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Market Realignment: Labor, Mexico and the U.S. Regionals

Variable Compensation and “Upside Protections”

A commenter on my most recent post wrote:  “Variable compensation?? That implies that you think I trust airline executives to treat me fairly. Their behavior over the past decades clearly shows that they can't be trusted, and you want me to buy-off on a scheme where they CONTROL the data?”

Another commenter wrote quoting AMR CEO Gerard Arpey:  "And again, our hypothesis is that we’re going to continue to work in good faith, cut responsible agreements with our unions and that all of the network carriers in the next 24 months are going to go through the same funnel. And that when we all come out of that funnel, ultimately the market is going to be brought to bear on all of these companies and the market will determine wages and benefits in this industry just like it largely does other industries."

Just what is a responsible agreement? For one, a responsible agreement benefits both sides. It is one unlike those negotiated in the past where companies were forced to ask for concessions in a downturn because they cannot afford the terms of what had been agreed to previously. And for labor, it is one that is sustainable – one that won’t require concessionary bargaining in a downturn and provides protection on the upside to prevent companies from earning outsized profits on labor’s back. 

This is the area where unions have missed the boat in the past.  Too often, labor leaders spend too much time negotiating protections on the downside and ignore similar protections on the upside.  Think back to the period when this was most relevant - between 1995 and 2000 when the U.S. airline industry earned record profits.  Unions had just completed ratified concessionary agreements negotiated during the economic downturn begun in 1991.  As the industry’s fortunes turned, employees did not share in the most profitable period in U.S. airline history.  Rather employees sat and watched because their unions did not negotiate protections on the upside that would have ensured their sharing in the profits – some of which were made possible from lower labor costs.

The industry has been anything but profitable in the years since, so upside protections would have returned little if anything following the negotiations during restructuring.  Instead many employees got performance bonuses when their companies met stated operational goals.  But let’s suppose the U.S. industry now sits on the brink of a profit cycle.  If upside protections had been negotiated then, employees would share in the profits while new collective bargaining agreements are under negotiation. That would send a far stronger signal about the connection between productivity, competitive costs and profitability than has the long and painful cycle of give-some, take-some negotiations.

Can we expect realignment in labor during this round of airline negotiations?   And what will that mean for labor rates by the time every airline makes it through the funnel of negotiations? 

One thing is clear: carriers with relatively expensive labor rates today will need to adjust expectations at a time that industry economics, particularly domestic market economics, do not support outsized increases in flying rates, mechanic rates or most assuredly “below the wing” rates.


Two days ago, Mexico’s largest carrier filed for bankruptcy protection in the U.S. and insolvency proceedings at home.  Precipitating the filing, according to the carrier, was its inability to achieve significant wage and productivity concessions from its flight crews.  When negotiations did not produce the company's desired outcome, the employees were offered the keys to the company for one peso.  The employees said no thank you.  Like bankruptcy filings here in the U.S., the burden of proof will be on the company to make a case that deep concessions are necessary.

Like the U.S., the Mexican market is deregulated.  Like the U.S., low cost carriers (LCCs) fly in major markets throughout Mexico, driving down prices all the while the Mexican economy has suffered more than most around the world.  In fact, Mexicana holds two low cost carriers in its fold (neither of which will be affected by the bankruptcy filing of the larger legacy carrier).  Mexico is a microcosm of what occurred in the U.S. where LCCs grew at the expense of the network legacy carriers, driving prices down because they enjoyed cost advantages.  And like in the U.S., the Mexico domestic market does not produce sufficient revenue premiums for the legacy incumbents to offset their high and out-of-market cost structures.

Might Mexicana’s bankruptcy filing result in liquidation?  It could.  Already planes have been repossessed in anticipation of the filing.  Sounds like the U.S. industry immediately after deregulation but before Section 1110 protections became part of the bankruptcy code.  Today, unions in the U.S. are calling for changes to the bankruptcy code (Sections 1113 and 1114 specifically).  Ever wonder just how many U.S. airline jobs might have been lost if there were no Section 1110 protections?  I digress.

