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NY TIMES Fare Idea Returns to Haunt Airlines

October 27, 2002 By SAUL HANSELL

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 percent.

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 ticket.

“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 fares.

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 fees.

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 visible.”

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.”† 27ORBI.html?ex36755597&ei=1&en\0d758824e43a6e


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