Air Travel Gets A New Model

By Daniel Eisenberg

You might think, after seeing the barrage of bad news about the major airlines, that the entire industry is going to be stuck on the tarmac by Thanksgiving. But far from all the chatter about bankruptcies and cutbacks, a few enterprising carriers are quietly soaring. Discount pioneer Southwest is readying its first transcontinental flights, from Baltimore, Md., to Los Angeles, starting this fall, while New York City-based upstart JetBlue is adding more flights on the West Coast and in Florida. These and other discount carriers today account for 20% of domestic air travel, up from 10% in 1992.

So why haven't American, United, US Airways and the three other full-service carriers, which lost $11 billion last year and stand to lose an additional $5 billion this year, followed the lead of the profitable discounters by cutting costs and fares? Because that's not the way their business works. They have made, and lost, their money by providing the frequent departures, quick connections, spacious seats and other amenities that have been demanded by business flyers and charging them dearly for that service--more than five times the cost of a discount fare.

It's no wonder, then, that since 9/11, which accelerated the worst downturn in U.S. aviation history, the major carriers have been whistling in the dark, waiting for their business to return to "normal." But with US Airways' move last week to seek bankruptcy protection, United's warning that it was sliding that way and American's announcement of "fundamental structural changes," the majors as much as admitted that they can't wait any longer for the friendly skies to return. They have to start building a new business model--one focused on both leisure travelers and the growing ranks of business travelers who are mimicking their penny-pinching ways.

Recent events underscore how much more turbulence lies ahead for the beleaguered carriers as well as the disgruntled traveling public. Fares will drop on some routes and rise on others. More direct flights could open up, even as layovers grow longer at airline hubs. Satellite airports (Baltimore; Long Beach, Calif.) near metropolitan areas could see more traffic while service is reduced to smaller cities like Syracuse, N.Y., and Greensboro, N.C. And forget those promises of more legroom in coach. Those days are over.

Rather than cause brief setbacks to the airline industry's fortunes, 9/11 and the recession exposed a raft of deeper problems: high fixed costs, a convoluted fare structure, a boom in online bargain hunting by consumers and the growing disaffection of business travelers and their bosses. The full-service airlines' soak-the-rich business model, which has always prized maximizing revenue over operational efficiency, looks all but busted.

Rebuilding it will be wrenching for an industry that collected a record $22.7 billion in profits from 1995 to 2000. With the country enjoying an unprecedented economic boom, corporate travel managers were willing to pay the $2,000 walk-up fares for New York to Dallas or San Francisco to Miami. So it didn't matter how many vacationers were snapping up $400 deals to fly to Hawaii. From January 1996 to December 2001, business fares rose 75%, according to American Express Corporate Travel.

But 9/11 and the recession changed everything. At first, it was not so much the fear of a terrorist attack as the worry of being stranded far from home that crimped air travel. Long waits at security checkpoints took their toll. Companies sought alternatives--driving and taking Amtrak; doing business by phone and e-mail or via better-quality and lower-cost videoconferencing technologies--and found they weren't so bad, especially since they helped cut costs. When they did fly, business travelers and their bookers joined leisure travelers in seeking the best deals on the Internet, even if that required planning trips further in advance. And firms learned to rely more on private charters or fractional jet ownership for their top executives, who had been the airlines' most lucrative customers.

The result: business travelers, who make up just 10% to 15% of all passengers, accounted for only 23% of total airline revenues in 2001, down from 35% in 1999, according to a McKinsey & Co. report. At the same time, total domestic passenger traffic has been falling at an annualized rate of 7%, after growing 4% annually for the previous decade. "Four-figure business fares are like heroin to the airlines. They're addicted to them, but they're bad for their health," says Richard Aboulafia, an analyst for the Teal Group, an aerospace and defense consulting firm in Fairfax, Va.

