A Sinking Ship? The Air Travel Industry in the 21st Century

April 21, 2003

James Lloyd Ji Chong Liam Patrick

Prepared For:

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Table Of Contents:

Introduction………………………………………………………… 3

Five Forces Industry Analysis Market Definition.…………………………….……………... 4 Internal Rivalry……………………………….……………… 4 Substitutes and Complements…………………………… 6 Entry and Exit………………………………….….…………. 7 Supplier Power………………………………….…………… 7 Buyer Power……………………………………….………… 8 Conclusions………………………………………………..... 8 Financial Summary…………………………………………. 9

Strategic Outlook Current Strategy………………………………….…………. 14 Strategic Outlook and Recommendations……………... 15 Specific Policy Recommendations………………………. 17

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Introduction

Delta Air Lines began passenger air service in 1929, flying from Dallas, Texas to Jackson, Mississippi via Shreveport and Monroe, Louisiana. Since then, Delta has expanded routes to airports all around the globe, connecting 208 domestic and 46 international cities. A trailblazer for the industry, Delta pioneered the hub and spoke network in 1955i, opening up air travel between more different cities, through central hub airports.

Now one of the largest and most recognizable companies in the world, Delta has weathered a very difficult several years. Highlighted by the events of September 11, 2001, demand for air travel has fallen dramatically while associated costs have risen. Though Delta has fared as well as any other similarly structured airline, emerging challenges such as a successful discount sector, heightened competition among the major carriers, rising costs and declining demand have hurt profits. Some of this difficulty is due to a lull in the business cycle. However, many of the pressures, including rising insurance costs and pressure from discounters, appear permanent.

Delta has engaged in vast cost-cutting measures, and we at Blaisdell Consulting encourage them to continue doing so. In particular, it is crucial that Delta follow ’ example and re-negotiate their industry-leading contract with the pilots’ union. Delta’s long-term strategy, though, should be to address the challenges of the new market head-on.

Blaisdell Consulting believes that the hub and spoke network is no longer a viable business plan in an industry increasingly dominated by discounters. As there are compelling public interest arguments for the continued existence of hub and spoke carriers, Delta should spearhead a lobbying campaign seeking limited regulation that would allow hub and spoke carriers to compete profitably with discounters.

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Five Forces Industry Analysis

Market Definition

Delta Air Lines is fairly focused in its business objectives, with a simple product in a well-established and definable industry. As classified by the North American Industrial Classification System (NAICS), Delta fits into category 4811, “Scheduled Air Transportation.” NAICS defines two sub-categories, and Delta is significantly involved in each of them. They are “Scheduled Air Passenger Transportation” (481112) and “Scheduled Air Freight Transportation” (481111). Though somewhat unrelated as services on the demand side, these two categories exhibit high cross-elasticity of supply, requiring the same basic inputs, save some service and ultra-specialized equipment. Delta’s involvement in passenger transportation is far greater, both in terms of market share and revenues, than its involvement in cargo and freight transportation. For instance, its 2001 revenues totaled $500 million from cargo transportation and nearly $13 billion from passenger transportation. However, Delta does benefit from the economies of scope of flying cargo as well as passengers.

Through a combination of flights linking Delta’s hub-and-spoke system, Delta provides transportation between any two of hundreds of cities. Delta operates passenger flights between airports in 208 domestic cities in 45 states (plus several US territories), and 46 international cities in 31 countries. In addition, Delta is involved in several alliances that expand the reach of its operations. Alliances have been hailed as a savvy strategic solution to industry struggles. SkyTeam is an international alliance between Delta, AirFrance, AeroMexico, CSA Czech Airways, and others. “For an industry struggling to match global ambitions with strained finances, alliances are increasingly seen as the way forward. All the major carriers are tied up with one of the big-three global alliances; medium size airlines are rushing to join. That's why this year, for the first time, the global award goes to an alliance. With Air France and Delta at its core, SkyTeam is not yet the biggest grouping in the industry, but it's the one with a tailwind.”ii

Delta has also recently agreed to an alliance with Continental and . As of February 1, 2002 (so, excluding the Continental-Northwest alliance) Delta and its partners together service 230 domestic cities in 48 states and 182 cities in 71 countries.

