Dear Chairman Oberstar: What Do You Mean This Is Not What You Voted For?

Responding to the news that the U.S. Department of Justice had approved the merger of Continental and United, House Transportation and Infrastructure Chairman, James Oberstar said, “This consolidation of the mainline companies into three or four mega-carriers is not what I voted for in 1978. Nor did anyone foresee three international alliances dominating the global airline market.” 

For a guy that has been in and around the U.S. airline industry for longer than it has been deregulated, Oberstar should know better. Since 1978, the predictions have all pointed toward three network carriers.  The formation of the global alliances also addresses exactly what Oberstar and other members of Congress intended three decades ago… more choices for consumers.  

Don’t take my word for what the goals and objectives of U.S. airline deregulation was intended.  The November 6, 1985 report by the General Accounting Office (GAO) spells them out.  The GAO report was requested by U.S. Representatives Norman Mineta (D, California) and James Howard (D, New Jersey) to assess the effects of deregulation as compared to the intentions and expectations.  The GAO report stated the purpose of the deregulation act was to allow competitive market forces, rather than the federal government, to decide the quality, variety, and price of domestic air service.  It was aimed at encouraging the formation of new airlines, expanding service by existing airlines, and bringing lower fares and better service to passengers. Recognizing free competition might result in some communities losing air service, Congress created an Essential Air Service Subsidy Program protecting service to eligible communities.

The GAO compared economic expectations of deregulation with actual changes in the industry's structure (the number of airlines, each airline's share of traffic, and the ease with which they can begin new service to a city-pair), conduct (behavior in setting prices and levels of service), and performance (profitability, efficiency, and responsiveness to consumer preferences). The report does not address airline safety. 

Now, let’s look at today’s aviation industry keeping the goals of the Airline Deregulation Act of 1978 (ADA) in mind.

The GAO report states five years after enactment, there were more airlines competing.  It also highlights a trend prevalent today.  “With increased competition, the largest airlines have been losing passengers to smaller and new airlines (which often offer lower fares). Nationwide, the percentage of passenger miles flown by the largest airlines (formerly called trunks) fell while smaller carriers combined with new airlines almost doubled their percentage of passenger miles flown.”

I think the number of airlines is less important than understanding the levels of domestic capacity held by the top three, five and 10 largest airlines operating in the domestic marketplace.  I looked at available seat miles by all competitors from 1974 to 2009.  In 1979, the three largest U.S. airlines held 48.6% of domestic capacity; the five largest, 72.3%; and the 10 largest, 93.1%.  In 2009, the three largest U.S. carriers held 43.8% of domestic capacity; the five largest, 61.7%; and the 10 largest, 81.8%.  These numbers exclude code sharing and regional capacity.  If included, the levels of concentration would still be less than the levels of concentration in 1979.

The 1985 report cited trends shortly after passage that still hold true today like. Average fares fell, service improved for most passengers, efficiency improved, consumer choice increased but not everyone benefited and, thirty years later, airlines are still adapting to deregulation.

 While 2010 fares are rising as compared to an abysmal 2009, the long term trend is still decreasing real fares. Domestic networks provide passengers in markets large and small with significant choice and access to virtually any market. Airline efficiency including labor, operations and fuel consumption has improved. It’s true not all markets have enjoyed similar levels of benefits, but that is less about consolidation and more about individual community economies and the price of oil. The industry is not static (some would even say stable) and is still adapting to a series of crises including September 11,  SARS, $147 per barrel oil, the Great Recession, Avian Flu, H1N1, volcanic ash and numerous and onerous regulations and taxes imposed by government as well as new competition in domestic markets and emerging world networks.

The Deregulation Debate Leading Up to Passage of the ADA

Congressman Oberstar, I assume you listened to the learned economists that participated in the debate as to whether passage of the Airline Deregulation Act would prove to be good policy.  I will highlight some of the economic theories espoused during that debate.  If you read carefully, I believe you will find many of the trends prevalent immediately after passage are still intact.

• Analysts expected deregulation to result in a more competitive market structure by removing barriers to entry into individual markets and allowing new firms to enter the industry.
• According to economic theory, a single firm operating in a market invites entry by a competitor if it is inefficient, charges too high a price, or fails to provide the price/service options consumers want. While entry of a competitor forces the existing firm to become efficient and more responsive to consumer preferences in order to survive, economic theory holds potential competition-- the realistic possibility of entry by a competitor-- may be sufficient to produce performance similar to competing firms.
• The report of the Civil Aeronautics Board special staff on regulatory reform concluded the most detrimental effect of regulatory protection on airline industry performance was probably limiting potential competition.
• Deregulation spurred airline competition by increasing their ability to alter route structures, service offerings and fares to attain the maximum competitive advantage. (true today through domestic code-sharing and alliance formation)
• Economic theory suggested the ability of lower cost firms to enter markets and compete on the basis of price would create downward pressure on fares.

The GAO concluded, “Trends in fares and service quality are generally consistent with predictions of deregulation's effects. It appears that increased competition generally restrained fare increases so that fares are now more closely related to costs and are probably lower on average than they would have been if the regulatory policies in effect from 1974 to 1977 had continued. Service generally improved, a result that not all analysts anticipated, with increased departures and seats and more markets receiving through-plane service by scheduled airlines. It is possible that analysts generally underestimated how much air travel would increase in response to lower fare/lower service options. As expected, smaller airlines using smaller aircraft replaced major airlines in some of the smaller, short-distance markets. Convenience improved as more passengers were able to complete a trip without changing airlines. Load factors, expected to increase, have varied, generally staying above pre- deregulation levels but varying too much from year to year to identify a long-term trend.”

The GAO reported in 1985 in the six years following deregulation, the airline industry recorded the worst financial performance in its 45-year history.  High operating losses raised questions about the industry's future performance under deregulation, but analysts had expected some airlines to have financial problems during the transition from regulation. “Airlines that cannot fully adjust to deregulation will continue to have financial problems; more may go bankrupt. Yet, in the long run, airlines that can reduce costs to match fares of lower cost competitors and find new profit opportunities in meeting unfulfilled passenger preferences will survive. In this way, the industry will become more efficient as those less able to meet the challenges of a deregulated environment go out of business.”

The GAO reported financial performance varied widely, suggesting airlines can be profitable in a competitive market.  “Analysts warn that the transition is not yet complete. During this period of adjustment, airlines that cannot adjust to the more competitive environment may be forced to reorganize or go out of business. Once the industry has fully adjusted to deregulation, it should be profitable over time, although some airlines may occasionally suffer losses and even leave the industry.”

Economists and other analysts expected deregulation would increase efficiency in several ways: (1) new, lower cost airlines would enter markets, reducing average industry cost levels (2) airlines would alter their route structures and aircraft mix, seeking to lower per-passenger costs (3) the ease of entry and increase in fare competition would keep pressure on all airlines to keep costs down. In an unregulated and unprotected environment, bankruptcies would occur when less efficient airlines were unable to adapt to the more competitive environment. By giving airlines freedom to profit or fail, competition would help assure only the most efficient airlines survived.

The GAO concluded “changes in fares, service, and profit are consistent with economists' and other analysts' expectations of the effects of increased competition on a formerly regulated industry.”

Perplexed

In your statement, Congressman Oberstar, you say “This action [DOJ approving the United – Continental merger] points strongly to the need to give broader authority over such mergers to the Department of Transportation, allowing DOT to consider such factors as the impact a merger will have on service to communities and customers, as well as the effect the merger could have on the industry as a whole. There must be consideration of whether a merger will inevitably trigger others, ultimately reducing the industry to a few large carriers, each of which is unwilling to compete seriously in markets dominated by one of the others.”

Like you, I agree the Department of Transportation should have broader authority over such mergers because they understand the industry. The Department of Transportation had the wisdom to approve the immunized alliances all the while recognizing the benefits conferred on customers and communities of all sizes.  Whether mergers spur others will always be speculation.  Just like the economic theory surrounding deregulation, which I assume you relied upon to ultimately vote in favor of deregulating the industry, a single carrier operating in a market invites competition. The same is true today. 

To say large carriers are unwilling to compete with one another is simply not true.  Look at some of the recent markets the U.S.’s largest domestic carrier, Southwest Airlines, has entered:  Washington Dulles - a United hub; Denver - a United hub; San Francisco - a United hub; Minneapolis/St Paul - a Delta hub; Milwaukee - a Midwest/Republic hub; New York Laguardia and Newark – a Continental hub. These large markets are homes to all major carriers.

You said “when Congress deregulated the airlines in 1978, we were promised better service, added competition, and more choices for consumers. With the United-Continental merger, our domestic carrier fleet will have shrunk to four network carriers. Moreover, each merger appears to trigger another, as carriers feel the need to get bigger in order to compete with the newly merged airlines. American merged with TWA, then America West merged with US Airways [I ask, would either carrier be here today if they had not merged?], followed by Delta absorbing Northwest, and now United merging with Continental. Can a US Airways-American Airlines merger be far behind?”

Congressman, just look at some of the choices enjoyed by consumers.  They are plentiful and choice continues to be built into the consumer’s decision to buy or not to buy.  One can even argue the consumer is more empowered today than at any time over the past 32 years.  There is a choice to fly on a full-service airline or a low cost, no frills airline; there are choices when ticketing like paying more for a better seat; there is a choice to fly on an airline that charges for bags or one that does not. Under the bilateral regime, airline choices were limited by the number of destinations and frequencies allocated to respective carriers. Today that is not true, and today, alliances give consumers the option of garnering frequent flyer miles and benefits for their entire trip, not just portions of a trip. I could go on but the promise of more choices for consumers in the ADA is alive and thriving.

There are many issues that are considered when thinking about a merger partner in addition to the structure of the market.  But I take you back to the analysis performed that points to the fact that the industry is less concentrated today among the largest airlines than it was in 1979.  Throughout the deregulated period, there have been mergers, there have been failures, there has been opportunistic growth by various sectors of the industry, and there have been significant cuts in capacity in response to the price of oil and the strength of the economy.  In every instance the industry has adapted to change in one way or another, but no fix concentrated the industry more heavily.

Concluding Thoughts and An Ask of You

Congressman Oberstar said, “airline consolidation brings consumers and communities fewer choices and less competition, usually leading to increased fares and reduced levels of service. And that runs directly counter to the promise of deregulation” is confounding.  Confounding in that the opposite is happening today.  Confounding because the Airline Deregulation Act you supported is playing out in the manner in which it was envisioned based on the economic analysis performed by the GAO.  To re-regulate will only make the industry even smaller following the cutbacks since 2002 employing still fewer people all the while disenfranchising small communities from the airline map.  Consolidation activity was prevalent before deregulation as six of the 16 trunk airlines were gone by the time the ADA was passed.  Consolidation at home should not be feared nor should alliance formation.  Each action is about adapting to a new environment and that is precisely what the industry is doing.

