swelblog

Liquidations and/or Use of the Failing Carrier Doctrine?

On the day when Bernie Madoff gets sentenced to 150 years for orchestrating the financial fleecing scheme that put its namesake, Charles Ponzi, to shame, I am pondering the balance sheets of airlines. And it comes down to this: some carriers have little room to maneuver. Investors (read: credit) are not lining up to provide new capital without demanding ransom in terms of collateral or sky-high coupon rates well above those paid in other industries.

Ponzi and pyramid schemes work by gathering proceeds from one group of investors to pay off earlier investors. It is no small irony, then, that much the same has been happening in the airline industry for years. The financial scams fall apart when they run out of money to pay new investors. In airlines, the end result is pretty much the same. Airlines continue to seek new capital even as previous investors fail to earn a respectable return on their investment. It’s not illegal, but neither is it sustainable. Indeed, it is fast becoming apparent that capital is quickly tiring of this industry and its inability to sustain profits, return its cost of capital and thus reinvest in itself at market rates.

In an industry that has succeeded mainly in destroying decades of capital, the end game for some airlines may be near. To inject new funds into its operation, United Airlines’ required collateral was reportedly three times the $175 million in cash it raised. More troubling yet -- the coupon rate on the new debt was 12.75 percent. Even with exorbitant collateral demands and above-market interest rates, new investors were willing to pay only 90 cents on the dollar for the security, which equates to an effective return to the investor closer to 17 percent.

At the same time, American announced it will sell $520.1 million in debt . American’s collateral requirements will be hefty, but slightly less than twice the amount it plans to raise. According to the Associated Press, American’s debt is investment grade based in part on the assets pledged as collateral. Therefore, American will pay significantly less for its capital than will United, even if the investor interest level is on par. But with corporations of this size, and of this importance to the US economy, “investment grade” ought to be the baseline, not the high bar. That’s not the case today. Earlier in the year, Southwest -- the industry’s only capital-worthy airline -- was forced to pay in excess of 10 percent on its loans. Wow. In other circumstances, that might be considered usury.

Data Points

Market perceptions, and cold, hard cash, demonstrate a new industry pecking order is emerging. Allegiant, AirTran, Alaska and SkyWest – airlines many Americans have never flown -- each today have a market capitalization greater than that of either United or US Airways.

In Spring 2009, Fitch’s Airline Credit Navigator outlined current liquidity and expected debt maturities for airlines over the next three years. It found “most of the biggest U.S. airlines ended the first quarter in "unfavorable liquidity positions.”

For three of the top seven carriers (US Airways, American and United), this liquidity ratio fell below 15 percent of trailing twelve month revenues - a benchmark commonly used to target an optimal amount of cash to be held on the balance sheet.

According to Fitch’s data, American, Continental, Delta, United, US Airways, Southwest and jetBlue held nearly $17 billion in liquidity at the end of the first quarter of 2009 (and with a market capitalization of $13.7 billion for the same group of carriers, the market says that a dollar today is not a dollar tomorrow). Southwest and Delta constitute two-thirds of the group’s market capitalization.

Assets are only one part of the disturbing picture the Fitch data paints. The other half is liabilities. Together, the carriers have debt obligations of nearly $12 billion due by the end of 2010. And these obligations come at a time where negative free cash flows are anticipated for the foreseeable future.

Take as one example Delta, which claimed title as the world’s largest airline following its merger with Northwest. While in the first quarter of this year Delta did not fall below Fitch’s relatively arbitrary liquidity rating. Fitch nonetheless downgraded the debt ratings of Delta and Northwest on June 25 to reflect “intense revenue pressure” and expected negative cash flows. As a result of its combined balance sheet with Northwest, Delta has a stronger absolute cash balance relative to the industry, but still faces nearly $5 billion of fixed debt obligations through 2011.

The shift of capacity by the U.S .legacy carriers to international markets has suffered from poor timing. For United, its exposure to once lucrative trans-Pacific markets is even more painful as the geographic region is closest to intensive care. By comparison, American and US Airways are fortunate to have little relative exposure in the Pacific. But the winner is likely the new Delta which, with lots of eggs in all international baskets. This diversification will certainly produce better results than either Northwest or Delta would have achieved individually.

Renewed Consolidation Focus Based on an Old Tool?

In prior eras, the airline industry has relied on the “failing carrier doctrine” to combine companies on the verge of collapse or unable to meet debt obligations. That doctrine might be dusted off and used again during the next 12 months. Precedent shows mergers and acquisitions are viewed more favorably – with fewer concerns about competition – when the economy is in a swoon and airlines are at greater risk of going under.

US Airways chief Doug Parker is not alone in making a case for consolidation. United’s Glenn Tilton is also in the chorus. Both carriers are on Fitch’s list of those in the “liquidity danger zone.” United and US Airways still have some room to maneuver, but recent attempts to raise capital have proven, in the airline industry particularly, money is getting increasingly expensive.

We may be entering a new era in which the “failing carrier doctrine” no longer applies. Instead, we are now facing the “failing industry doctrine.”

On Second Thought

One of the big issues related to mergers not discussed enough is the preservation of the tax loss carry forwards that each airline has accrued (accrued losses can be used to offset profits in future years). So in the short to medium term, the industry may resist the urge to merge because a change of control could or would have significant tax ramifications. If this is the case, why not apply the failing carrier doctrine to anti-trust immunity?

First, there is no doubt we will see additional capacity cuts, with the next round showing up in the schedules for fall of 2009. This industry is not shrinking because it wants to, but rather because it has to. By the time airlines cut further at the end of the summer travel season, the industry’s two decades of economics-be-damned growth may be nothing but a memory of bad decisions gone by. Then the U.S. airline industry can finally get down to the business of being a business. Or be resigned to failure.

As I have written time and again, in this economy, capital will determine the survivors. Access to capital is the lifeline airlines need now. Those who control that capital are sending a message to legacy carriers, and that is they will pay dearly for funding until they can demonstrate a sufficient return for investors.

Republic Airways Holdings, Inc.

Recognizing the importance of that lifeline might shape the airline industry of the future. Republic Airways CEO Bryan Bedford seems to already be moving that way. As a result of his purchase of Midwest, Bedford now has investment firm TPG on his board - - basically, capital now in is the role of decision maker.

Whether other carriers can accept that kind of change might very well decide the future of the industry and whether some airlines even survive. Right now, that future for many airlines and the hundreds of thousands of people they employ is anything but bright.

Keep in mind, the next industry shakeout is not reserved for the big players alone. Look for entities other than the five legacy carriers (American, Continental, Delta, United and US Airways) to have input into any new architectural renderings of network structure. And input will not only come from Alaska and from the so-called low cost carriers, (Southwest, jetBlue and AirTran) but also some regional carriers like SkyWest.

And I keep coming back to Republic.

On June 22, Reuters reported that Republic Airways Holdings Inc. (RAH) will sponsor Frontier Airlines’ exit from bankruptcy, noting that the “US regional carrier” would pay $108 million for 100 percent of the equity in the reorganized entity. The next day, Republic announced that it will buy the remains of Midwest Airlines for a mere $31 million (only $6 million in cash), from TPG, the private equity group that has had some success in the US airline industry. While the story got some play in the mainstream press, the possibilities are much bigger than many may realize.

Think About It

Prior to these announcements (and keeping in mind that the Frontier deal is subject to Bankruptcy Court approval), Republic Airways Holdings was soley in business as a provider of “regional airline” capacity. The holding company offers potential purchasers three brands: Chautauqua Airlines, Shuttle America, and Republic Airlines. Under this model, Republic Airways Holdings operates under the flags of its contractual partners, including United Express; US Airways Express; Delta Connection; AmericanConnection; and Continental Express. Therefore it has its fingers into each of the five legacy carrier networks

RAH’s CEO, Bryan Bedford has been in this industry a long time. And he is smart, really smart. Bedford makes this move in an environment in which it is increasingly clear that the legacy carriers do not – and cannot – now operate under a cost structure that will support the number of airlines trying to survive in the hypercompetitive domestic US airline business.

