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34 Passenger Air Service Development Techniques LCCs tend not to Table 3.1. LCC fleets (as of September 2008). serve smaller Aircraft Seating communities. Their Airline Type Capacity fleets are not Southwest B737 122137 JetBlue A320 150 appropriate for E190s 100 Frontier A318 114118 the amounts of A319 132136 A320 162 passenger traffic Q-400 (Lynx) 74 that those AirTran B737s 137 B717 117 communities Virgin America A319 122 A320 149 generate. They may also serve smaller communities like Burlington, Vermont; Wichita, Kansas; or Pensacola, Florida; but those are the exceptions rather than the rule. LCCs tend not to serve smaller communities because their focus on business traffic in larger markets means they do not operate aircraft appropriate for small communities. Table 3.1 shows the fleets of the main U.S. LCCs. Except for JetBlue's 100-seat Embraer ERJ 190 aircraft and Frontier subsidiary Lynx Aviation's 74-seat Bombardier Q-400s, LCCs do not operate smaller regional aircraft. Small Communities and Niche Airlines Airlines that cater to a particular market segment--or niche--sometimes provide specialized services to small communities. Niche airlines serve major leisure destinations such as Orlando, Las Vegas, or the Caribbean and may also fly to other major U.S. cities, usually in southern states (e.g., Phoenix or Tampa). Depending on the airline, they may operate from smaller airports that are nonetheless close to substantial populations. U.S. niche airlines include Allegiant Air, Spirit Airlines, and USA 3000 Airlines. Allegiant focuses on flying travelers from 51 smaller cities to leisure destinations such as Las Vegas, Nevada; Phoenix, Arizona; and Fort Lauderdale, Orlando, and Tampa/St. Petersburg, Florida. The carrier operates a low-cost, high-efficiency airline offering air travel both on a stand- alone basis and bundled with hotel rooms, rental cars, and other travel-related services. During the second quarter of 2008 Allegiant Air announced new service, including the following: Bellingham, Washington, to San Diego and San Francisco Santa Barbara, California, and Monterey, California, to Las Vegas Wilmington, North Carolina, to Orlando Grand Forks, North Dakota, and Casper, Wyoming, to Las Vegas Since the industry Spirit and USA 3000 operate mostly from larger cities to destinations in the Caribbean and was deregulated in Latin America. 1978, commercial airlines have struggled to find What are the most significant recent trends in the airline industry? business models Since deregulation, commercial airlines have struggled to find business models that are that are viable over viable over the long term. Airlines have consistently labored to control their costs while gen- the long term. erating enough revenue to earn a return on investment. According to the Air Transport

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Understanding the Context for Air Service Development 35 Association, since the industry's inception, it has failed to generate a long-term positive net operating profit. Despite these challenges, the industry has attracted new entrants that believe they can operate successfully. New competition forces a competitive response from incumbents. The net result has been that most consumers have enjoyed long-term decreases in ticket prices when adjusted for inflation. Consumers also have more choices of airlines that are competing in more markets, allowing them to fly to more destinations on either a nonstop or one-stop basis. New entrants have also brought new technology to in-flight entertainment, with live television programs and satellite radio. However, many small communities have great difficulty attracting and retaining service. Congestion and delays are much worse than in years past. Many U.S. carriers have not been able to invest in new aircraft in a number of years, and passengers' on-board perceptions reflect that wear and tear on the equipment. Older equipment needs more maintenance. Some legacy air- lines are charging fees for items that were formerly included in the price of a ticket. How did the industry come to this point? The industry has a long-term record of growth in total capacity and enplanements. The demand for air travel is closely related to growth in national economic activity (as measured by the Gross Domestic Product). As shown in Figure 3.4, the total amount of capacity offered by commercial airlines and the total number of passenger enplanements have risen relatively constantly, except (000s) 1,200,000 1,000,000 800,000 600,000 400,000 Sept. 11 200,000 Gulf War Pres. Reagan fires air traffic controllers 0 RPMs ASMs Note: Capacity is expressed in available seat miles (ASMs)--a measure of the number of seats available for purchase and the total number of miles those seats are flown. Passenger demand is expressed in terms of revenue passenger miles (RPMs), which counts the number of ASMs for which a passenger has paid. Figure 3.4. Capacity and traffic have grown over time.

