The Economic Implications of the O Hare Modernization Program

Transcription

1 The Economic Implications of the O Hare Modernization Program May 2004 Jon F. Ash, Managing Director Global Aviation Associates, Ltd. (ga 2 ) 1800 K Street, NW Suite 1104 Washington, DC

2 Table of Contents LIST OF CHARTS... I i LIST OF TABLES... II ii EXECUTIVE SUMMARY: O HARE MODERNIZATION PROGRAM (OMP)... 1 ES 1.0 BACKGROUND... 2 ES 2.0 OBJECTIVES OF THE STUDY... 3 ES 3.0 SUMMARY CONCLUSIONS... 3 ES 3.1 Project Capital Cost...4 ES 3.2 Financing Plan...5 ES 3.3 Economics Of The Project...7 ES 3.4 Economic Impact Of The OMP...11 SECTION I. INDUSTRY IN TRANSITION... 2 I.1.0 INTRODUCTION... 2 I.1.1 Strategic & Structural Change...4 I.1.2 The Current Airline Industry Crisis...5 I.1.3 Declining Major Airline Market Share...6 I.2.0 LONG TERM PROBLEM... 7 I.2.1 Marginal Profitability...7 I.2.2 Contributing Factors...8 I.2.3 Local Versus Connect Traffic...8 I.2.4 Air Fare Trends...9 I.2.5 Taxes And Fees...11 I.2.6 Labor Cost And Productivity...12 I.3.0 THE FUTURE I.3.1 Economic Recovery...13 I.3.2 Yield Decline...14 I.3.3 Airport Congestion...14 SECTION II. THE O HARE CARRIERS II.1.0 RECENT TRENDS II.1.1 Airport Costs...19 II.2.0 O HARE CARRIERS CANNOT AFFORD COST INCREASES Global Aviation Associates, Ltd.

3 SECTION III. OMP IMPACTS III.1.0 BACKGROUND III.2.0 FINANCING PLAN III.2.1 AIP Program...29 III.2.2 PFC Financing...30 III.2.3 GENERAL AIRPORT REVENUE BONDS (GARBs)...30 III.2.4 THIRD PARTY FINANCING...30 III.3.0 ECONOMICS OF THE PROJECT III.4.0 CITY ESTIMATES OF THE ECONOMICS ARE FLAWED III.4.1 The City Claims OMP Would Cost Only $6.6 Billion...35 III.4.2 The City Claims OMP Would Increase Passenger Traffic By 42% To 46.5 Million Enplanements Between 2003 And III.4.3 The City Claims that Non-Airline Revenue Will Increase By 7.7% Per Annum Between 2003 And III.4.4 The OMP Seemingly Fails To Consider The World Gateway Program (WGP)...37 III.4.5 The OMP Has No Contingency For Capital Cost Overruns...37 III.4.6 The OMP Assumes That The PFC Will Increase By $1.50 Per Enplaned Passenger From The Current Legal Maximum of $4.50 To $ SECTION IV: REPORTED ECONOMIC IMPACT OF O HARE IV.1.0 SUMMARY AND DISCUSSION IV.2.0 ECONOMIC IMPACT OF CHICAGO O HARE AIRPORT IV.2.1 Airport And Tenants...44 IV.2.2 Chicago Visitors...44 IV.2.3 Access-Sensitive Impact...45 IV.3.0 ECONOMIC IMPACT OF THE OMP IV.3.1 The Future Economic Impacts Depend On Traffic Growth...46 IV.3.2 Economic Impact Gains Will Occur Without OMP...47 IV.3.3 Economies Of Scale...49 IV.3.4 Airport And Tenants...49 IV.3.5 Chicago Visitors...50 IV.3.6 Access Sensitive Impact...50 IV.4.0 COMPARISON WITH OTHER NORTH AMERICAN AIRPORTS IV.5.0 ALTERNATIVE ECONOMIC IMPACT ESTIMATE IV.5.1 Incremental Economic Impact without OMP...55 IV.5.2 Incremental Economic Impact of the OMP...57 IV.5.2 Economic Impact Generated by the OMP...58 LIST OF APPENDICES Global Aviation Associates, Ltd.

4 LIST OF CHARTS Number Description Page 1 Traffic Controlled by Top 20 Carriers 2 2 Distribution of U.S. Passenger Enplanements 7 3 Net Profit Margins 8 4 U.S. Domestic Yields 10 5 U.S. Domestic Passenger Enplanements 10 6 Burden of Fees & Taxes on Air Travel 11 7 Southwest vs. Major Carriers 12 8 Domestic RPM Changes and Revisions 13 9 O Hare Market Shares LCC Impact on O Hare Pricing Large Hub Cost/Enplaned Passenger Comparative Fees/Enplaned Passenger Total Annual Economic Impact Airport & Tenant Economic Impacts 54 Global Aviation Associates, Ltd. i

5 LIST OF TABLES Number Description Page 1 U.S. Carrier Earnings History 3 2 Domestic Hub Yields 9 3 U.S. Economic Growth Forecast 14 4 O Hare Capacity and Traffic Mix 21 5 United and American Financial Performance 22 6 United Leverage 23 7 American Leverage 25 8 O Hare Activity and Cost Forecast 33 9 Projected O Hare Airline Cost/Enplaned Passenger Projected OMP Cost Structure Transportation Cost Overruns ga 2 Adjusted Forecast of OMP Base Data Annual Economic Impact of Chicago O Hare Airport Incremental Economic Impact Generated by Additional Passenger Traffic Revised Incremental Economic Impact Revised Air Traffic Forecast Incremental Economic Impact without OMP Air Traffic Forecasts Following the OMP Incremental Economic Impact with OMP Economic Impact Generated by the OMP 59 Global Aviation Associates, Ltd. ii