Even when the economy starts to grow again, it's hard to see business-travel revenue returning to its boom-time levels. The economy, after all, is unlikely to be cruising along at the breakneck pace of the '90s. Overall, business travel has fallen more than 20% since 2000, according to the Business Travel Coalition. As many as 80% of road warriors surveyed by the coalition plan to trim air travel even more this year, and nearly three-quarters think some of the cutbacks will be permanent. Phil Condit, CEO of Boeing, has said that at least 10% of the peak business-travel demand could be gone forever. No wonder the S&P Airlines Index is off 37% this year, double the decline in the broader stock market.

When the Federal Government set up the Air Transportation Stabilization Board (ATSB) last fall to help prop up the ailing airlines with $10 billion in loan guarantees, many credit-strapped CEOs licked their chops in anticipation of yet another big, fat government handout. But this time, at least so far, Uncle Sam hasn't turned into Uncle Sugar. Trying to impose some much needed discipline on the free-spending flyers, the Stabilization Board has required stringent cost-cutting measures as a condition for its help--and hasn't been shy about turning down such requests, as it did with National and Spirit airlines last week and may soon do with United (though sources tell TIME the board has agreed to let United amend its application with more drastic cost-cutting proposals).

Since Wall Street and private-sector outfits like Texas Pacific Group are willing to step into the breach and provide temporary assistance, many wonder why the government needs to play such a role at all, especially when pro-subsidy European counterparts are letting their failing carriers fail. "The ATSB is going to do no one any good in postponing the big bang," says Peter Walsh, an aviation expert at Mercer Management Consulting in Dallas. Not only does Washington seem to be in the curious position of picking winners and losers--America West and US Airways, yes; smaller players like National and Spirit, no--but the carriers it decides to support may well gain an artificial competitive advantage against their peers. Says Gordon Bethune, CEO of Continental: "I don't need the government giving United $2 billion to beat the crap out of me and inflate my wages."

Keeping dying carriers on life support, critics argue, only deters the industry from undertaking the consolidation it needs to return to health--which oil companies and aircraft manufacturers have already done. Pat Murphy, a former Transportation Department official, asks, "Do we really need six major network airlines?"

For the moment, that number isn't likely to change. Bad as things are at US Airways, which has the highest costs in the industry (15.2[cents] per seat mile, vs. around 7.5[cents] for Southwest) and has repeatedly failed to expand much beyond the crowded and competitive Eastern Seaboard, it's probably not going under, at least not yet. The airline has reached agreements with some of its workers to save $550 million this year, and plans to scale back service at less profitable cities, as it did earlier this year in Baltimore. United's challenge may be greater. Many observers believe that its unique, employee-owned corporate structure ensures that labor costs will never go low enough to fix its ailing bottom line. American still has to digest its ill-advised acquisition of TWA; and Delta, whose low-cost Delta Express carrier has been hammered by JetBlue, is said to be close to starting a second low-cost provider. Continental and Northwest have done a better job of reining in costs over the past year.

The industry's overhaul will no doubt bring manifold changes for passengers. Not all have taken shape yet, but here is what industry experts advise:

BRING A BOOK

If American Airlines' new strategy becomes a flight pattern for the rest of the industry, most passengers can probably expect longer layovers. Today full-service airlines concentrate most of their flights around peak rush hours to keep connection times tight for business travelers. But the airlines "get low productivity for the high convenience of short transfers," says Ray Neidl, an airline analyst at Blaylock & Partners in New York City. Under the new system envisioned by American, the flow of traffic will be spread more evenly over the day.

Discounters and majors alike will provide more direct flights between popular destinations, but the hub system will continue to play a major role because feeding passengers from smaller cities into central hubs is still the only way to move people from Sacramento, Calif., to Sarasota, Fla., or Birmingham, Ala., to Los Angeles at a reasonable price. American says the average layover will increase by 10 to 12 minutes, but many travelers could spend an extra 30 minutes to two hours sitting in the airport bar or browsing the newsstand, especially as airlines cut back the number of connecting flights. "I'm not sure running an airline for operational efficiency at the cost of customer satisfaction is the way to go," says a rival airline executive. But look on the bright side: lines at the ticket counter and security checkpoints should be shorter, and there should be fewer delays and a smaller chance your luggage will get lost.

