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9 – 704- 403 REV: J A NUARY 25, 200 5 J A N W. R I VKI N LAU R ENT THE R IVEL Delta Air Lines (A): The Low-Cost Carrier Threat The most dangerous competition we face is not United. It’s not American or Northwest or Continental. It’s low-cost competition from companies like JetBlue or Southwest. — Leo Mullin, Delta Chairman and Chief Executive Officer 1 In March 2002, a cross-functional task force convened at Delta Air Lines’ headquarters, on the grounds of Atlanta’s Hartsfield International Airport. Mark Balloun, vice president of corporate strategic planning and one of three team leaders, explained the situation: The challenge of low-cost competition from carriers like Southwest and JetBlue had been building for years. We had been looking at the problem for a long time, but because Delta is organized by function, solutions focused on individual parts of the company. The marketing organization provided marketing ideas, the customer service organization offered customer service ideas, and so forth. We didn’t have a comprehensive response to low-cost carriers [LCCs] across functions, and pressure from the board made it clear: we needed one. We promised the board we would propose an LCC strategy at their July meeting. 2 With four months left before the board meeting, the task force considered Delta’s options. Among the options on the table was the possibility that Delta would launch its own low-cost subsidiary. Nearly all of the major airlines, including Delta itself, had launched such subsidiaries in the recent past. Although airlines rarely revealed the financial results of their subsidiaries, industry observers thought the low-cost efforts launched to date were either failed experiments or unsustainable over time. “We’ve never seen a high-cost carrier transform itself into a low-cost carrier,” said Darrel Jenkins, director of the Aviation Institute at George Washington University. “They’ll still be a highcost carrier selling cheap seats.”3 With or without a low-cost subsidiary, Delta would have to find a way to deal with LCCs and do so in the midst of the most challenging conditions the airline industry had faced in decades. The Airline Industry in the United States In nearly a century since the Wright brothers’ historic flight, the U.S. airline industry had grown huge, transporting more than 620 million passengers and collecting over $81 billion in fares in 2001. 4 Size, however, had not brought profitability. Since deregulation in 1978, airline margins were Professor Jan W. Rivkin and Research Associate Laurent Therivel prepared this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2004 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. 704-403 Delta Air Lines (A): The Low-Cost Carrier Threat persistently well below the average for U.S. industries. 5 For each of the five largest carriers, the average return on investment over the 1990s was below its cost of capital. 6 The terrorist attacks of September 11, 2001, brought tragedy to an already troubled industry. In the wake of the attacks, demand for air travel declined sharply, sending industry profits into a tailspin (Exhibit 1). The legacy of regulation For 40 years prior to 1978, the U.S. airline industry had existed within a predetermined set of operating rules under the structure imposed by the Civil Aeronautics Board.7 The CAB assigned a mix of high- and low-density routes to each carrier, with lucrative routes subsidizing unprofitable ones. The board controlled fares and largely passed cost increases along to customers, allowing airlines a reasonable profit. Protected by cost-plus pricing, airlines regularly assented to labor union demands. Salaries and benefits increased steadily, supplemented by strict work rules that reduced labor flexibility. Airlines strove to differentiate themselves by improving service offerings, introducing meals and movies to flights, and adding capacity to offer a variety of flight times. The resulting combination of high costs and excess capacity led the major airlines to charge prices roughly twice as high as did their unregulated, intrastate counterparts for flights of comparable lengths.8 With the regulated system increasingly inefficient, President Carter signed the Airline Deregulation Act in 1978. The act phased in freedom of pricing and route entry and exit. Fares dropped almost immediately, and by 1980, 22 low-cost airlines were attempting to unseat the incumbents.9 Airline economics and the hub-and-spoke system After deregulation, an airline’s profitability hinged largely on the fraction of its flown seats that were occupied by paying passengers, its load factor. Costs were commonly measured by cost per available seat mile (CASM), that is, the cost required to fly one seat, occupied or empty, for one mile. Yield equaled total passenger revenues divided by the number of revenue passenger miles (RPM). (RPMs were calculated by multiplying the number of revenue seats occupied by the number of miles flown.) (Exhibit 2 details the relationship among the various metrics.) The marginal costs incurred by adding an incremental passenger to a flight were negligible. The marginal costs incurred to add an incremental flight to a schedule were higher, of course, but the fixed nature of many cost items (see below) meant that an airline could lower its CASM considerably by increasing the number of hours per day that its aircraft were in service. Daily utilization, in turn, depended a great deal on how quickly an airline could “turn” its aircraft and prepare them for takeoff. Turn times varied considerably among the major airlines in 2002, with Southwest’s 27-minute turn leading the pack.10 An airline’s CASM was also sensitive to its average stage length (i.e., flight distance). Since most cost items did not increase in proportion to a flight’s length, costs per available seat mile were low for airlines that flew long distances. For a given airline flying a given aircraft, the CASM for a 1,000-mile flight might be 25%–35% lower than the CASM for a 500-mile flight. Saddled after deregulation with high fixed costs and expensive labor, major airlines had to develop a system that would ensure high load factors. After 1978, most of the major airlines shifted operations to a hub-and-spoke model: flights on small planes from lightly traveled cities, or “spokes,” would feed passengers into “hubs” in major cities and route them on to their eventual destinations. Flights between hubs or to large cities would use large planes. The hub-and-spoke system enabled major airlines to achieve high load factors and, according to some industry analysts, enjoy market power in the hubs they dominated. By 2002, most of the major airlines had adopted the hub-andspoke approach, with the notable exception of Southwest Airlines. Competition On routes shorter than 600 miles, airlines competed with automobiles, buses, and railroads,11 while competition on long routes was almost exclusively internal to the industry. 