Why is the airline industry so terrible? What frequent flyer has not asked him- or herself this question? There is an answer, and it has to do with the dynamics of disruption. One of the most powerful corporate growth mechanisms – and at the heart of disruption theory — is moving upmarket. Chasing the next-higher-margin consumer requires both new firms and incumbents to leverage their resources, processes, and priorities. Instead of getting into a price war or squabbling over a shrinking market, both disruptors and incumbents find new ways to create value. This benefits customers – both the high-end customers being chased by incumbents, and the low-end or middle-market consumers being served by disruptors — and the industry at large. The upmarket mechanism is also what separates a company from being just another niche player or becoming a serious disruptive threat. Consider that, in the steel industry, Nucor and Chaparral both pioneered making steel using scrap in an electric arc furnace, and both were successful at gaining market foothold in the low end of the steel industry. In computers, Dell and Gateway were both disruptive to the PC industry by targeting the low end. But Chaparral and Gateway were happy with the initial success that they found, and chose to colonize their respective niches rather than invest in upmarket growth. They were very successful and profitable for some time, then stagnated, and today are subsidiaries of other companies. By contrast, both Nucor and Dell, after gaining a successful market foothold, were very aggressive at moving upmarket and relentlessly continued capturing the next higher margin consumer. The upmarket mechanism is ruthless: either you engage in moving upmarket or you will stagnate. There is no Plan B. Far from bad news, this is actually great for revitalizing industries and benefiting consumers. After all, in 2015 Nucor recycled 17 million tons of scrap. In 2016, we have marvelous computers from companies that did not exist when Dell was founded. Which brings us back to the airline industry. It turns out that there are industries where the equivalent of the 1980s personal computer still dominates. The poster child here is the commercial aviation industry. Instead of having a few companies stagnate because they don’t move upmarket, the entire industry has ended up in stagnation. Customers are receiving the same or worse service as they did decades ago. Mere company survival is considered success. If the commercial aviation industry worked like the PC industry, things would look this way: Disruptive entrants would start by targeting the hyper-local air-taxi market, the lowest end of the commercial aviation industry today. Then they would move upmarket to regional flights, private aviation, and eventually, national flights. Finally, they would take over the international air travel market. This would renew the industry as competition from disruptive entrants either compelled incumbents to improve, or forced them out of business. But instead what we observe is a bunch of companies trapped in their customer layer and unable to grow in revenue — except through external means such as oil prices (when oil prices dropped, ticket prices didn’t, and airlines pocketed the difference — some went as far as buying a refinery), the global economy (in boom times, people fly more), and other industries (such as tourism). This explains the three major trends we see in the airline industry today: Aggressive pursuit of efficiency: Every air traveler is now familiar with the cost-cutting efficiencies of contemporary air travel, from smaller seats to baggage fees to airplane food that has gone from “terrible but free” to “terrible and you have to pay for it.” Airlines are also pursuing efficiency in ways customers don’t see so easily, such as reducing the number of short-haul flights they offer and centralizing passengers in large airports. Unable to create new value, airlines focus on increasing margins by cutting bottom-line costs. Internationalization: An empty seat is a full cost for the airline. To minimize empty seats, airlines have enrolled in Global Airline Alliances (GALs) such as Oneworld, Star Alliance, and so on to at least make the carrier portion of the revenue for that passenger and monetize that seat. Today the airlines that participate in GALs transport more than two-thirds of all international traffic. Basically, unable to innovate their core offering, airlines have figured out a way to innovate in the way costs are allocated. Mergers and acquisitions: If you can’t move upmarket, another option is to buy growth. We can expect many more deals like the recent purchase of Alaska Air Group that has recently bought Virgin Airlines, which, at heart, is a much cheaper way to access new routes than engaging in direct competition. Now, the airline industry is pretty heavily regulated. So has regulation somehow disabled the disruptive mechanism? It’s not that simple. The only elements that really disable disruption are the absence of over-served customers, or the absence of non-consumers. There are clearly still people who deliberately choose not to fly. Thus, disruption still ought to be possible. Consider Southwest Airlines. Starting in the early 1990s, Southwest stock delivered among the best rates of return in the history of American business. People might think that introducing the Low-Cost Carrier model (LCC) explains this great success in an industry where competitors fight for survival. Indeed, the LCC model does have cost advantages, after all, flying just one model of a plane, flying only point-to-point routes, and not offering first class, meals, or assigned seating does save money, but does that alone explain such a terrific performance? In fact, what explains Southwest’s continued performance is moving upmarket inside the regional and national markets. Southwest started flying inside Texas to avoid incurring regulatory costs (which partially worked) and, most importantly, because their initial plane model, the Boeing 737-200 had a short to mid-range but very attractive cost per revenue passenger kilometer. From that point of entry, the low-end of the national flight market, they slowly but relentlessly moved upmarket by upgrading their fleet to newer plane models and adding more routes of greater average length for more passengers. This is the classic upmarket march described by the theory of disruptive innovation, and today it represents 25% of the worldwide commercial aviation market. Of course, Southwest is a lone bright spot in an otherwise stagnant industry. And there is a sense in which poor regulation is to blame. Consider the lowest end of the market today: air taxi companies. Today, air taxi companies operate in a similar fashion to the Southwest of yore. Air taxis are regulated as charters in an industry where customers are more often redirected to intermediate stops because non-stop flights are making less and less economic sense to large airlines that are exclusively focused on efficiency, internationalization, and mergers and acquisitions to maintain profitability. But regulation prevents air taxi companies and other regional players from moving upmarket, thus preventing these small companies from continuing their disruptive upmarket march and becoming the American Airlines or Delta of tomorrow. Or consider Netjets, with their coupon of miles per year and per customer revenue model. Such a revenue model could easily expand with bigger planes and become more attractive to more people, thus engaging in new net growth, but instead Netjets finds itself stuck in a narrow category of the airline industry. Many CEOs think that the decision to go upmarket is a strategic choice, not an inevitability – but a look back at Gateway and Chaparral should be reminder enough that the price for not moving upmarket is usually irrelevance or losing independence. In a well-regulated industry, it’s a choice more companies are able to make. Changes to airline regulations would spark a much-needed growth and renewal process that would revitalize an industry that is in desperate need of an upgrade. Not to mention giving customers the choice and service that they enjoy in other industries.
