High fuel costs, 9/11 and low-fare competition proved to be too much

By Paul Beebe

The Salt Lake Tribune

Five years ago, Delta Air lines was at the height of its power.

The Atlanta-based company was the largest U.S. airlines in terms of aircraft departures and passengers boarded. In 1999, Delta bought Atlantic Southeast Airlines. A year later, it added Comair. The company employed 81,000 people. Based on the market value of its stock, Delta was worth more than $6 billion.

``For the year ended June 30, 2000, we reported record net income of $1.3 billion, an 18 percent increase over our previous record of $1.1 billion for fiscal 1999,`` the company bragged in its annual report that year.

Today, the company, formed as a small crop dusting outfit 76 years ago, is bankrupt.

How did that happen? What pushed Delta to file the ninth-largest bankruptcy in history and the second-largest airline bankruptcy of all time? Only United Airlines` 2002 bankruptcy is bigger.

Although Delta says it is difficult to overstate the effect of escalating fuel prices on its financial health, the airline`s problems go deeper than a 66 percent increase in the cost of crude oil this year. It traces the roots of its crisis back to 1978, when Congress deregulated the airline industry. That action unleased market forces that eventually ``made it impossible for Delta to regain economic viability as it currently exists,`` Delta said in a 43-page document filed last week with a U.S. Bankruptcy Court in New York.

The document is a rich summary of events that led to Delta`s financial collapse, but it provides only sketchy information about how the nation`s No. 3 airline intends to reorganize. Those details emerged Thursday, when Delta told employees it will cut as many as 9,000 jobs, or 17 percent of its workforce. The company also will reduce pay, make changes to its flight network and focus more on international routes. Delta says the actions are meant to make the company profitable ``in just over two years.``

Dogged by deregulation: In the bankruptcy document, Delta said deregulation transformed the airline.

Instead of flying point-to-point, most large carriers adopted hub-and-spoke networks that increased the number of cities they served and stimulated more air travel. That drew new competitors into the market. The result: Air travel changed from a luxury service to a largely ``commoditized`` product, marked by new airline companies, lower fares and a spate of mergers and failures, Delta said.

The airline adapted to deregulation in a variety of ways. In 1987, it bought Western Air Lines, which operated a hub in Salt Lake City. The merger made Delta much bigger. Two years later, it formed alliances with Swissair and Singapore Airlines, boosting its international scope. And in 1991, it bought Pan American`s transatlantic routes and its East Coast Shuttle.

The early 1990s were money-losing years for the airline industry, and Delta was no exception. But, in the mid-1990s, with the nation`s economy in high gear, the company was raking in cash. By 2000, it had amassed five consecutive annual profits totaling more than $3.3 billion, which allowed it to spend heavily on more airlines and labor contracts.

In 2001, the profit era that began in 1995 came to a screeching halt. Trouble in the economy reduced demand for air travel, especially in the business sector. In the first quarter of 2001, Delta reported a net loss of $133 million. More losses piled up in the second quarter.

Then came Sept. 11, 2001.

Flying after 9/11: Like deregulation 27 years earlier, the attacks by terrorists flying commercial jets into New York City`s World Trade Center and the Pentagon in Washington, D.C., set off widespread changes in the airline industry.

``The terrorist attacks were crippling for legacy carriers,`` Delta said. ``Indeed, in the September through December 2001 period, revenue passengers fell by 22.2 percent versus the same period a year earlier. Consumer confidence in airline travel was significantly shaken, and fear of more terrorist attacks kept many people from flying.

Some analysts think the document gives the impression Delta didn`t make mistakes. The company, for example, doesn`t dwell on its decision to give its unionized pilots contracts in 2000 that made them the nation`s highest paid. Delta didn`t see relief from the pilots until 2004.

Nor does Delta concede that it built a business model that charged fares to business travelers that eventually drove them into the arms of low-cost carriers.

``It`s a long-winded way of saying that Delta tried to cuts costs before 9/11, but was unable to. I think it`s self-serving,`` said Helane Becker, an airline analyst at The Benchmark Co. in New York.