Internal Rivalry

Because of the scope of Delta’s network, many partial and some full competitors can be cited. However, the air transportation industry has become increasingly specialized to tailor to several different categories of traveler. In the very broadest sense, Delta is the third largest passenger air carrier in the United States in terms of revenue-passenger

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miles. Therefore, its chief competitors are others near the top of that list, namely United, American, Northwest, and Continental Airlines, US Airways, Southwest, America West and .iii Both America West and United have recently had major problems including bankruptcy, and TWA, previously the number 8 airline, has been acquired by American. American has also remained on the brink of bankruptcy. In 2000, the industry had a four-firm concentration ratio of 74.1.iv

Within the passenger air carrier industry, there is a strong and growing trend of specialization. Discount airlines such as Southwest and the newer but successful JetBlue offer a lower-end product geared toward business and leisure travelers with a higher price elasticity. These carriers fly heavily traveled routes between alternative airports (such as Ontario and John Wayne instead of LAX, and Oakland instead of San Francisco) where they pay lower runway and terminal fees and can provide a quick turnaround. They fly on a “point to point” basis, rather than through a “hub and spoke” structure. This allows discounters to pick up only the most profitable routes, saving an enormous amount of money on specialized equipment for smaller routes, but limiting the breadth of air travel. Additionally, the discount airlines lower costs by simplifying the product, flying fewer different airplane types, and providing little in the way of amenities—in some cases they do not even offer advanced seating reservations. They charge a substantially lower price than traditional carriers. By 2005, it is estimated that as many as 40% of all American and European travelers will fly discount carriers.v Both Delta and United have recently announced major projects under different names (Delta has launched Airlines) to tap this market, and analysts are mixed on their possible future.

“By 2010, the domestic market share of the "Big Six" plus Alaska Airlines will fall to about 62% from the current 75%, drop another 12% by 2017, and settle in at around 45% by 2020, predicts Edmund S. Greenslet, head of ESG Aviation Services. He foresees Southwest passing American to become the largest U.S. airline by 2013, and JetBlue passing Delta to become the third largest by 2020, based on the differential in growth rates of the two groups of carriers. Greenslet's forecasts are used by the U.S. Transportation Dept. and the Transportation Research Council, among others.”vi

In contrast to the discount market, Delta, American, and other principal competitors operate out of a hub-and-spoke network that connects tens to hundreds of cities through flights out of a few major hub airports. Competition varies from airport to airport, with Delta controlling as much as 80% of its hub and having a smaller presence in other locations. The strategy is to have strategically located hubs—for Delta these are Atlanta, Salt Lake City, Cincinnati, and Dallas/Fort Worth—that connect different areas of the country through “spoke” routes. For Delta, regional subsidiaries such as ASA, and SkyWest connect some cities, while jumbo jets carrying the Delta logo connect others. Elaborate, sometimes overtly collusive price schemes have been used in order to charge more to business travelers, marked by certain trends such as the timing of purchases and not staying away over Saturday nights, and who are less price elastic due

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to company funding. However, with the recent downturn in the economy, businesses are looking to substitutes both within the airline industry (discount airlines) and outside the industry (see later discussion on substitutes), and once lucrative multi-part price schemes are failing.

Airlines using the hub-and-spoke system previously held their market share in place with often-complex frequent flier reward systems such as Delta’s Skymiles. However, as benefits have been reduced in such programs and the discount sector has emerged, businesses have become more tight-pocketed, and consumer lock-in has become less and less relevant. Websites such as expedia.com and priceline.com survey across airlines to find the lowest prices from location A to location B, and many consumers see the rewards of low trip prices as outweighing the attraction of frequent flier plans. So, to a large degree, competition between traditional hub-and-spoke airlines has also escalated in recent years.

Substitutes and Complements

The closest substitutes for Delta’s main focus—passenger air travel—are train, bus, and automobile travel. However, these serve as substitutes only in a very regional context such as the northeastern United States. There is no direct substitute for cross-country or international travel, though new videoconferencing technology has decreased the demand in some cases for face-to-face business meetings.

