A tale of two airlines

Two PwC alumni at the helm of major US airlines reflect on the industry’s past decade and offer an insider’s view on what’s to come.

Emerging from a challenging decade, the US airline industry made a dramatic comeback last year. Airlines posted a fourth-quarter net profit for the first time since the start of the 2008 recession and capped off one of the most profitable years since 2000. Called “historic” by The Wall Street Journal, the turnaround signals a symbolic end to the difficult period initiated by 9/11 as well as the 2001 economic downturn, and a reaffirmation of the 80-year-old industry’s powers of adaptation. A rebounding economy isn’t the only factor contributing to this upswing. It’s also a result of the ambitious restructuring efforts airline companies undertook after 2001. So how did they do it, and what’s next for the industry? We spoke with two PwC alumni uniquely positioned to shed light on that story.

Brad Tilden is president of Alaska Airlines, the “think small” Seattle-based airline that prompted enthusiastic accolades from Wall Street for its successful cost-containment measures and bold pledge to earn 10% average annual return on invested capital, achieved on schedule last year.

Ed Bastian is president of Atlanta-headquartered Delta (Air Lines), which arose from Chapter 11 bankruptcy protection and merged with Northwest Airlines to become one of the world’s biggest airlines. Delta is projected to generate approximately $34 billion in revenue and carry 160 million passengers to nearly 360 destinations around the globe in 2011. Keyword recently caught up with both men to discuss the changes they helped implement, and to get their take on the challenges and opportunities that lie ahead for the industry.

Brad Tilden

Brad Tilden is piloting Alaska Airlines to success by making smart and effective decisions.

A private pilot earns his executive wings

In early 1991, Brad Tilden was moving up the ranks at Price Waterhouse. The Seattle native had joined his hometown’s Price Waterhouse office after graduating from Pacific Lutheran University; eight years later, the business administration major had risen to the position of manager in Price Waterhouse’s audit practice in Melbourne, Australia. The diversity of the work, and the opportunity to help companies in a broad range of industries address financial risks, engaged his inquisitive mind. “I loved Price Waterhouse,” Tilden says with a grin. “I really liked public accounting. I kind of thought I would stay and attempt to become a partner.”

Instead, he received a call from a former Price Waterhouse colleague who was then director of general accounting for Alaska Airlines back in Seattle. Expecting a child and intending to pursue motherhood full time, she was looking for her replacement and asked Tilden if he was interested in her job.

“I’d never responded to any job offers while at Price Waterhouse,” Tilden recalls. But this one was different. “It was the airline industry,” says the private pilot, who remembers watching Alaska planes take off and land while growing up a couple of miles from his present office. “And, it was Alaska Airlines!”

Tilden accepted the offer, taking naturally to an industry that had fascinated him since he was a boy. He was named controller of Alaska Airlines and Alaska Air Group in 1994, earned an MBA from the University of Washington in 1997, and then became Alaska’s chief financial officer in 2000. But it was in 2002, serving as executive vice president of finance, that Tilden seized an opportunity to truly “earn his wings” in industry parlance, when he led an ambitious restructuring of the company.

In the late 1990s, two decades after the rash of bankruptcies and wholesale reorganization propelled by the Airline Deregulation Act of 1978, the airline industry seemed to be approaching a new equilibrium. Deregulation had transformed the market, enabling emergent low-cost carriers to win over price-sensitive customers with no-frills flights, exerting steady downward pressure on fares. But stronger legacy carriers such as Alaska had adapted to the new conditions, streamlining operations and reasserting the value of their superior service offerings. Buoyed by a strong economy and moderating oil prices, the airline industry as a whole was profitable for five straight years, from 1996 to 2000.

But then the 2001 recession hit. The economy slowed, oil prices began a precipitous upward climb and demand for air travel decreased. Between 2000 and 2002, revenue miles—the distance traveled by paying passengers in a given year—suffered an unprecedented drop of 8%; in the second quarter of 2002, the industry’s collective losses troughed at $11.3 billion.

We had to get down to the very basics of our business and make sure that we were designed around what our customers wanted.
— Brad Tilden

“Following 9/11, all legacy airlines had to fundamentally restructure,” Tilden recalls. “We had to get down to the very basics of our business and make sure that we were designed around what our customers wanted and were willing to pay for.”

Bold changes bring big returns

Alaska was searching for new answers even before the 2001 downturn. A primarily regional network serving the West Coast since its founding as McGee Airways in 1932, the company had made its first foray into transcontinental markets one week before 9/11 with inauguration of service from Seattle to Reagan National Airport. But the recession acted as both a warning and an opportunity to push Alaska’s competitive efforts even harder, Tilden says.

