LaHood Protecting Consumers? Pretending To Protect Consumers?

Some time ago, I asked this question to an audience of airport executives:  If the airline industry is consolidating, shouldn’t the infrastructure supporting the industry consolidate as well?  The converse action of consolidation is fragmentation.  Fragmentation of markets has long been a practice of the US airline industry that has attempted to be everything to everybody.  Fragmented industries earn poor returns.

For example, the LA Basin is served by five airports:  Los Angeles (LAX), Ontario (ONT), Orange County (SNA), Burbank (BUR) and Long Beach (LGB).  Not every airline serves all five of the Basin’s airports.  But in every case the core traffic is Los Angeles traffic and by serving different airports the industry is fragmenting the Basin’s traffic.  Now Los Angeles may not be the best example given its huge population base and underlying wealth.  Nevertheless, the concept is as prevalent in Indianapolis as it is in Atlanta as it is in Washington, DC.

Between 1980 and 2010, LAX has accounted for increasingly less of the region’s domestic traffic.  To compound the problem of intra-regional competition, nominal domestic air fares at each of the five Los Angeles airports were lower in 2010 than they were in 1980.  This is but one reason why the infrastructure needs to consolidate.  Fragmentation produces unsatisfactory and unsustainable financial results.  As individual carriers increasingly realize, airlines cannot be everything to everyone.  Just last week, the following news story hit the wires:  Delta to Adjust Service to Smaller, Underperforming Markets.

As Jad Mouawad wrote in his recent New York Times article Air Service Cutbacks Hit Hardest Where Recession Did:  “. . . the [air service] cutbacks are redrawing the nation’s air service map to reflect the industry’s new priorities and changed economics. As recently as a decade ago, the airlines put a premium on growth, competed on every possible route and sought to connect to even the farthest outposts. Now, they are emphasizing fiscal discipline, which means paring back service to many cities and forgoing unprofitable destinations altogether as higher fuel prices weigh on their bottom line.”

I’ve weighed on this topic before:  Regional Airline and Small Community Air Service: It’s Time to Regionalize, Not Marginalize, the System.  As has analyst Mike Boyd of Boyd Group International whose thoughts in his weekly Hot Flash make clear the topic also will be discussed in depth at The Boyd Group International’s 16th Annual International Aviation Forecast Summit, August 28-30, in Albuquerque, NM.  As with many things Mike, the conference is a no-holds-barred discussion of third rail issues that affect the entire industry, whether airports, airlines, vendors, media, manufacturers and government, to name a few.

Under structural consolidation, a number of airports will ultimately lose direct air service, and more Americans will have to drive farther to get to an airport.  No doubt that for many communities this will come as a shock.  But as is the case with even urban areas, travelers already often bypass the local airport to take advantage of lower fares at another airport a bit farther away.

Unfortunately, the Obama Administration isn’t doing much to help an industry already burdened by regulations, battered by the economy, squeezed by oil prices and constantly beset by competition. Consider the response of U.S. Transportation Secretary Ray LaHood who, in the classic tradition of “I’m from the government and I’m here to help” last week unveiled a new proposed federal rule to force airlines to report more data on fees, baggage and mishandled wheelchairs..

This is an industry that earned a scant two cents on every dollar in 2010 and yet the government wants to dig further into the file cabinets of every airline in the country in a misguided attempt to account for the money those fees are bringing in. In case you have been living under a rock, the genesis of ancillary fees has been among the most covered and scrutinized stories since 2008.  In 2010, US airlines generated $3.4 billion in baggage fees and another $2.3 billion in reservation change fees for a total of $5.7 billion.  What about the fact that the industry’s fuel bill in 2010 was $6.5 billion higher than in 2009?  The Air Transport Association forecasts that the industry’s fuel bill in 2011 will be $14 billion more in 2011 than it was in 2010.  Remember, it was the rising cost of fuel in 2008 that served as the catalyst to unbundle the airline product.

This latest proposed rulemaking coming out of LaHood’s agency under the guise of consumer protection is anything but.  Today fees are not taxed.  The government wants to get its paws on any new revenue it can find and of course the airline industry is targeted.  LaHood’s proposed rule would require airlines to report 16 additional categories of fee revenue in addition to the baggage and reservation change fees.  Outrageous.

Let’s turn the tables.  As a consumer and a taxpayer, I’d like to see a complete breakout of the special aviation fees and taxes collected by the government.  All I get on my ticket is a total: an amount that includes what the ATA counts as 10 categories of special aviation fees and taxes. 

