Airline Consolidation End-Game

Posted on 18. May, 2007 by in Featured

While most analysts look over seas for the airline consolidation end game, I believe it will play out right here in the good ol’ USA. A quick review of industry problems can be summed up in one phenomena; an inability to control ticket prices. There are a multitude of problems or watershed events since de-regulation that led to this. A few of the big ones; the presence of low cost carriers, over expansion of Network Carriers, RJ’s and the Internet.
Briefly: LCC’s have been able to cherry-pick routes driving down ticket prices while not having to cover the secondary and tertiary “thin” markets. As they expanded so did their influence on the percentage of Network routes and the bottom line.
The Network Carriers expanded at an incredible rate during the late 90’s. The Internet Bubble kept prices high and seats full of high revenue passengers. When the Bubble collapsed in March of 2001 so did the revenue picture for the Network Carriers.
Mix in THE ABSOLUTELY DISASTEROUS DECISION to “out-source” mainline flying with ULTRA high cost RJ’s and these events alone could account for the Network Carriers melt down. As the revenue side spiraled out of control the Network Carriers were bringing on line ultra high CASM (cost per available seat mile) aircraft. Small in-efficient 32-50 seat jets that were designed for corporate travel, not scheduled carriers. Even more damaging, they entered into cost plus contracts guaranteeing the Small Jet Providers a profit with fixed percentages above operating costs regardless of how many passengers were on board. As load factors fell off a cliff post 911, the bleed out increased exponentially. The LCC’s smelled blood, and piled on by slashing prices, and expanding at break neck speed.
The Internet changed the way passengers bought tickets, under the old GDS systems tickets were sorted and listed by elapsed time as a priority. Travel agencies where encouraged to sell expensive tickets by receiving a percentage of the total ticket price. The Internet changed this cozy arrangement, perhaps forever. Potential passengers could now sort tickets by price, from their own desk. This change initially aided the LCC’s the most. Throw in 911 and fuel prices and you have a perfect storm for Network Carriers.
The Network Carriers hunkered down, canceling aircraft orders and retreating from the expansion mode. They further responded by slashing costs, on the back of their employees and creditors, most through the bankruptcy process.
The slashing of costs were initially effective, however management made a huge blunder by rewarding themselves with lavish pay and bonuses that has convinced Labor that they were suckered. While slashing costs at the production level can bring short term gains, in the long term it is a disaster. Production is the financial bed-rock any company is built on.
In the airline industry the results of wringing the production side have come home to roost. The industry wide passenger satisfaction rates are the lowest they have ever been, even lower than the IRS’s! The industry can no longer draw quality workers; RJ (Regional Jet) operators have lowered their requirements for pilots to an absolutely unprecedented level. Twenty-somethings are flying jets, with passengers, after a few short months of experience.
Even more telling is the fact that furloughed pilots, experienced airline pilots that have been laid off, are not returning. The Major Carriers are getting less than a third, on average, of their laid off pilots back In fact they are having to initiate new hire classes, while still having thousands of pilots on furlough who are differing recall. This too is unprecedented; the job of Airline Pilot historically has been highly sought after. Now, even pilots who would not have to go through the hiring and probationary head aches are not returning.
The job simply is not worth it. Pilots have left the industry or moved to another airline, (South West/FEDX/UPS) that has not slashed the production level. Management simply doesn’t understand that the average pilot is more educated than the average manager, and not merely in aviation. Virtually all Airline Pilots have a College degree, a high percentage of Airline Pilots possess Graduate Degrees, they fly because they like it. But their love of flying is limited and when the job is “dumbed down” to a point that they can not justify it financially, they will and quite obviously have moved on.
The result; the Network Carriers are having problems getting experienced crews, and those that remain are looking to get the pay cuts back that they gave to save their collective airlines. Supply and demand, ECO-101, costs are headed up, and not just for the legacies.
South West has some of the highest paid pilots in the industry, unlike what is often reported in the press, SWA is the one of the most Unionized Airlines in the industry. The SWA Management Team is clearly the most forward leaning in the industry today and is looking to increase REVENUE vice slash the production level. They understand that the front line employee is the most important employees in a service oriented industry. They are in it for the long haul. They are moving outside of their business model to raise revenue by entering high revenue markets like Denver and Philadelphia and recently announced a contract with a GDS company to list their flights like a Network Carrier.
The LCC’s have realized that just having low costs is not enough, JetBlue for example has one of the lowest CASM’s in the industry, however JetBlue continues to be unprofitable. They have over expanded and have huge orders for new airplanes on the books they will have to pay for. The LCCs are moving into the higher revenue markets as well as trying to expand their Networks. The biggest chink in the LCC armor is a lack of International flights to connect the business traveler to the markets of the world.
So on one side of the fence we have the Network Carriers with old fleets, manning issues and an inability to control revenue. On the other side LCCs, with aircraft orders they can’t sustain, spiraling costs and the lack of an international Network required to expand their revenue stream.
Open Skies will drastically affect the out come of the post de-regulated industry. Most analysts think a foreign invasion of capitol will be the result. Doubtful, with a Democratic Congress in-place, this will be a non-starter. A more likely scenario is that Congress will allow the US industry to rationalize, enabling it to strengthen against the perceived foreign onslaught. Virgin USA is the first shot across the bow, the notion of foreign citizens controlling US airlines will not play well inside the beltway.
The problem with recent mergers is that they were a merger of “likes”; a merger of equal types, if not sizes. There were no synergies because they both had elaborate overhead necessary for a Network Carrier and drastically different systems that could not just simply be dropped. In the end they came with problems that doomed them to failure and while reducing seat count it had the affect of raising the costs of the acquiring carriers because the fixed overhead was not reduced linearly with the added expense of acquiring an airline and its liabilities. The only gain being the frequent flyers of the acquired airline. Historically the markets of the acquired were greatly reduced or eventually abandoned, further raising the cost of the merger.
Ultimately the entire motivation for consolidation, reducing seats and gaining control of revenue were not achieved because the LCCs would expand to fill the void left as the Network Carriers abandoned markets driving revenue down, not up. The true irony being, that past mergers tended to strengthen the LCCs not the Network Carriers spending the money.
The law of unforeseen consequences is brutal. For the LCCs it manifested in Network Carriers CASM’s being drawn down to near their level, while retaining International revenue to shore up the bottom line. They have become victims of their own successes. Open Skies will further complicate the future for LCCs. They are looking to enter the International market, but know it will drastically change their cost structure. You can’t fly someone 12 hours and not feed them. It also means a multiple aircraft fleet; in short it trades in the low cost business model for a Legacy model.

