Continental airlines work hard fly right

CASE SUDY

Read the following case studies:

"Continental"
"Starwood Hotels and Resorts"
"Jet Blue"
Choose one to provide an analysis of the case to include:

Overview of the company
Overview of the problems the company faced
List of the key players in the case
Solutions to the problems the company faced
Your personal assessment of the situation and three strategies you would have used to approach the problems differently.
Assess the performance of the company since the case study was written
ABSOLUTELY NO PLAGIARISM, PAPER MUST MAKE SENSE, NO GRAMMATICAL ERRORS. MINIMUM 900 WORDS WITH AT LEAST 3 SCHOLARLY/PEER REVIEWEDAPA REFERENCES. MUST INCLUDE A PROPER INTRODUCTION AND A WELL CONSTRUCTED CONCLUSION. DUE JANUARY 12, 2018 AT 11AM NY EST TIME.

Written by Stephane Duchenne, Carol Ann Fisher, Jeffrey S. Harrison, Cheryl Farr Leas, Yash Krishna, Michel Rugema and Yongqing Yang at the School of Hotel Administration, Cornell University. Copyright c Jeffrey S. Harrison. This case study was written for the purposes of classroom discussion. It is not to be duplicated or cited in any form without the copyright holder’s express permission. For permission to reproduce or cite this case, contact Jeffrey S. Harrison (harrison@richmond.edu). Permission to use in the classroom will be granted free of charge.

The Center for Hospitality Research AT CORNELL UNIVERSITY

CAN CONTINENTAL AIRLINES CONTINUE TO WORK HARD, FLY RIGHT & FUND

THE FUTURE? We weren't just the worst big airline. We lapped the field.

– CEO Gordon Bethune1

When Gordon Bethune arrived in Continental Airlines' executive offices in February 1994, he almost turned around and left again. Continental was the lowest- performing of the major U.S. airlines. It had the worst on-time record, filed the most mishandled-bag reports, and received customer complaints at a rate of nearly three times the industry average.2

1 Bethune, Gordon with Scott Huler. From Worst to First: Behind the Scenes of Continental's Remarkable Comeback. New York: John Wiley & Sons, 1998, p. 4.

2 Ibid.

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Worst of all was employee morale. Sick time, turnover, on-the-job injuries, and worker's compensation claims stood at record highs, and a culture of mistrust reigned. Airport employees were so embarrassed by the company that they ripped their logo patches from their shirts to avoid having to answer for the company's behavior to customers and airport coworkers.3

Within two years, Continental Airlines was transformed from almost-certain doom as one of the worst performers in the airline industry into a standard-bearer in all respects: profitability, reliability, customer service, and employee satisfaction. And despite the turmoil in which the airline industry finds itself in the post-September 11th world, Continental continues to survive. The key is a well-focused brand and a clearly defined corporate culture in which everybody works together to win.

A Short History of Continental Airlines Continental Airlines has such a fascinating history that it has been the subject of at

least two books. Maverick tells the Continental Airlines tale from 1937 to 1980, the 43-year span when the airline's guiding influence was Robert Forman Six, CEO for 40 of those years.4 From Worst to First, takes over the narrative in 1994, revealing how the current CEO, Gordon Bethune, turned a woefully unprofitable company--Continental Airlines declared bankruptcy twice between 1983 and 1990--into one of the most admired airline companies in the industry today.5 Exhibit 1 contains some of the highlights of Continental Airlines’ History.

The Maverick Years Louis Mueller and Walter T. Varney created Varney Speed Lines in 1934. Varney

transported mail and some passengers in the southwestern region of the United States. In July 1936, Mueller sold 40% of the company to Robert Forman Six, who renamed the fledgling carrier Continental Airlines in 1937--and went on to become one of the greatest leaders of the industry. In Maverick, author Serling states: “Without question, he is as complex a person who ever headed an airline. He is hard, quick-tempered, profane and dictatorial. He is also soft, warm-hearted, sentimental, deeply religious and generous.”6

3 Ibid, p. 5-6; also Brenneman, Greg. "Right Away and All At Once: How We Saved Continental," Harvard Business Review, Sept-Oct 1998; HBR OnPoint product no. 4193; p. 12.

4 Serling, Robert J. Maverick. Garden City, NY: Doubleday, 1974. 5 Bethune and Huler. From Worst to First. New York: John Wiley & Sons, 1998. 6 Serling, Maverick, p. 321.

