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Friday
Jan102014

A Walk Across the Last Five Business Cycles

On Monday January 13, 2014 I am pleased to be joining two panels at the 93rd meeting of the Transportation Research Board in Washington, DC.  On one panel, Airline Consolidation: Impacts on Stakeholders and the Industry, I will be joined by my MIT colleague Mike Wittman to speak to a series of MIT white papers on small community air service.  The panel will be moderated by one of the industry’s good guys, Paul Aussendorf of the Government Accountability Office.

The other panel, Economic Deregulation of Airlines: A Promise Realized?, will have as its moderator another industry good guy in Robert Peterson of Boeing.  Some might say deregulation is a tired topic, but there are many critical lessons to learn from the past 35 years as we anticipate what’s ahead for investors and stakeholders in today’s industry.

ACROSS THE BUSINESS CYCLE

With shareholders now demanding profitability across the entire business cycle, I’ve analyzed the industry since deregulation across five distinct economic rounds.  It was interesting to look back on each of the five cycles and what insiders and observers said about the airline business. Consider Alfred Kahn, the so-called Father of Deregulation, who in 1977 admitted he did not know one plane from another.  “To me,” he said, “they are all just marginal costs with wings.”

Based on that over-arching simplification by the man in charge, the industry was being led down the marginal cost path all the while that a fully allocated cost approach should have been adopted.  Ah, hindsight. It was too late, but the story is a great one.  It’s got colorful characters like Marty Shugrue and Frank Lorenzo, smart guys like Michael E. Levine and Warren Buffet, and current wisdom from the guys now running the big airlines, including Jeff Smisek and Richard Anderson.

A hard look at the financial data shows that the industry actually made a few pennies on a pre-tax basis through the fourth quarter of 2001, the end of the third business cycle.   The average cost of fuel was then $0.62, down from $0.84 during the first business cycle.  On a cost per seat mile basis, labor costs were managed with a deft touch during the entire 35-year period, despite that fact that the average cost per employee grew roughly at the rate of inflation.  Average wage growth outpaced productivity growth.  And any financial or economic efficiencies were competed away in the form of low and lower fares.

Warren Buffet said it best:  “The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines.”

All told, the industry lost $36 billion on a pre-tax basis, or 1.2 cents on every dollar of revenue.  But that is changing.  Load factors are up over 14 points across the last two business cycles as capacity growth slows. The current cycle is producing an operating profit margin that is 1.2 points higher than that earned during the best performing cycle – and after 17 quarters, the macroeconomic indicators are starting to be true tailwinds.

I can’t overstate the effect of load factor and ancillary revenue on unit revenue.  In the current cycle, the increase in unit revenue actually outpaces the increase in the consumer price index – an achievement long overdue.  Yet despite what is described by one prominent analyst as a “Goldilocks economy,” margins remain below the targeted level.

The first four cycles were defined by cost cutting and sheer survival.  Given that there is little low hanging expense fruit remaining on many airline income statements, the current cycle is all about the revenue.  As it should be.

WHAT COMES NEXT?

Whereas the current cycle shows incredible promise for profits, without some technological breakthrough that allows us to fly faster and longer, where will we find the efficiencies on the expense side of the ledger? Spirit and Allegiant are prospering by carrying passengers that the network carriers cannot afford to carry.  So how much more can airfares rise before an Ultra Low Cost Carrier (ULCC) revolution breaks out in the US domestic market?  As we test the limits of price elasticity, cost creep is a reality in labor and non-labor unit costs. 

Near-term, all things point bullish on the airline sector.  However, we know that growth prospects are limited for the higher cost network carriers in the domestic market.  Internationally, the next logical step (or the only step remaining after joint ventures) is to allow cross-border mergers. Is that the answer? I think not, at least if I am a US carrier looking to buy something outright.  Removing barriers is a good thing, but I can’t see too many U.S. carriers buying a European alliance partner that operates at 21 cents a seat mile - a cost that likely goes higher before it goes lower.