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36 Passenger Air Service Development Techniques for times of significant economic downturn (often precipitated by major external shocks, such as the first Gulf War; the events of September 11, 2001; and the 2008 spike in fuel costs). Commercial aviation has historically experienced pronounced business cycles. As the indus- try has grown, so too have the peaks of profitability and troughs of losses. Figure 3.5 illustrates the swings in net operating profits since the industry was deregulated. It highlights the five years of losses that began with the first Gulf War, followed by the six-year period of profitability in the late 1990s, and the significant losses that severely crippled the industry beginning in 2001. The increasing penetration of LCCs has contributed to the industry's difficulties in generating "enough" passenger revenue to earn net operating profits. LCCs' abilities to offer lower airfares force network carriers to offer competitive fares as well. For many years, the major network air- lines were able to fend off start-up LCCs. Many of those new entrants suffered from strategically questionable business plans and/or a lack of sufficient capital to withstand a prolonged competi- tive response from incumbents. Carriers like Air South, Kiwi International Air Lines, Legend Airlines, Western Pacific Airlines, and Vanguard Airlines briefly competed in various markets. Beginning in the late 1990s, however, other new entrants were able to adopt the Southwest model more successfully. They came into the industry with considerably more capital and bet- ter management. These carriers managed to compete head-to-head with the legacy network air- lines and survive both the downturn associated with the "dot.com" bust and the events of September 11, 2001. These LCCs--Southwest, AirTran, Frontier, Virgin America, and JetBlue-- have slowly expanded their overall market penetration. According to the GAO, these carriers compete in about 40 percent of the nation's largest 5,000 markets (which account for more than 90 percent of total passenger traffic) (4). Bombardier reported that LCCs' share of U.S. domes- tic capacity has grown to 27 percent (see Figure 3.6) (5). $ Millions 6.0 2007 Reagan fires air traffic controllers 1.0 "Dot.com" bust -4.0 Gulf War Sept. 11 -9.0 -14.0 Figure 3.5. Cyclicality of U.S. commercial airlines' net operating profits.

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Understanding the Context for Air Service Development 37 2000 0.69 0.16 0.15 2001 0.66 0.18 0.16 2002 0.64 0.19 0.17 2003 0.60 0.21 0.19 2004 0.57 0.22 0.21 2005 0.54 0.23 0.23 2006 0.51 0.26 0.23 2007 Q1 0.50 0.27 0.23 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Regional Low Fare Mainline Source: Bombardier Corp. Figure 3.6. Capacity shares held by mainline, regional, and low-cost carriers. Markets are becoming more competitive. GAO's 2008 report indicated that the average num- ber of competitors in the largest 5,000 city-pair markets has increased since 1998. The increased competition--especially from LCCs--added pressure on all airlines to keep airfares as low as possible. As a result, average fares have fallen over time. Between 1998 and 2006, the round-trip average airfare in the top 5,000 markets fell from $198 to $161 (in 2006 dollars), a decrease of nearly 20 percent. Expressed in terms of passenger yields (that is, fares paid divided by the total miles flown), airlines have had difficulty raising fares. See Figure 3.7. Increased fare competition has pressured airlines to reduce their operating costs to improve Increased competi- their financial positions and better insulate themselves from the industry's boom and bust cycles. Excluding fuel, unit operating costs for the industry [typically measured by cost per available seat tion has pressured mile (CASM)] have decreased 16 percent since reaching peak levels around 2001. Despite the airlines to reduce efforts made by legacy carriers, the cost gap between legacy and low-cost airlines still exists. operating costs. In the difficult years immediately after September 11, 2001, many airlines achieved dramatic cuts in their operational costs by negotiating contract and pay concessions with their labor unions, through bankruptcy restructuring, and through personnel reductions. For example: Northwest Airlines pilots agreed to two pay cuts--15 percent in 2004 and an additional 23.9 percent in 2006, while in bankruptcy--to help the airline dramatically reduce operating expenses. Frontier used its recent bankruptcy protection to break ties with its regional partner Republic Airways. Republic flew the 76-seat Embraer 170 in its code-sharing relationship with Frontier. Frontier subsidiary Lynx Aviation will replace that capacity with its Q-400s, which burn 30 percent less fuel.

