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Entries from August 1, 2009 - August 31, 2009

Monday
Aug172009

US Airline Labor Says Cyclical; Reality Says Secular

Last week, the Labor Department reported preliminary unit labor cost and productivity numbers for the second quarter. It reported that non-farm productivity increased at an annual rate last quarter of 6.4 percent and unit labor costs decreased 5.8 percent. The increase in productivity was the highest since the third quarter of 2003 and the decrease in unit labor costs was the most since the second quarter of 2001.

In theory and in practice, highly productive work forces give companies flexibility in economic upcycles as well as downcycles. That means flexibility that helps companies meet demand – including flexibility to increase wages in return for greater productivity as higher product output can be achieved with less labor input. During this difficult economic period, second quarter corporate earnings results generally exceeded expectations.  Some amount of corporate success in the quarter can be attributed to increased workforce productivity, as many jobs left unfilled meant more work for those on the payroll.

But this is not, sadly, the case in the airline industry.

The Reality of Today’s Airline Revenue Environment

This morning, The Wall Street Journal carried a piece by Susan Carey entitled: “Airline Industry Sees Pain Extending Beyond the Recession.” In this critically insightful piece, Carey examines the relationship of airline revenue to US Gross Domestic Product. “For decades,” she writes, “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.”

In the article, Carey cites US Airways President Scott Kirby and his view that the rapid growth of discount airlines is the primary culprit behind what he called "a long-term secular decline" in the revenue-to-GDP relationship.

“Since [before] Sept. 11, low-cost airlines have grown rapidly, putting downward pressure on fares, while travelers increasingly shop for the cheapest tickets on the Internet.” Carey writes. “The Transportation Department estimates that budget airlines now account for 40% of the domestic market, up from 22% in 2001. While lower fares stimulate demand, Mr. Kirby said, airlines still wind up losing revenue overall.”

Carey also offers props to the Massachusetts Institute of Technology Airline Data Project, citing data there that “if the revenue-to-GDP ratio had stayed where it was pre-2001, the airlines would have raked in an additional $27 billion in revenue in the year ended in March.”

She continues,”if thrifty consumers and cost-cutting businesses are this recession's legacies, airlines will be forced to shrink even more. Growing smaller means parking planes, laying off workers and dropping destinations, meaning potential customers have fewer reasons to book. Earlier this month, Delta Air Lines Inc. cited a gloomy revenue outlook for the rest of the year in its plans to cut more management jobs. If passengers don't return to the skies and fares don't rise, some airlines could run low on cash, raising the specter of additional bankruptcies.”

The US Airline Industry is Neither Flexible Nor Agile

An industry governed by a seniority system is virtually assured of decreased productivity as capacity (productive output) is reduced. We’ve recently posted our analysis of 2008 US airline employee compensation and productivity on the Airline Data Project. And that data paints a very clear picture: by the end of last year, US airlines showed neither increased productivity nor decreasing wages, despite an industry beset with very sick revenue generation.

What the data does demonstrate is the industry’s difficulty in its efforts to shrink and realize immediate labor cost benefits. To get smaller, legacy airlines lay off employees – those, of course, with less seniority -- and end up retaining those employees that have accrued more time off. Therefore, more labor is necessary to do the that reduced level of flying. Compounding the problem, the employees that remain are paid at higher hourly rates, trending the average wage for employees upward.

Using Pilot Labor as an Example

Overall, the industry has made tremendous progress in increasing the average number of flight hours per month per pilot – a necessary increase over the artificially low “monthly maximums” that pilot unions protected through collective bargaining agreements since the early years of this decade. [This trend was generally the case across all airline employee groups as well.] But what I find most interesting is this: after years of sequential progress, each of the network carriers nonetheless experienced a decline in pilot productivity in 2008.

I think it important to mention the Delta and Northwest pilot productivity data appears to be affected negatively by their merger completed in 2008’s fourth quarter. But the declines in United’s pilot labor productivity appear to me to highlight the conundrum a unionized airline industry faces – the inability to reduce workforce in concert with capacity.

With productivity in decline, average salaries per pilot equivalent generally increased in 2008 versus the prior year. On the other hand, average salary and benefit costs per pilot equivalent show mixed results. But there are a lot of factors in that calculation, including the costs driven by defined contribution pension plans as companies made historically high contributions; modest increases in compensation negotiated during the restructuring periods; and uneven financial results as many airlines attempt to reduce health care costs and other efforts related to restructuring.

