TERRORIST attacks in Madrid spelled bad news for the airline industry, especially for America's big carriers that have seen a gradual pick-up of business on their normally lucrative transatlantic routes. Indeed, prior to the latest attacks, the industry's outlook had seemed beguilingly upbeat. In the coming months there will be plenty of news about airlines recovering: this week, for instance, Virgin Atlantic unveiled big expansion plans.

Financial markets have been anticipating this bounty. Already this year the share price of American Airlines' parent company, AMR, at one point had climbed by one-third, while that of British Airways (BA) rose by over a third as its profits recovered faster than predicted, up by £100m ($170m) in its third quarter to £125m. Analysts are forecasting that BA will finish the year to the end of March with profits of around £600m, close to the record level of 1996. Last year the share prices of the big American network carriers jumped by 61% (admittedly from the sub-basement), as investors scented recovery (airline share prices have since retreated on concerns about terrorism and the oil price, though by much less than their previous gains—see chart below).

Behind the new mood of optimism lie signs of a revival in air travel and big cuts in costs. Most of the six-biggest American network carriers (American, United, Delta, Continental, US Airways and Northwest) negotiated new wage concessions last summer with their perennially tough unions. Carriers in America saw revenues growing by 5% in the fourth quarter, and forecasters are predicting good numbers this spring. After losing $7.4 billion in 2002, the six-biggest American carriers were in the red by a slightly less awful $5.3 billion last year. This year some of them might even make a small profit, unless they are scuppered by pension liabilities.

Giovanni Bisignani, director-general of the International Air Transport Association (IATA), is forecasting a $2.4 billion profit for the industry worldwide, after losses totalling $30 billion since 2000. After a drop of 2.4% last year, caused by the SARS epidemic and war, IATA expects global passenger traffic to rise by 7% this year, with cargo (which can make a big difference to airline results) growing by 5%.

Meanwhile US Airways, which emerged from Chapter 11 last spring, is struggling, with an operating loss of $251m in the fourth quarter, compared with the small $44m profit it had forecast in its recovery plan. It will probably have to sell off some assets, even some routes, to comply with the terms of its $900m bailout, which require it to have about $1 billion in free cash by the end of June.

In Europe the recovery of BA is still the exception. Lufthansa plunged into a €€980m ($1.2 billion) loss, hit by problems in its non-core airline-catering and travel businesses. Although Air France has won regulatory permission to merge with KLM, it will have its work cut out to stem losses at its Dutch operations, as well as overcoming the normal run of post-merger problems. No wonder Air France's partial privatisation has been postponed, yet again.

Nor can Air France yet welcome Alitalia into its grand alliance, because the Italian carrier is still in chaos. Its chief executive resigned recently after unions refused to accept job and salary cuts; Alitalia made an operating loss of more than €400m last year, its fifth year of losses in a row. BA is trying to stop it receiving further state aid. SAS also had an operating loss last year, and even fast-recovering Iberia saw its profits slide.

In Asia carriers such as Cathay Pacific, Singapore Airlines and Thai Airways are all bouncing back rapidly from the SARS epidemic which halved traffic last spring. But Japan Airlines is still losing money as ever. New low-cost carriers led by AirAsia, which is about to float to fund further expansion, pose a growing challenge to the region's network carriers. They have long believed that the longer distances involved in most Asian travel would immunise them from the threat of budget carriers, but that has now been shown to be nonsense. In response, many are setting up their own budget subsidiaries, but that is a recipe that has failed before in both Europe and America (though United and Delta are trying again).

Network airlines everywhere face the same challenge. They were designed for an age of regulation and state ownership that is passing. Competition from budget airlines is the biggest manifestation of this change, while creeping international de-regulation and new planes, big and small, that can fly longer distances direct are undermining the dominance of the traditional hub-and-spoke network in many regions. Meanwhile, on-line booking has made fares more transparent—and lower.

