the net after-tax loss will top $2 billion.

To acknowledge the specific challenges facing US carriers is not to slight the strong performance of leading airlines in other parts of the world in containing and even rolling back costs. For example, IATA estimates that Europe's airlines have improved labor utilization 54% since 1996 and become 21% more efficient in the use of fuel. But IATA data also show that the cost advantage enjoyed by LCCs on intra-EU markets actually is increasingexactly the opposite of what is happening in North America. Ryanair had a 52% unit cost advantage on 800-km. segments in 1997 and this had risen to 67% in 2004. Over the same period, easyJet's advantage grew from 38% to 42%.

Asia/Pacific carriers, which on the whole have tended to be the industry's lowest-cost producers, continue to emphasize cost control, particularly with the rise of LCCs, although the latter still play a very small role in that region. However, these airlines are less hedged than are those in Europe, according to IATA, and so will face increased cost pressure this year.

Both European and Asia/Pacific network carriers face a new type of competitor in the rise of Emirates, which is one of the industry's most profitable airlines and has an expansive appetite for the very-long-haul sixth freedom services that heretofore have been relatively free of low-cost competition (ATW, 1/06, p. 44). As Milton noted in his speech, "Who would have thought that Emirates with a home market of just 4 million people could become a major player in the international aviation market out of the UK and Europe?"

On a macro level, IATA projects that nonfuel costs fell 4.4% in 2005 and expects a further 3.5% reduction this year, which translates into more than $11 billion in savings to the industry. According to ICAO, the increase in costs last year was limited to just 4% on a 5% lift in traffic combined with a 4% rise in yield.

Technology, properly applied, is a major contributor to cost savings and IATA has made it the cornerstone of its Simplifying the Business campaign intended to recover $6.5 billion annually when fully implemented. The organization's flagship goal is 100% e-ticketing by the end of 2007 and it also is pushing for widespread introduction of airport check-in kiosks, barcode boarding pass scanners and the transition to "e-freight."

Nevertheless, cost-cutting is not the main reason for the comparative well-being of airlines outside North America. "The recent financial performance of the industry has been in large part supported by the unusual strength of revenues, which in the past three years averaged 10% annual growth," IATA Chief Economist Brian Pearce noted at last month's AGM in Paris. "Usually, industry revenues grow by 5%, as traffic growth of 6%-7% is coupled with a 1%-2% decline in yields," he explained. IATA expects passenger traffic to rise 6.7% this year while yields increase 1.6%.

Still, as he pointed out, it would be a mistake to believe that "exceptional revenue growth [will] persist indefinitely." This is particularly so given that the world's airlines have been on a buying spree of late, having ordered more than 2,000 aircraft in 2005 (ATW, 3/06, p. 22) and added more than 500 in the first half of 2006. As Bisignani noted at the AGM, "Sometimes we have been our own worst enemychasing growth instead of profitability." Record aircraft orders "could be our Achilles Heel if we stop managing capacity carefully." It will be a significant challenge, but one that must be managed if airlines are to make money with $70/barrel oil. (ATW's World Airline Report continues on page 37.)

ATW's World Airline Report is a combined effort of the ATW staff led by Editorial Director & Editor-in-Chief Perry Flint and Managing Editor Kathryn Young. Contributing to the report were Sandra Arnoult, Cathy Buyck, Danna Henderson, Aaron Karp, Brian Straus and Geoffrey Thomas. Fleet data beginning on p. 102 are from Airclaims. Special thanks to Brian Elliott who prepared the financial and traffic tables beginning on p. 39.