Read the case on p. 472-486, then solve the problem: Case 5 The US Airline Industry in 2015 During the first quarter of 2015, it was clear the strong upswing in the profitability of US airlines that had begun in 2012 was continuing into 2015. The turnaround in the industrys fortunes was reflected in the airlines stock market values: Figure 1 shows the airline industrys index of share prices. Airline profitability was benefiting from the fall in oil prices and the revival of the US economy. However, whether this was a temporary upturn or a more fundamental transformation in the fortunes of the industry was unclear. The major carriers had done much to reduce the cost gap between themselves and the low-cost carriers (LCCs), such as Southwest. They had won substantial concessions on pay, benefits, and working practices from their labor unions and gained efficiency benefits from outsourcing, better use of IT, and investment in new, fuel-efficient planes. Moreover, the consolidation in the industry as a result of mergers and acquisitions had created the conditions for a more restrained price competition. Meanwhile, the major airlines were showing unusual restraint by allowing increased demand to fill existing capacity rather than rushing to add new capacity. Others were less sanguine. The US airline industry had been plagued by intense competition and dismal profitability since it was deregulated in 1978. All the major airlines, with the exception of Southwest, had been in Chapter 11 bankruptcy some multiple times. Legendary investor Warren Buffett had observed: The money that had been made since the dawn of aviation by all of this countrys airline companies was zero. Absolutely zero. Even with the recent revival, the profit margins of the major US carriers remained thin (Table 1). The airlines financial weakness was also evident from their credit ratings: Southwest was the only US airline whose debt was not classified as speculative. The financial woes of the airline industry were not restricted to the US: the global airline industry had consistently failed to earn returns that covered its cost of capital (Figure 2). Of the hundreds of airlines surveyed by IATA over the period 20002009, only 15 earned a return on capital that exceeded their cost of capital. Among these were Ryanair, Emirates, Singapore Airlines, and Southwest Airlines.1 The airline companies propensity to invest in overcapacity that triggered a new round of fare wars was noted by the Financial Times Lex column which suggested that, Perhaps the newfound confidence in US airlines was misguided. The US airlines response the revival in their profits and share prices had been to add capacity at a rate that far outstripped demand growth. Particularly ominous was the warning by Doug Parker, CEO of American Airlines Group, that his airlines would not cede market share to discount rivals such as Southwest.2 This case was prepared by Robert M. Grant. 2015 Robert M. Grant. Case 5 The US Airline Industry in 2015 473 FIGURE 1 Dow Jones Index of Airline Stocks, ten years to April 13, 2015 275.00 242.87 225.00 175.00 125.00 75.00 25.00 2009 2010 2011 2012 2013 2014 2015 From Regulation to Competition The history of the US airline industry comprises two eras: the period of regulation up until 1978 and the period of deregulation thereafter. The first scheduled airline services began in the 1920s: mail rather than passengers was the primary business. In the early 1930s, a transcontinental route structure was built around United Airlines in the north, American Airlines in the south, and TWA through the middle. To counter the threat of instability from growing competition (notably from Delta and Continental), the Civil Aeronautics Board (CAB) was established in 1938 to administer the industry and competition within it. The CAB awarded interstate routes to the existing 23 airlines, established safety guidelines, approved mergers and acquisitions, and set fares and airmail rates. Industry structure ossified: despite more than 80 applications, not a single new carrier was approved between 1938 and 1978. During the 1970s, the impetus for deregulation were supported by new developments in economics which undermined the conventional view that scale economies and network effects caused the industry to be a natural monopoly. The theory of contestable markets proposed that an industry did not need to be competitively structured in order to result in competitive outcomes. So long as barriers to entry and exit were low then the potential for hit-and-run entry would cause established firms to charge competitive prices and earn competitive rates of return.3 The outcome was the Airline Deregulation Act, which, in October 1978, abolished the CAB and inaugurated a new era of competition in the airline industry. The height of barriers to entry into the airline industry is unclear. While capital costs of setting up an airline can be modest (a single leased plane will suffice), establishing a scheduled airline service requires setting up a complex system