Most disturbing are the trends in output per dollar of total pilot labor cost. The most important metric to me is the marginal cost of a unit of output. Consider the trends in Available Seat Miles per dollar of pilot cost, where labor costs are increasing faster than capacity is being produced. The same downward trend is evident when looking at output per dollar to all employee compensation – which amounts to a steady and stubborn increase in labor costs to productivity that could have a particularly negative impact on Southwest and American over the long term absent a significant new source of revenue.

You Cannot Look at Labor Costs without Understanding Productivity and Revenue

The Journal piece could not have come at a more important time as it provides the revenue backdrop against which all labor negotiations are set. The economy may not continue to shrink, but reality for the airline industry is that its piece of the economic pie is shrinking. While it’s hard to know if the continued sequential relationship of revenue as a percent of GDP will continue, it is increasingly evident that the relationship is not returning to that of the 1980s and 1990s heyday upon which historic labor negotiations patterns were built.

Labor needs to grasp that revenue premiums generated by the legacy carriers are largely gone. When all pricing is transparent and any Internet user can compare any airlines’ fare on any route, there is little room to cross-subsidize, or any grounds for expectations that the industry can repay concessions granted in the past. The revenue environment absolutely underscores that this is the right time in the industry’s maturation cycle to rethink how employees are compensated.

The National Mediation Board is not the answer. There is little logic to the notion that the company and the unions can come in with wide disparities in their respective positions and the Board will merely split the difference. Not unless either party is willing to accept the inevitable result: that this type of decision in today’s world would likely force another carrier into, or back into, bankruptcy court.

Historically, “pattern bargaining” has created an inflationary cycle in which labor groups chase best contracts among other labor groups in the industry. This practice, however, ignores the competitive mix and thus the revenue environment in which any carrier operates.. The only relationship that matters is an airline’s unit cost relationship to its unit revenue. And that is different for every airline.

Simply, Changes Are Secular and Not Cyclic

This is a subtle point. Cyclical and seasonal changes in a longer-term trend line are generally easy to identify and explain and are supported by historic patterns. However, when the changes in a trend line cannot be easily explained in line with historic patterns, then the pattern is broken. We know that the US airline industry’s revenue relationship since the fourth quarter of 2000 has been in decline. We know that the trend cannot be fully attributed to either seasonal patterns or cyclic economic variations. So, those variances that we can’t explain usually point to a permanent or secular change in the industry – and in the airline industry the change has been underway for some time. A return to the past is, quite simply, unlikely.

Therefore airlines will be forced to either adapt their operations to the new environment or to accept their fate in the airline graveyard. A revenue environment that has atrophied to this level can only support so much cost. Therefore as labor negotiations continue into the fall and winter months and become a bigger airline industry story, it is important to acknowledge this change. If I am a union leader, I would bet on smaller fixed wage increases and include a bet on an improving revenue environment as the economy improves in return for flexibility in order that companies can quickly adjust their respective operations.

This is one reason I like what Republic Airlines has accomplished with multiple brands under one umbrella that can succeed in an industry where one size no longer fits all. In some ways, it is not dissimilar to what the successful mega carriers in Europe have been doing all the while the US wallows in the unsustainable cost structure of its past. In this industry, wallowing is a secular trend to be sure.

Is US airline labor ever going to get that featherbedding their own membership roles is actually hurting a smaller number of employees necessary to support a struggling industry?

 

Thursday
Aug132009

Again Dear Richard: You Are Not A Virgin Anymore 

This article is a repost of a piece written last October.  As Virgin Atlantic boss Sir Richard Branson lobbies President Obama and the US Congress to reject antitrust immunity for American Airlines/British Airways/Iberia/Finnair/Royal Jordanian - I find myself well ........ blown away that a British company should have any say in US competition policy.  US airlines cannot operate as true global companies because of parochial thinking lawmakers like Jim Oberstar.  In case you did not read before, see below.

 

One of the more amusing bumper stickers I have ever seen/read occurred at an intersection of Woodland Avenue and Jean Duluth Road in Duluth, Minnesota. I was a senior in high school and had been driving for a year and a half or so. The bumper sticker read: Virgins: Thanks for Nothin’.

Last week, Terry Maxon of the Dallas Morning News Airline Biz blog wrote a piece discussing the data analysis that Virgin Atlantic is using to frame the antitrust immunity application recently filed by American, British Airways and Iberia. We will touch on a few of those issues later and in future posts. But first, I have held a late August 2008 interview with Branson done by Karl West of the UK's Daily Mail that I would like to speak to.

