Case Study on "Delta Is a Legacy Carrier, the Largest"

Case Study 9 pages (2824 words) Sources: 9

[EXCERPT] . . . .

Delta is a legacy carrier, the largest in the United States. It has faced difficult financial times in recent years, with two major writedowns that have crippled profitability and wiped out the company's equity. Delta has very little pricing power and the industry itself is not favorable. Firms compete on the basis of monopolistic competition, but most airlines find it difficult to foster sustainable competitive advantage through differentiation. They are also limited by regulator constraints from engaging in international expansion, although further domestic competition is entirely possible.

It is recommended that Delta seek further domestic consolidation as a means to build out sufficient size and scope to improve both market share and margins. It is also recommended that Delta focus on controlling fixed costs. The company can do little about most of its costs, so it need to find efficiency wherever it exists.

Strategy

Delta competes as a mainstream air carrier. Using Porter's typology, the strategy on which Delta competes loosely that of a differentiated player, implying that the company must develop points of differentiation and competitive advantage in order to succeed in the market (QuickMBA, 2010). There are a few main points of differentiation in the airline industry, including the routes that the planes run, the service levels that the airline offers, pricing, and brand value. Delta has one of the largest fleets of any airline, and that helps it to offer a wide range of routes, with multiple hubs.

The airline industry in the United States is in a state of monopolistic competition. This implies that firms in the industry must differentiate themselves in some way in order to earn revenues about equilibrium (i.e. be able to earn a profit). The larger legacy airlines like Delta typically rely on a combination of route network, service and name recognition. They employ strategies to win customer loyalty in order to boost their load factors. In addition, firms typically compete on price. The best profits are typically earned on routes with limited competition, so having a larger fleet allows Delta to have more of those routes. Routes with heavy traffic, such as that from Delta's Atlanta hub to LAX or New York, would be subject to more competition and therefore would likely be less profitable.

There are several key metrics that are used by airlines to measure the effectiveness of their strategies. Load factor is a capacity measure that reflects the finite nature of any seat offering -- load factor is the percentage of seats sold for any given flight. Revenue per passenger is another key metric in the industry, and this reflects the reality that airline pricing schemes are complex and customers on any given flight will pay different prices for their tickets. The higher the average revenue per passenger, the most successful the airline is likely to be.

This strategy, however, is facing obsolescence. Delta's stock price is down to $7.43 and the company has lost money in three of the past five years, including two years with very heavy losses (MSN Moneycentral, 2011). There are several reasons for this. The level of competition is intense, leading firms to compete on price while simultaneously competing on a differentiated strategy. Fixed costs are high for the legacy airlines, including the cost of the aircraft, landing rights and the contracts and pensions that most airlines have with their unions. The economy is a major factor as well, as downturns tend to reduce air travel not just in general, but in the lucrative business travel sector in particular. Additionally, the regulatory environment has been a source of considerable burden of late, discouraging air travel. The combination of these factors has made it difficult for airlines, especially the legacy carriers with their high fixed costs, to be profitable.

Competitive Forces within the Airline Industry

The Five Forces model (QuickMBA, 2010) can help to explain the competitive forces within the industry, in particular how those forces affect the ability of the firms within that industry to earn a profit. For each firm, the forces will work slightly differently, and this report will focus on the impact of each force on Delta specifically. The bargaining power of buyers is high. Consumers can readily gain access to pricing information, especially with the proliferation of websites that aggregate travel information for sale, like Expedia. Other sites serve as discounters (Hotwire, Priceline) and this further enhances the bargaining power of buyers. There are even websites that seek to demystify the airlines' pricing algorithms. As a result, airlines have pricing power only over last-minute shoppers who have a lower price elasticity of demand than do casual purchasers.

Pricing power of suppliers is moderate. Some suppliers, such as unions, are able to exert pricing power over the key input of labor, but the airlines are sufficiently large that they also have power in this bargaining arrangement. Delta is the least unionized of major carriers in the U.S. And the company actively campaigns against unionization (Jacobs, 2011). Where airlines have little bargaining power is with the other key input -- jet fuel. Airlines, while large, do not have significant bargaining power over the price of crude, the core ingredient in jet fuel. Delta has hedged its exposure to fuel prices since at least 1994 (Cobbs & Wolf, 2004). This strategy allows Delta to enjoy some cost certainty over the price of fuel, and that in turn allows it to manage both its prices and other costs. However, even sophisticated hedging strategies are of limited impact when the price of crude skyrockets like it did in early 2008. In 2011, the company shifted its hedging strategy away from U.S. crude to Brent crude, which performed more in line with jet fuel prices -- this also indicates that there are no perfect hedges for jet fuel and airlines must suffice with imperfect crude oil hedges.

The threat of new entrants is surprisingly high. Deregulation in the U.S. lowered the barriers to entry. This brought in new players, and what the rest of the world has seen is the rise of discount airlines. There are few true discounters in the U.S., but the regulatory environment does permit such airlines to operate, so their future entry is likely. Despite the high fixed costs associated with starting an airline, new players are constantly emerging ranging from JetBlue to RyanAir to Emirates.

The threat of substitution is high on shorter-range flights, very low on intercontinental flights. The main substitutes are alternate methods of transportation (cars, trains, etc.). For shorter flights, this threat is very high (for example, Miami-Orlando or Washington-New York). For longer flights (New York-Los Angeles) this threat is very low. As a result the company's strategy to deal with this threat will differ depending on the route. The substitution threat has become more serious in recent years as the TSA and Homeland Security have made flying more onerous than it used to be.

The intensity of rivalry within the industry is high. Each flight represents fixed, perishable capacity. This leads to intense competition to fill seats (load factor). This competition drives down prices and squeezes margins. The competition also causes airlines to maximize their routes, as the route network is another point of competition between airlines. As a result, they must simultaneously build out expensive route networks while competing on price. As a result, the airline industry in the United States is generally an undesirable one in which to operate. The companies in the industry have very little pricing power -- even the business segment is highly competitive -- and they have very little control over the major external cost and demand drivers.

Change

In the airline industry, change is driven by three types of forces -- technological, regulatory and competitive. Technology drives change in many ways, and most of what we recognize in this industry today is based on new technology. Consider the way we purchase airline tickets -- first through reservation systems like SABER and now through the Internet after comparison shopping. When buying through a travel agent, consumers never had the ability to truly comparison shop. That changes the dynamics of marketing substantially. Another major change is with the types of airplanes used. There is duopolistic competition both in large aircraft (Boeing, Airbus) and smaller aircraft (Bombardier, Embraer) and this drives innovation on both fronts. Manufacturers are developing planes that are more fuel efficient, more comfortable and safer. The result is that companies with fleets full of older planes are at a competitive disadvantage to companies with new fleets of planes.

Regulatory change can have a number of impacts. One of the most significant was deregulation in the 1970s, which ultimately set the industry into consolidation mode. Today, security measures increase costs and make the flying experience less pleasant, affecting the demand conditions of the industry. Other regulatory burdens can include issues like airport access (a problem for Southwest at its main hub of Love Field). Many countries have closed air markets, which has an impact on the level of competition in… READ MORE

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