U.s. Airline Future

[BoeingBoy]

U.S. Airline Future: In the Eye of the Storm
Aviation Week & Space Technology
03/01/2004, page 42

Anthony L. Velocci, Jr.
New York

IN THE EYE OF THE STORM

When Aviation Week & Space Technology last took the collective pulse of the U.S.' six legacy hub-and-spoke airlines in November 2002, their vital signs were weak. All of the operators were suffering from high labor and fuel costs, a recession, the lingering aftermath of the 2001 terrorist attacks, grinding competition from low-fare rivals and, except for one or two of the companies, weak management. Most of the conditions over which carriers have little or no control have improved or don't exist now, and demand for travel is rebounding. Still, the industry's health remains fragile and airlines face an uncertain future. In the following update on the state of the traditional majors, their challenges and prospects are explored.

For the six largest U.S. legacy airlines, the maelstrom is over--for now.

But the calm won't last. The day of reckoning has only been postponed, thanks mainly to a strengthening domestic economy and a gradual recovery in air travel demand.

In the 15 months since Aviation Week & Space Technology published its special report on the U.S. airline industry's precarious financial state (Nov. 18, 2002, pp. 52-69), there's no denying that the majors as a group have made progress.

They've reduced expenses, due in some cases to lower labor costs and higher productivity. While revenues are still depressed from the pre-Sept. 11, 2001, doldrums, ticket sales are increasing. Near-term liquidity and operating margins have improved. The carriers no longer are piling up unsustainable losses, though they're still swimming in red ink. Net losses totaled $5.3 billion in 2003--most of it in the first half of the year--versus $7.4 billion in 2002. Furthermore, some carriers may actually break even or post a slim profit in 2004.

American Airlines, which barely escaped Chapter 11 filing last summer, and United Airlines, which has operated under bankruptcy protection since December 2002, have come the farthest. Embattled US Airways, which exited Chapter 11 in April 2003, is again teetering on the brink, while Delta Air Lines and Northwest Airlines are lagging. Continental Airlines is doing a respectable job but was recently overtaken by American as the lowest cost operator among the legacy hub-and-spoke carriers.

The airline crisis of 2001-03 is over, and there is unlikely to be any more Chapter 11 filings anytime soon, declared Philip Roberts, vice president and managing partner of Unisys R2A, a transportation management consulting firm. That's how UBS Warburg analyst Samuel Buttrick sizes up the sector too. Barring a serious shock to the U.S. air transportation system, he thinks the most recent cyclical downturn is unlikely to force any more major airlines into Chapter 11. "They will muddle through," he said. That's if they're lucky.

Despite the majors' current and near-term momentum, J.P. Morgan bond analyst Mark Streeter pointed out they face numerous long-term problems. Roberts put it more bluntly: "Although the short-term results suggest the worst is over, the picture is still very ugly." Analyst Philip Baggaley, managing director at Standard & Poor's, offered a similar assessment: "They're coming out of the downturn alive but crippled." (S&P, like Aviation Week, is a unit of The McGraw-Hill Companies.)

The cost of labor is still too high in relation to operators' revenues and overall cost structure, according to many of the 14 industry observers interviewed by Aviation Week for this special report. The price of fuel remains stubbornly high and shows no signs of easing in the foreseeable future. Thus far, the majors are taking only baby steps toward true restructuring of their expensive hub-and-spoke business models. In addition, low-cost competitors--such as AirTran, JetBlue Airways and Southwest Airlines--are continuing to take market share away.

Attacks by new-generation airlines on the fortress hubs of legacy carriers have begun in earnest--and many observers believe it's just a matter of time before low-cost operators launch an assault on majors' transatlantic business. Little by little, legacy network airlines are finding they have fewer safe havens from the low-costs. Against this backdrop, there's the huge financial burden all of the traditional network players are carrying.

"They must dig out of such a deep hole that even meaningful progress in any one quarter will bring them only part of the way up the side of this incredibly deep pit," Baggaley said. Even if they became respectfully profitable tomorrow--most operators have never earned their cost of capital--they would still be carrying a substantially heavier financial burden than they have historically, he added. "It is very unlikely they will ever prosper or get on a solid financial footing, and it is very likely we'll have an airline sector in which the participants will be weak and vulnerable for the next decade. Who survives and how much market share they give up will depend on geopolitics and how skilled their management teams are."

Of course, one of the six existing majors could fail and have to liquidate its assets, reducing total industry capacity. Even then, Baggaley thinks the remaining survivors would get only short- to intermediate-term relief. Still remaining would be the vexing problem of how to effectively counter low-cost competitors. The latter almost certainly would snatch a sizable amount of whatever capacity came up for grabs. The rate at which they are gaining domestic market share may slow, but the basic trend probably is irreversible. In time, low-cost operators are expected to dominate 40-50% of the U.S. market, up from 7-8% 10 years ago and about 20% now.

