M I T I n t e r n a t i o n a l C e n t e r f o r A i r T r a n s p o r t a t i o nM I T I n t e r n a t i o n a l C e n t e r f o r A i r T r a n s p o r t a t i o n

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WHAT’S WRONG WITH (SOME) US AIRLINES?Recent Airline Industry Challenges

Dr. Peter P. BelobabaProgram Manager

MIT Global Airline Industry Program

January 2005

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2

Recent Airline Industry Challenges

US Airline Industry Since 20009/11 Attacks and Subsequent EventsImpacts on Capacity, Traffic and Profits

Pricing and Revenue ChallengesLower Total Industry RevenuesGrowth of Low-fare CarriersFare Simplification

Cost and Productivity ChallengesUnit Cost ComparisonsStage Length and Aircraft UtilizationShifts in Operating Cost Categories

Key Questions for the Future

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US Airline Industry Before 9/11

Current industry “crisis” began before 9/11:Dot.com bubble burst, stock market slide, and softening economy led to unprecedented decreases in yields and business traffic bymid-2001Industry losses forecast for 2001 even before 9/11 attacks

Other airline industry concerns at the time:Air transportation system capacity constraints led to record flight delays in 2000 Consumer perceptions of poor service and airline indifference, exacerbated by delaysDominance of large network airlines, accusations of anti-competitive actions vs. new entrantsDifficult labor/management relations, with labor demanding a share of 1990s airline profits

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Impacts of 9/11 Attacks and More

Most airlines reduced operations almost immediately after 9/11:

80,000 layoffs by US airlines alone, many more since thenUS airline capacity (ASMs) cut by 25%, hundreds of aircraft retired/parkedUS airline traffic (RPMs) initially dropped by 45% due to passenger fears, security hassles

Post-9/11 setbacks haven’t helped:Invasion of Afghanistan (October 01)Iraq War (March 02)SARS epidemic (March 03)Airline fuel prices increased 60% in 2004US Terror Alerts keep security concerns in passengers’ minds

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3 Years Later, Traffic Has Recovered

US airline RPMs returned to 2001 levels in mid-2004But August 2004 US airline capacity 7% lower than August 2001Average load factors in 2004 are now above pre-9/11 levels –83.5% ALF in July 2004 is highest month on record

Almost no expectation of US industry profits in 2005:Revenue mix of traffic is extremely weak, despite recovery of traffic and load factorsAverage fare (yield) is still running about 14% lower than in 2000

US airline bankruptcies United, Hawaiian in Chapter 11American threatens, but achieves cost reductionsUS Airways emerges, but files for 2nd timeDelta on the brink

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US Airline Capacity Still Down 7% from 2001

Source: ATA data

CAPACITY: Available Seat Miles

55

60

65

70

75

80

85

January February March April May June July August September October November December

Billions

2001 2002

2003 2004

Source: ATA Monthly Passenger Traffic Report

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Domestic Traffic Now Back to 2001 Levels

TRAFFIC: Revenue Passenger Miles

30

35

40

45

50

55

60

65

70

January February March April May June July August September October November December

Billions

2001 2002

2003 2004

Source: ATA data

Source: ATA Monthly Passenger Traffic Report

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Load Factors are at Historical Record Levels

Source: ATA data

LOAD FACTOR: Percent of Capacity Utilized*

55%

60%

65%

70%

75%

80%

85%

90%

January February March April May June July August September October November December

2001 2002 2003 2004

Source: ATA Monthly Passenger Traffic Report

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US Industry Losses Over $30 Billion Since 2000

US Airlines Operating and Net Profit

(15,000)

(10,000)

(5,000)

0

5,000

10,000

15,000

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Year

Pro

fit ($

mill

ions

)

OperatingNet Profit

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Pricing and Revenue Challenges

Industry profits in late 1990s driven by improved revenue generation through pricing and distribution:

Multiple price levels, restrictions and effective revenue management of low fares led to higher load factors and unit revenues ($/ASM)

Revenue power of legacy airlines has virtually disintegrated, with little relation to 9/11:

Business passengers no longer willing to pay 5 to 8 times the lowest available fareInternet distribution channels give more passengers more information about air travel optionsCutbacks have reduced service quality differences between network and low-cost carriers

