War, Disease and the Economy Are Battering the Airlines. What Lies Ahead?

The airline industry can’t catch a break. First it was battered by a weak economy, then clubbed over the head by travelers’ fears after September 11. Just as the airlines started to adapt to a recessionary market, the SARS disease crisis and the Iraqi war arrived.

 

The industry has gone from merely trying to figure out how to survive a world of lowered demand to figuring out how to survive unexpected crises approaching from all sides. It’s not easy. As Wharton professor of Business and Public Policy W. Bruce Allen says about the current unrest in the Middle East: “The war is the concrete life preserver you’re throwing to the drowning man.”

 

More Cancellations than Bookings

If you listen to the airlines, things are bleaker now than they have ever been. The Air Transport Association, the air carriers’ trade organization, released a dire report two weeks ago where the airlines begged for help from Congress to relieve the impact of the war.

 

“The airline industry is in a seriously weakened state and now is beginning to buckle from the non-market blow being dealt by the war,” ATA President and CEO James C. May said in a statement. The ATA noted that domestic bookings are down more than 20%, trans-Atlantic routes more than 40%, Latin American routes more than 15% and Pacific routes to and within Asia more than 30%. “Airlines have reported that on some days cancellations are exceeding bookings.”

 

As the airlines are right now trying to squeeze money out of taxpayers, it’s understandable that May would make things look as dire as possible. But he does have a point. Last week, Air Canada filed for the Canadian equivalent of Chapter 11. In March, Hawaiian Airlines and Colombian flag carrier Avianca went into Chapter 11 in the U.S. American Airlines announced recently that it would lay off 2,000 flight attendants and eliminate 2,500 pilots’ jobs. KLM said last week that it plans to cut up to 3,000 jobs and slash flights to the US by up to 20%.

 

“With the war, traffic is way off,” says Lew Platt, a member of Boeing’s board of directors and former CEO of Hewlett-Packard. “I was supposed to go to a conference in Miami. It was cancelled, and there were 75 people attending.” Meetings are being called off and people who can postpone travel are choosing to do so, he adds. “Even if a meeting isn’t cancelled, people are just not traveling.”

 

But there are bright spots on the airline horizon. US Airways emerged from Chapter 11 last week. American Airlines said job cuts will allow the company to stave off bankruptcy. And low-fare stalwarts Southwest, AirTran and JetBlue are in no danger of collapse. (In fact, the low-fare airlines are expanding; last week, ATA started new service from its hub at Chicago Midway to US Airways’ hub at Pittsburgh.)

 

Still, US Airways spokesman David Castleveter cautions that you shouldn’t mistake emerging from bankruptcy with having a solid financial footing. “We’re not at all out of the woods. What will dictate when we’re out of the woods is when the war ends, when the economy strengthens and when customers start traveling again,” he says.

 

It’s Not (Necessarily) the War

Buried in Castelveter’s quote is what Wharton professors are saying is the true problem: not the war, but the economy. Even without the war, the major airlines’ business models just don’t work when demand is sluggish.

 

“The problem isn’t the war itself; it’s that the war is going to be a drag on the economy,” says Wharton professor Robert Mittelstadt. “You had an industry with significant overcapacity and high cost structures that hasn’t earned its cost of capital in years. That only works when business is really, really good. When business goes bad, regardless of the reason, then you get a lot of companies that are in deep trouble.”

 

Allen agrees, to some extent. American Airlines and US Airways managed to somewhat rationalize their labor contracts as part of their deals to dodge bankruptcy, he notes. But pilots at profitable Southwest still work harder for less pay than at any of the majors. And although SARS and the war are depressing demand, the major airlines were already in the financial dumps, hit by a lack of business travel, a depressed economy and the growth of teleconferencing.

 

“In a growing world, there’s lots of room for things to grow. But in a world that’s not growing so much, if I discover teleconferencing isn’t so shabby, I think the airlines have a lot to worry about,” Allen says.

 

The Wharton professors suggest that liquidation is still a possibility if the major airlines don’t take steps to radically reorient their businesses – and if the economy doesn’t suddenly take off in a dramatic way. “One of the best things that could happen is that one of the major airlines go out of business,” says Platt. “We need that kind of fundamental restructuring” for the industry to survive.

 

Avoiding the Elephant

The airlines are asking for bailouts and trying to cut maintenance costs, but they’re going to need to do much more than that to survive in today’s world. Two areas for reform have often come up in discussion: the airlines’ nigh-incomprehensible fare structures and the hub-and-spoke system.

 

Even US Airways’ Castelveter admits that the major airlines’ perplexing fare systems need an overhaul. He says the majors are working on a new system, but that they haven’t come to any agreements yet. But he adds that US Airways is married to the hub system – something Wharton professors say should be up for debate.

 

“The big elephant in the room which nobody’s talking about is the hub and spoke system,” says Wharton marketing professor George Day. “Southwest and JetBlue have really compromised the hub-and-spoke model.”

 

The result of eliminating hub-and-spoke systems would be more profitable airlines, and it could increase competition in populous cities such as Philadelphia and Chicago. But it could also lead to much higher fares in markets that are currently hubs but don’t have much natural demand, such as Cincinnati and Salt Lake City. And Castleveter warns that killing off hubs would endanger service in very small markets. “Demand doesn’t exist today to fly nonstop from Harrisburg to San Francisco,” he points out.

 

Of course, serving unprofitable small markets is one of the things that got Air Canada into trouble. Canada’s national airline has 80% of the national market, but is “getting nibbled to death” by small players cherry-picking the most profitable routes, Day says. Meanwhile, if Air Canada tries to pull out of Flin Flon or Medicine Hat, the company could get slammed by Canadian politicians.

 

Switzerland and Belgium let their respective flag carriers fail after September 11, but huge, thinly-populated Canada is far more dependent on air transportation than either of those pocket-sized European states. “They won’t let Air Canada completely fail,” says Day. “The planes never go away; bankruptcy is just a way to reorganize your finances and stiff your creditors.”

 

What Now?

War has doomed airlines before. The first Gulf War, in 1991, led to the liquidation of two then-tottering major carriers: Eastern and Pan Am. Eastern was beset by labor troubles, and its routes largely got snapped up by Continental; Pan Am was still trying to rebuild its image after the terrorist bombing of Flight 103 in 1988 and its routes were later bought by Delta and United. Allen cautions not to make too many comparisons, though. “Eastern and Pan Am had been in trouble longer than what we’re having here,” he says.

 

If the airlines don’t pull back from hub-and-spoke systems, Day predicts a consolidation to a few big players (maybe three) and a proliferation of small carriers like JetBlue and AirTran.

 

“In a surprisingly large number of markets you have a consolidation of market share, and then an absolute proliferation of small players. The book industry is dominated by a few large retailers, but there are hundreds of little boutiques. And think of all the microbrews in the beer industry,” Day says.

 

Platt agrees that liquidation is still a possibility. Eliminating one of the major airlines and redistributing its capacity among the other players could bring capacity down to sustainable levels. “If it’s one of the really big ones,” he says, “if it’s American or United, that would be enough to fix the problem.”

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