A Sinking Ship? The Air Travel Industry in the 21st Century April 21, 2003 James Lloyd Ji Chong Liam Patrick Prepared For: Delta Air Lines 1 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 2 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 American Airlines’ 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. 3 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 Northwest airlines. 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 4 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 Alaska Airlines.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 Song 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 Atlanta 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, ComAir 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 5 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