Fare War Triggered By Delta Could Lead To The Carrier’s Demise
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Airline Business Report
January 17, 2004 l Joe Burey
The bold move by Delta Air Lines [DAL] to slash fares up to 50 percent will accelerate an industry
restructuring that could lead to a bankruptcy filing by Delta itself, according to Vaughn Cordle, an
analyst with Airline Forecasts LLC who has become a leading voice in highlighting the enormous
challenges facing legacy carriers.
Delta first introduced its new fare structure, dubbed SimpliFares, in August 2004 in Cincinnati, its
second-largest hub. The airline contends the fare cuts have been working as envisioned in that test
market. But Cincinnati is a highfare airport, and it only stands to reason that cutting fares at a high-
fare airport would stimulate business dramatically, according to Cordle. He does not believe this
will be the case for many low-fare airports around the country. In fact, Delta could end up in
bankruptcy, in large part because of its actions to simplify and cut fares. When considering
additional factors such as high oil prices and excess capacity, triggering an industry-wide fare war
could be a “recipe for disaster,” Cordle said in an interview with Airline Business Report.
Delta’s CEO, Jerry Grinstein, insists he is responding to demands from passengers. “We’re
expanding SimpliFares based on feedback from our customers, who are calling for simpler, more
affordable everyday fares,” he said. But while Delta felt compelled to take action to ward off the low-
cost sector, its fare-cutting efforts may have some serious negative consequences for all legacy
carriers. Cordle believes Grinstein is overestimating the ability of the fare cuts to stimulate new
business and underestimating the revenue hit from fare cuts (see stories, pages 6 and 7).
Before Delta announced the new fare structure, Cordle envisioned 2005 as a breakeven year for
the airline industry, but only if oil prices dropped to about $32 or $33 a barrel. “But the fare wars
have already started, and that could knock off a few billion dollars,” he said. He estimated that the
airline industry could lose from $1 billion to $3 billion from the ongoing fare war, assuming it
continues throughout the year. Therefore, if a barrel of oil costs about $42 this year, and that is a
reasonable projection, and the fare cuts stick industry-wide, airlines could lose about $5 billion in
2005.
The fallout from Delta’s decision could have vast ramifications. For example, Continental Airlines
[CAL] said it has to cut labor costs by $500 million by the end of February. Other carriers in jeopardy
are America West Airlines [AWA], Independence Air [FLYI] and possibly Delta, which still has to
shed 25 percent of its debt. Cordle believes “it is a given” that US Airways [UAIRQ] will go out of
business, especially in the wake of the negative publicity it received from the employee sick-out
over the holidays. “There could be a series of bankruptcies, including Continental, if it does not get
its costs down,” Cordle said. He added that cash levels of America West and Continental will reach
critical levels if yields (average fares) continue to decline and oil stays above $40 a barrel.
US Airways may have to liquidate before March. With new labor contracts and help on its aircraft
leases from General Electric [GE], it can pay its bills. But the threat is that labor disruptions and
negative publicity will hurt forward bookings and revenue to the point the airline cannot recover.
Jetblue Airways [JBLU] and Southwest Airlines [LUV] know this, and that is why they are picking up
the pace in introducing lower fares in US Airways’ markets, according to Cordle. Delta’s pricing
strategy means the days of aggressive “yield management” are over — unless Delta rescinds the
new fare structure. Southwest Airlines is generally credited with taking the lead in terms of fair and
consistent pricing. It’s the beginning of the end of “gotcha” pricing by the legacy airlines, according
to Cordle. Historically, high load factors in the industry have masked big yield declines.
Traffic is now above 2000 levels but business and leisure fares are 25-35 percent lower. It is a
matter of too many seats chasing too few passengers who are willing to pay the price airlines
require to make a profit. Cordle views it as a war of attrition, and the airlines with the strongest
balance sheets and most efficient operations will win in the end. Cordle has believed for some
time that average fares will continue to decline. It was his opinion that legacy carriers would need to
move toward a fair and consistent pricing scheme that does not alienate customers, especially
coveted business customers. Until the move by Delta, legacy carriers maximized revenues by
putting restrictions on tickets through a sophisticated system of yield management.
