The New Flight Plan
The nation's airlines miraculously survived their post-9/11 tailspin. Too bad that wasn't their only problem
If you've taken a commercial flight lately, you might think that the U.S. airline industry is sputtering back to life. Over the summer, airplanes were the fullest they've been since 1970. Revenues were up too, rising 8.1 percent in July from a year earlier. And airline investors, starved for good news, have sent stock prices soaring from March lows; American's beleaguered shares rose 9 percent in one day last week when Merrill Lynch praised the carrier's efforts to cut costs by $4 billion and improved its earnings forecast.
But this is an industry that excels at disappointing, and two years after the September 11 terror attacks the airlines may be in more precarious shape than ever. To reach profitability, the airlines have slashed pay, furloughed workers, cut service, and grounded hundreds of aircraft. Yet for the third year running, every major carrier except Southwest will lose money in 2003, with combined losses approaching $7 billion. And revenues will still need to grow by a hefty 10 percent, according to Credit Suisse First Boston, for the industry just to break even. "We thought two years ago that everything would be normal by now," says Continental CEO Gordon Bethune. "Unless business improves, some of the [big carriers] won't be here."
The September 11 catastrophe was obviously an unprecedented shock to the airline industry. But it now appears that many airlines misconstrued the resulting plunge in business as an anomaly whose effects would eventually dissipate. They cut capacity and trimmed costs but quickly reversed those moves when the economy showed signs of a rebound in mid-2002. That false start sent many airlines deeper into the red.
United Airlines' bankruptcy filing last December began a new round of shock therapy. United was able to force once-unthinkable pay cuts on pilots and other workers, while the threat of a similar fate at American persuaded its employees to give up some pay and benefits this spring. The carriers finally got serious about reducing supply, too. Nearly 600 aircraft--about 15 percent of the U.S. fleet--are parked in desert holding pens, their engines shrink-wrapped to keep out blowing sand. Overall, the total supply of seats in the air this year will be about 6 percent lower than in 1999.
Slimming down. If this were a typical industry downturn, those moves might suffice until demand bounced back and the airlines fattened up again. But the market for air travel is changing in ways few airlines anticipated. "September 11 permanently resized the U.S. airline industry," says analyst Sam Buttrick of UBS. As a percentage of GDP, airline revenue has fallen 20 percent to 30 percent from levels of the past 25 years. And instead of bouncing back during an economic recovery--as airline executives clearly hope will happen--revenues may remain depressed. Long security lines and other inconveniences make air travel slower, and videoconferencing and webcasting are becoming sound alternatives for business travelers--the airlines' cash cows. "The value proposition for business travel is declining," says Buttrick.
In many industries, tough times produce consolidation, when big, strong companies absorb smaller, weaker ones. But the airlines are a persistent exception to textbook economics. There are no big, strong companies, excluding Southwest, which would rather fly passengers in hot-air balloons than absorb a troubled competitor. And while some mergers might make strategic sense, antitrust regulators are notoriously suspicious of airline deals, such as the United-US Airways merger they scuttled in 2001.
Meanwhile, low-cost carriers like Southwest, AirTran, Frontier, and JetBlue are taking market share away from the network Goliaths and growing at rates that seem more typical of an Internet startup than an airline. JetBlue, which serves about 20 cities, mostly out of New York, is likely to grow by more than 60 percent this year, while Delta, one of its closest competitors, should shrink by about 8 percent. Overall, low-cost carriers could control 40 percent of the seats before their growth levels off, up from 22 percent today.
As has been obvious since deregulation in 1978, airline economics favor new entrants--for a while. Most new carriers hire nonunionized pilots at low pay and cherry-pick the most profitable routes. Big airlines must sustain elaborate hub-and-spoke networks designed decades ago and pay union wages, including seniority premiums. Continental's Bethune asked his accountants to estimate the company's 2002 bottom line if all employees had been on the payroll only two years, as at JetBlue. The result: a swing from a $361 million pretax loss to a $469 million gain. "All I've got to do to be profitable is fire everybody," he quips.
