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.

How many times have you heard the word “lucrative” associated with international and/or business class flying? Yeah, me too. That was obviously the thinking behind upstarts like EOS (whose lie flat beds in their all-premium class 48-seat 757 aircraft are shown at right), SilverJet, and others. I can imagine how the discussions that led to those start-ups went: “Hey, airlines make all their money flying business passengers on overseas routes, so how about we start an airline where that is all we do! We’ll get all the lucrative customers and be a lucrative company!” Of course, there is a lot of truth to that, but can such up-starts get a positive return on investment before the inevitable competition squashes those “lucrative” margins?

So, why, exactly, is it that international business class flying is so much more lucrative than “normal” flying? I see two predominant factors at play: restrictive bilateral agreements and “soft” competition on international routes. Typical bilateral agreements between nations put a cap on the number of flights between two sovereigns and the respective governments are typically responsible for awarding routes to airlines. These were effectively government sponsored monopolies on routes. Additionally, I believe competition has been relatively soft on these routes because the major carriers are better at not triggering price wars, which is a lot easier to avoid when you don’t have LCC’s flying the same routes.

The business landscape on this lucrative flying is changing very quickly and the factors that allowed for abnormal profitability are waning. The EU-US Open Skies agreement obviously opens up the trans-Atlantic flying to new market entrants and therefore increased competition. Market entry by the all premium class international carriers such as EOS, SilverJet, L’Avion, and MaxJet (which has already gone out of business) simply prompted the carriers whose business these new entrants intended to steal to react with similar offerings. British Airways (flying an A318 to where?!?!) and American Airlines have responded with increased amenities and offerings for the premium international traveler on trans-Atlantic routes, and Singapore International Airlines has just announced that they intend to the same on the trans-Pacific front. Add to that the desire of Low Cost Carriers to enter the fray, the prime example being Ryan Air’s stated intention of offering bargain fares to cross the pond.

Expect abnormal profitability from international routes and business/premium class customers to be competed away (think “reversion to the mean”, for you statistics-minded people out there). In the end, “lucrative” is great if you are in business, but “sustainable” is probably better. Mark my words, competition for international and business travelers will get vicious, first on the EU-US routes followed next by US-Asia routes. Airlines that are relying on this business to subsidize other pieces of their enterprise need to get in front of this and expect a reversion to normal levels of profit from this component of your business (it’s scary to think what “normal levels of profit” means in the airline industry). It won’t happen over night, but expect it to happen.

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?

When I wrote about door to door service back in September I didn’t realize that Emirates has been offering such a service, called Chauffer-Drive (Note to Firefox users: this link may crash your browser) to its first- and business-class customers for years. While it’s nice to have my line of thinking validated, it also illustrates how hard it is to have a unique idea in a world of over 6 billion people.

I was struck by the seeming contradiction in the October 16th conference call with Delta Airlines. Namely, Richard Anderson, CEO of Delta, spoke of consolidation within airline industry and then later implied that Delta is likely to divest its regional subsidiary, Comair. So, consolidation “makes sense” to Mr. Anderson, but so too does spinning off its regional? On the surface, this seems contradictory, but a closer look at how competition within the airline industry works reveals that, at least superficially, this makes a lot of sense.

The distinction that must be made here is between the different relationships that mainline carriers have with regional airlines compared to other mainline carriers. Other mainline carriers are direct competitors whereas regionals are really act as suppliers to mainline carriers. Thus, when a mainline carrier acquires a regional, it is essentially an act of vertical integration. Although the airlines avoid trying to say it out loud, the primary benefits from mainline consolidation are anticompetitive in nature. I.e., cancel overlapping flights and hopefully raise prices. The benefits from integrating a regional into a mainline are, supposedly, lower costs and more control. However, most of the benefits from such a relationship would appear to befall the regional more so than the acquiring mainline. The biggest downside from a mainline owning a regional subsidiary is that they can not employ the thumbscrews when it comes time for the next contract negotiation. Delta, for example, has contracts with several regional carriers, including Comair. These regionals have to compete against each other for Delta’s business and regionals live or die by their relationships with the majors. Mainline carriers clearly have the advantage at the bargaining table as they can easily make a credible threat of flying the routes themselves. Regionals lost the credibility of making a similar threat when Independence Air went bankrupt after striking out on its own. Competition for these contracts is fierce. So, it should not be surprising that Delta feels it would be better off with Comair as a separate entity. As such, Delta will be able to put outside pressure on Comair that it likely can’t do as the owner.

American Airlines seems to share the same view as Delta, as Gerard Arpey indicated in their last conference call that they are also considering selling their regional subsidiary, American Eagle. Unlike Delta, however, American seems more realistic about the difficulties of consolidation of mainline carriers and projected a more pessimistic tone for such transactions.

There is one other timely reason for mainline carriers to spin off their regionals: airport congestion. Given the increased traffic delays and increasingly louder outcry from public officials, there has been a call on airlines to replace regional jets with larger aircraft making fewer flights. Shifting the ownership of those regional jets gives the mainlines a little bit more “plausible deniability” for their role in the problem.

Thus, the industry is left in an awkward position where it makes little sense for mainline carriers to own their own regional carrier when it is easier for them to pit the regionals against each other for their business. This, in turn, leads me to believe that consolidation within the regionals is the next logical step. Only when there are fewer regionals at the bargaining table with the majors will the regionals have the ability to negotiate from a position of power. Of course, if that happens, then it will make sense for the mainlines to consider acquiring regionals again….