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When Robert F. Six took over as Continental’s CEO, his long-term goal was to provide reliable and profitable flights, which would eventually fly beyond the borders of the United States.7

In the years preceding World War II, Continental flew to destinations that included El Paso, Albuquerque, Las Vegas, and cities within Colorado. As the war approached an end, Continental expanded its regional route structure with service between Denver, Colorado, and Kansas City, Missouri; and between El Paso and San Antonio, Texas. By 1945, the company had 400 employees and was serving 26 cities.8

Determined to expand its role as a regional airline, Six merged Continental with Pioneer Airlines in 1953 and expanded its routes to 46 cities. The new, larger carrier provided service to every city in Texas with a population of more than 100,000 inhabitants.9

In June 1959, Six determined to set Continental apart from its main competitors, who were then just joining the jet age. He introduced the Boeing 707 into the fleet. To maintain its small jet fleet, Continental developed an innovative “progressive maintenance” program that enabled the jet fleet to fly 7 days a week, 16 hours a day.10

In the 1960s, Continental doubled its route structure and achieved its goal of flying internationally. The airline began servicing routes to Southeast Asia, and launched charter services to such European cities as Frankfurt, London, Paris, and Rome. In 1967, Continental won a five-year contract for routes to Micronesia. Out of the pact a new enterprise was born to fly the routes: Air Micronesia (informally known as “Air Mike”).11

The Era of Deregulation Federal regulation of domestic airline fares and markets ended with the U.S.

government's Airline Deregulation Act of 1978.12 What followed was a period of evolution and metamorphosis that changed the nature of flying forever. The goal of the act was to promote competition within the industry: It essentially gave airlines unrestricted rights to enter new routes without Civil Aeronautics Board (CAB) approval. The companies could also exit any market as well as raise and lower fares at will.

7 Ibid., p. 37. 8 Serling, Maverick. Also online at www.boeing.com/commercial/aeromagazine/aero, 11/8/02. 9 Ibid. 10 Ibid. 11 Continental Airlines website, “History 1959 to 1977,” Online at www.continental.com/company/history/1959-

1977.asp (viewed 11/10/02) The contract became a permanent operation that became Continental Micronesia and celebrated 30 years of success in 1998.

12 The Department of Transport and its affiliated agency, the Federal Aviation Administration (FAA) continue to regulate the industry with regard to safety, labor, operating procedures, and aircraft fitness, and emission levels. Corridore, Jim. Standard & Poor's Industry Surveys: Airlines, p. 21.

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At the same time, the oil-producing countries in the Middle East formed a cartel and raised the price of jet fuel 88% in 1979, capped by an additional 23% in 1980. Higher jet fuel costs--combined with tumbling fares and increased passenger loads due to increased competition after deregulation--caused Continental’s profits to drop. Although deregulation allowed Continental to add 18 new routes in 1979, it also brought about an end to the airline’s long stretch of sustained profitability.

By 1980, after 40 years of service at Continental, Robert F. Six was no longer involved with the day-to-day operations at Continental; still, he remained Chairman of the Board of Directors. Due to losses, Continental suffered its first decrease in work force in 45 years of operation. Employee morale was at an all-time low. Help came in the form of a merger with Texas International, led by Frank Lorenzo, in 1982. Lorenzo became Chairman, President, and Chief Executive Officer of the new Continental Airlines. The merger allowed Continental to provided flight service to four continents--and Six’s goals were at last achieved. It did not provide an instant solution to the pressures of deregulation and increasing oil prices, however. Lorenzo was unsuccessful in negotiating restructured salaries for unionized employees, and, in late 1983, Continental was forced to file for Chapter XI bankruptcy reorganization.

Lorenzo reacted strongly to the news: He fired the entire staff, closed the doors to the airline for three days, and emerged with a company about one third Continental’s original size. By firing all employees, Lorenzo was able to reopen Continental with a non- union staff.13 The new company regained its competitive position by the end of the year, posting a small profit by the end of 1984. In 1986, Continental reported the largest profits in the airline’s 51-year history. In the same year, Lorenzo acquired Eastern Airlines, People Express, and Frontier Airlines, which gave Continental the largest route network in the United States.

Under Lorenzo’s direction, Continental adopted the dual strategy of developing hubs and strategic alliances as a way to remain competitive in the era of deregulation. Continental needed a steady flow of passengers to and from its hub cities, so it created Continental Express in 1987 as a means to deliver passengers to hub airports for onward flights, and formed a global alliance with Scandinavian Airlines (SAS) in 1988 in which SAS acquired 18.4% of Continental.

While the partnership with SAS has long since ended, Continental continues to follow this two-pronged strategy today. The airline's hubs in Newark, Cleveland, Houston, and Guam are fundamental to Continental’s route design. Its large family of

13 “Public Broadcasting System, Innovators: Frank Lorenzo,” online at www.pbs.org/kcet/chasingthesun/ innovators/florenzo.html (viewed 12/2/02).

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partners are as important as its hubs, as they allow passengers traveling to overseas markets to connect to other destinations using the alliance’s market routes.