2 The Delta Air Lines (A): The Low-Cost Carrier Threat 704-403 industry was segmented by annual revenue into major (over $1 billion), national (between $100 million and $1 billion), and regional (less than $100 million) carriers. In 2002, 10 major passenger airlines operated in the United States: Alaska, America West, American, American Trans Air, Continental, Delta, Northwest, Southwest, United, and US Airways. Customers were a varied lot, but many selected a carrier primarily on the basis of ticket price. By one estimate, price was the “overriding” concern of one-third of all passengers.12 Emphasis on lower prices had reduced fares by nearly 45% in real terms since deregulation 13 and had made at least one legacy carrier desperate enough to try to fix prices. In 1982, after years of fare wars in Dallas, Robert Crandall, American’s CEO, placed a call to Howard Putnam, president of Braniff Airlines. “Raise your $#%@ fares by 20%,” he said, “and I’ll raise mine the next morning.” Rather than comply, Putnam recorded the conversation and reported Crandall to the Justice Department. Beyond price, passengers choosing an airline focused on safety, reliability, and convenience, with other factors such as service quality, amenities, entertainment, and food also influencing the purchase decision. Airlines encouraged loyalty among frequent travelers through branded frequent-flyer programs and attempted to differentiate themselves through a variety of service offerings, frequent departures, and distinctive cultures. Business travelers were far less price sensitive than leisure travelers; in one survey, business “road warriors” rated an airline’s schedule as more important than price in the purchase decision and the airline’s frequent-flyer program as slightly less important than price.14 The Department of Transportation (DOT) required that airlines regularly submit a variety of reports. Information on safety, reliability, capacity, and profitability metrics was supplemented with statistics on market share and traffic in specific geographies and city pairs. Armed with such information and competitive fare data, airlines could deploy flights to profitable routes and respond quickly to competitor prices. By the late 1990s, widespread access to airline fares and schedules via Internet reservation systems allowed consumers to compare fares easily and become more aware of low-priced alternatives. Yield management The development of airline reservation systems, starting in 1953, was initially intended only to automate the customer reservation process. By the 1980s, computer systems had become powerful tools for “yield management”—efforts to raise fares without losing many customers, attract numerous customers with small fare decreases, and charge different fares to different customers on the same flight. American’s Crandall joked that yield management provided “the adjustable-rate air fare—tell us what you can afford and we’ll sell you a ticket.” 15 To tap the price insensitivity of business travelers, for instance, airlines charged high fares for tickets with travel flexibility, for flights booked at the last minute, and for trips that did not include a Saturday night away from home. Accordingly, many of the major airlines focused their efforts on attracting business travelers. With yield management, airlines boosted immediate profitability but risked the ire of business travelers, who felt exploited, and the distrust of bargain hunters, who never knew if they were getting the lowest prices. Emerging distribution technologies changed the way airline tickets were sold and made airline pricing more transparent to customers. The Internet resulted in the development of numerous travel Web sites that gave consumers more efficient access to travel information than ever before. The rapid growth of these online channels placed increased pressure on airlines to offer the best fares possible to consumers, who gained the ability to easily compare airline fares on multiple travel Web sites. Inputs Notwithstanding substantial layoffs in 2001, employee salaries and benefits were the largest expense for the typical major airline in 2002, representing roughly 40% of total costs. Exhibit 3 shows the portion of this cost attributable to each type of employee. Most airline labor was 3 704-403 Delta Air Lines (A): The Low-Cost Carrier Threat unionized, with separate unions for each worker type, such as the Association of Flight Attendants and the Air Line Pilots Association. Unions negotiated individual agreements with airlines and, by law, had to undergo mediation before being allowed to strike. In addition to negotiating salaries and benefits, unions negotiated work rules such as defined duties and flight-time restrictions. Unions often believed that “employees are better off in an adversarial relationship” with management16 and occasionally chose tactics such as reducing customer service to force managerial concessions. Management, in turn, referred to the low labor costs of nonunion competitors in order to seek union concessions. Most employees were paid on a sliding scale based on tenure and hours worked, with the exception of pilots, who were paid according to aircraft flown, crew position, hours flown, and tenure. Exhibit 4 shows the salary structure of an aircraft’s captain for a unionized hub-and-spoke