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38 Passenger Air Service Development Techniques Yield (cents) 16 Nominal Dollars 14 12 10 8 6 4 Constant Dollars 2 0 Source: InterVISTAS analysis of U.S.DOT data. Figure 3.7. Average yields have declined. Legacy airlines cut personnel as another means to reduce costs. The average number of employees per legacy airline decreased 26 percent from 1998 to 2006. Several airlines also used bankruptcy to significantly reduce their pension expenses, as some airlines terminated and shifted their pension obligations to the U.S. Pension Benefit Guaranty Corporation. As is now well known, fuel costs soared over the last few years before collapsing in the second half of 2008. In early 2008, jet fuel climbed to over $2.85 per gallon. By comparison, jet fuel was $1.11 per gallon in 2000, in 2008 dollars. As shown in Figure 3.8, despite the downturn in jet fuel costs, total industry fuel expenses in 2008 approached $60 billion--nearly four times total indus- try expenses in 2003. As a result, cost savings that the industry achieved from labor have been more than offset by increases in the cost of fuel. (See Figure 3.9.) Historically, fuel expenses ranged from 10 percent to 15 percent of U.S. passenger airline operating costs. Now, those costs are between 35 percent and 50 percent. Many industry experts believe that airlines simply are not able to raise fares sufficiently to cover the costs of increased fuel charges, at least not at this point in time, without losing consid- erable portions of their passengers. For example: "The industry can attempt to pass on its higher fuel costs in the form of multiple fare increases, but given the elasticity of demand, only so much can be done without substantially reducing domestic capacity. We continue to believe that there is likely to be another large cut to domes- tic capacity in 2H 2008 if the industry does not see any relief from record high fuel prices." --Merrill Lynch Equity Research (6) "[R]aising airfares isn't like raising the price of milk at the grocery store. Consumers have almost perfect information for price comparisons--the Internet can hunt the cheapest fare

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Understanding the Context for Air Service Development 39 Billion dollars Billion gallons 70 25 60 20 50 15 40 30 10 20 5 10 0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 Expenses Consumption Figure 3.8. Fuel costs have soared over the past five years. Percent of operating costs 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Fuel/Oil Labor Figure 3.9. Fuel costs now exceed labor.

