52-Price Leaders Against Standard Leaders in Troubled Times

Overcapacity and Hostility can last a very long time. Here is an industry that was Hostile for more than two generations. Leaders came and went. Innovations brought helpful changes or faded away to irrelevance. Managements tried many approaches to reduce competition and improve prices and returns. Finally, these many market changes had their desired effect. The blog is a short reprise of the story.

Posted 10/9/08

For once, the airline industry Standard Leaders, the legacy airlines seem to be improving their positions compared to the Price Leaders, the discount airlines. In our system of analysis, a Standard Leader is a competitor, or one of several competitors, or products that set the standard for performance and price in an industry. A Price Leader is a competitor, or product, that offers below industry-standard performance for a very low price. So far, none of the legacy airlines has gone back into bankruptcy. On the other hand, a number of Price Leader discount airlines have failed, including Frontier Airlines and Skybus Airlines. What has happened? Three things.

First, the bankruptcies of the legacy carriers helped those companies drastically reduce their high costs. Some analysts have noted that the difference in operating margins of the Price Leader discounters and the Standard Leader legacy carriers is only 2% today, down from 7% five years ago. A 5% cost advantage is not much in the way of a Price Leader’s low cost structure, which it needs in order to offer its lower prices and attract its customer segment.

In order to succeed over a long period of time, discounters always must offer a significant discount on a product that is “acceptable” in the market, if not as good as the Standard Leader product. In order to offer the substantial discounts, Price Leader competitors must have a lower cost structure. In turn, this lower cost structure is largely the result of the discounter offering fewer benefits than the Standard Leader product. We have done extensive analyses on these Price Leader companies. Our research suggests there are two separate types of Price Leaders who follow somewhat different business models (see the Perspective, “Turmoil Below: Confronting Low-End Competition” in StrategyStreet.com).

Second, the legacy carriers have begun selectively competing with the discount carriers on price. In many markets, the legacy carriers offer prices that are within reach of those of the discount airlines. (See the Symptoms and Implications, “As large competitors match low prices other competitors face difficulties” on StrategyStreet.com.) In most markets, a successful Price Leader needs to offer a discount of 25% or more on its product in order to grow significantly at the expense of a Standard Leader.

Third, the discount airlines’ natural market is shrinking during these troubled times. In fact, the airline industry in general is shrinking, as measured by revenue passenger miles flown. However, the discount airlines carry a higher proportion of price-sensitive leisure travelers. This market segment is off a good deal more than is the business traveler segment, which makes up a higher proportion of the legacy airlines’ customers.

Even though today’s airline industry is seeing the discounter product become more like the legacy airlines’ product, and vice versa, these discounters still need to offer a notably lower price than do the legacy carriers. That seems to be more difficult these days.

***

Update 2022:

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 individual flight 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.

Throughout the teens and early 20s the US domestic airline industry became experts at understanding the various benefits they offered and how to price them. They introduced pricing variations around legroom, seat pitch, flight cancellation and change policies, preferred seating and boarding, checked baggage and meals. The legacy air carriers have used these pricing toggles to take away virtually any opportunity for a discount carrier to succeed against them over any long period of time. The erstwhile Price Leaders do not have enough benefits to cut in order to save costs and create a compelling price difference with the low Standard Leader legacy airlines’ pricing packages.  However, with Capacity constrained and prices at very high levels, the legacy airlines will see a resurgence in low-cost carriers.

Standard Leaders eventually win in all tough markets. See how HERE in this short video.

***

Update 12/25

The US domestic airline industry is out of Overcapacity and Hostility in 2025. Its best competitors enjoy product mix and cost advantages that produce high returns on equity.

The leading legacy carriers used mergers and acquisitions to consolidate the industry, also in the hope of raising industry prices. While the mergers helped lead to the oligarchic structure of today’s domestic industry, they did not raise current prices nor did they stunt the growth of the Low Cost Carriers. The legacies frittered away much of their acquired market shares. Delta merged with Northwest Airlines but still lost about two percentage points in market share. American Airlines acquired US Airways and then lost about 5 percentage points of the combined airlines’ share. United merged with Continental and lost nine percentage points of the original airlines’ market shares. Both American Airlines, and United struggled to consolidate their acquired airlines. In the meantime, SWA gained five share points in this period, while the three legacy airlines lost a total of the combined companies’ 16 share points.

In 2008, Low Cost Carriers enjoyed a 3.8 cents per seat mile cost advantage over the legacy carriers. They used this cost advantage to reduce prices and invest in operational efficiencies. Most of that cost advantage has disappeared as the Low Cost Carriers faced ever increasing infrastructure costs and the challenge of offering attractive benefits to business customers.

Total cost levels reflected in comparative returns on equity indicate that the legacy carriers in the industry now have good control of pricing. While the four major carriers have gained a great deal of pricing power, they are not all equally profitable. See HERE to portray and interpret differences in margins and costs among competitors. Both Delta and United Airlines enjoy mid-20s returns on equity. American, even though it has gained share, has low and highly variable returns on equity. In a clear indication that the Low Cost Carrier business model has become problematic, Southwest has struggled with low returns over the last three years, again despite gaining share.

Southwest has begun to move away from part of that Low Cost Carrier business model by instituting its own fee structure for services like checked bags and seat assignments. Every day they look more like the three legacy airlines who have benefited from these fees and their premium priced international route structures (Performance Leader products).

***