carrier and a nonunionized low-cost carrier. Salaries were supplemented by benefits and sometimes by profit-sharing and stock-option packages, which could represent 40% of total earnings in a 15-year career,17 and some unions accepted lower wages or more flexible work rules in exchange for more substantial profit-sharing or stock-option plans. Airlines spent roughly 10%–15% of total costs on fuel, the consumption of which varied widely with the age and type of aircraft as well as the stage length. Longer stages led to relatively low fuel costs per available seat mile since takeoffs and landings consumed a large portion of fuel. 18 Airlines engaged in several activities to hedge fuel costs, such as commodities trading and long-term contracting. Airlines services, representing 15%–20% of total cost, included sales and marketing, insurance, and commissions to outside contractors such as travel agents. The rapid rise in online ticketing enabled the major airlines to reduce travel agent commissions, and carriers that could maximize reservations through their own Web sites were able to reduce costs substantially. Most service cost reductions were offset by the rising costs of security and insurance after the terrorist attacks of September 11. Aircraft and facility rental costs represented approximately 15% of total cost. The two primary aircraft suppliers, Boeing and Airbus, competed for long-term contracts with airlines. Some carriers preferred to work with a single aircraft supplier in order to obtain more favorable contracts, while others preferred to diversify their fleets and avoid the leverage a single supplier might wield. Some airlines even chose to operate a single airframe type to simplify maintenance and reduce complexity. Other sources of aircraft were leasing and the used plane market. Major airlines rented approximately 55% of their fleet due to the lower rates offered by lessors, who could obtain more attractive financing because of their superior credit ratings.19 Other items accounted for the remainder of costs. Food costs varied widely across the industry, as some airlines provided full meals while others chose to serve only light snacks. The cost of maintenance material was directly affected by fleet age and aircraft type, with newer planes incurring substantially lower costs. Landing fees were paid to airports on a sliding scale, depending on the weight of the aircraft. Landing slots at four slot-restricted airports were difficult to come by. The impact of September 11 The terrorist attacks of September 11, 2001, inflicted personal loss and tragedy on the airline industry. Financial hardship followed quickly. 20 After the attacks, a two-day grounding of all U.S. flights caused an immediate loss of over $650 million. Heightened federal security mandates placed numerous additional costs on airlines, from the installation of bulletproof cockpit doors to an airport security tax ($2.50 per passenger segment). Insurance costs skyrocketed. Exacerbating the effect of increased costs, demand for air travel decreased sharply. Annual passenger revenues dropped 13.5% in 2001 to $80.9 billion, only the second annual decline in 4 Delta Air Lines (A): The Low-Cost Carrier Threat 704-403 history. Amplifying the effects of the terrorist attacks was a global economic slowdown that curtailed full-fare business travel. Faced with the imminent bankruptcy of several airlines, the federal government quickly passed the Air Transportation Safety and System Stabilization Act, which attempted to compensate airlines for losses incurred due to the attacks. The act included $5 billion in cash grants and $10 billion in loan guarantees. Despite the act, US Airways, United Airlines, and American Airlines teetered on the brink of bankruptcy in early 2002. Over 80,000 employees were laid off following the September 11 attacks, with few rehired afterwards. The industry as a whole reported an operating loss of more than $10 billion in 2001, and 2002 losses were likely to be even larger. In the words of American CEO Don Carty, the industry found itself “with a disconnect between money coming in and money going out that is unprecedented.”21 The Low-Cost Carrier Revolution Of the major and national carriers, only the low-cost carriers Southwest, JetBlue, and AirTran remained profitable in 2001. Even before September 11, indeed for years, the LCCs had been gaining market share from and earning higher long-run profits than so-called legacy carriers. Legacy carriers tended to be slightly more profitable than LCCs during the peaks of business cycles but much less profitable during the troughs.22 Southwest Airlines and its imitators In 1967, Rollin King and Herb Kelleher founded Southwest Airlines to provide intrastate service within Texas. After deregulation, the airline slowly expanded service through the Southwest states and California, then onward to the East Coast, limiting itself to a 10%–15% growth rate to “manage in good times in order to survive in bad times.” 23 Founded on a “love” theme, Southwest prided itself on doing things differently. The carrier provided frequent point-to-point service between secondary airports that were, on average, 515 miles apart. Operations were designed for simplicity: an all-Boeing 737 fleet, an absence of meals and seat assignments, an all-coach cabin with no frills, flexible work rules, and an enthusiastic workforce contributed to very short turn times and high aircraft utilization. Southwest management worked closely with employee unions, adding profit-sharing plans to industry-equivalent pay and receiving flexible work rules in return. The phrase “. . . and whatever else might be needed to perform the service” was inserted into employment contracts.24 Southwest set its prices very low, typically to compete with the cost of auto travel rather than other airlines’ fares,25 and load factors were high. Incumbent airlines usually chose to match Southwest’s fares in order to protect market share. Industry observers came to speak of “the Southwest effect”—the combination of lower fares and the often 1,000% increase in traffic between cities that Southwest chose to serve. Southwest’s pricing