06.7.2011 In The Airline Business We Just Do Not Talk About Balance Sheets Enough
In the Gulf States, we have Qatar CEO Akbar Al Baker saying to Gulf Business Nothing Can Stop Us Now. In the article Al Baker talks about the high cost and inefficient airlines in the west. In the U.K., a headline in The Independent reads: More Carriers Could Fold Warns IAG’s Willie Walsh. Bruce Smith, writing for the Indianapolis Star publishes a story on hometown Republic Holdings titled: Republic Emphasizes Cost Cuts As It Fights To Compete. Like a lot of airlines these days, Republic’s branded carriers – otherwise known as Frontier and Midwest – are not only fighting to compete, they’re fighting to simply stay alive.
It’s easy to forget Republic now flies its own airline flag. Prior to purchasing Frontier and Midwest out of bankruptcy, Republic Holdings’ predominately did fee-for-departure flying for U.S. network carriers. In October 2008, I asked: Just Who Will Inherit the U.S. Domestic Market? Don’t Forget Today’s “Regional Carriers”. Nearly two years ago, after Republic staved off Southwest from sponsoring Frontier’s exit from bankruptcy, I asked, Is Republic Changing the Face of the US Domestic Market?
In each of the Swelblog.com articles referenced above, I talked about how smart Bryan Bedford, CEO of Republic Holdings (RJET) is. Bedford made the move to acquire Frontier and Midwest in an environment where it was increasingly clear the legacy carriers did not – and cannot over the long-term – operate under a cost structure that will not support the number of airlines trying to survive in the hypercompetitive U.S. domestic airline business. Since then, consolidation among U.S. carriers has taken off – for network, low cost and regional airlines alike.
Smart or not, the price of jet fuel puts pressure on Bedford’s balance sheet more so than other carriers given Republic’s incipient fragility. I have written time and again the most important financial statement for any airline today is its balance sheet. As Republic Holdings trades near a 52 week low, many analysts are jumping off the RJET bandwagon.
Mike Linenberg, equity analyst at Deutsche Bank, wrote following Republic’s first quarter results, “Republic ended the March quarter with $467 million in total cash, $37 million higher than at the end of the December quarter. While the company’s restricted cash balance increased $87 million to $226 million, driven by the seasonality of its Frontier business, unrestricted cash declined $50 million to $241 million, impacted by the company’s relatively high credit card holdback provision of 95%. Regarding additional sources of cash, Republic indicated that it had some collateral-backed debt that could be refinanced to produce an additional $70- $80 million of net cash to the company.”
In the airline business, cash is king and fuel is the wildcard. With its fee-for-departure contracts, Republic left the fuel risk to its mainline partners. (Of course the price of fuel affects the decision of the mainline carrier as to whether to buy regional capacity). Now Bedford has to buy fuel for his Frontier and Midwest subsidiaries… that helps to explain why RJET’s unrestricted cash declined by some $50 million.
Why I was bullish on the Republic – Frontier combination in the early days was because the Indianapolis based holding company had bought a brand, one that came with a vibrant flying community – Denver. With a community comes inherent demand. With demand comes revenue. But Last month, Ann Schrader of the Denver Post reported Southwest had jumped over Frontier in terms of market share at DIA.
Republic announced the acquisition of Frontier on June 22, 2009. On that date, the price of a barrel of West Texas Intermediate (WTI) crude oil was $64.58 and the price of a gallon of jet fuel was $1.78. In 2011, WTI has traded in excess of $100 per barrel and one gallon of jet fuel tops $3. It is one thing to be in the regional business when the cost of fuel doesn’t directly affect you. It’s another when you actually have to pay for the gas.
Southwest
On the flip side, I think that Southwest’s purchase of AirTran is brilliant. In many catchment areas around the contiguous 48 states most populated and wealthy areas, the combined carrier has at least two beachheads. While I still don’t believe Southwest, jetBlue, Frontier and Spirit will inherit the domestic U.S. marketplace; I am increasingly convinced the not-so-meek Southwest will inherit more earth than any of the others. The U.S. domestic market has always been about the survival of the fittest.
Might we be headed for another round where Southwest captures five points of domestic market share? Possibly. What’s different this time versus the 2001 – 2006 period when Southwest and the other LCCs captured nearly 20 points of domestic market share is the airlines losing ground won’t be the network carriers. More will come from weak competitors – like Frontier, Midwest and Spirit. . There should be little surprise that Spirit sold a fraction of its intended shares at 25 percent less than desired price in its Initial Public Offering (IPO).