Waiting in the wings are embryonic groups that aspire to be the next JetBlue success story. "There are a lot of people who are trying to launch a low-cost carrier," said Ray Neidl, an analyst at Blaylock & Partners. "Most won't get off the ground, but you can't dismiss the possibility that someone will have the same winning formula--a good concept, good management and plenty of capital."

There was a time when traditional hub-and-spoke airlines gave little or no credence to the low-costs. "Now majors are more worried about low-cost competition and less about terrorism," Baggaley said.

They have good reason to worry, of course, but it's US Airways whose survival is most at risk.

This spring, Southwest plans to invade US Airways' fortress hub in Philadelphia, which generates about 17% of the latter carrier's total system revenues. US Airways already faces stiff competition from other low-cost airlines in the six markets Southwest will serve initially. As a result, the immediate impact may not be as dramatic as many observers expect.

But in the longer run, Southwest is expected to make mincemeat of US Airways because its operating costs are so much lower (7.7 cents per available seat mile versus US Airways' 11.7 cents in the fourth quarter of 2003). The likely outcome of this competitive mismatch is that US Airways' viability as a network carrier may well come to an end forever. To make matters worse, JetBlue has also successfully penetrated some US Airways markets on the East Coast.

"I don't see much future for US Airways and believe they could go under sooner rather than later," Neidl said. "Management failed to reduce the company's operating costs enough while the airline was still under Chapter 11 bankruptcy protection. By exiting prematurely, the carrier is as vulnerable to low-cost competitors as it ever was, and Southwest's entry into Philadelphia could be the proverbial straw. The fact that they started talking about asset sales three months ago underscores how serious a situation they're facing."

Buttrick shares Neidl's somber outlook. "It's extremely difficult to be optimistic about US Airways' long-term future," he said. "As the carrier is now configured, it will be almost impossible for them to make it."

Still, even the most troubled airlines have demonstrated a remarkable ability to hang on in the face of seemingly impossible odds. There's no better example than Trans World Airlines, which practically was on life support for 10 years. In the case of US Airways, Buttrick pointed out that it posted respectable profits several years in the mid-to-late 1990s. There is nothing to preclude a bout of profitability in the future as demand for travel continues to improve, although its long-term outlook is extremely poor, he said.

"Not everyone will survive--only those who are nimble enough to respond to market demands," outgoing Continental Chairman and CEO Gordon Bethune said. He ought to know. In 1994, Continental was on the verge of Chapter 11 for the third time, and Bethune was able to inspire all of the carrier's stakeholders to pull together and adopt a more business-like approach. But steering clear of Chapter 11 and doing well is not all about forcing wage cuts on an otherwise dedicated workforce, he said. "It's also about how you run your company. You've got to listen to your customers."

Could the majors actually be in control of their own fate? One would never know it, judging from how rare it is for executives running major airlines to be called to task--despite the billions of dollars of wealth they have destroyed through the years relative to their compensation packages. Management's role is a subject everyone seems to tiptoe around, as opposed to the subject of labor, which is usually pilloried as the principal cause of the airlines' troubles. But as one industry analyst put it, "Who's supposed to be running the show?"

While all of the legacy airlines currently in operation won't survive, Bethune also noted they aren't all going to disappear in mass either. The question is how many, if any, will ever become truly healthy and resilient, as Southwest is, regardless of business cycles. Some industry observers believe none will achieve such success until there is sweeping change in executive suites as managers are brought in, probably from outside the industry. "These companies aren't going to get where they need to go through incremental change," one observer said.

No such transformation appears in sight, although one never knows. Former Delta Chairman and CEO Leo Mullin recently stepped down, and Bethune--the last Big Six CEO who dates from Sept. 11, 2001--plans to retire at the end of this year. Both companies could settle for only minor adjustments to their business models--or seize the opportunity to implement real structural change. But if past is prologue, don't count on it.

As the majors' market share continues to erode, Edmund S. Greenslet, head of ESG Aviation Services, expects to see their numbers also drop. It's impossible to predict the stages this "forced consolidation" will go through, he said, but it's likely to span a combination of possibilities. These include at least one failure, a merger or two and code-sharing agreements that stop just short of a full merger. "There is room for four or five, but not all six," he said.

As that process plays out, the financial condition of majors individually or collectively won't make antitrust regulators any more sympathetic to merger proposals, said Charles Biggs, former acting deputy assistant attorney general for enforcement at the Justice Dept. "What may improve the odds of more outright consolidation is the fact the industry is moving toward a different business model, and the barriers of entry don't seem to be as formidable," he said. "The ability of operators like JetBlue to compete successfully has got to be taken into regulators' analysis." While all proposed mergers should be viewed with a great deal of skepticism, he predicted some will be approved.

Assuming the U.S. economy continues to improve in 2004, Greenslet expects the industry to move into the black either this year or next. Whether the profits will be sufficient to sustain them is another matter, but he feels certain that profits will be substantially less than they were in the late 1990s. Consequently, legacy majors will remain "extraordinarily vulnerable to economic twists and turns." He suspects it will be some combination of these events that will cause the group to lurch toward the next round of consolidation.