The Mexicana story causes me to reflect on the U.S. domestic market.  The realignment of the U.S. domestic industry is not done.  Mainline carrier presence in the domestic market will continue to shrink unless the labor economics change.  Network carrier presence in the domestic market is now more a function of moving a passenger from Lansing to Lagos than it is Lansing to Los Angeles. 

Since 2000, network carrier revenues are down 36 percent.  Since 2000, when mainline network carrier domestic Available Seat Miles (ASMs) reached their historic apex, capacity flown by the same carriers has been reduced by 30 percent.  Over the same period, domestic ASMs added by the U.S. LCCs increased by 134 percent.  ASMs flown by the regional sector have increased by 178 percent.

These trends are a function of the economics of flying today.  Labor contracts in the past were based on $30 “in the wing” jet fuel.  Today’s reality is $90.  With domestic revenue generated by the network carriers down more than capacity since 2000, it is uncertain what kind of contracts will come out of that funnel, and whether the U.S. airline industry as we know it today we be able to sustain higher costs.

SkyWest Subsidiary Atlantic Southeast Airlines to Purchase ExpressJet

Another story occurring within the industry that has labor ramifications is the consolidation taking place within the regional industry. One of the catalysts for consolidation within the regional sector is the unknown outcomes of scope negotiations between the mainline carriers and their managements as to what kind of flying will be done by the regional providers tomorrow.  Another catalyst is the known, but yet undetermined, push for new regulations governing how much regional pilots can fly.   

Readers at Swelblog.com know that we have been talking about consolidation and realignment of the regional industry since the beginning.  Does a consolidating network carrier sector need nine providers of regional capacity?  No.  

Given that new, expensive changes to regulations governing regional carriers and their relationships with mainline are expected this year, the network carriers would be wise to look carefully at their regional feed composition. With the merger of Continental and United and new regulation pending, it simply makes sense to realign regional relationships.  United is one of SkyWest’s two major partners and it does business with each Atlantic Southeast and ExpressJet (who is Continental’s primary regional partner).

The SkyWest/Atlantic Southeast announcement comes on the heels of Pinnacle buying Mesaba and expanding its presence under the Delta umbrella.  These types of realignments are now a trend and not one-off and ill conceived acquisitions.  Just like network carriers need scale economics, so do the regional partners in order to minimize labor and maintenance costs regardless of what type of flying they are permitted to perform tomorrow. 

This is healthy consolidation and the idea of scale economics may be what just makes American Eagle attractive.

More to come. 


1st Quarter Earnings Calls: Unbungling; Unbundling But Not Unshackled

Three legacy carrier earnings calls down, two to go. Southwest and Allegiant have reported. So has SkyWest. But the clear takeaways are difficult to discern. Everyone wants to know if the industry has reached a bottom. But there are no clear answers while we are still in the middle of an economic tsunami. For all those who have said the domestic market is stabilizing (me among them) the only hard evidence on our side right now is that the environment is not getting worse.

Every carrier is supremely focused on unbungling their operations. Yes, unbungling. Because we all know that operations at many carriers have been a mess, with many factors to blame. And, as painful as the process has been, many carriers are making progress getting their operations and costs in order. US Airways led an amazing turnaround focused on its once-troubled Philadelphia hub. Many very good reforms are underway at United. And all things operational are improving at American, albeit at a slower pace than at some of their legacy peers.

Moreover, virtually every carrier – except for Southwest – remains committed to continuing the unbundling process and to maximizing secondary revenue sources. Today, Delta went so far as to announce a fee for the second checked bag on international flights -- becoming the first in the industry to do so. The industry is unequivocal that the fees will stay and that where opportunities are present to do more, they will. Further, a heartening storyline has emerged regarding distribution, where carriers increasingly see opportunities to move away from paying intermediaries to sell their tickets and to turn that model on its head so that airlines get a fee from the middle man for the right to sell their product.

The United Call

I do not have the transcript of this call in front of me, but this was a most interesting listen. My favorite part was when Morgan Stanley’s Bill Greene posed a very fundamental question that went something like this: With planned capital expenditures less than depreciation, how are we supposed to think about United, or the industry, on a going forward basis from an investment point of view?

