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Entries from July 1, 2011 - July 31, 2011

Wednesday
Jul272011

Thinking About American’s Contrarian Path to Transformation

The list is long of those kicking American Airlines for not producing near-term results because that is, after all, what Wall Street wants and needs.  Wall Street’s lead striker and headline maker has been Jamie Baker, airline equity analyst at JP Morgan Chase.  Baker was quoted in a Wall Street Journal story last week saying AMR's poor financial results and worsening margin deficit raises questions about the wisdom of a giant aircraft purchase. He said,  “We cannot reconcile spending incremental capital while failing to earn returns on [the] existing capital base.”

It was Baker who, on a company earnings call that outlined some near-term strategies to address American’s underperformance, first asked AMR executives, “Is that all you got?”  In the WSJ story referenced above, Baker stated “we think the best thing AMR can do is figure out a way to generate more profitable flying with the current fleet." 

Jamie, is that all you got?

Baker and much of Wall Street’s short-sightedness is perplexing, even for a group that has a hard time seeing six months ahead.  I agree American’s quarterly revenue performance relative to peers was disappointing and concerning, as pointed out by Bank of America/Merrill Lynch analyst Glenn Engel. The point I think the Street is missing is American’s re-fleeting isn’t about six months from now or even next year. It’s about transforming a Robert Crandall vintage 1983 airline spending nary a dime. 

American’s MD80 fleet has basically been around since the earth cooled.  And it shows.  American flies more small narrowbody aircraft (150 seats and less) than any network carrier except for Southwest.  In 2009 (2010 data incomplete/incorrect) it’s the fuel guzzling, maintenance intense 140 seat per aircraft fleet flies about 9.7 hours per day (less than its peers); with an average stage length of 870 miles (about the same as its peers); and less than 4 departures per day (less than its peers).  More importantly, on those missions, the fleet burns 957 gallons of jet fuel per block hour – the same amount of burn as in 1995 when jet fuel was 56 cents per gallon – not $3.00+ per gallon.  No airline, except for maybe portions of Delta’s fleet, has to keep more spares available to maintain some sort of schedule integrity and thus have the potential for more operating leverage than American from a re-fleeting order.

And yet Baker and Wall Street want American to do more with less than its industry peers?  Maybe – and this isn’t a stretch - that aging fleet contributes to some to the airline’s under performance?  I’d say yes even though it’s difficult to quantify and I like my numbers cold and hard.  Perhaps most puzzling is the Street never offers a better time to re-fleet. When was it supposed to take place?  When it was too late and even more spares would have been required to maintain some semblance of a schedule?  That might have slaked some analysts’ thirst for capacity cuts, but that type of cutting is eerily close to shuttering an airline… and more expensive than marginal revenue improvements might lead you to believe.

Let’s Think About This Aircraft Order

American is not alone.  All of the industry, especially the more mature United, US Airways, Delta and Southwest – yes Southwest - all face some sort of replacement order.  It is just that American has a more real-time issue than do those that effectively used bankruptcy – not Southwest - and other means to get rid of aircraft with poor operating economics.  I am not being self-righteous… bankruptcy was necessary to address many legacy issues that would have buried others in the airline graveyard.  Fleet replacement is not like going to the store and grabbing something off the shelf.  Long lead times define aircraft purchases. 

What is wrong with placing an order at the bottom of the cycle versus the top of the cycle? It's a long-standing industry practice to do the opposite. It’s been a proven recipe for bad economics by adding capacity during a weakening economy that only leads to even poorer results. This quarter was less about writing down results than communicating a contrarian message – a re-fleeting announcement.  The rest of the industry, along with American, has been engaged in balance sheet repair over the past two years. 

The Street immediately pointed to the increased financial leverage associated with the new order and the fact that even though American will finance the first 230 aircraft with operating leases there will be a need to adjust upward the Fort Worth carrier’s debt by seven times the lease cost to reflect the long term commitment stemming from the lease financing negotiated with Boeing and Airbus. American’s hard won terms with the manufacturers does little to nothing to impact the company’s near term liquidity.  There is nothing to stop American from further balance sheet repair should operating results improve over the next five years as the first 230 aircraft are delivered.