When the ADA was passed, trunk airlines were predominantly domestic airlines.  During the past seven years each of the network carriers except one has nearly 50% of their capacity exposed to international markets.  The domestic systems the network carriers operate are most important extensions of their international operations.  These extensions have a domestic benefit to customers as well.  Airlines are consolidating at home in order to prepare to compete globally unlike the consolidation period in the mid-1980s which was domestically focused.  Today’s industry is less about getting to Duluth from Dubuque and more about getting to Duluth from Dubai. That’s the world today, one deregulation helped open up to all of us.

Congressman Oberstar, in your statements surrounding the approval of the most recent two mergers you have not provided a single shred of evidence contradicting the GAO study that dutifully outlined the foundational facts and analysis upon which you cast your vote in 1978.  It would seem that you are basing your comments largely on perception and even making some statements – like US Air merging with AA - that are specious at best.

Congressman Oberstar I have one ask of you.  Reconsider your position on mergers and consolidation.  The United States was once the absolute leader in aviation. That cannot be said today.  We need carriers that have the financial wherewithal to raise the (our) flag in every world region.  The solution you seek in your message will only further marginalize U.S. commercial aviation in a global context. 

Time to Rethink the Virtuous Circle

You know how it goes in the U.S. airline industry: improved economic conditions lead to increased demand for air travel which leads airlines to grow and increase employment.  And so the virtuous circle goes – ‘round and ‘round.  At various times in an economic cycle certain stakeholders tend to do better than others – usually at other stakeholders’ expense.  Front and center in the airline industry rent sharing game are labor and management.

Dan Reed, writing in the USA Today this week, reminded us of the numerous labor and management conflicts out there.  That much is true. But it was the subtitle that gave me pause:  “Unions want pay, benefits restored,” it said.  Not improved – restored.  Nice dream, but it’s just that: The restoration of wages and benefits to 2001 levels is a dream.  Reed quotes long-time industry observer Mike Boyd saying labor has to walk away with something.  Boyd says: “Labor has been on hold for the last seven years.”

Boyd is absolutely right.  Labor has to walk away with something – and they will.  However the airline industry is no position to write the check that would restore wages and benefits to pre-restructuring levels.  Furthermore, the shape and size of the industry today requires that certain work provisions contained in collective bargaining agreements need to be changed in return for improved wages, benefits and working conditions.  This necessary trade gets lost in the mainstream discussion.

Industry Eyes on American

This past week, three of the employee groups represented by the Transport Workers Union (TWU) at American voted on tentative agreements reached months ago.  Two of the three groups rejected the terms and conditions bargained for in those tentative agreements.  Initial rumblings cite provisions contained in the tentative agreements deemed “concessionary.”  Yes in “non-crisis” collective bargaining you trade one thing for another.

I, however, can make a case that the agreements reached were too rich in favor of the TWU.  American resides in a most fragile position in this round of negotiations because its labor costs already are the highest in the industry, even as it goes first among the legacy carriers to negotiate new contracts following restructuring..  The TWU members walked away from structural pay increases, leaving money on the table many in the investment community might have argued against offering in American’s financial position. And I’m among those critics. And while the company would have got increased productivity in certain areas of the contract in return, any savings generated from work rule relaxation is only as good as it’s ability to implement change.

One group that rejected the tentative agreement was the Mechanics and Related employees – a group that has worked closely with the company over the past decade to improve operations and attract third-party work. In part because of those efforts, AA outsources less maintenance work than any legacy carrier. 

Now look ahead.  Can American ignore that most of their competition is paying far less similar services? And without better productivity, can American bring in enough work to justify the current headcount within the Mechanics and Related group?

Just as with the pilots union at American, maybe some in Maintenance really believe that the company can pay labor costs that far exceed the company’s ability to pay.  Everyone points to the industry’s single quarter of terrific profits and suggest – somehow – that a secular trend is underway.  Has anybody been paying attention to the stock market this week?  The market which serves as the barometer guaging expectations for tomorrow?   Or maybe the mechanics are just taking an old trick out of the hat that was popular in the late 1990’s and in 2000 and 2001 when everyone rejected the first agreement assuming that a return to mediation would pressure the company to enrich the agreement, too often without any expectation of giveback.

If that is what happens this time around at American or at any airline for that matter, then the management team making those agreements have no one to fault but themselves.  Overpaying rent has been tried in the past and while it may help mollify labor for the short-term, it does nothing to promote the long-term sustainability of the agreement. Labor, too, is complicit in this short-sightedness, primarily because unions are not structured to manage the responsibility they possess. Unions are highly simple political organizations that too often have only have a short-term view, with leaders looking only to the next contract negotiation and the next leadership election.  

In his 2010 State of the Air Transport Industry speech, IATA Director General Giovanni Bisignani said, “Labor, out of touch with reality, is the next risk. We cannot pay salary increases with our $47 billion in losses. Pilots and crew must come down to earth and strikes at this time are shortsighted nonsense. Labor needs to stop picketing and cooperate.”

Concluding Thoughts

I am not naïve enough to suggest cooperation is a possibility everywhere.  It is not.  For both labor and management it will be tough to manage expectations set by those with short-term mindsets.  And those expectations collide with the need to manage for the long term.

Yesterday’s virtuous circle was largely predicated on plentiful and dumb capital willing to chase failing companies, jet fuel that was roughly one-third the cost it is today, and a general view that the only way a commodity industry could increase revenue was to add capacity.

In the U.S., we should be modeling a better path. Today’s virtuous circle in the U.S. is less about growth and more about making the kind of change and creating a model that will maintain and marginally enhance an airline’s ability to compete globally.

Market Realignment: Labor, Mexico and the U.S. Regionals

Variable Compensation and “Upside Protections”

A commenter on my most recent post wrote:  “Variable compensation?? That implies that you think I trust airline executives to treat me fairly. Their behavior over the past decades clearly shows that they can't be trusted, and you want me to buy-off on a scheme where they CONTROL the data?”

Another commenter wrote quoting AMR CEO Gerard Arpey:  "And again, our hypothesis is that we’re going to continue to work in good faith, cut responsible agreements with our unions and that all of the network carriers in the next 24 months are going to go through the same funnel. And that when we all come out of that funnel, ultimately the market is going to be brought to bear on all of these companies and the market will determine wages and benefits in this industry just like it largely does other industries."

Just what is a responsible agreement? For one, a responsible agreement benefits both sides. It is one unlike those negotiated in the past where companies were forced to ask for concessions in a downturn because they cannot afford the terms of what had been agreed to previously. And for labor, it is one that is sustainable – one that won’t require concessionary bargaining in a downturn and provides protection on the upside to prevent companies from earning outsized profits on labor’s back. 

This is the area where unions have missed the boat in the past.  Too often, labor leaders spend too much time negotiating protections on the downside and ignore similar protections on the upside.  Think back to the period when this was most relevant - between 1995 and 2000 when the U.S. airline industry earned record profits.  Unions had just completed ratified concessionary agreements negotiated during the economic downturn begun in 1991.  As the industry’s fortunes turned, employees did not share in the most profitable period in U.S. airline history.  Rather employees sat and watched because their unions did not negotiate protections on the upside that would have ensured their sharing in the profits – some of which were made possible from lower labor costs.

The industry has been anything but profitable in the years since, so upside protections would have returned little if anything following the negotiations during restructuring.  Instead many employees got performance bonuses when their companies met stated operational goals.  But let’s suppose the U.S. industry now sits on the brink of a profit cycle.  If upside protections had been negotiated then, employees would share in the profits while new collective bargaining agreements are under negotiation. That would send a far stronger signal about the connection between productivity, competitive costs and profitability than has the long and painful cycle of give-some, take-some negotiations.

Can we expect realignment in labor during this round of airline negotiations?   And what will that mean for labor rates by the time every airline makes it through the funnel of negotiations? 

One thing is clear: carriers with relatively expensive labor rates today will need to adjust expectations at a time that industry economics, particularly domestic market economics, do not support outsized increases in flying rates, mechanic rates or most assuredly “below the wing” rates.

Mexicana

Two days ago, Mexico’s largest carrier filed for bankruptcy protection in the U.S. and insolvency proceedings at home.  Precipitating the filing, according to the carrier, was its inability to achieve significant wage and productivity concessions from its flight crews.  When negotiations did not produce the company's desired outcome, the employees were offered the keys to the company for one peso.  The employees said no thank you.  Like bankruptcy filings here in the U.S., the burden of proof will be on the company to make a case that deep concessions are necessary.

Like the U.S., the Mexican market is deregulated.  Like the U.S., low cost carriers (LCCs) fly in major markets throughout Mexico, driving down prices all the while the Mexican economy has suffered more than most around the world.  In fact, Mexicana holds two low cost carriers in its fold (neither of which will be affected by the bankruptcy filing of the larger legacy carrier).  Mexico is a microcosm of what occurred in the U.S. where LCCs grew at the expense of the network legacy carriers, driving prices down because they enjoyed cost advantages.  And like in the U.S., the Mexico domestic market does not produce sufficient revenue premiums for the legacy incumbents to offset their high and out-of-market cost structures.

Might Mexicana’s bankruptcy filing result in liquidation?  It could.  Already planes have been repossessed in anticipation of the filing.  Sounds like the U.S. industry immediately after deregulation but before Section 1110 protections became part of the bankruptcy code.  Today, unions in the U.S. are calling for changes to the bankruptcy code (Sections 1113 and 1114 specifically).  Ever wonder just how many U.S. airline jobs might have been lost if there were no Section 1110 protections?  I digress.

The Mexicana story causes me to reflect on the U.S. domestic market.  The realignment of the U.S. domestic industry is not done.  Mainline carrier presence in the domestic market will continue to shrink unless the labor economics change.  Network carrier presence in the domestic market is now more a function of moving a passenger from Lansing to Lagos than it is Lansing to Los Angeles. 

Since 2000, network carrier revenues are down 36 percent.  Since 2000, when mainline network carrier domestic Available Seat Miles (ASMs) reached their historic apex, capacity flown by the same carriers has been reduced by 30 percent.  Over the same period, domestic ASMs added by the U.S. LCCs increased by 134 percent.  ASMs flown by the regional sector have increased by 178 percent.