I want to know how much the passenger facility charge is on my ticket.  I want to know how much is going to the Department of Homeland Security for the September 11 fee, immigration fee, the customs fee, the Aviation Security Infrastructure Fee (ASIF) and APHIS Passenger and Aircraft fees.  I want to know how much is going to the FAA in the form of domestic and international passenger taxes, jet fuel tax and the cargo waybill tax.  If the airlines are to report out on 16 incremental items in the name of consumer protection then I want to know where each dollar of taxes and special aviation fees goes.

So as the industry struggles to earn a meaningful profit, LaHood grandstands.  As he states in the DoT press release: “Our goal is to improve the quality of data we collect from airlines and make airline pricing more transparent. In an era of rising fees, passengers deserve better information about how airlines are performing, particularly when it comes to fees, baggage and accommodating passengers in wheelchairs.” 

Meanwhile communities are losing air service.  Maybe if some or all of the tax and fee revenue were returned to the airlines, then fewer markets would be underperforming and thus avoid service cuts.

The conversation about regionalizing air service should begin with a sober assessment of the market and clarity from the Secretary of Transportation on this administration’s vision of what constitutes the right air transportation market. 

This difficult discussion already is underway in some markets, including in Kansas where Dodge City and Garden City are discussing whether or not to form a regional airport. 

The article notes new urgency on the issue in Kansas because Congress may decide to eliminate the Essential Air Service program.

"The EAS program has come under attack in the past, but never really did we feel that the program was in jeopardy," Dodge City Manager Ken Strobel is quoted. "This year, however, there's more concern that the program may be phased out or funding cut substantially.”

The EAS program is but one reason for communities with marginal air service to consider “regionalizing.”  A stark example of another market is Pittsburgh and its catchment area.   There is one strong airport in that catchment area that includes Akron/Canton.  Latrobe, Morgantown, Franklin, Johnstown, Clarksburg, DuBois, Altoona, Parkersburg, Cleveland, Youngstown and Erie.  All have realized decreases in traffic or a total loss of service since 2000.  But demand within this area is the same as it was in 1990, signaling that fact that some areas have far weaker economies than others.

As the industry’s route map is redrawn maybe the Department of Transportation should be thinking about bigger picture things than wheelchairs, data reporting and fee transparency.  Rather than threatening the existing Essential Air Service Program, begin to define what is tomorrow’s essential.  Work with industry to identify the airports of tomorrow (airports serving a region that can fill either a large regional jet or turboprop or mainline with sufficient local traffic) and ensure that money is being spent wisely (as opposed, for example, to building air traffic control towers in Johnstown, PA.)  If it is determined that certain airports are closed to commercial air traffic, then each of those airports should remain closed to that traffic to ensure that regionalization produces positive results for an industry that desperately needs to be run like a business as opposed to a make work project.

Maybe the Department of Transportation turns out to be the agency that behaves the way former Congressman Oberstar behaved toward the industry – standing in the way of progress in building a sustainable system.  But I certainly hope not.

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. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

More to come.

Mirror, Mirror On the Wall: What About US Airways After All?

One fascinating story resulting from the news that Continental and United intend to merge is what might happen to those on the sidelines, namely US Airways and American. 

Let’s begin with US Airways.  I have written before that US Airways’ route portfolio is inferior relative to other US legacy network carriers. I also have written before that US Airways is hamstrung because of its precarious labor position – a constraint primarily caused by the dysfunction in its pilot corps.

Immediately following Delta’s January 2008 rejection of US Airways’ overture, it was clear to me that US Airways CEO Doug Parker was right in his efforts to be a first mover in the consolidation arena. In making a run at Delta, Parker provided a blueprint for the industry to merge networks, and ensure air service to communities of all sizes, while at the same time reducing fixed costs. But something stood in the way then:  Parker’s pilots. He was hamstrung by pilot leadership blinded by the prospect of an unlikely outcome – a better seniority arbitration decision. [See note below:  Delta attempt came before seniority list decision was issued]  As I wrote then:  “For Parker, bringing labor along would certainly have proven expensive – and maybe just too expensive.”

Today the US Airways pilots await a decision from the 9^th Circuit Court of Appeals stemming from a lawsuit initially won by the former America West pilots after USAPA, the union that represents the US Airways pilots, refused to honor a binding arbitration decision on seniority integration.

Because of that circumstance—and the consistent objection by USAPA to every strategic initiative generated by US Airways management—last month I challenged speculation that United and US Airways could put together a merger where they twice failed before.

