Keynote Address

1

• Keynote Address
• Understanding Airline Strategic Choices
• How Much Do Legacy Carriers Have to
• Change to Survive?
• Michael E. Levine
• Professor, Yale Law School

2
Keynote Address Understanding Airline Strategic
Choices How Much Do Legacy Carriers Have to
Change to Survive? Michael E. Levine Yale
University Embry-Riddle Aeronautical University
Airline Economics Seminar Washington, D.C.
April 7, 2004
3

• What it will take for existing legacy airlines to
  survive over the medium and long term?
• How can I provide context for the presentations
  and discussions we will be hearing today?

4
Dickens Said It Best

• Annual income twenty pounds, annual expenditure
  nineteen nineteen six, result happiness. Annual
  income twenty pounds, annual expenditure twenty
  pounds ought and six, result misery.
• David Copperfield

5
How Does An Airline Achieve Happiness?

• A management needs to locate a pool of revenue
  that it has some advantage in capturing.
• An airline needs to spend less money serving that
  pool than the pool can provide.
• Both these tasks are very challenging, especially
  in times of transition.

6
LETS FOCUS ON STRUCTURE
7
Structure Comes from Strategy

• Define sources of competitive advantage
• Configure system to take advantage of them

8
To Make Strategic Comparison of Alternate
Structures, We Must Assume Competitive Input Costs

• Legacy network airlines have major historical
  cost disadvantage
• We must separate structural costs from
  historical costs

9
Legacy Cost Handicaps

• Contractual and Historic Commitments
• Labor contracts
• Funding retiree benefits
• Fleets
• Software
• Facilities
• These must be distinguished from costs that stem
  from strategic choices
• Product costs
• Schedule efficiency
• Fleet utilization
• Facilities utilization
• Labor utilization
• Distribution Costs

10
Issue Is Not Absolute Cost Level But Input Cost
Parity With Competitors

• Almost 80 of travelers now have low-cost
  alternatives
• As LCCs continue to expand and take market
  share, that number will continue to grow
• LCC costs will rise, but remain far below
  historic legacy-carrier levels

11

• Legacy Network Carriers Must Make Input Costs
  Competitive to Survive
• Chapter 11
• Workout
• Chapter 11 necessary backdrop as default case

12
Third Managing Transition To Competitive Costs
And Strategy

• Management Reorientation
• Labor Democracy
• EETCs
• Bankruptcy and Reorganization Risks

13
Worst-formulated Question of the Moment

• Is the hub and spoke model dead? Will point to
  point airlines rule the air transport world?
• Misunderstands the economics of air transport
• Assumes that there are only two kinds of
  airlines
• Ignores history
• Ignores whats really going on at WN

14

• Lets Return To Basics

15
BASICS - I

• Every traveler wants to go from someplace to
  someplace, portal to portal.
• No traveler wants to spend any more time than she
  has to doing it.
• No traveler wants to spend any more money than
  she has to doing it.
• Every traveler wants to be as comfortable as
  possible.
• No traveler wants to stop.
• No traveler wants to change planes.

16
BASICS - II

• No traveler really wants to pay for any of this.
• Every traveler would prefer to pay less rather
  than more, all other things being equal.
• But many travelers are willing to pay something
  for convenience and some travelers will pay quite
  a bit for convenience

17
BASICS - III

• Every airplane is flown point to point, and that
  point is never the point from which the traveler
  wants to leave to the point to which the traveler
  wants to go, unless she lives at an airport and
  is going to a meeting at another airport.

18
After Much Study

• NO EVIDENCE of economies of firm scale in airline
  industry
• SOME EVIDENCE of economies of scope
• OVERWHELMING EVIDENCE of economies of route
  density

19
THE DENSER THE MARKET, THE BIGGER THE PLANE THAT
CAN BE USED
20
The Bigger the Plane, and the Fuller it is, the
Lower the Cost of Production

• RD, systems, flight crews all fairly constant
  costs
• Engineering factors
• Effect is not linear, costs tend to flatten at
  100-150 seat inflection point (point changes with
  technological change)
• Labor price discrimination obscures some of this

21
THE DENSER THE MARKET, THE MORE FREQUENCY IS
POSSIBLE AT COMPETITIVE COSTS AND THE MORE
ATTRACTIVE AIR SERVICE IS TO TRAVELERS
22
How Can We Make Markets Dense?

