Airlines in Crisis: From Bad to Worse

The airlines suffered one of the new war's biggest blows; $15 billion won't begin to fix it.

(Continued, page 2)

In late 2000, the airlines began losing their most lucrative customers--business travelers--in hordes. Part of the reason was the normal cost cutting that occurs during a downturn. "Air travel is one of the expenses you can shut down fastest," says Greenwald, now a managing partner at Greenbriar Equity, which invests in transportation companies. Airline tickets were an especially fat target. Between 1996 and 2001, business prices rose 76%, according to the Business Travel Coalition. Delta roundtrip fares from Atlanta to San Francisco ballooned from $1,216 to $2,048. Says Douglas Steenland, president of Northwest: "The spread between business and leisure prices got wider. We now get 15% of our traffic from unrestricted business customers and 40% of our revenues." On average, business fares are twice the cost of leisure fares, vs. 1.5 times in the early 1990s.

Why did business fares explode? The strong economy packed planes with corporate travelers far faster than the airlines could add new seats. Production gaffes at Boeing slowed deliveries of new planes that would have eased the pressure and prices. It was business customers, booking a day or two before departure, who paid top dollar for the few remaining seats. The problem was especially dire in "fortress hubs" with one dominant carrier, notably American in Dallas and Northwest in Minneapolis. "If most of your business was concentrated in that hub, you had little leverage to get discounts, no matter how much business you gave the airline," says Charles Braswell, director of global travel management at DaimlerChrysler.

But the runaway prices that swelled profits eventually caused them to collapse. "CFOs were boiling about the airline bills, ordering their travel managers to slash them," says Mitchell of the Business Travel Coalition. Since late 2000, DaimlerChrysler had pared its spending on tickets from $100 million annually to $60 million. "We're moving much more to teleconferencing and videoconferencing to save money," says Braswell. All told, the airlines' business travel had dropped a staggering 30% since January. That alone should have been a red flag for the airlines. They would no longer be able to heap their big cost increases onto corporate customers.

Though airlines managed to lure leisure travelers to replace much of the departed business crowd, the corporate exodus hit hard. By September revenues were running 7% lower than last year. Before the disaster, the industry had already lost $2.5 billion and was on track to lose $3.5 billion, its worst performance since 1992. Now the losses will be truly staggering: between $10 billion and $11 billion. To cut costs the airlines are laying off about 20% of their work force. But because union contracts oblige them to furlough their lowest-paid employees first, the labor savings will be modest. And because the industry has high fixed costs--about 75% of its spending goes for airplane leases, interest payments, and labor--revenues fall much faster than expenses when air traffic plummets. "We've never faced anything like this--all these fixed costs and a period where no one is flying," marvels Northwest chairman Gary Wilson. "It's incredible."

To bolster the case for a bailout, the Air Transport Association, the industry's lobbying arm, assembled a detailed forecast for Congress. Although some of its numbers are predictably alarming, one seems far too conservative: In calculating the airlines' expenses, the ATA doesn't include interest payments on any new debt--not even on the $10 billion the government could guarantee. Between now and the end of the year, the ATA says industry revenues will drop 40% from pre-Sept. 11 levels. Total revenue for the quarter will be about $15 billion--vs. $25 billion in 2000--temporarily shrinking the industry to the size it was in 1989.

To soften the losses, the industry will do three things: reduce flights and personnel, delay the delivery of aircraft, and--here's the main fix--tap $15 billion in government cash and guarantees. On average, the airlines are eliminating one-fifth of their flights. At Newark, Continental is erasing 75 of its 377 daily departures. But in airline math, 20% less capacity doesn't mean 20% lower costs. "Our expenses will drop only about 10%," admits Continental CEO Gordon Bethune. It's that sticky fixed-cost problem.

The carriers also face pockets of rising expenses. Because security checks will take longer, the airlines won't get as many flights a day from each aircraft. "You increase the time it takes to turn around each plane by 15 minutes, and you could lose two out of ten departures a day," says Darryl Jenkins, director of the Aviation Institute at George Washington University. "That raises costs by reducing how much business you get out of your fixed assets." As for security costs, most of the proposals in Congress have the industry paying about what it does now, with the government assuming the rest.