These trends are a function of the economics of flying today.  Labor contracts in the past were based on $30 “in the wing” jet fuel.  Today’s reality is $90.  With domestic revenue generated by the network carriers down more than capacity since 2000, it is uncertain what kind of contracts will come out of that funnel, and whether the U.S. airline industry as we know it today we be able to sustain higher costs.

SkyWest Subsidiary Atlantic Southeast Airlines to Purchase ExpressJet

Another story occurring within the industry that has labor ramifications is the consolidation taking place within the regional industry. One of the catalysts for consolidation within the regional sector is the unknown outcomes of scope negotiations between the mainline carriers and their managements as to what kind of flying will be done by the regional providers tomorrow.  Another catalyst is the known, but yet undetermined, push for new regulations governing how much regional pilots can fly.   

Readers at Swelblog.com know that we have been talking about consolidation and realignment of the regional industry since the beginning.  Does a consolidating network carrier sector need nine providers of regional capacity?  No.  

Given that new, expensive changes to regulations governing regional carriers and their relationships with mainline are expected this year, the network carriers would be wise to look carefully at their regional feed composition. With the merger of Continental and United and new regulation pending, it simply makes sense to realign regional relationships.  United is one of SkyWest’s two major partners and it does business with each Atlantic Southeast and ExpressJet (who is Continental’s primary regional partner).

The SkyWest/Atlantic Southeast announcement comes on the heels of Pinnacle buying Mesaba and expanding its presence under the Delta umbrella.  These types of realignments are now a trend and not one-off and ill conceived acquisitions.  Just like network carriers need scale economics, so do the regional partners in order to minimize labor and maintenance costs regardless of what type of flying they are permitted to perform tomorrow. 

This is healthy consolidation and the idea of scale economics may be what just makes American Eagle attractive.

More to come. 

Time to Sustain to Avoid the Inevitable Pain

Webster’s defines sustainability as:  “of, relating to, or being a method of harvesting or using a resource so that the resource is not depleted or permanently damaged.”  I am not talking agriculture; I am talking about the airline industry’s financial performance.  Why?  Eight of the nine largest US airlines have reported earnings for the second quarter (only Southwest remains).  Thus far the industry has reported $2.8 billion in operating income and $1.9 billion in pre-tax income.

The margins (respective profit as a percent of revenue) are impressive.  The industry’s operating margin of 9.9 percent and the pre-tax margin of 6.5 percent compare to 2000’s margins of 5.7 percent and 4.7 percent respectively.  I compare to 2000 as that was the last profitable year of the last up cycle prior to the restructuring decade of 2001 – 2010.  In past times margins like this would provide the industry comfort – whether to negotiate fat labor contracts, continue to deploy regional jets or even to place a sizeable aircraft order.  But all that achieved was to begin the process of depleting the key resource, in this case airline earnings, that is critical to the overall sustainability of the industry.  

These second quarter earnings are one sign that the difficult restructuring work done over the last decade can and have produced a desired result. Much can also be attributed to a robust revenue environment.  Passenger revenue for the first half of 2010 is a healthy 14 percent greater than in 2009.  But 2010 first half revenues are 10 percent less than the same period in 2008, albeit on 9 percent less capacity.

The second quarter will mark the first time since the third quarter of 2000 when the entire industry will be profitable on an operating basis.  What followed – indeed what began in the second half of 2000  --was significant unit revenue deterioration spurred by low cost carriers and internet pricing that together changed the ticket prices network carriers could command.

Now we must change the focus, away from operating earnings as was common in the past, to pre-tax earnings which matter more for the future.  Why?  Mostly because of the interest on debt that remains outstanding.  Today the eight largest carriers have more than $47 billion dollars in long-term debt and capitalized leases on their balance sheets.  That is nearly $20 billion more than the same carriers held in 2000.  Whereas the industry borrowed nearly $20 billion over the past decade, the same group of eight carriers holds nearly $12 billion more in cash today than they did in 2000.

Cash balances for the industry are at the comfortable level of 20 percent of revenue – the new norm following the events of 9/11.  Given that debt has swelled, there is balance sheet repair to be done.  2010 promises to be a year when the industry produces reasonable levels of free cash flow.  But before the carriers purchase new airplanes or increase capacity or agree to rich new labor contracts, I hope that they reinvest in themselves by repairing their respective balance sheets.  This way there is sufficient collateral to borrow against when the inevitable next downturn takes place versus the mad scramble to find sufficient collateral – as we saw in 2008 -- to prop up liquidity and live to see another day.  Even when the loans were arguably over collateralized in 2008, the costs of borrowing were high by historic standards.  Thus credit worthiness must also be repaired.

There is much talk from IATA, ATA and others about the need to create a sustainable industry.  Increasing debt while cash balances are not keeping pace is not the way.  It can be a short-term strategy, even a necessity to stay alive, but it is not the way to build a resource that so many depend on for their livelihoods.

Speaking of Labor

What is nice to see in the second quarter earnings reports are discussion about earnings before profit sharing.  Imagine having a first dollar profit sharing plan in place as the industry recovers from a troubled decade.  There is a fundamental financial concept called Net Present Value (NPV).  The calculation applies a discount rate to a stream of cash flows in order to define today’s value of future benefits. 

Variable earnings are increasingly being offered and negotiated as part of closed collective bargaining agreements.  If one believes that the industry is at the commencement of a long and “sustained” profit cycle, then as a union leader I would want to move and close my negotiations.  There is an immediate benefit in receiving dollar one sooner rather than later.  The NPV of a stream of income beginning today is often of greater benefit to the recipient than holding out for some contractual increase three years from now.

I understand that labor values variable earning less than a fixed increase to an hourly rate.  But some adjustment to the hourly rate plus the opportunity to participate in a first dollar profit sharing plan could prove quite interesting if this indeed the beginning of an economic up cycle for the industry.  But we know that this recovery is a jobless one and that the full impacts of housing and commercial real estate are yet to be felt.  Nonetheless, the difficult decisions for labor to grant concessions early in the decade and the wrenching decision for management to aggressively cut capacity in 2008 are pieces of the puzzle that are contributing to profits thus far in 2010.

Concluding Thoughts

Past managements have ultimately caved to stakeholder interests – those other than shareholder interests, that is -- during profit cycles.  I abhor any talk of significant capacity increases at this point in the cycle. The industry has come too far to begin a renewed growth spurt particularly in the domestic market. Thus far capacity discipline has been has been the rule, with the exception of Delta later in 2010 and jetBlue.  [This morning I sold my jetBlue stock]. 

So the next hill to climb is balance sheet repair.  It is time to educate employees on the importance of a healthy balance sheet and why it is in employees’ interest to cut debt rather than pay higher and ultimately unsustainable wage rates.  Improving employee relations in the airline industry will be much easier if carriers aren’t in the position of requesting concessions during the inevitable next down cycle.  Wouldn’t it be healthier to see employees share in the up cycle and keep what they have in a down cycle? Now that sounds more like a sustainable plan than any other plan we’ve seen over the past 30 years. 

And the NPV would undoubtedly be higher.

Ramblings on Meddling and the “Public Good”

The U.S. airline industry has been on a bit of a losing streak in Washington D.C. of late.  Between the tarmac rule, increased compensation for over booking, a new push to have a total cost of trip (fare and fees) made known to the purchaser, the expectation of new and costly rules governing regional carriers, the National Mediation Board, the rejection of the slot swaps between US Airways and Delta and the loss on appeal of the right of airports to implement congestion pricing, 2010 has not gotten off to a good legislative or regulatory start.

The past two weekends, The Philadelphia Inquirer’s Tom Belden has posed serious questions in his “Winging It” column about what is going on in Washington regarding airlines and the airline industry.  While I don’t agree with the conclusions drawn by either of the columns on government interference or the perceived need of more government regulation, one point Belden makes is hard to shake. The airlines brought some of this on themselves.

Yep, between poor handling of several tarmac delays and not “selling” the idea of economic pressures forcing charges for things customers previously got for free, the industry finds itself on the wrong side of the whip.  The industry has substantial issues, but never effectively sold them to the public or Congress. Airlines didn’t come off as poorly as automakers in D.C.’s chambers, but they still reeked of big, bad company. Now, whether those issues are perceived or real, the industry helped to put its own self under the regulatory and legislative microscope.

Belden quotes US Airways' senior vice president C.A. Howlett as saying there is "a feeling in Washington now" that the airlines are more of "a public good than a private industry."  Belden responds, “Most regulation of airlines is in place because the public demanded it in response to the industry's bad behavior. The tough airfield-delay rules are the most glaring example. And if the airlines, like all forms of transportation, aren't operated for the "public good," then what good are they?”

Can commercial entities accountable to their shareholders also operate as a public good?  If so, then all aspects of the public good provided need be considered in any final analysis.

What is “Public Good”?

Randall G. Holcombe, writing for the Review of Austrian Economics, defines public good as “according to economic theory, is a good that, once produced, can be consumed by an additional consumer at no additional cost.  A second characteristic is sometimes added, specifying that consumers cannot be excluded from consuming the public good once it is produced. Goods with these characteristics will be under produced in the private sector, or may not be produced at all, following the conventional wisdom, so economic efficiency requires that the government force people to contribute to the production of public goods, and then allow all citizens to consume them.”

Holcombe continues,  “Simple observation of the real world suggests two problems with the application of public goods theory as a justification for government production. First, many public goods are successfully produced in the private sector, so government production is not necessary. Second, many of the goods government actually does produce do not correspond to the economist's definition of public goods, so the theory does a poor job of explaining the government's actual role in the economy.”

The airline industry does not fit the pure economic definition of a public good.

The Air Service “Public Good”

Belden talks about how airports have largely been built with public monies in order to support economic development.  Then he asks THE question, “But if a city-owned airport builds a new terminal to accommodate airlines, and the carriers later abandon the city because they're not making enough money, guess who's stuck paying the mortgage?”

These are the very economic decisions airlines have to make each and every day.  Should I put a $40 million airplane into market X and a $15 million airplane into market Y? Or vice versa?  Market X and Y are each deriving some economic impact as a result of the service, yet the airline might only break even on the route.  Who pays the mortgage on $60 billion in losses over the past decade?  Not federal, local or state governments. Shareholders, creditors, vendors and labor do. 

Pulitzer Prize winner Daniel Yergen wrote, "Every day, the airline industry propels the economic takeoff of our nation.  It is the great enabler, knitting together all corners of the country, facilitating the movement of people and goods that is the backbone of economic growth. It also firmly embeds us in that awesome process of globalization that is defining the 21st century."  In Washington, this simple and fundamental fact is forgotten in the offices of the political decision makers.

