"deltaBlue": Return of the low-fare airline-within-an-airline? December 2002

In a remarkable strategy reversal, some of the US major airlines are looking to return to the low–fare "airline within an airline" concept as a means of defending their markets from low–cost competition. Most notably, Delta has just announced plans to create a new low–fare airline subsidiary in early 2003. UAL, in turn, has been considering resurrecting United Shuttle (though averting bankruptcy is obviously a priority for UAL at present).

This comes barely a year after the major airlines seemingly lost all interest in operating separately branded low–fare units in the post–9/11 environment. The final months of 2001 saw US Airways phase out MetroJet, United discontinue the Shuttle brand and Delta halve its Delta Express operation.

Shedding the low–fare units was part of efforts to better match capacity with sharply reduced customer demand. There was less demand for high utilisation, quick turnaround flights. The airlines wanted flexibility to use larger or smaller aircraft depending on market conditions and frequency needs (all of the low–fare units had dedicated fleets of Boeing 737s).

However, the majors also gave the impression that they were taking the 20%-plus post–9/11 capacity cuts as an opportunity to revamp their networks. In effect, they withdrew from the lowest- yielding market segments, which they could not serve profitably at their high cost levels.

Although the low–fare units may have served a useful purpose in helping their parents retain market share, they never got their unit costs anywhere near the original targets (Southwest’s levels).

All of that enabled low–fare airlines that actually have low cost structures — the likes of Southwest, AirTran, Frontier and JetBlue — to significantly gain market share (and remain profitable) during the post–9/11 industry crisis. The low–cost carrier inroads have again been the greatest on the East Coast, affecting US Airways and Delta the most.

US Airways, which has been in Chapter 11 bankruptcy since August, estimates that, over the past four years, low–cost carriers have almost doubled their share of East Coast capacity from 10.7% to 19.4%, while its own capacity has fallen from 21.9% to 18%.

According to Delta’s calculations, low–cost carriers' share of industry capacity has grown by one percentage point annually since 1990 and will increase from the current 22% to 30% by the end of the decade. Almost 40% of its passengers already have a meaningful low–fare carrier option. Delta’s surveys also showed that 70%-plus of its passengers make their purchase decision almost exclusively on price. Delta considers low–fare competition its "single greatest emerging challenge" and a much bigger threat than that posed by other hub–and–spoke competition.

Of course, having already downsized, US Airways' priority now is to complete a financial reorganisation and emerge from Chapter 11. If it succeeds, it is looking to strengthen its hub–and spoke operations through a major expansion of regional jet services, rather than trying to resurrect MetroJet.

However, Delta is the most obvious candidate to continue head–to–head battles with low–cost carriers in the core leisure markets — and probably the one most likely to succeed in that task. First, it is in a relatively strong financial position by current industry standards. Second, it has the experience and strong market position built with Delta Express (the sole remaining low–fare unit operated by a major). Third, it is already an industry leader in RJ operations. Fourth, it has a primarily non–union workforce and lower than average labour costs.

In the November 20 announcement, Delta said that the new venture would be a wholly owned, separate subsidiary that would utilise a dedicated fleet of 36 757s by the end of 2003. Operations would begin in the spring, initially in major Northeast–Florida markets, with later expansion across Delta’s US network. The unit would have a "cost competitive business model", a simple low fare structure, a distinctive brand and "amenities and services to meet the expectations of price–savvy customers".

The venture is still a work in progress, with details such as name, product and service elements and marketing and people strategies to be determined and unveiled in the coming weeks and months. According to Delta executives, the name will be announced by February.

It is already quite clear that the new venture is being both modelled on and targeted at JetBlue, rather than Delta’s traditional rival AirTran Airways. This is despite the fact that only 6% of Delta’s domestic revenues are currently exposed to JetBlue, compared to 26% to AirTran (JP Morgan figures).

Delta’s choice reflects JetBlue’s huge all around success — operationally, financially and in the marketplace. But JP Morgan analyst Jamie Baker also suggested recently that thanks to a new fare structure introduced in the summer of 2001, "Delta already has AirTran on the run".

As evidence, Baker pointed out that AirTran now derives less than 40% of its revenues from Atlanta, compared to more than 60% two years ago.

The new Delta subsidiary will replace Delta Express, the low–fare unit created in 1996 that currently serves 14 cities in the Northeast- Florida market. It has helped Delta maintain market share in Florida but, despite the fact that its pilots worked at lower pay, was not much of a success on the cost front. Also, Delta now feels that a more powerful response is needed to the low–cost carrier threat.

The new unit’s 757s will come from the secondary hubs of Salt Lake City, Cincinnati and Dallas, where Delta has identified a need to slightly reduce hull size. The Delta Express 737- 200s will go to those hubs as the reconfigured 757s are delivered.

The new unit’s president, former Midway Airlines chief John Selvaggio, presented an impressive list of five things that the new venture needed to be successful. It sounded like the Southwest/JetBlue model: a clear mission, strong focus on costs, operational simplicity, the right markets and a distinct brand.

However, history is not encouraging as regards to the major network carriers' ability to successfully execute such strategies for their low–fare units. There is considerable scepticism especially about Delta’s ability to reach the ambitious cost targets and to create an attractive, distinct brand.

Sustainable low cost structure?

