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Airline Mismanagement

The recent spate of airline failures has been blamed (especially by the remaining airlines) on high fuel costs and on many other things.

But is that really the reason?  After all, high fuel costs affect all airlines much the same.

Fuel costs might be a reason, but it is not the reason.

Here's a look at another reason why smaller weaker airlines are disappearing.

 
 
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Is Airline Competition Always Fair?

Should established carriers be allowed to sell tickets below cost, and below startup carriers' fares, so as to starve the startup carrier into bankruptcy?
 

RIP Eos Airlines, 2005 - 2008.

Eos is merely the most recent of many airlines that have started up, briefly traded, and then closed down to vanish without trace.

 

 

It is a classic scenario that has been played out many times before.  A new airline starts up, offering a lower priced service on a route that had previously suffered from either very high fares or very few flights.

All of a sudden, existing carriers - by amazing coincidence - discover the same route.  They add extra flights and drop their fares, sometimes to less than half their earlier fares.

The traveling public, which had reacted supportively and with pleasure to the new airline, is now doubly delighted, and flock to their preferred carriers to take advantage of the new services, rock bottom fares, and often other benefits such as double frequent flier miles too.

A vicious cycle of matching discounts and promotions, and too little support for the new airline, sees the new airline fail and disappear.

And then, by amazing coincidence, the established carriers cut back their services, and increase their fares once more.  Within only a few short months, there's no longer any trace of the former massive over scheduling of flights and discounting of fares.

The Department of Justice and the courts believe this to be fair competition and open market forces working the way they should, and has refused to sanction the major airlines when they adopt these tactics.

What do you think?

Another week passes, another airline passes. Or so is the situation at present (this is being written in April 2008), with airlines dropping like flies.  The last week saw the sudden shutdown of Eos - the all first class airline that formerly operated service between London's Stansted airport and New York/JFK.

Background to the Eos Airlines Failure

Eos seemed to have a lot going for itself.  The closure of a competitor in December 2007, Maxjet (an all business class airline, also with service between Stansted and JFK) had presumably removed one source of competitive pressures from Eos; the regular bullish statements from Eos itself about its tremendous ongoing success, growth plans and financial security; and, lastly, a press release barely a week prior to its closure advising that it had secured an injection of additional funding from one of its current shareholders which was described as sufficient to carry them over to profitability in 2009.

All these factors would have seemed to indicate an airline that was growing and thriving.

Here's what Eos said about itself after the Maxjet closure in Dec 07 :

Industry failures, rising oil prices, a weakening economy and planned reductions in corporate travel have neither diminished travelers enthusiasm for Eos Airlines' "uncrowded, uncompromising" Eos Class experience, nor hindered the company's march toward becoming an unqualified business success. Eos today announced record Guests during October and November 2007, citing a surge in passengers of 64% versus the same time last year and 14% since September, after adding 12 additional weekly flights in October. The company recently secured $50 million in equity capital from institutional and private sources and took delivery of their fifth and sixth aircraft. Continued expansion is expected for 2008, with as many as three new routes and the delivery of aircraft seven and eight.

Eos President and CEO Jack Williams commented, "I am delighted that after our second successful year more people than ever are choosing to fly with Eos. Our passenger numbers are at record highs and load factors are consistently strong - including peaks in June (76%), July and September (both 73%). We are flight level profitable and all signs point toward continued success in 2008."

With a strong financial position and backed by committed investors, Eos delivers both service and value by offering a first class experience at fares that are 25% less than traditional carriers' business class. Designing the world's only fleet of Boeing 757s outfitted for just 48 Guests and removing the crowds and stress from air travel has resulted in an unprecedented amount of word-of-mouth endorsement from a community of loyal and like-minded Guests. ...

And here's what Eos said on 19 April about securing more financing

In the face of tight credit markets and an economic environment that has led to several industry failures, Eos Airlines announced today that it has agreed to a term sheet outlining the terms on which Eos will secure an additional $50 million in capital from a current investor. The transaction, which is scheduled to close May 1, 2008, is seen as underscoring confidence in Eos’ business model built around an entirely new class of air travel.

“When we closed on our last round of financing, we were clear that we would need to raise additional capital,” said Jack Williams, Eos President and CEO. “Our success - in the face of this extremely challenging economic and credit environment - shows that investors continue to be enthusiastic about our business model.

“At a time when much of the airline industry is mired in misery, we have provided outstanding service and shown an uncompromising commitment to quality. We’ve achieved an extremely high level of satisfaction among our Guests, many of whom have personally embraced the company and become our de facto ambassadors. We have the most efficient business model, our flight loads have increased and our revenues have risen consistently.