The shortest route to the scrap heap will be following a business-as-usual approach, which has been the historical pattern of the majors, said Thomas Hanson, who heads the airline consulting practice at Booz Allen Hamilton. "As it is, all of them suffer from corporate cultures that have blinded them to the fact that it's a new world," he said, "and that culture is fundamentally incompatible with the new paradigm."

That thought was echoed in a recent edition of Unisys R2A Scorecard: "The salvation of the legacy carriers does not lie in external events--waiting for Southwest to lose control of its costs, for example, or fuel prices to return to 40 cents a gallon, or government intervention. Rather, it lies within the grasp of each airline that is willing to seize control of its own destiny and make the hard choices--based on a realistic analysis of the world as it is, not as one would like it to be--necessary for success."

 

[BoeingBoy]

[Second Article in the Series - Jim]

Big Six: Cutting Costs, on Their Way
Aviation Week & Space Technology
03/01/2004, page 45

David Bond
Washington

The Big Six U.S. majors aren't there yet, but they're cutting costs and on their way

Work in Progress

"There's no question whatsoever in Delta's mind that we are in the midst of a profound, fundamental and truly irreversible series of changes in which the value proposition to the investors and the customers is changed unalterably. In this new world some airlines are winning and some airlines are losing, and I would say that Delta is still positioning for long-term success."

The speaker is Fred Reid, president and chief operating officer of Delta Air Lines, and the occasion is a Feb. 4 Goldman Sachs transportation conference. But apart from the references to Delta, the assessment could have been made just about any time during the past couple of years by almost any senior executive of the five other members of the Big Six network airlines--American, United, Northwest, Continental and US Airways.

About two years ago, in the spring of 2002, even the most diehard industry optimists were beginning to conclude that the revenue environment of the late 1990s was gone, for the foreseeable future if not forever. Until then, a segment of the industry still believed yields would come back once the U.S. economy recovered from recession and travelers recovered from the shocks of Sept. 11, 2001. Airlines had turned quickly to massive capacity reductions and layoffs to ride out the downturn, but sooner or later the free-spending business travelers of the dot.com bubble would be back.

It turned out that the wish was father of the thought. The Iraq war and setbacks from the severe acute respiratory syndrome outbreak of 2003 made things worse, but these were side issues. The essential message was clear then as now: The time when airlines could count on revenue increases to relieve them of the need to control costs was gone. They needed to reform. And as they did so they would face growing pressure from airlines whose costs already were low and thus could turn a profit in the new low-fare environment. Market conditions that threatened the old-line network carriers were what the new breed was designed for.

Old paradigms die hard, but in varying degrees of conviction and zeal the Big Six set out to reduce their costs. What follows is an assessment--preliminary, with much remaining to be done in coming years--of how well they have done so far.

Each of the Big Six has squeezed millions of dollars out of its operations, and the financial losses of 2001-03 are much reduced. But a significant percentage of some carriers' operating results during this period, as reported, were distorted by counting federal grants (2001-02) and security fee "refunds" (2003), as well as income tax refunds, as offsets to operating costs. They were nothing of the sort, and handling them that way left a false impression of how well the carriers were doing. Conversely, sometimes aircraft writedowns, provisions for layoffs and other unusual items were counted as operating costs, worsening the picture.

Also, the Big Six were pursuing cost cuts that represented true reductions, not just reflections of reduced capacity. A simple way of measuring this is to count costs per available seat mile, not costs alone. The distinction also in effect measures an airline's efficiency in producing its product--passenger seats flying from one point to another.

In a sense, counting costs per available seat mile is a stringent test. The marginal cost of one more seat mile is low, well below the average cost. That's why fare sales make sense as long as they don't become fare wars, and the airlines are offering them now, during a slow travel period of the year. But just as it costs relatively little to add a small amount of capacity, it saves relatively little to subtract it. And unit costs increase as capacity is reduced unless the costs are lowered by the same percentage.

The graphs on this and the previous page show how each of the Big Six airlines has reduced its unit costs since 2000, the most recent year of an industry-wide profit. For each carrier, the year-2000 unit costs for personnel, nonpersonnel and total operations are indexed at 100. The amounts in the following years show how much unit costs increased or decreased above or below the 2000 benchmark. Costs exclude unusual items and fuel, for which sharp price increases had a heavy impact in 2003.

The data lead to three compelling conclusions:

* The advantages of winning labor concessions can't be overemphasized. United and US Airways renegotiated union contracts as part of Chapter 11 bankruptcy protection proceedings, and American secured givebacks once a Chapter 11 filing became the only alternative. It's hard for Delta, Northwest and Continental to reduce overall unit costs competitively when their unit personnel costs are 16.8% to 23.7% higher than they were in 2000, and they haven't been able to.