Through May of 2009, airlines have cut capacity another 11 percent. At the same time, passenger revenue is down 21 percent versus the first five months of 2008. When compared to the heyday of 2000, mainline capacity is down 28 percent in the domestic market and passenger revenue is down 33 percent. Despite all of the work done by the legacy carriers to reduce costs – whether through the hammer of the bankruptcy court or not – these revenue trends illustrate an industry all but unsustainable in its current form. And while much has been made of the shift of capacity from domestic to international markets, those revenue trends are even worse in recent months.

Back to Republic

So what‘s behind Republic Airway’s maneuver? Consider this. Chautauqua is a carrier with relatively senior workforce and a fleet that offers little in terms of improvement in technology or scale. Shuttle America is much the same. And parts of Republic Airline’s fortunes are tied to United and US Airways where it operates the latest and greatest 70-seat technology. Happily for Republic, no other carrier is better positioned to capture this flying, in part because it owns its fleet rather than leases it from its mainline partner.

RAH’s structure allows it the necessary flexibility to provide a range of services for a range of clients. It has the flexibility to move from one segment of the business to another. The holding company is designed to work around pilot scope agreements. Nobody does it better. As a result, Republic and Bedford have built a business that provides them with a capital base that allows them to “pay to play.”

Indiana Hold 'em

Bedford “played the river” and now, in this observer’s view, has won enough chips to move to the final table. Providing debtor-in-possession financing is among the safest bets in restructuring. It results in little to no loss of capital in return for increased business. The result is a widely diversified portfolio of flying at increasing revenues as aircraft have gotten larger. Based on the cash flows, Republic has a fleet of aircraft well suited for tomorrow’s US domestic market. For Republic, the next move is building fleets in the 90-120 seat range and that will only augment its cost advantage.

The Frontier Card

Now Frontier provides Republic with something it previously lacked: a technology infrastructure that gives it long-term viability in the market. A technology infrastructure not tied to a legacy system. Today’s “regional carriers” are merely a wet lease of capacity to fly to small markets where mainline aircraft and crews cannot operate economically. They don’t sell tickets. Their purchased capacity merely moves people onto a mainline aircraft at a hub. With Frontier, Republic could change the game.

When it comes to changing the way consumers buy airline tickets, few see Air Canada as the bellwether - they were. But Frontier’s CEO, Sean Menke, came from Air Canada and brought with him the concept and a blueprint of giving consumers a choice of the services and amenities they want at a price they were willing to pay. There, he was recently joined by Air Canada’s Daniel Shurz, a marketing/strategy visionary wunderkind who has further strengthened the Frontier management team.

Frontier may well be the next new thing in the market. It’s not the Independence Air model or just another regional carrier. It is tomorrow’s solution for outdated domestic capacity. Bedford could now buy an Airbus fleet for a song. Bedford could now buy Milwaukee at a bargain. Who cares about Milwaukee? Only Southwest and AirTran and each and every legacy carrier that depends on Milwaukee traffic to feed operations at their hubs.

Imagine This Scenario. . .

1. Republic continues to collect revenue per departure for the feed it provides to each of its five current clients.
2. Republic maintains a financial interest in cities with three carriers trying to maintain or obtain market dominance. There is little evidence to suggest that many cities can support three aggressive carriers vying for market share. It’s been tried at DEN and it sure as hell cannot work at MKE.
3. Come Fall, as mainline carriers realize that previously announced capacity cuts are not sufficient, they turn to Republic and attempt to renegotiate their contracts. Republic says “Hell No” and instead makes a move to turn to develop its holding company portfolio into an airline that will compete for the very same traffic.
4. Maybe it then becomes apparent to one of those competing airlines that flying to DEN– largely reliant on feed traffic –no longer makes sense and it negotiates with Republic to replace its capacity there? Certainly, labor issues abound, but economic realities could prove persuasive.

All of this comes at a time of seachange for the big players in the US market. Ultimately, there is little left for the legacy carriers to restructure. There is no way to restructure zero demand. There is no way to restructure free-falling fares. There is no way to restructure rising fuel costs. And under current labor contracts, there is no way to restructure labor costs other than to get rid of minimum employment requirements.

That given, and with liquidations possible if conditions don't begin to quickly improve, Republic is well positioned to take advantage of vacuums in the domestic market. And we all know that nature abhors vacuums.

We’re entering a new era in the US airline industry. Change likely won’t depend on the kind of calamity or crisis that triggers the “force majeure” clause that allows airlines to suspend or break contracts. Instead, new market economics may force a restructuring of the industry in which the victors are those, like Republic, which simply have a better business model - a flexible and agile model. The top domestic airlines of tomorrow might be Southwest, jetBlue, Republic and maybe two of the five current legacy carriers.

Hubs will remain in the largest metro areas because that is where the population is gravitating. Thus, the focus of air service providers is no different today than it was in the early 1990’s when we lost Eastern and Pan Am. And once again, the industry will discover that presence in all the big markets doesn’t give them pricing power anywhere. Republic’s move demonstrates that the major carrier’s reliance on feed markets to cross subsidize this fact could be over. Air travelers want low fares and, time and again are showing they’ll drive to whatever airport – and airline -- offers them.

In the very near future, it might be a very different set of carriers that dominates the US domestic landscape.

I started writing this on Thursday as the 109^th US Open golf championship got underway on the vaunted Black Course at Bethpage State Park on New York’s Long Island. At 10:17am on Day 1, play was suspended due to heavy rains that added to the overnight rain resulting in standing water on numerous parts of the course.

As the tournament played out, the weather - and what side of the draw you were on - was as much the story as the winner. For golf fans, the US Open annually represents a most stern test designed by the United States Golf Association to identify the world’s best player.

The US Open is as much a test of mental strength as it is physical skill. There is not one player that would enjoy being subjected to US Open conditions week in and week out. Well, maybe one, and I am not sure he enjoyed this year’s version either.

It seems as if the US airline industry has been playing under this year’s US Open conditions every week since October 2000. But the airline industry does not get play suspended when conditions are less than ideal. Rather, the industry has been forced to adapt to one economic and geopolitical event after another. And there is no end in sight.

There have been a number of good stories over the past few weeks that have looked at individual carrier’s fates. During that time, I have been on a speaking tour where it is clear that, whatever the audience, the question of airlines’ survival is top of mind.

And congratulations to Lucas Glover on winning his first golf major.

Meanwhile, I have just completed updating the 2008 analysis in the MIT Airline Data Project that puts a klieg light into the cost side of the US airline world. At the same time, I got a glimpse of the new revenue report from the Air Transport Association and together, the picture for the industry is pretty ugly.

The ATA report reminds me of the impossible lie David Duval encountered Monday morning on his first shot after Sunday’s suspension due to darkness that led to an undeserved triple bogey.

While the US airline industry has endured much bad luck over the past eight years, it, like Duval, has continued to persevere and take advantage of what the course offers. But in an Open, it is next to impossible to win after making such a score on an individual hole. Fight as he did, Duval ultimately finished two shots out of what would have been a most unlikely – and welcome - win. The same just may be true for some carriers out there that may be near the point where one more misstep – or one more bad bounce - will eliminate any chance of competing as well.

For long-time readers, you know I love the game of golf because of what it exemplifies and what it represents. You can find me glued to a television during any of the season’s four majors. The sadistic side of me appreciates the course set up of US Open’s as it challenges the world’s best players in ways that weekly tour stops rarely inflict.

But you always know that it is only a few days each year that golfers face this brutal test. The US airline industry has endured the unthinkable since late 2000. With rare exception, there is not one year that can be described as a whole, but rather a tale of two halves. Even the year 2000 was that way when the first half had all stars aligned and the second half was the beginning of a revenue decline that still continues.

As fuel marched from $90 per barrel in early 2008 to $147 on July 11, unit revenues were on the rise. Ancillary fees became a part the industry vernacular. Then in late summer of that year, as fuel prices dropped nearly as fast as they rose, unit revenues began to freefall. And they continue.

The Airline Data Project demonstrates that passenger revenue for the airlines covered increased $3.8 billion in 2008 while fuel expenses increased some $11 billion. Year-to-date passenger revenue in 2009 is down some 20 percent thus far, while capacity has dropped 8 percent.