The traditional network carriers are not just grappling with a cyclical slump aggravated by the external shocks of the past three years. Some observers take the view that the basic business model of the network carriers is broken, and that they will have to reinvent themselves or go out of business, despite the stream of subsidies emanating from the federal government

Budget airlines such as Southwest, AirTran and JetBlue enjoy about a 30% cost advantage. If the comparison is adjusted for the fact that budget airlines do shorter (ie, proportionately more costly to operate) routes, some think the budget carriers' costs, measured on a comparable basis, would be as low as half those of traditional airlines. Nor is a non-unionised workforce the budget airlines' only advantage. In a recent study of American and European airlines, Booz Allen Hamilton pointed out that about two-thirds of their cost advantage comes from having superior, more economical business processes such as selling seats over the internet or flying their aircraft more hours each day.

The network carriers have cut about 20% of their capacity since things started to go awry nearly three years ago. But much of that consisted of just parking aircraft on the ground, saving on fuel and landing fees but still leaving the airline with the heavy cost of leases or repayments.

Now the competition between network carriers and low-cost airlines is intensifying on several continents. In America, Southwest Airlines is mounting an attack on US Airways' main hub at Philadelphia, which brings in almost one-fifth of its revenues. Given that Southwest's operating costs are barely two-thirds of the network carrier, it should be able to make big inroads. Another low-cost carrier, JetBlue, has already penetrated many markets in north-eastern states, the home market of US Airways.

Nor is it only US Airways that faces such competition: four out of every five airline markets (ie, the area served by a pair of airports) now feature a budget carrier as well as a network airline. The share of air travel enjoyed by budget airlines is fast approaching one-third, and many think it will be half of all domestic air travel within five years. More than two decades ago, deregulation sparked a similar wave of low-cost competition, but the big carriers fought back with their hub-and-spoke route systems and domination of major airports, and prevailed. This time they may not be so fortunate.

The European market is going the same way, and it is all happening much faster, since deregulation only arrived fully in 1997. Budget carriers such as easyJet, Ryanair and over a dozen smaller start-ups still account for less than a fifth of European air travel, but most analysts expect their market share to grow rapidly. This year the budget airlines will carry more than 50m passengers around Europe. In the past couple of months another six budget airlines got off the ground in Britain, Ireland, Hungary, Germany and Poland.

While the full-service carriers are struggling to get back to the traffic levels they enjoyed in 2000, the budget airlines are growing by more than 10% a year and little is getting in their way. True, Ryanair has withdrawn its London service to Charleroi in Belgium. But that was in a fit of pique after the European Commission slapped it on the wrist for a sweetheart deal in which the airport paid much of Ryanair's costs. In fact, as a big rise in Ryanair's share price demonstrated, the ruling was far milder than many had expected—Ryanair had to repay only one-quarter of the €15m of subsidies it had received from Charleroi, and the commission simply demanded that future deals be more transparent, last for no more than five years, and be open to all. That will do little to stop hungry, secondary airports from continuing to offer subsidies to budget airlines in an effort to lure tourists to their areas.

The biggest difference between budget carriers and mainstream airlines is their radically different way of working. Traditional airlines run networks, based around hubs, while low-cost airlines offer simple point-to-point services, with no provision for transfers and no frills such as lounges and free food and drink. The value of hubs (whether the big domestic ones in America or international ones such as London's Heathrow, Paris's Charles de Gaulle or Singapore's Changi) is that they minimise the risk to an airline's revenue. They do this by sucking in passengers from a variety of cities (including many small ones, in America) to fill up a given flight, by offering a wide range of destinations via the hub.

But to make this work, airlines tend to have their planes sitting around on the ground for a long time to make the connections. The same thing goes for flight crews, and there are extra ground staff hanging around as well.

Budget airlines running point-to-point services fill their planes by making the ticket so cheap it expands demand, even for a new destination, while their simple route model means that aircraft fly more hours each day. The no-frills service makes it possible to clean up and turn round a plane in about 25 minutes, compared with the hour-and-a-half or more it takes to turn round a jumbo jet.

Network carriers have already learned some tricks from budget rivals, such as selling flights over the internet and doing away with printed tickets. They have also copied with some success the variable pricing used so brilliantly by budget airlines to fill seats at times of low demand.

