Stuffing Romy’s Thanksgiving Turkey with Items for Secretary LaHood to Consider
On Friday, November 20, Montie Brewer, most recently Air Canada’s President and CEO, made a presentation at MIT titled: “Five Reasons Why the Airline Industry Will Never be Profitable.” Prior to making his way to Air Canada in 2004, Mr. Brewer (Montie) held senior positions at United Airlines, Northwest Airlines, Republic Airlines, Braniff and Trans World Airlines. He has planned and developed over 20 hub operations worldwide and played an integral role in the founding of the STAR alliance.
I sat down with Montie following his presentation with the intention to write about it, but also to use his talk as context as Secretary of Transportation Ray LaHood considers establishing a Blue Ribbon panel to study the woes of the U.S .airline industry. It seems like the perfect stuffing for 2009’s Thanksgiving turkey.
Brewer’s Five Reasons Why the Airline Industry Will Never be Profitable
The boom and bust cycles of airline industry earnings are well documented, as is the fact that subsequent down cycles to industry up-cycles destroy those earnings and more. The fact remains that any annual airline industry profits rarely exceed the average pre-tax earnings for U.S. corporations. As a preface to his talk, Brewer made clear it would be wrong to surmise individual airlines will not be profitable. Instead he contends the industry will always suffer due to structural reasons.
1. It’s A Capacity Lead Business Model (Causes Constant Overcapacity)
Since deregulation the airline product has been commoditized. In the commodity framework, the only way the industry, or an airline, can grow revenue is to grow capacity. Then, the Computer Reservations Systems and the Global Distribution Systems institutionalized the notion that in order for an airline to grow revenue, it needed to offer more and more capacity even before demand warranted.
The addition of capacity led to low and lower operating costs. On the margin, revenue exceeded cost. Uneconomic capacity was being deployed each and every day. Ultimately an industry too big to be sustainable was created.
The GDS’s were a major contributor to the commoditization of the airline product. Based on this fact, airlines that distribute directly to the consumer have the best likelihood of differentiating, and more importantly, not commoditizing, their product. This fact contributes to the notion that certain airlines can do well while the industry suffers.
2. Airplanes Don’t Go Away (They Just Become More Efficient)
A bad airline industry assumption is consolidation of the industry, whether through a merger or carrier liquidation, leads to industry capacity reduction. The airline industry time and again has demonstrated that once a carrier’s capacity is pushed to the edge, that carrier’s capacity (efficient and inefficient) does not go away.
With the working premise that the only way to grow revenue is to grow capacity, then new aircraft need to ordered. The problem is aircraft do not go away, and: aircraft do not make their way from an inefficient operator to a more efficient operator; aircraft CAN fly forever; even when an airline tries to retire aircraft, they come back like a bad spaghetti sauce (remember ValuJet using Delta’s DC-9s to compete directly with them in Atlanta); and, when carriers grow they realize great efficiencies.
An example of those efficiencies is a 3 percent growth in capacity results in only a 1 percent increase in total operating costs. However, this works in reverse when carriers pull capacity down as the cost savings cannot be achieved commensurate with the reduction. This fact is what plagues the industry today as a floor is created on just how much capacity can be reduced by any one airline.
[Note: If Brewer had his way, Airbus and Boeing would each be allowed to produce 10 new aircraft per year but he would allow the manufacturers to charge whatever amount they could earn on each of those 10 aircraft.]
3. Labor Leverage (Political Organizations Cannot Manage Commercial Reality)
Labor organizations are not structured to manage the responsibility they possess. In Brewer’s view labor has tremendous leverage over the industry. However, they are highly simple political organizations and, as such, only have a short-term view. For the politicians, the short-term view is to remain in their elected position. To overcome this flaw, labor organizations need to completely overhaul their governance structure.
Like the ordering of airplanes, management historically reaches agreements with labor at the very end or the peak of economic up cycles and then faces the prospect of paying the bill during subsequent downturns. Given the high fixed costs of the industry, airlines can rarely afford a strike or intermittent work stoppages. During negotiations, both the airline and labor pretend management is in control. According to Brewer, the working assumption is management will not allow labor to take too much, but in reality, labor can take all it wants - - then both live with the outcome. Brewer believes, when costs like labor, fuel, maintenance, airport fees are factored in on a daily basis, the typical airline has 10 - 20 profitable days a year.
With 10-20 days of revenue to spend, some in labor have asked, “Why would management agree to a contract it can’t afford”? Well, because somewhere during the year, fuel exceeded budget, or the government issued a new airworthiness directive involving aircraft in an airline's fleet, or airport fees increased, or…….the false belief that management will contain labor’s desires from doing stupid things.
4. Input Costs are Too Volatile (Revenue Cycle and Cost Cycle Out of Sync)
Even in the best of years, the airline industry is a low margin business where it is not uncommon for any number of input costs to increase at least 20 percent. A low margin business with volatile input costs is a toxic mix. A good example occurred in 2008 when the price of oil increased from $80 per barrel to $147. As is typical in the airline business, tickets are often purchased months in advance. During the first half of 2008, it was not uncommon for passengers to be flying in June on a ticket purchased when oil was $50 per barrel cheaper.
