For Airlines, Poor Customer Service May Be The Route To Profit

by: Adam Levine-Weinberg

Earlier this week, I read a very interesting piece by Ian Altman about the airline industry. He lambasts United Airlines (NYSE:UAL) in particular, and the airline industry in general, for failing to serve customers well. He claims that poor service will impact loyalty and that chasing profit through ancillary fees and the elimination of benefits is short-sighted. He cites Southwest (NYSE:LUV) and JetBlue (NASDAQ:JBLU) as the "enlightened" carriers that still offer benefits such as free checked bags, no change fees (for Southwest) and free satellite TV (for JetBlue).

It's perhaps natural to think that treating the customer well is the route to building a successful business. Generally speaking, this is true. In the airline industry, however, there's not much evidence to support this idea. Disgruntled customers frequently complain about being nickel-and-dimed by airlines (and also about losing amenities that used to be free). However, through their behavior, customers have shown overwhelmingly that price is the dominant driver of purchase decisions. People will almost always book the cheapest ticket, even if it means sacrificing some amenities such as extra legroom, free checked bags, or in-seat entertainment. The proof is in the results:

Spirit Airlines (NASDAQ:SAVE) is a no-frills airline that aims to get people from point A to point B at the lowest cost with little customer service. Standard seat pitch (the distance between rows) on Spirit is 28 inches, which is the lowest of any carrier in the world. As a result, the airline's seats are "pre-reclined"; customers cannot adjust the recline angle. However, this allows Spirit to fit 178 seats on an A320 jet, while JetBlue's A320s seat only 150. Furthermore, Spirit created outrage in the travel community when it became the first U.S. airline to charge for carry-on bags back in 2010. Next month, this carry-on bag fee is set to rise to a very steep $100 one way for customers who pay at the gate. In spite of this customer-unfriendly behavior, Spirit posted a very healthy 11.5% pretax margin in 2011, and the company is expected to post strong earnings growth in 2012 and 2013.

Allegiant Travel (NASDAQ:ALGT), the parent of Allegiant Airlines, is another prime customer service offender. Allegiant makes lots of money from ancillary revenue streams, and even charges customers for booking flights on the Allegiant website (the only way to avoid that fee is to buy tickets at the airport counter). The company primarily flies an aged fleet of MD-80 aircraft. Recently, Allegiant embarked on a project to add several rows of seats to each MD-80 aircraft, at the expense of legroom. Furthermore, like Spirit, Allegiant has begun to charge customers for carry-on bags as well as checked luggage. Allegiant posted a 10.2% pretax margin in 2011, and is expected to show strong profit growth in 2012 and 2013.

Delta Airlines (NYSE:DAL) occupies a middle position in terms of customer service. After spending a long time in the lower half of the annual Airline Quality Rating survey, Delta bottomed out in 2009 at #15 of 18, and improved to #6 in 2011 (slightly ahead of Southwest, but well behind JetBlue and Southwest subsidiary AirTran). The company has not succumbed to the excesses of carriers like Spirit and Allegiant, but does charge for checked baggage. On the plus side, Delta does waive bag fees for its best customers. However, better customer service has not nearly made up for Delta's high cost structure relative to Spirit and Allegiant. Despite posting a respectable $1.2 billion annual profit ex-items for 2011, this represented a very thin 3.4% pre-tax margin.

JetBlue, while it markets itself as a low-cost carrier, has also made a point of providing extra amenities and comfort to attract passengers. The company provides more legroom in coach than any other carrier, free satellite TV and Sirius XM satellite radio at every seat, a free checked bag, and other amenities at no additional charge. The company's reputation has suffered somewhat in recent years due to various minor scandals: particularly several incidents of passengers being stranded on planes due to bad weather. That said, JetBlue still placed #3 in the Airline Quality Rating study for 2011 (cited above). JetBlue's customer-friendly policies have not helped its profitability, though. The company reported a meager 3.2% pre-tax margin in 2011.

Finally, Southwest Airlines has been considered the gold standard in customer-friendly policies. Since checked bag fees became common during the Great Recession, Southwest has frequently featured its "Bags Fly Free" policy in advertisements. Recently, the company has also been emphasizing its lack of change fees. It is even possible to cancel your flight at the last minute and receive a credit valid for a year from the purchase date. Southwest staff are also generally recognized for delivering superior customer service. In spite of this service outperformance, Southwest delivered a paltry 3.0% pre-tax margin in 2011, excluding special items.

The bottom line is simple and quite striking; offering more amenities and better customer service does not generally pay off in the airline industry. The additional cost cannot be fully recouped through higher fares. Obviously, there are companies like American Airlines (AAMRQ.PK) that have poor customer service and have encountered financial problems. But to this point, no U.S. airline has figured out how to turn customer service into not only loyalty, but also superior profitability. Thus, while airline investors should always keep an eye on customer service issues, these should not be a primary driver of investing decisions. Ultimately, high margins and profitable growth opportunities create value for shareholders, and these are uncorrelated with customer service.

Disclosure: I am long DAL, UAL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.