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The US Airline Industry &Herbert Steins Law William S. Swelbar
MIT International Center for Air Transportation36 th Annual FAA Aviation Forecast Conference
February 16, 2011
www.swelblog.com
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HERBERT STEINS LAW
Herbert Stein (1916-1999) was chairman of the Council of Economic Advisers under Presidents Nixon and Ford
If something
cannot go on forever,
it will stop
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US Airline Industry: The Last Three DecadesBarriers to entry for new and existing carriers were removed If one had a dollar, an airplane and a certificate: an airline was born Entry and growth of Low Cost Carriers a major driver of change
Barriers to exit for inefficient carriers were erected Bankruptcy, government, labor as an internal source of capital Inefficient providers remained in the market
Finally in the 2000s, cost reductions and efficiency improvements that wereexpected during the previous two decades began to happen
A market share mentality created an industry grew too big to be sustainable
The market share mentality giving way to a profit mentality?
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LOOKING BACK
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With Rare Exception, Capacity Growth
Exceeded the Growth in Real GDP
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
Real GDP Percent Change ASM Percent Change
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The Market Share Mantra
Built An Industry Too Big
0
50
100
150
200
250
300
Real GDP Index ASM Index
1 9 7 8 =
1 0 0
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40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
0
200,000
400,000
600,000
800,000
1,000,000
1,200,000
Passenger Load Factor Percent RPMs Millions ASMs Millions
Filling Airplanes Not A Problem
As Evidenced by the Growth in Load Factors
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Enabled by Decreasing Real Fares
I n f l a
t i o n
A d j u s
t e d C e n
t s p e r
R e v e n u e
P a s s e n g e r
M i l e
( 1 9 8 2 =
1 0 0 )
0
1
2
3
4
5
6
7
8
9
10
Domestic International System
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As Real Fares Declined,
The Industry Was Paying the Middleman More
-15%
-10%
-5%
0%
5%
10%
15%
Commissions as % of Operating Expenses Real Yield Percent Change
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A Classic Example of Competing Away the Efficiencies Got Rid of the Middleman, Gave $6B in Savings to the Consumer
T o t a l C o m m
i s s
i o n
C o s t
( m i l l i o n s
)
P e
r c e n
t o
f P a s s e n g e r
R e
v e n u e s
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
Total Commission Cost (millions) Percent of Passenger Revenues
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Unit Revenues Began to Drop Dramatically
During the Second Half of 2000
5
6
7
8
9
10
11
12
13
14
15
Passenger Revenue per ASM Total Operating Expenses per ASM
Pre-9/11 Average Difference:$0.73
Post-9/11 Average Difference:$2.61
C e n
t s
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The Relationship of Revenue to GDP
As It Turns Out, That Change Was Structural
Source: MIT Airline Data Project
0.30%
0.40%
0.50%
0.60%
0.70%
0.80%
0.90%
1Q90 1Q91 1Q92 1Q93 1Q94 1Q95 1Q96 1Q97 1Q98 1Q99 1Q00 1Q01 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09
$27B$36B
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Through 2000, Unit Labor Costs on the Rise As
Productivity Remained Relatively Unchanged
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
0
500
1,000
1,500
2,000
2,500
3,000
ASMs per Employee Total Labor per ASM
A S M s
( 0 0 0 ) p e r
F T E
C e n
t s p e r
A S M
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The Restructuring Increased Output, but
The Cost Per Unit of Output Going the Wrong Way
20
25
30
35
40
45
50
0
500
1,000
1,500
2,000
2,500
3,000
Total ASMs per Employee (thousands) Total ASMs per Labor Dollar
A S M s
( t h o u s a n d s
)
A S M s p e r
L a
b o r
D o l l a r
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An Industry Built on $30 per Barrel In the Wing Oil5-Year Average* U.S. Price per Gallon of Jet Fuel
* 3-Year Average for 2007-2010
$0.88$0.78
$0.69$0.60 $0.57
$0.73
$1.51
$2.22
$0.00
$0.50
$1.00
$1.50
$2.00
$2.50
1978-1983 1983-1987 1987-1991 1991-1995 1995-1999 1999-2003 2003-2007 2007-YE3Q10
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Fuel Surpasses Labor As Largest Cost Category
0
100
200
300
400
500
600
700
1 9 7 8 =
1 0 0
FuelIndex
PassengerYield
Consumer PriceIndex
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200 of the roughly 450 mainland U.S. markets comprise97% of domestic demand
Yet the 250 airport markets comprising 3% of domesticdemand compete for the same pool of dollars Spending money in all of the wrong places?
