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Airline Mismanagement

The major 'dinosaur' airlines offer many different reasons why their current financial crises are not their own fault.

Often these excuses go hand in hand with pleas for government assistance.

But are any of their excuses valid reasons, or are they all a sham designed to obscure a simpler fundamental failing such as basic mismanagement?

 
 
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The Overcapacity Excuse (and others, too)

If a dinosaur airline executive claims the sun is shining, you better bring an umbrella.

Whether it be due to stupidity or dishonesty, the latest excuse for the dinosaur airlines' financial disaster fails to stand up to a factual examination.

 

 

The dinosaur airlines have a new excuse to explain away their financial failures - the market is suffering from 'overcapacity' - or so they'd have us believe.

This excuse is just that.  A weak excuse and one which fails to hold up when confronted by the facts.

Spare no tears for the dinosaurs.  They're either too stupid to understand - or too dishonest to admit - the real reason for their failures.

 

Let's hear the excuse first

Most of the dinosaurs have been referring to excess capacity in recent months as a major contributing reason for their losses.  Indeed, their chorus of claims has sufficed to fool some of the more gullible journalists and analysts into accepting what they say at face value and repeating their claims as if they are established facts.

Here are three recent examples.

In announcing his airline's filing for Chapter 11 two weeks ago, ATA Chairman, President, CEO and 69% shareholder in the company (wow, what a busy guy; he probably spends much of every day having business meetings with himself, but I wonder how he balances his conflicting duties to the company, to himself, and to the other 31% of shareholders) George Mikelsons said

Excess capacity, extremely high fuel prices, which continue to escalate, and declining fares have necessitated that all airlines, including ATA, re-examine their business

At the same time America West's Chairman and CEO, Doug Parker, said

We are disappointed to see our string of profitable quarters come to an end. These results are driven by an extraordinary increase in fuel prices and excess industry domestic capacity

United's CEO, Glen Tilton, also used the excuse last week to explain away his airline's dismal third quarter loss, by saying

Excess capacity has led to the lowest fares in more than a decade

What is Excess Capacity?

Excess capacity simply refers to a situation where there is too much of something compared to the demand for it.

For example, if an electrical supply utility can supply 150 MW of electricity, and its customers only need 125 MW, then it has excess capacity (of 25 MW).

In the case of an airline, excess capacity occurs when there are more seats available on flights between two cities than there is passenger demand.  For example, perhaps there are 1500 seats a day on flights between Des Moines and Omaha, but perhaps, on average, only 1200 people a day fly between these cities.

On the face of it, with the example above, it might seem that there are 300 seats a day of excess capacity on this route.

But the situation is not that simple.  There are (at least) two other factors to consider.

Elasticity of Demand

The first factor is what economists and marketers refer to as elasticity of demand.  If the average price of a ticket for a flight between the two cities in the example above is $150, then we see a matching demand for 1200 seats.  But if the price drops to $100, perhaps the demand might then increase to 1500 seats, or even 1800 seats.  So the actual underlying demand, against which capacity must be measured, is not a constant.  It varies tremendously based on price.

It is not uncommon to see the amount of travel more than double when a discount airline starts offering low fares on a route.  Although dinosaur airlines have long pretended that demand - particularly for their most expensive fares - is close to constant (ie inelastic) the demonstrated reality contradicts this belief/hope.

A low cost carrier might be delighted to sell tickets at $100 each, whereas a high cost dinosaur might find that this price is below the average price they need to exceed to cover their costs.

Operational Limits

It is undesirable and almost impossible for an airline to fly its routes with 100% full flights.  This would be possible if people bought airline tickets one by one; flight by flight.  But people don't do this.  The airlines themselves force their passengers to buy tickets itinerary by itinerary, in complete roundtrip sequences.

A typical roundtrip often has four or more flights in it.  If you are flying from home, through a hub, to your destination, then from your destination, back through the hub, and home, there are four flights.  More complicated itineraries may have six or eight or more flights in them.

