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Wednesday
Mar062013

US and AA: AIRLINE MERGER and SMALL COMMUNITY AIR SERVICE MEET AT LGA AND DCA

Note:  this blog is largely comprised of the text contained in a white paper written by me, William S. Swelbar. I would like to acknowledge Mr. Michael D. Wittman for his data collection efforts and deft analytical work that is included in the white paper. All of the air service related tables included in the white paper have a basis in Mr. Wittman’s research.  The conclusions and implications are William Swelbar’s.  The airports are referenced as large, medium, small and non-hub per the FAA’s definition of airport size.

EXECUTIVE SUMMARY

Small community air service and the structural factors that threaten it are certain to be a topic for policy makers in the immediate future.  The threats begin with the per barrel equivalent price of jet fuel in excess of $120; the fact that there is no replacement aircraft in production or even on the drawing board configured at 50 seats or less (the right size for small community air service) because of the high price of oil and associated capital costs [other than the ATR-42]; a looming pilot shortage that will impact the regional sector of the industry before it impacts other sectors; the new flight time/duty time regulations scheduled to be implemented in 2014 that will only exacerbate a potential pilot shortage; and new legislation that requires 1500 hours of flight time for a regional pilot versus the current 500 hours.

Many of these factors stem from past policymaking decisions. The unintended consequences will be reduced service to the nation’s smaller communities.  As the U.S. nears the end of the airline industry consolidation process, policy makers may be faced with yet another decision that could have a further negative impact on small community air service:  a reallocation of slots at each Washington Reagan National Airport (DCA) and New York LaGuardia Airport (LGA) because of the proposed American Airlines – US Airways merger announcement.

If slot divestiture is decided to be necessary, there are important facts to keep in mind:

  1. It is the network carriers that are the air service lifeline to small community markets keeping them connected to the national and global air transportation grids – not the low cost carriers;
  2. In 2012, US Airways offered service to 40 small and non-hub markets from Washington – DCA while all the low cost carriers combined served 2 such markets;
  3. In 2012, Delta Air Lines offered service to 25 small and non-hub markets from New York – LGA while all the low cost carriers combined served 3 such markets;
  4. Even before any slot divestiture, service to small and non-hub markets from each DCA and LGA is less than 20 percent of the total service offered from each respective airport.  To disenfranchise these small markets from one or two of their largest passenger demand markets would not be good policy; and
  5. Today’s perceived low fare carrier is not yesterday’s low fare carrier:  Between 1995 and 2011, average fares for the low cost carriers as measured by yield increased 45%, average fares for Southwest increased 41% and average fares for the network carriers increased only 14%.

Small community air service faces numerous headwinds just to remain viable over the medium and long-term.  Some of those headwinds cannot be controlled while others stem from policy decisions already put in place.  To exacerbate a situation where small community air service would certainly suffer if slots were to be required to be divested at each DCA and LGA would not be good policy at this late stage of industry consolidation.

BACKGROUND

There is little dispute among the analyst community that the announced intent on February 14, 2013  to merge American Airlines and US Airways will result in the last “big deal” among U.S. airlines.  In the final analysis, the four largest U.S. airlines (American/US Airways, Delta, United and Southwest) would possess more the 85 percent of the capacity flown domestically.  While there may be some consolidation among carriers comprising the remaining 15 percent, no remaining transaction will be the size of American and US Airways or the three transactions that preceded it. 

American Airlines and US Airways have networks that are largely complementary—there are only twelve domestic city-pairs that receive duplicate service by both airlines out of nearly 900 routes in the combined AA-US network.  However, the combined slot holdings of the merged airline at each Washington Reagan National Airport (DCA) and New York LaGuardia Airport (LGA) will undoubtedly receive scrutiny by the US Department of Transportation (DOT) and the US Department of Justice (DOJ).

We don’t have to look too far back in time to find a transaction that involved slots at DCA and LGA.  In August of 2009, US Airways and Delta Air Lines entered into an agreement to swap slots with each other at each DCA and LGA.  In the initial transaction, US Airways agreed to transfer 125 slots at LGA to Delta in exchange for 42 slots at DCA.  Delta was seeking to expand its presence at LGA to establish a domestic hub just as US Airways was looking to augment its position at DCA and bolster connectivity for an increasing number of small communities it proposed serving from National. 

