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An Analysis of the Future Trends of the Airline Industry Justin Weller Faculty Mentor: Dr. Tommy Eshleman Abstract The airline industry has gone through tremendous change since government deregulation in 1978 and shows indications of continuing this dynamic behavior. This paper analyzes the operations of major airlines, discount airlines, and private business travel to make predictions of where this industry is heading. The research explains why in recent years most of the major airlines have experienced financial trouble, while many discount airlines have seen record growth. This study examines the reasons why the airline system of travel may be cost efficient but time inefficient, especially for business travelers, and emphasizes the additional costs this imposes on businesses. An evaluation of new technologies with air traffic control systems and innovative commercial aircraft provides insights as to how and why business travel is evolving into a system utilizing an increasing number of smaller commercial and private aircraft which may soon make the current hub-and-spoke system obsolete. Background Most studies that have been conducted about the airline industry are very broad, examining current profit margins, industry trends, and forecasting future trends for the next few financial quarters. Many times these studies will offer insight about why growth may be sluggish or what particular airline is performing poorly and what the future may hold for the struggling airline. Standard and Poor’s Airline Industry Survey, May 2004, offers this type of information about the airlines. This series, published periodically dating back to 1973, offers insight on the operations of airlines and how the industry is performing in the midst of change. It

Weller 2 notes the evolution from an industry dominated by a few large carriers to the current situation where smaller discount carriers are gaining market share. This type of information is beneficial to those interested in purchasing stock in one of the emerging discount carriers or those interested in obtaining information about the current airline market. The scope of this study draws upon a variety of industry sources in an attempt to determine a general consensus on the future of airline travel. These sources ranged from innovations in ways of conducting business in the airline industry to new technologies which may dictate, or support, new methods of business travel. The “Big Six” Airlines Twenty years ago, if you were a business traveler or a recreational traveler and you wanted to get to a destination, chances are you would have contacted a travel agent who then would have contacted one of the major airlines for a reservation. As a traveler, you would have a strong possibility of finding yourself seated in an aircraft with United, American, Continental, TWA or Eastern painted on the tail. For many years these giants have commanded the skies and have been successful at keeping most other airlines in the distance, serving a few small markets on out-of-the-way routes. The majors enjoyed this way of business for many years until a slowdown in the economy in 2000 caused a contraction in business travel. The terrorist attacks of September 11th 2001 greatly accelerated this downturn in air travel, which continues to weigh heavily on the industry today. That day changed the entire air travel industry forever. Major airlines experienced tremendous growth since government deregulation in 1978, and especially throughout the nineties, until the terrorist attacks. For instance, United Airlines experienced annual net income increases of $2.07 billion from 1998 to 2000 (Adams). The six industry leaders, which after mergers and acquisitions now consist of United, American,

Weller 3 Continental, Delta, Northwest, and U.S. Airways, helped evolve a “hub-and-spoke” travel system that allowed them to save large amounts of money, enabling these giants to purchase billions of dollars worth of new and larger aircraft. The “hub-and-spoke” system was crafted and utilized because it was considered the most cost efficient way to transport an ever increasing number of passengers. This system is operated by establishing around four to six hub airports spread throughout the country that are in high travel areas. For example, United Airlines uses San Francisco, Los Angeles, Denver, Chicago (United’s hometown) and Washington as its primary hubs. Passengers fly from one hub to another until a connecting flight will “spoke” from the closest hub to the final destination. For example, a passenger in Buffalo, New York may need to travel to Austin, Texas. That passenger will fly from Buffalo, a “spoke” airport, to the Washington “hub,” and then the passenger will connect with a flight that “spokes” to Austin. Other destinations may require the traveler to fly to several hubs before reaching their final location. The hub and spoke system allows more popular routes from hub to hub to be serviced by larger aircraft that will carry more passengers, and from the hubs smaller aircraft can travel to “spoke” airports where demand is not as great. Boeing Commercial Airplanes’ CEO Alan Mulally believes that seventy percent of the passengers arriving at each airport are connecting with another flight to fly to their ultimate destination (Ranson). Because the hub-and-spoke system is cost-efficient on a per passenger basis, it is very popular with these large airlines, but unfortunately very time inefficient for travelers. The average passenger aboard a commercial aircraft will only average “88 miles per hour, door to door” (Scott) due to the added time required to make multiple stops at hubs, as well as traveling longer distances to reach these hubs since they are usually far removed from a direct route to their final destination.