Critical to this effort was the resolve of Alaska’s leadership to adjust the company’s defensive stance toward low-cost, low-fare competitors. “We needed to go on the offensive,” Tilden explains. “We saw the need to start offering our customers low fares because that’s what we want to do—not because we were pushed there by a more customer-friendly airline. Restructuring our fares enabled us to grow, and that enabled us to stay out of bankruptcy and keep our people working.”

These and other bold realignments formed the basis of Alaska’s 2010 Plan. The massive restructuring effort trimmed $325 million from Alaska’s cost structure between 2003 and 2006. Key elements included upgrading the fuel efficiency of Alaska’s aircraft fleet, transitioning to the operation and maintenance of just one model of airplane, the Boeing 737, and installing aerodynamic winglets on planes. Alaska also made it easier for customers to purchase tickets online, thus bypassing pricey agent commissions, and reorganized labor arrangements, which included outsourcing aircraft maintenance and baggage handling functions.

Customers saw the difference as Alaska realized its product-restructuring goals. “To improve flexibility, we went to all one-way fares, and no required Saturday-night stay,” Tilden says. “Customers can use frequent flyer miles one way, and they can buy the fare the other direction. We brought the gap between the lowest fare and the highest fare way down. Our highest fare now is $699 for a single segment.”

Tilden describes himself as a numbers “geek” whose love of algebra came in handy not only in helping Alaska redefine how and how much customers could expect to pay for fares—but also where they went. “For 20 years, there was a late-night flight on Saturday night from San Diego to Seattle that was always light,” Tilden says. “We don’t operate that flight anymore.” By trimming excess capacity from its traditional north-south markets along the West Coast, Alaska was able to redeploy craft to more Midwest and East Coast markets, coupling this growth in transcontinental service with “massive growth in Hawaii,” Tilden recounts. “Three-and-a-half years ago, we had no flights to Hawaii at all. Now we’ve got 18 flights a day.”

The result is a transformation in the value Alaska extracts from its hubs in Seattle, Anchorage and Portland. “Ten years ago, we had a shot at 70% of the passengers traveling out of Seattle but only 50% of the revenue because we didn’t fly to New York, or Washington, D.C., or Boston, or Florida, or Chicago,” Tilden explains. Now that Alaska is flying to 27 of the top 30 markets out of Seattle, that revenue portion has increased to 84%.

The payoff from the arduous restructure is evident today. Alaska led the industry in on-time performance in 2010 and earned J.D. Power and Associates’ customer satisfaction awards for three years in a row. The carrier also led the industry by posting seven straight quarters of profitability and rewarding employees with 2010 gain-share checks equal to 9% of base pay on average—or more than one month’s pay. As of the close of last year, the company also achieved the feature benchmark goal of its 2010 plan, earning an extraordinary return on invested capital of 10.7%, higher than the company’s goal of 10%.

Ed Bastian

Ed Bastian guided Delta through restructuring before becoming president.

From passenger to president

Across the country in Atlanta, Ed Bastian reflects on his role leading a different kind of corporate reinvention. His preparation for that endeavor also began at Price Waterhouse.

The St. Bonaventure University business major joined Price Waterhouse’s New York office as an intern in 1979. After joining Price Waterhouse full time and making audit partner in 10 years, he worked with a broad array of multinational advertising, entertainment and manufacturing firms. He laughs as he realizes his frequent business travel may have contributed to his eventual landing in the airline industry. More important, though, was his exposure to accounting, the fundamental “language of business.”

“Learning how to read financial statements, learning how to understand how businesses communicate— coupled with the benefit of working in different industries with different types of clients—helps you understand what it takes to be successful, to run a good business,” Bastian says. “You see the common themes that run across industries. It gives you confidence to deal with business challenges as you embark on them.”

Bastian served as a vice president with both Frito-Lay International and Pepsi-Cola International before joining Delta in 1998 as vice president of finance and controller. Named senior vice president in 2000, and executive vice president and chief financial officer in 2005, Bastian, like Tilden, played a crucial role in leading his company out of the 2001 recession.

From a crop-dusting outfit founded in Macon, Georgia, in 1924, Delta had built itself into one of the world’s great airlines. Establishing its base with a major regional network serving the Southeast— launching passenger service (based in Louisiana) in 1929 and moving its headquarters to Atlanta in 1941—the company has expanded steadily. Through a series of acquisitions, Delta established a foothold in virtually every major US market, along with select international destinations, including the Caribbean islands, Tokyo and London. By the late 1980s, with a fleet of approximately 375 aircraft, Delta ranked as the fourth-largest airline in the country and the fifth-largest in the world.