Per the initial transaction, “US Airways would raise its share of departures at DCA from 47 to 58 percent. US Airways' share of slot interests at DCA...would increase from 44 percent to 54 percent...Delta would ascend to a dominant position at LGA, raising its share of departures from 26 percent to 51 percent. Delta's share of slot interests at LGA would more than double, growing from 24 percent to 49 percent.”  To protect the “public interest”, the FAA proposed a divestiture of slots.  The slots would largely be made available to Southwest Airlines and other so-called low cost carriers (LCCs).  This was found to be unacceptable by each Delta and US Airways.

In 2011, a compromise deal was reached between the two carriers and the FAA.  The compromise deal shifted about 20 percent of the LGA slots from US Airways to Delta where about 3 percent of those slot holdings were divested.  At DCA, about 8 percent of the slots were transferred from Delta to US Airways and 2 percent of the slots were divested.  Ultimately this framework was approved and a final order was issued permitting the transaction to move forward.

If slot divestitures are ultimately required at DCA and/or LGA as a result of the combination of American and US Airways, then the same type of analysis of the “public interest” is necessary.  Some regulators, as well as Southwest and other so-called LCCs, will likely suggest using the AA-US merger as an opportunity to reexamine the service makeup of these slot controlled airports. They are likely to claim that at this late stage of consolidating the U.S. market structure to be one of the last opportunities to readjust the competitive profiles at LGA and DCA.  However, an important tradeoff exists between allocating slots to LCCs instead of network carriers: while additional LCC slots may contribute to more robust frequency competition in highly-served city-pair markets or to vacation destinations, it is unlikely to bolster service to struggling small community airports.  On the other hand, further network carrier service allows for small communities to remain connected to the strategically and economically important Washington and New York markets. 

While the network carriers have invested hundreds of millions of dollars in their respective operations to ensure that these smaller markets have access to the nation’s and the globe’s air transportation grid, LCCs have traditionally shown very little interest in serving smaller U.S. markets

In 2012, 44 small and non-hub sized markets received nonstop service at DCA.

In 2012, 35 small and non-hub sized markets received nonstop service at LGA.  

Given the strength of the small community air service network provided from both DCA and LGA and US Airways’ concerted effort to build a connecting hub at Washington National to connect northeastern and southeastern U.S. cities, a comprehensive slot divestiture program at these slot controlled airports as a result of the AA-US merger would likely have a detrimental effect on the nation’s smallest airports that have already been negatively affected by network carrier capacity reductions over the last six years.

TRENDS IN SMALL COMMUNITY AIR SERVICE ACROSS THE ENTIRE U.S. TRANSPORTATION NETWORK

Small community air service as a whole has suffered in the last six years. As a result of the rampant increase in the price of jet fuel and the prolonged economic downturn, U.S. airlines—in particular, the network carriers—began to rethink their service strategies. As a result, the entire U.S. air transportation system has seen a wide-scale reduction in both departures and seats since 2007. Between 2007 and 2012, nearly 1.7 million yearly departures have been removed from the US domestic system in response to the economic shocks mentioned above.  While most U.S. airports were affected by this newfound “capacity discipline,” a disproportionate share of the cutbacks occurred in the non-large hub airports.  In 2012, only 40.6 percent of US domestic departures were flown in non-large hub markets as compared to 44.2 percent in 2007 when there were 1.7 million additional departures.  A large percentage of this reduction in service was due to network carriers—on average, network carrier flights were cut by 27.2% at smaller U.S airports.

However, it was not just the network carriers that were reducing service at the nation’s smaller airport markets.  Southwest Airlines, the carrier hailed as the archetypal LCC, has also started to behave like the network carriers by practicing “capacity discipline” across its network.  In addition to reducing capacity in smaller markets, Southwest also made a decision to vacate 13 small community markets previously served by merger partner AirTran Airways:  Allentown, PA; Asheville, NC; Atlantic City, NJ; Bloomington/Normal, IN; Charleston, WV; Harrisburg, PA; Huntsville, AL; Knoxville, TN; Lexington, KY; Moline, IL; Newport News/Williamsburg, VA; Sarasota-Bradenton, FL; and White Plains, NY.  Southwest flights at smaller airports have been cut by 9.8% since 2007.

On the other hand, other LCCs and ultra-low cost carriers (ULCCs) generally increased service over the analysis period. 

Yet other than jetBlue and Frontier, none of the other LCC and ULCCs operates a hub and spoke system per se; Spirit Airlines is an opportunist with low fares and no frills, Virgin America is struggling to be profitable and Allegiant Air is a travel company that provides only infrequent service to vacation destinations.  While they may offer low fares, these airlines do not offer their passengers high-quality connecting service to the global air transportation network.