Because the carriers are locked into contracts with the manufacturers, they don't have much room to reduce the $20 billion a year they devote to capital spending. Much of that goes toward planes already on order or on the factory floor. By delaying deliveries for six months to a year, they might be able to save a couple of billion dollars annually.

The airlines' biggest source of cash is the $15 billion they are getting from the government. They will divide a $5 billion grant in proportion to their size; American will pocket $900 million, while AirTran will get about $30 million. The $10 billion loan guarantees also will likely be distributed by size. Though the bailout package is huge, the airlines' potential losses swamp the grants and guarantees, even factoring in savings on capital spending and downsizing. The ATA estimates that by next October the industry will need an extra $9 billion. What's truly scary is the outlook beyond. Even if traffic rebounds late next year, the ATA says the airlines will lose money at the rate of $5 billion a year.

While all the carriers have been hurt, some are feeling more pain than others. The industry is divided into two main groups: low-cost or discount airlines like Southwest, and high-cost, hub-and-spoke carriers like American and United. Philip Baggaley, an analyst with S&P, says Southwest is "the strongest carrier in the U.S." The company had solid profits for the first half of 2001. It also has excellent relations with its unions and one of the strongest balance sheets in the business. Among discounters, other probable survivors include JetBlue, which flies out of New York's JFK, and AirTran, a bargain rival to Delta in Atlanta. AirTran charges an $89 one-way business fare to Newark. The endangered discounters are Frontier and Spirit, smaller players with shallow pockets. Their demise would be a shame for travelers. Frontier, for example, does yeoman's work challenging United--and holding down fares--in Denver.

Among the hub-and-spoke majors, US Airways and America West are almost certain to disappear. America West lacks the size and reach to fly profitably. US Airways is trying to recast itself as a regional carrier. But it has the costs of a major, and the lengthy shutdown of Washington's Ronald Reagan Airport may quicken its demise. It's unlikely that a big airline would buy either US Airways or America West because of their weak finances; instead, different carriers would compete to buy their routes.

Financially, the strongest hub-and-spoke carrier is Delta, which has $2.5 billion in cash and could raise another $5 billion by mortgaging its aircraft. Continental is more profitable than Delta; it and Southwest were the only major carriers to make money in the first half of 2001. Continental's labor costs are relatively low, and it has better relations with its unions than rivals like United. But despite its strengths, Continental is in danger; it is deeply in debt, and its planes are highly leveraged.

United, American, and Northwest are somewhere in the middle--stronger than US Airways, weaker than Delta. United has high costs and a lot of debt, but if traffic recovers it will have enough cash to last through the end of 2002. American is slightly better off than United. Its balance sheet is stronger. It also got a lucky break shortly before the disaster when its pilots turned down a fast-track negotiating proposal that included generous pay raises; now, the ravaged landscape could help American executives negotiate a better agreement. Northwest also has high costs but plenty of cash. If business rebounds, it will reap the benefits because it dominates two of the most lucrative hubs in the industry: Minneapolis and Detroit.

At the most basic level, the government's rescue plan will do exactly what it must in the short term: keep the planes in the sky. But Greenspan and his board should also step up the pressure on the airlines to do what they must: face down their unions and radically lower their costs. Unless the industry and its CEOs take these radical, courageous steps, they'll eventually run to Washington for more money. Before it pledges a single additional dollar, the government should ask the carriers to demand big pay cuts from their unions; it should require concessions from the airplane manufacturers, such as lower interest rates on leases; and it should ask for sacrifices from the banks and bondholders that will own tens of billions in airline debt.

In return, Washington can lift the industry's most crushing burden: the power of strikes--especially by pilots--to cripple a carrier. The airline CEOs support a bill sponsored by Senator John McCain that could impose mandatory arbitration when the unions and management can't agree; that would go a long way toward eliminating the coercive power of strikes. "It's the only way to make the balance of power relatively equal," says Delta's Mullin. Although mandatory arbitration has had an inflationary effect in baseball, it would still be an immense improvement for the airlines. Caving in, even when you know the demands are disastrous, would no longer be the only option.

Tough love, as every parent knows, is never easy. But it often works. The government should remember the trauma and triumph of Chrysler as the airlines plead their case in Washington.

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