Vaughn Cordle
03/01/2005
No investor or traveler should be surprised if America’s commercial airlines never recapture the glamour days when first-class cabins were like four-star hotel lounges in the sky. With the rise of low-cost carriers—LCCs in industry parlance—and the growing use of the Web to locate the cheapest fares, business travelers and their companies are no longer willing to pay the high prices that once subsidized special deals for other passengers. In past decades, some 40 percent of airline revenues came from 9 percent of the passengers; now the big spenders provide only 20 percent of revenues.
Significantly lower pricing is perhaps the most important single factor that has led to the transformation of the airline industry. The result—troubled Independence Air aside—has been the growth and success of six carriers that discount all fares (Southwest, JetBlue, America West, AirTran, American Trans Air, Frontier and Spirit) and the struggles of the six legacy carriers (American, Continental, Delta, Northwest, United and US Airways).
Together with a recession that began in early 2001, the 9/11 terrorist attacks and the SARS outbreak, this new environment has witnessed unprecedented losses among the legacy carriers: $30 billion between 2001 and 2004. Traffic for the LCC group grew 37 percent between 2000 and 2003, while domestic legacy carrier traffic declined by 10.5 percent during the same period. Delta’s decision at the start of the year to cut its top fares further has accelerated a shakeout that was already underway.
The legacy carriers have suffered a record-level drop in fare revenue per mile that began in March 2001—well before 9/11—and persisted into 2004 despite traffic levels approaching those of 2000. My firm’s long-term forecast shows the legacy carriers growing less than 2 percent annually between 2005 and 2020, while we expect the LCCs to grow about 9 percent annually in the same period.
Even with high oil prices, average airfares are going to continue to decline in real terms, and cost and fare differentials between the LCCs and legacies will continue to narrow. It is Southwest that sets the market rates, and Southwest can afford to keep its fares low because it has been able to lock in a price of $24 a barrel through hedging in the derivatives market. This strategy is unavailable to distressed airlines because counterparties will not assume their risk. Success has bred success.
All airlines are pursuing activities to increase their productivity and operational efficiency. However, absolute improvement translates into little or no relative improvement if everyone joins in the latest management fad or copies the same productivity-increasing activity. The most important variables to watch will be labor-cost differentials between the two airline segments, specifically the productivity of the respective workforces and costs of the defined-benefit pension and post-retirement health care plans.
Capital costs remain higher at the legacy airlines, partly because of anachronistic labor agreements that reduced productivity. The legacy airlines have older and more expensive workers than the LCCs, and they have large populations of retirees and their dependents. Legacy expenses include the off-balance-sheet costs of the pension deficits and the net expense of maintaining the plans. As the legacy airlines are forced to cede market share to the faster-growing, lower-cost competition, their relative unit labor costs will increase because the airlines will be left the older and most senior employees. Faster-growing airlines have a greater proportion of younger new hires, driving their average labor costs even lower. Additionally, their new aircraft, under warranty, have lower maintenance costs.
Today even senior airline executives are receiving compensation below the average for companies of their size. In the past, unions may have justifiably resented the money being paid at the top, but now the airlines face a more critical problem in finding and keeping their best executives, just when strong leadership is most crucial.
Recent events, such as Delta’s decision to drop its Dallas hub, and American and United grounding some of their domestic aircraft, will help reduce excess capacity and allow for some revenue improvement. The relief, however, is at best a short-term stopgap. The overriding fundamentals of LCC growth and the need for the legacy carriers to reduce their costs are driving the decline in average fares. This is good news for the consumer, but bad news for legacy airline employees.
 | Vaughn Cordle is chief analyst for AirlineForecasts, a transportation research firm, and a senior Boeing 777 captain for a major airline. |