To be fair, as discussions proceeded between US Airways and United, it was becoming clearer to this observer that USAPA was beginning to understand and even embrace the idea that consolidation may not be a bad thing for employees.  The math is easy.  A $30 billion corporation is in better shape to provide for raises and long term employment stability than is a $13 billion company susceptible to geopolitical, oil and economic shocks.  But it remains to be seen if this was just USAPA being opportunistic or a sign that the union is changing its stripes.  As I will discuss below, a change in approach by USAPA will be necessary to secure an improvement in pay for the US Airways pilots in the short term and the benefits of consolidation for all US Airways employees in the longer term.   

Let’s Put Some Things into Perspective

In recent days, I’ve read many stories that attempt to etch US Airways’ livery on the next gravestone in the airline cemetery. But the rumors of the airline’s demise have been greatly exaggerated.  In theory, US Airways, American and other carriers should benefit, albeit indirectly, from industry consolidation.  Moreover, most of these stories missed the fact that this consolidation is taking place at the bottom of a recovery cycle, not at the top.  Assuming that the health of the US airline industry is inextricably tied to the health of the US macroeconomy, then a rising tide should float all boats.  Right? 

On May 3, Vaughn Cordle of Airline Forecasts Inc. published a white paper titled:  “United + Continental is Good News for all Stakeholders:  More Mergers are Needed.  Is American and US Airways next?” Cordle writes: “If the industry is not allowed to consolidate in the most rational manner, the result will be a continuation of the slow liquidation and the inevitable failure of US and AA, the two remaining network airlines in need of restructuring.  The most likely outcome would be an AA bankruptcy and outright liquidation of US.”

Cordle makes a case for consolidating US Airways and American citing expected future increases in fuel prices, airport charges, security and labor costs against the backdrop of less than credit worthy industry.  And these come before the industry begins paying to conform to inevitably new environmental regulations.  Don’t misunderstand, I agree that participating in consolidation is the best outcome for US Airways.   But I don’t buy the gravestone argument.  Let’s take a look at the fundamentals.

Everybody remembers America West Airlines.  A legacy-like model—that we all knew ultimately would be combined with another airline—around the turn of the century America West "flirted" several times before tying the knot.  Before its 2005 merger, America West survived and produced competitive margins through focused management, the support of labor unions that recognized the company’s place in the industry, and by offsetting a revenue generating disadvantage by maintaining a cost structure advantage.  Oh yeah, and the airline was based in Tempe, AZ and run by a guy named Doug Parker.  Sound familiar?

Today US Airways does suffer from about a 12 percent stage length adjusted unit revenue disadvantage versus its legacy carrier peers.  But it also enjoys about a 12 percent stage length adjusted unit cost advantage versus these rivals.  Despite the revenue generating deficiency, for the first quarter of 2010 only United among the legacy carriers saw a bigger increase in total unit revenue than the Tempe-based airline.  Like the rest of the industry, US Airways continues to see its corporate revenue and booked yield (passenger revenue per revenue passenger mile) improve.

Maintaining a Cost Advantage Is Critical for US Airways

And this revenue disadvantage is offset by US Airways continuing to maintain a cost advantage.  For the first quarter of 2010, only Delta saw its unit cost (operating expenses per available seat mile) increase less than US Airways when compared with all legacy network carriers. As a result, US Airways’ pre-tax margins show little to no difference when compared to other legacy carriers.  In fact, during the first quarter, US Airways saw a pre-tax margin improvement of 7.2 points, which compared favorably to its peers. The cost advantage the carrier enjoys cannot be overstated nor can the company hide behind the fact that the vast majority of that difference can be found in lower labor costs.  By contrast, United and Continental are only now beginning to navigate what it might cost to buy labor peace, particularly among the pilot groups. 

One imperative for US Airways will be to educate employees about the difference between US Airways when compared to Delta and the new United.  If US Airways’ unions push the company to match rates paid by other carriers with significantly bigger networks, more profitable hubs and less capacity dedicated to the US domestic market, then Cordle just may be right in predicting the potential for liquidation.

But what if the unions recognize US Airways position in the industry and adopt a longer term approach?  What if US Airways can maintain its current cost advantage?  Or enough cost advantage to offset the company’s structural revenue deficiency?  What if the airline get its internal labor house in order so that old US Airways and old America West contracts are one with matching seniority lists and affordable economics?  Is that really any different than America West at the beginning of the last decade?  Is this any different than United going back to Chicago in 2008 after being snubbed by Continental and getting its house in order?  I think not.