comprising gates, airline and aircraft certification, airport facilities, baggage handling services, 474 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS FIGURE 2 Return on invested capital (ROIC) and weighted average cost of capital (WACC) for the world airline industry, 19932014 Source: IATA. ROIC WACC 0 1 2 3 4 5 6 7 8 9 10 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 TABLE 1 Revenues and profitability of the largest US airlines, 20092014 2014 2013 2012 2011 2010 2009 Revenue ($bn) Uniteda 38.3 38.9 37.2 37.1 23.3 16.3 Delta 40.4 37.8 36.2 35.1 31.8 28.1 Americanb 42.6 26.7 24.9 24.0 22.2 19.9 Southwest 18.6 17.7 12.1 15.6 10.4 Net margin (%) Uniteda 2.9 1.5 (1.9) 2.7 1.1 (4.0) Delta 1.6 6.7d 2.7 2.4 1.9 (4.4) Americanb 10.0 (4.7) (8.3) (8.2) (2.1) (7.4) Southwest 6.1 4.2 2.5 1.1 3.8 1.0 ROA (%)c Uniteda 3.0 1.6 (1.9) 2.2 0.6 (3.5) Delta 1.2 4.8d 2.3 2.0 1.4 (2.8) Americanb 9.7 (3.0) (8.8) (8.3) (2.1) (5.8) Southwest 5.7 3.9 2.3 1.0 3.0 0.7 Notes: a AMR until 2014, after American Airlines Group. b UAL Corp. until 2010, there after United Continental Holdings. c Net income/End of period total assets. d Based upon pre-tax net income. Case 5 The US Airline Industry in 2015 475 and the marketing and distribution of tickets. At some airports, the dominance of gates and landing slots by the major carriers made entry into particular routes difficult. Nevertheless, immediately following deregulation, 20 new carriersincluding People Express, Air Florida, and Midwayhad set up, and new entry into the industry has continuedone of the most recent entrants being Virgin America in 2007. Since deregulation, the industry has been subject to turbulence caused by external shocks and internal competition. During 19791983, high oil prices, recession, and strong competition triggered bankruptcies (over 100 carriers went bust) and a wave of mergers. Further profit slumps occurred in 19901994, 20012003, and 20082010. Figure 3 shows industry profitability since deregulation. Profitability is acutely sensitive to the balance between demand and capacity: losses result from industry load factors falling below the breakeven level (Figure 4). The role of competition in driving efficiency is evident from the near-continuous decline in real prices over the period (Figure 5). Firm Strategy and Industry Evolution Changes in the structure of the airline industry during the past three decades were primarily a result of the strategies of the airlines as they sought to adjust to the conditions of competition in the industry and to gain competitive advantage. Route Strategies: The Hub-and-Spoke System During the l980s, the major airlines reorganized their route networks. Systems of point-to-point routes were replaced by hub-and-spoke systems where each airline concentrated its routes on a few major airports. These hubs were linked by frequent services using large aircraft. Smaller cities were connected to these hubs by shorter routes using smaller aircraft. The hub-and-spoke system offered two major benefits: ? It allowed greater efficiency through reducing the total number of routes needed to link the airports within a network and concentrating traveler and FIGURE 3 Profitability of the US airline industry, 19782014 Source: Bureau of Transportation Statistics. Operating margin (%) Net margin (%) Index of inf lation-adjusted crude oil prices 15 10 5 0 5 10 15 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 476 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS FIGURE 4 Load factor in the US airline industry, 19782014 Source: Air Transport Association, annual economic reports (various years); Bureau of Transportation Statistics. 55.0 60.0 65.0 70.0 75.0 80.0 85.0 90.0 95.0 Load factor (%) Breakeven load factor (%) 50.0 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 maintenance facilities into fewer locations. It permitted the use of larger, more cost-efficient aircraft for interhub travel. The efficiency benefits of the hub-and-spoke system were optimized by scheduling flights so that incoming short-haul arrivals were concentrated at particular times to allow passengers to be pooled for the longer-haul flights on large aircraft. ? It allowed major carriers to establish dominance in regional markets and on particular routes. Table 2 shows airports where a single airline held a dominant market share in 2014. The hub-and-spoke system also created a barrier to the entry of new carriers, who often found it difficult to obtain gates and landing slots at the major hubs. The hub-and-spoke networks of the major airlines also involved alliances with local commuter airlines. American Eagle, United Express, and Delta Shuttle were franchise systems established by AMR, United Airlines, and Delta, respectively, whereby regional airlines used the reservation and ticketing systems of the major airlines and coordinated their operations and marketing policies with those of their bigger partners. Mergers The effect of continued new entry in reducing seller concentration in the industry has been offset by mergers and acquisitions between existing players (Figure 6). Since 2007, as a result of a more permissive attitude from the Department of Justice, the pace of consolidation in the industry accelerated with several mergers among leading airlinesDelta acquiring Northwest, United merging with Continental, and Case 5 The US Airline Industry in 2015 477 FIGURE 5 Average fares in the US airline industry (cents per revenue passenger mile), 19602015 Source: Bureau of Transportation Statistics. 