93-The End of This Story is Predictable
For a while last year, it looked like the legacy airlines were well on their way to profitability. Business and international demands were strong and the companies had pricing power. The legacy airlines attributed much of this pricing power to their strategy of removing capacity from the marketplace. Let’s look at how that capacity removal is working out over time across the entire industry.
Recently, the Wall Street Journal’s “The Middle Seat” column conducted an analysis of some Morgan Stanley research data. The analysis evaluated changes in capacity in the industry over the recent months. They found that the legacy carriers, such as American and United, were seeing competitors grow faster than they did on overlapping routes. The faster growing competitors included jetBlue Airways and Southwest, the usual suspects. Southwest grew aggressively in Denver, while Frontier Airlines shrank capacity there. JetBlue grew in the Caribbean region as American Airlines pulled capacity from those routes. So as the legacy carriers, the industry’s Standard Leaders, reduce their capacity, the industry’s low-cost carriers, in this case Price Leaders, expand to take their places.
Why would the low-cost carriers be able to expand in a market where the industry’s legacy carriers are losing money? The answer lies in costs.
Recently, Scott McCartney, the author of “The Middle Seat” column in the Wall Street Journal’s travel section, cited another analysis from the consulting firm Oliver Wyman. Some of these conclusions were striking and scary for the legacy airlines:
- In 2003, low-cost carriers carried 26% of domestic passengers. By 2007, they carried 31%. These Price Leader airlines have been able to grow in both up and down markets.
- In the third quarter of 2008, the legacy carriers’ average revenue per seat mile was 12.46 cents, while their costs per seat mile were 14.86 cents. The airlines were losing money on each seat mile.
- The low-cost airlines fared better during the same period. Their revenue per seat mile was 10.92 cents, while their costs were just 10.87 cents. Note that the average unit cost of the legacy airlines during that period was 35% higher than the average unit cost of the low-cost carriers.
- The absolute spread between the legacy and low-cost airlines is increasing. In 2003, the low-cost airlines had a cost advantage over the legacy airlines of 2.7 cents per seat mile. By 2008, the gap was 3.8 cents. In both cases, though, the percentage gap has remained about the same.
- The reason for the growth of the low-cost carriers compared to the high-cost carriers is, in part, due to their different growth rates. (See the Symptom and Implication, “Some competitors are using growth to reduce their costs” on StrategyStreet.com.) The low-cost carriers are expanding. They are able to hire employees at the bottom of the tiered wage scales. On the other hand, legacy airlines are shrinking, so they have a harder time reducing unit costs. Many of their employees are already at the top of their wage scales.
These analyses should serve as important warnings for the legacy carriers. They are no different than U.S. Steel or Bethlehem Steel, Chrysler or General Motors. If these Standard Leader airline companies cannot achieve cost levels equivalent to those of the low-cost competitors, they will inevitably cease to exist in their current form.
Some of the legacy carriers have labor contracts coming up for renegotiation. People costs make up about 60% of the costs of legacy airlines. I hope that the representatives of these employees are reading the same studies that we are. Restrictive work rules, rather than hourly rates of cost, are the usual culprits when low cost competitors are competing with unionized Standard Leaders. These work rules spread jobs around and ease the burden of work on the unionized employee. They also open an umbrella over non-unionized or less-unionized employees in competing companies. This begs the question: What good are these work rules if the employee does not have a secure job…or any job at all?
The legacy airlines have preempted much of the growth of the smaller Price Leader competitors by offering some seats on most flights at very low prices. In other words they have covered the price points low-end competitors offer. This did not take away all the revenues of low-end competitors but it did impact their revenues and profitability. See HERE for more on industry price points.
By early 2020 the US domestic airline industry had become an oligopoly. The top 4 legacy airlines (Delta, American, Southwest and United) controlled nearly 2/3 of the total market and had good control on pricing. Low-cost carriers were having little effect on corporate pricing. The average corporate price from 2015 to 2020 hovered around $500 per ticket. The legacy airlines control the market with their business structure of hub and spoke flights, high service, multiple price points on each flight and significant ownership of airline infrastructure. The low-cost carriers have a different business model, offering point-to-point flights with limited services and usually single aisle small jets from one manufacturer.
For the last few years, it has been difficult for the low-cost carriers to thrive in competition with the legacy airlines. The low-cost carriers offer about 10% of their capacity at very low prices and then gradually raise the price as flight occupancy rises until their prices are comparable to those of the competing legacy airline. Aside from losing some of its price advantage, a low-cost carrier has difficulty entering or expanding in an airport dominated by the legacy carriers because of limited gates and take off slots.
The retrenchment of the airline industry, following the disastrous falloff in demand in 2020, may offer new opportunities for these low-cost carriers to expand because of the high pricing in the industry with capacity constraints.
THE SOURCES FOR STRATEGYSTREET.COM: For over 30 years we observed the evolution of more than 100 industries, many hostile. We put their facts into frameworks applicable to all industries and found patterns. Strategystreet.com describes the inductive results of these thousands of observations and their patterns.