Not Even a Slight Glimmer of Hope from Network Airlines

“We’re all suffering from a significant decline in business travel demand,” said Southwest chairman and chief executive Gary Kelly. “We’ve detected a slight improvement in July, but post-summer we are prepared for significant continued weakness on the revenue front.

“It’s clear right now that we’re living on the back of strong leisure demand facilitated by low fares.” [The Continental CEO] added that the drop in business passengers appears to have “stabilized,” but “at a very low level.”

Delta executives said they did not expect any meaningful recovery for the remainder of the year, adding that they did not project a profit for 2009.“We may face some tough choices,” Richard H. Anderson, Delta’s chief executive, said.

Ouch.  Yes yes, you knew it was bad out there.  But when airlines actually start announcing the numbers, it’s ugly.  Historically ugly.  Continental’s Q2 trans-Atlantic revenue was down 28% over last year.  When you adjust for the capacity drops, it’s only a 23% drop.  Overall, their revenues were down 24% over the previous year.

And pretty much every network airline looks like that.

You may be saying to me and/or yourself:

1) But the airlines reduced capacity, so of course revenues will shrink;
2) But AirTran and Allegiant had real profits.

Yes, the airlines have been dropping capacity like I dropped European History in 9th grade, but that’s not enough.  Oil is getting more expensive.  Business travelers have disappeared or traded down to the low fare buckets in unprecedented numbers.  That last part is important – we’ve never seen this before.  Never.  Although the airline industry is 70+ years old, the deregulated industry in the US is only about 30, and it’s never been this bad.

Network (hub & spoke) airlines are suffering the most, which is how AirTran is able to avoid some of the problems facing the others (Allegiant is a juggernaut that manages their costs better than anyone).  But let’s put AirTran, Allegiant and JetBlue aside for a moment.  They are pretty much a different type of company than the network airlines.  Hub-and-spoke airlines, as I’m pretty sure I’ve said here before, are basically manufacturing companies — they manufacture connections.  They use a just-in-time manufacturing technique to ensure that raw materials (people and planes arriving in Minneapolis from the West) do not sit on the ground too long idle before heading off as finished goods (the connecting flights) to cities in the East.  They need to minimize the cost of getting the raw materials to the Minneapolis factory, and they need to maximize the revenues they generate from selling the manufactured good (the connected flight).

That system actually works pretty well when there is predictability in the market.  Regulation provides predictability, for example.  If you know roughly what you’re going to earn from the connection you’re making next week in Minneapolis, then it’s easier to run a profitable company, since you just need to make sure that your costs are below that set level.

When times are good there’s predictability in the market, since you are fairly sure people will be buying your seats at whatever price you sell them for (remember $2400 transcon coach fares?).  That also makes it easier to plan.

That manufacturing strategy pumps through the whole airline system when you think about it.  Airlines can talk all they want about customer service, but in reality they do 2 things pretty well:  they make connections at a pretty reasonable price, and they have fare sales to generate demand.  In other words, their basic job – getting flights from here to there on-time and safely – is a home run.  And when they cut fares, people do buy more tickets.

But that’s pretty much the only lever they’ve ever had.  Until 2 years ago, airlines were loathe to shrink themselves which, for a business with high fixed costs, means that you’re not willing to take costs out of the system except by asking unions for lower wages.  Which is what had happened up until 2007.  How many airlines in the 1980s and 90s disappeared because of labor-related strife.  Continental?  Eastern?  Continental again?

That fare sales were the only lever is what has driven the business case for nearly every new entrant since deregulation.  Each has thought the same thing:  We will come in without the legacy costs and legacy mentality and simply undercut the competition, driving consumers into our open arms.  And that works…until network airlines have a war of attrition and match prices until competitors are driven out of business.  Or until competitors grow large enough that they find out they are a low fare-driven airline and not an operations-driven airline (People Express figured this out quickly).  If you grow too fast, without understanding how to manufacture the connections (or worse – even run a point-to-point operation), it’s over.

The successful new entrants – JetBlue and Southwest being the two most successful — had completely different approaches.  Southwest started during regulation by flying intra-state, where they did not face fare regulations.  They grew up under unique circumstances.  That they’ve been able to continue to grow to this day is a testament to how well they’ve been run for 35 years.  But they were one of a small handful of airlines to run like a deregulated carrier during a regulated time.  That makes them unique.

JetBlue was the first to use the Target cheap chic model, which meant truly focusing on experience rather than simply low fares.  That they were able to do this and have a well-run operation speaks volumes about their founding management team.  That is, until the February storms a few years back in JFK that nearly destroyed every bit of goodwill they ever had and probably allowed Virgin America to come in and compete with them.  Striking the balance between operations and marketing is unbelievably difficult.

So where does this leave the network airlines?  Incredibly, only American Airlines has not gone through a bankruptcy in the past 30 years.  If every other company in an industry has been driven to bankruptcy (at least once), it suggests that there is a fundamental problem with having that many airlines, and such low barriers to entry.  Yes, business travel will come back at some point.  Oil prices will likely drop at some point.  Carriers will re-gain pricing power on some level.   But that doesn’t mean things will be good.  It will mean that it’s time for a new entrant to come in an knock the incumbents around.

I see only 2 options:

1) Re-regulation.  This will never happen.  It’s bad for consumers, and no administration wants to be seen as Communist.  It is, however, good for airlines.

2) Allow foreign ownership and eliminate the incredibly ridiculous cabotage rules.  This may, and should, happen.  What if I told you in 1977 that your only car options were a Ford Pinto and a Chevy Nova… and that while we knew that Toyotas and Hondas were superior in both quality and price, since they were made in Japan you couldn’t have them.  Because of border security.  You would think I’m insane.  That’s what’s happening now.  Let Singapore and Ryanair and Air Asia come here and show us how it’s done.  Closing off international competition has accomplished exactly nothing.  No wait, it’s accomplished exactly what you’d think:  allowed airlines to offer a middling product at the highest price they can possibly charge.  Nowadays that means they can’t charge much.  But when times get better, look out.

The current state of the industry is untenable.  A turnaround will not lead to anything, other than 12-18 good months, allowing airlines to grow like weeds before things go bad and a couple of them go bankrupt again.  That cycle needs to stop, and it will stop when we let the foreigners in.

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