The Long Haul

As airlines struggle to survive, the role of finance in decision-making takes off.
Roy HarrisFebruary 1, 2005

The nation’s air-service net-work is still reeling from 9/11, economic doldrums, its own bloated capacity, waves of defensive fare-slashing, and expensive fuel. But along with the daunting challenges has come an opportunity for CFOs: to reshape their airlines to fly profitably in the industry that emerges from the wreckage.

Indeed, airline finance executives are taking charge as never before. Three of the four lowest-cost major carriers have put their former CFOs at the helm: Gary Kelly at Dallas-based Southwest Airlines Co., Larry Kellner at Houston-based Continental Airlines Inc., and Doug Parker at Phoenix-based America West Airlines Inc.

“I think CFOs are emerging in the airline industry,” says Aaron J. Gellman, a professor at the Northwestern University Transportation Center. “Before deregulation [was begun in 1978], the CFO sort of rolled with the punches. It wasn’t a critical issue that he be top-flight (no pun intended). The financing was done formulaically.” One lesson that legacy carriers are learning from Southwest and other successes, he says: “Always put finance people in a key role counseling senior management.”

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Unfortunately, the legacy airlines — led by American Airlines, Delta Air Lines, Northwest Airlines, United Airlines, and US Airways — have learned too slowly the make-or-break nature of cost structures. Right now, with soaring fuel prices pushing even such lower-cost carriers as America West into the red, Southwest and start-up JetBlue Airways Corp. top the short list of “haves” in the industry. Meanwhile, the real legacies of the legacy airlines are uncompetitive labor costs, poorly planned fleet investments, and routes vulnerable to fare wars. When high-cost carriers lead in price-cutting — as Delta did recently — it may well increase their own pain.

It’s 25 Years; Get Over It

At JetBlue, CEO David Neeleman hired John Owen as CFO. Owen was the long-time treasurer of Southwest, which JetBlue unabashedly proclaimed as its model. “Without a doubt, the airline industry collectively has not been well managed,” says Owen, who says it has rolled up a “cumulative net loss for its entire history.” But he gives high marks to Southwest, America West, and Continental for managing to outperform most of the competition.

Southwest CEO Kelly sees the industry’s deregulation as a poor excuse for the extent of its current problems. “We’ve been deregulated for 25 or 26 years,” he observes, and it’s long been clear that “the number-one criteria customers use to select their airline seat is price, so you’d better have your costs under control.” In his view, “as recently as 2000, carriers were making decisions that assumed the heyday would continue. And those have been very bad mistakes.”

The industry was the victim of a “tipping-point phenomenon,” says Yale University law professor Michael E. Levine, a former top airline executive. As discounters with lower cost structures expanded their services geographically against a backdrop of severe overcapacity, a situation was created where “it’s estimated that 75 percent of people buying tickets have some sort of reasonable low-cost alternative,” he says. “So yields have been dropping dramatically,” and the failure to reduce contractual commitments sufficiently pushed airlines deeper into the loss column.

Another obstacle he sees: “The natural instinct of CFOs is to maintain liquidity, because that maintains their flexibility. I’m not suggesting that the obsession with liquidity is wrong, but building up cash reserves has been a problem” in cases where airlines have other needs, such as keeping the labor force happy.

American “Wins”

In terms of actual flexibility — the basic ability to change with the times and make money — America West, the nation’s eighth-largest airline, has shown some signs of developing into a survivor that could one day rival number-six Southwest.

From their conference room looking north across Arizona’s Salt River to the red mesas beyond, Doug Parker and his CFO, Derek Kerr, talk about their experiences since their high-school days together in Farmington, Michigan. Kerr became an aerospace engineer, working for a time on the B-2 bomber program before moving to American, and later Northwest, to work with Parker in finance. Parker joined America West as CFO in 1995, and Kerr followed the next year, becoming senior director of planning. The two men clearly believe that legacy carriers have handicapped themselves in recent years by failing to recognize their real low-cost competition.

“I think they looked too much at each other; they viewed the industry as American, United, Northwest, and Delta,” says the 43-year-old Parker, three years Kerr’s senior. “American was clearly interested in making sure it was better than United. And at the end of the day, it won that game: it was bigger and more profitable, so United went into bankruptcy first.” Meanwhile, though, “Southwest was doing much better than all of them put together. And that opened the door to others that could do a good job of keeping their costs low.”

