It is difficult these days to avoid news stories on the troubled U.S. airline industry. Three of the seven largest U.S. passenger airlines are currently in bankruptcy. Over the past four years, the U.S. passenger airline industry has lost more than $32 billion, with an additional $9–10 billion loss projected for 2005. Have you ever wondered why this happened, where the industry is going and what the future of flying will be like? Do these events represent an extended dislocation in the industry or are they the harbinger of a vast structural change?

In answering these questions, we must first introduce two terms commonly used in the industry: “legacy carriers” and “low-cost carriers,” or “LCCs.”

Legacy Carriers

You may have heard the term “legacy carrier” in the news. Legacy carriers are the large airlines that existed before the economic deregulation of the U.S. aviation industry in 1978. They exhibit the characteristics of the pre-deregulation period such as large, established route networks and unionized workforces, contracts with restrictive work rules, and generous wages and benefits including defined benefit pension plans for their workers. Today the legacy carriers include the following major passenger airlines: American Airlines, United Airlines, Delta Air Lines, Continental Airlines, Northwest Airlines and US Airways.

Legacy carriers are generally full-service airlines that operate what are referred to as “hub-and-spoke” systems through which they funnel passengers from different locations into central hubs at major airports and sort the passengers onto connecting flights to their ultimate destinations. Thus, passengers often have to change planes at the hub before flying on to their destinations. This system provides the airlines with a broad network and geographic reach and improved load factors. However, the system can result in inefficiencies because the aircraft arrive in waves, thereby creating congestion, and the aircraft and crews may have longer waits between flights. The airlines are also burdened with the expenses of having to handle connecting passengers at origination, hub and destination.

Low-Cost Carriers (LCCs)

Low-cost carriers are airlines formed post-deregulation that offer lower fares but eliminate a number of traditional passenger services. They are also known as “no-frills” or “discount” carriers. There are a number of low-cost carriers, but the major ones in the United States include AirTran, Frontier, JetBlue and Southwest.

Since deregulation of the U.S. airline industry, there have been 160 airline bankruptcy filings, 20 of which have occurred in the last five years.

The typical LCC business model includes several of the following practices: a single passenger class (some, such as AirTran, also offer business-class service); a single or limited number of aircraft types, which allows the carrier to reduce training, servicing and maintenance costs; a simple fare structure, which rewards early reservations; outsourcing of major aircraft maintenance to third-party repair shops, which is generally cheaper than doing the work in-house at higher wage rates; utilization of cheaper, less-congested secondary airports, which reduces air traffic delays, landing fees and airport charges; shorter flights and faster turnaround times, which maximize the utilization of the aircraft; flying primarily point to point, which reduces costs and maximizes the utilization of the planes as compared to the traditional hub-and-spoke system; emphasizing direct sales of tickets and usage of the Internet, which reduces fees and commissions paid to travel agents and other third parties; employment of fewer employees, which reduces personnel costs; and the elimination or reduction of in-flight catering and complimentary services, which further reduces costs.

Just under half of all airline flight seats available in the United States are now operated by airlines under bankruptcy protection.

Troubles of the Legacy Carriers

As noted, airline bankruptcies have been much in the news recently. According to the Government Accounting Office (GAO), since deregulation of the U.S. airline industry, there have been 160 airline bankruptcy filings, 20 of which have occurred in the last five years. Although many of these failures were ill planned and poorly financed start-ups, it is undeniable that in the post-deregulation world, airlines have failed at a high rate. Old, well-established brands such as Eastern Air Lines, Pan Am and TWA have disappeared entirely, ceasing operations after one or more bankruptcy filings. And currently, three of the six U.S. legacy carriers are in bankruptcy and a fourth only emerged from Chapter 11 protection in September. United Airlines filed for bankruptcy in 2002. US Airways filed in September 2004, its second filing since 2002 (US Airways emerged from bankruptcy in September 2005 and merged on that date with an LCC, America West). Northwest Airlines, the nation’s fourth largest airline, filed for bankruptcy on September 14, 2005. Delta Air Lines, the nation’s number-three carrier, filed on the same day as Northwest, in what was the ninth largest bankruptcy filing in U.S. history. Continental Airlines, although not in bankruptcy now, underwent bankruptcy reorganizations twice in the ’90s. American Airlines is the only legacy carrier that has not sought bankruptcy protection. According to the Air Transportation Association (ATA), just under half of all airline flight seats available in the United States are now operated by airlines under bankruptcy protection. Moreover, the revenues of the major carriers have declined drastically. According to Air Transport World, operating revenues for the 10 largest U.S. airlines totaled $80.8 billion in 2003, down from $97.7 billion in 2000, as to which it noted “there is simply no precedent for this type of contraction in the deregulated era.”

There are multiple causes for the failure of the legacy carriers, both internal and external, many of which are intertwined. Some of them are examined below.

