NYTimes.com Article: Fare Idea Returns to Haunt Airlines

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Fare Idea Returns to Haunt Airlines

October 27, 2002


IT was, someone in the room said, "a Don Corleone moment."
The room was in the New York office of the Boston
Consulting Group, to which top Microsoft executives had
been summoned in November 1999. 

The offer, made by executives of four big airlines, was
this: They would give Microsoft's online travel agency,
Expedia, access to their discounted "Web fares" and, in
return, get half of Expedia. And the threat: If Microsoft
refused, the airlines would announce their own travel site
the next day, which happened to be the day of Expedia's
initial public offering. 

Microsoft, unaccustomed to being on the receiving end of
threats, refused. So on the morning of Expedia's offering,
the airlines said they would start a rival service,
ultimately known as Orbitz. 

The code name for the venture was T2, which the travel
industry took to mean Travelocity Terminator. The airlines
wanted protection against the rising power of Expedia and
Travelocity, another online agency. They also saw Orbitz as
a way to force down the costs of reservations systems, like
Travelocity's owner, the Sabre Group. And, of course, they
wanted to make a mint by taking Orbitz public. 

Three years later, the airlines have been able to use
Orbitz as a blunt instrument to make sure the savings from
the Internet - which is used for booking 20 percent of air
travel - accrues to their benefit, not the other travel
agents. But Orbitz has also compounded the beleaguered
airline industry's biggest problem: falling revenue. By
disseminating their Web fares so widely on Orbitz, the
airlines have created another way to ratchet fares even
lower when they can least afford it. Indeed, some carriers
have called a halt to Web discounts, threatening to
undercut Orbitz's biggest selling point. 

"Orbitz accelerates the difficulties that the airlines have
with the Internet" because it provides such complete
pricing information, said Jamie N. Baker, an airline
analyst at J. P. Morgan. He estimates that Internet sales
by Orbitz and others have saved airlines $3 billion a year,
but he says reduced fares, especially for business
travelers, cost airlines even more. What is worse, he said,
the pressure will continue if the economy revives and war
threats abate. 

ORBITZ'S owners - American, United, Delta, Northwest and
Continental - have had to postpone their dreams of profit
from taking it public and instead keep funding its losses.
Indeed, there is a growing opinion in the industry that in
trying to fortify Orbitz, the airlines made a Faustian
bargain: Orbitz would charge the airlines unusually low
fees, and the airlines promised to let Orbitz sell every
discount fare they offered to the public, through any other
travel agent or on the airlines' own sites. 

In theory, that is great for travelers, who can click on
Orbitz and see nearly every discount fare. Orbitz was also
to be a major disadvantage to other travel agents, both
online and traditional. Agents, in fact, have lobbied
extensively - but so far unsuccessfully - to have that deal
declared an antitrust violation. 

It is not so clear, however, that airlines benefit from
having all their fares in one place. Like any retailer,
airlines advertise sales. But they also try to move unsold
seats through the equivalent of outlet malls: charter
companies, cruise lines and, more recently, promotions on
their Web sites. Their deal with Orbitz essentially forces
every liquidation into the front window on Main Street. 

"The airlines are shooting themselves in the foot," said
Edward P. Gilligan, president of American Express Global
Corporate Services. 

Web fares are so low that more business travelers want
them, even with the fares' restrictions. The airlines "are
cutting their fares by 50 or 60 percent to save 2 percent
in distribution costs," Mr. Gilligan said. 

A few airlines are pulling back from Web fares. Last March,
America West lowered business fares and ended most deep
discounting on the Internet. Last week, US Airways agreed
to give travel agents who use the Sabre systems all the
fares it makes available on Orbitz. In return, Sabre agreed
to cut the fees it charges the airline by 10 percent. 

"We were fooling ourselves to think we could put this
product here and it wouldn't affect prices there," said B.
Ben Baldanza, senior vice president for marketing at US
Airways. "It's gotten to the point where the outlet store
has taken over the retail store." 

If other airlines adopt this approach, it could mean the
end of Web-only discount fares. 

"How can you have a Web fare if travel agents sell it over
the phone?" asked Terrell B. Jones, former chief executive
of Travelocity. "Whatever incentive there was to create
incremental traffic or to shift people to using the Web
will be gone." 

In the last 18 months, average domestic fares have fallen
27 percent, to a 20-year low, according to the Air
Transport Association. Indeed, fares have fallen more than
the economic slowdown would predict: for two decades,
industry revenue has been roughly 0.9 percent of the gross
domestic product each year. So far this year, it is 0.8

The airlines readily agree that falling fares are largely
responsible for their woes. But the wounds, they contend,
are not self-inflicted. Web discounts, they say, were never
as big and widespread as travelers had thought, and the
savings that Orbitz is helping them achieve more than
outweigh the discounts it propagates. 