By taking away restrictions and eliminating the wide volatility of fare prices, Delta in effect is
lowering it average fares. Like other legacy carriers, Delta was afraid to take the revenue hit in the
short term by revising its complicated yield management system. But now that it took the plunge,
other legacy carriers have been forced to go along. It would be a “PR nightmare” for legacy carriers
if they did not match the new Delta fares, according to Cordle.
>>Contacts: Vaughn Cordle, Airline Forecasts LLC, (703) 830-1701; Tom Parsons, Bestfares.com,
(800) 576-8255; Anthony Black, Delta Air Lines, (404) 715-4132.<<
New Price War Seen As Ill-Timed By Some, Long Overdue By Others
Wall Street analysts are divided about whether the move by Delta Air Lines [DAL] to slash fares was
long overdue or will precipitate a messy and ill-timed restructuring that triggers multiple
bankruptcies among legacy carriers. While all legacy carriers have been thrown into the pricing
vortex, US Airways [UAIRQ] is particularly vulnerable to going out of business. Low-fare airlines are
not expected to adjust their prices because their fares already are the lowest in almost all the
markets they serve.
Delta cut domestic fares by as much as 50 percent, and Helane Becker, an analyst at the
Benchmark Company, views the move as “revenue negative” for the carrier. It is likely to cost Delta
hundreds of millions of dollars, if not close to $1 billion, according to Becker. “The industry should
be raising fares, not lowering fares to cover higher jet fuel costs,” she said. "We view this move to
be hugely negative for Delta and for the airlines in general. ”The decision by Delta quickly cascaded
through the airline industry, putting additional pressure on already-weak airlines operating under
Chapter 11, including US Airways, which she does not believe will emerge from bankruptcy
reorganization, and United Airlines [UALAQ], which is having difficulty putting together a plan of
reorganization. Most people in the airline industry appear “disgusted” by Delta’s decision to
establish a new fare structure, according to Becker. She thought this type of fare program would
have occurred at the start of the second quarter, when the industry was generating cash — not the
first quarter when the industry is burning through cash. It looks as though Delta took its pilot cost
savings and applied it to the lower-fare program, so nothing has changed with respect to the
outlook for the carrier, according to Becker. “We expect Delta to have its back against the wall again
later this year,” she said.
This harsh assessment contrasts sharply with the view of Robert Ashcroft, an analyst at UBS
Investment Research. He says Delta is on the right course by substantially reducing walkup (i.e.,
business) fares and eliminating conditions for getting lower fares. Alienating business travelers by
charging high multiples of what leisure travelers pay was always a bad idea for a service business,
according to Ashcroft. While the experiment may be negative for Delta initially, he said it is
necessary to put it in perspective, especially if the move helps tip US Airways into liquidation. “It is
difficult to assess how revenue ‘dilutive’ this initiative might be,” he said. “But if it were a $500
million hit to Delta in 2005, we estimate that would be equivalent to a $7 increase in oil and less
than the possible gain we think Delta would get from a US Airways liquidation, which value-pricing
makes more likely, in our view.” Northwest Airlines [NWAC] pounced on Delta before the details of
its new fare structure came to light. In a statement, it said the new fares “would immediately
adversely and significantly affect industry revenues.”
The Business Travel Coalition then pounced on Northwest, saying the statement telegraphed that
Northwest did not contemplate changes in its fares in response to the move by Delta. Kevin
Mitchell, BTC’s chairman, threatened to call upon the U.S. Department of Justice and state
attorneys general to investigate. Of course, Northwest and the other legacy carriers quickly matched
Delta’s lower fares in select markets.
