Richard Turen
Richard Turen

Sometimes, you have to scratch around a bit to really get a feel for the "whys" in travel. This is particularly true in the airline sector.



We know that the major carriers are making record-breaking profits. But how do they see the industry from the inside? How do they see their customers?

I read any number of sources to try to discover how airlines see their current success in terms of the competition and a plan moving forward. The most interesting account of major airlines' intentions was offered in a recent earnings call with key airline sector analysts and American Airlines President Scott Kirby.

Writer Adam Levine-Weinberg, who covers the industry for the Motley Fool stock adviser group, pointed out that American announced a record quarterly profit on the morning of Oct. 23. The stock had risen a mere 67% year-over-year that morning. Then the scheduled call with analysts took place, and by the end of the day the stock had returned most of its gains.

What the analysts heard that day might help us understand some of the thinking that goes on behind the scenes at airlines' headquarters.

One of the more surprising things that analysts heard was American's concerns about discount carriers. However, the name that kept popping up was not Southwest, American's longtime nemesis in its home-base Dallas/Fort Worth market. It was Spirit.

American's annual revenue last year was just over $40 billion, while Spirit managed to generate a paltry $2 billion in revenue. So why worry about them?
Kirby's explanation was fascinating in that it illuminated the disruptive nature of a well-positioned discount carrier.

Obviously, Spirit operates far fewer flights than American. On the surface, this should not be something that keeps American's executives up at night. But it turns out that just one flight out of a gateway where American might be operating 10 flights a day can impact pricing in some major ways. That is all based on a core belief that was clarified in Kirby's remarks to the folks who follow airline stocks. American, he pointed out, feels that it "must" match discount carrier fares on competitive routes.

This might seem like an arbitrary business decision. But if you drill down a bit, you discover a rather interesting fact revealed in this conference call: More than half of American Airline's total revenue comes from passengers who fly the carrier no more frequently than once per year.

Kirby's leadership at American seems to be based, thus far, on some really interesting assumptions about his core customers. An amazing 87% fly the airline just once a year, and they tend to choose American based on price. This means that price-based customers with fleeting loyalty now represent at least "50% of American's current revenue."

We are constantly hearing airline execs talking about loyalty programs and service enhancements that will create loyalty. But this analyst call was unique in that we had a major airline saying that its figures are showing that only about 13% of its customers are driven by factors other than price.

Spirit and its business plan clone, Frontier Airlines, have been extremely successful at dominating large portions of the low-price market. Norwegian Air and Mexico's Volaris are also following the low-cost formula to success. Their appeal is simple. They seek to attract those flyers who are willing to pay only the absolute lowest price on any route. And, it turns out, this is the vast majority of flyers.

The depth of concern about low-cost carriers on the future of the majors seems to be growing, which is why Kirby told the analysts, regarding low-cost flyers, "we just can't walk away from them. We have to compete for them."

Kirby explained how he came to view Spirit and other low-cost airlines as true competitors. None of the majors had a policy in place to match Spirit's fares, and that did not have a good business outcome: Spirit became larger than Delta in Chicago and bigger than both United or Delta in Dallas/Fort Worth.

The nation's business schools have been cautioning leaders to avoid a major pitfall of the past: the inclination to underestimate lower-cost competitors who seem to be moving in on your territory.

A prime example is Ryanair, which has had a major impact on traditional carriers in Europe. It has become extremely good at what it does, and it is tapping into the surprisingly heavy weekend vacation traffic patterns in Europe.

Easyjet is a competitor that started out as a heavy-discount carrier, then started raising prices with service enhancements. They now compete on major routes in Europe, often flying out of more convenient airports. It took years for the major airlines in Europe to fully grasp the impact of these discount airlines on their bottom line. "I'll just do Ryanair" is now a phrase that sums up the consumer's desire to pay bottom dollar for transportation at least some portion of the time.

The need to fight the entrance of low-cost competitors aggressively is addressed in a book by Tim Calkins from the Kellogg School of Management at Northwestern University. In "Defending Your Brand," Calkins points out that you "can get into trouble when you don't defend. You can trace a lot of business problems back to ineffective defensive efforts."

American seems to have decided on its strategy to deal with Spirit and other low-cost rivals: They will actually match most of Spirit's pricing initiatives in competitive markets. They are defending themselves against massive customer defections. No one wants to see the "Ryanization" of U.S. air travel. But American is going to try to soften the financial impact of price matching by doing it with a new, custom-designed fare category with the specific purpose of heavy discount competition.

Experts expect that American's initiative will match Delta's "Basic Economy," a fare designation created specifically to match Spirit and other low-cost carriers. Delta's lowest fares have no advance seat assignment, do not allow changes and cannot be upgraded.

If we step back a bit and look over the travel landscape, we find that the major airlines really are unique in their conclusion that they can only defend against low-price predators by no longer ignoring them.

The hotel sector, for example, does not seem to be preoccupied with the loss of customers from five-star to two- or three-star properties. Much of the focus, instead, seems to be on upping the game, on making the experience even more memorable. Of course, it is easy to see why. Just imagine if all hotels were ordered from the same three factories and your competitors at several price levels had the same model.

Instead of competition, there seems to be tacit agreement that some consumers require no more than a clean room, a comfortable bed and a shower.

The cruise industry also seems relatively sanguine about low-cost competitors. Cruise lines seem to have delineated clear options, and they have even assigned names to the various price sectors, such as "mainstream," "premium" and "five star." For the most part, it is assumed that they are not competing for the very same potential cruiser.

It is interesting that what keeps airline executives up at night is less the guests in the forward compartment than, most often, the vast majority of the revenue producers seated in the back who seem to have no loyalty other than to bottom- line price.
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