LOSING ALTITUDE

By TAMMERLIN DRUMMOND/MIAMI

Given the airline industry's fundamentals--rising prices and full planes--low-priced airlines should be in first-class condition. They're not. In the aftermath of the ValuJet disaster last year, air travelers began to redefine "no frills" airlines as "no safety" airlines. In the six-month period after the crash, their bookings went into free fall, taking their stock prices along for the ride.

Launching a carrier into this turbulence isn't much more difficult than flying a kite in a hurricane. Yet Martin Shugrue, no stranger to troubled airlines, insists that Pan American World Airways, a new carrier with an old name, can compete as a low-cost, full-service discount carrier. "We'll make money with a high-quality product at an affordable cost," Shugrue says. Pan Am's promise is cheaper fares without the cramped seats and the bag of peanuts masquerading as in-flight service. Says he: "It's not rocket science."

No, rocket science is predictable, and there aren't other rocket companies waiting to shoot yours out of the sky, as is happening to the discounters. Of all the newer crop of start-ups (those in business since the early 1990s), one of the few winners is Reno Air Inc., which posted a net profit of $2 million last year. The five sizable publicly traded discount airlines lost a combined $58 million in the first quarter of 1997, while most big carriers enjoyed sky-high profits. "You have to find a niche and stay with it," says Bob Reding, Reno's president and CEO. "A lot of start-ups try to grab too much, and they overextend themselves."

Despite the robust economy, the discounters are facing a dual predicament that is stalling their development. With a small number of planes flying limited routes, the upstarts can't tap the lucrative business-travel market. Instead, they're forced to low-ball fares to attract leisure travelers, a strategy that works only when planes are flying full--and their bigger competitors will do anything to make sure that doesn't happen. "It's very hard to make money feeding at the bottom of the barrel," says Perry Flint, executive editor of Air Transport World, a trade paper.

And those discounters who fly fearlessly into business markets risk heavy counterattacks. Giants like American, United and Delta are becoming increasingly aggressive in defending their hubs, even though their planes are running at more than 70% of capacity. The idea is fundamental and ruthless: don't let a competitor get a toehold in your most profitable turf.

How tough is it? Western Pacific, a two-year-old company based in Colorado Springs, Colo., is a good example. Last year Western Pacific chalked up a $23.7 million net loss and in the process jettisoned both its management and its business plan. The company tried to avoid a head-on battle with United Airlines in its Denver hub. But Western Pacific was also missing out on the flush business market that connects there. "A lot of low-fare carriers make the mistake of trying to hide in the weeds," says Western Pacific CEO Robert Peiser, former CEO of FoxMeyer Drug Co., who took over last December. "But in the end, you always get found."

So Western Pacific is moving the bulk of its operation to Denver and enlisting help in its fight against United. The company announced last Monday that it will purchase Denver's Frontier Airlines for about $40 million in stock. The agreement averts what could have been a catastrophic price war between the two low-fare carriers. But ailing Frontier had fared none too well against United. Last year the company lost $12 million. Peiser says the merger, effective Aug. 1, will give both companies the critical mass they need to compete. The combined carriers will operate 34 Boeing 737s, serving 26 markets. Western Pacific plans to knock heads with United in the Denver-Los Angeles market by adding six daily flights. United has a dozen. This could get nasty.

The ceiling seems to be lowering for other niche players. Vanguard has been bleeding red ink since it began service two years ago, and is struggling to remake itself as Kansas City, Mo.'s hometown airline. Vanguard posted a $7.9 million loss for the first quarter despite higher revenues and passenger loads. Two weeks ago, CEO John P. Tague pulled the rip cord and resigned from Vanguard. He also left the helm of Air South, based in Columbia, S.C., another struggling low flyer that shares some big investors with Vanguard.

A bankruptcy court will settle the fate of New Jersey-based Kiwi International this month. Although Kiwi got great marks for service, last fall Federal Aviation Administration officials ordered the airline to ground four of its 15 planes amid concerns about the qualifications of its flight instructors. Kiwi was also forced to suspend service from Oct. 13 to Jan. 20 because of financial difficulties.

