Airlines believe menu-pricing trend has staying power

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What a difference a few inches can make.

On one hand, Continental’s decision to cut the maximum size for carry-on bags to 45 linear inches from the previous 51-inch limit helps maximize onboard overhead storage space.

But it comes just as Continental joins other carriers in charging coach passengers $15 for a first checked bag. Since the checked-bag fee pushes passengers to cram as much as possible into their carry-ons, the simultaneous reduction in size limits is clearly designed to divert as much baggage as possible into the carrier’s revenue stream.

Though many passengers see such fees as obnoxious nickel-and-diming, the airlines see them as revolutionizing decades-old revenue models, which means that the trend is likely to continue for a long time. Airline executives told analysts this month that not only would they retain the checked-bag fees and other ancillary charges they’ve initiated since the run-up on fuel prices earlier this year, but they are committed to hunting for even more such revenue opportunities.

Carriers are trying to better align their revenue with their costs, said Darin Lee of the airline consulting firm LECG, meaning that “the trend toward unbundling is accelerating.”

With technology increasingly able to accommodate their appetites for a la carte fees, carriers will likely start to offer a broader menu of “value-added services” with a transparency that passengers have not seen before, increasing cash streams for carriers and even third-party distributors.

Airlines and analysts are counting on the extra revenue. The new bag fees have also resulted in fewer checked bags and thus less weight onboard the aircraft and fewer complaints about lost or mishandled baggage. That, in turn, enables carriers to cut back on staff, resulting in even more savings.

“About 40% of second bags have gone away,” J. Timothy Griffin, Northwest’s executive vice president of marketing and distribution, told analysts this month. “The cost savings associated with that is material. We’re seeing some of the same customer behavior with respect to the second bag as customers pack more prudently. That 40% reduction will roll through staffing models.”

John Tague, United’s chief operating officer, told analysts, “In September, we announced that we would increase the fee for a second checked bag from $25 to $50. Combined, we expect these new revenue streams to generate well over $1 billion in 2009, a $400 million increase relative to 2008.”

Similarly, Alaska Airlines reported a 70% increase in ancillary revenue for the third quarter this year. JetBlue reported that added fees had almost doubled per-passenger incidental revenue, to $20 per flyer.

Both American and Continental reported increases in revenue and decreases in checked bags because of the added fees.

“We are clearly seeing less second bags,” Continental Chairman and CEO Lawrence Kellner told analysts. “That’s a result we’re very comfortable with because there’s clearly a cost, both in handling and fuel, related to the second bags. So our goal is to get a fee in place that we believe will help us offset those costs.”

Some analysts, including Chris Cuomo at Goldman Sachs, question whether the carriers could maintain the fees and extra revenue streams with oil costs coming down.

In response, Delta CEO Richard Anderson said, “We think it is sustainable. We have probably been a little less aggressive in a couple of areas than some of our competitors, and we are still looking at that as we move forward.”

United says that passengers stand to benefit in the long run from a menu of ancillary services and charges because they can tailor their travel costs to their needs.

“We believe that these unbundling initiatives are resettling the value proposition for both non-elites and elites,” Tague said, “giving price-sensitive customers new, relevant options to purchase the value they want while reinforcing our elite frequent flyer travelers with the value we place on their loyalty.”

Added Glenn Tilton, United’s CEO: “We are seeing benefit from putting more choice in the hands of our customers, both financially and in our customer satisfaction metrics.”

Even so, there is clearly a limit to passengers’ willingness to continually cough up more and more extra fees. For example, United’s attempt to charge for some meals on international flights sparked a passenger revolt that forced the airline to retreat from the plan.

Moreover, Southwest claims to be benefiting from other airlines’ extra fees, marketing itself as a “no hidden fees” carrier.

Tague admitted: “We’re seeing very moderate friction on the fees in the unbundling. Certainly, customers are frustrated. But at the end of the day, we’ve got to run this business to make a real margin. These are just things that are going to be necessary if we’re going to be a real industry.”

Industry experts say one of the reasons customers have expressed frustration is that they feel they’re being nickel-and-dimed with little transparency and thus no way to anticipate the true cost of flying.

On the other hand, some GDSs now argue that airlines, and even distributors, can benefit from providing full transparency in what they are offering and charging, enabling even more unbundled fees.

A global airline survey in October by Sabre Airline Solutions Consulting suggested that travelers value maximum choice when deciding which airline products and services to buy, with one-third of passengers preferring a hybrid of bundled and unbundled pricing options.

Robert Buckman, director of airline distribution strategies for Amadeus North America, pointed to Air Canada as an example of a hybrid approach. “They have core attributes that are core to each fare family,” he said. “But they also have buy-up or buy-down features for those fare families to different ancillary products.”

He added that Air Canada “has really laid out a beautiful business model for their airline and their market. We can see here that over a three-year period, Air Canada has grown its ancillary revenue by $71 million. Main contributors are advance seat selection, excess baggage fees, cancellation fees, same-day changes and meal purchases.”

But many other revenue possibilities remain, including airport lounge passes, valet parking and other services. Amadeus this spring rolled out technology that it said would help airlines break down and capture those service fees.

The GDSs stand to cash in, he said, as their online sites become test beds.

“We may be looking at an unprecedented change in the way airlines will retail their products and services, which has essentially been the same since they began selling tickets decades ago,” Buckman added.

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