Airlines are back

Brian Smith of VerticalSearch.net asked recently for a guest post on the state of the airline industry. Having spent time at an airline, I agreed to pull something together. The post is at VerticalSearch.net and also right here...

These days the skies are much brighter for many of the nation’s largest carriers. Reduced capacity and high demand (load factors) this summer culminated in airfare prices not seen since before September 11th. This, coupled with lower cost structures (bankruptcy threat resulted in major cost reduction efforts) has translated in solid earnings for many airlines recently. As a former airline employee, I’m thrilled to see that airlines are back. With this post, I want to drill into the evolving relationship between airlines and their distribution partners, specifically GDSs, and how it’s changing the landscape.

The balance of power between GDSs and airlines is shifting
For decades, the GDSs (global distribution systems) held all the leverage in negotiations with airlines. Times are changing.

In recent years, airlines have increased their share of bookings that bypass the GDS channel. Many carriers are now booking close to 50% of their seats direct via their websites. Some airlines have established direct connections into large agencies, such as Orbitz. GNEs (GDS new entrants) such as G2 Switchworks (founded by the former Orbitz CTO), Farelogix, ITA Software (raised $100 million last year) and others have emerged to offer agencies and airlines an alternate booking solution. For more detail on the GDS to GNE evolution check out a deck posted by Richard Eastman.

To apply further pressure on the GDS channel, Northwest Airlines (NWA) announced in August of 2004 that it would charge a “shared GDS fee” for tickets issued through a GDS by U.S. and Canadian online and traditional agencies. Although this move did not stick, it was no doubt effective positioning for the upcoming round of GDS negotiations and demonstrated that the airlines leverage was reaching critical mass.

And now, earlier this month, American announced that on Sept. 1st it plans to begin charging agencies a “booking source premium” of $3.50 per segment for all bookings made through Sabre and Amadeus (GDSs they have not signed new, long-term contracts with). Northwest, United, Delta, and Continental have followed, which means it is likely even more airlines will add the “booking source premium” fee in the weeks/months ahead.

Airline and GDS relationships will be redefined by new negotiations
As a result of the changing landscape and strong positioning, airlines have, in most cases, renegotiated more economically attractive agreements with GDSs. These agreements are generally long-term and provide airlines with lower segment fees. GDSs, in return, get access to airlines lowest fare content (on parity with their websites).

Sabre’s expiring set of agreements are called DCA-3 (direct connect availability) and their new agreement is called EAS (efficient access solution). Sabre has successfully signed EAS agreements with Delta, United, Continental, and Alaska Airlines. American has not signed the agreement.

Although on the surface this looks to be a win for Sabre, the economics of the new deal are not clear. How much more of the pie are the airlines now taking? And, who’s taking a bigger hit, the agencies or the GDS?

And, although Sabre is locking up agreements with airlines and agencies, other GDSs with less market presence may have a much harder time.

Who’s worse off?
1) GDSs will certainly feel the pain both in the short and long-term. First, they will lose market share over time as airlines encourage bookings direct and through lower cost channels, such as GNEs. Second, in order to get access to airlines lowest fare content in the next round of negotiations, they will be required to reduce segment fees. (Interestingly, on Sabre’s Q2 earnings call, management did not make any significant revisions to outlook based on the new economics of the EAS agreements. However, they mentioned a need to reduce their costs in order to make good on long-term goals – I’m sure airlines love hearing that.) Third, although Sabre’s scale motivates most carriers to come to an agreement, the second tier GDSs (Worldspan, etc.) may not be as fortunate.

2) OTAs will also see less attractive economics, as GDSs reduce incentive fees to compensate for the less attractive terms with airlines. (As Brian noted, TWP believes Expedia’s annual EBITDA could drop by $30-35M as a result. Also, for perspective, Michelle Peluso stated on Sabre’s Q2 earnings call that GDS incentive fees for the second quarter made up 16% of Travelocity’s overall revenue.) In addition, airlines will continue to apply pressure on any transactional or commission fees they may be paying currently – threatening removal of low fare content. Further, if low loyalty levels continue and TSEs gain share, some airlines may remove themselves from one or more of the three top OTAs in an effort to drive more business direct.

Who’s better off?
1) The horizon looks great for airlines. They will continue to lower distribution costs and establish direct, more valuable, relationships with their customers. As their direct to consumer share plateaus, they will likely look to exit non-direct channels (OTAs, GDSs, etc.) in order to force continue growth.

2) GNEs are bolstered as now agencies have an incentive to book via their direct channels. Although GDS technology was built in the 60’s and the new technology platforms being introduced by the GNEs are much more efficient, the GNEs lack the broad supplier and agency penetration to pose a significant threat to the GDSs in the short-term.

3) The TSEs (travel search engines), I would suggest, are slightly better off. It could be argued that as airlines become more agnostic as to the booking channel, as distribution costs by channel converge, they will be less likely to play with TSEs. However, I believe airlines will increasingly care about owning the customer relationship and assign more value to website direct bookings, which gives TSEs a growing edge.