Energy and Air Service to Markets of All Sizes

On Thursday of this past week, I was asked to participate on a panel that was moderated by Will Ris, American Airline's Senior Vice President of Government Affairs at the American Assocition of Airport Executives (AAAE) Summit on Energy and Air Service. The timeliness of the topic could not have been better and the quality and scope of speakers was first rate.

But to be truthful, the impact of airline capacity cuts will not be fully realized by communities of all sizes until the clocks change in early November. That is when the reduced schedules will be fully implemented - or at least the schedule changes that have been announced thus far.

REMARKS OF WILLIAM SWELBAR
AAAE ENERGY AIR SERVICE SUMMIT
July 10, 2008

My top ten list, but before I go there……..

I am pleased to have been invited today to participate in this most important summit. My guess is that there will be even more questions than answers at the conclusion of the day’s program just as there are few answers to confront the most difficult economic environment facing the US and global airline industries today.

As I stand here today, I certainly have lots of questions with few answers.

This industry has been morphing since it was deregulated nearly 30 years ago. Its work is far from done. Along the way, the airlines have learned to operate more efficiently, but at the same time, as carriers competed their way to low and lower ticket prices, they didn’t reap the financial benefits from the efficiencies they found and implemented.

Despite the cyclical noise emanating from the headlines regarding airline labor issues, this industry have actually managed total labor compensation very well as it relates to inflation. Compared to other legacy industries – autos and steel and their respective unions – airline labor can say that they preserved many high-paying jobs. That said, and given the magnitude of the labor cost reductions in the past restructuring period for many, reducing labor rates is probably not an answer and could not be sufficient to turn the expected earnings deficit positive.

When it comes to distribution costs: it is hard to imagine any other area where costs have come down so significantly through the use of technology and business practices, yet the $5 billion in run-rate savings have largely been competed away in the name of lower fares.

In the latest round of restructuring, airlines began to challenge the historic practice of performing heavy maintenance work in-house. Outsourcing has long been a practice at airlines like Southwest and others but less so for the legacy carriers. During the recent bankruptcy period, carriers began to make the transition from in-sourcing to outsourcing and the financial advantages are unclear at this point.

One of the difficulties of the transition has come in the cost of materials. Since late last year, materials costs to the industry grew at double digits, driving maintenance expenses to rise beyond budgeted forecasts. Aging fleets and repairs go hand in hand. Isn’t it ironic that another input in the airline profit equation has commodity pricing attributes as well? There are many industries competing for the metals and composites that are necessary to make airplane parts.

There just are not any line items on an airline’s income statement left that can be cut or restructured to produce sufficient revenues to offset the high cost of fuel . . . Except for the cuts in capacity most airlines have begun.

It has been and remains my view that the industry was over-exuberant in its use of small jets. While the economics of small jet operations were challenging at $50 per barrel, there is no question what today’s economic reality of oil at $140 per barrel means to air service for many communities represented in this room.

Much was made about mainline capacity reductions over the past 5 years, but much of that flying was replaced by the regional sector. So in reality, the industry failed to do much other than to control the supply going forward.

What’s responsible for too much capacity in the industry? Some say it is the legacy carrier’s decision to outsource growth to the regional segment, creating networks that are simply “over-connected” and not profitable. Some say, as I do often, that the barriers to entry in the airline industry are too low, and barriers to exit too high. Clearly several factors are at work including the incursion of the LCC sector in the US industry.

So before I go to my top 10 List, let me say that I see this new era as one of the most exciting periods for airlines in recent history. There is a lot more change in the works and work to be done, because in the past few decades, strong economic times have simply masked the fact that the airlines haven’t done enough to restructure or rethink a business model that was increasingly being held together by chicken wire and duct tape.

This industry is now recognizing that it cannot be everything to everybody. Yes, the industry has met its match – and it is not labor, government, or the macro economy. It is the high price of fuel. Most analysts believe that high fuel prices are here to stay, and that is causing the industry to continue the process of fully transforming the way business is done. Without this trigger, it is likely that the industry would not have had the will or the necessary pressure to make some of the changes underway, perpetuating the long-running boom and bust cycles that characterize an unhealthy industry.

The current industry architecture is a picture of what the deregulators envisioned – and the industry delivered. The problem? The foundation won’t hold.

10 Items That Were Top of Mind As I Was Preparing to Speak Today

1. In the name of competition. Aircraft technologies; airline marketing strategies; and one could even say airport strategies (think LAX) have all been designed in some way to fragment markets. A question to be asked: does the policy and practice of fragmentation lead to healthy or destructive competition? At current fuel prices, fragmenting markets cannot be sustained -- which is one big reason why capacity must be cut.

2. The “boom and bust” cycle that characterizes this industry’s financial performance is good for no stakeholder group.

3. We finally can define over-capacity. The correct term should be uneconomic capacity, an inherent weakness that is compounded by an industry practice that emulates other capital intensive, commodity industries. The US airline industry has too often expanded too much during the up cycles and kept uneconomic capacity in place in the down cycles - all in the name of market share.

