Can Anything Fix the Airlines?

It's clear that another government bailout won't be a permanent solution. Here's why

There's no question that the war in Iraq is taking its toll on the airline industry. In the week the war started, traffic fell by 10% and advance bookings by up to 40%. High oil prices are hurting, too. But it's also clear to politicians and passengers that the industry is perpetually in trouble and never satisfies shareholders, customers, or employees for long. A divided White House and Congress are now pondering granting more financial aid to the ailing industry, but simply handing the airlines another slug of money won't end their troubles. The debate over a bailout has already raised critical questions about how the industry got to this sorry spot in the first place and, more important, how to fix the mess. Here's a primer on an industry that for too long has made little economic sense.

Why are the airlines in such dismal shape?

Carriers have been hit with an unprecedented series of crippling events: the popping of the tech and telecom bubbles, which sharply reduced business travel; the terrorist acts of September 11; and now, a war. But the airlines deserve plenty of the blame for their current agony. During the boom of the '90s, they lost control of costs and then passed the burden along to high-paying business passengers by raising business fares 79% in five years. That worked, until recession and terrorism put the brakes on business spending -- and lower-cost rivals increasingly took to the skies.

Are there just too many airline seats chasing too few passengers?

Yes, overcapacity is part of the problem -- at least for the high-cost carriers. While the major lines have grounded some 300 planes since the terrorist attacks, and industry capacity was down 13% in February from 2000 levels, supply and demand are still out of kilter. That's why the carriers have been forced to offer what even airline executives consider "irrational" fares to fill seats.

Some analysts think another 10% to 20% of capacity must be permanently cut to help the airlines regain their footing. Why doesn't it happen? The hypercompetitive network carriers such as American (AMR ), United (UAL ), and Delta (DAL ) are always looking over their shoulders, fearful that if they mothball any planes, a rival will snatch up market share. That's why some airline executives and analysts are hoping for outright liquidations of such major carriers as bankrupt United Airlines, which has 16% of the domestic market. At the end of the day, though, individual airlines have little control over industrywide capacity.

Why are costs such a big issue now?

Because big hub-and-spoke carriers face a huge cost disadvantage compared with rapidly growing rivals such as Southwest Airlines Co. (LUV ) and JetBlue Airways Corp. (JBLU ) Adjusting for differences in the lengths of their trips, the network carriers' costs are a staggering 66% higher than the low-cost airlines, figures Gary Chase of Lehman Brothers Inc.

While the network airlines have shouldered that cost disadvantage for years, a few critical things have driven down airfares. The low-fare carriers now compete directly on routes that account for about 55% of the network airlines' domestic revenue, up from 14% in 1991, says Chase. At the same time, Internet sales have made it far easier for passengers to compare prices across carriers.

Given the dire situation, why don't management and labor each agree to some compromises in order to get costs down?

With the help of the bankruptcy court, US Airways Group Inc. has already slashed its costs almost 25%. And the other big players will be forced to follow or face Chapter 11 themselves. Labor is target No. 1 because it's the biggest piece of the airlines' costs, about 40%. That's why American and United both want to cut their overall labor costs by up to a third. It's not clear yet how those talks will turn out.

Continental appears to have succeeded in cutting costs. Could it serve as a model?

True, Continental Airlines Inc. (CAL ) has weathered this storm better than others, due in part to its lower costs. Yet the carrier continues to lose money, and its unit-cost disadvantage to the low-fare players is more than 60%. That's better than the 80% gap at American. But Continental, too, will have to make changes to survive.

The carrier already has scored big savings in labor costs. Thanks mainly to advantages in work rules and pensions, won as a result of its last two bankruptcies, the carrier has enjoyed about a 15% unit labor-cost advantage over some of its rivals.

Labor savings alone didn't do it, though. It wasn't until CEO Gordon M. Bethune arrived in 1994 that the airline decided to spend some of its cost advantage to improve operations and boost morale, avoiding another bankruptcy. Bethune and his team got out of the executive suite, laboring side-by-side with frontline staff. They also worked hard to reward employees for results, such as improving on-time performance. The esprit de corps that Continental has created -- during a booming economy and while it was improving pay -- will be tough for others to match when they're seeking massive concessions.

So can work rules at the other majors be improved in a similar way?

They're trying hard, albeit belatedly. Consider some of the work rules that United is now trying to change in bankruptcy court. By planning a vacation that overlaps with workweeks, a senior pilot can turn 10 days of leave into a full month off with pay. Because of such rules, United pilots fly an average of 44 hours a month, compared with 62 at Southwest. United is demanding that pilots raise that total by 15 hours. The airline also complains that it employs 427 skilled mechanics at 18 airports to oversee the push-back of planes at the gate -- a task that is assigned to lower-paid workers at other airlines. Changing that alone could save United $40 million a year.

Is the hub-and-spoke system part of the problem, too?

Yes and no. The hubs allow the airlines to economically serve routes that might otherwise be too lightly traveled to merit direct flights. These are the kinds of routes -- such as Sarasota to Sacramento -- that would likely never generate enough traffic to interest Southwest or JetBlue. At the same time, the hubs allow major carriers to create international networks that appeal to business customers, who prefer to book their travel with a single carrier.

For now, the hubs are just too costly to operate. The big carriers are trying to change that -- not by dismantling hubs but by spreading out the flow of traffic throughout the day to use gates, aircraft, and employees more efficiently. The jury is still out on how big the savings from those moves will be.

So will the cost-cutting goals of the network players put them on a level playing field with Southwest?

No, and they're not aiming to meet Southwest's costs. That's because most of the hub-and-spoke carriers still believe they can offer a better product that will attract higher paying passengers. That includes such amenities as business-class service and broad frequent-flier programs. American says it can sustain a 30% revenue premium over its low-cost rivals, a rate it has achieved historically. But a 10% premium might be more realistic as the low-fare carriers spread and improve their own products. If the big airlines guess wrong, they could find themselves permanently out of business in the next downturn.

By Wendy Zellner in Dallas, with Michael Arndt in Chicago

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