Working under Frank Lorenzo was not an easy experience, however. The CEO position was in constant turmoil between 1980 and 1990, with six chief officers filling the position in ten years. In fact, all employees found conditions under Lorenzo difficult to endure. Labor relations under Lorenzo were amazingly bitter between 1980 and 1990. On October 26, 1989, the Congressional Record noted that “Frank Lorenzo has sabotaged a distinguished airline and disrupted the lives of its employees”--and the United States Congress declares him “unfit” to run an airline. In 1990, Lorenzo was forced out of Continental and Holland Harris took command.

Harris was unable to work a rapid turnaround. Citing rising fuel costs and the onset of the Gulf War, Continental filed for Chapter XI bankruptcy protection for a second time.

Climbing the Ladder from Worst to First14 In 1993, Continental Airlines emerged from bankruptcy when leveraged buyout

firm Air Partners, led by David Bonderman, invested $450 million in the company. In an attempt to compete with low-cost carriers, Continental launched a new company in 1993 called Continental Lite—which turned out to be not only unprofitable, but also detrimental to the already floundering image of Continental Airlines. Continental Lite was dismantled in 1995.

When Gordon Bethune left Boeing to become president of Continental in 1994, stakeholders despised the company—travelers, employees, and shareholders alike. However, under his leadership, Continental achieved 21 consecutive profitable quarters and has won more awards for customer satisfaction than any other airline.

The turnaround of Continental Airlines wasn't magic—far from it. Rather, it was the result of decisive leadership and a simple but clearly defined strategy that focused on understanding who the airline's target market is, improving products to compete in the marketplace, increasing revenues, and giving employees with the power and enthusiasm to make success happen.15

14 Bethune, Gordon with Scott Huler. From Worst to First: Behind the Scenes of Continental's Remarkable Comeback. New York: John Wiley & Sons, 1998.

15 Ibid; introduction, "The Idea in Brief."

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Believing that there was nowhere to go but up, newly minted CEO Gordon Bethune and his chief operating officer Greg Brenneman, sat down and defined the Go Forward Plan.16 Its cornerstones are:

Fly to Win: The marketing plan, focused on identifying who Continental's customers are and how the company can best meet their needs;

Fund the Future: The financial plan that laid the foundation for profitable growth;

Make Reliability a Reality: The product plan geared to realizing tangible results for customers and employees alike; and

Working Together: The people plan, defining a workplace culture of trust, involvement, empowerment, performance-based incentives, civility, and respect.

Major aspects of the plan included bonuses to travel agents to book passengers to Continental, bonuses to employees if the flights landed on time, and a significant reduction in management/employee barriers. This four-point vision statement laid the foundation for Continental's reinvention--and continues to drive both brand identity and corporate culture today.

But Is Continental Ready to Face Fundamental Shifts in the Airline Industry?

On January 17, 2001, Continental Airlines announced its financial results for the year 2000–proudly announcing six straight years of profitability. This continued profitability was even more remarkable when compared with Continental filing for Chapter XI bankruptcy protection for the second time in seven years in 1990. The “Go Forward Plan” allowed Continental to improve operational performance and working environment for employees and achieve sustained profitability.17 In early 2001, all indications pointed to a solid and enduring recovery for Continental Airlines.

But then the foundations of the airline industry were shaken to the core on September 11, 2001. The federal government grounded all flights in response to the terrorist attacks on New York City and Washington, D.C. The unprecedented suspension of airline operations continued until September 14, 2001, when Secretary of Transportation Norman Mineta allowed certain general aviation flights back into the US airspace in late afternoon.18

16 Ibid.; pp. 4-5. 17 Continental Airlines, “History 1991 to Now,” online at www.continental.com/company/history/1991-now.asp

(viewed 11/18/02). 18 Federal Aviation Agency Press Release, “Secretary Mineta Re-Opens Skies to General Aviation,” 11/14/01; reference

DOT 97-01, online at www2.faa.gov/index.cfm/apa/1062?id=1408 (viewed 11/13/02).

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In the last four months of 2001, Continental Airlines, the fifth largest airline company in the United States (as measured by 2001 revenue passenger miles), lost $189 million despite a $417 million grant from the federal government.19 During the first nine months of 2002, Continental’s net loss was $342 million,20 with Continental losing approximately $1.3 million each day of the year; by year's end, Continental's net losses totaled $451 million.21 On August 11, 2002, U.S. Airways filed for Chapter XI bankruptcy protection.22 Given this turbulent environment, will Continental Airlines be able to survive and prosper?

The Environment Continental Airlines is battling for its very survival in an extremely turbulent

broad environment that has forced many carriers, including the mighty United Airlines, to the brink of bankruptcy.23 In fact, the entire commercial air transport industry is mired in a complex web of socio-cultural, economic, technological, political, and competitive forces. Competition is fierce, and investments needed to succeed are high. At the end of 2002, air carriers were still trying to figure out how to navigate the shock waves resulting from the terrorist attacks of September 11, 2001, as well as a sea change in business travel patterns that may well be permanently undermining the legacy carriers' longstanding business models.

