« Unbundling, Rebundling and Now De-Commoditization »

As the new year begins, I’m encouraged that airline industry is truly making changes necessary for long-term survival.  Over the past decade, airlines have engaged in a restructuring period like no other since deregulation – in fact making the kind of meaningful structural changes some thought deregulation itself would bring .

American Airlines’ aggressive posture in restructuring the way airline tickets are distributed is an obvious next step in this process.  In most businesses, low-hanging fruit is found where a middleman is involved, as is the case with the aggregators like Orbitz and Expedia.  For the airlines, this effort has some risks and involves more than just cutting costs.  It is about addressing some of the core issues that plague airline pricing and can be termed the de-commoditization of the very product airlines sell – a seat from A to B.

On November 25, 2009, Swelblog wrote about a presentation that former Air Canada President and CEO Montie Brewer gave at MIT titled:  Five Reasons Why the Airline Industry Will Never Be Profitable.  According to Brewer, one significant reason the industry will fail to earn a profit over a sustainable period is the presence of the Global Distribution Systems (GDS).   Now before our very eyes, American Airlines has taken the leadership to challenge the roles played by the Online Travel Agencies (OTA) and the GDS.

Reason #1 cited by Brewer as to why the industry will never be profitable is that the capacity-lead business model causes “constant overcapacity”.

Since deregulation the airline product has been commoditized.  In the commodity framework, the only way the industry, or an airline, can grow revenue is to grow capacity.   But that model didn’t work for airlines, where Computer Reservations Systems and the GDS’s institutionalized the notion that in order for an airline to grow revenue, it needed to offer more and more capacity even before demand warranted.

The addition of capacity led to low and lower operating costs.  On the margin, revenue exceeded cost.  Uneconomic capacity was being deployed each and every day.  Ultimately, it created an industry too big to be sustainable.  If not for the price of oil, the airline industry would never have shed the level of capacity it did between 2008 - 2010.   

The GDS were a major contributor to the commoditization of the airline product.  Therefore, airlines that distribute directly to the consumer have the best likelihood of differentiating, and more importantly, not commoditizing, their product.  This fact contributed to the trend in which certain airlines did well even as much of the industry suffers. Note the one airline in the US that does distribute directly to the consumer:  Southwest.  And Southwest has differentiated, not commoditized, its product. 

What is a commodity?  According to Miriam Webster, a commodity is a good or service whose wide availability typically leads to smaller profit margins and diminishes the importance of factors (as brand name) other than price.  Commoditization can be defined as the process of prices moving substantially lower because of strong competition. Commoditization happens because too many competitors enter a market when they see the large returns that can be earned on certain products. However, those returns soon disappear as competition drives prices lower.

Each defines the airline industry.  Each defines patterns that today’s industry executives are trying to break.  Just because it was done one way or another yesterday does not mean it is the best way of doing business tomorrow.  Enter the Business Travel Coalition (BTC).  Under the veil of protecting consumers, the BTC is doing nothing more than protecting the interests of the money that keeps the organization in business.  Every time the airline industry makes a strategic or commercial move to improve its profitability, the BTC pushes back because change does not serve its clientele well. 

Which leads us to Brewer’s Reason #5: “Nobody Really Wants It to Be Fixed.”  Brewer makes a powerful case that things are fine the way they are . . . and, for the most part, the airline industry value chain, consumers and the government know it.

When it comes to low fares,  consumers can shop the internet and find some market on sale (and the same will be true tomorrow if American and others are successful). They may even find the price of a ticket today equal to or less in nominal dollars than a fare charged two decades ago.  When adjusted for inflation, it is hard to find any consumer product that is a better bargain than air travel.

Taxes and fees account for nearly $60 - or 20 percent - of the average price of a ticket today.  This compares to $22, or 7 percent, in 1972.  In other words, the government is getting a bigger share of a shrinking pie.  GDS fees go up as the real price of a ticket is in decline.  Anything that the industry can do to address margin degradation in the business should be considered and be done.  And that is precisely what American is doing.

There are few areas that remain on the income statement where costs can be cut.  Distribution happens to be one just as the industry is asking the government to examine whether the tax burden imposed on the airline industry is disproportionate.   As the old saying goes: Two percent here and two percent there on top of taxes and fees that consume 20 percent of the ticket price adds up to real money . . . money the industry cannot afford over the long term.

Perhaps most compelling is that all the players in industry's value chain -- GDSs, OTAs, airline caterers, aircraft lessors, ground handlers, manufacturers, airports, fuelers, travel agents, maintenance repair organizations and freight operations -- don’t want it changed.  That’s because each earn a higher return on invested capital than the airline companies that keep them in business.

BTC members do not want the airlines to take control of their inventory because it is sure to weaken the powerful grip the GDS and OTA have over the industry today.  Ask yourself, would you really want to be in business if you did not have near complete control over your inventory?  I think not.   Do GDS and OTA know your customers better than you do?  I think not.  In short, a commodity is a product that has a low degree of differentiation.  Over the past decade, the product offered by the network carriers and the low cost carriers have converged to where there is little to no differentiation because schedule and price are the only differentiators.  This must change if the industry is truly committed to achieving a structure where it earns at least it cost of capital.

Loyalty has increasing value to air travel consumers today, in part because elite members of frequent flyer programs typically aren’t charged the ancillary fees other passengers pay.  Base fares will be disciplined by competition whether American is successful in its attempt to rewrite distribution rules or not.  This industry always adapts.  Travel agents continue to exist today even after the industry stopped paying domestic commissions in 2002 – assuming they evolved and adapted to find replacement revenue streams. 

One can make a case that the GDS have been every bit as destructive a tool as constructive.  Any system that promotes adding inefficient capacity should be changed.  They served their purpose when market share was king.  They serve significantly less purpose in an industry increasingly focused on its bottom line.  Short term this may be about saving some portion of a booking fee.  More important is the long term notion that an airline that takes control of its inventory creates value for its customers based on the knowledge the airline has of its customer.  To say the customer loses out is a tired refrain coming from the same "Chicken Littles" that "Cry Wolf" every time the industry tries to institute systemic change. 

Let the restructuring continue.