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US Airline Industry Revenues

Source: Air Transport Association

$60

$70

$80

$90

$100

$110

$120

$130

$140

US

$ B

illio

ns

93 94 95 96 97 98 99 00 01 02 03

Total industry revenues dropped by almost 20% and are still 12% lower than in 2000

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Domestic Unit Revenues Are Down 15%

Source: ATA data

R A S M -- M a in lin e D o m e s tic1 2 M o n th s E n d e d

8 .0 0

8 .5 0

9 .0 0

9 .5 0

1 0 .0 0

1 0 .5 0

Jan-

96 Jul

Jan-

97 Jul

Jan-

98 Jul

Jan-

99 Jul

Jan-

00 Jul

Jan-

01 Jul

Jan-

02 Jul

Jan-

03 Jul

Jan-

04 Jul

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Growth of Low Fare Carriers in US

Recent conditions favorable for low-fare airlines:Less business travel overall, reduced willingness to pay for premium servicesMore stable demand for price-sensitive leisure travelLeisure travel demand less affected by post 9/11 “hassle factor”

Low-fare carriers threaten the viability of Majors:Share of domestic passengers flown by low-fare carriers increased to almost 25% in 2004, from 16% in 2000 and only 5.5% in 1990Largest low-fare carriers continue to increase both capacity and traffic, in sharp contrast to most MajorsMajor airlines are looking for new “business models” to respond to changed environment and to compete with low-fare airlines

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Legacy and Low Fare Airlines

LOWFARE AIRLINES

WN – Southwest Airlines

HP – America West Airlines

AS – Alaska Airlines

TZ – American Trans Air (ATA)

B6 – JetBlue Airways

FL – AirTran Airways

These airlines carried another 18% of US traffic.

LEGACY AIRLINES

AA – American Airlines

UA – United Air Lines

DL – Delta Air Lines

NW – Northwest Airlines

CO – Continental Airlines

US – US Airways

Legacy group carried 73% of US passenger RPMs in 2003.

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Changes in Market Share by Carrier

Change in % Market Share from 1st Qtr 99 to 3rd Qtr 03

-4.00%

-3.50%

-3.00%

-2.50%

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

AA UA DL NW CO US

While 4 out of 6 network carriers have lost market share since 1999, all low-fare airlines

gained market share during this

period, led by Southwest and

Jetblue

Change in % Market Share from 1st Qtr 99 to 3rd Qtr 03

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

WN AS HP TZ B6 FL F9 NK

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US Airline Yields (Revenue/RPM)

Yields began decreasing prior to 9/11 and have shown little sign of recovery

$0.0900

$0.0950

$0.1000

$0.1050

$0.1100

$0.1150

$0.1200

$0.1250

$0.1300

$0.1350

$0.1400

19991

19992

19993

19994

20001

20002

20003

20004

20011

20012

20013

20014

20021

20022

20023

20024

20031

20032

20033

20034

Top 6 MajorsLow-Fare Majors

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All Legacy carriers have lost revenues; UA and US revenues have dropped by

over 30%

Change in Passesnger Revenues -- Legacy Carriers 2003 vs 2000

-40

-30

-20

-10

0

10

20

30

40

50

60

AA CO DL NW UA US

%

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Lowfare group maintained or increased revenues – biggest % gains at JetBlue,

AirTran

Change in Passenger Revenues -- Lowfare Carriers 2003 vs 2000

-40

-30

-20

-10

0

10

20

30

40

50

60

AS HP TZ WN B6 FL

%

845%

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Differential Pricing Theory (circa 2000)

Market segments with different “willingness to pay” for air travel

Different “fare products”offered to business versus leisure travelers

Prevent diversion by setting restrictions on lower fare products and limiting seats available

Increased revenues and higher load factors than any single fare strategy

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Differential Pricing and Airline Fare Structures

Differential pricing was embraced by all airlines:Charge more for flexibility and highest-demand flights while selling off “excess” seats at lower but more restricted faresEven low-fare carriers offer differentiated price levels and practice some form of revenue management/seat inventory controlDifference with traditional airlines is that their differentiated prices are both less restricted and closer in ratio of fare levels

Example of a “traditional” fare structure shown on following slide for Boston-Seattle market (2001):

Highest unrestricted economy fare (Y) is 5 times that of lowest discount fare with restrictionsAll fares with any meaningful discount from the unrestricted fare require advance purchase and a Saturday night stay

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BOS-SEA Fare StructureAmerican Airlines, October 1, 2001

Roundtrip Fare ($)

Cls Advance Purchase

Minimum Stay

Change Fee?