Industry Overview The world's airlines carry 1.4 billion passengers per year24, and the airline industry

is a significant part of the American economy. In 2000, the U.S. airline industry launched over 24,600 flights a day, employed roughly 680,000 people, and recorded $129.5 billion in revenues.25

Since 1978, when federal government regulation of domestic fares and markets ended with the Airline Deregulation Act,26 passenger demand for air transportation has

19 Continental Airlines, Inc. Continental Airlines 2001 Annual Report, pp. 6, 18. 20 Continental Airlines. Securities & Exchange Committee Quarterly Report for Continental Airlines, Inc. for period ending

9/30/02. p. 3. 21 Source: Continental Airlines, Inc. 2002 Annual Report, p. 22. 22 Carey, Susan. “UAL Posts $889 Million Loss for Third Quarter,” The Wall Street Journal, 10/21/02, p. A3. Also Power,

Stephen and Susan Carey. "Panel Rejects United's Call for Federal Loan Guarantee," The Wall Street Journal Online, 12/5/02; online at http://online.wsj.com/article/0,,SB1039043151540787993,00.html (viewed 12/5/02).

23 Associated Press, "United Airlines, Mechanics Hoping to Prevent Bankruptcy," 12/1/02; online at www.cnn.com/2002/TRAVEL/12/01/united.airlines.ap/index.html (viewed 12/3/02).

24 Goeldner, Charles R. and J.R. Brent Ritchie. Tourism: Principles, Practices, Philosophies, 9th Edition. Hoboken, NJ: John Wiley & Sons. P. 124.

25 Ibid. p. 125. 26 Corridore, Jim. Standard & Poor's Industry Surveys: Airlines, p. 21.

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grown at an average rate of 4% per year. As the Air Transport Association reported in 1999, "Now there are more than twice as many people fly today as did two decades ago, and at prices that have dropped dramatically. These facts reflect that the airline industry is an economically vibrant, highly competitive and productive industry.”27

During 2000, the U.S. airline industry provided services to 666.2 million passengers. However, in 2001, the number of passengers dropped to 622.1 million, a decrease of 6.6%.28 The airline industry measures its capacity in terms of Available Seat Miles (ASMs), and its utilization of that capacity in terms of Revenue Passenger Miles. By comparing the two, the industry calculates its passenger load factor. Exhibit 2 describes recent trends in U.S. airline traffic and operations29.

The airline industry has a clear size-based classification structure, according to

airline revenue base:30

Major Airlines: Carriers that have annual revenues exceeding $1 billion. The leading nine major airlines in the U.S. include United Airlines, American Airlines, Delta Air Lines, Northwest Airlines, Continental Airlines, Southwest Airlines, US Airways, America West Airlines, and Alaska Airlines.

National Airlines: Carriers that have annual revenues that between $100 million and $1 billion. National airlines include JetBlue, Frontier, Midway, and others.

Regional Airlines: Carriers that have annual revenues of less than $100 million. Regional airlines include AccessAir, Ameristar Jet Charter, Falcon Air Express, Laker Airways, Sun Pacific, and many others.

Commercial airlines have two major types of customers: travel passengers, and clients who ship cargo. The U.S. airlines transport more than 665 million passengers and nearly 30 billion ton miles of cargo annually; in the U.S., more than 1.8 million passengers fly every day. On average, airlines generate 75% of their revenues from passengers, while 15% of revenues are from cargo transport fees; another 10% in revenue is generated from additional fees, such as the sale of in-flight alcoholic beverages and entertainment.31 Airlines compete for travel passengers by offering products differentiated by destination,

27 Air Transport Association of America, Facts & Figures of the U.S. Scheduled Airlines 1999 , online at www.air- transport.org.

28 Air Transport Association of America, 2002 Annual Report, p. 6. 29 Ibid., p. 7. 30 Corridore, Jim. Standard & Poor’s Industry Surveys: Airlines. March 28, 2002. p. 16. 31 Air Transport Association of America, "Keeping Customers First," online at www.customers-first.org (viewed

11/17/02).

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class of service, frequent-flyer programs, change restrictions, in-flight amenities--and, of course, price.

The industry is characterized by high fixed costs. Roughly 80% of airline costs are fixed in that they do not vary depending on customer demand.32 Equipment costs are very high, especially for aircraft, which require large maintenance expenditures. Airlines also make significant investments in facilities infrastructure, such as airports and maintenance facilities. In 2001, “the total value of these investments, net of depreciation, reached $89.6 billion of assets totaling $158.4 billion,” reports the Air Transport Association of America.33 Labor costs, including both fixed and variable components, absorb about 40% of total industry revenues, and represent the largest portion of expenses for an airline. While they continue to rise sharply, industry watchers report no sign of labor productivity improvements since 1996.34 After salaries and wages, the second-largest operating cost for airlines is jet fuel.