Keep in mind, this order isn’t just about American. It’s also very much about Boeing and Airbus. They’ve thrown their balance sheets on the table as well, betting on American’s strategy and willing to take on the cost of building planes with no cash up front. That doesn’t normally happen in the airline industry. That’s serious backing and just how much of a deal both manufacturers gave American could very well be a game changer.

This Order Is About Both Finance and Competitive Positioning

When comparing American’s small narrowbody economics with Continental’s, American burns 262 more gallons per block hour than does the newly Chicago-based carrier.  I use Continental because its fleet is the most modern among the network carriers. Let’s not forget Continental began its re-fleeting project at the bottom of a profit cycle beginning in 1995 upon exiting bankruptcy #2. At 10 hours per day per month and with fuel assumed to be $3 per gallon, American’s new planes would immediately save $236,000 per month per airplane in fuel costs versus its MD80 fleet.  For every 10 cent increase in the cost of jet fuel, American would save an additional $8,000 per month per aircraft.

Few fleets have realized maintenance cost increases like American’s narrowbodies over the past decade.  I appreciate there are many ways to pay for maintenance expenses across the life of an aircraft, but during the honeymoon period of 5-10 years, American will, at least, not be paying $600 per block hour just to keep its MD80s in the air.  Instead it will likely save about $400-450 per hour.  Using the same calculus as in fuel savings, that saves the company another $135,000 per month per aircraft.

Yes, American still has to pay for the airplanes. As a general rule, the lease cost of an airplane is one percent of the sticker price.  If the retail cost of the various airplanes is $40 million per copy, then the lease cost is somewhere around $400,000 per month.  The fuel and maintenance savings are estimated at $370,000 per airplane per month. 

But wait a minute. We know that American did not pay retail for the airplanes.  Reuters reported American will only pay 70 percent of the list price on the Airbus equipment.  Airbus disputes that and I normally don’t believe numbers bantered around in the press, so let’s split the difference. Assume American is paying 85 percent of sticker price.  That brings the operating lease cost of the first 230 airplanes to $340,000 per month.  Even Wall Street can do this math.  If the planes cost $340,000 per month and the potential exists to save $370,000 per plane per month (and we haven’t talked about ancillary revenue possibilities from IFE, crew cost efficiencies from a simpler fleet once complexity costs are addressed, crew cost savings from a more reliable fleet, new passenger acceptance of a modern fleet etc), all of a sudden, American’s income statement and thus its balance sheet looks much different.

Is The Fleet Order Itself Transformational?

In a word, no.  Or maybe, sort of. The fleet is transformed, but that alone doesn’t necessarily transform the way American works today.  What would make this order even more exciting is to see a pilot agreement that really is transformational and recognizes the sub optimum economics of the U.S. domestic market.  What if the pilots were to negotiate pay banding, training language that does not create a bubble and benefit packages better resembling what corporate America provides its employees?  That would really make things interesting.  Problem is, those are all long-term realizations, which makes no one in New York any happier than they are today.

Another benefit from a pilot deal that could be labor transformational is to break the current regional – mainline mold.  If the economics of the smaller mainline airplanes (pilots, flight attendants and airplane) just ordered can match the economics of the largest regional jet airplanes out there, then much of the discussion over scope just might be over.  American needs access to more 76 seat aircraft (existing scope relief) with two class service, but the ask of the mainline pilots would not be further relief into the 90 and 120 seat range – unless of course there is no headway with APA making necessary changes.

Another thing to consider is, if some of the new planes are less efficient than even newer models or the price of oil goes significantly higher, the leasing options let American re-fleet the re-fleet.

Odds and Ends

Some say that American’s transatlantic partners are not the same airlines today as they were in yesteryear – namely British Airways.  That may be true in some respects, but either way, 1 + 1 is greater than 1 and that addresses those that believe American and their London counterpart are but half of their previous selves.  It was nice to read BA’s earnings release Wednesday morning citing improved traffic flows from American.  That will only continue to get better.  Realizing the full benefits of the joint business agreements is transformational for American as it evolves from a single entity into a much broader network.

But the most important fight taking place to transform American – and the industry for that matter – is the fight with the Global Distribution Systems.  Imagine the revenue benefits that will accrue to American in addition to just passenger revenue if they are able to package the product for the individual consumer.  If they are successful in breaking the monopolistic practices and reclaim their inventory – now that is transformational.