With all going so well, why even bring this up?  Because we need to be thinking from the position of financial strength that has taken so long to reach.  I trembled a couple of weeks ago when a headline in the Washington Post read:  GDP Grows an Adjusted 4.1%.  With indifferent macroeconomic indicators in play during the first phase of this business cycle quickly becoming tailwinds today, one hopes that the lessons learned this decade stick.  The cost creep found in some areas of the income statement gives pause particularly if one believes, as I do, that the industry is approaching a passenger revenue inflection point.

Robust periods of past business cycles have led to some bad management decisions.  I hope the leaders of today’s airlines will not repeat them.

Sunday
Sep052010

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

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

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

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

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

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

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

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

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

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

The Deregulation Debate Leading Up to Passage of the ADA

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

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

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

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

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

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

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

Perplexed

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

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

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

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

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

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

Concluding Thoughts and An Ask of You

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

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

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

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

Monday
Oct272008

04. It’s Airline Deregulation Bday Week: Stakeholder Winners & Losers

This month, in honor of the 30th anniversary of deregulation, I’m focusing on where deregulation got it right; wrong; backwards; and indifferent. Today we look at what is right. In the most simple of objectives

Click to read more ...

Thursday
Oct232008

03. It’s Airline Deregulation Bday Week: Management & Labor; Boom & Bust

Earlier this week, I promised to write my views on 30 years of deregulation, with a focus on where deregulation got it right; wrong; backwards and indifferent. One area where the industry had it wrong and continues

Click to read more ...

Wednesday
Oct222008

02. It’s Airline Deregulation Bday Week: Triangulating Southwest to the Point of Indifference

Second in a series on Deregulation

There cannot be a discussion on the morphing of the US airline industry over the past 30 years without a few words on Southwest Airlines. The presence of this one airline, and its unique model in the US market, has influenced everything from network development; to labor costs; to non-labor costs; to the fostering of an environment that screams “I luv my job,” – rare in the US airline industry.

As I said in Monday’s post, I believe the industry’s discussion of commercial aviation’s economic impact is backward, I am indifferent about the role of Southwest and the Low Cost Carriers sector in general. But I believe that Southwest has had profound influence on the industry, both good and bad.

Network Triangulation

In the late 1980’s and early 1990’s, the Dallas-based carrier was increasingly recognized as a potential force. In May of 1993, the US Department of Transportation published what is now a highly recognized piece analyzing that force: The Airline Deregulation Evolution Continues: The Southwest Effect. Many know Southwest’s storied beginnings, beginning with a napkin on which the initial route network was drawn: Houston – Dallas – San Antonio. As the name implies, much of its network was confined to west of the Mississippi River until 1995.

In addition to the obvious airport market attributes Southwest looks for before it enters a new city, the carrier employed a fairly rigid network strategy as well. One day, I sat down at a table and mapped out Southwest’s growth city by city over its history. Lo and behold, when the initial nonstop segments were announced from a new airport market, you could bet that new triangles were formed. For example, from Indianapolis, Southwest might announce Orlando and Kansas City service. Southwest made sure before announcing any two new segments from a new city that there was existing service between the two points, just as there was in the case of Orlando-Kansas City when Southwest began service in Indianapolis.

Airline observers often refer to the hubs of the network legacy carriers as “fortress hubs.” Southwest built its own fortresses of sorts through the use of its network triangle strategy, protecting its own flows no matter how small. Over time, the carrier took small hub airports and made them medium hubs – or nodes -- which like fortress hubs serve to protect Southwest’s primacy and discourage competition.

Southwest’s construction of its nodal network provides it with both the flexibility of being a point-to-point carrier as well as a carrier that connects traffic across its system at super nodes like Baltimore, Nashville, Phoenix and Las Vegas. While it serves only 64 of the nation’s 340+ commercial airports within the contiguous United States, Southwest impacts more than 90 percent of nation’s domestic origin and destination traffic.

This calculation is tedious but its methodology is simple. Draw a circle of two hours driving distance around each of Southwest’s 64 points – a clear visual of their strategy that aims to expand the catchment area, or reach, of the airport markets it chooses. Then, envelope multiple airports within the catchment area; each of them becomes a source of demand for the carrier’s lower fares. Southwest service has demonstrated clearly that the highway is an acceptable entry point to access the US air transportation system, but it also has had a negative and profound effect on small airports.