In the US Airways route structure, Philadelphia and Charlotte are gems.  I will concede that Phoenix is confounding given the extent of direct competition from Southwest Airlines.  And while US Airways does enjoy a 23 percent unit revenue advantage versus its low-cost competition, it also carries a 29 percent cost disadvantage when adjusted for stage length.  No legacy carrier has more direct exposure to Southwest.  But this is not new and it is not a death knell.  Parker and his colleagues have been successfully managing this challenge for 15 years.  Rather an important part of the education of US Airways employees and unions need to fully understand the importance of keeping costs low.

It’s Hard to Kill an Airline

In my view, an airline today is like a cockroach.  You can beat it, burn it, kick it and starve it, but it doesn’t die easily.  And over the last ten years Doug Parker has defied even a cockroach’s odds on numerous occasions. Remember, we are at the bottom of a recovery cycle – a fragile recovery cycle to be sure.  US Airways cash as a percent of twelve month trailing revenue is comparable to its legacy peers and relative to its size (revenue), comfortable.  Compared to its peers, the company also has fewer debt obligations to be repaid as a percent of revenue over the next two years.

This is not to say that US Airways does not have its issues – some that are easier absorbed by consolidated balance sheets that produce a higher cash cushion.  And there are plenty of sensitivities that can disrupt the company’s vulnerable cost advantage:  1) a 1 percent change in mainline unit cost ex-fuel cost the company an additional $60 million per year; and 2) a $1 change in price of a barrel of crude cost the company $34 million assuming that crack spreads stay at today’s levels resembling historic norms.  On the other side, as little as a 1 percent change in unit passenger revenue bolsters the company’s top line by $93 million.

Also US Airways’ labor unions need to recognize the value of cooperation and moderation in the near term.  Those unions also need to consider that “moderation” could mean significantly improved pay—if they are prepared to eliminate anachronistic scope restrictions and improve productivity.  And they need to see that there is a big pay day if US Airways is involved in industry consolidation, and that their behavior—and the terms of their collective bargaining agreements—will play an important role in determining whether that pay day occurs.

Message to US Airways’ Labor Generally; USAPA and AFA-CWA Specifically

Git’r’done. Enough already.  The pundits who suggest that US Airways is dead do so partly in recognition of the dysfunction of union leadership at your company.  They are not all together wrong.  But most are not aware that there may be recognition by US Airways’ labor leadership that their members may actually benefit by participating in consolidation.  To participate in a strategy designed to promote industry stability requires labor stability as well – and this is an area that needs improvement at US Airways particularly among the two unions representing flight crews, USAPA and AFA-CWA. 

Some suggest in comments to this blog that management is keeping the groups apart to save a few bucks.  If that is what they are doing, then shame on them.  But no one can make me believe that this is the case.  What's in it for Parker to do that?  Also it is in everyone’s best interest to negotiate joint collective bargaining agreements with competitive productivity and scope language that permits a company to navigate the complex competitive landscape and to have a single seniority list for the various class and crafts of employees.   And it is critical to both shareholders and employees that impediments to mergers be eliminated from collective bargaining agreements.

What makes this round so damn difficult is that every carrier is now a little different and it stems from an individual carrier’s portfolio of flying.  For this reason it is increasingly difficult to compare costs at one carrier to another and, as such, pattern bargaining should be a practice of the past.  If airlines engage in union efforts to chase the best contract – even when their networks don’t pay the tab -- then they deserve their place in the airline graveyard.  The price of buying “labor peace” is too high if it means an airline can’t ultimately support or survive its own labor cost structure.

These negotiations, whether at United, Continental, American or US Airways, are about the future of the airline industry as we know it.  As such, the negotiations are about more productivity and flexibility in return for higher wages.  Fixed costs must be removed.  And a union’s demand that a company carry more employees to do the same level of flying as a competitor simply creates a structural disadvantage any rival can exploit.  For a standalone US Airways, the company is in a position to survive given the up cycle ahead.  But come next the down cycle, or geopolitical event, or oil at $100 . . . then all bets are off.  So at US Airways, the negotiations need to be about ensuring the company's relevance while supporting industry consolidation.

Mirror, Mirror On the Wall: In a couple of years give US Airways a call. 

More to come.

Update on 05.6.2010 by swelbar

I have been made aware of a factual error included in this piece.  I have had more than one reader write to remind me that US Airways attempt to merge with Delta occurred before the seniority list decision was handed down by Arbitrator Nicolau.

