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Can Airlines Bring Costs Down to Earth?

More than a year after the September 11 attacks decimated air travel, the airline industry is still facing sharp criticism for out-of-control expenses. The latest broadside: Cost-structure analysis from Unisys R2A Transportation Management Consultants that shows why the major carriers still can't compare to consistently profitable Southwest Airlines (LUV).

The large carriers together would have to cut some $18.6 billion, or 29%, out of their cost structures to get to Southwest's pared-down model, according to the study. Can the industry pull it off? The prognosis isn't good. "There's no easy way to do it," says Unisys R2A Vice-President Ron Kuhlmann. "The problem is that major carriers are preserving their own model rather than paying attention to what customers are willing to pay for."

Labor costs have traditionally been the biggest drag on the airline industry. Now, on top of that, it's also footing the bill for the increase in insurance and airport-security costs as a result of September 11. Analysts figure 10% to 15% more in savings by the large carriers is achievable, but squeezing the rest out is far harder.

TIGHTER SEATS. Where will the savings come from? Some analysts recommend cutting back on services like meals and on-board entertainment -- à la Southwest. "In the past, airlines have been able to look at [services] as part of the overall product," says Alan Sbarra, vice-president at Unisys R2A. But those amenities are no longer sacred, he adds.

Reconfiguring seating on existing planes would also increase revenues per flight, adds JP Morgan airline analyst Jamie Baker. "I hate hearing that as a consumer, but I think domestic first class is at significant risk."

Another tactic would be to fly existing aircraft harder. Typically, planes now spend one hour less in the air per day than prior to September 11. But spreading out peak travel times at hub airports by several more hours each day, a concept known as rolling hubs, may be one way to make operations more efficient. American Airlines is experimenting with a rolling hub in Chicago, and it will start using the system at Fort Worth, Tex., in November. Delta (DAL) has also said it's taking steps to spread flights more evenly.

STREAMLINED FLEETS. Already, airlines have managed to save billions over the last several years by selling tickets on the Internet, thereby cutting out travel-agency commissions. The next step in lowering distribution costs is decreasing reliance on travel-reservation systems like Sabre and Galileo, says Standard & Poor's airline industry bond analyst Philip Baggaley. Though such systems are big players in the travel business, airlines continue to squeeze them out by using online services like Expedia and, better yet, their own Web sites to sell tickets. "The trends are a net negative for Sabre," Baggaley says.

Airlines are also exploring the idea of trimming their fleets to rely on fewer models -- another cost-savings tactic used by Southwest and fellow bargain flier, JetBlue (JBLU), says Michael Boyd, president of Denver-based consulting company Boyd Group/ASRC. Fewer types of planes would result in lower training and maintenance costs. "[The industry] is going in that direction," Boyd says. Aircraft manufacturers like Airbus have pitched in by making the cockpits of different planes similar, so that pilots spend less time learning to fly them.

Dropping underperforming corporate-discount agreements could be another potential cost savings, says Michael Boult, chief operating officer of Eclipse, the technology-procurement division of corporate-travel managers

Rosenbluth International. Worldwide, corporations reap about $10 billion worth of flying discounts annually, but the deals don't always work out to airlines' advantage. "Most of the risk is held by carriers," Boult says.

"VERY CONCERNED." Eliminating the corporate accounts that don't deliver the promised amount of business would result in about $5 billion in eliminated discounts. Says Boult: "'Why give them a deal?' is our hypothesis."

The ultimate goal: Sustainable lower costs in combination with improved efficiency and higher revenues. These aren't easy targets. And barring bankruptcies that might eliminate the weakest players' labor agreements and other debts, cost reductions are certainly difficult to come by.

Boyd fears that consumers will spend some $12 billion to $13 billion less every year on air travel, as they view flying more and more like a commodity, valuing price over the perks of individual airlines. And raising ticket prices, especially on business travelers, may no longer be a safe way to juice revenue. "That's where I'm very concerned over whether the airline industry can survive," Boyd says. But JP Morgan's Baker figures that big hub-and-spoke carriers can use premium pricing on international flights to offset the cost of more cheaply priced domestic flights.

ON THE BRINK. A war with Iraq could further distress passenger traffic and cause fuel prices to spike in the short term. "Nothing on the horizon is showing an upturn," S&P's Baggaley laments. He sees United Airlines, which says it's on the brink of joining U.S. Air (UAWGQ) in Chapter 11 bankruptcy protection, as most vulnerable, followed by Continental (CAL), Northwest (NWAC), and finally Delta.

The real remedy would be a base of business and leisure customers willing to pay higher prices. But that's not going to happen any time soon. In the meantime, airlines may have no choice but to find more ways to fly light on the cost side. By Amy Tsao in New York

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