4. In 2003, I made a presentation in Washington entitled: The LCCS: Thou Shall Not Inherit the Earth. There are few profitable growth opportunities remaining for the low-cost sector absent contraction in the largest US markets. LCC’s own 26+ percent of the domestic market today. How much tomorrow after attrition? Is this what the consumer wants? I believe that we will begin to test not only the elasticity of demand but also test the true needs and wants of the air travel consumer.

5. Will we ever talk about fundamentals in this industry? Will we finally make route profitability the rule and network contribution the excepting practice? Will we ever talk again about profitability and the income statement or will we continue to assess survivors by relying on the cash flow statement and the balance sheet?

6. Attributes of a successful US airline industry are no different for an airline than for an individual investor or a portfolio manager. Instead of diversifying a portfolio of financial assets, airlines hold a portfolio of routes. Modern Portfolio Theory suggests how investors employ diversification to optimize their portfolios. The model that proposes this diversification assumes that investors are risk-averse, meaning that if the expected rates of return on two separate investments are equal, the investor will choose the one with the least risk. On the other hand, an investor will not accept more risk without a commensurate increase in the expected rate of return.

This characterizes current airline thinking. Parochial-thinking on the part of lawmakers like Oberstar, regulators and the Business Travel Coalition promote the notion that the US airline industry should continually accept more risk while accepting a commensurately lower expected rate of return . . . Much of it driven by policy and entitlement and preservation of uneconomic competition. This is bad economic thinking.

7. Rather than scare people about losing air service to small communities, maybe it is time to design an Essential Air Service program that actually works for airlines, airports and air travel consumers. This means a program based in commercial reality. Networks have evolved, but policy has failed to morph along with the changed network architecture.

8. Reconnecting the virtuous circle of airline industry prosperity because the current circle has a disconnect. You know how it goes: liberalization leads to new and better services which fuels traffic growth which contributes to economic growth which facilitates job growth. Then we start all over again. My question: when will we start?

9. Revenue management – the “Dark Science” adapts but will it subtract? The days of 10-30 seats per flight being sold below cost are over. Will the concept of cross-subsidization be over as it takes place everyday across a network and across each flight segment?

10. As we approach the 30th birthday of US Airline Deregulation, it is the price of oil that is demonstrating its power to force the industry to complete the resetting of the legacy mindsets that have remained in existence for too long. And this includes customers’ belief that they actually pay the “all-in” price of the service and are therefore entitled to multiple access points to the air transportation system. And the concept of entitlement is not limited to just the consumer.

Here in this room, we have representatives from nearly every airline industry stakeholder group. The truth is, only one stakeholder group has been a winner since deregulation, and that is the air travel consumer. Consumers have won on price and have come to consider safe and affordable air travel as an entitlement. I would expect to hear an argument regarding reliable air transportation however.

But the industry can’t and won’t succeed in its current state while confronting the fuel price headwinds, and that is something we can all agree on and that needs to be addressed as we move forward. Because there are no stakeholders if there are no airlines.

Thank you.

Grab a Big ‘Ol Cup of Jo, and Let’s Talk Airline Service Cuts

Starbucks, Airlines and Air Service Cutbacks

This morning’s headline in the Wall Street Journal on B1 reads: Starbucks to Shut 500 More Stores, Cut Jobs. The story by Janet Adamy offers many insights as to what is plaguing the airline industry, at least from this observer’s perspective. The announced shutdowns will occur throughout the remainder of 2008 and will continue into early 2009. The 500 store closures announced yesterday are in addition to the 100 the coffee proprietor announced earlier this year. I will highlight some of the points made by Adamy in her story:

· “The pullback is a sign that the Seattle-based coffee giant is continuing to see weak sales as high gas prices and other pressures on consumer spending prompt Americans to cut back on extras.”

· “It also shows how badly the specialty-coffee business is struggling just as mainstream companies, such as fast-food giant McDonald’s Corp., are beginning to invest in it.”

· “Starbucks didn’t disclose which of its about 11,000 stores U.S. stores it will shut, but said the affected stores are spread across all major U.S. markets. About 70% of them have opened since the Fall of 2005, it said”.

· “The purpose of its rapid expansion (2,500 stores globally during the last fiscal year) was to boost sales growth and siphon traffic away from some of its stores where long lines were driving away customers. Also fueling the push was company research that showed people sometimes weren’t willing to cross the street to buy a cup of coffee.”

· Last year, as Starbuck’s sales began to soften, it became clear that the company’s expansion was cannibalizing its sales in a way that was threatening the chain’s success, as well as causing the quality at its existing locations to slip”.