6 Executive Summary Global Aviation Associates, Ltd. ES-1

7 EXECUTIVE SUMMARY: O HARE MODERNIZATION PROGRAM (OMP) ES 1.0 BACKGROUND The City of Chicago currently operates two very successful commercial airports O Hare and Midway. O Hare and Midway today support a Metropolitan Statistical Area (MSA) with an 8.5 million population base generating over $92.2 billion in annual retail sales. The area airports are a platform for increased trade and development, and generate substantial job creation and economic growth. There is general agreement that demand growth for commercial aviation in the Chicago metropolitan area will exceed the existing capacity of both Midway and O Hare if new airport facilities are not built either at O Hare or Midway or at a new airport in the region. The demand growth at the existing O Hare and existing Midway has been a contributing (though not the sole) factor in substantial delays that have been experienced at both airports. The City of Chicago has not presented any plan to increase Midway s capacity. Chicago has, however, put forward a plan called the O Hare Modernization Plan or OMP which Chicago says will significantly increase capacity at O Hare and will significantly reduce delays. Chicago has publicly released a number of documents containing its assertions as to the benefits of the OMP. According to Chicago, the OMP will: Allow O Hare to grow from a current passenger traffic level of approximately 34 million boarding passengers (called enplanements ) to 57 million enplanements by Allow O Hare s current aircraft operational throughput to grow from 900,000 operations per year to 1.6 million operations per year. Reduce overall delays by 79%. Produce 195,000 new jobs and contribute an additional billion dollars to the regional economy. Cost $6.6 billion dollars which the City claims can be financed with a combination of federal grant Airport Improvement Program ( AIP ) funds, federally authorized Passenger Facility Charges ( PFCs), and airline backed General Airport Revenue Bonds. Global Aviation Associates, Ltd. ES-2

8 ES 2.0 OBJECTIVES OF THE STUDY The communities of Bensenville and Elk Grove Village retained Global Aviation Associates, Ltd. (ga 2 ), to assess the OMP, related documents, and public releases by the City in order to determine the potential economic impact of the OMP on major stakeholders such as O Hare International Airport (ORD), airlines generally, ORD hub carriers United Airlines and American Airlines specifically, consumers, and the community at large. This includes examining the assumptions underlying the forecast demand and capacity growth contained in the O Hare Master Plan, the expected financing sources for the project, the likely capability of the airlines (particularly United and American) to support the financing, and the economic impacts attributed to the OMP by the City. ga 2 was also asked to examine the impact on airline costs and airfares should the OMP be implemented as set forth by the City. Finally, we were asked to evaluate the program in the context of the airline environment as it exists today, and as it is likely to look in 2012 and 2013 when the OMP is to be substantially completed. ES 3.0 SUMMARY CONCLUSIONS The study s primary conclusions as outlined below and in more detail in the body of this study are: 1. The U.S. air carrier industry is in serious economic turmoil, and under extreme pressure to control costs. 2. O Hare hub carriers United and American are unlikely to support the OMP as now structured because its $15 billion capital cost will produce only modest incremental traffic, thus making the per passenger cost untenable in the current competitive environment. 3. To finance the OMP will be a serious challenge, even if United and American support it. Both carriers balance sheets need repair and even American s unsecured debt is rated below investment grade. 4. The OMP, if implemented, would drive the 2012 unit cost per passenger from today s level of about $9 to over $26, a nearly 200% increase. It would also increase the carriers airport cost/revenue ratio from 5.4% to over 13%, a level that would normally be viewed as unacceptable. 5. The economic benefits attributed to the OMP are seriously exaggerated. The City ascribes to the OMP an additional $18 billion in economic output and an incremental 195,000 additional jobs. The City s claimed economic benefits attributable to the OMP are unrealistic. First, Chicago s claimed benefits are overstated because they assume that airspace capacity, and therefore traffic growth, is and will be unconstrained. Second, the City s benefits are based on faulty economic multipliers and erroneously ascribe all forecast growth to the OMP. Third, Global Aviation Associates, Ltd. ES-3

9 airline costs would increase substantially (to over $26 per enplaned passenger) in order to pay for the investment, causing air carriers to increase airfares to the local Chicago air traveler. Given the elasticity of demand, certain traffic will opt to not travel, or to use alternative means and modes of transportation. This could well dampen travel, tourism, and investment, and result in losses to the region in terms of businesses, jobs and tax revenues, among other adverse economic impacts. Under the most optimistic of circumstances (i.e. assuming unconstrained operations and traffic growth), Chicago has overstated the economic impact benefits by at least 150%. The frame of reference and detailed background and supporting information for the above summary conclusions is set forth below. It is important to note that our examination of all available public documents, including the OMP filed with the FAA in early 2004, the LOI document from Thomas Walker and Rosemarie Andolino filed with the FAA on March 1, 2004, and OMP documents available on the O Hare International Airport OMP website, among others, suggest serious deficiencies in the transparency and consistency of information. Equally important, there is a lack of specificity with respect to a number of critical issues addressed in the Master Plan and OMP, thus leaving open serious questions relative to the Plan s viability as currently constructed. Consequently, we have worked with the information available, and have relied to the maximum extent possible on the information and data provided by the City, notwithstanding its limitations. These deficiencies, discrepancies, or contradictions in data and information are set forth below, along with further explanation of our conclusions. ES 3.1 Project Capital Cost It is clear from different documents filed in various versions of the Master Plan that the full capital cost of the OMP is not being dealt with in a fully transparent manner. Although the City claims the cost of the OMP will be $6.6 billion, our research and analysis indicate that the cost will be closer to $15 billion. For example, the OMP cost of $6.6 billion is a 2001 capital cost, while the World Gateway Program (WGP) cost is a 1999 capital cost as shown in Appendices 5 and 6. While nominal costs may have been utilized to arrive at the total annual airline burden of $938,005,000 in 2012, there is no documentation available to support these numbers. As shown in Table ES-1 the annual airline burden will be higher according to our estimates. Global Aviation Associates, Ltd. ES-4