The Airline Industry Changes: Deregulation (1978) Prior to 1978, the Civil Aeronautics Board (CAB) regulated airline activity in the

U.S., controlling routes that airlines could fly and the fares they could charge. The federal Airline Deregulation Act of 1978 phased out the federal government’s control over airfares and services in the domestic market. Since 1978, market forces have determined the price, quantity and quality of domestic air services. The act sparked a fundamental shift in the history of the airline industry, leading to improved service, lower airfares, and increased air travel--all benefits derived from free-market competition.35

Deregulation opened the airline industry market for existing airlines as well as newcomers, since airlines no longer needed to apply to the CAB for authorization to fly the routes they wanted to operate. As a result, the airline industry has witnessed the entry (and exit) of many low-fare carriers, as well as several established airlines that could no longer compete in the new environment, such as Pan Am and Eastern Airlines.36

Increased competition brought more scheduled U.S. passenger carriers and more convenient travel options than what was available 20 years ago. In 1978, there were 30 scheduled passenger airlines classified by the Civil Aeronautics Board; after deregulation,

32 Dr. Rob Britton, Managing Director of Advertising, American Airlines; lecture at Cornell University School of Hotel Administration, 11/22/02.

33 Air Transport Association of America, 2002 Annual Report, p. 13. 34 Ibid., p. 2, 12. 35 Kahn, Alfred E., “Airline Deregulation,” The Concise Encyclopedia of Economics, online at

www.econlib.org/library/Enc/AirlineDeregulation.html (viewed 12/4/02). 36 Corridore, Jim. Standard & Poor’s Industry Surveys: Airlines, 3/28/02, p. 8.

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the number of scheduled U.S. carriers peaked at 49 in 1985. At the end of 1998, there were 42 large scheduled certificated air carriers.37

However, significant operational limits hamper the development of new airlines. At an increasing number of major airports, the lack of access to gate stands in the way of new entrants and becomes the new entry barrier.38 Existing leases for gate access give leaseholding airlines exclusive rights to an airport’s gates over a long period of time, commonly 20 years, which prevent entrants to a market access to these gates. In some cases, major airlines that have the exclusive-use gate leases will sublease to other airlines, including startup airlines, at non-preferred times and at high premiums.39

Since deregulation, consumers have experienced some dramatic changes in the level of air service in most U.S. communities. The General Accounting Office defines service levels for a given community as a combination of several factors: number of departures, number of available seats, number of destinations served non-stop from the community, and number of jet departures (compared to the number of turboprop departures). “In general, airports serving larger communities have benefited from a greater increase in overall quality of air service . . . than those serving smaller communities.”40 Thanks to the hub-and-spoke operating structure favored by the major airlines--particularly such legacy carriers as American, Delta, Continental, and United-- domestic destination availability has increased by 35% to 40% over the last 20 years.41

During the period 1978 through 1998, domestic Revenue Passenger Miles (RPM) grew at almost double the rate of the growth of the economy, while regional RPMs grew at over five times the rate. (From 1978 to 1998, average GDP increased 2.6% per year, while air carrier RPMs increased 4.8% and regional RPMs increased 14.3%.) International travel has grown at an even faster pace than domestic travel: In the past 20 years, international RPMs have grown at 1.5 times the rate of growth of domestic RPMs, reaching 7.0% per year.42

Increased competition following deregulation also resulted in lower airfares for passengers. The U.S. General Accounting Office reports that, overall, average airfares declined by about 21% in constant dollars between 1990 and second quarter 1998.43 Price competition was unleashed by deregulation, according to the Air Transport Association:

37 U.S. General Accounting Office. “Barriers to Entry Continue to Limit Benefits of Airline Deregulation,” 5/13/97. 38 Ibid. 39 Ibid. 40 United States General Accounting Office. “Airline Deregulation: Changes in Airfares, Service Quality and Barriers to

Entry,” March 1999. p. 11. 41 Kahn. “Airline Deregulation,” The Concise Encyclopedia of Economics. 42 U.S. General Accounting Office. 20 Years of Deregulation, 1978 to 1998, 1998. 43 U.S. General Accounting Office. Airline Deregulation: Changes in Airfares, Service Quality and Barriers to Entry, March

1999. p. 2.

