Passengers, Packages: The Paradox Of Air Transport

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 |  Includes: AAL, AMZN, FDX, LUV, UAUA, UPS
by: Victor Cook

Paul Goldberger's article Situation Terminal in the April 21, 2008 issue of The New Yorker magazine reminds us that "Airports are essentially machines for processing people, airplanes, automobiles, cargo and baggage." He also notes the most recent example of the huge impact passenger baggage handling has on airport operations:

… Terminal 5, an eight-billion-dollar structure that was supposed to transform Heathrow from a congested tangle into a place that would thrill passengers with the joy of air travel, all but shut down on its opening day, when a computerized baggage system malfunctioned (p. 132).

In my last post in this series, Luggage Forward Flying: How to Restore Passenger Confidence and Carrier Profitability, I proposed a radical solution to the baggage handling problem: Removing baggage from the passenger air transport system by shifting it to the express shippers' transport system:

Suppose all the major carriers were to enter into a partnership with FedEx (NYSE: FDX), UPS (NYSE: UPS), DHL and the other shippers with Luggage Forward operating as the corner stone in a worldwide baggage handling solution. This would remove passenger baggage handling from airports and passenger carriers altogether.

I also reviewed nine of the operational issues associated with that proposal. These nine don't need repeating as they are more-or-less easy hurdles to clear in such a massive change in passenger baggage handling. That post concluded with three deal-breaker questions. Two of these are the focus of this post: (1) Do the package carriers have the capacity to handle the additional volume and (2) Are the scale economies associated with passenger carriers bundling Luggage Forward into their reservation system sufficient to produce affordable shipping rates?

THE PARADOX

The top ten U.S. passenger carriers had a combined market cap of $20.38 billion on April 25, 2008. The top two U.S. package carriers, FedEx and UPS, had a market cap of $104.19 billion. Here's the paradox of air transportation: Why do investors reward U.S. package carriers with five times the value they assign to passenger carriers? It's not because of revenue differences: American Airlines (NYSE: AMR) had a value/revenue ratio of 0.08 in 2007 compared with a UPS ratio of 1.50.

A LITTLE PERSPECTIVE

On Thursday I ordered a new HP Laser Jet P2015 printer from Amazon.com (NASDAQGS: AMZN). The retail price was $449. I paid just $289.99. The next-day Amazon Prime delivery charge for this 28.9 pound package on UPS was $3.99. Based on this rate significant scale economies must exist in AMZN's agreement with UPS as a result of huge shipping volumes.

My printer was picked up at the Amazon facility in Dallas TX at 8:53 on Thursday evening. The next morning I called the UPS toll-free number to ask for a delivery time. The local station called me back within the hour to say that the driver would deliver my package at 1:30 PM on Friday. He actually delivered it at 1:25 PM.

Think about this. Passengers must do a large share of the work in baggage handling: getting the bag to the airport, checking it in, waiting at the baggage carrousel after landing, carrying it to ground transportation and then to the hotel. So passenger carriers could eliminate the need for both paid and unpaid baggage handlers.

AMZN in partnership with UPS can ship that 30 pound printer overnight for $4. If I'm willing to have my bag picked up at 8:30 the night before my trip and delivered to my hotel at 1:30 the next day, why can't ARM, in partnership with Luggage Forward and UPS, ship my 30 pound bag for the same $4? With virtually no risk if loss or late delivery.

NO OBVIOUS ANSWER

Both passenger and package carriers are subject to the same forces. As Joseph Weisenthal said in a recent post Airline-In-A-Box:

Few businesses have as many variables and challenges as airlines. They are capital-intensive. Competition is fierce. Airlines are fossil fuel dependent and often at the mercy of fuel price volatility. Operations are labor intensive and subject to government control and political influence. And a lot depends on the weather.