Buses, trains and automobiles carry with them distinct disadvantages for many routes that would normally be serviced by air. They travel much more slowly—interstate highways restrict buses and autos to 70 miles per hour, in most cases, and even the highest speed trains traveling the corridor from to Washington, DC do not exceed 150 to 200 mph. Buses are often thought of as an inferior good, and are therefore less often used by businesspeople. Trains service only certain metropolitan areas, most notably the northeast, where a new high-speed track has been unveiled between three cities—Boston, New York, and Washington, D.C. The most often substituted good, more often used now due to the time required by new post-9/11 security measures, is automobile travel.

Complements to airline travel are less obvious, but still a factor. Rental cars and hotel prices are complements, as a rise in their price might lead to a decrease in the demand for air travel. Airport services, such as fast food restaurants and bookstores, make travel more pleasant, but are not significant complements. In-flight food service, which used to be considered part of the service for airlines, is now in some cases a complement, but it is much less substantial in determining the overall demand in travel than other less tangible complements. One such intangible is global (economic or political) stability. Political stability is of particular note in the wake of recent terrorist attacks that have exposed air travel as vulnerable.

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Entry and Exit

Air travel is an industry with enormously high fixed and variable costs. New aircraft can cost upwards of $100 million each, though a large used aircraft market exists. Large airlines fly many aircraft, allowing them to rotate planes out for service. For instance, Delta owned 451 planes as of December 31, 2001.vii In addition, runway, terminal, and hangar rights can be expensive and otherwise difficult to obtain. To combat these costs, upstarts have either used alternative airports (exemplified by the discussion above of Southwest) or bought the rights to abandoned projects, such as JetBlue’s purchase of the incomplete JFK terminal abandoned by Delta after the September 11 attacks.

Though Delta is the partial exception, most airline employees are union workers who therefore demand high wages. Particularly after September 11, 2001, insurance costs have been extraordinarily high, and with the current tension in the Middle East, jet fuel prices have also soared. However, an economic downturn like that in the current world economy provides the best opportunity for entry into the industry.

“The network carriers have faced competition from upstart carriers several times in the two decades since deregulation. In times of slow traffic, upstart carriers can lease equipment and ground facilities quite cheaply, and provide targeted service at lower cost than the big carriers, which have to carry the full cost of larger fleets and larger ground facilities. But when times get better and traffic surges, the network carriers are ready to work, while the upstarts have to make significant investments in order to expand. The network carriers return to profitability, and some of the upstarts die trying to grow.”viii

Exit from the industry requires that sunk costs in expensive capital be forfeited. As the airline industry is exceptionally vulnerable to shocks by way of physical crashes, terrorist attacks, and economic downturns, some, such as United, choose to wait the economy out, declaring bankruptcy in order to renegotiate contracts with labor unions and seek government assistance. Though some, like Continental in 1983, emerge from bankruptcy with great success, it is a difficult process and certainly undesirable.

Supplier Power

Suppliers have a fair amount of power over the passenger airline industry. There are very few manufacturers of commercial aircraft (Delta buys its jumbo jets exclusively from Boeing), and planes have a limited lifespan, so they cannot be resold indefinitely. Delta, and presumably others, buys airplanes on a long-term contractual basis. For instance, it has 191 aircraft (including, for instance, 65 B-737s) on order from Boeing from 2002 onwards through 2005.

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Many airlines contract labor for various positions through unions. Delta is the exception here, as only its pilots are union members. However, as the economic downturn has affected many airlines to the point of bankruptcy, union contracts continue to be in negotiations. American, for instance, just formally avoided bankruptcy by renegotiating with its three unions. Delta and its peers will likely have to undergo such restructuring. Fuel costs are significant, and insurance costs, particularly after the September 11 attacks, are a major economic cost.

Buyer Power

Through the 1990s, airlines utilized a high degree of price discrimination, particularly in their exploitation of business travelers. However, recently, we have seen many of the tools once used (such as the infamous Saturday night rule) removed by the airlines, and buyer power has increased dramatically. The growth of Internet shopping has had a significant impact, illuminating side-by-side the prices of different airlines, and the power of frequent flier lock-in has diminished greatly. Therefore, competition among airlines for passengers, particularly in a period of low demand, is intense. Consumers have a higher degree of bargaining power than ever before, and have shown less brand loyalty in recent years.