OPEN YOUR WALLET

After being pummeled by the discounters, the major carriers might be expected to make a better effort to compete on price. And at least initially--as hurting airlines do anything to lure passengers on board and bankrupt carriers have more flexibility to trim costs--that may be the case. But in the long run, as the major carriers further cut capacity and eventually consolidate, it's likely that most domestic fares--which declined on average almost 10% in June and are now near 15-year lows--will start to inch their way back up. One reason is that in order to increase the appeal of their business fares, airlines have to make up some of that lost revenue on the low end. At the very least, the majors may learn from the discounters and simplify their complex fare structures.

Passengers stranded on less popular routes not served by discounters will probably have their wallets hit especially hard. But as low-cost airlines like Southwest and JetBlue go after one another, certain direct fares should fall. Just last month JetBlue announced service from Long Beach to Oakland, Calif., starting at $19 each way, a price that Southwest matched in 48 hours.

KEEP SAVING THOSE MILES

One bright spot may be passengers with thousands of frequent-flyer miles. Carriers like United and US Airways or the relatively healthier trio of Continental, Delta and Northwest are trying to strike code-sharing agreements, which theoretically give flyers a wider choice of airlines on which to redeem their miles. But as carriers slash the number of flights and look to maximize every penny, there will be fewer seats available. Some airlines may even choose to award the number of miles based on the ticket price paid. One thing there will definitely be fewer of is first-and business-class seats. First class, which is filled mostly with upgrades, is on its way out, as evidenced by American's plans to cut it on flights to Hawaii and some European cities, including Madrid, Rome and Zurich.

PACK A LUNCH

Now that the airlines are trimming their schedules and moving to smaller fleets, odds are that you're going to have even less legroom than before. Many observers think the prolonged slump could force American, its denials notwithstanding, to reconfigure its coach seats, the roomiest in the industry after a two-year, multimillion-dollar redesign.

When it comes to the food, let's just say you might want to fill up before boarding or carry on a picnic. As the economic pressures get fiercer, the quality of the food will get worse and more meals will be cold. Even getting a reservation agent on the phone could get tougher; you can read more of that book while you're on hold.

DON'T START IN FARGO

An air traveler's experience is going to depend more than ever on where the trip starts. The smaller cities that were the biggest beneficiaries of the hub system could well be among the principal losers in any industry overhaul. Cutbacks could be facing cities such as Albany, N.Y.; Fargo, N.D.; and Fresno, Calif. US Airways has said it will drop flights to Saginaw, Mich. Smaller, regional jets may help plug some of the gaps, but the economics of such planes require more business passengers and fewer tourists.

People who live near secondary airports around major metropolitan areas may be in luck, however. Discounters are increasingly breathing new life into less congested, long-underused airports, from Providence, R.I., and Hartford, Conn., to Long Beach and Oakland; JetBlue's successful move into Long Beach caused American to suddenly make its own big push for the onetime aviation backwater.

Amid all the upheaval, one thing seems certain: the airlines will probably leave passengers more confused and frustrated than they are today. "You get what you pay for. Southwest isn't a business airline. American is. But they're in danger of losing that distinction," says Chad Robertson, 25, a district manager for DaimlerChrysler who commutes once a week on American between Dallas and Texas outposts like Amarillo, Lubbock and Odessa. "The airlines may be hurting, but so are we."

--Reported by Sally B. Donnelly/ Washington, Cathy Booth Thomas/Dallas, and Jyoti Thottam/New York City

With reporting by Sally B. Donnelly/ Washington, Cathy Booth Thomas/Dallas, and Jyoti Thottam/New York City