Why the Big Boys Won't Come Back
For the nation's beleaguered airline industry, the tipping point is finally here: The discounters are winning.
By Shawn Tully , Fortune Magazine

Ask Dave Ulmer, chief of planning at JetBlue, about his industry and he can
hardly contain his glee. To him, the towering fares charged by the major
U.S. airlines are a gilt-edged invitation to make tons of money. As we
speak, he's loading up on 100-seat Embraers-planes that are the perfect size
to compete in the majors' regional markets. "We'll fly routes like JFK to
Charlotte, Norfolk, and other East Coast cities where the average [one-way]
fares are over $200," he says. "We could easily cut those fares to
one-third, or around $70!"


For the six major airlines that date from pre-deregulation days-American,
United, Delta, Continental, Northwest, and US Airways-that's a terrifying
prospect. And it should be. While discounters have been nibbling away at the
big guys for years, now the industry is at a crucial point. For the first
time ever, the pricing pressure exerted by the discounters-which now have
close to a quarter of the domestic air travel market-has become so severe
that the majors can't raise prices significantly during a boom. On top of
that add higher oil prices; a burgeoning threat from small regional
carriers, some of which may take on their old major airline partners; and
growing resistance in Washington to solving the industry's problems through
bailouts.


The conclusion? Domestically, the majors are on a permanent path to decline.
They will continue to shrink in the U.S. while maintaining their lucrative
international routes. The only thing that can change this grim picture: If
the big airline unions get religion and grant pay cuts so steep that the
majors can compete head-to-head on costs with the discounters-an extremely
unlikely scenario. "The long war will be lost, barring radical changes in
the way these companies do business," says highly regarded airline analyst
David Strine of Bear Stearns in a recent report.


Meanwhile, the skies are buzzing with robust airlines waiting to take their
place. JetBlue, AirTran, America West, and Frontier are attacking the
old-timers' most profitable, protected routes. Of the top 1,000 "city pairs"
in the U.S.-New York to Houston, or Miami to Cincinnati, for example-the
majors faced low-fare competition on just over half four years ago, says
Darin Lee of LECG, a consulting firm in Cambridge, Mass. Now they tangle
with discounters on 80% of those routes. That means that the majors simply
can't raise prices to refill their coffers during the current economic
recovery-as they did in every previous boom. "The low-cost carriers are now
dictating pricing in our business," admits C. David Cush, the chief of sales
at American Airlines. Says Bear Stearns's Strine: "Every time the majors match the fares of the discounters, they lose money. That situation is clearly unsustainable."


The recent spike in oil prices is making life even more difficult. Jet fuel
accounts for 10% to 15% of the majors' operating costs, and every
1-cent-per-gallon increase drives up expenses by $180 million. (No one, not
even the discounters, has succeeded in raising prices to cover the extra
fuel bills.) It's no wonder the Big Six are on track to lose $5 billion this
year; if oil prices stay at $40 a barrel, that figure will jump to over $6
billion. Those losses have saddled the majors with $41 billion in debt and a
negative $3.2 billion in equity. By contrast, in the first quarter,
Southwest, JetBlue, and AirTran earned a total of $45 million, and all
posted strong increases in revenue. Wall Street has noticed: The market
capitalization of the six biggest discounters, including America West, ATA,
and Frontier, now dwarfs that of the six majors, $18 billion to $4 billion.


To be sure, the major airlines have come back from trouble before. That's
because until recently they could rely on three things to protect themselves
from low-cost competitors. They controlled most of the landing slots at
half-a-dozen crowded airports such as New York's LaGuardia, Chicago's
O'Hare, and Washington National. They maintained "fortress" hubs in which a
Northwest or US Air controlled as much as 80% of the traffic. And they were
just about the only game in town for transporting passengers on long-haul,
coast-to-coast routes and from midsized cities to their big hubs.


But starting in the late '90s, the Department of Transportation and local
governments pushed airports to give more gates to newcomers, helping
Frontier, Spirit, and AirTran establish a presence at Washington National
and JetBlue fly from New York's JFK. The fortress hubs are crumbling too.
While they still exist in some spots-Northwest totally dominates Detroit,
for instance-in May both Southwest and Frontier invaded Philadelphia, a
longtime bulwark for US Airways, hammering away at US Airways' fares to
dozens of destinations, from Tampa to Las Vegas.


In coast-to-coast markets the discounters have made major inroads as well.
JetBlue challenges American and United with increasingly frequent flights
from JFK to the West Coast; since it arrived in 2000, those fares have
dropped around 30%. Late last year, America West, a former major that
reinvented itself as a discounter, started rolling out extensive West Coast
service from both New York's JFK and Boston's Logan-including the
Boston-to-San Francisco route dominated by United and American. (United was
forced to match America West's three-day advance-purchase fare of $205 one
way; its old fare was a breathtaking $1,166.) The battle extends to a host
of routes between large cities. On June 20, Frontier will break United's
monopoly on nonstop service from Nashville to Denver by offering two flights
a day between those cities. Frontier will charge $199 for a three-day
advance purchase one-way ticket; United charges $464, but
it says it will match Frontier's fares.