The Ubiquitous Airline Industry

Adamy mentions ubiquity in her story and it absolutely applies to the US airline industry as well. You know: the seeming need to be present everywhere. As we have written here many times: presence everywhere and pricing power nowhere. Ubiquity is synonymous with fragmentation. Fragmentation best describes the US airline industry’s domestic market. [In fact, IATA suggests that fragmentation describes the construct of the global industry’s marketplace.] The US airline industry’s domestic market lies at the heart of the US airline industry’s woes. Hyper-competition has led/contributed to the non-economic prices that persist. So if fragmentation is present and structurally undermining your performance, consolidate around your strengths – right?

Based on the story about Starbucks closing stores let’s talk about the US airline industry and the planned capacity cuts that are known and those that might not be known. We have heard about some airlines either discontinuing service altogether or reducing frequencies to large markets like Ft. Lauderdale and Oakland. Will Ft. Lauderdale and Oakland passengers suffer as a result? My answer is NO as they will have other options available like Miami or on other carriers, mainly those with the outdated low cost carrier moniker, continuing to serve the market. Will Oakland customers suffer? My answer is NO as they will have access to remaining service at OAK and will have a menu of offerings available at alternatives like San Jose and San Francisco. So customers will continue to have options, and options with low cost carrier presence, just as they have before.

Just like Starbucks realizes it cannibalizes traffic with certain store openings, the US airline industry cannibalizes itself with nearly every new service in some way it seems. My numbers may be off a bit here, but hear me out. At one point I was looking at the Greenville-Spartanburg, SC (GSP) to Los Angeles market. At that time there were 100 passengers per day each way (PDEWs) in that market. Those 100 passengers had a choice of 24 nonstop flights to access the air transportation system over 15 different hubs.

So I have 24 nonstops competing for four passengers per flight. As oil skyrockets, how can I possibly raise fares enough to cover the cost with that many consumer choices in the market? Simply, you cannot. Another question should be: how many choices is too many choices for a mid-size market like GSP?

To make matters worse, it can actually be said that carriers competing in that market actually compete with themselves. Delta carries traffic in this market over each its Atlanta and Cincinnati hubs. There are a multitude of examples just like this one where consumer choices to get from A to B are much more than the market can economically support. Unfortunately, it has taken the price of oil to demonstrate that the choices provided air travel consumers over the years cannot be economically sustained in many instances. So just like Starbucks, the US airline industry will pare back choices and consolidate that demand around markets that are, or can be made, economic by consolidating traffic.

So as the Business Travel Coalition paints the landscape with scare tactics, their back of the envelope analysis tells us very little. The BTC fails to mention that in the vast majority of service reduction announcements thus far, passengers demanding service to a particular destination will still be accommodated albeit by fewer frequencies or over fewer hubs – and few will be disenfranchised from the air transportation system.

Another Question I Have: Why Is It OK for Southwest and No One Else?

You know the story. Everything Southwest does is somehow the best and always in the best interest of the consumer. Southwest, circa 1995, enters a market. Fares go down and significantly in some cases. Traffic at that airport market is stimulated. Southwest’s success in entering a market had much to do with expanding the catchment area of that airport market. So while the carrier still only serves less than 65 airport markets in the US, if one were to draw a circle equivalent to a 2-hour drive to that airport, the carrier impacts more than 90% of US domestic air travel demand.

But the question should be: how much of that demand is/was created because air travel was made affordable to some new segment of the population and how much is/was diverted from airport market(s) located within that 2-hour catchment area? It is some combination of the two. Is that stimulation or diversion? The answer is diversion.

There are many examples of airport markets that have suffered as the Southwest’s, jetBlue’s and AirTran’s and other “bottom fishers” entered markets across the US. Their lower costs at the time allowed them the “freedom” to price aggressively while exploiting the bloated cost structures at the legacy carriers that existed. The low fares worked to stimulate new demand all the while diverting traffic from smaller airports with higher prices enveloped by the catchment area. It is the sum of the two - not one or the other.

But why is it OK for Southwest to offer service at an airport and rely on the highway system to be the first leg of access to the air transportation system – all in the name of low fares?

Why is it not OK for the remainder of the industry to cutback frequencies that may result in the highway system being the first leg of access for some – in the name of preserving as much of the network architecture that has been built and can be made economically viable?

The existing network architecture has provided more than sufficient choice for air travel customers in cities of all sizes, not just the largest metro areas that have secondary airports that are the backbone of Southwest, and its LCC brethern, service.

There Is a Lesson Found In Starbucks’ Decisions That Apply

At some point Congress, BTC and others may actually realize that the industry has grossly overbuilt through the over exuberance in the use of regional jets. For many markets it means you will still not have to walk across the street to get a cup – or access in airline vernacular. For others, it will mean having to walk three blocks for a cup. But in any case, you will pay the “all in” cost of that cup. Like Starbucks, you will go for that first or even second cup. The trick for the US airline industry will be the demand for that third cup or the iced cup that lies the heart of the demand equation and the ultimate decision on how much capacity to cut is right.

More to come.