Or, as Helane Becker of Jessup and Lamont put it: Should UAL have public equity at all, or instead raise only debt capital from the public markets? Then there was Ted Reed of TheStreet.com, who was blunt in asking whether, just maybe, United had “shrunk too much.”

Good questions. Unfortunately, they are ones that the current environment makes very difficult to answer with conviction.

In my last post, I questioned the airline industry’s access to capital given fragile economic fundamentals in an industry that, over its long history, has failed to produce so much as a dime in retained earnings. In my view, the industry is at a tipping point in which smart investors should question the structural integrity of some carriers and networks during what amounts to a market stress test . . . one that just might reveal which airlines have few moves left to shed uneconomic capacity.

This is the “new and irreversible development” I referred to, a trajectory that might change only through serious effort to remove the many regulatory shackles around this industry. Some necessary changes might not be politically popular -- increased foreign ownership of US airlines comes to mind – but the industry’s options are narrowing when you consider that revenue trends do not hold out much immediate promise.

Looking ahead, with credit tight, where will capital – affordable capital – be found unless it is from another participant in the same industry? If companies are struggling to realize any return on invested capital today, then what happens as interest rates continue to increase in lockstep with capital scarcity? As standalone companies, there is just not enough room for individual carriers to maneuver around an income statement that holds little promise of further significant reductions in the short-term. Based on Greene’s point, even United seems reluctant to reinvest much of its own, and limited, capital into a business that does not hold promise of a reasonable return.

This is not just about United. This is an industry issue. And not just a US industry issue . . . it is fast becoming a global industry issue.

In North America, Air Canada has long been the poster child of an airline that needs an influx of foreign capital necessary to keep the company relevant in the global market place. Air Canada faces some unique challenges: namely that nearly two-thirds of Canada’s air travel demand is found in just eight markets.

Meanwhile, the Delta/Northwest merger is fast proving that the combined entity is far less vulnerable than either of the two carriers would have been had they not merged. Just think about the vulnerability of each Delta’s and Northwest’s respective hubs to the economies in the interior of the US footprint.

With US Airways the exception among the legacy carriers as to international market exposure, we as a nation should at very least acknowledge the reality that globally-oriented airlines need to be just that. I’m not talking about domestic airlines with global extensions -- we tried that, in a way, with TWA, Eastern and Pan Am . But absent any real alliances that left each of them dependent only on US-origin traffic, those carriers suffered a common fate -- shut down in sagging economies as capital became tight.

Concluding Thoughts

Following an industry life cycle of value destruction, US legacy carriers now face a dilemma: whether to invest in their core businesses or not?

As the US airline industry is now six full years into a major restructuring, the tendency to legislative and regulatory gridlock did not get restructured. An inflexible labor construct did not get restructured. Policies promoting the fragmentation of the US domestic market did not get restructured – until the airlines themselves took on this task through capacity reductions in redundant markets out of necessity. 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.

In truth, the US market should not fear individual carrier failures or consolidation. Indeed, this market has demonstrated time and time 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. Where there is insufficient capacity, capacity will be sure to find the insufficiency.

At a minimum, government should take a very serious look at where this industry sits. The US airline industry is not asking for government handouts. Rather it is my view that this industry seeks nothing more than the same rights to operate as virtually every other successful US industry selling to the global marketplace is permitted.

Few shackles unless consumer harm can be proven. Going backward will result in significantly more dislocation for virtually every stakeholder remaining in the industry today as it begins with an industry even smaller than today’s.  It would be a shame to waste six years of some very good work.


Just Who Will Inherit the US Domestic Market? Don’t Forget Today’s “Regional Carriers”

Will the legacy carriers today be the domestic providers tomorrow?

This post has been partially written for about six weeks. The US domestic market presents us with many things to consider as it evolves. “Darwinists” will say it will be the “survival of the fittest”, or the strongest competitor will be the last standing. In October 2002, Eric A. Marks wrote a book: Business Darwinism: Evolve or Disolve: Adaptive Strategies for the Information Age. Marks was writing on the critical importance of information technology in accelerating the necessary grab for global market share. He used the phrase the “survival of the fastest”.

