Profits and Customer Service: Available In the Airline Business?

http://knowledge.wharton.upenn.edu/article.cfm?articleid=2479

There are lots of people who don't want to fly anymore commercially. That's understandable.

Things were so bad that there is now a "Passenger Bill of Rights" that went into effect April 29, 2010 and will be administered by the Department of Transportation: any airline that has a plane waiting (with passengers on board) to take off longer than 3 hours will pay a fine of $27,500 per passenger. That's roughly a $3 million fine for a 737 size passenger load. This, of course, comes from the horrendous situations that occurred in 2006 and 2007 (in Dallas, San Francisco and New York) where passengers sat on the ground and were not allowed to deplane for 10 to 12 hours (think of the food, water, and bathroom situations on those planes). Worse, knowledgeable people report that, in some of those situations, the gates of another airline could have accommodated those passengers but the airlines involved did not want to pay a "fee" for use of the competitor carrier gate to deplane!

How did we get here? Well, we can thank "deregulation". Back in 1978, Congress decided to deregulate the airline industry as a way to encourage lower airline ticket prices. Up until then, prices for routes were dictated by government regulators as a way to guarantee profit margins because the industry was considered to be much like a public utility.

Transportation Economics (if there is such a thing) is a discipline fraught with the pitfalls of regulatory macroeconomics, microeconomics, and transportation optimization. None of this represents how modern airlines are run. Over the past ten years, the airlines have lost $60 billion. That is because we have too many airlines (too much capacity) chasing too few passengers.

This being true, there should be "natural" merger/acquisition activity. But this activity is prevented by an ever vigilant Justice Department which, when United tried to buy US Airways in 2001, blocked the deal ("conspiracies in restraint of trade"). But United, ever vigilant as well, put a move on the Justice Department in 2010 (just this past month) when they began talks with US Airways again only because they wanted to "attract" Continental Airlines into talks to merge UAL and Continental. Nobody ever merges: United is acquiring Continental but the math is pretty close to "equal" in the sense that United is using its own shares to buy Continental for what looks like a premium of $1.02 per share - if we can call that a premium. This time, it would appear that the ever vigilant Justice Department (except when they need to be) will not attack this deal because the route systems of both airlines are complimentary. Experts on the economics of the airline industry indicate that the implications of this specific deal are that the two carriers would cut their combined domestic flying by close to 10%. That would translate into about a 2% reduction in industry capacity.

The merged Continental Airlines and United Airlines would have the highest operating revenue and largest number of employees among U.S. airlines. Based on 2009 results, the 5 largest airlines would look like this:

Operating Revenue Net Income Employees

UAL/Continental $28.9 billion -$1.4 billion 82,340

Delta $28.1 billion -$1.2 billion 81,106

AMR $20 billion -$1.5 billion 78,900

US Airways $10.5 billion -$205 million 31,333

Southwest $10.4 billion $99 million 34,726


With AMR's slip to third on the list above, it could be problematic for them, according to industry consultants, because the U.S. airline industry can only support 3 major network carriers. Unless something changes, one of those carriers will always be Southwest. According to the experts at Wharton, consolidation of carriers would only become worrisome to regulators now if the number of major carriers fell to three (or two). We'll see.

Assuming American sees the handwriting on the wall, where are the candidates for them to buy? According to Terry Maxon at the Dallas Morning News there are:

US Airways: its domestic network would add little to American's system, and its cost advantage would disappear after American absorbed it.

Alaska Airlines: it focuses its routes on the West Coast, and American hasn't done well with West Coast mergers.

AirTran Airways: an AirTran merger would put American competing against Delta at Delta's Atlanta stronghold, and a variety of cities where AirTran comes up against Southwest.

JetBlue Airways: JetBlue could offer American a valuable feed of passengers at New York Kennedy for international flights. But American will be getting that through a partnership without the need to merge.

Southwest Airlines: it would be like mating a moose and a giraffe - the ultimate in high-cost hub-and-spoke carriers pairing up with the airline that is the model for low-cost, low-fare carriers.

While we may have many reasons to be critical of American Airlines relative to how they have handled union concessions, management pay and customer service, we must side with Robert Crandall, their retired CEO, who points out that American is the only domestic carrier left that repairs 90% of its fleet domestically and performs work for other airlines. The rest "outsource" most of their maintenance abroad to stations like El Salvador where most of their mechanics are not FAA certified. Mr. Crandall supports an effort by the Business Travel Coalition and the Teamsters Union to crack down on sending jets abroad for maintenance. Crandall has gone further to support legislation that would require (for safety and quality reasons) that all U.S. airline maintenance be done domestically.

Given the above, American makes less of a profit per ticket than the other airlines because it is committed to its own mechanics and its own maintenance standards. According to John Goglia, a National Transportation Safety Board member from 1995 to 2004, FAA oversight of foreign repair stations is "weak at best" and more than 90% of the "people turning wrenches" are not certified mechanics.

Overall, where this leaves the flying public (until the airline industry has reduced capacity enough to raise prices) is that it becomes victimized by the kind of "cost saving customer service" that charges per checked bag and an airline management that entertains proposals like American's 2005 classic where removing "pillows" as an option for passengers would save $365,000 per year.

Two years ago, Southwest CEO Gary Kelly drew a competitive line in the sand when he decided not to charge passengers for their bags. He didn't want employees to face customer wrath for an issue that would have gone against the essence of Southwest. He shored up morale by giving raises. He let attrition trim the workforce. And, he wasn't going to "nickel and dime" the customers (what a concept!). He thought he could pick up market share and galvanize the airline's popularity.

Today Southwest has gained nearly $1 billion in annual market share thanks in large part to people avoiding bag fees. According to Kelly, "We have fewer seats offered every day, and we're carrying more passengers. We're defying gravity."

Carriers in bankruptcy or close to bankruptcy are just trying to cut corners. Ultimately, consumers end up suffering. If this slow moving downsizing of an industry thru consolidation reduces "seats available" and raises prices, perhaps there's a chance for the airlines to save themselves. But, as Gary Kelly would point out, customer service has something to do with it too.

Gordon Bethune, shortly after he retired as Chairman and CEO of Continental Airlines put it best: "Our problem is that we're a stupid industry run by stupid people."

Perhaps American will solve its problem of who to "merge" with as the "musical chairs" situation continues within its industry. But, things don't look hopeful.