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  • Disruption – Part Four – The US Airline Industry

    Posted by Carl from Chicago on March 6th, 2016 (All posts by )

    I have been considering “disruption”, including what is hype and what is real. Here is one on the cab industry where it occurred, in the electric and gas utility industry which has proven resilient in its current business model, and retail which is in the process of being disrupted.

    My theory under these posts is that increasing supply (broadly defined) has been the key to whether or not “disruption” is truly real or not occurring. I don’t know if it will play out that way or not in the end but this is a starting point.

    I have been interested in the airline industry for decades… in high school for my statistics class I built a model which correlated the profits of United Airlines with the price of oil. As an auditor and consultant I spent hours every week on a plane crossing the country serving utilities. And ever since I have traveled at least ten times a year for business or pleasure. So perhaps I would not consider myself an expert on the airline industry but certainly an interested observer.

    The airline industry famously de-regulated in 1978. From 1978 to 2010 the airline industry added myriad new entrants and saw them fail along with much of the old guard. Wikipedia summarized this era here. In recent years, through bankruptcy and mergers, the US airline industry consolidated into four major carriers – American, United, Delta and Southwest. These four carriers control the vast majority of gates at major cities and effectively operate as an oligopoly. Now these four carriers are in rude health, as you can see in the stock chart below. Their stock prices have increased between 135% to 355% over the last 5 years. As an investor I bought Southwest after 9/11 and held on to it for years as the price languished; unfortunately I exited the stock before they became today’s oligopoly.

    Another contributor to these gains is the collapse in oil prices. During the “peak oil” era, the airlines profits were strangled by the high cost of fuel – today they benefit immensely from today’s commodity price crash. This article describes how lower fuel costs saved them $4.3B in the third quarter 2015 alone and these lower costs have generally not come through to end users as price decreases – the airlines have banked the money or used them for dividends and capital improvements.

    A major potentially disruptive force for the US airline industry are the new foreign carriers out of the middle east. In this blog post I describe how the airlines are using every trick in the book including appealing to nationalist sentiment to keep these carriers, which offer a much improved flight experience with new jets, out of the USA, in order to retain their cozy oligopoly.

    This photo, which I took from a recent flight, is a complete anomaly – the plane was only about 1/3 full. When I used to fly frequently in the 1990s this was a common sight. In recent years, however, I am used to completely full fights where many can’t even fit their bags in the overhead storage bins and passengers on “standby” are left behind in the jetway.

    Airlines use technology and pricing to fill their available seats far more effectively. Their analytics let them plan flights more effectively in the first place and then they are able to use “variable pricing” to fill many more of the seats. Finally, the absence of upstart competitors and the fact that they control most of the gates in the largest and most popular airports allows them to force customers to take their flights in the first place.

    Disruption, as defined in the modern, immediate context, is not happening to the airline industry. Here’s why:
    1. Barring new entrants – Foreign carriers such as Emirates Airline, Etihad Airways and Qatar Airways have mostly been barred from offering flights within the USA. These airlines would provide fierce competition because of their newer fleets and higher levels of amenities
    2. Lock up of infrastructure – by locking up gates in the major US airports, new entrants have a much more difficult route in becoming anything more than a niche player in the market
    3. Lack of price wars – as oligopolistic competitors, the airlines certainly do compete on prices but are not launching the desperate fare wars that were common in the past. Instead, the airlines are using the proceeds to shore up their balance sheets and return cash to shareholders

    The airlines also have benefitted from lower oil prices but these benefits would accrue to all industry participants, including new entrants. Likewise, the airlines benefit from new technology that enables them to efficiently sell tickets, sell upgrades, and communicate to passengers without adding customer staff (just try to get someone on the phone). Once again, these benefits would accrue to all participants. In the past an online reservation system or airline scheduling system was a technology marvel; while still a difficult system to run and construct, the technology to do this today is common and is much simpler than running Facebook or a real-time ad system by page views, for example.

    Cross posted at LITGM

     

    13 Responses to “Disruption – Part Four – The US Airline Industry”

    1. Mike K Says:

      I flew quite a bit in the 50s and 60s and the experience was far superior. I remember going home to Chicago on Continental for Christmas 1956. The fare was about $60 and there was no meal. There were three classes, and I took the cheapest which was called “tourist.” You bought a box lunch, just like American does now. For years, I was a frequent flier on American but got fed up with terrible service and quit. Now, I take Southwest domestic and have gone to Paris several times on Air France. At first I would not take Southwest because of the cattle call style seating but since they began online checkin I have used them almost exclusively.

      The last time I flew Air France to Paris, I took their business class advance fare deal which was $3500 round trip. American business class was $10,000. I did fly once on Royal Jordanian to Vienna in 1988 because they had the only non-stop to Vienna. It was interesting. You gathered in a security area and your carry on luggage was searched by two guards who then, after everyone boarded, got on the plane as air marshals and flew with us. We were the only ones getting off in Vienna, which was fuel stop, and they wheeled stairs to the plane so we could get off.

      Last September I flew to Britain. We originally had planned to go on to Greece but the “migrant” crisis caused us to cancel the Greek part of the trip. I figured we would just cancel the Greek leg and stay in London but the airline would not let us do that. We had to rebook the whole flight and I was angry at the additional charges. Part of the problem was Expedia and I will not use them again, even though they bombard me with e-mails almost daily.

      We plan to go to Quebec this summer and to Hawaii in the fall. If I could find a Qatar Airline flight to either, I would take it.

    2. dearieme Says:

      We once flew Air Ethiopia. On the way to Rome it made an unscheduled stop; on the way back to London it failed to make a scheduled stop. The goats were nice.

