Print this article | Return to Article | Return to CFO.com
Why airline pricing can't be fundamentally changed without an overhaul of industry cost structures.
Lori Calabro, CFO Magazine
September 1, 2002
When the airline industry announced second-quarter results in July, the numbers were not pretty: a combined $1.4 billion of red ink, after even larger losses in the first period. At the same time, US Airways was clearly on the brink of bankruptcy. So how did the airlines respond? They launched a new summer price war. Go figure.
Among the folks who fly on the corporate dollar, though, airfares create anger as well as confusion. That's because they face last-minute fares that are, on average, five times more than the lowest leisure ticket price.
"The price variation is so significant that it just doesn't make sense," says Alex Wasilov, president and COO of Philadelphia-based Rosenbluth International. "It doesn't make sense to the travelers, the [travel] agency community, or to the airlines themselves."
Until recently, many airlines stubbornly refused to admit that disgust over fares might be a factor in today's severe slump--even though business travel is estimated to be down 20 percent to 25 percent from 2000 levels, according to Business Travel Coalition Inc., an advocacy organization for corporate-travel purchasers. But it's now painfully obvious, says BTC chairman Kevin P. Mitchell, that some corporate falloff is "permanent," and won't be rekindled by an economic rebound.
Lately the industry seems readier to address the gouging of its best customers, with executives including American Airlines CEO Donald J. Carty declaring that a simpler fare structure is in order. "Everybody knows the industry's current pricing model is badly broken," Carty told analysts in June, two months before he unveiled a broad redesign of American's operations, which made no mention of fares. "Many of our best customers feel as though they're being cheated. It's clear that something dramatic needs to be done."
What that something is, however, isn't clear. Some big airlines, including American and United, have tested lowering business fares. And in August, Northwest Airlines and several other large carriers experimented with cutting "walk-up" fares used by the business market by some 30 percent. That followed a retooling of pricing structures by some lower-cost carriers, led by America West. By the end of the month, however, most deals at major airlines had disappeared, leaving business airfares "at historical highs," says Mitchell.
The problem, though, is that most airline business models depend on a steady stream of higher business-travel dollars. Indeed, usually they account for three-quarters of revenue and half the passenger total. Big carriers "need that high-yield, close-in traffic," explains Paul Tate, CFO of Denver-based Frontier Airlines, "in order to support their high cost structures." Therein lies the problem with streamlining or radically lowering prices, says Scott Gillespie, CEO of Travel Analytics. "Only by reducing their costs can any of the major airlines rationally afford to reduce their prices. If airlines reform pricing first, it will be a financial disaster."
BTC's Mitchell traces all this pricing complexity to the super-saver fares of the 1980s. "Through certain restrictions, such as the Saturday-night stay, the airlines could differentiate and price-discriminate," he says. That disparity grew, fueled by the same economy-boosting technology bubble that sent corporate executives into the skies in droves. Six years ago, in fact, the average business fare was only 2.5 times--not 5 times--the average leisure fare, according to American Express Corporate Services.
The airlines' own affair with technology, meanwhile, only complicated matters. Sophisticated inventory-management tools now provide "the mousetraps for complexity," says Mitchell. And meanwhile, cost-conscious business travelers have turned to low-fare airlines (which now account for a fifth of domestic air capacity) or they book early, like the leisure crowd does.
Still, airlines have been cautious about cutting the walk-up fares that are so vital both to them and to business travel. They fear sacrificing that high-revenue potential--or being the first to try it. Being first hurt American badly in 1992, when its "value pricing" structure last attempted to narrow the gap between business and leisure fares. "Value pricing didn't work, because American just did it without consulting its corporate clients," says Cheryl Hutchinson, president of the Association of Corporate Travel Executives. Rivals, led by Northwest Airlines, refused to go along, leading to a massive pricing war and forcing American to abandon the program in seven weeks.
This time, there are at least signs that some airlines may be game for another attempt. In March, America West announced it was simplifying its everyday fare structure, eliminating the Saturday-stay requirement and lowering unrestricted walk-up fares by 50 percent to 75 percent compared with its major rivals.
America West could afford it, according to CFO Bernie Han, because full walk-up fares account for only 5 percent of its total revenue. There was "greater-than-expected retaliation by competitors," he says. But for the Phoenix-based carrier, the plan seems to be working; second-quarter revenue fell only 7 percent, half the plunge of the large airlines.
Meanwhile, Frontier Airlines narrowed the gap between its low- and high-end fares in July, and was immediately followed by United, part of what was then seen as a rare experiment by a major airline to gauge the effect of cutting business fares. At the end of the month, however, $445 million Frontier announced its first quarterly loss in four years, $2.9 million in the red, compared with a $7.7 million profit the previous year.
CFO Tate, however, maintains that Frontier can offer significantly lower fares going forward because of its lower cost structure. In the March quarter, "our break-even load factor was 55 percent, which means we needed to fill 55 percent of our available seats on average on every flight in order to break even. United's was 91 percent." United's handicap is that "it's very difficult to build up an economies-of-scale-type infrastructure when you try to be all things to all people."
What Won't Fly
Universal appeal, of course, is what attracts business travelers to the major airlines, and why those carriers can charge more. Their hub systems meet scheduling needs, and frequent-flier programs inspire loyalty.
To date, few majors have copied the fundamental price restructuring of America West or low-fare leader Southwest. Doing so, says Gillespie of Travel Analytics, means fundamentally addressing "the three major costs to an airline: fleet, labor, and jet fuel." While fuel cost may be beyond an airline's control, he maintains that airlines can influence the other two factors.
Costly labor contracts, for example, force most major carriers to charge higher-margin business fares. Labor accounts for 40 percent of total expenses at American, for example, versus 30 percent at Southwest and 25 percent at Frontier. So airlines soon will have to negotiate more employee givebacks. Frontier cuts costs and increases pricing flexibility by using a single jetliner model instead of the varied fleets of most rivals. And the hub system can also be a cost albatross, requiring multiple crews, baggage handlers, and gates to remain idle while awaiting connecting flights.
American's latest plan involves eliminating all 74 Fokker 100 jetliners and "de-peaking" its Dallas-Fort Worth hub. De-peaking its Chicago hub last April increased productivity by spreading connections throughout the day. Senior vice president and CFO Jeffrey Campbell says the changes allow fewer aircraft to be used and cut the need for gates. He adds that in other cost-saving changes being reviewed, "there are no sacred cows."
How fares will fare in the future is uncertain, especially with the bankruptcy scenarios unfolding before us. Much may depend on whether there are mergers and capacity reductions to go with the cost cutting. And while experts expect a fundamentally different pricing approach to emerge within two years, they debate whether airlines or Washington will initiate the changes.
"The government has already stated that it is a matter of public policy to have a robust aviation system in this country," says Tate. Stepping in to force price changes, however, "would be a de facto admission," says Mitchell, "that airline deregulation was a dismal failure."
Lori Calabro is a deputy editor of CFO.
Airline financial woes, experts predict, may soon squeeze the discount programs companies now enjoy.
Traditionally, airlines "leverage loyalties and [give upfront] discounts," says Cheryl Hutchinson, president of the Association of Corporate Travel Executives. But going forward, companies will "have to commit to a certain amount of volume" and carry through on the commitments to win those discounts. By year-end, Hutchinson estimates, airlines will start asking major customers to pay penalties if they fall short of volume commitments.
This would force CFOs to become involved, she predicts. "If travel managers have to commit X amount of money, CFOs will have to sign off."