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By the end of the 1990s, roughly 90% of all passenger miles traveled were traveled on discounted-fare tickets, at an average discount of 65% off the posted coach fare.44

Another Sea Change: The Terrorist Attacks of September 11, 2001 The terrorist attacks on New York City's World Trade Center and the Pentagon on

September 11, 2001, changed the airline industry forever. In an unprecedented move by order of the federal government, the U.S. airline system was suspended for several days following the attacks. According to the Air Transport Association, the industry suffered losses of approximately $1.4 billion as a result of the shutdown. Furthermore, the global airline business lost $11 billion in 2001, with losses in the U.S. market along reaching $9 billion. The ATA's forecast that the U.S. airline industry would lose another $6 billion in 2002 as the turbulence from 9-11 persisted45 proved to be a conservative estimate; ultimately, the net losses incurred by the top ten U.S. carriers alone totaled $11.3 billion in 2003.46

Influential Forces in the Industry Environment Customers

Airline passengers include business travelers and leisure travelers. Business travelers accounted for about 34% of domestic airline revenue in 2000 and 36.3% in 1999, but account for only about 15% of domestic RPMs (Revenue Passenger Miles) and some 10% of capacity.47 Business travelers have historically paid a premium for travel: Despite leisure travelers accounting for around 85% of RPMs, their fares only generated 66% of the revenues.

Leisure travelers are traditionally price-sensitive, so airlines have discounted fares for leisure travelers – typically requiring advance purchase and including restrictions on changes and refunds. Airlines will also offer deeply-discounted last-minute fares to leisure travelers to fill capacity on undersold flights.

Travel-agent intermediaries are the primary distribution channels of air travel to customers, generating roughly 70% to 80% of all airline bookings. Some 135,000 travel agents and 29,000 travel agencies operate throughout the United States.48 However, the rate of bookings conducted through travel agents is declining as travelers have easier access to direct travel bookings through online services. 49

44 Kahn. “Airline Deregulation,” The Concise Encyclopedia of Economics. 45 Corridore, Jim. Standard & Poor’s Industry Surveys: Airlines, 3/28/02, p. 1. 46 Corridore, Jim. Standard & Poor’s Industry Surveys: Airlines, 9/25/03, p. 1. 47 Corridore, Jim. Standard & Poor’s Industry Surveys: Airlines, 3/28/02, p. 3. 48 Ibid., p. 20. 49 Ibid.

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Suppliers In the large commercial aircraft market, there are two main worldwide

manufacturers: Boeing and Airbus. For smaller regional jets, the main suppliers are Embraer, Bombardier, and Saab. Even though these aircraft manufacturers’ business success is significantly intertwined with the success of the commercial airline industry, they also make significant sales to governments and military establishments. For example, 60% revenue of Boeing comes from commercial airplane and 39% from integrated defense system funded by government and 1% from others.50

When acquiring the aircraft, airlines also deal with multiple other vendors, selecting options such as engines--essentially from Pratt & Whitney, General Electric, and Rolls Royce--interiors, and entertainment systems vendors. Most airlines also work with specialty finance companies who structure financing in loans or leases. GE Capital, Boeing Capital, International Lease Finance (ILFC), GATX, and CIT are the leading financiers of aircraft in the world.

Fuel supply enables airlines’ daily operation, and it is a significant expense for the industry. In 2001, fuel costs accounted for about 14.9% of total airline expense. For each airline, fuel expenditures can vary significantly, depending on the age and fuel efficiency of the fleet, and the length of flights conducted by the airline. Variations also come from the fluctuation in oil prices on the world’s commodity markets. Fuel cost in 2001 was lower than in 2000, only 14.9% of total expenses in 2001 compared to 15.4% in 2000. Standard & Poor's reported in early 2002 that “jet fuel price changes are less important today than they were in 1980, when fuel accounted for 30% of industry cost.”51

Most airline carriers have to hedge their fuel costs by striking deals with suppliers or by buying and selling futures on the commodities market. In this way, by setting up financial options, they can limit the fluctuations in fuel prices and have more predictable operating costs.

Another key supplier in the airline industry is the labor unions. Wages and salaries are the single largest operating expense of any airline. The industry is highly unionized, leading to inflexible wage costs and labor structures. There are three large unions in this industry: the Airline Pilots Association; the International Association of Machinists and Aerospace Workers; and the Association of Flight Attendants. Over the last business cycle, from 1992 to 2001, labor costs in the airline industry increased dramatically and gave airlines a heavy financial load. For example, “pilot costs increased by 127% at Continental, 79% at America West, and 59% at American.”52 Labor negotiations between

50 The Boeing Company, online at www.boeing.com, 11/13/02. 51 Corridore, Jim. Standard & Poor’s Industry Surveys: Airlines, 3/28/02, p. 3 52 Unisys, Unisys R2A Scorecard: Airline Industry Cost Measurement, Vol. 1, Issue 1, Oct. 2002; p. 14.

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the airlines and unions consume significant time and effort by management and union representatives, as “at any given time, a half-dozen or more contracts may be in negotiation.”53 Negotiations and concessions at one airline typically causesunions at the other airlines to demand reopening of negotiations to match industry standards--and these tactics and negotiations often causes strife and contention in the industry. Some newer entrants to the industry, such as JetBlue, are not yet unionized, giving them a significant competitive advantage.

