Author’s note: The following is a response to Bernie Leighton’s excellent op-ed, Thomas Malthus Would Love The U.S. Flying Market. You should read said op-ed in its entirety before reading my response.
MIAMI – I’d have to disagree that there isn’t an airline or at least a product offering for every segment of the market in the U.S.
If you want the cheapest ticket possible and you don’t care about comfort, you can go to Spirit, Frontier, or soon the back of the bus on one of American’s 737 MAX 8s. If you want slightly better service that is relatively comfortable while paying a slightly higher price point, you can go to Southwest or (non-basic) economy on most of the legacies and JetBlue/Alaska.
If you want an extra legroom product with some differentiation at a reasonable price point, you can go with extra legroom seats on JetBlue, Alaska, or the legacies. And if you want to pay for it, you can still have an excellent experience with really comfortable seats, free alcohol, and (admittedly mediocre) food.
For all of the economy or extra legroom offerings, you can even (thanks to emerging technologies) bundle in the exact set of frills that you want in your experience (whether that’s meals, Wi-Fi, expedited check-in, and security, or a window/aisle seat).
There is an offering in pretty much every segment of the market, and (as long as you are willing to connect) multiple competitive options on routes representing 90% of U.S. air travel volume.
The second claim that I take issue with, is that airlines don’t compete on “things that actually matter to the customer.” Airlines, in fact, do compete each and every day on things that do matter to the U.S. consumer.
The simple fact of the matter is that seat pitch, comfort, and even customer service don’t actually matter to the U.S. air travel consumer, at least not in the back of the bus. In consumer markets, the only things that “matter” are what consumers are willing to pay for and pay more for.
The classic example is legroom – despite everyone and their brother moaning and groaning about declining seat comfort standards, no one was willing to pay more for American’s “More Room Throughout Coach” product in the early 2000s.
Not enough passengers are willing to pay a measly 8% Premium to enable JetBlue to keep the A320s at 150 seats as opposed to growing them to a more packed 162. I mean, if this were something that customers truly cared enough to pay for, I’d rarely be on a legacy or even low-cost carriers (LCC) flight where the Premium was more than 15-20% for an extra legroom seat (like Main Cabin Extra or Even More Space).
Yet on pretty much every flight I fly, Economy is usually booked solid while multiple extra legroom seats remain open. Passengers don’t care enough about this stuff to vote with their pocketbooks.
The ultimate example is Virgin America. Yes, they didn’t fly everywhere that passengers wanted to go, and yes the frequent flyer program wasn’t the greatest. But this was truly a world class short haul operation, arguably better than that of most European or Asian carriers.
And even in markets where they were present, customers still chose other carriers over Virgin America all the time. You simply can’t make a credible argument that U.S. customers actually “care” about this stuff if they’re not willing to pay for it.
Now let’s address the elephant in the room, which is, of course, the recent spate of “incidents” surrounding onboard service and airline employees allegedly (and in some cases actually) mistreating passengers.
The actual culprit here is a cocktail of factors, ranging from post 9/11 security requirements to additional responsibilities for already overworked flight attendants. But as someone that has built and scaled customer service organizations, I have to say, customer service is really, really hard, even at the best of times.
If I were running an airline’s service team and my only job was to improve customer satisfaction with service, I’d want to have a team of highly paid, highly trained flight attendants, gate agents, etc. making a minimum of $60k+ a year ($80k+ for the flight attendants).
But guess what, that would push flight costs up by 8-10% and if I were the only airline to make that choice, I’d lose my shirt. Again, good customer service just isn’t something that U.S. consumers are willing to pay for.
I think that more broadly, you and I have a philosophical difference in how we think about balancing the payoff in the U.S. airline industry between different stakeholders. If you take it as a given that the different stakeholders in the U.S. airline industry are (1) consumers, (2) front line airline employees, (3) management & shareholders, (4) communities.
I think you broadly focus almost exclusively on consumer interests above all else, that consumers need a better deal. But air travel is ridiculously cheap by historical standards (adjusted for inflation), and (adjusted for employee costs and regulatory overhead) reasonably priced even relative to global standards.
I instead believe that the returns in the airline business should be spread across all of those stakeholders, and in the current system, you finally see airline employees getting some financial security and stability, and more importantly, you see shareholders finally getting a reasonable return.
Now knowing you, I think your next argument is going to be that actually, employees should still get what they get and shareholders should be the ones to take it on the chin. Which sure, let’s say that I concede that any excessive returns that shareholders get can come down a bit to help fund your ideas. But here’s the thing, U.S. airline shareholders aren’t actually getting these astronomical returns.
First of all, the U.S. airline industry as a whole made a grand total of $0 between 1978 and 2010, and only in recent years has it seen something resembling sustained profitability. Second, I want to be really careful about how we define excess returns.
Something that I think most folks that criticize airlines for being “too profitable” (apparently one of the great crimes of human history) don’t recognize, is that access to capital is competitive – investment capital flows to the companies that produce the best returns.
Without getting too far into the financial minutiae, a company, in the long run, isn’t going to get a ton of capital to flow to it unless it produces returns that exceed a metric known as the weighted average cost of capital (or WACC).
This doesn’t matter as much if you’re in a low capital virtual business like Twitter, but in a capital intensive business like the airlines, access to capital is a must (even if you aren’t growing, you have to replace your fleet). And since the U.S. is a relatively mature market, that means that your long run net profit margin (post-tax) has to exceed your WACC by a decent amount for you to continue to receive capital.
The WACC for the S&P 500 sits between 7 and 9% in most years. In 2016, Delta generated a post-tax net profit of 11% and for most U.S. carriers that number is 8-12%. But remember that we’re in the peak of an economic cycle and capital is competitive in the long run.
In the next recession, you can expect Delta’s net returns to drop to somewhere in the 4-6%, yielding an overall long run net margin of 6-8%. There aren’t excess returns that you can just seize from shareholders.
Let me ask you this. Are you okay with forcing every U.S. airline passenger to pay an extra 15–20% on every route to get the service improvements that you want?
And remember, the effect isn’t really going to be bad for you and me who can afford it – it’s going to be bad for the lower middle-class family that can no longer take the vacation of their dreams to Disney World, or the retired grandma who can’t afford to visit her grandkids anymore.