10 Table ES - 1 ga 2 Adjusted Forecast of OMP Base Data 2012 Cost ($000) Passengers (000) Cost/Passenger Airline Data Per City 1/ $938,005 46,450 $20.19 Retail Adjustment 2/ From: 7.2 % per Annum $82,984 To: 3.0% per Annum Passenger Growth 3/ From: 4.0 % per Annum (5,283) To: 2.6% per Annum Absence of $6.00 PFC 4/ ($4.50 in place) $63,000 Adjusted Cost/Passenger $1,083,989 41,167 $26.33 Percent G/(L) than OMP 15.6% (11.4%) 30.4% 1/ City estimate per O Hare Master Plan Table V11-9 2/ Retail adjustment to reflect historical growth 3/ Passenger growth to reflect historical trend 4/ Assuming no increase in PFC Based on information that is available, we have developed an estimate of the full capital cost estimate in nominal dollars, using very conservative (i.e., favorable to the City) assumptions. That cost, $14.7 billion, with attendant cash flows is outlined in Appendix 9. This estimate includes only three components, OMP, WGP, and a 25% contingency based on recent experience in transportation infrastructure project cost overruns. (See Chapter IV, Table 10). Questions relative to the transparency and adequacy of the capital investment cost estimates are being raised by others. A March 1, 2004, article in Crain s Chicago Business stated With the full $15 billion price tag for Chicago s plan to expand O Hare International Airport coming into focus, questions are emerging about how the city will pay for the costliest public works project in its history. And further, Can the city squeeze 42% more passengers into the airport by 2012, and nearly 76% more by ES 3.2 Financing Plan The Plan to finance the expansion, as set forth in the various Master Plan and OMP documents is seriously flawed for several reasons. First, the federal Airport Improvement Program (AIP) is presumed to fund significant portions of the OMP. The City, however, is requesting $30 million per year for ten years from the AIP, which will produce only $300 million, or 2% of the $15 billion required. Global Aviation Associates, Ltd. ES-5

11 Second, the City assumes that the current Passenger Facility Charge (PFC) of $4.50 will be raised to $6.00 by The airlines appropriately view these types of charges either as another tax, or as an increase in their ticket price, and consequently will vigorously oppose any changes. Given the difficult environment faced by airlines, their opposition to anything that increases prices, and the sympathy in Congress for the plight of the carriers, it is unlikely that any increase could be expected. Since the $1.50 increase assumed by the City would have generated roughly $63 million per annum, that amount becomes an additional burden the O Hare carriers will have absorb as shown in Table ES-1. Third, General Airport Revenue Bonds (GARBs) are expected to be a considerable source of financing, according to the OMP. The Master Plan stipulates that GARBs will finance 59%, 54%, and 58% respectively of the OMP Capital Improvement Program (CIP) and WGP. In light of United s bankruptcy, and related rejection of airport lease agreements, there is a question as to how much and at what levels GARBs could be issued. As the Master Plan notes, the issuance of GARBs is subject to Airport Use and Lease Agreements which must be approved by the carriers. This, of course, raises the question as to whether the principal carriers, United and American, let alone the others operating at O Hare will have the inclination or the wherewithal to support this program. Fourth, Third Party Financing is forecast to cover 10% of the OMP and 22% of the WGP (OMP Table VII-5, pg. VII-28). A recent Reuters release dated February 6, 2004, reads, in part, as follows: Special facility revenue bonds backed solely by an airline will no longer be used to finance large airport facilities in Chicago after defaults on outstanding bonds soured investors against them, city airport officials said on Friday. Thomas Walker, Chicago s aviation commissioner, said investors were not likely to buy any of those bonds, particularly in the wake of defaults like those by United Airlines when it filed for bankruptcy protection in December Separately, Fitch Ratings, according to Chicago Business Wire on March 31, 2004, believes that yesterday s court decisions in the United Airlines bankruptcy proceeding regarding the treatment of the carrier s special facility bonds sets a troubling precedent which may weaken security provisions behind certain municipal lease-backed, bonds,.. Thus, not only is the project cost apparently well beyond what has been stated by the City, but the underlying plan to finance the project is questionable. Global Aviation Associates, Ltd. ES-6

12 ES 3.3 Economics Of The Project An initial underlying issue is whether or not the primary air carriers operating at O Hare, and particularly United and American, are inclined to, or capable of supporting the financing of the OMP. Today, the airline industry is in the midst of a massive restructuring in response to a myriad of events that have occurred over the past three years. Air carrier losses, selected bankruptcies, and structural changes are evolving in response to: 1. A recession that began to impact the industry in early The impact of 9-11 on the propensity of the public to travel. 3. Traffic declines resulting from the Iraq War and Severe Acute Respiratory Syndrome (SARS). 4. Increasing damage being inflicted by rising fuel prices. 5. Losses from 2001 through 2004 that will exceed $25 billion. 6. The successful incursion into markets formerly dominated by the Legacy Network Carriers (LNCs) by the Low Cost Carriers (LCCs) represented by Southwest, jetblue, AirTran, ATA, Frontier, America West, and Spirit. 7. A significant shift in the airline distribution system, resulting from increasing Internet use to purchase travel, and the concomitant increase in the transparency of airfares for both leisure and corporate travelers. These factors have produced the largest industry losses ever experienced. Table ES-2 shows the actual and expected losses for airlines over the period 2001 through Table ES - 2 Major U.S. Passenger Carrier Earnings History $ Billions E 2004E Revenue $92.2 $78.9 $71.0 $71.7 $79.1 Operating Income 5.4 (8.3) (9.5) (5.8) (0.7) Net Income 2.3 (7.5) (11.2) (6.3) (3.0) Yield ( ) Unit Cost ( ) Load Factor (%) Note: Data excludes American Trans Air and American Eagle Source: The Airline Monitor Global Aviation Associates, Ltd. ES-7