Of course, the replacement of traditional network carrier service with LCC/ULCC service to high-frequency markets already served or to vacation destinations does indeed boost airline activity at an airport.  To be sure, many small communities are today relying on carriers like Spirit or Allegiant or Sun Country as their primary/sole provider of commercial air service.  However, is infrequent service to vacation destinations on a ULCC as valuable to air travel consumers as frequent service from a network carrier to a hub airport, from which connections can be made to other destinations within the U.S. and throughout the world?  This would seem to be a paramount policy question to consider if slot divestitures are mandated.  A small community with a nonstop flight to a single network carrier hub can open up hundreds of potential domestic and international connecting itineraries.  However, low-frequency service from an ULCC will have a limited impact on improving airport connectivity. 

Mandatory slot divestitures would cause network carriers to potentially drop direct flights from these small community airports to LGA and DCA—limiting the connecting potential for passengers at these airports and hurting small community residents’ access to the global air transportation network.  Replacing network carrier service with LCC or ULCC service is often a poor substitute due to comparatively inferior options for nonstop and connecting destinations. Already, a small percentage of domestic airport markets served by the LCCs are small and non-hub sized airports versus the network carriers where nearly two-thirds of airports served are small community markets.

On the other side of the policy aisle, the DOJ continually points to a tired argument that the entry of LCCs results in lower fares and stimulates new demand.  That may have been true in 1993, but it is less true today.  Again using Southwest Airlines as the archetypal LCC, in the markets entered by the carrier between 2006 – 2011, fares increased 4 percent and traffic increased but 10 percent.  To demonstrate the fact that the LCCs behave a lot like the network carriers today and vice versa, let’s examine system passenger yield growth for the LCCs, Southwest, and the network carriers between 1995 – 2011.  Since 1995, Southwest passenger yields have increased 41 percent on a stage length adjusted basis; all LCC adjusted yields have increased 45 percent and network carrier yields have increased only 14 percent.

SLOT DIVESTITURE AND SMALL COMMUNITY AIR SERVICE AT DCA AND LGA

In the initial Delta – US Airways slot swap comment period, Southwest spent inordinate time and resources claiming that the two carriers needed to surrender more slots than originally proposed because the transaction would “permanently lock out” low fare competition.  But each Delta and US Airways were promising more than low fare competition—the two applicants were offering to build and augment their respective connecting complexes at each DCA and LGA. 

The timing of Delta’s and US Airways’ claim could not have been better as small community markets had seen hub access and connectivity at Pittsburgh and St. Louis virtually disappear.  Hub access at Cincinnati and Memphis was being eroded in a significant way as service cuts at those secondary hubs was proving necessary in the face of high oil prices and a damaged economy.  Now there were two new alternatives for improved connectivity in the name of DCA and LGA.  Even more important was the fact that DCA and LGA are among the largest origin and destination (O-D) markets for many communities in the U.S. – big and small. Hence, DCA and LGA provided the opportunity to build connecting hubs at airports with significant existing local demand – a particularly important ingredient for sustainable air service.

The DOT listened and wrote:  “While we acknowledge Southwest’s claims regarding potential inefficiencies resulting from hub development at slot controlled airports, we must consider both potential operating inefficiencies and expected network benefits typically resulting from hub development or expansion. The Joint Applicants [Delta and US Airways] claim that numerous benefits will accrue to consumers as a result of their transaction. Among the more compelling benefits that they articulate, we are most convinced by their arguments that development of a LGA hub will lead to enhanced service to small communities (even with the small aircraft that Southwest contends would be used) and improved competition versus other east coast hubs, including United’s Newark hub and US Airways’ hub in Philadelphia.”

In that case, the carriers asserted that primary benefits of the transaction will include enhanced service to smaller communities on an overall basis.  And that is exactly what has happened. 

During 2012, US Airways served 69 airports from DCA—the beginning of a true connecting hub.  40, or 58 percent, of those cities served were small and non-hub markets. 

At LGA, Delta served 58 airports during 2012, including 25 (43.1%) small or non-hub markets.

CONCLUSIONS

Despite the growing connecting hubs being built by US Airways and Delta at DCA and LGA respectively, it is important to note that as a whole, small community air service at these airports is already becoming a rare commodity. Today, only about 17 percent of service offered from New York’s LaGuardia Airport is to small communities—down from about 25 percent of all departures just six years ago.