High Wages, Benefits and Mounting Pension Obligations. Legacy carriers continue to be burdened by many of the characteristics of the pre-deregulation period: unionized work forces, high wages, comprehensive benefits, hugely expensive pension plans and restrictive work rules. Given their level of fixed costs, high ratios of debt to equity and the prevailing competitive environment, airlines cannot generally withstand a strike that would shut down flying. Not surprisingly, airline unions resist reducing wages and benefits or easing work rules. Thus, union contracts, which have been negotiated and renegotiated over the legacy carriers’ long history, contain successive accretions, tradeoffs and concessions made by management over the years to avoid strikes and maintain labor peace. But the weight of these accretions has gradually but surely resulted in such carriers being saddled with the twin burdens of high wages and benefits and restrictive work rules, thereby fostering an environment in which many employees have developed an attitude of entitlement. Management of legacy carriers has had only limited success in addressing these problems outside bankruptcy. Union leaders are, after all, political animals and few of them are ever re-elected based upon a record of agreeing to reduce pay or benefits or change favorable work rules. Nor do all of their members really yet believe that the world they knew in the ’90s is gone forever. For example, Northwest’s recent attempt to avoid bankruptcy by, among other things, obtaining concessions from its 4,400 mechanics, resulted in a strike in August 2005. Northwest’s bankruptcy filing followed in September.

The costs and attitudes associated with these collective bargaining agreements, and similar wages and benefits granted to nonunion employees, have become embedded in the culture and cost structure of many of the legacy carriers and have made it increasingly difficult for them to compete with their LCC counterparts, which pay their workers less and have far more flexible work rules. Similarly, even when the pay scales are comparable, the legacy carriers generally have older workforces with more on-the-job seniority and thus higher effective wage costs.

Pension costs under defined benefit (as opposed to defined contribution) plans designed on the old “Rust Belt” model are also a major factor forcing legacy carriers into bankruptcy. Many such plans have become significantly underfunded. For example, at termination, United’s pension plans were underfunded by $9.8 billion and US Airways’ by $5 billion. Delta’s pension plan is estimated to be underfunded by $10.6 billion and Northwest’s by $5.7 billion. Both United and US Airways terminated their pension plans in bankruptcy. It is not clear whether Delta and Northwest will do the same. If these bankrupt airlines are allowed to terminate their pension obligations while also reducing wage and benefit costs, this development will put significant economic pressure on American and Continental, the only remaining legacy carriers not under bankruptcy protection.

Competition from Low-Cost Carriers. Competition from LCCs is one of the most direct and significant causes of the failure of legacy carriers. The market share of LCCs has increased significantly in the last 10 years. LCCs represent 25 to 30 percent of the U.S. domestic market and they compete on 70 percent of the routes. Three of the 10 largest passenger airlines in the U.S. are LCCs: Southwest, JetBlue and AirTran. LCCs have managed to keep their operations simpler and more efficient than legacy carriers. Because costs are lower, LCCs can charge bargain fares and still make a profit. Even if they match the LCC fares, legacy carriers may not be able to make a profit (or as much of a profit) because of their higher costs. Legacy carriers are also not at liberty to charge a much higher fare than the LCCs because consumers are generally price sensitive and will book the airline with lower fares.

The legacy carriers have made significant cost-cutting progress in the last few years by, among other things, obtaining concessions from employees and eliminating in-flight services such as meals and even snacks, pillows, blankets and headphones. Some have scaled back their hub-and-spoke operations. For example, Delta Air Lines closed its connecting hub at Dallas/Fort Worth International Airport. However, legacy carriers still have a considerable distance to go to bring their costs in line with their LCC competitors. According to the GAO, the LCCs maintained a 2.7-cent-per-available-seat-mile advantage over legacy carriers in 2004.¹

Soaring Fuel Costs. Record high fuel costs are said to be the most direct cause of the recent airline troubles. Although certainly not the only reason, both Delta Air Lines and Northwest Airlines cited, among other things, skyrocketing fuel costs as reasons for making their bankruptcy filings in September after the interruptions in supplies from Gulf Coast refineries due to the hurricanes. Fuel prices reached record levels after Hurricane Katrina. The ATA estimates the airline industry’s jet fuel expense could increase by $9.2 billion this year.² While all carriers are exposed to high fuel costs, certain of the LCCs have had the resources to hedge against much of the impact. For example, Southwest has hedged 85 percent of its fuel requirements in the second half of 2005 at the equivalent of $26 per barrel while spot market prices hover in the high $60s. Legacy carriers that are already deeply in debt, flying older, less fuel-efficient aircraft and whose fuel purchases are generally unhedged, are less capable of weathering such spikes in fuel prices.