0 5 10 15 20 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Current prices Constant 1984 prices 25 TABLE 2 Local market share of largest airline for selected US airports (by domestic passenger numbers), 2014 City Airline Share of passengers (%) Miami Americana 80.8 Dallas/Fort Worth Americana 73.5 Atlanta Delta 73.4 Baltimore Southwest 68.8 Charlotte Americana 60.2 Houston Continental 53.5 MinneapolisSt. Paul Delta 53.0 Newark United 48.3 Detroit Delta 47.2 Seattle Alaska 40.7 San Francisco United 39.3 Chicago (OHare) Delta 26.0 Note: a Includes US Airways. Source: Bureau of Transportation Statistics. American merging with US Airways (Figure 7). Yet, despite consolidation, there is limited evidence that competition has been significantly affected. As a result of capacity reduction by the biggest airlines and market share gains by smaller carriersnotably Alaska, JetBlue, Frontier, and Virgin Americaconcentration has continued to decline since 2000. A report by the US General Accounting Office concluded that: 478 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS FIGURE 6 Concentration in the US Airline Industry (four-firm concentration ratio) 19702015 Note: The four-firm concentration ratio (CR4) measures the share of the industrys passenger miles accounted for by the four largest companies. During 19701981, the four biggest companies were United, American, TWA, and Eastern. During 19822005, the four biggest companies were American, United, Delta, and Northwest. During 20062015, the four biggest were American, United, Delta, and Southwest. Source: US Department of Transportation. In recent years, the average number of competitors has not substantially changed in markets traveled by the majority of passengers, despite several major airline mergers. From 2007 through 2012, the average number of effective competitors (defined as airlines with more than a 5 percent market share) ranged from 4.3 to 4.5 in the markets with the most passengers.4 However, this conclusion did not take account of the 2014 merger between American and US Airways. Pricing The intensification of competition that followed deregulation was typically led either by established airlines becoming financially distressed or by LCCs. People Express, Braniff, New York Air, and Southwest all used their highly efficient cost structures and a bare-bones service to aggressively undercut the legacy airlines. Although most new budget airlines failed within a few years of entry, there seemed to be an inexhaustible supply of aviation entrepreneurs enthralled with the opportunity to run their own airlines. Among recent entrants, JetBlue and Virgin America have been the most successful. 20 30 40 50 60 70 80 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Case 5 The US Airline Industry in 2015 479 Price cutting by the major carriers tends to be highly selective, with airlines seeking to separate price-sensitive leisure customers from price-inelastic business travelers. As a result, fare bands widened: advanced-purchased economy fares with Saturday night stays were as little as one-tenth of the first-class fare for the same journey. Price cuts were also selective by route. Typically, the major airlines offered low prices on those routes where they faced competition from low-cost rivals. Southwest, the biggest and most successful of the LCCs, complained continually of predatory price cuts by its larger rivals. However, the ability of the major airlines to compete against the budget airlines was limited by the majors cost structures, including infrastructure, restrictive labor agreements, old airplanes, and commitments to extensive route networks. To meet the competition of low-cost newcomers, several of the majors set up new subsidiaries to replicate the strategies and cost structures of the budget airlines. These included Continentals Continental Lite (1994), UALs Shuttle by United (1995), Deltas Song (1993), and Uniteds Ted (1994): all were expensive failures. The quest for cost efficiency among the legacy airlines involved them adopting many of the operational practices of the LCCs. They also renegotiated union FIGURE 7 Mergers and acquisitions among major US passenger airlines, 19812012 American TWA Ozark America West Allegheny Piedmont United Pan American Continental People Express Texas International Eastern Airlines Delta Western Comair Northwest Republic Southwest Morris Air ValuJet American United Delta Southwest Acquired by American 2001 Acquired by TWA 1986 Bankrupt 1991 Continental and Eastern acquired by Texas Air 1986 