The interesting challenge becomes that if any one of the flights you're booking is full, your entire itinerary collapses, because (and again due to the airline rules) you can't mix and match flights on different airlines to build your complete itinerary.  If you can get three flights on Delta, but the fourth flight is only available on United, you're either going to change all your flights to fit a different itinerary on DL or UA or perhaps a totally different airline.  What this means is that one single full flight has 'cost' the airline in question sales of seats on three other flights.

Nearly full flights make fares more expensive

This operational issue gets even more subtle.  Because airline pricing varies roughly based on how full flights are, a nearly full flight on one sector of a four flight itinerary, while still having available seats, might force up the total ticket price by an extra $100 or $200.  Remember the elasticity of demand?  That means that many people will either choose different flights, or a different airline, or just give up on their hoped for travel entirely and wait for a later time.  In this case, a nearly full flight on one sector cost the airline the loss of all four sectors.

As a quick rule of thumb, once an airline starts averaging higher than 70% loads, it is starting to lose business.  It is getting in to a region of vanishing returns.  This is the reason why most airlines historically try and budget for a break even load factor somewhere in the 60%-70% range, because they know it gets very hard to achieve loads much above 70%.

Difficult is not the same as impossible, and some dinosaurs have been enjoying load factors in the upper 70s during the last year or so.  Unfortunately, their cost models have moved so far from where they should be (for a while United had to average above a 100% load factor just to break even - an impossible circumstance unless you had people standing in the aisles on their flights!) and so loads which should normally have caused the airlines to be massively profitable have instead barely staunched the flood of red ink pouring onto their balance sheets.

Excess Capacity Summarised

To summarize the 750 (!) words above into 100 words below :

  • Excess capacity is not the percentage gap between how full an airline's flights are and 100%.  Maximum capacity is a vague inexact number, but less than 100%.  Any time a typical hub and spoke airline is flying with loads averaging much above 70%, they are beating the odds and their loads are operationally almost full.

  • Market demand is not a constant nor is it an exact number.  The market demand for seats increases or diminishes based on price and schedule convenience.  Therefore, neither is any measure of capacity a fixed or exact number either.

Excess Capacity Rebuttal

The simple fact is that most airlines are enjoying passenger load factors way above typical historical percentages, and very close to the maximum levels that can operationally be supported.  When was the last time you flew on a three quarters empty plane?

Not only are planes being flown with more passengers than almost ever before, passenger numbers in total are also increasing.  The LA Times says 2004 will be the US travel industry's best year since 9/11, with domestic travel spending totaling $592.6 billion, a 6.9% increase on last year.

The International Air Transport Association is similarly optimistic. International air passenger traffic is up 17.7% in the first nine months of this year compared to last year, and cargo traffic is up 14.1%. IATA says that North American traffic is up 16.6%.

And as for actual planes and flights, flight numbers are only now returning back to pre 9/11 levels.

So, by all measures - more passengers than ever before, no more flights than back when the airlines were making huge profits with the same or fewer flights and the same or fewer passengers, and a greater percentage of seats sold on every flight - there is no tangible confirmation of what the airline industry is claiming.

Let's look at some specifics :

1.

American Airlines - the world's largest carrier, and so a fair measure of capacity issues - reported its October traffic on Tuesday 2 November.

For October 2004 AA reported the highest ever October load factor in the company's history - 74.9%. And, as further proof of the nonsense beneath the excess capacity excuse, the company's second highest October factor was in October last year (70.2%). There was not excess capacity a year ago, and there doubly is not excess capacity today.

Interestingly, not only did passenger numbers grow, but at the same time, AA reduced its domestic capacity by 2.6%.

In total, AA boarded 7.5 million passengers in October.
 

2.

Last week America West announced their October traffic data. Revenue passenger miles were at an all time record high, and 11.7% up on last year. And their load factor was also up, both for the month (a new record of 79.4%) and for year to date.