[Editorial question for policymakers: why is access to the air transportation system via the highway acceptable when Southwest is involved and not acceptable if a network legacy needs to close a market because it is not economic to serve a particular airport market?]

Earlier this month, Southwest announced it would start service to Minneapolis/St. Paul making the Twin Cities its 65th node. To give you an idea of the power of the carrier’s "no-connect network", it advertises that modest service between the Twin Cities and Chicago-Midway will provide access to more than two-thirds of Southwest’s entire network.

Great to be a Southwest Employee, Not so great for other airline employees

In recent years, Southwest employees have fared significantly better than their network legacy carrier peers in winning wage and benefit improvements. Today, Southwest workers are, on average, the highest compensated employees among the top dozen carriers. Their secret in providing industry-high average wages is simple. Their model incorporates and employs high productivity across a network of shorter stage lengths and smaller aircraft that should, by definition, make this achievement most difficult. And all of this is made possible through their unique network.

Keep in mind however, that Southwest did not enter the competitive fray burdened by labor contracts with provisions held over from before the advent of jet airplanes. It didn’t have a senior workforce or the labor costs bloated by seniority pay. And it didn’t have a network like those of its competitors that entered the market well before deregulation – in other words one designed by regulators who determined which cities, from which carrier, would get commercial air service with little regard for efficiency. Instead, Southwest got to draw its own lines and routes that define the company today. And they did so with an evangelical approach to labor and employee relations that many believe give the airline an edge in customer service and reliability as well.

Productivity is the Southwest mantra – whether it is labor, aircraft or facilities. Southwest’s non-labor costs have always been a competitive advantage. Many observers believe that unit labor costs are the airline’s most effective weapon, but I argue that is not the case. Instead, it is the relationship of productivity and pay that has provided Southwest with flexibility to pay relatively high wages as it negotiates with its highly-unionized work force.

This is the concept that the unionized work forces of the network legacy carriers struggle to comprehend. Traditional hub and spoke carriers with vast operations cannot achieve Southwest’s level of productivity. But there is a relationship, or an equilibrium, that can be found at each and every carrier. If the will to ”find it” could only be found.

Now, 30 years after the deregulation experiment began, Southwest has grown to be the largest domestic carrier in the US, with low costs and network scope that will continue to pose a significant competitive challenge to other airlines. Southwest may well be the best managed airline in the business, as most industry observers agree. But its success was also helped by the fact that Southwest did not enter the fray with a legacy noose around its neck. Instead, Southwest succeeded because it was small, nimble and could easily adapt and exploit opportunities as the competitive landscape evolved.

Triangulating Labor, Network, and Southwest

In an ideal world, an airline’s network would drive the labor and staffing decisions to achieve the best possible efficiency and productivity for the respective airline. In the real world, the legacy network carriers are often forced to create a network around the labor contracts that have put strict limits on productivity and constraints on how best to serve markets in its system.

Low cost carriers are most often cited as the primary driver of consumer benefits because low fares have opened the skies to the masses. But are they? Have they been? No. Consider that Southwest serves only 20 percent of the commercial airports in the contiguous United States. So how can they, and their low cost carrier peers, be considered the shining light(s) of deregulation? Yes they drove prices down in the larger markets – the only markets the low cost sector serves with few exceptions - and in some small markets indirectly, but the effect was to kill off many small airports in their wake.

Through its efficient and methodical approach to building a company, Southwest puts pressure on incumbents to be just as efficient. We see this most recently as network legacy carriers have reduced wages and increased productivity. But the process has been supremely painful and, in some cases, required a trip or two through the bankruptcy courts, in part because neither management nor labor leaders had the will to make changes necessary to adapt to new competition.

Today, Southwest’s network touches virtually every geographic market of size in the US. As the domestic market is now contested at each and every point, the network legacy carriers are left with two choices: 1) attrit and possibly exit the domestic space; or 2) negotiate a new labor construct that can cohabitate with the likes of Southwest. Neither choice is ideal. But one choice is better than the other.

