Speeches & Commentary

"Are we there yet? Restructuring the airline industry"

By Perry Flint, Editor-In-Chief
Air Transport World Magazine

September 27, 2004

Presented to the Worldwide Airline Customer Relations Association
Vancouver, British Columbia

When Don asked me to address the Worldwide Airline Customer Relations Association on the state of the airline industry, I eagerly accepted, not only because of the locale, which certainly is beautiful, but because I thought it would be nice to meet with a group of professionals who get criticized--unfairly I should add--nearly as often as we journalists.

I hope that when I'm done you think it has been worthwhile, or at least that no one has an asterisk placed beside my PNR for the trip home, to notify airport security that I am in need of a full body search and that while I am checked through to Washington, my bag needs to go to Hawaii.

In any case, for the next half hour or so, I welcome your attention as I share some thoughts about all that has befallen the airline industry over the past four years and how far along we are in its evolution.

Of course, much of the news these days is disturbing: oil is tipping $45 a barrel, the tax and regulatory burdens continue to grow and terrorism remains an ever present concern, In the US, fees and taxes now represent 26% of a $200 ticket1and the situation is not that much different elsewhere. The European Union's new passenger rights legislation, which will penalize airlines for operational disruptions caused by air traffic control and airport congestion, is an excellent example of the kind of unhelpful solutions too often provided by legislators and regulators.

But there are also a number of positive trends that often get overlooked. One of these has to do with safety. In spite of all that you and your airlines have been through over the past four years you continue to deliver a product that is remarkably safe, day in and day out. Last year, the world's scheduled airlines suffered the fewest number of fatal accidents since the end of World War II and the second fewest number of passenger fatalities.2Large US airlines have not experienced a fatal passenger accident since November 2001, a period of nearly three years.

The industry's superb safety performance in spite of the tremendous financial pressures to which it has been exposed, will I hope, finally lay to rest the myth that carriers will shortchange safety to improve the balance sheet.

I have some more good news. Airplanes are full again. According to IATA, international passenger traffic--by which I mean RPKs--rose 20.1% through the first seven months of 2004 compared to the year-ago period3. Even more impressive, however, is that for the first time in three years, international traffic is exceeding levels set in 2000, our last normal year. International RPKs are up 8.2% versus the January-July period of four years ago.

It's also important to recognize that airlines in every region of the world are experiencing positive traffic growth, not just in North America and Europe. Africa is up 16%, Asia/Pacific has shrugged off SARS and is up 12.2%. War or no, Middle East traffic rose 47.8%, while South America climbed 10.4%. By the way, I'm not quoting against last year's figures, these are against Y2K numbers.

Revenues are also on the upswing. Despite the impact of SARS and the war in Iraq, world airline turnover rose 2.2% in 2003 to $312.9 billion from $306 billion in 2002.4Now 2% may not sound very significant, but it marked the first year-over-year increase since the 1999-2000 period.

True, many airlines remain mired in red ink. But here as well, the numbers are moving in the right direction. Industry losses last year are estimated by ICAO to have been approximately $6.6 billion and although I know that sounds pretty dismal, consider that it represents a 42% improvement compared to an $11.3 billion deficit in 2002, and nearly $13 billion shed in 2001.

Furthermore, if you remove the US airline industry's share of losses for 2001-2003, which total $23.2 billion5, only around 25% of the more than $30 billion in red ink since 2000 has been borne by airlines outside the United States, although non-US airlines generate more than 60% of airline traffic.

Does this mean that regions like Europe and the Asia/Pacific have gotten off relatively lightly and that the worst is behind them? That's a possibility. But I think a more realistic assessment would be that the economic forces that have been at work in North America for several years are only now making themselves felt in Europe and Asia.

And that's why, despite the improving financial outlook, I'm afraid I must agree with experts who believe that we are by no means out of the woods and that continued restructuring is the name of the game not only for airlines in North America, but also for Europe, Latin America and the Asia-Pacific. For those of you from airlines in those regions, fasten your seatbelts, because it's going to be a bumpy flight!

Given all the attention it has received, it is only natural to attribute most of the current difficulty to the price of oil. According to IATA, every dollar increase in the price of a barrel of Brent adds $1 billion to the industry's costs and since oil has risen from around $26 a barrel in 2002 to more than $40 today, that's about $14 billion in unanticipated costs.