Executive VP Scott Kirby had obviously not been clued in to the new excuse, because he said 'We are pleased to report our fourth consecutive month of record load factors'.

So how do four months of record load factors (ie fewer than normal empty seats) equate to excess capacity?
 

3.

Delta's October load factor increased to 74.1% in October, up from 72.9% the year before, with an 8.3% growth in system traffic and a smaller 6.5% increase in capacity.
 

4.

Even floundering US Airways, laboring under the negative of its second Chapter 11, reported that its October load factor of 75.6% was the highest October load in its entire corporate history.
 

5.

If there is so much overcapacity in the industry, how to explain ultra-successful Southwest Airlines' plan to add 34 new planes to its fleet in 2005?

Plainly Southwest isn't worried about overcapacity - quite the opposite - it sees opportunities for further growth and expansion!

Even a dinosaur such as Northwest is adding capacity next year.  It is recalling 200 furloughed pilots in the first half of 2005 due to a forecasted increase in flight activity, and has also added ten new Airbus A330s to its fleet in 2004, with plans to add seven more Airbus planes in 2005.

Surely NW wouldn't be doing this if it believed the marketplace already had too much capacity?
 

6.

Southwest's growth is significant because Southwest is a mature and profitable airline, and so its growth broadly reflects a credible opinion of growing market opportunities by an established airline.  And NW's growth shows that dinosaurs too believe they need to add more capacity.

In addition, startup carriers are also continuing to add more planes.

In total, for the three years through 2008, low cost airlines have either ordered or placed on option 550 new planes.  That is about the same number of planes as United operates in total.

Whether this shows there is a current shortage of capacity, or whether it indicates that there might be an overcapacity - but in the future, not in the recent past - is a matter for some conjecture.

 

Updated statistics for entire 2004

The Bureau of Transportation Statistics has now released (Mar 05) data for the entire 2004 year.  Total revenue passenger miles increased 9.9% in 2004, while available seat miles increased by only 7.3%, meaning that average load factors increased 1.8%.  Too much capacity?  Nope.  Flights are more full now than a year and more ago.

So What is the Problem?

Two things - quite possibly related - happened at the end of the 20th century.

Businesses and individuals realized that it made no sense to pay millions and sometimes billions of dollars for dot com lunacies.  Dot com ventures with no hope of ever achieving a profit, and no real strategy other than to hyper inflate an idea and then sell it on via IPO or buy-out found their cash sources dry up, and the ridiculous stock prices on chronic loss making companies collapsed down closer to the zero level where they should always have been.

Common sense proved contagious.  Businesses and individuals also realized it made no sense to pay $1000+  to fly somewhere at short notice, when the alternative was to pay vastly less on an advance purchase ticket with a discount airline, or just not to fly at all.  This common sense flowed through to prospects and customers, who also stopped expecting people to drop everything and fly instantly to meet them, no matter what the cost.

The Big Thing that is/was Not the Problem

9/11 had little or nothing to do with either of these developments.  The dot com bubble was already bursting in 2000, and airlines were painfully transitioning from being massive profit earners to finding themselves once more in familiar financial problems before 9/11/2001. 

How the Airlines Responded to the Problem

As recently as 2002, dinosaur airline executives could still be found proudly proclaiming that their customers would happily pay as much as a 30% premium to fly on their airline.  Two realities were overlooked in these bold statements - often times, the extra cost was much more than 30%; and, no matter what the cost differential, many customers were demonstrably no longer willing to pay a premium at all.

At the same time, the dinosaur airlines weakened their so-called premium services.  They cut every corner and cost they could to cheapen their first class, as well as of course accelerating the decline of their regular coach class product, making the difference between their service and those of competing new airlines less and less real.