Price isn't the discounters' only advantage. Back in the day, bad service
was the tradeoff for low prices. No more. Now these airlines offer new
planes, big smiles, and assigned seating. And discounters like JetBlue and
Frontier provide every passenger with a seat-back monitor showing live TV
and sometimes movies. AirTran, America West, and Spirit even offer
business-class cabins just as plush as those of the old-line carriers.


The only routes the majors still fully dominate-and where they continue to
extract premium fares-are those linking small and medium-sized cities to
their hubs. For years big airlines have been using regional carriers to fly
passengers from the smaller cities to those hubs. These airlines, which
include Mesa, Chautauqua, and SkyWest, are separate companies. But they fly
under the names of the airlines they serve, which sell the tickets and set
the schedules. These regionals generally operate jets with between 30 and 70
seats. "The reason the majors use regional airlines is that under their
union rules they can usually outsource flights only to planes that carry 70
passengers or fewer," says JetBlue's Ulmer. Because the regionals have far
lower labor costs, the small-city business is quite lucrative for the
majors, each of which faces virtually no discount competition between the
smaller city and its hub.


But now-you guessed it-the discounters are massing to offer competing
nonstop service to those cities. Some regional airlines that now serve the
big boys are itching to break free and join them. One former regional,
Atlantic Coast Airlines, has reinvented itself as the appropriately named
Independence Air. Starting this summer, it will fly hundreds of daily
flights from Washington Dulles, a United hub, to places like Portland,
Maine, Syracuse, N.Y., and Norfolk. Those routes from Washington are
dominated by United and US Airways. Meanwhile, Jonathan Ornstein, CEO of
Mesa, one of US Airways' regional carriers, may move into Pittsburgh now
that US Air is cutting back there. "We're studying the opportunity of
forming an ultra-low-cost carrier," he says. "We believe we could achieve
costs lower than those of the existing discounters."


In addition, the discounters' low fares will attract new customers who
wouldn't pay the higher prices charged by the majors. The result: Even more
discounters will flock to the medium-sized markets. Southwest CFO Gary Kelly
says that Southwest, which now uses only 737s, finds the regional markets so
tempting that it is studying the possibility of adding a fleet of smaller
jets to provide nonstop service to small and medium-sized cities.


To fight back, the majors have been piling on additional flights, hoping to
avoid ceding even more market share. Problem is that strategy simply drives
prices lower. United and Delta's new "low-fare" airlines, Ted and Song,
aren't likely to help either. They sidestep some of their parents'
restrictive work rules, but they come nowhere near matching the discounters'
low labor costs. Not surprisingly, the majors disagree. They claim that to
prosper, they don't need to match the discounters' costs, just narrow the
existing gap. And they're trying hard. Delta, for example, is seeking a 30%
pay cut from its pilots. "We'll never have their cost structure," says American's Cush. "But with our revenue premium, we can compete effectively."


What will become of the majors? Right now, US Airways is the shakiest (the
strongest are American, Continental, and Northwest). It's highly possible
that US Air will simply sell its assets: If the airline's cash position
falls below $700 million (it's about $1 billion now), the U.S. government
can declare it in default of its loan guarantee, possibly forcing
liquidation. United, after 18 months in bankruptcy, is now seeking a $1.6
billion federal bailout. But given US Air's problems, United probably won't
get it. As for Delta, it has told the SEC it may soon file for bankruptcy.

And that may be the industry's Hail Mary pass. In the airline business there
are only two ways to get big cost reductions: Use the threat of bankruptcy
to push the unions, or renegotiate the union contracts in Chapter 11.
Unfortunately, the cuts the majors need to compete are so deep-on the order
of 30% to 40%-that their hostile unions will never grant them. Even the
savings from bankruptcy have never been sufficient to put the majors on a
par with the discounters.

The smart money, then, says that we will see a combination of mergers,
liquidations, and, finally, a group of fewer carriers concentrating on niche
markets. An industry insider predicts that only three majors will be flying
in five years. They will keep their lucrative international routes,
especially the well-protected ones to Asia. They will also continue to
connect medium-sized cities to other medium-sized cities-that's a business
that's perfectly suited to their hub-and-spoke networks.

When you think about it, this all makes complete sense. After all, the
deregulation of the airline industry was designed to give consumers lots of
competition and lower prices. To achieve deregulation's promise, the
discounters had to win. It just took 26 years for that to happen.