What Is the Secret to US Airways' Ultra-Profitable Washington Hub?

Today, US Airways (NYSE: LCC  ) operates a small but highly profitable hub at Washington's Reagan National Airport. Its president, Scott Kirby, has previously estimated that it is the second most profitable airline hub in the country, trailing only United Continental's (NYSE: UAL  ) much larger hub at Newark International Airport.

The Reagan hub was the primary subject of the recent settlement between US Airways, AMR (UNKNOWN: AAMRQ.DL  ) , and the Department of Justice, which will allow the AMR-US Airways merger to proceed. The two companies have to give up 44 slot pairs at Reagan National Airport, which will go to low-cost carriers, or LCCs.

American Airlines and US Airways are merging. Source: AMR.

This merger settlement will destroy US Airways' business model at Reagan Airport. Unless the new American can come up with a business model that will work better in a highly competitive environment, the Reagan hub will be much less profitable in the future.

The secret to US Airways' success
US Airways has had a very simple secret to success at Reagan Airport: Avoid competition at all costs. In a typical U.S. hub, the hub airline offers frequent flights to every major U.S. metro area and less frequent service to smaller cities near the hub. Offering a comprehensive set of nonstop flights allows the hub airline to win valuable corporate contracts and to provide connections between smaller cities in the region and any major metro area in the U.S.

By contrast, US Airways flies to just four of the 10 top metro areas in the U.S. (excluding D.C., of course) from Reagan Airport, including just one of the top five. Missing from US Airways' Reagan Airport route map are major urban centers such as Los Angeles, Chicago, Dallas, Houston, Atlanta, and San Francisco!

In other words, US Airways' success at Reagan Airport is the result of a counterintuitive strategy. Clearly, it's not trying to appeal to corporate travelers by serving major business routes. It's also not interested in maximizing the number of useful connections available to travelers. Instead, US Airways has made the Reagan Airport hub successful simply by avoiding other legacy carriers' major hubs.

The reason that this strategy works is that Reagan Airport is slot constrained -- an airline needs to control a slot for each takeoff or landing it schedules -- and US Airways has 55% of the slots. Overall, the legacy carriers (including their regional affiliates) carry 83% of the traffic at Reagan Airport and hold an even larger percentage of the slots (around 90%). This situation has made it nearly impossible for low-cost carriers to enter the market and compete with US Airways.

US Airways managers know that the other legacy carriers will primarily fly to their own hubs. So by concentrating its service on non-hub cities, US Airways has assured itself of monopolies on most of its routes from Reagan Airport. Some of the larger cities with US Airways monopolies from Reagan Airport include Pittsburgh, Indianapolis, Columbus, Hartford, and New Orleans (in addition to the US Airways hubs in Philadelphia, Charlotte, and Phoenix).

While US Airways thus serves some sizable cities from Reagan Airport, it almost exclusively does so with small, regional aircraft. These have higher unit costs than mainline jets, but by keeping seats in short supply, US Airways can charge a premium for its flights to and from Reagan Airport.

An unsustainable strategy
With 44 slot pairs about to be distributed to LCCs as part of the merger settlement, the current US Airways strategy at Reagan Airport is unlikely to be viable going forward. No matter which LCCs gain slots at Reagan, they will be interested in entering many of the larger markets that US Airways currently monopolizes.

Since the major LCCs exclusively use larger mainline jets, they will be able to serve these routes at a much lower cost per seat than the "new American" can with regional jets. This will allow the LCCs to profitably undercut American's fares. If American counters by introducing its own mainline jets, the additional supply would lead to even lower ticket prices.

The new American's leaders will need to rethink their Washington, D.C., strategy, as the current one only works because LCCs are largely locked out. LCCs will gain enough slots at Reagan Airport to enter numerous routes that are currently monopolized by US Airways. There won't be enough high-traffic routes left for the new American to fly away from the competition, as US Airways has historically done.