A concept that came up early in my marketing class at Cornell is that customers don’t by drills, they buy holes. The point being that no one really wants a drill because they want a drill, but that they want a drill because they need a hole in something. If something comes along that can make holes better than a drill, you can count on the market demand for drills declining.

This got me thinking about the analogy in the airline business. What are customers of airlines really buying? A plane ticket? A plane ride? Hospitality? It seems to me that customers buy plane tickets because they need to get from one place to another. But if you consider it for a moment, airlines don’t really fulfill that service. What do I mean? Well, when was the last time you said, “I think I need to go to O’Hare”, or “a trip to La Guardia sounds fun”? More likely, you needed to attend a conference in Schaumburg or make a business presentation in Manhattan. If you are sitting in Pittsburgh, that means that the airlines only provide a piece of the service that you really need. In other words, airlines don’t provide the service of moving passengers from where they are to where they want to go. Instead, airlines tell their customers to get their items together and be at an airport close to their origin 2 hours before flying out, and then they transport their customers to a an airport closest to the their destination. From a marketer’s perspective, airlines are focused on selling seats on airplanes instead of providing the service that customers are really looking for.

This concept has been bouncing around in my head for the past few weeks, and this evening I learned of a tiny movement in the direction of really providing true point-to-point transportation services. EL AL Airlines has recently introduced an early, at-home check-in service. The service is only available in Israel, though, and as such, only helps with connecting the dots on the point-of-origin side of the trip. But, it’s a start, and I’ll be curious to see how it pans out for EL AL and if anyone else copy-cats it.

Charles Revson of Revlon Cosmetics once said, “In the factory we make cosmetics, but in my stores we sell hope”. What are airlines selling? I would say most are just selling seats on an airplane.

I came across this piece of captivating journalism in “Consulting Magazine”, and was struck by Rick Garlick’s bold comment “Airlines are part of the hospitality industry”. Mr. Garlick would be happy to know that Cornell University’s “Airline Service and Management” graduate course is actually taught by Cornell’s renowned School of Hotel Administration. Despite the fact that Cornell’s Hotel School teaches the University’s sole class devoted to the airline industry, I doubt many firms on Wall Street are going to move their airline analysts out of their transportation departments any time soon. Still, I was intrigued by Mr. Garlick’s comments so I pushed onward with a little Googling and came up with the original news release on Maritz Research and was rewarded with this gem, also from Mr. Garlick: “Competing on price is no longer an option for airlines”.

Oh, Rick, I think you may have just done yourself in with that one.

If I were to give Mr. Garlick the benefit of the doubt, I would guess that what he really meant to say was “competing on price alone is no longer an option for airlines”. It would be hard to find much fault if he had just added one little qualifying word.

But lets move on and consider the more salient point that Mr. Garlick was attempting to make: airline passengers want more. They want more legroom, they want more quality in their food, they want more peace and quiet on their flights, and they want more flights that they can utilize their frequent flyer rewards for. I can not imagine one airline that would disagree with any of that, but most airlines would be quick to point that although passengers do want all of those things, not enough of them are often willing to pay enough for them to make it a profitable affair. As a 6′5″ passenger, I was thrilled when American Airlines introduced their extra leg room on all domestic flights. AA become my favorite airline over night and I was willing to pay more to fly with them. But AA soon found out that not enough of the flying population was like me and they eventually canned the service.

Ultimately, I’m afraid that the good folks of Maritz may not realize that they only cover about half of the problem. Finding out what customers want is obviously an important step in the process, but, ultimately, it is finding out what enough customers will really pay enough extra for such that the airline can increase their bottom line that really matters.

Oh, and telling potential clients that they don’t know what industry they are in is probably bad marketing, too.

I’ve been curious to see how Midwest Airlines would implement its change in strategy announced earlier this year to offer both “Signature” and “Saver” seats on all of its flights. Primarily, I’ve been wondering how they are going to price the seats, and today that question as been answered for me:

Seating Choice Available September 16
Our MD-80 aircraft will soon offer customers a choice of seating. Along with Saver seats, a limited number of Signature seats will also be available. Customers who prefer to sit in a Signature seat can pay a $60 per segment fee at the time of Web check-in or at the airport kiosk, ticket counter or gate.

At $60 per segment, I think the strategy may actually work. I have been wondering if, by having both types of seats aboard all aircraft in the fleet, Midwest would no longer be differentiating itself from its larger competitors. After all, having “1st Class” and “Coach” is hardly a novel idea. Midwest’s Signature Service, however, was innovative and is a pleasure to fly on. When I flew on Midwest’s Saver Service to Phoenix a few years ago, I did lament the fact that they seats weren’t as comfortable as I had become used to on their B717 flights. A $60 premium for their Signature service seats, however, makes them very competitive against the 1st class options available on other airlines. Choosing the seats at check in also helps with the differentiation, although I suspect that many who would happily pay the extra $60 will be unhappy that they can’t reserve those prime seats at the time they make their reservation. My guess is that that option will be available shortly.

Given that the Signature seats are better than many 1st class seats I’ve seen on competing airlines, an extra $120 for a round trip will likely be attractive to many fliers, at least on the longer flights like MKE to PHX, and having an additional choice is almost always a good thing as far as consumers are concerned. The real test, of course, will be to see if this leads to an increase in profitability.