Airline Stuff: A Little of Last Week; A Little of This Week; A lot of Cynicism

Consolidation; the National Mediation Board; APFA; Republic Holdings and Captain Prater

Last week, Reuters held its Travel and Leisure Summit in New York.  A number of airline CFOs participated, including Kathryn Mikells of United, Tom Horton of American, Derek Kerr of US Airways and Laura Wright of Southwest.  It was, overall, a really good group of voices who spoke pretty much in concert about the challenges facing the airline industry. Then came the sour note, from another invitee, Captain John Prater, president of the Air Line Pilots Association, whose. comments nearly caused me to choke on Cheerios. But more on that later.

Consolidation was the big storyline in the coverage.  Southwest continues to not rule out the possibility of a merger, although Wright made it clear that organic growth is its preferred route.  Mikells talked more broadly about consolidation and did not limit herself to discussing consolidation within sovereign borders.  Kerr, too, spoke favorably about consolidation but suggested that merger activity would have a more positive effect on the industry’s fundamentals if it involved a carrier with a US domestic presence.

"It's five major carriers, it's too fragmented," Kerr said of the U.S. airline industry. "You have too many hubs, all chasing the same passengers trying to connect through the country. We believe that it needs to be consolidated."

One issue that puzzles me though is that the consolidation discussion focuses only on the five legacy carriers. I think the most interesting sector for consolidation is the regional sector (on which, as it turns out, Prater appears to agree with me.)  But why are names like Alaska, jetBlue and AirTran not part of the discussion? What about Air Canada?  Is consolidation limited to just two carriers?  What if United, or American, or US Airways, wanted to sell part of their domestic operation to one carrier and another part to a third carrier? That concept is not so different than the slot swap deal that Delta and US Airways negotiated only to have the government make such dramatic changes to the terms of the deal that it now makes no sense.

Now back to Prater. In his remarks, Prater said that ALPA is for what he called the “right: consolidation – one that “actually protects and enhances jobs and creates a profitable carrier."  Just to be sure, I read it twice.  Yep, those were the words of the same pilot leader who has done little to nothing for his membership for the past three years.  Then I remembered that it is an election year at ALPA. Maybe that is why Prater’s words and tone have changed to better mirror what Captain Moak said and carried out at Delta during its largely successful merger with Northwest. 

Where was Prater when the US Airways and America West guys needed leadership?  If my memory serves, I believe he was flexing his muscles after winning election on a “we will take it back” campaign.  Of course, there is still little evidence to suggest that United is any better positioned than any other legacy carrier to return to the days of the bloated and inefficient labor contracts that helped tipped the carrier into bankruptcy. So Prater might be testing out a new campaign platform to convince UAL pilots that he deserves a second term.

From the management perspective, the CFOs wholeheartedly agreed that capacity discipline is the key for the industry to become and possibly remain profitable.  They also agreed that alliances are here to stay as the industry’s answer to mergers across borders that are forbidden by rules and regulations. 

"What you will see United and other industry participants doing, is basically within the regulatory framework that we have today, trying to get some merger-like benefits without merging," United's Mikells said.  The discussion that followed focused on the big three alliances and their efforts to find cost synergies as well as the revenue synergies already in place.

And that’s where airline labor comes in.  In the past, many unions have been cool to any merger that might threaten the union’s stranglehold on flying for its own members, even when that flying comes at a high price. Prater’s ALPA, for example, is a loud opponent of global mergers, even when the alliances in place today support so many pilot jobs in the US.  Surely he does not think that each of the five legacy carriers would be as big as they are even today if they were not carrying alliance partner traffic?  So the “consolidation that actually protects and enhances jobs” he talks about actually occurs every day when that United flight leaves Washington Dulles for Frankfurt with 60 percent of its passengers bound for points beyond Frankfurt on STAR partner Lufthansa.  Just like the American Airlines flight leaving Washington Dulles for Los Angeles that is carrying a cabin full of passengers connecting with Qantas to Sydney and beyond?

Republic Is Confusing, Confounding

What the Hell Is Republic Doing?  I get notes from really smart people in the industry asking me this question.  After all, I was really jazzed over the prospects for Republic’s purchase of Frontier and wrote a lot about the possibilities here on swelblog.  Now I am confused.  First, I have not understood the level of management energy spent on the presumption that Midwest can be reborn.  TPG had already destroyed the carrier literally and figuratively.  I can see the possibilities of keeping in place some of Midwest’s best flying.  But messing with Frontier’s brand to right-size Milwaukee makes absolutely no sense.