Are the airlines themselves enablers? Or facilitators?  Yergen is right in suggesting a combination of inputs is necessary to create the commercial aviation industry. Each and every day the airline industry is producing a “public good” for all dots on the airline map.

If all politics are local, and local economies depend on airline service, then shouldn’t politicians in local markets explore ways to “buy” the air service they believe is necessary to support the regional economy while also satisfying the expectations of their constituencies on the price of that air service?

Politicians and community leaders boast about the economic benefits of air service and those facing air service reductions are the first to cry foul based on their estimates of sunk economic costs. If politicians and the communities they represent can’t abide higher fares, fees and reductions in service, then the answer should be a simple matter of economics. Have the community pay the difference between the ticket revenue and the cost of maintaining the air service, plus some reasonable profit for the airline to reinvest in its business.

Communities fund sports stadiums to attract teams and tax breaks for large companies to entice them to their area -- all in the name of economic impact. Why shouldn't air service be the same?

Economic activity stemming from commercial aviation service is calculated every day, so it should be a simple investment decision for communities. There is a price to pay for being a node on the global trading map and what type of service best meets the need of a community. But it is not the responsibility of airlines to ensure a dot remains on the map.

Death by a Thousand Paper Cuts

Just how much regulatory oversight, except for safety and security, is necessary?  Low and lower fares are the cry from the legislators, the regulators and consumers.  Each and every day, the airline industry delivers.  But it seems that the industry faces one new regulation after another.  Many of the regulations are presented in the name of consumer protections.  Regulation increases costs.  Yes, there are instances when regulation is necessary - - like preventing bias in computer reservations systems.  Yes, regulation is necessary surrounding the backlash from the Colgan accident – but then again safety should be regulated. 

There is a hue and cry from many governments regarding the explosive growth of the carriers in Gulf region.  While critics claim Emirates, Ethiad and Qatar are state subsidized, the fact remains government leaders of the Gulf States understand full well the importance of commercial aviation to each of their respective economies.  They understand that meddling with commercial decisions is best left to the airlines and that taxation of airlines does not facilitate economic growth.  Economic growth is facilitated by a healthy and prosperous airline industry.

In the U.S., communities of all sizes enjoy the 10.9 million jobs and 1.2 trillion (with a T) dollars in economic impact generated by money-losing U.S. airlines.   Just like the housing bubble, one could say there is an airport bubble.  Yet 450+ airports get served each and every day within the contiguous 48 states

Ask an airport manager how much economic impact is produced by their airport and I guarantee they’ll know the answer.  But who brought the passenger to the community to spend?  Which stakeholder helped create the competitive environment that stimulated demand that uses the airport?  Just how much of that impact ties directly to the airline service received?

The airline industry does not fit the economist definition of a "public good".  But they do bring a lot of good to publics of all sizes.  More taxes, fees and regulation will only ensure that communities will suffer a death by a thousand paper cuts because increased airline costs has to eventually mean fewer airports served.  Political decision makers should take that into account and consider all sides of the airline industry story before increasing its costs in “the public good.”

THE UNITED ARAB EMIRATES: UNDERSCORING THAT THE MARKETPLACE IS NOW ABOUT GLOBAL FLOWS

Over the past month, there have been a number of stories written on the growth of Dubai-based Emirates Airlines.  In reality, it is not just Emirates, but rather the combined United Arab Emirates (UAE) entities of Emirates in Dubai and Ethiad Airways in Abu Dhabi along with Qatar in Doha that present one of the next real competitive challenges for airlines (particularly in Europe) and each of three global alliances.  By 2020 the airports housing the three airlines are expected to handle nearly 200 million passengers.  To put that number in perspective, the 200 million passengers are more than what established world markets like London Heathrow, Paris Charles deGaulle and Frankfurt handle today.

Much of the noise and the news surrounding Emirates’ growth plans came last month at the Berlin Air Show where the carrier ordered an additional 32 A380 aircraft.  That’s in addition to the 48 Airbus 380’s; 70 Airbus 350’s; 18 Boeing 777’s; and 7 Boeing freighters the airline already has on order.

Where Is the Traffic Going to Come From?

Dubai and its counterparts in Doha and Abu Dhabi do not enjoy large local traffic bases.  Rather, the emerging operating model is designed to take full advantage of a geographic position of strength and serve as mega-connector airports.  The model is used on a smaller scale by Singapore Airlines and KLM at Amsterdam where local traffic levels are undersized when compared to Tokyo, London and Paris.  In addition, the Dubai government is solidly pro-aviation (a lesson that could be learned or at least appreciated by U.S. lawmakers).

According to The Economist:  “these pro-aviation policies stem from a conviction that aviation could act as a spur to Dubai’s economy, by facilitating trade, financial services and tourism.  At Sheikh Ahmed’s prompting, the government has implemented a highly liberal open skies policy encouraging other countries to open routes to Dubai and allowing Emirates to build its network.  It has streamlined immigration and visa policies, making it easier for people to pass through or stay.  It has made sure that airport and air traffic control capacity has kept ahead of demand.”  The Economist goes on:  “The government’s approach is to say, ‘whatever you do, don’t restrain aviation in any way’”.

Not all governments around the world are interested enough to open their markets to the same degree.  Canada and South Korea have already said no to more landing slots for Emirates.  The carrier is involved in a dispute with the Germans over fare setting as the Gulf carriers seek to undercut prices by legacy network carriers in the European Union (EU).   And the French are said to be limiting access to Paris and secondary cities like Lyon. 

For U.S. readers, remember the fear of Singapore Airlines gaining extraordinary route opportunities from the U.S. at the time in return for open skies?  It never came to fruition.  Yet the Europeans seem to be protecting their airlines from lower cost competition emerging in the Gulf.   Here in the U.S., we don’t have a lot of room to criticize as we can’t agree to lift the ownership and control limit or allow cabotage for political reasons.  U.S. carriers, though, have faced similar competition from the growth of low cost carriers and there just might be some lessons to be learned.

Lessons in the U.S.?

There is no marketplace more keenly aware of competition than North America generally and the United States specifically.  The aviation network evolved from linear systems; to hubs and spokes with a focus on building regional dominance;  to connecting regional hubs in order to create national networks; and then to establishing a connection between U.S. gateways with a gateway of an alliance partner.  Each of these evolutionary steps led to increased traffic through the stimulation of local and connecting traffic. 

As hubs began to compete with hubs, the U.S. domestic market delivered outstanding bargains to the consumer through low - and then lower - fares.  Much of this hub-to-hub competition stemmed from the aggressive use of regional jets that expanded the reach of individual hubs from 400 miles to more than 1200 miles.  As the regional jet was intensifying hub competition, the growth of the low cost carrier segment began in earnest in the mid-1990s.  Fares were disciplined in markets of all sizes as low cost carriers grew rapidly and regional jets expanded the scope of hubs competing with hubs. 

“An Investment in the World”

What we have in the United Arab Emirates is a combination of the use of technology (Airbus 380) with low costs and government policies designed to promote aviation to compete with Europe’s (and U.S.)network carriers for the same traffic.  Not all of the same traffic as North America to Europe, the largest air travel market, can be accessed by Emirates and others to the same degree that North America/Europe - Middle East, India, Southeast Asia and the Tasman markets can be.  Nonetheless, these are very important markets to Europe’s and U.S. carriers, just as they are critical to fill the large capacity equipment being flown by Emirates and its UAE brethren.

Wolfgang Mayrhuber, CEO, Lufthansa, said, “It’s a miracle that Emirates already has more intercontinental seats than Air France and British Airways combined." He added, "It took us 40 years to get 30 747s in the air in one of the biggest global economies, so one must assume that this is an investment for the world.”  The geographic position allows one-stop service to and between every world region.

The evolution of the global market does look a bit like the evolution of the U.S. market.  The real difference is the competition wrought by the United Arab Emirates carriers on the European network carriers aims to capture a share of global connecting flows whereas the U.S. low cost carriers were targeting the largest domestic traffic flows to build their businesses.   It emphasizes just how fast the borders and the airline models are blurring. 

Yes, we still have an outdated bilateral regime present as Emirates tries to negotiate rights to fly more into France, Germany and the United Kingdom and other countries.  These too will fade away. 

Pro-aviation policies that embrace the airline industry’s role as an economic facilitator cannot be overemphasized and should serve as a lesson to all governments that want to tax their respective carriers into oblivion.  In order to compete with this new world order, cutting costs and reduced taxes will have to remain the mantra for the network airlines in Europe and North America.  Those who say that the three alliances do not provide sufficient competition need look no further than Dubai, Abu Dhabi and Doha.

Some will say that the growth of Emirates, Ethiad and Qatar will only impact the EU carriers largely dependent connecting traffic.  But there will be a downline impact on U.S. carriers as well given the interdependencies of the global alliances and the flows created by the combined networks.  But also think about the U.S. east coast traffic flows to Southeast Asia and Australia and New Zealand and even India.  Might traffic that once connected across a west coast U.S. gateway instead choose to use a UAE gateway?  Technology (aircraft range) and cost (low labor and a government aversion to aviation taxation) are at work in attempting to redraw the airline map as we know it.

There has been competition and innovation at every corner of the industry's evolution.  This fact will remain.

More to come.

Buried Alive: Signed Tentative at American Declared Dead

As Gilda Radner on the old “Saturday Night Live” might say, “It’s always something.”

Less than a month ago, the Transport Workers Union (TWU) representing the Fleet Service Group at American Airlines (baggage handlers, freight service workers, aircraft fuelers/de-icers and aircraft cleaners) said it was “suspending” a tentative agreement (T/A)  reached with the company after more than two years of discussion.  Yesterday, after a meeting between American, TWU and the National Mediation Board (NMB), the union pronounced the agreement dead and asked the NMB to release the 11,000 workers in the group into a 30-day cooling off period.

But it’s been a twisting road to this point. When the TWU first announced the agreement, the union said it was strong armed into signing a T/A by NMB member Harry Hoglander.  In a May 28 press release, the TWU said:  “Although the committee cannot recommend the T/A, we believe the membership should have the final say. The decision to bring the T/A was made based on the NMB's premise that there would not be any other meetings scheduled until the end of year or possibly later.” 

The union then went on to say:  “The committee also took into serious consideration that the NMB would not look favorably upon the negotiating committee not allowing the membership to vote on the Company’s final offer.”

By June 3, 2010 the TWU bargaining team had decided to send the agreement to the membership with a “no” recommendation. President Jim Little then jumped in and said that the union would not send the agreement out for a vote without a recommendation to ratify the agreement.  At this point, the union “suspended” ratification of the agreement citing “unresolved Issues.”  

