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Aug052010

« 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. 

Reader Comments (20)

I believe it's fairly well understood that the industry's dilemma post 9/11 was not caused by employee compensation.

It was caused by excess capacity that forced management into a Prisoner's Dilemma of "THEIR" own making and their fate sealed by poor government policies that force an incompatible market structure on an industry that can't exist in it. aka "the EMPTY CORE" problem.

With over half the airline industry's capacity bankrupt at same time....it was obvious that the "status of the core" was empty. The simpliest explaination is usually the best. An industry that competes on capacity with high fixed costs and low marginal costs is one that can not reach a market clearing equilibrium on it's own.

As Crandall said.....
"I FEEL LITTLE NEED TO ARGUE THAT DEREGULATION HAS WORKED POORLY IN THE AIRLINE INDUSTRY. THREE DECADES OF DEREGULATION HAVE DEMONSTRATED THAT AIRLINES HAVE SPECIAL CHARACTERISTICS INCOMPATIBLE WITH A COMPLETELY UNREGULATED ENVIRONMENT. TO PUT THINGS BLUNTLY, EXPERIENCE HAS ESTABLISHED THAT MARKET FORCES ALONE CANNOT AND WILL NOT PRODUCE A SATISFACTORY AIRLINE INDUSTRY, WHICH CLEARLY NEEDS SOME HELP TO SOLVE ITS PRICING, COST AND OPERATING PROBLEMS. "

So....who's really to blame.

Executives who feel knowing engage in a Prisoner's Dilemma , the government for creating an market structure that is incompatible with an industry that is more like a utility than a private industry, or the employees who simply work for wages.

I think you know....but keep the ruse going. There's some really stupid pilots in the ranks of APA. They spent their careers learning to fly airplanes and don't know how to play your game.

08.5.2010 | Unregistered CommenterOccam's Razor

I'm a big fan of the variable pay scale, or at least something different than the current system, but to play devil's advocate...

Airlines havent honored clauses like furlough protections or other downside protections that unions have negotiated in the past. Why should they believe the company will honor any upside benefits when times are good? Will that bonus payout be in arbitration for 5 years before anyone sees a dime of it?

08.6.2010 | Unregistered CommenterBW

It is interesting that the network carriers are not expressing more concern over consolidation of the regionals. With fewer regionals to choose from, the risk of oligopoly pricing increases. I'm sure the regionals won't price themselves out of flying opportunities. But, they won't be shy about filling their own pockets as much as possible at the expense of the network carriers.

I understand that network carrier opposition to consolidation of the regionals could be perceived negatively in light of their own consolidation efforts. Perhaps this is another reason why the regionals are making their move now.

08.6.2010 | Unregistered CommenterJames

Hey Bill ...
You took my quote out of context.

Here's the best part of my post/commet on your variable compensation idea.

"AHAHAHAHAHAHAHAHAHAHHAAHHAA!"

Any promise made by this executive team must be severely discounted.

7300 pilot floor!
Iron clad SCOPE!
Pension expenses but no pension contributions

I got your game figured out. It'll be cash on the barrel head from here on out!

The dopes at APA are a little slow but the clue light's coming on.

Your "carwash of bankruptcy" vs Arpey's "free market funnel"

My money's on the latter. You can't hide forever behind the skirt of the NMB/RLA. The threat of release will soon be reality and the free market will have it's say.

If Arpey can compare his skills to a Coca Cola executive, then I certainly can match my skill set to a Fedex/UPS pilot any day of the week.

Remember tiny little Spirit Airlines, they can strike in a timely manner but we can't?

Who's the real adversary here?

The bitterness created in the airline employee ranks is most unfortunate and understandable. It is dangerous because it hardens attitudes and may lead employees to take self destructive actions.

Just as flying the aircraft is ultimately governed by the laws of physics, no airline can long ignore its economics.

If I were a pilot at American Airlines, my biggest concern would be that another employee group with less to lose would go on strike and push the company into bankruptcy.

After that, my next concern would be that another decade of my career would pass with no growth.

08.7.2010 | Unregistered CommenterBob M.

There's no escape from the Vortex of the Free Market Funnel!!

"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."

So the bankruptcy card is simply a temporary tactic. Ultimately the government must decide if if this type of instability is good public policy.

Are we building the aviation infrastructure that our nation needs to expand a growing nartional and global economy or are we simply waging war on the pilots?

The bankruptcy ploy simply delays the inevitable.....all previously bankrupt carriers MUST go through the Free Market Funnel as Arpey says. There no escape! That's the way it works in the rest of industry.

So you can hire guys like Swelbar, MIT, Eclat, AirCon, F&G and try to keep the battle against the pilots going....creating a false market for wages....ultimately this industry will be forced into the VORTEX of the Free Market Funnel!!

Enjoy the ride!!

