The message coming out of this year's Phoenix symposium was clear - cost reduction is paramount if the major US carriers are to survive the low-cost onslaught. And life is likely to get worse before it gets better

"Run, man, run" was the comment offered by America West chairman Doug Parker when asked what advice he would give to Bruce Lakefield, who just days before had taken the helm at US Airways following the sudden departure of his predecessor David Siegel.

The comment brought laughter and quite a few nods from airline chief executives and others at the 13th annual Phoenix International Aviation Symposium. But it also highlighted the daunting task facing Lakefield and other top executives of the loss-making and battered US legacy carriers. Siegel's departure was "unfortunate", Parker added, because he "was doing what needed to be done".

The all-too-familiar predicament of the old-line carriers was summarised by Dorothy Robyn, senior consultant with the Brattle Group. They are faced with a big shift in business travel. Low-cost carriers have reached critical mass, decimating the pricing structure of the legacy carriers and eliminating their one-time double-digit premiums. And then there is their cost structure, with especially high labour costs - fed by pattern bargaining - and low productivity compared with their low-cost competitors.

"The forces bearing down on legacy carriers are permanent, not cyclical," she concludes. "The problem is not the business model; it's excessive costs."

Siegel did not attend the conference - although he had been lined up to speak - but instead he sent a prepared statement in which he made clear that industry changes were both significant and permanent. "There is a different type of supply and demand in the marketplace; it is no longer an excess of supply, but both a shortage and an imbalance," he contends. "There is simply too much ¢10 capacity and not enough ¢6 capacity." Siegel predicts that this will correct itself over the next three to five years as low-cost carriers grow and legacy carriers shrink and/or get their costs in line, permitting a "competitive equilibrium" to be reached.

There appeared to be wide agreement at the conference that cost reduction is paramount if legacy carriers are to survive. Jeffrey Knittel, president of CIT Leasing, noted that there has been less talk during the last six months of "revenue coming back", and "the focus now is on getting costs in line". He was not alone in suggesting that legacy carriers, with long-term imbedded costs, would struggle to match low-cost competitors without the same "burdens". But matching is not necessary, he adds: "There are some benefits of the legacy carriers so they do not have to be dollar for dollar."

Daniel Kasper, managing director of global consulting firm LECG, agrees. Because there are synergies in the hub-and-spoke systems, the legacy carriers do not necessarily have to get costs down to low-cost carrier levels "this time", he says, predicting that most of the existing carriers will make it through this cycle. "Longer term, the cost disadvantage the legacy carriers have is not sustainable," he warns.

Legacy carriers are clearly seeking to cut costs in many areas. Gerard Arpey, for instance, talked of reducing the number of aircraft types in the American Airlines fleet from 14 (with 30 subtypes) to six (with 14 subtypes). But some question whether old habits may be dying hard. Coming in for particular criticism at Phoenix, not least from the budget carriers themselves, is the way that the network majors add substantial capacity and match fares when new low-cost rivals arrive on a route. "It's crazy to be adding capacity when they're losing so much money," says America West's Parker.

Pricing is also an issue. Scott Kirby, who helped turn round America West as its executive vice-president sales and marketing, notes that some carriers still seek to maintain market share "at all costs" by matching the lowest fares offered by competitors even though they lose money. "Sometimes it makes sense to give up market share," he says.

Pricing pitfalls

Especially with the prevalence of online distribution channels, he says, some low fares get put in place for long periods of time because a carrier matches a weekend fare, then it gets extended, then matched, published and so on. As an example, he cites a $158 return fare on an Orlando-Seattle route that was in place before America West restructured its pricing. Although it had an 80% load factor, it had a ¢2 yield on the route. "We can't make money at that," he says, adding that airlines need to do a better job of pricing on the internet and should only offer low fares on their own websites. "Airlines need to be careful not to create a demon, turning customers over to third parties," he warns.