Yesterday the TWU used the same phrase, claiming that ”unresolved issues” with the agreement have created an “impasse” – a legal term under the Railway Labor Act to signal that the sides can’t reach agreement. The release quoted TWU International Administrative Vice President John Conley: “We are now at an impasse with AMR,” Conley said. “We no longer have a tentative agreement and no ballots will be presented to members for a ratification vote. We urge the NMB to promptly grant us release so that we can begin the self-help process.”

My Simple Question

So what exactly changed in the last month? By my read of it, nothing. It appears to me that the NMB won’t likely schedule any new mediated negotiations until 2011. 

But there is no evidence that the two sides are at an impasse.  Rather they are immersed in a political quagmire in which one side cannot convince its members that there must be some “give” in the agreement to make possible the “gets” the union wants in terms of wage increases and other contract enhancements. An impasse is declared only when the two sides cannot agree after exhausting the mediation process.

In this case the sides agreed to the economics – that was the basis of the tentative agreement that, if ratified by TWU members, would result in a new collective bargaining agreement.

A Conundrum in This Case

Let’s be clear: the company’s proposal would put more money in the pockets of fleet service workers. Now they will be forced to wait until negotiations are scheduled to reconvene yet again.  I do appreciate that there was a perception of layoffs associated with the agreement.  That is simply not the case – rather AA agreed that no TWU employee would be furloughed as a result of the company’s efforts to be more competitive, much the same guarantee AA has made in negotiations with other workgroups.

The conundrum is twofold.  First, the concessionary negotiations concluded during the restructuring round has resulted in a "mark to market" scenario that is no longer uniform among employee groups.  Remember that the bankrupt carriers took multiple "bites at the apple" by first reducing cash compensation; then achieving productivity gains that reduced headcount; and then reducing pension and health and welfare expenses.  American’s 2003 concessions were based mostly on that first bite, which means American’s labor costs remain higher than those airlines that restructured through bankruptcy - and it is different by work group.

Second, current negotiations are complicated by the increased use of outsourcing throughout the airline industry, which serves to fundamentally alter the comparisons of similar work from one airline to another.  This fact is most prevalent in “below the wing” work that most other airlines now outsource at significantly lower wages.

Today’s market for fleet service employees is not the fault of the Transport Workers Union per se.  But the union does have a responsibility to read the marketplace and negotiate an agreement that takes into account the economic realities out there. This is no impasse.  Rather it is a union’s misguided act in taking a live proposal that includes improved economics for its members and burying it alive.  Once again, the line workers see nothing in their pockets while the union lets a business agenda of maximizing headcount win the day. 

This is one tough round. 

my testimony on the continental - united merger before the house judiciary committee

Good afternoon Chairman Conyers, Ranking Member Smith and members of the committee.

My name is William Swelbar.  I am a Research Engineer with the Massachusetts Institute of Technology’s International Center for Air Transportation.  Our program is focused on the economic, financial, operational and competitive aspects of the global airline industry.  I appreciate the opportunity to speak today in support of the merger of United and Continental Airlines.  Whereas I have worked with each United and Continental in a consulting capacity in the past, I appear today as an independent expert on the U.S. and global airline industry.

Many see the global airline industry as somehow U.S.-centric.  It is not.  In aviation, the U.S. is but one piece of a big puzzle that is influenced by global economic interdependencies, just as the U.S. economic recovery could be affected by events in Greece, Portugal, Spain and Hungary.

United and Continental presented in their testimony before the Senate Committee on Commerce Science and Transportation an exhibit showing where U.S. airlines have fallen in their ranking among the globe’s largest airlines.  I am bothered by the fact that the U.S. carriers have been surpassed by Lufthansa/Swiss and Air France/KLM.  This fact is but one reason that helps to explain why United and Continental are pursuing this merger.

For the network carriers like United and Continental, this round of consolidation is as much about preparing to compete with the world’s other big carriers for international traffic as it is about competing with low cost carriers (LCCs) like Southwest, AirTran, jetBlue or Frontier in the domestic market. After all, it is the network carriers and not the low cost carriers that serve communities of all sizes. Despite the footprint established by the low fare carriers that is now national in scope, with their share of domestic traffic approaching 40 percent, it is the network carriers that connect the smallest U.S. markets to the globe’s air transportation grid.

I would like to debunk some of the myths I have heard said about the merger of United and Continental.

• OVERLAPPING ROUTES/HIGHER PRICES:  There are just 15 nonstop, overlapping routes flown by each United and Continental.  None of the 15 would be a monopoly United route after the proposed merger.  Eleven of the 15 overlapping city pairs would have at least two competitors.  Of the four routes that would have but one other nonstop competitor (Houston – Washington, Houston – Los Angeles, Houston – San Francisco and Cleveland – Denver), that other competitor is Southwest Airlines in three of the four and Frontier on the other.  In each of the four routes, the LCC competitor has at least a 25 percent share of traffic. 

In addition to a nonstop competitor, two of the routes have four other carriers providing connecting service; one has three other carriers providing connecting service; and one has two other carriers providing connecting service.  The airline industry is a network industry and connecting options for passengers must be taken into account when considering competitive impacts as they also work to discipline prices.

The U.S. market should not fear the “end to end” network consolidation like Delta – Northwest and the proposed United – Continental merger. The low cost carrier segment of the US airline industry would regale in the fact that network carriers would price well above the market as was the case in the late 1990s and early 2000s as it would serve as the catalyst for growth at the expense of the network carriers again.  The market has demonstrated time and 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. And where there is insufficient capacity, capacity will find the insufficiency.

• START OF ANOTHER BIG MERGER WAVE:  Some predicted that the Northwest-Delta merger in 2008 would be the catalyst to a big merger wave.   Two years later, we have a second merger announcement.  That hardly seems to be a wave.  Nonetheless, each merger case should be considered on its own merits, not based upon what someone speculates might happen.  Moreover, the concerns are most relevant in highly concentrated industries.  The U.S. domestic airline industry will remain fragmented should the proposed merger be approved as seven airlines will have at least a 5 percent market share. 

When thinking about airlines in a global context, no one airline has a 5 percent share of the global market.  The top 10 firms producing mobile handsets comprise 85 percent of their industry; the top 10 automotive manufacturers make up 76 percent of their industry; and the top 10 container shipping firms equal 63 percent of their industry.  Yet the world’s 10 largest airlines make up only 36 percent of the global airline industry.  These define a fragmented industry prohibited from operating as other global industries, not a concentrated one.

• HUB CLOSURES AND FLIGHT REDUCTIONS:  The fear mongers would have us believe unequivocally that there will be reductions in flying, the dislocation of small communities from the global airline map and even hub closures because of consolidation.  Many use TWA and its St. Louis hub as an example.  American Airlines did not merge with a failing TWA.  Rather it acquired certain assets of a failed TWA.  As a result it is a very poor example of what could happen to a hub. 

But was it consolidation of the industry that ultimately caused American to downsize St. Louis or was it the events of 9/11 and the changed economics of the industry that followed that ultimately rendered St. Louis uneconomic?  Might the local economy in St. Louis have contributed to the city no longer being an attractive hub city that produces significant local traffic to support the hub carrier?  St. Louis is but one example of hub closures since September 2001 as US Airways/America West has in effect closed it Las Vegas hub and its Pittsburgh hub.  Neither of the closures can be laid at the feet at the carrier’s merger with US Airways.  In fact if America West had not agreed to merge with US Airways it is highly likely that the old US Airways would have been liquidated.

In the case of this merger, there has been much speculation about the future of Continental’s Cleveland hub.  There is nothing that I can see from this merger that would make Cleveland redundant.  Without knowing what the internal data might say but being knowledgeable about airline planning models, I would guess that the modeling would suggest that Cleveland would be made stronger as a result of the merger and not weaker.  The answer to Cleveland remaining a critical point on the combined carrier map will have everything to do with the condition of the local Cleveland economy as well as the price of oil and little to nothing to do with the decision to merge.

• EMPLOYEE/EMPLOYMENT DISRUPTIONS:   Since 2001, the industry has shed nearly 140,000 airline jobs.  But 400,000+ good jobs where wages and benefits average over $81,000 per year per full time equivalent remain.   In fact, the average wage for airline employment reached its high point for the decade during the third quarter of 2009.  This average employee cost comes after the significant concessions granted at each of the five remaining network carriers between 2002 and 2007.  Headcount reductions were significant during the period as well as companies were forced to reduce their size in response to a changed revenue environment and increasing fuel prices.  The reductions continued into 2008 as oil climbed to $147 per barrel and jet fuel to the equivalent of $172 per barrel.  2009 marked the second largest decrease in industry capacity since 1942.

Susan Carey of The Wall Street Journal wrote an article titled: “Airline Industry Sees Pain Extending Beyond the Recession.”  In this critically insightful piece Carey examines the relationship of airline industry revenue to U.S. Gross Domestic Product.  “For decades U.S. airlines could rely on a remarkably stable relationship between their revenue and gross domestic product. Year after year, domestic revenue came in at 0.73% of GDP on average, and total passenger revenue was equal to 0.95% of GDP. For the year ended March 31, domestic revenue was 0.54% of GDP, while total passenger revenue was 0.76% of GDP”.  What this means is that based on the historic norm of the revenue to GDP relationship, there is $27 billion less in revenue today to be shared among the industry’s competitors than there was just 10 years ago.

Consolidation is not the culprit of lost airline jobs or declining airline wages.  Airlines were left with little choice but to restructure given the changed revenue environment precipitated by the growth of the low cost carriers and the transparency in fares facilitated by the internet as a distribution vehicle.

What is clear to me is that no individual airline except possibly Southwest and Delta would have the financial wherewithal to withstand another geopolitical event similar to what occurred on September 11, 2001. Unlike other rounds of consolidation that focused primarily on network scope, scale, revenue and cost synergies, this round is different.  Now the industry is looking at the balance sheet.  Consolidated carriers promise more stability to employees and communities that benefit from the combined strength of the respective balance sheets.

• RE-REGULATION:  Some suggest that re-regulation of the industry will improve the economic well being of certain stakeholders.  Isn’t a goal of policy makers to maximize the number of good paying jobs?  The airline business sells what is best characterized as a highly price elastic product.  Only a segment of the buyers of airline services is less sensitive to price.  Over the past 30 years, the industry has competed away the savings/benefits of nearly every innovation (ex. reduced commission expense) in the name of low and lower fares for consumers.  Some think that reverting back to the days of a regulated industry will benefit certain segments of the industry.  I firmly believe it would harm the industry by causing it to contract further as prices rise as inefficient costs are passed through to the consumer.  A smaller industry would employ fewer workers.