*None of the Big Six is anywhere near done yet. Even though United was in Chapter 11 throughout 2003 and US Airways was in Chapter 11 for eight months in 2002-03, only American has reduced its overall unit costs. US Airways has concluded that it didn't reduce costs enough when it was in bankruptcy protection.

*The low-hanging fruit has been picked from the tree. The next three years of cost reductions will be much more difficult than the first three were.

Cost-cutting accomplishments at United and US Airways are understated in this tabulation because these carriers have reduced capacity more than the others. As available seat miles decrease, the per-seat-mile cost of a given expense increases. In that light, US Airways' personnel and overall indices of 92.0 and 103.8, respectively, stand out. Although the carrier's nonpersonnel cost data are colored by the way it accounts for capacity purchases from regional associates, its continued increase in nonpersonnel costs last year, despite the advantages of bankruptcy protection, is a setback.

American has attained consistent, steady development of nonpersonnel initiatives as well as its brink-of-bankruptcy union concessions. American was the only Big Six airline that reduced nonpersonnel unit costs during 2001 as the industry-wide revenue shortfall deepened, and it maintained reductions throughout the three years. United and US Airways, accelerating toward bankruptcy, didn't even reduce nonpersonnel costs during 2002.

Delta, Northwest and Continental, lacking labor concessions, reduced nonlabor unit costs during 2002 and 2003 to 3.2%, 3.4% and 4.1% below 2000's levels, respectively. They continue to seek givebacks from their unions (Delta estimates that it would have been profitable last year if it had had United's labor costs), but unions haven't been receptive so far when they don't see an imminent threat of bankruptcy.

Where do the Big Six go from here? More cost-cutting and process improvement, more substitution of technology for personnel, more reductions in service quality or products that travelers aren't willing to pay for. And for the first time since 2001, stand-and-fight competition against the low-cost airlines.

As the catastrophic losses of 2001-03 recede, the big network carriers are in a position to increase capacity a bit, and they plan to do so. At least some of that increase will go toward reversing their roll-over-and-play-dead response to the entry of low-costs into some of their most profitable markets. They will be able to avoid unit-cost increases if they can limit overall increases to the percentage by which they grow capacity. They will have to match their competitors' low fares, and the key to their success will be filling the seats they throw into the fray.

In the longer run, it will take years of profitability to repair the Big Six balance sheets. During the past three years, they borrowed to the hilt, first with secured loans and eventually with convertible notes. They deferred delivery of new aircraft even as they retired and parked old ones, sold off assets and tapped Congress for grants and security-fee "refunds," all aimed at amassing enough cash to ride out the period in which they were burning cash day after day. Now that the cash fires have dampened, the carriers have large amounts of cash on hand and the probability that they won't need all of it. Instead, they need to pay down debt.

 

[BoeingBoy]

[Article 3 of series - Jim]

Old Labor Issues Fade Under Economic Pressures
Aviation Week & Space Technology
03/01/2004, page 47

James Ott
Cincinnati

Economic realities pervade contract talks, but labor has plenty to say about management

Old Issues Fade

Labor is adjusting reluctantly to management demands for wage cuts and productivity gains in this latest airline crisis. As contract negotiations heat up in the months ahead, countdowns, bluffs and eleventh-hour dueling may evoke images of doomsday, but unions are likely to continue exchanging pay cuts for job security.

Snapback provisions, a feature of concession contracts that in the past returned wages and work rules to previous high levels, are scarce this time. Industry consultant John Adams of Washington said, "Airlines and labor have to look at the marketplace to guide their decisions, not for political solutions." An industry is troubled, he said, when wages are not based on market realities but on "what everyone else is getting."

Union negotiators are not idle. They are seeking contract advances where they can, especially at the regional airline level. But no contracts in the most recent rounds obtained benefits that disturb the all-important cash flow to the financially weakened airlines.

Retired United flight attendant Jackie Matazzoni distributes leaflets protesting what the union refers to as the airline's plan to defraud retirees of low-cost health care.Credit: GETTY

The realities of the current business environment are widely accepted. Old labor rallying cries have faded. The hot-button congressional issue concerning striker replacement, an all-consuming controversy prior to Sept. 11, 2001, has cooled. Work slowdowns have passed from the scene. No one wants a strike, particularly veteran pilots with seniority whose pensions are at stake.

"It's a long fall from the left seat of a defunct carrier to the bottom of another seniority list," said a veteran pilot close to labor negotiations. "Plenty of pilots have had an opportunity to fly the line with former Eastern and Pan Am pilots and recognize the struggle and hardship of working one's way back up another list. Seniority is definitely a two-edged sword, so any work stoppage or slowdown which has the risk of starting over is considered career suicide."

Delta Connection's Comair pilots carried out the most recent strike, an 89-day walkout, in the late spring of 1991. More recently Mesaba pilots threatened to shut down that regional operator, but a deal was struck finally. In each case, among other benefits, wages were increased, especially for pilots in the first years who had been underpaid.

