EconSouth (Third Quarter 2003)


INDUSTRY FOCUS

Americans’ love affair with air travel has soured a bit since Sinatra crooned “Come fly with me.” Even before the dramatic downturn set off by the 9/11 tragedy, major airlines were struggling to fill enough flights to remain profitable, and the recent economic doldrums have brought some airline Goliaths to their knees. But many of the smaller, economy airlines are thriving and are luring travelers back to the skies. The secrets of these discount carriers’ success are likely to spell lasting changes for the airline industry, the infrastructure that supports it, and the customers it serves.

Tmerging largely unscathed from an accumulation of woes that have pushed some major air carriers to the brink of bankruptcy and beyond, discount airlines in the United States are defining the shape of what’s to come in the air transportation industry.

Major airlines, still reeling from the catastrophe of Sept. 11, 2001, have suffered further setbacks from the SARS epidemic, the Iraq war, high fuel costs, new security considerations and a sluggish national economy. Government reimbursement for airport security fees helped Delta Air Lines, Northwest Airlines and Continental Airlines post modest profits for the second quarter of 2003, but excluding these one-time sources of income, the three carriers collectively lost $421 million. United Airlines, the nation’s second-largest carrier, is in bankruptcy, and US Airways has only recently come out of Chapter 11 bankruptcy.

In the meantime, economy carriers such as AirTran Airways, Southwest Airlines and JetBlue Airways have prospered. AirTran’s net income for the second quarter, without government aid and one-time earnings, stood at nearly $22 million. Its revenues for the quarter were up 23 percent over the previous year’s. Southwest posted gains of 23 percent over last year, not counting government aid, and JetBlue recently raised $129 million from a secondary stock offering.

The big carriers are scrambling to catch some of the market that fuels discount air travel, but how successful will they be?

The recent prosperity of the discount carriers and the seeming inability of most giant airlines to right themselves signal major industry shifts that industry experts believe will demand new approaches to the structure of air transportation. The hub-and-spoke system of organizing air travel that has been predominant in the industry since the 1970s seems destined to give way, at least partially, to the point-to-point system favored by most low-cost carriers.

But the logistics of getting air travelers from one place to another are daunting, and the economics of the air industry is complex. While changes are inevitable, they may not be simple and straightforward. The costs of dismantling the hub-and-spoke system would be considerable not only for major air carriers but also for the economy carriers that use a modified hub-and-spoke system. There would also be a significant impact on economies that have grown around hub-and-spoke operations and on the travelers who depend on them.

“Our industry is in the midst of a major crisis,” said Delta CEO Leo Mullin in a recent speech to the Aero Club of Washington, D.C., “and the path from here is far from clear.”

The new economy is luxury
For decades, flight amenities have been steadily declining. In an attempt to cut costs, the major airlines have progressively eliminated many of the niceties passengers associate with flying. Once-gracious in-flight service has devolved into a package of peanuts and a cup of soda as major airlines attempt to compete with no-frills economy carriers.

While some economy carriers have held costs down by offering few amenities, others are once again trumping the major airlines by restoring the amenities to flying, re-packaging themselves to provide a whole new set of perks. JetBlue and Song, Delta’s new economy subsidiary, offer more leg room and leather seats. JetBlue also provides satellite TV at every seat, and Song plans to follow suit. By early 2004, the carrier plans to equip each seat with a video monitor and satellite service so that passengers can watch digital TV and pay-per-view programs, play computer games and listen to MP3 audio files. Budget airline customers can also forget the little TV dinners that have become standard on the major airlines. While economy passengers will have to pay for their meals, airlines like Song now offer deli-quality in-flight food service.

BUT THE LONG-TERM ANSWER TO THE QUESTION OF WHETHER THE ADDITION OF POINT-TO-POINT ECONOMY CARRIERS WILL WORK FOR MAJOR AIRLINES SEEMS TO BE A FIRM “YES AND NO.”

Diseconomies of scale
How can economy airlines provide leather seats or in-flight satellite TV while traditional carriers can hardly afford peanuts? Major airlines bear the expense of creating and maintaining a massive infrastructure of hub-and-spoke connections that enable people to fly from, say, Wichita, Kan., to Montgomery, Ala., or from Portland, Ore., to Tallahassee, Fla., by connecting with flights at a central hub such as Hartsfield International Airport in Atlanta, one of the world’s busiest.

Major airlines make up for the costs incurred on undercapacity flights through earnings on heavily booked flights, especially from business travelers who once seemed willing to pay premium fares for last-minute flights. Cutbacks in business travel, even prior to Sept. 11, 2001, have made serious dents in the profitability of hub-and-spoke carriers.

