The Worst is Yet to Come

Is the title overdoing it? After all, legacies have suffered through the rise of their low-cost competitors, the 9/11 attacks, and skyrocketing oil prices, not to mention record low customer satisfaction. Could the next crisis really be worse? Many say the answer is yes, and I'm inclined to agree.

Due to the recent financial meltdown that has plagued the world, corporate travel managers are ordering emergency travel cutbacks at unprecedented rates. According to one survey, 25% of firms have issued cutbacks, and this number is only likely to increase as the crisis gets worse. If companies are cutting back, airlines are being deprived of some of their most profitable clients at a time when they are desperately needed.

To make matters worse, many legacy carriers announced a wave of capacity cuts over the summer in response to rising fuel prices. While fuel prices have (thankfully) fallen, overcapacity continues because airlines were not anticipating economic collapse when the announcements were made. Leisure travel has suffered due to the latest stock market falls. Even with fares higher than they have been in some time and fuel relatively low, that doesn't make for a good recipe.

While the Delta/Northwest merger will help alleviate some overcapacity, the two carriers have very few overlapping routes which can see trimming. Instead, most of the cuts will come from significant capacity cuts at certain hubs (eg. Memphis and Cincinnati) or downsizing to smaller aircraft. But the fact still remains that there is an excess of capacity in the market, and unless legacy carriers take more and more of their mainline aircraft out of service, lots of empty seats will exist. But airlines can remove capacity. DC-9s and MD-80s probably should head to the scrapyard; they're old. The reason further downsizing is a problem to airlines is not so much their inability to do so, or even their reluctance to lose market share (heck, even the prolific grower Southwest is trimming capacity this winter). Rather, it could be resistance by labor.

In 2009, a plethora of new labor negotiations will come to the fore, and with a pro-union Obama administration in the White House, airline workers could have the upper hand. Labor tensions could run high at virtually all major US carriers this year, and that could create further angst for passengers. Employees are going to resist further job cuts, especially given the limited job prospects at other carriers. In the Delta/Northwest situation, Delta's mostly non-union employees will need to decide whether to join the unions of their Northwest brethren. Employees at all legacies have made significant sacrifices to help keep their companies afloat since 9/11 and they deserve better. While major airline CEOs are not as lavishly paid as some of their banking counterparts, they have received remarkable salaries for lackluster performance in recent years. Employees are feeling pressed, and if airlines refuse to given on wages, it could get ugly.

If the industry continues to weaken, and mainline employees fail to receive wage increases, the employees most likely to benefit are those at some airlines' regional affiliates, who could see increased job security. Because of falling demand, more and more flying duties are being passed onto the regional carriers that operate 50-100 seat planes for legacy carriers. Many 70-seat jets are currently flying between major hubs and large cities, such as Chicago and Philadelphia. These regional lift contractors have lower payscales and are often exempt from some of the more onerous work rules that legacies are subject to. Unfortunately, if the demand isn't there, more and more flying will be outsourced. This means less comfort for passengers, lower wages for workers, and an overall downsizing of the industry.

So this brings me to the all-important question. Can the industry weather this crisis? Of course. Most legacies, with the possible exception of US Airways, are too big to fail (just like AIG), and the Federal Government will not let them collapse. One legacy could fall victim to this mess, and be bought out or partially liquidated, but I don't see any one of the four key legacies (American, United, Delta/Northwest, and Continental) failing entirely. Too many jobs would be lost, and the market couldn't handle that seismic loss in capacity.

Whether profitability comes soon is a different question. Southwest is facing its own set of problems including risky fuel hedges, which will turn out to lose the airline money if oil stays put for the next few years (possible if there's an extended downturn, but not likely), and industry-leading labor costs, which suggest that the carrier may feel pressure to raise fares, triggering fare increases from competitors. If this happens, airlines will have a better shot at achieving profitability.

However, while legacies are likely to survive, even if they are not profitable for awhile, some LCCs are in a more precarious state, most notably Frontier. The carrier seems to be without a viable business plan, and is getting hammered by Southwest in Denver. The company is trying to stay afloat by appealing to its local loyal customers, and launching its Lynx turboprop service, but it could be too little too late. Frontier is hemorrhaging cash (the company just lost $30 million in its fiscal second quarter) and seems to be on the defensive as Southwest takes more and more of its market share. Frontier is not yet a lost cause, but unless the company is able to post better numbers, it will soon run out of cash. In this liquidity environment, the company cannot count on getting more financing to operate, without which, it could fail.

Some argue that Sun Country, if it can make it to the winter season (their most popular time of the year), may be able to survive. I disagree. I don't see this company as having a viable business plan even if they make it through the winter, and I am skeptical that they will survive the next six months. I have been wrong before, and I may be wrong again, but with demand for leisure travel falling precipitously as families worry about their 401(k)s and new potential competition from Southwest on some domestic routes (albeit with a connection in Chicago), I simply do not see Sun Country surviving as a scheduled carrier. However, the company may be able to survive if it reverts to mostly charter operations, but that will depend partly on the demand for package tours.

Midwest is not as important a player as it once was. The TPG/Northwest buyout has helped reduce the company's route network and transform its culture into another LCC. Midwest plans on subcontracting much of its flying out to Republic Airways on smaller regional jets, making the company much more dependent on short-haul routes in the Midwest. Even during this downturn, AirTran has made a concerted expansion effort in Milwaukee, and I expect that, if things stay bad in the industry, Midwest will be increasingly marginalized.

While Southwest, JetBlue, and AirTran have all had major challenges, these three "core" LCCs should survive the downturn relatively unscathed. Each of these companies has a solid business model, and all three are working to diversify themselves, adding international routes (or in the case of Southwest, international codeshares), as well as working to improve ancillary revenue streams. Although the days of rapid growth and $200 transcon fares are over, these three carriers will continue to be important. There will also be a continued role for LCCs that operate mainly in one region. Alaska, Hawaiian, and Spirit should all survive. Even Virgin America looks like it can make it (although this cannot be independently verified, as the company has refused to release traffic and financial data, citing competitive concerns).

With one or two exceptions, most US airlines have viable business plans and are adequately prepared to handle potential setbacks in the near future. Passengers continue to demand low fares more than anything else, and carriers are working diligently to provide. However, to do this, airlines will continue to make changes that will likely irk passengers such as increasing ancillary charges or replacing mainline aircraft with regional jets, all in the name of saving money. As the industry shrinks still further, one hopes that airlines will gain the necessary pricing power to provide a better product to customers, a living wage to employees, and fair returns to investors. It's possible, just don't count on it.