Many government officials and certain industry watchers have instilled fear into the marketplace regarding the impact of current and prospective industry consolidation.  Fears of higher prices, reduced service, more monopoly routes, and labor strife are not well founded.  Their analysis of the industry today parallels an analysis appropriate in a regulated period.

Simply put, the network carrier model of the 1980’s and 1990’s does not work in today’s environment. Consolidation is a logical step to position airlines in a highly fragmented domestic and global industry to better weather the financial challenges that have caused years of economic pain for many stakeholders and a rising tide of red ink.

Thank You.

Mirror Mirror on the Wall: What about American after All?

This week AMR CEO Gerard Arpey and CFO Tom Horton are taking their “look at American” story to Wall Street. The AMR Investor Presentation starts and ends with the company’s Flight Plan 2020 – a plan that frames the company’s strategy around 5 tenets:  Fly Profitably; Strengthen and Defend Our Global Network; Invest Wisely; Earn Customer Loyalty; and Be a Good Place for Good People.  It’s not uncommon for Wall Street to be skeptical of this kind of strategic framework. Consider, for example, the sharp-tongued response of JP Morgan analyst Jamie Baker during AMR’s 1Q earnings call with Arpey and Horton. Referring to Flight Plan 2020 and its bullet-pointed strategy, Baker asked:

“Is this really all you have got?”

But Baker didn’t stop there. “I don’t want to beat around the bush here,” he said during the Q&A with analysts. “You have the highest costs. You have the lowest margins. You are the only major airline expected to lose money this year. Your year-to-date equity performance has trailed that of your peers. In other businesses I can think of when there is a company standing out like this you sort of expect a major overhaul and it isn’t clear to me that Flight Plan 2020 is that plan.”

In many ways, Baker’s question is a fair one for a company that appears more plodding in its strategy than what we’ve seen elsewhere in the industry during recent years of bankruptcies, mergers and acquisitions. I think American is looking at anything that flies and assessing whether the benefits of the combination outweigh the costs of combining.  And there’s no doubt that American is taking stock of how Delta’s merger with Northwest and the proposed merger between Continental and United will hurt AA sales in key US and global markets.  It is the ability to sell to corporate customers that may be the ultimate arbiter of whether to merge or not.

In its investor presentation, AMR rightfully focuses on its network and the expected approval of both its transatlantic and transpacific joint ventures..  It talks about its focus on the largest population centers in the US – New York, Los Angeles, Chicago, Dallas/Ft Worth and Miami.  It talks about AA and oneworld’s focus on the largest population centers around the globe – New York, London, Los Angeles, Tokyo and Hong Kong.  The AA/oneworld strategy clearly targets the STAR Alliance with United and Continental and its focus on the largest population centers in the US, but pays less heed to the SkyTeam network with more small cities in its route portfolio. I am not saying that oneworld is ignoring SkyTeam at all and New York is but one example.

Let’s Talk Network

My review of the latest available origin and destination data offers some surprises about where AA is strong relative to other carriers.  The markets are listed in descending order of American origin and destination passengers for the first quarter of 2010.

1.           Dallas (DFW, DAL):                          AA, 52.7; WN, 21.4%; US, 5.8%; DL, 5.6%
2.           Miami (MIA, FLL, PBI):                      AA, 24.1%; DL, 13.4%; B6, 9.7; WN, 9.0%
3.           Chicago (ORD, MDW):                      AA, 25.3%; UA, 24.6%; WN, 22.6%; DL, 6.2%
4.           New York (EWR, JFK, LGA):              CO, 19.4%; DL, 16.4%; AA, 14.2%, B6, 13.6%
5.           LA Basin (BUR, LGB, LAX, ONT, SNA): WN, 26.3%; AA, 12.2%; UA, 11.3%; DL, 8.5%
6.           Washington (BWI, DCA, IAD):          WN, 21.6%; UA, 16.8%; US, 13.7%, AA, 9.8%
7.           Boston (BOS):                                  B6, 19.1%; AA, 15.1%; DL, 14.2%; US, 13.8%
8.           SF Bay (OAK, SFO, SJC):                   WN, 31.7%; UA, 18.4%; AA, 7.8%; DL, 6.2%
9.           St Louis (STL):                                  WN, 38.1%; AA, 25.2%; DL, 11.0%; US, 6.8%
10.           Transcon:                                         UA, 21.7%; AA, 18.2%; B6, 15.1%, VX, 12.0%
11.           Raleigh (RDU):                                  WN, 23.6%; AA, 20.9%; DL, 18.4%; US, 15.4%

So AA enjoys a position of strength relative to other network carriers in 4 out of 5 of the markets in its “cornerstone strategy” ­ -- Los Angeles, Chicago, Dallas and Miami.  In New York, AA is currently third, But coming in fourth is jetBlue, AA’s most recent partner feeding 12 international markets from 18 of the low cost carrier’s markets.  If one of the tenets of Flight Plan 2020 is to strengthen and defend its network, then AA is beginning to address its relative weakness in New York with the jetBlue relationship.  Among AA’s largest  ”origin and destination” markets, it is neither #1 or #2 in New York, Washington or the San Francisco Bay Area. 

American’s strength in the domestic markets will translate into added benefits if, as expected, anti-trust exemptions are approved to allow joint ventures with British Airways/Iberia/Finnair/Royal Jordanian and JAL.  Whereas American receives significant traffic from its partners today, there will be significant new benefits that will accrue to American as a result of being able to coordinate schedules and prices as well as jointly market the combined services – a benefit the other two global alliances already enjoy.  So alliance competition is about to take off as we transition to a three carrier contest for travelers rather than the global market that today favors STAR and SkyTeam.

Cost Advantages/Disadvantages

I’m no fan of American’s answer to its labor cost disadvantage, in which the company has said that labor costs will inevitably rise at the other airlines to even the playing field among carriers where now AA labor costs are markedly higher than its competitions’. Sadly this suggests that pattern bargaining is alive and well and that the industry will simply recycle profits among stakeholders as it has done for decades rather than focus on producing some return on capital. 

But I understand why American cannot talk any other way about its labor cost disadvantage.  Why? Because it is smack dab in the middle of negotiations with its unions – in some cases in mediated contract talks or in the process of awaiting union member votes on tentative agreements.  That makes any talk of labor costs particularly delicate, even considering the reality that the company’s current labor costs – in all cases at or near the top of the industry, means that AA doesn’t have much to give at the bargaining table.  Based on the tentative agreements reached so far, American is clearly willing to trade higher wages for the promise of higher productivity.  Beyond that, it remains to be seen – and the devil is in the details -- whether better productivity can mitigate the costs of the agreements.  If not, American’s labor costs are only going to increase further.

One thing the company can and should be talking about is what’s known as “non-labor” costs – all those costs outside of wages and benefits that are not driven by collective bargaining agreements. In this area AA has led the industry in lower costs over the past five years. In fact, non-labor costs at American should only keep coming down as the company takes a new aircraft every 10 days to replace the outdated and inefficient MD80 fleet, American should be touting this other side of its cost equation – the fact that its success in trimming non-labor costs mitigate some of its labor cost disadvantage, rather than bank on the hope that labor cost convergence at the other carriers will ease some of its labor pain.

So what should American say to the Jamie Bakers of Wall Street?

American says that between its cornerstone strategy and its expected immunized alliances, once fully implemented, could mean an additional $500 million on the books.  I believe that it could be even higher, particularly given American’s current position in which it lacks the legal ability to coordinate schedules, set prices and jointly market services with its partner airlines.

Some say that bankruptcy is the only option for American to strip out costs and strengthen the balance sheet against strong competition.  But this is not the post-9/11 era when it was a geopolitical catalyst that allowed several airlines to leverage bankruptcy to rewrite contracts and jettison debt and pensions.

I’ve read many stories that attempt to write American Airlines’ obituary. But the rumors of the airline’s demise have been greatly exaggerated.  In theory, the unmerged US Airways and American and other carriers should benefit, albeit indirectly, from industry consolidation.  Moreover, most of these stories missed the fact that consolidation is taking place at the bottom of a recovery cycle, not at the top.  Assuming that the health of the US airline industry is inextricably tied to the health of the US macroeconomy, then a rising tide should benefit the entire industry.

On May 3, Vaughn Cordle of Airline Forecasts Inc. published a white paper titled:  “United + Continental is Good News for all Stakeholders:  More Mergers are Needed.  Is American and US Airways next?” Cordle writes: “If the industry is not allowed to consolidate in the most rational manner, the result will be a continuation of the slow liquidation and the inevitable failure of US and AA, the two remaining network airlines in need of restructuring.  The most likely outcome would be an AA bankruptcy and outright liquidation of US.”

The analysts may want a more compelling story, but sometimes slow and steady wins the race. After all, past acquisitions at American have not produced much for the airline’s bottom line. I believe American would benefit more by getting its labor house in order before making a big play.  There is enough work to be done in the interim to coordinate schedules with its immunized alliance partners.  There is enough work to be done to get the tentative agreements ratified and complete negotiations with its pilots and flight attendants.  And there is enough work to be done to improve the operational integrity of the system -- a renewed fleet will help but it is not the complete answer.  I am willing to believe that bankruptcy may be an answer for American only if its employees push it there . . . and they may be the ones hurt most by the experience. 

Mirror mirror on the wall:  the tortoise may beat the hare after all. 

Consolidation Is the Logical Next Step in the Industry’s Evolution

Over at the National Journal's Transportation blog site, the question of the week is:  “Should Continental and United Be Allowed to Merge?  Lisa Caruso, the blog’s editor asks:  “What do you think of the proposed merger? Will it benefit the two airlines? What about customers and the airline industry as a whole? Should the Justice Department approve it? 

To date there have been responses to the question from Robert L. Crandall, former Chairman and CEO of American Airlines; Carol J. Carmody, formerly the Acting Chairman and Vice Chairman of the National Transportation Safety Board; Kevin Mitchell, Chairman of the Business Travel Coalition; and yours truly, William S. Swelbar, the author of www.swelblog.com. 

I urge you to read the comments as they are diverse and even “agnostic” toward the proposed merger of United and Continental.  Swelblog readers can comment directly to the National Journal Transportation blog.

Below are my comments to the question posed by the National Journal’s Ms. Caruso.