which renamed itself Continental Allegheny became US Air; Acquires Piedmont 1987. Merges with America West 2005 Acquired 1993 AirTran Becomes AirTran in 1997 Acquired 1986 Acquired by Delta 1999 Acquired by Northwest 1986 Merges with Delta 2009 Continental merges with United 2010 Acquired by Southwest 2010 US Airways Merges 2014 Acquired 1987 480 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS contracts, terminated inefficient working practices, abandoned unprofitable routes, and reduced staffing levels. In many instances, radical cost cutting was preceded by Chapter 11 bankruptcy. Major airlines entering Chapter 11 bankruptcy since 2000 have included: TWA (2001), US Airways (20022003), United (20022005), Northwest (20052007), Delta (20052007), and American (20112013). The legacy airlines also adopted many of the pricing practices of the LCCs: notably charging separately for baggage, seat preferences, refreshments, and boarding priority. Baggage and reservation change fees collected by US airlines increased from about $1.4 billion in 2007 to $6.1 billion in 2013. The overall tendency was for the legacy carriers and LCCs to become increasingly similar in their strategies: What was once a clear division between network, low-cost, and charter models is now less clear, with network carriers operating low-cost, short-haul subsidiaries; LCCs providing frequencies and services to attract business passengers; and charter carriers venturing into single-seat sales. LCCs are even starting long-haul service, competing with network carriers on point-to-point routes.5 The Quest for Differentiation Under price regulation, competition among airlines focused upon branding, customer service, and in-flight food and entertainment. Deregulation brutally exposed the myth of customer loyalty: most travelers found little discernible difference among the offerings of different major airlines and their choice of airline on a particular route became increasingly dependent upon price. As airlines cut back customer amenities, efforts at differentiation became primarily focused upon business and first-class travelers. The high margins on premium fares provided a strong incentive to attract these customers by offers of spaciousness and in-flight pampering. The most widespread and successful initiative to build customer loyalty was the introduction of frequent-flyer schemes. Americans frequent-flyer program was launched in 1981 and was soon followed by all the other major airlines. By offering free tickets and upgrades on the basis of miles flown, and setting threshold levels for rewards, the airlines encouraged customers to concentrate their air travel on a single airline. Airlines unredeemed frequent-flyer miles represented liabilities running into billions of dollars by 2015. At the same time, by involving other companies as partnerscar-rental companies, hotel chains, credit card issuers frequent-flyer programs became an important source of additional revenue for the airlines. The Industry in 2015 The Airlines At the beginning of 2015, the US airline industry (including air cargo firms) comprised 151 companies, many of them local operators. Table 3 lists those with annual revenues exceeding $100 million. The industry was dominated by five major passenger Case 5 The US Airline Industry in 2015 481 airlines: United, American, Delta, US Airways, and Southwest. The importance of the leading group was enhanced by its networks of alliances with smaller airlines. In addition to these domestic alliances with regional airlines, the Big 3, were also core members of international alliances: United with Star Alliance, American with the oneworld alliance, and Delta with SkyTeam. Market for Air Travel Airlines were the dominant mode of long-distance travel in the US. For shorter journeys, cars provided the major alternative. Alternative forms of public transportationbus and railaccounted for a small proportion of journeys in excess of a hundred miles. Only on a few routes (notably WashingtonNew YorkBoston) did trains provide a viable alternative to air travel. Most forecasts pointed to continued growth in the demand for air travel, but at a much slower rate than in earlier decades. During the last two decades of the 20th century, North American air travel had grown by almost 5% per annum. Between 2013 and 2033, Boeing predicted that North American airline traffic would grow by an average of 2.9% a year (in terms of passenger miles). Some observers thought this overoptimistic, citing the increasing discomfort of air travel and the upsurge in video conferencing, suggesting that the long-anticipated shift from face-to-face to virtual business meetings had finally arrived. Changes were occurring within the structure of demand. Of particular concern to the airlines was evidence that the segmentation between business and leisure TABLE 3 The leading US airlines, 2014a Airline Market share (%)a Passenger numbers (million) Load factor (%) Southwest 16.90 26.0 82.8 Delta 16.85 106.2 86.8 United 15.07 64.7 86.1 American 12.40 66.4 85.0 US Airways 8.32 50.6 85.4 JetBlue 5.12 26.4 84.7 Alaska 4.28 19.2 85.6 SkyWest 2.33 26.0 83.5 ExpressJet 2.33 28.0 81.4 Spirit 2.13 12.6 86.8 Frontier 1.65 11.3 89.8 Hawaiian 1.62 9.1 85.0 Envoy 1.16 14.7 77.5 Endeavor 0.96 11.4 78.7 Mesa 0.69 8.3 83.3 Horizon 0.33 6.5 79.2 Air Wisconsin 0.33 5.6 78.2 Chautauqua 0.19 3.1 75.8 Note: a Based upon revenue passenger miles. Source: Bureau of Transportation Statistics. 