But higher fuel prices affect all parts of the globe, and yet the heaviest impact is occurring in the US, whose airlines are now forecast to lose as much as $4.3 billion this year6. Meanwhile, companies such as Air France/KLM, Qantas, Air New Zealand, Singapore Airlines, British Airways and LanChile, are reporting strong and in some cases rising profits, in spite of the same fuel environment. And, as former American Airlines Chairman and CEO Robert Crandall pointed out last week, "in constant dollar terms, fuel prices have been higher in the past then they are today."7Industry sage Edmund S. Greenslet even claims that, "you can comb the record of the last 30 years?and you will fail to find any clear evidence that higher fuel prices caused earnings to decline."8

Thus while it is tempting to focus on high fuel prices this year, just as we zeroed in on SARS and the war in Iraq last year, and the impact of 9/11 and security costs in the preceding year, we need to look deeper.

Historically, when airlines have been hit by big increases in the price of fuel, they have been able to pass some or all of this on to the consumer in the form of higher fares. US airlines have just emerged from one of the strongest traffic summers in recent memories, with record sustained load factors and traffic back up to pre-9/11 levels. For the first time in three years, there was no terrorism, no new war, no dread disease, nothing that would discourage traffic. Yet nearly every fare increase by a network airline failed.9

The core problem then, isn't the price of fuel, but rather the total lack of pricing power to offset rising operating costs. And that is something new and it is a result of the massive changes roiling the industry there and soon, elsewhere.

Let's take a look at some numbers.

In 2000, the nominal domestic yield for the legacy US airline industry, by which I mean the large hub-and-spoke Majors, was 14.5 cents per revenue passenger mile.10Over the next three years it plunged nearly 18% to just 11.95 cents and through the first seven months of 2004, it dipped another percentage point to 11.81 cents, a level not seen in nearly a quarter of a century. By the way, if we adjust the picture to factor in inflation, it gets even uglier. Indexed to 1978 prices, real domestic yield fell to 4.32 cents last year, the lowest it has been in the 78 years for which data exist!

The result of this collapse in yield translates into some $20 billion in revenue that has vanished from the income statements of the mainline carriers, or around 25% of industry revenues in 2000. No one knows if or when this revenue will come back, but many analysts now see a permanent disconnect between consumer spending on air travel and GDP. Historically, nine tenths of one penny out of every dollar of US GDP was spent on air travel. But today it accounts for just seven-tenths of a penny of GDP.

This development raises a very interesting question, which is, has demand for air travel shrunk? Lehman Brothers analyst Gary Chase says yes, stating that "Since we view demand for air travel as the combination of price and volume, we conclude that the demand is materially reduced." He added that in his opinion, the reduction is permanent.11

I'm not an analyst, but I am not sure I'm prepared to go this far. I would agree, however, that there has been a permanent decline in demand for air travel at pre-9/11 fare levels.

This is the result, largely, of two related developments. The first is the emergence of the Internet as a distribution channel. The second is, of course, the growth of the low cost sector, which is well positioned to take advantage of Internet technology, because it is not tied to legacy mainframe distribution systems, and is simultaneously able to deliver a product for considerably less than the network airlines for reasons that are generally well understood.

Let's begin with the Internet. Although originally viewed as a cost-saver for airlines because it bypassed the high-price GDSs, it has also had the effect of introducing virtually 100% pricing transparency to the consumer. In the old days, before Expedia and Travelocity, Orbitz and Sidestep, Hotwire and Priceline, distribution mostly meant a travel agent sitting in front of a computer monitor fed by one of the GDSs. At peak, almost 90% of tickets were being sold that way. Flights were displayed in order of elapsed time, a paradigm that also drove airline scheduling and hub behavior. The agent looked at the screen and you listened to the agent. Even if you could see the screen, it might take about a dozen discrete keystrokes to generate a fare.

Today, when you click on an airline website, or Orbitz or Travelocity, the default setting isn't elapsed time, or time of day, it's the lowest fare. You don't need to memorize arcane software commands to make sense of the information. Even agency GDS displays default to lowest fare, not time of departure. And with one click of the mouse anyone searching his or her home PC can see who is charging the least in any market. In 1999, the Internet accounted for less than 10% of US ticket sales12. By 2002, the figure was around 30% and my own estimate is that for the low cost sector, it's probably over 75-80% today.