    3. dearieme Says:

      P.S. The goats bit was a joke.

    4. Grurray Says:

      I guess now that oil has bottomed it looks like AAL’s stock is about to drop.

    5. Michael Hiteshew Says:

      Some part of me does not mind the airlines are raking in the cash at the moment, since no one cried for them when they were taking a beating. I don’t fly too much, but I generally pick up one of Southwest’s low fare flights a month or so in advance online. For me, it’s a few hours of travel and I don’t require a lot of amenities.

      The profit versus fuel cost correlation is interesting and points to an obvious underlying relationship between ongoing costs and profit, especially in a noncompetitive market.

      BTW, is that a 777 or 787 in the photo?

    6. Mike K Says:

      “On the way to Rome it made an unscheduled stop”

      About five years ago, I was flying Southwest to Baltimore for a sailing thing. We were about two hours into the flight when I heard, “Is there a doctor on Board?” and I thought oh, sh*t. Fortunately, another doctor quickly responded and we made an emergency landing in Kansas City to drop off a passenger who had some sort of heart emergency. We continued on the flight and an hour later, “Is there a doctor on board?” The other guy was still aboard and took the call. We made another emergency landing in Atlanta.

      We eventually got to Baltimore.

      A friend of mine was on a transatlantic flight when somebody had a cardiac arrest. He was very critical of the airline’s emergency kit. I was glad I wasn’t there.

    7. DirtyJobsGuy Says:

      The Gulf airlines will pose an interesting debate. They pay the same prices as US/EU airlines for new aircraft and engines, also fuel. But they tend to have much lower labor costs for both maintenance and flight crews (somewhat less for pilots, but a lot less for cabin staff and ground crews). By staffing the planes from remittance countries like the Phillipines, costs are lower.

      So the same argument applies with other offshoring industries in that how to you compete with high US labor costs and regulations? Do you take the traditional AFL-CIO argument about unfair labor regulations for trade? You need bilateral permission to fly international routes so not easy.

    8. DirtyJobsGuy Says:

      A good example is a junior flight attendant on Qatar gets around $1650/month tax free and a free (shared) apartment in Doha. So $10/hour on an equivalent 40 hour week. Tax free but at that level tax is not a huge component anywhere.

    9. phwest Says:

      As a capital-intensive industry, airlines have a strong tendency to boom and bust cycles. Although you would think that capacity would be brought on line relatively smoothly, the long lead times for aircraft orders still result in periodic over-capacity. When that happens, prices are rapidly driven down to marginal costs, and profits collapse.

      A lot of the stress experienced by airlines in the 1980-2008 period was due to the long, slow decline in interest rates. In a declining interest rate environment, industries where capital requirements are the primary barrier to entry are very vulnerable to new debt-financed competitors (particularly when the incumbents are heavily debt-financed). New entrants can borrow money cheaper than the outstanding bonds of the existing players, and if that is also coupled with labor-cost advantages (younger workforce) that can be a significant advantage. Bankrupcy for incumbent firms also feeds off the same cycle (repricing debt and renegotiating labor deals). Spikes in fuel costs may be the proximate cause of failures, but the capital cycle is the fundamental issue.

      Now that rates have bottomed (commercial rates anyway – a new airline would almost certainly be issueing junk, and that would not be competitive with the current oligarchy) the business has stabilized and profits can be made. National carriers play by different rules, not the least of which is that profit is less of a driver than for US carriers. Pointing this out is obviously self-serving on the part of US carriers, but it is still true (not unique to airlines either). Current oil prices probably give US-carriers a double benefit, in that they reduce the funds available to subsidize middle eastern national carriers.

      Commodity markets that are capital intensive always struggle with long-term profitability. Cartels of one sort or another are the only real way to generate above market, and quite possibly even market-level, returns. Railroads were much the same when they dominated passenger travel. (another parrallel, most of the money made by railroads in the 19th century was made in their construction, not operation, much like Boeing and Airbus are more profitable than their customers).

    10. Gurray Says:

      Chet Richards writes about airlines from time to time. Awhile back he was on the subject of the gradual end of economy class and the airlines moving to premium service. Eventually Chet is expecting private fractional ownership of flights. He mentioned Surf Air, which sells a subscription service. Surf financed 15 single engine turboprop Pilatus PC-12’s, decked out with luxury interiors, all for the price of one new Gulfstream G650 jet.

    11. dearieme Says:

      There used to be a company called Suckling Airways that flew Manchester-Cambridge-Amsterdam. Mr S flew the plane and Mrs S ran the show and brought the sandwiches aboard. It had charm. Them wuz the days.

    12. Grurray Says:

      Best movie about an airline : Only Angels Have Wings.
      Terrific aerial sequences, plus Rita Hayworth and Jean Arthur. About as good as it gets.

    13. Mike K Says:

      “Although you would think that capacity would be brought on line relatively smoothly, the long lead times for aircraft orders still result in periodic over-capacity. When that happens, prices are rapidly driven down to marginal costs, and profits collapse.”

      Pinal Airpark near Tucson and a similar storage site near Mojave, CA that I drove by yesterday, should provide some flexibility for such cycle. Both are filled with older model passenger jets including 747s. The drop in fuel prices should help.

      I agree that subscription services will take part of the First Class market.

      “Mr S flew the plane and Mrs S ran the show and brought the sandwiches aboard. It had charm. Them wuz the days.”

      I flew from La Paz Mexico to Cabo San Lucas about 30 years ago. The airport in La Paz was empty, then this guy in a baseball cap came out and picked up my luggage and carried it to the plane, a small one. Then he got in and flew us to Cabo which had a dirt runway in those days.