Does the Withdrawal of Capacity Help?

As industry prices fall, and companies’ fortunes decline with the resultant squeeze on their margins, some companies, especially the leaders, seek to withdraw capacity from the market.  The leading companies expect the capacity withdrawal to do two things: redress the imbalance between capacity and demand; and raise prices to more attractive levels because of this better balance.  In practice, the withdrawal of capacity often fails to achieve either of these objectives.

Whenever a leader in an industry reduces its capacity to force price increases, it must consider how competitors will respond.  In many, if not most, cases low-cost competitors expand their capacity to make up for the withdrawal of capacity by the industry leaders.  The end result often is even more capacity available in a marketplace and the same or lower prices available for the industry leaders.

After several quarters of improving profits, the airline industry is again slipping into hostile market conditions as rising fuel prices reduce margins and force higher prices.  Higher prices limit demand growth.  In response to the margin squeeze these tougher times bring to the industry, the industry leaders are restricting the growth in their capacity and, in some cases, reducing the capacity they offer in the domestic U.S. market.  The problem is that several of the industry followers are not going along.

United Continental Holdings and AMR Corporation’s American Airlines have both posted losses for the most recent quarter.  Both of these industry leaders plan to reduce their domestic capacity as a result.  They will be reducing seats available flying into and out of selected domestic markets. 

The pattern of leaders reducing capacity and followers adding it seems to be holding in the current airline industry.  Southwest Airlines, JetBlue Airways and Alaska Air Group derive most of their revenues in the domestic U.S. market.  Each of these companies reported profits in the most recent quarter.  This profitability of the three follower airline competitors indicates that their costs are lower than are the costs of the two legacy airlines that have reported losses, United Continental and American Airlines.  Southwest plans to increase its capacity by 5% to 6% in 2011.  JetBlue plans to add 6% to 8% this year, while Alaska Air plans to grow its capacity by 9%. 

The industry followers are able to add capacity in the face of capacity withdrawal by their larger industry-leading competitors because they have these lower costs.  The lower costs enable the follower companies to make a profit while their larger competitors suffer losses.  In the long run, the only way that the industry-leading competitors will be able to stop the expansion of these follower competitors will be to match or beat their lower cost structures

I Guess it Takes Bankruptcy...

In our previous blog (see Here), we described the resuscitation of the comatose manufacturing employment due to renewed flexibility in many union shops, such as GM. I guess it takes bankruptcy to get attitudes to change. Look at American Airlines, for an example.

Over the last several years, its big airline competitors have been getting bigger. United and Continental combined, as did Delta and Northwest. U.S. Airways merged and Southwest has just purchased Air Tran. Through it all, American stood largely on the sidelines.

Most of the other competitors had a real advantage. They went through bankruptcy. Of course, Southwest did not, but the other legacy carriers did. What those airlines and their workforces learned in bankruptcy created a lower cost and more flexible set of work rules for these airlines. Now American Airlines is beginning to pay the price for its competition with lower cost airlines.

American is clearly a high-cost airline. Its 2010 cost to fly a seat mile is 12.76 cents. This is the highest among the six largest carriers. Predictably, its pretax margins for the first half of the year were negative, while its peers produced positive operating earnings.

The problem American faces is primarily due to high labor costs. This may surprise you since several of the unions agreed to give-backs in 2003. Further, the American Airlines pilots claimed to be working at 1993 hourly rates. In short, all the unions working at American seem to be up in arms in frustration over their lack of economic progress.

The problem is less the rate of pay for the workforce than it is the work rules. American is at the bottom on industry measures of productivity because of restrictive work rules. Does that sound like the American automobile industry’s problem before the recent spate of bankruptcies?

Still, the unions are up in arms. Despite long term negotiations, the company has reached little in the way of agreements. Some unions are now threatening a strike. Let’s see. Take a high cost airline that is losing market share, increase its costs and scare away its future passengers with a threat of a strike. That sounds like a prescription to insure the future of an airline and the jobs that go with it, doesn’t it?

A Low-End Competitor with Low Industry Costs

Southwest Airlines is an unusual competitor. Since its inception, the company has been a low-end, discount competitor. What makes it an odd duck is that it provides service levels equivalent to the industry’s large legacy carriers while it also has very low costs compared to the industry’s erstwhile leaders, such as Delta, United and American Airlines. Southwest enjoys this low cost structure because it is less encumbered by onerous union work rules. Southwest has unionized employees, but their work rules are less restrictive than are those of the legacy airlines. Southwest uses this low cost structure to reduce prices and gain share against their larger legacy competitors. This has been going on for long enough that Southwest really is approaching industry leader status, if it’s not there already. Surely flying Southwest has become nearly as convenient and comfortable as flying one of the legacy airlines. The service of the legacy airlines has come to the level of Southwest, rather than the other way around.

