Airline Industry Analysis Page 1 of 15. Memorandum. Adam Brown, Radmila Gogzheyan, Greg Huwel, Marie Meininger, Josh Riedel, Christina Ryan

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1 Airline Industry Analysis Page 1 of 15 Date: July 13, 2009 Memorandum Subject: To: From: Airline Industry Analysis Dr. Matt Ford Adam Brown, Radmila Gogzheyan, Greg Huwel, Marie Meininger, Josh Riedel, Christina Ryan Introduction The following is an analysis of the airline industry. Using collected information and Porter s Five Forces model, we will provide information about the attractiveness of the airline industry and provide a recommendation based on that information. Industry Background We will be outlining the Scheduled Air Passenger Transportation, NAICS number This U.S. industry comprises establishments primarily engaged in providing air transportation of passengers or passengers and freight over regular routes and on regular schedules. Establishments in this industry operate flights even if partially loaded. Scheduled air passenger carriers including commuter and helicopter carriers (except scenic and sightseeing) are included in this industry. 1 We will focus on domestic travel, that is, travel within the continental United States. We have also limited our scope to include only flights that carry passengers or passengers and cargo. Flights carrying exclusively cargo will be excluded. Geographic Scope Airlines performing passenger flights within the continental United States will be focused on. Flights outside the continental United States and flights carrying only cargo are not included in this analysis. Each airline is located at a number of locations in major cities, at major airports, all over the country. Some airlines have hubs at multiple airports all over the country. Many airports are hubs for multiple airlines. 1

2 Airline Industry Analysis Page 2 of 15 Supply Chain Inputs: Air Planes Fuel Water Lavatory Items Concession Items Equipment Labor Process: Fleets of planes constantly performing flights or preparing for the next flight Output: Providing ontime flights with correct baggage and cargo Downstream: Anyone who needs or chooses air travel as a form of transportation Those upstream are those who provide planes as well as those who provide goods and services that make the planes work, and work efficiently, and make the flights more comfortable for customers. Downstream customers are those who use air travel in order to travel quickly for recreation or for business. Industry Size After several years of decline the industry size showed growth in The following chart shows the number of Full-Time Equivalents (FTEs) for the U.S. airline industry over the past five years 2. After consistently falling from 2000 through 2006, airline employment in 2007 grew to an average of 560,997 FTEs. Despite the year-over-year increase, the workforce remained 118,970 FTEs below the 2000 peak. Though pilots, copilots and other personnel experienced a modest decline in headcount, all other work groups showed gains, lead by flight attendants at 9.5 percent 3. Market Value Year Average Full-Time Equivalents Change (%) (FTEs) ,778 (5.2) ,498 (.0004) ,857 (2.9) ,540 (1.5) , The US airline industry consists of about 3,000 companies, with combined annual revenue of $120 billion. Major airlines include American, Delta, United, and Continental, and the air operations of cargo and courier companies, such as FedEx and UPS DC9AEB4E7E12/0/2008AnnualReport.pdf

3 Airline Industry Analysis Page 3 of 15 The government classifies airlines as "major," "national," "regional," and various others. About 40 national airlines have annual revenue between $100 million and $1 billion, and 90 regional airlines have annual revenue under $100 million. The remainder of the industry consists of small air companies that generally have annual revenue between $5 and $50 million. Age The first airline was the St. Petersburg-Tampa Airboat line. It started flying across Tampa Bay on January 1, It covered about 18 miles and reduced travel time (compared to train) by only 23 minutes and served just over a thousand passengers. Unfortunately, the airline only lasted about three months 4. Next came United Airlines in Industry Life Cycle Position As shown above, the airline industry has not experienced consistent growth or decline over the past few years. It seems as though the industry is fairly concentrated and entry is fairly low. These are signs that the airline industry is in the maturity stage of the industry life cycle. The declines may indicate that they will soon be reaching the decline stage. Competitors There are ten major competitors that make up the majority (81.9%) of the market. The top ten competitors are shown in the market share pie chart shown on the next page. The market share is determined by the percentage of overall industry revenues

4 Airline Industry Analysis Page 4 of Market Share American Airways Southwest United 13.2 Delta US Airways Continental Northwest JetBlue 11 AirTran Corporation Alaska Other Below is a chart outlining information about each competitor including headquarters, start-up year, fleet size, and number of hubs 7. Company Location (Headquarters) Birth Fleet Size Hubs American Airways Fort Worth, TX Southwest Dallas, TX United Chicago, Il Delta Atlanta, GA US Airways Tempe, AZ Continental Houston, TX Northwest Eagan, MN JetBlue Forest Hills, NY AirTran Orlando, FL Alaska Sea Tac, WA