13 These losses, experienced principally by the major LNCs and resulting from the events described above, produced heretofore unheard of increases in unit costs, a reduction in the average fare paid by the consumer, and thus breakeven load factors (the percentage of seats that must be filled to produce a financial breakeven) close to 90%. While attempting to deal with this unprecedented economic environment, the LNCs found themselves having to increasingly compete with LCCs that could produce the same basic commodity, a seat, at a cost of at least 25% less than it cost the major carrier to produce the same seat. Within this environment, United Airlines and U.S. Airways were forced to file for protection under Chapter 11 of the Bankruptcy Code. American Airlines narrowly escaped the same path through a last minute agreement with its labor unions. This industry environment, which the major LNCs are attempting to deal with, is the framework within which the OMP must be evaluated. Because of the economic turmoil and strategic restructuring in the airline industry, it is unlikely that the airlines will support a $15 billion program, which they will have to pay for through increased costs, and ultimately increased fares. Raising fares in the current or future competitive environment will be difficult for the O Hare LNCs. As noted below, Chart ES-1, the rapid growth of the LCCs at Midway (MDW), stated in percentage of Chicago area available seat miles (ASMs) has been a significant factor in driving the average fare at O Hare down by 21% between 1999 and 2003 (Appendix 2). Chart ES - 1 Impact of MDW LCCs on ORD Fares 24% $200 MDW LCC % of Chicago ASMs MDW LCC % ASMs 22% 20% 18% 16% 14% 12% Avg. Domestic Ticket Price LCC % ASMs $180 $160 $140 $120 $100 $80 $60 $40 $20 Average Domestic Ticket Price Average Domestic Ticket Price 10% $- Note: 2003 Average Domestic Ticket Price is YE 2Q 2003 Global Aviation Associates, Ltd. ES-8

14 Consequently, the O Hare air carriers are going to be reluctant to support an investment of $15 billion, unless it produces both a significant increase in airport capacity, and a total cost per passenger that allows them to continue to compete with the LCCs at Midway. Table ES-4 below, O Hare Activity and Cost Forecast, displays the likely 2012 economics of the OMP. Under this scenario, aircraft operations at O Hare would increase by roughly 15%, and the cost per enplanement would increase by 185%, from $9.24 today to $26.33 in In the context of the highly competitive environment, MDW s cost per enplanement today is $5.39, and there is little likelihood that it will increase substantially over the next ten years since the MDW carriers are continuing to grow enplanements, despite capacity limitations. Table ES - 4 O Hare Activity and Cost Forecast 2012 G/(L) Amt. % Enplanements (000) 1/ 32,628 41,167 8, Passenger A/C Departures 2/ 425, ,220 62, Enplaned/ DPTR On-board/DPTR Seats/ DPTR Load Factor 74.4% 77.8% 3.4 pts Average Ticket Price $ $ $ Cost/Enplanement $9.24 $26.33 $ Cost/Revenue Ratio 5.4% 13.4% 8.0 pts 1/ Assumes 10% growth in seats/departure and 15% growth in passengers/departure 2/ Departures are forecast to growth to almost 15%, the amount by which all activity could grow assuming that 1.1 million departures per year is feasible. The City estimates that in 2012 the airlines will have to support a total cost of $938,005,000 per annum, and that that annual cost will support 46,450,000 annual enplanements (Table ES-1). Under these assumptions, the cost per passenger enplaned to the airlines will average $20.19, according to the City. We believe that this forecast of costs and enplanements is not realistic. For Global Aviation Associates, Ltd. ES-9

15 example, there are serious airspace capacity limitations that will impede traffic growth, regardless of runway configurations (See JDA Technology Solutions letter to Messrs. Cooper and Smithmeyer (FAA), dated January 16, 2004). In order to produce a more realistic estimate of future costs, we have made three adjustments to the City s forecast: 1. Reduced retail revenue growth to 3% per annum, more consistent with likely traffic growth 2. Reduced traffic growth to 2.6% per annum, from 4% per annum to be more consistent with likely average growth, given the capacity constraints, and 3. Eliminated the $1.50 increase in PFC charges These minor adjustments raise the annual cost burden to $1.1 billion, reduce 2012 enplanements to 41.2 million, and increase the cost/enplanement by 30% to $ The capital cost of the program, and relatively modest incremental benefit in terms of capacity, raise serious questions as to the viability of the program: 1. When the carriers examine the cost of the project, and the return in terms of truly incremental capacity added, we believe they are likely to look for more reasonable and less expensive alternatives for capacity enhancement. 2. The City is going to be seriously challenged to finance a project of this scope, particularly given the creditworthiness of the carriers that would have to back the financing. 3. The City either overtly, or implicitly, ascribed all of the forecast growth at O Hare to the OMP. It should ascribe only that portion of the growth that would be incrementally facilitated by the OMP investment. The ga 2 forecast suggests that it is not unrealistic to expect a 26.2% increase in traffic at O Hare between 2003 and 2012 as a result of the OMP; however, an increase in seats per departure (which is unrelated to the OMP) could produce more than 1/3 of the 26.2% growth. Additional growth in local demand can be accommodated through greater availability of aircraft capacity for local traffic and a commensurate shift of through (connecting) traffic to other hubs. Thus, a significant portion of the 26% increase can be attained without the OMP. 4. The City has not provided a Benefit-Cost Analysis to support the LOI filing of March 1, In summary, It is clear that there needs to be more capacity in the Chicago area; however, it is also clear that financing the project will be challenging, and if financed, the OMP would significantly raise the cost per passenger to the airlines, both in an absolute sense and relative to the revenue generated, a key Global Aviation Associates, Ltd. ES-10