Foolish conclusion
Reagan Airport has been the most profitable US Airways hub in recent years, due to the carrier's unique strategy of avoiding most of its competitors' major hubs. US Airways has been very successful at flying to small- and medium-size cities from Reagan Airport because legacy carriers are focused on flying to their own hubs while low-cost carriers do not have enough slots to offer significant service.

The merger settlement will undermine the profitability of the Reagan Airport hub for the new American Airlines. Its slot divestitures will allow low-cost carriers to start competing service on multiple routes that US Airways currently monopolizes, at a lower cost per seat. Overcoming this sudden change in the Reagan Airport market dynamic could be one of the first big challenges for incoming American Airlines CEO Doug Parker.

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Comments from our Foolish Readers

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  • Report this Comment On November 14, 2013, at 4:44 PM, mwwestiii wrote:

    You Fools clearly don't understand the role of corporate air travel contracts, and neither did the DOJ evidently. The premise of this article is flawed because the government books air/hotel through a few select travel agencies that have large, financially complex contracts with the major carriers. With this merger, the new American can now more effectively compete with DAL and UAL. Government employees and contractors don't shop price when they book travel, they book through a preferred supplier contract.

  • Report this Comment On November 14, 2013, at 5:17 PM, TMFGemHunter wrote:

    @mwwestiii: That's not the point, though. Nationwide, government travel represents less than 5% of air traffic. Obviously, that percentage is much higher at Reagan Airport because of its location, but I would guess it's still something like 25% or less.

    While the Big Three love to have high-yielding traffic in the "front of the plane", they still need to fill the back of the plane to be profitable. That means catering to customers who are paying for their own tickets and are therefore more price-sensitive. I don't expect Southwest or JetBlue to win lots of gov't travel business in D.C., but they will take over the majority of the small business and individual travel on the routes they enter. That will have a major impact on airfares at Reagan and the hub's overall profitability.

    Adam

  • Report this Comment On November 14, 2013, at 5:35 PM, McCard58 wrote:

    Lets see US and DL swapped multiple gates and slots between Reagan and LaGuardia last year in anticipation of this merger. So what does US really lose ? The losers are the employees at both DCA and LGA !! US is still above the 55% and New York traffic moves to NY Kennedy. Winner winner chicken dinner. Its amazing how the media displays ignorance to what's really going on.

  • Report this Comment On November 14, 2013, at 6:28 PM, mwwestiii wrote:

    Adam: I confess to having a little bit of an unfair advantage here because I was in management for one of the largest government travel agencies a few years back and have been involved in many airline and government presentations/proposals.

    There are a lot of airline financial incentives for travel agencies that hold government contracts to send business their way. Government employees, defense department, politicians, contractors, etc., don't care about price, they just call the contracted agent and the agent books the flight/hotel. That agent books according to the contract requirements.

    Further, these government travel agencies will steer their non-government corporate accounts in the Washington region towards airline contracts that net them the largest financial incentives.

    Southwest, Jetblu can't really compete on these big government contracts because they lack the networks, pricing power and sales forces.

    I expect AMR/LCC to remain very profitable at National because the demand for their product will remain yet availability will be constrained by fewer slots. This means higher load factors.

    Southwest and JetBlue will likely follow suit by increasing their pricing as well because AMR/LCC will set the market.

    You see, like with most things the government meddles with, the opposite usually happens.

  • Report this Comment On November 14, 2013, at 7:05 PM, philcski wrote:

    Huge error in the analysis of the US Air traffic at DCA. Up until 2010, NO flights over 1,250 miles were allowed out of National, and now there are only 40 slots allowed over that number (so 20 roundtrips split by 9 carriers). US Air owns only 10 of those slots: 3X daily to Phoenix, 1X daily to Vegas, and 1X to San Diego. That SD flight was a trade for a Dallas (inside the 1,250 statute) slot. So in reality, the LAX/SFO flights aren't even possible from DCA.

