Early in 2001, most US airlines began to experience operating losses, which were only exacerbated by the events of September 11. The period from December 2000 to date has arguably been the worst time in the history of aviation. Airline passenger traffic declines and airline operating losses have reached new record levels. According to the Air Transport Association (ATA) statistics, 2001 had the sharpest decline in enplaned passengers ever, with 2002 expected to be even worse.

Despite these negative trends, most airports have been able to make swift adjustments and maintain financial strength and credit quality. In the US, Moody's has downgraded only two airport related ratings and continues to have a negative outlook for 24 airport related ratings. In addition, we have upgraded two airport related ratings and have a positive outlook on two airports.

The airport sector faces an uncertain outlook. While airports have been weathering the storm remarkably well, uncertainty persists due to the weak national economy, the continued demands of additional security regulations and the potential for war with Iraq. As in the past, the deteriorating financial condition of the airlines has not translated into airport financial stress. However, the airlines' own financial recovery strategies remain fluid. Potentially dramatic changes in airlines' fleet mix, as well as their routing, scheduling, and hubbing strategies will have implications for airports' operations and finances, and these are very unclear at the moment.

Looking ahead, we expect more variability in the success of different airports at adapting to stress than in the past. The airport industry as a whole is performing well under the current stress, but individual airport performance shows a wide variation and the air traffic industry is still very much in flux. Airport ratings, traditionally clustered in a narrow range, are likely to become more dispersed in the future. Moody's believes that some airports, now in the process of demonstrating their resiliency, harbor the potential for higher ratings as the air travel industry moves to find equilibrium.

When will US airport sector fully recover?

The events of September 11, combined with the weak national and world economies and the deteriorating airline industry, created a very challenging landscape for the US airport sector in 2001 and 2002. According to the ATA, the level of enplaned passengers in 2002 declined 7% through November compared to the same period in 2001. In Moody's view, the rate of recovery in the airport sector will depend on the pace of national economic recovery and the possibility of disruption to air traffic due to terrorist actions or a potential war in Iraq. Moody's expects passenger traffic will return to 2000 levels no sooner than the end of 2004.

While the events of September 11th are unprecedented, the airport sector has weathered severe stress in the past. Today's headlines are similar to those of the early 1990's when airports were dealing with an economic recession, declining passenger traffic, increased security regulations, and additional costs as a result of the Gulf War. However, the current cycle of distress has not yet run its course, and today's traffic declines and financial losses are much more severe than those of a decade ago. Nevertheless, if history is any indication, the depressed passenger levels for 2001-2003 will likely prove to be a downward blip on a generally upward curve, spurred by ever-growing demand for air transportation for an increasingly global economy.

Reaction to market downturn swift and effective

Immediately after September 11, airport management was able to make swift adjustments to both capital and operating budgets to head off the potential financial damage of declining traffic. The responses to dealing with depressed passenger traffic, increased security costs, and decreased revenues were relatively consistent across the sector. Many airports reviewed and cut both annual operating budgets and capital programs, in many cases extracting cost savings in the range of 15% of the year's operating budget. In some cases, budget pruning produced efficiencies that may prove valuable as the airlines sharpen their pencils in an era of cost cutting. In other cases, budget reductions deferred essential spending that will return in a year or two. Although most airports relied as heavily as possible on cost-cutting solutions, many also raised revenue, from both airline and non-airline sources. For example, Los Angeles World Airports reduced the operating budget by 14% and also initiated a revenue enhancement program, including increasing landing fees. Despite the financial frailty of the airlines, airports report no payment problems from the airlines as a result of these fee increases. Parking fees also proved to be a source of revenue raising flexibility for some airports. Even though the number of cars declined, those that did continue to park at the airport proved to be relatively insensitive to price increases. Remarkably, total airport system revenues actually grew at some airports last year.

