Of Changing Airline Business Models & Urban Economics

As the economy is finally emerging what looks to be a period of sustainable growth, it’s interesting to take stock of the last few years, and see how the recession and upheaval of the last few years has affected a variety of industries, and the consequences that these changes have for society as a whole. The airline industry is one that’s particularly fascinating to think about in this regard, since it seems to have been permanently changed in a way that other industries haven’t. We’re curious to think about how some of these changes will affect the economic growth in larger and smaller cities throughout North America.

Broadly speaking, there are two dominant business models within the airline industry: 1) the hub-and-spoke model, utilized by American Airlines, United, and most of the flagship carriers of foreign countries; and 2) the “low-cost-carrier” or point-to-point model, favored by Southwest, RyanAir and others. The hub-and-spoke model requires aggregating passengers from smaller second-tier “spoke” airpports (say, Philadelphia, St. Louis, etc) at a larger hub airport (e.g. Chicago’s O’Hare, Heathrow) and in order to fly passengers to a similarly large hub. In general, hub-and-spokes usually break-even or take a small loss on at least some of the spoke-to-hub flights in order to maximize the the profits they can create on the lucrative hub-to-hub flights. Airlines can charge a premium—especially on business class and above—on some hub-to-hub cross-continent routes, and especially on some transatlantic or transpacific routes: hence, these routes are disproportionately important to a hub-and-spoke. Furthermore, since the fixed costs associated with building a hub-and-spoke are so high—aircraft, gates, landing rights—they create a powerful barrier to entry for potential competitors, thereby limiting further limiting supply, and raising the premium an airline can charge on these routes. Contrastingly, point-to-point low cost carriers (LCCs) try to fly shorter distances between secondary airports (Chicago’s Midway, Love Field in Dallas) where landing rights are less expensive. Crucially, these airports are less congested, enabling LCCs to turnaround aircraft much more quickly than competitors, thereby allowing for more frequent flights, more efficient aircraft usage, and most importantly, increase the amount of revenue they can generate per each aircraft seat by getting x many more flights per year out of each plane. LCCs generate barriers to entry by locking up gate rights at the airports they operate in, thereby keeping particular carriers out. (We’d guess this is ultimately the challenge JetBlue will face vs. Southwest, since the latter has a dominant position at the lion’s share of good secondary airports in the US.)

The consequences of the recession within the airline industry has been to validate one type of business model in the airline industry—the point-to-point low-cost carrier business model—while largely invalidating the previously dominant hub-and-spoke model . While the hub-and-spoke model can create huge profits during boom years—and we agree that it eventually will, as soon as corporate travel spending picks up again—the aforementioned high fixed costs of the model mean that it racks up huge losses during a bust period. This means that the hub-and-spoke model bears greater risk for investors, and therefore has substantially higher capital costs than a well-run LCC, further cutting into profits. (Moreover, in a post 9/11 and post-SARS world, the international destinations served by a hub-and-spoke have a greater risk associated with them, translating into added security and insurance costs for hub-and-spoke carriers.) In contrast, while the LCC point-to-point model offers slightly lower margins (since these carriers offer lower prices than hub-and-spokes), the flexibility of this model, and the lower prices, mean that it thrives in boom years as well as bust years, making it a safer investment over the long-run.

As hub-and-spoke airlines climb out of recession, they’re trying to trim their high fixed costs by offering a “leaner” version of themselves. In a nutshell, what this generally means is that smaller regional cities—the feeders of the hub in the hub-and-spokes, e.g. places like Pittsburgh (Brad’s hometown), Edmonton (my hometown), or Clevelands of the world now have many less flights connecting them to hubs than they did previously. Since these hub airports tend to be located in larger cities, and offer gateways to other larger cities either domestically or abroad, one potential consequence of changes in the airline industry is to reduce the connectedness of smaller regional cities to major hubs in the overall world economy. In short, it makes them less cosmopolitan and less global.

Being less connected to the world and national economy, and being less cosmopolitan and less global has significant competitive ramifications for smaller cities. Economically, this means that cities have less access to capital , since most capital tends to be clustered in what University of Chicago sociologist and urban studies guru Saskia Sassen has termed the “global cities,” e.g. larger first or second tier cities—London, New York, Chicago, Tokyo, Hong Kong. Less capital means less fuel for growth, and a less dynamic economy overall.