The Internet also has put low-fare airlines in the living rooms of millions of potential customers. Think about that. Before the age of the Internet, if you wanted to start a new airline you had to have a way to get your product in front of the traveling public and that meant hiring lots of sales reps and participating in the GDSs with all those costs and promoting your services to every important travel agent in the relevant city pairs with all that that entailed. It meant buying lots of advertising. And even after you did all that, what chance did you have against a United or a British Airways, which had the corporate clients and were paying agency overrides and full commissions to steer business their way?

But when Independence Air launched last summer, it didn't even bother with the GDSs and it sells more than 90% of its tickets off its own website. JetBlue doesn't use GDSs either. Ryanair sells 95% of its seats online. Paradoxically, although the legacy carriers moved quickly to embrace online ticketing, they are still very much locked into the more costly GDS paradigm, as Northwest learned three weeks ago when it tried to challenge the GDS hold on agency sales. NWA is not atypical among legacy carriers in that only around 15% of its ticket sales come off its website.

Now, of course, we come to the biggest change, which is the rise of the low cost carriers. As legacy airlines reduced domestic capacity by 16.8% since 2000, LCCs reported capacity increases of 25.9%.13LCCs now enjoy a 26% share of domestic O&D passengers, up from 18% five years ago.14

This growth will continue: According to Citigroup Smith Barney, Southwest, JetBlue, AirTran and Spirit will introduce at least 250 more jets to the market by the end of next year,15at which point it is estimated that 40% of domestic airline movements will be produced by LCCs.16LCCs now operate between 922 of the nation's 1,000 O&D top citypairs and have a presence in markets that serve 85% of passengers.17Last fall, JP Morgan identified more than 600 city pair markets in which the one-way walk-up fare had been capped at $299 or less owing to low fare competitors.18

In its second Chapter 11 bankruptcy filing two weeks ago, US Airways cited the presence of these carriers as the biggest factor in undermining its recovery plan in its first reorganization. According to US Airways, "LCCs have crossed the tipping point and have achieved pricing power in the market?They now establish price levels in most of the markets in which legacy carriers fly." And here's the kicker: "The LCCs price fares at levels where they make money and the legacy carriers flying those same routes with higher costs lose money."19

So let's return to the missing $20 billion: Legacy carrier revenues are down 25% from 2000-2003, while low cost airlines have increased passenger revenues over 12%.20So I'll ask again. Has some portion of demand disappeared forever, or has high priced demand simply been replaced by low-priced demand? And before you decide, consider this fact: Southwest Airlines is the third largest airline in the world in terms of passengers, yet it is only the 17th largest in terms of operating revenues. 21Has Southwest's market permanently shrunk? I don't think so. Like all leading companies, Southwest has learned how to deliver a product for less than the other guy and the world is beating a path to its door.

Up until now I've focused on the US market. But these trends are occurring elsewhere. Fare competition from LCCs--primarily WestJet--was a major contributor to the bankruptcy of Air Canada. Across the pond things are happening fast. Credit Suisse First Boston has identified 33 low cost operators in Europe.22Over the past eight years LCCs have been growing at a compound annual rate of 38%. Of course many and probably most do not have long term prospects for survival. Nevertheless they are a force to be reckoned with for every day they are in business. In total they operate 454 aircraft and offer 377,500 seats each day. They enjoy a 20% share of the overall European market in terms of passengers. Looking at seats on offer, the figure rises to 42% in the UK domestic market and it is 19.4% in Germany.

LCCs have also penetrated almost all of Europe's busiest air travel routes. They are on 26 of the Top 29 routes where they enjoy a 22% seat share and an estimated 25% passenger share. An example of their impact is the London-Barcelona route, which in 1995 was owned by BA and Iberia with a 99% combined seat share. EasyJet now accounts for 40% of seats offered.

And guess who is the dominant player on Europe' second largest city pair, London to Dublin? I'll give you a hint: It isn't BA or Aer Lingus. In fact, Ryanair now carries more passengers in Europe than BA! It is the dominant carrier on 88 of its 155 routes.

CFSB estimates that by 2010, LCCs will have 33% of the European market and by 2015, will have 41%.

It is only necessary to look at the situation at carriers such as Alitalia, SAS and Swiss to see the impact these LCCs are having. Each is trying to come up with a solution to the downturn in full fare travel in Europe, but as we have learned from studying the US model, many of those full fare travelers are simply taking advantage of price competition that didn't really exist 10 years ago between most European citypairs.

