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Published: Apr 06, 2005 in Knowledge@Emory

Sky-high fuel costs and crushing price wars have led to near-record losses for the airline industry, reaching some $9 billion of red ink in 2004, second only to 2003’s $10 billion low point. Yet earlier this year Delta Air Lines—the third-largest carrier behind American Airlines and United Airlines—surprised some analysts by slashing fares across the board by up to 50%. Delta called it a move to capture market share and ensure the company’s survival, but some analysts have wondered if the airline is instead hastening its own demise. And in another potential threat, last year the carrier engaged in an early sale of its fuel-hedging contracts, betting on a drop in prices that never came about.

For the fourth quarter and full year 2004, Delta’s numbers—like much of the industry— didn’t look very promising. Net loss for the quarter was $2.2 billion, while the airline clocked a $5.2 billion loss for the full year.

“While these results are clearly not sustainable, we are implementing a transformation plan that takes us to a very different cost platform,” said Michael Palumbo, Delta’s CFO at a February 17 JP Morgan 2005 Airline Conference held at New York’s Plaza Hotel. Among other accomplishments, he said Delta had achieved some $2.3 billion in productivity improvements during the two years ended December 2004, and also noted that a November 2004 agreement with the pilots union will deliver $1 billion a year in savings over a five-year period.

In January, Delta went national with its SimpliFares program—which was previously tested in Cincinnati—streamlining the carrier’s ticket-pricing structure and significantly reducing ticket prices. At the time, CEO Gerald Grinstein said that the move was “part of Delta’s commitment to improve the travel experience and also to produce significant savings through simpler, more efficient ways of doing business.”

But “a lot of people are shaking their heads over Delta’s fares,” says Richard Metters, a professor of decision and information analysis at Emory University’s Goizueta Business School. “Simplifying and reducing fares for business travel—as well as for leisure travel—is an odd move. The price cuts will likely bring about a strong, positive leisure travel response, along the lines of what Southwest Airlines sees when it enters a market. But, it’s tough to see how lower fares would spur much more volume from businesses.”

Essentially, he says, Delta—which averted a last-minute bankruptcy filing in October when its pilots union approved $1 billion in givebacks—may simply be taking money from its own coffers.

“There must be a reason for the action, but it’s not clear to me,” he says. “It’s possible that Delta is aiming at other ‘legacy’ airlines that are teetering. Perhaps Delta is trying to push companies like United and US Air over the edge, which could result in a smaller field.”

The company says that “SimpliFares is a Delta solution that provides an affordable product with less complexity,” according to company spokesman Anthony Black. “Our customers told us that they wanted to know how to easily purchase the best available fares, and that’s what this program does.” Some observers see the company’s revamped flight and pricing program as a necessary response to a structural change in the industry, brought about by the 9/11 attacks, a prolonged recessionary business climate and the steady growth of the low-cost carriers.

Obviously, Delta’s performance in next few months will be closely monitored. Just last week the company announced that its February domestic load factor—a measure of the number of seats sold and used—was up 2.2% compared to February 2004. Also during the month, revenue passenger miles—a measure of the number of passengers and the distance flown—were up 7.1% on a period-over-period comparison. February, traditionally the slowest month of the year, represented the first full month of Delta’s revised flight schedule.

But has another Delta move undermined the company’s recovery efforts? In February 2004, according to SEC filings, the company settled, or sold, all its fuel hedge contracts “prior to their scheduled settlement dates.” Hedge contracts can offer the purchaser the right to lock in the cost of a commodity, like fuel, at a certain price for a specified period of time, shielding the buyer from any upturn in market cost. But by selling its hedges early, Delta may have given up an important advantage, since jet fuel—which continues to reach near-record cost levels on the open market—is generally considered to be an airline’s second-largest expense, behind labor costs.