Your BK concerns are a worn path.

Japan AIrlines files for bankruptcy
http://news.bbc.co.uk/2/hi/business/8466997.stm

What was the response of AMR and it's oneWorld partners?

Guarantees of $100 milliion in annual incremental revenues

Offers of capital investment of $1.4 Billion dollars

AMR's portion of this investment is estimated at $300 million

Here's the deal in their own words...

"As a part of these commercial benefits, American determined that with ATI and by participating in a joint business agreement with American, JAL could realize approximately $100 million in annual incremental revenue.

American has given JAL a guarantee to that effect covering the first three years following implementation of the joint business agreement, subject to certain terms and conditions. The Company and other oneworld members have also discussed various possible financing arrangements with JAL.

The Company also expects that the amount of such a capital investment, if any, would not exceed $1.4 billion, with the contribution by American and other oneworld carriers not to exceed $300 million, and the remainder to be made by a private investment firm. "

Of course, implicit in the FlightPlan 20/20 tenent of strengthening and defending the GLOBAL network implies that no such tenent exsists for the DOMESTIC network. This puts the JetBlue "commercial collaboration" in a totally different light.

Spirit Airlines pilots showed what can be done.

Third place and deep in debt with an old fleet is not a great place to be! American Airlines is going to have to find a way to make a profit after it signs new contracts with all its employee groups.

IMHO, AA is unlikely to be able to do that in the current atmosphere without a change of management and a change in the expectations of the union members.

Just my $.02...

08.9.2010 | Unregistered CommenterBob M.

A couple of commenters here suggest that I am advocating bankruptcy or that BK remains an option. I guess never say never, but nothing could be further from the truth. I was simply drawing parallels between the US and Mexico domestic markets. After all, it was largely the health of the domestic market in the US that was the catalyst causing over half of the industry's capacity to file for bankruptcy.

As for this post being an American Airlines-centric post, it was never intended as such.

08.9.2010 | Unregistered Commenterswelbar

Flying is an inherently unnatural endeavor. The airline industry depends on the perception of safety for its very existence.

If people do not perceive the industry to be safe they will not simply fly on a temporary basis...due to SARS or a volcano eruption....no...They will not fly on a permanent basis.

By putting pilots in a command position with no meaningful experience or training jeopardizes the very existence of the airline industry.

Recent events have shown us there are pilots commanding aircraft who can't even recognize they’ve entered a stalled flight condition, let alone recover from one. What is the long term impact on industry financials from such a reality once the general public realizes this?

If these pilots were only flying boxes then the perception of safety would not nearly be as important as putting your children on an airplane commanded by such pilots. Cargo crashes do not seem to linger in the news as do the ones that involve the loss of human life.

These are the decisions forced upon management by poor public policy and industries characterized by an empty core problem.

Future pilots were often mentored by their airline pilot Dads, with practical flying experience and advice handed down from father to son adding another immeasurable dimension to aviation safety. Today, the advice these pilot-Dads give their kids is to become anything other than an airline pilot.

Do not become airline pilots. The risks are too great, the investment in your skills too expensive and the return too little.

This is the long term future of the airline industry.

I think the discussion about the free market funnel for pilot wages is an interesting one.

The free market mechanism establishes the value of certain assets and liabilities. Yet, as we all know, markets are not perfect. The concept of perfectly competitive markets and thus a free market prices are a best theoretical.

One of the requirements of a "free" market is the requirement for many buyers and many sellers. With respect to the free market wage for pilot services...the market has been moving away from a model in which there are "many" buyers to one in which there are "few".

This situation disadvantages the bargaining power of pilots. Collective bargaining like a farmer's cooperative is designed to overcome this disadvantage. Yet we see the NMB/RLA has taken an active role as an impediment to the proper functioning of the collective bargaining process. Further aggravating the equilibrium of the market mechanism for pilot wages.

It would be helpful if we all take a step back and take a look at what the definition of market price or fair value really is.

Below is GAAP's definition of fair value...you will note that this definition is much closer to Arpey's Free Market Funnel than it is to Swelbar's Bankruptcy Carwash.


"U.S. GAAP defines fair value, establishes a framework for measuring fair value and enhances disclosures about fair value measurements. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. "


"Most Advantageous Market" .... this is a key component of the Free Market Pricing. Free market prices are not set in Bankruptcy court they are set under Section 6 of the RLA using collective bargaining with minimal interference from the government.

Free Market pricing for pilot wages are best represented as those set by FEDEX/UPS/SWA and now little ole Spirit Airlines.

Bill, I think there is mainly only one commenter here who likes posting under different pseudonyms (who evidently has a low self-esteem).

Clearly, no amount of reasoning and logic will get through with this recurring spammer.

The market will correct itself one way or another and the airlines (and by extension their employees) that are not prepared for that correction won't survive. Mexicana was one who wasn't prepared. I think there are a few more out there that are less than prepared as well.