Concluding Thoughts

Throughout my career, I’ve been engaged in some battles involving Southwest – but only on the other side. I can attest that they are a hard-nosed competitor. But I am a professed network carrier guy that fervently believes the low cost sector receives entirely too much credit for bringing the benefits this industry drives each and every day.

Southwest is often first to cry foul with claims of being competitively disadvantaged when it tries to enter new markets or protests paying for what it believes is its fair share of the air traffic system. But that so-called “disadvantage” has done quite well for Southwest’s leaders, employees and shareholders.

I applaud and admire the airline’s culture and competitive success. But before we give all of the awards, I ask that small communities and legacy carrier labor ask what good Southwest has done them? In fact, it is the network legacy carriers that deserve awards for keeping many small communities alive by continuing air service, even when some of these routes can’t be flown profitably. It is also true that ticket prices have been contained or even reduced by the hub competition that exists in the US domestic market today.

In the future, look to the horizon for the new competitive battleground. It will be more about Auckland than Amarillo. It really will.

More to come.

Monday
Oct202008

01. It’s Airline Deregulation Bday Week: Economic Impact of Commercial Aviation

First in a series on Deregulation

For the past couple of months I have been doing a fair amount of public speaking. Appreciating that this month/year represents the 30th birthday of the passage of the Airline Deregulation Act of 1978, most of my engagements have focused on the industry's evolution over the past three decades. Over the coming days on this blog, I will focus on where deregulation got it right; wrong; indifferent; or maybe even backwards. Today, I am going to start with one idea that just might be backwards.

Between Airlines and Airports: Who Really Creates the Economic Impact?

Do a Google search for the economic impact of aviation. The impacts on North Carolina, Oklahoma, Wyoming, Oregon, Nebraska and Texas will all populate the first page of that search. On the same page of the search you will find the Air Transport Association’s study of the economic impact of commercial aviation on state economies. As the ATA’s study and other studies say in their own ways: commercial aviation is inextricably linked to the health of the local, national and global macro economies.

The first page of ATA’s report quotes Pulitzer Prize winner Daniel Yergen:. "Every day, the airline industry propels the economic takeoff of our nation,” Yergen observes. “It is the great enabler, knitting together all corners of the country, facilitating the movement of people and goods that is the backbone of economic growth. It also firmly embeds us in that awesome process of globalization that is defining the 21st century."

My question: Are the airlines themselves enablers? Or facilitators? Yergen is probably right in suggesting a combination of inputs are necessary to create the commercial aviation industry. Any economic assessment of the impact of commercial aviation will measure direct benefits of the service; indirect benefits generated from the service; and induced benefits derived from air service on the economy as a whole.

In the most simple form, direct impacts are the earnings and employment generated by the service. Indirect benefits typically measure expenditures driven by the passengers who travel to the destination on the service. And induced economic activity is measured by related industries that benefit from the direct and indirect economic activity of the service – typically a multiplier of the direct and indirect activity.

Can Airlines Make Themselves Profitable on a Sustainable Basis?

Given estimates that the US airline industry will lose nearly $20 billion since deregulation, while local and national economies have expanded, could it be argued that the model is backward? Government policy is hell-bent on promoting competition in each and every market. The industry has delivered a network platform comprised of carrier-to-carrier competition, hub-to-hub competition, and the competition between network legacy carrier and low cost carriers. There is not a single airline flying for which the current revenue model works if only the fares charged passengers are counted.

In an article published in the current edition of Foreign Policy magazine, I note that US carriers of all ilks lose money per enplaned passenger when only passenger revenue is counted – a simple but telling analysis. Counting only passenger revenue, both the legacy and low cost carrier sectors have lost money per passenger since 2001. In fact the low cost carrier sector has only made money based on this metric three times since 1995. Thus the industry absolutely needs to raise fares, charge ancillary fees and/or continue its efforts to cut fixedcosts - or all of the above - as the loss per enplaned passenger calculations exclude interest expense and direct investments in the business.

Airlines have a long way to go before they find a sustainable operating model that manages to “feed” various stakeholders. In some circles there are calls for re-regulation. But this ignores the fact that the federal government already heavily regulates this so-called “deregulated” industry, so it is unlikely that further regulation is the answer.

Now the Question?

