Fees are now so essential to U.S. airline profitability, even Southwest may alter its model
is the last carrier in the U.S. that allows passengers to check their baggage for free, a differentiator that the carrier has highlighted in many ad campaigns. The hint that it may start charging—though not until 2015 at the earliest—shows just how lucrative baggage fees and other ancillary charges have proven themselves, and how tempting it is for Southwest to follow its competitors' lead.
Ancillary revenue has made “the difference between profitability and loss in the airline industry,” said Jay Sorensen, president of IdeaWorksCompany, a consultancy that began analyzing nonfare sales in 2007. “It is here to stay, and is only going to grow. It is no longer the frosting, it's part of the batter.”
Checked bags added $3.5 billion to U.S. airlines' revenues last year, according to the Bureau of Transportation Statistics. And fees for priority boarding, aisle seats, food, blankets and other services boosted that nonfare figure even higher, though the bureau does not track the total.
Globally, ancillary revenue more than doubled in the four years through 2012, to $27.1 billion, and will add another 57% this year to reach $42.6 billion, according to Sorensen's group.
European carriersand were the first to start charging baggage fees; the U.S. industry did not jump onboard until a few years later when higher fuel prices and the recession in 2008 made an impact, Sorensen says. Since then, all major U.S. carriers except Southwest have begun charging to check bags in some fashion.
And that is not all. Airlines have become creative in finding other ways to keep published fares low, helping them to compete in an increasingly cost-conscious environment.
Low-cost carrierhas been the most aggressive with its business model of breaking up the product—stripping out costs and reducing the fares by a commensurate amount—says Bob Mann, a former airline executive who is now an industry consultant. The majority of carriers, though, have added extra fees only onto their fares.
“The economics are almost pure profit,” Mann says.
There is no added cost to an airline for it to charge an extra $15 for an aisle seat, and carriers have to pay for luggage-moving infrastructure and personnel whether they charge for bags or not, so ancillary revenues go straight to the bottom line.
That hasn't convinced Southwest yet, despite pressure from Wall Street, but the airline did soften its stance.
“Right now, it is our belief that we get more customers and more revenue by not charging for bags,” because passengers appreciate Sothwest's transparency and the brand image of “being different than the herd,” CEO Gary Kelly said on an Oct. 24 call with analysts.
“However, if over time, if customers prefer the unbundling approach, sort of an a la carte approach, and they understand it and favor that, well, we'd be crazy not to provide our customers with what they want,” Kelly explained. He added that no changes were planned through 2014 while the carrier focuses on its international expansion plans and integration of AirTran Airways.
Southwest's resistance may have begun to weaken because of industry surveys showing that passengers now expect to pay extra for their luggage, say Sorensen and Michael Derchin, an analyst with CRT Capital Group.
Bag-checking fees can actually strengthen a carrier's claim to have the lowest fares, Sorensen says. “If they want to foster a reputation for having the lowest fares out there, this works against them,” he asserts. “Consumers inherently have problems understanding that you can have the lowest fare and still provide something for free.”
Ancillary revenue helped boost the U.S. airline industry's financial performance last quarter. The country's seven biggest carriers reported combined third-quarter net income of about $2.87 billion, according to Aviation Week calculations, more than double the $1.29 billion earned a year ago.led the way with $1.37 billion of that, and only showed a decline. The group's revenue rose more than 6% to about $39 billion in the three months through September.
“They're doing extremely well,” with Delta, American and Southwest all reporting record numbers for the quarter, says Derchin. “The economy's not great, so it is impressive to have these results in a lackluster economic environment. The ancillary fees are certainly a part of the positive story.”
And a necessary part at that, especially after almost every U.S. airline has undergone bankruptcy restructuring, “some more than once,” Derchin says. “The industry was forced by necessity to change the way they were operating. . . . This will be the fourth consecutive year of profits. They're going to make quite a lot of money in 2013 in a slow-growing economy with oil prices high, so that is pretty good.”
Bookings look solid for the Thanksgiving/Christmas holiday period, Derchin says, so he expects fourth-quarter results to also improve from last year.
Most airline executives, on third-quarter calls with analysts, talked up the anticipated growth in extra charges.
Delta CEO Richard Anderson said the carrier expects “significant upside” for ancillary revenue going forward.' chief revenue officer, James Compton, noted that the segment rose 16% in the quarter from a year ago, to more than $20 per passenger, and the airline is “well-positioned” to exceed its 9%-increase goal for the year.
Alaska Air, which was slow to impose baggage fees and then priced them lower than competitors, saw ancillary charges rise 16 cents per passenger in the quarter, to $11.94. Executives say they are raising prices for some services and looking for ways to boost the figure to help mitigate cost pressures because of increased competition from Delta and United.
Some carriers, including American and United, are moving on from unbundling and are experimenting with ways to rebundle, offering various price points that include different types of services or selling packages with a year's worth of free checked bags or lounge access, Mann says.
It may be years before consumers show a clear preference for fare and fee systems, Mann warns. Until then, it could behoove Southwest to wait and watch its competitors try new models.
“I'm not sure there's a first-mover advantage here, in fact there may have been some high-profile failures,” such as charging for carry-ons, Mann notes. “As Bob Crandall [former president/CEO of] used to say: 'Pioneers sometimes get arrows in their heads.'”