Conclusions

Force Threat to Profits

Internal Rivalry High Entry Medium Substitutes and Complements Medium Supplier Power Medium Buyer Power Medium

Internal Rivalry plays the largest role in the current airline industry, due almost wholly to the emergence of low-cost discount airlines. Entry presents a medium risk, demonstrated by the inception and relative success of JetBlue. Substitutes have also played a medium role, up from their minimal pre-9/11 involvement, and Supplier Power has likewise become more of an issue, due in the most part to rising insurance costs. Closely tied to Internal Rivalry, Buyer Power has also increased with the emergence of online travel agents such as expedia.com.

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Financial Summary

Through the first months of 2003, Delta Air Lines (DAL) continues the downward trend it has experienced for the past several years. As of April 16, 2003, DAL closed at $10.49 per share, compared to the January 2, 2003 value of $12.46. Delta’s stock has been in a fairly consistent decline since early 1999, highlighted by the negative shock of the September 11, 2001 terrorist attacks. As of January 18, 2003, Standard & Poor’s estimates that a $10,000 investment in DAL five years ago would now be worth $2,330. Though other factors, including the current recession, the emergence of discount airlines, and labor issues both within Delta and its subsidiaries (notably, ComAir) contribute to the decline, the negative demand shock and costs related to the September 11 attacks receive most of the blame for poor stock performance.

Delta’s recent financial history is indicative of the airline industry as a whole in the United States. Airline stocks across the board have fallen considerably since 1999, and in extreme cases, losses have been considerable enough to cause bankruptcy. To combat losses in the industry, President Bush signed the Air Transportation Safety and System Stabilization Act into law on September 22, 2001. Importantly, this law allocated $5 billion to airline companies, including roughly $650 million to Delta. However, continued struggles in the airline industry, indicated by stagnant and falling stock prices and United’s recent bankruptcy, may lead to the necessity of fundamental structural changes in the industry.

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A general overview of the financial statement from 2001 follows:

Dollar amounts in millions, except per share data 2001 2000 Change ------Operating revenues $ 13,879 $ 16,741 (17)% Operating expenses $ 14,996 $ 15,003 -- Operating income (loss) $ (1,117) $ 1,738 (164)% Operating margin (8.0)% 10.4% (18.4)pts Net income (loss) $ (1,027) $ 897 (214)% Diluted earnings (loss) per share $ (8.46) $ 6.81 (224)% Passenger mile yield 12.74(cent) 13.86(cent) (8)% Operating revenue per available seat mile 9.39(cent) 10.80(cent) (13)% Operating cost per available seat mile 10.14(cent) 9.68(cent) 5% Dividends declared on common stock $ 12 $ 12 -- Dividends per common share 10.00(cent) 10.00(cent) -- Common shares issued and 123,246 123,013 outstanding at year end (thousands)

Revenue passengers enplaned (thousands) 104,943 119,930 (12)% Revenue passenger miles (millions) 101,717 112,998 (10)% Available seat miles (millions) 147,837 154,974 (5)% Passenger load factor 68.8% 72.9% (4.1)pts Breakeven passenger load factor(*) 74.7% 64.8% 9.9 pts Cargo ton miles (millions) 1,583 1,855 (15)% Cargo ton mile yield 31.95(cent) 31.46(cent) 2% Fuel gallons consumed (millions) 2,649 2,922 (9)% Average aircraft fuel price per gallon, net of hedging gains 68.60(cent) 67.38(cent) 2% Number of aircraft in fleet at year end 814 831 (2)% Average age of aircraft fleet at year end (years) 9.1 9.6 (5)% Average aircraft utilization (hours per day) 7.3 8.0 (9)% End of year full-time equivalent employees 76,273 83,952 (9)%

Operating revenues were $13.9 billion in 2001, decreasing 17% from $16.7 billion in 2000. Passenger revenues fell 17% to $13.0 billion, reflecting a 10% decrease in RPMs [Revenue Passenger Miles] on a capacity decline of 5%, and an 8% decrease in passenger mile yield to 12.74(cent). These decreases were primarily the result of the effects of the terrorist attacks on September 11, the slowing U.S. and world economies and pilot labor issues at both Delta and Comair. ix