Where will the LCCs go next? Last week Ryanair COO Michael Cawley told our website that the Irish carrier aims to launch domestic services within Spain within the next two years, with perhaps France and Italy to follow. Currently LCCs have only 2% of the Spanish market, 2% of the French market and 4% of the Italian market. But within the next five years, I would expect their share to be in the double digits.

The rise of LCCs in Europe has been many years in the making. Indeed, it was not until adoption by the EC of the so-called Third Package of liberalization measures a decade ago that the necessary prerequisite of open access to all markets within the European Union was created. Developments in Asia, on the other hand, have followed a wholly different track. I think that we have all been surprised by how quickly the region has bought into the idea, particularly in light of the fact that many nation are still making the transition from tightly-drawn bilateral agreements to free-wheeling open skies arrangements.

But as our Senior Editor Geoffrey Thomas pointed out last month, the momentum in Asia is driven not by liberalization per se, but through the support of government investment agencies and major airports that regard LCCs as weapons in the ongoing battle for hub domination and the economic benefits of tourism. This means that they can thrive here despite the lack of open skies.23

Certainly the catalyst of the low-cost revolution in Asia has been Kuala Lumpur-based AirAsia, which expects to carry 4 million passengers this year--double that of 2003--and will have 24 aircraft in service by year end, up from 17 today. Singapore is now home to two LCCs, Valuair, founded by former Singapore Airlines senior executive Lim Chin Beng, and Tiger Airways, which is partly owned by Singapore Airlines. Yet a third, JetStar Asia in which Qantas and SIA's government owner Temasek Holdings are partners, will take off shortly. Of course Virgin Blue has established a major presence in Australia and is now on the transtasman as well, while Qantas has established its own low-fare brand to compete.

LCCs still account for only a small portion of the market and there are those who reason that the long distances involved will limit their development, to which I can only point out that last week Valuair said it intends to begin flying from Changi down to Perth, using A320s.

In Latin America, GOL is both the biggest LCC and Brazil's most successful airline. It now claims a 19% marketshare, operating around 210 daily flights to 29 cities with a fleet of 25 737s. Earlier this year it completed a highly successful IPO on the Sao Paulo and New York exchanges and it has ordered and optioned 43 737NGs. Before the end of the year it will launch its first international route, linking Sao Paulo and Buenos Aires.

So there we have it. LCCs are present in Calgary and Sao Paulo, in Singapore, and Dublin, in Perth and Philadelphia. Legacy carriers have been slow to recognize their impact and slower to respond, however, there is no question that they are now fighting back.

US airlines have gone through dramatic restructurings--American has taken nearly $4 billion in costs out of its budget since 2002. United Airlines has cut labor expense by two-and-a-half billion dollars, US Airways by $1 billion. Northwest Airlines, although it has yet to achieve any restructuring of labor rates, claims to be saving $1.6 billion annually following eight separate rounds of belt tightening since 2001.

In total, US legacy majors have taken $13.4 billion out of their operating expenses in recent years.24I know some of you in this room have been participants in this extremely painful process in which 100,000 jobs representing 24% of the industry workforce have been lost. Some of you are working harder for less money and benefits have been reduced.

But there is a payback: In aggregate, US legacy airlines have reduced the unit cost gap with the LCCs from 42% to 33% in just one year, and are likely to pare it back to 25% in 2006. Despite a 9% decrease in capacity, the airlines have rolled their unit costs back to 1999 levels.25

Yet there is general agreement that, in the words of JP Morgan airline analyst Jamie Baker, "Much more needs to be done."26Both US Airways and United now acknowledge that they did not cut deeply enough. Delta hopes to reduce its expenses by $5 billion and may well have to enter Chapter 11 to do so. No major network airline can believe its future is assured, yet all are working to avoid the fate of Eastern, Pan Am and Braniff.

But transformation is not impossible. Aer Lingus was struggling to survive even before 9/11, yet today it is a thriving, profitable airline, having carried out the Houdini like trick of moving from a high cost flag carrier without a protected niche into a lean and hungry low cost competitor that can seize market opportunities heretofore unavailable. It's no surprise that earlier this year the carrier was the recipient of ATW's first Phoenix award for making this transition.

Under CEO Rod Eddington British Airways is engaged in a massive overhaul of its cost structure aimed at making itself more competitive by examining every aspect of its operation. Through the "Future Size and Shape" initiative it has cut 869 million pounds from the budget and a new program to slash a further 300 million pounds already is underway.

