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Airlines still struggle with paths to profit

Air travel has proven time and again that anything is possible for a price, but that price often is more than the market will bear. A century after we took to the skies, even the most storied airlines face hard financial realities.
Two passengers dine aboard a Pan American Martin Clipper flying boat. The 1930s transoceanic service offered the height of luxury — but at prices that would equal $10,000 a ticket in today's dollars.
Two passengers dine aboard a Pan American Martin Clipper flying boat. The 1930s transoceanic service offered the height of luxury — but at prices that would equal $10,000 a ticket in today's dollars.Corbis file
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In the late 1930s, helped by a fleet of new DC-3s, American Airlines finally turned a regular profit and allowed its president, C.R. Smith, to show air travel could be indeed profitable.

It was a proud but rare moment for an industry with so many cashflow problems that an old joke echoes in every corner of aviation: You can easily make a small fortune by flying; just start with a big one. For when people want to travel through the air, fiscal common sense often bails out the window.

Few other industries inspire such grand dreams and invite such cruel interventions of reality. After all, we love to fly. Even when we hate it -- the endless airport lines, the thimble-sized seats, the mad-dash connections -- we love what it provides: the ability, in just hours, to go almost anywhere around the world.  "It's tremendous mobility," says Aaron Gellman of Northwestern University's Transportation Center, "and it's ubiquitous."

No matter how bad the service or how mundane the trip, we know a voyage somewhere indescribably exotic could be just a few gates away. We know that plush seats, champagne and foie gras -- true luxury at 36,000 feet -- would be ours if we could afford it.

If we could afford it.

That's the tricky part, no?  Air travel has proven time and again that anything is possible for a price, but that price often is more than the market will bear -- the Concorde's swan song this year the most recent example.

Financial heartbreak is almost hardwired into aviation history. The 20th century is dotted with names that embodied globe-trotting luxury before facing fiscal demise: Pan Am, Braniff, Eastern, TWA. In the United States alone, the Air Transport Association records at least 100 airline bankruptcies since deregulation in 1978.

"More airlines have gone out of business than have stayed in business," says Tom Cauthen of Accenture's airline consulting practice.

The rest of the world has fared little better. Many flagship carriers are artificially preserved with government support, only to collapse when officials pull the plug or when the airlines try to expand beyond their borders. Swissair and Belgium's Sabena are recent casualties. And the merger of KLM and Air France shows that even the most storied airlines are facing hard financial realities.

"The notion that there's something magical about running an airline that makes it impossible to make rational business decisions is pretty hard to believe," says Indiana University aviation economist Clinton Oster.

Profits stuck on the ground
In an oft-cited barb, Warren Buffett once said any right-minded capitalist who had seen the Wrights' contraption take to the skies in Kitty Hawk might have shot it down and saved investors 100 years of agony. Quite simply, he argued, airlines as a whole hadn't netted a dime since 1903.

Unidentified passengers check in with United Airlines ticket agents at O'Hare International Airport in Chicago, December 24, 2002. Airline personel said travel was light on the last day before Christmas. REUTERS/Frank PolichX80002

That's largely true. The three decades after the Wrights first flew were marked by persistent losses for those brave -- or perhaps foolhardy -- enough to try and make a buck in the air. Since then, it's largely been a wash. U.S. airlines have faced a bumpy ride toward cumulative profits since 1947, with the industry currently down by about $1.4 billion. Data from the International Air Transport Association shows airlines around the world have lost $5 billion since 1982.

For those many airlines still in the red, some uncomfortable, if long overdue, belt-tightening has come of late. Thin profit margins, often around 2 percent, hinge on predicting the number of seats needed and maximizing the percentage of those seats with behinds in them.

After the financial havoc of 9/11 and record losses in 2002, carriers have struggled to reduce capacity: the total number of seats available. Overall, U.S. airlines have 1.2 percent fewer seats filled this year against 3.7 percent fewer seats available. That translates into a load factor of 74.1 percent: The average airplane was three-quarters full in 2003 -- perhaps the fullest since the end of World War II.

