www.pwc.com/us/transportationandlogistics Aviation perspectives The impact of mega-mergers: a new foundation for the US airline industry January 2014
The impact of mega-mergers: a new foundation for the US airline industry? The fourth and likely last airline mega-merger in the US was recently approved. Once the merger integration is complete, the largest four airlines and their regional partners will control more than 80 percent of US commercial airline traffic. 1 While this certainly is an historic level of consolidation, there remain other sizeable airlines serving the US domestic market. In addition to the largest four airlines and seven regionals that serve them, there are seven other US passenger airlines that each earned more than $500 million in revenue last year; 2 and more than 30 airlines are on pace to carry more than 10,000 passengers each on the top 1000 US domestic routes in 2013. 3 In this latest edition of Airline Perspectives, we refresh our previous analysis on the impact of US airline mega-mergers on fares. We also include new analyses on operational improvements and the customer experience as well as a discussion of the implications of mega-mergers on the future of the airline industry. Average increases in US domestic airfares continue to lag behind major cost drivers Contrary to popular opinion and widespread media coverage, average US domestic airfare increases since 2004 have been quite modest, rising at approximately two percent on an annual basis, and actually decreasing when adjusted for inflation. 4 When airfare increases are compared with an airline s two major cost drivers fuel and wages the profitability challenge most airlines experienced in the prior decade becomes evident. While the average US domestic airfare rose almost as much as the average US transportation industry worker s labor cost, 5 there was a dramatic gap between the increase in air fares and fuel prices. 6 Q1 2004 - Q2 2013 US Domestic Airfares 2.0% US Domestic Airfares (inflation adjusted) (0.5%) Transportation Wage Index 2.3% Brent Crude Quarter Close 14.1% 1 http://www.justice.gov/opa/pr/2013/august/13-at-909.html 2 Bureau of Transportation Statistics, Form 41 3 Bureau of Transportation Statistics, T-100 4 Bureau of Transportation Statistics, National Level Air Fares 5 Bureau of Labor Statistics, Transportation and Material Moving Wages and Salaries 6 US Energy Information Administration Aviation perspectives PwC [1]
Figure 1: Index of quarterly average US domestic airfares and quarter-close transportation wages and Brent crude prices (Q1 2004 - Q2 2013) 400 350 300 250 200 150 100 50 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Air Fares Brent Crude Transportation Wages As the chart above illustrates, the generally accepted assumption that airline consolidation would result in significant fare hikes has not been realized at the network level, although there have been increases in average fares in certain markets. A primary reason for the moderate growth in airfares over the past few years has been the expansion of low-cost carriers (LCCs) into many major domestic routes. To understand better the impact of the LCCs, we looked at fare changes from 2008 to 2013 7 under four different market conditions: 8 Stable LCC markets routes on which LCCs carried greater than 30% of total passengers in both 2008 and 2013 LCC entry markets non-lcc markets in 2008 that became LCC markets by 2013 LCC exit markets LCC markets in 2008 that became non-lcc markets by 2013 Non-LCC markets routes without significant LCC presence in either year 7 Bureau of Transportation Statistics, DB1B Market Database. First half of 2008, first half of 2013 8 An LCC market in this analysis is defined as a route on which 30% or greater of the total passengers are carried by an airline with a LCC business model. Analysis included markets which averaged more than one passenger per day. LCC definition consistent with A4A report, Airlines for America, 2013-2014 Winter Holiday Travel Forecast for U.S. Airlines, published December 12, 2013. Aviation perspectives PwC [2]
Figure 2: Passenger and one-way fare changes for LCC and non-lcc routes (1H 2008 1H 2013) 1H 2013 sdfr Change from 1 H 2008 to 1H 2013ad Share of passengers Average fare Passengers Average fare Stable LCC markets 40% $189-9% 19% LCC entry markets 13% $229 36% -5% LCC exit markets 4% $237-31% 28% Non-LCC markets 43% $269 0% 9% As Figure 2 shows, LCC entry markets were the only markets with significant passenger traffic growth and a decrease in average airfares over the five-year period. In the much smaller set of LCC exit markets, fares increased 50% more than stable LCC markets and three times as much as non-lcc markets. In stable LCC markets, fare increases were greater than in non-lcc markets, likely attributable to LCCs costs rising at a greater rate than mainline carriers. Despite the fare increases in stable LCC markets,the average fare is still lower than in the other market groups, and LCC carrier fares in these markets are 20% below the fares of non-lcc carriers. 