West writes that “he [Branson] believes an alliance of the two giant airlines, plus BA merger partner Iberia, would allow them to dictate the market, charging higher prices between Europe and America." This makes no sense to me whatsoever because if it is high prices you are worried about, then who better than your own Virgin Atlantic, to offer lower prices and show the air travel consumer that you are the answer to their high air fare plight.

Your business model takes you to only the largest metropolitan areas, so your pricing actions will benefit the lion’s share of US – London Heathrow (LHR) demand. Because of your “network’s presence” in these large markets, you have, and will continue to have, a strong voice in attracting these customers because your product offering is very good and even different.

Whether it is the US domestic market or the transatlantic market, mature/maturing airline markets have demonstrated time and time again that where competition is vulnerable, a new entrant will exploit that vulnerability. Where there are market opportunities, there will be a carrier to leverage that opportunity. Where there is insufficient capacity, capacity will be sure to find the insufficiency. Simply, if the US - LHR market shows signs of “price gouging” by BA/AA, then surely Virgin Atlantic is among the best positioned to discipline the behavior.

West’s interview was the first one done with Branson following the BA/AA announcement that they would try for an immunized alliance for the third time. Branson believes the 'monster monopoly' will be bad for passengers, bad for competition, and will result in higher ticket prices. “It patently does not make sense,” he fumes. “Monopolies are good for companies, but they are never good for the consumer.” Branson adds: “BA has improved as an airline as a result of Virgin Atlantic keeping them honest.”

First of all where is the monopoly?

To answer that, I turned to Wikipedia for a definition. In Economics, a monopoly exists when a specific individual or enterprise has sufficient control over a particular product or service to determine significantly the terms on which other individuals shall have access to it. Monopolies are thus characterized by a lack of economic competition for the good or service that they provide and a lack of viable substitute goods. Monopoly through integration: A monopoly may be created through vertical integration or horizontal integration. The situation in which a company takes over another in the same business, thus eliminating a competitor (competition) describes a horizontal monopoly (and that is what you are talking about I believe).

Surely no one believes that a monopoly would exist, or even be created, by granting Anti-Trust Immunity (ATI) to BA/AA/IB between the US and LHR. Branson’s arguments are LHR-centric and totally ignore the fact that the airline industry is a network business today and not the cozy structure protected by Bermuda II when Virgin Atlantic first flew in 1984. Yes, LHR is coveted, and is served, by nearly every major carrier of substance from around the world. Those US carriers that were not permitted to serve LHR are now allowed to serve the market and provide Bermuda II incumbents with significant new competition.

But fundamentally, today’s airline industry is about networks and not city pairs. It is a simple fact that oneworld cannot sit and watch STAR and SkyTeam grow anymore. Air France/KLM and Lufthansa/Swiss have grown into the world’s largest revenue producing airlines. Delta and Northwest [completed] will alter the ranking once their merger is approved but that will probably only last as long as it takes Lufthansa to get its hands on SAS and/or Austrian. Branson mentions his thirst for British Midland (BMI) and its extensive LHR slot holdings, but what about Lufthansa’s option on those LHR slots? Surely Richard you are not implying that with meaningful STAR alliance presence at LHR a oneworld monopoly would exist?

Branson talks in the interview about how AA and BA are using the current difficult economic and operating environment to accomplish what they have not been able to accomplish in two prior attempts. Quite honestly Richard, the entire world is being forced to transform their business models to adapt to the new realities.

US carriers are using this time to make difficult decisions on capacity cuts in order to diversify their route structures away from an over-weighted position in the US domestic market. Maybe you should be questioning whether Virgin Atlantic should be considering something other than LHR. Oh you have with Virgin Blue, Virgin Nigeria (and you might sell your stake in that Virgin) and Virgin America.

Or maybe you should be putting more energy into changing the ownership laws in order that Virgin Atlantic can realize all possible synergies from your family of Virgins. Abstinence from industry realities might be safe in the short-term but potentially lonely over the long term. You talk about the AA/BA/IB’s ability to strong arm travel agents and corporate customers. You are a branding genius and now you are saying that you cannot differentiate your product from AA/BA?

At what point do we take you serious?

Your data arguments are weak as well. It is about the local US – London/LHR market and that does need to be studied just as it is done on other deals. At least AA and BA have performed the best analysis to date using the best data source available to make that assessment. The competition authorities will make the same informed analysis and draw the distinction between local and connecting traffic as well.

