Throwing a demand curve

By Bill Poling
Airline demand 2013After deregulation in 1978, we watched the airline industry reinvent itself with fare wars, hub wars, GDS wars, new entrant wars, labor wars, cost-cutting, bankruptcies, mergers, international expansion. Nothing worked. But today, they seem to be onto something, a strategy that appears to make money.

It's called Filling the Planes.

The traditional dilemma of the airline industry, up until the last decade, was pretty much the story of a rock, a hard place and a brown banana.

In a competitive industry with high fixed costs, the marginal cost of accommodating one more passenger was very low, which gave every competitor a powerful incentive to cut prices to fill seats, even if it meant losing money.

Airlines knew they were better off carrying traffic at cost, or even below cost (the rock), than not carrying it at all (the hard place), because the airline seat is the quintessential perishable product. If it goes out empty, it's worse than a brown banana. It's dead weight. You can't even use it in a smoothie.

In this environment, airline marketing became a constant battle for market share, and fare wars were common. If one carrier offered a discount, it was usually matched instantly, because no carrier could survive for long at a price disadvantage in a market where pricing information was instantly available to all. Pricing battles were wars of attrition, the winner being the airline that lost the least.

Ever since the jet age, inflation-adjusted airline unit costs have been trending downward because of efficiency improvements, but inflation-adjusted fares have been driven down right along with them by the perpetual scourge of overcapacity: the age-old airline problem of too many seats and too few bottoms. Supply and demand.

Of course, passengers loved it, particularly after deregulation, when air travel went from being a luxury to a mass-market commodity.

For three decades, with time off for recessions and wars, traffic continued to grow, fueling further increases in capacity, even as airline profits wobbled and many airline brands lost their balance, went out of business or merged into oblivion.

This story line dominated the careers of a generation of airline executives and is well known to many travel professionals and frequent flyers.

But the story is changing.

The story line taking shape today is that 30 years after prices were deregulated, and after 30 years of bankruptcies and mergers, U.S. airlines have finally managed to adopt a more disciplined approach to capacity growth and pricing. Having learned that they can't repeal the law of supply and demand, they are using it to their advantage to stabilize the market and manage for profit rather than for share.

Passengers On US Scheduled AirlinesToday's airline business is still recognizable, but some of today's statistics and trend lines look remarkably different than they did just a few years ago. As shown in the chart here, U.S. airline passenger enplanements for the past five years show the predictable seasonal fluctuations, but there is no longer a pronounced upward curve to the overall trend line. (Click here or on the image for a larger view of the chart.) 

The chart below shows that domestic traffic, capacity and passenger boardings for 2012 were pretty much flat. The number of flight departures actually declined somewhat, and load factors hit an all-time high: an unheard-of 83.4%.

This is not a picture of an industry suffering from chronic overcapacity.

More, and also less

Domestic Scheduled Air On US AirlinesOne oddity in these data is that the most widely used measure of capacity, the available seat mile (ASM), doesn't tell the full story of what the airlines are bringing to the market. In the chart here, for example, capacity as measured by available seat miles rose slightly in 2012, by 0.3%. By that measure, airlines increased their output. (Click here or on the image for a larger view of the chart.) 

But the data also show that the number of domestic airline flight departures fell in 2012 by 2.4%, the fifth consecutive year of such declines. By this measure, airlines have been reducing their output.

In fact, over the last five years, U.S. domestic flight departures, as measured by the Transportation Department's Bureau of Transportation Statistics (BTS), fell 14%, from 9.8 million in 2007 to 8.4 million last year. Over the same period, aggregate capacity as measured by seat miles fell only 8%.

These declines in output more than offset the 5% decline in the number of domestic passengers accommodated during this period.

The effect of this trend is to reduce the number of choices presented to consumers and travel sellers, whether they're shopping for flights on a screen or empty seats in a plane.

In addition to operating fewer flights, airlines are using larger aircraft and/or aircraft with more seats and are operating over longer distances. According to government data, the average passenger trip length was about 870 miles in 2000; it will reach 1,025 miles this year or next.

Take the example of a 100-seat aircraft operating three 500-mile roundtrips per day. Each roundtrip is 1,000 miles, so three roundtrips generates 300,000 available seat miles per day. If the schedule changes and the aircraft is deployed in an 800-mile market, offering two roundtrips per day, the result is a slight increase in ASMs, to 320,000, yet a decrease in the number of flight departures.

In a report on airline industry performance last September, Transportation Department (DOT) Inspector General Calvin Scovel found that the changes in airline service patterns have resulted in "reduced travel opportunities for passengers" and specifically cited the reduction in short-haul flights, saying three-fourths of the cutbacks between 2007 and 2012 involved flights of under 500 miles.

A recent study done at the Massachusetts Institute of Technology (MIT) by Michael Wittman and William Swelbar confirmed the trend, noting that the 29 largest airports in the U.S. lost nearly 9% of their yearly scheduled domestic flights between 2007 and 2012, whereas smaller airports experienced a 21% reduction.

'A different business'

Among the factors influencing these trends is what consultant Robert Mann calls "the declining value of ubiquity," or a belief among airline managers that "there is less of a need to be everywhere."

A few years ago, Mann said, airlines would typically battle each other for every scrap of traffic to fill seats, even to the point of pitting their regional feeder carriers against each other at secondary cities in order to pull traffic into their competing hubs.

Airlines tended to place a high value on having numerous departures throughout the day with relatively small aircraft, rather than fewer flights with larger aircraft. They were sometimes accused of "overscheduling" or making inefficient use of airport resources with this pattern of flying.