Competitors The airline industry is highly competitive, with numerous airlines operating in all

sectors. In the U.S. alone, according to the Air Transport Association, at the end of 2001 there were 15 major airlines (with annual revenues exceeding $1 billion), 39 national airlines (revenues from $100 million to $1 billion), and 46 regional airlines (revenues under $100 million).54 In addition, U.S. airlines compete with non-U.S. airlines for international routes and for alliances that allow customers to find continuing services in routes not covered by U.S. airlines.

In general, there are two basic business models for major U.S. airlines: a full- service model based on hub-and-spoke route maps, and a limited-service, low-cost point- to-point model. In general, airlines that existed prior to the 1978 Deregulation Act operate in the hub-and-spoke model. This is often called the “legacy” model.55 Other airlines, notably Southwest Airlines, developed the low-cost point-to-point model after deregulation.

Legacy carriers may have profound structural disadvantages thanks to the high cost of unionized labor, overly complex route networks, and decades of intensive economic regulation in both the United States and Europe56--which is why newly created airlines like jetBlue Airways are avoiding the limited flexibility imposed by the hub-and- spoke structure by basing their business models on the Southwest model. This new breed of low-cost carriers boasts a less expensive, less unionized workforce as well as the more flexible point-to-point (rather than hub-and-spoke) route structure. In addition to jetBlue, this alternative business model is serving a growing list of profitable carriers like the UK's easyjet, Canada's WestJet, and Ireland's Ryanair,57 which are able to compete toe-to-toe with legacy carriers in many major markets. Their presence benefits even consumers who don't choose to fly them simply by exerting downward pressure on prices.

53 Corridore, Jim. Standard & Poor’s Industry Surveys: Airlines. March 28, 2002. p. 19. 54 Air Transport Association of America, 2002 Annual Report. p. 19. 55 For instance, see comments about “legacy carriers” on p. 3 of Unisys’s Unisys R2A Scorecard: Airline Industry Cost

Measurement report, Vol. 1, Issue 1, Oct. 2002. 56 Dr. Rob Britton lecture at Cornell University, 11/22/02. 57 Unisys, Unisys R2A Scorecard: Airline Industry Cost Measurement, Vol. 1, Issue 1, Oct. 2002, p. 3.

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Despite the inherent competitiveness of this industry, airlines do work together when part of alliance and strategic partnerships. Partnering with one or more competing or complementary carriers allows airlines to offer more services--a broader route network serving more destinations, increased flight frequency, better frequent-flyer programs--at the same time they expand their access to customers and lower their own costs by sharing airport infrastructure, engaging in joint procurement, developing cooperative advertising budgets, and much more.58 Benefits depend on the nature of the alliance--whether it's a marketing or code-share agreement, or even a franchise or equity-transfer relationship. In order to provide international service, for instance, having a global partner means a U.S. airline can feed traffic through to this partner through an international hub, generating cost savings and smooth connection for all parties. For example, Northwest and China Air have developed a code-sharing strategy to exploit the promising China/U.S. line. In the domestic market, airline companies may share cargo and passenger terminals to save cost and consolidate sales. Continental Airlines has an extensive marketing alliance with Northwest Airlines that includes code-sharing and shared frequent-flyer programs.

But airlines also continue to compete fiercely for client bases on particular routes, many times in spectacular price wars. When jetBlue announced a deeply discounted tickets on Oakland, CA to Washington D.C. route in August 2002, it triggered a new “price-war” on east-west coast line. United Airlines responded immediately by matching its fares at the same price level as jetBlue, in the hopes that United will be able to maintain higher fares on other non-competing flights. These price wars have put pressure on airfare yields since deregulation occurred in 1978.

One way to avoid price wars is to develop frequent-flyer loyalty programs. In many cases, the privileges that come with membership in these reward programs-- upgrades, priority on standby, access to business lounges, and so on---are enough to convince members to fly with an airline at a somewhat higher fare than one offered by the competition on the same route.

Flying in Turbulence: The Broad Environment It's scarcely news that 2001 was the worst year ever for U.S. airlines.

– Unisys R2A Transportation Management Consultants 59

External factors have a tremendous impact on any industry--and possibly more on airlines than most industries, due to their high fixed costs and limited flexibility in adapting to changes.

58 Corridore, Jim. Standard & Poor’s Industry Surveys: Airlines, 3/28/02, p. 14. 59 Unisys, Unisys R2A Scorecard: Airline Industry Cost Measurement, Vol. 1, Issue 1, Oct. 2002; p. 1.