Calyon Securities analyst Ray Neidl thought Delta did a good job summarizing its woes. He believes the airline will be a nimble company when it emerges from bankruptcy, although it will shrink by as much as 15 percent as it lays off workers, cuts unprofitable routes and takes other steps to repair its finances.

``They will be more internationally oriented, and domestically they`ll have more regional feeders, as they`ve been doing in Salt Lake and Cincinnati. I`ve got a feeling that Salt Lake will be more a part of their domestic presence,`` Neidl said.

Delta says 9/11 accelerated changes in the U.S. airline industry that deregulation started. The attacks unleased an environment that made it nearly impossible for any major airline to price services at a level that covered their costs. The result: Even before the spike in fuel prices, the industry lost $32.3 billion between 2001 and 2004, wiping out gains made in the latter half of the 1990s.

``As a result, legacy carriers have incurred substantial losses, [several] major airlines are operating under Chapter 11 [of the U.S. Bankruptcy Code], and other airlines may need to seek to restructure under Chapter 11,`` Delta said.

United Airlines filed for bankruptcy in December 2002. US Airways sought protection twice, in August 2002 and again in September 2004. Delta and Northwest Airlines filed bankruptcies within minutes of each other on Sept. 14. Almost half of the seat capacity of the airline industry is now flying in bankruptcy, Neidl said.

Each airline sought protection from its creditors because it was unable to cut costs or raise fares enough to turn a profit. Over the past several years, fares have been under intense downward pressure, and ``any residual pricing power held by the legacy carriers has almost disappeared,`` Delta said.

Delta said fares have been kept in check by the rapid expansion of low-cost airlines, especially on heavily traveled routes that traditionally have earned big profits for the major airlines. At the same time, business travel has declined sharply. And the rise of Internet search and booking engines have made it easier for travelers to find low fares.

Citing a U.S. Transportation Department report, Delta said average airfares fell more than 21 percent between 2000 and early 2004.

The low-cost carrier factor: Delta said it competes with low-cost carriers in virtually all of its biggest markets. Yet it has a higher cost structure. Low-cost carriers usually have significantly lower labor costs and more flexible work rules. They stick with only a few airplane types, which reduces the cost of pilot training, maintenance and maintaining a spare parts inventory.

Many discount airlines don`t provide first-class service, which allows their jets to carry more passengers. Discount airlines sell most of their tickets through their own Web sites. And they don`t provide defined benefit pension plans to their employees.

``These cost advantages permit low-cost carriers to price their services at significantly lower average fares than legacy carriers and still earn a profit,`` Delta said, noting that its nonfuel costs are nearly 70 percent higher than Southwest`s nonfuel expenses.

Meanwhile, low-cost carriers are growing rapidly. They tripled their market share between 1990 and 2005 and now carry almost one-third of all domestic passengers. Most travelers live close to airports served by low-cost carriers, Delta said.

Low-cost carriers once competed against major airlines only on busy routes. Lately, however, they have encroached on smaller routes, transcontinental runs and in international markets. With low fares, they compete with Delta in 46 of its 50 biggest markets, up from seven markets in 1990.

Competition is sure to intensify. Two days after Delta sought bankruptcy protection, US Airways received approval to exit bankruptcy and merge with America West. The combined companies will become the nation`s fifth-largest airline. They will operate as a low-cost carrier.

The merger was made possible partly because US Airways was able to transfer its defined-benefits pension plan to the Pension Benefit Guaranty Corp., the government agency that guarantees worker pensions. It was also able to renegotiate its labor contracts during bankruptcy to bring them into line with other low-cost carriers. When the merger closes, US Airways will become the first discount airline with a national hub-and-spoke system that overlaps most of Delta`s routes.

