Who's Hauling Mass: Chicago

According to the latest traffic statistics from the U.S. Department of Transportation, over six million passengers traveled through Chicago's two airports -- O'Hare and Midway -- in the month of February (2007).

United, American (including their express affiliates), and Southwest, the city's three largest carriers, handled 5 million of those passengers, and together they combined for roughly 75% of the total traffic in and out of Chicago.

"Changes" at Delta

Delta Air Lines (NYSE: DAL) came out of bankruptcy early this week. What emerges is virtually a brand new company with startling differences from the past: Fresh $4 billion in cash; annual costs reduced by more than $500 million; pilots’ pensions transferred to the government; planes with new paint jobs (flight attendants had new uniforms earlier); and no more takeover by a second-rate bidder from Tempe. These changes are exciting alright. But is Delta now cleared for takeoff to success?

The most remarkable change taking place at Delta is how its route map looks today. Domestic routes were cut, and widebody aircraft transferred to international flights. Delta also started flying to cities such as Kiev, Pisa, Santo Domingo and Managua—secondary markets, primarily in Europe and Latin America, that previously had no direct service from the U.S. Almost overnight, Delta’s domestic share of system capacity dropped from 75% prior to bankruptcy to around 63% today. Eventually, Delta sees half of its flying to be international.

The shift from domestic to international flights rests on the rationale that Delta would face less pricing pressures in international markets where there are fewer competitors, especially low cost carriers such as Southwest, JetBlue, and AirTran that for years had eaten away Delta’s domestic position. Going the international route is also a template for success, as demonstrated by Continental Airlines’ success in recent years—not coincidentally—in secondary markets of Europe and Latin America. Continental’s domestic capacity is only about 55% of its total, compared to around 63% for the other major U.S. carriers of American, Northwest, and United. Emulating Continental is thus Delta’s way to go.

But Delta is trying to change very quickly, on different fronts, from all directions. It is adding routes from not just one main hub, but two (Atlanta and New York Kennedy) or possibly three (Los Angeles). At the same time, it is renovating its airport terminals and upgrading inflight services. And just is case anyone misses the point, the current marketing campaign is called “Change.”

Employee morale is very high. Many analysts also share in the exuberance, pointing to rosy first quarter results that declared an operating profit of $155 million. However, to already declare Delta a success story this early is overly optimistic, because despite seemingly robust numbers, Delta may not be doing as well as management touts it is.

One area of concern is unit revenues (PRASM), a performance measure that shows where the airline’s position is in the market. The higher the PRASM, the better the airline’s ability to fill seats without lowering fares. The lower the PRASM, however, the less likely it is able to be profitable. Delta’s international expansions raised the question whether they will help improve PRASM. In the Atlantic and Latin America markets, where much of the expansion is focused, PRASMs saw year-to-year gains of +6.5% and +5.6% respectively. That’s good, because Delta is now generating more cash per seat than it did before. However, compared to other airlines, Delta’s PRASM gains are the smallest in the bunch, suggesting that it still faces pressures that keep the fares low.

In one region where Delta outshined its competitors is the domestic market—one in which it cut back capacity.

Certainly, you can’t determine whether an airline just coming out of bankruptcy will be successful based on its unit revenues alone. However, they are an indicator of how well the new business strategy is affecting the bottom line. Because unit revenue growth is smaller in comparison with other airlines, many of the high expectations for Delta may need to descend to a more reasonable level.

Transcon At A Glance: Los Angeles-New York/Newark

Competition is heating up over the air between Los Angeles and New York. Ever since Transcontinental Air Transport established the first cross-country air service in 1928, L.A.-N.Y. has been the most glamorous airline route in America, the highway of the rich and famous. Today it remains the busiest domestic airline market in the United States, with many flights and a variety of services, all vying for a chunk of this hotly contested market. How are the airlines doing here lately?

Most L.A.-N.Y. travelers fly between Los Angeles International Airport (LAX) and either New York John F. Kennedy Airport (JFK) or Newark Liberty International Airport (EWR). A third New York airport, La Guardia (LGA), bans LAX nonstop flights through an F.A.A. regulation called the “Perimeter Rule.” No low cost carrier competes in the L.A.-N.Y. market; instead they serve airports further afield such as Long Beach, Burbank, and Ontario (all in California), as well as Islip (N.Y.).

United’s (Nasdaq: UAUA) presence in the L.A.-N.Y. market has diminished in recent years. It used to offer wide-body 767 flights to JFK—comparable to American—and four daily flights to EWR. However, bankruptcy in 2003 forced cutbacks, including the retirement of the 767s. In their place was the introduction of “p.s. service” on the JFK route in 2004. Using the smaller, narrow-body 757 configured in three classes of service (like before), p.s. signaled United’s change in market strategy whereby reduced capacity and improved product would generate higher fares and revenues. The strategy was a smashing success, to some extent. United’s average one-way fare jumped from $293 in 2004 to $539 in 2006—more than double Delta’s take today. However, United’s market share has fallen to last place. Also, p.s.’s success was EWR’s loss, as traffic was siphoned off United’s own LAX-EWR service, which is now down to only one daily nonstop.

p.s., when it was first announced, was a much unanticipated move that caught everybody—particularly American—off guard. Now they are catching up. Last December, American (NYSE: AMR) announced a $20 million upgrade to its 767-200 fleet, which is dedicated to its 11 daily LAX-JFK nonstops (as well as San Francisco-JFK flights). Most of the improvements will be done to first and business classes—frequented by celebrities, power brokers, and cadres of corporate contract customers. It is American’s intent to recapture some of the high yield traffic lost to United, and bring its fares closer to parity with its longtime nemesis. On LAX-EWR, American operates two daily nonstops.

