Future of Airline Distribution System

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Table of Contents

Introduction
The Past, Present, and Future of U.S. Airlines
Consolidation in the Future
The Future of the Airline Distribution System
Conclusion
Bibliography

Introduction

Today, the U.S. Airline industry has reached a crossroads. In 2005, federal bankruptcy laws and fuel prices had the combined impact of sending Northwest and Delta into bankruptcy, and this is just a minor incident in the challenges and obstacles that America’s airline industry has experienced in the recent past.

Between 2001 and 2005, the U.S. airline industry suffered massive losses to the tune of $32 billion as it desperately tried to maintain its footing despite the economic slowdown, declining business travel, increased competition from low-cost carriers, the 9/11 terrorist attacks, the SARS epidemic, and rising fuel costs. Even after these obstacles, some discount carriers like American, Continental, and United still managed to report small operating profits (Current Situation and Future Outlook of U.S. Commercial Airline Industry).

The future, however, is an uncertain one. As oil prices continue to increase and reach unprecedented highs, airlines are reacting by passing these costs onto consumers. Other external shocks which the industry is facing are in the form of stiff competition from the LCCs and high fixed costs which make profitability difficult in recessionary times. The ensuing discussion will demonstrate the nature of these obstacles as well as the possibility of a consolidated industry in the future. In the end, the future of the airline distribution system will also be examined.

The Past, Present, and Future of U.S. Airlines

The airline industry has attracted a lot of attention in the recent past and this is well-justified: before the US Airways Group emerged from bankruptcy to merge with America West Airways and started operating as a single airline in September 2005, it wouldn’t have been wrong to claim that almost half the capacity of the airline industry was struggling with bankruptcy. Most legacy carriers have reduced their labor, operational, and other administrative costs, and when left with no other option, have declared bankruptcy.

With so many major carriers going bankrupt and the historically high failure rate of airlines, combined with the airline industry’s substantial losses compared to other business sectors, there have been a number of different reasons proposed for this condition. Some blame the structure of the industry where there are few barriers to entry and high fixed costs, while others blame the highly cyclical nature of demand to be the reason for the instability of this industry. Over-capacity in the industry can also be a possible reason, and while bankruptcies might reduce capacity, they will only provide short-lived relief. A major reason for the losses can also be the spiraling high oil prices (Current Situation and Future Outlook of U.S. Commercial Airline Industry).

In 2005, the International Air Transport Association announced that the industry has suffered losses to the extent of US$7.4 billion due to high oil prices. That was the fifth successive year of net losses faced by the global airline industry and according to Giovanni Bisignani, IATA’s Director General and CEO, “Oil is once again robbing the industry of a return to profitability. Each dollar added to the price of a barrel of oil adds US 41 billion in costs to the industry. Cost reduction and efficiency gains have never been more critical” (Council, 2005).

While the global air industry went through its share of problems, the U.S. carriers were the most badly affected. As Done (2005) reported, these airlines suffered net losses of $9.1 billion in 2004 while Asia Pacific airlines showed net profits of $2.6 billion and European airlines made $1.4 billion in profits.

This disparity was attributed to the protection that non-U.S. airlines have from the increase in oil price because of the weak U.S. dollar. Additionally, they have also been able to hedge their fuel requirements, something U.S. carriers were unable to do owing to their weak financial situation and low credit ratings. Mr. Bisignani also blamed the ‘structural problems in the U.S. where labor costs remained high and low-cost competition had continued to drive down yields or average fares at leading hub airports. Both Europe and Asia had managed to salvage their airline industries by consolidation (to enable better capacity management) and low labor costs respectively.

There are some who have now acquired an advantage over others because they hedged against rising higher fuel prices many years ago. Southwest Airlines is one such example, which today owns long-term contracts to purchase a large portion of its fuel through 2009 for the same price as it would be if the price of oil were $51/barrel. These hedges are today highly valuable, worth more than $2 billion as the price of oil exceeded $90/barrel.

Southwest will realize these gains throughout 2008 and 2009 and while it does feel the impact of rising oil prices, it has a distinct advantage because this impact is considerably less than the blow competitors are feeling: Roger E. King, an analyst at CreditSights, an independent research company, predicted that “some other airlines, meanwhile, could start reporting losses as early as the current quarter, unless they are able to rapidly raise fares” (Bailey, 2007).

While the hedges enabled Southwest to maintain profitability as it earned profits on its hedging contracts of $455 million in 2004, $892 million in 2005, $675 million in 2006, and $439 million till September 2007 (Bailey, 2007), the near-doubling of oil prices are now ‘taking the airline industry into uncharted territory and raising doubts about the future sustainability of many of the industry’s players.

