February 2003 Vol. 86, No. 2

Several converging factors—not just terrorism—have made life difficult for the nation’s commercial carriers.

Grim Days for the Airlines

By Richard J. Newman

Just about every traveler in America is aware of the havoc the Sept. 11 terrorist attacks have wrought on the US airline industry. After losing $7.7 billion in 2001, the airlines are set to post a $9 billion loss for 2002 and another $4 billion to $5 billion in 2003—all told, enough red ink to wipe out all the profits from the boom years of the late 1990s.

Terrorist fears and the hassle factor associated with X-rayed baggage and confiscated tweezers and other rigorous new security precautions drove away passengers. The airlines mothballed at least 600 perfectly good airplanes and cut thousands of jobs, including nearly 8,000 pilots. Profitability won’t return until 2004 at the earliest—barring any more unforeseen catastrophes.

“What will emerge over the next months and years will be a very different industry than what we see today,” predicted Carol B. Hallett, president and chief executive officer of the Air Transport Association, in a speech last fall.

No Longer Such a Magnet

Needless to say, the prospects for military aviators looking for civilian airline jobs are grimmer than three or four years ago, a time of record hiring. Most major airlines have furloughed pilots, with bankrupt US Airways cutting furthest into the seniority ranks. Many of the furloughed pilots, in fact, are military aviators brought on board in the hiring binge of the late 1990s, when the Air Force raised bonuses and took other measures to stanch a torrent of pilots flooding into the private sector. That’s one reason military Stop-Loss provisions, which have prevented pilots and other specialists from separating or retiring during a time of multiple military operations, have met with fewer protests than in prior eras.

Airline jobs haven’t completely disappeared, however. At least five airlines have still been hiring, including Southwest, Fedex, and Alaska. Since pilots furloughed from other airlines tend to wait for their jobs to return—so they retain their seniority, instead of starting at the bottom with another airline—fresh jobs often remain open to new pilots. “It’s not that you won’t have a job when you get out,” said Kit Darby, president of Aviation Information Resources Inc., an Atlanta–based employment–consulting firm. “You’re just not going to get the job you want.” Darby estimated that airlines may hire about 500 new pilots in 2003.

Tangible villain that he is, Osama bin Laden is only partly responsible for the snarl facing the perennially turbulent airline industry. Also culpable are airline executives who made decisions assuming the boom times would never end. Flush with cash in the late 1990s, airlines ordered new fleets of airplanes that even ordinary traffic flow probably couldn’t have sustained. United Airlines—which declared bankruptcy in December—and other carriers struck lavish deals with pilot, mechanic, and flight attendant unions, and most management teams generally failed to anticipate an inevitable downturn in the economy.

“The problem is a number of cumulative events,” said John F. Walsh, president of consulting firm Walsh Aviation in Annapolis, Md. “It’s difficult to sort out what’s mismanagement and what’s terrorism.”

Industry representatives like it that way. They’re quick to point out that overall revenues for 2002 will likely be at least 20 percent below levels in 2000, the last full year before the terrorist attacks. That’s a severe shock in an industry that pops the champagne if it can achieve a five percent profit margin. And before Sept. 11, annual revenues had never fallen—not even in 1991, when the Persian Gulf War spooked air travelers for several months.
Less than 18 months after the terrorist attacks, two leading carriers—United and US Airways—had been forced to declare bankruptcy. Many analysts think Delta Air Lines and American Airlines could face similar hardships in 2003.

Capt. Steven Rosborough, 128th Air Refueling Wing, Wisconsin ANG, pilots a KC-135 in support of Operation Enduring Freedom. The prospects for military aviators looking for airline jobs are slimmer now than a few years ago.

Long-standing Troubles

Although they are often attributed to the shock waves of Sept. 11, the airlines had troubles that probably would have surfaced anyway. The terrorist attacks can plausibly be blamed for traffic that fell about eight percent in 2002, after a 6.6 percent drop in 2001. But the other major contributor to revenue—prices—has been falling for 40 years, a trend that has been exacerbated by the very technology boom that fueled the US economy in the late 1990s and helped make 1999 the most profitable year ever for airlines.

The rise of Internet travel sites like Orbitz and Expedia has helped consumers find low fares they may not have been aware of when they booked through a travel agent or directly through an airline. The result: Average fares in 2002, after adjusting for inflation, were comparable to those in 1988. “Airlines used to get a premium for an imperfect market, because consumers didn’t know the lowest prices every day,” said Duane E. Woerth, president of the Air Line Pilots Association, the largest pilots’ union. “Airlines lost control of the pricing model.”

Price-conscious leisure travelers have always looked for the lowest fares, but business travelers—who account for 60 percent of revenue and typically book the most costly seats—have joined their league. A sluggish economy, characterized by intense pressure on many companies to cut costs, has led to a surge of business travelers booking cheap fares on the Internet, too, or flying discount carriers such as Southwest or AirTran.