5 Airline Industry Analysis Page 5 of 15 Aggregate Financial and Operational Data Operating Revenue $117,920 $134,462 $151,255 $164,912 $173,104 Operating Expenses 120, , , , ,894 Profit $(2,371) $(7,643) $ (5,782) $ 3,123 $ 4,998 Operating Profit Margin -1.80% -1.10% 0.30% 4.60% 5.30% Net Margin -2.00% -5.70% -3.80% 1.90% 2.90% Departures 10,848 11,401 1,158 11,264 11,365 Air Miles 7,070 7,647 7,887 7,917 8,109 Available Seats 893, ,466 1,002,735 1,005,534 1,037,116 Key Trade Groups The main trade group for the airline industry is the Air Transport Association. Members of this trade group transport more than 90% of US airline passenger and cargo traffic 8. The Air Transport Association addresses all aspects of airline issues on their web-site. Key Trade Publications There are three major publications that make up key essentials for the airline industry. They are 9 : 1. Business and Commercial Aviation 2. Aviation Daily 3. The Weekly of Business Aviation F1) Intensity of Rivalry Price-based rivalry. Industry prices help determine the level of intensity among competitors. These firms will often compete on price in order to improve their respective position within a given industry. A highly competitive industry will see prices decline as competitors will battle by lowering prices, hurting the industry as a whole by shrinking revenues 10. As we can see by the table on the next page, prices have steadily increased in the airline industry over a period of 5 years Porter, Michael. Competitive Strategy (1980)

6 Airline Industry Analysis Page 6 of 15 Increases in Actual Fares (Inflation Included) Year Fare 2003 $ $ $ $ $13.00 Since prices are rising, there is evidence that priced based rivalry in the airline industry is very low. (-) Non price-based rivalry. Non-price characteristics include convenience of flight schedules, frequent flyer programs, the quality of in-flight service. Since most airlines have high levels of similarity in their versions of each of these, that is, since these competitive factors tend to be standardized, it can be seen that there is not a high level of non-price rivalry. (-) Competitors and Concentration. Assessing the number of firms in an industry as well as its level of concentration is a crucial step in discovering whether an industry is conducive to new entrants 11. Although there are many firms within the airline industry, only 10 major airlines, which combined makeup 81.9%, hold the majority of the market share. Domestic Market Share* Airlines Market % American 14.3 Southwest 13.2 United 11.0 Delta 10.8 U.S. Airways 8.3 Continental 7.6 Northwest 6.3 Jet Blue 4.2 Air Tran Corporation 3.3 Alaska 2.9 Other 18.1 *Statics based from April 2008-March With 10 major market holders within the airline industry, an assessment will be made on its level of concentration using both the concentration ratio and the Herfindahl index. 11 Porter, Michael. Competitive Strategy (1980) 12

7 Airline Industry Analysis Page 7 of 15 Concentration Ratio. Market share of the top 4 domestic airlines were evaluated to determine the level of concentration in the industry. These airlines included: American 14.3%, Southwest -13.2%, United- 11.0%, and Delta- 10.8%. A concentration ratio of 49.3% indicates a more intense rivalry within the airline industry because the 4 largest airlines combined hold less than 60% of the market share. CR4 = 49.3% (-) Herfindahl Index. To gain a further perspective on the level of concentration within the airline industry another method, the Herfindahl index, was used. The Herfindahl index measures concentration of market share as the sum of the squared market share of each firm in the industry. A monopolistic industry would have a Herfindahl index of 10, while an industry experiencing no concentration would have a Herfindahl index of zero. The 10 major airlines were used in the formulation. HI = (-) Capacity Utilization. Capacity utilization is also a way that airlines can compete. As shown below, airlines have had trends of extra, unused capacity that allows them to sell more tickets as needed to stay competitive 14. Airlines.org Since there is such a high level of excess capacity, those in the industry won t seem to have a problem increasing production, making competition that much more fierce. (-) Specific assets. The airline industry faces major entry and exit barriers because of the capital investment requirements. Many of the assets are industry specific and difficult to sell once they are acquired. New planes cost millions of dollars and airlines are 13 Dr. Matt Ford, in class, MGT