“Delta is completely unhedged against oil swings at this time,” says James Corridore, an equity strategist with Standard & Poor’s. “But I hesitate to say it was a bad move, since the company was on the brink of bankruptcy at the time, and needed the cash [realized by selling the hedge contracts].”

During his presentation, Palumbo noted that “as we speak, Delta is without any material fuel hedges.” While he acknowledged the need for such price protection, Palumbo also noted, “It is unlikely we will be able to hedge the entirety of our requirements, but it is our objective to get at least competitively hedged.”

So even as Delta’s costs are rising, the company is cutting revenues in an attempt to stimulate traffic. It’s a gamble, some observers say, that Delta had to take.

“The fare cut was a necessary move to respond to low-cost carriers that are taking the lion’s share of passenger miles,” suggests James Corridore, an equities analyst with Standard & Poor. “Anecdotal evidence indicates that the reduced fares have stimulated business and other travel, but in the short term the lower fares are having a degrading effect on profitability.”

That may be an understatement. According to published reports, high fuel prices and low fares have blunted the effect of record passenger volume, leading to a situation where three top carriers— United Airlines, US Airways (for the second time in two years), and ATA—are operating under bankruptcy protection, while only two of the top 10—Southwest Airlines and JetBlue Airways—managed to stay profitable in the just-ended quarter. AirTran also managed to squeeze out a profit.

Of course fuel costs aren’t the only challenge facing Delta and other older, or “legacy” carriers that were launched before industry deregulation in 1978. High labor costs–carryovers from the days when air travel costs were regulated by the government and unions wielded a great deal of strength—bedevil many of them, while more recent startups, which faced free-market competition from their birth, tend to have lower-cost contracts with pilots and other high-salaried workers.

Another obstacle is the “hub and spoke” business model that the older carriers utilize. Under this format, high numbers of passengers are funneled through a central location, or hub, where they then pick up spokes, or connecting flights. In contrast, many low-cost airlines have embraced a simpler point “A” to point “B” structure.

“The hub and spoke model was created to enable service to second or third tier cities that would have been otherwise abandoned altogether due to rapid deregulation (Big Bang Theory) of the airline industry, and by CAB which set prices and routes for point to point traffic under regulation,” says Jagdish Sheth, a professor of marketing at Goizueta. “Major carriers, through the hub and spoke model, had a hub monopoly that could subsidize spokes.”

For example, he says, a passenger flying from Atlanta to Los Angels with no restrictions used to pay $1,600 for the round trip. However, if a person flew from Birmingham via Atlanta to Los Angeles, the round-trip price was under $600.

“This model of subsidizing spokes created opportunities for low-price carriers to create a beachhead in such hub cities as Chicago, Atlanta, Dallas, JFK, Newark, Los Angeles, Salt Lake City, and Cincinnati where they could easily attack the cross subsidy created for spoke passengers in places like Birmingham,” explains Sheth. “This might have been sustainable, but increased competition emerged when the cost of entry was lowered dramatically with the “leasing” of planes offered by GE Capital and others.”

Although the carrier’s low-cost Song subsidiary uses a point-to-point model, Delta appears to remain committed to its hub-and-spoke model. But it’s also tinkering with the format, announcing, for example, that it will “dehub” its Dallas/Ft. Worth operation and redeploy those assets to grow its hub operations in Atlanta, Cincinnati and Salt Lake City. Delta also recently announced that in May it will launch point-to-point service between Fort Lauderdale, Fla., and Nassau, Bahamas.

“We know that the competition from low-cost carriers continues to increase,” says Palumbo. “Delta competes against low-cost carriers in some 70% of our markets, the industry in general speaks to lost-cost carrier content of about 30%.”

“Delta has to try to balance its traditional hub and spoke operations and it’s low-cost “Song” point-to-point format,” says Goizueta’s Metters. “If it fails it’ll be in a lot of trouble, but it may not go under. Instead, it may just keep bleeding if the government and lenders continue to be lenient when it comes to airlines.”

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