Whether it applies to the US airline industry and its participants or not, the use of a phrase like “evolve or disolve” certainly applies to the current carriers of all ilk providing service to customers within the US domestic airline market. So as we move into the season of capacity cutting in a significant way, one could ask if we are dissolving or simply engaged in a practice of attrition of uneconomic capacity? No matter how we choose to refer to this period, it is an evolution of an industry structure that is unknown.

Republic Airways, SkyWest and Possibly Others

In the past weeks, Republic Airways, a “US Regional Carrier”, has made some aggressive financial plays at each Frontier and Midwest. Both carriers have strong local market followings and that could be described as an understatement. Warren Buffett likes brands. Are hub markets brands? And if these hubs are joined?

Pilots at Midwest might say that the current ownership is using the Indianapolis-based carrier as a stalking horse to win pay and productivity relief from current contracts. In Frontier’s case, Republic is part of the group that provided the “Debtor In Possession” financing necessary for the Denver-based carrier to construct its plan of reorganization.

Neither Frontier nor Midwest are vital to tomorrow’s US domestic air transportation system - as we know it - and they are joined in that regard by Sun Country in Minneapolis. Whereas this observer has been vocal of a need to consolidate carriers in the “regional space”, I am thinking that there just might be something more to consider. I refer from time to time to a piece I did in 2003 entitled: Low Cost Carriers: Thou Shalt Not Inherit the Earth.

Not so much that there is a need to consolidate carriers in the regional space as many of them will simply dissolve as hubs are closed in the face of high oil; an overall slowing of demand; and less reliance on domestic traffic flows for the network legacy carriers. But I am thinking that carriers like Republic, under it visionary CEO, Bryan Bedford (who should have been a CEO at a legacy carrier already – but then again why would you want to do that?), and SkyWest just might be tomorrow’s US domestic capacity providers. Carriers like Republic and SkyWest just might be the competition for the surviving “Low Cost Carriers” like Southwest, jetBlue, AirTran and possibly Virgin America.

It is Republic and SkyWest that are buying the right-sized aircraft for a market with higher prices and slowing demand. It is Republic and SkyWest that are building fleet scope that provides each of them with the economies of scale that are critical to manage any and all associated costs. It is Republic and SkyWest that have aircraft to serve communities of all sizes that will make "narrow-minded" lawmakers happy. It is Republic and SkyWest that will be looking for "natural partners" to code-share with as they will need international network scope in order to maximize onboard revenue. Republic and SkyWest have learned the lessons from Independence Air and ExpressJet (edited) that built failed models focusing only on the US domestic market.


Hey Bill, what are you saying? I guess what I am saying very simply is that this labor negotiating period remains the most critical since deregulation – just as I have been saying for the past couple of years. As Aristotle first said, and was recently used by my dear friend Jon Abbet on the putting green when comparing the banking industries to the airline industry, “nature abhors a vacuum”. The US domestic airline system presents the greatest potential for a vacuum. Controllable costs have converged. But that will not last. Service from Lubbock to London would produce a vacuum if American were to leave and that will be filled. Lansing to Lagos would produce a vacuum if Northwest/Delta were to leave.

Carriers like Republic and SkyWest have the opportunity to take advantage of technology that ensures a “survival of the fastest” path. Remember the UPS whiteboard guy and the cargo industry - no real legacy impediments. Tomorrow they will be the carriers that deal more with an inefficient air traffic control system. STAR, SkyTeam and oneworld will only want to ensure that international connections arrive on time. Northwest and Delta have committed themselves to the US domestic market. But I am not sure that United, Continental, US Airways and American have. In the case of the latter two, they have more commitment today.

Whether it is seniority or a different compensation scheme for tomorrow’s "seniority" that works best for the future industry, never overlook a potential competitor - as it is present. That competitor is not the obvious but rather the well managed companies that have been tasked to adapt to the network model. Republic and SkyWest have.