Comment

458 N 21 days Sat. Night Yes Tue/Wed/Sat 707 M 21 days Sat. Night Yes Tue/Wed 760 M 21 days Sat. Night Yes Thu-Mon 927 H 14 days Sat. Night Yes Tue/Wed 1001 H 14 days Sat. Night Yes Thu-Mon 2083 B 3 days none No 2 X OW Fare 2262 Y none none No 2 X OW Fare

2783 F none none No First Class

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Fare Simplification:Less Restricted and Lower Fares

Recent trend toward “simplified” fares – compressed fare structures with fewer restrictions

Initiated by some LFAs and America West, followed by Alaska Most recently, implemented in all US domestic markets by Delta, matched selectively by legacy competitors

Simplified fare structures characterized by:No Saturday night stay restrictions, but advance purchase and non-refundable/change feesRevenue management systems still control number of seats sold at each fare level

PODS simulations of impacts show traffic mix and revenue impacts of simplified fares:

Revenue impacts of “simplified” fare structures

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BOS-SEA Simplified Fare StructureAlaska Airlines and American, May 1, 2004

Roundtrip Fare ($)

Cls Advance Purchase

Minimum Stay

Change Fee?

Comment

374 V 21 days 1 day Yes Non-refundable 456 L 14 days 1 day Yes Non-refundable 559 Q 14 days 1 day Yes Non-refundable 683 H 7 days 1 day Yes Non-refundable 827 B 3 days none No 2 X OW Fare 929 Y none none No 2 X OW Fare

1135 F none none No First Class

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PODS Simulation Results:Traditional “Restricted” Fare Structure

5:1 fare ratio; all fare classes below “full fare” have Sat. night stay and 7/14/21 day AP restrictions

74.6% load factor; total flight revenue $64,7165% revenue gains from use of RM booking limit controls

Loads by Fare Class

20.2

3.8

9.2

41.3

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

$625 $405 $240 $125Fare Class

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PODS Simulation Results: “Simplified” Fare Structure

Fare ratio compressed to 3.5:1; Sat. night stay restriction removed from all but lowest fare class; advance purchase restrictions retained

Load factor increases to 77.8%; but total revenues drop by 15% to $55,221% Revenue impact of RM controls increases to over 8%

Loads by Fare Class

16.6

4.06.6

9.2

33.0

8.4

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

$450 $375 $240 $180 $155 $125

Fare Class

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Impacts on Differential Pricing Model

Drop in business demand and willingness to pay highest fares

Greater willingness to accept restrictions on lower fares

Reduction in lowest fares to stimulate traffic and respond to LCCs

Result is lower total revenue and unit RASM despite stable load factors

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Summary: Revenue Challenges

Pricing actions by traditional airlines have increased unit revenues, but not to previous levels:

Price cuts to stimulate leisure demand and reduce restrictions on business fares returned load factors to 75%, but did not improverevenue qualityRecent experiments to decrease unrestricted fares have likely succeeded in re-attracting some business passengers But, fare simplification still leaves unit revenues 10-15% below levels of 2000

Conclusion: Pricing actions alone cannot return the network airlines to profitability

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Cost and Productivity Challenges

Post 9/11 operating costs increased substantially:Lower aircraft utilization due to schedule cuts affected productivity and increased unit costsAdded security requirements and associated delays Security fees and higher insurance costsFuel prices in Q1 2004 were 50%+ higher than in 2001

Given 15% shortfall in unit revenues, legacy airlines must cut costs and increase productivity:

Low-cost carriers often used as “benchmark” for unit costsChanging work rules, reducing workforce and cutting wage rates are all options for reducing labor unit costs ($ per ASM)But, unit cost differences are also due to aircraft productivity, as determined by configuration and pattern of operations

