No one imagined quite how much money the airlines would lose.


After Sept. 11, 2001, analysts predicted losses in 2002 for all the major U.S. airlines. But the airlines have done far worse than expected. Last September 28, major analysts expected a loss of $5.22 per share on the Dow Jones airline index for 2002, according to financial clearinghouse Thomson/First Call. Now, they’re expecting a loss of $25.31 per share. “It’s negative earnings over negative earnings,” says Thomson’s Tom O’Keefe.


Why were predictions so wrong? Analysts were far more optimistic about the national economy than they should have been, Wharton professors say. Depending on whom you ask, poor airline management, government bungling over security and basic structural flaws in the airline industry also doomed earnings this year. But what it all comes down to is, people just aren’t flying.


Wharton professor of business and public policy W. Bruce Allen puts it bluntly: “We don’t have ridership.”


Find the Flyers


Everyone agrees ridership is down – and that business travel, especially, is down. The average airplane ‘load factor’ – the percentage of seats filled – is off 10% from before September 11, according to Allen. Independent airline analyst Bob Mann says that average fares paid are down 20% from two years ago, reflecting a drop in business flying.


But September 11 is not to blame, Wharton professors and analysts unanimously agree. The problem is the national economy, not any particular stigma attached to flying after the attacks. The airline industry is a cyclical one, and suffered similar massive losses in the 1980-82 and 1991 recessions. In an industry so tied to the economy, management executives are debating what they can do to staunch the blood flow – other than cut capacity, which they have done.


“September 11 accelerated what was happening, but most of the major airlines were really in some trouble prior to September 11 because of the falloff in business traffic” due to the general decline in the economy, says Lew Platt, a Boeing board member, former CEO of Hewlett-Packard, and a Wharton graduate.


Allen, for one, thinks airline management has done an “okay job” of convincing people that it was safe to fly again after Sept. 11. But managers have sabotaged any potential recovery by complaining loudly that they are going bankrupt so they can reap federal bailouts, other analysts note.


“We literally had [Continental CEO] Gordon Bethune saying the sky is falling, and we had [America West CEO] Jim Parker saying, ‘If we don’t have a check by Friday we’re shutting the doors,’” says Mann. “This doesn’t do too much to infuse confidence in the industry. To some extent they got their wish; they got funded but they also got the collateral damage associated with saying they were a failing enterprise.”


Mann also points out that confusion over security has caused serious problems for airlines. Airport security regulations varied widely among airports and seemed to change week to week for most of late 2001 and early 2002. Now, the airports face a federal deadline to screen all checked bags for explosives by November 19. It’s a deadline that the airlines say is impossible to meet – or that will cause interminable waits at the airport.


Revolt of the Business Travelers


The major airlines’ business models are all based on one delicate concept – that business travelers will pay a tremendous surcharge for convenience. But the airlines haven’t been holding up their end of the bargain, and that’s threatening to ignite a business traveler revolt. “What airlines sell is productivity, and particularly they sell productivity to business travelers,” Mann says. He argues that airport-security hassles have gutted the short-haul airline market, and lays the blame on the federal Transportation Security Agency rather than the airlines.


But business travelers have also migrated to lower fares, and lower-fare airlines such as Southwest, because they don’t see the airlines’ service differentiation as worth the prices the major airlines are now charging, says air travel consultant Joe Brancatelli, pointing out that “10% to 15% of business travel has migrated to the lower fares.”


The tremendous gap between leisure and business fares encourages shopping, adds Wharton management professor Peter Cappelli. A little extra leg room and a refundable ticket may be worth some multiple of coach-class prices, but the price gap is now way beyond that. “I just flew to China, and the difference between the coach and business fares was seven or eight times. If you go to London, the business fare can often be 20 times the coach fare,” Cappelli says.


Business travelers have had access to lower fares in part because of the new focus on buying tickets online, Mann says. To save travel agent commissions, airlines have pushed tickets through their own web sites and through Orbitz and Hotwire, which are owned by groups of major airlines. Now 15% of tickets are sold online and many more travelers use web sites to shop for low fares, according to research firm PhoCusWright.


US Airways, for one, is trying to lock business travelers into high fares by placing new restrictions on leisure fares – making them ineligible for credit towards elite frequent flyer status, for instance. But that will just drive away fliers who like to mix their business and leisure travel on one airline, says Robert Mittelstaedt, vice dean and director of Wharton’s Aresty Institute of Executive Education. “I think they’re going to shoot themselves in the foot with this initiative. Unless everybody in the industry follows them, people will go to other carriers with fewer restrictions.”


