Unbundling, Rebundling and Now De-Commoditization

As the new year begins, I’m encouraged that airline industry is truly making changes necessary for long-term survival.  Over the past decade, airlines have engaged in a restructuring period like no other since deregulation – in fact making the kind of meaningful structural changes some thought deregulation itself would bring .

American Airlines’ aggressive posture in restructuring the way airline tickets are distributed is an obvious next step in this process.  In most businesses, low-hanging fruit is found where a middleman is involved, as is the case with the aggregators like Orbitz and Expedia.  For the airlines, this effort has some risks and involves more than just cutting costs.  It is about addressing some of the core issues that plague airline pricing and can be termed the de-commoditization of the very product airlines sell – a seat from A to B.

On November 25, 2009, Swelblog wrote about a presentation that former Air Canada President and CEO Montie Brewer gave at MIT titled:  Five Reasons Why the Airline Industry Will Never Be Profitable.  According to Brewer, one significant reason the industry will fail to earn a profit over a sustainable period is the presence of the Global Distribution Systems (GDS).   Now before our very eyes, American Airlines has taken the leadership to challenge the roles played by the Online Travel Agencies (OTA) and the GDS.

Reason #1 cited by Brewer as to why the industry will never be profitable is that the capacity-lead business model causes “constant overcapacity”.

Since deregulation the airline product has been commoditized.  In the commodity framework, the only way the industry, or an airline, can grow revenue is to grow capacity.   But that model didn’t work for airlines, where Computer Reservations Systems and the GDS’s institutionalized the notion that in order for an airline to grow revenue, it needed to offer more and more capacity even before demand warranted.

The addition of capacity led to low and lower operating costs.  On the margin, revenue exceeded cost.  Uneconomic capacity was being deployed each and every day.  Ultimately, it created an industry too big to be sustainable.  If not for the price of oil, the airline industry would never have shed the level of capacity it did between 2008 - 2010.   

The GDS were a major contributor to the commoditization of the airline product.  Therefore, airlines that distribute directly to the consumer have the best likelihood of differentiating, and more importantly, not commoditizing, their product.  This fact contributed to the trend in which certain airlines did well even as much of the industry suffers. Note the one airline in the US that does distribute directly to the consumer:  Southwest.  And Southwest has differentiated, not commoditized, its product. 

What is a commodity?  According to Miriam Webster, a commodity is a good or service whose wide availability typically leads to smaller profit margins and diminishes the importance of factors (as brand name) other than price.  Commoditization can be defined as the process of prices moving substantially lower because of strong competition. Commoditization happens because too many competitors enter a market when they see the large returns that can be earned on certain products. However, those returns soon disappear as competition drives prices lower.

Each defines the airline industry.  Each defines patterns that today’s industry executives are trying to break.  Just because it was done one way or another yesterday does not mean it is the best way of doing business tomorrow.  Enter the Business Travel Coalition (BTC).  Under the veil of protecting consumers, the BTC is doing nothing more than protecting the interests of the money that keeps the organization in business.  Every time the airline industry makes a strategic or commercial move to improve its profitability, the BTC pushes back because change does not serve its clientele well. 

Which leads us to Brewer’s Reason #5: “Nobody Really Wants It to Be Fixed.”  Brewer makes a powerful case that things are fine the way they are . . . and, for the most part, the airline industry value chain, consumers and the government know it.

When it comes to low fares,  consumers can shop the internet and find some market on sale (and the same will be true tomorrow if American and others are successful). They may even find the price of a ticket today equal to or less in nominal dollars than a fare charged two decades ago.  When adjusted for inflation, it is hard to find any consumer product that is a better bargain than air travel.

Taxes and fees account for nearly $60 - or 20 percent - of the average price of a ticket today.  This compares to $22, or 7 percent, in 1972.  In other words, the government is getting a bigger share of a shrinking pie.  GDS fees go up as the real price of a ticket is in decline.  Anything that the industry can do to address margin degradation in the business should be considered and be done.  And that is precisely what American is doing.

There are few areas that remain on the income statement where costs can be cut.  Distribution happens to be one just as the industry is asking the government to examine whether the tax burden imposed on the airline industry is disproportionate.   As the old saying goes: Two percent here and two percent there on top of taxes and fees that consume 20 percent of the ticket price adds up to real money . . . money the industry cannot afford over the long term.

Perhaps most compelling is that all the players in industry's value chain -- GDSs, OTAs, airline caterers, aircraft lessors, ground handlers, manufacturers, airports, fuelers, travel agents, maintenance repair organizations and freight operations -- don’t want it changed.  That’s because each earn a higher return on invested capital than the airline companies that keep them in business.

BTC members do not want the airlines to take control of their inventory because it is sure to weaken the powerful grip the GDS and OTA have over the industry today.  Ask yourself, would you really want to be in business if you did not have near complete control over your inventory?  I think not.   Do GDS and OTA know your customers better than you do?  I think not.  In short, a commodity is a product that has a low degree of differentiation.  Over the past decade, the product offered by the network carriers and the low cost carriers have converged to where there is little to no differentiation because schedule and price are the only differentiators.  This must change if the industry is truly committed to achieving a structure where it earns at least it cost of capital.

Loyalty has increasing value to air travel consumers today, in part because elite members of frequent flyer programs typically aren’t charged the ancillary fees other passengers pay.  Base fares will be disciplined by competition whether American is successful in its attempt to rewrite distribution rules or not.  This industry always adapts.  Travel agents continue to exist today even after the industry stopped paying domestic commissions in 2002 – assuming they evolved and adapted to find replacement revenue streams. 

One can make a case that the GDS have been every bit as destructive a tool as constructive.  Any system that promotes adding inefficient capacity should be changed.  They served their purpose when market share was king.  They serve significantly less purpose in an industry increasingly focused on its bottom line.  Short term this may be about saving some portion of a booking fee.  More important is the long term notion that an airline that takes control of its inventory creates value for its customers based on the knowledge the airline has of its customer.  To say the customer loses out is a tired refrain coming from the same "Chicken Littles" that "Cry Wolf" every time the industry tries to institute systemic change. 

Let the restructuring continue.

Time to Look Forward – Not Back

Historically,www.swelblog.com has taken space this time of the year to reflect on the biggest stories of the year. In this column, I want instead to spend more time looking at issues that will be important in 2011.

First, the look back: 2010 began with me taking sides in the battle for JAL and siding with the ultimate victor, American.  We wrote about the National Mediation Board, wondered aloud whether the labor-friendly Obama Administration would permit an airline strike given the fragility of the economy. We challenged Captain John Prater, President of the Air Line Pilots Association, on multiple fronts, offered a favorable perspective of the controversial Chairman and CEO of United Airlines, Glenn Tilton, and looked at mainline pilot scope and the pilot unions’ associated rhetoric. We challenged Southwest to put its money where its mouth was in the proposed slot swap between Delta and US Airways and noted Continental’s contract offer to its pilots that offered Delta wage rates plus $1 per hour. We laid out why we did not like the proposed United – US Airways merger; criticized the tarmac delay rule, pondered the American and jetBlue tie up at New York’s JFK airport; applauded the United and Continental merger and argued that American and US Airways will be fine in a consolidated world – at least for the foreseeable future.  We questioned why the airline industry was losing numerous battles in Washington, the looming threat from carriers in the Middle East,  the price of regulation in terms of what is a public good and lobbed yet another challenge to now ex-Congressman James Oberstar. We also weighed in on the Export-Import Bank; the Southwest – AirTran merger; the national elections; and questioned the need for the number of commercial air service airports in use today. We explained why pilot picketing and other union activity revealed only part of the labor quandary at US carriers, and predicted that foreign ownership restrictions will be the subject of ongoing debate.

Meanwhile, we only touched on airline profitability – a nice change, but noted with caution as three quarters do not make a trend. The airlines are doing what they should be doing in de-leveraging their balance sheets, with consolidation occurring not just in the mainline sector, but beginning to reshape the regional sector as well.  Oil was less of an issue in 2010, with price volatility muted compared to the prior two years. And the revenue picture brightened, particularly coming off a dismal 2009.  Finally we saw pivotal votes rejecting unionization at Delta, although the jury is still out whether labor’s defeat there was due to something unique to Delta or a broader referendum on a union’s ability to improve the lives of dues-paying members

Thanks to all of you who are regular readers and those who check in occasionally, readership was up significantly in 2010 and I hope you continue to read in 2011.

LOOKING FORWARD:

LABOR:  Labor promises to remain a significant story in the coming year.  There is new leadership at the Air Line Pilots Association; the Allied Pilots Association; and the AFA-CWA to name a few.  While it is hard to predict whether things will change at the largest flight attendant union, AFA-CWA, after multiple terms under Patricia Friend, I am confident that changes in leadership will benefit the pilots represented by both ALPA and the APA.  This is not to say that I expect either of the unions to roll over, but believe that there is much to gain for both sides in a constructive dialogue that was too often absent in the previous union administrations. It is safe to say that the terms served by Captains Prater and Hill did more to set the unions back than advance the pilot profession.

