United Airlines just announced that they are increasing their fee on the second checked bag from $25 to $50 for, essentially, economy seats on North American domestic flights. Their 1st check bag fee remains $15. This is great timing for me, personally, because the subject of my business law class this morning was tort law. The connection being that damages available under tort law include compensatory, nominal, and punitive. Airline fees seem to be falling into the same categories lately, with some airlines adopting what can only be considered punitive fees. $50 for a second checked bag being a prime example.

Continental Airlines reported last week that it expects to generate up “in excess of $100 million dollars in net benefits” from their baggage fees over the next year. Following the trend of many U.S. airlines, CAL has put in place a $15 fee for the first checked bag for its domestic economy passengers. You have to wonder if their definition of “net benefits” would show that a customer lost to the competition is a “net benefit” since you won’t incur the cost of servicing that customer. Frontier Airlines demonstrated this week that it really isn’t a whole different animal by following the industry trend and introducing its own checked baggage fee schedule that starts with $15 for the first checked bag, $25 for the 2nd and 3rd checked bags, and $50 for the 4th and higher check bags.

Now, getting back to tort law, Frontier’s checked baggage fees make good fodder for my “damages” example. I.e., a $15 fee could be considered “nominal” meaning that it isn’t that big of a deal and gets the point across that, yes, checking in a bag for a flight is in fact a service that one could reasonably be expected to pay for. The $25 fee being more “compensatory” in nature, meaning that it is really just there to cover the costs of handling the extra baggage. Then, lastly, my favorite. The punitive fee of $50 for the 4th and all subsequent bags. Punitive meaning that it is really more like a fine than a fee. Clearly, such behavior is harmful to society and you need to be made an example of, lest others commit similar atrocities.

As fun as that all is, baggage fees really are, by and large, simply revenue grabs. An appropriate nominal fee would be $1, and a justifiable compensatory fee would be in the $5 - $10 range. I do hold, however, that $50 for any checked bag is really a punitive fee. It makes sense that handling and transporting baggage is a service, and providing that service costs the airline money that it should be able to recoup and, dare I say, profit from. However, what do you think it actually costs an airline to carry a 50lb bag on a flight? Well, if you are a 737-800 flying 1,200 nautical miles, throwing one more 50 lb bag onto an already loaded aircraft would mean that would burn about 1 extra gallon of fuel on the flight. In economic terms, the marginal fuel burn for 50lbs is about 1 gallon. An A321 flying coast-to-coast would need about 2 extra gallons of fuel to take on that extra 50lb bag. Keep in mind, though, that most short haul flying is less than 500 nautical miles. Granted, there is also a ground handling cost involved which I don’t have a good estimate for, but I would guess to be around $1 per bag at the margin.

Now, no one will blame a money losing airline for trying to increase revenues, but in a highly competitive market you have to be suspect of prices that grossly exceed the marginal cost of providing the product/service. They are just not sustainable. In other words, if there is that much margin built in to baggage fees, then you have to expect that they’ll eventually be competed away. Indeed, Southwest is making quite a big deal of the fact that it does not charge such fees. Now, that isn’t to say that baggage fees, in some form, won’t hold. I think “nominal” and “compensatory” level fees, to stick with the analogy, can stand up to competitive pressure, but $50 for a second bag will likely cost United more money in lost customers than it will generate in revenues.

The Johnson School at Cornell University just held its capstone event for 1st year MBAs, an “Integrative Case Competition”. The case? Essentially, “What airline should Continental acquire and why?”. The case was set up from and investment banker’s perspective, pitching the deal to Continental. Given all the talk of consolidation within the airline industry the case was both relevant and timely, although I don’t think that many expect CAL to be the first to initiate a deal.

Before reading on, take a second to consider who you think would be the best acquisition target for CAL.

The winning case team pitched that CAL, NWA, and a European Private Equity firm partner up for a Joint Venture to establish a Special Purpose Acquisition Vehicle and acquire BMI. A highly improbable deal, to put it mildly, but certainly the most creative recommendation.

I believe the most popular pitch was that CAL acquire Alaska Airlines. Their homogeneous fleets of Boeings (increasingly dominated by 737-800s), complementary route structure, and similar reputations seemed to make the most sense from a long-term strategic point of view. Alaska Airlines would give CAL a west coast presence from which to further expand internationally.

The next most-pitched deal was a CAL-NWA merger. Few would argue this doesn’t make any sense from a “synergies” point of view, but I question if CAL is in a position to lead such a deal, or could come out a winner if Delta decided to join the bidding. I have similar doubts for CAL’s ability to acquire United or Delta, which were also pitched.

The best part of the competition was the quality of the judges panel, which included professionals from Citi, Northwest Airlines, AWAS, and McKinsey, among others. Several of the judges have been working in the airline industry for 20 years or more.

The MBA students got a crash course in the airline industry and quickly discovered its inherent difficulties from a management perspective. Unsteady cash flows, very high debt to equity ratios, heavy use of operating leases, regulatory constraints, and labor issues make it very difficult to place a value on an airline, and also limit the many of the strategic alternatives management has available. Like most industry watchers, I believe we’ll see some M&A activity within the industry within the next year or two. I am tempted to say that it is an exciting time for the airline industry, but then again, when isn’t it?

I just finished reading From Worst To First and wanted to share my impressions. A quick disclaimer: this book was published in 1999, so there is nothing new or trendy here. That said, I found Gordon Bethune’s narration of his efforts that led to the successful turn-around of Continental Airlines in the mid-90’s to be a very worthwhile read even 8 years later. The problems Mr. Bethune faced and the strategies that he and his team formulated and implemented could apply to almost any business in any industry at any point in time. It is a tale of leadership. I was actually a bit disappointed that more than 95% of the book really isn’t specific to the airline industry, however I quickly came to realize that many (most?) of the problems airlines really face aren’t really that unique to the airline business anyway. Companies in every industry need a good product, they need to be strategic in how they employ their capital, they need to position themselves against their competitors, and they need good leadership. In this book, Gordon Bethune outlines the approaches he took on these topics after becoming the CEO at Continental which was in rather dire straits at the time.

Although the book could have been condensed fairly easily, I found this to be a good read that anyone who manages people should consider reading despite its age.