In 2002, revenues fell an additional $600 million to $13.3 billion, and earnings per share, which had fallen roughly $10 in 2001, fell again $10.44. In addition, “huge losses have necessitated large additions to company debt; debt increased by $3.4 billion in 2001, and DAL’s debt to capital ratio at June 30, 2002 was an unhealthy 80%, up from 53% at December 31, 2000.”x

Following are three graphs. The first shows the positive growth and inferred gain in market share for (LUV) compared to Delta and United (U), which is truncated at its declaration of bankruptcy in late 2002. The second graph compares the relatively stagnant Dow Jones Industrial Average to the somewhat more volatile Dow Jones Transportation Index and Delta Air Lines. The third graph shows the stock performance over the past year of the top five airlines, American, Continental, United, Delta, and Northwest.

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Analysts give mixed opinions on the future outlook of Delta stock. Following are several positive points:

“Delta Air Lines (rated Buy) remains our top pick of airlines stocks to own. We believe Delta is positioned to outperform its peer group in 2003 due to both its balance sheet and strategic outlook, which are superior to its peer group.”

“Delta’s pilots are its only large work group that is unionized, which gives it more work rule flexibility than its peer group. This should help the airline as it seeks to scrub costs and increase productivity anywhere it can in the upcoming months. Additionally, its pilot labor contract is not amendable until 2005, which allows for labor peace.”

“Delta has the largest RJ [regional jet] fleet in the industry flying under its code and has twice as many regional jets as either American or United. This has helped the airline to better adjust supply to demand in markets that cannot support a larger jet while still maintaining a presence and keeping feeder traffic.”

“From a strategic standpoint, we think that Delta’s SkyTeam alliance is in a good position to benefit as Transatlantic traffic eventually rebounds. This is especially true since American and British Airways are constrained at Heathrow Airport and United’s Star Alliance is currently disrupted by United’s issues. This would be further enhanced by a link up with Continental/Northwest which would add an estimated $200-$250 million to the airline’s revenue stream.”

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“Our main concerns for Delta Air Lines are more in line with the airline industry as a whole and not specific to Delta alone. They are as follows: another terrorist incident specific to the airline industry, labor flare-ups and another meaningful dip in the economy.”xi

Not all analysts agree, however. Citing record losses in 2001 expected to be repeated in the 2002 report, Standard & Poor’s rates Delta “avoid.” Evidence of Delta’s recent suffering, and measures it has undertaken, is found in the 2001 annual report.

“When flights were permitted to resume, our passenger traffic and yields were significantly lower than before the attacks. In addition, new security directives increased our costs and negatively impacted our ability to operate a pre- September 11 schedule. We estimate that the September 11 terrorist attacks negatively impacted our revenues by approximately $1.25 billion for the year. This is in addition to revenues that were adversely affected by the slowing U.S. and world economies and the pilot labor issues at Delta and Comair.

Due to the significant reduction in traffic, we reduced our scheduled capacity by 16% effective November 1, 2001. In making these capacity reductions, our goals were to keep our route network intact and to minimize the impact on our customers, while achieving significant cost reductions. Accordingly, we focused on reducing service on high-frequency routes with high potential for recapturing traffic, suspending winter service in seasonal markets, reducing international flying, decreasing Delta Express capacity and using regional jets to maintain presence and to provide connecting traffic.”

Additionally, Delta has reduced its workforce by approximately 10,000 employees.

In addition to streamlining its domestic service and cutting employment costs, Delta has recently introduced Song Airlines, a discount carrier that will begin running East Coast routes in mid-to late-2003. This introduction, when combined with the recent Northwest/Continental alliance, should lead to higher revenues in 2003, more revenue- passenger miles, and a higher stock price. However, we should not expect to see positive profits any time soon, barring a major change in the structure of the industry itself.