Small community service is also already limited at DCA. Today, small community air service makes up only about 19 percent of service offered from Washington’s Reagan National Airport.

An important and fundamental question to ask is:  Does it really make good policy sense, assuming that slots are required to be divested, to make a slot pair available to a carrier proposing to serve Orlando, Tampa, or Ft. Lauderdale – all markets with metropolitan area nonstop service and a plethora of connecting options by each major carrier with hub choice as well?  Or, does it make better policy sense to maintain slots for small community access to some of the nation’s largest local O-D markets that offer connections as a result of the recent US Airways – Delta Air Lines slot swap?

One more nonstop from a large market to a large market does very little in improving the quality of service for airline consumers on either end of the itinerary.  Whereas the loss of a nonstop service from a smaller community to a large O-D market that offers connections would have a significant negative impact on that smaller community’s connectivity to the global air transportation network.  It is simply intuitive.

DCA and LGA already have excellent service to the nation’s largest markets from both network and low cost carriers.  Maintaining at least the status quo of slots for small community air service at this late juncture in market consolidation helps to maintain quality air service at some of the nation’s smaller markets at a time when service is being cut and hubs are being eliminated for reasons beyond the industry’s control.

Wednesday
Mar242010

Dear Southwest: Grab Your Bag of Fiction; It’s On

On Tuesday morning a headline in The Washington Post read “Southwest Airlines Feeling Squeezed Out at National Airport”.  Terry Maxon wrote on The Dallas Morning News blog “Delta, US Airways Maneuver Around Southwest Airlines.”  The headline in Business Week read “Delta, US Airways Sweeten NYC-Washington Plan by Boosting Small Rivals.

As I prepared to write this piece, I began by reviewing the various comments submitted to the U.S. Department of Transportation (DOT) by the air carriers during the comment period set forth following its tentative decision on the proposed Delta Air Lines – US Airways slot swap deal.  When I got to Southwest’s, I thought I was in a time warp.  A time warp whereby many of the same arguments used in Southwest’s fight to repeal the Wright Amendment were being dusted off and employed again.  Another opportune time for poor, little Southwest Airlines to get something on the cheap from the carriers that have invested hundreds of millions of dollars in their respective infrastructures over the past decades.  But here’s the thing:  Southwest is neither poor nor little.

Background

All of these stories of course pertain to a repackaging of the proposed Delta-US Airways slot swap first announced in August 2009.  In the initial deal made between Delta and US Airways, US Airways would receive 42 slot pairs from Delta Air Lines at Washington’s Reagan National Airport and a route authority to Sao Paulo and Tokyo Narita in exchange for 140 slot pairs at New York’s LaGuardia Airport. 

In February 2010, the DOT tentatively approved the deal between Delta and US Airways. The caveat was each carrier had to sell 14 National and 20 LaGuardia slot pairs to U.S. or Canadian carriers that have less than 5% of the total slot holdings at the respective airports. This stipulation materially impacted the value of the deal, so US Airways and Delta went back to the drawing board.

Late Monday, the two airlines announced a restructured proposal.  Only this time, they included provisions providing slots to competing carriers.  Delta concluded deals with WestJet, AirTran and Spirit to transfer up to five slot pairs each at New York’s LaGuardia Airport (LGA).  US Airways will transfer up to five slot pairs to JetBlue at Washington Reagan (DCA).  The inclusion of WestJet, AirTran, Spirit and jetBlue certainly satisfies the DOT’s requirement that divested slot pairs be provided to a U.S. or Canadian carrier with less than a 5 percent share.

Let’s Get Some Southwest Non-fiction on the Table

In its submission, Southwest complains that at LGA, "instead of an airport balanced among three airlines of roughly equal size, the slot swap would catapult Delta into a dominant position more than twice the size of the nearest competitor."  But Southwest does not ever mention anything pertaining to its size within the U.S. domestic market. In 2008 there were only 6 airport markets with more domestic origin and destination (O&D) traffic than LGA.  Southwest is the largest carrier in three of those six markets.  At the 48 domestic airports where Southwest is the largest carrier of O&D traffic, it is at least twice the size of the next largest carrier in 27.