Given the demonstrated resilience of the sector to the volatility of last year, the anticipated recovery of passenger traffic and revenues in 2003-2004 will likely enable a number of airports that currently have negative rating outlooks to stabilize. In Moody's view, the sector has the potential for higher ratings over the medium term. At the same time, some airports may see further erosion of market share and financial performance as airline strategies and traffic patterns take shape, and those may face potential rating downgrades.

When to build? ? capacity problems still looming

Airport management is facing more challenges than ever to develop financing plans to address future capital needs. It is not as simple as scrubbing the current capital plan and deciding what or what not to build. Future capital plans need to incorporate the modifications airlines are making at airports, including fleet and schedule changes, as well as the ever- changing federal security requirements. During the summer of 2001, one of the biggest issues facing the industry was the lack of airport capacity to accommodate anticipated demand. As traffic recovers to pre-September 11 levels, we expect to see capital plans dominated by capacity-related projects. The concept of ?depeaking? certain hubs recently announced by American Airlines also will have capital plan implications. While regional jets provide operating efficiencies for cash-strapped airlines seeking to reduce costs, the frequency of regional jet service is usually increased and therefore likely to further pressure airport capacity.

Even though most airports reexamined their capital plans immediately after September 11th, we have seen a number of large airports move forward with capacity-related projects as presented in Figure 3.

Airline strategies unclear in face of mounting losses

The abysmal financial state of the airline industry creates substantial uncertainty regarding the level and character of future airport capacity needs. In 2001, the airlines lost more than $7 billion and are expected to lose an additional $7 billion in 2002. These losses would have been exacerbated in 2001 if the Congress had not enacted the Air Transportation Safety and System Stabilization Act, which included $5 billion of payments to compensate domestic airlines for losses incurred following the terrorist attacks. Already, there two major airlines currently operating under bankruptcy court protection. If revenue growth does not return to the industry soon, Moody's expects to see additional bankruptcy filings and airline consolidations. Short of consolidation we are seeing an increase in code-sharing agreements, such as the recently approved US Airways ? United code-share agreement and the proposed agreement between Delta, Continental, and Northwest.

In the short to intermediate term, cost cutting rather than revenue increases are expected to be the primary driver in the recovery of airline profitability in the US. Most major hub and spoke carriers are expected to reduce capacity, and overall capacity is expected to decline in 2003. In order for the airlines to return to profitability, Moody's expects that fares will increase over time and overall capacity will likely continue to decrease in the medium term. While many major airlines have already announced system-wide capacity reductions beginning in November 2002, lower fare carriers such as JetBlue, Southwest, AirTran and ATA will all see increases in capacity in 2003, in some cases rather significant ones.

Hub airports remain significant to overall system

The viability of the hub and spoke structure has been widely debated over the past year. Despite the major losses sustained by hubbing airlines and the fact that airlines that provide mostly point-to-point service, such as Southwest Airlines, are actually making money, Moody's believes that the hub and spoke system is here to stay. The cost-effectiveness of hubs is currently being debated because of the seriously weakened financial condition of the airlines that have established extensive hubbing networks. Although a hub and spoke system is more expensive than point-to- point service, Moody's believes that there are other reasons for the poor financial condition of the airlines. Excess investment in capacity, the drags on earnings from capital costs (rent and interest) due to high financial leverage, and operational inefficiencies as a result of complex and expensive work rules at many major airlines all contribute to high airline operating costs and low profitability. We believe that the hub and spoke model will continue to be valuable and will generate a revenue premium when compared to the point-to-point model. The key for the hubbing and major airlines is not to match the costs of the point-to-point carriers but to lower the cost differential to match the revenue premium.

Implementation and funding of TSA mandates still uncertain

In response to the terrorist attacks of September 11th, Congress passed the Aviation and Transportation Security Act (ATSA) that created the Transportation Security Administration (TSA) and mandated a number of initiatives with specific completion dates. The two most comprehensive initiatives mandated were the federalization of passenger and baggage screening and the requirement for 100% of checked baggage to be screened using explosives detection systems (EDS). The major uncertainties facing airports is the capital costs associated with achieving these two initiatives while continuing to maintain desired levels of customer service.