It still makes economic sense in many high-value business markets with time-sensitive travelers, because experience has shown that the airline with the most departures spread throughout the day tends to get the majority of the passengers.

Judging by the drop in the number of flight departures, there appears to be a little less of that going on today. Mann said it's as if airline managers figured out that "there are only so many passengers that make money."

Henry HarteveldtHudson Crossing analyst Henry Harteveldt has come to the same conclusion, saying there are some passengers whom the airlines "would not mind losing" and that some carriers might have made a conscious decision to, in effect, "fire the customer."

In Harteveldt's view, the marching order from airline stakeholders these days is, "Don't chase market share at the expense of profit," and airline managers are heeding the advice.

He said he's hearing airline executives these days tossing around phrases like "return on invested capital," which weren't part of the conversation just a few short years ago.

"It's a different business than it was five years ago," Harteveldt said.

The DOT inspector general's report last year noted that airline developments since the recession present "a marked contrast from the business model of the 1980s." Similarly, the recent MIT study said the data on flight patterns reveals "a major shift in airline management strategy."

Conventional wisdom has it that recent trends in traffic and capacity reflect industry consolidation, particularly the most recent wave of mergers. Last year, for example, the top 10 U.S. airlines carried 80% of systemwide passengers, a jump of 5 percentage points from the previous year, according to BTS data.

If the American-US Airways merger is approved, the five largest U.S. airlines will control nearly 70% of domestic traffic, with individual market shares ranging from 15% to 21%, or three to four times the 5% market share of what will be the sixth-largest carrier, JetBlue.

There's little doubt that flight cutbacks, particularly at some large hubs, have been triggered by mergers. The DOT inspector general's report, for example, said that the level of flight operations at the Cincinnati and Memphis hubs in mid-2012 were 63% and 36% lower, respectively, than they were in mid-2007, a year before the Delta-Northwest merger was announced.

But fuel costs are also a factor. Although wild price swings have abated, fuel costs remain high and have become the airlines' largest single cost item. When fuel averaged about 10% of airline industry costs, as it did in 1998, airline managers still had some semblance of control over 90% of their operating expenses. Room to wiggle.

But when fuel costs tripled and overtook labor as the largest single cost, as it did a decade later, it had a leveling effect. Less wiggle room. As Harteveldt put it, airlines discovered that they "can't afford to do Stupid Airline Pricing Tricks anymore."

Both he and Mann also concluded that the slow-growth scenario might be with us for a while, as did the inspector general's report, which said the new trends "are not a brief phase, but rather are signs of a greater shift in the industry that will remain for years to come."

Demand destruction

If these are indeed the new realities, a consequence for the travel industry could be what Mann called "demand destruction," a long-term drop in demand brought on by high prices and reduced output.

Annual Change in US Airline Passenger Revenues and EnplanementsAnalysts at industry research firm PhoCusWright superimposed a graph of passenger boardings and airline revenue that illustrates this supply-and-demand relationship. (Click here or on the image for a larger view of the graph.)

PhoCusWright Principal Analyst Douglas Quinby noted in an email, "The total number of air travelers is still below the 2007 peak. So you have a narrow band of air travelers who are paying higher fares, and we believe this combination of industry dynamics has been depressing leisure travel demand."

He continued, "This is also a major headwind for online travel agencies [OTAs] and, to some extent, tour operators, who rely on cheap fares. For OTAs in particular, cheap flights are like the milk in the grocery store, to get price-sensitive leisure shoppers in the door and hopefully upsell a hotel. This is negative for OTAs and also their packaging business."

Harteveldt believes that hotels, convention centers, cruise lines and other travel suppliers "have every right to be concerned" about what he called "the disappearance of lift," particularly for discretionary travelers, who might increasingly turn to what he called the "ultra" low-fare carriers such as Spirit, Allegiant and Frontier. Those three have usurped Southwest as the low-fare leader in some markets.

But he also sees some upside. For one thing, a "consistently profitable" airline business could serve the broader travel industry in the long term. Nobody really knows because, by most measures, the U.S. airline industry has never been "consistently profitable" for very long.

Moreover, there are signs that as the airlines turn away from fare wars, they will place more emphasis on enhancing the customer experience.

In fact, there's some evidence that a more modest growth rate, by itself, leads to a better passenger experience. Dean Headley, a marketing professor at Wichita State University in Kansas and co-author of an annual report on airline performance measures, notes that whenever the aviation system is "tightly used," it doesn't perform very well. In fact, it "goes haywire" and produces a spike in consumer complaints, which he said happened in the late 1990s and again in 2007, just before the recession put a damper on things.

The evidence suggests to Headley that airlines can "run a more efficient system" with fewer flights, even though it's "not necessarily best for consumers" in terms of pricing.

But it's not as if the cheap seat has gone away. Airfare expert Tom Parsons, who runs the BestFares website, said that despite high load factors, reasonable fares can be found if shoppers stay alert to sales and avoid peak days. More than ever, though, Parsons is advising bargain-hunters to "be patient and be flexible."

And if consumers run out of patience with the new realities, the theory of deregulation holds that a free market will attract new entrants to woo consumers with new price and service offerings.

At the moment, however, Mann said, "I don't see a lot of new entry out there." It might have taken the starry-eyed entrepreneurs a while to figure it out, but "this is a tougher business than it seems."

Also, their potential backers in the capital markets, Mann said, have figured out that by enabling new entrants during previous business cycles, "they helped to collapse the original business. I think they've figured out that they're better off not feeding this thing."
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