482 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS customers was breaking down. Conventional wisdom dictated that the demand for air tickets among leisure travelers was fairly price elastic; that of business travelers was highly inelastic. Hence, the primary source of airline profit was high-margin business fares. However, following the 20082009 financial crisis, growing numbers of companies were limiting or eliminating employee access to premium-class air travel.6 Changes in the distribution of airline tickets contributed to increased price competition. The advent of the internet had decimated traditional travel agenciesretailers that specialized in the sale of travel tickets, hotel reservations, and vacation packages. Airline tickets were increasingly sold by online travel agents such as Expedia, Priceline, and Orbitz, or through airlines own websites. By 2015, the traditional travel agency industry was dominated by a few global leaders such as American Express and Carlson Wagonlit. Although airlines had benefited from the cuts in travel agents commission rates (commissions paid by airlines to resellers fell from 6 to 1% of operating expenses between 1992 and 2013), the key impact of the internet was providing consumers with unparalleled price transparency, greatly increasing their responsiveness to fare differentials. Cost Conditions The structure of operating costs is shown in Table 4. A key feature of the industrys cost structure was the high proportion of fixed costs. In the short term, most costs varied little with fluctuations in demand. For example, because of union contracts, it was difficult to reduce employment and hours worked during downturns. Similarly, the need to maintain flight schedules meant that planes flew even when occupancy was very low. The desire to retain the integrity of the entire network made the airlines reluctant to shed unprofitable routes during downturns. An important implication of the industrys cost structure was that, at times of excess capacity, the marginal costs of filling empty seats on scheduled flights was extremely low. The industrys labor costs were boosted by high levels of employee remuneration: average pay in the airline industry was $72,634 in 2013, compared to an average for US employees generally of $44,888. Pilots and co-pilots earned an average of $141,306.7 Pension and other benefits were also more generous than in most other industries. Labor costs for the major network airlines were boosted by low labor productivity resulting from rigid working practices that were part of the employment contracts agreed with unions. The industries main labor unions were the Association of Flight Attendants, the Air Line Pilots Association, and the International Association of Machinists and Aerospace Workers. Despite these unions tradition of militancy and past successes in pay negotiation, since 2001 the precarious financial state of the airlines and the flexibility offered by Chapter 11 bankruptcy have enabled the airlines to impose pay restrictions and more flexible working practices. Fuel Expenditure on fuel depended on the age of an airlines fleet, average flight length, and oil prices. Newer planes and longer flights led to higher fuel efficiency. Fuel-efficiency considerations had encouraged plane manufacturers to develop longdistance, wide-body planes with two rather than four engines. Fuel represented the most volatile and unpredictable cost item for the airlines due to fluctuations in crude oil prices. Case 5 The US Airline Industry in 2015 483 In principle, an airline can use forward contracts and options to hedge against fluctuations in fuel prices. In practice this is difficult: futures and options in jet fuel are not widely traded, hence airlines typically use crude oil and heating oil derivatives to hedge. However, the differential between jet fuel and crude oil prices tend to fluctuate greatly. The extent of hedging varied between airlines according to their expectations about the future direction of prices and whether they have the financial resources for hedging. Southwest has historically hedged most of its fuel purchases; US Airways has traditionally left its fuel cost unhedged. The decline in oil prices during 2014 encouraged most airlines to reduce their hedging. Delta Airlines took its fuel hedging one step further by becoming an active trader of jet fuel and crude oil. In 2011, it moved its jet fuel procurement unit into its treasury services department and hired oil traders from Wall Street. However, its most audacious move was buying the Trainer oil refinery in Pennsylvania from