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Strategic Outlook

Current Strategy

Delta’s current course of action is multifaceted and, to a large degree, lacks focus. Initiatives for 2003, as outlined by the 2002 annual report (released March 12, 2003), include the following. Delta intends to reduce staffing of non-pilot employees by as many as 8000 jobs as a cost-cutting measure. Delta estimates that this initiative, begun in October 2002, will save as much as $350 million annually. The company will continue investment in supply chain technology, and is purchasing more than 400 new self-service kiosks, in part to offset the service effect of layoffs. Delta is focusing on the strategic utilization of its regional jet aircraft in order to maintain full and frequent flights on routes with lower consumer demand. Additionally, Delta is reviewing its employee benefits plan, and hopes to save as much as $80 million annually on healthcare benefits and $600 million over the next five years on its restructured pension plan. Delta aims to increase efficiency by simplifying its fleet and it hopes to immediately save on capital maintenance costs by deferring production of 31 aircraft on order.

Delta has also recently announced the launching of a new fully-owned subsidiary, Song Airlines, to compete in the low-cost market with Southwest and JetBlue. Song replaces Delta’s now-defunct Delta Express subsidiary, and it aims to cut costs by simplifying maintenance (Song only flies 757s) and flying only highly trafficked routes with the possibility of quick airline turnaround.

Finally, in his letter to shareholders, CEO Leo Mullin writes, “Airlines are unique in shouldering part of the burden of protecting US citizens from the war on terrorism, and we will continue to seek federal government funding for these homeland security concerns.”xii Post-9/11 security taxes, Mullin claims, are absorbed fully by airlines, and new security measures introduce a “hassle factor” that was previously much less significant.

Each of these initiatives is a step toward greater efficiency and lower costs, but Delta executives need to ask other key questions if they intend to keep the company structured as is. The most obvious of these questions is, given that Delta’s pilots are the industry’s highest paid, can Delta negotiate a new pilots’ contract that lifts their exemption from recent pay cuts (which affected everyone else up to the executives) and layoffs? As an estimated 45% of Delta’s costs are personnel costs, this would seem not only a logical step, but a necessary one in the race to cut costs. Other areas to examine would include the profitability of certain hubs and Delta’s expansion plans in Boston. Clearly, Delta is adopting a macro-strategy of “business as usual,” but is expansion appropriate in a marketplace with low, volatile and declining demand? Working backwards a bit, is “business as usual” an appropriate strategy at all in today’s airline industry?

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Strategic Questions and Recommendations

The partners at Blaisdell Consulting are convinced that the hub and spoke structure of the airline industry is no longer a viable business model, moving forward. A close look at the outlook for hub and spoke rivals such as American and United reveals an industry that is deeply troubled. Online travel agents such as expedia.com, combined with possibly permanently higher insurance and security costs and decreasing and volatile demand for air travel, have forced hub and spoke airlines to compete at unrealistic price levels. Discount airlines like Southwest and JetBlue provide the only currently successful business plans, but limit the reach of the airline industry. Given that hub and spoke airlines provides air travel infrastructure to as many as 75% of America’s airports that might not otherwise be serviced, we believe there are compelling arguments above and beyond the ones Mullin has already laid out for Federal assistance and limited regulation.

The emergence of a successful discount sector of the airlines industry has put much pressure on traditional hub and spoke carriers. Southwest Airlines, JetBlue Airways and AirTran Airways each earned positive profits in 2002 “as the rest of the industry combined to lose more than $7 billion.”xiii Though none of these three airlines rivals the top five in size, they represent a growing trend in the marketplace and a quickly emerging threat. According to Robert Lamb, an expert on airline strategies, by 2005 “more than twice as many American and European travelers -- or about 40 percent of them -- might be flying low-cost carriers.”xiv Discounters cut costs through a number of different measures. They tend to fly into alternative airports (such as Oakland instead of San Francisco and Ontario instead of Los Angeles), and they fly exclusively highly trafficked routes, where quick turnaround is possible. They often have simplified fleets (Southwest flies exclusively 737s) to reduce maintenance costs, and they cross-train employees to work a variety of jobs. Some of these seem like healthy cost-cutting measures that Delta and other airlines should, and are implementing. Even still, cutting costs to the extent of Southwest’s 7.5 cents per available seat mile is a daunting task, which Song is not even attempting to beat (Song’s target is 8 cents).xv In addition, not all of the cost-cutting measures are feasible for major airlines. Part of the Delta, American, United, Continental or Northwest product is flying into more convenient airports, which costs more and requires varied aircraft to fit varied demand between different locations. Hub and spoke airlines, by the very definition of their structure, cannot operate with costs as low as discount airlines.