Overcapacity. Today’s airline troubles are partly due to overcapacity in the system. When capacity exceeds demand, airlines are unable to charge higher fares to offset their costs without risk of losing market share. Nonetheless, aircraft manufacturers’ order books for new aircraft are full. Older aircraft are not typically scrapped but sold off to new start-ups and other second- and third-tier carriers. Thus, capacity remains in the system and continues to restrain pricing. The healthier carriers argue that allowing bankrupt carriers to continue to operate under the protection of the bankruptcy courts in Chapter 11 only adds to the industry’s problems because the overcapacity is never eliminated, and that the industry will remain unstable until the government ceases allowing failed airlines to reorganize in bankruptcy over extended periods and instead forces failed carriers to liquidate. Under bankruptcy court protection, bankrupt airlines renegotiate and restructure aircraft, engine and facility financing and lease arrangements, revise labor contracts, and reduce or eliminate pension obligations — all while continuing to operate. Although they may choose to cut services in certain areas or reduce the number of aircraft in their fleet, they are not forced to wind up or cease business. Therefore, even bankruptcy does not measurably reduce capacity. As the supply of available airline seats does not decrease and demand remains at approximately the same levels, the remaining players do not have the power to influence pricing.

When capacity exceeds demand, airlines are unable to charge higher fares to offset their costs without risk of losing market share.

Low Fares and Lack of Control Over Pricing. Airlines have limited control over the pricing of airline tickets. This is not an industry where most passengers have deep-seated brand loyalty. The Internet enables consumers to have more accurate competitive pricing information and to search for bargain fares. Because of price competition, legacy carriers have been unable to raise their fares much above the fares charged by LCCs without risk of losing customers.

High Leverage. Legacy carriers have accumulated heavy debt obligations due to their higher operating costs, wages, benefits and pension obligations and their inability to raise prices much beyond the fares charged by the LCCs. The debt they carry has a snowball effect because it becomes more difficult to finance acquisition of new, more fuel-efficient aircraft needed to modernize their fleets. And because they are not replacing their fleets with lower maintenance, more fuel-efficient aircraft, they are not able to bring their costs down as fast as needed in order to compete effectively with the LCCs. Heavy debt also means that the legacies have not had as much flexibility or resources to hedge their fuel costs which puts them at a further disadvantage to those LCCs that are able to hedge such costs effectively.

Old, well-established brands such as Eastern Air Lines, Pan Am and TWA have disappeared entirely, ceasing operations after one or more bankruptcy filings.

Little Leverage Over Powerful Suppliers. It is also sometimes said that airlines are held captive by their suppliers and have little influence on the prices they pay for the goods and services they acquire.³ Many key suppliers enjoy oligopoly or monopoly status and some have regulatory power. For instance, major airports, air navigation service providers and security services can essentially dictate the prices they charge for use of their facilities and services.

While all airlines are subject to powerful suppliers, legacy carriers tend to be more at their mercy. For instance, legacy carriers’ hub-and-spoke systems require them to use the primary airports around the country, which charge higher landing fees and other expenses. Compared to the legacy carriers, several of the LCCs (most notably, Southwest) are able to reduce their costs by utilizing secondary airports in their point-to-point systems. Another example is the transaction fees charged by the distribution systems that airlines use to sell tickets. So long as the airlines are more or less dependent on these systems for distributing tickets, they have limited leverage bargaining against rising transaction costs. LCCs are less vulnerable to such costs because they tend to utilize the Internet for a higher proportion of their ticket sales and are less dependent on more costly distribution systems.

Additionally, aircraft and engine manufacturers have significant market leverage over the airlines, not just in prices charged for the aircraft and engines, but also in the supply of spare parts. By lobbying the airline regulatory agencies to require that airlines use the spare parts produced by them or their licensed suppliers, and demanding that such parts be used in order to preserve aircraft and engine warranties, airlines have only limited ability to avoid high prices charged for many spare parts. Though this issue affects both legacy carriers and LCCs, LCCs are better able to reduce the maintenance cost by utilizing fewer different types of aircraft.

High Fixed Costs. To establish and maintain their services, airlines have a high level of fixed operating costs such as labor, fuel, aircraft, engines, spare parts, IT services, airport equipment, airport handling services, sales, catering, training, insurance and other expenses. The majority of the proceeds from ticket sales are paid out to different external providers and internal cost centers. Most of the costs for airlines are fixed. The variable cost associated with serving another passenger on the flight is often negligible compared to the fixed costs. Airlines will sell seats at anything over their variable costs. This means that revenues may not always be sufficient to cover the fixed costs. While this is true for all airlines, this factor is exacerbated for legacy carriers due to their higher fixed costs than LCCs.

Operating revenues for the 10 largest U.S. airlines totaled $80.8 billion in 2003, down from $97.7 billion in 2000.

