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Inside Delta's Low-Fare Strategy

By Philip Baggaley Delta Air Lines (DAL

; S&P credit rating, CC; CreditWatch Positive) announced a restructuring of ticket fares across its route system on Jan. 5, 2005, lowering many unrestricted fares often used by business and capping ticket prices at $499 one-way ($599 in first class).

Standard & Poor's Ratings Services believes this is an important move -- and is likely to trigger pricing changes by Delta's competitors. Ultimately for Delta, the risks of adopting a simpler, lower-fare structure have decreased, while the risks of not taking action have increased. S&P Ratings attempts to answer some key questions arising from Delta's fare cuts:

Q: How significant is Delta's change in fare structure?

A: The change, labeled "SimpliFares," simplifies Delta's ticket pricing, removes some restrictions (e.g., Saturday-night stays) and reduces some fares, but it doesn't move all the way to the pricing structure used by Southwest Airlines (LUV

; A; CreditWatch Stable) and some other low-cost carriers.

Also, most of Delta's passengers already fly on fares aimed at the leisure market or low fares offered in response to those of competitors, and these fares will be much less affected. Because of limits on the number of seats sold in each fare class and various other restrictions, the full extent of the change cannot be estimated yet.

Q: Does this move have implications for the ratings or outlook on Delta?

A: Ratings on Delta are currently on CreditWatch with positive implications, due to changes achieved in November, 2004 (a new pilot contract, some limited debt refinancing, and new secured borrowings to bolster cash). The fare action will be analyzed along with other factors that could affect Delta's credit quality, but an upgrade of the corporate credit rating from the current very low level remains quite likely.

Q: Why is Delta making this fare initiative?

A: Traditional hub-and-spoke airlines like Delta (the so-called legacy carriers) face a difficult choice in their revenue planning. If they change to a simpler fare structure and lower business fares, they'll lose some revenue in the short term (as the lower pricing more than offsets some stimulation of traffic).

On the other hand, if they retain their current fare structure, they'll gradually lose more and more customers to low-cost competitors. Low-fare airlines have caused domestic fares to drop and diverted a sufficient number of passengers so that the short-term revenue loss, while material, is much less than it would have been during the late 1990s.

Also, the long-term risk of keeping the current fare structure has increased over time, because low-fare carriers represent a more plausible alternative for business travelers than previously, and because of their greater market share, improved service offering (in some cases), and corporations' more stringent and effective travel cost-control policies. Accordingly, the legacy carriers now stand to lose more by keeping the old fare structure.

Q: Why is Delta launching SimpliFares now?

A: It has been experimenting with this fare structure at its Cincinnati hub since August, 2004, and now has sufficient data (and evidently, good-enough results) to introduce it throughout its system. In addition, Delta significantly increased its dangerously limited cash reserves by borrowing about $1 billion under new secured credit facilities arranged by General Electric Capital (GE) and American Express Travel Related Services (AXP). That gives Delta greater capacity to withstand the near-term revenue hit of launching this change now. Delta may have other motives it hasn't disclosed, as well.

Q: Is this move likely to increase or decrease Delta's revenues?

A: In the near term, it's likely to hurt revenue, as the company acknowledges. In the long term, Delta believes that SimpliFares will generate more revenues than the carrier otherwise would (which doesn't necessarily mean more revenues in absolute terms than now). Whether that's true will depend in large part on how its competitors react.

In 1992, American Airlines (B-/CreditWatch Stable), a unit of AMR Corp. (AMR), launched a somewhat similar, though more sweeping, fare reduction and simplification called "Value Fares." That triggered an industrywide fare war and heavy losses, and the change was eventually abandoned.

Standard & Poor's changed its ratings on all U.S. airlines to CreditWatch with negative implications immediately following the announcement and eventually downgraded most of the airlines. Such a scenario is less likely today, because legacy carriers' revenues have already been reduced by low-fare competition, and the airlines rely much less on high business fares.

Q: Which competitors are most likely to be hurt by Delta's SimpliFares?

A: AirTran Airways, a unit of AirTran Holdings (AAI

; B-; CreditWatch Stable) has the highest overlap with Delta, with both airlines operating their largest hubs at Atlanta. However, AirTran, a low-cost carrier, already offers lower and simpler fares, and Delta has largely matched them on competing routes. Still, Delta could recapture some of those lost business travelers.

Among the legacy carriers, Continental Airlines (CAL

; B; CreditWatch Negative), US Airways (rated D), and American Airlines have the greatest overlap with Delta. Each of these still has markets where they charge relatively high fares (though these are dwindling), and they'll have to match Delta's price cuts. US Airways, already struggling in bankruptcy, is at greatest risk, having already had to introduce similar changes at its Philadelphia hub in response to Southwest Airlines entering that market (see BW Online, 1/6/05, "The Ups and Downs at US Airways").

United Air Lines (rated D) and Northwest Airlines (NWAC

; B CreditWatch Negative) have much less overlap with Delta, but they could be affected if other legacy carriers match Delta, causing the changes to ripple throughout the domestic market.

Q: What are the key risks in Delta's plan?

A: Competitors could respond by undercutting the new fares, setting off a downward spiral in prices. Alternatively, they could match Delta and introduce other changes that hurt Delta (e.g., offering more frequent-flyer miles or dropping some fare restrictions that Delta is keeping). If fuel prices spike back up or a terrorist attack hurts travel while Delta is still going through the near-term period of revenue loss from the fare change, then its financial condition could deteriorate dangerously. So, the final impact may not be known for a while. Baggaley is a credit analyst following the airline industry for Standard & Poor's Ratings Services

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