Pilot pay at regional airlines has become the B-level wage scale that American Airlines introduced at its mainline in the 1980s. The two-tier scale was widely copied to the chagrin of labor. The bi-level pay for doing the same job became a major cause of workforce dissension and has been eliminated from mainline contracts.

Automatic snapbacks are disappearing from current contracts. "Companies are not willing to ever go back to the way they were," said Pat Friend, president of the Assn. of Flight Attendants (AFA), the U.S.' largest flight attendant union. Instead, the unions look for "success sharing." It was a pleasant surprise to many, she said, when the profit-sharing provisions taken in concession contracts by Hawaiian Airlines' employees, including its AFA members, paid off at the end of 2003. The participating employees split $3 million.

Management has been seeking long-term labor contracts. Unions prefer the short term. The AFA contract at United Airlines runs through May 2009. At US Airways, the contract may be amended at the end of 2008. When negotiations start again, the flight attendants are likely to make an effort to restore pay levels, especially those that are regarded as out of line.

"Flight attendants have lost a lot," said Friend. "Obviously there is the reduction in wages, and we've tried to minimize that every place we could, by raising the cap for hours per month you can work. We've tried to minimize the direct impact on the pocketbook. In most cases, flight attendants are working more for the same amount of money."

NEGOTIATORS HAVE tried to balance company requirements with the wage needs of flight attendants raising families, said Friend. The result is a more demanding working environment. The union chief said some airlines have reduced staffing levels to the FAA-approved minimums. Duty days have been extended and minimum rest times are shorter. The minimum required rest time is 8 hr., but the legal minimum does not take into account the time of transportation to a hotel. Frequently, flight attendants are "exhausted" by the end of the day, she said.

AFA has become an entity of the Communications Workers of America, a union divided into nine districts with a membership of 700,000 people, many in the telecommunications field. AFA has gained stability with the merger, said Friend, with access to resources that formerly were beyond the stand-alone AFL-CIO union. When United filed a motion in bankruptcy court to reduce health care benefits of retirees, AFA conducted a campaign involving newspaper advertising and billboards "getting into their face with this."

In the Allied Pilots Assn. contract ratified last year, pilots at American Airlines took an equity stake in the carrier as their pay was cut deeply. American pilots now are the lowest paid of their counterparts at the six network carriers, including US Airways and United which sought court protection in bankruptcy proceedings.

The concessions taken by American's pilots set a new bar for negotiations underway at Delta Air Lines, Northwest and Continental airlines. But the bar may not be influential. Unions are expected to push for significant equity in return for wage cuts, more than what American's pilots received. In the APA contract pilots received 967 stock options. The pension formula at American was protected, but the final average earnings calculation is based on new pay rates.

Under the terms of the contract, American forgave the $27-million balance on the $45-million assessment that a federal judge had issued against APA for conducting an illegal "sick-out."

The Air Line Pilots Assn. made overtures last year to APA members at American under the banner of a union drive for pilot unity that had already drawn pilots at Continental Airlines and FedEx back into the ALPA fold. "We are not critical of APA, but we would do better with shared resources," said Duane Woerth, president of ALPA International. "We made that pitch and heard some rumblings, but the ball's in their court," he said.

Woerth keenly understands the predicament of the network airlines, but he's critical that management often "leaves everything at labor's door." He recommends the six network carriers simplify their fleets from multiple aircraft types to three or four, which would be sufficient to operate in the domestic, short-haul and international markets. Woerth said it's not labor's fault that management fielded a complicated fleet of aircraft and absorbed huge training costs as a result. Labor is also not responsible for oil at $35 a barrel and high security expenses imposed by the government, he said.

In an interview with airline analyst Susan Donofrio of Deutsche Bank in New York, Woerth agreed that improving productivity was a key goal for the network carriers. He said the airlines with high productivity "are not in many cases even low-wage carriers--they just have high productivity which offsets high wages. But that productivity comes from their business model, not from a more liberal contract. The Southwest pilots' contract has much tighter work rules than the typical ALPA contract. But they have a high-productivity business model to work in."

Woerth said Southwest's ground staff is far more productive than network carrier employees because the business model calls for aircraft of a single type, serving city-pairs with at least six frequencies a day, and with ground personnel busy all day long. "The network model loses its efficiencies on the ground. Small cities with low frequencies and small airplanes will always have high unit costs," he said.

The union president also recommends that network airlines implement high-productivity operations in large markets where low-cost competition has centered.

ALPA has adopted the Air Transport Assn. position that the airlines are unduly burdened by taxes and fees. Airlines collected $11 billion in taxes annually for the government, he said, which was passed through from the consumer. Taxes now represent 24% of the price of the average ticket, a higher rate than liquor and tobacco taxes. Woerth also believes that consolidation will help U.S. airlines. Overcapacity is a problem, he said, and a consolidated industry would do a better job rationalizing capacity. He expects employees would find consolidation more palatable than continued long-term concessions.

