CTAC03 4/13/07 17:21 Page 26 case 3 The US Airline Industry in 2007 Here’s a list of 129 airlines that in the past 20 years filed for bankruptcy. Continental was smart enough to make that list twice. As of 1992, in fact – though the picture would have improved since then – the money that had been made since the dawn of aviation by all of this country’s airline companies was zero. Absolutely zero. Sizing all this up, I like to think that if I’d been at Kitty Hawk in 1903 when Orville Wright took off, I would have been farsighted enough, and public- spirited enough – I owed this to future capitalists – to shoot him down. I mean, Karl Marx couldn’t have done as much damage to capitalists as Orville did. WARREN BUFFETT, CHAIRMAN, BERKSHIRE HATHAWAY As they returned to work at the beginning of January 2007, the senior executives of America’s leading airlines experienced a feeling of optimism and joie de vivre that had been largely absent for most of the previous six years. Between 2001 and 2005, the industry had been ravaged by the horror of September 11, 2001 and the raft of new security measures that followed in its wake, by a tripling in the price of jet fuel, and by unprecedented competitive pres- sures from a new generation of low-cost airlines. During this period, the indus- try racked up losses of $35 billion and four of the countries six biggest airlines were forced into Chapter 11 bankruptcy. Yet, 2006 appeared to be a turning point. For the first time since 2000 the industry made a profit (albeit a small one); only three of the leading carriers reported losses (see table 3.1). United Airlines followed US Airlines out of bankruptcy, leaving only Delta and Northwestern still in Chapter 11. Even the Copyright © 2008 Robert M. Grant 26 CTAC03 4/13/07 17:21 Page 27 THE US AIRLINE INDUSTRY IN 2007 27 TABLE 3.1 Revenues, profits, and employment of the seven largest US airlines Return on Revenue Net income assets* Employees 2006 $ 2005 $ 2006 $ 2005 $ 2006 2005 2006 2002 billion billion million million (%) (%) AMR 17.4 20.7 680 (861) 0.5 (3.2) 86,800 109,500 UAL 13.7 17.4 (4,160) (21,176) (0.3) (4.1) 57,000 72,000 Delta 13.3 16.2 (3,610) (3,818) (4.8) (10.0) 55,700 76,100 Northwest 9.5 12.3 (3,210) (2,533) (2.6) (7.0) 32,460 44,300 Continental 8.9 11.2 420 (68) 3.2 (0.4) 42,200 43,900 US Airways 7.0 5.1 228 (537) 2.6 (2.1) 12,100 46,600 Group Southwest 5.9 7.6 738 548 6.7 5.8 31,729 33,700 TOTAL 75.7 90.5 (8,914) (28,445) n.a. n.a. 317,989 426,100 10-K REPORTS. * Return on assets = Per-tax operating income/Total assets; n.a. = not applicable. SOURCES: battered stocks of the airline companies were experiencing revival. The AMEX Air- line Index had hit a high for the year in December 2006, while the stock prices of AMR (the parent of American), Continental Airlines, and US Airlines Group had all more than doubled since the beginning of the year. Stock market interest in the sector had been stimulated by the prospects for a new round of consolidation in the industry. The merger of US Airlines Group and America West Airlines at the end of 2005 was followed by a hostile bid by the newly merged company for Delta Airlines in November 2006. Responding to news of the bid, United’s CFO, Jack Brace, told investment analysts: “We think consolidation is good for the industry, and if it makes sense for us to participate, we will. Consolidation is a natural phase for the evolution of an industry as mature as ours.” Brace believed that the domestic airline industry would consolidate around two to four legacy network carriers, with three being the most likely number. This would help limit seat capacity and provide more pricing power to the airlines. Among industry executives and investment analysis, opinions on the prospects for the US airline industry were mixed. Some pointed to a new climate of realism and financial prudence in the industry. After more than five years of struggle, the major car- riers had done much to get costs under control. They had confronted the labor unions and gained substantial concessions on pay, benefits, and working practices. They had gained efficiency benefits from outsourcing and better use of IT, and retired many of their fuel-inefficient older planes. Others were less sanguine. The problems of the airline industry could not be attributed just to 9/11 and high fuel prices. For decades the industry has generated poor returns on the capital invested in it – not just in the US, but in other countries too. Nor could poor industry performance be attributed to inept management. It was notable that, while the “legacy