Risk factors affecting the US airline
industry
The US airline industry has suffered from high systematic risk and
huge operating costs (Lee & Jang, 2007). The US airline industry had
economic recession and was further aggravated by 9/11 terrorist attacks. The
recession and growing concern over the safety and security result in drastic
consumer budget cut in air travel that led to a net loss of $7.7 billion for
the period of September, 2001- June 2002 (Lee & Jang, 2007). Furthermore,
the burden of high operating costs rose due to increasing security, labor,
insurance costs, and volatile fuel prices. The rising fixed costs increase the
operating leverage and consequently business risk of a firm (Lee & Jang, 2007).
Because of risky market environment and high operating leverage, many airlines
hardly generate enough income to bear their operating costs, hence they rely
more on external finance to maintain their businesses. This increases high
financial leverage that makes airlines vulnerable to the systematic risk (Lee
& Jang, 2007).
The US airline industry faces two types of
risks that include: systematic and unsystematic risks. The systematic risks are
changes in the US economy, tax reform by Congress, or a change in the world
energy situation (Lee & Jang, 2007). Unsystematic risks are strikes,
competition, product defects, poor management, and technological break though.
Unsystematic risks are avoidable but systematic risks are non-diversifiable.
Unsystematic and systematic risks negatively impact on the industry
performance, especially stock price. Rapid growing firms in the US airline
industry are weak in economic changes, possibly with internal stress arising
out of fast growth (Lee & Jang, 2007). As firms’ assets are on the rise,
their earnings are likely to increase. The profitable business is more likely
to be exposed to the competition in the future that may make the firm more
vulnerable to economic fluctuations (Lee & Jang, 2007). In this sense, the
firms whose assets are rapidly growing will seek more finance and therefore
face the higher systematic risk (Lee & Jang, 2007). Put differently, firms
with higher growth need more resources which, in turn, cause the firms to look
for outside financing (Lee & Jang, 2007). These costs lead firms to high
leverage; growth is positively related to systematic risks (Lee & Jang, 2007).
Firms with high debt financing pay high interest expenses; they may fail to pay
short-term obligations, this can increase bankruptcy risk (Lee & Jang,
2007). Low resources, incompetent flight crew, poor training system, and older
aircrafts are major sources of aviation accidents that have negative impact on
the airline industry (Lee & Jang, 2007).
How the US
airline industry can minimize the risk factors
Investors can hold diversified stock
portfolio to eliminate unsystematic risk that includes: strikes, product
defects, poor management, among others (Lee & Jang, 2007). The airline industry
can mitigate the fuel price. Lowering operating costs should be an effective
way forairline companies (Lee & Jang, 2007). Fuel cost is a major concern
in airline cost control. Airline companies should hedge fuel to control
unstable fuel price (Lee & Jang, 2007). For example, Southwest Airlines
successfully exercised beta management; the company generated profits by successfully
managed fixed and operating costs (Lee & Jang, 2007). Southwest has the
most competitive Cost Per Available Seat Mile of $7.07 in 2004 (Lee 7 Jang,
2007). Southwest pilots are independent of the National Pilots Union and hence
often fly more hours than the pilots in other major airlines (Lee & Jang,
2007). Southwest hedges fuel price and avoid the risk arising out of unstable
fuel price. The operating practices enable Southwest to control performance volatility
and systematic risk (Lee & Jang, 2007). Air France and KLM report that
replacing Boeing 747-300 s with 777-300ERs could reduce fuel consumption by 26%
(Lee & Jang, 2007).The capital that management obtains via internal
financing rather than external financing are suitable for airlines that are
susceptible to systematic risk; this policy helps reduce debt financing (Lee
& Jang, 2007). The company should have safety investments that include: purchase
of the latest safety-related equipment, frequent maintenance, experienced human
resources, and effective training programs (Lee & Jang, 2007). Continuous investment in the highest standard
of maintenance and safety technology should achieve financial and safety
benefits (Lee & Jang, 2007). This will reduce the systematic risk.
Management should optimize the investment in firms’ size through effective
financing and operating policies to check the firms’ assets rapid growth and to
avoid seeking external finances (Lee & Jang, 2007).
Companies should efficiently utilize their
assets in generating revenues to reduce possible losses, this will minimize the
beta (Lee & Jang, 2007). The companies should be highly liquid to minimize
the level of systematic risk because the greater the liquidity, the lower the
beta and vice versa (Lee & Jang, 2007). The airlines should invest in
profitable ventures to generate adequate profits to lower the systematic risks
(Lee & Jang, 2007). Large firms should diversify their businesses more
efficiently to avert bankruptcy which, in turn, will reduce the systematic risk
(Lee & Jang, 2007). Large firms should intensify their investments to
benefit from economies of scale that reduces unit costs, this will increases
profits; hence reduces probability of bankruptcy. This will reduce systematic
risk (Lee & Jang, 2007).
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