Not quite. The big carriers' volume usually allows them to match discounters' low fares on a portion of seats and often drives the latter out of the market altogether by offering better perks like more extensive frequent-flier mile programs and reserved seats. They're certainly fighting some fierce battles now. When JetBlue launched service from Atlanta to Long Beach, Calif.--key Delta turf--the big airline matched the lower fares, added flights, and promptly chased JetBlue out. When Indianapolis-based ATA announced plans to fly to San Francisco out of Continental's Newark hub, Continental began pointing out that its 737s carry just 155 passengers, compared with the 175 on ATA's 737s. "That's a huge difference in comfort," says Bethune.
Free TV. What's different, however, is that the urgency to cut costs and stem the bleeding at the majors leaves little left over to combat the discounters. When American, for instance, reduces flights at its St. Louis hub in November--part of its ambitious cost-cutting plan--Southwest is expected to double its share of the market there from 15 percent to 30 percent. And unlike fly-by-night carriers of the past (anybody remember SunJet?), "the average quality of secondary discounters has never been higher," according to Buttrick. Delta, for example, has formed a low-cost unit called Song to compete with JetBlue on the East Coast, but so far passengers are actually paying higher average fares to be on the startup--presumably because they enjoy the experience and free TV in every seatback.
That phenomenon is producing a revelation in Airlineland: Maybe customers deserve a little more attention. Song plans to offer its own in-flight TV, and other carriers are considering it. Meanwhile, the big carriers have been relaxing some onerous rules, such as high fees to switch nonrefundable tickets. And some new cost-cutting schemes are flier-friendly too. Continental, Southwest, and other airlines have been installing hundreds of kiosks that allow travelers to check themselves in, which cuts labor costs for the airlines and often means one less line for travelers.
If the mainline carriers recover, JetBlue and other aggressive startups could go the way of PeopleExpress and dozens of other defunct discounters, taking with them the benefits that trickle down to travelers. But predicting good health for the big airlines is a risky bet. United announced recently that its emergence from Chapter 11 would be delayed until next year. Investors have been bidding up American, but they are so skittish about the company itself that the average holding period for the stock is only 15 days, according to Morgan Stanley, down from 72 days last year. And the industry isn't likely to turn an overall profit until at least 2005--barring any further shocks. Even if that happens, a study by Raymond James & Associates argues that the big carriers, hamstrung by high costs, will back away from the most competitive domestic markets and settle for more-profitable long-distance and international routes.
Harried sky warriors may delight in seeing the airlines get their come-uppance. But be careful what you ask for. A shrinking industry, even with a rising proportion of cheap carriers, could accelerate the erosion of service to less profitable regional markets, like Fresno, Calif., and Bangor, Maine--which don't have enough daily fliers to attract Southwest-style airlines. And discounters don't always mean improved service. When Southwest entered Jackson, Miss., in 1997, it offered cheap flights to a handful of cities. But it eventually drove out TWA (since purchased by American), which had connected Jackson to the rest of the country through its St. Louis hub. And even if the big carriers remake themselves as nimble middleweights, they may be forced to pull out of marginal hub airports like Pittsburgh, Memphis, and Cincinnati, with nobody else interested in replacing the home carrier. "We'll have a viable, robust industry," predicts consultant Michael Boyd of the Boyd Group in Evergreen, Colo. "But it's not going to be plebeian. It will be more exclusive." At least you'll be able to watch TV.
THE BIG GET ... SMALLER
While most major U.S. airlines are losing money and reducing capacity, discount carriers are doing the opposite.
Estimated net earnings, 2003
Southwest $292 million
JetBlue $81 million
AirTran $61 million
America West -$65 million
Alaska -$74 million
Continental -$240 million
US Airways -$615 million
Northwest -$659 million
Delta -$1.0 billion
American -$1.7 billion
United -$2.2 billion
Estimated changes in available seat miles, year-end 2003
JetBlue 66.3 percent
AirTran 21.6 percent
Alaska 7.0 percent
Southwest 4.9 percent
America West 3.3 percent
Continental -2.0 percent
American -3.7 percent
Northwest -4.3 percent
Delta -8.0 percent
US Airways -8.7 percent
United -9.0 percent
Source: UBS; USN&WR
This story appears in the September 15, 2003 print edition of U.S. News & World Report.