Will Customers Be the Excess Baggage of Airline Consolidation?

May 28, 2010
Wharton School of Business article

Size matters -- or does it?

Airline carriers in the United States would seem to say yes. The industry has lost $60 billion in the last decade and took a big hit more recently due to a cloud of volcanic ash that grounded flights across Europe. Major airlines are looking to consolidate as a way to return to profitability amid continued struggles with high fuel prices, competition from low-cost carriers, and a limited customer pool that shriveled even more when the recession curbed travel for business and pleasure. Two years ago, Delta and Northwest merged, making Delta the nation's largest carrier. United and US Airways recently broke off merger talks, but many believe those discussions were simply a way for United to entice Continental to come to the bargaining table -- a strategy that has reportedly worked.

But experts are skeptical about the "bigger is better" strategy. They acknowledge that, if the deal is done right, merging two carriers into one will cut down on competition, reduce capacity in a saturated industry that already has too many planes in the air, and allow the newly consolidated company to trim its employee ranks and merge costly operations for services like reservations and gate maintenance. If profits return, the carriers could invest them into improving customer service and possibly waiving fees for baggage and in-flight meals that have raised the ire of travelers. But the key words are "if done right." Many observers say the carriers have proved downright flighty at following through on changes that improve operations and put the customer first.


"[Consolidation] doesn't mean you can't have fewer players in the market that are still competing like crazy," says W. Bruce Allen, a Wharton professor of business and public policy. "If you learn to play the game correctly, fewer carriers should equal higher ticket prices and higher profits. But the airlines have never learned to play the game correctly."


The path to prosperity for the airlines lies in reducing flight capacity -- taking planes out of the air or using smaller aircraft for the majority of domestic routes, Allen says. He argues that much of the cost of operating a flight is fixed, while there are only so many travelers who will fly more often due to plunging ticket prices. Thus, it makes more sense for airlines to save money by shrinking the number, or size, of flights, than to battle it out for the limited profit that can be made from bargain-hunters. "We love price wars as consumers," Allen notes. "But they are bad for the airlines."


The average price of a domestic airline ticket in the third quarter of 2009 was $306 -- the lowest level for a summer season since 2005 and more than 14% less than what it was during the same time in 2008, according to the most recent data compiled by the federal Bureau of Transportation Statistics. Raising prices has become more difficult for carriers for several reasons, notes airline industry consultant Jay Sorensen. Low-cost carriers such as Southwest, AirTran and JetBlue have expanded rapidly in recent years -- they controlled 15% of the market in 2000 but accounted for 25% last year, according to the Bureau of Transportation Statistics. And long gone are the days when airlines could price tickets with a degree of obscurity. Any traveler logging onto Orbitz or Priceline can immediately see how one carrier's fare stacks up against the others.


"America has enjoyed a fantastic deal [due to falling ticket prices] for many years. It can't keep going on because the industry simply needs profits and more investment," Sorensen says. "The American airline industry is pretty darn threadbare. If you look at the condition of the airplanes or ... the gates, they're not shiny and new like they should be. It's an industry that is suffering from a lack of fresh capital."


With the exception of JetBlue, all of the major U.S. carriers have cut their capacity over the last two years. United's decreased by nearly 10% between the second quarter of 2008 and the second quarter of 2010, while Continental's went down by 9%, American by 8.5%, Delta by 7.3% and US Airways by 5.1%, according to the Air Transport Association, an industry trade group.


"No airline is really expanding," says Basili Alukos, an airline analyst with Morningstar. "If you go back to the recession after [the September 11, 2001, terrorist attacks], Southwest expanded aggressively, JetBlue and AirTran became public, and regional flying took off. Even the best of airlines -- Southwest -- has [now] cut capacity. They've entered new markets, but on an absolute basis, their market is down.... The industry has reached its saturation point.... It hasn't been profitable because you have too many costs chasing a limited amount of revenue."


Is Consolidation a Cure?

Despite cuts to capacity, the airlines continue to struggle. As the carriers reported their quarterly earnings last week, only Alaska Airlines and Southwest were in the black. United's parent company lost $82 million for the quarter that ended March 31, although the loss was less than analysts expected. Meanwhile, Continental lost $146 million in the first quarter. Although passenger revenue increased, the Houston-based company was hurt by higher fuel costs. The cost of running aircraft has been a constant challenge for the airlines in recent years; in 2008, passenger and all-cargo carriers spent $16 billion more on fuel than in 2007 and $42 billion more than in 2003, according to the Air Transport Association.


