It's Showtime for the Airlines

Execs say they get it: Change now or head for the hangar

The bad news just keeps buffeting the airlines. Continental (CAL ) is grounding 11 more jets. American (AMR ) is slashing 7,000 jobs. US Airways (U ) is in bankruptcy. And United is threatening to follow suit unless it gets big labor concessions. The industry hasn't looked this bleak since September 11. Penny-pinching business travelers and rapidly growing low-fare carriers like Southwest Airlines Co. (LUV ) and JetBlue Airways Corp. (JBLU ) are squeezing the biggest carriers like never before. Not in his 20 years in the business has UAL Corp.'s chief financial officer, Frederic F. Brace, experienced "a more extreme downturn."

Increasingly, though, industry insiders see the current mess as an opportunity for real change. While it's still questionable whether the big carriers will move far and fast enough, at least some have heard the wake-up call: Give customers what they want at the price they're willing to pay--which is a lot less than it used to be--or prepare to go the way of Eastern and Pan Am. "Stepping up to the new reality is a healthy thing," says Continental Airlines CEO Gordon M. Bethune. "Only those companies that change with it will survive."

So the goliaths are grappling with their costs, capacity, pricing, and product features in ways they haven't seriously contemplated since the start of deregulation in 1978. American is changing the way it operates its hubs to gain new efficiencies. Continental is slashing capacity and experimenting with ways to offer different levels of service to passengers paying different prices. US Airways' workers have offered significant changes in wages and work rules to keep the carrier afloat. Even in the painful downturn of the early '90s, such sweeping change wasn't on the table. Now, says Darryl Jenkins, director of the Aviation Institute at George Washington University, industry execs are "willing to fundamentally change the way they run their airlines."

Does that mean following the no-frills business model of such discount carriers as Southwest? Not exactly. The big network carriers know that they can never match Southwest on costs. So they aim to narrow the cost gap while keeping what differentiates them from the discounters: broad route networks and services that business passengers are willing to pay more for, including assigned seats and business class cabins. Those advantages help a carrier like United produce revenues that are 25% higher than Southwest's for every seat-mile it flies. Besides, there are thousands of routes with few passengers that Southwest and its ilk will never serve. Only the majors, with their hubs, can economically fly these routes.

As the big players seek to streamline their operations and boost productivity, labor remains the wild card. Years of distrust stemming from management missteps and past union concessions will make it tough for the major carriers to bring down the labor costs that account for a third of their expenses. Nowhere is this more true than at United, which is threatening to enter Chapter 11 if it can't get pay cuts and work-rule changes by mid-September.

But staring into the abyss of bankruptcy could make labor more flexible. Faced with a Chapter 11 filing, US Airways' pilots and flight attendants agreed to $550 million a year in wage and benefit cuts. And some 500 pilots could be furloughed by early 2003. Analysts are betting that United employees ultimately won't let their carrier fail, either. With their schedules and working conditions tied to their seniority, pilots, in particular, would be loath to find themselves starting over at another airline. And concessions at United could have a "domino effect" on labor costs at other airlines, which will have to match to stay competitive, predicts Yale University law professor and former airline exec Michael E. Levine.

Wisely, though, carriers such as American Airlines Inc. and Continental Airlines Inc. aren't waiting for labor to bail them out. They're chasing the cost-cutting and revenue-building moves that they can control. "If you are going to ask for any help from labor, you have to try to do everything else you can to make the operations efficient," says Philip A. Baggaley, an airline analyst at Standard & Poor's. So American is spreading out flights throughout the day at its hubs to more efficiently use planes, gates, and people. It's also simplifying its fleet to cut training and maintenance costs. Continental is trying to match its products to what passengers will pay. Those who buy the cheapest tickets, say, might not get assigned seats or frequent-flier miles.

The cost-cutting and capacity reductions are already leading some analysts to predict a new period of profitability for the industry starting in 2004. Will it last? Don't count on it. In this cyclical business, costs and complexity have a way of creeping back in. But if the big guys can survive to fight for another day, they'll consider that victory enough.

By Wendy Zellner in Dallas, with Michael Arndt in Chicago and Lorraine Woellert in Washington

    Before it's here, it's on the Bloomberg Terminal.