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40 Passenger Air Service Development Techniques worldwide in seconds. If one carrier has some empty seats to fill, it will have to cut the price because getting something for that seat is better than flying it empty. And there's lots of com- petition in the industry--some airlines have lower cost structures than others, or better fuel hedges, and can absorb more of the higher costs than others." --Scott McCartney, The Wall Street Journal (7) In conjunction with a 2008 slowdown in the U.S. national economy causing consumers to reduce discretionary spending, carriers have begun to take extraordinary measures to reduce fuel costs and cut capacity. For example: US Airways announced that it will reduce its domestic mainline capacity by 6 to 8 percent in the fourth quarter compared with a year earlier, and slash capacity in all of 2009 a further 7 to 9 percent. It will return 10 narrowbody aircraft to lessors by 2009 and cancel leases of two widebody aircraft. The carrier announced that it will cut 300 pilots, 400 flight attendants, 800 airport employees, and 200 staff and management employees. Continental will reduce its domestic capacity by 11 percent. Continental's capacity in Cleveland will drop 13 percent and it will cut service to 24 cities. United announced that it would reduce its mainline domestic capacity after the summer travel season, eliminating 30 older 737s from its fleet. At the end of 2008, United's domestic capac- ity will have decreased by 6 to 7 percent. Ten airlines have filed for bankruptcy or ceased operations since December 2007, with many citing the significant increase in fuel costs as a contributing factor. The airlines that filed for bankruptcy or ceased operations in 2008 included Air Midwest, Aloha Airlines, ATA Airlines, Big Sky Air, Champion Air, EOS Airlines, Frontier Airlines, MAXjet Airways, Skybus Airlines, and Sun Country. ExpressJet suspended its "branded flying" (i.e., flying not as Continental Express or Delta, but as ExpressJet). The regional carrier connected many smaller communities with its 29 ERJ 145s. Despite flying 503 million revenue passenger-miles (RPMs) and a load factor of 71 percent in the second quarter of 2008, record-breaking fuel prices forced the airline to abandon those operations on September 2, 2008. The Cost and Revenue Challenges of Operating Small Aircraft Over time, U.S. carriers have been flying more capacity and more passengers in increasingly smaller aircraft. Carriers now operate very few widebody aircraft in domestic service. Since 2003, the number of departures by widebody aircraft has decreased 46 percent. On the other end of the aircraft spectrum, the use of turboprop aircraft has also decreased. Figure 3.10 illustrates the change in the use of turboprop, regional jet, and narrowbody aircraft since 2003. It indicates that U.S. network air- regional jet usage remains slightly higher than 2003 levels. Turboprop departures, on the other lines have moved hand, have dropped by nearly 25 percent. toward using Airlines have moved toward smaller aircraft in part because those aircraft are operated by regional partners' regional affiliates, which have a lower cost structure than mainline operations. In larger markets, using smaller aircraft gives network carriers an option to offer additional frequencies spread smaller aircraft, throughout the day, which allows passengers--especially business travelers--more flexibility in because of cost when they can travel. In other communities, using smaller aircraft also allows carriers to offer service because the capacity is better suited for smaller markets. reasons. The Regional Airline Association (RAA) notes the importance of regional aircraft to the U.S. national aviation system. In 2007, regional airlines: Smaller aircraft also Operated a fleet of 2,462 aircraft, with an average size of 52 seats; Completed nearly five million departures, with an average stage length of 464 miles; and allow for greater Provided the only scheduled service at 70 percent of the U.S. airports that received commer- frequencies. cial service.

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Understanding the Context for Air Service Development 41 40% 30% 20% 10% 0% -10% -20% -30% Narrowbodies Regional Jets Turboprops Source: InterVISTAS analysis of DOT data. Figure 3.10. Percent change in use of aircraft since 2003. Over recent years, the average size of the regional fleet has slowly increased. The number of 19- to 37-seat turboprop aircraft in the regional fleet has slowly dwindled, replaced by larger regional jets. Now, the most widely used aircraft in the regional fleet are the 50-seat regional jets manufactured by Bombardier and Embraer (Table 3.2), and more flying is now being done in 70- and 90-seat jets. The popular tide began to turn against small regional jets (RJs) in the last few years. As net- work airlines replaced mainline flying with RJs and began deploying RJs over longer routes, pas- sengers became less enamoured with the aircraft. Passengers complained about their cramped interiors and relatively poor ergonomics compared to the larger narrowbody aircraft in which they were accustomed to flying. RJ costs have also risen recently, making them less attractive to mainlines. Fuel costs have been Because of rising even more important to RJs. The critical difference between the two types of aircraft is that regional jets simply have fewer seats across which an airline can spread uncontrollable costs-- fuel costs and their such as fuel. So as fuel costs have risen, so have RJs' unit costs. Fuel might account for 25 percent inability to pass of the cost of flying a mainline jet, but it can be 40 percent or more of the cost of flying a regional jet. With American Eagle's Embraer 145 operations, fuel costs have risen from 26 percent of those costs on to operating costs to nearly 50 percent. See Figure 3.11. passengers in a In response to the increase in fuel cost and airlines' inability to pass all of those costs through declining market, to passengers because of slackening demand, carriers had little choice except to reduce their carriers had no capacity. Figure 3.12 summarizes the cuts that carriers announced for the last quarter of 2008. The reductions allowed the airlines to remove some of the more inefficient aircraft from their choice except to fleets, but it also meant decreases in services and competition at many communities. decrease capacity.

