Airline Merger Frenzies (I): Deep Cost Structure, Restructuring & Outlook
The airlines have managed to occupy a prominant place in the headlines for several years no, starting with the implosion of their traffic demand post-bust, going thru their painful re-structurings, downsizings and cost cutting and now, their merger frenzies. It's not musch discussed but all of these are surface phenomena based on the nature of their deep cost structures. In fact a discussion of that structure has never come to my attention. In the interests of aiding a broader understanding we're reproducing an e-memo we sent out in the Spring of '03, excerpted immediately below and reproduced on the continuation.
"As Warren Buffet pointed out years ago the airlines have never made their cost of capital and always disguised that fact with the next big recovery in a cyclical business (b.t.w. - I recommend Slywotsky's "Art of Profitability" and the chapter on cyclical businesses to understand how cost structures interact with cycles - there's a chapter on that very topic).
Simple reform of the surface of ticketing etc. won't do it. Also b.t.w. - AMR spent at least $150M I know of trying to get to the next level of the end-to-end travel experience but ran a terrible software project trying to clone Sabre in the early to mid-90s. Rumor has it that the real figure was closer to $300M.
Unless the airlines rethink their basic business model in terms of network design, route cost structure, including labor but exclusively, and their pricing and customer service strategies this nonsense will continue until there's major collapses."
If you'd like to have a framework and toolkit for analyzing the mergers as a traveler, investor or employee this might be quite helpful. It also serves as decent example of a point we emphasize that investing in an industry is, at least to some extent, "Inside Baseball". That is it really helps to understand how it works and what it's capable of. A point the Sage of Omaha makes as well though you have to dig back into his history to see it. (Masterclass: Buffett on Investing and Business Analysis).
A second version of the memor, from a slightly later date, is available as a dloadable PDF.
ORIGINAL E-MEMO
To: <scott.mccartney@wsj.com>
Subject: Airline Restructuring
Date: Wednesday, April 02, 2003 8:56 AM
Dear Scott:
Been meaning to write for sometime as I watch you discussion of airline conditions and strategy evolve. Having worked for nearly a decade in Fedex's corporate planning group I have some familiarities with some of the economics and drivers of flying planes, though not all of course.
As it happens you may recall that Fedex was the grandfather of the hub & spoke system which still forms the backbone of their network. However many years ago now we went to complementary point-to-point service where the volumes supported the infrastructure and ground-based capital investments. The model here is one of network connectivity - think of a matrix with all the origins as rows and the destinations as columns. In a pure hubNspoke there's a single row of 1s for direct connect and a single column. You put in other connections and for us the associated large ground installations when the volumen pays the capital and operating costs.
This is a critically important model to understand and I don't see it being discussed.
All the low-cost airlines grew up by cherry-picking the point-to-point connections of the national network. It would be worth your while to wander over the some local university and talk to the OR department to have this discussion.
Now on top of that one has to look at the total cost and understand how each cost element is driven by the underlying route structure. One way to eliminate major cost disadvantages is to not fly a particular route. A reconceuptualization that doesn't appear in any of the airlines thinking.
The airlines have also made the mistake of assuming that they have a semi-captive audience rather than looking to deliver value. In the late 90s boom this was re-enforced. I was flying every week from NYC to ATL and generally choose Delta because it and AirTran were competitive until Delta got to feeling it's oats and I couldn't get a ticket under $600 while AirTran was continuing with the $300 tickets. The airlines have no sense of customer value and responsiveness but they're learning what the penalties for that are.
A deeper and more corrosive force is labor relations. I'm not sure what the history is but when Frank Borman was driven out of Eastern and later the mechnics, et.al. let the airline die rather than negotiate you got a measure of the level of dislike. That's happened several times. I had the opportunity to have lunch w/Borman in Las Cruces, me, him and my cousins at a little outdoor picnic table at a very cheap local Mexican place, if you can envision it. And Borman viewed his employees still the way a military man views expendable troops - as fungible commodites. I've seen that attitude at every airline I've been around.
As Warren Buffet pointed out years ago the airlines have never made their cost of capital and always disguised that fact with the next big recovery in a cyclical business (b.t.w. - I recommend Slywotsky's "Art of Profitability" and the chapter on cyclical businesses to understand how cost structures interact with cycles - there's a chapter on that very topic).
Simple reform of the surface of ticketing etc. won't do it. Also b.t.w. - AMR spent at least $150M I know of trying to get to the next level of the end-to-end travel experience but ran a terrible software project trying to clone Sabre in the early to mid-90s. Rumor has it that the real figure was closer to $300M.
Unless the airlines rethink their basic business model in terms of network design, route cost structure, including labor but exclusively, and their pricing and customer service strategies this nonsense will continue until there's major collapses.
I don't see any discussion and therefore no liklihood of this happening. You might find it interesting to investigate and report on these various factors and see if I'm smokng something myself but I think you'll find not.