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Thursday
May202010

Consolidation Is the Logical Next Step in the Industry’s Evolution

Over at the National Journal's Transportation blog site, the question of the week is:  “Should Continental and United Be Allowed to Merge?  Lisa Caruso, the blog’s editor asks:  “What do you think of the proposed merger? Will it benefit the two airlines? What about customers and the airline industry as a whole? Should the Justice Department approve it? 

To date there have been responses to the question from Robert L. Crandall, former Chairman and CEO of American Airlines; Carol J. Carmody, formerly the Acting Chairman and Vice Chairman of the National Transportation Safety Board; Kevin Mitchell, Chairman of the Business Travel Coalition; and yours truly, William S. Swelbar, the author of www.swelblog.com

I urge you to read the comments as they are diverse and even “agnostic” toward the proposed merger of United and Continental.  Swelblog readers can comment directly to the National Journal Transportation blog.

Below are my comments to the question posed by the National Journal’s Ms. Caruso.

After decades of destructive competition, consolidation is the logical next phase of evolution in the U.S. airline industry.  This, after all, is an industry that lost $60 billion over the past decade – making folly of the goal of the 1944 Chicago Convention in charging the International Civil Aviation Organization to “prevent economic waste caused by unreasonable competition.” 

Instead, the U.S. domestic passenger market produced plenty of economic waste over the past 32 years, affecting shareholders, lenders, employees and most other stakeholders.  The only clear winner from the industry’s singular strategy of adding uneconomic capacity was the consumer.

Today, the legacy network carriers are focusing away from the bloodletting in the domestic market with an eye toward international flying. Too often, regulators and legislators and even some analysts see the global airline industry as somehow U.S.-centric.  It is not.  In aviation, the U.S. is one piece of a big puzzle that is influenced by global economic interdependencies, just as the U.S. economic recovery could be affected by events in Greece and possibly Portugal and Spain.

For the legacy carriers, this round of consolidation is more about preparing to compete with the world’s other big carriers as much as it is about competing with Southwest or AirTran or jetBlue.  That’s why so many are shaping their networks and alliances to attract domestic and international bound passengers.   The footprint established by the low fare carriers is now national in scope, while the fares they charge should be considered as much of a  contributor to that fact that many smaller communities are losing air service as is the economy and the price of oil.

The 1978 Airline Deregulation Act clearly accomplished the goal of delivering safe and affordable air service to the masses.  Today, airplanes are packed with flyers paying, on average, 55 percent less for a ticket when adjusted for inflation than they paid in 1978.  Why?  Because most U.S. airlines responded to deregulation in the 1980s and 1990s with a capacity-led business model that made cost control imperative.  Some of today’s cost controls can be found in the outsourcing of maintenance or downguaging the size of airplanes to adapt to the realities of the marketplace.  

For decades, the only way the industry knew how to grow revenue was to grow capacity.  Airlines used the tools and methods that had their roots in regulation and were focused on estimating market share.  Fundamental to that analysis was the belief that growing revenue meant the need to grow capacity – and most airlines did, even before demand warranted it.

Everybody focused on “screen display.”  Statistics showed that if an airline’s flight did not appear on the first few CRS screens of available flights in a market, that airline didn’t get as many bookings. The more sophisticated the global distribution system (GDS), the more important electronic “shelf space” became.

Only recently has the industry worked to rid itself of too much capacity brought about by this market share mentality – one result of the role of CRS/GDS bookings that made an airline seat a commodity.

Today’s consolidation is working to undo the capacity-added wrongs of the past. Consider labor.  For too long, airlines carried uneconomic capacity, employed too many people and signed on to labor contracts that created unreasonable expectations for airline employees.  That steady growth also created expectations that airlines were somehow required to serve smaller communities, even when demand did not warrant service and those routes could not be flown at a profit.

Much of this is still true. U.S. airlines have used bankruptcies and other restructuring efforts to cut capacity and increase productivity, but many did not go far enough.  The real catalyst to capacity discipline was $147 oil.  And that capacity discipline needs to continue if the industry is ever to get to a period where it earns at least its weighted average cost of capital. 

Unlike other rounds of consolidation that focused primarily on network scope, scale, revenue and cost synergies, this round is different.  Now the industry is looking at the balance sheet. The market rewarded Delta following its acquisition of Northwest with a market capitalization that exceeds that of United, Continental, American and US Airways combined.  Consolidated carriers promise more stability to employees, shareholders and communities that benefit from the combined strength of the respective balance sheets.

Capital has smartened up.  We do not see as much creative financing or unsecured lending as was common in the past.  Assuming successful mergers, combined airlines will be able to raise capital more easily, carry their labor costs and offer passengers more choice of routes and destinations. 