Weller 4 Airlines reduce per passenger costs as a greater percentage of seats in the aircrafts are filled with paying customers. The major airlines have a tremendous amount of fixed and variable costs. The traditional carriers have billions of dollars tied up in fixed costs such as diverse aircraft fleets and massive training and service facilities. An airline’s variable costs are generally connected to the time the aircraft are in use. Aircraft expenses are analyzed not by individually taking each expense into account, but rather by combining the initial cost, constant servicing, fuel consumption and employee pay all together, and dividing the costs by the time in the air. For many years, firms in this industry would make the majority of their profits from business travelers booking their reservations at the last minute and paying a premium price for the same seat as a leisure traveler who had booked months before. Because these industry leaders were so successful at utilizing the hub and spoke system and charging prices for their services that no other method of travel could compete with, profits were large. Since profits had been climbing, union power grew for most workers in the airline industry. The pilots, mechanics and flight attendants unions all demanded higher compensation. The industry leading airlines eventually complied and began to meet the unions’ requests for higher pay, less work hours and scheduled pay increases. Ultimately, the average airline worker’s pay increased at a faster rate than overall airline costs, and because of complex work rules and flight schedules established by the unions, inefficiency was the result. “For example, pilots can get paid 75 to 80 hours a month while actually flying 50 to 55 hours” (Reed). Beginning in the year 2000, the major airlines soon found themselves in a tug-a-war with workers desiring higher wages and customers seeking lower fares due to a slowing economy. Ironically, even after all the concessions that management at major airlines agreed to, both “management and labor leaders agree that most airlines could wring up to 30% more

Weller 5 productivity out of pilots and other workers;” however, “workers would have to give up some lifestyle advantages” (Reed), meaning they would have to become more productive on the job. Because September 11th hit the major airlines very hard, changes in operations had to take place in order to keep these giants afloat. The terrorist attacks severely worsened the already floundering profit margins of the major airlines caused by the sluggish economy, as “midlevel and small-business travelers had become increasingly price sensitive” (Reed). Some of these thrifty business travelers relied on Internet travel sites to aid them in finding the best fares. These savvy business travelers were rewarded by booking flights on smaller, low-price airlines called “discounters”. These airlines would often charge half as much as the majors would charge for the same flight. According to Edmund Greenslet, President of ESG Aviation Services, in a recent article featured in the Seattle Post-Intelligencer, one of the biggest changes for the airline industry is “the decline in airline revenue generated by those full-fare passengers.” Greenslet goes on to say, “The decline has been on the order of 50 to 60 percent, or from $10 billion down to $4 billion” (Wallace). After combining the emergence of the thrifty business traveler and the tragedy of the terrorist attacks, the major airlines’ future began to look bleak. The major airlines began to cut back on as many expenses as possible. Most of the “Big Six” have negotiated with union leaders to cut workers’ wages. United’s pilots agreed to a 29% wage reduction, flight attendants to 9% reduction, and the bankruptcy court ordered a 14% cut on machinists (Reed and Adams). Another tactic that the majors are beginning to utilize is the operation of smaller aircraft call “regional jets”. Delta Airlines has shifted its fleet to 54% regional jets and Continental Airlines’ fleet is now comprised of half regional jet aircraft. Regional jets are much cheaper to operate than traditional jet carriers. According to a Reuters report, “Industry figures show that it can cost up to twice as much to operate an older-model

