t is no secret that the world airline industry has been plunged into its deepest crisis yet. To be sure, the industry has always been highly cyclical, and past downturns have claimed some of the most storied names in commercial aviation. But most of those carriers clearly were among the weakest members of the herd. This time, some of the largest airlines in the world face the very real prospect of bankruptcy, followed by liquidation, if they cannot persuade creditors and unions to restructure costs before the cash runs out.

After the disastrous 2001 and the leveling off of last year, 2003 is turning out to be a year of painful lessons for many people.

Aircraft owners and lessors are facing the harsh reality that the value of their assets has fallen sharply, and perhaps permanently. Union workers - especially pilots and mechanics - are learning that working for the world's largest airlines does not automatically confer job security, much less a guaranteed pension. Meanwhile, passengers are discovering that service can, in fact, get worse.

Against this grim background, the good news is that cargo demand has been, and likely will continue to be, far more resilient than passenger traffic. Cargo doesn't care about the possibility of terrorist attacks, or the SARS virus, or the host of other reasons that passenger airlines face such a dismal revenue environment.

Rather, cargo cares about economic growth, trade and investment - the drivers of freight demand for which prospects appear to be brightening in most parts of the world despite the disruption and uncertainty caused by the war in Iraq. Indeed, output and corporate profits continue to rise in the United States and most parts of the developed world.

Moreover, the painful changes being forced on the large passenger carriers bode well for the long-term profitability of freighter operators.

Passenger flights generate roughly half of intercontinental airlift capacity, and passenger carriers generally price their belly cargo based on marginal cost, exerting downward pressure on air freight rates.

Ironically, 2002 (and, so far, 2003) have been good times for most freighter operators, which have enjoyed rising load factors and rates largely because the passenger airlines' travails have forced them to cut flights and thus belly capacity.

Additionally, the large number of U.S. and British military charters to the Middle East absorbed a lot of excess freighter capacity, further tightening the supply/demand balance. Over the longer term, the painful reminders now being administered to the financial markets should reduce the future flow of capital to passenger airlines, imposing greater discipline on future belly capacity growth.

This is not to say that established freighter operators have it made. Price competition from passenger carriers may diminish, but that from new-entrant freighter operators - taking advantage of depressed aircraft prices and out-of-work pilots - will likely increase. Cargo cares very much about rates.

Of course, both passenger and cargo traffic depend on commercial activity and trade. Prolonged weakness in the passenger revenue environment would reflect, and ultimately exacerbate, underlying weakness in the world economy that would affect cargo demand.

Global economic growth is increasingly, and worryingly, dependent on the U.S. and specifically on free-spending, heavily indebted U.S. consumers. Sooner or later, American consumers will grow tired of laying out cash and credit. And if big European and Asian economies (including Japan's) have not resumed significant growth by then, cargo traffic will suffer.

Our view is that this unhappy outcome is unlikely, but it cannot be dismissed - especially by asset owners who would suffer the most.

Overall, we estimate that in the 2003-2007 period covered in this year's forecast, cargo traffic in terms of daily tonnage will grow at a rate of 5.8 percent per year.

This growth follows a five-year period that included the Asia currency crisis of 1997-1998, the heights of the technology boom and the depths of the technology and terror-related bust of 2001, ending with an average annual growth rate of 1.9 percent.

After mild 3.6 percent growth last year, we project 4.7 percent growth this year and 5.6 percent growth in 2004. The growth will not be spread evenly, as North America and Europe show signs of their size and maturity with relatively small growth after bearing the greatest weight of the weakness between 1997 and 2002. By contrast, the largest growth markets will be tied to Asia.

We forecast that intra-Asia tonnage, which grew at a 3.2 percent average annual rate in the historical period, will grow 7.4 percent in the 2003-2007 forecast period. The growing market for express services will lead to a 14.1 percent average annual growth rate for package volume in the intra-Asia market.

Industry Structure

istorically, freight transportation demand was segmented by mode: air, ocean, truck, and rail. However, modal boundaries are blurring. For example, a large percentage of regional "air express" traffic never touches an airplane because trucks can offer similar door-to-door transit times and reliability at a fraction of the cost. This is particularly true in North America and the trend is being duplicated in Europe to some extent.

Modal distinctions are still fairly clear in intercontinental markets. However, the rise of intermediate products such as sea/air threatens to undermine the mode definition.

We believe that freight demand should be segmented based on shipment size and velocity rather than "mode."

Shipment size is a function of the number of pieces per shipment, and the average weight per piece. The vertically-integrated express carriers have a natural advantage in moving documents and small packages that can be fed through the conveyor belts at a sorting hub. Non-integrated freight forwarders have the advantage in moving larger consignments, from unitized small packages - multiple small packages loaded onto a single pallet - up to heavy or outsize pieces that could not pass through the integrated carriers' sorting systems.