Other hub and spoke airlines in the top five have experienced more ill effects of these new realities than has Delta. On December 9, 2002, filed for Chapter 11 Bankruptcy. While United restructures, American Airlines is frantically negotiating with its unions and has reached a tentative deal as of March 31, 2003, to avert bankruptcy proceedings. What effect will all of this have on Delta? According to its 2002 annual report, Delta believes other carriers’ bankruptcies are a major concern. “Historically, air carriers involved in reorganizations have undertaken substantial fare discounts in order to

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maintain cash flows and to enhance customer loyalty…Moreover, carriers operating in bankruptcy, or that successfully emerge from bankruptcy, may be able to achieve reduced costs which could place us at a competitive disadvantage.”xvi This was certainly the case with Continental, following its 1983 bankruptcy. The Wall Street Journal’s Susan Carey and Scott McCartney outline the difference in labor costs of United, a firm entering bankruptcy, and Continental, a firm that has successfully restructured. Though the details are relevant and interesting, the most stunning overall statistic is that United spends 49.7% of its revenue on labor, while Continental spends only 35.2%. Delta, meanwhile, spends 46.3%.xvii Given that American may have averted bankruptcy by restructuring, and that restructuring as a result of bankruptcy appears to have saved Continental, then, should Delta and others simply restructure their labor contracts in order to save revenue for other rising costs? Yes, and Delta continues to do that. However, the only union Delta works with, the pilots’ union, has yet to concede any portion of its contract, and Delta is generally not considered to be on the doorstep of bankruptcy, so negotiations might be difficult.

The important aspect of this discussion is not its implicit management recommendation, but what it indicates about the market as a whole. Airlines are losing money. Though compounded by the difficulty of a trough in the business cycle, this loss is due to new, increasing, and permanent pressures on the hub and spoke airline industry and the industry as a whole.

Additionally, the emergence of online travel agencies has turned what once acted as a highly concentrated, even oligopolistic industry into one that behaves in near-perfect competition. Using popular online search tools such as expedia.com and orbitz.com, consumers can receive a side-by-side lineup of all flights from airport A to airport B within a certain time window, ordered by price. Airlines not only have to compete with emerging discounters, but also with each other in a very fluid, competitive marketplace where consumers have gained most of the power.

Finally, the terrorist attacks of September 11, 2001 have permanently affected domestic air travel in the United States. Due to an increase in overall societal fear and anxiety over terrorism, many consumers are simply traveling less. In addition, due to increased security standards, longer airport waits, and what Delta management calls the “hassle factor,” many regional travelers are simply switching to the imperfect substitutes that exist for travelers, such as driving between cities in the same general region. According to Dow Jones Business News, “several airlines have seen passenger bookings plunge between 20% and 30% from a year ago.”xviii Increased security has also led to measurably higher costs for the airline industry. Insurance costs have ballooned from $100 million to $700 million annually as a result of the attacks.xix In addition, due to the increased price sensitivity on the part of consumers discussed earlier, Delta claims that it shoulders the entirety of airline taxation, which now, according to Mullin, amounts for 26% of a $300 plane ticket.xx In a jittery, terrorism-age nation, it can even be argued with

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success that air travel is more sensitive than other industries to shocks, such as the War in Iraq and even the SARS outbreak.

Taking these new challenges into consideration, it becomes clear that Delta and its peers in the hub and spoke sector of the airline industry are being squeezed from all sides. Revenues are decreasing due to permanently shifted demand and increased shock sensitivity, the ease of shopping for alternative airline tickets and the emergence of a discount sector. Costs are increasing as a result of new security measures. Though small steps can be and are being taken to reverse both trends, the overall problem is a permanent and industry-wide problem. The airline industry, structured as it is in the hub and spoke format, is not profitable. However, the partners at Blaisdell Consulting believe that the hub and spoke network is worth saving, and Delta should spearhead an intense lobbying campaign aimed at achieving limited regulation. In addition to the argument Leo Mullin has already articulated, Delta should argue that access to airline service to cities around the country is a public good, like interstate highways and passenger trains, basic infrastructure that the government should make sure is provided. Airline consultant Michael Boyd points out that "if everyone were like Southwest, 75 percent of the United States wouldn't be served."xxi With the negative shock of the mid-March invasion of Iraq, each of the top five airlines cut between eight and twelve percent of its routes, and it would only make sense that these routes were the ones deemed least profitable. Limited regulation appears the only way to preserve routes through unprofitable airports.

