Jubak's Journal Recent articles: • 5 short-squeeze candidates, 7/7/2004 • ID theft fears scare up 5 stocks , 7/2/2004 • How to shop the interest-rate fire sale, 7/2/2004 More... | Jubak's Journal The next wave of airline bankruptcies Competition with low-cost carriers is only going to get fiercer. US Airways and Delta look vulnerable, Continental is on the bubble and even Southwest may not be safe. By Jim Jubak Theres a dogfight in the skies over Europe, and the outcome of the battle very well could foretell the future of the airline industry in the United States. The continent is now home to more than 50 low-cost carriers, including Wizz Air, Snowflake, VolareWeb, Air Polonia, Now and SkyEurope. And, of course, Easyjet With so many players, no one is surprised that five newcomers have gone bust recently. And airline analysts expect more to exit the business this winter. What surprised analysts, however, was the Jan. 28 earnings warning from Ryanair. Earnings for the fiscal year ending in March 2004 would be 10% below earnings for fiscal 2003 and 20% below earlier projections for fiscal 2004, management said. Investors, reeling in shock, asked How is this possible? and drove down Ryanairs share price by 30% in just one day. After all, Ryanair and its neck-and-neck competitor Easyjet together dominate the intra-Europe low-cost market with a joint share of 58%, according to Credit Swiss First Boston. And the number of passengers flying low-cost airlines intra-Europe has grown at a compounded 38% annually over the last eight years. The problem was that all that competition, even the competition from failing competitors, was forcing fares lower faster than even Ryanair could cut costs. The company estimated that the average fare would fall by 20% to 30% in the March quarter of 2004. Informed consumers and too many seats Things have become both better and worse since Ryanair warned. Fares and profit didnt drop as much as the company predicted in January. But the price war that began last winter has extended into the summer season when airlines earn most of their profit and will extend into the winter. Ryanair is now predicting a 20% drop in fares for fiscal 2005 from the fiscal 2004 level.
The problem is too much supply of a commodity that, thanks to the Internet, is driven by price-sensitive customers. No one expects supply to drop much, even if more low-cost carriers go broke this winter. In the current aviation market, planes are just so cheap and money so easy to raise either from equity investors or from airplane-leasing companies that it seems that just about any management group with some airline experience can start a new carrier. Europes high-cost majors are fighting back, too, giving ground in the short-haul market only grudgingly. Many are in fact trying to build traffic in advance of the delivery of the new Airbus 380 with its higher passenger capacity. 5 rules for a free-for-all So here are the five characteristics which, from the evidence of the European example, define the dynamics of the low-cost airline industry:
Why the majors can't compete Sure, the European majors can match Ryanair by removing the seatback pockets in its planes because they increase cleaning time, but they cant lower the wages of experienced pilots and maintenance workers to match the entry-level salaries at low-cost carriers. They operate at a serious cost disadvantage to the low-cost carriers on benefits as well. A startup doesnt have to pay any retirement costs because it doesnt have any workers with enough seniority to retire. Contrast that with an established carrier that has to wage a bloody battle just to reduce pension costs. Related news and commentary on MSN Money But winning this free-for-all doesnt offer the survivors any security. Since entering the business is so easy, the survivors constantly face new competitors. Some of these drop by the wayside relatively quickly because they are underfinanced or incompetently run. But others gain at least initial success and threaten to devour older survivors. Because air travel has become a commodity, carriers cant use their brands to defend market share. Because pricing information is so readily available, increasing market visibility isnt an effective way to defend market share. Any company with enough financing can offer prices low enough to win market share almost instantly. And as the survivors age, they gradually become vulnerable on the cost front to startups which, again, dont pay the higher salaries that workers with seniority command or face the higher benefit costs that come with worker seniority. Same forces at play in the United States You can see this at work right now in the U.S. low-cost air industry, where newcomer JetBlue Airways But both show a huge edge over the established carriers. In 2003, despite heroic efforts, cost per seat mile at American Airlines was still 10.1 cents, lower than the 11.1 cents in 2001 but still badly trailing Southwest and JetBlue. Continental Airlines Add this to another number and you can see the true extent of the trouble that the established carriers face. Not only is JetBlues cost lower, but its planes are fuller. The load factor -- thats the percentage of seats filled with passengers -- at JetBlue in 2003 was a whopping 84.5%. At Delta, it was just 74.3% and just 73.3% at US Airways Group Low prices create unit sales in a commodity business, and low unit costs turn those sales into profits. Which U.S. airlines are now at risk, according to this model? US Airways, with its declining market share and high costs, is under direct assault by low-cost carriers who smell blood. The company is in its third round of labor negotiations in two years in an effort to cut costs. Delta will probably go into bankruptcy to cut costs if it cant win major concessions from its pilots in negotiations. Continental should be OK if air travel continues to recover, but the airline has very few unencumbered assets that it can use to secure additional financing if something does go wrong. United Airlines costs are still way, way too high. Although cost per seat miles declined to 10.5 cents in 2003 from 11.4 cents in 2002, thanks to cost-cutting, thats at the high end for the established carriers. In addition, United parent UAL Corp. The American Airlines unit of AMR Corp. The most interesting case is Southwest. The company has managed to keep costs per seat mile steady since 2001 at 7.5 cents. But thanks to recent expansion into new markets, the carriers load factor was just 66.8% in 2003. That should rebound as new markets build traffic. But if it doesnt, it will show that the challenge from the newer low-cost carriers may be more serious than anyone now thinks. Its clear the new low-cost carriers are taking share from the established airlines. The jury is still out on what effect they are having on Southwest. Challenging the establishment The five characteristics that I used to define the dynamics of the European low-cost air travel market apply to the future of other industries that sell commodity products as well. In an industry like that, companies must run as fast as they can just to stay in place. Price pressure from new entrants to the industry with lower costs are a constant threat. Since part of those lower costs is simply a result of newness, investors in these sectors need to reverse the conventional wisdom that gives the edge to the established companies in that market. The established nature of these companies may put them at a cost disadvantage, and the Internet-enabled price sensitivity of these commodity industries may minimize any advantage that comes with longevity. In my next column, Ill take a look at some of those other industries and the way that design can offer a way out of the commodity price crunch. Changes to Jubak's Picks Buy Performance Food Group Continued problems at the company's fresh fruit and salad division have led to an earnings warning for the second quarter that has pummeled the stock. Thats created a buying opportunity for patient investors willing to be patient while Performance Food Group New developments on past columns On July 5, BP Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday. E-mail Jim Jubak at jjmail@microsoft.com. At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: BP and Performance Food Group. He does not own short positions in any stock mentioned in this column. | ||||||||||||||||||
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