The Boyd Group, Inc.
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Since 1984

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The Boyd Group Advantage

Airline Industry Bankruptcies
Facts V Myths

Cutting Through The Lore

With the emergence of both Delta and Northwest from bankruptcy, a major chapter in airline history has closed - namely, chapter 11.

Some of the current lore is that this is just a respite until airlines make the same mistakes again, and cycle back into the bankruptcy abyss. All the chanting about the immediate and impending rush to mergers and consolidations - which seemed to be the unchallenged media dogma two years ago - has gone away. It's been replaced by a new dogma - "don't worry, when airlines screw up again, they'll merge."

It's the kind of nonsense that has its factual foundation only in the number of times it gets repeated.

It's understandable how many folks get the wrong idea when they hear the term "airline bankruptcy" - especially in light of the number we've seen over the past five years. But some of the immediate conclusions coming from various media sectors have done nothing to really inform the public about the real nature of this situation, particularly the Delta and Northwest filings.

Somehow, several "unquestioned truths" were promulgated in the wake of the DL and NW bankruptcy filings, many of which had no basis in fact, only in accepted lore. The accepted "facts" often are nothing more than "everybody knows" opinion. Yet they seem to be stated over and over, with nobody daring to question them, lest the questioner be burned at the stake as a heretic.

Let's note a couple of them:

Southwest's Profitable. That Means Other Airlines Should Be Just Like Them

Fact: The current Southwest model is really not particularly profitable, at least not if they had to pay "retail" for fuel at over $2+ per gallon. It's a tribute to its management that it made a bet - i.e., hedges - that fuel would go up, and for a period of time has enjoyed fuel at well below market rates. But the fundamental Southwest model, on an all-up cost basis is not immune to losing money. And it's becoming less competitive compared to other LCCs, too. (More below on this)

Chapter 11 Just Kept Sick Carriers Alive

No, it bought time for carriers such as Delta and Northwest. Neither had a sick route system, although Delta still needs to address its over-reliance on 50-seat RJs. As noted below, Northwest has a route system that is geared for the future.

In fact, it is precisely airline systems such as Delta and Northwest that will inherit the future. The LCC model is great, but it has limited in regard to where it can access new and growing revenue streams. There's only so many people who can be convinced to chuck their plans for a new refrigerator and use the dough to take a low-fare LCC airline to Florida instead. But the current and future revenue streams between the fast-growing US centers of Asian investment on one hand - most of which are too small to support LCCs - and points in Asia and China on the other, are huge.

Chapter 11 allowed Northwest and Delta to adjust to what were immediate crises in fuel costs. That doesn't change the fact that their diverse fleets have the advantage of accessing diverse revenue flows. The LCC model is more limited in this regard. (Note that it's typically university professors and other dwellers in the academic mushroom gardens who spout about the need for "single fleet types" and decry the "outdated" hub-and-spoke systems. It would be nice it they checked into the real world occasionally.

The fact is, too, that all mega-carrier systems - including the ones that didn't file bankruptcy - went through the same fundamental changes, albeit via different methods.

If We Let'em Die, LCCs Will Take Their Place

Another oft-repeated mantra from some journalists whose idea of research is reading yesterday's newspaper, and particularly from university professors who are intellectual lightweights. Ask the folks in places like ROA, LYH, and BPT about the flood of LCCs that rushed in to replace service lost when a mega-carrier pulled down a hub.

The LCC model, not to mention investment capital, chases big markets, not small and medium size ones. Southwest and AirTran have made that quite clear - they're not interested in expanding at small or medium markets any longer. Flint is a great place for AirTran, but economics point to future expansion in Southeast Michigan being at Detroit.

The same windbag politicians who call for letting airlines fail will be the very ones who will rant and rave when East Upchuck loses all scheduled air service, and Southwest declines the unique opportunity to operate there.

LCC's Are The Future

Fact: It's here where the next shake-out is coming.

First, they are not by and large really profitable, and the picture looks worse going forward. Second, there is an ultimately finite number of places where 100-seat to 150-seat airliners can be placed to make money with the LCC model. Third, take a look at the airplanes coming on line just at AirTran, jetBlue, and Southwest. Hundreds and hundreds. From a marketing point of view, they're already beginning to bump into each other. And for the folks ascribing to the "over-capacity" theory, these new aircraft offer no hope for getting a good night's rest.