The NMB will remain on my watch list.  We could see action sooner rather than later at American, where Larry Gibbons, Director of the Office of Mediation Services, will now oversee the negotiations that have been underway for several years. Will the NMB become even more political as Gibbons sits closer to the board members than do other members of the team he oversees?  Will the Board play a crucial role in facilitating new and joint agreements at Continental – United?  Will the Board side with the unions in determining whether Delta interfered in the IAM and AFA representation elections as the unions allege? Ultimately, the unions will determine how aggressive they need to be to leverage the support of employees at the merged carriers anxious about recent changes in working conditions and how the seniority list is constructed.

It is clear that the industry will be watching as Delta manages one of the least-unionized workforces, particularly as former union members from Northwest are brought into the fold. One might say that the hard work is now done as the votes have been cast and the election is over.  But I say the hard work is just now beginning.  It won’t be that long until another election can be called.  And the difficulty of the task is highlighted by the civil war between the work groups at US Airways that continues into yet another year.  It seems unlikely that the legal issues dividing the merged pilot groups and pilots and management are near resolution. All eyes will be on United CEO Jeff Smisek and Southwest CEO Gary Kelly to see how they manage culture change at their bigger, more complex carriers.

Finally, look for organizing activity to increase at other airlines.  The losses at Delta will make the unions hungry for increased membership and recent changes to federal election law under the Railway Labor Act make it easier for union to win a secret ballot election.  Already unions are targeting jetBlue and SkyWest –where unions lost past elections under the old rules.  If the Delta vote is a referendum on the former Northwest employees not being content with their union, might there not be opportunities for the International Brotherhood of Teamsters to begin raiding select work groups?

FUEL:  As I write, West Texas Intermediate is trading at $91+ per barrel.  As Southwest CEO Gary Kelly, put it, volatility in fuel prices is the industry’s “No. 1 challenge” and “the single biggest threat to aviation.”

The price of oil is sure to be a story in 2011.  Goldman Sachs, the firm that predicted $200 per barrel oil in 2008, is predicting $100 per barrel during the first half of 2011.  Given growing confidence that economic recovery is finally taking hold and the levels of new industrial production activity in the Asia-Pacific region that often drives market oil prices, $100 per barrel seems reasonable. 

Here at Swelblog, we were among the first to suggest that the best thing that happened to the US and global airline industries was oil at $147 per barrel, which more than anything else served as the impetus to reduce capacity from an industry that had grown too big.  If oil prices continue to climb, it will serve as a discipline on any efforts to add marginal capacity to the system, particularly in the domestic market.  And this time around, a Southwest does not enjoy the same hedge book and fuel cost saving potential v. the industry as it had when oil prices surged in the 2004 – 2008 period. 

Should oil continue its rise, we will begin to see further reductions in small community air service.  For many communities, a fuel surcharge on top of what many believe are high fares will test the price elasticity of even the more inelastic customers - who will take to the highway as their first point of access to the air transportation grid.  This would be a healthy outcome for the industry that is still arguably over-connected.  Rising oil prices – along with regulation imposed costs that will come to fruition in 2011 - should be a catalyst for continued consolidation in the regional sector.

If fuel prices rise, the passenger carriers will likely be successful imposing fuel surcharges to fares, just as the cargo carriers were in the past.  Southwest may not charge for bags, but even they will have to consider fuel surcharges this time around.  That is a big differentiator for the US airline industry in 2011.  What makes this tricky is that the US consumer was long conditioned to paying fares based on industry costs of $30 per barrel in-the-wing jet fuel.  The industry has adapted.  At $95 per barrel the industry begins to be tested yet again.

WASHINGTON:   the Air Transport Association has a new leader in Nicholas E. Calio, a former Citicorp executive with keen bipartisan skills. Calio becomes the new President and CEO of the industry’s trade group on January 1, 2011, hoping to turn the airline industry fortunes after some trying legislative and regulatory losses in 2010.  With new costs and operating constraints posed by rigid new tarmac delay rules, increased passenger compensation for overbooking, a new push to have a total cost of trip (fare and fees) made known to the purchaser, proposed constraints on regional carriers,  changes at the NMB, investigative actions by the FAA, the rejection of the slot swaps between US Airways and Delta, and the loss on appeal of the right of airports to implement congestion pricing, airlines are hoping for kinder, gentler treatment in Washington in the new year.

In a recent media release, the ATA said it was pleased with the recommendations of Secretary LaHood’s Future of Aviation Advisory Committee.  I am assuming this will prove to be a blueprint agenda for Calio and his team at ATA.

And with Oberstar now gone from the House Transportation and Infrastructure Committee, new Chairman John Mica (R-FL) has an opportunity to make some headway on relevant and important issues that threatened to make US aviation a second-tier player in the global industry under the misguided direction of the former chairman.

I am encouraged by the leadership changes taking place in the industry and hope that we can finally have a discussion on issues with a mindset on positioning the industry within the global sphere.

CONCLUDING THOUGHTS

The industry’s work is far from done.  Progress on consolidation, cutting capacity, new technologies and efficiencies, and re-balancing labor costs have dramatically improved the cost structure in the industry, just as anti-trust immunity, open skies agreements and global partnerships have improved revenue opportunities for US carriers. But work must continue on alternative fuels and reducing the impact of aviation on the environment and ensuring that the airline industry is not paying more than its fair share of the tax burden.

There are still barriers to better operations on the labor front as well. Union leaders need to decide once and for all how to address the split between mainline and regional flying all the while securing/maintaining some form of scope protection their members expect.  A good start would be to stop the charade that this is a 76-seat issue.  The mainline does not want that flying because they will not accept the rates necessary to do the flying.  Once again, labor did much to create the problem, now it is time that they figure out how best to fix it.

Finally, it is time to stop playing politics with the FAA Authorization bill and put together a clean bill to address the aviation infrastructure.  Let’s get rid of the pet projects loaded into a bill that should be designed for efficiency.  And airlines and airports need to figure out how to work together.  The debate should not be about an increase in the PFC but the extent to which the industry has a say in how the money is spent.  Just as airlines need to be positioning themselves to succeed in a global industry, airports that add little to no value to the airline map of tomorrow should not be spending precious money building out an infrastructure that may not be used.

Let’s hope that in 2011, we can stop living in the past and look toward a strong future for the US airline industry. We have to get our impediments fixed at home to prepare for the next upcoming competitive battle for advantage in the global market.  For some this next competitive battle will be much tougher to win.

Happy New Year. 

Will Restrictive Foreign Ownership Finally Lose Its Virginity?

Sky News Online reported that Sir Richard Branson’s Virgin Atlantic Airlines is assessing various merger and/or tie up proposals.  While there is no formal process underway, US carrier Delta Air Lines is rumored to be among the interested.  Sky News City editor Mark Kleinman has learned that “Delta's interest, while at an early stage, may have gone as far as recruiting investment bank Goldman Sachs to advise it.”

Just last week, I was addressing the ACI-NA International Aviation Issues Seminar on the very topic – that we should expect to see a serious push, and hopefully a meaningful discussion among stakeholders, to consider changes to the archaic restriction that limits foreign ownership of airlines.  Whether or not this Virgin – Delta story has merit, I am confident that it will not be the last headline we read regarding tie-ups of airlines with different nationalities in the coming years.  The motivations for mergers or tie ups with various airlines will vary depending on strengths and weaknesses of the carriers involved.

The financial case for this merger activity is quite compelling.  In my presentation, Emerging Markets and Evolving Models: Challenging the Industry’s Structure, I questioned whether the alliance structure is the best operating model to compete with the emerging airline models in Latin America, the Middle East or China.

Some Numbers for Context

Consider earnings.  In 2010 the global airline industry is expected to report a $15 billion profit.  While impressive in absolute terms it represents net earnings of 2.7 pennies for each one dollar in revenue.  This is paltry when compared to other businesses that earn on the order of 6-7 cents and more for each dollar of revenue.  Even with a slow recovery underway, profits for the industry are forecast to decline by 40 percent in 2011, which means that industry earnings are forecast to fall to 1.5 cents for every dollar of revenue generated.  Surely 2010 is not as good as it gets? 

Such slim profits cannot support the 1,500 or so airlines out there for long.  The industry simply needs to be able to consolidate shares of a disparate and a highly fragmented global structure just as steel and autos and shippers have done.  Those industries would certainly not be happy earning 2.7 cents on the dollar if that was as good as it gets.

It is not the mature economies that are expected to grow at high rates, but rather the emerging economies in Asia, the Middle East, Africa and Latin America.  Moreover, it is the emerging airline models serving these regions that are certain to pose serious threats to iconic names like Lufthansa, Air France/KLM, Alitalia, Air Canada, British Airways/Iberia and the alliances of which they are members. 

Just as there is consolidation activity within the US and European airline industries primarily, traffic is consolidating around and among the largest metropolitan centers on the global map.  Competition for this traffic is already vigorous.  Strong brands and strong balance sheets will be required to mine this traffic.  Can alliances be brands?  I think not given the large numbers of airlines that make up these alliances.