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42 Passenger Air Service Development Techniques Table 3.2. U.S. regional fleet (as of July 2008). Average Number in Total Company Aircraft Type Seats Service Seats Bombardier CRJ 100 / 200 50 748 37,400 Embraer EMB 145 50 524 26,200 Bombardier CRJ 700 70 230 16,100 Embraer EMB 135 37 157 5,809 Embraer ERJ 170 70 137 9,590 Saab Saab 340 35 135 4,725 Bombardier DHC-8 100 / 200 37 125 4,625 Bombardier CRJ 900 86 110 9,460 Raytheon Beech 1900 19 79 1,501 Embraer EMB 120 30 68 2,040 Bombardier DHC-8Q-400 74 58 4,292 ATR ATR 72 60 51 3,060 Cessna Cessna 402* 9 49 441 Bombardier DHC-8Q-300 50 39 1,950 Bombardier DHC-6 19 20 380 Cessna 208-Caravan 10 13 130 Britten Norman BN Islanders 9 8 72 Embraer ERJ 190* 106 8 848 Fairchild/Dornier Metro 19 6 114 Piper Chieftain* 9 4 36 Reims-Cessna 406 9 4 36 ATR ATR 42 48 2 96 Raytheon B200 9 2 18 Embraer EMB 110 15 1 15 Convair 340/440 50 1 50 *Includes only aircraft for RAA members. Source: Regional Airline Association 2008 Annual Report Continental, for example, announced a total capacity reduction (mainline and regional) of 6.4 percent compared to the prior year, beginning in September 2008. It plans to reduce regional operations from Cleveland to 24 cities, most of which were served by its Continental Connection regional partners. Some of the smaller cities losing service included Toledo, Des Moines, Tulsa, and Green Bay. Delta expects to cut service to smaller markets by eliminating 60 to 70 regional jets by the end of 2008 and reducing the number of regional carriers it uses. According to Credit Suisse, Delta is cutting service in markets where there is no direct competition, such as in Cincinnati and Salt Lake City. Another target for cuts is regional nonstop flights that bypass hubs, which the carrier does not believe are economical in this fuel environment. Very Light Jets and Air Taxis--an Emerging or a Dying Niche? Generally speaking, very light jets are jet aircraft with a maximum take-off weight of 10,000 pounds, certified for single pilot operations, equipped with advanced avionic systems, and priced below other business jets. Two models of VLJs--the Cessna Citation Mustang and Eclipse 500 (See Figure 3.13)--received FAA type and production certification and began delivering aircraft. Market conditions in 2008 and 2009 have seriously hampered the development of this niche. DayJet Corporation operated a fleet of Eclipse 500 aircraft in the U.S. Southeast, connecting

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Understanding the Context for Air Service Development 43 Percent of operating expenses 60% 50% 40% 30% 20% 10% 0% Figure 3.11. Fuel costs represent nearly half of American Eagle's Embraer 145 operating costs. Decreases in Available Seat Capacity 14% 12% 10% 8% 6% 4% 2% 0% United American Continental Delta Northwest US Airways Airtran Figure 3.12. Announced airline capacity reductions, fourth quarter 2008.