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Wednesday
Jul022008

Grab a Big ‘Ol Cup of Jo, and Let’s Talk Airline Service Cuts

Starbucks, Airlines and Air Service Cutbacks

This morning’s headline in the Wall Street Journal on B1 reads: Starbucks to Shut 500 More Stores, Cut Jobs. The story by Janet Adamy offers many insights as to what is plaguing the airline industry, at least from this observer’s perspective. The announced shutdowns will occur throughout the remainder of 2008 and will continue into early 2009. The 500 store closures announced yesterday are in addition to the 100 the coffee proprietor announced earlier this year. I will highlight some of the points made by Adamy in her story:

· “The pullback is a sign that the Seattle-based coffee giant is continuing to see weak sales as high gas prices and other pressures on consumer spending prompt Americans to cut back on extras.”

· “It also shows how badly the specialty-coffee business is struggling just as mainstream companies, such as fast-food giant McDonald’s Corp., are beginning to invest in it.”

· “Starbucks didn’t disclose which of its about 11,000 stores U.S. stores it will shut, but said the affected stores are spread across all major U.S. markets. About 70% of them have opened since the Fall of 2005, it said”.

· “The purpose of its rapid expansion (2,500 stores globally during the last fiscal year) was to boost sales growth and siphon traffic away from some of its stores where long lines were driving away customers. Also fueling the push was company research that showed people sometimes weren’t willing to cross the street to buy a cup of coffee.”

· Last year, as Starbuck’s sales began to soften, it became clear that the company’s expansion was cannibalizing its sales in a way that was threatening the chain’s success, as well as causing the quality at its existing locations to slip”.

The Ubiquitous Airline Industry

Adamy mentions ubiquity in her story and it absolutely applies to the US airline industry as well. You know: the seeming need to be present everywhere. As we have written here many times: presence everywhere and pricing power nowhere. Ubiquity is synonymous with fragmentation. Fragmentation best describes the US airline industry’s domestic market. [In fact, IATA suggests that fragmentation describes the construct of the global industry’s marketplace.] The US airline industry’s domestic market lies at the heart of the US airline industry’s woes. Hyper-competition has led/contributed to the non-economic prices that persist. So if fragmentation is present and structurally undermining your performance, consolidate around your strengths – right?

Based on the story about Starbucks closing stores let’s talk about the US airline industry and the planned capacity cuts that are known and those that might not be known. We have heard about some airlines either discontinuing service altogether or reducing frequencies to large markets like Ft. Lauderdale and Oakland. Will Ft. Lauderdale and Oakland passengers suffer as a result? My answer is NO as they will have other options available like Miami or on other carriers, mainly those with the outdated low cost carrier moniker, continuing to serve the market. Will Oakland customers suffer? My answer is NO as they will have access to remaining service at OAK and will have a menu of offerings available at alternatives like San Jose and San Francisco. So customers will continue to have options, and options with low cost carrier presence, just as they have before.

Just like Starbucks realizes it cannibalizes traffic with certain store openings, the US airline industry cannibalizes itself with nearly every new service in some way it seems. My numbers may be off a bit here, but hear me out. At one point I was looking at the Greenville-Spartanburg, SC (GSP) to Los Angeles market. At that time there were 100 passengers per day each way (PDEWs) in that market. Those 100 passengers had a choice of 24 nonstop flights to access the air transportation system over 15 different hubs.

So I have 24 nonstops competing for four passengers per flight. As oil skyrockets, how can I possibly raise fares enough to cover the cost with that many consumer choices in the market? Simply, you cannot. Another question should be: how many choices is too many choices for a mid-size market like GSP?

To make matters worse, it can actually be said that carriers competing in that market actually compete with themselves. Delta carries traffic in this market over each its Atlanta and Cincinnati hubs. There are a multitude of examples just like this one where consumer choices to get from A to B are much more than the market can economically support. Unfortunately, it has taken the price of oil to demonstrate that the choices provided air travel consumers over the years cannot be economically sustained in many instances. So just like Starbucks, the US airline industry will pare back choices and consolidate that demand around markets that are, or can be made, economic by consolidating traffic.

So as the Business Travel Coalition paints the landscape with scare tactics, their back of the envelope analysis tells us very little. The BTC fails to mention that in the vast majority of service reduction announcements thus far, passengers demanding service to a particular destination will still be accommodated albeit by fewer frequencies or over fewer hubs – and few will be disenfranchised from the air transportation system.

Another Question I Have: Why Is It OK for Southwest and No One Else?

You know the story. Everything Southwest does is somehow the best and always in the best interest of the consumer. Southwest, circa 1995, enters a market. Fares go down and significantly in some cases. Traffic at that airport market is stimulated. Southwest’s success in entering a market had much to do with expanding the catchment area of that airport market. So while the carrier still only serves less than 65 airport markets in the US, if one were to draw a circle equivalent to a 2-hour drive to that airport, the carrier impacts more than 90% of US domestic air travel demand.

But the question should be: how much of that demand is/was created because air travel was made affordable to some new segment of the population and how much is/was diverted from airport market(s) located within that 2-hour catchment area? It is some combination of the two. Is that stimulation or diversion? The answer is diversion.

There are many examples of airport markets that have suffered as the Southwest’s, jetBlue’s and AirTran’s and other “bottom fishers” entered markets across the US. Their lower costs at the time allowed them the “freedom” to price aggressively while exploiting the bloated cost structures at the legacy carriers that existed. The low fares worked to stimulate new demand all the while diverting traffic from smaller airports with higher prices enveloped by the catchment area. It is the sum of the two - not one or the other.

But why is it OK for Southwest to offer service at an airport and rely on the highway system to be the first leg of access to the air transportation system – all in the name of low fares?

Why is it not OK for the remainder of the industry to cutback frequencies that may result in the highway system being the first leg of access for some – in the name of preserving as much of the network architecture that has been built and can be made economically viable?

The existing network architecture has provided more than sufficient choice for air travel customers in cities of all sizes, not just the largest metro areas that have secondary airports that are the backbone of Southwest, and its LCC brethern, service.

There Is a Lesson Found In Starbucks’ Decisions That Apply

At some point Congress, BTC and others may actually realize that the industry has grossly overbuilt through the over exuberance in the use of regional jets. For many markets it means you will still not have to walk across the street to get a cup – or access in airline vernacular. For others, it will mean having to walk three blocks for a cup. But in any case, you will pay the “all in” cost of that cup. Like Starbucks, you will go for that first or even second cup. The trick for the US airline industry will be the demand for that third cup or the iced cup that lies the heart of the demand equation and the ultimate decision on how much capacity to cut is right.

More to come.