“Now we have a term sheet with a current investor for the financing needed to take us to corporate profitability in 2009. ...

Well, apparently Eos hadn't secured the financing and were a bit premature in sending out their press release, because one week later, they filed for bankruptcy and ceased operations entirely.

'Many a slip 'twixt cup and lip' seemed to be the applicable adage, and the press release advising their closure referred obliquely to 'some issues arose that we could not overcome' that prevented them securing the financing that had seemed to have already been obtained.

Why did Eos Fail?

So, what caused the demise of this airline and are there any lessons to be learned?  Interestingly, the airline avoided trotting out the usual scapegoats, and didn't even refer to high fuel prices at all.

The obvious immediate cause of the Eos failure was the inability to secure necessary additional funding to enable it to continue operations.  The peculiar situation where they first issue a press release announcing an agreed input of $50 million extra funding, and then a week later announce the collapse of the funding and of the entire airline for non-specified reasons leaves much unanswered.

It is not for me to determine the cause of Eos' failure when they themselves prefer not to comment.  Clearly we don't have all the facts at our disposal to fully understand the EOS collapse just yet, in particular what caused the financing they had announced the previous week to evaporate unexpectedly.  But some things are already plain, and have a very familiar ring to them.  We've seen such things many times before, with other startups and other markets.

The pony-in-the-corner, and the odiferous pile of dung associated with it, is the curious coincidence of American Airlines choosing to inaugurate twice daily competing service between JFK and Stansted (STN).

Did AA with its competing flights, complete with aggressive pricing, promotion, and mileage premiums, simply bludgeon Eos out of the market?  The answer to that will be seen as time passes - if AA keeps its STN services and current prices/mileage premiums/etc in place, then we'll know that AA was not acting in an unfair anti-competitive manner.  But if the STN services either disappear or skyrocket up in price, we should draw our conclusions accordingly.

I offered these comments about American's actions in my newsletter back on 5 October 07 :

London's Stansted Airport used to be a little airport north of London that no-one in the US had ever heard of.  Everyone wanted to go to Heathrow (for reasons I've never understood) and would grudgingly accept Gatwick as second best.  Other London area airports such as Stansted or Luton were deemed unacceptable for American flights and passengers.

But then two new startup airlines successfully challenged conventional wisdom.  They started offering flights between the US and Stansted (STN) rather than to LHR or LGW - Maxjet with all business class seating and Eos with all first class seating.  They offered excellent service at massively discounted rates compared to what major airlines were charging for first and business class.

So - guess what.  American Airlines, clearly hurting from the lost revenue caused by passengers switching from their overpriced premium cabins to Maxjet and Eos have suddenly discovered STN and decided they too will offer service to STN.  And, amazingly, AA's fare to STN is massively less expensive than its fare to LHR.  $2730 will get you to Stansted and back, but you could be up for $10,000 and more to get to LHR.

Oh - and you can get up to 12,000 bonus Aadvantage miles too.

What an amazing thing this is, isn't it.  We are expected to believe that American is fairly charging $2,730 to fly to one airport, but is also fairly charging $10,000 + (four times as much) to fly to another airport that is almost the same identical flight distance from New York.

Don't reward bad behavior.  Make a point of booking Maxjet and Eos rather than American, because without them, there's almost no chance that AA's flights to STN will continue, and even if they do continue, what do you think the chances are that fares will remain at a quarter the price of fares to LHR?

The most amazing part of this?  That such behavior on a dinosaur's part is not considered to be unfair by any of the various watchdog organizations (in both the US and UK).

After Maxjet had been forced out of the market in late December, I observed :

Let's see how much longer AA keeps up its discount flights to Stansted now that Maxjet has gone.  Already both BA and Virgin Atlantic have indicated they are slowing down on plans to introduce all business class service across the Atlantic; although neither airline is saying 'we don't need to do this so much now that one of our competitors has already been squeezed off the route'.

I repeat that comment now - let's see what AA does to its frequency of flights to STN and the fares it charges.  There is still one remaining competitor across the Atlantic though that AA may wish to see off - Silverjet, which operates all business class flights between London's Luton Airport and Newark Airport.  So there'll likely be some anomalous pricing and scheduling for a little while longer.

Update, June 08 :  Read the postscript at the bottom of this article for the totally unsurprising outcome of this story.

How to Starve a Competitor to Extinction

This situation highlights the vulnerability of any startup airline operating with only a few city pairs - a dinosaur can come along and bleed them dry. What does AA care if it loses a little money on STN services for a short while, if it kills off a competitor as an outcome - the money it lost on the STN services will quickly be recouped once the competitor is killed.