"Orbitz has turned out to be very successful from our point
of view," said Gregory T. Taylor, a senior vice president
of United Airlines. "Has it made it more difficult to have
a fare that is slightly higher than the marketplace? The
answer to that is yes. Maybe we could have charged a few
dollars more in the past to people who appreciated our
value. But I'm not sure the airlines had any choice about
participating in the Internet. And by having a distribution
channel that is really low cost, it puts competitive
pressure on the other channels to bring their costs down." 

IN the early 1990's, the costs of distribution - for agent
commissions, reservations systems and telephone agents -
represented more than 20 percent of revenue, and airlines
were looking for ways to reduce them. 

The Internet was their solution. Five years ago, as the
airlines were setting up their Web sites, they tried lures
for travelers. American Airlines invented Net Saavers -
last-minute discount fares, listed on weekly e-mail
messages, for weekend travel. 

"It was never anticipated, nor did it come to pass, that we
sold a lot of tickets through Net Saavers," said Craig S.
Kreeger, American's vice president for sales. "It engaged
people to come to our site and give their e-mail addresses
to us." All the other airlines quickly copied that program.

Then the airlines began introducing broader, Internet-only
discounts. Delta, for example, had fare sales in which
people who booked on the Web could save 5 or 10 percent. 

"Two or three years ago, it made sense to offer people a
small nudge to give online buying a try," said Kevin
Connor, Delta's director of pricing and revenue management.

By last year, the number and size of the Web discounts were
growing, with airlines sometimes offering hundreds of
dollars off their lowest published fares. The trend
accelerated as business travel fell off, and again after
Sept. 11. 

The growth of Web fares also coincided with the start of
Orbitz in June 2001. Some travel experts argue that the
airlines expanded their use of Web fares, at least at
first, to help attract customers to Orbitz. 

The site had other advantages, too, like software that
could display far more route and fare options than older
online travel agents. Moreover, the one-year delay in
starting Orbitz - caused by software problems and an
extended review by the Justice and Transportation
Departments - created a sense of anticipation. 

Once out of the gate, Orbitz became one of the
fastest-growing sites in history. In the first six months
of this year, it sold $950 million worth of tickets,
estimates PhoCusWright, a consulting firm. That gives it a
14 percent share of the online travel agency market.
(Expedia has 35 percent and Travelocity has 24 percent.) 

So far, Orbitz has not been a financial success. Last year,
it lost $103 million on revenue of $38 million. In the
first quarter this year, it lost $9 million on revenue of
$27 million. 

The company filed to sell shares to the public in May, but
the offering was delayed because both the Transportation
and Justice Departments had resumed investigations into
accusations that Orbitz was anticompetitive. The
Transportation Department inquiry could be completed as
soon as this week. 

But even if Orbitz gets a new green light, its offering is
not likely to advance while war clouds loom and air travel
is depressed. 

Over the summer, Orbitz's owners had to give it a cash
infusion of nearly $10 million, on top of the $205 million
already contributed, according to a person involved in the
financing. For the airlines, which are asking for huge
government subsidies, further investment in a controversial
Internet venture is politically awkward. But Orbitz found
the terms available from private investors unattractive,
this person said. 

It is also unclear how profitable Orbitz will be if the
market rebounds, particularly because the site has agreed
to charge the airlines - owners and nonowners alike - fees
that decline each year. The fee is now $6 a ticket. 

Jeffrey G. Katz, the chief executive of Orbitz, says it is
within striking distance of profitability - and that it
will prosper because of its low costs and the $5 fee it
charges travelers for tickets. It now has such a strong
reputation for its fare search technology and customer
service, he said, that it could thrive even without
exclusive access to discounts. "Ultimately, people will
find many of these prices at other places," he said. "We
believe having the most low fares isn't enough." 

After Orbitz appeared, other online travel sites started
demanding Web fares from the airlines, too. "We called up
every airline every day, and said: `Can we have the Web
fares? Can we have the Web fares? We have to have them,' "
said Richard N. Barton, the chief executive of Expedia, now
controlled by USA Interactive. The Orbitz rivals prevailed
after agreeing to cut their fees by several dollars a

"They created a big bat to beat us over the head with, and
it worked," Mr. Barton said. 

American, for example, signed a long-term deal in August to
provide Web-only fares to Travelocity, but it then cut off
Expedia, which did not agree to cut fees as much. 