ConocoPhillips for $180 million. The refinery would be supplied with crude by BP, which would also exchange refined products from the refinery for jet fuel. Delta believed that its fuel-trading activities would benefit from having a physical product to trade and access to detailed information on production costs.8 Equipment Aircraft were the biggest capital expenditure item for the airlines. In 2015, with list prices for commercial jetliners ranging from $64 million for a Boeing 737 to $428 million for an Airbus A380, the purchase of new planes represented a major source of financial strain for the airlines. While Boeing and Airbus competed fiercely for sales of new aircraft through discounts and generous financing terms, their major source of profits was aftermarket sales. Even with the huge delays and TABLE 4 Operating costs in the US airline industry, 2006 and 2014 Cost item Increase in cost 20002014 (%) % of total operating expenses 2006 2014 Labor 62a 23.8 24.7 Fuel 233b 25.5 28.0 Professional services 20c 7.8 7.5 Food and beverage (38)d 1.5 1.5 Landing fees 72e 2.0 1.9 Maintenance material 8f 1.4 1.9 Insurance 0g 0.1 0.3 Passenger commissions (78)h 1.3 0.9 Communication (28)i 0.9 0.8 Advertising and promotion (46)j 0.8 0.6 Other operating expenses 86 34.5 31.9 Notes: a Compensation per employee; b cost per gallon; c per available seat mile; d per revenue seat mile; e per ton landed; f per aircraft block hour; g aircraft and non-aircraft; h as % of passenger revenue; i per enplanement; j per revenue passenger mile. Source: Airlines for America, Passenger Airline Cost Index: US. Passenger Airlines. 484 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS cost overruns on its 787 development, Boeings return on equity during 20052014 averaged 54%. Airbuss return on equity averaged 9%. Regional jets were supplied by Bombardier and Embraer, both of which had developed larger aircraft which were increasingly competing with the smaller planes offered by Boeing and Airbus. The airlines weak finances and high borrowing costs meant a preference for leasing rather than purchasing planes. The worlds two biggest aircraft owners were both leasing companies: GECAS (a subsidiary of General Electric) with 1732 planes and ILFC (a subsidiary of AIG) with 1031. Airport Facilities Airports play a critical role in US aviation industry. They are hugely complex, expensive facilities and few in number. Only the largest cities are served by more than one airport. Despite the growth in air transport, Denver International Airport is the only major new airport to have been built since 1978. Most airports are owned by municipalities and generate substantial revenue flows for their owners. In 2013, the airlines paid over $2.5 billion to US airports in landing fees and a further $3 billion in passenger facility charges. Landing fees were set by contracts between the airport and the airlines and were usually based on aircraft weight. New Yorks La Guardia airport has the highest landing fees in the US, charging about $7000 for a Boeing 777 to land. Four US airportsJFK and La Guardia in New York, Newark, and Washingtons Reagan Nationalare officially congested and takeoffs and landings there are regulated by the government. At these airports, slots were allocated to individual airlines, who subsequently assumed de facto ownership and engaged in trading them. According to Jeff Breen of Cambridge Aviation Research, Slots are a lot like baseball franchises. Once you have one, you have it for life.9 Cost Differences Between Airlines One of the arguments for deregulation had been that there were few major economies of scale in air transport, hence large and small airlines could coexist. Subsequently, little evidence has emerged of large airlines gaining systematic cost advantages over their smaller rivals. However, there are economies associated with network density: the greater the number of routes within a region, the easier it is for an airline to gain economies of utilization of aircraft, crews, and passenger and maintenance facilities. In practice, cost differences between airlines reflect managerial, institutional, and historical factors rather than the influence of economies of scale, scope, or density. The industrys traditional cost leader, Southwest, created the LCC business model comprising point-to-point service from minor airports, single-class planes, limited customer service, a single type of airplane, and job flexibility by employees. Southwest, JetBlue, and Spirit Airlines continue to have the industrys lowest operating costs per available seat mile (ASM), despite flying relatively short routes. However, as shown in Table 5, the cost gap between the legacy carriers and the LCCS has narrowed. Managing costs requires meticulous attention to capacity utilization: the primary source of losses is load factors falling below the breakeven level. Moreover, excess capacity creates incentives to cut prices in order to fill empty seats. Adjusting fares to optimize load factors and maximize the revenue for each