The capital costs of compliance with TSA mandates have been estimated to varying degrees at different airports. Some airport operators are faced with difficult choices given scarce financial resources: prioritize funding for security-related projects or fund other long-term capacity enhancing projects. How airports finance these projects will likely factor into the future evaluation of airport credit. Moody's believes that most airport operators will be able to balance compliance with the security deadlines while funding the needed capital improvements, but this will be done at the expense of capacity and/or customer service-related projects.

Regional world airport outlook

Near term credit outlook is negative for Latin American and Caribbean airports

Moody's near-term credit outlook for the Latin American airport sector is negative. Latin American and Caribbean airports are facing a variety of challenges, the most significant of which are the weakened airline industry, economic recession, and the aftereffects of September 11, along with the possibility of war with Iraq.

The region is dominated by American Airlines and weak national carriers, and to a lesser degree Continental, Delta, and United. There are many discrete domestic markets that support large national networks. Moody's assumes that there will be continued concentration and a general lack of improvement in the national carrier finances. From an airport perspective this makes near-term planning difficult and could have a negative impact on operations and finances in the event of airline bankruptcy or retrenchment.

European airport ratings outlook is negative

The credit outlook for European airports rated by Moody's is negative. Airport management has been forced to confront concurrent problems of decline in passenger traffic, airline bankruptcy and economic recession. Airports have shown to be fairly resilient during this period though certain markets, particularly North Atlantic routes, have been more affected than others.

Two of the most significant trends in the European airport sector are the continuing concentration of European flag carriers and the growth of the low cost carrier segment. Moody's believes that both of these trends will continue over the near term and that they will affect airport credit. European airports, however, are faced with two issues that are somewhat different from the US experience: low fare carrier's affect on the charter market and the ability of small regional airport to finance facilities for low fare carriers. Over the near term Moody's expects that the growth in the low fare market will not be at the expense of the charter market but will be a response to price sensitive consumer demand particularly as the majors continue to increase fares. The ability to finance the potentially significant capital requirements of smaller regional airports that is being required by the growth in the low fare service will become a growing issue over the near term. This will be a challenge at smaller facilities that must grow to meet the needs of low fare carriers.

Near term outlook for Canadian airports may be tied to legislative initiatives and rent review

The near term ratings outlook for Canadian airports rated by Moody's will be tied, in part, to the outcome of the legislative initiatives that are currently in process. Transport Canada has been working on clarifying a number of areas with respect to rate setting and the relationships between airports and airlines, imposition of the Airport Improvement Fee, as well as corporate governance. In addition, Transport Canada is reviewing the rental agreements with the largest airports. It is unclear at this time what the credit impact of these initiatives will be, though Moody's does not feel that they will significantly affect individual ratings

Australian airport ratings outlook is stable reflecting passenger traffic recovery and aeronautical charge increases

The ratings of Australia's major five airports-with the possible exception of Perth-are expected to remain stable as the industry recovers from the September 11 terrorist attacks and the demise of Ansett. However, this overall stable outlook is highly contingent on developments in the Middle East and the possibility of future terrorist activity, notwithstanding the bombings on the Indonesian resort island of Bali.

The overall ratings stability for Adelaide, Brisbane, Melbourne, Perth and Sydney, whose underlying ratings range from A3 to Baa3, is supported by several key factors:

? The quasi-monopoly positions of each airport and their stable cash flows

? Recent change in regulation allowing airports to increase their aeronautical charges significantly

? The high percentage of O&D passengers each facility serves and the strong growth in airfreight

? Each airport's diversified revenues streams, the strength of which has been indicated in the growth of their non-aeronautical revenues

? The inherently large size of Australia's domestic aviation market, given the huge distances between the country's cities.

The Ansett crisis led to a decline in short-term capacity, but the impact of reduced passenger traffic on revenue was partly offset by deregulation of the price cap on the aeronautical charges the airports levy on airlines. All of Australia's major airports are privatized.