structures were simple and relatively transparent to passengers, with few classes of fares and few ticket restrictions. Numerous imitators had attempted to copy Southwest’s low-cost model but with very limited success. Many LCCs attempted to expand too quickly, made poor decisions regarding route selection, or confronted fierce competition from other airlines, sometimes provoking a forceful reaction from a major airline in response to flights introduced at its hub airport. JetBlue26 Among the handful of successful Southwest copycats was Morris Air, run from 1984 until 1993 by David Neeleman. Indeed, Morris Air was so successful that Southwest bought the airline in 1993, in its first and only acquisition. In 1999, right after his noncompete agreement with 5 704-403 Delta Air Lines (A): The Low-Cost Carrier Threat Southwest expired, Neeleman founded JetBlue. Neeleman’s goal for JetBlue was to “bring humanity back to air travel”27 with a combination of low costs, new technology, and a strong brand. With $130 million in venture capital funding, JetBlue was the most highly capitalized start-up in airline history. The capital enabled JetBlue to buy, not lease, a fleet of new Airbus A320 jets. The company flew 23 aircraft by March 2002 and was scheduled to take delivery of another 11 jets by the end of the year.28 The fleet flew point to point, primarily from New York City to Florida, to out-state New York, and to California—an average flight distance of 985 miles. The carrier focused on airports that were less traveled but not obscure. In New York City, for instance, it served John F. Kennedy Airport, not the busier LaGuardia Airport. (Southwest, in contrast, served New York via a more distant airport in Islip, Long Island.) Customers were encouraged to interact with JetBlue via the Internet, and indeed over 60% of seats were booked online. Fare structures were simple, and all tickets were electronic, not paper. Once on board, each passenger took an assigned, leather, coach-class seat equipped with a personal video monitor. Through LiveTV LLC, a provider of in-flight entertainment systems, JetBlue offered 24 channels of live television to each monitor. It was estimated that the television service added $1 to the cost associated with each passenger.29 Airplane Yoga cards in the seat pocket instructed travelers on in-flight stretching exercises and warned that “a flight attendant may ask you if you need something. Tell them that we all need inner peace.” Meals were not served, but blue potato chips were available. Neeleman himself made a habit of flying the service often and plying passengers for suggestions. Employees—all nonunion and many from outside the airline industry—maintained a high esprit de corps. JetBlue operated with very few work rules, expecting flexibility among employees, and it offered corresponding flexibility in its employment packages. One-year contracts were designed for college students who wanted a stint of travel, for instance, and job-sharing packages were created for people who wanted more time at home. Top management called all employees “crew members” and all supervisors “coaches.” Basketball hoops on some tarmacs gave ground crews an opportunity to practice their jump shots while awaiting arriving flights. JetBlue strove to become the world’s first paperless airline. 30 Each pilot carried a laptop computer with operations manuals and software for flight planning, which allowed the pilot to perform preflight checks and submit flight-related “paperwork” very quickly without support personnel. Pilots also used their laptops to e-mail suggestions to headquarters. Maintenance records for JetBlue’s modern A320 jets were computerized. The use of new technology extended to reservation operations. Reservation agents used Internet connections to work from home, not in a central call center. Each agent worked at least 20 hours per week at the industry-standard hourly pay scale but could earn a higher hourly rate by coming online as needed to help handle surges in call volume. In its three years of service, JetBlue had built a “cheap chic” image. “JetBlue has made it all right to fly on a low-cost airline,” explained Michael Roach, an industry analyst and cofounder of America West Airlines.31 Delta’s President and Chief Operating Officer Fred Reid described the target customers of the leading LCCs: “Southwest competes with the couch, the car, and the bus for their customers—people who might otherwise not travel. JetBlue, on the other hand, makes low-fare flying attractive to bankers, brokers, fashion models, and finance officers—people who have to travel, so they attach social significance to the experience.”32 With its initial public offering pending in April 2002, JetBlue was considered by industry analysts to be “the biggest threat to industry price stability since Southwest.” 33 JetBlue’s 2001 CASM of 6.7¢ was very low, and its load factor of 77% was far above the industry average. Moreover, the carrier was able to take a higher proportion of premium fares on some city pairs (Exhibit 5). 6 Delta Air Lines (A): The Low-Cost Carrier Threat 704-403 Low-cost subsidiaries of legacy carriers LCCs enjoyed large cost advantages over legacy carriers (Exhibit 6). Of the 30,000 pairs of cities linked by legacy, hub-and-spoke carriers, 5% had enough traffic to support the type of point-to-point service offered by LCCs. That 5% of city-pairs accounted for 73% of all passengers.34 Several legacy airlines responded to the LCC threat during the 1990s by establishing low-cost subsidiaries of their own. CALite, a stripped-down, no-frills service established by Continental Airlines in 1993, was the first such response to Southwest. Continental attempted to schedule passengers on a mix of CALite and mainline flights, which complicated logistics and confused passengers. It also caused many passengers to go an entire day without meals since CALite served only peanuts and mainline Continental served meals only at “appropriate times.” CALite was shuttered within two years after incurring hundreds of millions in losses. Passengers had such poor associations with CALite that Continental discontinued the use of peanuts on all flights, citing their “negative connotations.”35 Undeterred by the failure of CALite, several other airlines attempted to launch low-cost subsidiaries. Shuttle by United began service in California in 1994 in an attempt to slow Southwest’s expansion along the West Coast. Shuttle’s low costs were transient, however, as initial labor concessions were lost in subsequent negotiations and corporate authorities reduced the carrier’s independence. “Shuttle by United and United mainline’s scheduling and pricing were operated by the same individual,” said industry analyst Michael Roach. “Shuttle was essentially managed out of United headquarters in Chicago, and they were saddled with the same bureaucracy as United.” 