Maybe it is the communities that realize the economic benefits of commercial airline service that should subsidize the airline’s losses?

After all, it is not the airlines that are realizing millions– and in some cases billions - of dollars in economic benefits – profits that they would otherwise use to pay higher wages or invest in new equipment. Rather, most of the gains go to the communities in the US and around the globe that depend on air service to drive direct, indirect and induced benefits, even while many complain that air fares are too high. Some of these economic benefits go to support airports and the infrastructure around them, but most subsidize the local economy without direct gain for the airlines that generated benefits.

It Is All Local – Until You Have to Pay For It?
Let the Local Market Wet-Lease Service

If all politics are local; and local economies depend on airline service; then shouldn’t politicians in local markets explore ways to “buy” the air service they believe is necessary to support the regional economy while also satisfying the expectations of their constituencies on the price of that air service? In effect we already have a similar model in place in the practice of network carriers that purchase capacity from their regional providers that includes a cost plus arrangement.

If politicians and the communities they represent protest higher fares, fees and reductions in service, then the answer should be a simple matter of economics. Have the community pay the difference between the ticket revenue and the cost-plus of maintaining the air service, plus some reasonable profit for the airline to reinvest in its business. Already, politicians and community leaders boast about the the economic benefits of air service; alternately, those facing air service reductions are the first to cry foul based on their estimates of economic costs. The decades old airline-airport/community operating model of today could be reworked to meet the financial realities of tomorrow’s aviation market.

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

Today many think that the low cost providers would be the answer to end all discussion. We would see, wouldn’t we?

More to come.

Thursday
May222008

Unbundling Our Way On The Search To Find The Inelastic Demand

I am beginning to believe that there is a silver lining in the high price of oil.

Last month, I wrote a piece entitled The Elastic Induced Ride to Inelasticity. With seat belts on, seat backs and tray tables up, we are ready for takeoff. Yesterday, while American and Southwest were holding their Annual Meetings of Shareholders, I was on an airplane back from Honolulu. So I missed the news flying out of those meetings that found its way onto the wires as rapidly as it could be transcribed. I missed the latest $4 per barrel rise in the cost of crude oil that now equates to $4+ per gallon of jet fuel. I missed …….. or, did I really miss anything?

Oh, I missed something all right. Whereas I believed the industry would transform itself more through merger and acquisition activity, I am now a believer that the price of oil, and the market, is truly what is needed to fully address the many structural ills that have plagued this industry for years. I would like to return to a few paragraphs I wrote in an Airline Business piece earlier this year: Are US carriers really ready for competition?

Despite claims to the contrary, nothing is new in the US. The same old ways of doing business remain intact, which calls into question whether the industry’s fabled “restructuring” has made any meaningful changes in the competitive profile of the US airline business. Despite deep cuts, many outmoded, and troubling, business practices remain.

Following an industry life cycle of value destruction, US legacy carriers now face a dilemma: whether to invest in their core businesses or not? Certainly the tendency to legislative and regulatory gridlock did not get restructured. An inflexible labor construct did not get restructured. The fragmentation of the US domestic market did not get restructured. The infrastructure, whether it be ATC or the airport system, did not get restructured. And the historic mindset that capital will be forever recycled among manufacturers, vendors, labor and government imposed actions did not get restructured.

Little has changed when it comes to labor and regulator views on consolidation. The mindset among the 535 decision makers on Capitol Hill still assumes that any congressional district with a runway, a terminal building and security is entitled to air service. Compounding this sense of entitlement is labor’s sense that the industry will return to its previous “pattern bargaining” – a supposition that fails to recognize the structural change in markets, labor and city pair.

Gerard Arpey’s Words

The full text of Mr. Arpey’s comments to his shareholders can be found here: Remarks Of Gerard Arpey At American Airlines Shareholders Meeting. As we approach the 30th birthday of US Airline Deregulation, it is the price of oil that is demonstrating its power to force the industry to address the many legacy mindsets that did not get restructured during the post 9/11 period. Among many, it includes the customer’s assumption that they actually pay the “all-in” price of the service and are therefore entitled to multiple access points to the air transportation system. NOT.