16 benchmark for airline cost control. Additionally, we estimate that a significant portion of the of the 26% increase in traffic that we forecast for the year 2012 can be secured at no cost through an increase in the average number of seats per departure to pre 9-11 levels. ES 3.4 Economic Impact Of The OMP The estimates of economic impact and job creation attributable to the OMP by the City are excessive. In fact, because of factors set forth in detail in this study, it could well be that the OMP, if implemented, would result in negative economic impacts. That situation could be driven by the combination of the massive cost of the project, modest incremental capacity produced, the higher fares that would have to be charged to the local point to point traffic to pay for the OMP, and the local businesses and related jobs that would be lost. The City s Economic Impact Study suggests the following (Table ES-5): Table ES - 5 Annual Economic Impact of Chicago O Hare Airport (BAH-2000) Economic Impact Driver Employment (Thousands) Income ($Billions) Economic Output ($Billions) Airports and Tenants 130 $4 $14 Chicago Visitors 170 $4 $11 Access-Sensitive Impact $3-5 $9-16 Total Economic Impact $10-13 $34-41 Source: Update of a Study on the Economic Impact of Chicago s Airports, July 24, 2001, by Booz Allen Hamilton Thus, according to the City, O Hare generates $34-$41 billion in annual economic output, and thousand jobs. In addition, the City claims that the OMP will generate an incremental 195 thousand jobs and another $18 billion in Economic Output ( This City s forecast unrealistically assumes no constraints on O Hare s ability to achieve maximum airport operations and is based on a projection of 1.6 million annual operations. See, A Proposal for The Future of O Hare issued by the City of Chicago. While we do not have access to the City s detailed assumptions, and therefore cannot isolate the drivers of this presumed substantial economic benefit, it is clear that given airspace Global Aviation Associates, Ltd. ES-11

17 constraints and other factors, there are limits to the number of operations that can be handled at O Hare, and therefore limits to the economic value that can be generated from the OMP. At best, the economic value is well below what is being claimed by the City, but the economic impact may well be negative due to to loss of jobs, businesses, and future investment resulting from the higher fares the airlines would have to charge in order to offset the increased airport costs that they would have to pay to fund the investment. Under the most optimistic circumstances (assuming unconstrained operations and traffic growth) the City estimates overstate the OMP benefits by roughly 150%. Both the base case numbers and the incremental value imputed to the OMP reflect extremely aggressive forecasting. That is, the real benefit that could be ascribed to the OMP might be 40% of that projected by the City BEFORE offsets related to lost economic value related to lost future investment (and jobs and economic value) in the region due to higher air fares. There are numerous aggressive assumptions underlying the City forecast, and two which, on the surface, are patently unreasonable. First, the prediction of economic impact gains from the OMP is presumably based on the idea that without the OMP, growth in air traffic at O Hare would stagnate. That is, the economic impact gain from the OMP is relative to a do nothing scenario where no additional capacity is developed (again, no details are available to determine the assumptions made in the economic impact estimates). However, attributing all economic gains to the OMP is not realistic for a number of previously noted reasons. Substantial economic impact would occur even without the OMP. Second, our analysis determined that the incremental economic impact estimates in the City s study fail to account for any significant economies of scale. Economies of scale refers to the situation where the cost of producing one unit of a good or service decreases as the volume of production increases. Intuitively, this would seem to be case for the aviation industry. In the case of an airport, the cost of processing and servicing one additional passenger is lower than the average cost of servicing the existing passengers. The infrastructure and staff are already in place so there are fewer resources required to process that additional passenger. If the cost is lower, so is the economic impact. We also examined economic impact studies for 18 airports (excluding O Hare), and the results can best be described in Chart ES-2 below. Global Aviation Associates, Ltd. ES-12

18 Chart ES - 2 Total Annual Economic Impact (Jobs) Versus Annual Enplaned Passengers 500 Employment Economic Impact (Thousands) Source: YYC OAK BWI SJC IAD MCI DCA BNA YVR LGA JFK MIA YYZ SEA SFO O'Hare: 35.7 million passengers 440,000 jobs Atlanta: 38.3 million passengers 330,800 jobs YEG Enplaned Passengers (Millions) Economic Impact and passenger figures provided by the airports. Impacts include direct and multiplier impacts. Trend line based on all observations except O Hare DFW ORD ATL The job creation numbers for O Hare, at roughly 440,000, are substantially above those for any other airport, and even 33% higher than for Atlanta, despite Atlanta being a larger airport. After adjusting for the two faulty assumptions listed above, and in recognition of the benchmarks provided by other airports, we have estimated the incremental impact of the OMP as follows, compared to the City s original estimate. ga 2 % G/(L) PARAMETER CITY FORECAST ga 2 FORECAST than City ECONOMIC OUTPUT $18.0 $7.3 (60)% ($billions) JOB GROWTH 195,000 69,000 (65)% The estimates of the economic impact and job creation attributable to the OMP by the City are clearly excessive. Moreover, should the OMP be developed as Global Aviation Associates, Ltd. ES-13