WOERTH IS CRITICAL OF network airlines that attempt to operate with two or three carriers under a single brand. He said the arrangement is not manageable and has left network carriers puzzled as to how to allocate revenues and costs within the single brand. He cited the differences between once-partners United Airlines and Atlantic Coast Airlines over how to share the business risks.

The union chief speaks strongly against the rise of pay-for-departure contracts between mainline and regional carriers and the contracts known as Aircraft Crew Maintenance and Insurance (ACMI) in which an operator provides a crew and an aircraft for flying assignments. In a column written for Air Line Pilot magazine, Woerth wrote: "Thousands of pilots are being told daily that they need to lower their already inadequate pay to allow their 'fee-for-departure/ACMI' employer to bid for capacity within an airline brand."

Woerth said pilots faced a similar issue in the 1920s when airlines sought the lowest bidder to fly U.S. Mail contracts. ALPA was formed to carry out collective bargaining and do away with the bidding war.

 

[BoeingBoy]

[Article 3 of series - Jim]

Airline Consolidation Enters Final Stages
Aviation Week & Space Technology
03/01/2004, page 48

George James

AS I SEE IT . . . Then There Were . . .

The winnowing process that has been playing out in the airline industry since deregulation 25 years ago should come as no surprise to anyone.

It is a process not unlike what has occurred in other openly competitive sectors: a relatively large group of companies working their way toward a few major competitors. Observers need only consider the history of such industries as autos, cereals and steel to realize the airlines are on a similar trajectory, but one that has brought about an upheaval with little comparison. In 1978, before the sector turned into a free-for-all, there were 30 large carriers, each transporting more than 250,000 passengers annually. They have since dwindled to 10. The question is what the industry will look like when this attrition is over. Only a few will be left standing, most likely three large network airlines and a handful of scrappy, innovative, smaller ones.

There are good reasons why three seems to be the magic number. More than that results in intense price competition, often below costs, and unsustainable losses. Fewer tends to trigger Justice Dept. intervention.

Prior to 1978, the government decided which airlines could fly where and how much they could charge. Washington also made certain that not a single airline failed in bankruptcy in the 40 years they were regulated. All that changed with deregulation as new entrants flowed freely into the industry until the larger existing airlines learned how to use their unique strengths. Frequent-flier programs, hub-and-spoke route networks, sophisticated pricing programs and other innovations were the demise of all new startups by 1985 except one--America West.

With the newer airlines out of the way, the larger, established airlines turned on one another. First, they built up their sizes through mergers and acquisitions. Then they purchased international routes from failing carriers such as Pan Am and Eastern. Subsequently, they built up global alliances with foreign airlines.

Meanwhile, labor costs continued to rise inordinately, contributing to massive financial losses in the early 1990s as well as the failure of many large airlines. The remaining large carriers sought to cover these costs and found the answer in raising fares for business travelers. In the mid-to-late 1990s, these fares more than quadrupled and resulted in record profits.

A second wave of new entrants was triggered, including JetBlue and ValuJet (now AirTran), causing even more pressure on the large airlines to diminish toward three of the original 30. With the impact of Sept. 11, 2001, and the U.S. economic downturn, business travelers, concentrating on lower costs, went for the low-fare, low-cost newer airlines, and Southwest, in growing numbers. A decade ago, the smaller airlines, including Southwest, held 9% of the U.S. market. Today, their share exceeds 22%.

Now, many of the 10 remaining from the original 30 are in or close to bankruptcy including United, US Airways, Hawaiian, American and Delta. Alliances between domestic carriers (e.g., Delta, Northwest, Continental) have emerged as another path to just three major operators. By the time consolidation is completed, bankruptcy, or the threat of it, will have proved an effective means of addressing an airline's unacceptably high labor costs in a way nothing else has. Bankruptcy also is an effective means of ridding operators of excessive levels of management, as well as winnowing out unprofitable routes and allowing the leaner carrier to build on its core strength. In addition, bankruptcy paves the way for an airline to make wider use of regional jets and establish stand-alone subsidiaries, which may be able to compete more effectively with low-cost operators. Looking ahead, American, United and Delta will most likely be the legacy airlines left standing, along with Southwest. The Big Three will have lower labor costs, strong hub-spoke operations, international routes, global alliances, regional aircraft and larger size as they pick up parts of other carriers going out of business. Even mighty Southwest will face challenges; it will have to learn how to continue to prosper in the face of growing low-fare competition. Eventually, this latter group, including Southwest, will have to endure a shakeout not unlike the consolidation now playing out among the traditional majors.

As the consolidation progresses, what are the lessons for the surviving "Big Three"?