After decades of destructive competition, consolidation is the logical next phase of evolution in the U.S. airline industry.  This, after all, is an industry that lost $60 billion over the past decade – making folly of the goal of the 1944 Chicago Convention in charging the International Civil Aviation Organization to “prevent economic waste caused by unreasonable competition.” 

Instead, the U.S. domestic passenger market produced plenty of economic waste over the past 32 years, affecting shareholders, lenders, employees and most other stakeholders.  The only clear winner from the industry’s singular strategy of adding uneconomic capacity was the consumer.

Today, the legacy network carriers are focusing away from the bloodletting in the domestic market with an eye toward international flying. Too often, regulators and legislators and even some analysts see the global airline industry as somehow U.S.-centric.  It is not.  In aviation, the U.S. is one piece of a big puzzle that is influenced by global economic interdependencies, just as the U.S. economic recovery could be affected by events in Greece and possibly Portugal and Spain.

For the legacy carriers, this round of consolidation is more about preparing to compete with the world’s other big carriers as much as it is about competing with Southwest or AirTran or jetBlue.  That’s why so many are shaping their networks and alliances to attract domestic and international bound passengers.   The footprint established by the low fare carriers is now national in scope, while the fares they charge should be considered as much of a  contributor to that fact that many smaller communities are losing air service as is the economy and the price of oil.

The 1978 Airline Deregulation Act clearly accomplished the goal of delivering safe and affordable air service to the masses.  Today, airplanes are packed with flyers paying, on average, 55 percent less for a ticket when adjusted for inflation than they paid in 1978.  Why?  Because most U.S. airlines responded to deregulation in the 1980s and 1990s with a capacity-led business model that made cost control imperative.  Some of today’s cost controls can be found in the outsourcing of maintenance or downguaging the size of airplanes to adapt to the realities of the marketplace.  

For decades, the only way the industry knew how to grow revenue was to grow capacity.  Airlines used the tools and methods that had their roots in regulation and were focused on estimating market share.  Fundamental to that analysis was the belief that growing revenue meant the need to grow capacity – and most airlines did, even before demand warranted it.

Everybody focused on “screen display.”  Statistics showed that if an airline’s flight did not appear on the first few CRS screens of available flights in a market, that airline didn’t get as many bookings. The more sophisticated the global distribution system (GDS), the more important electronic “shelf space” became.

Only recently has the industry worked to rid itself of too much capacity brought about by this market share mentality – one result of the role of CRS/GDS bookings that made an airline seat a commodity.

Today’s consolidation is working to undo the capacity-added wrongs of the past. Consider labor.  For too long, airlines carried uneconomic capacity, employed too many people and signed on to labor contracts that created unreasonable expectations for airline employees.  That steady growth also created expectations that airlines were somehow required to serve smaller communities, even when demand did not warrant service and those routes could not be flown at a profit.

Much of this is still true. U.S. airlines have used bankruptcies and other restructuring efforts to cut capacity and increase productivity, but many did not go far enough.  The real catalyst to capacity discipline was $147 oil.  And that capacity discipline needs to continue if the industry is ever to get to a period where it earns at least its weighted average cost of capital. 

Unlike other rounds of consolidation that focused primarily on network scope, scale, revenue and cost synergies, this round is different.  Now the industry is looking at the balance sheet. The market rewarded Delta following its acquisition of Northwest with a market capitalization that exceeds that of United, Continental, American and US Airways combined.  Consolidated carriers promise more stability to employees, shareholders and communities that benefit from the combined strength of the respective balance sheets.

Capital has smartened up.  We do not see as much creative financing or unsecured lending as was common in the past.  Assuming successful mergers, combined airlines will be able to raise capital more easily, carry their labor costs and offer passengers more choice of routes and destinations. 

The U.S. market should not fear the “end to end” network consolidation like Delta – Northwest and the proposed United – Continental merger.  The market has demonstrated time and 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.  And where there is insufficient capacity, capacity will find the insufficiency.

Simply put, the legacy carrier model of the 1980’s and 1990’s does not work in today’s environment. Consolidation is a logical step to position airlines in a highly fragmented industry to better weather the financial challenges that have caused years of economic pain and a rising tide of red ink.

More to come.

The NMB Finally Issues Its Representation Rule: What’s Next For The US Airline Industry?

Today, the National Mediation Board issued a new rule governing union organizing that is probably the most controversial thing this government panel has ever done.

So, after sifting through 103 pages of legal citations falsely hoping that the rule as proposed in December would have been changed to address at least some of the opposition’s concerns, I now realize the truth: The NMB has become a political body.

Don’t get me wrong – I’m a registered Democrat so this not a rant against all things Obama. But there are places politics shouldn’t figure so heavily and the NMB should be one of them.

The new representation rule comes as Delta and US Airways are suing the government over its proposed solution to the slot swap between the two carriers; and just a week or so since implementation of that visionary tarmac rule.  So yes, I am in a bit of a cynical if not downright snarky mood today.

In the final rule filed in the Federal Register, the National Mediation Board summarized:  “As part of its ongoing efforts to further the statutory goals of the Railway Labor Act, the National Mediation Board (NMB or Board) is amending its Railway Labor Act rules to provide that, in representation disputes, a majority of valid ballots cast will determine the craft or class representative. This change to its election procedures will provide a more reliable measure/indicator of employee sentiment in representation disputes and provide employees with clear choices in representation matters.”

In its proposed rule, the NMB is seeking to change the election process by which unions organize workers in the railway and airline industries. The new rule that will change 75 years of practice, would for the first time determine the outcome of union representation elections in the airline and railroad industries based on a majority of those who vote rather than current practice, where a majority of all eligible voters must support joining a union.

It doesn’t take a magnifying glass to read between the lines. The NMB is doing organized labor a big favor with this rule. So it is laughable to me that the Board describes the change as part of its “ongoing efforts to further the statutory goals of the Railway Labor Act.”  Funny, because the overarching statutory goal of the RLA is to minimize the disruption on interstate commerce stemming from labor-management disputes.  And this rule would likely do just the opposite, with unintended consequences, by increasing the likelihood of union activities that could yet be another destabilizing force in an industry that needs anything but -- a destabilizer that comes just as the industry tries to consolidate in order to stabilize.

The first 81 pages of the document were a little dry.  But starting on page 81 the dissenting opinion of NMB Chairman (and sole Republican member) Elizabeth Dougherty began: “I dissent from the rule published today for the following reasons: (1) the timing and process surrounding this rule change harm the agency and suggest the issue has been prejudged; (2) the Majority has not articulated a rational basis for its action; (3) the Majority’s failure to amend its decertification and run-off procedures in light of its voting rule change reveals a bias in favor of representation and is fundamentally unfair; and (4) the Majority’s inclusion of a write-in option on the yes/no ballot was not contemplated by the Notice of Proposed Rulemaking (NPRM) and violates the notice-and-comment requirements of the Administrative Procedure Act (APA).”

Ouch.  But no matter. The Final Rule will become effective on June 10, 2010, unless opponents use the courts to stop it.

Let the Lawsuit Begin

The industry, speaking from the Air Transport Association platform said:  "It is quite clear to us that the NMB was determined to proceed despite the proposed rule's substantive and procedural flaws, leaving us no choice but to seek judicial review." 

The unions, of course, took a different tack. The AFA-CWA, a big winner here as it seeks for the third time to organize flight attendants at Delta, made clear where it stood on any legal challenge. "We applaud the NMB for taking this historic and courageous step to bring democracy to union elections. By allowing workers to have a voice in these elections, whether it be yes or no [author adds: or by write in], will only bring benefits to all parties. We look to airline management and their third party supporters to respect their employees' voices and the concept that guides our country every day, and not to bog down this significant achievement in legal appeals."

Having now devoted four blog postings to this subject, I may qualify as one of those third party supporters. Not because I’m carrying water for airline management, but because I think this rule stinks just like the tarmac rule and decision by this administration on the slot swap.  The only hope I have with this rule is that the incumbent unions start to be smarter in their negotiation strategies.

Included in a statement by AFA-CWA International President Patricia Friend’s statement lauding the cram down rule is her insistence that job security is a union function.  What is job security in today’s world?  Is it contract language?  Or is it a strong company?  When I think of pilot scope language that is designed and negotiated for the sole purpose of protecting jobs I see 14,000 mainline pilot jobs lost and nearly 800 narrowbody aircraft taken out of service because the economics (largely unproductive labor) could not translate into profitable flying.  But that unproductive labor paid union dues – for awhile.

I have a lot of union experience.  I worked as a local union president.  I have experience as an advisor to labor in distressed negotiations.  I serve in a union-appointed Board of Directors position at Hawaiian Airlines. While I know there is strong flight attendant union leadership at Hawaiian, the same cannot be said around the industry and I note in particular American and United and US Airways.

From what I can see, airline unions are all about yesterday.  Bankruptcy did not fix the labor problems at airlines or the ability of many airlines to manage their costs with still-bloated income statements.  But still the unions want to look back, back when labor costs were even higher and productivity was at an all-time low.  If productivity was given in the restructuring negotiations, union-represented employees would be earning more today.  But I digress.

Let me be clear.  I am not saying that unions are all bad.  Good leadership on the union side and a willing management can make deals.  Look at the most unionized carrier in the US industry – Southwest – which thanks in part to a strong relationship with its unions has managed to pay well and do well in the marketplace by building a great corporate culture and making productivity and customer service a priority.

But unenlightened and parochial thinking pervades the leadership ranks of many other airline unions.  The industry will continue to face change and challenges. Unions that adapt and are able to let go of the past will flourish.  Unions that cannot adapt to the new direction of the global airline industry will struggle to deliver for their members. 

And Why Are We Changing This Rule?

It is pretty simple and transparent.  Neither the AFA-CWA nor the IAMAW believes that they have the votes necessary to win an election in their efforts to organize the combined work forces from the merger of Delta and Northwest.  So labor prompted a friendly administration to change the union representation process to help them pick up these coveted new members – particularly on the Delta side where the flight attendants and maintenance workers have never been union.  Imagine how happy those former Delta employees must/will be?

Or, as the union leaders have clearly calculated, if you fail to win hearts and minds at the ballot box (as they have not once but twice) then change the rules. And despite an outcry and outpouring from the industry about the rule as first proposed by the NMB, the Board made no changes to address the concerns expressed by opponents. Instead the rules were relaxed even more to the advantage of unionization. Decrease the barriers to entry (union representation) and leave the barriers to exit high (no direct union decertification procedure).  So off we go to court.

As I have written before, it is not so much the rule change as the way the "politically neutral" NMB went about it.  With the tarmac rule it is the arbitrary nature of the three hours.  With the slot swap deal it is denying the incumbent carriers the right to sell what they invested in over the years and determine an adequate return on that asset.

