Delta's High-Risk Low-Cost Foray

The carrier is taking on upstart rivals with a new discount division. Most analysts, however, doubt it can slash expenses enough to succeed

By Amy Tsao

It's no secret that low-cost carriers like JetBlue (JBLU ) and Southwest (LUV ) are stealing passengers from traditional hub-and-spoke airlines. In a direct attempt to win them back, Delta (DAL ) on Nov. 20 unveiled plans for its own low-cost subsidiary. Delta executives promise that the new division, which has yet to be named, will be something to behold. Airline analysts, however, are hardly optimistic.

Why the skepticism? Delta is a relatively healthy major carrier addressing a nagging issue head-on. It'll confront the long-term trend of travelers favoring lower fares over big-name cachet with its own version of discount flying. But Philip Baggaley, airline bond analyst at Standard & Poor's credit-rating agency worries that "it does create some potential for diverting your own higher-fare traffic onto this lower-fare operation." (S&P, like BusinessWeek Online is owned by The McGraw-Hill Companies.) Still, he adds, "it's better to have a competitive weapon [against low-cost carriers] than not -- as long as you can set it up to compete effectively."


  The problem for Delta is it already faces a future in which profits will be elusive until 2004 -- at the earliest -- analysts estimate. Furthermore, the industry's recovery from the aftermath of the recession and the September 11 terrorist attacks is so tenuous that analysts don't even bother with quarterly earnings estimates for 2003. On average, Wall Street analysts see Delta racking up a loss of $8.46 per share all of 2002, a $4.21 loss in 2003, and earnings per share of $1.50 in 2004.

These forecasts assume that revenues, which were $13.9 billion in 2001, will climb gradually from year to year. And the expectation is that Delta's shares -- at about $12, they're well off a 52-week high of $38 -- will remain volatile as its fortunes are still primarily tied to a rebound in air-travel demand.

Critics see Delta's latest move as a stopgap measure that lacks teeth where it counts: cost. In the short term, it may win back some traffic and curb the advance of carriers like Jet Blue into Delta's markets. But as air travel is increasingly becoming a commodity business where the provider with the lowest costs wins, Delta will be hard pressed to show that it can beat discount operators at a game they've perfected.


  The full-fare airlines' "cost disadvantage means that they can't turn a profit by matching Southwest's prices. So the bottom line is that we're seeing a shrinking market for the legacy carriers, and I can't see any indications that it won't continue to shrink," says Alan Sbarra, analyst at Unisys R2A Transportation Consultants.

In the past, traditional airlines' attempts to run low-cost subsidiaries have mostly failed, in part because they don't achieve cost efficiency with just a small part of operations being low-cost and the rest using the regular high-cost model, Sbarra says. Similar efforts at a discount division by United Airlines (UAL ) and US Airways Group (UAWGQ ) aren't around any longer. Delta's own Delta Express is still running, but many observers contend that it has been only a mild success (as the need to replace it with another low-cost strategy implies).

The new subsidiary will feature all-coach seating on large planes, fewer flight attendants, quicker turnaround times for planes, electronic ticketing, and pricing that apes that of its low-cost competitors -- between $79 and $299 for one-way fares.


  Yet analysts say even if the new subsidiary's planes are reconfigured and services are ratcheted down, the strategy Delta has so far outlined falls short on a number of important points. First, it's hard to see how the biggest expense for any major airline -- labor -- will be lowered to fit the discount model. The majority of Delta's employees aren't unionized so the carrier, in theory, has considerably more flexibility.

However, its workers are paid competitively compared to other major airlines. And pilots, the one major unionized group at Delta, will get paid their standard rate for flying at the low-cost division. Jamie Baker, airline analyst at J.P. Morgan, figures that Delta's captains for the large 757s that will be used by the division are paid an estimated $245 per hour. That compares to hourly pay of $149 at Southwest, $118 at AirTran (AAI ), and $100 at JetBlue.

Delta, for the time being, says it's not asking for concessions. Instead, "new processes, productivity measures, and benefits programs will allow Delta to achieve substantial cost benefits while protecting employees' annual earnings," says a Delta spokesperson.


  That may be hard to achieve. And analysts fret that the low-cost division won't be broad-based geographically. So far, Delta has said the subsidiary will fly between the Northeast region and Florida where many low-cost players have been stealing share.

Meantime, Delta will keep charging higher fares in markets where it remains dominant. That approach, analysts say, is what other airlines, including Delta with Delta Express, have already tried. "I give them credit in taking a small step to try and do something. But if they were to seriously do it, they need to do it everywhere. They can't pick and choose," Sbarra says.

To fill the planes it has earmarked for the subsidiary, Delta has to prove to flyers that its low-cost option is appealing, not only because of price. "Clearly, they need to develop some kind of product niche to make their product unique," says Baker.


  He notes that in many markets, JetBlue often isn't the lowest fare, but consumers find the experience worth the premium. "Delta will need to brand its product and develop the type of offering that improves upon existing Delta Express," Baker says. He's hoping the outfit will have more to say about in-flight technology offerings that are on a par with JetBlue's satellite TV at every seat.

The head of Delta's new division, John Selvaggio, who once ran Midway Airlines, said during a Nov. 20 call with reporters that the airline will be "resetting the bar." Delta says it'll have more specifics on the low-cost division when it's launched in January, 2003.

In the long term, Delta's strategy will likely be the first of similar tries from the major domestic carriers. Barring two unlikely events -- a spectacular return to higher fares for business and leisure travelers or a total collapse of the low-cost players -- keeping costs down is Delta's only hope for profitability. But this latest concept appears inadequate, which ultimately wouldn't bode well for the carrier's grounded stock price.

Tsao covers financial markets for BusinessWeek Online in New York and contributes frequently to the Street Wise column

Edited by Beth Belton