So in this negotiation, labor will either figure it out or they will not. The US domestic network still provides the most jobs to the labor organizations representing the employees at the legacy network carriers. Will that be the case tomorrow? I am not sure. This is a time to negotiate a construct that rewards blood, sweat and tears. This is also a time to negotiate a construct that recognizes that tomorrow is different. And in the course of doing so, membership numbers can be protected, and possibly augmented.

So ask Boeing and the IAM if a strike is worth it? I am not sure. Ceding competitive advantage to Embraer and Bombardier and others in tomorrow's narrowbody market is the ultimate question. The same is true for airline labor. Domestic economics are different from international economics. Beware of the underdog as is it not the LCCs to fear, it is Republic and SkyWest. Attrit and dissolve; attrit and resolve. That is the question?

Never doubt that nature abhors a vacuum. For ALPA and pilot's unions this is a watershed issue as you represent both sectors. For the flight attendants, membership numbers might not grow but at least you will protect what you have. This is big. Really big.

More to come.


If It Doesn’t Add, Let’s Begin the Subtraction Process

What Is Wrong With US Regional Industry Attrition?

It is increasingly clear that, in addition to fuel, regional airline industry overcapacity – a “bubble” in this writer’s opinion - may be the second most important catalyst to consolidation in the US airline industry.

Today, USA Today wrote about the capacity issue in an article about cuts in airline schedules across the industry, even in the face of strong demand click here. Maybe this is a precursor of things to come.

When domestic market overlap is evaluated, it is the respective regional network webs that will give pause to regulators and legislators, particularly considering the extent to which consumers may be disadvantaged as the result of consolidation. This is where network overlap occurs, not on the densest routes replete with competition from all sectors of the industry.

At last week’s ACI-NA International Aviation Issues Seminar in Washington DC, I tried to come up with a politically astute answer when asked a question on consolidation. But given my inclination to tell it how it is, I ultimately acknowledged that, on this subject, there is no “politic” answer.

I think Doug Parker had it right. I’m in no position to make that call, but looking at Parker’s blueprint for US Airways, he was suggesting some smart decisions. Why does Jacksonville, NC need nine flights a day to connect its airport to the US air transportation system when six are sufficient? Why does Greenville-Spartanburg need 25 choices for 100 or so passengers a day to and from Los Angeles?

The US industry is now struggling to shed fixed costs in an era when many airlines already have achieved significant cost savings from labor; fuel costs are outside anyone’s control and therefore not an option; and most of the cost reductions already have been wrung out of the distribution area

Since 2002, transport related expenses as reported by the mainline carriers – the vast majority representing the purchase of capacity from regional partners - increased more than fourfold to more than $17 billion in 2006 click here. If there is a cost area that deserves, and needs, reevaluation it is regional capacity deployment.

To put it in perspective, the $17 billion in expense spent by the mainline carriers on regional capacity exceeds the market capitalizations of United, American, Northwest and US Airways combined.

A Contrarian View of American’s Decision to Shed Eagle

Since American announced its intention to spin out its wholly owned American Eagle unit, I am troubled by some of the analysis. This is not about American or even about the FL Group, an activist AMR shareholder that has pushed the company to divest assets. This is about a sector of the industry with failing economics – the regional sector. And this surely is not about mainline pilot scope clauses. This is about economics: pure and simple. This is about American continually persuing the cleanup of its balance sheet.

If Southwest is continually revising downward planned capacity, then this relatively expensive capacity is surely difficult to maintain, yet alone grow.

As I have written here before: there are too many network carriers; too many low cost carriers; too many hubs and too many regional carriers. Already, we are seeing some signs of a pilot shortage. And the growth of the regionals – much of it built on labor arbitrage and an over-reliance on regional jets over mainline narrowbodies – is now slowing to a crawl. So why shouldn’t we begin to shrink the regional sector? Delta has Comair up for sale or some other transaction, which has been public knowledge for some time.