According to Airbus, Asian demand is highly concentrated around 11 points on the map:  Tokyo, Osaka, Seoul, Beijing, Shanghai, Taipei, Hong Kong, Bangkok, Kuala Lampur, Singapore and Jakarta, with nearly half of the demand in the Asian-Pacific market traveling between these cities and 91 percent flying to and from these cities.  Given the rapid growth of the low cost carriers in Asia and the Middle East carriers targeting traffic from each of these points, it is clear that individual carriers cannot possibly compete with the emerging low cost juggernauts. So the next question becomes whether the alliances as they now stand could do so either?

Just as capturing and retaining connecting traffic is driving consolidation activity in Europe, flow traffic is the necessary ingredient in making the Middle East airline model work.  The geographic advantage to the Middle East carriers to compete aggressively for global flows is staggering.  Within 2,500 nautical miles of the region lives 36 percent of the world’s population and 16 percent of the world’s GDP.  Within 4,500 nautical miles lives 86 percent of the world’s population and 63 percent of the world’s GDP.  Move the distance to 8,000 nautical miles – the distance where new aircraft technology can and will fly – and the world is virtually captured on a one-stop basis.  North American and European carriers cannot make the same claim.

Today, Emirates’ route map alone covers Asia, Europe, China, the Middle East, the commodity-rich African continent and Commonwealth of Independent States. Ethiad and Qatar serve many of the same points as well.  Will the Middle East airline models under construction be the catalyst for the first global airline merger?

A Financial Case for Global Mergers

Why can industries that serve the airline industry consolidate – often across borders – and the airlines cannot? 

1. Air Traffic Control:  One per country
2. Aircraft Manufacturers:  Two to four providers with 95+ percent market share
3. Aircraft Leasing Companies:  Two providers with 45 percent market share
4. Global Airline Industry:  More than 1,500 providers.  Top 10 have less than 40 percent market share
5. Ground Handling:  Less than three providers at deregulated airports
6. Catering:  Top two providers have 40 percent market share
7. Airports:  Arguably are natural monopolies
8. Maintenance Repair Organizations:  Top five companies have 50 percent market share
9. Global Distribution Systems:  Top three providers have 85 percent market share

The global airline industry’s response to limited foreign ownership has been to create more and more elaborate relationships with partner airlines.  In the "Alliance Phase", we have gone from interline agreements to special prorate agreements to sales incentive agreements to codeshare and blocked seat arrangements to the free sale of code sharing.  Today the industry has evolved into an "immunized joint venture phase" either sharing profits or revenue.  Assessing the level of synergies that can be realized by either a JV or an outright merger, a joint venture only captures 50 percent of the financial potential.

Alliance relationships capture more than two-thirds of the revenue potential from new domestic and intercontinental origin and destination traffic.  The alliance JV’s capture nearly 70 percent of the benefits to be derived from the frequent flyer plan.  But the JV mines very little in terms of cost synergies, arguably deriving only 20 percent.  In addition a merger would permit a full network redesign that would benefit both the revenue and the cost sides of the equation.

While it is true that the size of the three alliances is increasing, the top five carriers in each alliance drive the strong majority of the synergy benefits.  The four immunized JV STAR alliance carriers generate 75 percent of the traffic share across the North Atlantic; the immunized JV carriers in SkyTeam garner more than 85 percent of the North Atlantic traffic; and the immunized JV carriers in oneworld are expected to carry nearly 100 percent of that alliance’s traffic.

Branson Has Reason to Explore His Options

The North Atlantic market is now hyper competitive as all three alliances have anti-trust immunity.  And while Virgin Atlantic is unaligned at this point, I can make a case that Virgin Atlantic’s value increased after AA and BA were granted the ability to form an immunized transatlantic joint business agreement.  Why?  Just like there has been a mad scramble among the three alliances to bolster their respective competitive positions at New York and Tokyo, London cannot be ignored given its importance on global airline map.  And Virgin has slots and a meaningful presence at London’s coveted Heathrow airport.

When you think about it, oneworld is in no position to increase its share of slots at LHR without inciting the envy of its rivals and the harsh scrutiny of regulators, while STAR has British Midland’s slot holdings through Lufthansa.  That leaves SkyTeam.  Delta has been exhibiting a thirst for new Heathrow flying from Miami and Boston (both important oneworld markets).  Delta has also enhanced service to Heathrow from each of its important gateways at New York, Atlanta and Detroit.  But there is only so much Delta can do on its own at LHR.  And there is only so much SkyTeam can do given its slot portfolio.

SkyTeam does not need a hub at London as it already has two of the finest connecting hubs on the European continent in Amsterdam and Paris Charles deGaulle.  In order to compete fully, airlines need to be able to sell on both sides of the ocean. Assuming that there is a modicum of truth to the Delta-Virgin Atlantic rumor, a Delta play at Heathrow is no different than what has been taking place in New York/Newark and Tokyo over the past year.  London’s importance in each alliance’s portfolio is no different.

Singapore Airlines owns a 49 percent share of Virgin Atlantic.  Singapore and Delta have had a long relationship, with both carriers having a cross 10 percent equity stake in a prior life.  Or, Branson may be feeling like he would like to monetize some of his 51 percent holding given the changed competitive dynamics taking place across the North Atlantic and the new and potential competition coming from the Middle East.  Imagine if he were to sell an equity piece to a Middle East-based airline?

The United States and the European Community still have the ownership issue to negotiate per Phase II of the original US – EU Open Skies Treaty.  The Europeans are interested in expanding the ownership levels while the US wallows in labor and Defense Department concerns.  In the past, the US has played catch up with global metamorphosis.  Now is the time to be proactive, not passive, as competition from the Middle East gains ground.

If:

• If vendors serving the airline industry are allowed to consolidate into dominant positions with few border restrictions, and . . .
• If other industries like steel are permitted to consolidate market power around 4 global providers, and . . .
• If the global airline industry has not one dominant player, and . . .
• If Joint Ventures only capture 50 percent of potential synergies, and . . .
• If the five biggest alliance members produce 60 percent of the benefits, and . . .
• If the new and emerging competition is obvious,

Then....

• Why should airlines be hamstrung in their ability to maximize financial performance?
• Why should airlines be forced into Band Aid solutions like alliances when new and emerging competitors are building truly seamless, organic and homogenous products?
• Why should companies that are, or are certain to be, under attack from new competition be prohibited from joining hands to mount the strongest possible competitive reaction?

A far flung alliance formation has less chance to build a global brand than the new and emerging competition.  Imagine a day when the carriers involved in today’s JV schemes are allowed to invest in one another and use the equity capital to homogenize service offerings.

Imagine a day when decades old protectionist thinking gives way to an understanding that the airline industry is a global industry.  Imagine a day when US flag carriers are able to adapt their business plans to the reality that the business is not domestic but rather how the domestic market interacts with the international market?  

Imagine . . .

The United and Continental Pilots Engage In MISInformational Picketing

Today in Newark; tomorrow in Houston; and on December 1 in front of UAL Headquarters in downtown Chicago the United and Continental pilots have announced they will engage in “informational picketing” regarding the new company’s decision to redeploy certain United 70-seat regional jet flying into former Continental hubs Newark, Cleveland and Houston.  In return for that redeployment, certain Continental 50-seat jets will replace the United 70-seat jets flying out of certain former United hubs.  Note the tradeoff:  no one loses flying; no one loses a job; no mainline flying is impacted; and everyone benefits from a network made stronger by matching the right-sized aircraft to routes that either need a larger or smaller aircraft.

Yet the message from the "informational picketing" will deflect what has been going on between the United and Continental pilots of late and make the company the villain.

Seems so simple.  Just like the combined Delta and Northwest networks moved quickly to best match aircraft size to markets with commensurate demand, Continental and United are moving to do the same. 

Part of the Continental and United pilots message to the public will be that the combined company is violating their respective collective bargaining agreements, in particular the section called scope that swelblog has covered so extensively..    In a November 12, 2010 Continental pilot communiqué, the call to arms read as follows:  “It’s time to get serious and stand united against outsourcing. In response to management’s attack on our current scope provisions, and their clear leveraging of it in negotiations for a new JCBA, the CAL SPSC, in cooperation with the UAL SPSC, will jointly organize informational picketing at both Newark and Houston airports as well as United world headquarters in downtown Chicago. It is time to show the new United management and the public that ideas and plans to violate our contract and outsource our jobs to the lowest bidder will NOT be tolerated by pilots.”

OUTSOURCING

The pilots first fallacy is ‘outsourcing”.  The fact is that the pilots’ union, ALPA, has played a major role in creating the labor Ponzi scheme that survives at the legacy airlines. Over the past 15 years, how did ALPA find a way to pay mainline pilots more?  By agreeing to allow another group of pilots to fly where mainline flying is no longer economic and to be paid less to do so in order to buy “better” contracts for the mainline pilots they represent. 

What the Continental and United pilots fail to share is ALPA’s dirty little secret: that the wage rates, working conditions, training provisions and other particulars they criticize at the regional carriers were negotiated by their very own union. ALPA represents the majority of regional pilots flying in the US today.  So maybe ALPA needs to step up and take some responsibility for its contribution to building the regional sector of the industry that they now deprecate.  Only by agreeing to lower rates of pay and more flying time at the regional carriers can ALPA justify and sustain the generous pay, benefits and work rules that benefit pilots at the mainline airlines. 