Most industrial consignments are unitized small packages. Thus the future boundary between forwarders and integrators depends largely on the extent to which industrial shippers break down large consignments that reduce per-kilo transport cost into smaller, more frequent shipments that reduce inventory-carrying costs.

Broadly, there are four speed options in any given market, ranging from "fastest" for time-critical traffic to "slowest" for rate-sensitive traffic. The velocity options can be split into air and surface categories in intercontinental markets but not in regional markets, where trucks are highly competitive with aircraft.

The air freight industry operates on two distinct levels: retail and wholesale. On the retail level, carriers and forwarders sell door-to-door transportation to individual shippers. On the wholesale level, firms sell specific parts of the door-to-door journey to retail competitors. Airlines are by far the largest wholesale players, selling airport-to-airport transportation to forwarders.

Within the wholesale and retail structure, there are two basic business models: integrated and non-integrated. Integrated carriers own or exclusively control all of the assets, people, and information systems necessary to move a shipment from retail point-of-sale to final delivery. Obviously, vertical integration is expensive, but integrated carriers command premium rates because they generally offer the fastest, most reliable service in any given market. The drawback in the business model is that the integrators are inflexible: their flight schedules are necessarily rigid in order to keep their hub-and-spoke networks on time, and their services are highly standardized to drive down unit costs as they build traffic.

In contrast, non-integrated carriers operate at either the retail or wholesale levels, but not both. Carriers include both airlines and time-definite trucking companies, which carry a growing share of "air freight" within North America and Europe.

Generally, forwarders can be more flexible than integrators because they use a number of carriers and different modes of transport, where necessary, to tailor door-to-door offerings for shippers. Forwarders also bundle non-transport services, from warehouse management to minor product repairs, in order to create logistics solutions for their customers - and to make it more difficult for customers to switch to other providers.

Forwarders account for more than 80 percent of international air freight tonnage. Yet the integrators are making inroads as they expand their international networks and move up the weight spectrum to heavier consignments.

For years, people have discussed how to overcome the well-documented problems of the airline/forwarder "partnership" by aligning their long-term economic interests through common ownership. Deutsche Post is moving aggressively to put theory into practice by agglomerating large forwarders - and their heavyweight business - under the DHL banner, and simultaneously moving closer to Lufthansa. It is far from clear that Deutsche Post can make all of the pieces fit together. But if they can, competitors will be forced to respond.

The industry's split-level structure creates the danger of double-counting. For example, airlines receive the majority of their cargo traffic from forwarders, so their business is mostly a subset of the forwarders' business. To avoid this problem, we count traffic only at the industry's retail level.

Forecast Overview

ir freight is a subset of world trade, which is directly related to world economic growth. By our estimates, there has been approximately a 2 percent increase in the value of world trade for each 1 percent increase in the size of the world economy. In large part, this historical relationship can be attributed to Asia's export drive, as it has successfully transformed itself into the world's manufacturing center. In the 1990s, the relationship was supported by the record-setting U.S. economic expansion, which led to seemingly insatiable demand for imported goods. In addition, the "outsourcing" trend heavily benefited Asian countries, especially China, with low input costs.

But the U.S. economy cooled off dramatically in the second half of 2000, officially went into recession in early 2001, and now seems to be staging a "jobless" recovery. While job creation has lagged, the dramatic productivity gains of the 1990s now seem to be durable - which bodes well for long-term economic growth.

Assuming the recovery continues, especially with the tax-cut and government spending stimulus injected by the U.S., the main question is when air freight volumes will rebound. Our view remains: the fundamentals are weak for air freight-intensive sectors (information technology, telecom, and general business investment), and we therefore we do not expect a significant recovery in air freight growth until 2004.

Our forecast assumes that world economic growth remains positive but unexciting, averaging 2.9 percent "real" growth, after removing the effects of inflation, during the 2003-2007 period.

Despite the current downturn, we believe that the economic forces driving air freight growth in the past will hold true for the foreseeable future. Simply put, the world will continue to become a "faster" and more competitive place, with the consequence that air freight will become progressively more important.

Having said that, we expect that international air freight growth is moving up the maturity curve, with the consequence that air freight will grow at a smaller and smaller multiple of underlying economic growth.

Air freight demand is geographically concentrated, as is the underlying economic activity. In 2002, almost 97 percent of world air freight tonnage moved to, from, or within the three pillars of the world economy: Asia, Europe and North America. Even more significant, 54 percent of world air freight tonnes moved to, from or within North America alone.

Definitions

or the purpose of a world air freight industry forecast, it is useful to group countries based on shared air freight characteristics, even if the groupings occasionally depart from conventional regional definitions. For example, passenger belly capacity and the availability of trucking connections as well as pure-truck substitutes for air transport are the primary considerations underlying our groupings.

MergeGlobal organized the world into six air trade regions: Africa (excluding Egypt); Asia/Pacific (including the Indian subcontinent); Europe (including Eastern Europe and the Commonwealth of Independent States); Latin America (Central and South America and the Caribbean); the Middle East (including Egypt); and North America (the United States, Canada, and Mexico).

