Today, US Airways (UNKNOWN:LCC.DL) 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.
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.
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.
Adam Levine-Weinberg is short shares of United Continental Holdings. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.