Look at any significant relaxation of the scope clause at the mainline carrier that allows the airline to increase its use of jets 70 seats or less. In just about every case the mainline pilots received a significant pay boost – or were able reduce the level of concession - in return for that “concession” as they were given economic credit for allowing the deployment of regional jet flying by regional partners.

Stop calling it outsourcing.  It is not.  It is a convenient word to use given the disdain for the practice by the now lame duck Chairman of the House Transportation and Infrastructure Committee.  The practice of relaxing scope to permit regional partners to perform uneconomic flying has kept more mainline pilots on the payrolls than it has cost jobs as the network has been kept largely intact when routes would have needed to have been cut because it was not economic for 100+ seat aircraft to perform the flying.

SOME FACTS

This redeployment, or better said a swap of one-sized regional jet for another, has gone so far that an expedited grievance has been filed by the joint Continental and United pilots.  On November 15, 2010 the union filed grievance:  File 11.10.041CG.  “Pursuant to the Collective Bargaining Agreement (CBA) between Continental Airlines, Inc. and the airline pilots in its service, as represented by the Air Line Pilots Association, International, (ALPA) the undersigned hereby files this grievance, on behalf of all affected pilots, protesting the Company’s violation of Section 1 (Scope) and all related sections of the CBA by placing and planning to place the CO code on United Express flights using jet aircraft with an FAA certification of fifty-one or greater seats to and from CLE, EWR and IAH.  As a remedy, ALPA requests that the Company cease and desist advertising and placing the CO code on such flights, and all other relief that may be appropriate.”

The union’s position “is that Section 1, Part 3-A of the CBA clearly prohibits the Company action, unless it is authorized by some other Part of Section 1. No other Part of Section 1 authorizes the Company course of action, as none of the express carriers performing the work is a Company affiliate; only 50-seat and turboprop flying, not 70-seat jet flying, is permitted by Part 4; and flying to a Company hub (if not to or from a hub of the other carrier) is not permitted by Part 5.”

The union says that the Company’s position relies on Part 7, arguing that it is flying by another air carrier while participating in a Complete Transaction in accordance with Part 7. The union suggests, however, that while Part 7 specifies rules for separation and merger of mainline operations, Part 7 does not change the rules in Parts 4 or 5 for operation of Express carriers or Complementary Carriers. Nor does Part 7 license Continental to permit United Express carriers SkyWest or Shuttle America to carry the CO code without observing the limits in Parts 4 or 5, because neither of them is a "participant" in a Complete Transaction. Neither express carrier is acquiring any part of Continental, nor is it becoming a Parent of the Company. Nor is Continental acquiring Control of assets of either carrier. Further, if either of these air carriers were participating in a Complete Transaction with the Company, that participation would trigger a series of obligations that the Company has not applied.

Note to self:  Then what comprised the United network at the time the combination was contemplated?  and the transaction closed?  Mainline flying only?  I think not.

The union says the Company also argues that following the merger closing, United and Continental will each continue to operate as an air carrier, but they are not prohibited from integrating their marketing, reservations systems and livery, ultimately marketing and operating their service under a blend of the United name and Continental livery. But this argument relies on general actions associated with a merger to dissolve specific protections at the heart of the CBA, as well as mixing those actions which the Company can undertake now with those that must wait until after a JCBA (and integrated seniority list) are reached.

Note to self:  Why should the company wait to maximize revenue when it can do so today?

The union concludes, their [the company’s] actions are not an effort to transition Continental and Continental Express operations to the single UA code, but to replace 50-seat jets in Continental hubs with 70-seat jets and to connect them with Continental flights, branded as Continental flights under the CO code, strictly as a way of carrying more passengers and thus making more money.

A Paper Tiger

A paper tiger is seemingly dangerous and powerful but is in fact timid, or as Frederick Forsyth put it: "They are paper tigers, weak and indecisive."

Sometimes the actions of pilots and scope are like that of a paper tiger – a mighty roar but no real threat. I thought the pilots of the combined carrier were looking to share in the synergies of the combined carrier.  In this instance, they talk about the company redeploying regional lift – remember no loss of jobs – as a way of carrying more passengers and thus making more money.  If the carrier makes more money, then don’t the UA and CO pilots potentially make more money?

The pilots claim that this is about the company trying to gain leverage in negotiations.  Let’s not forget that on August 27, 2010, the United and Continental pilots made a proposal to management to end outsourcing to regional airlines.  This is the issue pure and simple.  The joint UA and CO pilots are fishing for ways to block the carrier from finding the most economic way to serve cities of all sizes all the while somehow making the case that the same network economics can be achieved at the mainline level for performing tomorrow the regional flying of today.  It cannot be done absent significant concessions at the mainline level.

Finally, the joint bargaining teams have been publicly lobbing grenades at one another over compensation proposals that might favor one group over another during the seniority list integration process.  This is a group that has said publicly that they will first negotiate a joint collective bargaining agreement before engaging in the seniority list integration process, just like the Northwest and Delta pilots did so successfully.  If memory serves me, the Delta – Northwest negotiation was not without its disagreements and wrinkles.  That said, the Delta – Northwest agreement ultimately paved the way for sufficient numbers of 70+ seat flying to be performed by a number of regional partners. 

At least in Delta’s case, the union recognized that the regional flying being performed today was critical to supporting mainline jobs.  Regional carriers were contracted to perform domestic flying in markets where the poor underlying domestic economics remain.  The Continental and United pilots should be looking at the very same thing.  The unintended consequence of undoing the regional relationships today will be a smaller mainline tomorrow.  Smaller network architecture does not produce the synergies promised by a combined United and Continental.

Less in generated synergies means less to be shared among the pilots of the combined company.  Less in generated synergies means that the collective bargaining agreement ultimately reached will have less upside and will look more like the agreements that would have been ultimately reached if the companies remained as standalone entities. Less in generated synergies means that the combined entity will likely not attain its status as the world’s best airline.

There is a financial concept lost on union leaders today:  Net Present Value or NPV.   It means simply that cash flows realized in the short term have more value to the firm (or individual) than cash flows generated years down the road.  Captain Jay Pierce, the head of the Continental ALPA unit, argues rightly that the company’s action of swapping five 70 seat jets in Continental’s hubs for five 50 seat jets is strictly a way of carrying more passengers and thus making more money.  It is what companies should be doing - maximizing the revenue earning power of the network.

The benefits to the new United’s actions in this limited case are obvious.  The risks are, well,  timid and weak as no jobs are being lost.  Energy spent during one of the most traveled weeks of the year should be spent negotiating a joint collective bargaining agreement and not preparing for an arbitration that in reality is nothing more than a desperate grab of leverage that - if the pilots prevail - will result in fewer jobs, less mainline flying, fewer synergies to be shared among pilots and a degradation of the combined carrier’s status within the STAR Alliance.

A Post Election Thought: Just How Many Commercial Air Service Airports Do We Really Need?

It is hard to imagine a mid-term election like the one that took place last week.  For this independent, I am most happy to see a balance of power restored.  The 24 hours after the first poll closed also proved to be significant if you were an airline industry watcher.  First, the Delta flight attendants voted to stay non-union, dealing a blow to the Association of Flight Attendants (AFA-CWA).  Hours after learning of AFA’s defeat, the news that Jim Oberstar did not get re-elected in the 8^th District of Minnesota hit the wire (my home district growing up).  I needed an asbestos glove to pick up my iPhone with the Oberstar rejection.  How ironic that it was a former Northwest pilot that defeated airline labor’s favorite congressman.

For the U.S. airline industry, the election results would seem to assure a more sympathetic ear to issues important to the carriers on Capitol Hill.  The current Congress has been anything but sympathetic, making the airline industry the whipping boy on issues important to labor and advocates falling under the broad umbrella of consumer protection.  But where does it go come January 2011? There are many issues that could be revisited now without the representative from Minnesota’s destructive rantings, but there is one issue that also can finally be considered.

Maybe with Oberstar gone, we can actually have a cogent conversation on just what air service is essential.  After all, it was the Congressman that generally refused to revisit the Essential Air Service Program and make alterations to language drafted 30+ years ago.  Does an airport really require subsidized air service when an alternative airport is 70 miles away and offers better hub connections?  The Congressman would say that the community had air service when we deregulated the industry in 1978 and we promised the community would have service in perpetuity.  Absolute insanity.  Oberstar’s office was the incubator of such entitlement thinking.

Over the past year I have delivered the following message to many airport groups and conference venues.  Not a popular message for some, mind you, but the day of reckoning is coming.  Ninety-seven percent of U.S. domestic air service demand is concentrated around 40 percent of mainland commercial air service airports.  Should the remaining 60 percent of airports comprising just three percent of demand be enabled to compete for infrastructure dollars better spent in obviously more critical markets?  A global trend is emerging as air service concentrates around the most populated areas.  Forty-five percent of passengers in China only want to fly to and from Beijing, Shanghai and Hong Kong.  While not as dramatic given the maturation of the U.S. market, similar statements can be made here.

With no replacement aircraft for the 50-seat jet on the drawing board as of today, and with nearly 500 of those aircraft coming off lease between now and 2016, there are communities that are going to be disenfranchised from the U.S. air transportation grid.  The highway will be their first access point to the air transportation system.  That is already true today for many small communities where consumers can/and do drive to a larger airport with more service options – particularly those airports with a low cost carrier present. 