19 envisioned, it is not inconceivable that it could result in negative economic growth. Even if all of Chicago s most optimistic assumptions proved out (an unlikely scenario) the economic benefits claimed by Chicago would not produce the size of the benefits claimed. Our analysis suggests that less than half of the benefits claimed, even if all of Chicago s assumptions proved true. But it is much more likely that the high cost of the OMP will curb aviation growth and the jobs and economic benefits associated with such growth. The high cost per passenger at O Hare with the OMP will force the major carriers to increase their fares to cover the cost. To compete with other hubs for connecting passengers, the O Hare carriers will likely pass on this high unit cost primarily to the Chicago based traveler leading to slower, if not negative growth at O Hare due to elasticity of demand and other low cost carrier alternatives at Midway. The high-cost O Hare operating environment created by the OMP will put further stress on the ability of United and American (the principal O Hare carriers) to compete effectively with low-cost carriers in today s highly competitive environment. -- END -- Global Aviation Associates, Ltd. ES-14

20 Section I Global Aviation Associates, Ltd. 1

21 SECTION I. INDUSTRY IN TRANSITION I.1.0 INTRODUCTION In October 1978, then President Jimmy Carter signed the Airline Deregulation Act of This change in the historical regulatory environment governing commercial aviation changed the face of the competitive landscape forever. However, it was not until the early 1990 s, and then more prominently in the post 9/11 environment that it became evident that the Low Cost Carriers (LCCs) would begin to shape the U.S. marketplace and in particular, drive the historical pricing models of the major legacy carriers to relative obscurity. During the late 1970 s and early 1980 s it was evident that numerous existing carriers and new start-up carriers believed that they could drive the marketplace as long as they could control costs, and thereby, pricing. This proved to be erroneous, at least for a number of years to come. In the recession of the early 1980 s, as evidenced in Chart 1, there was a significant increase in the number of bankruptcies, and thus evolved a higher level of concentration than the proponents of deregulation would have predicted. Chart 1 RPM Share (%) Deregulation Top 20 Airlines Share of World RPMs Domestic Consolidation International Consolidation 4 Alliances = 63% 50 Proliferation Source: Boeing, ga 2 Global Aviation Associates, Ltd. 2

22 Again in the mid-to-late 1980 s there was a re-growth of new entry into the market, with an accompanying decrease in the level of market concentration. However, once again an early 1990 s recession led to substantial industry losses, a Presidential Commission to examine the health of the industry, and numerous calls for subsidy to the industry. Industry losses were once again at an all time high, erasing all of the earnings that had been produced since the Wright Brothers first flight at Kitty Hawk. By the mid-1990 s, the economic cycle once again turned up, and there was a strong recovery through the year This recovery also produced a growing level of concentration and the development of LNC alliances. While these alliances were not entirely new, they evolved to a more sophisticated state by the end of the decade of the 90 s. Table 1 Major U.S. Passenger Carrier Earnings History $ Billions E 2004E Revenue $92.2 $78.9 $71.0 $71.7 $79.1 Operating Income 5.4 (8.3) (9.5) (5.8) (0.7) Net Income 2.3 (7.5) (11.2) (6.3) (3.0) Yield ( ) Unit Cost ( ) Load Factor (%) Note: Data excludes American Trans Air and American Eagle Source: The Airline Monitor This growth in earnings led to relatively aggressive forecasts for future traffic and profitability. Following historical patterns, the air carriers responded by placing large orders for new aircraft at the end of the 1990 s just as the cycle was about to once again reverse itself. Consequently, by the time these new aircraft were being delivered in , the market had deteriorated beyond that which could have been forecast by any historical benchmark. The deterioration was driven by a failing economy, the events surrounding 9/11, and a vast improvement in the transparency of airfares created by online websites. While Global Aviation Associates, Ltd. 3

23 traffic was declining, the average ticket price was declining as well, and unit costs were increasing. Breakeven load factors, the percentage of seats needed to be filled in order to generate a 0 profit or loss, escalated to the 90% range a level clearly unattainable. While the events of 9/11 produced nothing but negative consequences as far as the economic well-being of U.S. commercial aviation was concerned, the fact remains that the industry s financial health was more at peril than many acknowledged at the time. The decline in economic activity and the attendant impact on business travel (relatively high yield tickets with minimum restrictions) was generally regarded as a temporary setback, typical of the cyclic nature of airline earnings. In retrospect, it was anything but typical. The slow-growth economy characteristic of late-2000 and early-2001 came at a time when airline customer dissatisfaction had reached record levels. Airport congestion, flight delays, declining passenger service, and a bifurcated pricing environment had the combined affect of curtailing activity generally but also driving loyal (and frequently high yield) passengers to explore alternatives to the major LNCs. I.1.1 Strategic & Structural Change In the more than twenty years since the airline industry was deregulated, a number of novel strategies and systems have been developed by carriers, put inplace, and further refined. Frequent Flyer programs, yield management systems, corporate discount programs, the hub-and spoke network, and code-sharing are some of the most obvious -- and there were many others to be sure. Given the highly competitive nature of airline operations during this period, the most significant of these innovations were adopted (and frequently modified) by virtually every major carrier in turn. With the obvious exception of Southwest Airlines and its imitators, the commonly accepted business model of how to run a profitable company was thought to fit within a relatively standard set of parameters -- until now. The important conclusion is relatively simple: standard and generally accepted business practices can no longer be held as sacred. Given the dramatically different operating conditions post-9/11, every airline must assess precisely how they conduct business and make changes where necessary -- a re-engineering process that has only just started in earnest. Some of the more significant changes to be announced or contemplated are as follows: Hubs: The de-peaking by American at its Chicago O Hare and Dallas/Ft. Worth hubs (in actual fact, copying an earlier experiment undertaken by Delta at its Atlanta hub) proved that these complexes operate far from optimally. Indeed, the long-held theory that hubs must consist of distinct waves of departure and arrival banks has recently been re-thought. Aircraft: While it is far to soon to anticipate or even discuss an industry refleeting, concerted efforts are being made to eliminate older, more costly, and less efficient sub-types and extraneous (non-family) models of Global Aviation Associates, Ltd. 4