That outpaces global performance. Airlines around the world were down 4.2 percent in filled seats between January and October, according to IATA, while available seats were slashed by just under 1 percent. Airlines worldwide continue to suffer from a capacity glut.

Squeezing costs
At the same time, airlines are struggling to minimize costs. U.S. carriers, for example, have become obsessed with trimming cost per available seat mile, or CASM. American Airlines now spends about 9.4 cents for each seat on every mile it flies.  That's a big improvement from an 11.7-cent CASM a year ago -- but far higher than lower-cost competitors like Southwest (7.6 cents), ATA (6.9 cents) or JetBlue (6.4 cents). All the legacy carriers face a stark mandate to close that gap.

"They will either find a way to get their costs in line, or they'll go out of business," says Yale Law School professor and former airline executive Michael Levine.

Part of the problem is that many airlines have been operating in a time warp, reluctant to abandon certain time-honored notions. Pilots used to be modern heroes, dashing role models that got salutes from their stewardesses. Hardball-playing airline chiefs like Pan Am's Juan Trippe cut a dashing profile, pressuring companies like Boeing to build aircraft to their whims, demanding impressive (if costly) service standards and catering to a deep-pocketed clientele. Air travel was a vital component of national commerce; each airline had a right -- no, a responsibility -- to fly everywhere at all times, even if it meant a fare war.

Except somewhere along the way, the dream dried up. Air travel remained vital to the global economy, but individual carriers were just another bunch of companies with payrolls to meet and shareholders to appease. After the dark days of 2001, it became starkly clear that if we couldn't live without air travel, we could certainly survive without some current players.

The revolution catches on
Spurring this rude awakening were the low-cost airlines, led first and foremost by Southwest.  Yet if Southwest pioneered the low-cost business -- and spawned imitators from Finland to Brazil -- it took a critical mass of cheaper carriers to prompt a revolution of sorts.

Earlier attempts by discount carriers generally failed in the years after deregulation, either because of flawed business models or because they were squeezed out by the majors' loss-leading efforts to undercut prices. This time, low-fare folks were armed with shiny new planes and savvy marketing; it was impossible to paint them as the industry's ugly ducklings.

No single carrier could take on the entire route structure of a stalwart like United, American or Delta, but they have each grabbed a chunk of the network -- most recently with Southwest's entry into Philadelphia, US Airways' longtime hub. A new global price war has emerged, in reverse: Lower-cost carriers offer lower default fares on the majority of routes, with legacy airlines scrambling to compete.

"They don't have any choice," says Levine. "The dominant mode in the market now is that you have to respond to low-cost airlines."

The big boys have matched many of those prices. But a low-fare game of chicken is difficult even in the best of times and nearly impossible when you're struggling to manage debt -- or, in United's case, emerge from bankruptcy.

The low-fare revolution has also targeted airlines' most frustrating pricing practices.  For three decades, major carriers kept faith that intricate mathematical models would help squeeze every possible dollar out of travelers. It was effective when passengers could be segmented by price, but eventually the middle-seat road warrior with an $800 ticket was going to resent the $200 vacationer across the aisle.

At the same time, service expectations are shrinking. The glitz of the past is mostly reserved for long-haul international flights or for those who can pay more to be comfortable.

The low-fare model has enough appeal that established carriers like United and Delta are joining the parade with jauntily named lower-fare offshoots -- Ted and Song, respectively. But previous low-cost effort by the majors have crumpled; operating two different cost models can prove schizophrenic.

"Can you run a low-cost airline with the philosophy that seems to be necessary to run a low-cost airline in the same corporate structure that’s necessary to run a major airline?" Oster wonders. "We've yet to see anyone do that or even come very close."

A bruising business
Plus, airlines remain an fundamentally expensive proposition. Changes in government oversight and financing deals have allowed smaller fish into the pond, but equipment is still costly and workers are highly specialized; even a cross-trained gate agent at Southwest can't fix a broken power unit.