Some airlines have further alienated their most prized customers by reducing the number of frequent-flier lounges and cutting back on waivers and favors, such as free booking changes, extended to top-tier customers. “It’s almost like the airlines have decided the customer is the problem,” complained consultant Michael Boyd of The Boyd Group/ASRC in Evergreen, Colo. “The message is, we’re going to nail you every chance we get.”

At least a couple of airlines may have gotten the message. Delta and American, for example, began experimenting with lower fares for “walk-ups”—last minute customers who would normally pay full price—last fall in a small number of markets. Early results suggested the reduced fares might actually enhance revenue by attracting more fliers.

Several of the major airlines have also been slow to respond to the dramatic change in the nature of flying and the demand for air travel since Sept. 11. Last year, the airlines reduced the frequency of flights, canceled service to some communities, and replaced larger jets with smaller ones. Even with about a seven percent cut in capacity, for most of 2002 the percent of seats filled with passengers, known as the load factor, was lower than it was in 2000. When there was a short-lived rise in traffic last spring, carriers immediately began adding flights to protect their market share, which proved to be a costly defensive maneuver when a rebound in air travel failed to materialize.

The Blame Game

“It’s like an oil cartel, where all blame each other and want everybody else to cut capacity,” said Woerth. That causes worry that undisciplined recovery strategies and a need to protect share at any cost could quickly undercut reforms. Morgan Stanley analysts William Greene and Robert Susman wrote in a note to investors last fall: “We are … concerned that at the first sign of an uptick in traffic, the airlines will increase aircraft utilization and thereby create more capacity (as they did in spring 2002).”

The major airlines’ biggest problem, however, is a cumbersome cost structure that makes quick adjustments to their business plan difficult and leaves them increasingly vulnerable to the most efficient carriers, such as Southwest—which has added capacity, not reduced it, since Sept. 11. Over the last 18 months, the airlines have announced billions of dollars in cost reductions. However, that’s not nearly enough to generate profits, raise battered stock prices, or persuade analysts that they are financially sound.

A Morgan Stanley analysis argued that American and US Airways each need to cut more than $3 billion in costs—on top of savings already announced—to remain competitive. And many experts remain skeptical that planned savings will actually materialize. United, which lost at least $7 million a day in 2002, claimed that it had plans to cut costs by nearly $6 billion by 2004 when it applied for a $1.8 billion federal loan guarantee. Yet the Air Transportation Stabilization Board, established after Sept. 11 to administer such assistance, found United’s plans to be unrealistic and rejected the application in early December, leaving the carrier with no alternative but to file bankruptcy.

The ATSB provided few specifics, but industry analysts have questioned United’s goals, too. About 25 percent of $2.2 billion in pay cuts that pilots agreed to in November, for example, was in “nonwage areas and foregone wages,” according to Credit Suisse First Boston analysts James Higgins and Cristopher Kennedy. Such savings, they claimed, are “either suspect or not meaningful from a cash flow standpoint.”

The airlines face numerous problems, and critics differ over what may be the best structural reforms or government initiatives. Most agree that labor costs, which equal 40 percent of airline revenues, are too high for many airlines to survive as they are. United is the poster child for exorbitant labor costs. In 2000, when the company was near the peak of its profitability, the airline’s pilots extracted a 40 percent pay hike over five years that raised the top salary for a 747 captain from about $250,000 a year to nearly $350,000. That made them the highest-paid pilots in the industry. Mechanics got a more than 30 percent raise, and flight attendants 25 percent.

The United deals set the bar for unions negotiating with other airlines—leading to a huge disparity between the labor costs for big carriers like United, US Airways, and Delta, and low-fare airlines with nonunionized employees. On a typical 2,700-mile trip, for example, pilot wages account for $7,259 of costs at US Airways and $6,342 of costs at United, according to the Morgan Stanley study. For the same trip on Southwest, pilots account for just $2,931 of expenses. The difference at the big carriers must either be passed on to consumers in the form of higher fares or be deducted from revenues.

Still, few complained about generous labor deals back in 2000. The roaring economy filled airports with business travelers who didn’t mind paying $2,000 for a ticket. In the summer of 2000, load factors hovered near the record level of 80 percent. “We were flying the socks off of every airplane that we had,” said David A. Sweirenga, chief economist for the Air Transport Association. Aircraft-makers Boeing and Airbus were competing fiercely for business and offering deals that airlines, with cash on hand, couldn’t pass up. With income and spending relatively lavish, labor unions seemed to have a good case for raises that would make up for earlier years when they had gone without any.

In ways that few airlines appreciated at the time, the industry was slowly changing in a manner that would put traditional “network” carriers at a sudden disadvantage after Sept. 11. In addition to Internet pricing, low-fare “discount” carriers were making inroads in an increasing number of markets. Southwest continued its steady expansion into communities served by smaller airports. Other carriers, such as AirTran, the descendant of Atlanta–based ValuJet, and JetBlue, which began flying to Florida and the West Coast out of New York’s Kennedy airport in 2000, got airline passengers’ attention with rock-bottom fares.