A report titled “The Oil Crisis and its Impact on the Air Cargo Industry” prepared by the Institute for the Analysis of Global Security predicted a bleak future of the global oil industry, because of a number of reasons such as mounting volatility in major oil-producing countries, geological depletion, terrorism, the decline in investment and unstable weather conditions.

According to the report, which was presented in Beijing before leaders of the airline industry in May 2006, “No doubt increasing oil prices are likely to dampen global trade. Air cargo traffic is a leading indicator of any economic slowdown. The air cargo industry itself, in which fuel accounts for 20-30% of the operational cost, is poised to be the prime casualty of the new era of expensive oil.” The triple-fold increase in jet fuel prices from 2002 to 2006 has led to the world’s airlines having expended more than $100 billion on fuel in 2005 (IAGS, 2006).

Airlines have largely reacted bypassing this increased cost to the consumers. Most have increased their airfares and/or reduced their flights. As Fleming (2007) reported, American Airlines, Continental Airlines, Northwest Airlines, United Airlines, US Airways, and Delta Airlines all increased their round-trip domestic fares by $20. AirTran raised its round-trip prices by $10 on last-minute tickets and increased its round-trip fare for longer flights by $20.

Round-trip domestic fares were increased by $20 by American Airlines, Continental Airlines, Northwest Airlines, United Airlines, US Airways, Delta Airlines. Expansion plans are being curtailed and growth estimates, revised. As high fuel prices are likely to continue into 2008, the future seems one of more fare hikes, and more capacity cuts as the industry struggle to salvage its position and make a reasonable profit. Airlines are also focusing on reducing labor costs and other costs as well via fleet simplification, changing hub operations, purchasing efficiencies, and other initiatives Current Situation and Future Outlook of U.S. Commercial Airline Industry).

However, the bleak scenario described above is not shared by the Low-Cost Carriers (LCC) as while they have also felt the impact of these factors, they have still been highly profitable and have enjoyed high growth rates. Southwest has been the most prominent name in the LCCs and has earned 57 consecutive quarters of profit. But others like Jet Blue (18 consecutive quarters of profit), AirTran, ATA, and Frontier have all been rapidly expanding. Today, LCC service is no longer restricted to a few cities, but it has an extensive network that reaches all corners of the country. This has obviously translated into benefits for the consumers who have further fueled the growth of this low-fare environment (Current Situation and Future Outlook of U.S. Commercial Airline Industry).

The market share of LCCs has grown by almost 300% in the last decade and they are now an integral part (1/4th) of the domestic airline industry. The critical point to note is that their business model is not derived as much from low costs as it is from low fares. Low costs are simply a consequence of their low fare structure, something legacy carriers can not emulate. In this regard, LCCs have been profitable players in an industry suffering losses. The future is also expected to be bright for LCCs, and as they now target transcontinental markets which up till now were the strict domains of the major network carriers, they will become the focus of more industry attention in the near future (Ito & Lee, 2003).

Consolidation in the Future

At the moment, there is also a lot of talk about consolidation in the U.S. airline industry’s future, as mergers are proposed as the cure for the problems of this industry. This has advocates and critics alike, as they all argue the relative merits and downsides of this option.

US Airways chief executive Doug Parker believes that the current aviation system is still highly ‘fragmented’ and this means that airlines do not have as much pricing power, which creates obstacles for them as they try to recover the more than $30 billion of losses that they have sustained over the past five years. Mergers will lead to higher efficiency levels, and Parker, whose company proposed to merge with Delta in November 2006 to create one of the world’s largest airlines, said that this merger would enable the merged company to reduce costs and capacity and make it a more profitable competitor (Marks, 2006).

Talks of mergers gained added momentum when rumors started floating that American Airlines and Northwest were considering a deal and if rumors of possible mergers have any truth to them, the number of traditional carriers would come down from six to three. But industry analysts do not perceive there to be an actual need for mergers, aside from the obvious reduction in competition it would lead to. Michael Boyd, president of the Boyd Group, aviation consultants in Evergreen, Colorado, opined, “If you put US Airways together with Delta, and there’s no additional strength there, that’s all about reducing competition. It’s Wall Street wanting to make money that’s driving the merger talk” (Marks, 2006).

Congressional leaders might also object to the mergers because of serious antitrust concerns. For example, U.S. Airways and Delta both cater to similar routes in the South and East and is the owner of one of the two shuttles between Washington, New York, and Boston. If their merger was given the go-ahead, one of these shuttles would have to be sold. This is just one of the problems the authorities might foresee in the scenario. Other possible red flags would include the raising of prices and lack of consumer choices in a number of cities.

