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New strategies could help the business recover—but will also put more pressure on established players.

Peter R. Costa, Doug S. Harned, and Jerrold T. Lundquist
The McKinsey Quarterly, 2002 Number 2 Risk and resilience

Nowhere have signs of an economic upturn in the US economy been welcomed more eagerly than in the commercial-airline industry. Already ailing from the global economic slump early in 2001, airlines then became the prime industry victim of the September 11 terrorist attacks. The impact of the current downturn in air travel has been severe not just on the airlines but also on lessors and aircraft manufacturers, which have seen their order books shrink as a result of numerous cancellations and postponements. Now, with signs of an economic updraft accumulating, many across the industry express hopes that demand will recover quickly. The optimists point to increases in travel during the first quarter of 2002 and also assume that the airlines learned how to manage cyclicality better after the last cycle.

We do not expect such an optimistic scenario of recovery but rather see airlines struggling with a far more complicated and difficult trajectory. At a time of unprecedented risk and uncertainty for the industry, an examination of its fundamentals reveals nothing to suggest that this downturn will be any shorter or less severe than previous ones, which typically lasted at least three to four years. Indeed, most signs suggest that the current slump could be worse and that the industry emerging at the end of it will be significantly different.

Airlines are once again heading into a period of intense pressure to cut costs to counter slowing growth and may see a dramatic change to their traditional networks and fleets as a result. The dominance of many of the major players that rely on a hub-and-spoke model, in which an airline operates from one or a few large hub airports and serves all passenger types, will decline. Alternative models, ones that emphasize the needs of specific customer segments and use aircraft more efficiently, will continue to emerge. Traditional carriers that do not significantly overhaul their service models and cost structures risk eventual failure, and government efforts to support them will only prolong the difficulties of the industry.

The current downturn is only part of the story, however. Unless the industry changes significantly, it faces a slowing of the long-term growth rate in passenger traffic, which has historically been well above GDP growth rates. If, in fact, these long-term growth rates decline, aircraft manufacturers will be severely affected as demand for new aircraft becomes more tied to the replacement of older aircraft than to fleet expansion. It will therefore be of paramount importance for manufacturers to support the airline business models that will provide the most opportunity to increase demand.

The cyclical downturn began before 9/11

Over the past 30 years, worldwide passenger traffic has averaged an annual growth rate of 6.2 percent—nearly double the rate of real growth in global gross domestic product. Furthermore, from 1995 to 2000, airlines earned profits of $39 billion and took delivery of more than 4,700 jetliners, both record levels.

But in the first eight months of 2001, passenger traffic for US carriers rose by an anemic 0.7 percent, a sharp fall from annual growth of nearly 4 percent over the previous decade. The slump came despite aggressive price cuts as airlines tried to fill seats and profits vanished. The US airlines’ net profits dropped from margins of nearly 4 percent during 1998–2000 to losses of greater than 3 percent during the first half of 2001.

The industry was deteriorating before the shock of September 11 caused an unprecedented drop in air travel and airline performance, thus prompting the US government to provide $5 billion in compensation and to make available $10 billion in loan guarantees. The effect of the terrorist attacks was most acute in the United States, where passenger traffic dropped by 6.8 percent for the full year and net profit margins sank to an estimated –8.5 percent. Passenger traffic dropped by more than 4 percent worldwide. The current slump has already taken its toll. Four US carriers—American Airlines, Delta Air Lines, United Airlines, and US Airways—reported record losses in 2001, topping $1 billion each. Elsewhere, airlines, including British Airways, Japan Airlines (JAL), Philippine Airlines, Scandinavian Airlines System (SAS), and VARIG, also posted substantial losses.

Filling seats isn’t enough

Industry optimists who see a relatively quick return to profitability point out that passenger traffic had started to rise again at the end of last year. We would note, however, that this happened only because seats were being filled at bargain prices—fares in the United States were down by more than 13 percent in March 2002 compared with levels a year earlier, and even then traffic was off 9 percent on a year-over-year basis.