Frontier is quickly losing pricing power in the very place it called home. Presumably the value in the Frontier franchise was its cult following in the Denver local market. Without a meaningful, and growing, share of the local market, pricing power is compromised. No pricing power in a high jet fuel cost environment does little to bolster a fragile balance sheet. Southwest has the time and the financial wherewithal to whittle Frontier's following and, thus, its franchise value.
Southwest isn’t Frontier’s (and Bedford’s) only headache. United has a presence in Denver as well, one that’s not necessarily focused on local traffic. That makes Denver somewhat different than other cities where three carriers have tried to hub. My guess is something is going to give in Denver because, at some point, the law of diminishing returns is sure to play out for any one of the three competitors. And I’ll bet on Southwest’s balance sheet winning the war.
Southwest is an opportunistic competitor. I expect Southwest to fill any voids left by either Frontier or United in Denver. Where United or Frontier might be vulnerable, Southwest will likely exploit that weakness by adding capacity. It can be patient because Southwest has a balance sheet that is far stronger than either of its two Denver competitors. Frontier is, by far, the weakest. The high cost of fuel is its immediate enemy and Frontier has fewer options than either Southwest or United.
Labor - It Really Is About The Balance Sheet
The one thing that the pre-Frontier/Midwest Republic did not have to worry about was earnings as long as it delivered the product promised to the mainline carriers. Today, the branded operation is suffering losses and is forecast to lose money going forward while most major players are going to make money. As Linenberg’s analysis suggests, Frontier needs to generate cash internally because it has limited borrowing capability.
The strong get stronger. The weak get weaker. Survival of the fittest at its most emblematic. As Bryan Bedford told his shareholders – and the world - he needed to find $100 million in cost savings, his pilots protested outside. No earnings and a weak balance sheet usually do not equal wage increases. It’s not about whether pilots deserve increases – that’s not what I’m talking about. Balance sheet repair is not sexy. Balance sheet repair does not add to earnings. Balance sheet repair does not produce wage increases and work rule changes that resemble 2001.
What balance sheet repair does is keep airlines flying. If struggling carriers don’t find ways to fix their sheets, they won’t be around. I don’t mean they’ll file Chapter 11 and hope to reorganize or sell themselves off at the last minute. I mean they will cease to exist. Their one-time employees will be out of work, their assets will be auctioned off. No one is going to pump capital into an airline whose balance sheet is out of whack, whether that’s because of fuel, diminished market share or labor costs.
It really is why pattern bargaining should be a thing of the past. Every airline is different. Every airline competes in different geographies, with different goals and has labor needs that other carriers don’t.
The more I think about it, US Airways pilots – and whichever union/group is currently representing them - are really doing the company a favor by not coming to grips with reality. US Airways is more exposed in the U.S. domestic market than any other network carrier. The U.S. domestic market is a low-fare environment and requires lower labor costs than, say, a United or a Delta that have more capacity in international markets. The same holds true for flight attendants and below-the-wing personnel. More to come on this one.
I see employees picketing and I scratch my head. This industry lost nearly one in every four jobs during the past decade, yet still has more than 350,000 employees with wage and benefit packages in excess of $85,000. This is an industry of good paying jobs despite the economic environment it operates in. Yet many labor groups refuse to recognize the need for balance sheet repair… and that labor costs have to be part of the fix. You can’t just tweak revenue or fuel costs or charge more for a ticket. Shoring the balance sheet requires a holistic approach.
Without that type of approach, as Willie Walsh recently said, more airlines will fold. I’ll even venture more could merge. Frontier is a classic example of why this industry is not out of the woods. And why even the network carriers are not done. And why the regional carriers are not done. Isn’t it interesting that Sean Menke, the former head of Frontier just joined Pinnacle Airlines – a truly regional carrier at this point in the industry lifecycle? What does he know that the rest of us do not? Me thinks that the domestic market will also be made up of today’s regional carriers; today’s low cost carriers and of course; today’s network carriers as Jeff Smisek, CEO at the new United said, "A domestic operation sized solely to feed our international traffic". It will be different no matter what pilot scope clauses suggest.