At Dallas Love Field, Southwest controls 94.3 percent of O&D traffic and the second largest carrier has 2.2 percent.  At Houston Hobby Airport, Southwest controls 86.2 percent of O&D traffic versus 5.2 for the nearest competitor.  At Chicago Midway, Southwest has 79.1 percent control while the next largest competitor has 8.8 percent.  At Love Field, Houston Hobby and Chicago Midway the average fares rose at those airports 36.2 percent, 21.8 percent and 29.4 percent respectively between 2005 and 2008.  In each of the 48 airport markets where Southwest is the number one competitor, fares on average increased 17.5 percent between 2005 and 2008. 

Southwest would have us all believe that their presence at an airport is the ultimate discipline on fares and they claim it in every regulatory filing and certainly on every advertisement.  Despite what Southwest likes to say, it is not the same Southwest that sprinkled the “Southwest Effect” on markets in 1992. The claims of low fares stimulating new demand just do not hold today - because everyone offers low fares. 

During the period between 2005 and 2008, wasn’t Southwest enjoying the benefits of a fuel hedging program that provided the carrier with a most significant cost advantage relative to an industry that had largely restructured itself?  I assumed that cost advantage benefit garnered from a fortuitous bet on the price of oil was being passed on to the consumer.  Instead Southwest was raising fares.  In their filing they actually go as far as calculate the cost saving their low fares would bring to each the DCA and LGA markets.  The calculation is performed after including a $25 bag fee on top of the fare of the competition. 

Fiction Fatigue

If Southwest wants to gain entry to the few remaining slot controlled airports, then it should make the incumbents an offer – one that provides the slot holder a return on that carrier’s prior investment.  In a 2006 regulatory filing, Delta described how it took 22 years to build its slot portfolio at LGA.  The Buy-Sell Rule is a mechanism in place permitting such purchase.    

The filing states, “In sum, Delta acquired the right to operate most of the 243 LGA slots it currently operates at LGA through market-based transactions.  Delta acquired them through diligent investment in private market transactions, not by regulatory fiat. Delta has also invested hundreds of millions of dollars in expanding its service at LGA because Delta valued the right to expand its service at the airport, believing it would be profitable to make such investments.  Delta’s decisions to acquire slots in market-based transactions and develop its landside infrastructure at LaGuardia over three decades have permitted Delta to grow steadily and to offer greatly expanded services there to meet consumer demand.”

Carriers that purchased slots at the controlled airports did so expecting they would earn a commensurate return on their expended capital.  Of course that would mean average fares would more than compensate the cost of operating at those airports.  The average fare at LGA in 1990 was $150; by 2005 the average fare had fallen to $136; and in 2008 that fare was $159.  A similar trend can be found at Washington National, although fares in 2008 were higher.

Southwest Is Not Special

Southwest’s growth has caused/forced the industry to reduce costs in order to match the fare offerings from it and the so-called low-cost carriers it helped spawn.  Today, however, Legacy carriers with iconic names like American, Continental, Delta, United and US Airways are also offering low fares to passengers.  Low fares to air travel consumers in smaller communities that the Southwest operating model ignores.  It is these legacy carriers that have invested hundreds of millions of dollars at slot controlled airports. 

If Southwest wants to play, it should have to write the same type of check.  They won’t because the low fare structure at either of these airports will not produce adequate revenue streams to justify the investment.  Instead Southwest somehow believes it is “entitled” to the slots being divested by US Airways and Delta.

Southwest is no longer the only game in town.  It talks about all the money consumers will save as a result of Southwest’s entry into DCA and LGA, subtracting its entry level fares from average fares plus bag fees for the incumbents. Once Southwest is imbedded, there’s a new “Southwest Effect.” As mentioned above, in markets where Southwest is the largest carrier, fares increase the fastest.

Ted Reed at TheStreet.com wrote “Southwest Blasts Revised Slot Deal.”  In his story, Reed quotes Southwest, "Allowing two of the country's largest airlines to collude on trading assets in a way to reduce competition while dramatically increasing their market dominance at two of the United States' most important airports is, on its face, an alarming prospect that should not be permitted."

Who is the largest US domestic airline?  Southwest.

To me the more alarming prospect is allowing Southwest to get something for free – yet again.  Think Wright Amendment and the undoing of a deal because the market had changed and they needed to find a new way to grow.  Simply you have to pay to play, Southwest.  You have the cash.  Make someone an offer they cannot refuse.  The rules to do so are in place.  I have every confidence that neither LGA nor DCA absolutely needs Southwest.  I am confident that JetBlue, AirTran, Spirit and WestJet can do just fine.

It’s On.