Generally, I care a hell of a lot less about the relationship of traffic to capacity as I do about the relationship of revenue to capacity. The trends defy the usual rule of thumb that a drop in capacity leads to pricing traction. That simply is not happening. And that tells me that this industry should be even smaller than it now is.

The Airline Data Project also shows that legacy carrier capacity is now roughly equivalent to what it was in 1997. But the combined capacity of legacy carriers and “low cost” carriers is 15 percent larger than it was in 1997, and that excludes the affiliated regional carriers like Republic, SkyWest, Pinnacle et al and includes Alaska, Hawaiian and Midwest Airlines. So the industry is not smaller – it is bigger. The legacy carriers simply have a smaller slice of the pie.

The MIT data will show that the legacy carriers spent more than $20 billion in 2008 on their contracts with regional partners – an expense largely contained in transport-related expenses. American spends the least on regional flying, while Delta/Northwest spends double plus 20 percent more than number two on the list -- United. What does this tell me? We have to cut back. We have to cut back!

At least the US Open sets strict boundaries on how many players qualify for a national championship. The same is not true for the US airline industry. As I say often, if you have a dollar, have an aircraft, and find an airport with security, you too can have an airline. There’s a lesson in that data. It’s time for limits on entry unless and until there is real change to the industry’s business model and structure. I am no protectionist, but anyone who challenges – or even suggests– that a lack of completion exists in the US airline industry fails to acknowledge the bottom line.

Unlike the US Open, the open market in the US airline industry does not identify the best. Rather it just keeps expanding the field until someone less than the best is crowned the best because they are younger - if only on a quarterly basis based on our fixation with results. Labor leaders should look at seniority as the only real weapon the upstarts have to whipsaw you. Management must make the best business case it can to stop the madness of continually having to average down labor costs as the only controllable means to manage overall costs.

The US airline industry, like the US Open, should be an examination of competition between the best. Instead it is about luck – and timing. It is about playing the “river.” I don’t know which airlines will survive. But I do care about the integrity of the field – something that is fundamental to the rules of golf. Like in the US Open, the field should be the best. Many are fit but few can deliver the full range of consumer service that established airlines offer.

Lucas Glover, David Duval, Ross Fisher and Soren Hansen earned finishes that may get them named to a Ryder Cup team. In that event, they’ll be required to play team events like 4-ball and Foursomes.

Too bad that, in the US, too many politicians view team events like consolidation and alliances as a threat to competition and the sure path to domination. Who has won the majority of the last two decades Ryder Cup matches? Not the US. And the same will be true of survivors in the global airline industry if we do not change our thinking about global competition.

Last October, I penned a piece on swelblog entitled: Just Who Will Inherit the US Domestic Market? Don’t Forget Today’s “Regional Carriers”. I thought it appropriate to repost the piece based on the news that Republic has offered to buy 100 percent of Frontier's equity for $108.8 million upon its emergence from bankruptcy protection.

I have a long institutional history at United, primarily working on behalf of the Association of Flight Attendants. In this role, I worked with the flight attendants through every concessionary period, the ESOP attempts, and Phase One of bankruptcy -- a long association that ended when I spoke my mind in a media interview on the vulnerability of defined benefit pension plans and, in doing so, angered some in the union leadership with my candor. .

All by way of saying that there is very little in United’s recent history, at least between 1985 and 2003, that I did not witness up front and personal.

The Recent Spat

The latest static at UAL involves a war of words surrounding United, Continental, Air Canada and Lufthansa in their application for anti-trust immunity to operate an international alliance. This debate is creating much more noise in Chicago than it is in either Washington or Brussels and that’s for one reason: the noise comes from a desperate union leader who waited ten months to voice concern about any potential impact on United workers.

This is the very same union leader who sits on United’s Board of Directors. His administration was subject to a federal court injunction to end what Judge Joan H. Lefkow ruled was a job action in clear violation of federal law. This, in fact, is a union leader who fancies himself as the second coming of ALPA boss Rick Dubinsky – the legendary golden goose hunter that worked more than 15 years to create many of the problems that still plague United. But, Mr. Wallach, you are no Rick Dubinisky.

Sometime after Wallach’s anti-trust immunity concerns were made known via the press, United COO John Tague, sent a letter to employees explaining United’s successful alliances with ten airlines over the course of the past ten years – none of which had led to problems or complaints with the carrier’s unions. A day later, Wallach responded with an open letter to Tague and copied all United employees – a tirade he then shared with the media as demonstrated by this submission to Forbes.com.

Wallach’s Letter

Wallach opens citing what he calls blatant mischaracterizations and outright falsehoods contained in Tague’s letter. But after reading Wallach’s letter, I am of the mind that it is he who is guilty of blatant mischaracterizations and outright falsehoods.

In building his case, Wallach attempts to blame United’s role in the STAR Alliance for the airline’s trouble today . . . a dubious case he makes by comparing the size of United in 1997 when it first joined STAR to the carrier’s size today. That argument conveniently fails to note that 1997 marked the middle of the greatest up cycle in US airline history, and then neglects to account for all the industry trouble that has transpired since. But that’s what the industry has come to expect from unions that spend more time and capital attacking companies through half truths and blatant misinterpretations rather than working to address the economic and competitive realities at the root of the industry’s struggles.

A more honest analysis would take into account the full breadth of events that have had a profound impact on the airline industry since 1997, including but not limited to SARS

1. SARS
2. The growth of the US low cost carriers
3. The rapid deflation of the IPO bubble
4. The puncture of the stock market bubble
5. The advent of internet distribution and pricing (transparency that contributes to lower ticket prices
6. The Summer of 2000 (where actions by UA pilots to “work to rule” impacted service)
7. Ratification of a new pilot contract with rates far higher than the rest of the industry
8. September 11, 2001
9. US Airways bankruptcy filing that led to significant reductions in labor rates
10. United bankruptcy filing
11. Oil prices begin increase to historic levels; crack spreads depart from historic norms
12. Delta and Northwest bankruptcy filings
13. Oil reaches $147 per barrel, driving run up of other commodity prices
14. New rash of airline industry oil hedges in anticipation of further price spikes,
15. Followed by plummeting prices that put many hedge contracts underwater
16. Credit crisis takes hold
17. Consumer confidence falls
18. Economy enters recession in late 2007
19. Recession deepens to become worst on record since 1930’s with global reach into Asia and Europe
20. Pandemic flu outbreak with hardest initial impact in Mexico.
21. United pilots in negotiations over new contract for first time since bankruptcy agreement.

The real lesson is in the extent to which the entire industry has changed over the past 12 years with a permanent impact on the legacy carriers. Wallach weakens his own case by suggesting that alliances have hurt US airline employment without identifying the many factors in the equation.

In fact, I would argue that without the alliance partners United works with today, the airline would be even smaller.

Has the management at United made some mistakes along the way? Of course. The current UAL leadership has no compunction about forgetting the past other than to recognize that the carrier’s past was largely a dysfunctional disaster. But that recognition led to many of the changes to United’s structure and operations in place today. As CEO Glenn Tilton often makes the case, the industry has to earn its cost of capital – something the global industry has rarely achieved over its long history.

Corporate Campaigns and Organized Pilot Labor

The airline unions – particularly those now in contract negotiations, have not shied away from full-barrel attacks on the carriers as one method of soliciting support during labor talks. Ginning up opposition to airline alliances seems to have become the latest tactic in this long-running campaign. But it should not be lost on any industry watcher that the loudest rhetoric comes from the union halls of the pilots at United and American. Ironically, the least noise is coming from the most successful US legacy carriers – Continental and Delta. I’ll leave it to the readers to weigh in as to whether there’s a connection.

But outside the rhetoric there’s a pretty clear case for the benefits of these alliances, particularly for an industry that needs desperately to hold on to its customer base. Maintaining and expanding the current alliance structure is one sure way to do so.

Concluding Thoughts

It is important to filter the daily missives fired from the labor bunker with the understanding that many in the industry are understandably frustrated by the changes and challenges in the airline industry. At some level, the best labor leaders recognize that the industry will not return to the unsustainable bargaining patterns and demands of yesteryear. Captain Wallach should take a very careful look at his union’s history at United and role in contributing to the precarious position the airline now finds itself in.  In other words, make yourself relevant in shaping United's tomorrow.