So, scaling back airport service won’t be an economic disaster for these smaller communities that, in many cases, get only minimal attention from airlines anyway. That means essential air service shouldn’t be a concern – and won’t be unless there is a Congressman or Senator trawling for votes, determined to keep the “prestige” of the airport for his or her constituents, even though that airport provides little or no incremental value to the quality of air service in the U.S. And, in reality, little economic benefit for the community.

An unspoken fact is Southwest Airlines has long been the nemesis to small airports around the country.  Why has Southwest not entered Cincinnati?  Because it doesn’t have to.  The 69 cities Southwest serves envelopes no less than 242 markets of all sizes – or more than one-half of all mainland commercial air service airports.  Southwest can access Cincinnati’s traffic with its existing services at Louisville, Indianapolis or Columbus. 

Each of the three markets is within a two-hour drive of Cincinnati.  This fact could also be a reason why Delta has drawn down the Queen City’s hub as pricing is indirectly influenced by low-cost carrier service.  Paired with the fact the 50-seat jet cannot generate sufficient revenue at $87 per barrel oil makes Cincinnati difficult to serve economically.  Cincinnati is not losing its hub because of Delta’s merger with Northwest; rather it is losing hub breadth because of economics -- low fares and high oil prices.

Let’s take some examples where markets encompass smaller cities currently receiving air service.  Today, within a 2-hour drive of Columbus, OH are:  Dayton, OH; Parkersburg, WV; Akron, OH; Cleveland, OH; Huntington, WV; Toledo, OH and Cincinnati, OH.  Now, I appreciate that passengers from some of these cities would probably not drive to Columbus, but I bet passengers from Parkersburg, Huntington and Toledo might, and probably are, doing so to some extent today.

Another middle of the country example is Detroit, MI.  Today, within a 2-hour drive of Detroit are:  Toledo, OH; Flint, MI; Jackson, MI; Lansing, MI; Midland/Bay City/Saginaw, MI; and Kalamazoo, MI.  We have also just identified two markets that envelope Toledo,  a market hanging onto to air service by its very last fingernail. 

If you look at those examples from a regional perspective, it’s hard to figure why it’s necessary to maintain such redundancy. Or why cities with overlapping airports should claw to hold onto non-competitive air service, forced into adopting dramatic programs to retain carriers – and passengers – using dollars they can’t afford. All the while draining important federal infrastructure funds from more critical needs.

No politician wants  to play God and determine which airports should be closed to commercial air service and which airports should remain open – at least not any who want to get re-elected or re-appointed.  Still, it needs to be done and I would argue it is a more important intermediate action for Transportation Secretary Ray LaHood than building railroads – or at least talking about building railroads.  We should be rationalizing and streamlining the air transportation grid. That might let the government be smarter about where infrastructure dollars are spent. Not just at other airports, but on prioritizing the highway and bridge repairs necessary to access the air transportation system.  And, yes, we might even build a rail line or two.

Like many things aviation in the U.S., we put off difficult decisions until it is too late.  Labor needed to be making bankruptcy-like changes to collective bargaining agreements decades ago.  Instead, it feels as if it all happened at once - and was exponentially more painful.  The hard truth is, the economic expectations of deregulation - where inefficiencies and uncompetitive costs were wrung from the system - has largely played out over the past ten years (and not the first 22) because people avoided the inevitable – including airline companies.  If the market were left to its own devices, my guess is many of the efficiencies found in the last decade would have been found earlier, or companies would have simply failed.

Swelblog’s opinion of small airport closings has wide implications.  Implications for the Regional Airline Association and the sector of the industry it represents.  Implications for mainline labor as they rethink how regional flying should be performed and who should do that flying.  Implications for smaller community air service.  Implications for how infrastructure dollars are allocated. Implications for government leaders thinking about transportation policy on a medium to long-term planning horizon.  Implications for network airlines that have made smaller community air service critical to the makeup of their route structures.

There is a new essential - and it is not Oberstar’s essential - when it comes to air service.  Regionalization of air service sounds scary, but at the end of the day, would you rather fly a Bombardier C-Series to a hub/gateway with multiple service options from Columbus or a Cessna from Toledo.  That is where we are headed over the next five to seven years.

Give the small airports time to think about what their business model should be when the day of reckoning happens.  There is still time and there is still the need for those airports to play their parts inside the system – just not in receiving direct air service.

Maybe we should be thinking of it as the Non-Essential Air Service Program?

Swelblog: On Election Morn

This has been a busy month for the US airline industry with earnings and all.  As a result there has been lots of news and most of it good. Of course, two quarters do not make a trend -- something I'm frequently reminding people when I'm out on the road speaking on all things airline industry. 

So as we sit awaiting results on what promises to be a most interesting mid-term election, I want to look back on what has been a very political two years

First up: labor. Unions are all politics all of the time and that has played a big role in the airline industry since President Obama took office.  A cynic would say -- and I might agree -- that unions are simplistic organizations that too often focus on only on the next contract or the next election.  The result is too often a strategy in which they do everything they can to “choke the golden goose” for all of the pay and benefits possible at the time, which only puts their successors in the difficult position of presiding over concessions when the "gains" are no longer economically viable. There are some who say that this blog is too quick to bash unions.  But as I've said before, I'm equal opportunity in calling out bad behavior when I see it. And when it comes to airline labor leadership, I've seen a lot of it.

I've spent a lot of time challenging the leadership at the two largest pilot unions: Captain Lloyd Hill of the Allied Pilots Association and John Prater of the Air Line Pilots Association, both who ended their terms as president this year.  My fundamental criticism was each man’s decision to run on the opportunistic platform that all concessions would be returned and more.  Unrealistic.  Unfortunate.  Unfulfilled.

Lo and behold, the two important pilot unions have replaced “over promise and under deliver” with two new but seasoned presidents: Captain David Bates at the APA and Captain Lee Moak at ALPA.  [Moak has been the subject of much commentary on this blog and I encourage you to learn more about him].  I had the opportunity to spend time with both men last week at the Boyd Group International’s 15^th Annual Aviation Forecast Summit in New Orleans.

I don’t want warm and fuzzy from union leaders and I don't expect it from management. What I want is a sense that each side understands and negotiates with a clear understanding of the economic environment in which the industry operates.  From both pilot leaders I am confident that principled negotiations and decisions will be the rule of the day.  From both pilot leaders I sense a potential to depart from gridlock and enter disciplined negotiations.  From management I want to see a renewed effort on communicating clearly the rigors of the business from a global perspective.  That would be true leadership.

Unions and management must break through the gridlock that leads to protracted contract talks and ultimately keeps money from pilots' pockets.  And both sides need to be honest with pilots about the extent to which the world has changed and the industry continues to change with it.  For example, today’s union negotiations should be less about who should fly 76-seat small jets and more about how to position an airline to challenge new and vigorous competition in Latin America, the Middle East and the Asia-Pacific regions. For the mainline carriers, competition is now more about Dubai than Duluth, and more about Auckland than Austin.

It is fast becoming clear that flight attendant union leaders are also increasingly out of touch.  And no one is more out of touch than the President of the Association of Professional Flight Attendants President Laura Glading. Glading, more than any union leader in the past or present, is too quick to threaten chaos and strikes without a clear understanding of the competitive realities that affect contract negotiations.

In her latest unconscionable act, Glading is calling on American Airlines flight attendants to write letters demanding a release to a "cooling off period" and possible strike from the National Mediation Board. Maybe Glading doesn't really understand the Board and its mission which, last I checked, is to try to prevent work actions that would threaten the nation's air transport system. Further, it would be unconscionable if the NMB were to cave into a letter writing campaign by a union that has done more to cause dissension in its ranks than promote the high level of customer service and professionalism the airline needs to compete. 

It has been interesting to watch the flight attendant negotiations at Continental and United. The Continental flight attendants actually voted down a tentative agreement that would have put money in their pockets immediately at a time the industry remains vulnerable economically. "Immediately" should have been an important factor considering that there will need be a representation election between the AFA-CWA and the IAM before any real negotiations can begin at the merged carrier.  My guess is that it could now take a couple of years before either the Continental or United flight attendants realize any economic gains over what they earn today.

As for negotiations with under-the-wing employees other than mechanics, the TWU negotiations at American provide a lens for one of the most difficult issues facing airlines: how to appropriately compensate ground workers.  In almost every case, this work could be outsourced for a fraction of the costs of keeping the work "in house" -- particularly when you consider the comparatively rich benefits package most airline employees receive. The baggage handlers are the most vulnerable yet the union group still holds out with demands for more. 

But if the unions may have a false sense of power because the worst-kept secret in the airline industry is the fact that baggage handlers have long ridden the coattails of the more skilled mechanic group, demanding wages that far exceed what these workers could command outside the airline industry. Said another way, because the skilled mechanic group has "carried" these less-skilled workers for so long, they have received less in negotiations over the years because the political structures of the TWU and the IAM includes baggage handlers in the same "class and craft" as a way to boost their ranks.