You see the common themes that run across industries. It gives you confidence to deal with business challenges as you embark on them.
— Ed Bastian

Delta was a pioneer of the hub-and-spoke system that is now the industry’s standard method of routing passengers, and it prospered in tandem with its primary hub in Atlanta, at the Hartsfield-Jackson Atlanta International Airport. In the 1970s, Mayor William B. Hartsfield led the drive to modernize the airport and turn it into an international routing point. That prescient investment helped Atlanta grow into an economic powerhouse, with Delta serving as the largest employer both in the city and in the state.

Like most airlines, Delta struggled to survive the post-deregulation upheavals of the 1980s and early 1990s. But by the mid-’90s, the company was prospering again. It won a string of national and international industry awards, earned the title of official airline of the 1996 centennial Olympic Games, and posted profits for six consecutive years, from 1994 to 2000. But that high-flying performance came to a halt in 2001. Like so many airlines, Delta watched profits wither in the face of the 2001 recession. In 2005, it filed for Chapter 11 bankruptcy protection. Bastian, prior to his appointment as president, served as chief restructuring officer.

Going global sets a course for success

Like Tilden, Bastian says that sagging consumer demand and rising fuel prices weren’t the only risks facing his company during those troubled times in the early part of the decade. The hub-and-spoke system that defined Delta’s operating model, and its special relationship with the city of Atlanta, was also under threat.

“What we found in the 1990s, and in the early part of this century,” says Bastian, “is that you had low-cost carriers with new airplane technologies that were allowing people to fly over the hubs. ‘Overflies’ is what we called them.” Instead of routing customers through Atlanta or Cincinnati, carriers such as Southwest and JetBlue were offering direct, point-topoint flights between smaller markets, effectively giving customers “a better experience at a cheaper price,” Bastian says.

After the 2001 downturn, as larger airlines pulled down capacity, low-cost carriers jumped into the void, further building out the overfly model. But while some legacy carriers shut their eyes, and others such as Alaska worked at beating low-cost airlines on their own turf, Delta looked elsewhere: What could it provide customers that low-cost competitors couldn’t?

“We clearly needed to change,” Bastian acknowledges. “But rather than look to more domestic points, we needed to re-direct our aircraft toward international destinations, where there wasn’t the competition from low-cost carriers.” Globalization represented a massive transformation for the company. But at the same time, it signaled a reaffirmation of Delta’s core identity.

“It’s who Delta is,” Bastian says. “We are a different brand than an AirTran or a Southwest or a JetBlue. And we need to play to our strengths, rather than try to change who we are to level the competition.” Key to Delta’s reorientation toward the global market was its merger with Northwest Airlines in 2008. In one swift move, the companies (which took Delta’s name) formed what was at the time the world’s largest airline, with 80,000 employees, more than 700 aircraft and $30 billion in annual revenue. The merger also culminated what Bastian emphasizes was a doubling of Delta’s international footprint. Post-merger, Delta planes now fly to 65 countries, transporting more passengers than any other carrier between the United States and Japan. Today, fully 40% of the company’s revenues are globally derived, a ratio that Bastian says will soon move closer to 50%.

The benefits of the merger are being realized on the cost side, as well. The combined company has grounded 150 planes and redirected others—using Northwest’s larger planes in Delta’s larger markets, and vice versa—thereby maintaining pre-existing levels of service and revenue while making more efficient use of its integrated fleet. It has also kept intact much of the cost rationalization undertaken during the throes of Delta’s bankruptcy. Twice as large as it was three years ago, the company is entering the new decade stronger and leaner than before.

The fuel factor

Both Tilden and Bastian say that oil-price volatility is the biggest challenge facing the industry today. Efficiency measures are part of the solution, and both companies are engaging in ongoing efforts to reduce fuel consumption. As Alaska has, Delta is installing winglets on its planes—anticipating a payback period of just one year at current fuel prices.

Brad Tilden

Tilden has been able to increase customer satisfaction and lead his company to profitability.

Bastian also cites the pending arrival of the next generation Boeing 787, which is advertised to be 15% to 20% more fuel efficient than previous wide body jets, and the adoption of larger gauge jets in general, which use less fuel per seat-mile. But the savings wrought by reducing fuel use won’t necessarily balance the impact of fuel prices that have quadrupled in the past decade.

Putting it in perspective, Tilden notes that “every dollar change in price of crude oil costs our company $10 million.” Fuel hedging contracts are one tool airlines use to manage this risk, but they aren’t the ultimate answer. Hedging is like taking out an insurance policy, Tilden explains: The riskier the climate, the more the contracts cost. The limited benefits come with major outlays to brokers and the uncertainty of beating the speculative market.

Bastian concurs. “We have hedge portfolios, but they’re more tactical than strategic; it buys you some time in terms of being able to manage fuel prices, but the reality is that we need to get to a place where we can actually pass along the cost of fuel as part of our ticket price to our customers.”

