The Endless Turbulence of the Airline Business

One of the things that has surprised no one this gloomy earnings season is the bad news reported by most airlines. This week attention has focused on US Airways, which appears to face a hard future now that its hoped-for merger with United Airlines has been scotched: The company has lost money for the last four quarters in a row, with no immediate relief in sight.

On the other hand, United last week reported one of its worst quarterly performances ever, losing $292 million in the three months that ended June 30. American Airlines, the biggest U.S. passenger carrier, recently absorbed the failing TWA. Nevertheless, its losses for the same period were about $507 million. Analysis of this mess invariably notes that this is one of the toughest periods for airlines in years. Which led one of my Slate colleagues to observe in an e-mail that “airlines are ALWAYS facing the most competitive environment in years and are financially struggling.” Why is that?

It’s a reasonable question. While it’s not strictly true that every airline is always on a financial precipice, the airline business viewed broadly is unusual in several ways that practically guarantee regular bouts of extreme financial turbulence.

The industry was pretty strictly regulated from the 1940s through the late 1970s, a period during which the business obviously grew at a steady clip and technology of flying (especially bigger passenger jets) improved dramatically. That scenario left a tremendous amount of pricing power in the hands of airlines, who had little motivation to compete aggressively on price. The 1978 deregulation of the industry in the United States obviously changed all that fairly drastically, and the upshot is that a typical airline customer now pays 70 percent less per passenger mile (taking inflation into account) than he or she would have 20 years ago, according to a recent Economist air travel survey.

It’s worth noting that that survey, published in March, was upbeat on the subject of the airlines’ profitability. After a protracted grim period in the early 1990s, the last couple of years have actually been pretty good for carriers. More recently the magazine backtracked a bit and noted some of the various factors that have put the sector in a tailspin. These include high fuel costs, problems with the industry’s various unions, and the drastic impact of a widespread economic slowdown on travel, especially business travel.

Business travelers are the real source of airline profits, for reasons that should be clear enough if you’ve ever noticed the difference in your flight-booking habits when you’re paying and when the company is paying. The other day the New York Times noted in a dispatch from a business-travel convention that a trade organization had changed its forecast of a cumulative $2 billion profit for the major U.S. airlines in 2000 to a $1.5 billion cumulative loss. Plenty of people are still flying, but the number paying last-second full fares has dropped off, and there’s been a migration of many from business class to coach.

Such a rapid drop-off is particularly hard on big airlines because these businesses are anything but nimble: Fuel costs are beyond a carrier’s control; capital spending on new planes takes years to play out; and pilot unions are among the most effective labor organizations in existence. (Delta earlier this year agreed to a new contract with its pilots widely described as raising the bar for major carrier pilots in general.) If an airline is filling roughly the same number of seats with people who, on average, have paid less the for the privilege, it can’t simply cut costs by using less fuel or outsourcing the pilot’s job to a desperate Third World worker. (And would you fly with an airline that could?)

So why don’t they simply pass their costs along to consumers by raising prices across the board? Although you hear a lot about frequent flier clubs and incremental leg-room improvements, these things end up carrying comparatively little weight with price-focused consumers. Generally speaking, if one airline raises its rates and the others don’t follow suit, the lone outlier ends up capitulating for fear of losing business. In May of this year a few carriers attempted a 5 percent fare increase, but when other carriers didn’t jump on board, the hikes were rescinded just days later.

There’s one more complicating factor: airports. Most air traffic in America is concentrated in major “hub” airports, such as Dallas-Fort Worth or Chicago O’Hare. (According to James Fallows, “more than 80 percent of all airline traffic takes off from or lands at one of the fifty busiest airports, and most of it at the twenty-four major hubs.” That’s from an interesting excerpt of Fallows’ book Free Flight, which proposes an alternative to the current big-plane, hub-and-spoke air travel system, spurred by the use of a new breed of small planes that could operate outside the constricted hub system.) Most airports are owned by local governments, which grant long leases to airlines willing to make the investments and guarantee the income that makes the airport viable; what the airlines get back is huge clout in limiting the access of rivals. And not just limiting access to a particular airport, but to a whole metropolitan area—which helps explain why there’s pretty much no airport-building going on in the United States, despite predictions that air traffic will double in the next 10 years. (A solution favored by the Economist is to loosen up lingering regulations and allow more competition within the U.S. from foreign carriers.)

All of that sounds like a great advantage to airlines, but it’s a two-edged sword that also makes it hard to expand to reach new customers and new destinations, and spread costs over a wider network. The upshot is that airlines must focus on wringing profits from an increasingly inflexible system that routes everything through hubs.

Having said all of this, it’s worth noting that big carriers can and do make money, at least when the economy is doing well. American Airlines had earnings of $1.3 billion in 1998, $985 million in 1999, and $813 million last year; the last time the carrier had a net loss was 1993. (And despite its woes this year, its stock is easily outpacing the S&P 500 over the past 12 months.) And then there’s Southwest Airlines, one of the few regional carriers that has survived from the initial welter of upstarts in the post-deregulation period. While its profits are down in the most recent quarter, Southwest did at least make money; while by now it’s practically a national carrier, Southwest’s operations differ from the majors in ways that are, perhaps, worthy of a separate column at some other time.

Point is, making money in the airline business involves a delicate balance of controllable factors that can whipsaw profits in a heartbeat. It can be done, and shareholders can go along for the ride; those who do are advised to bring an air-sickness bag because that ride is generally a bumpy one.