36 Labor unions were hesitant to help Shuttle cut its costs. In the words of Greg Davidovitch, president of United’s Association of Flight Attendants, “Why would, or why should, current employees give up thousands of jobs and other cuts to fund the startup of a new carrier that will only benefit corporate executives and others while it competes with us and drags us down even further?”37 Taking a page from United, US Airways launched MetroJet, a low-cost subsidiary focused on Northeast-to-Florida routes, in 1998. Saddled with 69% higher costs than Southwest, MetroJet received significant wage concessions from its pilots and hoped to offset the remaining cost differential with the strength of US Airways’ frequent-flyer program.38 Before MetroJet even began operation, critics were doubtful of its ability to succeed. During a conference call of airline CEOs, while waiting for people to join the call, one chief executive asked Southwest’s Herb Kelleher to tell a joke to pass the time. His one-word reply: “MetroJet.”39 By 2002, nearly all of the low-cost subsidiaries had been shuttered. “Subsidiaries don’t work because they’re not truly low cost, and the parent hides the true expense in its financials,” stated Alan Sbarra of Unisys Transportation Consultants.40 Notwithstanding previous failures, airlines continued to consider new low-cost subsidiaries. “If you’re on a burning platform, you dance around, but does it really put out the fire?” asked Stan Pace, a partner at Bain & Company with airline expertise. “Still, dancing around looks better than standing still.”41 Delta Air Lines Delta’s roots could be traced back to what was, in 1925, the world’s largest privately owned fleet of aircraft, Huff Daland Dusters’ 18 crop-dusting planes. C.E. Woolman, the principal founder of Delta Air Lines, led a movement in 1928 to buy Huff Daland, rename it Delta Air Service, and begin passenger service in 1929. Delta operated primarily within the Southeast until its merger with Northeast Airlines in 1972, which gave it access to routes from New York and New England to Florida. After its merger with Western Airlines in 1987, Delta became the third-largest domestic 7 704-403 Delta Air Lines (A): The Low-Cost Carrier Threat passenger carrier as measured by operating revenue. The acquisition of transatlantic routes from failing Pan Am in 1991 gave Delta global reach. In 2002, Delta was the third-largest passenger carrier in the world in terms of revenue and the second-largest in terms of passengers flown. The carrier enplaned over 100 million passengers annually, primarily through its hubs in Atlanta, Cincinnati, Dallas, and Salt Lake City. After deregulation, Delta was the most profitable—or least unprofitable— of the Big Three legacy carriers (American, United, and Delta). Delta had avoided bankruptcy in the wake of September 11 but incurred an operating loss of $1.6 billion in 2001 (Exhibit 7). Of Delta’s more than 75,000 employees, among the major work groups only the pilots were unionized. Compensation and benefits at Delta, among pilots and non-pilots alike, were generally near the top of the industry. Though work rules for non-pilots existed, they were less restrictive than at other legacy carriers, which gave Delta a significant productivity advantage among flight attendants and ground crew. Delta’s managers emphasized to employees that it was this productivity advantage that enabled the company to offer generous pay and benefit packages. Nonetheless, there were occasional efforts at union organizing. A claim filed with the National Mediation Board by the Association of Flight Attendants (AFA), which aimed to organize Delta’s flight attendants, charged Delta with “harassment, intimidation, surveillance . . . that amounts to the most expensive and largest illegal anti-union campaign in history.”42 The board rejected the AFA claim. Historically, Delta had great strength in the Southeast of the United States. Florida markets alone accounted for 30% of Delta’s revenues.43 The carrier’s hub operations in Atlanta made Hartsfield International Airport the busiest airport in the world. Among older Southerners, it was often said, “When you die, you may go to one destination or you may go to the other. Either way, you have to fly Delta through Hartsfield.” Delta’s other hubs were not considered as strong and, indeed, were “overgauged” in some cases. That is, they were served by overly large Boeing 757s. A 757 carried 70% more seats than a 737 but cost roughly 30% more to fly. 44 Hence it was cheaper per passenger to fly a set of passengers on a 757 than to fly them on a 737 if the set was sufficiently large, but cheaper to fly them on a 737 if the set was small enough to fit onto the 737. Low demand into some smaller hubs meant that certain Delta 757s were flying with very low load factors. By 2002, Delta faced three types of competitive threat to its market position: mainline hub-andspoke carriers had been systematically dropping fares, regional airlines were eating away at Delta’s traffic in midsized markets, and LCCs had made significant inroads into Delta’s Florida market (Exhibit 8).45 Delta’s management team had grappled with the LCC issue for some time, and the company’s board placed the issue on the list of 2002 Corporate Initiatives, a set of hot-button topics for the coming year. By January 2002, management had determined that systematic cost cutting within Delta mainline could combat