The U.S. market should not fear the “end to end” network consolidation like Delta – Northwest and the proposed United – Continental merger.  The market has demonstrated time and again that where competition is vulnerable, a new entrant will exploit that vulnerability.  Where there are market opportunities, there will be a carrier to leverage that opportunity.  And where there is insufficient capacity, capacity will find the insufficiency.

Simply put, the legacy carrier model of the 1980’s and 1990’s does not work in today’s environment. Consolidation is a logical step to position airlines in a highly fragmented industry to better weather the financial challenges that have caused years of economic pain and a rising tide of red ink.

More to come.

Wednesday
Apr152009

Liquidity, Labor and Legislation

Earnings season is upon us and we all anxiously await guidance from airline executives on a forward looking basis. On the eve of past earning seasons, cues from industry executives have mostly used words starting with “C.” This time around, I want to hear commentary on topics starting with “L” namely:

Liquidity

I believe that we are nearing the final chapters for one carrier, possibly two. I do not know which they might be, only that there are not enough rabbits left in the hat for every airline to survive in this market.

Why?

- Because labor will not be the internal source of capital that it has been in the past;
- Fuel costs are uncontrollable;
- Maintenance repair and overhaul will not offer hundreds of millions of dollars in savings in the future as most airlines already have outsourced as much of that business as they can;
- Distribution costs already have been wrung out of the system at every airline;
- Airport costs ebb and flow with the level of traffic;
- Aircraft rentals and other vendor contracts are largely fixed;
- Commitments made to feed providers are contractual;
- Interest obligations are known.

In other words, there just is not much room on the income statement for airlines to maneuver.

In the U.S. airline industry, we could be fast approaching the tipping point– the critical juncture in an evolving situation that leads to a new and irreversible development. With credit tight, would you put money into an industry that has historically destroyed capital? Would you bankroll an industry that has few opportunities to reduce costs in a weak economy? Would you lend money to companies facing labor strife? To get to the bottom line, would you invest in a company in an industry that has never made a dime? In this economy, there may not be many takers.

The airline industry is not special. Like other industries, it needs a plan to earn at least its cost of capital and compete for a limited pool of funding. And those who hold the capital will likely look first toward companies and industries that reward their capital providers more than once or twice every two decades.

I share the belief of some others that the domestic market may be stabilizing, but think this recovery will be an uneven one. The real driver may be the international market and the global economy’s interdependencies that I do not pretend to fully grasp. So I have concerns about American, Continental, Delta and United. Asia has been troubled in certain spots for nearly a decade now. Europe was a strong performer while the US industry faltered, but now shows signs of weakness across the continent. And Latin America’s economy appears to be similarly troubled.

Beginning today, when American leads the first quarter’s earnings parade, I will be all ears. Because what I see for some is troubling. Others will benefit from the weakness.

 

Labor

The recalcitrant unions at American remain the lead story as outlined in Mike Esterl’s piece in an April 14 Wall Street Journal entitled: Labor Negotiations Cloud Outlook for American Airlines Parent. American is being joined by United which opens negotiations with all of its major unions this month. Between the two, there will be plenty to read and write about as union leaders at each airline continue to promise outcomes to their members that could not be met even in the best of times. Real leadership would instead recognize that no airline can long survive overpriced labor contracts that put them at a competitive disadvantage in the industry.

I read somewhere this week that the United Airlines flight attendants union is promising its members a new contract that will give them industry-leading pay rates. The American pilots union is taking an old page out of the Continental pilots’ playbook that “the loan is due” to gain back pay levels the industry no longer supports. The problem is that concessions granted or forced in past years were a necessary correction of market costs that had risen above the industry’s ability to absorb those costs. Those concessions were never a “loan” and there isn’t a labor contract in the industry that includes terms on rates or principal that would make them so.

American has a first – at least in my recollection – in having all of its negotiations in mediation at the same time. United could be in the same place as date certain contractual understandings are in place to file for mediation in the event no agreement is reached. As for US Airways and the labor unions that have not been able to complete an agreement following the airline’s merger with America West, I have given up trying to apply logic to that situation. The damage done to employees is done and that was the work of the unions involved.

OhhhhhhBama – Release Me (And Let Me Love Again)

The Allied Pilots Association, which represents American pilots, has been on an ill-conceived, death-march strategy that the leadership somehow believes will get them closer to a release from mediation. Negotiations began in September 2006 -- a long haul by any perspective – but the clock was reset when a new union president, Lloyd Hill, was elected in June 2007. I don’t pretend to know the union’s strategy in these negotiations beyond what plays out publicly, but I do know that the Hill administration has made contract demands that are so far removed from reality that I question whether he is really representing the best interests of AA pilots.