But will consolidation help the ailing industry? Experts agree that a partnership between Continental and Chicago-based United makes more sense than a deal between United and US Airways. A combined Continental and United would leapfrog Delta for the title of world's largest airline, and the two companies have limited overlap in their current routes, meaning less scrutiny from antitrust regulators. A merger between the two could lead to more consolidation, Allen says. "If something happens here, American has got to be in play. American is not just going to sit by itself."


The U.S. airline industry was regulated by the government until the late 1970s, and that oversight kept capacity issues in check. For the airlines to lower capacity on their own is easier said than done, notes Wharton management professor Peter Cappelli. Airlines have to pay to maintain grounded aircraft, and eliminating one route could throw others into turmoil if they feed passengers to each other. "It's not like manufacturing where you can just cut back a shift." A merger, however, naturally leads to flight reduction. "Studies have shown pretty convincingly that fares were a lot higher at airports where there was a dominant carrier. If you take a carrier out of the system, there are more of those [kinds of] airports," he says.


But there are plenty of examples in the industry of partnerships that fell apart, or created additional challenges for the newly combined company. Merger talks in 2008 between Continental and United broke down due to the former's concern over the latter's financial health. It has been five years since US Airways merged with America West, but the Arizona-based company is still mired in labor conflicts involving how to merge two pilot seniority lists. Seniority determines pilots' pay, schedules and the types of planes they fly. "Every airline that merges has to [consolidate its seniority lists]," Cappelli says. "The politics of actually working that out are pretty unpleasant because of problems between the union and the airline and, for example, the pilots at Continental versus the pilots at United."


When two large companies consolidate, advance planning and strategizing is key because "if you don't worry about redundancy and union problems or some of the other things that pop up to threaten a merger like this, you're going to have some trouble," says Wharton management professor Lawrence G. Hrebiniak. "One of the hurdles they have to get over is that, when it comes to consolidation or mergers and acquisitions, [airlines] worry so much about plans and executives and the complexity of the labor dimensions that they forget the customer. Sometimes the customer becomes the victim of this process, even if the airlines don't intend it that way."



Bag Fees and Volcanoes

The airlines aren't responsible for the cloud of volcanic ash from Iceland that grounded millions of passengers in Europe. But they are responsible for other customer woes -- such as the announcement by Florida-based Spirit Airlines that it plans to start charging passengers up to $45 for carry-on bags. The ash cloud, which closed European air space for days, is expected to cost the global airline industry more than $1.7 billion in lost revenue, according to the International Air Transport Association, a trade group. But the actual loss over time could be even greater, says Wharton marketing professor David J. Reibstein. The ash cloud reminded customers "how vulnerable air travel is to some of the climactic conditions. Suddenly it makes every flight look a little riskier.... Millions of people have been affected and are going to have second thoughts when they have a choice about flying," Reibstein points out.


Spirit's announcement about carry-on fees followed the 2008 introduction of charges for checked bags. Most airlines now charge $15 to $25 for a customer's first checked bag, with additional fees for more luggage. Some have also started charging fees for in-flight meals and snacks. The airlines collected $740 million in baggage fees in the third quarter of 2009, according to the Bureau of Transportation Statistics.


"It would be nice, for a change, to have a somewhat profitable carrier that is not simply thinking about survival, [but about] 'How do I get ahead now that I'm not dying anymore?' and 'What can I do to attract more customers?'" notes Wharton operations and information management professor Serguei Netessine. That means better customer service. The airlines are "starting to charge for carry-on luggage and starting to charge for everything because they're trying to make money anyway they can. Carriers in bankruptcy or close to bankruptcy are just trying to cut corners.... Ultimately, consumers end up suffering," he says.


Netessine had personal experience with airline customer service dilemmas when he was stranded in Paris due to the ash cloud. He says the airlines did not have enough personnel working at customer service centers to handle the call volume; the carriers' websites were not able to handle the sharp upturn in traffic, and employees who could be reached said they were too busy to talk, or had no information to offer. It's these kinds of operations that airlines could make more efficient while in the process of consolidation, Netessine suggests. He and other experts pointed out that Dallas-based Southwest, the largest U.S. carrier in terms of number of passengers, has been able to consistently remain profitable through efficient turnaround of planes, travelers and baggage. Southwest has also been able to play the role of "good guy" in the airline fee fights, with an advertising campaign built around the fact that the carrier does not charge for travelers' first two checked bags.


"A culture transformation is integral to this kind of turnaround," Netessine says. "You definitely need strong leadership that declares: 'Look, this cannot stand anymore.... We are going to invest in reengineering the entire way that we operate; we're going to go back to the mode where we actually cared about customers.' But to do all that, you need some money. It's an investment that pays back, but if you are near bankruptcy and if you keep losing money, that's just not a good place to start."