When it started up in 1983, America West, too, used the legacy-carrier model, worrying less about fare competition than about offering full service through its hubs in Phoenix, Las Vegas, and Columbus, Ohio. While designed with a lower cost structure than its rivals, America West lost some of that advantage in the small-margin Las Vegas market. Like most competitors, it had severe ups and downs. Overexpansion led it into bankruptcy in the early 1990s, but it then established a solid profit-making record until economic woes hit the airline hard early in 2001. The terrorist attacks caught it cash-short, making it among the first carriers to seek a federal loan guarantee.

Parker, named CEO only days before 9/11, says that corporate “near-death experience” had a profound effect on his view of the future. “The fact that we got that close makes you rethink the entire business model,” he says. His conclusion: “Let’s just change everything we’ve ever thought about ourselves.”

Good-Bye, Columbus

The airline’s recovery plan started with a study of the carriers that performed best after 9/11. “There were smaller airlines getting higher revenues than we were,” notes Parker. “Frontier was one, because it had a price advantage.” The major carriers, he says, had decided not to match Frontier’s initiative of reducing fares for tickets purchased less than seven days in advance, the kind of business service that gave airlines a large price premium. The following March, America West eliminated the Saturday-stay requirement and matched Frontier’s late-purchase discounts.

The airline had already shifted to buying Airbus 319 and 320 jets, which were much cheaper than Boeing 737s, the mainstay of America West’s early fleet. While the Airbus purchases continued — the airline now has 87 Airbus planes, 42 737s, 13 larger 757s, and 43 regional jets from Canada’s Bombardier Inc. — picking the cheaper Airbus planes was hardly a no-brainer. “We do 10-to-20-year price-outs,” says Kerr, who became CFO in 2002. He reviews such long-term aircraft outlays as maintenance, one area in which Boeing planes offer savings. But, Parker says, any Boeing savings “just get overwhelmed in the purchase-price decision.”

The CEO had a tough system decision to make in February 2003, when he scrapped the Columbus hub — part of an industry trend to remove the least cost-effective hub operations. “It wasn’t fun flying out to tell those people they weren’t going to have jobs there. But it was the right thing to do,” says Parker. Also right, he says, was America West’s offer of transfers to the 228 affected employees. (The airline has 13,000 employees overall.) Parker thinks his airline and Southwest have done especially well at avoiding layoffs and pay cuts during hard times, dodging the extreme labor strife of some other airlines.

One thing that’s here to stay is fuel-price hedging. “I think airlines will always hedge from now on,” says Parker, who remembers when hedging was seen as foolish in the days before deregulation. “If fuel prices went up, fares went up,” he says. “And if they fell and you’d hedged, the fares went down and everybody else made money, while you lost money.” America West uses a “costless collar” hedge on prices, currently covering 67 percent of its fuel purchases. It installs a put and a call on either end of a predetermined price range (currently $1.10 to $1.32 a gallon) to help ensure against price spikes up to nine months in advance. Its system doesn’t offer the one-year-plus protection that Southwest has achieved, but Kerr notes that other airlines lack the credit ratings Southwest has to support such longer-term arrangements.

CASM and RASM (cost and revenue per available-seat mile, respectively) are still the basic metrics used by America West and others (see “Airline Fracture”). In the third quarter of 2004, America West ranked third behind Southwest and JetBlue in CASM, with a per-seat-mile cost of 7.90 cents. (Its RASM was 7.57 cents, helping to explain its loss for the period.)

Only half-jokingly, Parker says a third metric grabs his attention these days: days cash outstanding relative to the rest of the industry. It’s basically the airline’s way of asking, “Who’s going to file for bankruptcy next?” he says. “It’s not your standard CFO kind of measure, but it’s fascinating.”

These days airlines consider cash reserves as something of a small hedge against the havoc another terrorist attack could wreak. “I can’t remember looking at [relative airline cash positions] on a regular basis until 9/11,” says Parker.

Penciling in the Five-Year Plan

America West has a long-term planning function, even in this fast-changing competitive environment. “You can have a five-year plan,” says Parker. “It just needs to be in pencil.” (Delta’s new fare initiative, for example, has forced America West and other carriers to prepare responses on routes where they fly against Delta.) America West plans to stay hub-based — “hub-and-spoke airlines have much greater unit revenues,” says Parker — and the company figures that in this area, at least, legacy carriers will not model themselves after Southwest and JetBlue.

Long term, Parker expresses optimism that industry overcapacity will abate somewhat, in part as a function of industrywide combinations and liquidations. “When you get airlines consolidating back to their real core assets, there’s clearly room for three or four strong hub-and-spoke carriers,” he says. But not seven, as there are now.