hub-and-spoke competition, and Delta’s industry-leading position in regional jets could adequately defend its share in midsized markets. However, Delta’s major LCC response to date—an intended low-cost subsidiary named Delta Express—had not proven an adequate deterrent and was, in fact, being replaced by mainline aircraft. Delta Express In January of 1996, Southwest had entered the Florida market, and by October of the same year, Delta had launched Delta Express, a low-fare subsidiary that served Florida leisure markets from non-hub airports in the Midwest and Northeast. Delta’s 1997 annual report announced Express as an effort to “build on Delta’s leading position in Florida” and stated that Express would “allow Delta to compete effectively with the large number of low-cost carriers serving Florida, and to capture a leading share of the rapid growth in leisure traffic.”46 To avoid internal competition, Delta removed 8 Delta Air Lines (A): The Low-Cost Carrier Threat 704-403 all mainline flights on the Florida routes that were served by Express. Express, in turn, would not fly into Delta’s Atlanta hub. Delta Express flights were distinguished by separate gates, flight attendants in casual attire, and specially painted aircraft.47 As aircraft were repurposed for Express in 1996, they were given a maintenance overhaul. The overhaul was expensed immediately, giving Express low apparent maintenance costs for several future years. Express operated older Boeing 737-200s, each with 119 coach seats, and it served only light snacks. Express’s major sources of cost savings were lower labor rates and higher aircraft utilization. Significant concessions were obtained through negotiations with the pilot’s union, resulting in a 32% pay cut. Aside from distinct labor arrangements and some separate marketing, Delta Express was operated as an integral part of mainline Delta. All decisions concerning routing, flight frequency, and pricing were made centrally, and maintenance, pilots, flight attendants, and ground services were shared. Initially, Delta Express achieved its intended economics. By 2002, however, its profitability had deteriorated considerably. Delta negotiated with all of its pilots, mainline and Express, at once, and in negotiations between 1996 and 2000, the union fought a hard battle—a “jihad” in the words of COO Fred Reid—to erase the pay differential between the two operations. By 2000, the differential was essentially gone. In addition, JetBlue had established new standards for service for the Florida customer. Though Delta Express was the only low-fare subsidiary to survive after September 11, CEO Leo Mullin felt “it was a bit of a delusion to say it was a low-cost carrier.”48 On the other hand, some Delta executives believed that Express had fulfilled much of its mission. “Delta Express was a decent success,” said Subodh Karnik, senior vice president of network and revenue management, “because it enabled us to compete in the late-1990s—with competitive costs and a product that, at that time, had not been eclipsed by others such as JetBlue.”49 The Mandate The “low-cost environment” appeared only to be intensifying as the cross-functional task force convened in Delta’s headquarters. JetBlue, for instance, flew on routes that provided 6.5% of Delta’s revenue, and the team knew that that figure might rise substantially in the future. Leading the task force were Balloun of corporate strategic planning, Karnik of network and revenue management, and Jim Whitehurst, senior vice president and treasurer. A steering committee consisted of Chief Financial Officer Michelle Burns, Chief Marketing Officer Vicki Escarra, and COO Reid. The task force itself included a roughly equal mix of Delta personnel and McKinsey consultants. Tasked with formulating Delta’s response to low-cost competition, the team had a full array of options available to it. Continuation of the status quo would pit mainline Delta, Delta Express, and Delta’s fleet of regional jets against the LCCs. Delta Express might be modified in some manner or, at the opposite extreme, reintegrated with the primary Delta brand. Delta might also launch a new lowcost subsidiary. Doing so would likely require tens of millions of dollars of up-front investment. Delta could bear this burden, but the move would have to be explained carefully to shareholders and industry analysts, who had watched the dramatic failure of other low-cost subsidiaries. Delta’s board of directors eagerly awaited the task force’s recommendation. 9 704-403 Delta Air Lines (A): The Low-Cost Carrier Threat Exhibit 1 U.S. Airline Industry Performance Operating Revenues ($bn)a Year 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001a 22.9 27.2 33.8 36.7 36.4 39.0 43.8 46.7 50.5 57.0 63.7 69.3 76.1 75.2 78.4 85.3 89.0 95.1 102.4 109.0 113.8 119.5 130.8 115.5 Passenger Revenues ($bn) Operating Profit/(Loss) ($bn) Yield (cents)a 18.8 22.8 28.0 30.7 30.6 32.7 36.9 39.2 40.1 44.9 50.3 53.8 58.5 57.1 59.8 64.3 65.7 69.8 75.5 79.5 81.1 84.4 93.6 80.9 1.4 0.2 (0.2) (0.5) (0.7) 0.3 2.2 1.4 1.3 2.5 3.4 1.8 (1.9) (1.8) (2.4) 1.4 2.7 5.9 6.2 8.6 9.3 8.4 7.0 (10.3) 8.49 8.96 11.49 12.74 12.02 12.05 12.80 12.21 11.08 11.45 12.31 13.08 13.43 13.24 12.85 13.74 13.12 13.52 13.76 13.97 14.08 13.96 14.57 13.25 Load Factor (%)a 61.5 63.0 59.0 58.6 59.0 60.7 59.2 61.4 60.3 62.3 62.5 63.2 62.4 62.6 63.6 63.5 66.2 67.0 69.3 70.4 70.7 71.0 72.4 70.0 Source: Adapted from Air Transport Association. a“Operating revenues” include passenger revenues plus revenue from cargo, mail, charter flights, and other sources. “Yield” is equal to total passenger revenues divided by the total number of miles flown by paying customers. It reflects the price (in cents) that a passenger pays to fly one mile. “Load factor” is the portion of flown seats that are occupied by a paying passenger. Figures for 2001 include cash compensation remitted to carriers under the Air Transportation Safety and System Stabilization Act. Exhibit 2 Airline Profitability Equation Income / ASM = [Revenue / RPM x RPM / ASM]—Cost / ASM or Income / ASM = [Yield x Load factor]—CASM ASM = available seat mile. RPM = revenue passenger mile. Source: 10 Adapted