``In short, for the first time, a carrier with a low-cost . . . structure will have both a nationwide domestic presence and a sizeable international presence. US Airways has been Delta`s biggest competitor. It just got bigger and effective,`` Delta said. ``The significance of this development as a competitive threat . . . is profound.``

Obstacles grow: Delta`s challenges are getting worse. Business travelers, the airline`s most profitable customers, are beginning to regard discount airlines as an acceptable means of flying. In recent years, some low-cost carriers courted business travelers with business class seating and lower walk-up fares. Other carriers fly new aircraft with leather seats, more legroom and seatback video entertainment systems. About 25 percent of business travelers now prefer low-cost airlines, Delta said.

Technology also is compounding the airlines` woes. Companies are exploiting advances in teleconferencing, e-mail, online presentations and other technology to conduct business without sending employees on the road.

``The proportion of Delta`s domestic passengers purchasing either first-business, or unrestricted coach fares has fallen from nearly 20 percent during the first quarter of 1998 to less than 7 percent in the first quarter of 2005,`` the airline said.

While business travel is shrinking, Internet shopping for tickets is becoming pervasive, allowing all travelers to find the best fares but making it harder for airlines to raise prices. Airline revenues booked via the Internet reached 33 percent last year, up from 5 percent in 1999, according to Delta.

Delta said the weakened revenue environment has made it vulnerable to events outside its control. Jet fuel, which averaged 67 cents a gallon between 1985 and 2003, surged to $1.89 in August and is expected to stay high because crude oil prices likely will remain above $60 a barrel for years to come.

Meanwhile, taxes jumped from 13 percent of a $300 ticket in 1992 to 20 percent this year, according to the Air Transport Association. And rival airlines have used their bankruptcies to cut their labor costs and end their pension plans, freeing cash that can be used to compete against other carriers.

Because it hasn`t made money for several years, Delta was unable to protect itself against escalating fuel costs. By contrast, Southwest has agreements with refiners that hedge much its costs through 2009. About 85 percent of its fuel cost is hedged for the rest of this year at $26 a barrel of crude oil. Two-thirds of next year`s fuel expenses is hedged at $32 a barrel, Delta said.

Delta said 9/11 sped up the cost-cutting process started two years earlier. By eliminating flights, laying off workers and taking other steps, it reduced expenses by $1 billion in 2002. A year later, costs were down by another $1.2 billion. In 2004, Delta`s employees gave up $1.4 billion in annual wages and benefits, allowing Delta to avert bankruptcy.

The company also restructured some debt and launched a ``transformation plan`` to save $5 billion a year by the end of 2006. In January, it redesigned flight schedules at its Atlanta hub, closed its Dallas-Fort Worth hub and introduced a new fare plan. Two months later, it outsourced most airplane maintenance. Last month, it sold Atlantic Southeast Airlines to St. George-based SkyWest Airlines for $425 million.

Not enough: The transformation plan ultimately failed to keep Delta out of bankruptcy court because it was based on jet fuel priced at $1.22 a gallon in 2005. Instead, the company paid $1.51 a gallon in the first six months. At the close of August, Delta`s on-hand cash had declined to $1.2 billion, a 33 percent decrease from the beginning of the year. And then Hurricane Katrina hit the Gulf Coast, damaging oil platforms, refineries and pipelines and driving fuel prices even higher.

The unexpected fuel increases ``forced an immediate liquidity crisis`` that Delta said it could not withstand outside of bankruptcy. The airline is saddled with nearly $21 billion in debts and leases. It estimated it will need to contribute $2.6 billion to its already underfunded pension plans between 2006 and 2008. The company will continue to press Congress for legislation that will make its pension plans more affordable. But, it told the bankruptcy court, United will save $645 million annually by shifting its plans to the Pension Benefit Guaranty Corp.

To boost revenue, Delta plans to remove fuel-guzzling aircraft from its fleet and rearrange routes. The company will deploy smaller aircraft on many routes. It will continue to modify operations at its three remaining hubs. And it will increase its international routes, normally more profitable than domestic routes.

Delta also intends to squeeze out another $1 billion in annual savings by expanding its transformation plan. It didn`t provide specifics, but said it needs ``to reduce further its labor and retiree costs in order to compete.``

pbeebe@sltrib.com