Clipped wings: CEOs may not be able to save the traditional major airlines as low-cost challengers win the battle of the skies.

Leo Mullin, CEO of Delta Air Lines, unexpectedly announced his retirement as of January after disclosures about executive pay packages at the struggling carrier. Don Carty, his counterpart at American Airlines, also was forced to step down in a scandal over his outsized perks. At United Airlines, Glenn Tilton, the company's third CEO in three years, is struggling to pull the airline out of bankruptcy.

Chief executives of major U.S. airlines are obviously facing huge difficulties. It's not just 9/11 and declining travel volumes, nor is it solely the issue of compensation. The roots of the problem run deeper: huge overheads and inflexible union contracts. Overall, the airline industry lost $18 billion during the past two years. "We don't want to become another Bethlehem Steel or Jones & Laughlin," US Airways CEO David N. Siegel told his employees recently, referring to two failed steel companies.

At the same time that major airline CEOs are embattled, low-cost carriers have seized about 25 percent of the market and want more. Top executives at Southwest and JetBlue, two of the more successful upstarts, talk about expansion, profits and better prospects. It's a far cry from the late 1990s when the major airlines were accused of driving the upstarts out of business. The seeming reversal of fortunes between the established airlines and their challengers is beginning to raise the possibility that the upstarts might just prevail over the long run. "Don't compete with Southwest; you will lose," warns Adam Pilarski, a senior vice president at Avitas, an airline consulting firm in Chantilly, Va. "Nobody wins against Southwest. It's like a high school team playing against the [Oakland] Raiders."

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What caused such travail? Certainly, September 11th had much to do with it. The nation's airlines suffered a catastrophic blow that day, as concerns about airport security kept many travelers at home. Compounding that was a plunging economy that shriveled business travel, the major carriers' financial linchpin. However, the airlines did receive $15 billion in aid from the federal government. And although the economy staggered well into 2003, it has since picked up.

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Exogenous shocks aside, the major airlines remain saddled with a cost structure out of whack. The majors pioneered their "hub" concept, which worked just fine in one era. But in the current volatile times, it shapes up as a giant money loser, just as exorbitant contracts with squabbling unions do. Labor, which accounts for 25 percent of the overall cost and 30 to 40 percent of a carrier's operation, determines the success or failure of any airline. Despite the fact that unions have been losing bargaining clout as a result of cutbacks, their imprint remains on current airline contracts. Every other cost--planes, landing fees, rental fees and fuel--is basically the same for small and large carriers.

As with supermarkets, profit margins in the airline industry are extremely tight, so huge labor costs among pilots, for instance, can tip an airline into losses, even financial peril. Southwest is paying its senior pilots about $150,000 a year, says Henry J. Oechler Jr., a partner in the New York law firm of Chadbourne & Parke and a nationally recognized expert on the industry. By contrast, he notes, before the company declared bankruptcy, United was paying its pilots twice that. United has obtained much lower senior pay for its pilots during its restructuring, but a 2-to-1 ratio still holds between pilots at Delta and Southwest, says Oechler.

How did the big airlines come to pay their pilots so much? "It happened because airlines created a Byzantine level of work rules and high pay back in an era of regulation when everybody was on the same playing field," Oechler says. In 1978, deregulation of the industry changed all that. More routes, more freedom and more carriers meant more problems for the trunk carriers. While Southwest and, years later, JetBlue started free of the old cost constraints, the established airlines like United continued to suffer under the old contractual burdens.

More than 25 years--and several bankruptcies and liquidations--later, the major carriers still retain a restrictive cost structure. It is embedded in their companies. In 2002, United had a breakeven factor of 118 percent, meaning that even if the airline filled every seat on the flight, it would still lose money. A year later United had lowered its breakeven point on load factor to 90.3 percent, still an extremely high number, while Southwest's breakeven point in 2003 was a much more manageable 61 percent.

At the same time, the CEOs of large airlines have forged combative relationships with their employees, accentuated by an imperial leadership style. For instance, last April, American, the world's largest airline, barely avoided Chapter 11, saved by three cost-cutting agreements with its unions, totaling $1.8 billion in annual wage cuts and other concessions. However, then-CEO Carty failed to disclose ample retirement perks for the company's top executives, including himself, leading to his ouster. At Delta, the No. 2 airline in the U.S., Mullin's pay almost doubled to $13.8 million--even though the airline had lost $1.8 billion. After bitter complaints from workers, he accepted a pay cut of $9.1 million (though he will receive a $16 million retirement package).