So go paint your airplanes and while doing so recognize that Willie Walsh is right. He said broken record and I will not take a shot at another of your brands. What I will say is that your arguments are not virgins anymore and maybe you should be writing letters to Oberstar rather than McCain and Obama [which you have]. If you write to McCain and Obama, the subject should be about changing the ownership laws that stand in the way of allowing the industry to become the global industry that rewards world class competitors like Virgin Atlantic. Because the large and small can cohabitate and as you say, make competitors even better competitors.

Oh and while you are thinking about some new arguments, take a look above London. On a clear day, at 40,000 feet, you will see liveries like Emirates, Ethiad, Qatar and others that do not necessarily believe that a network industry requires London to be the center of the airline universe.

Unless you recognize that 1997's arguments need to change the third time around, thanks for nothin’.

Monday
Aug032009

Pondering Southwest’s Potential Play on Frontier

By a multiple, the most widely read swelblog.com post ever read was the piece entitled: Is Republic Changing the Face of the US Domestic Market? I wrote the piece thinking about the regional carrier holding company’s play for each Midwest and Frontier. In that piece, I suggested that technology was a, if not the, most important attribute supporting Republic’s decision to make the play for Frontier: “Now Frontier provides Republic with something it previously lacked: a technology infrastructure that gives it long-term viability in the market. A technology infrastructure not tied to a legacy system.”

Most importantly, the technology would give Republic the opportunity to begin selling tickets directly to air travel consumers, something it does not and cannot do today.

Last week as I was walking off of the eighteenth green at the storied Butler National Golf Club in Chicago with dear friends Jack Ginsburg, Pete Robison and Ro Dhanda, I turned on my iPhone and noted dozens of messages. The news had just broken that Southwest Airlines was considering upping the ante over Republic and will prepare its own bid for Frontier.

For Southwest, the Best Offense Is a Good Defense

History is not clear whether someone actually said that the best offense is a good defense. It is believed to be a misstatement of a quote attributed to Carl van Clausewitz, military strategist and the author of On War, a book, published in 1832, that was required reading for me in a graduate school marketing class. Clausewitz was quoted as saying the best defense is a good offense. Either way, Southwest’s motives for this deal had me thinking.

If Republic is successful in gaining control of Frontier, it would produce, overnight, a new and potentially threatening competitor to Southwest’s domestic dominance. This past April, I made a presentation to the 34th Annual FAA Forecast Conference entitled: Cost Differences Suggesting a New Mid-Term Structure. There, I warned of the difficulty of analyzing cost differences between carriers, particularly in light of Southwest’s unique influence on the market. I believe it is now wrong to include Southwest among the group traditionally known as “low cost carriers” because its sheer size distorts the results. It was clear to me then, as it is more so now, that Southwest is losing the significant cost advantages that have historically been its primary competitive weapon and driver of its organic growth.

My analysis relied on MIT's Airline Data Project. When I prepared the analysis for the FAA Conference, final fourth quarter 2008 data had not been filed but has now been updated. The story remains the same. In order to make an apples-to-apples comparison of cost per available seat mile, adjustments must be made.

First, transport-related expenses (largely the fees paid to regional carriers for capacity) must be removed as there is an offsetting revenue account. Second, fuel cost per available seat mile should be removed as varying hedging strategies make for distorted comparisons. This is particularly true of Southwest where I estimate that its fuel hedging strategy accounted for 53 percent of its cost advantage versus the network carriers for the first nine months of 2008.

I also compared unit costs of the network carriers (American, Continental, Delta/Northwest, United and US Airways) to Southwest and a group of carriers I refer to as Midscales (AirTran, Frontier and jetBlue). Absent removing transport-related and fuel expenses, Southwest has a cost advantage versus both groups of carriers –in the case of the network carriers, a 6.4 cent advantage. When transport-related expenses are removed, then Southwest’s cost advantage is nearly halved. When fuel expenses are removed, the advantage versus the network carriers shrinks to 1.6 cents.

Now consider this: When transport related and fuel expenses are removed Southwest has a cost disadvantage versus the Midscale group. Just imagine what Southwest’s cost disadvantage could be if Republic were to get its hands on Frontier? Southwest non-labor costs are the envy of any carrier, and it still has an advantage versus the network and Midscale carriers. But Southwest now has a labor cost disadvantage against those carriers. In fact, the unit labor costs of the Frontier, AirTran and jetBlue sub grouping are nearly a full penny per seat mile lower than the unit labor costs at Southwest. Pennies in this instance can quickly add up to tens of millions of dollars in cost to Southwest when competing directly.