The optimists also argue that airlines have improved their ability to control costs and capacity. It is true that in the late 1990s, airlines did appear to be preparing for a downturn. They reduced orders for new aircraft, began using older jets to absorb peak demand, and signed shorter-term leases. Nevertheless, total aircraft capacity still rose by 2.7 percent during early 2001 against a backdrop of stagnant passenger traffic—weakening the optimists’ claim that airlines are now capable of effectively managing capacity in preparation for downturns. We estimate that in 2002 excess capacity will be greater than it was at the same stage in either of the previous two downturns, in 1982 and 1992 (Exhibit 1).


A cycle like other cycles . . . only worse

Even a solid economic rebound may provide little immediate relief. History shows that downturns in the airline industry go on for years after the end of general economic recessions. In each of the past three cycles, in fact, the trough has become progressively longer. The 1990s cycle, though mild, showed a typical pattern, passing through four phases from boom to slump (Exhibit 2). It took five years before airlines regained profitability in 1995 as they passed cost reductions on to consumers in an effort to fill excess capacity. As a result, yields remained low until capacity was balanced and business travelers began to accept increasingly high fares. After the two previous cycles—from 1970 to 19751 and from 1980 to 1984—there were also long periods of slack before recovery kicked in (Exhibit 3).





The current downturn resembles earlier cycles but in several areas appears more severe. For example, passenger traffic, yields, and profit margins were weaker in 2001 compared with the same phase of the cycle in the 1990s because of the devastating impact on the industry of the September 11 events (Exhibit 4).


A slow climb to recovery

Profitable airlines are a prerequisite for recovery in the aircraft industry. In general, carriers begin ordering new aircraft only when they can confidently see sustained growth and high utili-zation levels. That typically occurs a year after carriers return to profitability. Since it takes one to two years to build a commercial jetliner, this means that new aircraft won’t be delivered to an airline until two to three years after the company returns to profitability.

In times of low demand, airlines are badly hampered by high fixed costs. As an example, the newest Boeing or Airbus wide-body jetliners cost between $80 million and $150 million each, and lease or loan payments are due whether a plane is parked on a tarmac or cruising with a cabin full of paying passengers. Meanwhile, strong unions have historically made it difficult to reduce labor costs.2 From 1995 to 2000, operating costs for the US majors stayed roughly constant, with costs rising even higher in 2001 prior to September 11. After September 11, costs moved still higher to pay for increased security and insurance provisions (probably 1 to 2 percent of revenues)—and that is before adding the high cost of increased debt levels.

Cutting capacity is considered critical to cost reduction, but the full impact on profits still takes time to emerge. Analysts estimate that after September 11, airlines reduced the number of seats available for each kilometer they were flying by more than 20 percent in the United States. However, more than three-quarters of these reductions came from using active aircraft less, with the remaining cuts coming from putting aircraft into storage. Both measures allow airlines to lower variable costs, notably fuel and maintenance, by dropping unprofitable flights, but fixed costs such as lease and debt payments remain. What is more, because the excess capacity is readily available, it can come back quickly. In early 2002, airlines were already bringing back capacity into their networks rather than lose market share on key routes. This is particularly important, since available excess capacity in the present downturn exceeds that at similar points in the past two cycles.

As scheduled deliveries arrive during the next two years, the record surplus may continue growing despite the fact that the number of orders as a percentage of total fleet size is lower than it was at this point during the most recent cycle.

Another important element in recovery is passenger yield—the price paid for each passenger-kilometer flown. The problem here is that, given near-term fixed costs, airlines must sacrifice yield to keep seats filled. Business travel has been the primary source for high-yield passengers, critical to the economic viability of the hub-and-spoke model used by the major airlines. However, over the past several years, business travel has accounted for an ever smaller share of airline revenues. In 2001 before September 11, the share had dropped to 23 percent, from more than 35 percent in 1999, in the United States. While some of this drop is normal cyclicality as companies cut back on travel, other factors indicate that the decline may be longer term. After September 11, the inconveniences caused by time-consuming new security measures have made business travel even less attractive, and the likelihood is that these inconveniences will continue for the foreseeable future.