Kevin Mitchell (Business Travel Coalition, Radnor Pennsylvania) also believed mergers to do more harm than good as they would lead to increased prices, overcrowded planes, and decline in the quality of customer service for subsequent years ‘precisely because it is so difficult to merge aviation corporate cultures’ (Marks, 2006). However, critical opinions aside, most experts do predict some consolidation among the remaining five legacy carriers over the next several years.

The Future of the Airline Distribution System

Alamdari and Mason (2006) provided an exhaustive overview of the changes in the airline distribution system and the impact these changes are expected to have on the airlines, travel agents, global distribution systems companies, and corporate travelers. As distributions cists rise for airlines, most have reacted in two ways: by reducing, or completely eliminating fees to intermediaries and increasing direct sell via the Internet. US airlines have either set travel agent commissions at a very low level or done away with them altogether. Another battle that airlines pursued was to reduce the fees charged by Global Distribution Systems as the latter reaped huge profits while the airlines reported losses or negligible profits.

To boost sales through their websites, airlines introduced a concept called channel-based transaction fees, where travelers are charged minimum or no fees for direct online booking. They also offer the lowest fares on their websites, as an incentive for travelers to book direct. Today, the internet has revolutionized the airline distribution system, as July 2004 figures for online ticket sales showed that the U.S. led the way with 37% of all tickets being sold online (Alamdari and Mason, 2006).

The innovations in technology as well as the external economic and business events experienced by the industry have affected each member of the distribution chain and caused them to re-evaluate their strategy and processes. As the GDS was deregulated in the U.S., Alamdari, and Mason (2006) perceive this to be another factor that has added turbulence to the market and has changed the business relationships between corporate travelers, airlines, GDS’s and travel management companies (TMCs) (Alamdari and Mason, 2006).

For airlines, one implication of the GDS deregulation is content fragmentation and screen preferencing or display bias. Larger airlines could gain from the latter as they would be able to pay a premium for preferential treatment from GDSs. However, travel agents would suffer from inefficiencies as the nature of their work requires them to consult a variety of sources of travel content in order to offer the best alternative to their corporate clients.

The business model will itself undergo a change, as for GDSs, their primary clients would now be airlines and corporates rather than travel agents. The needs of these segments will now have to be catered to and more customized solutions will be demanded by segments with diverse needs and preferences. GDSs, which will derive a major portion of their revenue from airlines, will also need to invest in technology that fulfills the needs of both large airlines and smaller carriers and LCCs.

On the other hand, airlines will continuously look for ways to reduce their distribution costs via GDS fees and e-ticketing. Another major concern for airlines is the selection of a distribution strategy for airlines within alliances. Regarding their relationship with TMCs, airlines will modify their old models and gain a better understanding of the value added by TMCs for both airlines and consumers. New relationships will be built consequently, and airlines will use the expertise of TMCs to sell the products that are difficult to sell and use their own direct channels to sell easy selling products (Alamdari and Mason, 2006).

Conclusion

The above discussion shows that trying times lie ahead for the U.S. airline industry. High jet fuel prices and well strict competition in the domestic market have led to most airlines reporting losses. Airlines have taken a number of steps to trim their losses but these measures have not proved to be sufficient so far. Restructuring and mergers can be possible solutions to the problems which plague the industry but only if they serve to reduce operating costs as well as capacity. The airline distribution system is also undergoing changes in strategic direction as well as business processes due to technological advancements and external shocks endured by the industry.

Bibliography

Alamdari, F., & Mason, K. (2006). The future of airline distribution. Journal of Air Transport Management, 12(3), 122-134.

Bailey, J. (2007). An airline shrugs at oil prices. The New York Times. Web.

Council, A. (2005). US$7.4 Billion Losses for Global Aviation in 2005 – Skyrocketing Oil Prices Deepen Industry Losses. IATA Pressroom. Web.

Current Situation and Future Outlook of U.S. Commercial Airline Industry. (2005). Hearing before the Subcommittee of Aviation. Web.

Done, K. (2005). Oil prices ‘destroying’ airline profitability. The Financial Times. Web.

Fleming, A. (2007). Rising oil prices = Rising airfare costs. Web.

IAGS. (2006). The Oil Crisis and its Impact on the Air Cargo Industry. Web.

Ito, H. & Lee, D. (2003) Low Cost Carrier Growth in the U.S. Airline Industry: Past, Present and Future. Web.

Marks, A. (2006). If more US airlines merge, who would benefit? The Christian Science Monitor. Web.

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