For Delta, 2006 saw the ill-conceived “Song” replaced by traditional mainline service. Many long-time and loyal customers left Delta because of Song’s coach only service. Sitting in coach didn’t sit well with elite-level frequent flyers wanting some perks. Europe-bound business travelers also avoided Delta because the LAX-JFK part of their itineraries—and a sizeable one at that—had to be flown in coach. Alas, first class is now back, and traditional Delta service is fully restored with some of Song’s service innovations like leather seats and enhanced in-flight entertainment. Still, it will be a tough task ahead to win back old customers. For now, Delta relies heavily on discounting to fill seats, but it is gaining market share. And as it will soon emerge from bankruptcy, Delta stands to become a stronger and more competitive force in the market.

Continental (NYSE: CAL) has strengthened its position on the LAX-EWR route, now that American has reduced frequencies to two daily and United is down to one. Continental currently carries two-thirds of the traffic on the route. However, the toughest challenger is not another airline but the city’s other airport—JFK. Fully 70 percent of the L.A.-N.Y. traffic passes through JFK, while EWR has the remaining 30 percent. Therefore, despite dominating EWR, Continental must keep fares low in order to attract passengers who would otherwise choose JFK. The average LAX-EWR one way fare is about $100 lower than LAX-JFK—$275 versus $377. Continental does enjoy a little, but not much, pricing advantage because of a solid base of frequent flyers it has in the New York City area.

The Not-So Southwest Effect

Southwest Airlines (NYSE: LUV) posted a first quarter net profit of $93 million. It also warned of expiring fuel-hedge advantages and weakening passenger traffic that will negatively affect second quarter results. While fuel-hedging has a couple more years to go before expiring, lackluster traffic growth—partly the result of Southwest’s overambitious expansion and not just a sign of a slowing economy—looms as Southwest’s more pressing problem.

Of late, Southwest’s expansions into new cities have not created the “Southwest Effect” that for decades had been its formula for success. Back in 1993, Southwest, still a regional airline at the time, successfully used the Southwest Effect to sweep into Baltimore-Washington International Airport (BWI), its first Northeast destination and a hub of then-called USAir. Within one year of service, Southwest had carried more passengers than USAir on every route it served, and eventually caused USAir to dismantle the hub.

Now, at Philadelphia International Airport (PHL), Southwest grew from the original 16 daily flights and 6 destinations in May 2004 to today’s 47 flights and 18 destinations. However, passenger enplanements trail US Airways on every route, and the planes are flying emptier. Service to Hartford, which was discontinued in March, had an average load factor in the low 30s. Five other routes have load factors below 60 percent. Columbus, O., may be the next to get the axe.

The latest foray into Washington-Dulles Airport (IAD) began last fall with flights to Las Vegas, Orlando, Chicago/Midway (MDW), and Tampa. Early numbers show some mixed success in capturing traffic from low cost competitors AirTran (NYSE: AAI) and US Airways/America West (NYSE: LCC), and there is also little evidence that the flights are cannibalizing Southwest’s own traffic out of BWI. On the other hand, Southwest is flying a lot of empty seats on the seven daily flights to MDW, which have an average load factor of 43%. The flights may also be cannibalizing Southwest’s BWI-MDW service. Meanwhile United, the largest carrier at IAD, has added capacity and filled proportionally more seats than Southwest—and therefore increased its market share.

Southwest’s expansion into Denver International Airport (DEN) is seeing similar disappointments, as it continues to trail the airport's two hub carriers–Frontier (Nasdaq: FRNT) and United (Nasdaq: UAUA) on most routes it competes, even though it offers nearly the same number of seats as Frontier.

Southwest has traditionally operated with lower load factors than competitors because of its focus on saturating markets with frequent flights. However, there is reason to be concerned about the inability to fill more seats lately. As many of the competitors have successfully restructured in bankruptcy, Southwest no longer enjoys the kinds of cost advantages it once enjoyed. Had there not been fuel hedging, it’s not exactly clear how profitable Southwest would actually be.

At issue is the airline’s current pace of growth. This year the airline plans to add more than 30 aircraft and expand capacity by 8 percent. Where are the new planes going to go? Recent expansions into congested hubs are a symptom of the problem of too many seats. Southwest is running out of new markets, so it is banking on a wing and a prayer that it could drive out one of those carriers at one of those hubs.

It won’t be as easy this time as it was at BWI. Competitors are financially stronger for a prolonged fight, and at hubs Southwest faces huge disadvantages against dominant carriers that offer more flights and have huge frequent flyer bases. In failing to create the Southwest Effect lately, Southwest faces the difficult challenge of keeping revenues in pace with rising costs, without raising fares that Southwest has repeatedly stated it won’t do.

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