The market share mentality created a system thatcompeted with itself. Airlines the culprit of fragmentingtheir own marketplace at home
What About the U.S. Airport System?
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40 Percent of Mainland Airports Produce 97% of Demand
Top 200 Airports
Airports #201-450
3%
97%
Percent of Domestic Demand
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Per Enplanement Profit and Loss
Passenger Revenue Only1980 - 1989 1990 - 1999 2000 - 2009 2010E
Passenger Revenue $105.16 $129.44 $135.91 $144.81
Labor $39.66 $47.33 $49.04 $45.56Fuel $24.94 $17.64 $34.21 $44.30Commissions $8.99 $12.91 $3.16 $1.99Landing Fees $2.03 $2.90 $3.46 $4.05Aircraft Ownership $7.36 $12.87 $14.19 $12.82All Other $30.98 $44.12 $48.26 $49.45
Total Op Expenses ex TR $113.96 $137.77 $152.33 $158.17
Passenger Revenue Less Expense ($8.80) ($8.32) ($16.42) ($13.35)
Interest $3.99 $3.16 $4.87 $6.11
Passenger Revenue Less Expense + Interest ($12.80) ($11.49) ($21.28) ($19.47)
Ancillary Fees $0.14 $8.70
Restated With Ancillary Fees ($12.80) ($11.49) ($21.14) ($10.76)
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Producing Unacceptable Annual Net Profits
1978 2010
-30,000
-25,000
-20,000
-15,000
-10,000
-5,000
0
5,000
10,000
15,000
20,000
P r e
T a x
P r o
f i t ( b i l l i o n s
)
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Or. A Cumulative Loss of Over $40 Billion Since 1978 1978 2010
-50,000
-40,000
-30,000
-20,000
-10,000
0
10,000
20,000
C u m u
l a t i v e
P r e - T a x
P r o
f i t ( b i l l i o n s
)
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And Not a Chance in Hell that the Industry
Could Earn at Least Its Cost of Capital
Source: IATA
Return on Invested Capital in the Airline Industry v. the Cost of Capital
P e r c e n
t o
f I n v e s
t e d C a p i
t a l
Cost of Capital(WACC)
93
14.0
12.0
0.0
Return on Capital
(ROIC)
94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 11F
2.0
4.0
6.0
8.0
10.0
10F
Forecast
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If something
cannot go on forever,
it will stop
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B a n
k r u p t c i e s
BANKRUPTCIES
CUMULATIVEBANKRUPTCIES SOME HIGHLIGHTED CARRIERS
19781979 2 2 New York Air
1980 4 61981 5 111982 10 21 Braniff 1983 5 26 Continental1984 17 43 Air Florida, Wien1985 10 53 PBA, Cascade1986 6 59 Frontier1987 9 68 Air Atlanta, Air South1988 11 79 Mid Pacific1989 7 86 Eastern, Presidential1990 6 92 Continental1991 16 108 Pan Am, Eastern, Bar Harbor, Midway, America West1992 5 113 TWA1993 3 116 Hawaiian1994 2 1181995 5 123 TWA1996 4 1271997 4 131 Air South, Western Pacific1998 2 1331999 4 1372000 7 144 Tower, Legend2001 2 146 TWA, Midway2002 4 150 Vanguard, United, US Airways2003 2 152 Hawaiian2004 6 158 US Airways, ATA, Polar2005 7 165 Delta, Northwest, Independence Air2006 1 1662007 2 168 Maxjet2008 5 173 Aloha, ATA, Skybus, Frontier, Air Midwest
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Airline Industry Restructuring Along the Way
Labor was the bank of first resort throughout the 1980sand 1990s (Barrier to Exit) Temporary fixes Labor gives concessions and gets paid back and more time and again
Consolidation among regional competitors in the mid1980s proved key in building national networks Strong carriers buying strategic assets from weakcompetitors
Recession in the early 1990s serves as catalyst to firstround of hub closures
Poor attempts at building airlines within airlines tocombat low cost competition still in its infancy
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Airline Industry Restructuring Along the Way
Travel agent commission structure targeted by the industryNegotiation of Open Skies Agreements becomes goal of USaviation policy Alters carrier thinking regarding international flying
International alliances in formative yearsSignificant changes to US Bankruptcy Code
The over exuberant use of 50 -seat regional jet begins Begins process of replacing mainline domestic flying