Many established carriers also remain hobbled by long-fought labor wars. Though the recent slowdown forced a bit of retrenchment on salaries and hiring, few industries are as unionized as airlines and few have such rigid work rules. Airline executives' weighty pay packages often left a bad impression, and some airline heads (like Eastern's Frank Lorenzo) instilled such bad blood that even now, sitdowns around the bargaining table remain nasty.

With labor accounting for nearly 40 cents of every dollar an airline spends, unions represent a major challenge to cost-cutting.

"They're very stubborn and dig in their heels on salary, on income," Gellman says, "and that has been greatly harmful to the airlines."

Massive pension plans, often protected by union deals, are another huge liability for legacy carriers. And the aircraft themselves are a big challenge. Planes essentially cost the same to fly whether empty or full -- that's why load factor is crucial -- and difficult to buy and sell.  New routes are expensive to establish and hard to scrap. Legacy carriers usually need time to make big changes.

All these factors contribute to airlines' massive debt loads. Companies with steady incomes might be able to pay that down, but air travel is closely tied to the cyclical nature of national economies. When times are bad, cash flow problems explode.

"The boom and bust cycle is really kind of a fundamental character of the industry," says Fitch Ratings airline analyst William Warlick. "There's no indication that big carriers are going to be able to move away from debt financing for these big assets."

Subsidies linger
Airlines also remain a point of national pride, and that too can hamper competition. Carriers partner and code-share internationally, but old-fashioned regulations still bar most foreign ownership of airlines -- which turns away many global investors.

But the industry's new realities have forced those ownership rules to be reconsidered. The Air France-KLM deal pushed the envelope, if only through an intricate merger scheme, and more pressure is likely, with Virgin's Richard Branson now plotting a path into the U.S. market.

Many U.S. carriers, though, seem happy to let the government watch their back. Pleas for help began soon after 9/11 and haven't stopped; United wants federal aid as part of its current restructuring.  The airlines deserve that help, the argument usually goes, because they form the nation's transportation backbone. But as new carriers grow without help from Washington, pleas like that from legacy carriers may sound hollow.

"The government doesn't owe them a living," Levine says. "To the extent the government behaves as though it owes them a living, all it does is delay the restructuring that has to happen one way or another."

More routes to revenue
There's other ways to make money in the air, too -- in cargo, for example. While not free from economic whims, the cargo side of the business is comparatively stable. Even in 2001 and 2002, major U.S. cargo airlines turned a slight profit.

So what's the lesson?  Money can be made, but in pragmatic, quotidian ways. That portends nothing good for our glamorous view of air travel -- but it's probably a savvy indication of the future.

There are other profitable models. Regional airlines, which often devise cost structures and point-to-point routes that mirror low-cost models, have come into their own. Major carriers have invested heavily in regionals, save United, which was recently devastated when regional partner Atlantic Coast Airlines severed ties. (Mixing two successful cost models, ACA recently announced plans for a low-cost regional airline, Independence Air.)

Business travelers with big expense accounts can now pay a premium for international flights tailored just to them. After a brief stumble, the corporate jet market is booming; even proverbial airline scourge Buffett put money into fractional jet firm NetJets, which is now planning transatlantic charters.

New, efficient jets are also on the way. Boeing has had a difficult few years -- huge layoffs, CEO Phil Condit quitting amid an ethical dust-up and a sales year that marked the first time ever it trailed Airbus in deliveries. (Airbus isn't free of its own ethical ruffles, namely its close ties to European governments.) But the new 7E7, poised for a go-ahead from Boeing's board, would be a major jump forward in aviation technology, integrating composite materials and providing some of the biggest changes to fleets since the 747.  Airbus has major plans as well; its A380 superjumbo will be the biggest passenger jet in the sky.

Going forward, even the new lower-cost reality may not provide long-term riches. But Southwest founder Herb Kelleher, who helped figure out how to make money putting airplanes in the sky, drilled one guiding principle into employees: Their business was not about flying, it was about serving customers. Keep passengers happy and the money will follow.

In an era when air travel is struggling to find a profitable future, that may be the most rational advice of all.