CEOs at the challenger airlines have displayed a different style--more communicative and less imperious than their counterparts at the big airlines. They exhibit an attitude of "we're all in this together," engendering good will with their employees. For instance, Southwest CEO James F. Parker made just $492,241 in 2002, literally millions less than CEOs at the "big iron" carriers. The model has been Parker's predecessor, Southwest founder Herb Kelleher. When Kelleher learned that mechanics on the graveyard shift found it difficult to participate in company picnics, he held a 2 a.m. barbeque with himself and the pilots as chefs. At company gatherings he arrived on a motorcycle in jeans and a T-shirt. More seriously, when Southwest started in 1971 the carrier found it could not meet its payroll. The company faced a choice: sell one of its planes or lay off people. It chose to do the former and asked its employees to cut turnaround time at the gate from 55 to 15 minutes. The tradition of Southwest employees, from pilots to ramp agents, pitching in to do what's necessary in order to help the company was born.

Other factors give the newbies an advantage, too. They have newer fleets, which require less maintenance, and have less experienced crews who make less money. Southwest operates only one type of aircraft, Boeing 737s, so pilots don't have to train on five or six different models, further reducing costs. Also, Southwest flies into smaller cities, such as Providence, R.I., and Oakland, Calif., which means less congestion and lower landing fees. "We always look for markets that are overpriced and underserved," Parker told Chief Executive. "Hubs are overpriced by definition." (See Q & A, page 22.) By following these strategies, Southwest has soared to 50 straight profitable quarters. Most of the major airlines would love to string together just two.

In a desperate attempt to better compete with the low-cost carriers, all of the major CEOs have been slashing costs. They are laying off workers; trimming services, including meals; demanding labor concessions; deferring purchases of new aircraft, closing hubs and reducing flight schedules. American Airlines is in the midst of a $4 billion cost-cutting plan. US Airways, which emerged from bankruptcy proceedings last year, has cut $2 billion, bringing its revenue per available seat mile, including fuel costs, to just under 11 cents. But that still appears to be too high. Southwest's revenue per seat mile (adjusted to US Airways' route network) is 6.3 cents. "Even with our substantial sacrifices, our unit costs are almost double those of Southwest," Siegel, the US Airways CEO, bemoaned to employees in one of his weekly telephone addresses. (JetBlue has the industry's lowest-fare structure, at 6 cents per available seat mile.)

Siegel has particular reason to worry because Southwest plans to begin service in May to and from Philadelphia, US Airways' hub. "This is very serious stuff," Siegel warned his employees, "a direct assault on our core strength from the airline that wrote the book on low cost and low fares. We absolutely have to stay competitive with a lower fare structure if we expect to maintain market share." That will mean cutting fares for business travelers, analysts say, a clientele that the big carriers have consistently gouged, particularly on last-minute bookings.

To further compete with Southwest and JetBlue, the major carriers have formed smaller, lower-cost versions of themselves to fly secondary routes. Initially, United launched its Shuttle; US Airways tried Metrojet; Continental tried Lite; and Delta introduced Express. All of them failed because they still couldn't compete. Undaunted, Delta started Song in 2003. United planned to launch a similar venture, called Ted, in February of this year, and American Airlines may follow suit. Analysts doubt any of them will be successful. The idea, says Pilarski, "has limited life on certain routes. You have a huge low-cost airline within an airline. It's Looney Tunes."

An alternative strategy is to outsource: using smaller carriers, with regional jets, for secondary routes under the logos of the big carriers. But this, too, still can't compete with Southwest.

The big carriers also are evolving from the hub-and-spoke model to a point-to-point system. American Airlines trimmed its St. Louis hub, which was competing with its Chicago and Dallas hubs because all three were in the middle of the country. US Airways is threatening to close its Pittsburgh hub unless it gets concessions to help cut its costs there. Some industry experts believe the carriers should still maintain some hubs, but price flights from smaller cities into those hubs accordingly higher.

In fairness, even today's smaller airlines, including Southwest, could one day become bloated with higher labor costs and find themselves in exactly the same position the major carriers are mired in today. The question is, how much of the market will Southwest, JetBlue and the other low-cost carriers grab before their natural momentum slows?

As for the once-soaring CEOs of American, United, Delta and the other major carriers, they seem trapped in no-win situations despite their desperate restructuring efforts. As long as the current economic climate prevails, it will be difficult to cover the costs of their huge infrastructures. "The future growth of the U.S. airlines belongs to low-fare airlines," says Southwest's Parker.

Speaking of Southwest's muscling in on his airline's largest hub, Siegel of US Airways told his employees, "When those 737 jets start landing in Philadelphia, we're going to be in the battle of our lives." The same could be said for all the major airlines.

Changing Skies

% change in number of passengers 1993 to 2003

American       9.42
Continental    2.94
Delta          9.51
Northwest     19.11
Southwest    133.53
United         2.63
US Airways   -13.72

Note: Table made from bar graph.