Specific Policy Recommendations

As government regulation in its most extravagant form has already been used on the airline industry and abandoned for good reason, Delta and other hub and spoke carriers should lobby for a more competitive, incentives-based and hands-off form of regulation.

The most obvious and direct solution would be to require that airlines fly to non- profitable routes as well as the high profit routes often skimmed by discounters. A key part of the recent business failure of hub and spoke airlines is that they have been forced to compete near marginal cost on the highly profitable routes, rather than near average cost over all routes. Airlines previously had used these highly profitable routes to subsidize the other 75% and create a viable national network. However, with Southwest and JetBlue skimming only the high turnaround routes, the two airlines have had a much simpler cost structure, even down to the very planes that they fly. By indexing cities into tiers of profitability, the Federal Aviation Administration could enforce a very simple form of regulation. All airlines flying through a “Tier A” or “Tier B” city—that is, a profitable airport—must fly through a certain ratio of A and B to C, D, or E cities. Once the burdensome task of organizing and classifying airports was complete, the FAA would have a remarkably easy time enforcing its regulation, simply asking the question, “is the flight from Madison, WI to Chicago actually flying?”

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Another idea would be to assign grants for airports servicing different geographical areas. An airline would procure these grants by flying a set schedule through the airports in question. The grants, however, would be of variable size based on bidding wars between the airlines, and would go to the lowest bidder. The grant size would ideally be exactly equal to the airline’s loss under free-market circumstances for flying that route. The government then would not have to distinguish and discriminate between discount carriers and traditional hub and spoke carriers, as the point is simply to ensure service to each airport. Such regulation would simply make unprofitable routes profitable, and thus encourage competition for airlines to lower costs and compete for each grant.

Either way, the message to federal regulators should be clear: given emerging industry forces, the hub and spoke structure cannot compete in today’s air travel market. Though Delta fares as perhaps the best of the industry leaders in hub and spoke air travel, it is the captain on a sinking ship. As the existence of hub and spoke carriers is essential to the fluidity of air travel, such airlines must be preserved through limited, incentives-based regulation.

i http://www.delta.com/home/press_url/dal_stats_facts/daltimeline/index.jsp ii “The world's best companies 2002.” Global Finance New York; Nov 2002. Mark Johnson; Paula Green; Gordon Platt; Adam Rombel; Amanda Williams iii http://www.goodjobsfirst.org/crp/sep01.htm iv http://www.activemedia-guide.com/totalusairline_mrkt.htm v Stempel, Jonathan. “Discount Airlines May Crowd Skies.” Reuters 3/2/03 vi Velocci, Anthony L. “Can Majors Shift Focus Fast Enough To Survive? Question haunts industry as low-fare carriers grab market share, and high costs, low productivity begin to strangle some airlines.” Aviation Week & Space Technology New York; Nov 18, 2002. vii Delta Air Lines 2001 Annual Report viii Donlan, Thomas G. “Delta’s Upstart.” Barron’s 12/2/02. ix Delta Air Lines 2001 Annual Report x Standard & Poor’s xi Deutsche Bank Securities, p. 3 xii Delta Air Lines 2002 Annual Report xiii Bond, David. “Let the good times roll.” Aviation Week 3/10/03 xiv Stempel, Jonathan. “Discount airlines may crowd skies.” Reuters 3/2/03 xv Bond, David xvi Delta Air Lines 2002 Annual Report xvii Carey, Susan and McCartney, Scott. “Long Knives: United’s Bid to Cut Labor Costs Could Force Rivals to Follow.” Wall Street Journal 2/25/03 xviii “Delta to Trim Flights as War Curbs Passengers Demand.” Dow Jones Business News 3/24/03 xix Haddad, Charles and Zellner, Wendy. “Getting Down and Dirty with the Discounters.” Business Week 10/28/02 xx Delta Air Lines 2002 Annual Report, 4. xxi Stempel, Jonathan

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