There are also economic disadvantages stemming from the cultural consequences to being less cosmopolitan and “worldly.” One result of removing some of the connections between a city like, say, Cleveland to that of New York, London, Paris or Tokyo is that smaller regional cities offer slightly less variation than their big city counterparts, making them less interesting on the whole. This lowered access to culture is far from trivial, if you subscribe to the Creative Class argument (which we do) proposed by Carnegie-Mellon economist Robert Florida, there’s a strong desire on the part of “knowledge workers” to locate in cities that offer greater cultural amenities and a dynamic environment. Knowledge workers—the computer programmers, consultants, analysts, venture capitalists and so forth—create and attract disproportionate amounts of wealth and capital, and therefore growth, and are therefore of pivotal importance to any city’s long-term future. For a small regional city, having less access to these workers only dims growth prospects.

So given that shifts in the airline industry seem likely to result in a new set of challenges for the economies of smaller regional cities, what should they do? While this is definitely a topic for another blog, we do have some high-level thoughts on the subject. One potential option would be for smaller regional cities to make the world come to them, either by playing up their unique resources (be they economic or cultural resources), to ensure that the world comes to them. For example, smaller cities like Austin, Portland or Vancouver have ensured that they’ve remained connected to the larger world either through adopting policies to develop or stress their cultural amenities (physical beauty and a vibrant downtown core in the case of Vancouver and Portland). An even more effective strategy for these smaller cities is to use the cultural amenities as a platform from which to drive future economic growth—coupling cultural policy that attracts knowledge workers with economic policy that encourages firms and workers to locate in a particular region. Austin, Texas is a case study in this regard, since it combines an eclectic local culture (South by Southwest) with a dynamic technology industry (Dell et al). In short, despite the fact that smaller cities will probably face a growing array of economic challenges, smart strategic planning can provide some templates for sustainable future growth.

Posted by Matt Percy | Permalink | Comments (30) | TrackBack

Microsoft Merger Or Google Gamesmanship

This morning, reports from the New York Times as well as other sources suggest that Microsoft initiated merger/acquisition talks with Google over two months ago. The pairing of the two companies would marry the world's largest software company with the world leader in search. Is the recent annoucement of a pending IPO by Google a certainty or merely gamesmanship to better their bargaining position with arguably one of the twentieth century's greatest m&a gamesmen? Regardless of the outcome, it has been an exciting week with pre-IPO Google-mania on the rise, Amazon's creative solution for outflanking Google's squishy ball entrepreneurs in the short-term, and Bill Gates' team is on the prowl.
And we thought that what looks to be the greatest economic rebound in two decades was going to be the most exhilarating sign of things to come. Silly us.

Posted by Bradley Peacock | Permalink | Comments (0) | TrackBack

A Three Mile Moment For J&J

Now is a Three Mile moment for Johnson & Johnson. Sixty people have died. The FDA is on its case. Its greatest success story of 2003 is on the ropes. And shares in J&J have rebounded slightly from their lowest point in over a year. Sure it may be the "world's largest and most diversified health care company" consisting of pseudo-latinate corporations such as Ethicon, Centocor and Cordis among others, but in the end of the day Johnson & Johnson most powerful perceptual position is less about biotech and more about its role as protector of the "mother-baby" bond. General Robert Wood Johnson intuitively understood this and drafted J&J's famous Credo to insulate J&J's unique focus from the fuzzying effects of multinational delusions of grandeur. The credo has been revised over the years, but the principals remain intact. The credo provided a gameplan to then Chairman Charles E. Burke during the Tylenol Scare nearly twenty years ago. Today's Chairman & CEO of J&J, William C. Weldon is the newest keeper of the credo and he is faced with an issue that may be even more dangerous to the long-term viability of the company than that faced by Burke. Arguably his most valuable constitency (physicians) has been given reason to doubt J&J. We believe that Weldon missed an opportunity live the credo and pre-empt the FDA report by taking the bad news public himself. What could have been framed as the responsible actions of a confident company, has been characterized in the press as just another example of the careless profiteering so common among "big companies". Weldon's next move will be just as critical. Will he make a public mea culpa and take the defective stents from the market (as any responsble mother would do and his credo demands) or will he be influenced by his financial stakeholders (Wall Street) and follow in the footsteps of Coke and another great brand killing moment of late? Only time will tell. We hope that he lets the credo be his guide.

Posted by Bradley Peacock | Permalink | Comments (0) | TrackBack

Sometimes Silence Is Golden

Successful co-branding is more than simply slapping two logos on a product or a piece of communications. In fact, sometimes a silent partner is best. That is the lesson to learn from yesterday's announcement that Barnes and Noble was going to stop financing Book Magazine.