In 2005 - 2007, there have been some very disturbing events that have proven that the LCC model isn't the wave of the air transportation future. Southwest's entries at PHL, DEN, and IAD apparently didn't get off to starts historically typical for that carrier - but such expansion is needed to place the airplanes that WN has coming on line. jetBlue is not the sure-fire money maker Wall Street touted. Other LCCs are not wildly profitable, either.

The reason - which parrot analysts and me-too consultants who work off their kitchen tables will be "forecasting" after it's obvious - is that the future for airlines is not only in the area of controlling costs, but controlling new emerging revenue streams. Places like Shreveport, Columbus, MS, Greenville-Spartanburg, Shanghai, Taipei, and Beijing. It's comprehensive network carriers like Delta and Northwest that access these streams better than can LCCs.

The Reasons For C-11 Filings Are Essentially All The Same

Again, wrong. The causes for Continental to file in the 1990s, for TWA to file more than once, and United's filing, are very different than the reasons for DL and NW going the C-11 route. Again, look at the specifics of each incident, and there are few common threads beyond them all being airlines.

Letting A Couple Carriers Go Down Will Reduce "Over-Capacity"

Fact: we've already lost essentially the equivalent of one airline on the East Coast. US Airways dumped over 100 airplanes between 2002 and 2005. And, indeed, we have seen capacity reductions. In places like Roanoke. But where the huge passenger numbers are, airlines are still fighting for share.

It's lunacy to believe that in these "over-served" markets the failure of say, a United, would permanently reduce capacity, allowing fares to go up. Just for starters, again, take a gander at the fleet plans for jetBlue, Southwest, Spirit, and AirTran. It's going to be a capacity free-for-all, and a major airline failure will only zap mid-size communities. Ask the ones who got the short end of the US PIT pull-down, or the DL DFW pull-down.

The Regionals Are Profitable, So Let Them Take Over

This was a statement often heard early on, and even now sometimes repeated. It's one that can only come from somebody who literally is on another planet from airline industry reality. Or a university professor.

Fact: "regional airlines" are vendors, not airlines. They get their revenues based on selling services to mega carriers, not from passenger tickets. For example, Delta pays Comair on a cost-plus basis to provide it with feed traffic. Without that cost-plus deal, Comair would instantly be transformed into Independence Air, Phase II.

Consolidation Will Fix Everything

Sounds good. Gee! Look at the great synergies that would come from a combination of say, Northwest and Delta!

Unfortunately, there are some very expensive things that would have to come about to merge the two airlines and get operating synergies. Like, fleet commonalties. Taking a Boeing-operator and putting it together with a predominantly Airbus operator would require enormous amounts of expensive pilot training, maintenance training and the like. Just bridging maintenance programs between two fleets of 757s can be hugely expensive, even assuming they have the same engines, systems, and cockpit configurations. The bid-and-bump routine for pilots and other staff (which would be necessary if there were to be a combination of disparate fleets) would entail possibly hundreds of millions in costs to train and shift crews around.

Sorry, it looks good, but the results would not be as grandly positive as some seem to think. The continuing saga of America West trying to absorb US Airways (including the name) validates this point.

Other Common Myths - And Some Hard Facts

Myth: The Legacies Are Dead, The LCCs Are The Future: Lots of the alleged "experts" up until recently were telling the world that legacy carriers simply cannot compete anymore with the likes of Southwest and jetBlue, which, they point out, were consistently profitable.

Where are these "experts" today?

Fact: Today, anybody who makes such a statement doesn't know any more about the fundamentals of today's airline industry beyond what they just read someplace else.

• Note: Let's look at an example in 2005 - in the second quarter of that year  American and Continental reported profits, and they were essentially paying "retail" for their jet fuel.  In the same quarter, if Southwest had been paying retail for their fuel, they'd have reported a loss. True, they hedged fuel, but that was a bet they made long ago - a bet that, fortunately, they won big-time. But it does not change the fact that on an apples-to-apples basis, AA's cost restructuring gave it an all-up quarterly profit, and on an all-up basis, Southwest's system didn't making money.