Kiwi's troubles are directly related to the horrific ValuJet crash in the Florida Everglades in May 1996, which sent the FAA scurrying after low-cost airlines following revelations that the agency had been lax in its inspections. Another ValuJet casualty, Nations Air, spent a mere 15 months aloft running flights between Boston, Philadelphia and Pittsburgh. Following the crash, 40% of its passengers canceled their reservations. To cope, CEO Mark McDonald remade Nations Air into a charter airline.

Despite this financial carnage, Pan Am's Shugrue, a former trustee of Eastern Air Lines, is pressing ahead with a low-fare, high-service strategy. Shugrue teamed up with investor Charles Cobb, now Pan Am's chairman, who had purchased the famous blue logo in 1993 on the notion that the brand had some vestigial credibility with consumers. Shugrue is sticking the brand into some markets where Pan Am got its ticket punched on the last go-around. This month, for instance, Pan Am is adding a third nonstop flight between New York and Los Angeles, a move certain to draw fire from American and United.

This time, Shugrue reasons, by offering everyday transcontinental fares as low as $386, roomier seats, decent food and a generous frequent-flyer program, Pan Am can lure both frequent business travelers and leisure flyers. The company is also trying to position itself as a domestic feeder for a network of medium-size international carriers, such as AeroPeru in Latin America and Iceland Air in Europe, that serve Miami, Los Angeles and New York. "We have a global outlook," Shugrue says. "We're not trying to dominate a particular market." The airline has its fans. Says Xose Alvarez-Alfonso, 38, who has started flying the carrier's Miami-to-New York route: "I like the historical aspect. I used to fly Pan Am before, and now I'm flying them again."

Pan Am had a hard time just getting off the ground. Post-ValuJet, the FAA got very particular about certifying new carriers. Pan Am was forced to postpone its July 4, 1996, launch to Sept. 26. Delays in the delivery of aircraft required the company to lease other jets, resulting in higher than projected costs. "The only reason we were able to avert a financial crisis is because we had enough start-up capital," says Shugrue. Having collected some $40 million, he had a cushion to withstand the unexpected losses, though Pan Am has yet to turn a profit.

To get into the black, Pan Am must reduce its available seat-mile costs, a standard industry measure, to 6[cents] a mile on the Airbuses it flies. In the first quarter, the company was spending 9.28[cents] per available seat-mile, slightly higher than the majors. Like other low-cost carriers, Pan Am outsources maintenance and uses nonunion workers. (A jet was recently vandalized after the company announced a decision to shift its maintenance contract from TWA to a nonunion shop.) The company posted a first-quarter loss of $14.7 million, but Shugrue insists the airline will ratchet down costs by the end of this year.

Pan Am's acquisition of Carnival Air Lines, expected to be completed by the end of summer, may help. Carnival was started by cruise-ship magnate Micky Arison, chairman and CEO of Carnival Corp., to ferry passengers seamlessly from air to sea and gain control over airline seat costs, since most cruise passengers buy a combination fly-cruise ticket. But Carnival couldn't fly as well as it could sail, so Arison will acquire 42% of Pan Am's stock and invest $30 million in the new company. Carnival can now feed shipbound passengers to Pan Am; the combined company should improve its operating ratios. Says Paine Webber's airline analyst, Samuel Buttrick: "There's enough juice between the two companies to make it work."

And what of ValuJet, whose Everglades crash staggered the industry? The company, perhaps the most inspected airline in history, is struggling back, a mere shadow of its precrash, fast-growing, profitable self. In the three years before the disaster, sales had tripled, and the carrier had expanded service to 31 cities from three and laid claim to a booming passenger roster. Grounded for three months and forced to scale back its fleet from 51 to 28 aircraft, ValuJet lost $41.5 million in 1996. It has begun reinstating routes and inaugurating new ones, but the company is now flying at 52.7% capacity, well short of what it needs to make money.

The new ValuJet has a new competitive problem too. When ValuJet launched its low-cost service in Atlanta, incumbent Delta didn't pay much attention. But Delta's service level crumbled as it tried to cut costs, and ValuJet proceeded to inhale market share.

Delta won't make that mistake again. This time it is consistently matching ValuJet's fares out of Atlanta. Delta now has a low-cost airline, Delta Express, to fight ValuJet on its own rock-bottom terms. This is a lesson that the other major airlines have learned in battling upstart competitors, to their considerable profit. Alas, for travelers, the major airlines' profit is the flying public's loss.

--With reporting by Jane Van Tassel/New York

With reporting by Jane Van Tassel/New York