Southwest crosses the MississippiIndustry enjoys most profitable period in its historyAt the peak of the cycle, the industry tries to buy labor peaceand overpays
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Airline Industry Restructuring Along the WayFirst transatlantic alliances immunizedNetwork carrier cost structures exploited by the vigorousincursion of low cost carrier capacityInsurance costs skyrocket after 9/11
Five of the seven network carriers file for bankruptcyNearly $12 billion in labor savings won150,000 jobs shedMaintenance outsourcing becomes a more widespread practice
First round of meaningful capacity reductionsSignificant shift of domestic flying from network carriers totheir respective regional partners takes placeNetwork carriers shift capacity away from US domestic marketand redeploy aircraft to international markets
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As fuel prices increase, various hedging strategies employed withmixed success
As fuel prices peak, industry employs a number of strategies togenerate ancillary revenue
As fuel prices peak, industry announces significant capacityreduction and puts a capacity discipline mantra to work
New round of consolidation not limited to network carriers
Industry seems intent on not implementing their patternbargaining sins of the past with labor
Pushing the envelope to find new ways to take cost out of theoperation Few magic bullets remain
Airline Industry Restructuring Along the Way
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A LOOK AT CERTAINAIRLINE COSTS
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The Expense Portion of the Income Statement
Labor: Expectations far exceed industrys ability to pay Want a restoration of pay without commensurate productivity Hard to restore pay when benefit costs so high
Maintenance: Outsourcing has slowed as a practice
Commissions: Low hanging fruit has been picked but Americanbelieves the middleman still has too much influence in this area
Airport Costs: Along with employee benefits and GDS fees, thisarea promises to be a cost center scrutinized by airlines goingforward
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Landing Fees
The Age Old Airline v. Airport Conflict
$-
$2
$4
$6
$8
$10
$12
$14
$16
$18
0
50
100
150
200
250
Capacity Tons Landed (millions) Cost per Capacity Ton Landed
C
a p a c
i t y
T o n s
L a n
d e d
( m i l l i o n s
)
C o s
t p e r
C a p a c
i t y
T o n
L a n
d e
d
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Unit Costs that Grow in Real Terms
Have Been Addressed in the Past
100
150
200
250
300
350
400
1 9 7 8 =
1 0 0
Indexed Landing Fees Consumer Price Index
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But the Cost of Benefits Are a Concern
0
100
200
300
400
500
600
0
100,000
200,000
300,000
400,000
500,000
600,000
Total Employee FTEs Benefits per FTE Index CPI 1978=100
T o
t a l E m p
l o y e e F
T E s
B e n e
f i t s / C P I
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WHAT TO MAKE OF THE LAST
30 YEARS OF THE USCOMMERCIAL AIRLINE BUSINESS
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What to Make of the Last 30 Years?Then: Barriers to entry for new and existing carriers were removed
Now: Interestingly, fuel costs/volatility proving to be a barrier to entry Fuel costs have limited the growth of the Low Cost sector in a significant way
Then: Barriers to exit for inefficient carriers were erectedNow: Unlikely that labor is a source of capital this time around Traditional external sources of capital not likely to fund inefficient operators
Then: Finally in the 2000s, cost reductions and efficiency improvements thatwere expected during the previous two decades began to happen
Now: Will the industry stand and not give in to destructive pattern bargaining? Will the industry stand and not give in to the urge to add capacity? Along those lines, will the industry stop competing with itself? Will the industry finish the work of removing the middleman where possible?
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If something
cannot go on forever,
it will stop