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Socio-Cultural Forces Baby boomers believe they possess an inalienable right to travel. Real median

family income (after adjusting for inflation) has increased by 11.8 percent since 1982 alone.60 And as post-World War II babies have matured into affluent boomers with a great deal more discretionary income than previous generations enjoyed, they are using those extra dollars to travel more.61 Younger generations have also been bitten by the travel bug; as travel has become more accessible and affordable, they consider a long- haul flight to Eastern Europe or Southeast Asia to be just as viable as a road trip to the Grand Canyon.62 With increased globalization of business, international travel has also become extremely common for business travelers. According to a 1997-1998 Gallup poll, 81% of the entire U.S. adult population had flown at least once, and two out of every five U.S. citizens flew during 1997-1998.63

However, seasonality in travel demand is a constant issue for airlines. Temporal changes in patterns of travel demand result in overdemand for air travel in some periods and low load factors in others.64 The airlines' product – seat miles – are highly perishable, and excess capacity is a chronic problem. In fact, American Airlines reports that 30% of its seat capacity went unused in 2001.65

Demand for flights in all seasons has turned downward in the wake of the terrorist attacks of September 11, 2001. North Americans felt a new vulnerability to terrorism which they had largely been able to dismiss as somebody else's problem. Airlines – the vehicle of choice for the most devastating terrorist attack on U.S. soil ever – have borne the brunt of travelers' resulting security fears. The tangible results have been devastating: The airline industry experienced a record loss of $7.7 billion in 2001, with air traffic down in all domestic and international markets a total of 5.9 % – the largest drop in air traffic in U.S. history.66 All of the major domestic carriers with the exception of Southwest Airlines experienced substantial financial losses in 2001.67 Similar (albeit less devastating) declines also occurred following the TWA and related hijackings in 1985-86; the Pan Am Lockerbie disaster of 1988; and the Gulf War in 1990-91.

As a result, carriers have been forced to respond with cuts in service; available seat miles were down 2.8% in 2001 over the previous year, with the number of scheduled

60 Goeldner and Ritchie, Tourism, p. 307. 61 Neilsen, Stefan K. "Determinants of Air Travel Growth," World Transport Policy & Practice, Vol. 7, No. 2, 2001; pp. 28-

37. 62 Ibid. 63 Goeldner and Ritchie, Tourism, p. 127. 64 Ibid., p. 124. 65 Dr. Rob Britton, Managing Director of Advertising, American Airlines; lecture at Cornell University School of Hotel

Administration, 11/22/02. 66 Air Transport Association of America, 2002 Annual Report. p. 9. 67 Unisys, Unisys R2A Scorecard: Airline Industry Cost Measurement, Vol. 1, Issue 1, Oct. 2002; p. 1.

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flights are down by about 600 a day. Furthermore, carriers shrunk their fleet size by decommissioning less fuel-efficient and more maintenance-intensive aircraft, and by postponing deliveries on roughly one-third of the new aircraft that they had planned to take delivery on in 2002 and 2003.68

Based on the recovery pattern that followed each of these blows, the airline industry is facing a slow turnaround; it is likely to take some time to build air travel back to what are considered "normal" levels of demand.69 The outbreak of war in Iraq in early 2003 made the possibility of quick recovery little more than a pipe dream for the suffering air carriers.

Further complicating matters post-September 11th has been the increased security measures at airports, which can substantially lengthen flight-departure lead time – sometimes by as much as an hour or more –and add to an increased distaste for unnecessary air travel as travelers find themselves subjected to multiple body and bag searches. Furthermore, extra security taxes have been passed on to passengers,70 resulting in increased ticket prices without any revenue benefit for the already strained carriers. Many short-haul travelers are resorting to other forms of travel in order to avoid such delays and hassles, such as the train;71 Amtrak's Acela trains, for example, can deliver travelers point-to-point along Northeast Corridor routes such as New York to Boston or Washington, D.C., in roughly the same amount of time it takes to fly.

Technological Forces The Internet has revolutionized the way airline passages are bought and sold, and

has opened up a whole new world of direct distribution for carriers. Airlines can sell directly to consumers via their own websites at a fraction of the cost of employing customer service agents to take call-center reservations. Furthermore, easy-to-navigate websites with up-to-the-minute availability, pricing, schedule, and fleet information as well as one-click reservations have diminished the need for intermediaries; as a result, carriers have been able to cut back on base commissions to travel agents.72 According to Standard & Poor's, most major airlines had cut their commission rates to 5% of fares, with a $20 cap on domestic round-trip fares, by late 2001 (down from 8% of fares with a $50

68 Air Transport Association of America, 2002 Annual Report. p. 10. 69 Goeldner and Ritchie, Tourism, p. 125. 70 The Bulletin, "The Price of Airport Security," online at http://bulletin.ninemsn.com.au/bulletin/eddesk.nsf/

All/4DD4F67689A6B1B3CA256C47001FB3DC (viewed 12/2/02). Also ABC KGO-TV, "The Price of Security," 10/18/02, online at