In this morning’s Wall Street Journal front page, column six, story by Susan Carey and Paulo Prada, they wrote: “If oil prices keep climbing, rising fares could start to push a significant percentage of travelers away from flying entirely. That could reverse one of the most dramatic effects of the industry’s deregulation in 1978, which led to a huge increase in flights, and brought intense fare competition, opening the world of air travel to millions of people”.

Ms. Carey and Mr. Prada are right. And the industry is right to evaluate the cost of providing the product at every juncture. And the industry is absolutely right to charge what it costs to produce the product. From the time the customer logs onto the internet to consider purchasing the ticket; to the actual purchase of the ticket; to the airport experience including check-in; the trip through security; down the jetway; taxi out; inflight service; taxi in; deplane; and collect luggage. Everything has a cost. And the management teams of each and every airline are being forced to “drill down” as never before in order to fully calculate those costs. And after calculating the costs of provision, many, many difficult decisions are being made.

Now this does not make any CEO popular. But being a CEO today is not a popularity contest during these difficult times. [And the most popular CEO of all time, stepped down from a 40+ year career BOD position yesterday] Being a CEO today means having the fortitude to say no. Being a CEO today means questioning anything and everything just because that is the way it has always been done. Being a CEO today means making the tough decisions even though dislocations of certain stakeholders might occur. And being a CEO today means having the guts to say out loud what CEOs knew before them but failed to act.

Mr. Arpey said and the WSJ highlighted: “The airline industry will not and cannot continue in its current state”.

Concluding Thoughts

With all of the actions being taken by the industry to charge for things that were never charged for before, what is interesting is how each carrier is sure to ensure that their most important customers will not pay those fees. Loyalty programs have just become a/the most important asset to an airline – not that they were not before – but rather it is this “inelastic” air traveler that the industry needs to rediscover. And cater to. And build for. And so on. And maybe this is why Mr. Arpey suggested that it was just not a good idea to sell its AAdvantage program. And maybe the market will begin to rethink how it values these currently undervalued assets.

This industry is now recognizing that it cannot be everything to everybody. Yes the industry has met its match – and it is not labor, government, or the macro economy. It is the high price of fuel that is causing the industry to continue the process of fully transforming the way business is done. My guess is that if we had not faced this potentially murderous economic period, then the industry would not have been forced to fully examine itself. The current industry architecture is a picture of what the deregulators envisioned – and the industry delivered. But the architecture produced does not work.

So Mr. Arpey, as your unions marched, I for one am glad you spoke. And you spoke clearly as to how American is moving forward. Your message was not popular. Your message pushed the envelope a little further and added to the debate significantly. No one knows how all of this will really play out. There has to be recognition before there is action. The industry is taking action and one can only hope that labor and government begin to recognize that we are not going back to the same old, same old.

Except for the fact that each airline will "return their attention" to those core, “inelastic”, customers that are willing and able to pay for the service being provided. And those customers will complain less over time. As for the rest of the traveling public and lawmakers that believe they are entitled to air service - well you are not.

More to come.

Thursday
Jan312008

Swelblog.com: Taking Great Exception with Congressman Oberstar

Congressman Oberstar says: “Hell No”; I Say What’s Different

In today’s Aviation Daily, Correspondent Madhu Unnikrishnan published a story entitled “Oberstar Strongly Opposed to Airline Consolidation”. The full text of the story is included at the end of this post.

Congressman Oberstar, I grew up in your congressional district and am quite familiar with the “Socialist Republic of Minnesota” moniker that is sometimes used to describe politics there.

You speak often, and proudly, about deregulation and the consumer benefits derived from the Act. But wasn’t it also designed to allow the free market to work? Wasn’t it designed to force efficiency that would ultimately bestow lower prices on the consumer and to get them flying?

A Lot of Questions About Why “Hell No”

I am attaching a 1979 - 2005 chronology of actions between the State of Minnesota and Northwest Airlines that were compiled by Senate Majority Research. Certainly there are a number of actions included on the list that are anything but free market. As you reflect back on many of these actions that have your fingerprints all over them, how would you measure their success? Certainly you would not make the case that this was the free market at work. Parochial and protectionist -- yes. Free market -- no.