carriers” (the major, established network operators) had cut costs and eliminated losses, many of the low-cost carriers were beginning CTAC03 4/13/07 17:21 Page 28 28 THE US AIRLINE INDUSTRY IN 2007 to struggle. Jet Blue and Air Tran were both barely profitable during 2006. “We’ve been here before, many times,” observed one industry veteran, “Just when the industry seems to be climbing out of the mire, the industry’s dire economics reaasert themselves.” From Regulation to Competition The history of the US airline industry breaks into two main phases: the period of regulation up until 1978, and the period of deregulation since then. The Airlines Under Regulation (Pre-1978) The first scheduled airline services began in the 1920s – primarily for carrying mail rather than passengers. By the early 1930s, transcontinental routes were controlled by three airlines: United Airlines in the north, American Airlines in the south, and TWA through the middle. New entry and growing competition (notably from Delta and Continental) led to the threat of instability in the industry, and in 1938 Congress established the Civil Aeronautics Board (CAB) with authority to administer the struc- ture of the industry and competition within it. The CAB awarded interstate routes to the existing 23 airlines, established safety guidelines priorities, and strict rules for pas- senger fares, airmail rates, route entry and exit, mergers and acquisitions, and interfirm agreements. Fares were set by CAB on the basis of cost plus a reasonable rate of return. The outcome was an ossification of industry structure – despite more than 80 applications, not a single new carrier was approved between 1938 and 1978. Instead, new entrants set up as local carriers offering intrastate routes. Rapid expansion of the industry after World War II and a wave of technological innovations – notably the jet – led to increasing concerns over airline safety and the establishment of the Federal Aviation Administration to regulate airline safety. During the 1970s, a major shift occurred in political opinion as increasing support for economic liberalism resulted in demands for less government regulation and greater reliance on market forces. Political arguments for deregulation were supported by new developments in economics. The case for regulation had been based tradi- tionally on arguments about “natural monopoly” – competitive markets were impos- sible in industries where scale economies and network effects were important. During the early 1970s, the theory of contestable markets was developed. The main argu- ment was that industries did not need to be competitively structured in order to result in competitive outcomes. So long as barriers to entry and exit were low, then the potential for “hit and run” entry would cause established firms to charge com- petitive prices and earn competitive rates of return. The outcome was the Airline Deregulation Act which, in October 1978, abolished the CAB and inaugurated a new era of competition in the airline industry. The Impact of Deregulation The elimination of restrictions over domestic routes and schedules and over domes- tic fares resulted in a wave of new entrants and an upsurge in price competition. By 1980, 20 new carriers – including People Express, Air Florida, and Midway – had set up. CTAC03 4/13/07 17:21 Page 29 THE US AIRLINE INDUSTRY IN 2007 29 TABLE 3.2 Financial and operating data for the US airline industry, 1978–2006 Available Load Breakeven Operating Net Operating Net Rate of return seat miles factor load factor revenue income margin margin on investmenta (billions) (%) (%) ($ billion) ($ million) (%) (%) (%) 1978 369 61.5 57.4 22.9 1,197 6.0 5.2 13.3 1979 416 63.0 62.5 27.2 347 0.7 1.3 6.5 1980 433 59.0 59.1 33.7 17 (0.7) 0.1 5.3 1981 425 58.6 59.2 36.7 (301) (1.2) (0.8) 4.7 1982 440 59.0 60.0 36.4 (916) (2.0) (2.5) 2.1 1983 465 60.7 60.1 39.0 (188) 0.8 0.5 6.0 1984 515 59.2 56.3 43.8 825 4.9 1.9 9.9 1985 548 61.4 59.7 46.7 863 3.1 1.8 9.6 1986 607 60.3 58.7 50.5 (235) 2.6 (0.5) 4.9 1987 649 62.4 59.6 57.0 593 4.3 1.0 7.2 1988 677 62.5 58.9 64.6 1,686 5.4 2.6 10.8 1989 684 63.2 61.6 69.3 128 2.6 0.2 6.3 1990 733 62.4 64.0 76.1 (3,921) (2.5) (5.1) (6.0) 1991 715 62.6 64.1 75.2 (1,940) (2.4) (2.6) (0.5) 1992 753 63.6 65.6 78.1 (4,791) (3.1) (3.1) (9.3) 1993 771 63.5 62.4 83.8 (2,136) 1.7 1.7 (0.4) 1994 784 66.2 66.8 88.3 (344) 3.0 (0.4) 5.2 1995 807 67.0 64.9 94.6 2,314 6.2 2.4 11.9 1996 835 69.3 66.9 101.9 2,804 6.1 2.8 11.5 1997 861 70.3 65.0 109.6 5,168 7.8 4.7 14.7 (VARIOUS YEARS); BUREAU OF TRANSPORTATION STATISTICS.