That history lesson should begin with the pilot-led majority purchase of the company in 1994, a process that began following a strike in 1985. With that purchase, the unions had unprecedented power in the governance structure and influence so strong it included hiring and firing power. But as the ESOP sunset, there was no transformation – no new culture or structure that prepared the airline to weather the trials to come. Instead, the transformation has come as the result of seismic economic factors that are redrawing the global airline industry map. And that map includes alliances – a necessary partnership in an industry in which US airlines aren’t permitted to act like other global businesses and merge.

There is not one legacy carrier in the US today that could stand alone and compete on a global scale. To stand in the way of market evolution is to stand on a dangerous path.

Justin Bachman at Business Week is fast becoming a must-read aviation reporter. In a May 17, 2009 column, Bachman asks: Have Airlines Cut Too Deep? This question of course was also being asked at the NTSB hearings on Colgan Airlines flight 3407. What makes Bachman’s work a must read is the context he provides on the economics of the situation. That is what the best reporters do.

But context in the reporting on Colgan 3407 was generally lacking in many of the press accounts. We read about the most sensational aspects of the story, like one pilot commuting from Seattle; like the other sleeping on a couch in the crew lounge; like the salaries paid at regional airlines; that somehow flight time/duty time was at issue; and of course fatigue. You didn’t need to read too far between the lines to see the supposed correlation between salary and safety.

Fatigue and Commuting

Unless the flight crew was on a suicide mission, this is a grossly unfortunate attempt at sensational reporting. It is incumbent on flight crews that choose to commute to arrive at their domicile rested and fit to fly a schedule that complies with flight time/duty time regulations. And through it all, there was no mention that “Sully” Sullenberger lives in Danville, CA and is based in Charlotte, NC. Or that the same flight time/duty time limits that applied to Sully’s trip applied to the Colgan crew’s trip as well.

Fatigue is a difficult issue. To conduct a meaningful scientific study, one must first assume that the crew is rested prior to the trip that they are scheduled to fly. That is their responsibility. In the case of the Colgan crew, the two pilots did not meet that obligation to the company, their fellow crew members or the passengers on the doomed plane. What is certain to come will be scrutiny on the issue of commuting and a debate as to whether we will return to the days when crew members are required to live in their domiciles.

Already some claim that low salaries force airline employees to live in places other than the metro areas where hubs are located. But that’s an individual choice, and most cities have a broad range of housing available.

The subject didn’t come up in the Sully case in part because, as a captain for a major carrier, he likely makes a pretty good living even after the concessions imposed on US Airways employees and so many airline workers as the industry struggles to turn a profit. But I’m pretty sure living in Danville, CA is not cheap, nor is Seattle known for its budget housing.

But long commutes for airline professionals should be reviewed and possibly prohibited if there is a connection between that travel and fatigue. And the fatigue issue cannot be studied until commuting practices are completely divorced from the regulations covering time on duty for flight crew members.

My guess, however, is that as the Colgan investigation continues, the real debate is going to involve pay.

Over the past weeks, there has been discussion here and elsewhere about the role of seniority in the airline industry and a system that chains flight crews to the fortunes of a single carrier because they risk losing the benefits of seniority if they change jobs. I’ve joined others in advocating for a national seniority list that will help crews preserve the seniority credits they’ve earned in the event of a merger of two airlines. A national seniority list also would provide portability in the event of furloughs or an airline’s shut down, meaning a pilot or flight attendant wouldn’t have to land at the bottom of another carrier’s list and all but start over.

This system wouldn’t offer a job guarantee – there’s no such thing in the airline industry -- but in the event a surviving airline is hiring, an employee would have the opportunity to compete for an open position and be paid in keeping with his or her experience.

As I envision it, a national seniority list would not serve the whims of those who perhaps want to fly for a carrier in Florida in the winter and a different carrier the rest of the year. Seniority is not necessarily an indicator of the industry’s or a company’s best employees – as important as experience is. But it does serve as the structure that governs pay and benefits.

So let’s talk about pay. Today’s regional industry is yesterday’s B-Scale. Back when the industry began experimenting with a tiered pay scale, the unions argued to get rid of B-Scale wages because one employee doing the same job with the same seniority should not be paid less than another. While the advent of the B-Scale compensation structure in the mid-1980’s led to explosive growth for the industry, the unions were successful in eliminating the two-tier wage scale in the subsequent round of negotiations.

Today, regional carriers like Colgan, Comair, American Eagle and others account for roughly half of all domestic departures. The regional sector has experienced explosive growth because small jet aircraft have allowed airlines to continue to serve smaller markets that couldn’t support bigger planes, in addition to cost and competitive pressures in the industry that have forced down average wages and benefits.

Here is where Business Week’s Bachman provides the proper context: “Anyone horrified by Shaw's [first officer on Colgan flight 3407] salary must also confront their own primary motivation when booking an airline ticket: finding the lowest possible fare. The two are connected, say airline executives and pilots. "People will spend three hours on the Internet to save $8," says Arne Haak, vice-president for finance at AirTran Airways (AAI). "You know this! You do it yourself."

So, What to Do?

Pay rates for pilots have been largely dictated by the size and weight of a particular aircraft type. Supporting this is the idea that more responsibility is associated with flying 250 people versus 130 or 50. The recent NTSB hearings highlight the pay discrepancies between mainline pilots and regional pilots. They are very different sectors flying very different revenue generating flights. But . . .

The pay differences between the mainline and the regionals have become too great. In many ways, the gap between what captains earn and what first officers earn has grown too large. It used to be said that unions employ practices that eat their young. But with an industry in contraction, we have reached a point where current pay practices even eat the old. As the legacy carriers are forced to reduce capacity even further, we now have former captains flying as first officers on the mainline. That’s taking seat progression the wrong direction.

Much has been made about executive compensation in this industry and across the US. But perhaps we should look at pay practices elsewhere in the industry as well. Should a pilot flying 130 passengers be paid three times more than a pilot flying 50 passengers? I think not. Just as it is time to rethink seniority; it is also time for the airline industry to rethink how flight crews are paid. With lighter materials ensured on tomorrow’s airplanes, weight becomes less of an issue. Carriers’ fleets are increasingly made up of smaller aircraft. Perhaps it is time to shed the complex calculation that goes into pilot pay, and consider salaries for cockpit personnel and flight attendants.

Such a system certainly would have better served the first officers at the mainline today who once sat in the captain’s seat. Those pilots took a disproportionate cut in pay relative to the captains that were not forced to move from the left seat to the right during the last restructuring. Given that segments are typically divided between captains and first officers, the industry should reconsider the 35-50 percent difference in their pay. And differences between the mainline and their regional partners should not be 200 percent.

I am certain that a transition to a new pay system will increase costs to the industry. But either the unions get their arms around the issue and come up with a more equitable system, or someone will make that decision for them. Pilot wages are inextricably linked to the industry’s ability to bring in revenues. As we continue to rethink what will help strengthen our domestic airline industry, we should also be thinking about how we allocate those pilot labor dollars.

I am suggesting a sea change in thinking about compensation. Further what I am suggesting will require a challenge to those who fail to recognize new realities in the industry, among them some of the union leaders who have responded to new competitive challenges with nothing but stubborn recalcitrance. In an industry that cannot earn a profit on a sustainable basis let alone earn its cost of capital, maybe the compensation structure that Captain Sullenberger speaks to should be changed to in order to obtain the best and the brightest on all levels.

The upside would be less but the perception that somehow safety of the airline system is somehow tied to salary would be addressed. Moreover, a salary structure is more stable, more predictable, more in line with revenue picture that drives the global industry and certainly more in line with an industry that will not experience the rampant changes in technology that drove productivity of employees in the past.

It is a conundrum. But while in the restructuring mode, address the fundamentals. The airline industry can learn from the head in the sand mistakes made in the auto and steel industries because if not fixed, the industry will continue to contract.

A group of former America West pilots prevailed this afternoon in a Phoenix, Arizona courtroom.The jury ruled that the US Airline Pilots Association failed to uphold its Duty of Fair Representation. Read the story by Dawn Gilbertson of the Arizona Republic.

