Getting the Carriers Back in the Air

As things look ever-grimmer at the major airlines, chances are a shakeout is coming. What's really needed is a new business strategy

The airline industry has more lives than a cat, judging by how often the nation's major carriers have taken a nosedive, only to recover and, occasionally, prosper. They've muddled through so well over the past two decades that, despite a bankruptcy casualty here and there, the industry has figured that if it just soldiers on, it will one day achieve sustainable prosperity.

Even before the events of the past 18 months, that optimism was starting to look dubious, however. And now, with the war in Iraq threatening to become a drawn-out affair that hurts airline traffic for months, key pieces of the strategy upon which the major carriers have based their businesses since airline deregulation are beginning to look not just risky, but downright unworkable (see BW, 4/7/03, "Can Anything Fix the Airlines?").

The current crisis will force airlines to reexamine every aspect of how they operate. "The full-service carriers need to shrink and change their business models," says David Gillen, adjunct professor of civil and environmental engineering at the University of California, Berkeley. "It will require a product redesign, process redesign, and organizational redesign. It's not about mimicking low-cost carriers."


  The industry has been approaching this crossroads for a very long time. In only 11 of the 25 years since deregulation have the airlines earned a profit. Hub-and-spoke systems, which feed passengers into central locations from which they can fly to just about anywhere, are highly profitable when hordes of business travelers pay high fares and airlines run close to full capacity. But hub-and-spoke scheduling is also complex -- and hard to scale back during downturns. The tried-and-true solution that airlines have turned to is cutting costs -- mainly compensation under union contracts, which accounts for around one-third of operating expenses at most carriers.

Yet, in the past, no sooner have the airlines cut pay than they've dissipated the savings by lowering fares -- and ended up back in the same bind. That's how industry leader UAL's United Airlines (UAL ), which is now in Chapter 11 bankruptcy, ended up being majority-owned by its employees back in 1994, an experiment that couldn't make United financially stable, despite its noble aims of labor-management teamwork and efficiency.

These vicious cycles explain why the industry has ended up with $100 billion in debt and $18 billion in unfunded pension liabilities -- about $33,000 for every employee. Only when the economy has remained unusually strong over uncharacteristically long stretches have the carriers consistently made money.


  Any illusion that such performance was normal ended abruptly with the September 11, 2001, terrorist attacks on New York and Washington. Airfares and ridership both dropped -- the latter is still down 10% from pre-September 11 levels and is now heading lower again, thanks to the reluctance of travelers to fly during a war.

By the end of 2003, predict analysts and the Air Transport Assn. (ATA), the airlines' lobbying group, the industry could have lost $24.4 billion in just three years, eclipsing the $22.7 billion in profits it recorded from 1995 to 2000. Because of the war, the ATA says, air travel could fall an additional 15%, and this year's losses could reach $10.7 billion, vs. an estimated $6.7 billion loss if the U.S. hadn't invaded Iraq. On top of that, the spread of a mysterious viral infection -- sudden acute respiratory syndrome, or SARS -- is further eroding travel demand, especially to Asia.

That combination of events is threatening, at last, to push this most resilient of industries past the point of no return. On Mar. 31, with its stock lingering under $1, United was delisted from the New York Stock Exchange. True, No. 5 carrier US Airways (UAWGQ ) is about ready to emerge from Chapter 11. And No. 2 American Airlines (AMR ), which had been depleting its $1.9 billion cash reserve at the rate of $5 million a day, bought some time on Mar. 31 by persuading its labor unions to absorb pay cuts of up to 20%, which American figures could save it $1.8 billion per year.


  Still, analysts think if hostilities in Iraq last longer than a few months, any number of major carriers could be headed for Chapter 11 or liquidation. Such prospects have prompted the industry to seek $13 billion in relief from Congress. The airlines want the government to take over $4 billion a year in security costs and $9 billion in aviation taxes and fees. (As part of US Airways' coming out of bankruptcy, Washington has already agreed to a $900 million loan guarantee, which will back $1 billion of private financing.) On Apr. 1, House and Senate Appropriations Committees approved President Bush's budget request of nearly $80 billion to begin paying for war with Iraq -- of that, $3.2 billion would be earmarked for airlines. There's no guarantee the industry will get this amount, however, since the White House has called it "excessive."

Even point-to-point carriers Southwest Airlines (LUV ) and JetBlue (JBLU ), which because of their simplified route structures and lower costs have been more consistently profitable than hub-and-spoke rivals, could take a hit. Southwest already has delayed some growth initiatives. Jet Blue still plans to add new routes and two planes to its 38-plane fleet by yearend.

The stocks of both carriers -- Southwest at around $14 and JetBlue around $27 as of Apr. 1 -- are the picture of health compared with those of the major carriers, which have lost around 80% of their market value in the past year. US Airways is trading at 10 cents a share, American at $2, and Continental (CAL ) and Northwest (NWAC ) are at $6 and $8, respectively. Delta (DAL ) trades at $9 per share.


  To their credit, since September 11, the six biggest airlines have cut $4.5 billion from their operating expenses and $5.6 billion from their capital spending. But the key to long-term survival, experts say, is to go beyond reflex reactions such as wage concessions and delayed plane purchases, and focus on a permanent fixes, one of which is likely to be contraction.

"The combination of these recent shocks and the growing significance of low-cost carriers really put the airlines on notice," says Clifford Winston, an economist at the Brookings Institution. "They've got to work things out much quicker" than seemed necessary only a few months ago.

At every carrier, the war is igniting a belated examination of operations. Increasingly, the focus is on coming up with flexible business models that continue to provide reasonable prices and traveling options for the public while ensuring that airline financial results don't turn disastrous when demand fluctuates. "The boom-bust [cycle hurts less] if a foundation is there," says Seth Young, associate professor of business administration at Embry-Riddle Aeronautical University in Daytona Beach, Fla. "The airlines have to take a steadier approach and find a strategy for sustained growth."