Financial engineering the AA deal is not. Pinnacle was the last financial engineering attempt using a regional platform and in the end the market correctly valued the expected revenue streams based on activity in the industry at the time. Mainline carriers began paying lower margins based on reduced revenue flows as the bankruptcy parade commenced. If AA were looking to enhance shareholder value, they have two or three other options that surely would have been announced before this one.

Prior to its Chapter 11 filing, Delta sold ASA to Skywest for a fraction of the price it paid for the regional carrier. Skywest negotiated certain terms in the event of a bankruptcy filing by the parent. More importantly, the broken carrier Skywest bought at a deep discount also came with a 15-year Air Service Agreement with Delta on pay out terms that are believed to be significantly better than newcomers to Delta’s regional stable receive.

This is the type of deal I would expect in the case of AA and Eagle. American has signaled to the market that it plans to maintain the current lift being purchased from Eagle. Yes, a new Air Service Agreement would have to be negotiated along with the transaction. What will be different with this deal is that aircraft will begin to come “off lease” over the term so the “buyer” may be purchasing reduced cash flow streams going forward. This is not financial engineering but economic reality. But they will be buying cash flow streams nonetheless – and that revenue is what matters to the analysis, not scope clause limitations.

Some Concluding Thoughts

Maybe this deal could be a catalyst to begin a long and overdue attrition of the regional industry as we know it. If there is a pilot shortage, then you are buying pilots. If you are looking to build a capital base that could be leveraged in other areas, this could be an economical means to buy what you could not build organically – particularly in this environment.

Growth is not occurring with 50 seat flying; that has been a well- documented fact for the past two years. But it takes the same number of crews to fly a 70 or a 76 seat plane as it does to fly a 37, 44 or 50 seater. Carriers participating in new flying with mainline partners are now purchasing their own aircraft. The purchase of new aircraft requires both cash flow and a sufficient capital base. The inclusion of Eagle assets and cash flow will surely provide a regional provider with more long-term staying power to withstand the necessary changes within this sector.

Just as we have talked about a domestic airline industry that could ultimately shrink to three or four legacy carriers, then it also is safe to say that three or four regional carriers are more than sufficient to meet demand. Skywest and arguably Republic will be there in the end. The question is who will join them in supplying capacity to the mainline carriers. The regional carrier space needs multiple providers, not only to ensure the competition for feed that the buyers want in the marketplace, but also to avoid the labor disruptions possible when a carrier is dependent on feed from just one provider.

Concluding Thoughts For Government

This is not a time to be “knee jerk” in a federal response to U.S. carriers that are struggling to be profitable at home while quickly being relegated to secondary status in the global arena. Just because there is an airport in a congressman’s district does not necessarily mean it makes economic and financial sense for airlines to offer service.

Yes, the government should ensure access to the US and global air transportation systems for as many communities as possible. But it is not commercially viable to offer each of those airports around-the-clock service. This bubble has raised unrealistic expectations for air service. Now we need to relieve pressure on an industry before it breaks.


Heeding the Divestiture Cry? American to Spin Off Its Eagle Unit

This afternoon, American announced its intention to spin off its American Eagle unit click here. Given the talk surrounding the company to consider spinning off AAdvantage, American Beacon Advisors, American Eagle and its maintenance unit, this announcement should come as no surprise.

Calls for American to spin off AAdvantage were first made by Reykjavik-based FL Group, which owns 9.1 percent of American in September. All US carriers, and not just American, are considering means to respond to increased shareholder pressure as airline shares have significantly underperformed the Standard & Poor's 500 Index this year.

One might say that AA is considering the divestiture of a regional carrier late in the cycle when growth has slowed considerably. On the other hand, if you believe that the regional sector of the US airline industry is not immune from consolidation, it just may be the right time to participate in the purchase of a carrier with a $2+ billion revenue stream that American says will remain intact as the parent plans to maintain all current feed provided by Eagle.

That revenue stream and an increased capital base will certainly have some attraction to regional sector’s biggest players: Republic, SkyWest, Pinnacle and others looking to assure their survival as its sector of the industry matures as well. American suggests the transaction will be a 2008 event with all the necessary caveats. No details have been provided on a deal structure other than a blank whiteboard.