The most obvious is the critical importance of controlling the growth of labor costs. High labor costs generally have sprung from the perception that passengers wanted safety at all costs. The fact is, however, that passenger airlines can maintain superb safety records without having to agree to astronomical, unsustainable wage and benefit contracts. Every new low-cost carrier has demonstrated that.

The remaining Big Three also can streamline their hub-and-spoke networks to obtain higher aircraft utilization and incorporate regional jets into their spokes. The global alliances are essentially in place and should be enhanced with cost-saving steps, such as multicarrier purchasing of everything from equipment to commodities. By making these moves, American, United and Delta can apply their strategy of the early 1980s, when large airlines essentially defeated the smaller carriers by using their unique strengths.

With few exceptions, the majors that are left will no longer have to battle other large carriers. Their real competition will be the smaller, low-cost, low-fare airlines that have no traditional hub-and-spoke networks or global alliances. This will become a huge advantage after the Big Three have markedly lowered their labor costs. At that point, they finally will be able to take advantage of their size and provide a level of service, profitably, that is beyond their capability today.

Airline Consolidation Enters Final Stages
Aviation Week & Space Technology
03/01/2004, page 48

George James


AS I SEE IT . . . Then There Were . . .

The winnowing process that has been playing out in the airline industry since deregulation 25 years ago should come as no surprise to anyone.

It is a process not unlike what has occurred in other openly competitive sectors: a relatively large group of companies working their way toward a few major competitors. Observers need only consider the history of such industries as autos, cereals and steel to realize the airlines are on a similar trajectory, but one that has brought about an upheaval with little comparison. In 1978, before the sector turned into a free-for-all, there were 30 large carriers, each transporting more than 250,000 passengers annually. They have since dwindled to 10. The question is what the industry will look like when this attrition is over. Only a few will be left standing, most likely three large network airlines and a handful of scrappy, innovative, smaller ones.

There are good reasons why three seems to be the magic number. More than that results in intense price competition, often below costs, and unsustainable losses. Fewer tends to trigger Justice Dept. intervention.

Prior to 1978, the government decided which airlines could fly where and how much they could charge. Washington also made certain that not a single airline failed in bankruptcy in the 40 years they were regulated. All that changed with deregulation as new entrants flowed freely into the industry until the larger existing airlines learned how to use their unique strengths. Frequent-flier programs, hub-and-spoke route networks, sophisticated pricing programs and other innovations were the demise of all new startups by 1985 except one--America West.

With the newer airlines out of the way, the larger, established airlines turned on one another. First, they built up their sizes through mergers and acquisitions. Then they purchased international routes from failing carriers such as Pan Am and Eastern. Subsequently, they built up global alliances with foreign airlines.

Meanwhile, labor costs continued to rise inordinately, contributing to massive financial losses in the early 1990s as well as the failure of many large airlines. The remaining large carriers sought to cover these costs and found the answer in raising fares for business travelers. In the mid-to-late 1990s, these fares more than quadrupled and resulted in record profits.

A second wave of new entrants was triggered, including JetBlue and ValuJet (now AirTran), causing even more pressure on the large airlines to diminish toward three of the original 30. With the impact of Sept. 11, 2001, and the U.S. economic downturn, business travelers, concentrating on lower costs, went for the low-fare, low-cost newer airlines, and Southwest, in growing numbers. A decade ago, the smaller airlines, including Southwest, held 9% of the U.S. market. Today, their share exceeds 22%.

Now, many of the 10 remaining from the original 30 are in or close to bankruptcy including United, US Airways, Hawaiian, American and Delta. Alliances between domestic carriers (e.g., Delta, Northwest, Continental) have emerged as another path to just three major operators. By the time consolidation is completed, bankruptcy, or the threat of it, will have proved an effective means of addressing an airline's unacceptably high labor costs in a way nothing else has. Bankruptcy also is an effective means of ridding operators of excessive levels of management, as well as winnowing out unprofitable routes and allowing the leaner carrier to build on its core strength. In addition, bankruptcy paves the way for an airline to make wider use of regional jets and establish stand-alone subsidiaries, which may be able to compete more effectively with low-cost operators. Looking ahead, American, United and Delta will most likely be the legacy airlines left standing, along with Southwest. The Big Three will have lower labor costs, strong hub-spoke operations, international routes, global alliances, regional aircraft and larger size as they pick up parts of other carriers going out of business. Even mighty Southwest will face challenges; it will have to learn how to continue to prosper in the face of growing low-fare competition. Eventually, this latter group, including Southwest, will have to endure a shakeout not unlike the consolidation now playing out among the traditional majors.

As the consolidation progresses, what are the lessons for the surviving "Big Three"?

The most obvious is the critical importance of controlling the growth of labor costs. High labor costs generally have sprung from the perception that passengers wanted safety at all costs. The fact is, however, that passenger airlines can maintain superb safety records without having to agree to astronomical, unsustainable wage and benefit contracts. Every new low-cost carrier has demonstrated that.