  One avenue may be to modify the hub-and-spoke system. This framework, around which the largest airlines are organized, works fine with a blockbuster economy but turns into an albatross in less buoyant times. That's because it imposes huge fixed costs -- for baggage handlers, mechanics, different models and makes of planes, and specially trained pilots to fly them -- that are much harder to roll back compared with what's possible with point-to-point scheduling by carriers that fly just one type of plane. The trade-off airlines such as Southwest and JetBlue make is that they miss the peaks when air travel is strong -- but to compensate, they avoid the troughs when it collapses.

Better yet, the point-to-point carriers can eat into the markets of their larger competitors by adding specific routes at minimum additional cost even when overall air traffic is slack. "If [a carrier relies] too much on people connecting in hubs, you get hurt now that low-cost players offer nonstop service," says Alan Sbarra, an analyst at Unisys R2A Transportation Management Consultants in San Francisco. Already, hub-based carriers have had to lower prices on their most profitable routes to match point-to-point carriers.

Still, few airline experts are calling for a dismantling of the hub-and-spoke system. "Without it, we would have 50% less travel," says Michael Boult, chief operating officer of Eclipse Advisors, a subsidiary of corporate travel agency Rosenbluth International in Philadelphia. "It's losing money now, but that doesn't mean that there's a better system."


  Rather, Sbarra argues, tweaking the hub system is in order. The goal should be to reduce the cost of running it, in part by downsizing big hubs such as United's in Chicago and Northwest's in Minneapolis. The consequence would be less-frequent service to destinations that generate the least traffic. Some experts even think that secondary hubs, such as Delta's in Cincinnati, could be phased out entirely, since they exist mainly to link connecting traffic, rather than as a final destination themselves.

Capacity, which is down 8% from pre-September 11 levels, could still stand further reduction, especially considering the overexpansion of the late 1990s, when carriers increased their available seats by as much as 30%. One way to achieve that, albeit with significant disruptions, would be to allow a major airline to fail. For instance, a liquidation of United -- which accounts for 18% of all seats -- could nearly eliminate the estimated 10% to 20% excess capacity in the system.

Alternatively, any government bailout could force consolidation of routes, if not companies, perhaps by requiring a minimum market share for carriers that are awarded gates at specific airports -- or by establishing price floors for tickets on certain routes. This would be "regulation-type stuff," says Boult. But it would help weed out the weakest players and in theory help the industry recover its strength within a few years.


  A similar effect might be accomplished by dividing the flying world into regional niches, says Young. Big carriers could focus on higher-revenue, transcontinental routes used primarily by business travelers. American, which is already strong in South America, could build on its presence there. Northwest, which has many routes to Asia, could focus on that region. And Continental could get bigger in Europe.

In that scenario, short trips between popular markets in the U.S. would naturally become the domain of Southwest and JetBlue, while regional carriers could focus on the smallest markets. Such an idea raises, but doesn't answer, difficult questions: Who would divide the pie? How to ensure that such mini-monopolies wouldn't lead to out-of-sight fare increases?

The major carriers could be shoved in that direction anyway, as point-to-point carriers attract price-conscious passengers on the biggest airlines' best routes. Without much fanfare, Southwest has become the fourth-largest domestic carrier in terms of passengers carried. In response, United and Delta have unveiled plans to start low-cost, point-to-point subsidiaries. If they can earn a profit on these, they might help stem the loss of market share to the discount airlines. But pulling that off will be tricky: Analysts note that no previous efforts to build a cheap-fare airline within an existing major carrier have succeeded.


  None of these ideas will matter unless the carriers persuade their employees and unions to do more work for less pay. Phil Baggaley, a credit analyst at Standard & Poor's notes that airline labor costs have risen faster than the rate of inflation since 1993. Unisys R2A Transportation Management Consultants figures that Southwest's pilots spent on average 800 hours in the cockpit in 2000, while United pilots spent about 400 hours in the sky -- a difference that United's pilots would attribute partly to hub-and-spoke scheduling inefficiencies.

The difference between pay and benefit packages was equally wide. At Southwest, pilots in 2000 earned a salary and benefits package of $139,000 on average, including profit-sharing, while United pilots on average made $180,700. The United figure is inflated, though, by the fact that its highest-paid pilots fly larger planes than Southwest owns -- in an industry where pay rises, in part, with the size of the plane.

Of course, carriers could also try to force wage concessions by going into Chapter 11. Although bankruptcy judges seldom do so, it's within their power to cancel union contracts. That would let airlines remake themselves entirely, though probably not without a good deal of labor turmoil. Consider that Continental, one of the strongest airlines financially, got that way in part because management wrangled its way out of labor contracts during a bitter stint in Chapter 11 bankruptcy in 1990.


  Of course, the airlines have become chronic basket cases partly because of the compete-at-all costs mentality born of deregulation. Any change in strategy will have to be accompanied by a massive psychological shift on the part of industry executives away from gaining market share at all costs -- and of making employees foot the bill when things go awry.

Southwest, which is 85% unionized, also provides some lessons on that. It has been able to negotiate more lenient work rules thanks to a management approach that, for the most part, has avoided adversarial situations. As a result, the Brookings Institution's Winston says, "Southwest has been able to be more entrepreneurial" than the major carriers.

Execs of the biggest airlines have recognized the weaknesses of their hub-and-spoke systems for years. Perhaps they've failed to adjust because of plain old human nature -- the tendency to sometimes let problems slide until they become acute. Another aspect of human nature, though, is the instinct to survive. The industry's best hope may be that, any minute now, it kicks in.

By Amy Tsao in New York

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