from Pankaj Ghemawat and Nancy Donohue, “The U.S. Airline Industry, 1978–1988 (A),” HBS Case No. 390-025 (Boston: Harvard Business School Publishing, 1989). Delta Air Lines (A): The Low-Cost Carrier Threat Exhibit 3 Components of Salary Expense Portion of Total Salary Expense Employee Type Pilots Airport 704-403 42% Personnela 31% Flight Attendants 18% Maintenance 6% Management 3% Source: Casewriter analysis based on a sample of DOT Database, Form P-6. aAirport personnel include traffic managers, baggage handlers, and gate agents. Exhibit 4 Airframe Aircraft Captain Compensation Boeing 737-300 Hub-and-spoke carrier (Delta Air Lines) Boeing Boeing Boeing Boeing 727 737-800 757/767 767-400 Boeing 777 LCC (JetBlue) Airbus A320 20.0 20.2 20.4 20.5 20.7 20.9 21.0 21.2 21.4 21.5 21.7 21.8 6.2 6.8 7.2 7.6 8.0 8.0 8.0 8.0 8.0 8.0 8.0 8.0 Compensation ($000 per month) for captain with tenure of… 1 year 2 years 3 years 4 years 5 years 6 years 7 years 8 years 9 years 10 years 11 years >11 years 14.5 14.6 14.7 14.8 14.9 15.1 15.2 15.3 15.4 15.5 15.7 15.8 Guaranteed hours/month Estimated average hours/month 15.0 15.2 15.3 15.4 15.6 15.7 15.8 15.9 16.1 16.3 16.4 16.6 16.1 16.2 16.4 16.5 16.6 16.7 16.9 17.0 17.1 17.3 17.4 17.5 16.6 16.8 16.9 17.0 17.2 17.3 17.4 17.6 17.7 17.9 18.1 18.3 18.9 19.1 19.2 19.4 19.6 19.7 19.9 20.0 20.2 20.3 20.5 20.6 75–82 78 70 80 Source: Adapted from 2001–2002 U.S. Airlines Salary Survey and Career Earnings Comparison. Note: An Airbus A320 has roughly as many seats as a Boeing 737-800. 11 704-403 Delta Air Lines (A): The Low-Cost Carrier Threat Exhibit 5 Average Fare Comparisons—New York Markets (2Q 2002) Market Average Delta American JetBlue Continental AirTran $117 $ 95 $113 $ 96 $100 $123 $ 93 $105 $ 92 $ 94 $171 $ 95 $113 $ 96 $100 -$102 $112 $108 $ 98 $109 $121 $124 $116 $130 $ 97 $ 94 -$102 $111 NYC-Atlanta NYC-Orlando NYC-Palm Beach NYC-Fort Lauderdale NYC-Tampa Source: Adapted from “Delta Air Lines Company Update,” Lehman Brothers Equity Research, April 30, 2003. Exhibit 6 Financial Comparisons Across Airlines, 2001 Legacy carriers Low-cost carriers American Delta United US Airways Yield (¢ per occupied seat mile) Load factor (% of seats occupied) 14.83 68.7% 14.25 68.3% 15.10 70.1% 19.66 67.9% 14.75 69.7% 9.78 76.9% 12.48 68.0% Revenue per available seat mile (¢) 10.19 9.74 10.58 13.35 10.29 7.52 8.49 4.81 1.58 4.31 1.21 5.25 1.55 6.01 1.60 2.70 2.16 2.16 0.98 3.03 1.30 AirTran JetBlue Southwest Cost per available seat mile (¢) Salary and benefits Fuel Services Advertising & promotions Other services Aircraft and facility rental Depreciation & amortization Rentals Food Maintenance and other materials Landing fees Other Total 0.15 1.96 0.11 1.74 0.05 1.87 0.08 2.44 0.29 1.65 0.37 1.16 0.24 1.26 0.77 0.86 0.41 0.51 0.20 1.25 12.49 0.88 0.77 0.29 0.51 0.17 0.42 10.41 1.21 1.03 0.32 0.39 0.23 0.95 12.85 0.74 1.48 0.28 0.41 0.23 2.11 15.38 0.44 0.89 0.05 0.22 0.21 0.84 9.43 0.25 1.16 0.05 0.16 0.25 0.16 6.69 0.49 0.55 0.03 0.19 0.22 0.23 7.53 Income per available seat mile (¢) -2.30 -0.68 -2.27 -2.03 0.86 0.83 0.97 Average stage length (miles) 1,021 747 951 610 533 985 515 Source: Casewriter analysis based on Department of Transportation, Bureau of Transportation Statistics, Form 41 data. Note: 12 Domestic operations only. “Other services” include travel agent commissions, insurance, and other items. Delta Air Lines (A): The Low-Cost Carrier Threat Exhibit 7 704-403 Delta Financial and Operating Metrics Operating revenues ($bn) Operating expenses ($bn) Operating margin (%) Revenue passenger miles (bn) Available seat miles (bn) RASM (¢) CASM (¢) Load factor (%) Number of aircraft in fleet at year-end Average age of fleet at year-end (years) Average aircraft utilization (hours per day) End-of-year full-time employees 1997 1998 1999 2000 2001 13.6 12.0 11.6 98 137 9.94 8.78 71.4 553 11.8 8.6 65,383 14.1 12.4 12.0 101 140 10.09 8.88 72.2 569 12.3 8.7 70,846 14.9 13.1 12.0 106 147 10.12 8.90 72.2 782 12.0 8.2 72,791 16.7 15.0 10.4 113 155 10.80 9.68 72.9 831 9.6 8.0 82,127 13.9 15.5 -11.5 102 148 9.39 10.47 68.8 814 9.1 7.3 76,300 Source: Adapted from Delta company documents. Note: Figures for 2001 do not match those in Exhibit 6 precisely. Exhibit 6 includes domestic operations only, and this exhibit includes all operations, domestic and international. Exhibit 8 Florida Market Statistics Total passengers (millions) Market share (%) Delta Other legacy carriers AirTran Southwest JetBlue Average fare ($) Delta Other legacy carriers AirTran Southwest JetBlue 1994 1995 1996 1997 1998 1999 2000 2001 2002: Q1–3 56.3 56.7 63.4 68.2 69.2 74.3 78.9 77.4 56.8 27.6 59.5 24.4 56.5 1.3 25.7 52.5 1.6 3.2 28.4 49.6 1.6 5.5 29.7 48.0 2.3 6.5 28.8 46.1 2.7 7.3 28.0 44.6 2.9 8.9 0.7 26.8 42.6 3.0 10.6 2.0 26.3 41.5 4.3 12.2 3.3 193 164 196 173 82 160 168 179 104 172 173 128 109 181 178 122 114 182 181 129 123 184 188 137 126 121 170 181 141 121 135 163 174 133 120 147 Source: Casewriter analysis based on Department of Transportation, Bureau of Transportation Statistics, Airline Origin and Destination Survey data. Note: Delta figures include Atlantic Southeast Airlines and Comair after Delta’s purchase of the companies in 2000. 13 704-403 Delta Air Lines (A): The Low-Cost Carrier Threat Endnotes 1 Leo Mullin, chairman and chief executive officer, Delta Air Lines, interview by author, Atlanta, Georgia, July 15, 2003. 2 Mark Balloun, vice president of corporate strategic planning, Delta Air Lines, interview by author, Atlanta, Georgia, July 15, 2003. 3 Heather Draper, “Low Fares, High Stakes; United Flying Against Dismal Odds With Plan to Start Low-Cost Carrier,” Rocky Mountain News, March 15, 2003, sec. C, p. 1. 4 Air Transport Association, 2002 Annual Report, p. 7. 5 Air Transport Association, Airline Handbook (Washington, D.C.: ATA, 2002), http://www.airlines. org/public/publications/display1.asp?nid=961, accessed June 16, 2003. 6 Jim Whitehurst, senior vice president and treasurer, Delta Air Lines, personal communication. 7 This section draws especially on Pankaj Ghemawat and Nancy Donohue, “The U.S. Airline Industry, 1978– 1988 (A),” HBS Case No. 390-025 (Boston: Harvard Business School Publishing, 1989), p. 3. 