Taken together, there are some interesting possibilities taking shape in Fort Worth, Texas.  What needs to take shape immediately are the unit revenue benefits supposedly coming from the cornerstone strategy.  As analysts have correctly pointed out, that hasn't happened yet, which might explain the Street’s shortsightedness about other things American.

Look, I’ve been teasingly picking on Baker, Keay (indirectly) and Wall Street types. I realize their job is gauging the near-term forecast for clients.  But we’ve gotten so wrapped-up in Street predictions and instant opinions we’ve forgotten long-term, especially in the airline industry, like January 2015. American is resetting itself with a bold move that, honestly, shocked competitors and analysts. It deserves credit for making an astounding and first comer economic deal. Whether it works won’t be known 24 months (or five years given the jet fuel price) from now or even possibly 72 months.

But I doubt anyone is going to be asking if that’s all American’s got anytime soon.

Thursday
Jul212011

Congress Considering More Taxes On The Airline Industry Is A Sin

ATA President and CEO Nicholas E. Calio, comparing taxes on airline travel to sin taxes:  “The industry already pays more than its fair share of taxes – more than alcohol and tobacco, products that are taxed at levels to discourage their use. Today on a typical $300 round-trip ticket, passengers already pay $63 in taxes and fees.”

The U.S. airline industry pays 17 different federal taxes totaling nearly $17 billion.  Or, put another way, the U.S. airline industry pays more in federal taxes than the combined market capitalizations of American Airlines, Delta Air Lines, United Airlines and US Airways.

Note the point Calio makes:  heavy taxes are usually levied to discourage their use.   Are the White House and Congress looking to discourage air travel?  I would hope not, but let’s again revisit the law of unintended consequences. 

In the Concise Encyclopedia of Economics, Rob Norton says, “The law of unintended consequences, often cited but rarely defined, is that actions of people—and especially of government—always have effects that are unanticipated or unintended. Economists and other social scientists have heeded its power for centuries; for just as long, politicians and popular opinion have largely ignored it.”

The government is apparently considering imposing $1.5 to $2 billion in new taxes on the airline industry.  That would be bad enough for a healthy industry, but could be potentially disastrous for one that is barely emerging from one of the worst decades in its history, during which it lost $55 billion and bankruptcies, failures and service cuts were common place.

The White House and Congress won’t believe this, but their “easy” fix comes with a simple, unintended consequence:  MORE TAXES = LESS FLYING. 

Oh, I know the argument is going to be if airlines can charge for baggage and ticketing changes and other ancillary fees then a few more dollars in taxes will have little to no effect on the industry.  Problem is, those ancillary fees have kept carriers flying, covering the difference in the base fare charged and the total cost of the trip and helped staunch the gush of red ink caused by volatile fuel prices. (Usually caused by unregulated fuel speculation, but that’s an entirely different topic.)

Let’s not forget about fuel. Ancillary fees and fuel surcharges have helped airlines offset – but not completely make up for – the high cost of Jet A. Tacking on dollars to the base ticket price in taxes probably means carriers won’t be able to curb fuel price effects by passing some of the cost on to the consumer. We’re back to unintended consequences as those additional taxes could cost the airline revenue and, if airlines aren’t careful, keep passengers from flying.

Worse, new airline taxes won’t put a dent in the national deficit.  Rather than do the job they were sent to Washington to do and make difficult spending cuts, the politicians would rather nickel and dime their way to some sort of feel good fix while inflicting damage on an industry that helps propel the economy each hour of every day.

It will be interesting to see if service cuts similar to what Delta announced last week don’t increase if new taxes are imposed.  Certainly some profitable flights will become unprofitable.  Some breakeven flights will become unprofitable.  Reading the lips of today’s CEO’s, unprofitable flying must be culled from the system.  How will that sit with 535 representatives that call Congress home for at least two years?  If members of Congress are frustrated by service cutbacks as a result of high oil prices and weak economies, then what might they tell their constituents when more tax on the industry results in even more lost service. 

Communities are being disenfranchised from the air transportation grid.  The highway will increasingly become the first access point.  Service cutbacks triggered by new taxes won’t only force more communities to the road, but they’ll also strangle their economic opportunities. Yes, another unintended consequence.  