Now Southwest has the economic where-with-all to do things that the poorer legacy airlines can not afford to do. For example, the company has made a major financial commitment to a new air traffic control system called “Required Navigation Performance” (RNP) routes. RNP is next generation technology that allows a flight to be less costly for the airline and more comfortable for passengers. (See the Symptom & Implication, “The industry is adding new, more efficient capacity in the effort to reduce costs” on StrategyStreet.com.) Airplanes can shorten their flights because they are able to use narrower and shorter descent patterns, reducing time and fuel. Passengers will find the descent more continuous, quieter and more comfortable.

This new technology will set Southwest back by $175 million. It put each of its pilots through ground school training on the new cockpit equipment and rewrote all of its flight procedures. Southwest made this investment on its own ahead of its competitors. The legacy carriers have delayed their own investments, hoping that the government will subsidize them. They can not afford this investment as easily as can Southwest. So, here we have a low-end competitor who has become an industry leader and continues to invest to reduce its operating costs and improve its performance for customers. (See “Video #46: The Place of Cost Management in Hostility” on StrategyStreet.com.) These investments slowly bleed away the advantages of the legacy carriers, adding to their economic strife.

There have been other low-end competitors who have been able to rise to industry leader status by taking advantage of the onerous work rules of their unionized competitors. The Japanese automobile manufacturers, especially Toyota, Honda and Nissan, certainly took that path. It appears that Hyundai is now following their lead in today’s automobile market.

An Update on Cutting Capacity to Raise Prices

Several months ago, we wrote a blog (See Blog Here) that noted the capacity reductions in the airline industry. In particular, the large legacy airlines were reducing their capacity in order to raise industry pricing. At the time, this effort was showing relatively little help with industry pricing.

As part of this original blog, we noted that there was a problem with the withdrawal of capacity in order to force prices up. The problem is expansion of capacity by low cost competitors. We explained that we had seen many cases in other industries where industry leaders reduced capacity to force industry prices up, only to be stymied by the addition of capacity by low-cost competitors.

Well, some new numbers have shown that the same thing is happening in the airline industry. AirFinancials.com has measured the change in domestic capacity of the airline industry between 2003 and 2009. The four largest legacy carriers, Delta, American, United and U.S. Airways, reduced their available seat miles, the best measure of domestic capacity, by 85 billion miles, a 21% average reduction. However, during the same period of time, low-cost competitors, including Southwest, JetBlue, AirTran and four other smaller carriers, added 84 billion available seat miles to their capacity. (See the Symptom & Implication, “Foreign competitors are expanding with low prices” on StrateyStreet.com.) So the legacies reduced capacity by 85 billion and the smaller, low-cost carriers, added 84 billion. The industry’s total capacity dropped by 1 billion available seat miles, far less than demand has fallen over the last year. Price competition and low industry returns continue.

The legacy carriers are shrinking away their network and scale advantages to the low-cost carriers. The low-cost carriers are more than happy to replace the capacity that the legacy carriers drop. (See the Symptom & Implication, “Some competitors are using growth to reduce their costs” on StrategyStreet.com.) Bad news for the legacy carriers.

Price Increases in a Recession

Our recession continues, but not every industry suffers in this recession. One industry that is not suffering today is the auto rental market. The average rental rate, at an airport, for a compact car in 2009 was up over 50% from that of 2008. This, while demand in 2009 fell 20%. What accounts for this surprising result of a price rise despite a fall-off in demand? Capacity reduction. (See “Audio Tip #116: The Withdrawal of Capacity to Raise Prices” on StrategyStreet.com.)

The industry reduced its fleet size by an average of 25% in 2009. And capacity is down by 50% compared to a few years ago. This capacity reduction has given the industry power to raise its prices because the industry is running at a high rate of its fleet utilization. (See Audio Tip #101: When is Price Likely to go up in a Market?” on StrategyStreet.com.)