The aim is to get the new low–fare carrier’s unit costs 20% below those of Delta’s mainline 757s. The cost per ASM target is "a number that begins with seven", which would be truly impressive (Southwest’s unit costs in the first nine months of this year were 7.39 cents, while JetBlue’s were 6.48 cents).

Interestingly, there is no intention to seek separate lower pay scales. Instead, Delta is counting on getting the cost savings through increased productivity of people, aircraft and other assets. The savings would arise, first, from the aircraft and route structure changes. Single class seating (199 seats, as opposed to 180–184 in two–class configuration) and point–to–point flying will inherently improve unit costs.

Second, Delta is aiming for average daily aircraft utilisation of 13.2 hours — a rate that would be among the highest in the industry. It would compare with 10.7 hours for the mainline 757s and about 11 hours that Delta Express achieved at its peak. It would even be higher than the 13 hours currently achieved by JetBlue.

According to Delta, the 13.2 hour utilisation would be achieved by extending the operating day and opting for a specific route structure (making east–west long haul services highly likely in the near term). Also, Delta has apparently developed a process that will reduce the 757 turnaround time at airports from 80 to 50 minutes.

Third, there will be savings from operational efficiencies, primarily employee productivity. For example, going single class will reduce the number of flight attendants per flight from 5–6 to four.

There will also be efficiencies from new airport and in–flight processes, increased self–service and automation.

Fourth, the new unit is expected to benefit from an aggressive direct distribution goal of having 70% of all tickets purchased directly from the airline’s website or reservations service centres.

The plan is to recruit for the new unit directly from Delta’s active workforce, the idea being to select the right type of people to meet Southwest/JetBlue–style service and efficiency targets. Delta expects there to be opportunities for income enhancement through higher productivity.Nevertheless, the plan not to seek reduced wages has drawn criticism from analysts. Several have argued that it will make it harder to fight low cost competitors. According to JP Morgan’s Baker, a senior Delta 757 captain earns $245 per hour, which is substantially more than the $149, $118 and $100 earned by senior captains at Southwest, AirTran and JetBlue respectively. Baker is finding it hard to accept Delta’s efficiency improvement assumptions. He estimates that the new unit’s seat–mile costs will still be 10% higher than Southwest’s and 30% higher than JetBlue’s (based on 2Q02 DOCs, adjusted for a higher seat count and a 7–8% efficiency boost at "deltaBlue").

While agreeing that it makes sense for the new unit to use 757s in the large markets, many analysts are unimpressed by a strategy of lowering unit costs by bringing larger aircraft to point to- point markets. It is certainly much easier than reducing labour or overhead costs. However, labour or overhead cost reductions are not necessarily any more sustainable in the long run.

Then there are the thorny cost allocation problems. As Raymond James analyst Jim Parker pointed out in a recent research note, the majors may claim low costs for their low–fare units when many cost items, such as overheads, airport facilities, maintenance, marketing and distribution, remain the burden of the parent.

A distinct brand

Delta is establishing a new subsidiary, rather than just expanding Delta Express, because it wants to create a distinct brand. By doing that, it hopes to avoid the customer and employee confusion that has plagued other low–fare subsidiaries, including Delta Express.

No doubt influenced by JetBlue’s success, the new brand will offer more amenities than Delta Express. The details will not be announced until early 2003, but Delta executives described it as "very relevant, very attractive and quite popular". It would "address the yet–unmet needs of customers", though it would also include an element of Delta’s FFP and interlining at New York JFK. There have been reports that the name would be as "snappy" as JetBlue’s. And Delta executives have hinted that there would be entertainment options competitive with JetBlue’s popular in–flight satellite television. LiveTV has been so vital for JetBlue that it ended up buying the company in September (for $80m, including the retirement of $39m of debt). While JetBlue is not allowing direct competitors access to LiveTV, Delta executives hinted that similar alternative technology is available.

The problem from Delta’s point of view is that an attractive brand usually consists of more than just flashy amenities. It may include components such as a special corporate culture, entrepreneurial spirit, high–profile leadership and high worker motivation, which are much harder to emulate.

Markets and growth strategy

One of the new unit’s strongest points is that it will enter high–density markets where low–fare demand is proven and where Delta already has a strong presence. In other words, it will not have to take a risk with small new markets that require stimulation.

There are no plans at this point to bring the new unit to Atlanta, but Delta is not ruling out bringing it to hubs. Its route structure is certainly expected to be much more diversified than that of Delta Express, with some non–East Coast flying likely to be added in 2003.

If all goes to plan, by the end of next year the low–fare unit will represent about 10% of Delta’s total ASMs — the same as Delta Express at its peak. Delta is expected to grow it relatively slowly and stick to the concept.

Even if it is hugely successful, there is virtually no chance that the low–fare unit could eventually take over the rest of Delta’s operations, because Delta has a valuable hub–and–spoke mainline franchise to maintain. The two types of network require fundamentally different operating and pricing strategies.

When announcing the new venture, Delta spoke of it as just one important component of its current "portfolio of businesses", which also includes network service through hubs, international service, code–share relationships and RJ operations. Like AMR and others, Delta is also focusing on trying to fix problems with the mainline business model. The $75m capital budget allocated for the low–fare venture is only a small part of Delta’s anticipated total $1.6bn capital spending next year.