Steve Trinkle, vice-president of Navitaire's Open Skies reservations system, used by many low-fare carriers, agrees. He reckons that about 75% of transactions on Open Skies are processed through own airline websites, giving carriers "control over their own destiny". He adds: "The absolute lowest fare doesn't matter. It's about perceived low fare."

The conference also tackled the issue of investment in the airline industry - it is not a pretty picture. Eugene Weil, managing director of Milestone Merchant Partners, set the stage: "We've seen a massive increase in leverage, and the safety net of unencumbered assets is gone. Can these tremendously leveraged balance sheets be repaired? Will we see true equity flow back into this industry?" Not without significant changes in their cost structures, was the answer from most conference participants.

Richard Schifter, partner in Texas Pacific Group, a private equity firm that had key stakes in Continental Airlines, America West and Ryanair at one time and was close to a stake in the bankrupt US Airways, says that his company does not believe that airlines represent a long-term attractive investment. Texas Pacific's model is rather to look for a relatively distressed situation, get a meaningful stake at an attractive price and "get out before the next downturn", he says. "We don't invest, we trade".

The airline industry's problem, says Schifter, is focused on cost structure rather than balance sheet. He argues that the balance sheet will repair itself once the carriers get their costs down. "They cannot survive otherwise," he warns.

Like others at the conference, Schifter says that tackling labour expense, which he identifies as "the most significant" component of industry costs, is crucial in the effort to restructure. "It's not that they're getting paid too much," he says of airline employees, "but getting paid more than the low-cost carriers. Look at the differential; 80% is labour costs."

With their dismal balance sheets, even financing aircraft is a problem for legacy carriers, according to CIT's Knittel. During most of the 1990s, an airline could finance aircraft for up to 25 years, with the lender looking only at cash flow of the airline to get a return. "That's gone," he said.

The picture is also likely to get worse before it gets better. According to Douglas Runte, managing director of Morgan Stanley, 2005 is likely to be another "very challenging year for many carriers". Congressional action to provide carriers with pension relief is only temporary, he points out. And some carriers, like Delta Air Lines, have debt maturities coming due. In addition, instruments such as convertible debt cannot be accessed easily by airlines, Runte says, "because most of the furniture has been burned, tossed into the fire to keep warm".

While legacy carriers may not garner investment until their costs are in line, financing is available for start-ups with sound business plans and good management, the conference was told. Especially in the last six months, according to Texas Pacific's Schifter, they have been seeing more start-up capital and viable business plans than in the 1990s. "We're now seeing embedded carriers pulling back marginal or unprofitable routes, creating opportunities for new start-ups," he said. But he was not very confident about their prospects. "We will continue to see start-ups," he predicts, "and 90-95% of them will fail."

Schifter is not alone in highlighting the strength of the management team as what sells investors on new entrants. "The biggest barrier to entry is management talent," agrees Morgan Stanley's Runte. "JetBlue was able to bring everything together." Henri Courpron, president and chief executive of Airbus North America, concurs: "A business plan is only as good as the assumptions in it and they will change in two to three years, so you need good management able to respond to the marketplace."

Consolidation doubts

While the idea of consolidation was raised at the conference, few see it as solution. "I am extremely sceptical that mergers are the answer," says LECG's Kasper. "I am not aware of any airline merger that resulted in lower costs."

AirTran Airways chief executive Joe Leonard agrees. "The long-term answer is to let businesses fail," he argues. It is a sentiment that won wide approval from the audience in Phoenix. Asked whether carriers should be allowed to fail, 92% voted that they should.

Although bankruptcy was not embraced as a solution to carrier woes - too expensive and too inefficient, most said - it has given some, an opportunity to restructure successfully, including Hawaiian Airlines. "While majors enjoy huge network benefits a small carrier is able to understand the customer and deliver to them what they demand," says Hawaiian's president Mark Dunkerley.

Hawaiian, which has reduced unit costs but increased seat revenue by double digits, has been able to "focus business, change when needed and bring employees along," he says. "There's plenty of room for different business models." The US ajors too may need to experiment.


Source: Airline Business