Ask the pilot

What's the problem with U.S. airlines? The low-price paradox.

By Patrick Smith

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Feb. 24, 2006 | The depth-charging of airline industry wages and benefits, examined in this space a week ago, is of course symptomatic of the ongoing malaise afflicting America's largest carriers -- a sickness that continues to confound many travelers. What exactly is our problem? Throughout Europe, Asia and elsewhere, profits are running high, with passenger satisfaction levels and employee dignity fully intact. Here at home, even with overbooked cabins and payrolls pared to the bone, airlines continue to post substantial losses while service standards are shameful. United and U.S. Airways have, for now, escaped the bankruptcy shackles (the latter after two separate visits to the courts since 2002), though not before Delta and Northwest stumbled into the tar pit of Chapter 11, their fates highly uncertain. Don't look now, but even JetBlue went red by $42.4 million for the fourth quarter of 2005.

To some degree, comparing and contrasting American carriers with those in other regions is a game of peanuts and pretzels. Overseas, the competitive variables are often quite different, taking in everything from government subsidies to marketplace monopolies. It's unfair to say that the templates of success Emirates or Cathay Pacific adhere to are workable schemes for Northwest or United. Indeed, some foreign contenders have been rudely introduced to the kind of warfare their American counterparts know all too well, as Southwest-style low-cost carriers (LCCs) continue to spring up all over, giving at least a few old-timers a literal run for their money. But we're foolish to go searching overseas for answers. The problem isn't between the U.S. airlines and those in other countries, it's between the U.S. airlines themselves.

As noted in this space a few months ago, you can make pretty quick sense of the situation by having a look at your ticket receipt. Over the past few years, ticket prices have dropped to the lowest levels in the history of commercial aviation. Never before has the world been smaller -- or cheaper.

For that, you can thank those rapacious LCCs -- most notably JetBlue, AirTran and Southwest. These agile youngsters are ultra-streamlined, mostly unencumbered by unionized labor or the need to support ponderous, decades-old infrastructures. Of those just mentioned, only AirTran features more than one aircraft type in its fleet. It costs JetBlue 7.51 pennies to fly one passenger one mile. At Southwest, it's a similar 7.85 cents. This cost per available seat mile, or CASM, tells the story, and it allows the LCCs to sell passage at rock-bottom prices. The average one-way fare at Southwest Airlines is under $100.

At American, United, Continental et al. -- collectively known as "legacy" airlines (that expression has always irked me, but we're stuck with it) -- CASMs for 2005 were somewhere around 10.5 cents. In other words, their expenses per passenger lurk around 30 percent higher than at the LCCs.

To cover those costs, the legacies can raise fares, at which point the LCCs would need to start ordering 747s and A380s to pick up the overflow of defections coming their way. Or, they can match them, absorb the loss, and continue hatcheting their unions for concessions (and continue subsidizing your chance to travel on the cheap).

Operational simplicity and lower wages are obviously a large part of keeping CASMs down. Another important tool is aircraft productivity. At Southwest, planes make half-hour turnarounds in order to remain airborne as much as possible. Compare that to a Delta 767 that flies the red-eye from Atlanta to Santiago, Chile, then sits on the ground for 13 hours until the overnight return. Routes like this are profitable, sure, but fares are high and the effects of such limited use ripple through an airline's entire operational matrix. Aircraft leases can run millions of dollars per month, and downtime is murder.

The wild card is fuel. Subtract the bill for kerosene from CASMs and the gap between the LCCs and legacies gets tighter. Fuel is a more critical factor for the latter because they tend to fly older, thirstier aircraft. Had last year's prices-per-gallon not soared 50 percent above those of 2004 -- reaching double what they were a few years ago -- this would be a different discussion. Continental and American were otherwise destined for the black, and JetBlue's fourth quarter deficit is entirely fuel-related. For each of the biggest carriers, fuel bills in '05 were more than a billion dollars higher than they were in '04. In some cases, for the first time ever, fuel has overtaken labor as the biggest piece of the company cost pie.

(And to ward off a common question, the answer is no; despite some laboratory tinkering and a couple of token fuel cell designs for small, private-size planes, there are no serious efforts being made to switch commercial aircraft to alternative energies like hydrogen. Progress is moving at about the same speed as that for cars. Which seems baffling, maybe, considering how beholden the airlines are to fuel prices. Aviation seems to be in a perfect place to become a vanguard of new energy technologies, but it's no less entrenched than Detroit. We'll have to wait and see if Mr. Branson can catalyze some progress.)

Fares did increase last year to compensate for spiking fuel tabs, but not enough. What we haven't seen, despite full cabins and the presumed need for all airlines to offset the fuel spike, is the return of pricing power. That's partly because profit-prone players like JetBlue can willingly take a hit for a while without undue duress. They'll make that sacrifice in order to hold fares down. For them, the longer-term effects are mild. For Northwest or Delta, on the other hand, already mired in Chapter 11, they could be devastating.

So, assuming things stay more or less the same on the oil front (more than a few analysts, with eyes toward Caracas, Venezuela; Baghdad, Iraq; and Tehran, Iran, see little promise in their crystal balls), the carnage won't end until two things happen. First, the legacies must reduce their expenditures to levels at least resembling those at the LCCs. Delta, for instance, believes it can succeed by getting to within 10 percent. Second, we need to have rational, sustainable airfares. To this point, most of the emphasis has been on the first item -- which, as a practical matter, means cutting employee pay and benefits.

One thing we're already seeing is a shift from domestic to international flying, where battling the LCCs isn't (yet) a problem, and premium class yields are traditionally very strong (the pitfalls of my Santiago example, above, notwithstanding). As part of United's reemergence from Chapter 11, it added 35 international routes despite shrinking some 20 percent in overall size. Delta has similarly eyed overseas expansion, with new services either announced or already underway to India, Hungary, Israel and beyond.

Some have proposed the idea of reregulation. If not a return to full-fledged control similar to what existed prior to the Deregulation Act of 1979, perhaps the setting of minimum fares based on mileage could stave off the liquidation of one or more airlines. Price controls might seem decidedly anti-free market, but with the stakes measuring in tens of thousands of workers and tens of billions of dollars, it's worth a debate. Additionally, it would better buttress the industry against utter calamity in the event of another terrorist attack or an economic meltdown.

That's a serious step, and one I don't foresee. There are simpler, less conceptually radical steps the government can take, starting with a reevaluation of the taxes and surcharges that are levied on fares and fuel. Go back and take another look at your ticket receipt, and behold the numerous fees and taxes. On average, about 16 percent of the price of an airline ticket -- more for international trips -- is composed of surcharges: federal ticket tax; federal segment tax; passenger facility charge; federal security service fee; customs fees; international arrival and departure taxes; cargo waybill tax. Last but certainly not least, a 4.3 cent-per-gallon jet fuel tax is also passed along to consumers.

Next page: The low-cost template is here to stay