We analyzed and forecast air freight flows within and between these six regions. The regional and world totals represent MergeGlobal's estimate of all domestic and international air freight, including "air freight" that moves entirely by truck within North America and Europe.

The data are organized into three categories: actual (1997-2001), for which all historical data have been received; estimated (2002E), for which only partial historical data are available; and forecast (2003F-2007F). These categories reflect the reality of delayed and 'revised' data that affect our calculation of historical air freight demand.

All traffic figures are in metric tonnes per day, assuming 312 operating days per year. All monetary measures - GDP, trade value - are expressed in "real" terms; that is, the effect of inflation has been removed. Except for year-over-year percentage-change figures, all growth calculations are expressed in terms of compound average growth rate (CAGR).

Why Pay More?

lthough air freight is fast and reliable, it is also expensive. Long-haul air freight rates per kilogram are typically seven to 10 times higher than comparable ocean rates. To forecast future air freight demand, it is critical to understand why shippers (the end-users) are willing to pay such large premiums for air transport.

Different types of shippers use air freight for different reasons. However, all air shippers have one thing in common: they do not focus on minimizing transportation costs, but rather concentrate on minimizing total distribution costs (TDC) and maximizing economic value-added (EVA).

Total distribution costs represent all of the costs incurred in the process of making, storing, and distributing a product to the end-customer. Transportation charges are the largest, but not the only, component of TDC. Product packaging, warehousing and inventory shrinkage are also significant expenses.

Economic value-added reflects the benefits of a well-functioning distribution system - and, conversely, the costs of not having the right goods in the right place at the right time. For example, stockouts can result in lost sales and production line shutdowns with economic consequences that far outweigh total distribution costs.

For both TDC and EVA reasons, air freight is most attractive to producers of high-value and perishable goods. High-value goods include obvious examples such as semiconductors and precision instruments.

The chart on page 28 shows the leading air freight commodities based on tonnage.

For analytical convenience, MergeGlobal grouped air trade into six main commodity categories based on shared demand drivers and other similar characteristics. The categories are: capital equipment, consumer goods, food and flowers, high tech, intermediate (components and work-in-process), and primary (raw materials with little or no processing).

Demand Drivers

e believe that the primary drivers of worldwide air freight traffic growth are:

Economic growth. Air freight is a subset of world trade, which is directly related to world economic growth. By our estimate, air trade has grown faster than the world economy and world trade in value and in tonnage.

Globalization. Progressive economic integration, and steady reduction in protectionism, should boost both overall trade flows and competitive intensity in almost all industries. Both trends have and will continue to drive air freight traffic growth.

Lean inventory strategies. More companies, large and small, are focusing on order-cycle time reduction and lean-inventory strategies - including just-in-time, make-to-order, and so on - as a competitive advantage. More firms are planning to use air freight to shorten delivery times to the end-customer. Of course, these firms must also increase emergency use of air freight because they have less safety stock.

Declining rates. Adjusted for inflation, air freight rates have declined for 30 years. Clearly, air freight demand is stimulated by cheaper rates, but the price elasticity cannot be calculated from the available data.

Constraints

he most significant constraints on air freight growth include:

Recession. Any decline in world economic activity, cyclical or shock-induced, obviously would harm air freight growth. Despite the perception that the U.S. and world economies are just "mushing through," it seems to us that recession is unlikely due to fiscal stimulus, especially by the U.S. government, and pent-up demand, especially long-deferred business investment in computers, high-tech and other short-lived assets.

Trade barriers. Just as economic integration stimulates trade, protectionism hurts it. Trade barriers take many forms and will always exist to some extent. Admittedly, the Bush Administration's commitment to multinational institutions such as the World Trade Organization is open to question. But we believe that economic logic will prevail over domestic political considerations, and that the Doha round of trade talks will be successful.

Regulation. Government regulation - of aircraft noise, emissions, and safety - has always had a significant impact on air freight economics. The single biggest concern is that still-evolving security regulations may have a profound impact on both costs and revenues. For example, authorities may ban some or all belly cargo traffic. Another, less obvious concern is that new security checks will undermine the cargo competitiveness of passenger airlines and hub airports relative to freighter operators, and of air cargo itself relative to trucks in shorter-haul markets. Of course, security concerns extend to other transport modes as well. New security regulations may make containerships less reliable, thus driving the most time-sensitive box traffic to aircraft.

Modal competition. Aircraft usually cannot be beat in terms of speed or reliability, but they are vulnerable on price. Containerships are becoming more effective competitors, especially as ocean carriers make progress in unsnarling port operations and improving door-to-door on-time performance. In addition, there is always the prospect of technological change - in the form of "fast ships," airships, or other substitutes for jet aircraft in intercontinental markets. The timing or impact of such change cannot be predicted with confidence.

Our forecast assumes that new security regulations do not materially shift traffic between modes, and that the other drivers of, and constraints on, air freight demand maintain the balance of the historical period.

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