Airline Industry Not Yet Flying High

It is one hundred years since the Wright Brothers took off from Kitty Hawk. Over that century America’s airlines have operated at a net loss, repeatedly turning to the government for bail-outs. The most recent subsidies are dressed up as reimbursement for post-September 11 security losses and costs. The first post-attack package included $5 billion in cash and $10 billion in loan guarantees. The latest added $2.3 billion of taxpayer money to cover security costs that should more properly be borne by passengers. Delta led the parade of beneficiaries ($390 million), followed by American Airlines ($361 million), United Airlines ($300 million), and U.S. Airways ($216 million).        

Europe’s airlines get no such handouts. For example, in the past sixteen months British Airways has incurred additional security costs of £100 million for steel cabin doors and other security measures. Compare that with the £135 million in pre-tax profits that the airline earned in the year ending March 31, 2003, and you can see why the difference in government policies places BA and other European carriers at a competitive disadvantage.

America’s carriers blame their financial plight on security costs and the fall-off in travel following September 11. But they were bleeding oceans of red ink long before the world ever heard of bin Laden, and long before the paucity of merger deals grounded the high-flying Wall Street bankers that filled their first-class and business-class cabins.

The hard truth is that the managers of America’s carriers never did learn to control costs. What the unions demanded, the unions got, the alternative being costly and disruptive strikes, and rows with the congressmen whom the unions carefully cultivated. The killing blow for America’s carriers came when United inflated the industry’s cost base by granting its pilots a 30 percent wage increase in 2000. Result: an industry that has $100 billion in debt, and a puny market capitalization of $4 billion. Nothing in the recent cheery reports about an upturn in traffic can counter that fact, or its huge underfunded pension liability, or its historic ability to turn temporary good fortune into enduring disaster.

Add a few more ingredients and you have a prescription for economic madness. Governments refuse to allow air space and airports to be used in an efficient way, and many persist in propping up loss-making national flag carriers. And U.S. bankruptcy laws permit carriers to remain in business no matter how badly managed, how trivial and uncertain the concessions offered by the unions, and how inadequate their managements’ plans for coping with the changes in the air travel market.

Thanks to deregulation, millions of people who could never contemplate air travel found that competition brought fares to levels that made visits to grandma and vacations in far-off places affordable. Business travelers, who frequently have little advance warning that their presence is required at some meeting or other, did not have the flexibility that leisure travelers have, and so ended up paying far higher fares than their vacationing seatmates.

While the major carriers fed passengers into hubs, and out again to the many cities each serve, a few point-to-point, no-frills carriers, operating from secondary airports, emerged—and made money while the bigger carriers contrived to destroy shareholder value at an astonishing rate. Worse still from the point of view of the major airlines, the gap between the fares they charged business travelers and the fares offered by the no-frills carriers became so great that businessmen began to accept less leg room and a bag of peanuts as costs worth bearing to keep travel costs down.

So where does the industry go from here?—a question I put to BA boss Rod Eddington. He credits the no-frills carriers with being smart enough to uncover an under-served market, witness the success of Southwest, JetBlue and AirTran in America and RyanAir, and easyJet in the U.K. True. But I would add that load factors at Southwest are declining, easyJet ran up $76 million in losses in the most recent half year, RyanAir is in a fare war that is forcing it to cut its yields to fill the seats of its expanding fleet, and Brussels-based Virgin Express chalked up a loss of almost $20 million in the first quarter of this year. Which may explain why United Airlines has abandoned plans to become a no-frills carrier when it emerges from bankruptcy.     

In short, the no-frills airlines may have seen their best days, and may find profits harder to come by in their now more fully served market. Eddington, not a man to knock unsubsidized competitors, confines himself to noting that these carriers are starting to “bump against one another” as the market for their product begins to grow less slowly, making it more difficult for them to find bums to put on the seats of flock of planes ordered two years ago but only now being delivered.

Eddington is more willing to offer a view of the future of full-service, network carriers such as BA. Just as the market discovered by the no-frills lines was underserved, he thinks the market for full-service carriers was, and still is, over-served. He is predicting that many of the airlines now in business won’t be around in a few years time, a consolidation trend likely to be accelerated by new European Commission rules that will facilitate pan-European mergers. The “three, four, or five survivors” will have to cut costs and staff without reducing customer service. Since “I don’t mind copying from the no-frills lines,” says Eddington, BA has followed their lead and chopped its distribution costs by more intelligent use of the Internet.

If he has his way, governments will stop subsidizing inefficient national flag carriers, and America will drop rules that prevent foreign carriers from competing in its vast domestic market, and abandon the “fly American” rules that prevent foreign carriers from competing for the business of government employees.

Meanwhile, the full-service carriers will continue to experiment with pricing schemes that might please passengers, such as lowering fares by charging separately for advance seat assignments, the use of lounges, and food and wine. But that is for the future, after BA figures out how to “retire Concorde with grace” in October, and keep the crestfallen supersonic crowd happy in slow-motion first-class cabins.

This article appeared in London’s Sunday Times on June 5, 2003.