It's true that both passenger airlines and package carriers are capital intensive. In 2007 FDX and UPS had capital intensity ratios of $0.68 and $0.79 respectively. The two largest passenger carriers AMR and United Airlines had capital intensity ratio of $0.80 and $0.83 respectively.

The packages carriers have far less exposure to fuel price volatility than passenger carriers because they rely on indexed fuel surcharges. In 2007 FDX and UPS fuel costs as a percent of revenues were 10% and 6% respectively. AMR and UAUA had fuel costs of 29% and 25% respectively. One might wonder why the passenger carriers don't also relay on indexed fuel surcharges. Today David Enke posted an interesting answer to this question in To Hedge or Not to Hedge.

The package carriers actually are more labor intensive than the passenger carriers. In 2007 FDX and UPS posted labor intensity ratios of 39.0% and 63.9% respectively. The two largest passenger carriers, AMR and UAUA, had labor intensity ratios of 29.5% and 21.2% respectively. Southwest Airlines (NYSE: LUV) had half the revenues of United but operated with a labor intensity ratio of 32.6%.

The number of employees per aircraft is a more telling indicator of the package carriers labor intensity. In 2007 FDX and UPS had 432 and 1,587 employees per aircraft respectively. The top two passenger carriers, AMR and UAUA, had 131 and 138 employees per aircraft.

Of course, all the extra people per plane employed by package carriers are required to make sure packages are picked-up and arrive on time. For example, in 2007 UPS had:

• 4,647UPS Stores®
• 1,306 Mail Boxes Etc.®
• 1,000 UPS Customer Centers
• 17,000 Authorized outlets
• 40,000 UPS Drop Boxes
• 1,800 Operating Facilities
• 93,637 package cars, vans, tractors, motorcycles
• 268 jet aircraft and
• 311 Chartered Aircraft

Maybe this is why UPS was able to offer next-day delivery at 1:30 PM!

PACKAGE CARRIER CAPACITY

It's impossible to calculate what the industry calls the "letter/box" ratio without inside knowledge of package carrier operations. This ratio tells if the package carriers have the capacity to take on passenger baggage delivery. I asked an industry source to give me an opinion on this. Here's what he reported in an email:

I don't know their Letter/Box ratio but according to the UPS Q1 2008 earnings report, they shipped an average of 15.1 Million packages per day. I know FedEx moves less packages than UPS. I've been told that UPS has a smaller Letter/Box ratio than FedEx.

I know that there are approximately 2 Million emplaned passengers (DOT Stat) per day in the US and they average about 2 bags each. So, we're talking about 4 Million pieces of luggage per day in the US. My guess is that the carriers can handle that type of increase. I think it is safe to assume the shippers are not operating at capacity and they could handle a 10-20% increase.

It looks like package carriers could scale up to handle passenger baggage. And based on the AMZN/UPS shipping rate of $4 per bag it seems reasonable to think an affordable express shipping charge could be built into the air fares of passenger reservations systems.

BECAUSE PACKAGES CAN'T WALK

The American Consumer Satisfaction Index [ACSI] was created by Professor Claes Fornell of the Michigan Ross School of Business. The ACSI measures customer satisfaction for over 200 companies in 43 industries. Both passenger and package airlines are included.

FedEx and UPS have had ACSI customer satisfaction scores around 80% in each of the last ten years. In the same period AMR and UAUA have barely broken 60% customer satisfaction barrier. It's been shown that higher ACSI consumer satisfaction scores are associated with significantly higher shareholder returns.

Some will say high customer satisfaction with express shippers is "because packages can't walk." The carriers must do everything with very little customer involvement. Of course that's true. But it's also true that almost everything express carriers do is dedicated to delivering packages on time. That's their specialty.

Wouldn't it improve consumer satisfaction if passenger carriers took baggage out of their equation? And specialized in transporting passengers? In economics this is called the "division of labor." An idea famously created by Adam Smith in The Wealth of Nations using "the trade of the pin-maker" as an example. What do you think?

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.