Book Magazine was a favorite of ours. It provided quality information to an increasingly underserved niche, the book lover. The advent of the rise big box booksellers like B&N, Waldenbooks, Borders, etc. brought an end to arguably the most valuable aspect of the independent bookseller, "intimate expertise". It wasn't possible to walk into one of the "big boxes" and ask for a recommendation from someone who not only not only loved books, voraciously consumed books and actively crituqued books...but also who had an intimate understanding of your personal literary inclination. Intuitively understanding this intangible advantage, Mark Gleason and Jerome Kramer started BOOK. Billed as a "Rolling Stone" for booklovers, BOOK was launched in 1999 and effectively supplemented the lackluster "referral power" of the big box booksellers. Sold in book stores of all shapes and sizes, independent and publicly traded, BOOK magazine began its quest to become the source for intelligently written reviews of the products of trade publishing--and the bible for the avid reader.

Fast forward to 2001, BOOK needs increased distribution/circulation and B&N needs a value-added resource (12 month subscription to BOOK) to drive traffic to its frequent buyer program. Seemingly it was a partnership born in business heaven. B&N took 50% of BOOK, BOOK gained access to the 1.3 million B&N customers who signed up for the Reader's Advantage frequent buyer program (many of whom became subscribers to the magazine in a year's time). In addition, BOOK's role as unbiased "book authority" was a natural means of promoting B&N and the books that B&N wanted to sell.

"We're an independent magazine," he says. B & N simply thinks it's "a great magazine" that interests the company's customers: "To their credit, they recognize that the magazine is only of the highest value to readers if it's got an independent editorial voice."- Mark Gleason

Then it happened, Barnes and Noble made the "strategic decision' to put its name on the cover of BOOK Magazine. You can hear the conference room rationale, "Book Magazine--brought to you by Barnes & Noble. It'll be like 'Intel Inside'. A confidence-builder. Brand equity. Blah blah blah." At first blush, it makes sense, they are "partners" after all, right? Wrong. What Barnes and Noble couldn't appreciate was that overt co-branding eroded the value of BOOK immediately transforming the magazine perceptually from "unbiased book authority" to "Barnes & Nobel newsletter". Let's consider what effect that would have on Book's two most important customer consituenties, subscribers and booksellers. Why would subscribers want to pay good money for a B&N newsletter? "If BOOK is a B&N advertising vehicle, let B&N pay for me to read it". Goodbye subscribers. Furthermore, why would a non Barnes & Noble bookseller want to stock BOOK magazine? To drive traffic to Barnes & Noble? I am certain that is not what Barbara's and Powell's had in mind. Goodbye distribution.

Book was sold in numerous stores besides Barnes & Noble outlets, it lost business after "Barnes & Noble" began appearing, in small print, on the cover earlier this year. "A lot of independent sellers pulled out,"- Jerome Kramer, Editor, BOOK magazine (via CNN)

One would think that Amazon-obsessed Barnes & Noble would have taken a page from Jeff Bezo's playbook and left Book well enough alone. Bezos certainly understands both the power of strategic parnterships and the influence of a respected, unbiased, intelligent source of referral. Brand rule #1 is that "trust is hard to come by". Unfortunately Barnes & Noble mistook its unique trusted resource for an awareness vehicle.

Goodbye BOOK we will miss you. On the bright side, we can't wait to see what Mark and Jerome dream up next.

Posted by Bradley Peacock | Permalink | Comments (0) | TrackBack

The Long Harm Of The Law

A Google search on Kazaa Lite produces the following disclaimer (scroll to bottom)

In response to a complaint we received under the Digital Millennium Copyright Act, we have removed 9 result(s) from this page. If you wish, you may read the DMCA complaint for these removed results.

If you are intested, here is the actual DCMA complaint.(Thanks Metafilter)
When will the recording industry realize that their business model is broken and that attempts to limit the free flow of information are not only futile but an unnecessary impediment to progress? All that the DCMA does is provide a means of protecting the S.O.P. of an out-of-date industry. Tarriffs won't save the American steel industry. The DCMA won't save the traditional record company. Maybe the record industry needs to tear a page from the success of The Grateful Dead and take heed of innovators like McSweeney's. Both have taught us that the artists are the brand and that as the velocity of information sharing rises so does the value of the corporate entity that finances the information source.

Posted by Bradley Peacock | Permalink | Comments (1)