08.10.2010 | Unregistered CommenterRichard R.

Thanks Richard. A bit of a tired refrain from the very early days of the blog as well. The market will correct but unlike in past patterns, the correction will not be as uniform. That is what will leave some unprepared as well.

Swelbar

08.10.2010 | Unregistered Commenterswelbar

Your points are well taken, and those airlines that have instituted profit sharing and performance bonuses may be steps in the "upside protection" direction.

Certainly airline managements understand that shifting some portion of fixed costs to variable is valuable in an industry with large fluctuations in both passenger demand and the largest input cost (fuel).

What will be interesting to see is whether unions are politically able to advocate the long-term value in variable compensation to all their members (the virtuous cycle of better company profitability through cycles leading to lower borrowing costs and higher investment leading to better product offerings for customers leading to better profitability leading to better pay for members...) vs. a short-term focus on pay maximization for those members closest to retirement (and seeking "big numbers" in their last working years to maximize a pension payout based on final average earnings forumulas).

That's where I wonder if AA's "negotiation funnel" story breaks down -- by maintaining their traditional defined benefit plan have they created the structural conundrum that their unions will always be seeking that "industry leading" contract? Tub-thumping to date may support that view.

08.10.2010 | Unregistered CommenterTristan

So, what is the market rate for an airline pilot?

I guess we won't know until the government stops interfering with the market mechanism.

Traditionally, the market rate for an airline pilot has always been higher than that of a cargo pilot. Perhaps that's where' we'll find the equilibrium point. Higher than SWA/FEDEX/UPS.

One commenter brought up defined benefit plans. What value should we put on a plan that is expensed every year but little to no cash flows into these plans. Are we somehow better off?

It is very likely, based on the past behavior of management, that any variable compensation scheme would simply be viewed as another management challenge to rise to. To give the employees as little as possible. Release the accountants!!

For example....to most pilots the interpretation of a 7300 pilot floor was a pretty real expectation agreed to in a contract. However, we learned that things are not as they appear when dealing with these executives.

Our expectation in a variable compesation scheme is that we will be shortchanged.

What is real? Cash is real! Not a empty promise of it.

Variable compensation schemse are an appropriate incentive and pay scheme for executives and/or salesmen not for people who work for an hourly wage and expect an hourly wage in return.

Have the government release us and we'll see where the market rate is.

08.10.2010 | Unregistered CommenterICBM

Get rid of the RLA and let the free market set rates for airline pilots. Then we'll talk about variable compensation models.

08.14.2010 | Unregistered CommenterAM

The comments by these APA members about market failures would be funny if not so ignorant. Your union is a manifestation of a lawful market distortion. A true free market would operate as follows: individual becomes pilot, receives high wages due to industry profitability, others become pilots (additional supply) or capacity is reduced due to industry losses (reduced demand), wages drop, etc. etc.

08.20.2010 | Unregistered CommenterWW

WW said...
"Your union is a manifestation of a lawful market distortion"

So is the amount of industry consolidation we've been witnessing since this industry was deregulating.

That fact is the theoretical underpinnings of the Collective Bargaininng process is the only mechanism that can insure an "approximation" to the fair market that would exist if their we're numerous INDIVIDUAL buyers to match the sellers.

The industry is moving towards monopsony power in the market for pilot wages...aided and abetted by the NMB/RLA.

Release us...and let the Collective Bargaininig process do the market clearing job it is supposed to do.

08.21.2010 | Unregistered CommenterTeamster

Adam Smith was the first to talk about labour's disadvantage in the marketplace for negotiating his wages with his master.

"It is only when
workers act, he said, "in that simultaneous manner
which is EQUIVALENT TO A COMBINATION . . . that it
becomes the immediate interest of the masters to
comply with their demand." (Without) "an open or
avowed, or (of) a tacit and REAL COMBINATION, workmen
would not be able to obtain a rise of wages by
their own exertion, but would be left to DEPEND on
the COMPETITION OF THEIR MASTERS."

Economist Henry Fawcett noted....
"I believe it can be
easily shown," he wrote, "that the labourer is placed
at a disadvantage, if he attempts simply AS AN INDIVIDUAL
to arrange this bargain, and I further believe
that labourers MUST SHOW THAT THEY HAVE THE POWER
OF COMBINING, in order at all times to be able to sell
their labour on the BEST POSSIBLE TERMS."

The NMB/RLA is not an impartial faciliator to negotiations under collective bargaining. They have a vested interest and that interest is aligned against labor.

They must be our target of protests as well as industry executives.

My sadness is that my brother in law was or is a Mexicana Pilot of 30 years my heart and tears go out to the Family that was once Mexicana

11.4.2010 | Unregistered CommenterTERRY GRAF

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