Most low-cost airlines, on the other hand, provide point-to-point service or a modified hub-and-spoke system rather than maintaining an elaborate network of connecting flights. Because these economy carriers use nonunion labor, their pay scales for pilots, technicians and flight attendants are lower. In addition, their aircraft are typically smaller and more fuel efficient, and turnaround time for flights is quicker. All these factors mean less operational overhead. Industry analysts calculate that Southwest breaks even when its planes are 59 percent full, but United must utilize 90 percent of its capacity to break even. The estimated average cost for a major carrier to fly a Boeing 737-700 1,000 miles is $14,000, or about $120 for each paying passenger. In contrast, Southwest can fly 1,000 miles at a cost of around $10,000, or $102 per passenger.

In addition to underwriting service to less profitable destinations and sustaining higher labor costs, hub-and-spoke operators tend to group arrivals and departures in short blocks of time to ensure speedy connections, so that hub terminals are extremely busy at certain times and nearly idle at others. The large support staff necessary to accommodate the busy times of the day are underemployed during the slow times, as are the terminal’s many gates and ports.

Spreading air traffic more evenly through the day could result in significant savings for hub-and-spoke operators, according to R. John Hansman, a professor from the Massachusetts Institute of Technology (MIT) and director of MIT’s International Center for Air Transportation (ICAT). Some major airlines are already experimenting with less concentrated flight schedules. But this change comes at the expense of passengers’ convenience because many will have longer waits for connections. Cutting back too much on the conveniences that appeal to business and first-class passengers will cause higher-cost hub-and-spoke carriers to lose their chief advantage over low-cost point-to-point airlines.

Angling for a piece of the pie
Espousing the “if you can’t beat ’em, join ’em” philosophy, the nation’s large hub-and-spoke airlines have begun experimenting with low-cost subsidiary point-to-point carriers of their own in hopes of winning back some of the leisure travel market that has migrated to airlines like Southwest and JetBlue. Several of these experiments have flopped — United’s economy regional carrier, Atlantic Coast, has recently decoupled from its bankrupt partner, and Delta’s economy effort, Delta Express, was lackluster at best. But Delta has taken a cue from JetBlue and has launched another economy service — this time with pizzazz.

To kick off service between Orlando and Las Vegas, Delta’s economy subsidiary, Song, sponsored an in-flight wedding contest on Orlando radio stations. Winners were married in midair en route to Las Vegas, where they were greeted by showgirls and banquets to celebrate their nuptials.

Launched in April 2003 at a cost of $75 million, Song plans to offer 144 flights daily this fall with one-way fares of $73 to $282 between northeastern cities, Atlanta and Florida destinations. It hopes to nudge the competition by flying into New York’s LaGuardia Airport, a service not provided by other discount airliners. In July 2003 the airline filled 77 percent of its seats, exceeding Delta’s expectations. Thus far Song has proved most popular with Floridians, who accounted for 43 percent of the calls to Song’s reservations centers in the summer of 2003.

Will Song’s strategy work for hub-and-spoke giants? By shortening turnaround times and employing nonunion labor, Delta hopes to keep costs down; by adding amenities to low-cost flights, it intends to claim its share of the leisure travel market.

But the long-term answer to the question of whether the addition of point-to-point economy carriers will work for major airlines seems to be a firm “yes and no.” Yes, it seems likely that Delta can create air service that will compete effectively with JetBlue and AirTran. However, most analysts believe that the air travel market has been fundamentally transformed by the economy carriers. While consumers will enjoy the new amenities, price and scheduling will continue to be the primary considerations in choosing an airline, especially for short flights.

Large carriers’ financial crises may also indicate a more fundamental problem in the industry: an overcapacity that is damping prices down and making profits hard to come by. Thus far, low-cost carriers seem immune to industry woes, but continued expansion could affect their performance as well.

“IS HUB-AND-SPOKE SERVICE SIMPLY AN OUTMODED BUSINESS MODEL? THE ANSWER IS AN EMPHATIC ‘NO’. THE SERVICE HUB-AND-SPOKE CARRIERS PROVIDE IS NOT JUST AN IMPORTANT COMPONENT OF OUR NATIONS’ TRANSPORTATION SYSTEM, BUT AN ABSOLUTELY ESSENTIAL ONE.”
LEO MULLIN
CEO
DELTA AIRLINES

Overcapacity threatens all players
Even before the setbacks that began with the tragedy of Sept. 11, 2001, airlines faced a problem with overcapacity, according to a report in the Chicago Tribune. The economic expansion of the 1990s sparked a spree of aircraft acquisition and route expansion. Furthermore, competition between aircraft manufacturers Boeing and Airbus kept prices for new carriers low, encouraging airlines to shop for bargains.