This week we will know the outcome of vote of the Delta and Northwest flight attendants, who are deciding whether to organize under the AFA-CWA banner (which would be a first for Delta flight attendants) or be a non-union group.  This election is the biggest yet under a new NMB rule that made the most significant change to the union election process under the Railway Labor Act in 75 years. That new rule likely will be the deciding factor in the outcome.  The change in the rule was all about politics, with a clear disregard for prior practice and arrogance in its refusal to address key subjects in the labor arena, including the ability of employees to decertify a union.

But that is reality in Washington today as it pertains to the airline industry.  We have had a number of issues become political in the name of consumer protection.  There are a number of matters being regulated or legislated in the name of safety.   A FAA Reauthorization bill cannot get passed because of all the non-FAA issues lawmakers stuck in the Senate and House versions as goodies for their own political constituencies.  But no matter the outcome of the national elections tomorrow, gridlock promises to rule the day in Washington for the next two years as well.

As British author Ernest Benn wrote:  “Politics is the art of looking for trouble, finding whether it exists or not, diagnosing it incorrectly, and applying the wrong remedy.”  That sums up how Washington deals with an industry that delivers value and jobs to the economy each and every day.

Analyst Engel Does RJ Math; Swelbar Opines

Bank of America/Merrill Lynch airline equity analyst Glenn Engel could not have been more timely in his report published yesterday: “Regional Jet Analysis:  A Look at Profits Per Plane.”  Given the industry-wide focus on the future of the regional jet industry, Engel’s analysis cuts to the heart of the economics of RJs, particularly as to how they are used by network carriers and what effect changes may have on those carrier’s route systems. I do not read the report as having investment implications but rather as an analysis of the economics of regional jets utilized inside of each network carrier’s route system.

A Note on Engel’s Methodology

Engel notes up front the limitations of the analysis:  “1) Disclosure and accounting for regional revenues and costs are inconsistent across the carriers. 2) Differing fleet ownership and usage complicates comparisons; Pinnacle and ExpressJet sublease planes and as a result show lower nonfuel costs relative to SkyWest and Republic. 3) Mainline operations and regional feed mutually benefit each other, which can help cross-subsidize losses.”  In my mind, I acknowledge the importance of accounting but it is the network effects that are most difficult to discern.

Engel’s analysis is done on a per plane basis.  In order to counter the underlying differences in airplane size and the subsequent effect on traditional metrics used to compare like per seat mile costs, he normalizes regional jets operating on behalf of mainline partners into 737 equivalents.  He then assesses efficiency and profitability without structural distortions that are inherent across the entire spectrum of RJ usage.

Engel’s Analysis  

Based on Engel’s analysis, United enjoys the highest profit per regional unit by a factor of three over US Airways, which has the second-highest profitability.  American Airlines is the least profitable, losing $3.1 million per RJ equivalent.  It is no coincidence that the most profitable is the carrier that has among the most liberal mainline scope clause agreements, while the least profitable has the most restrictive contractual rules governing RJ deployment.  According to Engel, Continental, Delta and American each lose money on their RJ operations in that order before network synergies are accounted for.

Today, according to Engel, American is limited by its collective bargaining agreement with the Allied Pilots Association to flying no more than 47 70-seat regional jets.  At Delta, with the most relaxed scope clause, regional partners fly 284 70 and 90 seat jets; at United, regional partners are flying 153 70-seat jets; and at US Airways, regional partners are flying 110 70 and 90 seat jets.  [US Airways is the only network carrier permitted by the mainline agreement to fly regional aircraft larger than 76 seats.] Continental is not permitted to fly any regional jet larger than 50 seats.

Engel estimates that the mainline today flies 5.1 seats to every seat flown by the regional partners compared to 5.8 seats in 2006.  At that time, Delta and Northwest had not completed their restructuring in bankruptcy and United had just aggressively begun replacing unprofitable 737 flying with 70 seat regional jets.  United was able to replace the unprofitable flying only by negotiating the right to relax the scope clause during its bankruptcy restructuring.

At the Core of RJ Profitability:  FUEL

Ultimately, Engel’s analysis underscores the critical role fuel plays. “When fuel prices doubled in 2004, regional jets, especially 50-seat planes that have high fuel consumption per seat, became less attractive relative to mainline flying,” he wrote. Since 2004, mainline airlines have made $1.72 million per 737-equivalent (or $580,000 per CRJ-200 equivalent) more on their mainline aircraft than their regional fleet. The mainline-regional spread peaked at more than $3.20 million per 737-equivalent (or $1.09 million per CRJ-200) when oil prices spiked in 2008.”

The Exception is United

While the US Airways regional jet operation has been the most consistently profitable and American the least profitable, Engel finds that United earns the most per regional jet and is the only carrier where the regional jet operation is more profitable than the mainline operation. According to Engel, United does much less non-hub flying with its regional jets than its peers, operates a higher percentage of larger regional jets (more than half have more than 50 seats) and leverages its powerful domestic and international connections to increase profits.

Engel makes other points:

-          United has the highest utilization of RJs; Delta the lowest primarily because of a disproportionate number of 50-seat RJs.  Delta’s utilization should improve as it goes forward with plans to remove 10 percent of the RJs it operated in 2009. 

-          Legacy carriers fly RJs less but generate more revenue per plane.  United generates 41% more revenue per 737-equivalent from its regional fleet than the industry as a whole, and Delta produces 16% less revenue per regional plane.

-          United pays least for its feed while American pays most.  United spends 27% more per equivalent regional plane while garnering 41% more seat-miles and revenues. In contrast, American spends 10% more per regional aircraft while obtaining 4% fewer seat-miles and revenues.

Engel goes on to break down metrics between Republic, SkyWest, Pinnacle and ExpressJet – the publicly traded regional providers.  My read is that Republic and SkyWest are in the best position to weather the shakeout.  Pinnacle enjoys some strong attributes and SkyWest subsidiary Atlantic Southeast Airlines has announced its intention to purchase ExpressJet. A consolidation phase is playing out inside the regional sector as carriers look to create economies of scale.

What about the Regional Business?  Scope Negotiations?  Small Community Air Service?

New rules and regulations facing the industry will likely layer new costs upon costs, which could change this analysis looking ahead. Already regulators are suggesting that mainline carriers take a much more active role in overseeing their regional operators, which would impose upon them new responsibilities and potential liabilities. One question is whether new costs will tip the balance for Continental, Delta and American in terms of keeping the regional operations profitable.

As we add additional costs on top of already unprofitable flying (absent network effects), there are calls by the American and the United/Continental pilot unions to, in effect, bring all regional flying in-house.  Can the mainline pilots possibly do the flying with better economics?  In an earlier blog, Mainline Pilot Scope: Will Regional Carriers Be Permitted to Fly 90+ Seat Aircraft? I argued that pilot unions should find a more effective way than scope to think about job protection, focusing instead on the economics that will employ the most pilots at the mainline.  That challenge must acknowledge the fact that today’s industry is not the industry of yesteryear.

 As I see it there are two options:  Either 1) relax scope in order to win bigger increases in wages, benefits and working conditions for pilots that remain at the mainline; or 2) embrace the absolute fact that contractual rates, work rules and benefits need to be lower for US domestic mainline flying.   Domestic market flying differentials may be the new trading currency to adapt pilot contracts to the market realities of today.

It won’t be easy for pilot union leaders to agree upon a solution to a problem that they helped to create.  Just as the US Airways East scope clause defines small, medium and large regional aircraft, it is time to define small, medium and large narrowbody equipment necessary to profitably serve the domestic market.   As for the American and United/Continental pilots who believe that all flying should be done by mainline pilots, Engel’s analysis makes clear that United did a very good job in trading out 737’s for EMB 170’s.  The fact that United’s regionals outperform all of their industry peers in efficiency and profitability underscores how difficult it will be to undo the language that they negotiated in the first place.

With Congress’ influence being felt at every corner when it comes to what is best for the regional industry, it is time to discuss the unintended consequences.  As we layer on regulatory costs, it is certain that some of regional flying being done today will no longer be profitable.  Today’s carriers seem to be hell bent on removing unprofitable flying from their networks.  Won’t it be interesting when the next commercial air service airport is disenfranchised from the air transportation grid because the market cannot make money as a result of the new costs?

Then we will hear that the Essential Air Service program – a program that benefits a few at the expense of many taxpayers -- needs more funding.  Will anyone have the political mettle to acknowledge that the program has outlived its intended consequence? Today, 97 percent of US domestic demand is found at the 200 largest commercial airports. Given the razor thin margins in the regional industry Congress and the regulators should be careful for what they ask for. 

What is wrong with the highway being the first point of access to the air transportation system for markets that cannot support direct air service?  Customers seeking low fares have already proven they are willing to drive to whatever airport offers them. But when it comes to NIMBY (Not In My Backyard) Congressional Representatives, lawmakers who support policies that add costs to regional flying must realize that there are consequences to their actions.  Oil has made the 50-seat jet largely unprofitable.  With no replacement aircraft that size in sight, what happens to small community air service when leases are not renewed because small jet aircraft are just too expensive to operate?

Between the price of oil, scope, the legislators and the regulators, I fear that there will be many communities that lose service over the next decade.  And of course no one will take the blame.