Solution: To summarize, the Network carriers main problem is an inability to control revenue, other problems are fleet age and manning. LCC problems are rising CASMs and a lack of expansive networks. The solution for both is consolidation, not with each other but a hybrid of Network and LCC. AMR’s American Airlines for example could solve its fleet upgrade and manning issues over night by buying South West. The structural overhead of LCCs is miniscule by comparison and can be liquidated. However the biggest advantage would be eliminating the force that drives down AMR’s revenue.
The normal industry cycle is for LCCs to go up in value as Networks go down and vice versa. The cycle is now reversing; LCCs are devaluing as the Networks strengthen. As they devalue and the Networks build cash, the opportunity to finalize the deregulation process is looming large.
Consolidation is the probable outcome with Network Carriers swallowing the LCCs that affect their revenue control. Look for AMR to move on South West and Alaska, UAL to move on Frontier and perhaps JetBlue, DAL-Air Tran and JetBlue, North West-Spirit, Sun and Mid West. The new US Air could be the odd man out; they like the LCCs, need an International Network. Expect them to move on CAL, Continental has the International Network they must get to survive the coming consolidation and Open Skies. US Air knows this, it is why they moved on DAL.
With the US industry consolidated it will be in a position to aggressively compete in the Open Skies environment. The survivors will most likely be American, United, Delta, North West and either US Air or Continental. With the industry consolidated control will return to the revenue side and the survivors can be expected to move aggressively into the Open Skies of the world.

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