If higher fare pricing is to keep the industry in the black, it will depend on the tricky art of what industry analysts call capacity discipline, or what Bastian describes as finding “the right balance between supply and capacity and seats and price points.” In recent years, airlines have resisted the temptation to add seats whenever they see a bump in demand. In fact, Bastian reports that today there are actually 10% fewer seats in US skies than there were in 2000. As a result, airlines have found it easier to do what may seem like an obvious necessity—“to price their product with the total cost of the product included,” Bastian says.

It takes time, but the industry has demonstrated that it can deal with increasing fuel costs.
— Brad Tilden

Tilden predicts the industry will simply be forced to adapt to higher and more volatile fuel prices. “Oil was $25 a barrel for a long time,” he recalls, “and ‘volatile’ was going from $12 to $35 a barrel. Back then, we thought the airline industry would disappear if oil went to $100 a barrel. But it’s just timing. Fuel prices go up; you find a way to get more efficient and ultimately increase fares to cover the higher costs. When fares increase, demand decreases, and then the industry rationalizes capacity and finds a new equilibrium. It takes time, but the industry has demonstrated that it can deal with increasing fuel costs.”

Next on the horizon

Oil-price volatility notwithstanding, both executives point to promising ways in which they’ll build on successful restructuring efforts in coming years.

“We’re going to continue to grow internationally,” says Bastian. “We get much better pricing opportunities in Asian and Latin American countries than we do flying head to head in the congested US marketplace.” It will do so with the help of partners including two of the three largest Chinese carriers, China Eastern and China Southern. “The market between the US and Europe is largely a mature industry, but Asia is a massive growth opportunity, and that’s where Delta has a big leadership advantage.” Tilden says Alaska is planning modest growth, ranging from 3% to 6% for the next few years. Alaska recently placed a new order for fifteen 737-800s and 737-900ERs, and the company also may grow through higher aircraft utilization if the right opportunities present themselves.

The market between the US and Europe is largely a mature industry, but Asia is a massive growth opportunity, and that’s where Delta has a big leadership advantage.
— Ed Bastian

Tilden is also looking forward to reasserting Alaska’s historic role as a technology pioneer to further enhance safety and make flying even easier for its customers. He lists the many technologies that Alaska was the first to adopt, from Internet-based ticket sales and GPS flight deck technology to Honeywell’s recently developed runway awareness advisory systems, which provide flight crews with information about their aircraft’s position relative to the runway. Future goals include developing an iPhone app designed with business travelers in mind and, in the back of the house, completing an in-process upgrade to Alaska’s System Operations Control suite software.

Bastian is similarly intent on harnessing the power of technology. Between Delta’s bankruptcy, downsizing and merger, “our capital has been either constrained by the economic circumstances or tied up in the integration of Delta and Northwest,” he says. “It took two years to hook the two big legacy systems together.” As capital continues to be freed up, Delta will be investing in a waiting pipeline of technologies to improve the customer experience, while boosting the company’s bottom line. Many of these new services will involve giving customers more control over their travel experience. That could mean getting the chance to bargain electronically for alternatives to an oversold flight while standing at the check-in kiosk or buying a discounted upgrade from economy to first class. “Mobile is a big part of it,” says Bastian, who notes that Delta’s recently launched iPhone app is one of the leading apps of its kind on the market.

Ed Bastian

Bastian discusses the investments Delta is making in new technology.

Along these same lines, when asked to sum up the challenges and opportunities facing their companies in the next five years, both men talk about the centrality of the customer relationship. “We like to tell our folks that all airlines have a lot in common,” Bastian says. “We all fly the same types of airplanes. We have similar technology systems. We go to the same airports. We all buy our fuel from the same places. But it’s the service, and it’s the people who provide the service, that put a personality on the brand and will drive preference in the marketplace. And that’s what we try to reinforce.”

As for Alaska’s Tilden, he wagers that “caring a little bit more about our customers is the biggest reason we’ve been successful where others have failed.” It’s a winning formula he doesn’t intend to alter.

Taking the long view

Both Tilden and Bastian say the challenges of the past decade have motivated new ways of thinking and operating within their companies. Today, their companies are stronger and more attuned to their core values and competitive assets. Both say they are better able to withstand the challenges—and seize the opportunities—to come.

Many variables, foreseeable and not, will impact the industry’s future. They include shifting consumer demands, transformations in technology, and oil prices that will continue to rise and fluctuate with unprecedented speed. But both Tilden and Bastian are confident the industry will do what it’s always done: develop new answers.

“When you see oil prices skyrocketing, they’re skyrocketing for everybody,” says Bastian. “That just means we have to focus and find a better path than our competitors. People are still going to want to travel, and you have to find a way to serve that demand.” Tilden agrees, “The key for us is to use less gas than our competitors by flying the right aircraft and having the right technology.”