Southwest Puts Its Money to Work – Announces Intention to Buy AirTran

In March of this year, I wrote a blog titled:   Dear Southwest: Grab Your Bag of Fiction; It’s On.  This widely-read piece was about Southwest’s role in the proposed US Airways – Delta slot swap transaction. “If Southwest wants to gain entry to the few remaining slot controlled airports,” I wrote at the time, “Then it should make the incumbents an offer – one that provides the slot holder a return on that carrier’s prior investment.”

Well today, Southwest announced an investment – a $1.4 billion investment – in purchasing AirTran Airways, lock, stock and landing slots.  And that is what I was pining for in that post.  That is, I believe Southwest should pay, not get something for free or at some rock bottom price for assets the incumbents paid dearly for over the years. With AirTran come slots at New York’s LaGuardia and Washington’s Reagan National Airports.  Along with slots, Southwest gains meaningful entry into the one remaining legacy carrier hub where it offers no service – Atlanta.  It also gains entry into Charlotte, a US Airways hub.

Should Delta at Atlanta and US Airways at Charlotte be concerned with this transaction?  No, and there are a number of reasons why not.  First and foremost, the network carriers already compete with the low cost sector for nearly 85 percent of their domestic revenues.  Whereas AirTran serves 37 markets that Southwest does not serve, some of them smaller, there will be some new competition for passengers in those markets.  But for the most part, those cities already enjoy the low fares delivered via AirTran’s initial entry.  A second consideration is that while Delta and US Airways depend on local traffic at Atlanta and Charlotte, each are major connecting complexes and are not solely reliant on originating passengers.

If you ask me, the losers in this announcement are not the network carriers but rather Frontier and Spirit.  jetBlue will survive just fine.  But Frontier is now confined to one [maybe two] traffic base for all intents and purposes.  And that makes them vulnerable.  As for Spirit, which just announced its intentions to launch a $300 million Initial Public Offering, it is one thing to have a highly fragmented market competing inside their network.  It is a totally different animal to have Southwest and AirTran focused on carrying traffic to the Caribbean. The investment thesis necessary to market the IPO just got tougher.

Southwest Needs A New Reference

In its press release Southwest said: “Based on an economic analysis by Campbell-Hill Aviation Group, LLP*, Southwest Airlines’ more expansive low-fare service at Atlanta, alone, has the potential to stimulate over two million new passengers and over $200 million in consumer savings, annually. These savings would be created from the new low-fare competition that Southwest Airlines would be able to provide as a result of the acquisition, expanding the well-known “Southwest Effect’” of reducing fares and stimulating new passenger traffic wherever it flies.”

So where is the “Southwest Effect” in Akron-Canton?  AirTran serves the market and Southwest serves Cleveland up the road.  There should be significant stimulation in that market area? And in Dayton and Columbus, OH?  Perhaps Southwest is looking far back to a 1993 study.  Ding: the “Southwest Effect” as we knew it is dead.  The truth is today’s stimulation is largely diversion from another market or another carrier.  Fares may still be reduced in certain AirTran markets where the network carriers rely mostly on regional jets, but some markets will more than likely just recapture certain traffic from an airport in the catchment area that offered better fares to a unique geography.

Labor Issues

Some have questioned whether the acquisition will lead to labor troubles down the road. But one thing is for sure: If I was an AirTran employee the first words out of my mouth upon hearing the news would be:  “Ding, cha-ching!”  Like employees at United who are looking forward to enjoying the feel of a new culture, one can be sure that the AirTran employees feel much the same.  For them it is an opportunity to join one of the most admired and beloved companies, not just in the airline industry, but in the entire country

There will need to be union representation elections as a result of the merger as pilots and flight attendants are represented by different unions at each airline.  But it’s hard to imagine any vote going the way of the AirTran unions.  The main difficulty then becomes seniority list integration.  Southwest CEO Gary Kelly told investors that “equitable and fair” will rule the integration process.  That sounds like the words in the Allegheny-Mohawk Labor Protective Provisions and should be music to the ears of AirTran employees.  The question is whether each union will have it’s own definition of what is equitable and fair.  That was the case in Southwest’s most recent acquisition attempt, when the Southwest Airlines Pilots’ Association could not find a formula to integrate Frontier Airlines pilots – and the deal failed.

The integration process has evolved over the years since the Allegheny-Mohawk Labor Protective Provisions were enacted. Over that time, there have been more failures than successes in adopting fairness and equity. But it is incumbent for Southwest labor and management leadership to ensure that career expectations are met for all employees. Simply put, this concept means that the relative seniority in a combined list is not significantly different for any respective employee than it would be in their respective entity today.

Concluding Thoughts

Southwest will celebrate its 40^th birthday next year. It is a mature and maturing carrier operating in a mature domestic environment where it is no longer THE innovator. What I find most interesting in Southwest’s potential bid for AirTran is that the carrier is being forced to act just like the network legacy carriers in seeking a consolidation scenario that would lead to an improved revenue line systemwide.

Let’s give credit where credit is due.  Southwest put its money where its route system was weakest and made a very smart acquisition -- one that recognizes that two carriers will accomplish more together than either carrier could on its own.  The two carriers offer a combined network with minimal overlap that ensures that new revenue synergies will be generated.  With the deal there also will be new international opportunities derived for Southwest’s loyal passenger base.  Multiple fleet types are not an issue as the smaller airframe will allow Southwest to serve some smaller communities.

But I can’t wait to hear the arguments Southwest uses in Washington to gain regulatory approval, particularly as it will be hard pressed to make the argument that acquiring AirTran would further lower airfares in the US domestic marketplace.  After all, Southwest is not the only airline offering low fares, no matter what its boosters in Washington may think.

To make its case, the little ol’ Texas carrier that flies only to secondary markets will probably use the very same arguments to gain approval as did Delta/Northwest and United/Continental used.  Interesting indeed.   

Giving Thought to the Export – Import Bank Issue; Not to Protectionism

Below is an article I penned for the current bi-monthly edition of Routes News Magazine.  It questions whether the government of Canada should be protecting Air Canada from new competition originating out of the United Arab Emirates.

It would by hypocritical of me to suggest anything protectionist.  But when thinking about new competition from the capital rich Gulf State region, a question arises:  Do countries other than the United States (home to Boeing); and France, Germany, Britain and Spain (countries home to Airbus) realize a competitive advantage in the way they buy airplanes because they receive export credit?  [Canada (Bombardier) and Brazil (Embraer) have similar programs in place]  Export credit consists of loans or loan guarantees extended by a government to foreign buyers of the country's products and services.  Countries home to Boeing and Airbus are not eligible to receive the same below market financing.

We will explore at the end of the article.  

Article in Routes News Magazine – “Stand and Protect”

Depending on who you listen to, expanding bilateral rights between Canada and United Arab Emirates is good for Canada. Or it isn’t. But is it really about bilateral rights or more about short-term protectionism versus the long-term worldview? The issue is about whether Canada confines itself to its own borders or allows one or more of its cities to become global gateways that are relevant on tomorrow’s airline map. Similar decisions face governments in France, Germany, South Korea and the United Kingdom.

Emirates says allowing it to fly more services between the UAE and Canada would be a boon to the Canadian economy – but Air Canada vehemently disagrees. You’ll hear the same type rhetoric whether you’re in Germany, France, the UK or South Korea, just with different airlines like Etihad, Qatar and Emirates.

Emirates currently offers three weekly services between Toronto and Dubai operating a 489-seat A380 aircraft. What Emirates wants is a twice-daily Toronto service as well as to add Calgary and Vancouver to its Canadian flight offering.

Of course, Dubai is not a large local market, but it connects traffic all over the world, including the Middle East, South East Asia, South Pacific and the India subcontinent. In order to continue to build that mega-network, Emirates must continually add new destinations to its rapidly growing route map and these new market opportunities must be negotiated through the bilateral process.

Emirates s targeting Canada as it is a growth market. Or, is Emirates’ growth into the Canadian market really targeting a weakened Air Canada? 

Air Canada’s CEO, Calin Rovinescu, says, "What Emirates wants to do is flood the Canadian market with capacity. Its strategy is to scoop up travelers going elsewhere in the world and funnel them through Dubai, further strengthening Dubai as a global hub."  He also says Emirates' strategy will “constrain the growth of Canadian airports by turning them from hubs into stubs at the end of a spoke that leads only to Emirates' hub in Dubai". Just in case he didn’t make his point, Rovinescu added, "Sure, you will still be able to get to anywhere from Vancouver. But you will have to get there through Dubai."

Isn’t Emirates, along with the other Gulf carriers with global aspirations, really creating an airlines to compete with the big three global alliances? Alliances were originally built to accomplish what no one airline could do itself – create ubiquitous networks ferrying passengers from one point in one world region to another point in another world region.

Emirates is able to combine the use of new technology (the A380), with low labor costs, government policies that are designed to promote aviation and a unique geography that allows it to compete with global alliances. Should we really concern ourselves with flag carriers to the same extent today that we did 20 years ago or even 10 years ago? Alliances have caused borders to blur and the colors in some flags to cloud. Emirates, Ethiad and Qatar are simply doing what the oneworld, Star and SkyTeam alliances have already done.

