A radical change in the airline industry
The Airline Deregulation Act of 1978, while a boon for passengers, signaled a radical change in airline economics. Prior to 1978, interstate domestic airline traffic was regulated by the Civil Aeronautics Board (CAB), a bureaucracy that set pricing, schedules, and lanes. Thus, carriers had little control over frequencies or what they could charge, but received some degree of protection on their lanes. In other words, the airlines could be assured a certain level of profitability in the good times and would likely face losses when traffic declined. But lack of competition meant that pricing was stable.
Everything changed after 1978. With the airlines free to schedule and price as they chose, they moved from a point-to-point, price-protected system to a hub-and-spoke, competitive one. The hub-and-spoke system is a mixed blessing for airlines. It offers the ability to connect passengers more easily and thereby widen an airline's network, but it is also highly inefficient, as planes sit for longer periods of time, waiting for passengers.
Over the next three decades, airlines discovered that they were facing a worst-case scenario. True, airlines were able to enact monopolistic pricing in their hubs, but the majority of passengers were on connecting flights, and now passengers had several hubs over which they could connect. Since most passengers are price-elastic, fares fell to the point where they simply covered marginal costs. To this day, in fact, on an inflation adjusted basis, fares are lower than they were prior to deregulation (source: Wolfe Research, as of April 2014).
And while fares started to decline, costs moved in the opposite direction. Pattern bargaining became the norm, as work groups would look at the most recently signed contract at a competitor and generally demand 1-2% more than that level. Knowing that the unions' strike funds could last longer than an airline generating no cash, management generally conceded. Once labor recognized that "mutually assured destruction" was working in its favor, its demands increased. Work rules became looser while hourly pay continued to move up. No management team wanted to lead the next Braniff or Eastern Airlines. In the good times, airlines were flying enough passengers to be profitable, but when the economy turned down, their income statements were devastated, as were their stocks.
With wages largely fixed, airlines had no choice but to raise prices. Leisure passengers, however, were highly price-elastic; a small change in pricing led to a significant decline in the volume of passengers. Business travelers, however, were just the opposite. Their tickets were often purchased last minute and, with most hubs existing in major cities, they often had only one or two options to travel. Thus, last-minute pricing went up and was often 6-7 times the fare that would have been paid only a month earlier. Airlines implemented rules such as Saturday night stays to differentiate between business and leisure passengers further.
The major carriers might have been able to survive with their business plan intact had it not been for the low-cost carriers, Southwest Airlines in particular. Unlike the major airlines, which ran inefficient, high-cost hub networks, Southwest was largely a point-to-point carrier that was never subject to regulation, since it originally flew only intrastate. Competition from Braniff forced Southwest to become low-cost early and it maintained this culture. It had one class of service and kept fares low, attracting leisure passengers and small businesses. Its work rules were more favorable to the company and management, led by the charismatic Herb Kelleher, generally had a good relationship with labor.
Instead of competing with the majors in their hubs, Southwest chose secondary cities near the hub. For instance, it would fly into Love Field in Dallas instead of Fort Worth, or Providence, R.I., instead of Boston. While Southwest may have been a gnat in 1971, it was the largest domestic carrier in the United States (in terms of seat-miles flown) by the mid-2000s. The majors became terrified of "the Southwest Effect," which was the decline in prices that took effect when Southwest came into its markets.
A race to the bottom: The United–US Airways merger that wasn't
By this time, it was becoming clear that the only way for airlines to generate enough revenue to survive was to gain massive market share. The problem with market share, however, is that it is easy to gain and easier to lose. As soon as your competitors under-price you, they pick up your share. Ultimately, it becomes a race to the bottom in which nobody wins. But there is one other way to pick up share from your competitors: You consider buying them.
Mergers, however, are difficult to pull off in the best of times and next to impossible in the worst. And for the airlines, they were about to enter the worst. The wheels came off the planes, so to speak, in 2000, when United Airlines made a bid for US Airways. And while the government and consumer groups were opposed to the merger, the biggest detractors were the employees, particularly the United pilots. So management did what it always does in this situation: It bought off the pilots, promising them that they would not lose any seniority. (A pilot's pay and what they fly are determined by seniority.) Or, if they did, they would receive the pay that they would have received had the merger not gone through. United hoped that the combined entity would generate enough revenue to offset the extravagant (some would say ridiculous) contracts.
As the economy turned south in 2001, however, and the Justice Department continued to oppose the merger, United saw the writing on the wall, paid US Airways a break-up fee, and walked away. But there was one problem: United had already promised its employees large wage hikes. Pilots received 25% hikes, with smaller wage hikes for the rest of the employees. Overall, United enacted a destructive 13% increase in its personnel line and failed to generate any additional revenue. And because of pattern bargaining, every other airline eventually had to match. United filed bankruptcy in 2002. In fact, virtually every major airline filed bankruptcy at least once in the decade, with US Airways pulling off the trick twice, once before, and once after, its merger with America West. A combined Delta-Northwest combination made it to 2005 before filing.
Bankruptcy begins to pay off
Bankruptcy proved to be somewhat of a panacea to the airlines, at least in terms of labor costs. Contracts were broken, pensions were frozen, and staffs were downsized. While not quite lean and mean, its costs were more competitive and the airlines were making money by the middle of the decade. Stocks rallied, particularly after US Airways made a bid for Delta in 2006, one that ultimately failed but would have cut capacity (and raised prices) significantly on the east coast. But that merger attempt proved to be the peak.
As the economy tumbled into the "Great Recession," airlines felt the pressure and their stocks tumbled, as well. US Airways, for example, which had peaked above $60 in 2007, fell to almost $2 per share by 2009. American Airlines was hit even worse, falling from more than $60 per share to $2, and eventually filing bankruptcy a few years later. Once again, airline investors learned the hard way that these stocks were simply trading stocks. (Data: Bloomberg.)
But something different happened this time: the airlines survived. With lower costs and lawyers in charge instead of traditional airline guys, the airlines took the focus off of market share and cut excess capacity, instead. Meanwhile, Southwest, which had survived the mid-decade fuel price shock with a series of strategic hedges, lost control of its other costs and saw its gap with the majors narrow. Continental and United merged in 2010, followed a few years later by US Airways and American. And as we enter 2014, the airlines look healthier than they have ever been, in our view.