The White House and Congress should be thinking about the airline industry as a facilitator of economic activity.  To dismiss it as a make work project or generator of marginal tax revenue only undermines the United States global leadership position.  As I have said before, it is less about Altoona and more about Auckland. If you make it so people can’t get here from there, they simply won’t bother.

There’s another consequence the White House should be very sensitive to. The airline industry still offers high-paying jobs. Killing it with a thousand paper cuts – a little tax here, a little tax there – and, all of a sudden, carriers are cutting even more capacity. More employees are furloughed. More carriers head to bankruptcy and those jobs disappear.  Completely opposite of what the administration has been promising. 

The increased taxes under consideration are not industry killers by themselves.  They just pile on top of taxes and fees that really do impact the overall demand of an industry – an industry vital to the velocity of economy every day.

Congress and the White House should really think about what their intent is… and the consequences it might have. Picking the pocket of an industry that has little to give, costing not just businesses, but communities and employees isn’t smart government. In fact, it might be a sin.

Monday
Jul182011

LaHood Protecting Consumers? Pretending To Protect Consumers?

Some time ago, I asked this question to an audience of airport executives:  If the airline industry is consolidating, shouldn’t the infrastructure supporting the industry consolidate as well?  The converse action of consolidation is fragmentation.  Fragmentation of markets has long been a practice of the US airline industry that has attempted to be everything to everybody.  Fragmented industries earn poor returns.

For example, the LA Basin is served by five airports:  Los Angeles (LAX), Ontario (ONT), Orange County (SNA), Burbank (BUR) and Long Beach (LGB).  Not every airline serves all five of the Basin’s airports.  But in every case the core traffic is Los Angeles traffic and by serving different airports the industry is fragmenting the Basin’s traffic.  Now Los Angeles may not be the best example given its huge population base and underlying wealth.  Nevertheless, the concept is as prevalent in Indianapolis as it is in Atlanta as it is in Washington, DC.

Between 1980 and 2010, LAX has accounted for increasingly less of the region’s domestic traffic.  To compound the problem of intra-regional competition, nominal domestic air fares at each of the five Los Angeles airports were lower in 2010 than they were in 1980.  This is but one reason why the infrastructure needs to consolidate.  Fragmentation produces unsatisfactory and unsustainable financial results.  As individual carriers increasingly realize, airlines cannot be everything to everyone.  Just last week, the following news story hit the wires:  Delta to Adjust Service to Smaller, Underperforming Markets.

As Jad Mouawad wrote in his recent New York Times article Air Service Cutbacks Hit Hardest Where Recession Did:  “. . . the [air service] cutbacks are redrawing the nation’s air service map to reflect the industry’s new priorities and changed economics. As recently as a decade ago, the airlines put a premium on growth, competed on every possible route and sought to connect to even the farthest outposts. Now, they are emphasizing fiscal discipline, which means paring back service to many cities and forgoing unprofitable destinations altogether as higher fuel prices weigh on their bottom line.”

I’ve weighed on this topic before:  Regional Airline and Small Community Air Service: It’s Time to Regionalize, Not Marginalize, the System.  As has analyst Mike Boyd of Boyd Group International whose thoughts in his weekly Hot Flash make clear the topic also will be discussed in depth at The Boyd Group International’s 16th Annual International Aviation Forecast Summit, August 28-30, in Albuquerque, NM.  As with many things Mike, the conference is a no-holds-barred discussion of third rail issues that affect the entire industry, whether airports, airlines, vendors, media, manufacturers and government, to name a few.

Under structural consolidation, a number of airports will ultimately lose direct air service, and more Americans will have to drive farther to get to an airport.  No doubt that for many communities this will come as a shock.  But as is the case with even urban areas, travelers already often bypass the local airport to take advantage of lower fares at another airport a bit farther away.

Unfortunately, the Obama Administration isn’t doing much to help an industry already burdened by regulations, battered by the economy, squeezed by oil prices and constantly beset by competition. Consider the response of U.S. Transportation Secretary Ray LaHood who, in the classic tradition of “I’m from the government and I’m here to help” last week unveiled a new proposed federal rule to force airlines to report more data on fees, baggage and mishandled wheelchairs..

