The Domestic Airline Industry Eric Huang Chase Funderburk Vincent Russomagno Terry Wu My name is Eric, here are my partners. We will be examining the domestic airline industry today and the pricing strategies used.

Why the domestic airline industry? Personal enthusiasm Purchasing experience and familiarity Geographic and temporal pricing differences Variety of pricing possibilities Personal enthusiasm – chase travelled across Europe, Terry has Private Pilot’s license Very large potential for data- by competitor, geographic segmentation, pricing per different mediums like airline itself or agent websites, ticket types (first, business, economy), and price per time to flight.

Industry Overview Life Cycle Stage: Decline Revenue Volatility: High Rising fuel prices

Background Industry produces – mostly airline services of both regional airline and domestic mainline. Domestic mainline are flights to major cities (62% in 2008  53.8% 2013 as result of lowered demand) Regional airline services (feeder airlines) – niche markets to smaller communities. Bring passengers to major hubs—increasing revenue as consumers try to save costs. Air freight – also growing as packaging innovations increase (barring recession). Other – Excess baggage charges, reservation cancelation fees, sightseeing tours, etc. Basic technology? Production costs financed? Who buys products? Product or service distribution?

Background Major market – coach customer. Drops from 9-11 but increases as fear decreases and routes offered increase. Recession affected it—less so than businesses. Businesses: previously more multi-purposeful, both for business and pleasure and 10% children. However, post-recession  employees flying economy class. Shrunk section. Demand determinants: leisure travel, business travel, cargo transportation, sudden impacts

Background Capital intensity: high Wages: 10.0% of revenues (2013) Operating costs: -increased labor productivity (from 11.6%) from recessionary operation downsizing, technology improvements like online booking and check-in increasing labor productivity, and staff requirement. Also handling and landing fees.

Background Costs are reflected here, where many other expenses (other) are incurred in the airline industry—interest, tax, utilities, insurance, restructuring, administrative costs, etc. However, significant to note most of these are fixed, indicated increase in percentage of revenue when sales fall.

Major Companies Delta Airlines United Continental Holdings AMR

Major Companies: Delta Airlines Market Share: 15.1% Headquartered in Atlanta, Georgia 80,000 employees 5,000 daily flights Fleet size: 722 (mainline) Destinations: 247 (mainline) Member of SkyTeam alliance Regional servicing: Delta Connection Volatile yearly revenue changes Delta part of SkyTeam alliance (transatlantic routes) Volatile changes: 23.6% to 3.9% in last few years.

Major Companies: United Continental Holdings Market share: 14.7% Brand names: United Airlines 2010 Merger: United Airlines Corporation and Continental Airlines Headquartered in Chicago, IL 88000 employees 5656 daily flights Fleet size: 705 (mainline) Destinations: 376 (mainline) Founding member of Star Alliance Plans to cut unprofitable routes (rising fuel prices) Expanded Wi-Fi servicing through LiveTV Like Delta Airlines, also volatile revenue earnings. Reflects sudden changes presence in airline industry.

Major Companies: AMR Market Share: 9.0% 2011: AMR filed for bankruptcy American Airlines, American Airlines Cargo, American Eagle 2011: AMR filed for bankruptcy 13,000 jobs elminated Headquartered in Fort Worth, TX 80,100 employees 3,400 daily flights Fleet: 605 (451 on order) Destinations: 250 February 2013: AMR and US Airways Group merger Largest airline Close in Q3-2013 (72% AMR, 28% US Airways) New name: American Airlines Group Inc

Competition 6 Major Domestic Airlines/market shares: Delta Airlines, Inc: 15.1% United Continental Holdings Inc: 14.7% Southwest Airlines Co: 11.1% AMR Corporation: 9.0% US Airways Group: 6.4% JetBlue Airways Corp: 2.4%

Market Concentration Domestic Airline industry has a moderate level of concentration Top 4 airlines in the industry account for approximately 49.9% of the industry revenue in 2013 Market concentration has increased due to merger and acquisition activity: Delta Airlines and Northwest Airlines (2008) United Airlines and Continental Airlines (2010)

Government Regulation October 24, 1978 – Airline Deregulation Act Prior to 1978 government agency, the Civil Aeronautics Board (CAB) determined the airline routes and the prices charged Post 1978 Market-driven industry, customer demand determining price Hub and Spoke system (legacy carriers): funnel passengers from different locations into central hubs at major airports where passengers are sorted onto connecting flights to their final destination E.g. American Airlines, United Airlines, Delta, United Continental Low-Cost Carriers (LCCs) – airlines formed post 1978 deregulation Eliminate many traditional passenger services offered on legacy carriers E.g. SouthWest

Government Regulation (cont.) Low entry barriers; high exit barriers Post deregulation: many new start-ups Good for consumers; bad for legacy carriers Start-ups offer lower fares than legacy carriers to compete resulting in decreased legacy carrier revenue Results in many airline bankruptcies but credit card companies and aircraft manufacturers would rather keep bankrupt airlines alive rather than have them liquidate Survival of bankrupt airlines makes it difficult for other airline to raise fares to profitable levels