The drop in ridership has already claimed one major airline – US Airways, which filed for bankruptcy on August 11 after losing $2.1 billion in 2001. United Airlines, with a $3 billion loss so far since 2001, has also been teetering on the edge of bankruptcy. But bankruptcy doesn’t mean liquidation. Airline bankruptcies are drawn-out affairs; TWA went bankrupt in 1992 and 1995 but only sold out to American after a third bankruptcy in 2001, and Continental has gone bankrupt twice since 1978 but is still flying.


The key is cash. In a cyclical business, airlines build up huge cash reserves to ride out the down times. According to Merrill Lynch analyst Michael Linenberg, most carriers have “ample amounts of liquidity.” For instance, UAL burns $2.1 million per day – but they had $2.7 billion in reserves as of this June, which would enable them to go another three years before running out.


Linenberg says he expects Continental, Delta and Northwest to stabilize their cash positions this quarter. Industry liquidity is much better than it was during the last airline slump in 1990, adds Salomon Smith Barney analyst Brian Harris. And according to Tom Ronell, a Wharton graduate and president of an aviation consulting firm, “Airlines can lose billions of dollars and still have a positive cash flow. Because so much of [losses] are facility and equipment related depreciation charges, it’s really hard to tell what their real condition is.


Low Cost, High Profit


There’s been one bright spot in the airline sector this year – the ‘low cost’ airlines. Southwest is now predicted to be the only major airline to turn a profit in 2002, and smaller cousins JetBlue and AirTran are also expected to eke out a few pennies of positive earnings.


The lesson the majors can learn from these scrappy competitors is that efficiency pays off. Although airlines bemoan their labor costs, it is increased productivity, not lower individual salaries, that sets Southwest apart, Mittelstaedt says. “Airlines have to use people more efficiently, with quicker turnarounds, and airplanes loaded faster. The answer is not just to reduce what you’re paying the people but to find ways to make them more productive.”


The low-fare airlines also run much more homogenous fleets, cutting down on pilot recertification costs, parts inventories, and maintenance costs. Southwest, for instance, flies only Boeing 737s across its network. The major airlines, on the other hand, have patchwork fleets, raising costs. “United has everything that Boeing ever made,” Platt says.


As airlines have tried to reduce costs, they have been cutting in the wrong places, Ronell says, adding that airlines are pruning very inexpensive frills such as plastic knives while avoiding the major structural changes that would save them billions. Until those changes come about, airlines’ efforts to compete with the low-fare sector will fail. “All the big guys tried to invent a Southwest inside of them, but part of the difficulty is you can’t run a low-cost airline unless you indeed have low costs,” Allen says.


The major airlines will continue to repeat boom-and-bust cycles tracking the national economy. Without major structural changes that they are unlikely to make because of labor contracts, capital investments and competitive pressures, airline managements can do little to pull themselves out of this slump. “There’s not tremendous scope for innovative strategies,” Cappelli says.


Some measure of consolidation might change the airline industry. Three out of the six largest U.S. airlines may not exist in their current forms five years from now, predicts Brancatelli. Consolidation would distribute existing traffic over a smaller number of carriers, and thus might boost those carriers’ fortunes. But federal regulators have taken a grim view of airline mergers recently, shooting down a merger between United and US Airways because of concerns it would reduce choices for consumers.


If the economy doesn’t pick up soon, airlines will finally be forced to reengineer their businesses, Mittelstaedt says. “You can’t run forever with billion dollar losses. What’s happening now is that airlines are wasting all that money they had saved up. At some point, they need a sustainable economic model. Sadly, there’s only one airline in this country that has had a sustainable economic model over the past 25 years, and that’s Southwest.”


But some airlines are taking at least a few tentative steps towards reengineering. American, for example, recently moved to a ‘rolling hub’ system at Chicago’s O’Hare airport, where planes leave spaced throughout the day rather than at a small number of peaks. This makes more efficient use of personnel, although it lengthens connection times to some degree.


Platt has an even more radical idea – segmenting. Airlines should stop trying to be all things to all people, he says. A major airline might be able to find a market niche as an all-business carrier, with flexible tickets and high-quality service, the way low-fare airlines have segmented out the leisure market, he suggests.


“One of the majors who has properly built-out infrastructure could potentially morph into a successful specialized carrier,” he adds. “But my guess is, that’s not what anybody’s going to try.”