From 2002 to 2005, Delta, Northwest, United and USAir all filed for Chapter 11 bankruptcy protection. Meanwhile, Air Canada filed for the Canadian equivalent. Across the Atlantic, Alitalia, the 50-percent nationalized airline of Italy, has been losing 1 million euros per day for more than a year. Air France had been in talks with Italy's government to purchase the airline, but Air France withdrew its bid Monday. Alitalia has warned that without some sort of capital raising, the company will run out of cash and will have to suspend its operations in a matter of months.
Clearly, something is wrong with the airline industry -- and not just in the United States.
What happened?
The airline industry in its earliest form was regulated by the Civil Aeronautics Authority, which was created in 1938 and later split into the Civil Aeronautics Administration and the Civil Aeronautics Board. Any excess costs were eaten up by bureaucracy and hidden from prying eyes. Inevitably, business grew as people across the world realized the convenience of traveling faster by plane than by car. In response, airplanes got larger, and their prices got caught in the jet stream. World War II accelerated research into jet engine technology, and soon Boeing and McDonnell Douglas jetliners were carting businesspeople and tourists around the globe.
In 1978, President Carter deregulated the U.S. airline industry, which, at the time, was managed by the Federal Aviation Administration, a U.S. Department of Transportation agency. The airlines became subject to the market forces of economics. Without the protection of the government and its taxpayers, airlines had to begin to fight for airport space, airplane production, routes and, of course, customers.
What went wrong?
Competition became fierce, and ticket prices dropped accordingly. Airlines opened new, not necessarily profitable routes to satisfy smaller niches of passengers. Soon, planes were emptier, prices were too low and the overall loss of revenue became too great to cover the costs of buying or leasing planes. Today, a single Boeing 747 can cost as much as $300 million. Northwest Airlines operates 29 747s out of its fleet of 519 aircraft.
The boom in oil -- and fuel prices -- has only exacerbated the situation. From 2001 to 2005, U.S. airlines lost a combined $32 billion, enough to rival the financial services sector during the past year.
The difference is that this is the result for airlines every year. According to a New York Times article, Warren Buffett, CEO of Berkshire Hathaway and widely regarded as one of the best investors of all time, critiqued the airlines in a speech at the University of North Carolina at Chapel Hill. "Despite putting in billions and billions of dollars, the net return to owners from being in the entire airline industry, if you'd owned it all and if you put up all this money, is less than zero," he said. "If there had been a capitalist [at Kitty Hawk], the guy should have shot down Wilbur! I mean, you know, one small step for mankind, and one huge step backwards for capitalism!"
Now, how can we take a step forward?
April 14, Delta and Northwest Airlines announced they would merge under the name Delta in a deal valued at over $17.7 billion. This combination would create the world's largest airline, though it must pass through several layers of approval before the merger can occur.
First, pilots' unions have a lot to say. Pilots are organized into lists of seniority that determine routes, schedules and salaries. To combine the two seniority hierarchies would inevitably demote some senior pilots, causing considerable unrest. Accordingly, the two unions are in the middle of heavy debate, and the situation is stable but not quite positive. According to the Chicago Tribune, Lee Moak, chairman of Delta's pilots' union executive committee, wrote in a letter, "While we all recognize that there are two sides to every story, an extended tit for tat exchange is counterproductive and only serves to pit pilots against one another, a tactic that has traditionally been reserved for airline management."
Next, antitrust regulatory bodies need to make sure the new airline won't be so powerful as to reduce competition. This hurdle should not be too hard to jump, though. According to a Reuters article, Northwest CEO Doug Steenland said, "These two networks are largely end to end. There are plenty of alternative choices." Indeed, the two airlines' routes are complementary; according to the Los Angeles Times, while Delta's international operations focus on Europe, Northwest's are primarily in Asia. In other words, combining the routes will not create too much overlap.
Power may be exactly what the airlines need, though. Economically, consolidation like this is typical as an industry matures. Successful businesses become larger to take advantage of economies of scale and scope; the idea is that as production and specialization increase, input costs and the cost of producing an additional unit decrease.
In the airplane industry, for instance, expensive machinery is an example of a major fixed cost. The huge companies have more leeway to charge higher prices, giving them more profit and allowing them to focus on developing new technology and business practices, resulting in monopolistic profits. Airlines need these profits so they can stop worrying about staying solvent and instead concentrate on innovating new business practices that actually work. As Finance Assoc. Prof. David C. Smith noted, "the big airlines have always operated very much in the present -- they think, 'How do we make money now?' They have a lot of legacy costs, so it makes it difficult to get to the point where they can do better."
Once the airlines start realizing some substantial profits, economic theory dictates that others will want to partake. So, new competitors will spring up, increase competition and drive prices back down. And then the cycle repeats.
But is this cycle sustainable in the airline industry? And would it be good for the consumer? For many airlines, declaring bankruptcy, rather than increasing acquisitions, may be the most viable solution to staying afloat.
"Bankruptcies help better than acquisitions in the sense that it's easier to reduce the legacy costs," Smith said. That is, in a bankruptcy situation, a company gets the opportunity to just not pay some of its obligations, which directly reduces costs. This makes it easier for the still-single airline to get back on its feet.
And when airlines combine, it could take years for them to determine what they should fix. Then, when it's time for new entrants to reduce prices, how will they find enough capital to buy or lease a fleet of planes and secure airport space? It could be difficult, but the success of low-cost carriers like JetBlue and Southwest emits a glimmer of hope.
In the short-term, though, the biggest worry is that ticket prices will soar. To buy a round-trip Delta ticket one month in advance from Charlottesville to Atlanta -- Delta's hub -- a student will need to shell out $300. USAir flights from CHO to New York's LaGuardia start at more than $600. Any further price hikes could put serious strain on a student budget.
"I'm happy to see Delta is keeping their headquarters in Atlanta," third-year College student Greg Schlachter said, who is a native Atlantan. "But I don't think I'd want to give them any more of my money than I already do."
International flights not subsidized by study abroad programs could increase in price even more.
The announcement of the Delta-Northwest merger has set off rumors about further consolidation. United Airlines and Continental Airlines are supposedly in talks. According to The Wall Street Journal, United CEO Glenn Tilton stated, "The industry has changed dramatically ... Consolidation is but one of the changes necessary to achieve sustained profitability ... we will participate in consolidation when and if it is the right choice."
If this second merger happens, other airlines might have to follow suit simply to be able to compete, and the rest will be history. No matter what happens, hopefully we will eventually have both low prices and a high-flying airline industry.
David Victor-Smith is the president of the McIntire Investment Institute, a student-run equity fund.
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