• Find big ones
• Combine flows

23
Very Few Markets Are Big Enough To Support
Frequent Service Solely To Local Itineraries
(True Point To Point)
24
Virtually All Others Require Traffic Collection
Strategies

• intertemporal, intermodal, or itinerary
• Intertemporal (frequency limits)
• Intermodal, expanded catchment (WN, B6)
• Mix onboard itineraries by
• one-stop or two-stop flights (WN)
• connecting nodes (WN)
• small hubs (F9, FL)
• large loose hubs (WN, AA?)
• large tight hubs (CO, DL, NW, UA, US)

25
All the Known Solutions to the Density Problem
Trade Convenience for Cost

• Expanded catchment area means longer drives to
  the airport
• stops and connections to combine itineraries add
  to travel time, reduce reliability, consume
  aircraft capital
• lower frequency to allow use of larger planes
  means less preferred departure times

26
Tradeoff Defines Cost Base

• Less convenience means lower cost
• How much less convenience?
• For which markets?

27
Tradeoff Defines Revenue Base

• More convenience means higher value
• How much more convenience?
• For which customers?
• Geographic
• Purpose of trip
• Identity of purchaser
• Less convenience means lower value
• For which customers?

28
Tradeoff Defines Nature and Extent of Competitive
Exposure
29
All This Assumes

• INPUT PRICES APROXIMATELY THE SAME ACROSS CARRIER
  CLASSES
• PRODUCTION EFFICIENCY APPROXIMATELY THE SAME,
  GIVEN LEVEL OF CONVENIENCE CHOSEN
• THESE ARE NECESSARY CONDITIONS
• FOR SURVIVAL ONCE COMPETITIVE ALTERNATIVES ARE
  WIDESPREAD

30
Strategy Bottom Line

• Joint Convenience/Cost Optimization Problem,
  different solutions for different situations
• Network Structure is a DEPENDENT VARIABLE
• Lowest Cost doesnt automatically mean highest
  profit
• Complexity to create convenience creates value,
  question is how much at what cost

31
Some Strategies Are More Easily Pursued By Some
Airlines Than Others

• History
• Incumbent Displacement
• Transition Costs

32
Managing Transition To Competitive Costs And
Strategy

• Management Reorientation
• Labor Democracy
• EETCs
• Bankruptcy and Reorganization Risks

33
Strategies Can Be Combined,But Always With
Tradeoffs

• Note that WN is NOT a pure point-to-point play
• Four different structural strategies combine into
  a QUASI-HUB network
• Pure point-to-point
• Multistop
• Small loose hubs
• Large loose hubs

34
Advantages and Disadvantages of Quasi-Hub
Strategy

• Uncoordinated connections keep costs low
• Low fares expand catchment areas
• Provides flexible expansion path
• BUT
• Passenger inconvenience inhibits realizing full
  revenue value from frequency convenience

35
RECENT HISTORY HAS OBSCURED MUCH OF THIS

• LEGACY HUB AND SPOKE CARRIERS HAVE HIGH
  HISTORICAL COST
• NEW ENTRANT LCCS CALL THEMSELVES POINT TO POINT,
  BUT FEW OF THEM ACTUALLY ARE
• NEW ENTRANTS HAVE BEEN GIVEN PRICE UMBRELLA

36
What Will Customers Pay For?

• As some airlines adapt, we are beginning to get
  a better picture of what customers will pay for
  with respect to structure and product
• America West as low-cost hub competing with
  Southwest at Phoenix
• Alaska as low cost hub competing with Southwest
  over most of its route system
• Airtran
• All offer two-class product

37
How Much do Legacy Carriers Have to Change to
Survive?

• Necessary condition achieve competitive input
  costs
• Solve density problem in a way that creates
  more value than it destroys
• Find out what customers will pay for
• Optimum solutions will differ with different
  geographic reach, customer and competitive set
• Position Product so that it creates more
  value than it destroys
• Will also differ with circumstances

38
Public Policy Should the Government Try to Ease
the Transition?

• Little likelihood of success
• Adjustment will be painful
• for labor
• for equipment lessors/manufacturers
• for municipalities
• Bankruptcy likely for all legacy carriers
• Chapter 11 for some liquidation for others
• Adjustment will only happen if default case is
  worse
• slowing it down wastes private and taxpayer
  resources
• Preserve antitrust policy, no special airline
  competition policy
• ATSB has outlived its usefulness
• Economically hard to do politically impossible
  to leave alone
• Pension, retiree issues the most difficult

39
WE MAY NOT KNOW THE ANSWERS YET, BUT WE CAN GET
THE QUESTIONS RIGHT