This is an industry that earned a scant two cents on every dollar in 2010 and yet the government wants to dig further into the file cabinets of every airline in the country in a misguided attempt to account for the money those fees are bringing in. In case you have been living under a rock, the genesis of ancillary fees has been among the most covered and scrutinized stories since 2008.  In 2010, US airlines generated $3.4 billion in baggage fees and another $2.3 billion in reservation change fees for a total of $5.7 billion.  What about the fact that the industry’s fuel bill in 2010 was $6.5 billion higher than in 2009?  The Air Transport Association forecasts that the industry’s fuel bill in 2011 will be $14 billion more in 2011 than it was in 2010.  Remember, it was the rising cost of fuel in 2008 that served as the catalyst to unbundle the airline product.

This latest proposed rulemaking coming out of LaHood’s agency under the guise of consumer protection is anything but.  Today fees are not taxed.  The government wants to get its paws on any new revenue it can find and of course the airline industry is targeted.  LaHood’s proposed rule would require airlines to report 16 additional categories of fee revenue in addition to the baggage and reservation change fees.  Outrageous.

Let’s turn the tables.  As a consumer and a taxpayer, I’d like to see a complete breakout of the special aviation fees and taxes collected by the government.  All I get on my ticket is a total: an amount that includes what the ATA counts as 10 categories of special aviation fees and taxes. 

I want to know how much the passenger facility charge is on my ticket.  I want to know how much is going to the Department of Homeland Security for the September 11 fee, immigration fee, the customs fee, the Aviation Security Infrastructure Fee (ASIF) and APHIS Passenger and Aircraft fees.  I want to know how much is going to the FAA in the form of domestic and international passenger taxes, jet fuel tax and the cargo waybill tax.  If the airlines are to report out on 16 incremental items in the name of consumer protection then I want to know where each dollar of taxes and special aviation fees goes.

So as the industry struggles to earn a meaningful profit, LaHood grandstands.  As he states in the DoT press release: “Our goal is to improve the quality of data we collect from airlines and make airline pricing more transparent. In an era of rising fees, passengers deserve better information about how airlines are performing, particularly when it comes to fees, baggage and accommodating passengers in wheelchairs.” 

Meanwhile communities are losing air service.  Maybe if some or all of the tax and fee revenue were returned to the airlines, then fewer markets would be underperforming and thus avoid service cuts.

The conversation about regionalizing air service should begin with a sober assessment of the market and clarity from the Secretary of Transportation on this administration’s vision of what constitutes the right air transportation market. 

This difficult discussion already is underway in some markets, including in Kansas where Dodge City and Garden City are discussing whether or not to form a regional airport. 

The article notes new urgency on the issue in Kansas because Congress may decide to eliminate the Essential Air Service program.


"The EAS program has come under attack in the past, but never really did we feel that the program was in jeopardy," Dodge City Manager Ken Strobel is quoted. "This year, however, there's more concern that the program may be phased out or funding cut substantially.”

The EAS program is but one reason for communities with marginal air service to consider “regionalizing.”  A stark example of another market is Pittsburgh and its catchment area.   There is one strong airport in that catchment area that includes Akron/Canton.  Latrobe, Morgantown, Franklin, Johnstown, Clarksburg, DuBois, Altoona, Parkersburg, Cleveland, Youngstown and Erie.  All have realized decreases in traffic or a total loss of service since 2000.  But demand within this area is the same as it was in 1990, signaling that fact that some areas have far weaker economies than others.

As the industry’s route map is redrawn maybe the Department of Transportation should be thinking about bigger picture things than wheelchairs, data reporting and fee transparency.  Rather than threatening the existing Essential Air Service Program, begin to define what is tomorrow’s essential.  Work with industry to identify the airports of tomorrow (airports serving a region that can fill either a large regional jet or turboprop or mainline with sufficient local traffic) and ensure that money is being spent wisely (as opposed, for example, to building air traffic control towers in Johnstown, PA.)  If it is determined that certain airports are closed to commercial air traffic, then each of those airports should remain closed to that traffic to ensure that regionalization produces positive results for an industry that desperately needs to be run like a business as opposed to a make work project.

Maybe the Department of Transportation turns out to be the agency that behaves the way former Congressman Oberstar behaved toward the industry – standing in the way of progress in building a sustainable system.  But I certainly hope not.