American carriers have also altered their schedules, going for rolling waves of connecting flights rather than holding planes on the ground in anticipation of any particular connection. The aim is to get more flying hours out of each plane and its crew. In Europe the most striking changes have been those at BA, where about 14,000 jobs have been cut as the airline abandoned Gatwick, south of London, as an international hub. BA has also cut flight frequencies and chopped less-profitable routes in an attempt to eliminate the £300m it was losing on its short-haul European network: its latest profit figures suggest this plan has largely succeeded.

New aircraft technology is also forcing hub airlines to change, both posing extra challenges and offering potential solutions. The fact that the latest versions of single-aisle jets, such as the Boeing 737-800, have much longer ranges than those of 10 years ago means that budget airlines, which usually opt for a fleet using only one type of aircraft, can now contemplate some long-haul routes as well as the usual shorter ones. JetBlue led the trend when it started up several years ago with services from New York to America's West Coast. Some bosses, such as Ray Webster, chief executive of easyJet, think it is only a matter of time before an entrepreneur launches a budget transatlantic service with a few frills (but at a price) to ease the pain of the longer trip. Apart from lowering costs and fares, budget airlines have unbundled the old air-travel experience: now, if you want food and drink, you pay, and the airline pockets a healthy profit for every such transaction.

Another technical development, however, actually helps network carriers. The development of smaller 100-seater regional jets, made by Brazil's Embraer or Canada's Bombardier, is allowing the American carriers to reshape their networks by substituting smaller planes where the traffic does not always justify using a Boeing 737. Although the cost per seat is higher than that of a bigger plane, it takes fewer passengers to fill the seats and the overall trip cost is lower. Until recently, pilots at the big American carriers always resisted the encroachment of these cheaper aircraft flown by pilots who traditionally earn lower salaries.

There are also smaller models of regional jets coming along from the two manufacturers that could even serve to by-pass hubs. These 40-50-seat jets are now providing seat/mile costs that come closer than ever to those of bigger aircraft. That raises the possibility of an explosion of low-volume, point-to-point services.

Management consultants such as McKinsey and Booz Allen Hamilton have been poring over the plight of the world's airlines, seeing in it a lucrative source of new business. A consensus seems to be emerging that it is time for airlines to learn lessons from other mature sectors, such as cars. In particular, airlines are ripe for the lean techniques exemplified by Toyota's legendary production system. Their big suppliers, the aircraft manufacturers, have already had to learn a similar lesson. Boeing is belatedly trying to build its aircraft using lean, just-in-time production methods. Airbus had stumbled into this approach as a by-product of its distributed-manufacturing model which had, in turn, been dictated by the fact that it was a politically constructed consortium with partners in many countries. Now airlines are being forced to review their business systems from scratch.

A recent McKinsey study urging airlines to adopt lean techniques starts with a paradox. Each day airlines achieve the remarkable by safely moving 5m people some 40m air miles around the world. Yet they often fail to deliver ordinary things such as prompt arrival according to the published schedule. Too often a plane lands only to hang around for a ground crew to unload it, or for an earlier flight to move away from a gate. Routine maintenance work causes continual delays.

Booz Allen observes that connecting traffic is much less profitable than what the industry calls “origin-destination” (OD) traffic, which is passengers simply going from A to B. Its analysis of America's domestic market suggests that OD traffic is 1.6 to 2 times more profitable. Local business travellers from the hub city are the core of an airline's profitability. Outside America, the most striking example of this is BA: business travellers from Heathrow to New York and other American business centres are the source of most of its profits.

Connecting traffic, on the other hand, requires complicated check-in and passenger-handling systems geared to the most demanding of passengers, who are often allowed to change flight times right up to the last minute with no penalty. Scheduling flights to make easier connections leads to the low aircraft-utilisation that American carriers are trying to improve by “de-peaking” their hubs. Booz Allen suggests that American carriers should be combing through their flight operations and schedules with the aim of having a new business model that makes connections a by-product rather than a key objective. With this would go rapid turn-arounds and a 30% increase in plane and crew utilisation, as well as a doubling of productivity by ground crews.

Airlines that try to get lean should, however, note that few carmakers have learned to be lean winners. Several have been swallowed by rivals and others face extinction. The same would already be true of lots of big airlines, were it not for their indulgent governments. Even with help, big carriers will struggle to survive their industry's rapid transition towards a new business model.

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