For one thing, the Justice Department is very likely to soften its opposition to airline mergers. (It opposed the combination of struggling United and US Airways on antitrust grounds before the 9/11 attacks.) “The government is tired of hearing from airlines that they need help,” says Parker. “Therefore, they’ll find it hard to deter airlines that want to help themselves.” As for discounters, he believes their numbers will shrink, too, though he won’t speculate on which will end up being acquired or liquidating.

While some think JetBlue’s success could lead others to enter the low-cost market, Parker doubts that new entries will be extensive in the current market. Since JetBlue’s initial public offering in April 2002, he says, “I don’t see much money flowing to start-ups anymore.”

Further helping reduce industry capacity in the U.S., Parker expects a continuation of the recent trend of legacy carriers reassigning aircraft to more-profitable overseas routes, thus reducing the amount of domestic flying they do.

Parker and Kerr are reluctant to predict whether the industry really will become more efficient and profitable over time. They are not alone in their caution. “I wish I knew,” says JetBlue’s Owen, noting that the end of regulation, too, was supposed to spur rationality. “I joined the industry right when deregulation occurred. I naively thought we’d have five years when everything would shake out, and we’d have stability. So my predicting ability is not that good.”

Roy Harris is senior editor at CFO.

A Second Look at Service

Passengers may worry that it’s the job of finance executives to sacrifice service and passenger comfort for the sake of restoring bucks to the bottom line. Indeed, American Airlines has pulled pillows on some flights in a bid to save $300,000 a year, more carriers are charging for coach meals, and some are adding seats in planes on higher-profit routes.

But while “people with a short-term view of the world will cram in more seats,” says Aaron J. Gellman, a professor at the Northwestern University Transportation Center, “Southwest is taking seats out. The best of the finance guys are able to trade off. They understand the dynamic.”

That competitive dynamic has also led airlines to match rivals in moves that build the passenger base — as Delta recently illustrated by cutting fares in a way that simplified pricing and removed Saturday-night stays as a requirement for discounts.

“The finance profession has a bad reputation for being too focused on narrow things, and not on the big picture,” acknowledges JetBlue Airways Corp. CFO John Owen. Owen says he himself was thinking a bit small when CEO David Neeleman proposed investing in free live television in cabin seatbacks. “I was adamantly opposed; I saw it as a cost we could never make back,” says the CFO. But since the change was made in its fleet of 69 jets, Owen and JetBlue have come to view the service as “an essential part of the total JetBlue experience,” resulting in “loyalty and passenger buzz that will result in higher demand.” Says Owen, “We’ll make it up in the average fare, although we can never quantify it or prove it.” —R.H.

Picking Their Battles

For a time last December, it seemed that Southwest Airlines Co. and America West Airlines Inc. were ready to spar over some spoils of the U.S. airline industry fare war.

At an auction of assets by the bankrupt discount carrier ATA, Southwest proposed paying $177 million to secure six ATA gates to bolster Southwest’s Chicago Midway Airport operation, and for a 27.5 percent nonvoting preferred equity ownership in ATA. America West’s idea was grander: a possible offer for the entire ATA operation, a move that would have given America West over-water rights to allow it to begin offering service to Hawaii. Just before the bids were due, though, America West pulled out, leaving Southwest the winner.

While America West’s withdrawal might have seemed a surrender to Southwest, keen financial thinking governed the decisions at both airlines. In his final analysis, America West CFO Derek Kerr calculated that global demand for ATA’s Boeing fleet had suddenly increased — in part because the Chinese were buying up 737s — driving their used-aircraft value high enough that the net present value of the whole offer fell short of the target. As for the over-water service: “We were already targeting Hawaii in 2006,” says Kerr, and the ATA deal would have only “accelerated things.” In an environment in which a third of the nation’s airliners are being operated by carriers in bankruptcy, “there are going to be a lot of other opportunities.”

For others besides America West, Southwest remains the mightiest rival, as well as an object of envy for its low cost, cozy employee relationships, marketing skills, and tough voice in the industry.

“I don’t think any airline can be successful if the focus is only on cost,” says Southwest CEO Gary Kelly. “The airline industry is enormously challenging from a financial perspective, with airlines having to undertake every effort available to mitigate risks.” Southwest has managed to thrive — with 31 consecutive annual profits — because “we found a way to weave our way through those risks.”

But low cost is still the key to profits. Where once Southwest was about the only discounter in town, “lower-cost airlines are now 25 percent of the industry,” says Kelly. “The writing is on the wall. The legacy carriers are going to have to get their costs down, or else they’re going to just disappear.” —R.H.