Just like low-cost airlines, the Gulf carriers will place enormous pressure on network incumbents to match prices. That will be a problem for some of those incumbents, whose high cost structures make it difficult to reduce fares even when faced with cut-throat competition. Even if some of the carriers within the global alliances or the independents were to fail, 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. Networks evolve because of competition.

Aviation networks have evolved from linear systems to hubs and spokes with a focus on building regional dominance; to connecting regional hubs creating national/continental networks; and then to establishing connections between alliance partner gateways. Each of these evolutionary steps led to increased traffic through the stimulation of local and connecting traffic. 

I believe the next phase of evolution will do some of the same. The challenge from the three Gulf carriers to the three global alliances will accelerate the discussion about global mergers because the networks being built by Emirates, Ethiad and Qatar are truly seamless. The Gulf airlines are each one carrier, while the alliances are a patchwork architecture designed to circumvent archaic bilateral rules.

Emirates argues it will be a catalyst for new traffic growth that, according to a study commissioned by Emirates, will generate $480 million in economic activity. Air Canada claims all Emirates will do is take today’s traffic and redirect it to Dubai. The truth lies somewhere in the middle. There will be a stimulation of new demand producing new economic activity and Air Canada will be challenged to hold onto all of its traffic flying from its gateways today.

Mature markets like North America should embrace the competition brought by Emirates and others as these new carriers have networks designed to access both developed and developing economies. By any growth metric, it is the developing economies that are providing global airline industry growth and they are the industry’s future source of growth.

In the short-term, a loss of Air Canada would outweigh any economic benefit brought by Emirates to Toronto, Calgary or Vancouver. Over the long-term, Ottawa’s protectionist stance will only hinder the chances of at least one Canadian city emerging as one of the more important gateways in the world. The current regime will mean that there will be relatively few points on the map where the world can be accessed with one-stop and that will prove vital in determining tomorrow’s commercial flows.

Short-term protectionism standing in the way of long-term global relevance seems like a high price to pay to coddle the nation’s flag carrier. 

The Export – Import Bank Dilemma

Let’s focus on the United States for a minute.  In 2008 -2009, 11 wide-body aircraft were delivered to U.S. export – import bank eligible country competitors serving the U.S. for each one wide-body aircraft delivered to a U.S. carrier.  So, in essence, the U.S. government is giving foreign competitors a price break its own country’s airlines don’t get. It’s a distinct and often hefty – financing can be upwards of $4 - 5 million per plane – competitive advantage.

Competition is one thing. That’s why the U.S. has championed “Open Skies” agreements around the world.   Since 1995, the U.S. has negotiated 99 such agreements while other world governments combined have approved just 20.

The U.S. government creating an unlevel playing field is something entirely different.  The financing advantage enjoyed by recipients of Export Credit Agency (ECA) loans facilitates events that are neither good for airline employees, U.S. tax coffers or the prospects for the U.S. airline industry returning to profitability.

Small costs differences have added up to big change in the U.S. domestic airline market, triggering tectonic shifts in the makeup of competition. When cost differences between network airlines and the low cost carriers approached two cents per available seat mile, low cost carriers grew at the expense of the networks.  The same type of outcome could occur in the international arena - only it might not be U.S. flagged carriers replacing capacity lost by another U.S. carrier. 

ECA programs offering financing 4-5 percentage points less on a $260 million wide-body aircraft is not small change. Foreign carriers can save millions funding a fleet at a level and rate U.S. airlines can’t possibly match in the commercial markets.

ECA backed funding first came available in the United States and Europe in 2000.  U.S. competitors Emirates Airlines (UAE), Korean Air (Korea) and WestJet (Canada) have the distinction of not only being among the largest recipients of U.S. financing, but they are also the three airlines that have added the most capacity against competing U.S. carriers since 2002.

At a time when the U.S. government is imposing cost and regulation on top of the industry responsible for enabling more than one trillion dollars in economic activity, this would seem to be an easily resolved issue. Eliminate ECA funding and the ability it gives foreign airlines to use U.S. taxpayer dollars to simply swamp U.S. carriers with uneconomic capacity.  Again, I am all for competition...  Just not competition on an uneven plane that gives someone a significant advantage by subsidizing a cost center.

This is a slightly different virtuous circle than those we have referenced in the past – and one that can be stopped:  U.S. government backs loans to foreign competition; foreign competitor costs decline as a result; lower cost foreign competition accelerates growth; opportunity cost to U.S. airline industry equal opportunities lost because of cost disadvantage; fewer U.S. employees to bolster the tax rolls.

So why is the ECA case different from the challenge the Gulf airlines pose in Canada? That’s about access to the marketplace. The U.S. provides access.  ECA gives non-U.S. airlines a cash advantage to spend as they wish in that marketplace – whether by offering non-compensatory fares or to simply buy more airplanes to add new and marginal service to that marketplace that results in more non-compensatory fares.

You know how it goes from there.

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. 

Time to Rethink the Virtuous Circle

You know how it goes in the U.S. airline industry: improved economic conditions lead to increased demand for air travel which leads airlines to grow and increase employment.  And so the virtuous circle goes – ‘round and ‘round.  At various times in an economic cycle certain stakeholders tend to do better than others – usually at other stakeholders’ expense.  Front and center in the airline industry rent sharing game are labor and management.

Dan Reed, writing in the USA Today this week, reminded us of the numerous labor and management conflicts out there.  That much is true. But it was the subtitle that gave me pause:  “Unions want pay, benefits restored,” it said.  Not improved – restored.  Nice dream, but it’s just that: The restoration of wages and benefits to 2001 levels is a dream.  Reed quotes long-time industry observer Mike Boyd saying labor has to walk away with something.  Boyd says: “Labor has been on hold for the last seven years.”

Boyd is absolutely right.  Labor has to walk away with something – and they will.  However the airline industry is no position to write the check that would restore wages and benefits to pre-restructuring levels.  Furthermore, the shape and size of the industry today requires that certain work provisions contained in collective bargaining agreements need to be changed in return for improved wages, benefits and working conditions.  This necessary trade gets lost in the mainstream discussion.

Industry Eyes on American

This past week, three of the employee groups represented by the Transport Workers Union (TWU) at American voted on tentative agreements reached months ago.  Two of the three groups rejected the terms and conditions bargained for in those tentative agreements.  Initial rumblings cite provisions contained in the tentative agreements deemed “concessionary.”  Yes in “non-crisis” collective bargaining you trade one thing for another.

I, however, can make a case that the agreements reached were too rich in favor of the TWU.  American resides in a most fragile position in this round of negotiations because its labor costs already are the highest in the industry, even as it goes first among the legacy carriers to negotiate new contracts following restructuring..  The TWU members walked away from structural pay increases, leaving money on the table many in the investment community might have argued against offering in American’s financial position. And I’m among those critics. And while the company would have got increased productivity in certain areas of the contract in return, any savings generated from work rule relaxation is only as good as it’s ability to implement change.

One group that rejected the tentative agreement was the Mechanics and Related employees – a group that has worked closely with the company over the past decade to improve operations and attract third-party work. In part because of those efforts, AA outsources less maintenance work than any legacy carrier. 

Now look ahead.  Can American ignore that most of their competition is paying far less similar services? And without better productivity, can American bring in enough work to justify the current headcount within the Mechanics and Related group?

Just as with the pilots union at American, maybe some in Maintenance really believe that the company can pay labor costs that far exceed the company’s ability to pay.  Everyone points to the industry’s single quarter of terrific profits and suggest – somehow – that a secular trend is underway.  Has anybody been paying attention to the stock market this week?  The market which serves as the barometer guaging expectations for tomorrow?   Or maybe the mechanics are just taking an old trick out of the hat that was popular in the late 1990’s and in 2000 and 2001 when everyone rejected the first agreement assuming that a return to mediation would pressure the company to enrich the agreement, too often without any expectation of giveback.

If that is what happens this time around at American or at any airline for that matter, then the management team making those agreements have no one to fault but themselves.  Overpaying rent has been tried in the past and while it may help mollify labor for the short-term, it does nothing to promote the long-term sustainability of the agreement. Labor, too, is complicit in this short-sightedness, primarily because unions are not structured to manage the responsibility they possess. Unions are highly simple political organizations that too often have only have a short-term view, with leaders looking only to the next contract negotiation and the next leadership election.  

In his 2010 State of the Air Transport Industry speech, IATA Director General Giovanni Bisignani said, “Labor, out of touch with reality, is the next risk. We cannot pay salary increases with our $47 billion in losses. Pilots and crew must come down to earth and strikes at this time are shortsighted nonsense. Labor needs to stop picketing and cooperate.”

Concluding Thoughts

I am not naïve enough to suggest cooperation is a possibility everywhere.  It is not.  For both labor and management it will be tough to manage expectations set by those with short-term mindsets.  And those expectations collide with the need to manage for the long term.

Yesterday’s virtuous circle was largely predicated on plentiful and dumb capital willing to chase failing companies, jet fuel that was roughly one-third the cost it is today, and a general view that the only way a commodity industry could increase revenue was to add capacity.

In the U.S., we should be modeling a better path. Today’s virtuous circle in the U.S. is less about growth and more about making the kind of change and creating a model that will maintain and marginally enhance an airline’s ability to compete globally.

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.

Mexicana

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.