24 aircraft. This trend became quite apparent immediately in the wake of 9/11 as perhaps 1,000 units were removed from scheduled service and may be parked indefinitely. Pricing: Management of virtually every legacy major has acknowledged that the pricing structure is terminally flawed; that fundamentally, there is a huge disconnect between business and leisure fares (6 to 1 ratio in coach). Unfortunately, no single carrier has the leverage to remedy the situation. Change has to come in a logical and unified manner by all legacy majors simultaneously -- an outcome that is highly unlikely. Distribution: Long before its current ills, the U.S. airline industry had made great progress in extracting not only productivity gains but additional cost savings by embracing the Internet, and in turn, adding further distance from travel agents. Like the LCCs, the dynasty majors have also adopted high-tech strategies both on their own behalf (through proprietary portals) as well as through collaborative efforts such as Orbitz. Long-term, will this new-found fare transparency have a greater impact on airline revenue than on cost control? Labor: Alaska Airlines was recently the first U.S. airline to provide for baseball-style arbitration with its labor unions a sea change from the current process used by every other carrier and based on the Railway Labor Act of By trying to be all things to all people, the major LNCs have actually satisfied relatively few, leaving the carriers with scant options to fall back on once industry fundamentals (a strong economy and a loyal user base of high yield travelers) has fallen so dramatically. With little hope of a return to the good old days any time soon, the concept of business as usual simply does not -- and cannot -- fly any longer. I.1.2 The Current Airline Industry Crisis Former American Airlines CEO, Donald Carty, in Congressional testimony given in late-september 2002, highlighted the reasons for current airline industry ills. Key to the industry s problems, Carty told the House Aviation Subcommittee, is that business travel -- the bread and butter -- of large network carriers continues to be way down, with remaining business travel being done at leisure fares. He added, Business flyers are buying down, seeking lower, more restricted fares traditionally intended for leisure travelers. The key problem for American, he concluded, is that, only 1-in-12 passengers is flying full coach fare. Mr. Carty concluded by stating: Our task going forward is to re-define our business model, not only to stay a step ahead of our old rivals, but to compare and win in an environment where newer, lower-cost competition represents an ever-increasing slice of the marketplace, adding that American faces that type of competition on 70% of its routes. To change Global Aviation Associates, Ltd. 5

25 that model, American (like all Legacy Majors) recognizes the imperative to realign supply and demand and rebalance the revenue/cost relationship. 1 This customer frustration is well expressed as follows: 2 Flights are uncomfortable and unreliable, and higher fares don t address that. For long trips, I m willing to buy business or first-class tickets, but not at the 8 to 10-times price differential. Travel on mileage awards is losing its luster, making frequent flyer programs less attractive. I have been stranded at a hub for two days because my free ticket meant I had the lowest priority for a seat after my connecting flight was canceled. This is on top of unpredictable airport situations that make even a 1-hour flight something that could take a day. I m cutting back on my air travel; it s down 50% this year and going lower next year. I ll start flying again when the airlines offer me a better product, but that s probably going to require a new generation of carrier. I.1.3 Declining Major Airline Market Share One of the most important developments to result from more than twenty years of airline industry deregulation has been the imperative that major carriers differentiate their product or the service they offer consumers. When routes and fares were subject to strict government oversight, the airlines had little, if any, incentive to be creative. Today, the surviving major LNCs continue to provide much the same array of service that they traditionally had under regulation; products that appealed to both business (high yield) and leisure (discretionary) customers, on a vast system of domestic and overseas routes. The rise of niche carriers over the past years was a direct result of the inability by the majors to successfully be all things to all people. Chart 2 demonstrates precisely how well the new, post-deregulation (Regional and New Entrant/Low Cost Carrier) segments of the airline industry have been at tapping into consumer desire for alternative air service options. Notably, their share of total domestic passenger enplanements has grown from less than a 10% to more than one-third of total traffic activity in the post-deregulation era. 1 Carty to Analysts: AA Aims to Survive, Aviation Week and Space Technology, 30 September 2002, page 47 2 Letter to the Editor, Aviation Week & Space Technology, 7 October 2002 Global Aviation Associates, Ltd. 6

26 Chart 2 100% Distribution of U.S. Passenger Enplanements By Airline Type (U.S. Domestic Traffic ) Share of Total Activity 80% 60% 40% 20% 0% Q2002 Majors Low Cost/New Entrants Regionals Source: U.S. Department of Transportation filings. I.2.0 LONG TERM PROBLEM I.2.1 Marginal Profitability In year 2000, the 11 major airlines reported operating revenues of $92.2 billion, with an operating profit of $5.4 billion (5.6%) and a net operating profit of $2.3 billion (2.2%). 3 This was before the recession and events of 9/11 resulted in a $7.5 billion loss in The mediocre year 2000 net operating profit illustrates a chronic problem for the major airlines; they consistently operate at net profit margins well below U.S. industry as a whole as shown in Chart 3. 3 U.S. DoT Form 41 Global Aviation Associates, Ltd. 7