It's great that whoever lost the hedge bet is bearing much of the cost of WN's fuel, but without that, the basic model Southwest operates today isn't necessarily a slam-dunk money-making one with high fuel prices.

Myth: NW & DL Went C-11 Because They're "Legacy" Carriers. Wrong. It's not the "system." It's not the "legacy" problems from the 1970s that pundits try to point out through the haze of over 25 years since deregulation.

Their problems were that they got caught in the headlights by fuel prices that went up a lot faster than they could adjust to quickly. True, both were in the process of getting their labor costs down - something that American, Continental, and United had already done. When jet-A went to over $2 a gallon, the immediate need was to conserve cash while labor and other cost reductions were achieved.

Lots of "experts" go into diatribes about how these legacy carriers have unsupportable cost structures and route systems, dating from the days of regulation in the 1970s. Sounds great, but it is more nonsense. It's missed by these grand prognosticators - most of whom have never worked within the airline industry - that if oil had stayed right where it was at the beginning of 2004, as most of us expected, these filings would not have taken place.

The fact is that many of these alleged dead-man-walking legacies have addressed most of those structural problems. The fact is that most of these legacies - Northwest being at the top of the list - have revenue systems that will make them in the long run (and even in the short-run) the carriers to bet on.

But when fuel cost doubles in a period of only a few months, and a hurricane flummoxes both the price and the distribution of the stuff, the cash positions of airlines can get zapped quick. It's just that NW and DL had not gotten their labor costs down fast enough. In the case of DL, you could make an argument that the pre-Grinstein regime sat on its hands.

But what you cannot argue is that the basics of these two airlines - particularly Northwest - are fundamentally flawed. They are not.

Again, if fuel had stayed where it was projected to in early 2004, we would not be now bombarded by the dogmatic idiocy being spit out by a whole circus of sudden experts on the airline industry.

Fact: It's Management Decisions. Not A Fundamentally Faulty Model. It is arguable - and true - that Delta, an essentially non-union  company, waited too long to get things in order, and was caught right in the cost cross-hairs when fuel went for the moon. Northwest had the apparent strategy to get other costs down first and go to labor later, if necessary. (Continental at one early point had the same approach.) When fuel went up, NW, too, got caught, even though they already had de facto concessions from two of their four main unions. (Pilots, and, by virtue of bringing in replacements, their mechanics.)

But these are hindsight calls by the usual suspects of the school of veneer reporting. If oil had stayed in the mid-$30s, as expected, they'd all be singing a very different tune.

There's A Revenue Side, Too. Then let's talk revenue streams. To hear the "let'em die" analysts tell it, Northwest and Delta simply don't have route systems that work.

Wrong.

Northwest in particular has one of the strongest route systems and revenue flows in the industry. The mantra-chanters have no knowledge about things like where current and future revenue growth will be. Hint: the future is not in trying to get more families to take trips from the Northeast to Florida, which is a mainstay of LCC operations. It's not relying on the potential for stimulating new demand with low fares between Boston and Lincoln. It's not just cherry-picking heavy markets like transcons.

Sorry to disappoint them, but as we'll note below, the new, growth revenue flows are between places like Montgomery and Seoul. Tokyo and Grand Rapids. Charleston to Osaka. Shreveport to Lansing. Greenville-Spartanburg to Milwaukee.

These, and dozens of other destination pairs, are where the future is. And where the LCC model mostly can't go, because they don't have diverse fleets. Note that Frontier is moving in that direction, using Q-400 turboprops and, skipping away from the RJ stage, going into 76-seat E-170s. Other LCCs, including Southwest, will also need to consider diversifying their fleets. (Regardless of the shrieks from the analysts in the financial Peanut Gallery.)

Myth: The Hub-And-Spoke System Is Inefficient. There are the usual parrots that until recently were spouting the "fact" that "point to point" airlines were making money, therefore the legacy carriers' hub systems are obsolete. Wonder what they're saying now?