Weller 6 Boeing 737 than a fifty seat RJ [regional jet] on the same route.” Another reason “RJs” are so popular is they are faster and more cost efficient to operate, and since they are smaller, a greater percentage of their seats can be filled with paying customers on a more consistent basis. Rather than fly a Boeing 737 on a particular route that may only fill two-thirds of the seats on a regular basis, an RJ can be full and operate more cheaply. Both the fixed and variable costs of these smaller aircraft can be spread over fewer passengers than larger aircraft and still turn a profit. Discount Airlines Most savvy fliers, both business and leisure, know the value of flying for as small a price as possible. The most expensive part of a trip is usually the airfare. Discount airlines were originally started to compete with the major airlines on a regional basis. The best example of the emergence of a discounter is Southwest Airlines, the most successful discount airline. Southwest Airlines formed to compete with rival major airlines on routes throughout Texas. Most discounters establish themselves by flying into smaller airports that are in major cities that may actually be hubs for major airlines. Southwest Airlines flies out of Love Field in Dallas rather than Dallas/Fort Worth International Airport, used by rival American Airlines. Small airports that serve large communities are attractive for discounters because of significantly lower landing costs and less congestion. Ultimately, costs will be lower for the discounter and thus fares will be lower for consumers. Discount airlines flying in and out of these smaller airports have become so accepted that “Fort Lauderdale, another popular low-fare airport, now serves more U.S. destinations than nearby Miami International” (Woodyard). Discounters have made a science of cutting costs wherever necessary to bring down prices to consumers. Typically, most discounters only operate one or two types of aircraft. As a result, pilot and maintenance training costs are kept at a minimum. Most discounters strive to

Weller 7 have the newest and most cost efficient aircraft to operate, such as regional jets or newer Boeing 737s. These newer planes are much cheaper to operate and can keep the enormous fixed costs down, which will again result in lower costs to the discounters that operate the aircraft. Discounters have led the industry in adopting web based marketing and ticketing services. Thrifty consumers can utilize search engines and popular travel Web sites such as Travelocity and Expedia to find cheaper fares. These search engines and Web sites have given a tremendous amount of advertisement to discount carriers that lack the funding that major airlines have for marketing budgets. Some discount airlines have gone to exclusively booking flights online or by having customers calling the airline directly. According to Kerry Skeen, the chairman and chief operating officer of discount carrier Independence Air, “the per transaction costs [of booking directly through the discount carrier] will be limited to about 50 cents, compared to, up to $15 for some carriers using other online services or travel agents” (Mutzabaugh). Many discounters are able to charge low fares because they have few or no union ties or restrictions, lowering their labor costs considerably. Therefore, many low fare airlines pay their employees less than what that same employee would make at a “Big Six” airline. However, the most successful discounter has some of the most unionized workers in the industry. Southwest Airlines “actually pays some the highest wages in the industry [and still maintained] 52 straight quarters of profitability,” as of May 2004 (Lott). According to findings from a recent in Aviation Daily, Southwest Airlines devotes over forty percent of total expenses to labor, more than any other carrier except Delta, and ten to fifteen percent more than other discount airlines. Southwest is at the top of the industry pay scale for Boeing 737 pilots, ramp workers, and

Weller 8 mechanics. It is not uncommon for other discounters to devote similarly large portions of their total budget to labor (Lott). Discounters have significantly more efficient flight schedules. Since discounters have fewer aircraft than their “Big Six” competitors, they must rely on higher aircraft utilization, shorter turn times (aircraft spends less time on the ground between flights), and better crew scheduling. Shorter turn times are achieved by landing at less congested airports, which reduces the time spent waiting for other aircraft for fuel and other ground services, and by utilizing the crew that is already aboard the aircraft to help prepare the plane for its next leg of service. By combining these factors, discounters are able to land, discharge passengers and cargo from their aircraft, service the plane, and board new passengers faster than most major airlines. The result of this advanced scheduling is a more efficient utilization of inputs, including employees, than is being realized by the major airlines. In short, the discounters are getting more productivity out of their labor budget than the “Big Six” are getting out of theirs. These differences in operations and cost savings between the “Big Six” and discounters are clearly reflected in the fares they offer. Table 1 shows several popular business routes and the fares offered by discounters and major airlines. Table 1 Route

Carriers

Fares

New York to Buffalo

JetBlue vs. US Airways

*JetBlue: $217.20 US Airways: $535.21

Detroit to Denver

Spirit vs. Northwest

*Spirit: $507.19 Northwest: $2,480.00

Atlanta to Minneapolis

Air Tran vs. Delta

*Air Tran: $534.20 Delta: $940.20

Portland to Denver

Frontier vs. United

*Frontier: $438.20 United: $484.20

Boston to Los Angeles

America West vs. American

*America West: $998 American: $2,232.70

* Fares are as of February 2004, referred to by Joe Brancatelli, USA Today 2/23/2004