Meanwhile, new startups like JetBlue were actually providing superior service and comfort, and at measurably lower cost, than the dinosaurs.  Many passengers who had formerly been key dinosaur airline frequent business travelers abandoned the dinosaurs and switched to the lower cost and similar or often better service on new airlines.

The dinosaurs found that their market had changed two ways while they were not paying attention.  First, the small discount airlines had become big - and in some cases too big to painlessly squash.  And, secondly, the dinosaurs themselves had been so weakened by the drop in revenues that they could no longer afford to lose the hundreds of millions of dollars a fare war would cost them if they did choose to try and force the new carriers out of business.

The Emperor's New Clothes - Air Fares Collapse

Air fares have always been a carefully maintained illusion.  It doesn't directly cost much more than one tenth of any fare (even the lowest) to fly a person on their itinerary.

As long as the airlines all said with one voice 'the cost for this ticket is $1000' and as long as no passengers chose to question that statement, the illusion was maintained and protected - just like the fable of the emperor's new clothes.

But when on the one hand you have new upstart airlines saying things like 'no-one should ever have to pay more than $299 for any fare, ever' (Southwest Airlines said this when capping all their fares at a maximum of $299 one way in August 2002), and when on the other hand, you have passengers saying 'it doesn't make sense to pay $1000 and I neither need to nor want to' then the illusion collapses.

And that is exactly what happened.

  • People are no longer willing to pay overly inflated ridiculous fares for basic bare bones utilitarian travel on dinosaur airlines.

  • The new discount airlines have reached a critical mass in the marketplace where their fares are now influential in setting the public's perception about what all fares should be.

  • The major airlines have had to drop and drop and drop still further their airfares to the point where their impossibly inefficient structures can no longer be supported by the reduced income being generated.

The dinosaur airlines are saying their low prices are due to over-capacity.  Wrong.  Their low prices are due to the public not being willing to pay ridiculously high prices any more.

Neither Labor nor Fuel is the Problem, Either

Let's look a bit further.  The other two common excuses recently offered by dinosaurs to explain their losses are high fuel costs and high labor costs.  Are these any more real?

Some interesting insight was exposed in the second US Airways bankruptcy filing in mid September this year.  In their filing, they disclosed that their overall operating cost per available seat mile, excluding fuel, in the first half of 2004 was 10c a mile.

Compare this to a former dinosaur that transformed itself - America West. They paid 7.3c a mile. JetBlue pays 6.4c and Southwest pays 5.7c.

What does this tell us?  It clearly shows that even after ignoring fuel costs, a dinosaur airline such as US Airways (admittedly one of the worst) has way higher costs than more successful airlines.

Now, let's continue the exercise and take out the labor costs.  This shows US Airways had a cost, excluding fuel and excluding labor of 5.8c a mile.  America West's cost is 4.7c, JetBlue is 3.8c and Southwest is 2.7c.

Two conclusions :

  • First, if everyone at US Airways worked for free, the airline's operating costs are still higher than what Southwest pays, including Southwest paying full labor costs!!!

  • Second, if we exclude labor and fuel from all four airlines, and look at the remaining costs - which in a grossly oversimplified manner can be considered to partially represent how well the airline is managed, US' costs are 23% higher than America West, 53% higher than JetBlue, and more than double the costs at Southwest, its new head to head competitor.

What does that leave as possible explanation for this amazing discrepancy?  There are a number of factors, but they all fall under one umbrella statement - bad management.

Do you now see why the unions are reluctant to give still more money back to their employers?  No amount of giving back is going to solve US Airways' problems.  Labor costs are admittedly high, but the other costs are higher, both in absolute dollar terms and in percentage terms, than those at Southwest.

Summary

As long as management blames over capacity, high fuel and high labor costs, they are ignoring a massive remaining factor and one which surely they have the most direct control over.  Themselves.

 

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Originally published 12 Nov 2004, last update 19 Dec 2013

You may freely reproduce or distribute this article for noncommercial purposes as long as you give credit to me as original writer.

 
 
 
 

 


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