Indeed, depending on how American costs out those flights - ie marginal or full costing, and how they account for revenue from people flying extra sectors in addition to the JFK-STN flights, you can endlessly debate how much money they may have lost or not lost, and therefore if their rates are fair or unfair.  But, if they did lose some money, it is sure to be quickly recouped as their competitors fail, and if AA now returns their STN services to full rates.  Or, on the other hand, the loss would end if AA discontinues these flights entirely, and AA would then start generating profits by selling the $10,000+ JFK-LHR tickets to the people who would have otherwise purchased the $2730 JFK-STN tickets.

Eos and other similar airlines can indeed construct sensible business plans, operate profitably, and succeed, but for one small thing.  Unfair competitive response.

This is the Achilles heel of all such carriers, and is the blind spot of regulatory bodies the world over who see nothing untoward in an established airline suddenly flooding a market with flights when it previously operated none or only a very few, and with these new flights coincidentally timed the same as the new competitor's flights, and with these new flights at rates that (in this case) are one third the rates they had previously sold fares at.  Amazingly, the same 'regulators' (perhaps an inappropriate term that fails to recognize their passivity and gullibility) still see nothing wrong when, after the new airline fails, the established carriers suddenly cancel the new services and return fares to their historic levels.

Am I the one eyed man in the kingdom of the blind here? Is it only me that sees this for what it is?  Predatory and anti-competitive tactics on the part of established carriers to kill off competitors?

When Price Matching is actually Discounting

I'd written a commentary much as you read above on an industry discussion board, and got the following response back from an airline official :

Gentlemanly competition is more likely to run afoul of our competition laws than playing hardball against a new entrant.  Predatory pricing is a difficult and complex thing to prove.  It is not enough to show its affect on Eos, it is the AA’s ability to recoup its losses in the face of remaining competition.  Returning to the status quo is insufficient evidence of predatory pricing.

Competitors who enter the market thinking they can sell cheaper than an established competitor over the long term need more than high hopes and pre-entry market prices as their guide.

Consider a new gas station opening up across from an incumbent.  The incumbent replies by lowering his price below the new station and answering every competitive move with a lower price.  If the new entrant runs out of money and closes, must the incumbent continue to sell at the lower price?

Note that he is talking about things such as 'hard to prove' and 'insufficient evidence' rather than what is fair and right and proper.

There's a mile of difference between 'gentlemanly competition' (which he seems to offer as a pejorative term) and predatory pricing.  Somewhere along the continuum the overarching concept of 'fair competition' starts and stops - it isn't necessary to exactly define the limits of these grey areas, but suffice it to say that some of us (usually people who don't work for airlines) can readily recognize when those limits are clearly broken.

It is a bit like pornography, isn't it - there are some things which are in a grey area of maybe being acceptable and maybe not, but just because it is difficult to label these grey area things doesn't mean we can't clearly recognize flagrant pornography if we see it.

Only the airlines and 'regulators' seem unable to see the reality of predatory pricing, and to get hung up in the grey ambiguities without looking beyond them to flagrant uncompetitive actions.  There are any number of simple 'smell' tests that can be applied to determine the fairness or otherwise of airline pricing.

One of the major justifications by established carriers - 'we are not trying to kill the other guy, we're just competitively responding to something he started; it's not our fault, he made us do it' is so thin as to be almost completely transparent.  There is a valuable 'bundle of benefits' associated with a mainline carrier that a new tiny startup with a thin route structure can't offer, other than by pricing at a discount to reflect the lack of the soft and not so soft benefits associated with flying on the major carrier.

This 'bundle of benefits' includes such things as more flights to choose from, a frequent flier program, easier luggage transfer on to other airlines, a wider number of cities served, the 'brand equity' of the name brand carrier, airport lounges, and all sorts of various other things.

So when the major carriers set the same price as the discount carrier, they are in effect discounting, because they are including all these other benefits for free.  How much are these benefits worth?  That is hard to say, but let's look at what the dinosaurs themselves tell us.  Bob Crandall (former CEO of American Airlines) used to proudly claim that customers would willingly pay a 30% premium to fly on a name brand carrier, and his fellow dinosaur CEOs all enthusiastically agreed.  The airlines should be held to that claim, and 'regulators' should recognize that matching price responses to an inferior product are actually massively underpricing the new guy (because of all the included extra benefits), not matching the new guy.