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US Airline Unit Costs (per ASM)

Unit Costs differences between network carriers and LCCshave continued to increase despite cost-cutting efforts

Cost per Available Seat Mile (CASM)

6

7

8

9

10

11

12

13

99 1 99 2 99 3 99 4 00 1 00 2 00 3 00 4 01 1 01 2 01 3 01 4 02 1 02 2 02 3 02 4 03 1 03 2 03 3

Cen

ts p

er A

SM

Netw ork Carriers LCCs

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Airline Operating Cost Components

U N IT C O S T B Y C AT E G O R YC ents per A S M

0.00

0 .50

1 .00

1 .50

2 .00

2 .50

3 .00

3 .50

4 .00

Labo

r

Fuel

Ow

ners

hip

Prof

essi

onal

Serv

ices

Land

ing

Fees

Food

&

Beve

rage

Mai

nten

ance

Mat

eria

l

Pass

enge

r

Com

mis

sion

s

Insu

ranc

e

Ad &

Prom

otio

n

Utils

& O

ffice

Supp

lies

Oth

er

Source: ATA data

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Fuel Prices Up 90% Since Q1 2002

F U E L C O S T SC ents per G a llon

40

50

60

70

80

90

100

110

120

1Q90

1Q91

1Q92

1Q93

1Q94

1Q95

1Q96

1Q97

1Q98

1Q99

1Q00

1Q01

1Q02

1Q03

1Q04

Source: ATA data

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Travel Agency Commissions All But Eliminated – Down 85% Since 1994

P A S S E N G E R C O M M IS S IO N C O S T SC ents pe r R P M

0.00

0 .40

0 .80

1 .20

1 .60

2 .00

1Q90

1Q91

1Q92

1Q93

1Q94

1Q95

1Q96

1Q97

1Q98

1Q99

1Q00

1Q01

1Q02

1Q03

1Q04

Source: ATA data

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Food and Beverage Costs Cut in Half

Source: ATA data

F O O D & B E V E R A G E C O S T SC ents per R P M

0.25

0 .30

0 .35

0 .40

0 .45

0 .50

0 .55

0 .60

0 .65

1Q90

1Q91

1Q92

1Q93

1Q94

1Q95

1Q96

1Q97

1Q98

1Q99

1Q00

1Q01

1Q02

1Q03

1Q04

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Unit revenues dropped below unit costs in 2001 for legacy carriers

Unit Costs and Unit RevenuesLegacy

$0.06

$0.07

$0.08

$0.09

$0.10

$0.11

$0.12

1999 2000 2001 2002 2003

CASMRASM

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AA and UA have made biggest unit cost cuts, DL unit costs surged in 2003

Unit Costs / Legacy Carriers

0.07

0.08

0.09

0.1

0.11

0.12

0.13

0.14

0.15

1999 2000 2001 2002 2003

AACODLNWUAUS

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Lowfare carriers RASM also down, but lower CASM continues to decrease

Unit Costs and Unit RevenuesLowfare Carriers

$0.06

$0.07

$0.08

$0.09

$0.10

$0.11

$0.12

1999 2000 2001 2002 2003

CASMRASM

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Lowfare carriers have lowest CASM across all average stage lengths

C A S M v s . S ta g e L e n g th 2 0 0 3

A A

C O

D L

N WU A

U S

A S

H P

T Z

W N

B 6

F L

$ 0 .0 5

$ 0 .0 6

$ 0 .0 7

$ 0 .0 8

$ 0 .0 9

$ 0 .1 0

$ 0 .1 1

$ 0 .1 2

$ 0 .1 3

$ 0 .1 4

$ 0 .1 5

0 5 0 0 1 0 0 0 1 5 0 0

S t a g e L e n g t h ( m i l e s )

CA

SM

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Aircraft Utilization and Productivity

Aircraft “utilization” measured in block-hours/day:Southwest historically achieved system-wide utilization rates 5-10% higher than other Majors, despite flying shorter stage lengthsPost-9/11 cutbacks reduced aircraft utilization at Top 3 Majors more dramatically than at Southwest

Aircraft “productivity” measured in ASMs generated per aircraft per day:

= (# departures) X (average stage length) X (# seats)