In order to reduce the cost of travel, companies have made several fundamental changes that are likely to have long-lasting effects on business travel revenues. Large corporations have used their purchasing power to negotiate volume discounts on fares, with price reductions on some routes often as high as 20 to 30 percent. Furthermore, most corporations are now enforcing the travel restrictions tied to these volume agreements.

Some alternatives to business travel on commercial airlines may now finally take hold. Companies are turning increasingly to travel substitutes such as videoconferencing and have been experimenting with shared corporate jets as a replacement for first-class travel for top executives. New advances such as Web conferencing have boosted demand for videoconferencing services, with a 30 percent year-over-year increase prior to September 11. Forced behavioral changes in the aftermath of the terrorist attacks have pushed the growth rate for these services up to 40 percent. In addition, the expansion of fractional jet models for business aircraft significantly increases the availability of business jets as a travel alternative. The corporate jet option, which is becoming more attractive given the increased time required to negotiate security procedures at major airports, may take away at least 10 percent of first-class travelers by 2005. In view of these changes in the way corporations work and purchase travel, we believe that business travel revenues will remain under pressure even when the world economy recovers.

In the 1980s, increased yields drove recovery in the airline business. This time around, given the high levels of excess capacity and projected weakness in business travel revenues, we do not believe that yields will come back as strongly as in previous downturns. Instead, any recovery will have to come from long-term, structural cost reductions. For major airlines using the high-coverage hub-and-spoke model, such reductions may be difficult to achieve, and these airlines may struggle beyond 2004. In contrast, competitors that utilize a lower-cost strategy—such as Ryanair and easyJet in Europe, South-west Airlines and WestJet in North America, and Virgin Blue in Australia—look well positioned to expand their operations and profitability.

Toward a new model

In any event, the industry that recovers from these challenges is likely to look very different from today’s industry. As airlines emerged from the previous two cycles, they adjusted their operations—for example, by establishing and then improving yield-management systems, which price seats in a more discriminating way, and by outsourcing more services. The industry’s structure has remained fairly constant since the early 1980s, leaning heavily on a hub-and-spoke model. In this downturn, however, many new forces are working to weaken that model, including unprecedented pressure on prices, challenges to further cost cutting, the replacement of turboprops by more comfortable regional jets, and a change in flying habits since September 11.

The traditional model of the major airlines provides broad geographic coverage. That model has dominated the airline industry. But the economics of the "shared-factory" approach have become less attractive because the two customer bases that it tries to serve—business and leisure travelers—have competing priorities and more options. Leisure travelers seek the lowest prices and are less concerned with service, flight frequency, or a broad slate of destinations. Business travelers, on the other hand, demand frequent flights to a wide range of destinations, seek quality service, and are willing to pay a reasonable premium for these benefits.

Trying to appeal to widely different customer needs runs counter to the overall trend in service industries, in which distinctive approaches, tailored to different customers, have generally come to dominate. The majors’ business model functions well as long as there are enough high-yield passengers to balance the effect on an airline’s yield of price cuts for tourists. But with higher infrastructure, labor, and overhead costs, a large proportion of high-yield business passenger revenue is needed for profitability except during the peaks of the cycle.

Today, this high-yield revenue is no longer assured. In addition to the previously mentioned factors that are likely to lead to a longer-term decline in business travel revenues, business travelers often dislike having to negotiate many flight connections, frequently at congested hub airports, in a customer service infrastructure that also has to accommodate a mass of leisure travelers. The difficulties of business travelers have been heightened further by current and proposed security measures (for instance, gate screening and bag matching), which increase the time required for connections.

There are two alternative strategies that have succeeded in keeping costs considerably lower and have been good at attracting leisure travelers. The first focuses on the highly efficient utilization of aircraft. The second emphasizes the purchase of low-cost used aircraft. In many cases, these strategies provide for lower service levels and maintain lower overhead costs. Both strategies pose a significant threat to the higher-cost airlines that are constrained by their legacy fleet and network structures as well as onerous labor agreements. Both approaches can take advantage of the current downturn by taking over routes abandoned by the bigger airlines.