    As for the DCA-ORD and DCA-DFW directs. ORD has NINE nonstops on AA, and DFW has ELEVEN on AA. Now, I don't know about you, but to me that appears to be a hammerlock on the markets- just like USAir has on the midsize markets you mentioned. Because there wouldn't likely be a connection on one end or the other on USAir, a traveler would practically have to stumble onto their flight if they did anything less than 4-5 flights a day, and even then they wouldn't be the major player. Same thing applies with ATL (14 on Delta) and IAH (8 on United.)

    Don't get me wrong- I don't like USAir. I lived within earshot of LGA for many years, and they used to dominate there under similar constraints before the swap with Delta (there still is a 1,500 mile rule in place, so no nonstops to the West Coast except on Saturdays.) They were the shoddiest and laziest airline for many years. But you can't blame their approach at DCA and formerly LGA entirely on corporate greed. It's smart business with the hand that they are dealt. The reality is short to mid length flights were huge moneyburners when fares were super cheap. The only way to make money was dominate a route and drive up fares.

  • Report this Comment On November 14, 2013, at 7:30 PM, ferdiefor wrote:

    I don't accept the writer's thesis at all. LCC's are not as financially strong and they have to immediately expend large sums to acquire access and then fill the infrastructure in.

    Politicians and bureaucrats are not cost conscious at all and are going to use and continue to use the carrier with the biggest presence knowing they can get a flight out or into DC with the carrier with the biggest presence.

    The LCC's will make their nut dealing with the cost conscious portion of the public and that will be good for them and maybe better for American because they can focus on the higher end passenger for which cost is never an issue. There are people who value their time over money; especially if their employer and/or government is paying their airfare.

    Finally, assuming there are mileage programs you can bet the American program would be the one you would want to build your miles in rather than some LCC that may not fly to the destinations that represent where you like to go in your free time assuming your employer lets you keep your miles.

  • Report this Comment On November 14, 2013, at 8:47 PM, TMFGemHunter wrote:

    OK: I will try to reply to all of these comments:

    @mwwwestiii: Southwest and JetBlue are primarily going to put 140-150 seat aircraft into DCA, while US Airways/AMR are going to be taking out regional jets with 50-76 seats. To fill all of those extra seats, Southwest and JetBlue will have to lower prices. They can afford to do that, because their unit costs are something like 30% lower than regional jet unit costs (maybe even more, in some cases).

    While Southwest and JetBlue will take corporate and gov't traffic if they can get it, their focus is on people who pay their own ticket. I don't buy the idea that everybody flying US Airways in DC today is on the gov't dime. Even if only half of the plane is filled with people who are paying for their own ticket, and you have to slash prices by 30%-40% to match a low cost carrier, it will have a big impact on profitability.

    @philcski: I'm aware of the perimeter rules, but United and Virgin America both have flights to SF from DCA, while American and Alaska have flights to Los Angeles. Meanwhile, US Airways has beyond perimeter flights to San Diego and Las Vegas: decent-sized cities, but much smaller markets than LA and SF. If US Airways really wanted to be in the big metro areas, I think it could have gotten LA and SF slots instead of SD and LV.

    As for the other hub airports, there's no other example of a hub carrier avoiding other major cities just because there would be competition on those routes. In Charlotte, Philly, and Phoenix, US Airways has no problem competing with American and US Airways to Chicago, or United to Houston, American to DFW, etc.

    BTW, I agree that the US Airways strategy in DC was very smart. It just won't work anymore after the slot divestitures. Many of the mid-large markets where it has little or no competition today will have capacity double or triple with the entry of a LCC, and fares will plummet as a result.

    @ferdiefor: Southwest and JetBlue are at least as strong as the legacy carriers from a financial perspective. You're right that American will focus on high-paying government and corporate travelers. But you can't fill airplanes without having a good number of passengers who are paying for their own ticket. That's why the entry of LCCs into legacy markets always has a big impact on ticket prices.

    For one example, look at what happened when Virgin America started flying SF and LA to Newark. United had a complete monopoly on the former and a near monopoly on the latter until April, with hubs on both ends. Yet as soon as Virgin America entered, fares dropped 30%-40%.

    Adam

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