Weller 9 Future Business Travel When one thinks of travel by private jet, the first thing that comes to mind is most likely corporate executives, the very wealthy and elite individuals whose time is very valuable. This concept is changing rapidly. Clearly, the concept of traveling by private aircraft to conduct business is not a new idea. However, with advances in aircraft technology and innovations in new air traffic control systems, traveling by private aircraft will be far more accessible and economically viable for many types of business travelers. For many years, companies have owned and operated their own aircraft to transport members of their company. This is known as whole aircraft ownership. By owning their own aircraft, companies can enjoy an extremely flexible and precise travel schedule. Companies can access small airports that may not be serviced by either discount carriers or major airlines and companies can access these locations any time they may desire. However, owning and operating an aircraft can be extremely expensive. There are companies that choose not to own their own aircraft and would rather charter a plane that is owned by an operating firm to meet their travel needs. This concept is known as ondemand charter or an “air taxi.” “A traditional charter provides on-demand access to a wide range of aircraft for almost any conceivable type of mission” (PA Consulting Group). In addition to an air taxi service many charter companies will offer a block charter system. “In its purest form, block charter has been around for decades and involves simply buying a block of charter hours,” to be used within a certain time period such as one year (PA Consulting Group). Companies will buy blocks of flight time in increments of 25, 50 or 100 hours and use the hours of flight time to conduct business travel.

Weller 10 Finally, the newest and most innovative idea that has hit the private business travel sector is fractional ownership. This concept “is best viewed as a means of obtaining a partial interest in an aircraft, combined with a mechanism for sharing in all of the aircraft in a program” (PA Consulting Group). In short, a company will essentially buy a share, or part ownership, of a company that provides a fleet of planes that is managed by the company. The program manager of the company coordinates all the aircraft in the fleet according to the travel needs of all the companies that have bought shares in the program. By matching the needs of travelers with the appropriate type and size of aircraft for a particular trip, each jet in the fleet can be more fully utilized, reducing per passenger costs. This new concept has become very popular because it combines the advantages of owning a private aircraft with spreading the tremendous fixed costs of jet ownership among many owners. The research firm ARG/US “believes that the market for shared ownership aircraft will experience strong growth over the next five years, topping out at a fleet of around 1,600 aircraft shared among 13,500 owners” (Goyer). One new technology in air traffic control has the potential to greatly accelerate the already growing trend in private and commercial small aircraft utilization. The Small Aircraft Transportation System, or SATS as it is commonly referred to, is a new system that will combine “a new generation of inexpensive small business jets and an innovative computerized flight control network,” that will help private aircraft “provide direct service from and into any of the more than 5,000 public-use airports” (Scott). This system is currently being developed by NASA, the FAA, Embry-Riddle, and almost 60 other aviation-related entities. Ultimately, thousands of small airports across the country will be equipped with advanced computer systems that will allow complete access to corporate travel without the expensive electronics that major airports possess and without an extensive staff of air traffic controllers. The sophisticated

Weller 11 computer system will provide planned flight paths for advanced, small aircraft that will be enhanced by other sources of data, such as Global Positioning System navigation and collisionavoidance technology. The SATS will provide a very efficient and advanced way for business travelers to reach their destination. Because time is becoming more and more of a scarce commodity in the business world, the faster business can be conducted the better. Generally, business travelers have to spend countless hours waiting at airports for security reasons, ticketing and registration, and boarding, all of which are compounded by multiple stops in-route to their final destination necessitated by the hub-and-spoke system. This time could be spent by business travelers being more productive back in the office or with clients. These wasted hours, and the associated loss in productivity, are the opportunity costs of business travel. Advances such as SATS promise travel time savings, and thus lower opportunity costs, for business travel. This increases the overall cost efficiency of business travel. To illustrate this point, consider a business traveler who needs air transportation from Flagstaff, Arizona to Little Rock, Arkansas, two cities that do not possess hub airports. Reaching the destination with the current hub-and-spoke system requires a short flight to Phoenix, the major hub nearest Flagstaff, then a connecting flight to St. Louis, the nearest hub to Little Rock, followed by a connecting flight to Little Rock. The SATS option offers a direct flight from Flagstaff to Little Rock with less air time and considerably less ground time in-route. Table 2 shows a comparison of the cost and time differences between the two options.