As long as the economy was steaming, no one thought about the downside of acquiring more and more planes and routes. Now more than 800 aircraft are parked in the deserts of California and Arizona, and the nation’s largest airlines still cannot fill flights sufficiently to turn a profit.

Economy carriers, flush with success in the wake of major airline failures, are now embarking on their own spending sprees. AirTran, headquartered in Orlando, Fla., ordered 50 Boeing 737s on June 30, and Britain’s easyJet is slated to acquire 120 Airbus A320s. JetBlue, planning to increase its capacity by 55 to 60 percent in the coming year, ordered 100 regional jets from Embraer of Brazil on top of an order for 65 Airbus A320s.

The low-cost carriers, inspired by Southwest’s remarkable ability to remain profitable throughout the crises that have rocked the industry, are eager to move onto center stage. But industry analysts caution that the discount airlines need to manage their expansion carefully and be wary of overextending themselves.

Southwest, for one, is heeding this advice. The company’s 2002 annual report claims that “steady, manageable growth has enabled Southwest to keep its debt under control and profits intact.”

Whatever impact increased capacity among low-cost carriers has on their own profitability, the major airlines are bound to suffer further constraints as economy airlines battle among themselves for increased market share.

The impact of dismantling hubs
Ready access to air transportation stimulates economies, and economic growth increases the demand for air transportation, according to Hansman of MIT’s ICAT. Good air connections facilitate access to markets, people, ideas and capital, and a vital economy stimulates air travel. A lagging economy decreases demand for air travel; likewise, lack of access to air transportation dampens economies. An ICAT study that tracks the relation between per capita increases in income and air traffic finds that this correlation is a regional phenomenon that extends beyond state boundaries.

The study suggests that the cost of dismantling large hubs such as Hartsfield International Airport extends far beyond the airport and the metropolitan area it serves to affect the region as a whole. Smaller markets would lose air service, and the entire regional economic network would suffer.

Fortunately for the Southeast, the Hartsfield hub is not a likely candidate for the kind of extensive reduction that has afflicted cities like St. Louis. American Airlines recently reduced the size of its operation at Lambert-St. Louis Airport by nearly 50 percent, cutting the total number of daily departures from 417 to 207.

However, belt-tightening through hub consolidation, mergers and acquisitions is inevitable, according to Mullin, who spoke of the need for “hub rationalization” in his presentation to the Aero Club. “The enormous pressure that hub-and-spoke carriers will be under during the next two years to bring costs down may be adequate to precipitate some hub closures,” he said. “Of course, the situation that almost certainly would result in much-needed hub consolidation — and thus the removal of at least some of the excess capacity which continues to cripple the industry — is successful merger or acquisition activity.”

As the major airlines continue to enact cost-cutting measures such as pay cuts, layoffs and reductions in service, their ability to hold sway in hub airport facilities may also be compromised. At Denver’s airport, for example, United’s biggest rival, Frontier Air, is hungry for United gates and concourses that now lie idle as the insolvent giant limps toward financial recovery.

Prior to the financial woes that now strap the big carriers, the interest of the dominant hub airline was clearly the same as the interest of the host community, said Steve Van Beek, a senior vice president with Airports Council International-North America, an air industry trade group, in an interview with the New York Times. Communities were willing to make concessions to ensure the continued presence and prosperity of a major air company. “But when you get into bankruptcy, you create a new dynamic and a new skepticism in those communities,” he observed.

A premature death knell?
Some industry analysts contend that despite the success of the point-to-point carriers, the infrastructure of the hub-and-spoke system is essential for an efficient air transportation network. Delta’s Mullin states that even with escalation in point-to-point service, 95 percent of the 30,000 cities served by air transportation depend on the hub-and-spoke model.

“Is hub-and-spoke service simply an outmoded business model? The answer is an emphatic ‘no’,” said Mullin. “The service hub-and-spoke carriers provide is not just an important component of our nations’ transportation system, but an absolutely essential one.”

Market forces and consumer demand have historically shaped the airline industry’s structure, but these forces take time, according to an ICAT study by Hansman and coauthor Ryan Tam. They find it doubtful that the industry’s current two-tier structure — consisting of low-cost carriers and major network airlines — is sustainable over the long term. It remains to be seen, they note, whether “the industry will converge on one business model and which one will succeed.”

Whatever industry model emerges, it’s clear that the success of the discount airlines has spurred a competitive restructuring that promises to put a new face on flying.

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