Five years ago, American Airlines factored in on-time arrivals, lost baggage and consumer complaints to help calculate annual incentive payments for top management. Today, these bonuses are based exclusively on the company’s pretax income and cost savings.
United has also scaled back bonuses linked to reliability and customer satisfaction for senior executives in recent years. But in the wake of what happened in April, bonuses “will be made more comprehensively subject to progress in 2017 on significant improvement in the customer experience,” the company said in a financial filing.
“Fifteen years ago, airlines competed with each other over who could buy the most planes or have the most routes,” said Jamie Baker, a top airline industry analyst at JPMorgan Chase. “Executives are just as competitive today, but it’s about who can achieve an investment-grade rating first, who can be a component in the S. & P. 500, and who has better returns for investors.”
These new incentives also partly explain why airlines are packing seats more densely and squeezing more passengers into the back of the plane. “Densification is driven by the desire to sweat the assets and generate revenues without having to commit capital to building new planes,” Mr. Baker said.
Such a shift isn’t unique to the airline industry.
“As in other industries, like manufacturing or consumer goods, the focus is on more traditional financial metrics like pretax income, margins, return on capital and total shareholder return,” said Andrew Goldstein, head of the executive compensation practice in North America for Willis Towers Watson. “Airlines haven’t abandoned operational and customer-service metrics, but they are putting less emphasis on those factors.”
A Cost to High-Flying Profits
After a wave of bankruptcies and mergers that reshaped the airline industry, its profit margins have risen rapidly over the last five years. But with no-frills offerings from low-cost carriers like Spirit stealing market share, older airlines like United are being forced to cut costs to catch up.
Operating profit margins, 2012-2016
LOW-COST CARRIERS
AVERAGE
Operating profit margins, 2012-2016
LOW-COST CARRIERS
AVERAGE
And with the economy growing at a rate of only 2 percent while the stock market rallies on promises of soaring earnings, something must give so profit margins can grow.
In the case of United or Spirit Airlines, whose repeated cancellations led to a melee among travelers this month at a terminal in Fort Lauderdale, Fla., it was customer service. At other companies, like Ford and Alcoa, it was the head of the chief executive that was served up when profits failed to meet expectations.
Mature industries — where double-digit annual profit growth is a reach in the best of times — are especially vulnerable to activist investors’ demands for board seats, bigger stock repurchases and other short-term financial rewards.
The pressure is especially brutal in the airline industry because the key expense, fuel, is for the most part beyond management control. Yet airline executives have largely convinced Wall Street that the bad old days of bankruptcies and fare wars are over, replaced by the kind of predictable annual profits more common among industrial companies.
That’s among the reasons fees have popped up in recent years for everything from checking bags to securing an assigned seat before boarding. Known on Wall Street as ancillary revenue, this stream of income is especially favored by investors because it doesn’t swing sharply the way fares do.
And so far, despite occasional bouts of air rage and frequent consumer complaints, Wall Street has been getting what it wants.
United’s stock has surged to more than $80 per share from $25 per share five years ago, with profit margins rising to 13.6 percent from 3.7 percent over the same period. Overall industry margins hit 16.3 percent, up from 5.2 percent in 2012.
Spirit’s operating margins are among the highest in the industry, topping 20 percent in 2015 and 2016. But Paul Berry, a company spokesman, said Spirit had pivoted to focus more on customer service in the last year, even as some larger rivals keep cutting costs to compete.
Despite rewarding top executives strictly according to financial targets, American said it, too, was committed to improving the passenger experience.
“Every single person at American knows we succeed or fail based on how well we serve customers,” said Joshua Freed, a company spokesman. “We will only meet those financial goals if we keep our customers happy.”
Credit
Scott Olson/Getty Images
Still, the promise of steady profit growth has prompted even Warren E. Buffett to take a fresh look at airline stocks. He once famously called the industry a money-losing “death trap,” but reversed course late last year, with his company, Berkshire Hathaway, acquiring stakes in several airlines.
“In the past, airline stocks were seen as hazardous to one’s wealth,” said Mr. Baker, the JPMorgan analyst. “They were trading vehicles, and potential destroyers of capital.”
The pressure on United, American and other giants is only going to increase with the rise of so-called ultra-low-cost carriers like Spirit, Frontier and Allegiant. In fact, American and United are rolling out a stripped-down new class called Basic Economy.
Here, in exchange for the cheapest tickets, fliers can’t choose their seats before checking in and are more likely to be stuck in the middle of the row. They board last and are less likely to be able to sit with companions. No carry-on luggage is permitted, forcing anyone without elite frequent-flier status to check anything larger than a backpack — for a fee.
“That’s the experience on a ultra-low-cost carrier,” said Rajeev Lalwani, an airline industry analyst with Morgan Stanley. As the legacy airlines introduce similar no-frills offerings to hold off upstarts like Spirit, he said, “part of the idea is to get folks to upgrade to premium economy and collect fees.”
It’s also the wave of the future, at least for budget-conscious travelers.
“For the lowest price comes the most basic product,” said Alan Wise, a senior partner with the Boston Consulting Group, who leads the firm’s travel and tourism practice for North America. “Spirit has been a growth story in the space, and it’s forced the legacy carriers to adapt and innovate.”
To be sure, some industry veterans insist it is a mistake to simply blame investors or hedge-fund managers for fostering a race to the bottom in customer service.
“The response isn’t to Wall Street. It’s to customer behavior,” said Alex Dichter, a senior partner at McKinsey who works with major airlines. “About 35 percent of customers are choosing on price, and price alone, and another 35 percent choose mostly on price.”
Mr. Dichter noted that when American added two to four inches of legroom in coach in the early 2000s, “as far as I know, the airline didn’t see one bit of improvement in market share or pricing.”
“The great irony is that most C.E.O.s would love to compete on product and experience,” he added. “It’s much more fun. The problem is that customers aren’t paying attention to that.”
