In spite of the $15 billion cash and guarantee package from the U.S. government, it is clear that the airline industry was already in serious trouble before Sept. 11, and may not quickly emerge.
This will be the fourth such episode of trauma for the industry since 1969. It’s therefore worth asking: is this, as an investment, a basically unattractive business?
The airline business has peculiar economics. It is very high in fixed cost, both for initial operation and per flight, but the marginal cost of an additional passenger is almost zero. Pricing can be made almost infinitely arcane, but service is very difficult to differentiate. Labor costs tend to be very sticky downwards, and far above justifiable levels in certain instances (my colleague Ian Campbell has written very capably about the industry’s labor contracts and overpaid senior pilots). Historically, profitability has averaged well below the industry’s cost of capital, with upturns seeing a surge of new entrants to the business, and downturns seeing even the largest participants flirting with bankruptcy. (PanAm, where are you now?)
This dismal economics is not unique. Two other industries, in the past and present, have shared it, railroads and shipping.
In the case of railroads, fortunes were made in the initial railroad construction boom, largely because the revenues available from a sound railroad when completed were more than able to amortize the railroad bonds used to construct it. This was the reason for Wall Street’s traditional aversion to “watered” stock, or stock issued in excess of the hard asset value of the underlying corporation. In the case of a railroad, if stock and bonds were issued only to cover the cost of construction, and the railroad served an economically viable route, the return to bond investors was safe, and to stock investors was both safe and very interesting indeed. This is because, with such a capitalization, it was in general impossible for a second railroad to be built to serve the same route that did not have equal or higher costs than the first, and hence, the first railroad, when built, could be assured of a pleasant monopoly profit. If the first railroad’s stock was watered, then a second railroad could be built using non-watered stock, which would have cheaper debt and preferred stock service costs, and hence would be able to undercut the first.
Once the U.S. railroad network was substantially complete, by 1890, shippers found they could play competing railroads off against one another while in single-railroad “monopoly” areas, the Interstate Commerce Commission held down freight rates, thus preventing the monopoly railroad from raising rates in these areas to compensate for areas in which it was forced to compete at below full cost. With the marginal cost of shipping an additional passenger or additional ton of freight being so low, tariffs were forced down towards this marginal cost, thus preventing the railroads from servicing their debt or providing an adequate return on their stock. In each recession — 1893, 1907, 1920, 1932 — a number of railroads went bankrupt, allowing them to reduce their debt servicing costs and thus even further increasing the strain on any railroads that had not defaulted. The result, by the 1930’s, was a more or less general railroad default and debt reorganization, which for many railroads was the third or fourth such event. Thus necessary infrastructure investment was neglected, so that once serious competitors appeared in the form of trucks, buses and airlines, the railroad industry was hopelessly unable to compete.
In shipping, since 1973, more or less the same economics has obtained. Variable costs are low, so that for most of the time, shipping rates are driven down to levels that fail to service shipping debt, let alone provide an adequate return for the equity-holder. Only occasionally, in times of capacity scarcity, do shipping rates rise sufficiently to provide a profit, at which point huge amounts of excess capacity is built in the world’s state subsidized shipyards.
Like railroads a century ago, or shipping more recently, the airline industry is forced into a vise of unprofitability. Like the railroads, the industry was profitable during its stage of rapid expansion, in the U.S. before 1969, or in East Asia before 1997, but is now condemned to unattractive economics. Like the railroads, the industry is heavily unionized, because the workforce has discovered that their welfare is an easy cost item to cut, indeed almost the only cost item that can be cut. Like the railroads, like shipping, only an occasional operator, generally of smaller scale than the oligopolists, can make a profit by ignoring the rules and union contracts by which the oligopolists are bound. If the profitable operator grows, however, then either it becomes subject to the same cost constraints as the oligopolists, or the oligopolists free themselves from their cost constraints, driving down costs and tariffs and making the small profitable operator equally unprofitable with themselves.
Naturally, companies in these industries seek ways out of their dilemma. Three such have been common: adding service, providing hidden tariff rebates to favored customers, and getting subsidies from the government. In the case of the railroads, where a passenger journey frequently lasted several days, additional services, such as the Pullman Car and the Superchief, provided considerable relief from the industry’s iron economics until air travel came along. In the case of the airlines, the opportunity is less; flights are sufficiently short, and the general unattractiveness of the flight experience so universal, that an airline competing on superior service is like a dentist competing on the basis of having a more comfortable chair. Thus, far from offering superior service, airlines have been driven to cut, cut and cut again at economy class and even business class service, saving on cost but making the flying experience, for many people, a highly unpleasant one.
