The always-cyclical airline industry is passing through a particularly rocky time as established carriers – hit hard by recession, terrorism, SARS, war and now skyrocketing fuel costs – face tough competition from a new generation of low-cost airlines.


With most large carriers expected to lose money this year, the spike in airline-fuel costs that touched 13-year highs in May will add an extra $2.5 billion in additional expenses, according to the Air Transport Association. In response, several companies tried to attach a fuel surcharge, but with continued weak demand and fierce competition, the increases didn’t stick. “The rise in airline fuel costs is a killer for airlines. We haven’t seen anything like this in a long time,” says Elizabeth Bailey, chair of Wharton’s business and public policy department.


The hike in fuel prices is just the latest problem to hit the industry. The Sept. 11 terrorist attacks devastated companies’ already lackluster balance sheets, and travelers are still reluctant to fly, particularly when faced with delays due to new security measures, Bailey says. For a time, airlines were able to underwrite some of the domestic fall-off with international business, but those revenues took a hit with the SARS virus and wars in Afghanistan and Iraq. The collapse of a terminal at Charles de Gaulle Airport near Paris last month is yet another blow. “You sock it to them and they think they can recover,” she says. “Then comes the next sock, and the next sock, and the next sock.”


Many major carriers reported losses in 2003. American, Delta, Northwest, United and US Airways have negative, or very little shareholder equity, according to W. Bruce Allen, a Wharton professor of business and public policy. “These guys are just in awful shape,” he says. “That was also true for most of them in 2001 and 2002.”


Robert Mittelstaedt, vice dean of executive education at Wharton, says business travelers who once paid a premium to fly have cut back on travel or are shopping for discounts and using low-cost carriers. He also says executives are increasingly abandoning scheduled airlines to travel on corporate jets, including fractionally-owned aircraft in which companies share access to a plane, similar to a vacation time-share. “A big chunk of the price insensitive market has gone away as more and more companies have access to airplane time,” he notes. “The customers who wanted a higher level of service have left the industry so the established airlines are left with the price-sensitive market.”


Against this backdrop, the airlines are also facing fierce new competition from low-cost carriers, such as Texas-based Southwest, which have grown to the point where they can offer customers convenient travel schedules and low prices, says Robert W. Mann, president of an independent consulting firm in Port Washington, N.Y. “We have passed the tipping point where there are now sufficient low-cost alternatives to inefficient network services.”


Henry Oechler, an aviation specialist at the New York law firm Chadbourne & Parke, says Sept. 11 altered the whole structure of the airline industry. “It allowed the low-cost carriers, which were in their nascent stages, to become more ascendant.” Meanwhile, large carriers are weighed down by restrictive work rules that make it hard for them to compete with the new breed, even as they are attempting to rewrite labor agreements either through negotiations or in the bankruptcy courts. The new entrants have made workers at the more established carriers more willing to believe their employers are in serious danger of going out of business. “In a showdown, pilots will now blink,” Oechler says


The Hub’s the Rub

Another part of the established carriers’ business model that has been challenged is the hub-and-spoke system, in which passengers from smaller cities are consolidated at airline “hubs,” then dispatched to their next destination. The idea was to provide a cost-effective way to reach smaller markets and provide convenient scheduling for passengers, even though it meant changing planes.


Allen says airlines fine-tuned their schedules to limit passenger layovers. “The difficulty was that the minute it rained, the system got screwed up because every plane depended on another plane.” With increasing affluence and population growth, he adds, even smaller markets can now generate enough business to sustain point-to-point service, particularly for new low-cost airlines using regional jets and paying pilots lower salaries.


According to Wharton real estate professor Todd Sinai, who has researched delays at hub airports, the system is expensive because it requires airlines to hire large staffs to manage peak travel times even though the staffing level is not necessary at other times of the day. “The planes come in waves,” he says. “So you need lots of baggage handlers to load the bags and lots of gate agents – all at the same time.”


Bailey points to other fall-out from the hub-and-spoke system: As major airlines over-expanded at hub airports in the 1990s, they ended up with excess gates, which are now being subleased by low-cost carriers at bargain prices. This makes it even harder for larger carriers to compete. Low-cost carriers are also finding good prices on excess aircraft. “A lot of the new low-fare carriers are buying planes very cheaply and have found space at airports” that is newly-renovated and inexpensive, she says. “Meanwhile the old established carriers are stuck servicing debt on both of those kinds of capital expenditures. The low-fare guys are looking good. Part of it is they are able to take advantage of mistakes their bigger sister carriers made a decade ago.”


The advantage of a hub system breaks down, Sinai adds, if low-cost airlines poach profitable runs, such as coast-to-coast routes, which help subsidize the bigger airlines’ service to smaller markets. He predicts the hub system will change, but not disappear completely. “A lot of people are predicting the doom of the hub system. I think it’s going to be more of a shake-out period.”