SAS has not found the answer yet but it is not for lack of trying. It recently split its Scandinavian operation into three operating units, one for each home country, the better to react to cost and yield pressures and it is rolling out a new product offering aimed at better serving the price conscious as well as the non-discretionary business traveler. It has achieved significant cost reductions and efficiency improvements in its recent union negotiations, as has Alitalia, although it had to threaten to shut down to achieve them. All across Europe, former flag carriers are simplifying their fares and product offerings in response to the changing marketplace.

It would be a mistake to believe that the challenges facing the legacy sector of the airline industry are unique. Today the telecommunications sector in the US is facing challenges every bit as severe.27Companies offering new technology--in particular Internet telephone services--are stealing business away from the old-line telephone companies that have invested billions of dollars in creating networks of local phone lines. AT&T's revenue is down 18% in three years, and its bonds now trade as junk. It's stock, which in former days was a blue chip, has lost around 80% of its value. In aggregate the companies formed by the break-up of AT&T have lost some 28 million local phone lines since the end 2000, a drop of more than 18%. Thousands of employees have lost their jobs. Meanwhile, Cox Communications, best known for providing cable TV, entered the phone business just a few years ago and now is the 12th largest phone company in the US.

These new entrants, with younger non-union workforces and pension programs largely funded by their employees are able to deliver a product that is in any case inherently cheaper to provide, for less money than their competitors. And it is getting harder and harder for the legacy phone companies to differentiate their product in the marketplace.

Sound familiar? Yet there is a major difference between the two industries. The technology upon which the phone companies built their business model is threatened with obsolescence. Airlines are not. Absent the development of a flying car or a transporter room like the one on Star Trek, airplanes will remain the primary mode of transportation over long distances and especially over water, which--if I recall my geography, makes up something like 70% of the Earth's surface.

An A320 or 737 delivered today will very likely be flying long after many in this room--including myself--have retired from this crazy business. From the CEO to the ramp hand, the question every employee needs to ask is: What do I have to do to make sure that plane is still flying in my airline's colors?

I thank you for your time and will be happy to answer your questions.

Endnotes and Sources:

1. ATA, Economic Review, September 2004, p. 33

2. ICAO Preliminary Safety and Security Statistics for Air Carrier Operations in 2003, March 22, 2004

3. "Strong Traffic Growth but Profits Undercut by Sky High Fuel Prices, IATA Release No. 26, Aug. 26, 2004

4. World Airlines Reduce Losses in 2003, ICAO, June 29, 2004

5. Air Transport Assn. of America 2004 Economic Report

6. UBS Warburg 3rd quarter preview, Sept. 10m 2004

7. Robert Crandall Speech to the Wings Club, Sept. 21, 2004

8. The Airline Monitor, June 2004

9. ATA, pg. 24.

10. Data in this section from various ATA publications

11. Testimony of Gary Chase, Senior US Airline Analyst, Lehman Brothers, to the House Aviation Subcommittee, June 3, 2004

12. US GAO Report: "Legacy Airlines Must Further Reduce Costs to Restore Profitability, p. 8, Aug. 2004

13. US Airways bankruptcy filing, Supplemental Brief to first day motions, Sept. 12, 2004, p. 18

14. .Merrill Lynch Industry Update, Sept. 2004.

15. US Airways, p. 19

16. JP Morgan, Discount Domination, Oct. 3, 2003

17. US Airways, .pg. 20

18. JP Morgan

19. US Airways, pg. 6-7

20. US GAO Report: "Legacy Airlines Must Further Reduce Costs to Restore Profitability, pg. 30, Aug. 2004.

21. Air Transport World 2004 World Airline Report, Top 25 Airlines, July 2004

22. Statistical data from this section come from Credit Suisse First Boston Low Fare Airlines Market Penetration, July 12 and CFSB Low Fare Airlines: Market Saturation, March 8, 2004).

23. "A revolution deferred, but not denied, " by Geoffrey Thomas, ATW, Aug. 2004, pg. 28-30

24. ATA, pg. 27

25. JP Morgan, The road to reinvention, Aug. 16, 2004, pg. 1

26 The road to reinvention, pg. 1

27. Information about the telecom industry is taken from "Phone industry faces upheaval as ways of calling change fast," Ken Brown and Almar Latour, The Wall Street Journal, August 25, 2004, pg. 1.