27 Chart 3 Net Profit Margin U.S. Industry vs. Airlines Nonetheless, the key point is that the U.S. airline industry is barely able to sustain itself, in capital terms, in good times, and now, faces growing economic and structural uncertainty with little or no reserve to sustain itself during difficult times. I.2.2 Contributing Factors Source: State of the U.S. Airline Industry: A Report on Recent Trends for US Air Carriers Air Transport Association, 2002, page 10. In the run-up to 9/11, it had become abundantly clear that the major LNCs were overly if not exclusively reliant on high yield (business) travel to produce the industry s meager profit margins. Despite investments in the onboard product, record levels of consumer discontent toward the major LNCs focused on high fares, restrictive conditions, on-time performance, airport and airway congestion, and the perceived decline in service reliability overall. The resultant changes started in the late 1990 s, setting the stage for a large-scale (and potentially irrevocable) change in established consumer air travel patterns. I.2.3 Local Versus Connect Traffic While yield management systems have become very adept at producing high load factors, the price of this success has been a widely divergent set of fares/yields on many flight segments. Contributing to this has been the hub and spoke operating system, which has become ubiquitous enough that the majority of the major LNC operations are hub to spokes. Global Aviation Associates, Ltd. 8

28 Many local markets from hubs are monopolies (the exceptions generally being spokes to other carriers hubs). As such, the dominant airline can command reasonable yields in exchange for nonstop service. The connecting traffic that flows through the hub is almost always subject to competition, and tends to be lower yielding than local origin-destination traffic to and from the hub. Table 2 illustrates this phenomenon with respect to a domestic hub spoke. Two key points here are that the local traffic (that which originates its trip in a city and returns to the same city) contributes a greater percentage of onboard revenue than the flow traffic (that which connects over the hub), and that there is a significant yield premium in the local market -- approximately 60 percent. While this market may be profitable at an average yield of almost 20 cents, achieved by combining local and flow traffic, it is doubtful that profitability would be achieved if only flow traffic were available. Thus while the flow-through (connecting) traffic may be of lower profitability, it nonetheless contributes to the overall profitability of the flight through the hub. Similar results can be seen in international hub markets. Table 2 Domestic Hub Yields By Market O-D Vs. Connect 2002 Traffic Category Local O-D Flow or Connecting Composite % of Onboard Revenues 61.6% 38.4% 100.0% Average Yield $ $ $ These results clearly show that connecting traffic is not as lucrative as local traffic, from a unit revenue perspective, but without it, load factors and total revenues would be insufficient to generate profitability on virtually all hub-based spokes. I.2.4 Air Fare Trends Source: Global Aviation Associates, Ltd. analysis Overall, domestic yield at Air Transport Association (ATA)-reporting airlines has declined in real (constant dollars) terms throughout the period of deregulation. The trend in average yield decline and in various yield categories is illustrated in Global Aviation Associates, Ltd. 9

29 Chart 4. Yield is assumed to measure the trend in base fares (exclusive of taxes) as it quantifies the ticket price in cents per revenue passenger mile. Yield is not a perfect measure of fare trends as the increase in flight stage and passenger trip lengths have contributed to the decline in yields; however, it is still a reasonable benchmark and widely accepted. Chart 4 U.S. Domestic Yields (Constant YR2000) ( ) Yield (cents per RPM, 2000$) Full First Full Coach Discount Coach Average Yi ld But as illustrated in Chart 5 below, the decline in the average fare is only part of the story. In fact, what has occurred is a decline in the discount coach fare used by an increasing majority of the passengers coupled with a slight increase in the real full first (including business class) and full coach fares. Chart 5 U.S. Domestic Passenger Enplanements By Fare Category First Reduced Enplanements First Full Enplanements Coach Reduced Enplanements Coach Full Enplanements ENPLANEMENTS (Millions) Source: ATA Global Aviation Associates, Ltd. 10

30 Today, in excess of 90% of U.S. domestic air travelers utilize discount coach tickets. This share of the air travel market (which excludes data from Southwest Airlines) has grown from the more balanced fare mix that existed in 1980, soon after deregulation. At that time, 49% of passengers traveled on reduced fare tickets with 45% traveling on full coach fares. In the first half of 2002, during the trough of the recession in the industry, only 2% of passengers traveled on full coach fare tickets! (Compared with 10% 20% in ) If the expansion of reduced first (and business) fares is included, it appears that only about 3% of air travelers are currently paying full (walk-up) fare for the class they are flying. I.2.5 Taxes And Fees Taxes and fees paid by airline passengers have grown substantially over the past 10 years. Northwest Airlines, reported that taxes and fees now total over $60, comprising 26% of the price of the average ($270 roundtrip) ticket. This is a 141% increase over 10 years as shown in Chart 6. These charges are assessed for a variety of reasons, not just the recent concern over security. Some are embedded in the ticket price while others are added as surcharges. Some charges are airport-specific (such as the PFC s) while others such as the fuel tax support the AIP and part of the FAA s expenses and equipment investments. Chart 6 Taxes/Fees as part of a $270 Roundtrip Average Leisure Fare Ticket $28.49 Excise Tax $27.40 Fuel Tax $ Burden of Fees and Taxes on Air Travel 10.5% Airline Paid 25.5% Source: Richard H. Anderson, CEO, Northwest Airlines, FAA Forecast Conference, 2002 $68.76 Pending Excess Security Fee $4.00 Security Fee $10.00 Segment Fee $12.00 PFCs $18.00 Excise Tax $20.55 Fuel Tax $ Global Aviation Associates, Ltd. 11