Adding To the Speculation

Many observers already question whether Southwest would be adding to its burdens and its costs in acquiring Frontier’s airplanes and thereby introducing different aircraft to its famously one-sized-fits all fleet. That can be addressed.

Can the labor issues also be managed? In my view yes, even if that means Southwest buying labor’s favor. Independent unions represent the pilots at each airline, so the always-difficult task of integration would be made easier by the fact there is no national union constitution and bylaws to deal with. Frontier, through its bankruptcy, has moved toward more maintenance outsourcing and that fits Southwest’s current model. And because the Frontier flight attendants are not unionized, there are minimal labor hurdles there.

No doubt, the financial transaction would be accretive to whichever airline ends up making the play. I believe, though, that the most value from Frontier would be garnered only by another airline that could leverage its assets - a local market following and its IT platform – not by financial players that won’t see the same advantages.

Frontier would provide Republic a tremendous opportunity to transform not only itself but the US domestic market. For Southwest, the Frontier play is not so much transformative as it is defensive, by:

  1. Removing a local market competitor for a company struggling to find new markets (and there are no profitable 3-carrier markets in today’s revenue environment)
  2. Providing a solid technology foundation and expertise in value-added pricing
  3. Thwarting future competition by ensuring that Republic remains a capacity provider to the nations’ legacy carriers – at least in the near term.

Ding: The “Southwest Effect” is Dead

The Denver market is unique in that there are few alternative modes of transportation that can compete with air travel because of sheer distances in the western US. Boulder, Colorado Springs and other surrounding cities’ traffic already access the air transportation system through Denver. The truth is today’s stimulation is largely diversion from another market or another carrier.

Many point to the pain a Southwest takeover would impose on United. But there are two sources of traffic: local and connecting. United runs a large connecting operation in Denver. Onboard United airplanes is a traffic mix of 1/3 local passengers and 2/3 connecting passengers.  On the other hand, each Frontier and Southwest are highly reliant on local passengers.  Before we count United dead in Denver as a result of this combination, this fact needs to be examined. 

Fares for local traffic in the Denver market are largely dictated by the competition between Southwest and Frontier. Publicly available data would show that nearly half of Frontier's traffic at Denver is local and Southwest's is near 70 percent. Therefore which direction do you think fares will go if Southwest is successful in taking out an important competitor for Denver local traffic? And after reducing certain duplicative Frontier capacity?  Southwest’s fares will prevail, even though Southwest is not always the low fare provider in each market.

Southwest Showing Its Age

Southwest built its Denver operations quickly at a time when Frontier’s future was in doubt and United was struggling. As Southwest’s organic growth slows because of the anemic revenue environment in the US domestic market, then buying the carrier that competes largely for the same local traffic makes good sense. With a cost structure that no longer sets them apart from the crowd, it is clear why Southwest continually talks of the need to augment its revenue streams.

To be fair, some will say that analysis of Southwest’s cost advantage shrinkage is flawed because it does not account for stage length -- the length of the average flight. But in comparing one airline’s performance and costs to another, adjusting for stage length is somewhat arbitrary.

Rather, what is most important is the relationship of [system] cost per available seat mile to [system] revenue per available seat mile. It is this relationship that finds Southwest struggling at Denver where load factors have been in modest decline as the airline has grown and has been increasing fares from the carrier’s initial offerings. The net effect has been a modest decline in RASM - as CASM has been increasing.

The network carriers are challenged in this regard because of the black revenue hole created by the downturn in first and business class travel on international routes. Just as the network carriers have to adapt for shrinking revenue relative to costs, so does Southwest – without the magic of stimulating a mature market replete with competition from low cost and network carriers alike.

Southwest just celebrated its 38th birthday. It is a mature and maturing carrier operating in a mature domestic environment where it is no longer an innovator. What I find most interesting in Southwest’s potential bid for Frontier is that the carrier is being forced to act just as the network legacy carriers. Southwest is seeking a consolidation scenario that could and should lead to an improved revenue line in Denver where it has significant capacity deployed and where Frontier, a beloved (not LUVed) carrier in the region is all but assured of emerging from bankruptcy protection with its loyal local following in tow.

Keep tuned. I can’t wait to hear the arguments Southwest uses in Washington to gain regulatory approval, particularly as it will be hard pressed to make the argument that acquiring Frontier would lower airfares in the Denver region.

Funny how things change.