Nobody should be terribly surprised by the outcome. Unfortunately, it is only the fifth inning of a scheduled nine inning game for the US Airways pilots to agree to a merged list. The right decision was reached by the jury in this case.

Are represented employees ever going to learn that the grass is never greener when AMFA ideology is utilized? Their approach is simply to over promise and under deliver.

What no one will say publicly at least: without the plan of reorganization for the former US Airways that included a merger with America West, the former US Airways [East] pilots would likely have landed in the unemployment line.  And someone other than "Sully" Sullenberger would have been the captain on the flight that successfully landed on the Hudson.

It really is high time to put together a national seniority list in order that transactions like mergers can take place without labor diversions. 

Funny When the Shoe Is On the Other Foot

A major US industry employing hundreds of thousands of workers that was once the envy of the world is in trouble. Some of the biggest names in the industry have filed for bankruptcy, leading to significant job loss and cuts to retiree health and pension benefits.

No, I am not talking about the state of the US auto industry in 2009. I am looking back to 2002 at the start of the US airline industry's painful restructuring.

On Aug. 11, 2002 US Airways filed for protection under Chapter 11 of US Bankruptcy Code. On December 9, 2002 United Airlines followed suit.. On April 18, 2003 American announced agreements with all of its unions on concessionary contracts to cut labor costs outside the bankruptcy court. On September 12, 2004, US Airways having emerged from bankruptcy too weak to survive, filed Chapter 11 for the second time. On October 20, 2004 Continental announces plans to seek concessions from workers. Then on September 15, 2005, Delta files for bankruptcy, joined within the hour by Northwest Airlines.

Though years apart and radically dissimilar in many ways, the automobile industry might learn a few things from the experience of the airlines . . . then - and now.

US airlines were largely successful in using bankruptcy to reduce bloated operating cost structures, but the agreements between the debtors and the various stakeholders were based on the belief that the companies would achieve some sort of sustained recovery. We now know this not to be the case.

Since 1980, the US airline industry has lost nearly $20 billion. Over the same period, the non-US airline industry made nearly $20 billion. How do we account for the $40 billion dollar difference?

Bankruptcy can help whittle down costs and provide a mechanism to cleanse a balance sheet full of stupid capital. But it does not address government actions that dictate how an industry can compete. So, as “stress tests” become a part of banking vernacular, the very same tests should be applied to other industries struggling to adapt to a new economy.

Stress Test #1: Labor

For most US airlines, bankruptcy did little to address the expectations and entitlements common in unionized industries. For example, there is still scope language in most pilot contracts that serves as a sort of a “job bank” provision and there are plenty of contractual penalties to pay should the enterprise need to shrink capacity. So far, the airlines that have emerged from bankruptcy are anything but agile. One might say that networks were adjusted to adapt the market’s revenue reality, but my view is that they were really just outsourced to a carrier’s regional partners.  An economic fix in pilot contracts remains unfixed.

If Chrysler, and possibly GM, is to learn anything from airline bankruptcies regarding labor issues, start from a clean whiteboard and negotiate what you need to implement your new business plan. Airline bankruptcies, while incredibly painful to employees, gave too much leeway to the unions in negotiating the level of concessions. Real change comes in addressing emotional labor issues – many left over from an earlier era of trade unionism – like the work rules and job protections that constrain a company’s ability to be flexible and agile in its operations.

And while the airlines were able to make crude cuts to their cost structures, most retain many of the same labor constraints and “protections” that hindered their success in the first place.

Stress Test #2: Capital

Capital considerations are one area where the government and the auto industry each learned from the airline experience in bankruptcy: legacy costs like pensions and retiree health provisions take a tremendous toll on a company’s economic health and financing flexibility. Cerberus Capital may be the sole exception but, anyway you look at, it is clear that the airlines created a case study for other shrinking industries. A lesson the airline industry would have preferred not to teach.

As costs were cut and capital destroyed during the airline restructurings, it became apparent that, without significant changes to its legacy obligations, United was not going to be able to get to a Plan of Reorganization (POR) that would produce the kind of debt coverage any new capital would require. Other airlines inevitably followed United’s lead -- freezing or fleeing some of these expensive plans -- as the private capital waiting in the wings to fund airline exits offered the money with that as a chief condition.

The auto industry understood this as well demonstrated by the UAW’s significant concessions in the last round of negotiations.

All of this is not to say that other economic factors didn’t play a role. For the airline industry, it was the price of oil in the early stages of its march to unprecedented and unthinkable levels as several carriers began to emerge from bankruptcy. And for the auto industry, the ailing economiy exposed the reality that an industry already diminished in size and economic might cannot pay these bills alone.

Stress Test #3: Government

Isn’t it ironic, then, that some in the US government are trying to legislate and limit international airline alliances at the same time the White House opts to save Chrysler by putting it in the hands of Italian carmaker Fiat SpA. In that deal, Fiat acquired an initial 20 percent stake in Chrysler – a stake that will increase to 35 percent if it invests in US small car technology;and could eventually control 51 percent of iconic US automaker once all government loans are repaid.

Still, in Congress, Rep. James Oberstar is trying to push through new challenges to the very global alliances that help US airlines expand their networks and promote growth. The congressman already has cast a suspicious glare at granting immunity for a proposed oneworld alliance between American, British Airways and Iberia – even though those airlines seek only an even playing field with SkyTeam and STAR – the other alliances that include Delta, United and Continental. Oberstar is also gunning at those existing alliances, trying to subject them to a governmental review every three years .

He [Oberstar] claims he is acting only to protect consumers. But what Oberstar appears to discount is the fact that alliances have produced significant new revenue streams for US carriers and benefits for American travelers. Adding oneworld introduces yet more competition – hence, benefiting consumers.

Without leveraging these international partnerships, there is little new revenue for carriers to mine or easy cost-cuts to make. [Just ask US airline darling Southwest Airlines] Fiat plans to improve the bottom line by employing new technology and finding new efficiencies by joining forces with Chrysler. Why shouldn’t US airlines have the same opportunities by partnering with Lufthansa or Air France or KLM or British Airways?

Interestingly, one of the reasons cited for Chrysler’s continued financial problems was its near sole reliance on the US domestic market to sell its cars. And that sounds an awful lot like an airline industry that has struggled through nearly three decades of unhealthy domestic competition because lawmakers - parochial in their thinking - failed to recognize that competition for competition’s sake can destroy industries.

The US airline industry as we know it is at a tipping point. I don’t believe that foreign capital alone will make everything right in US airlineland. But these partnerships offer great potential, particularly if they provide domestic carriers with the ability to upgrade their products and services so that US airline offerings on transoceanic routes are on par with alliance partners. That would be a smart use of capital.

Foreign capital is not tainted. Hell, does anyone really think that US airline capital is not held by non-US parties today? US airlines need it to bring in new revenues and make investments that produce a product that people are willing to pay for. And airline alliances need to be permitted to go to the next step and reduce expenses as well.  Instead, we’ll continue to watch foreign carriers invest in that product while the US airlines slug it out for traffic from Lubbock and Boise.

Stress Test #4: Government Promises

The auto industry is lucky to have the full faith and credit of the United States in back of its restructuring. The airline industry had none of that except for the pension obligations offloaded to the Pension Benefit Guarantee Corporation . . . and for some of the employees affected that amounted to only pennies on the dollar.

But what the airline industry really needs is for the government to fulfill a decades-old promise to invest in the air-traffic control infrastructure that serves as the backbone for the entire industry.. That is a use of “government money” – one likely funded through taxes and user fees -- that actually offers a decent return on investment.

Concluding Thoughts

The airline industry has many lessons to teach Detroit.

One, you can’t simply cut labor costs without also getting the operational flexibility a corporation needs to compete effectively.

Two, any industry should seriously question whether equity in exchange for benefit obligations will produce a stronger company in the long run. The airline industry makes clear that smaller companies cannot pay for the past in a highly competitive revenue environment.

It’s a new era. What a difference a few years make when a Democratic President of the United States emphatically believes that transferring ownership to a foreign entity is in the best interest of a US company. This is an area where the US airline industry may finally have a case to make that what is good for one industry is good for another.