Southwest Airlines and JetBlue Airways in the United States, along with the United Kingdom’s easyJet, are prime examples of the high-utilization model. They design their routes to maximize the use of their aircraft, and by using the same types of aircraft throughout the network they save on maintenance and training costs. These airlines do not feel compelled to offer a broad slate of destinations and can operate from smaller, less congested airports or at off-peak departure times. With their lower costs (Exhibit 5), they can afford to charge the lower fares that leisure travelers are increasingly demanding. Furthermore, the growth of these competitors has been facilitated by the introduction of new, longer-range versions of the aircraft types they currently fly (for instance, Boeing 737–800s and 737–900s), allowing much greater reach without losing the advantages of a common cockpit.


The second model, which uses older aircraft to keep costs down, is typified by the original ValuJet (now AirTran Airways) and its initial fleet of old DC-9 jetliners. Such an airline can fly into hub airports, attracting passengers by reducing prices on prime routes. In the current downturn, prices for older jetliners have fallen by as much as 50 percent, opening the door for new players to use this model to break into the market. The model does have some drawbacks. While using an older fleet keeps asset costs down, maintenance and fuel costs tend to be higher, and ensuring on-time reliability can be more difficult. The impact of maintenance and fuel costs increases the more the aircraft are used, making it difficult for airlines that choose this model to expand profitably. Another constraint on growth is that when demand increases, fewer acceptable older aircraft are on the market, and those that are available are more expensive. In fact, as AirTran has grown, it has shifted to acquiring new Boeing 717s, which have much lower operating costs than do the older aircraft. Despite the drawbacks of this low-cost-asset model, the ready availability of a large number of low-cost aircraft—for example, 737–200s, for less than $2 million, that have been hushkitted to meet all current noise regulations—makes it likely that new players will pursue this approach, which will put more pressure on established airlines even if the new ones are not ultimately successful.

While the lower-cost strategies can be ideal for leisure travelers, they are not suitable for many business fliers, because they cannot offer the flexibil-ity, range of flights and destinations, or level of service that business travelers demand. As an example of one solution, regional jets can provide an increasingly attractive option to avoid time-consuming connections on certain routes and deliver greater convenience, with higher frequencies of departure and service from nearby airports. These 45- to 70-seat jets are quieter and more comfortable than the turboprop planes that were formerly the backbone of commuter airlines.

Up until the past two to three years, these commuter airlines provided feeder service to hubs from an average distance of about 200 miles. Today, regional jets can help passengers avoid connections by offering direct flights to a network of more distant large and small airports, with the average stage length of a flight now nearly 500 miles and the newest regional aircraft targeted at stage lengths of 1,000 miles. While regional jets are more costly to operate than larger aircraft on a per-seat-kilometer basis, on lightly traveled routes their overall profit per passenger can be higher. Since the planes are so small, their seats can be filled through limited discounting, allowing these airlines to target service effectively to the business traveler. Also, regional airlines have historically been able to operate with a more efficient cost structure for both management overhead and labor.

The regional-jet model has yet to be exploited fully by existing commuter airlines, which tend to be units of major carriers or tied to major-carrier labor agreements with code-sharing relationships. The limiting factor has been scope clauses—stipulations in union contracts that limit the use of smaller planes on longer routes. Nevertheless, as regional carriers (for instance, the spin-offs of Continental Express and Northwest’s Express Airlines I) achieve greater independence, the economic attractiveness of using new longer-range regional jets raises the possibility that change may eventually occur in these operations.

Despite the pressure on traditional players, the hub-and-spoke model will not disappear, as it will remain necessary for connectivity between smaller airports. Low-cost airlines currently represent less than 15 percent of the revenue-passenger-kilometers flown by US carriers and less than that for European and Asian carriers. These airlines, however, are poised to take much greater shares in view of their lower cost structures, the availability of attractive new aircraft options, and the sharp drop in high-yield-passenger revenue.