Start-up airlines offering cheap fares have been a perennial nuisance for the major carriers since the airline industry was deregulated in 1978. For most of the time since then, though, discounters typically appealed to the least profitable customers—including some who probably wouldn’t fly at all if not for the bargain rates. The most profitable business customers preferred big airlines that provided more perks and better service. Besides, most discounters didn’t last long anyway. The major airlines could usually match their low fares on a small number of seats without losing much money. Of perhaps 100 new carriers to enter the market since deregulation, only a few still were flying by the late 1990s.

Discounters Gain Credence

With almost no notice, however, the economic downturn and the reverberations from the Sept. 11 terrorist attacks made low-fare airlines a prominent force in the industry. Discounters now account for about 23 percent of the market, up from just five percent 10 years ago. With most airline stock prices thoroughly depressed, Southwest Airlines now represents 70 percent of the entire industry’s market capitalization, and Morgan Stanley predicts that within 10 years the once-humble puddle jumper will board more passengers than any other US carrier.

Perhaps most worrisome for the traditional airlines, Southwest and JetBlue have begun to invade the highly profitable long-haul routes long considered the exclusive domain of big carriers like United and American. Southwest recently introduced nonstop service from Baltimore to Los Angeles, and JetBlue provides flights from New York to the Los Angeles and San Francisco areas.

Some traditional advantages the discounters and new carriers have over established carriers often diminish over time. Southwest, for instance, has carefully selected lower-cost markets that are underserved by larger carriers, while avoiding head-to-head battles out of costly, clogged airports like Newark, O’Hare, and Atlanta. Newer carriers also typically have minimal retirement expenses and lower pay scales, since all of the employees are new.

Additionally, Southwest has been able to keep costs low by persuading its pilots to remain nonunionized and to take retirement benefits largely composed of the airline’s stock. Its strategy of flying just one kind of airplane—737s—has been so successful at increasing the flexibility of crews and mechanics and reducing maintenance expenses that it is now considered a virtual prerequisite for starting a new airline. Not just that, but the big carriers are following suit. United, for instance, plans to cut its fleet from about 10 types of aircraft to five.

The lower cost structure of discount airlines produces a dramatic competitive advantage over larger carriers that has been sharply defined with the sudden, unrelenting pressure to slash expenses. According to Morgan Stanley, the estimated cost for Southwest to make a 1,100-mile flight, for example, is about $9,861. That’s about 36 percent less than the industry average of $15,516. AirTran, JetBlue, Frontier, America West, and Alaska all registered costs below average, while Northwest, Continental, Delta, American, US Airways, and United all come in above the industry average. United’s costs, at the top of the scale, hit $21,428—or more than twice Southwest’s. The upshot is that discounters can offer break-even fares that are about 33 percent lower than those of the big carriers. In other words, the discounters could make a profit while charging fares that would lose money for bigger competitors.

In fact, that happens frequently and, under recent cost pressures, has led some airlines to reconfigure service where they are not competitive—often to their own detriment. A Merrill Lynch analysis of the Phoenix–Los Angeles market—a strong Southwest bastion—highlights how airlines have altered their operations to deal with lower-margin routes. After Sept. 11, American and United both pulled their mainline jets out of that market and replaced them with smaller aircraft flown by regional affiliates. Both lost market share. Southwest and America West, meanwhile, split the extra share abandoned by their larger competitors.

Other problems lie beyond the industry’s control. Government, for instance, has been less than helpful, despite debate over indemnifying airlines against terrorist events and the creation of the Air Transportation Stabilization Board. According to the Air Transport Association, federal fees and taxes account for about a quarter of the cost of an average airline ticket, up from 15 percent in 1992. New security measures and losses associated with the airport-hassle factor could cost the industry another $2 billion to $4 billion.

Yet air travel remains one of America’s most cutthroat businesses, and the most prominent carriers are baring their knuckles against upstarts and other competitors. The hub-and-spoke systems operated by virtually all the big airlines still offer efficient, powerful ways to funnel thousands of passengers into profitable air routes. To make better use of their hubs, airlines like American and Delta are spreading out flights instead of concentrating them during the morning and afternoon rush hours.

In addition to the universal war on costs, the established carriers seem to be taking cheaper competitors seriously. Delta plans to form a new low-cost unit to take on AirTran and JetBlue; the subsidiary is likely to fly just one kind of airplane, for greater efficiency, and concentrate on only the most profitable routes. United is considering a similar project, although skeptics think a mere resuscitation of the United Shuttle, which failed to match the service or prices of West Coast competitors, will be doomed. And the big airlines are making better use of regional affiliates like United Express and American Eagle, which increasingly fly small, efficient jets that are more comfortable than the turboprop aircraft travelers often associate with smaller carriers.

The battles aren’t just between brash new carriers and their grayer brethren, either: Delta, Continental, and American have all lobbied against federal assistance for United, arguing such a move would let it off the hook for bad management decisions and give it an unfair competitive advantage. If the industry could just eke out a profit, the clamor might sound just like old times.