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

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?