8 Airline Industry Analysis Page 8 of 15 constantly upgrading. The new Boeing 787 can cost between $150 million and $205.5 million 15. A total of 850 planes 787s have been ordered by 56 different customers for a total of $127.5 billion to $ billion in potential sales. This is just one example of the expense that airlines must endure to stay competitive. (-) Overall: there is evidence showing that those already established in the industry have no need for intense rivalry: prices are increasing, non-price competition offers standard output across the board, and there is plenty of excess capacity to gain an edge. There is also evidence showing that the airline industry is not very concentrated, leaving more room for smaller airlines to get an edge. The high costs of the specific needed assets for this industry are also a drawback. (-) F2) Availability of Substitutes Type and number of substitutes. The airline industry faces substitute threats in the form strategic substitutes. Strategic substitutes are products or services that provide the same function as the one being studied, but come in a different form 16. Train, automotive, and technology industries are all strategic substitutes to airlines. While both trains and automobiles are less threatening in the case of longer destination commuters, technological innovations (WebEx, NetMeeting, video-conferencing, etc.) have facilitated virtual communication and are an often overlooked substitute for air travel. Since these technological are such time, productivity, and money savers, there is a real threat to the industry due to these advancements. (-) Profitability of substitute industries. In order to compare the prices that are charged by substitutes, we tried to book travel from Chicago to Orlando the night before the hypothetical departure. We performed the inquiry for prices for round trip travel, with return taking place one week after departure. Delta s lowest price for this ticket is $ and would require four hours and eight minutes of travel time. Competitors prices are as follows: Competitor Price Time (one way) Amtrak 17 $ h 25m Greyhound 18 $ d 3h 20m Car 19 $ h 43m Dr. Matt Ford, in class, MGT Based on and average of 25 miles per gallon at a cost of $2.45 per gallon

9 Airline Industry Analysis Page 9 of 15 As you can see, the most comparable price is that of Amtrak. The difference in travel time, however, makes Amtrak an unlikely substitute. The lower cost substitutes, those that compete strongly with price, are not realistic substitutes with travel time, like Amtrak. During a period of poor economic performance, customers may sacrifice the luxury of short travel time in order to save money. Since we are experiencing an economic downturn, the airline industry will be soon feeling those effects. (-) Switching costs. Many airlines have established non price-based tactics to win over customer loyalty including frequent flyer programs and unique in-flight services. Many of these services are easily and frequently mimicked or imitated by competitors, so buyers may find the same, or similar, benefits with other airlines. Establishing new benefits, however, may cause the buyer to lose those they have accumulated, preventing them from switching. (0) Overall: the availability of substitutes and the effect of low costs of substitutes tend to make substitutes a real threat to the airline industry. Since the economy is not in a position where the general public feels comfortable spending money on air travel, substitutes will begin to put a larger dent in airline industry revenues. (-) F3) Bargaining Power of Suppliers Supplier Overview. The main suppliers for the airline industry are plane manufacturers and fuel suppliers since these are the two inputs that are absolutely essential to the industry. We will focus on the suppliers of the planes and outline general information about fuel suppliers. Fuel Suppliers. Currently, the cost of jet fuel is about cents per gallon (or about $1.75 per gallon). This is a decrease of almost 60% from last year 21. Also, prices differ based on region, just like regular gas prices 22. Since airlines are subject to the same fluctuations in oil prices as regular consumers, there is not a lot of control over the prices. This means that suppliers have a lot of bargaining power. (-) Suppler Size. Boeing and AirBus are the two suppliers of planes in the airline industry. AirBus made revenues of billion, or $60.13 billion, in Boeing made almost $61 billion 24. This is evidence of their enormous size. Income for these companies comes from both the manufacture of passenger planes, but also from defense contracts with the government. (-) Supplier Concentration. There are only two manufacturers of passenger airplanes. This means that this industry is highly concentrated. This gives the airlines an inability to