Government Regulation (cont) Maintenance Programs Federal Aviation Regulations (FAR) Part 121 Industrial Regulations Standard industrial regulations Occupational Health and Safety Administration (OSHA) Environmental Regulations 1990 Clean Air Act: National Emission Standards for Hazardous Air Pollutants (NESHAP)

Industry Organization Aviation Suppliers Association (ASA) Represents more than 490 global member companies that lead logistics programs, purchasing efforts and distribution of aircraft parts worldwide Focus on safety, international compliance and ethical business practices that impact the aviation parts supply industry

Industry Organization (cont) Horizontal Integration: Civil aircraft manufacturing: Boeing (60% of market), Airbus (30% of market) Aircraft assembly and aircraft engine components: Rolls Royce plc, General Electric (GE) Equipment and parts: Thales, Teledyne, Gables Engineering, Timken Aircraft interior refurbishment and completion companies

Industry Organization (cont) Numerous factors affect the aircraft manufacturing industry: Industry must develop more efficient and environmentally friendly aircraft parts to comply with environmental standards aimed at reducing negative aircraft externalities such as aircraft noise and engine combustion emissions

Introduction Overview of stats on IBIS Trends and future

Pricing Strategies – Pre Booking Short: 1 week Medium: 1 month Long: 3 months

Pricing Strategies – Trips Business Trips: Departure: Monday Arrival: Thursday Leisure Trips: Departure: Friday Arrival: Sunday

Raw Data Collection Using Yapta.com we collected prices for 9 selected routes over a one week time frame Focused on 3 route lengths: >5 hrs 2.5-5 hrs <2.5 hrs Identified 3 major players: American Airlines Delta United Focused on 3 booking periods: 1 week prior 1 month prior 3 months prior

Raw Data Sample

Business Trips – 1 Week Booking

The mid length flight was the cheapest Closer to departure, the >5 hr flight was clearly the most expensive Prices were stable for the <2.5 hr flight and increasing steadily for the other two

Business Trips – 1 Month Booking

The longest flight (>5 hrs) was the most expensive throughout The shortest flight was slightly cheaper than the mid length flight Prices were most volatile in the <2.5 hr flight

Business Trips – 3 Month Booking

The longest flight was most expensive Mid length flight was the cheapest Low price volatility in the mid length flight

Business Trip Analysis When waiting till the last minute to book a flight the distance has little impact On the 1 month and 3 month pre-booking times, the distance has a more significant impact on pricing Extemporaneous supply and demand factors in regional markets cause additional price fluctuation

Leisure Trips – 1 Week Booking Leisure vs Business Analysis looking at 1 Week Booking

Leisure vs Business JFK - LAX These flights are similarly priced over time There is a greater relative spike in business than leisure in the few days before departure

Leisure vs Business LAX - SEA There is a premium charged to business passengers The extreme leisure rate hike seen by American is an outlier Could be a result of too much pre-booking

Leisure vs Business ATL - IAH There is a premium charged to business passengers Delta attempts to take advantage of extreme last minute bookings with steep rate hikes

Leisure vs Business Analysis Airline appear to be effectively price discriminating against business customers Charge them a premium for late booking tendencies Example of 3rd degree price discrimination

Leisure Trips – 1 Week Booking

Interesting that the shortest flight started as the most expensive Ultimately the longest flight matched the shortest’s price

Leisure Trips – 1 Month Booking

The longest flight is the most expensive Shortest and mid length flights are comparable Shortest flight has the greatest price volatility

Leisure Trips – 3 Month Booking

The longest is the most expensive Delta is pricing higher than the competition for the mid length flight They may have less regional capabilities

Leisure Trip Analysis Similar findings to Business Trips Again we saw when waiting till the last minute to book a flight the distance has little impact On the 1 month and 3 month pre-booking times, the distance has a more significant impact on pricing Outside factors like regional supply and demand are difficult to nail down

Leisure Trips – 3 Month Booking Pre-Booking Analysis

Average Observed Prices by Weekdays Book on Monday or Wednesday to save the most money on flights Lets take out the one week bookings and see what this looks like

Analysis – Business vs Leisure Leisure travelers pay a $20 premium over business travelers for flights booked 3 months in advance Again this is successful 3rd degree price discrimination

Analysis and Recommendation Industry is heavily reliant on: Fuel Prices Seasonality of Travel Government Regulation Security Funding

Financial Analysis Industry P/E ratio is 10.4X on average This is extremely low compared to an S&P 500 average of 14.3X LTG forecasts are surprisingly high at an average of 28.8% This is likely explained by the airline industry weathering a few very tough years of high fuel costs and consumer uncertainty When the economy improves  people travel more American Airlines has undergone significant restructuring through a Chapter 11 bankruptcy filing Other major players have cut costs and are now lean and ready to grow so long as government regulation does not interfere

Fuel prices are volatile and directly effect the costs of flying Airlines hedge their exposure to fuel prices but this is more of an art than a science Low fuel prices will typically result in better industry performance With the emergence of alternative energy sources the airline industry may face less competition for fuel Crude Oil Futures

Final Recommendation The airline industry trades at a relative value to the market There are many risks involved but if you believe in management then “stock-picking” may be a successful strategy within the industry Suggest avoiding this sector as a long term play