Michael Linenberg, an analyst at Merrill Lynch, immediately cut ratings on several airlines after
Delta’s announced it would simplify its entire domestic fare structure. He believes the move by
Delta will highlight the formidable position of the strongest low-cost carriers: Southwest Airlines
[LUV] and JetBlue Airways [JBLU]. Industry-wide adoption of the Delta domestic fare structure could
mean annual revenue dilution of roughly $2 billion to $3 billion, Linenberg said. He views the move
as a negative for major carriers whose revenues continue to lag costs. But he concurs that one
possible outcome of Delta’s more aggressive fare structure could be the demise of US Airways,
which overlaps with about 60 percent of Delta’s domestic revenue. If that were to occur, it would be
positive for the industry.
The move by Delta is reminiscent of an attempt by American Airlines [AMR] to restructure airfares in
1992. That program was called “value pricing,” and when it was launched, airline shares rose as
the market embraced a simplified fare structure. But several months later, and after most carriers
matched (and even tried to undercut American’s fare initiative) major airline shares declined 20-30
percent, and the value pricing was withdrawn by the end of the year. Not surprisingly, low-fare
carrier Southwest was generally unaffected during the value pricing phase and publicly stated that it
“would have to raise fares to match American’s new fare structure.” Similarly, Southwest’s share
price appreciated by about 30 percent as major carrier stocks declined by the same magnitude.
The irony of the American led value pricing initiative was that American saw a much greater drop in
unit revenue than the competition.
Linenberg noted that American’s net unit revenue fell 6.5 percent in the September quarter of 1992
compared to the year before while United only had flat unit revenue during the same period.
Linenberg said he would not be surprised if Delta sees a similar result this time around. Delta’s
new SimpliFares policy is not a calculated effort to push US Airways over the cliff, according to
Jamie Baker, an analyst at JP Morgan. But he doubts that the US Airways business plan envisioned
sharp fare reductions this soon. Baker has long advocated fare reform, but has acknowledged the
near-term cost. Long-term revenue prospects will likely be improved for legacy carriers, but 2006
seems far away. “We can easily envision a 3 percent reduction in aggregate 2005 revenue
production, roughly the same as a $7/bbl increase in crude,” he said.
Tom Parsons, CEO of Bestfares.com, said the move by Delta is good news for smaller and mid-
sized airports. "Passengers have been abandoning smaller airports and driving to the low-fare
cities to save a buck,” he said. In addition, the less-restricted airfares by Delta now deter the
traveler from leaving nearby airports to get big airfare savings.
Terry Trippler, the president of the online travel agency terrytrippler.com, said that when all the dust
settles, the new air fares will be very close to what American, Continental Airlines [CAL] and
Northwest are adopting. Northwest was right when it said Delta’s lower fares would adversely
affect industry revenues, he said. "Regardless of the packaging, any fare restructuring in which the
average fare paid does not increase can only send an airline to bankruptcy court,” Trippler said.
“You can’t continue to sell a product for less than it cost you to produce it — no matter how it is
packaged.” Trippler does commend Delta in one regard: One way to generate revenue is to lower
first class fares, and he believes Delta got it right in this case. If first class is offered at $1,000 and
no one buys, the first class cabin is filled with frequent flyer upgrades. In this extreme scenario,
income from the first class cabin is zero. But if first class fares are lowered to around $450, people
would start to buy and income from the first class cabin would increase substantially.
>>Contacts: Helane Becker, the Benchmark Company, (212) 312-6764; Terry Trippler, terrytrippler.
com, (612) 339-0904; Jamie Baker, JP Morgan, (212) 622-6713; Kevin Mitchell, Business Travel
Coalition, (610) 341-1850; Michael Linenberg, Merrill Lynch, (212) 449-7170; Robert Ashcroft, UBS
Investment Research, (203) 719-6064; Tom Parsons, Bestfares.com, go through media relations
at (800) 576-8255.<<
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