9 In summary, LCC presence in markets significantly moderates increases in average fares. This growing competition between the mainline airlines and other segments of the industry, specifically LCCs and ultra-low-cost carriers, is also evident in capacity growth. LCCs have been expanding faster than traditional carriers and now account for over 26 percent of global capacity, compared to 11 percent in 2003. 10 In North America, LCC passenger traffic grew by 15 percent between 2008 and 2013, 11 and is now 30 percent of domestic traffic. 12 In the US, LCCs have recently gained an additional stimulus to growth: as part of the most recent mega-merger, LCCs are likely to benefit from the divestiture of nearly 170 take-off and landing slots and the transfer of ten gates in key markets such as New York, Washington DC, Boston, Dallas, Miami and Chicago. According to Attorney General Eric Holder, by guaranteeing a bigger foothold for low-cost carriers at key US airports, this settlement ensures airline passengers will see more competition on nonstop and connecting routes throughout the country. 13 With LCCs and competition continuing to moderate average airfare increases, airlines have turned to other sources of revenue, such as fees for baggage handling, ticket changes and standby status, while also expanding in-flight commerce to include a variety of food and beverage, entertainment, and Wi-Fi connectivity options. In particular, ancillary fee revenues have risen sharply. Between 2008 and 2013, 14 bag fees collected by the top ten carriers increased more than five-fold, from $290 million to $1.6 billion, 15 and reservation cancellation and change fees nearly doubled, from $760 million to $1.4 billion. 16 The magnitude of these fees can be better understood by averaging them across the number of passengers: the $1.6 billion in bag fees collected by the top 10 carriers added approximately $6 per passenger. 17 9 Bureau of Transportation Statistics, DB1B Market Database. First half of 2008, first half of 2013 10 http://centreforaviation.com/news/global-airline-seat-capacity-up-64-in-feb-2012-lcc-seat-capacity-up-18-oag-139911 11 Bureau of Transportation Statistics, T100, passenger seat miles, first half of 2008, first half of 2013 12 http://www.lowcostandregional.com/feature/air-traffic-data-amadeus 13 http://www.justice.gov/atr/public/press_releases/2013/301616.htm 14 First half of 2008, first half of 2013 15 Bureau of Transportation Statistics, Baggage Fees by Airline 16 Bureau of Transportation Statistics, Reservation Cancellation/ Change Fees by Airline 17 Bureau of Transportation Statistics, Baggage Fees by Airline, T-100 Aviation perspectives PwC [3]
Merger-driven consolidation has allowed US airlines to improve operations and the customer experience Airline operational performance is impacted in the short-term both by individual carrier issues as well as externalities such as weather and air traffic control decisions. So although 2013 on-time and flight cancellation performance declined compared with 2012 s record-breaking performance, 18 US carriers have measurably improved operating performance over the past five years. These improvements can be attributed in part to the impact of consolidation: as airlines have merged, carriers have removed capacity from the system and increased overall efficiency in their operations. Between 2008 and 2013, 19 the number of domestic flights decreased more than the number of domestic passengers driving increasing load factors. This reduced flying has created a better balance between runway and airspace supply and demand, reducing congestion delays and allowing airlines and airports to recover from disruptions and delays more quickly and with less passenger inconvenience. We compared three core operating metrics in 2008 and 2013 20 to quantify the improved passenger experience: on-time performance, flight cancellations, and baggage handling. 21 In addition to comparing overall network performance (i.e., scheduled passenger US domestic flights), we also analyzed carrier operating performance at the top 20 airports. As these are the most congested airports and include many of the merged carriers core hubs, they better highlight the extent of carrier and airport performance improvements. 1. On-time performance: We analyzed arrival delays, which are an important passenger experience measure, and departure delays, which are a key indicator of operational efficiency. Overall,US flights experienced a 17 percent decrease in arrival delays and an 8 percent decrease in departure delays. Taxi times, another operational metric particularly relevant at congested airports, also improved: while taxi-in times (the period of time between landing and gate arrival) stayed relatively flat, taxi-out times (from gate push-back to take off) improved six percent. 