A big question for you today asks: is it more important to have an airline with its headquarters based in Minneapolis/St. Paul or a strong industry carrying the US flag around the globe?

Did the numerous financial aid packages you helped to author keep Northwest out of bankruptcy?: No. Have Northwest workers been subject to the same loss of income and benefits that have been suffered across the industry?: Yes. Northwest’s need to reduce cost and the resultant employee loss of income is a function of the free market that you were part of creating. Are you confident that the current environment ensures the success and staying power of Northwest as an independent entity that will forever employ all its workers that remain?

If there was ever an airline antitrust issue that was bound to impact Minnesota – Minneapolis/St. Paul and Duluth for that matter - it was the Northwest – Republic merger that was announced in 1986 when you were a member of Congress. Why was it OK then to remove a competitor in a hub market and any talk of consolidation today of a fragmented and hypercompetitive domestic market gets a “Hell No” from you?

The Darwinian struggle to survive initiated by Airline Deregulation Act drove Northwest to buy its primary competitor in Minneapolis -- Republic. That new competitive environment created by the ADA caused virtually all incumbent airlines to evaluate the relative size of their respective networks to that of the other domestic competitors in the market. When Northwest bought Republic, the industry was in its infancy and the focus was on the domestic market as network size could not be built organically in the face of deregulated pricing.

Today US airline competitiveness in the global marketplace is in its infancy. All that is different is that now we’re talking about network size relative to the global marketplace. Just like when Northwest bought Republic, today’s networks that are necessary to survive cannot be built organically. Certainly not when airlines lack critical pricing power that stems from a fragmented and hypercompetitive home market.

The size of the commercial aviation market is not confined to the eighth district of Minnesota, the borders around Minnesota or the 48 contiguous states. I know you are sent to Washington to represent your Minnesota district – and you do it well. But in your Chairmanship role, you represent the entire US. I thought that Congress was interested in the success of US industries, particularly those that are inextricably linked to the health of the US economy and assuring that US industry can be as competitive as it can be in the global economy.

That is not what I read and hear in your public statements. Am I wrong on this one: “Hell No”.

Aviation Daily, January 31, 2008

Oberstar Strongly Opposed To
Airline Consolidation

The House Transportation and Infrastructure Committee this week reinforced its opposition to airline consolidation.

Aviation subcommittee Chair Rep. Jerry Costello, D-Ill. said at a news conference that airline consolidation will be on the Transportation Committee’s radar screen this year. He noted the subcommittee will “examine and investigate” any mergers that “develop beyond rumor and discussion.”

But Committee Chairman Rep. James Oberstar, D-Minn., stepped
up the rhetoric on airline consolidation considerably, offering his opinion on the subject as “hell no!”

“Airline mergers do not serve the best public interest,” Oberstar said, arguing that consolidation can cause service to decline in remote areas and will almost certainly cause fares to rise.

The architects of deregulation didn’t predict the hub-and-spoke system would be a result of their actions, Oberstar noted, and he fears that further consolidation will cause the passengers “at the end of the spokes” to suffer cuts in service. Moreover, passengers are benefiting from the lowest fares, in real dollar terms, since deregulation, and this will end if consolidation reduces choice in carriers, he said.

Airlines will take defensive actions against a “mega-carrier,” Oberstar believes, and this will further reduce passenger choice.

The Justice Dept.’s oversight of airline mergers has been “sporadic,”
Oberstar said, but if a merger does happen this year, he said he will press the DOJ to examine it closely for antitrust violations. The U.S. Transportation Dept. also has a role to play in “defending the public
interest in aviation,” and Oberstar said he will “badger” DOT if necessary to prevent its approval of any airline merger.

If any airlines move closer to merging, Oberstar said the Transportation
Committee will hold hearings to “mobilize public opinion against airline mergers.” Consolidation only “benefits airline executives,” he warned.

Costello implored the Senate to move on the FAA reauthorization bill. The passage of the bill is crucial to the committee’s continued “aggressive” oversight of FAA and the airline industry, he said. Costello added that the committee will pay special attention to the issue of runway incursions this year.
-madhu_unnikrishnan@aviationweek.com