flight is the goal of the airlines yield management systemshighly sophisticated computer models that combine capacity, sales data, and demand forecasts to continually adjust pricing. Case 5 The US Airline Industry in 2015 485 Looking to the Future At the end of April 2015, the US airline industry presented a mixed picture. Despite the sustained upturn in profitability, the balance sheets of most airlines remained weak. Among the leading airlines only Southwest had a ratio of long-term debt to equity of less than one. Deltas ratio of long-term debt to ratio was 106, for American Airlines Group it was 685, and for United Continental Holdings it was 408. Looking ahead, the critical issue was whether the recent improvement in industry profitability was a cyclical phenomenon driven by weak oil prices, an improving domestic economy, and the impact of higher load factors in moderating price competition, or whether it was supported by a more fundamental shift in industry structure and competitive behavior. The success of the major network airlines in reducing their cost base through productivity improvements and reductions in compensation and benefits provided one source of optimism. As a result, the LCCs no longer had a substantial cost advantage. However, a key issue for the airlines was whether the beneficiaries from improvements in cost efficiency were the airlines shareholders (through higher profits) or their customers (through lower fares). Previous revivals in airline industry profitability ended either as a result of external events or by the industrys own propensity to overinvest. In the case of the two previous upturns (19961999 and 20062008), external events were the critical factors (the September 11, 2001 terrorist attacks and the financial crisis of 20082009). In the absence of external shocks, the critical issue will be the willingness of the airlines to avoid overinvesting in new capacity. The revival of 20122015 was driven by rising load factors. This was the result not only of an improving economy but also of capacity restraint. During 20072009, the industrys ASMs fell from 744 to 667 billion. Subsequent capacity additions during 20092014 were modest. As a result, the legacy carriers had substantially less capacity in 2014 than in 2006 (see Table 5). As the disruptions caused by bankruptcy and merger faded into the past, would the TABLE 5 Operating data for the larger airlines, 2006 and 2014 ASMs (billion) Load factor (%) Operating revenue per ASM (cents) Operating expense per ASM (cents) Airline 2006 2014 2006 2014 2006 2014 2006 2014 American 175.9 154.4 82.0 85.0 12.5 17.3 12.5 15.8 United 139.8 104.1 82.1 86.1 13.1 18.2 13.1 17.3 Delta 133.5 115.5 77.8 86.8 13.0 19.0 13.6 16.8 Southwest 85.2 120.5 73.0 80.9 9.5 13.0 8.5 12.4 US Airways 83.9 58.0 77.6 85.4 15.7 19.5 15.2 17.7 JetBlue 23.8 36.0 82.5 84.7 7.6 12.9 7.5 11.9 Alaska 23.2 29.8 76.4 85.6 11.3 16.7 11.5 14.0 Source: Bureau of Transportation Statistics. 486 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS airlines resume their traditional propensity to compete for market share through new planes and fare reductions? One factor favoring moderation in price competition was the reduction in the number of legacy carriers from six in 2000 (American, United, Delta, Continental, Northwest, and US Airways) to three in 2015. Although expansion by LCCsespecially Southwest and Jet Bluehad partly filled the gap, by 2015 there were fewer airlines competing on most routes than in 2000. Yet, fewer major airlines did not necessarily translate into capacity discipline. During 2015 and 2016, the industry was expected to expand capacity by between 4 and 6% in each year, with the LLCs leading the way with capacity growth of over 10% annually.10 Moreover, the US airline industry would not be isolated from the international situation where Asian and Middle East airlines were continuing to add capacity on international routes. 1. International Air Transport Association, Vision 2050 (Singapore: IATA, February 2011). 2. Lex, US Airlines: Here We Go Again, Financial Times (May 28, 2015). 3. S. Martin, The Theory of Contestable Markets, Department of Economics, Purdue University (July 2000). 4. United States Government Accountability Office, Report to Congressional Requestors: Airline Competition (June 2014). 5. Boeing Company, About Our Market: Current Market Outlook 201415, http://www.boeing.com/commercial/ market/, accessed July 20, 2015. 6. CEOs Fly Coach? Business Travel Turns Frugal, Wall Street Journal (February 12, 2013). 7. US Dept. of Transportation, Form 41 via BTS, Schedule P6 and P10. 8. Delta Buys Refinery to Combat Fuel Costs, Financial Times (April 30, 2012). 9. Airlines Control of Landing Slots Affects Ticket Prices, Seattle Times (October 12, 2010). 10. Lex, op. cit. When the disruptions caused by bankruptcy and mergers are a thing of the past, will airlines regain their traditional tendency to compete for market share with new aircraft and lower fares?

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