22 For the 20 busiest airports, on-time performance showed an even greater improvement: a 21 percent decrease in arrival delays and a ten percent decrease in departure delays. Taxi times also improved at a greater rate: average taxi-in times improved by five percent and taxi-out times improved by ten percent. 23 It is worth noting that some of the on-time improvement can be attributed to schedule adjustments. Airlines increased the average scheduled flight time for just over 50 percent of the routes flown in both 2008 and 2013, 24 although the average increase was relatively small: about 3.5 minutes. In summary, it can be concluded that passengers on average are enjoying increased reliability when flying domestically. 18 Bureau of Transportation Statistics, Airline On-Time Statistics and Delay Causes 19 First half of 2008, first half of 2013 20 First half of 2008, first half of 2013 21 A recent US Department of Transportation Inspector General audit report found that regional airline performance is undercounted in current on-time and cancellation data as many regionals do not meet the reporting threshold of 1% of industry revenue. This undercounting affected both 2008 and 2013 data. See Office of the Inspector General Audit Report titled More Comprehensive Data are needed to Better Understand the Nation s Flight Delays and Their Causes, issued December 18, 2013. 22 Bureau of Transportation Statistics, On-Time Performance 23 Bureau of Transportation Statistics, On-Time Performance 24 First half of 2008, first half 2013 Aviation perspectives PwC [4]
2. Flight cancellations: Network-wide, passengers experienced a 26 percent decrease in flight cancellations, significantly decreasing the number of passengers requiring flight re-accommodation. Controlling for inclement weather and air traffic conditions, airline-caused cancellations as a percent of total flights decreased by 40% over the five-year period. 25 A more notable improvement in flight cancellations occurred at the busiest 20 airports. In 2008, passengers using these airports were experiencing a higher rate of carrier-caused cancellations than the network average. Yet, by 2013, carriercaused cancellations at these airports had improved by 49 percent, bringing the carrier flight cancellation rate from worse than the network average to better than the network average. 26 3. Baggage handling: Carriers reported a 31 percent improvement in baggage handling, with reports of mishandled bags dropping from 4.6 incidents per 1000 passengers in Q3 2008 to just 3.2 reported incidents in Q3 2013. Also noteworthy is that some of the lowest incident rates on record have been recorded in the past year. 27 Airline mergers have helped the industry achieve greater financial stability, which, in turn, has allowed carriers to make investments in improving their operations. Today, passengers are less likely to be inconvenienced by flights that are delayed or cancelled and are more likely to find their bags when they land. Some of the most significant improvements have occurred at the 20 busiest airports, an indication that the major US airlines are steadily improving the customer experience at their most congested hubs. Airline consolidation has set the industry on a new course Mega-mergers have re-shaped the US airline industry over the past eight years, magnifying four key trends that will define the industry in the near-term. Sustained Profitability. The domestic mainline airlines have been profitable since 2010, and analysts expect 2013 to be profitable for them as well. 28 This sustained profitability, particularly during a slow-growing economy and a period of persistently high fuel costs, indicates a change in the way the network carriers are being managed. Largely due to consolidation, the network carriers have been able to exert capacity discipline, eliminating redundant or unprofitable routes and rescheduling flights to better align with customer demand. Since 2010, US airlines have only had small capacity increases; and, last year, capacity was essentially flat, 29 despite an uptick in passenger travel. 30 Building on this capacity discipline, network carriers are finding themselves better able to gradually increase fares on certain routes and upgrade their operations. Finally, as these carriers replace their aging fleets, they will realize additional gains from newer, more fuel-efficient planes. 25 Bureau of Transportation Statistics, On-Time Performance 26 Bureau of Transportation Statistics, On-Time Performance 27 Bureau of Transportation Statistics monthly press releases 28 http://www.alpa.org/portals/alpa/magazine/2013/june2013_mainlineanalysis.pdf 29 http://www.alpa.org/portals/alpa/magazine/2013/june2013_mainlineanalysis.pdf 30 www.rita.dot.gov/bts/press_releases/bts057_13 Aviation perspectives PwC [5]