Expedia even stopped selling Northwest Airlines tickets for
three weeks this month because that airline also wanted
lower fees. A deal was reached a week ago, and Northwest
tickets are back on the site. 

THE airlines also hope to use Orbitz to put pressure on
what they consider outrageously high fees charged by the
reservations systems used by travel agents. But the
airlines have little leverage. 

The systems are under strict regulations to treat all
airlines equally, largely as a result of misdeeds by
airlines that set up systems and used them to try to favor
their flights. Now the two biggest - Sabre and Galileo -
are no longer owned by the airlines, but they can still
name their prices. This has allowed the systems to raise
prices far faster than their costs and to use the
difference to pay subsidies of as much as $2 a flight
segment back to travel agents. 

"Over the last decade, the average fare at United went up
by 14 percent, but the average fee to the reservation
systems increased by 350 percent," Mr. Taylor said. "That
is an intolerably high cost." 

Orbitz was set up to help the airlines in two ways. It
rebates some fees it receives from the reservations system
it uses, Worldspan, reducing its cost for each ticket to $8
from $11. And it has developed technology to bypass the
reservations systems entirely and connect directly to the
airlines. Orbitz will charge only $4 a ticket for airlines
that use that system. 

In August, American became the first to use the direct
connection, and 10 more airlines have agreed to use it the
next year or so. Mr. Katz said the move would save American
more than $10 million a year. 

Most technology experts say central reservations systems
are too useful to be replaced by a patchwork system of
direct connections. But the airlines have created enough of
a competitive threat to push the reservations systems to
propose some alternative financial structures. 

The deal struck last week by Sabre and US Airways is
significant because Sabre agreed to cut its fees and hold
them steady for three years in return for access to all the
airline's special deals. But it preserved the payment to
travel agents. 

Nowhere have Web fares caused more turmoil than at
corporations, where travelers complain that they can find
better deals on Orbitz or elsewhere than through their
travel agencies. 

In-house corporate travel managers "hate Web fares," said
Philip Wolf, president of PhoCusWright. "Their travelers
don't follow policy and book online." Most companies try to
concentrate their business with a few airlines, which offer
negotiated discounts, but those deals do not include Web

TRAVEL agents, to reassure clients they are getting the
best deals, have started to use so-called Web bots -
programs that search Orbitz and the airline sites. Some
airlines, like Northwest, invite agents to use their Web
sites, figuring that they can avoid the reservations system
fees. But American has sued FareChase, a provider of Web
bot software, arguing that travel agents should be able to
book Web fares only if they agree to its broader proposal
that would have agents pay most of the reservations system

Orbitz, meanwhile, reports that 20 to 30 percent of its
customers say they are buying tickets for business travel,
and it has started its own site to serve small businesses. 

Indeed, Orbitz and the other sites have hurt airlines'
ability to keep business fares high. The average business
fare is now six times as high as the average leisure fare;
the multiple was only three in 1995. That bubble was ready
to be popped. 

"Business travelers have known for a long time that we
charge them more because we provide them services that cost
more, then we top off the plane with leisure travelers,"
Mr. Taylor of United said. "The Internet has made this more

Over all, 42 percent of business tickets issued by American
Express are now discounted and nonrefundable, up from 25
percent in 2000. 

Tight corporate budgets have been a big force, but the
Internet is, too. In controlled experiments, American
Express found that when travelers book tickets for the same
route, those who use its Internet site spend 15 to 20
percent less than those who talk to its own travel agents. 

John Berkley, vice president for strategic planning at
American Express, said that was because someone might buy
the first convenient nonstop when talking to a travel agent
but might feel obligated to take a cheaper connecting
flight if it is displayed on a screen. 

The big airlines have responded to the increased use of
discounted, nonrefundable fares by prohibiting travelers
from using those tickets to stand by for later flights. 

America West took another approach in March by lowering
business fares substantially while eliminating Internet
discounts. "We used to sell close to 10 percent of our
revenue through online discount channels," said J. Scott
Kirby, America West's executive vice president for sales
and marketing. "And on transcontinental routes it got to be
that if you really wanted to sell tickets you had to price
them at $150 to $200 round trip." 

The business fare on those same routes was $2,300, and the
lowest published fare was about $300. Now the business
round trip is $800 and the Internet discounts are gone.
Revenue per seat mile at America West, which does not have
a big base of business travelers, has fallen less than at
the other carriers. 

"When we first started using the Internet, we were able to
shift market share, but now every airline is doing it," Mr.
Kirby said. "We decided this is a game that leads to
inexorably lower prices."  


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