Come Together … Right Now

In a market increasingly dominated by low-cost carriers, how will the consolidation of the "legacy" airlines actually affect the industry -- and consumers?

While the 1969 Beatles song Come Together was not intended by Lennon and McCartney to forecast consolidation in the U.S. airline industry some 40 years later, the song and the airline consolidation trend have at least two things in common: they are both very popular, and the meaning of each is subject to much speculation. While we won’t attempt to unravel the meaning of The Beatles hit, we can provide some insight into domestic airline consolidation and the effects it will have on the industry as well as the consumer.

Come Together

“Legacy” airlines are large U.S. airlines in existence prior to industry deregulation in 1978 that usually operate a “hub and spoke” network, with the term generally considered to include the “big six” of American, United, Continental, Delta, Northwest and US Airways.

In the past year, we have seen what many believe to be the beginning of significant consolidation by the legacy airlines, with Delta Air Lines and Northwest Airlines coming together in a merger that closed in October, 2008. The Delta/Northwest merger displaced American Airlines as the world’s largest airline.

While bigger is not always better, large corporate accounts typically have gone to the airline with the largest route structure as it offers more flexibility for business travelers in terms of both destinations and frequency of service. That being said, the fundamental problem of the airline industry is the high cost of excess capacity. Aircraft are expensive to operate. Thus, the primary benefit to the airlines from consolidation is an ability to decrease capacity by removing aircraft competing on the same routes.

For instance, if Delta and Northwest both operated flights pre-merger from New York to Dallas that are only half full, the combined entity will benefit from removing one of the aircraft from that route and operating one full aircraft. The “extra” aircraft can then be deployed on a different route or, as is sometimes the case, simply taken out of operation altogether.

While the cost of not utilizing a commercial jet aircraft that could easily have a purchase price in excess of $40 million or a rental rate or finance cost of more than $350,000 per month is steep, the fuel and maintenance cost savings from not operating the aircraft can, depending upon its age and efficiency, often justify parking it. Fuel costs also play a significant role, and the recent volatility in prices in the jet fuel market affect the relative costs (fuel vs. capital costs) of operating older, less fuel-efficient versus newer, more fuel-efficient aircraft.

In a similar move, Continental Airlines and United Airlines entered into an alliance in June, 2008 that will essentially merge their networks by the end of 2009 and allow both operators to achieve significant capacity reductions. There continues to be much industry speculation that the network integration is a first step toward an eventual merger of Continental and United, though most believe it is still some time away.

WHAT TO EXPECT

Delta’s third-quarter 2009 financial results indicate that it will have reduced domestic capacity this year by roughly seven to nine percent. And Delta is not alone. Northwest Airlines has been shedding capacity in connection with its merger with Delta, and Continental Airlines and US Airways having been doing the same at approximately the same rate as Delta. Similarly, corporate financial reports estimate that American Airlines will reduce domestic capacity by 7.5 percent this year, and that United Airlines will see a total reduction in domestic capacity of 10.5 to 11 percent.

He Say One And One And One Is Three

Though airline consolidation among the legacy carriers may become the trend, one and one and one may always equal just three. Notwithstanding the short-term benefits achievable by reducing capacity,
merging uncompetitive legacy carriers may not yield real, lasting synergies for a variety of reasons.

First and foremost, unlike other industries, beyond a certain level there simply are not significant scale efficiencies in the airline industry. That is to say, there is not a great benefit in terms of cost savings for an airline to go from operating 100 aircraft to operating 500 aircraft. The reason for this reality is that the costs of ownership or lease of each individual aircraft together with the related fuel, crew and maintenance costs associated with operating an aircraft are significantly independent of the structure in which they are operated.

While a larger airline may have better bargaining power to reduce certain costs on its margins, such as through the negotiation of more favorable fuel agreements and maintenance contracts (or even performing its own maintenance), the benefits that can be achieved through these means are small when compared to the total cost of operation.

Airlines of all sizes are also squeezed by powerful suppliers upstream, such as manufacturers and the jet fuel market, and are now also subject to an extraordinarily efficient consumer market driven by ticket sales over the Internet and companies like Orbitz, Hotwire and Priceline that allow consumers to compare all available ticket prices on the same route with a few quick clicks of a mouse. Further, unions continue to dominate domestic airlines. Rather than an airline benefiting from a reduction in labor costs, as is customarily the case in mergers in other industries, the labor costs of an airline in a merger are not likely to decrease meaningfully and may actually increase as the airlines involved are forced to contend with integration of separate union contracts being negotiated by unions with significant bargaining power backed by union-friendly laws.

Another challenge that cannot be overcome simply by being bigger is the fierce competition among carriers for profitable routes, or the “over-mining” of com-good routes. With regard to the latter, unlike other businesses, airlines can reallocate their assets overnight. A profitable route often remains so for only a short period of time. As margins improve, the natural tendency is for an airline to increase capacity on the route by serving it with additional or larger aircraft and for other airlines to divert capacity to the route. Once that happens, the increased capacity will eventually drive down margins as the supply of seats increases beyond customer demand. This self-defeating mechanism, although somewhat ameliorated by the limited supply of gates and traffic constraints at certain airports, makes finding and maintaining profitable routes an ongoing battle — a challenge where the size of the combatant may offer little relative advantage.

WHAT THIS MEANS FOR YOU

In light of the above challenges, the ultimate goal of the legacy carriers has to be to reduce operating costs in order to compete on price with low-cost carriers such as AirTran Airways, Southwest Airlines and JetBlue Airways. The barriers to doing so are substantial, however, and there is little to suggest that the prospects of accomplishing that goal are enhanced by merging entities with relatively high-cost structures. Many believe we will see further reductions in capacity by the legacy carriers in the domestic market and a reallocation of assets and focus to the more profitable international routes. This may ultimately lead to significantly more low-cost carriers competing in the domestic market.

One Thing I Can Tell You Is You Got To Be Free!

In principle, an air travel market dominated by low-cost carriers should be a fantastic scenario for today’s increasingly adventurous consumer, right? We will all be able to travel where we want, when we want, with little or no notice. The enhanced competition for our business will drive down prices and release our inner leisure traveler!

Of course, that may be a slight exaggeration, but there certainly are signs that a transition to domestic travel markets heavily influenced by low-cost carriers is already taking place. Although the data is somewhat difficult to compile and to analyze, it appears from information reported by the Air Transport Association in its 2009 Economic Report, together with data reported from other sources, that more than 25 percent of all passengers enplaned by U.S. airlines in 2009 were on flights operated by low-cost carriers.

Airline ticket prices are falling for reasons not just due to sluggish demand associated with the current weak economy. And looking ahead, there are few reasons to expect that this trend will change, as low-cost carriers take a more substantial hold in the market.

In fact, many observers believe we are likely to see even greater downward pressure on ticket prices, since low-cost carriers are extraordinarily intense and focused competitors and have much lower overall cost structures that allow them to operate profitably at lower prices.

However, it is also probably fair to say that the low-cost carriers will not be completely immune to countervailing pressures on their cost structures over a period of time — increasing unionization, higher maintenance costs as their relatively new fleets age, and so forth.

So, go ahead and plan your travel! While you’re at it, you may want to plan to get to the airport a little earlier than usual since all of the cheap tickets will mean more travelers, more pressure on airport facilities and more flight delays. But that is a topic for another day.

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