Business Model Convergence. Now that mega-mergers have changed the competitive landscape, the business models of the remaining airlines are converging. LCCs, which have historically done well in recessionary times because of traditionally lower airfares, are facing higher operating costs as rising fuel costs disproportionately impact narrow-body, short-haul flying. With their traditional markets becoming less profitable, LCCs are flying more frequently to more congested airports and carrying increasing numbers of connecting passengers, creating reliability challenges and leading to higher costs for landing fees, operations, and security. 31 As LCCs moderate their growth, they are contending with aging aircraft that are driving maintenance costs higher and a maturing workforce that increases labor cost pressure. 32 These developments are also driving convergence between LCC and mainline load factors: since 2008, the load factor gap between LCCs and the rest of the industry has been cut in half, from 5.7 percent to 2.4 percent. 33 Convergence has been evident on the revenue side, too. As LCCs have increased prices to cover increasing costs, their fares have crept closer to those of the network carriers: as presented previously in Figure 2, stable LCC markets experienced a 19 percent increase from 2008 to 2013, while non-lcc markets increased only 9 percent. Ultra LCCs and Mainline Unbundling. The rising fares of the LCCs have contributed to the rapid ascent and growth of a few ultra LCCs. These airlines distinguish themselves by charging the lowest base fare and collecting the highest ancillary fees. While this business model has drawn criticism from consumer groups, it has been quite successful in attracting passengers. Ultra LCC traffic has almost doubled from 2008 to 2013 (up 76 percent), accounting for three percent of overall domestic passengers and ten percent of LCC passengers in the first half of 2013. 34 It has also been profitable, with ultra LCCs recording margins of 15 percent, over three times the industry average. 35 Not surprisingly, this rosy picture has led to exponentially higher growth estimates for ultra LCCs: over ten percent annually vs. two percent for the broader airline market. 36 If the ultra LCC business model continues to prove successful, it will likely incentivize carriers to continue to unbundle their product and services mix, at least for certain passenger segments. Overall, the story of the ultra LCCs illustrates that despite the relative stability of the last few years, the airline business remains quite competitive. 31 http://www.flightglobal.com/news/articles/low-cost-carriers-growth-expectations-355702/ 32 http://www.faa.gov/about/office_org/headquarters_offices/apl/aviation_forecasts/aerospace_forecasts/2013-2033/ media/faa_aerospace_forecasts_fy20132033.pdf 33 Bureau of Transportation Statistics, T-100 34 T-100 revenue passenger miles 35 Form 41 36 Company financial and regulatory filings Aviation perspectives PwC [6]
Improvements to Product Quality. Airline consolidation has also altered the rules of competition. With network carriers and their new-found capacity discipline enabling fare parity with the LCCs on increasing numbers of routes, carriers will be competing for customers based on product and service offerings. Passengers continue to search for and book flights based on best price, but are also using new search engines and functionality to weigh reliability, convenience, and amenities. 37 As a result, airlines are increasing investment in customer experience improvements such as in-flight Wi-Fi, premium seating options, and operational reliability infrastructure. One study recently counted $32 billion in capital improvements planned by US carriers over the next three years. 38 Conclusion Merger-driven consolidation has had a significant and positive effect on the domestic airline industry. While the number of network carriers has declined over the past few years, LCCs and ultra LCCs have continued to grow and provide an important competitive option on many routes. Carriers capacity discipline has improved reliability for customers, and, along with ancillary fees, has made the industry s financial outlook much stronger. As airlines continue to upgrade their operations and improve their efficiency during this period of relative financial stability, they can turn to investing in improvements to the customer experience. 37 http://www.pwc.com/us/en/industrial-products/publications/airlines-experience-radar.jhtml 38 Airlines for America, 2013-2014 Winter Holiday Travel Forecast for U.S. Airlines, published December 12, 2013 Aviation perspectives PwC [7]
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