As for government promises, I only hope that the US auto industry fares better than the US airline industry.

At some point the duplicity must stop.

Update on 05.12.2009 by swelbar

After posting, Cliff Winston of the Brookings Institution offered another Stress Test to consider. For those who follow this industry closely you will recognize Cliff Winston as the author of numerous and authoratative pieces on the airline industry. I am a follower of his thoughts and insight and appreciate his offering below.

Let me suggest another “stress test”: Matching Capacity with Demand. That has been the biggest problem for the airline industry, especially because it has experienced several shocks that have made it difficult to forecast demand.

The problem with the US automakers is that they have been able to live in denial. Although their market share has continued to shrink, macro expansions, trade protection, and low gas prices have enabled them to be profitable. But they were losing the quality race with foreign automakers. The attached paper indicates that the entire loss in market share in the past decade can be explained by the US automakers’ inferior attributes. Their share would continue to shrink under those conditions. Add on a shock like the financial crisis and capacity greatly exceeds demand leading to bankruptcy—just like the airlines. BUT unlike the airlines, cutting prices and costs won’t fill much capacity if demand continues to shrink because of inferior attributes.

Regards, Cliff Winston

We awake this morning to reports that Chrysler will file for Chapter 11 bankruptcy . Despite efforts by the Obama administration to force Chrysler stakeholders to find an out-of-court solution, certain debt holders would not agree to the haircut they would have to take in forgiving debt to the auto giant. What they seem to be saying is that, under the terms of the proposed solution, labor would receive a disproportionate share of equity in the restructured company.

Where seniority for airline workers is earned through longevity, capital structure seniority is a bit different. In a bankruptcy, there are different classes of capital. Debt secured by company assets is the most senior on the list of creditors who will be paid. Unsecured debt capital is next in the pecking order, followed by preferred stock and, lastly, common equity.

Nowhere is “sweat equity” reported on a company’s balance sheet. However, worker concessions have been recognized as capital in a restructuring scenario and have been currency accorded a stake in a reorganized enterprise. Moreover, it is the sweat equity at Chrysler held by current and retired workers that might appear to some as being unduly enriched through the deal that gave them a 55 percent ownership stake in a restructured Chrysler.

A very different scenario played out in the airline industry. There, in bankruptcy cases that resulted in either a termination or freezing of pension plans and/or alterations to retiree benefit plans, creditors made it clear that they would not pay the bills from the past by forgoing profits in the future. For airline companies to emerge from Chapter 11, they needed public capital to fund their exit from bankruptcy. For car companies, the government is the source of exit capital.

This morning’s New York Times, quotes a statement from GM’s bondholders that applies to Chrysler’s issue as well: “We believe the offer to be a blatant disregard of fairness for the bondholders who have funded this company and amounts to using taxpayer money to show political favoritism of one creditor over another.”

As the article notes: “The U.A.W. members at both automakers stand to lose some of their pay and benefits, but the cuts are not as deep as those faced by airline and steel workers when their companies went bankrupt. Under proposed deals devised by the Treasury Department, U.A.W. pensions and retiree health care benefits would largely be protected”.

Airline Seniority In The News

On Tuesday, Terry Maxon of the Dallas Morning News wrote about the former TWA flight attendants and their dissatisfaction over their treatment from the flight attendant union when American purchased the assets of the troubled and iconic carrier in 2001. Also Tuesday, the four-year seniority battle between the merged group of pilots at US Airways got underway in US District Court in Phoenix, Arizona. Read Dawn Gilbertson’s reporting in the Arizona Republic and on the paper’s US Airways blog.

Whether it is in the airline industry or in the automobile industry, there clearly is something wrong with the seniority system. My question: should seniority really be sacred? The current seniority system does not work for shrinking industries like airlines and autos.

I am in stark agreement with the actions taken by the Association of Professional Flight Attendants, the union that represents AA flight service crews, which in protecting the seniority rights of its members decided that former TWA flight attendants would be put at the end of the seniority list when they joined AA ranks. The fact is this wasn’t a merger of equals. At the time of the purchase, TWA had sold most strategic assets and had reached its tipping point. There was nothing left to borrow and no hope except American’s offer to buy its assets.

I am in stark agreement with the America West pilots in their disagreement with the former US Airways [East] pilots who had little hope of a career absent the reorganization plan that involved a merger with America West.

Given that the economy will continue to call into question the future viability of any number of US airlines, this seniority issue is far from over. Plain and simple, it is about economics and the viability of individual carriers. US Airways [East] was not going to survive in its 2004 form for long. TWA would likely have died of natural causes as the effects of 9/11 ravaged the industry.

Concluding Thoughts

Given that the airline industry will likely get smaller before and if it gets bigger, it is high time that organized labor puts down its swords and constructs a national seniority list. Employees should have the right to move within the industry should their carrier cease to exist. Seniority should not be a shield for some to hide behind. Rather it should promote stability for those experienced workers that choose to offer their services for hire in an open market

The economic crisis and its impact on corporate America highlight the need for thoughtful analysis of labor issues. Seniority is only the first of the “third-rail” topics we shouldn’t be afraid to discuss. Another is the “legacy costs” like pension and retiree benefits and whether they should be the sole responsibility of the employer in today’s world. Best that I can tell, this growing financial burden on employers may serve only to stand in the way of active employees working to maximize their earnings.

Time will tell what ultimately will emerge from Chrysler’s bankruptcy; GM’s prospects for the future and whether the deal at Ford positions that company to compete for the long term. The same day might be coming for airlines which would be wise to learn lessons from the industries that come before them.

I make that final statement after reading through Obama’s statements. The US government is constructing a safety net for Chrysler and its workers. Some will fall through and others will be saved. Airline labor should be thinking about the same.

Three legacy carrier earnings calls down, two to go. Southwest and Allegiant have reported. So has SkyWest. But the clear takeaways are difficult to discern. Everyone wants to know if the industry has reached a bottom. But there are no clear answers while we are still in the middle of an economic tsunami. For all those who have said the domestic market is stabilizing (me among them) the only hard evidence on our side right now is that the environment is not getting worse.

Every carrier is supremely focused on unbungling their operations. Yes, unbungling. Because we all know that operations at many carriers have been a mess, with many factors to blame. And, as painful as the process has been, many carriers are making progress getting their operations and costs in order. US Airways led an amazing turnaround focused on its once-troubled Philadelphia hub. Many very good reforms are underway at United. And all things operational are improving at American, albeit at a slower pace than at some of their legacy peers.

Moreover, virtually every carrier – except for Southwest – remains committed to continuing the unbundling process and to maximizing secondary revenue sources. Today, Delta went so far as to announce a fee for the second checked bag on international flights -- becoming the first in the industry to do so. The industry is unequivocal that the fees will stay and that where opportunities are present to do more, they will. Further, a heartening storyline has emerged regarding distribution, where carriers increasingly see opportunities to move away from paying intermediaries to sell their tickets and to turn that model on its head so that airlines get a fee from the middle man for the right to sell their product.

The United Call

I do not have the transcript of this call in front of me, but this was a most interesting listen. My favorite part was when Morgan Stanley’s Bill Greene posed a very fundamental question that went something like this: With planned capital expenditures less than depreciation, how are we supposed to think about United, or the industry, on a going forward basis from an investment point of view?

Or, as Helane Becker of Jessup and Lamont put it: Should UAL have public equity at all, or instead raise only debt capital from the public markets? Then there was Ted Reed of TheStreet.com, who was blunt in asking whether, just maybe, United had “shrunk too much.”

Good questions. Unfortunately, they are ones that the current environment makes very difficult to answer with conviction.

In my last post, I questioned the airline industry’s access to capital given fragile economic fundamentals in an industry that, over its long history, has failed to produce so much as a dime in retained earnings. In my view, the industry is at a tipping point in which smart investors should question the structural integrity of some carriers and networks during what amounts to a market stress test . . . one that just might reveal which airlines have few moves left to shed uneconomic capacity.