It is very rare for an upmarket anything in any industry to respond to a downmarket competitor by selling their superior product at the same price.  Lexus doesn't compete against Toyota on price.  Ruth's Chris Steak House doesn't compete against Denny's on price.  Leather furniture doesn't compete against vinyl on price.  And so on and so on.  But when airlines do this, against a backdrop where they themselves have championed the price differential they claim people will willingly pay, we're expected to nod sagely and accept it as sensible and fair business practice?

It is (or should be) a valid assumption for a new entrant to believe it can sell cheaper than established competitors, as witness the Eos business plan.  Eos' problem was not any difficulty in getting passengers, or in operating profitably on the basis originally projected, and with lower fares than the ruling rates.  Their problem occurred when the established competitors unfairly responded.  If AA had ignored Eos, then Eos would still be laughing all the way to the bank.  There was a clear pricing differentiation between the low Eos fare and the high AA fare - more than the 30% needed to persuade customers to consider a non-mainline carrier - that many passengers felt was sufficient to justify the loss of frequent flier miles and other benefits.  But when AA dropped their prices by two thirds, that differential was no longer sufficient.

We're all grownups here.  We all know that when a major carrier massively increases frequencies, or introduces entirely new services, and when it halves its fares in response to a new entrant, and then when it pulls back frequencies, cancels services, and returns fares to their earlier levels after driving the new entrant bankrupt; we know those actions stink to high heaven and are in no way fair.  Only the airlines and 'regulators' seem able to suggest with a straight face that it is normal and fair.

Comparing Airlines to Gas Stations

As for the gas station analogy by the airline apologist/official, reasoning by analogy is seldom accurate because there is usually not a one to one relationship between the analogy and the situation being directly discussed.  In this case, like most others the analogy is not fair.  But let's make the analogy more fair, and see how it stands up then.

It would be more accurate if the established gas station offered full service and green stamps, whereas the new startup was a self-serve with no attendant benefits.  In that case, it would be unusual and worthy of comment to see the established station price match its superior service and extra benefits to those of the new no-frills startup.  And if it started offering double green stamps as well as price matching, that would be even more astonishing.

As best I remember it, full service (haven't seen any of it around here in years) used to command 20c or more a gallon premium, and that was back when gas was around $1 a gallon, and green stamps (also a thing of the past!) had some sort of trivial value too.  Now substitute concepts like broader network, greater frequency of flights, baggage transfer agreements, frequent flier miles, etc, for full service and green stamps, and you have a fairer analogy.

Back to the gas station.  If the incumbent station started selling below cost (due to the extra costs of full service and stamps) the new station would have valid cause for complaint.  So why not with airline competitors, too?

The Bottom Line - Who Benefits

An underlying assumption of a free economy and unregulated competition is that market forces are fair and end up giving consumers the best values and services as a result of the competitive pressures acting on the marketplace suppliers.

Can anyone talk about best values and best services, and the airline industry, in the same sentence and keep a straight face?

When Eos started service, there was a clear benefit to travelers.  Some travelers who couldn't previously afford first class tickets could then enjoy first class at a reasonable price, and other passengers who were choosing to pay massive premiums for first class could then do so with huge savings.  The consumers won from the competition.

But when American Airlines in effect undercut its competitor, and caused Eos to lose so much money that investors apparently lost confidence in it and refused to help it grow to profitability, Eos was forced to close down, and the consumer benefit disappeared.

I'm absolutely not advocating a return to a fully regulated airline industry.  But when the free market assumption proves to be failing, as happened with first Maxjet and now Eos, maybe it is time to consider some simple pricing and scheduling parameters which airlines must meet.  These would be easy to create, and even if the airlines could partially cheat in their responses and implementations, there might be sufficient control placed on the marketplace to allow quality discount carriers to succeed, which is, after all, surely what we as passengers most want.

Postscript, June 2008

The last of the three all premium cabin private airlines, Silverjet, closed down suddenly at the end of May.

Within days of that event, American Airlines cancelled its services to Stansted.  They have disappeared, and so too has their very low competition killing $2730 fare.

This is completely counter-intuitive.  In any other business environment, the loss of competitors in a marketplace means the remaining supplier(s) can expect more business and more profit because they have a larger share of the market, and don't have to contest it so fiercely with other competitors.  If there was a bona fide business case for AA starting service to Stansted last year, the loss of its two Stansted competitors, making it the only remaining airline operating that route, and the loss of the closely related competitor to Luton should have encouraged AA to add extra services, not to cancel their service.

Was it a coincidence that AA started competing service, and then ended it as soon as its competitors had been starved into submission?  Was it fair competition?  Or is it something more nefarious?
 

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Originally published 2 May 2008, last update 08 Jul 2017

You may freely reproduce or distribute this article for noncommercial purposes as long as you give credit to me as original writer.

 
 
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