8 Ghemawat and Donohue, “The U.S. Airline Industry, 1978–1988 (A),” Exhibit 1. 9 Ghemawat and Donohue, “The U.S. Airline Industry, 1978–1988 (A),” p. 4. 10 James Heskett, “Southwest Airlines 2002: An Industry Under Siege,” HBS Case No. 803-133 (Boston: Harvard Business School Publishing, 2003), p. 13. 11 Jim Corridore, “Airline Industry Profile: How the Industry Operates,” Standard & Poor’s, March 27, 2003, p. 6. 12 Amy Martin, Delta Air Lines, personal communication. 13 Air Transport Association, 2002 Annual Report, p. 11. 14 Marketrak survey, 2002, cited by Amy Martin, Delta Air Lines, personal communication. 15 Fortune, October 29, 1984, p. 8. 16 George C. Lodge and Charles Heckscher, “Note on the U.S. Airline Industry in the 1980s,” HBS Case No. 486-078 (Boston: Harvard Business School Publishing, 1986). 17 Kit Darby and Dan Gradwohl, “U.S. Airline Salary Survey 2001–2002” (Atlanta, GA: AIR, Inc., 2002), p. 149. 18 Corridore, “Airline Industry Profile: How the Industry Operates,” p. 9. 19 Ibid. 20 This section draws especially on the American Transport Association 2001 Annual Report (Washington, D.C.: ATA, 2002). 14 21 Don Carty, remarks to the Vancouver Board of Trade, June 27, 2002. 22 Jim Whitehurst, senior vice president and treasurer, Delta Air Lines, personal communication. 23 Heskett, “Southwest Airlines 2002: An Industry Under Siege,” p. 3. 24 Heskett, “Southwest Airlines 2002: An Industry Under Siege,” p. 2. 25 Heskett, “Southwest Airlines 2002: An Industry Under Siege,” p. 4. Delta Air Lines (A): The Low-Cost Carrier Threat 704-403 26 This section draws from Jody Hoffer Gittell and Charles O’Reilly, “JetBlue Airways: Starting from Scratch,” HBS Case No. 801-354 (Boston: Harvard Business School Publishing, 2001). 27 Roben Farzad, “Will Success Spoil JetBlue?” SmartMoney 102, June 2002, p. 2. 28 “Two Years Old, JetBlue Flies Five Millionth Passenger,” JetBlue press release, March 7, 2002. 29 Fred Reid, chief operating officer, Delta Air Lines, interview by author, Atlanta, Georgia, July 31, 2003. 30 For more detail, see Gittell and O’Reilly, “JetBlue Airways: Starting from Scratch.” 31 Michael Roach, interview by author, Cambridge, Massachusetts, June 24, 2003. 32 Fred Reid, chief operating officer, Delta Air Lines, interview by author, Atlanta, Georgia, July 31, 2003. 33 Corridore, “Airline Industry Profile: How the Industry Operates,” p. 6. 34 Remarks by Leo Mullin, Aero Club of Washington, D.C., June 19, 2003. 35 Michele McDonald, “Delta Express: We’ve Learned from Lite’s Mistakes,” Travel Weekly 55, August 15, 1996, p. 1. 36 Michael Roach, interview by author, Cambridge, Massachusetts, June 24, 2003. 37 Heather Draper, “Low Fares, High Stakes; United Flying Against Dismal Odds With Plan to Start LowCost Carrier,” Rocky Mountain News, March 15, 2003, sec. C, p. 2. 38 Wendy Zellner, “Will this Short-Hauler Fly?” BusinessWeek, June 8, 1998, p. 39. 39 Leo Mullin, chairman and chief executive officer, Delta Air Lines, interview by author, Atlanta, Georgia, July 15, 2003. 40 Alan Sbarra, Unisys, interview by author, Cambridge, Massachusetts, June 20, 2003. 41 Stan Pace, Bain & Company, interview by author, Cambridge, Massachusetts, July 7, 2003. 42 “More Charges of Illegal Conduct Filed Against Delta Airlines,” Association of Flight Attendants, filed_against_delta.asp. 43 Leo Mullin, speech at Delta Air Lines Annual Shareowners Meeting, October 25, 2000. 44 John 45 Leo Selvaggio, president, Song, interview by author, Atlanta, Georgia, July 31, 2003. Mullin, speech at Delta Air Lines Annual Shareowners Meeting, October 25, 2000. 46 Delta 47 Air Lines, 1997 Annual Report, p. 10. Terry Maxon, “Familiar Flight Plan,” The Dallas Morning News, August 10, 1996, sec. 1F. 48 Leo Mullin, chairman and chief executive officer, Delta Air Lines, interview by author, Atlanta, Georgia, July 15, 2003. 49 Subodh Karnik, senior vice president of network and revenue management, Delta Air Lines, interview by author, Atlanta, Georgia, July 15, 2003. 15 Answer the 4 questions listed below: 1. Why have most airline firms not been able to achieve profitability? (Hint: Do an industry analysis to show how industry structure has impacted profitability in the airline industry). 2. Why did the major legacy airlines like Delta and Continental not do well but low-cost airlines like Southwest and JetBlue did well in the same industry environment? (Hint – How did differences in the strategies and value chain activities of legacy airlines and low-cost airlines contribute to differences in competitive advantage and performance?). Draw the Value chain activities 3. Why have legacy airlines not been able to imitate the success of their low-cost competitors? Even when legacy airlines like Delta launched low-cost subsidiaries like Delta Express, such strategies have failed. Why? 4. Mark Balloun’s team at Delta is considering four strategic options (these are listed in the case). Which option would be the most effective strategy for Delta? Justify your answer. NOTE: The case questions have many aspects that require deep and sophisticated analysis from you. You demonstrate such mastery by applying the appropriate concepts and techniques to answer the case questions. Your answer to each case question must show evidence of an incisive analysis of the situation (rather than a mere synopsis of the situation). You must apply the appropriate concepts, theories, and techniques to justify your answer. I am also looking for answers that are specific to the situation in the case, not general descriptions of a concept or theory. Finally, your answers must be well written, making sure you answer all aspects of the question yet staying clear and concise in your response. Read the case and the assignment questions for clues as to what issues require special attention. Make sure that you have a thorough understanding of the theoretical concepts related to the issues in question. This may require a review of concepts covered in this or previous courses. Then, reread the case more carefully, taking notes and sorting assumptions, facts, and observations under relevant headings.



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