This is the “new and irreversible development” I referred to, a trajectory that might change only through serious effort to remove the many regulatory shackles around this industry. Some necessary changes might not be politically popular -- increased foreign ownership of US airlines comes to mind – but the industry’s options are narrowing when you consider that revenue trends do not hold out much immediate promise.

Looking ahead, with credit tight, where will capital – affordable capital – be found unless it is from another participant in the same industry? If companies are struggling to realize any return on invested capital today, then what happens as interest rates continue to increase in lockstep with capital scarcity? As standalone companies, there is just not enough room for individual carriers to maneuver around an income statement that holds little promise of further significant reductions in the short-term. Based on Greene’s point, even United seems reluctant to reinvest much of its own, and limited, capital into a business that does not hold promise of a reasonable return.

This is not just about United. This is an industry issue. And not just a US industry issue . . . it is fast becoming a global industry issue.

In North America, Air Canada has long been the poster child of an airline that needs an influx of foreign capital necessary to keep the company relevant in the global market place. Air Canada faces some unique challenges: namely that nearly two-thirds of Canada’s air travel demand is found in just eight markets.

Meanwhile, the Delta/Northwest merger is fast proving that the combined entity is far less vulnerable than either of the two carriers would have been had they not merged. Just think about the vulnerability of each Delta’s and Northwest’s respective hubs to the economies in the interior of the US footprint.

With US Airways the exception among the legacy carriers as to international market exposure, we as a nation should at very least acknowledge the reality that globally-oriented airlines need to be just that. I’m not talking about domestic airlines with global extensions -- we tried that, in a way, with TWA, Eastern and Pan Am . But absent any real alliances that left each of them dependent only on US-origin traffic, those carriers suffered a common fate -- shut down in sagging economies as capital became tight.

Concluding Thoughts

Following an industry life cycle of value destruction, US legacy carriers now face a dilemma: whether to invest in their core businesses or not?

As the US airline industry is now six full years into a major restructuring, the tendency to legislative and regulatory gridlock did not get restructured. An inflexible labor construct did not get restructured. Policies promoting the fragmentation of the US domestic market did not get restructured – until the airlines themselves took on this task through capacity reductions in redundant markets out of necessity. The infrastructure, whether it be ATC or the airport system, did not get restructured. And the historic mindset that capital will be forever recycled among manufacturers, vendors, labor and government imposed actions did not get restructured.

In truth, the US market should not fear individual carrier failures or consolidation. Indeed, this market has demonstrated time and time again that where competition is vulnerable, a new entrant will exploit that vulnerability. Where there are market opportunities, there will be a carrier to leverage that opportunity. Where there is insufficient capacity, capacity will be sure to find the insufficiency.

At a minimum, government should take a very serious look at where this industry sits. The US airline industry is not asking for government handouts. Rather it is my view that this industry seeks nothing more than the same rights to operate as virtually every other successful US industry selling to the global marketplace is permitted.

Few shackles unless consumer harm can be proven. Going backward will result in significantly more dislocation for virtually every stakeholder remaining in the industry today as it begins with an industry even smaller than today’s.  It would be a shame to waste six years of some very good work.

Earnings season is upon us and we all anxiously await guidance from airline executives on a forward looking basis. On the eve of past earning seasons, cues from industry executives have mostly used words starting with “C.” This time around, I want to hear commentary on topics starting with “L” namely:

Liquidity

I believe that we are nearing the final chapters for one carrier, possibly two. I do not know which they might be, only that there are not enough rabbits left in the hat for every airline to survive in this market.

Why?

- Because labor will not be the internal source of capital that it has been in the past;
- Fuel costs are uncontrollable;
- Maintenance repair and overhaul will not offer hundreds of millions of dollars in savings in the future as most airlines already have outsourced as much of that business as they can;
- Distribution costs already have been wrung out of the system at every airline;
- Airport costs ebb and flow with the level of traffic;
- Aircraft rentals and other vendor contracts are largely fixed;
- Commitments made to feed providers are contractual;
- Interest obligations are known.

In other words, there just is not much room on the income statement for airlines to maneuver.

In the U.S. airline industry, we could be fast approaching the tipping point– the critical juncture in an evolving situation that leads to a new and irreversible development. With credit tight, would you put money into an industry that has historically destroyed capital? Would you bankroll an industry that has few opportunities to reduce costs in a weak economy? Would you lend money to companies facing labor strife? To get to the bottom line, would you invest in a company in an industry that has never made a dime? In this economy, there may not be many takers.

The airline industry is not special. Like other industries, it needs a plan to earn at least its cost of capital and compete for a limited pool of funding. And those who hold the capital will likely look first toward companies and industries that reward their capital providers more than once or twice every two decades.

I share the belief of some others that the domestic market may be stabilizing, but think this recovery will be an uneven one. The real driver may be the international market and the global economy’s interdependencies that I do not pretend to fully grasp. So I have concerns about American, Continental, Delta and United. Asia has been troubled in certain spots for nearly a decade now. Europe was a strong performer while the US industry faltered, but now shows signs of weakness across the continent. And Latin America’s economy appears to be similarly troubled.

Beginning today, when American leads the first quarter’s earnings parade, I will be all ears. Because what I see for some is troubling. Others will benefit from the weakness.

Labor

The recalcitrant unions at American remain the lead story as outlined in Mike Esterl’s piece in an April 14 Wall Street Journal entitled: Labor Negotiations Cloud Outlook for American Airlines Parent. American is being joined by United which opens negotiations with all of its major unions this month. Between the two, there will be plenty to read and write about as union leaders at each airline continue to promise outcomes to their members that could not be met even in the best of times. Real leadership would instead recognize that no airline can long survive overpriced labor contracts that put them at a competitive disadvantage in the industry.

I read somewhere this week that the United Airlines flight attendants union is promising its members a new contract that will give them industry-leading pay rates. The American pilots union is taking an old page out of the Continental pilots’ playbook that “the loan is due” to gain back pay levels the industry no longer supports. The problem is that concessions granted or forced in past years were a necessary correction of market costs that had risen above the industry’s ability to absorb those costs. Those concessions were never a “loan” and there isn’t a labor contract in the industry that includes terms on rates or principal that would make them so.

American has a first – at least in my recollection – in having all of its negotiations in mediation at the same time. United could be in the same place as date certain contractual understandings are in place to file for mediation in the event no agreement is reached. As for US Airways and the labor unions that have not been able to complete an agreement following the airline’s merger with America West, I have given up trying to apply logic to that situation. The damage done to employees is done and that was the work of the unions involved.

OhhhhhhBama – Release Me (And Let Me Love Again)

The Allied Pilots Association, which represents American pilots, has been on an ill-conceived, death-march strategy that the leadership somehow believes will get them closer to a release from mediation. Negotiations began in September 2006 -- a long haul by any perspective – but the clock was reset when a new union president, Lloyd Hill, was elected in June 2007. I don’t pretend to know the union’s strategy in these negotiations beyond what plays out publicly, but I do know that the Hill administration has made contract demands that are so far removed from reality that I question whether he is really representing the best interests of AA pilots.

With each union that files for mediation, my guess is the American pilots move yet another group down the pecking order for a release and thus the ability to engage in Self Help. The APA should be taking a clue from the Obama administration and its dealings with the UAW. The UAW’s Gettelfinger demonstrated a real understanding of that industry in balancing the interests of his members with the economic reality, in part by working to preserve wages and benefits of current employees by negotiating lower rates for new employees. But even that didn’t change the reality that, as the economy continues to collapse; the UAW is still not close to having moved far enough from work rules and wage rates that put the Big Three at a huge cost disadvantage in the global auto industry.

Finally, to the pilot leadership, I can’t imagine what possible benefit you would gain through strikes or other work actions that few airlines could survive. First, there is little chance the White House would allow a union at a carrier the size of American or United or Continental to actually go on strike and potentially threaten the economy’s ability to recover. No matter how labor friendly the new administration is, I believe that any union will need to make a pretty powerful case to the White House as to why a strike is more important than the recovery of the United States economy. Any union that can make a case that restoration of inflation-adjusted wages can be easily paid for by the airlines may have a chance, but that’s going to be a tough case to make.

I refer to the American pilots union in this example, but it applies to any large airline. Too much stimulus is potentially threatened by a strike in an industry as crucial to commerce as the airline industry.

