The profit differences between the hub-and-spoke carriers and the low-fare airlines has some calling for the end of the hub. This would be a mistake
The post-11 September period has witnessed a drastic contrast in the financial performance of the world's airlines. The results posted by majors and flag carriers has largely verged on disastrous - cumulative losses among US majors alone have exceeded $6 billion. In Europe, where the flag carriers of Belgium and Switzerland have failed, the situation is not much better.
Meanwhile, the picture could scarcely be more different at low-cost carriers: AirTran, JetBlue and Southwest in the USA; easyJet and Ryanair in Europe; and Virgin Blue in Australia have all registered profits and pushed ahead with growth.
The varying fortunes of the two segments has led a growing chorus of voices to proclaim the demise of the traditional network carrier business model. The logic says that, as only point-to-point carriers make money, point-to-point networks must be the most efficient form of network design. Even planners at major airlines are asking if it is time to unwind their hub structures.
However, while there is no denying that the world's major airlines have much reforming to do of both their revenue and cost systems, moving away from the hub-and-spoke network is the last thing they should do.
Principles of network design
The US air services market features around 115,000 origin-and-destination pairs. Only about 18% of these markets are large enough to support non-stop service (at least 75 passengers per day). Since the advent of the hub, nearly all them are connected by non-stop flights.
Contrary to popular belief, a similar market distribution system exists in Europe, where about 15,000 of the 110,000 O&D markets transport more than 75 passengers per day. As in the USA, virtually all of these larger markets have non-stop service.
For the remainder of the thousands of smaller markets, it is impractical to design a network with point-to-point service. Even if the air space and airports could support tens of thousands of additional flights, the large unit costs associated with flying small aircraft in congested space would raise fares to unpalatable levels.
Although Europe's air service market is perceived as being point-to-point intensive, the hub is a key feature in the sector. Almost 60% of Air France's traffic connects through its hub in Paris, the development of which the company credits for its financial turn-around in the mid-1990s.
This connecting traffic provides Air France comprehensive competitive access throughout Europe, and a strong presence in Africa, Asia and North America. It also helped with the capture of Sabena's traffic flow when that carrier failed. Lufthansa is in a similar position with its Frankfurt hub. Both carriers are expected to report profits in 2002's difficult environment.
Competitive advantages
Connecting traffic creates more local service than can otherwise be supported. Traffic transferring through the hub allows the carrier to add more service, which in turn improves its presence in the local market. The process is circular, in that additional local traffic allows more frequencies that, in turn, create still more connections. A result is that large O&D markets are fragmented to levels that make it difficult for true point-to-point services to compete.
Chicago to Boston, for example, is a large market with around 900 passengers a day. American Airlines and United Airlines combine to offer 26 daily trips in the market, thanks to the large connecting flows both have through their bases at Chicago O'Hare. Assuming fair share, a point-to-point carrier entering the market with five trips on a 120-seat aircraft would garner only a 24% load factor.
An example of this concept in action is found in AirTran's attempt to connect Philadelphia and Pittsburgh, two hubs of rival US Airways. Despite significantly lower fares, the incumbent hub advantage enjoyed by US Airways proved insurmountable and AirTran pulled out of the market after 10 months, having managed only a 40% load factor.
Another airline that knows well the dangers of serving other carriers' hubs - and studiously avoids doing so - is Southwest Airlines. With a large network and more domestic jet departures than any other carrier, its network development continues to be characterised by no or limited direct service into the largest hub airports.
The low-fare giant does not schedule a single departure in major airports at Atlanta, Denver, Minneapolis and Philadelphia. Even with operations at secondary airports in Chicago, Dallas, Houston and Washington, Southwest's departure-share in major hub cities is less than 10%.
Similarly, JetBlue serves New York to Long Beach, Oakland and Ontario, but not Los Angeles or San Francisco. As with Southwest, the natural economic barriers to entry have kept them away from direct confrontations with major carriers. Ryanair, which serves none of Europe's top airports, is no different. The carrier's success is enviable, but unless its business model changes, its growth prospects are bound to be constrained.
And while Ryanair's new base at Hahn - about 120 kilometres from Frankfurt - may well be successful, it is short-sighted to believe it will drive Lufthansa to its knees in the Frankfurt market. The German flag carrier's hub at Frankfurt's main airport - where well over half of the traffic is connecting - will continue to be a source of the high-yield business traffic associated with local downtown commerce. Lufthansa's yields will drop in some local market sectors, but the strength of its global network and large traffic base will persist.
The Southwest/Ryanair model of sticking to secondary airports does mean reduced airport charges and faster aircraft turns. However, the major motivation for low-cost carriers to bypass major hubs is to avoid fights with entrenched majors.
Additionally, while Southwest's ability to maintain low costs and high traffic levels is enviable, the tendency to hold up these facts as proof that point-to-point networks are most efficient, and that the pursuit of connecting traffic is therefore a flawed strategy is dubious in itself. The reality is that the world's most famous point-to-point carrier is not really as point-to-point as it seems.
In truth, Southwest has developed a comprehensive and integrated network that relies heavily on connecting traffic flows. Analysis of US Department of Transportation ticket samples shows that over 30% of the carrier's traffic is connecting. In interior cities, transfer traffic is as high as 35-40% of total. These connections are created by virtue of higher frequency service in large cities, not at all unlike hub carriers.
Similarly, 45% of AirTran's traffic connects through Atlanta. And JetBlue, even with a lower percentage of transfer traffic, knows it would be unable to offer its short-haul services in the Northeast - where local traffic is less than 60% - without connections to Florida and the West Coast.
