Delta Gets Down and Dirty with the Discounters

The No. 3 airline has to stop the exodus of business travelers, but how?

As the airline industry struggles through its worst slump ever, Atlanta-based Delta Air Lines Inc. (DAL ) appears to be in the best shape of the big carriers. But while the No. 3 airline may have the resources to weather the economic slide, it's far less clear whether it can handle a longer-term threat: discount competition.

Like the other majors, Delta is expected to end up with a big loss for the year (chart). But it has far fewer labor problems than the No. 1 airline, United Airlines (UAL )--mostly because only pilots are unionized at Delta. And its operating costs are 14% lower than those of No. 2 American Airlines (AMR ). Moreover, with $1.7 billion in cash on hand, Delta also has a stronger balance sheet. That's why, unlike United or US Airways Group Inc. (U ), it has not asked for any federal loan guarantees.

But in truth, Delta may have more of its revenues targeted by discount competition than any of the seven biggest airlines. Nearly 30% of Delta's domestic revenue comes from markets that are under assault by low-cost rivals such as JetBlue Airways Corp. (JBLU ) and Southwest Airlines Co. (LUV ), a major competitor in Florida, industry experts say. And the threat is growing daily as business travelers, who represent two-thirds of any airline's profits, increasingly resort to the low-cost carriers.

Eventually the economy will rebound--but when it does, chances are good that many business travelers won't go back to paying $1,000 to book a flight on a day's notice between New York and Atlanta. Public relations consultant Jody Steinberg of Atlanta is the type of customer who will probably never return to Delta. Now she flies on discount carrier Airtran Airways (AAIR ) whenever she can. Delta's low-cost flights are few and far between, complains Steinberg: "Airtran is just less expensive across the board. I know Delta likes to say `more seats at lower prices,' but try to find one."

For Delta, the challenge is to find a discount-fighting strategy. Chief Executive Leo F. Mullin is marshaling resources for a major counterassault. And its centerpiece could be the establishment of Delta's own low-cost airline, built around an expansion of the existing Delta Express service that now shuttles vacationers from the Northeast to Florida. Heading Delta's team on the project is Senior Vice-President John Selvaggio, the former CEO of Midway Airlines. Midway is in bankruptcy and suspended operations this summer. But within the industry, Selvaggio is considered a pioneer in developing the low-cost, no-frills airline model that companies such as Southwest have exploited.

Selvaggio's team is considering several options. Insiders say Delta could build a discount network parallel to the company's existing hub-and-spoke system, anchored in Atlanta. Or it may choose a radical alternative, creating a separate company altogether, staffed with independent management and maintaining only a passive stake. Neither Mullin nor Selvaggio would comment. But details are expected to be announced before the end of the year, says a consultant familiar with the in-house debate.

To see why Delta is being forced to think outside of the box, just look at the mess in Florida, a market that accounts for 25% of Delta's total revenues. New York-based JetBlue has increased systemwide capacity 75% in the past year, mostly on its New York-to-Florida routes. And Southwest, which already has 13.7% market share in Orlando, has steadily added flights over the years in a bid to erode Delta's 26.3% share there. The same dynamic holds true in Tampa, where Southwest has boosted daily departures from 12 to 56 since 1996.

Delta is all too aware of the implications. In a speech to employees on Sept. 18, President Frederick W. Reid said discounters' national market share "will grow from 20% today to 40% in the near future." What was left unsaid is that Delta could be the biggest loser. "Discounters are a real thorn in the side of Delta, and the wound is only going to grow," says Fred Allvine, a marketing professor who specializes in airlines at Georgia Institute of Technology.

The challenge couldn't come at a worse time. Delta's insurance and security costs have ballooned to $700 million this year, from $100 million a year earlier. That figure alone wipes out any chance of profitability, say analysts. Delta's losses expanded to $326 million in the third quarter ended Sept. 30 from $259 million the year before. Quarterly revenues were stagnant, at $3.4 billion. In the past nine months alone, Delta has lost $908 million.

Delta won't break out figures for its six-year old low-cost operation, Delta Express, which ferries passengers from New York, Washington, and Boston to Florida. Michael Miller, of the Miller Consulting Group in Falls Church, Va., says he thinks it makes a profit. With the lowest debt-to-equity ratio of the majors--2.59 vs. an industry average of 13.52--Delta should be able to finance a discount expansion. And with a less unionized workforce, Delta has more flexibility to deploy smaller, more efficient regional jets. But critics say Delta Express is still hobbled by higher operating costs than discounters JetBlue and Southwest. And they point to the dubious record of big carriers reinventing themselves.

In fact, Delta is the only major still running a separate discount line. MetroJet, the US Airways unit that was based at Baltimore-Washington International Airport and served the East, closed last December. It was done in by costs that were still too high, even after labor concessions. Moreover, discounters usually prosper by flying point to point, negating the need for expensive hubs and their high fixed costs. But Delta would still retain hubs such as Atlanta--where, for instance, it maintains a fleet of $300,000 de-icing trucks that sit idle nine months of the year. Says Gary C. Kelly, chief financial officer at Southwest: "We are radically different than our competitors. It's hard for me to imagine how they [the majors] can come close to matching our cost structure."

Most industry observers think Delta should concentrate on making its existing system more efficient. In the end, it's all about hanging on to business travelers. Even a few dollars off a fare in a key market can make a difference, say the experts. That's why investors applauded when the company announced on Oct. 15 that it would save more than $1 billion by deferring delivery of 29 Boeing jets scheduled for delivery in 2003 and 2004. Meanwhile, Delta is beefing up its frequent flyer program, offering more opportunities to keep business flyers loyal.

For now, though, there are few signs those efforts will reverse the steady exodus of business travelers to discounters. That's why Delta may yet decide that its best bet is to join the crowd.

By Charles Haddad in Atlanta, with Wendy Zellner in Dallas

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