Airlines Scrape By, but What They Really Need Is a Shakeout

By DANIEL MICHAELS The airline industry has delivered a surprise amid the global economic meltdown -- it didn't collapse. Even in boom times, flying people around generates dismal profits. During downturns, carriers often bleed red ink. This time, however, airlines are scraping by, which is good news in the short term for both them and budget-minded travelers. But carriers' ability to survive this crisis may paradoxically bode ill for their long-term profitability. The global airline industry needs a major shakeout before it can generate sustainable returns. Airlines are unquestionably in bad shape. As many of them gather Monday in Kuala Lumpur, Malaysia, for the annual meeting of their trade group, the International Air Transport Association, the crisis-prone club will probably proclaim this one of their worst crises ever. IATA predicts its members will lose $4.7 billion this year and plans Monday to update the increasingly pessimistic forecast. International passenger traffic fell by 9.1% in this year's first three months compared with the same period a year earlier, IATA says. During that quarter, revenue from pricey first- and business-class tickets plunged by as much as 40%. Air cargo -- a leading indicator of both passenger traffic and broader economic trends -- has dragged along at volumes more than 20% below year-earlier levels since November, which points to a continued slump for airlines and the world economy. Airlines' chronic problem is familiar to any Econ 101 student: Too much supply -- of planes and seats -- chasing too little demand. In some industries, discounts jump-start demand, lifting sales volumes and boosting profits. For airlines, "lower pricing doesn't necessarily boost revenue," says David Swierenga, who runs AirEcon, a consulting firm in Vienna, Va. The demand airlines need is from passengers who can pay fares that are high enough to cover carriers' costs. For fliers, that glut means bargains. Unsold tickets are useless once an airplane door closes. When carriers get desperate, they ignore their costs and instead scramble for cash by dropping prices. "Competition does bring down prices, which brings down profitability," says Peter Morris, chief economist at Ascend Worldwide, an aviation-consulting firm in London. "But speaking as a consumer, I say, 'Hooray,' " he adds. Service can be abysmal, as domestic U.S. passengers know, but we get what we pay for. The inflation-adjusted price of an airline ticket has barely budged -- or has even fallen -- over recent decades. This summer, fares globally are down roughly 15% overall compared with last year, analysts say. Business class offers some of the most extreme markdowns: UAL's United Airlines and British Airways, for example, are both offering two-for-one sales or 50% discounts in the front cabin between the U.S. and London. Yet only a handful of small carriers have gone out of business over the past year. After the Sept. 11, 2001, attacks, more than a dozen major players disappeared, filed for bankruptcy protection or flirted with insolvency. Airlines in April showed their tenacity by filling three out of every four seats on international flights, according to IATA, which would be a strong showing in good times and is remarkable during a crisis. U.S. airlines, which struggled for the past decade, have led the industry in adapting. When oil prices soared last spring, American carriers slashed their fall schedules and fleets to cut expenses. Then fuel costs plunged, but demand did, too. Thanks to the precautionary cuts, U.S. airlines -- perhaps for the first time ever -- were braced in crash position when their market tanked last fall. European and Asian carriers belatedly followed. Airlines averted a blood bath because, after years of belt-tightening, they know how to cut back just enough to survive. Even as fares drop, they are ginning up other revenue sources, such as charging for checked bags. They also are expert at extracting concessions from staff and suppliers. Another factor is the industry's odd magnetism, which has reliably enticed people with a lot of cash to bankroll moribund carriers. That's despite airlines' formidable track record of failing to cover their cost of capital, be it debt or owners' equity. The net result of this mix is that airlines globally made no net profit on revenue of $3.6 trillion in the decade through 2007, the most recent year for which data are available, according to the Air Transport Association, U.S. carriers' trade group. To fix that, carriers need sustainable pricing power. Airline executives and analysts say the only way to gain that is through a serious culling. "If airlines don't cut enough now, the industry will come out of the downturn with too much capacity to make money in the upturn," says Chris Tarry, an independent airline analyst in London. The mass extinction that looked imminent when fuel prices soared last year might still happen. If oil prices continue their recent rise, if credit markets don't thaw, or if demand plunges further, carriers may be forced to shrink more drastically, and some may fail. But with signs the global economy has hit bottom, the prospect for dramatic upheaval amid the airline industry's pain looks increasingly remote. Write to Daniel Michaels at daniel.michaels@wsj.com