Flying in the Red

Airlines deregulation has allowed more competitive discounters to grow at the expense of high-cost traditional hub-and-spokes airlines. But instead of exiting the market, the unprofitable traditional airlines hang on for dear life.

America's six big traditional air carriers have lost a total of $27 billion since 2000, yet they are all still flying. The discount carriers, on the other hand, are healthy and profitable. They are circling around the weaker traditional carriers like so many vultures waiting to feast on their dead carcasses.

The demise of the traditional carriers and the strength of the discounters are the direct result of airline deregulation started in the 70's. Under regulation, entry and pricing were closely regulated to protect existing airlines. The fat profit from high airfares went mostly to the shareholders, executives, and union employees. At those inflated prices, very few people could afford to fly. With deregulation, the market was open to discounters who could cut fares drastically because of their low labor and infrastructure costs. The high air fares charged by the traditional air carriers just provide a lot of headroom for the discounters to duck under. Instead of competing with the traditional air carriers by setting up expensive hub-and-spoke networks, the discounters just compete on lucrative busy city-pairs by using secondary airports and lowering airfares by up to 80%.

With their high cost structure, the traditional air carriers are sure to lose money when they try to match the discounters' fare. The unexpectedly high fuel cost, the decline of business travel due to the recession, and the 9/11 terrorist attacks all have all contributed to a perfect storm to undermine the financial health of the traditional carriers.

Market efficiency dictates that the weaker carriers should exit the market and its assets be re-deployed by more efficient competitors. But in the real world, death never comes quickly. US Airways and United Airlines, two of the weaker traditional airlines, have been given more breathing room by Chapter 11 bankruptcy protection. This protection keeps the creditors from liquidating the companies' assets while the business is being re-organized. In addition, the bankrupt airlines were allowed to dump their unfunded defined-benefit pension liability ($9.6 billion) to the Pension Benefit Guarantee Corp (PBGC), the company-funded agency that insures old-line defined-benefit pension plans (Fortune 5/16/2005).

Companies that depend on the airlines for their revenues are also eager to keep the airlines afloat. For example, General Electric makes jet engines, offers aircraft finance, aircraft leases, servicing and even pilot training. Over half of its roughly 1350 planes have been leased to American carriers. If the carriers were liquidated, the released planes would depress their second-hand values and leasing rates. GE would also lose the tax write offs on the costs of those planes. GE has sunk more than $8 billion into global airlines, mostly money-losing American airlines, to keep them afloat. It has also allowed weak airlines to defer lease payments to keep more planes in the air (Economist 5/21/2005).

The longer the high-cost carriers are kept afloat with their high fares, the more room there is for the discount carriers to gain strength by expanding their market share through low fares. In the four years since 2000, the discount carriers have expanded their competition from 50% to 80% of the top 1000 city pairs. The discount carriers are now strong enough to encroach on even the previously secure major airports and hubs of the traditional carriers (Fortune 6/1/2005).

In order to be competitive with the cost structure of the lean and mean discount carriers, all the high-cost carriers may have to declare bankruptcy and renegotiate the labor contracts. Even if the reorganization is successful, the remaining traditional carriers will have to shrink back to their defensible market niches. Namely, the secure lucrative international routes to Asia and medium-sized city pairs more suited to the hub-and-spoke networks.

Market discipline is ruthless when it is allowed to work its logic. Any market power that is not based on efficiency is going to be competed away. But the staying power of vested interests should never be underestimated.