Weller 12 Table 2. Time & Travel Costs: Small Aircraft Transportation System (SATS) Versus Conventional Hub & Spoke System Round Trip, Flagstaff Arizona to Little Rock Arkansas Travel Time, Door to Door

SATS 8 hours

Hub & Spoke 24 hours

Air Fare Hotel Costs Meal Costs Total Costs

$1,400* 0 $50 $1,450

$800 $100 $100 $1,000

Extra Travel Time Cost Savings Cost Savings per Extra Hour of Travel Time

16 hours $450 $28.13

*Based on operating costs of 56 cents per mile plus 10-cent-per-mile surcharge. All fares & times are based on a round trip per traveler. Source: “Taxi, Taxi,” Popular Science Magazine, October 2002- Phil Scott

The hub-and-spoke system saves the traveler $600 in airfare compared to SATS, but adds an extra 16 hours of flight time to the trip, resulting in a loss in productivity for the 16 hours the traveler spends in-transit, away from the office. This requires the traveler to stay the night in Little Rock and increases the number of meals consumed and during the trip. A conservative estimate of these extra costs would add $100 for lodging and $50 for meals. This lowers the total cost savings of the hub-and-spoke system to $450. This is a savings of $28.13 for every additional hour of flight time incurred on the trip. If a business traveler’s time is worth $28.13 per hour in terms of productivity, his or her employer is indifferent as to whether they pay the extra $600 in airfare for utilizing SATS and gaining 16 hours of work from the traveler, or whether they save $600 in airfare by using the hub-and-spoke system and forgo the 16 hours of work from the traveler. If the traveler’s time is more valuable than $28.13 per hour, the employer will benefit by paying the additional $600 for using SATS, since the gain of 16 hours

Weller 13 of work from the traveler will return the employer more than $600 in worker productivity and reduced lodging and meal costs. If the traveler’s time is worth less than $28.13 per hour, the employer will benefit more by using the hub-and-spoke system and saving $600 in airfare, since the 16 hours of lost productivity is worth less than the $600 savings. Assuming that the value of a business traveler’s time is reflected in his or her salary or income, the travel decision above can be made based on the income level of the traveler. Using the $28.13 per hour figure as a break-even value for a traveler’s time, a break-even annual income level can be calculated for use in making this decision. Assume that a typical business traveler works an average of 10 hours a day, 5 days a week. Subtracting three weeks a year for vacation time, it can be estimated that this person will work approximately 2,450 hours per year (49 weeks times 50 hours/week). Using the $28.13 per hour break-even value of a traveler’s time, the break-even annual value of the business traveler’s time would be $68,918.50 (2450 hours per year multiplied by $28.13 per hour). So, for this particular flight situation, any business traveler who earns more than $68,918.50 per year will minimize the total cost of travel, including the opportunity cost for the value of time, by using the SATS and paying the extra $600 in airfare. If SATS becomes established and increased competition results in lower airfares in this system, the break-even annual income level will decrease as well. This would increase the number of business travelers who can realize total travel cost savings by using SATS. Conclusions SATS will not likely become a reality for several years, as the technology and implementation plans have not been completely developed. The huge growth in the private business air travel industry should aid the acceptance and transition to this system once it is

Weller 14 ready for wide-scale operation. Fares will initially be higher, but relatively competitive with current fares offered by airlines. The true savings will be time spent actually traveling on business trips, and thus a reduction in the opportunity costs of travel. Over time costs should drop as more charter services, block charter services, and fractional ownership companies become operational and compete for business travel clients. The transition to SATS will increase this competition, further increasing the efficiency of the system. Business travelers are constantly searching for the fastest way to travel to their desired destination to conduct business, while leisure travelers are looking for the cheapest fares. Most leisure travelers dislike the current hub-and-spoke system because it causes delays and long waiting times, but these travelers are likely to accept the delays as long as fares at kept low. Business travelers do not possess the luxury of time. Business travelers are more likely to pay higher prices for air travel as long as the trip is short and efficient, leading to lower costs for all other aspects associated with travel. The SATS concept will be embraced by the business world as the new standard of travel as long as the time savings pay off. There will almost certainly be a class of business travelers, such as lower level employees at lower income levels whose time is not as valuable, who will continue to travel utilizing the lowest air fares available to them. In addition, leisure travelers who have less at stake in terms of losses associated with wasted time will likely continue to be users of the travel method that provides the lowest fares possible. As a result, the current hub-and-spoke system may not completely disappear from the air travel system, but it will likely play a much different and reduced role in the future of air travel.

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