Depending on the source, the story was sometimes accessorized by babble about fleet utilization, assuming that just flying an airplane makes money. (Which was a wonderous strategy tried by the messiahs that ran the original Braniff in its last days. Great utilization, with nobody on the planes.) In another twist, they sometimes point to the number of airplane types legacy systems operate, and note that Southwest only has "one" type of aircraft in its system.

Fact: This is another badge of ignorance from people who get their airline knowledge from the cocktail party circuit.

• Note: The more successful new low fare carriers are indeed primarily hub-and-spoke. Guess Frontier didn't attend the same cocktail parties. Nor did AirTran. Even Southwest, contrary to the cognoscenti, operates substantial connecting and through-flight operations. We estimate that somewhere around half of the passengers on WN flights at Phoenix, Nashville, Houston, and Las Vegas are either connecting or going through the station. It is not a model that is nonstop, point-to-point as commonly believed.

• Note: Southwest doesn't operate just one type of aircraft. There are fundamental differences in their fleets of 737-300/500s and their fleet of 737-700s. Until the end of 2004, they actually operated a third type, the 737-200. It is a fact, however, that Southwest does focus on fleets of airliners between 124 and 140 seats, which is the general template for the LCCs that some of these "analysts" predict can and will replace Northwest and Delta, both of which have sinned greatly, according to some "experts," and must go out of business.

• Note: Airplanes are operated to generate revenue. Operators of "one type" are indeed rare, but for a specific type of route system, it can work well. What these "one airplane type is better" people miss is that a single type - or more correctly, a fleet which has a narrow capacity range - does represent market and operational limitations.

That's another indication that the folks who criticize a Continental or an American for having multiple aircraft types know nothing about the airline industry. They hear somebody say something about higher efficiencies in maintenance, pilot training, and parts inventory in having a much simplified fleet, and assume that if "fewer" is better, well then, just one type must be the ultimate. Noting that this is another accepted mantra they read all the time, it's safe for them to repeat it as gospel. It's also el toro doo-doo.

Fact: A Varied Fleet Can Generate Significant Revenues. Again, lots of people are forgetting that there is more than a cost side to the equation. There's also a revenue side.

Rather than go into trying to explain the obvious about revenue generation, let's point out Shreveport.

It's a major auto center that provides a lot of traffic to American's hub at DFW and to Northwest's hub at DTW. Lots of revenue that goes on to other points on existing AA and NW flights - including ones where they must compete with an LCC. To capture this revenue, they use 50-seat jets, and they pay an operator for the lift. These communities are too small to support the high-frequency LCC model operating 100 to 150 seat jets.

But AA can access these revenue streams. True, they do it with a small jet provider, but it's system revenue that Southwest can't access. The same for the strong yield flows that AA and CO are gaining from places like Saltillo, Chihuahua, and other points in Northern Mexico.

AA and Northwest also operate their own 100 to 150 seat jets. Like the RJs, these provide lift into their hubs from points such as New York, Tampa, and Los Angeles. Guess what these airplanes feed? Widebodies carrying passengers going to and from places like Shanghai, Tokyo, and Hong Kong.

Point: The LCC model is fine. But it cannot access much of the emerging revenue streams, particularly those where the future growth is. Montgomery, Shreveport, Charleston, and other gateways to regions that are targets for huge foreign investment. Southwest, AirTran, Spirit, Frontier, et al, are great airlines. But their chosen model focuses on specific consumer targets. Legacy carrier systems have much stronger and more fundamental route systems.

The Southwest model can't support service at SHV, or at MGM, or at BGR, or at TRI, or at TPE, or at SHA, or at BJS - places where huge growth in revenue will be generated in the future.

Going Forward

As of 2007, the US airline industry is in the strongest position it has ever been in, at least within the comprehensive network carrier category. Little new capacity coming on line, the ability to cut capacity relatively cheaply in the event of an downturn, and the combination of costs and revenue streams that point to very robust performance.

Clouds: LCCs, with over capacity and more coming - such as Virgin America and third-tier experiments like Skybus. More clouds: the small lift provider segment, a.k.a, regional airlines. The 50-seat shake-out is just starting.

(c) 2007, The Boyd Group, Inc.

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