Low Barriers to Entry and High Barriers to Exit. The GAO attributes the instability of the airline industry partially to the low barriers to entry.⁴ Since the barriers were lowered after deregulation, there have been many start-ups. The lower entry barriers have produced significant competition that drives down airfares. This may be good for consumers, but for legacy carriers, it means less revenue. Many of the new entrants charge significantly lower fares in order to gain market share. Established carriers cannot match these reduced rates without lowering their profitability.

The exit barriers for carriers tend to be higher than the entry barriers. For one thing, the government does not wish to see a carrier dropping an area of service for fear that the failure of legacy carriers would leave people traveling to less popular destinations without service. Credit card companies, lessors and manufacturers of the aircraft and engines also would typically rather keep a troubled airline alive than see it liquidated. The fact that bankrupt airlines continue to fly, and often at reduced costs, makes it difficult for other airlines to raise fares to profitable levels.

Cyclical Demand for Air Travel. The demand for air travel tends to be cyclical, depending on the economic environment, business needs, vacation time and the like. For instance, the industry suffered greatly reduced demand after the September 11, 2001 terrorist attacks frightened away travelers and deepened the recession. Air travel was undermined again by the SARS epidemic in Asia and the Iraq war. Cyclical demand applies equally to legacy carriers and LCCs, but LCCs have been in a financially better position to weather the storms.

Trends and Future of the Airline Industry

No consensus has emerged regarding the future structure or composition of the U.S. airline industry. Whether what we are currently seeing is an extended dislocation from the aftershocks of 9/11 and an aberration in fuel prices, or a fundamental structural change, is still uncertain. But many pundits warn that a fundamental shakeout is already in progress and that the industry as it currently exists is not sustainable.

In any event, some trends are discernable. For example, the legacy carriers will continue to use the bankruptcy laws to aid in reducing their debt and pension burdens and otherwise go back to the drawing board to find more effective ways to compete with the LCCs. Legacy carriers will continue to endeavor to cut their seat-mile costs and in the process tend to become more like larger versions of the LCCs. LCCs, on the other hand, will continue to grow and in the process become more like the legacy carriers but without the historical baggage such as defined benefit pension plans. This process, sometimes referred to as “convergence,” is not greatly different from what has happened to other industries in the process of consolidation and diversification.

Will either legacy carriers or LCCs disappear in the process? It is unlikely that either industry segment will disappear entirely, although it is foreseeable that certain individual legacy carriers or LCCs may fail in the process. Though LCCs have advantages over legacy carriers in many areas, it does not necessarily follow that the business models of the legacy carriers are outdated and should be replaced by LCC business models. Legacy carriers still have advantages in several areas. For example, legacy carriers have well-developed frequent-flyer programs and far more extensive route networks that allow them to serve more customers across greater distances as well as customers traveling to less popular destinations. They are often entrenched with most of the airport gates and landing slots in popular business destinations such as LaGuardia International Airport in New York. Their advantages are particularly pronounced in the international arena. With a few exceptions, LCCs have not tapped into the trans-Atlantic, trans-Pacific and Europe-to-Asia routes. Legacy carriers, on the other hand, have extensive international route networks enhanced by alliances and code-sharing relationships with large foreign carriers.

One way to look at the industry is by comparing it to the development path of the retail industry. In a sense, legacy carriers are similar to department stores and LCCs are like Wal-Mart, Target or specialty stores. Department stores traditionally attempt to carry a wide selection of brand names and products. They, in fact, previously eliminated many of their mom-and-pop predecessors. Then, along came discount stores such as Wal-Mart and Target, which significantly undercut department store prices. A significant number of their former customers, as well as new customers, naturally gravitated to the discount stores for many of the products offered in the department stores but at cheaper prices. Specialty boutiques also sprang up, where customers could go for greater product specialization, higher quality brands, better service and the convenience of not having to navigate the large department stores or the discount stores. All three types of stores co-exist.

The airline industry seems to be following a similar path. While the legacy carriers, as the “department stores” of the industry, continue to cut costs in an attempt to resemble and compete with the LCCs (the “discount stores” of the industry), the legacy carriers will continue to exist because of their more extensive route networks to more destinations and broader selection of services available. At the same time, the “discount stores” of the industry, the LCCs, continue to grow and expand to resemble the “department stores,” and will continue to thrive due to their low costs, low fares and convenience. The boutiques, such as various all first- or business-class airlines and premium charter services that offer special niche services to targeted consumers who are willing to pay for the premium services, will also make their presence felt from time to time.

The above is not to say that a number of legacy carriers and LCCs will not fall by the wayside. Some have already failed, as noted, and others may be in the process. Still others have consolidated or strengthened their competitiveness in the market. The stronger of the existing LCCs will undoubtedly continue to grow and new-entrant LCCs will regularly appear on the scene. However, the legacy carriers and the LCCs will likely continue to co-exist to provide their customers with a wide selection of flights and services according to the different preferences and priorities of the flying public.

Endnotes