Network carriers' problems
If hubs are so powerful then why are so many hub carriers in financial trouble? The answer lies in over-capacity and a cost structure that needs adjusting. Basically, however, hubs are excellent tools for maximising revenue, in large part because a carrier's presence at an airport creates natural economic barriers to competitive entry, which allows for substantial revenue premiums. This fact is illustrated by the fact that United's domestic unit revenue is 25% higher than Southwest's. When United's longer length of haul (1,760km versus 965km for Southwest) is taken into account, the difference grows to 60%.
Apart from events like war or terrorism, success or failure in the business has largely been explained by supply and demand: try to grow faster than underlying demand, and profits tumble; arrest capacity growth and unit revenues rise.
Because of over-capacity, enormous inventories have been sold at marginal levels, far below average cost. The industry has attempted to compensate by charging business fares significantly above average cost. With the cross-subsidy from the business side reduced and unlikely to return to previous levels, leisure fares will have to reach more compensatory levels. This will only happen if there are fewer seats to fill.
Happily, recent announcements by major US carriers suggest the traditional market-share-chasing mentality is being abandoned in favour of a more rational setting of capacity. Continental Airlines chairman Gordon Bethune recently said: ''We had hoped by this summer to make money. For whatever reason - testosterone, labour issues, plain stupidity - the industry is not able to size itself correctly to make a profit.''
As if in response, American, US Airways and others within days announced major reductions. While it has long been said that "you cannot shrink to profitability," the evidence points to the contrary, as well as to the idea that you can "grow to near insolvency."
The other problem plaguing the network carriers is their high costs. Some looking for ways to reform their cost structure have focused on the hub as the root evil. These strategists often highlight the notion that a hub-and-spoke system inevitably leads to lower aircraft and airport utilisation.
The efficient hub
Statistics, however, tell a different story. Southwest aircraft are in the sky 10.9h a day, while the network majors average a still respectable 10 hours on domestic flight (and 12.1 in international markets).
On the airport side, low utilisation of facilities and labour does occur at smaller stations, but the level of operations at major hubs is so large as to often create a continuous operation of flights. A review of Delta's operation at Atlanta, for example, shows gate utilisation similar to Southwest's at Baltimore (10.1 departures per gate versus 9.9).
That is not to deny, however, that there is ample scope to improve hub cost structures. Interventions such as retiring old and inefficient aircraft types and replacing them with common families is a good start.
Also interesting is American's recently announced plan to apply its "rolling hub" concept - already in effect at the Chicago O'Hare hub - to its Dallas-Fort Worth base. This move represents a creative attempt by planners to refine the efficiency and productivity of their major hub structures.
When comparing the respective benefits of the two systems it is also interesting to note that some of the cost differences between the majors and their point-to-point colleagues of which so much has been made are quite misleading.
Almost everyone recognises that the biggest cost difference between the majors and their low-cost counterparts is found in the labour bill, both in terms of wages and work rules. What is less understood is the role their respective ages and seniority levels play in this fact, and the likelihood that the differences will narrow in the not-so-distant future.
The majors have acquired their labour situation over several decades and through numerous cycles of contract negotiations, each of which has added more complexity in terms of work rules and wage structures. The low-cost carriers are relatively new - Ryanair's first Boeing 737 was delivered only eight years ago - and are growing fast. Southwest, for example, is now 50% bigger than five years ago. These facts conspire to keep their seniority levels low - but this will change.
Although Southwest has hired thousands of pilots in the last five years, their pilot leadership warns it will be aggressive about getting higher wages in the next round of talks. This stance is somewhat in contrast to pilots and other groups at such carriers as United and US Airways, where staff are agreeing to accept lower wages.
Still, while the disparity between major network carriers and low-cost carriers could lessen in time, it is difficult to imagine a cost-parity scenario. This reality makes generating higher revenues even more of an imperative for the hub-bound majors.
Strategic options
The hub-and-spoke carriers will continue to experience difficulties in the months ahead. Declining business revenues and worldwide political uncertainty paint a challenging picture. So what strategic options are now available for network carriers when it comes to their low-cost competition? The best course of action, as always, is to play to strengths. Specifically, they must use their hubs to:
compensate for higher costs with higher revenues. Hubs lead to comprehensive, high-frequency service in the local market, and result in higher yields. Hub-connecting flows represent a revenue source not easily available to new entrant carriers. focus on core cities. Hubs create leading positions in major cities and preserve them through natural economic barriers to entry. Number-one city positions consistently lead to yield premiums as the city's frequent fliers vest with the hub carrier. offer global access. Low-cost carriers have not penetrated intercontinental markets. Network carriers' unit costs taper significantly at longer stage lengths, which use larger, more efficient aircraft. Even if low-cost carriers do enter these markets, their cost advantage will be relatively small. Global alliances will help to solidify this vital advantage.Out of frustration, investors and analysts are looking for a dog to kick by making statements like "the traditional business model is broken" or "we have a new paradigm shift". Copying Southwest is not the answer for network carriers - nor is embarking on some sort of ill-conceived plan to fly only point-to-point routes.
United president Runa Dutta recently said that it would be worse for United to try to re-invent itself as a low-frills leisure carrier than to remain in the high-end, high-revenue business market.
He is right. Carriers should not scrap their powerful, interconnected, worldwide networks. These are their sources of strength. Instead, they must be diligent about sensible cost reduction and keep excess capacity growth under check.
The laws of economics are constantly at play in the airline business and - played out over time - supply and demand, costs and revenues will once again find compensatory levels.
BY STEPHEN STILL WITH APG IN WASHINGTON
Source: Airline Business