I understand that most things governmental are heavily political.  But politics have had too much influence over this industry, and not for the benefit of the airlines or the hundreds of thousands of workers they employ.

More to come.

Mirror, Mirror On the Wall: What About US Airways After All?

One fascinating story resulting from the news that Continental and United intend to merge is what might happen to those on the sidelines, namely US Airways and American. 

Let’s begin with US Airways.  I have written before that US Airways’ route portfolio is inferior relative to other US legacy network carriers. I also have written before that US Airways is hamstrung because of its precarious labor position – a constraint primarily caused by the dysfunction in its pilot corps.

Immediately following Delta’s January 2008 rejection of US Airways’ overture, it was clear to me that US Airways CEO Doug Parker was right in his efforts to be a first mover in the consolidation arena. In making a run at Delta, Parker provided a blueprint for the industry to merge networks, and ensure air service to communities of all sizes, while at the same time reducing fixed costs. But something stood in the way then:  Parker’s pilots. He was hamstrung by pilot leadership blinded by the prospect of an unlikely outcome – a better seniority arbitration decision. [See note below:  Delta attempt came before seniority list decision was issued]  As I wrote then:  “For Parker, bringing labor along would certainly have proven expensive – and maybe just too expensive.”

Today the US Airways pilots await a decision from the 9^th Circuit Court of Appeals stemming from a lawsuit initially won by the former America West pilots after USAPA, the union that represents the US Airways pilots, refused to honor a binding arbitration decision on seniority integration.

Because of that circumstance—and the consistent objection by USAPA to every strategic initiative generated by US Airways management—last month I challenged speculation that United and US Airways could put together a merger where they twice failed before.

To be fair, as discussions proceeded between US Airways and United, it was becoming clearer to this observer that USAPA was beginning to understand and even embrace the idea that consolidation may not be a bad thing for employees.  The math is easy.  A $30 billion corporation is in better shape to provide for raises and long term employment stability than is a $13 billion company susceptible to geopolitical, oil and economic shocks.  But it remains to be seen if this was just USAPA being opportunistic or a sign that the union is changing its stripes.  As I will discuss below, a change in approach by USAPA will be necessary to secure an improvement in pay for the US Airways pilots in the short term and the benefits of consolidation for all US Airways employees in the longer term.   

Let’s Put Some Things into Perspective

In recent days, I’ve read many stories that attempt to etch US Airways’ livery on the next gravestone in the airline cemetery. But the rumors of the airline’s demise have been greatly exaggerated.  In theory, US Airways, American and other carriers should benefit, albeit indirectly, from industry consolidation.  Moreover, most of these stories missed the fact that this consolidation is taking place at the bottom of a recovery cycle, not at the top.  Assuming that the health of the US airline industry is inextricably tied to the health of the US macroeconomy, then a rising tide should float all boats.  Right? 

On May 3, Vaughn Cordle of Airline Forecasts Inc. published a white paper titled:  “United + Continental is Good News for all Stakeholders:  More Mergers are Needed.  Is American and US Airways next?” Cordle writes: “If the industry is not allowed to consolidate in the most rational manner, the result will be a continuation of the slow liquidation and the inevitable failure of US and AA, the two remaining network airlines in need of restructuring.  The most likely outcome would be an AA bankruptcy and outright liquidation of US.”

Cordle makes a case for consolidating US Airways and American citing expected future increases in fuel prices, airport charges, security and labor costs against the backdrop of less than credit worthy industry.  And these come before the industry begins paying to conform to inevitably new environmental regulations.  Don’t misunderstand, I agree that participating in consolidation is the best outcome for US Airways.   But I don’t buy the gravestone argument.  Let’s take a look at the fundamentals.

Everybody remembers America West Airlines.  A legacy-like model—that we all knew ultimately would be combined with another airline—around the turn of the century America West "flirted" several times before tying the knot.  Before its 2005 merger, America West survived and produced competitive margins through focused management, the support of labor unions that recognized the company’s place in the industry, and by offsetting a revenue generating disadvantage by maintaining a cost structure advantage.  Oh yeah, and the airline was based in Tempe, AZ and run by a guy named Doug Parker.  Sound familiar?

Today US Airways does suffer from about a 12 percent stage length adjusted unit revenue disadvantage versus its legacy carrier peers.  But it also enjoys about a 12 percent stage length adjusted unit cost advantage versus these rivals.  Despite the revenue generating deficiency, for the first quarter of 2010 only United among the legacy carriers saw a bigger increase in total unit revenue than the Tempe-based airline.  Like the rest of the industry, US Airways continues to see its corporate revenue and booked yield (passenger revenue per revenue passenger mile) improve.

Maintaining a Cost Advantage Is Critical for US Airways

And this revenue disadvantage is offset by US Airways continuing to maintain a cost advantage.  For the first quarter of 2010, only Delta saw its unit cost (operating expenses per available seat mile) increase less than US Airways when compared with all legacy network carriers. As a result, US Airways’ pre-tax margins show little to no difference when compared to other legacy carriers.  In fact, during the first quarter, US Airways saw a pre-tax margin improvement of 7.2 points, which compared favorably to its peers. The cost advantage the carrier enjoys cannot be overstated nor can the company hide behind the fact that the vast majority of that difference can be found in lower labor costs.  By contrast, United and Continental are only now beginning to navigate what it might cost to buy labor peace, particularly among the pilot groups. 

One imperative for US Airways will be to educate employees about the difference between US Airways when compared to Delta and the new United.  If US Airways’ unions push the company to match rates paid by other carriers with significantly bigger networks, more profitable hubs and less capacity dedicated to the US domestic market, then Cordle just may be right in predicting the potential for liquidation.

But what if the unions recognize US Airways position in the industry and adopt a longer term approach?  What if US Airways can maintain its current cost advantage?  Or enough cost advantage to offset the company’s structural revenue deficiency?  What if the airline get its internal labor house in order so that old US Airways and old America West contracts are one with matching seniority lists and affordable economics?  Is that really any different than America West at the beginning of the last decade?  Is this any different than United going back to Chicago in 2008 after being snubbed by Continental and getting its house in order?  I think not.

In the US Airways route structure, Philadelphia and Charlotte are gems.  I will concede that Phoenix is confounding given the extent of direct competition from Southwest Airlines.  And while US Airways does enjoy a 23 percent unit revenue advantage versus its low-cost competition, it also carries a 29 percent cost disadvantage when adjusted for stage length.  No legacy carrier has more direct exposure to Southwest.  But this is not new and it is not a death knell.  Parker and his colleagues have been successfully managing this challenge for 15 years.  Rather an important part of the education of US Airways employees and unions need to fully understand the importance of keeping costs low.

It’s Hard to Kill an Airline

In my view, an airline today is like a cockroach.  You can beat it, burn it, kick it and starve it, but it doesn’t die easily.  And over the last ten years Doug Parker has defied even a cockroach’s odds on numerous occasions. Remember, we are at the bottom of a recovery cycle – a fragile recovery cycle to be sure.  US Airways cash as a percent of twelve month trailing revenue is comparable to its legacy peers and relative to its size (revenue), comfortable.  Compared to its peers, the company also has fewer debt obligations to be repaid as a percent of revenue over the next two years.

This is not to say that US Airways does not have its issues – some that are easier absorbed by consolidated balance sheets that produce a higher cash cushion.  And there are plenty of sensitivities that can disrupt the company’s vulnerable cost advantage:  1) a 1 percent change in mainline unit cost ex-fuel cost the company an additional $60 million per year; and 2) a $1 change in price of a barrel of crude cost the company $34 million assuming that crack spreads stay at today’s levels resembling historic norms.  On the other side, as little as a 1 percent change in unit passenger revenue bolsters the company’s top line by $93 million.

Also US Airways’ labor unions need to recognize the value of cooperation and moderation in the near term.  Those unions also need to consider that “moderation” could mean significantly improved pay—if they are prepared to eliminate anachronistic scope restrictions and improve productivity.  And they need to see that there is a big pay day if US Airways is involved in industry consolidation, and that their behavior—and the terms of their collective bargaining agreements—will play an important role in determining whether that pay day occurs.

Message to US Airways’ Labor Generally; USAPA and AFA-CWA Specifically

Git’r’done. Enough already.  The pundits who suggest that US Airways is dead do so partly in recognition of the dysfunction of union leadership at your company.  They are not all together wrong.  But most are not aware that there may be recognition by US Airways’ labor leadership that their members may actually benefit by participating in consolidation.  To participate in a strategy designed to promote industry stability requires labor stability as well – and this is an area that needs improvement at US Airways particularly among the two unions representing flight crews, USAPA and AFA-CWA. 

Some suggest in comments to this blog that management is keeping the groups apart to save a few bucks.  If that is what they are doing, then shame on them.  But no one can make me believe that this is the case.  What's in it for Parker to do that?  Also it is in everyone’s best interest to negotiate joint collective bargaining agreements with competitive productivity and scope language that permits a company to navigate the complex competitive landscape and to have a single seniority list for the various class and crafts of employees.   And it is critical to both shareholders and employees that impediments to mergers be eliminated from collective bargaining agreements.

What makes this round so damn difficult is that every carrier is now a little different and it stems from an individual carrier’s portfolio of flying.  For this reason it is increasingly difficult to compare costs at one carrier to another and, as such, pattern bargaining should be a practice of the past.  If airlines engage in union efforts to chase the best contract – even when their networks don’t pay the tab -- then they deserve their place in the airline graveyard.  The price of buying “labor peace” is too high if it means an airline can’t ultimately support or survive its own labor cost structure.

These negotiations, whether at United, Continental, American or US Airways, are about the future of the airline industry as we know it.  As such, the negotiations are about more productivity and flexibility in return for higher wages.  Fixed costs must be removed.  And a union’s demand that a company carry more employees to do the same level of flying as a competitor simply creates a structural disadvantage any rival can exploit.  For a standalone US Airways, the company is in a position to survive given the up cycle ahead.  But come next the down cycle, or geopolitical event, or oil at $100 . . . then all bets are off.  So at US Airways, the negotiations need to be about ensuring the company's relevance while supporting industry consolidation.

Mirror, Mirror On the Wall: In a couple of years give US Airways a call. 

More to come.

Update on 05.6.2010 by swelbar

I have been made aware of a factual error included in this piece.  I have had more than one reader write to remind me that US Airways attempt to merge with Delta occurred before the seniority list decision was handed down by Arbitrator Nicolau.