Is the relationship of volatile costs relative to revenue impossible to manage? No, but it would require companies to maintain outsized cash balances. Cash balances that look good to labor during contract negotiations and to financial raiders seeking to buy a company to harvest that cash.
5. Nobody Really Wants It to Be Fixed
Brewer makes a powerful case that things are fine the way they are… and, for the most part, the airline industry value chain, consumers and the government know it.
When it comes to low fares, the consumer can shop the internet and find some market on sale. They may even find the price of a ticket today equal to, or less, in nominal dollars than a fare charged two decades ago. When adjusted for inflation, it is hard to find any consumer item that is a better bargain than air travel.
Taxes and fees are nearly $60 - or 20 percent - of the price of a ticket today. This compares to $22, or 7 percent, in 1972. The government is getting a bigger share of a shrinking pie.
Perhaps, most compelling is the industry's value chain like airline catering, aircraft lessors, ground handling, manufacturers, airports, distribution systems, fueling; travel agents, maintenance repair organizations and freight operations. Each of these industry sectors in the airline industry value chain earn a higher return on invested capital than the airline companies that keep them in business.
Some Questions for Secretary LaHood to Ponder
- Can a commodity business (airline business) that does not have to be a commodity business (too much supply) be permitted to change sufficiently by its stakeholders to achieve sustained profitability?
- Can an industry where inefficient capacity never leaves achieve sustained profitability?
- Can an industry where organized labor has outsized leverage but cannot manage the inherent responsibilities that come with that leverage change sufficiently in order for the industry to achieve sustained profitability?
- Can an industry with widely volatile input costs raise sufficient capital to manage its business without being raided by either a financial investor or a stakeholder seeking outsized payments?
- Can an industry where every stakeholder seems to be happy with the way it is, including governments and their constituents, consider making the necessary changes in order for the industry to achieve sustained profitability?
Any Discussion Must Begin With a Plan for Roads, Rail and Runways
To date, the only public suggestions that I have seen for the Secretary to consider in forming the panel come from Kevin Mitchell at the Business Travel Coalition. Mitchell, who participated in the Secretary’s discussion with various stakeholders on November 12, wrote LaHood outlining five issues that need studying by the proposed commission:
- No National Air Transportation Policy
- Airline Over-Scheduling
- Broken Industry Work Force Model
- Obsolete Air Traffic Control Technology
- Airline Industry Financial Failure
Mitchell also outlined causes of each, including unbridled faith in market forces; lack of government and industry foresight and leadership; lack of a productive labor-management model; unworkable industry financial model; ineffective FAA management; fragmented industry positions and lack of Congressional leadership. While Mitchell is thoughtful about the problems and their causes, parts of his list of those affected sounds more like advocacy for his clients.
Among the best of Mitchell’s observations is the need for a coherent transportation policy. That policy, though, should not focus on an alleged broken regional airline business model; tarmac delays; that the industry is no longer a desired profession; pressure on safety margins; loss of skilled jobs; lost service; or a loss of international leadership.
The transportation policy should be about roads, rails and runways -- period. After all, there must be some very good reason why Warren Buffett is spending $34 billion to buy Burlington Northern? For aviation specifically, it should address the need to define, resize and equip the desired infrastructure for the 21st Century. For airports that might be disenfranchised from the air transportation grid, do highways need to be built that easily facilitate a different access point for those air travel consumers? It should not be about championing a unique labor force that already has considerable power and very good paying jobs relative to the overall work force or the calls of various consumer advocates.
Organized labor was a force behind LaHood's consideration to form a commission to study the airline industry. But nowhere based on what I have read does labor accept any responsibility for the current condition of the industry. Times have changed, and unions need to understand that. For organized labor – and by extrapolation, airline labor – to be successful, the unions can no longer be in the business of keeping themselves in business. It has to be about meaningful change. Change that entails understanding the new economic realities, or as the Harvard Business Review recently opined “that there will be no going home again…that the landscape of business has been forever altered.” [actually this question can be asked of every airline industry stakeholder] Can unions change or adapt to the idea that instead of being in business to secure decent jobs for the greatest number of people it might be better off securing great jobs for fewer workers?
Mitchell identifies the right stakeholders, but doesn’t ask ALL of the right questions. Brewer poses the right questions and does not suggest the market can answer them all. The answers lie in what this blog is about -- change: can industry stakeholders change and surrender unrealistic expectations of the past? Despite all of the cuts, we still have too much capacity, leading to too many inefficient operations, which lead to a government that really does not want to get out of the way --- because it has a stake in that inefficiency.
I hope that the administration is really going to evaluate the industry and recognize that all stakeholders need to change. And much of the change that needs to take place begins and ends with government accepting that an industry 50 years old ... well, needs to change.
More to come.