With each union that files for mediation, my guess is the American pilots move yet another group down the pecking order for a release and thus the ability to engage in Self Help. The APA should be taking a clue from the Obama administration and its dealings with the UAW. The UAW’s Gettelfinger demonstrated a real understanding of that industry in balancing the interests of his members with the economic reality, in part by working to preserve wages and benefits of current employees by negotiating lower rates for new employees. But even that didn’t change the reality that, as the economy continues to collapse; the UAW is still not close to having moved far enough from work rules and wage rates that put the Big Three at a huge cost disadvantage in the global auto industry.

Finally, to the pilot leadership, I can’t imagine what possible benefit you would gain through strikes or other work actions that few airlines could survive. First, there is little chance the White House would allow a union at a carrier the size of American or United or Continental to actually go on strike and potentially threaten the economy’s ability to recover. No matter how labor friendly the new administration is, I believe that any union will need to make a pretty powerful case to the White House as to why a strike is more important than the recovery of the United States economy. Any union that can make a case that restoration of inflation-adjusted wages can be easily paid for by the airlines may have a chance, but that’s going to be a tough case to make.

I refer to the American pilots union in this example, but it applies to any large airline. Too much stimulus is potentially threatened by a strike in an industry as crucial to commerce as the airline industry.

Here’s my bet on where pilot contract negotiations will end up at the legacy airlines: With the Delta deal done under the leadership of ALPA’s Captain Lee Moak, the remaining negotiations will be completed in the following order: 2) Continental; 3) United (following the lead taken in the CO negotiations); 4) US Airways (assuming a final resolution to the seniority issues scheduled for the end of April); and 5) American (and perhaps only after a “leadership” change takes place.)

Congrats to Southwest for having put to bed their negotiation with multiple groups at reasonable rate increases.  With little management distraction, the airline can focus on finding needed revenue.

 

Legislation

Finally, there are legislative issues important to this industry that deserves color in the upcoming earnings calls. First and foremost is a reauthorization bill that will fund the FAA’s activities. A committed industry must find a way to fund enhancements to the air traffic control system. Everyone in the industry recognizes the need to make changes. Now we’re just fighting over who will pay for them. It’s time to move forward and for the various factions to present a united front on "who will pay what".

Second on the legislative front is Oberstar’s bill to evaluate airline alliances every three years -- a clear attempt to make the formation of these alliances increasingly difficult. Never did I think I would write that former AMR Chairman Bob Crandall and Minnesota Congressman Jim Oberstar are on the same page regarding a controversial commercial issue, but I am - and I am even writing it in the same sentence.

In an interview with the National Journal’s Lisa Caruso, Crandall actually says: “In my view, an objective observer would have to look very hard to find a way in which alliances have benefited consumers.” His remarks point to the “dominance” of slots at Frankfurt and Paris by the aligned carriers. Is this any different than the structure "Crandall built" in the US domestic market where carriers were reluctant to offer service between the hubs of a competitor? Absolutely not. Instead, the competition offered a menu of one-stop competing services that presented the consumer a choice.

Are we not to acknowledge that the air travel consumer in Toledo benefited significantly from the Northwest – KLM alliance that offered seamless connecting service to Amsterdam and points beyond? Wasn’t it Crandall that coveted a partner in Brussels to partake in these very same traffic flows? Does Crandall really believe that Detroit and Minneapolis would have multiple non-stop services to Amsterdam if not for the alliance? Does Oberstar really believe that Minneapolis would have the international service to Europe it does without the network of KLM and now Air France on the other end?

Crandall even makes the point that the foreign carriers have been the beneficiaries at the expense of US carrier interests. Crandall is the one that brought the concept of time-of-day departures to the networks of the nation’s carriers. This alone has contributed to a significant amount of the uneconomic capacity that pervades the industry today. Do we really think that all of the departures that “Bob built” were good for anyone? If we did not have alliances to begin filling all of the ill-conceived capacity deployed in Crandall’s domestic network, then we would have even fewer US carrier domestic departures than we do today – even after all of the cuts.

For a guy I admired, Crandall’s comments leave me perplexed, confused and confounded. Some of his fixes are on point, like a changed labor structure. But Crandall should accept some of the blame for an industry struggling today as his pit bull instinct toward competition became a blueprint to build an industry too big. Or maybe he should explain to airline employees that his blueprint caused an industry to hire too many people that now believe they are entitled to wages higher than the industry can pay.

More to come on this one.