Adam Pilarski, senior vice president of Avitas, a consulting firm in Chantilly, Va., says the major airlines’ pricing structure is also encouraging customers to defect to low-cost carriers. In the 1990s, airlines set pricing based on yield management techniques, which allotted a portion of each flight for deep discount tickets sold to travelers willing to buy early and live with certain restrictions. Last-minute travelers, often on business, paid premium fares. “These were almost capricious amounts – at least the flying public saw it like this,” says Pilarski, adding that low-cost carriers such as Southwest and JetBlue have diminished much of the disparity. “The multiples aren’t so huge. You always feel bad when the person sitting next to you paid half what you did. You feel taken advantage of.”


Pilarski notes that pricing is just one element of service problems at the large carriers, which, he suggests, “have to learn how to treat people like customers. You get on JetBlue or Southwest and you feel you are welcome there. On United you feel like you’re imposing on them. You don’t survive in a service industry with that attitude.”


Airlines dominating a city usually jack up fares to compensate for lower prices in competitive markets, Mittelstaedt adds, pointing to US Airways in Philadelphia, Delta in Atlanta, American in Dallas and United in Chicago. “Where you have a major single carrier controlling a hub airport, fares are higher.” Again, Southwest chose a different path. Even in airports where it has a strong position, the company has kept fares within reason, says Mittelstaedt. Southwest has been smart enough to build a model that “ensures it will not attract competition.”


According to Serquei Netessine, Wharton professor of operations management, yield management is not likely to disappear from the industry where it has become a critical element of profitability. Low-cost carriers initially charged flat fares but have begun to introduce some varying ticket prices. “They are getting more sophisticated and my guess is we will see their fare structure becoming more and more complex.”

It is difficult to determine how much yield management customers will tolerate, he adds, noting Coca-Cola’s failed attempt to price drinks in vending machines higher on warm days. “Customers revolted,” he says. “So far, in airlines there is no revolt. Consumers understand that an airline seat is worth nothing tomorrow. It’s not like a book or a Coke that can be sold the next day. So consumers tolerate this pricing.”


Netessine is also examining how airlines price tickets and share revenue within the growing number of airline alliances. Getting a customer to fly multiple legs is more valuable to the allied airlines. As a result, they want to provide discounts, but it is often difficult to coordinate different prices when several carriers are involved in the same ticket. Another pricing issue that is emerging, he says, is how to package trips that include airfare, hotels, rental cars and other amenities.


Airlines within Airlines

While they are looking good compared to some of their older rivals, the new low-cost airlines are not without their own challenges. Mann says JetBlue has been a success story so far, but that the company is about to take on significant risk with the purchase of new 100-seat aircraft to reach smaller markets where there are high fixed costs. JetBlue may also have trouble finding enough top-quality employees to support its expansion, he says. “There literally is a limit to the number of people who are going to deliver that spectacular level of customer service every time.”


He predicts Song, Delta’s own low-fare airline, and Ted, a similar operation run by United, will become “footnotes” within a year or two. “The airline within an airline model has never worked. If you’re going to fix the factory, fix the factory. Don’t create a sideshow outside and say how beautiful it is. The most consistent comment coming out of Song passengers is, ‘Why can’t Delta be like this?’ If you need to fix Delta, fix Delta.”


Meanwhile, Sir Richard Branson, owner of Virgin Atlantic, a low-cost trans-Atlantic carrier, is attempting to start a U.S. airline, but is blocked by U.S. regulations barring foreign ownership, according to Mann. However, he adds, “there are rumblings that something may change that would enable some kind of U.S.-European Union détente [and] might provide a window for Branson to jump through.”


Allen says it is too early to declare JetBlue a success. “They are a young carrier, their planes are new and they have yet to go through the maintenance cycle. You look at Southwest. They have been through it all and there they are.” But even Southwest, he says, is seeing its costs inch up. The company recently announced an early-retirement package for employees in an effort to reduce costs.


As it expands into larger cities, such as Philadelphia where it is now locked in a battle with US Airways, Southwest could face troublesome delays, Allen notes, adding that Southwest’s productivity is tied to its ability to turn its planes around quickly and keep them earning money in the air. “The Southwest guys are smart, but you get into Philadelphia and the question is, ‘How do you avoid the delays along the East Coast in general?’ Their secret even in Podunkville was to turn the plane around in 20 to 25 minutes. The difficulty in a big city is even if you can turn the plane around, you can sit out there on the tarmac.”


Another potential issue for Southwest is the decision last year by its mechanics to leave the International Brotherhood of Teamsters and sign up with the Aircraft Mechanics Fraternal Association, a union with a feisty reputation. The current mechanics contract extends through 2005. “The mechanics are interesting,” says Allen. “If you’re a pilot and suddenly you’re not a pilot anymore, what are you? But the mechanics are highly skilled and there are a lot of places they could go. They are the scary guys in terms of being able to control the carrier.” Southwest has also had some problems with its flight attendants, Allen adds. Last year they staged informational pickets arguing that they work an extra 300 hours a year without pay cleaning up Southwest planes. “When it comes to Southwest,” says Allen, “the interesting question is, ‘Can they – as they have in the past – maintain their esprit de corps?’”