If the major airlines are to continue serving price-sensitive travelers on intracontinental routes, they will need to take significant steps to transform their networks, fleet structures, and labor agreements in order to compete effectively against newer competitors. The major airlines that rely on serving a large number of destinations and a broad range of passengers will have to reevaluate their cost structures and service offerings in the face of new incursions on their most profitable routes and the decline in their most profitable customer segments. It will take major steps to transform the networks, fleet structures, and labor agreements of these airlines so that they can compete effectively with aggressive new entrants. In the past, larger airlines have found it difficult to make these types of changes, which today may be a prerequisite for survival.

Ensuring robust long-term demand

Air travel has long enjoyed growth rates well above GDP—a particularly important phenomenon for aircraft manufacturers, which gain most of their orders from fleet expansion rather than replacement. These high growth rates, however, have eroded over time (Exhibit 6). The worldwide growth rate for revenue-passenger-kilometers has declined from nearly 6 percent in the 1980–90 period to only 4.7 percent in 1990–2000. Growth rates vary in each region of the world, with Asian growth being the fastest. In each region, however, the gap between traffic growth and GDP growth has been shrinking.


Over the past three decades, the principal engines that have kept passenger traffic growth above GDP growth have been globalization, lower ticket prices matched by lower costs, and increased convenience (frequent flights, few connections, and more nearby airports, for example). Looking forward, these drivers of strong growth are at risk. While globalization should continue to boost traffic, the other two drivers—cost cutting and convenience—are reaching their limits within the traditional model. In the past, major airlines could achieve significant profit improvement by increasing load factors; by moving from three- to two-engine aircraft, thereby saving on fuel; and by reducing the size of cockpit crews, saving labor costs. But load factors are now reaching their natural limits, and such large step-function improvements in cost are no longer easily available without major changes to business models and labor relationships. Furthermore, convenience has been declining of late; congestion and flight delays reached record levels before September 11, and the additional security measures now in place have added further difficulties for travelers.

The implication of these changes is that significant steps must be taken to improve convenience and lower the cost to the passenger if long-term growth rates for traffic are not to decline toward GDP levels. The emergence of new airline business models represents an opportunity for building demand growth by providing customers with a lower-priced but more convenient offering. Assuming that these models continue to take hold, the mix of aircraft being ordered will change, with more planes sold to the low-fare, high-utilization carriers and to the regional- and business-jet operators. If, on the contrary, airline business models remain substantially the same, manufacturers may have to contend with lower overall demand for new aircraft not just during the cyclical downturn but also as an industry norm. Purchases will focus more on replacement aircraft than on aircraft to expand fleets.


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The commercial-aircraft industry—hit by an economic slump, last September’s terrorist attacks, and a likely longer-term decline in business travel revenues—now faces an era in which many of its basic operating assumptions must be reexamined. The growth of new airlines that cater to specific segments places added pressure on the established players, as these newer airlines offer realistic alternatives for passengers at lower cost and greater convenience.

For aircraft manufacturers and their suppliers, both the nature of the current downturn and the growth of new airline business models are critical. Because the downturn will likely extend into 2004–05, deliveries will remain under pressure and orders are unlikely to exhibit strong growth until 2005–06. Manufacturers, however, must focus on supporting the airline business models that will provide a long-term attractive solution for the passenger—a solution that has important implications for the product mix. It will be the ability of the airlines to deliver lower cost and greater convenience that will ultimately support robust long-term aircraft demand.



Notes:

Peter Costa is a consultant, Doug Harned is a principal, and Jerry Lundquist is a director in McKinsey’s Stamford office.

1The impact on profits of the 1970s downturn was mitigated because it occurred before deregulation in the United States.

2Even when jobs are cut, as happened at many airlines in late 2001, these measures usually affect lower-paid workers and create large onetime costs for severance packages and the redeployment of the remaining workers. In addition, because it is generally the better-paid senior employees who remain, average wages paid can even rise following massive layoffs.