Example: B737-500 aircraft operated by CO, UA, WN:Each WN aircraft generates 37% - 51% more ASMs per day, with more seats per aircraft, more departures, and more block-hours

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Daily Aircraft Utilization by Legacy Carriers Plunged After 9/11 (not for Southwest)

8

8.5

9

9.5

10

10.5

11

11.5

12

98-1 98-2 98-3 98-4 99-1 99-2 99-3 99-4 00-1 00-2 00-3 00-4 01-1 01-2 01-3 01-4 02-1 02-2

Blo

ck H

ours

/Day

AAUADLWN

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Boeing 737-500 Productivity (2nd Quarter 2002)

400,1601224008.210.2Southwest

264,3471095644.37.5United

291,6261047193.98.3Continental

ASMsper Day

Seats

Avg. Stage Length

Flights per Day

Daily BlockHoursAirline

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Lowfare carriers lead in aircraft utilization at all average stage lengths

Aircraft Utilization 2003

AA CODL

NWUA

US

ASHP

TZWN

B6

FL

8

9

10

11

12

13

14

0 500 1000 1500Stage Length (miles)

BH

s/ a

ircra

ft d

ay

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Labor Costs: A Big Part of the Problem

Labor costs account for 1/3 of airline expenses

Real unit labor costs 21% lower today than 1980But RASM are 32% lower than 1982—costs exceed revenues

Unit labor costs of low cost airlines about 50% below top carriers

Wage movements out of synch with revenue movements

Past labor cost reductions provided short term relief but not long term improvements in operational performance (productivity or service)

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Legacy carrier employment down by 25% since 2000, a loss of over 100,000 jobs

Airline Em ploym ent 1997-2003

0

50000

100000

150000

200000

250000

300000

350000

400000

450000

1997 1998 1999 2000 2001 2002 2003

LegacyLow-fare

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Lowfare carrier salaries/benefits per employee 25% lower than legacy carriers

Salaries and Benefits per Em ployee

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

$80,000

$90,000

1997 1998 1999 2000 2001 2002 2003

CPI

Adj

uste

d to

200

0

LegacyLowfare

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Growth in Pilot Wage Rates vs. Growth in Revenue per Employee: 1993-1997 vs. 1997-2001

Pilot Wage Rate Changes Averaged Across Four Aircraft Types at 21 Airlines

4%

24%

18%

-8%-10%

-5%

0%

5%

10%

15%

20%

25%

30%

% Change 1993-1997 % Change 1997-2001

Pilot Wages

Revenue per Employee

Source: Department of Transportation Form 41 (from Database Products, Inc.) and Airline Industrial Relations Conference

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Summary: Cost and Productivity Challenges

Unit cost differences not entirely due to labor costs:Differences in aircraft productivity can account for up to one half of difference in aircraft operating expenses per ASMTranslates into about 25% of total unit cost difference between traditional carriers and LCCs

Network carriers are exploring alternatives for increasing aircraft productivity to reduce unit costs:

Continuous connecting banks to reduce ground times at hubsHigher density seating options (e.g. removal of First Class)More “point-to-point” flying to increase aircraft utilization

Successful new “business models” will depend on reducing both aircraft and labor unit costs

In addition to fine-tuning fare structures to maximize unit revenues

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US Airline Performance Since 2000

US airline industry is in the midst of its greatest transition in history

Fundamental shifts in airline business modelsMore efficient new entrants with much lower costs Changes envisioned by architects of deregulation more than 25 years ago

9/11 was not the primary cause of this “crisis”It did lead to increased operating costsOther unfortunate events have not helpedBut new competition is transforming the industry

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Key Questions for the Future

What industry structure will emerge from this crisis?Will (most) network carriers be able to adapt and survive?Or, will several network carriers have to cease operations, leaving LCCs as domestic carriers, and only a few international hub airlines?

What are the new revenue/operating paradigms for network carriers?

Are LCC pricing and operating models broadly applicable?Can network carriers reduce operating costs to competitive levels?

What will be the impact on small markets?Most domestic O-D pairs can only be served with a hub network

Should the government intervene?Stability and sustainability of air transportation system; vs.Disruption of “re-structuring” process spurred by market forces