Here’s my bet on where pilot contract negotiations will end up at the legacy airlines: With the Delta deal done under the leadership of ALPA’s Captain Lee Moak, the remaining negotiations will be completed in the following order: 2) Continental; 3) United (following the lead taken in the CO negotiations); 4) US Airways (assuming a final resolution to the seniority issues scheduled for the end of April); and 5) American (and perhaps only after a “leadership” change takes place.)

Congrats to Southwest for having put to bed their negotiation with multiple groups at reasonable rate increases.  With little management distraction, the airline can focus on finding needed revenue.

Legislation

Finally, there are legislative issues important to this industry that deserves color in the upcoming earnings calls. First and foremost is a reauthorization bill that will fund the FAA’s activities. A committed industry must find a way to fund enhancements to the air traffic control system. Everyone in the industry recognizes the need to make changes. Now we’re just fighting over who will pay for them. It’s time to move forward and for the various factions to present a united front on "who will pay what".

Second on the legislative front is Oberstar’s bill to evaluate airline alliances every three years -- a clear attempt to make the formation of these alliances increasingly difficult. Never did I think I would write that former AMR Chairman Bob Crandall and Minnesota Congressman Jim Oberstar are on the same page regarding a controversial commercial issue, but I am - and I am even writing it in the same sentence.

In an interview with the National Journal’s Lisa Caruso, Crandall actually says: “In my view, an objective observer would have to look very hard to find a way in which alliances have benefited consumers.” His remarks point to the “dominance” of slots at Frankfurt and Paris by the aligned carriers. Is this any different than the structure "Crandall built" in the US domestic market where carriers were reluctant to offer service between the hubs of a competitor? Absolutely not. Instead, the competition offered a menu of one-stop competing services that presented the consumer a choice.

Are we not to acknowledge that the air travel consumer in Toledo benefited significantly from the Northwest – KLM alliance that offered seamless connecting service to Amsterdam and points beyond? Wasn’t it Crandall that coveted a partner in Brussels to partake in these very same traffic flows? Does Crandall really believe that Detroit and Minneapolis would have multiple non-stop services to Amsterdam if not for the alliance? Does Oberstar really believe that Minneapolis would have the international service to Europe it does without the network of KLM and now Air France on the other end?

Crandall even makes the point that the foreign carriers have been the beneficiaries at the expense of US carrier interests. Crandall is the one that brought the concept of time-of-day departures to the networks of the nation’s carriers. This alone has contributed to a significant amount of the uneconomic capacity that pervades the industry today. Do we really think that all of the departures that “Bob built” were good for anyone? If we did not have alliances to begin filling all of the ill-conceived capacity deployed in Crandall’s domestic network, then we would have even fewer US carrier domestic departures than we do today – even after all of the cuts.

For a guy I admired, Crandall’s comments leave me perplexed, confused and confounded. Some of his fixes are on point, like a changed labor structure. But Crandall should accept some of the blame for an industry struggling today as his pit bull instinct toward competition became a blueprint to build an industry too big. Or maybe he should explain to airline employees that his blueprint caused an industry to hire too many people that now believe they are entitled to wages higher than the industry can pay.

More to come on this one.

What, Swelbar showing empathy for a labor leader? Yes. In fact, my feelings are not dissimilar to the emotion I felt for airline labor leaders a few years back, when the solvency of so many carriers was in question and some of the biggest went on to file bankruptcy. Trust me, no one wanted to be a labor leader in the airline industry following 9/11. Today, I’d bet that there is no human being that wants to sit in for Ron Gettelfinger, the damned-if-you do, damned-if-you-don’t President of the United Auto Workers (UAW).

On Tuesday, Fox.com posted a piece entitled: With GM's Wagoner Ousted, Should Union Head Have Met the Same Fate? In my view, absolutely not. In the early days of Swelblog.com I wrote a piece entitled Self Help in which I praised the negotiating strategy of the UAW. This was on October 11, 2007, long before the spike in oil prices, the freeze in credit markets and the downturn in the economy that has left consumers with little to no confidence in the future and contributed to a decline in consumer spending.

The contracts Gettelfinger negotiated at GM 18 months ago attempted to address many of the competitive disadvantages the US auto industry faced. Those negotiations resulted in, among other items: 1) freezing base pay for 4 years; 2) shifting a significant share of the burden of retiree health care from GM to the union; 3) creating a two-tier compensation structure in return for job protections for the current workforce.

Think about these terms. Unpopular? Anti-worker? Unsuccessful? Yes to all. But the new contract made significant ground in bringing about some of the necessary changes to a collective bargaining agreement born of decades of negotiation between the UAW and the Big Three carmakers and costs that had spiraled out of control. These were well-intended fixes to contractual language written when times were different – but the fixes allowed some historical language to remain. This was well-intended language that would only produce real benefit if the industry grew.

It is like pilot scope clauses: there is only value in the language when it happens. Some might argue this point – don’t scope clauses restrict airlines from even considering new routes/planes/partners when it would potentially violate scope – even when company growth presents itself? Only growth is not in the cards for U.S. auto industry, - or the US airline industry - at least not unless, and until, there is real change.

Just like the automakers, the legacy airlines continue to negotiate from outdated language. Most of these contracts were written when technological changes facilitated productivity improvements that could offset pay increases, and when targeted capacity growth would build airline markets where there was no evidence that the market could support new air service. At the time, collective bargaining agreements did more to ensure that labor would take advantage of technology change rather than to adjust work rules and expectations to account for the advantages new technology brought.

Unfortunately for the airline industry, there is no techological change on the horizon that will increase the speed of the aircraft in a meaningful way.

I have written many times here that the auto industry cannot make the necessary changes without a court-assisted restructuring. The same was true for the airline industry. The problem is that, even in bankruptcy, the airline industry still left decades-old and largely irrelevant language in their collective bargaining agreements. Bankruptcy was effective in dealing with the low-hanging fruit, but did not do enough to position the airlines for long-term success.  Simply, the flexibility to match the work force to the demand environment was not negotiated.

So here we sit with significant negotiations to be done at United, American, US Airways, Continental and AirTran. No labor leader at any of these carriers has stepped up the way Gettelfinger did 18 months ago when he was willing to challenge decade’s worth of old-labor ideas and ideals in return for better positioning GM in tomorrow’s world.

Lee Moak, the head of the pilots’ union at Delta, came closer than any other union leader in acknowledging that change was inevitable as the Delta-Northwest merger moved forward. Moak did what any first-mover in a merger world would do and negotiated the best deal for his members. The problem is that Moak did too good of a job given the state of international markets. I only hope he can hang on to what he negotiated.

We have new contracts getting done across the industry. Interesting and different mindsets at Alaska and Hawaiian have produced some very different agreements. Southwest ground workers have ratified a deal. Southwest has announced a tentative agreement with its flight attendants.

And Southwest this week revealed details of an agreement with its pilots that in my view will prove to be a mistake – with the company caving to the union and giving pilots too much specificity in scope. Southwest did show amazing restraint in agreeing to wage increases, but I had expected it to come without “handcuffs” on code sharing. With this contract, we can see quite clearly how Southwest is aging and facing many of the very same labor struggles that have long dogged the legacy carriers.

I feel for those employees that have “given back,” whether through concessionary contracts or at the demand of a bankruptcy court. But that doesn’t change the fact that the give back was from a level that was unsustainable and would have occurred, eventually, come hell or high water.

This current negotiating period is important to both management and labor. Hopefully, the airline industry will produce leaders like Gettelfinger that recognize that tomorrow has different challenges than yesterday, and that labor leaders have a crucial role in negotiating contracts that protect the workers who helped build the industry, while at the same time ensuring that US aviation can be competitive in the future.

Some call this approach “eating their young”. I call it smart. Because there is nothing that Gettelfinger and the UAW can do today to fix what was done 20 years ago. But labor leaders in the airline industry should do everything in their power to avoid the situation automobile labor now faces. Labor leaders who succeed in the long term will be those who set realistic expectations for their members, resist the urge to overpromise and, like Gettelfinger, recognize that change is inevitable and that labor can and should be a key player in making it work.

More to come.