The industry learned to reduce its capacity in order to get pricing power in 2001. The 9/11 attack led to a steep decline in business and leisure travel. In response to that, most major auto rental companies reduced their fleet numbers. Fleet sizes dropped 20% to 25% in the industry. This gave the industry pricing power despite the fall-off in demand. For example, Hertz raised its daily rates an average of 10% and weekly rates an average of 26% during this period.

Of course, the risk is always that low-cost/low-priced competitors do not go along with the industry-wide reduction in capacity.

Not all of the industry reduced its capacity in 2009. For example, off-airport auto rental locations, many of which are the home of low-cost/low-priced auto rental competitors, saw weekly rates rise by 12% in 2009 compared to 2008. Obviously, the capacity reduction was not as great in that market. Something similar happened in 2001 when Enterprise Rent-A-Car, a low-cost competitor, announced that it would not follow the industry leader’s plans to reduce capacity.

If the industry leaders reduce capacity but low-cost competitors do not follow, the low-cost competitors will gain share (see “Audio Tip #136: Should we put our Product on Allocation” on StrategyStreet.com). Enterprise Rent-A-Car is now the largest auto rental firm in the U.S. Southwest Airlines continues to gain share against legacy airlines, who have reduced their capacity by more than has Southwest.

The End of This Story is Predictable

For a while last year, it looked like the legacy airlines were well on their way to profitability. Business and international demands were strong and the companies had pricing power. The legacy airlines attributed much of this pricing power to their strategy of removing capacity from the marketplace. Let’s look at how that capacity removal is working out over time across the entire industry.

Recently, the Wall Street Journal’s “The Middle Seat” column conducted an analysis of some Morgan Stanley research data. The analysis evaluated changes in capacity in the industry over the recent months. They found that the legacy carriers, such as American and United, were seeing competitors grow faster than they did on overlapping routes. The faster growing competitors included jetBlue Airways and Southwest, the usual suspects. Southwest grew aggressively in Denver, while Frontier Airlines shrank capacity there. JetBlue grew in the Caribbean region as American Airlines pulled capacity from those routes. So as the legacy carriers, the industry’s Standard Leaders, reduce their capacity, the industry’s low-cost carriers, in this case Price Leaders, expand to take their places.

Why would the low-cost carriers be able to expand in a market where the industry’s legacy carriers are losing money? The answer lies in costs.

Recently, Scott McCartney, the author of “The Middle Seat” column in the Wall Street Journal’s travel section, cited another analysis from the consulting firm Oliver Wyman. Some of these conclusions were striking and scary for the legacy airlines:

* In 2003, low-cost carriers carried 26% of domestic passengers. By 2007, they carried 31%. These Price Leader airlines have been able to grow in both up and down markets.

* In the third quarter of 2008, the legacy carriers’ average revenue per seat mile was 12.46 cents, while their costs per seat mile were 14.86 cents. The airlines were losing money on each seat mile.

* The low-cost airlines fared better during the same period. Their revenue per seat mile was 10.92 cents, while their costs were just 10.87 cents. Note that the average unit cost of the legacy airlines during that period was 35% higher than the average unit cost of the low-cost carriers.

* The absolute spread between the legacy and low-cost airlines is increasing. In 2003, the low-cost airlines had a cost advantage over the legacy airlines of 2.7 cents per seat mile. By 2008, the gap was 3.8 cents. In both cases, though, the percentage gap has remained about the same.

The reason for the growth of the low-cost carriers compared to the high-cost carriers is, in part, due to their different growth rates. (See the Symptom and Implication, “Some competitors are using growth to reduce their costs” on StrategyStreet.com.) The low-cost carriers are expanding. They are able to hire employees at the bottom of the tiered wage scales. On the other hand, legacy airlines are shrinking, so they have a harder time reducing unit costs. Many of their employees are already at the top of their wage scales.

These analyses should serve as important warnings for the legacy carriers. They are no different than U.S. Steel or Bethlehem Steel, Chrysler or General Motors. If these Standard Leader companies can not achieve cost levels equivalent to those of the low-cost carriers, they will inevitably cease to exist in their current form.

Some of the legacy carriers have labor contracts coming up for renegotiation. People costs make up about 60% of the costs of legacy airlines. I hope that the representatives of these employees are reading the same studies that we are. Restrictive work rules, rather than hourly rates of cost, are the usual culprits when low cost competitors are competing with unionized Standard Leaders. These work rules spread jobs around and ease the burden of work on the unionized employee. They also open an umbrella over non-unionized or less-unionized employees in competing companies. This begs the question: What good are these work rules if the employee does not have a secure job…or any job at all?