10 Airline Industry Analysis Page 10 of 15 negotiate with airplane manufacturers effectively; making the airline companies price takers. (-) Suppler Substitutes. When working with one of the two manufacturers, there is always only one alternative, or substitute. In essence, there are no substitutes for the input that is needed. (-) Importance of Supplier Input. While new planes are very important for the airline companies to stay competitive, there is no constant need for airline companies to upgrade their planes or purchase new planes for their fleet. This causes the airplane manufacturers to constantly come up with new and more efficient planes. (+) Threat of Forward Integration. Since airplane manufacturers are normally focusing on research, development, and production, all of which require high amounts of capital, there is not a high risk of forward integration. Established airlines have experience and supply channels that may be hard to replicate easily. It would also be a very costly endeavor for airplane manufacturers to build up a fleet of planes since one (the least expensive of Boeing s 737 family) costs between 51.5 and 58.5 million dollars. (+) Overall: suppliers have a high amount of bargaining power. There are enough threats to make the bargaining power of suppliers a threat (or negative) to sustained industry profits. (-) F4) Bargaining Power of Customers Buyer Overview. The buyers of the airline industry s products are anyone who needs or elects air travel. Tourism is the main industry that is served by the airline industry. Other customers of the airline industry are those who fly for business, relocation, or other personal needs. Buyers are of all ages and other demographics. Buyer Size. Buyers of airline services are the millions of consumers who fly domestically every year. There are some groups, such as tour groups and businesses, who may purchase tickets at group rates, but the majority of buyers are individual consumers who need air travel. Because of this, we can see that the downstream market is not controlled by large, powerful buyers. (+) Buyer Concentration. Like buyer size, we can see that most tickets are purchased by one (or a few) of millions of other buyers. This means that there is virtually no concentration downstream. There are exceptions when businesses or travel groups purchase tickets. Since there will be so many tickets sold at once, some airlines offer discounts. Also, since some customers travel often, airlines are also starting to give frequent flier discounts. This is one way that those downstream are forcing those in the airline industry to compete. Even though customers have some power over prices, there is still a set range that services are sold for that those in the industry can control. (0)

11 Airline Industry Analysis Page 11 of 15 Alternative Buyers. There are many groups that those in the airline sell too. If one of the smaller groups, such as businesses who may buy bulk tickets, decided not to use air travel anymore, the airlines would be hurt, but they have such a vast pool of buyers that they would be able to recover from those losses fairly quickly. (+) Standard Products. For the most part, air travel is standard and those who use specific airlines are loyal because of past experience with those airlines. The differentiation in the airline industry comes from price competition, service, and repeat flier programs. So, the product is standard with differentiation coming from extras that are offered. (0) Switching Costs. There are no real switching costs between companies in the airline industry. Many buyers are constantly looking for lower prices between companies, giving birth to companies like Expedia and Priceline who specialize in searching for low priced flights. As a result, prices tend to be fairly standard. We used Priceline.com to search a round trip from Cincinnati, OH to Orlando, FL (from August 1, 2009 to August 8, 2009) and found prices ranging from $144 (Delta) to $992 (Continental). There were four different airlines offering flights for a price below $400 (Delta, US, North West, and United) 25. This shows that there is a freedom for buyer to pick and choose. Those who would face switching costs would be those who have taken advantage of repeat flier programs: they may have to forfeit their points (or miles) in order to switch. This gives some buyers incentive to stay. (0) Threat of Backward Integration. There is a fairly low threat of backward integration. The highest threat comes from those who can afford to purchase their own planes and commission their own staff. The majority of users of airline services do not have the ability, experience and capital, to establish their own airline. (+) Availability of Full Information. Customers of the airline industry have the ability to get information they want to see simply by visiting the specific airline s web-site. Also, the US Securities and Exchange Commission make any consumer able to search for and view financial information about any publicly traded organization 26. Again, companies like Priceline and Expedia offer customers the ability to compare prices of tickets in order to get the lowest price. (-) Overall: buyers have a fairly low amount of bargaining power due to the small size of buyers, availability of alternative buyers, and low threat of backward integration. (+) F5) Threat of Entry Entry Decision Model. Those wishing to enter the airline industry have many obstacles to face when deciding to enter, then if they should stay or leave if faced with opposition. For example, many established airlines have established hubs ( an airport or city through which and airline routes most of its traffic 27 ) across the country and may, as a

12 Airline Industry Analysis Page 12 of 15 result, hold some sway over decisions at that airport, thus preventing new entry. An example decision tree looks as follows: Those who attempt to enter the airline industry will end up at outcome R4 because of the minimized losses should the established airlines choose to fight entry (which there is high probability of happening). (+) Economies of Scale. Since there has been trouble with the economy, and even, perhaps before the trouble, airlines have been finding ways to reduce the prices that they offer to customers. Since most airlines, with the exception of JetBlue, started over 40 years ago and have already paid off most of their fixed startup costs. Surprisingly, JetBlue has been able to compete. This is due to the constant demand for new planes and more perks for customers. It seems as though there is almost no economy of scale (-) Product Differentiation. Most airlines have a repeat or frequent flier program which allows those who travel using the same airline to accumulate points (or miles) in order to obtain discounts from that airline or from other associated service providers such as hotels and car rental. Established airlines, those with enough capital, are also able to keep a high number of new model planes available for those wishing to travel using their services. Unfortunately, other than the different programs offered, there is little differentiation between services (other than price). (-) Capital Requirements. The initial startup costs and operating expenses start at about $8.5 million 28 and increase depending on various factors including fleet size and contracts with airports. This seems to indicate a fairly low capital requirement for 28