In terms of tariff rebates to favored customers, both the railroads (before the Interstate Commerce Commission) and the airlines have used the technique to an inordinate extent. The result, in the case of the railroads, was punitive legislation; in the case of the airlines, it has been a determination by consumers to “game” the airlines’ yield management systems to get the best deal, thus eliminating the profitability of the price discrimination while at the same time building huge and justified resentment among those who have paid a substantial or even huge premium for an exactly equivalent service. It is unlikely, therefore, that this tactic will produce a solution in the long run to the airlines’ economic problem.
The airlines have now found the third solution, as did the railroads before them, which is to get a handout from government. The $15 billion subsidy ($5 billion in cash and $10 billion in guarantees) voted by Congress is highly economically damaging, since it puts off the restructuring of the airline industry, which grossly over-expanded in the 90’s, as well as increasing the perceived return to industry in general from lobbying and political manipulation, an activity of great costs that is economically entirely without value. The principal moral case against Big Government is that it leads to Big Corruption; let nobody doubt that the corruption in the U.S. political system, already far too high, has been significantly increased by the airline industry bailout.
It cannot of course be denied that the airline industry has brought huge benefits to the U.S. and the world, by bringing the world together. Large cities, such as Las Vegas, would not exist were it not for the ability of such remote places to bring in customers by air. Since air travel as a whole offers such economic benefits; it is worthwhile to look at ways in which such benefits may more effectively be tapped to pay the cost of airline service itself. By looking at the air travel system as a whole, rather than simply the airline industry, it is possible to identify different sources of revenue related to air travel, that are currently a “free lunch” and should be tapped to cover the cost of infrastructure.
One such source is the airport system. With passengers compelled to spend more and more of their time at airports, as airline delays and safety holdups proliferate, such airports are potentially a huge source of revenue from the restaurant, shopping and entertainment services that can be sold to passengers in transit. With a large and literally captive market, a shopping mall, for example, cannot fail to be exceptionally profitable. In the U.K., the British Airports Authority was privatized in 1987 as BAA plc, and now operates Britain’s airports on a highly profitable basis. In the U.S., entities such as the Port Authority of New York and New Jersey and the Massachusetts Port Authority are nothing more than massive public sector bureaucracies, that inevitably breed corruption and mismanagement on a heroic scale.
Public sector airport owners should thus be privatized forthwith, and the resulting private companies should be given long-term licenses and permission to develop the food service, retail and entertainment potential of the airports to the fullest extent. Instead of charging fees to aircraft landing at the airport, they should in most cases pay the aircraft to land, since landing aircraft provide them with additional revenue opportunities. In this way, airline economics can be substantially improved.
There is an additional potential source of revenue for the airline industry, however, which is the incremental return achieved by cities that, without the airlines, would cease to exist. Primarily, these are resorts, particularly those that are not close to major conurbations, which have almost always grown up in the 40-50 years since air travel became possible.
For New York or Boston, an arriving passenger may or may not be a source of revenue; in any case, business destinations of this kind will normally generate as many passengers as they receive. For Las Vegas, that is not the case. Few local passengers are generated, while each arriving passenger is a new “sucker” to be fleeced, a new source of revenue for the local “businessmen.” To a lesser extent, this is also true of international resort destinations such as Cancun and the Caribbean.
The solution is thus clear. The airlines should charge fees to Las Vegas and other resort destinations, reflecting some percentage of the economic revenue that the destination can expect to gain by the airline offering service. Destinations to which fees should be charged could be determined quite simply; they are those for which far more round-trip tickets are issued into the destination than out of it. An additional premium could be charged for destinations such as Las Vegas, that reap exceptional returns from gambling activities that are detrimental to the economy as a whole. In this way, the benefits to remote destinations of air service provision can be captured, and used to improve the economics of the airline industry. Such a change would have an additional advantage in reducing the amount of frivolous air travel, thus benefiting the economy as a whole; also it might possibly tend to suppress the inexorable spread of casino gambling.
The economics of the airlines are hopeless if they remain isolated businesses; in that case only public subsidy can save them. Much less corrupting than public subsidy, however, is to provide the airlines with an appropriate share of the incremental revenues generated by air travel. By privatizing the airports, and by instituting resort fees for leisure destinations, the corruption of public subsidy can be avoided and the airlines can be enabled to finance themselves from the investor community in the proper way.
-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.