The remaining Big Three also can streamline their hub-and-spoke networks to obtain higher aircraft utilization and incorporate regional jets into their spokes. The global alliances are essentially in place and should be enhanced with cost-saving steps, such as multicarrier purchasing of everything from equipment to commodities. By making these moves, American, United and Delta can apply their strategy of the early 1980s, when large airlines essentially defeated the smaller carriers by using their unique strengths.

[George James was senior vice president and chief economist of the Air Transport Assn. from 1966-85. Subsequently, he founded the airline consulting firm of Airline Business.]

 

[boeing787]

Thanks for taking the time to do that. Nice posts.

 

[ktflyhome]

Yes, BoeingBoy- Many thanks. Very Interesting.

 

[BoeingBoy]

Cut and Paste is such arduous work....

Just wish the charts mentioned in the second article had come thru the process.

Jim

 

[BoeingBoy]

Ok, I'm gonna try to attach the charts from the second article. They're small and the print is hard to read - the blue line is personnel costs, the green is non-personnal, and the red is overall cost (all measured in cents per ASM)

The left side of each chart is the year 2000, the right side is 2003.

Jim

 

[ktflyhome]

BoeingBoy: So If I am reading this correctly, it looks like non-personnel for U as risen, personnel has decreased. Right?

 

[ktflyhome]

With the other airlines (if I am reading this right) their non personnel as decreased, where as U has increased. Why is this???

 

[ClueByFour]

"Not everyone will survive--only those who are nimble enough to respond to market demands," outgoing Continental Chairman and CEO Gordon Bethune said. He ought to know. In 1994, Continental was on the verge of Chapter 11 for the third time, and Bethune was able to inspire all of the carrier's stakeholders to pull together and adopt a more business-like approach. But steering clear of Chapter 11 and doing well is not all about forcing wage cuts on an otherwise dedicated workforce, he said. "It's also about how you run your company. You've got to listen to your customers."

Could the majors actually be in control of their own fate? One would never know it, judging from how rare it is for executives running major airlines to be called to task--despite the billions of dollars of wealth they have destroyed through the years relative to their compensation packages. Management's role is a subject everyone seems to tiptoe around, as opposed to the subject of labor, which is usually pilloried as the principal cause of the airlines' troubles. But as one industry analyst put it, "Who's supposed to be running the show?"

Two points here:

Little Dave, despite claiming Bethune as his mentor, has never understood that cost-out is only half the equation to running a successful enterprise (the easy half, actually--especially with the Chapter 11 hammer). Apparently, Dave is either slow on the uptake or not a very astute student of history.

The quote about executive compensation at the majors is spot on. It's all about accountability, and Herb and Neeleman have laughed all the way to the bank--on the strenght of the value their options have generated under their leadership.

 

[ClueByFour]

Although the carrier's nonpersonnel cost data are colored by the way it accounts for capacity purchases from regional associates, its continued increase in nonpersonnel costs last year, despite the advantages of bankruptcy protection, is a setback.

Once again, a failure that no amount of beating labor about the ears will solve.

I'm beginning to agree with PB--I don't think Little Dave is capable of any type of cost savings outside of beating labor to a pulp.

 

[usfliboi]

Dave has never said it was all labor and bethune gets paid a chunk as well. The bottom line the whole lot of it has to be cut plain and simple. You cant blame him for todays environment.

 

[Bear96]

Dave has never said it was all labor and bethune gets paid a chunk as well. The bottom line the whole lot of it has to be cut plain and simple. You cant blame him for todays environment.

Of course you can't blame him for today's "environment" but did you look at the graphs?

Every airline-- all operating in the same "environment"-- have lower non-personnel costs than they did in 2002. Except U.

So why is that?

How come ALL the other CEOs have managed to get their non-personnel costs down?

Fliboi I agree with you that some people here may blame Dave for some things unfairly. But certainly he must have SOME reponsibility and can't blame everything on the "environment," no?

 

[Doc]

Dave has never said it was all labor and bethune gets paid a chunk as well. The bottom line the whole lot of it has to be cut plain and simple. You cant blame him for todays environment.

I may not be able to blame him for the environment but I sure can blame him for a whole lot of mismanagement……….

Where is the marketing department been, where is the advertising this man has spent so much time on our pay that he hasn’t paid any attention to the airline we our floundering because he's inept of running a business he cannot walk and chew gum at the same time.
This company has never had an original thought all we do is follow and not even that well.

I will leave you with this. The business travel flies us for our amenities FF miles, First Class etc… Now we take first class away. I have always said listen to your customers they will tell you what they want. And they like upgrading but Dave and his gang take it away………US1 and 2’s are not happy why pay a little extra for nothing oh wait that’s right they can fight over the 8 seats on a 757……It’s a perk they fly us because of it.


How about seasonal flights from BOS to RSW for spring training

OH THAT’S RIGHT SONG IS THE OFFICAL AIRLINE OF SPRING TRAINING.



DAVE GO RUN A CAR WASH………………………….