13 Airline Industry Analysis Page 13 of 15 startup. However, during an economic downturn, banks tend to be conservative about new business loans. This may cause getting that much money together difficult. (0) Access to Distribution Channels. Though anyone considering entering the airline industry would not have a problem reaching the far downstream public, it may be harder for new entrants to organize themselves in airports where one or more of the established airlines already have hubs. Those airlines with hubs bring in a high volume of those who fly into and out of airports, especially when considering planning layovers, thus giving those airlines some sway about those who would be likely or not to enter that airport. (+) Excess Capacity. There is excess capacity in the airline industry. That is evidenced by the fact that some airline employees are able to find empty seats in order to fly for free (a benefit provided to airline employees) 29. This shows that there is what seems to be extra room on almost every flight. This is an indicator that airlines could easily increase the number of passengers they book on each flight in order to prevent new entrants from becoming established. Below is a chart of actual capacity and actual usage 30 : Capacity Utilization Year Actual Usage Capacity % Unused Space , , % , , % ,300 1,002, % ,200 1,005, % ,200 1,037, % This chart shows that there has always been at least 25% capacity available, indicating that airlines could increase production significantly and easily. (+) Learning/Experience Curve. Since JetBlue, a new airline company (established in 1999) can afford to charge a similar, and somewhat lower price, than Delta, an established airline, it seems as though the learning curve is not very steep. For a trip leaving Chicago on July 13 going to Orlando, then returning a week later, JetBlue offers tickets starting at $ Delta offers the same flight for $ Since JetBlue can compete with the prices Delta, one of the oldest established airlines, and can stay in business, the airline industry has a seemingly shallow learning curve. (-) Government Policy. Since the government has a stake in the airline industry, there is a lot of regulation. There is government insurance for airlines 33 and other forms of assistance for airlines, which subject them to rules and regulations. Also, since there 29 Christina Ryan, first hand experience

14 Airline Industry Analysis Page 14 of 15 are millions of people who trust these airlines with their lives, the government has many safety regulations. These regulations are very specific and include regulations for pilots, ground instructors, and other operators 34. Because there are so many standards and regulations that must be met in order to provide air travel, including random inspections 35, that it would be very difficult for new entrants to become fully established. It would be very costly and time consuming to meet all of the regulations. (+) Overall: there is little threat of new entry. Government policy, high capital requirements, economies of scale, low access to distribution channels, and excess capacity help ensure that there will be sustainable profits in the airline industry over time. (+) Summary of Five Forces Analysis Force Highlights Effect F1 Intensity of Rivalry F2 Threat of Substitutes F3 Bargaining Power of Suppliers F4 Bargaining Power of Customers F5 Threat of Entry Low priced based rivalry, standardization in nonprice based rivalry, low concentration, and low capacity utilization Availability and development of new and less expensive substitutes, the low cost of substitutes in poor economic times, and neutral effects of switching costs Little control over fuel prices, High concentration of airplane manufacturers, Low number of substitutes Large number of buyers, Many alternate buyers, Almost no threat of backward integration Competitors will likely fight entry, High number of government regulations, Low access to distribution channels (-) (-) (-) (+) (+) Overall Industry Grade:

15 Airline Industry Analysis Page 15 of 15 Strategic Map The following strategic map positions competitors in the airline industry comparing volume (number of passengers) and differentiation: Passengers (Capacity) ( in thousands) 100 UA AA DL CO 1 US NW OT H JB SW low Differentiation High The airlines to the lower right have high levels of differentiation but, as a result, are unable to service a high volume of passengers. The airlines to the left of the map represent the majority of airlines who provide standardized services but are more able to service high volumes of passengers. Final Recommendation Using Porter s Five Forces model, we were able to determine that the airline industry does not look as though they will have sustainable profits in the long term. After performing the industry analysis and finding an overall industry grade of 1-, we would not recommend investing in the airline industry.