Ann Schrader of the Denver Post wrote about Republic’s “bumpy integration” in her February 21 story Merger muddles Republic Airways' branding. I appreciate that piecing together an airline is much easier said than done.  But every day Republic seems to further confuse the confusion.  And if serious industry watchers are confused, then just imagine how former loyalists to Midwest and Frontier must feel. It is those loyalists that are the brand – or maybe were the brand?  I am a Daniel Shurz fan and I have every confidence that he can get the right aircraft in the right place at the right time.  But there is much more to this delicate exercise than moving airplanes and picking markets.

I will buy the decision to dismantle Lynx (Frontier’s regional operation) given that it would have taken many more aircraft in the Q400 fleet to realize scale economics.  Now Republic has placed an order for Bombardier’s C-Series airplane.  On paper the aircraft is interesting – but why have orders been so hard to come by – unless someone needed to trade out of an aircraft type?  Then Republic puts an unproven engine on a not yet embraced airframe.  Confused. 

A big part of the Frontier and Midwest brands was the people.  This is about as bad a job of managing work forces as I have witnessed.  Given the new representation rules likely coming this week from the National Mediation Board, Bedford’s Republic promises to be a ripe target for union organizers.  Surely this is not Bedford making these calls?  I have gone so far to say that Republic will play in tomorrow’s US domestic market in a meaningful way.  Now I am not so sure.   And I am simply confounded by any decision to upset the work force at Frontier.

The way this seems to be playing out is that under Republic, both the Frontier and Midwest names will disappear.  So why then buy Frontier, an acquisition clever because Republic was buying a great brand. The deal in fact gave Republic an actual airline – something Republic is not.  The purchase also bought Republic a management team that knew how to run an airline and an IT infrastructure that made the deal really interesting.  But now it seems that Republic’s management team thinks you can feed a cookie (Midwest) to Grizwald or Montana (Frontier) and out comes Herman the Duck (Republic).  Remember that brand?

The National Mediation Board

This is a week to pay attention to the National Mediation Board. Jennifer Michaels at Aviation Week reports that the Board’s “cram down” representation rule change will be published in the Federal Register on Friday.  I believe that there will have to be some comment time or at least that is the way things used to work in Washington prior to this administration.  Unfortunately this issue is playing out the way the health care debate is playing out – along party lines.

The other story playing at the NMB this week involves American Airlines’ which is again in “lock down” negotiations with its flight attendant union, APFA.  The APFA already has threatened to request a release from the NMB if the two sides fail to reach a deal by the end of this round of talks. Whether the NMB will do so is questionable given what I see as the administration’s reluctance to risk a strike in the midst of a fragile recovery.  Moreover, we typically do not see releases during the busy travel season – particularly when economic recovery is at stake.  And rarely do we see releases when, by all reports, the parties are still pretty far apart based on what the union is demanding and the company believes it can afford.

The APFA, in all that I have read, does not seem willing to embrace any productivity in return for increased income for its members.  American has been transparent in communicating its proposals, including on a public website. So what might the NMB do with the parties if a deal is not reached?  Grant the APFA a release?  No.  Grant the APFA its release with the full intention of creating a Presidential Emergency Board?  Maybe. Put the negotiations on ice?  Maybe.  Set new dates for the parties to resume negotiations?  I think not.

Will the Board be proactive in trying to close a deal?  That is the question.  It is what watchers of this incredibly difficult round are trying to discern.  How will this NMB deal?  So far, with only a few airline labor negotiations cases closed, the NMB has not yet been pushed to the brink. But there are still 82 open cases.  The AA – flight attendant deal might be the first big test.

Europe and Strikes

Speaking of the APFA and its loose-lipped talk of strikes, last week was most interesting in Europe.  The Lufthansa pilots.  The BA flight attendants.  The French air traffic controllers.  And of course, all things Greece

Europe is undergoing today what the US airline industry has been experiencing for the past 20+ years: the need to continually transform business models with relatively high cost structures in the face of declining revenues.  Unbridled competition in the US domestic market was its catalyst to reduce costs, particularly labor costs.  The decline in premium class revenue and the blurring of borders that used to protect individual flag carriers will serve as the catalyst for the European carriers to also reduce their labor costs.

The labor instability in the European airline industry demonstrates an expected collision of socialist policies promoting entitlement with an industry forced to adapt to market forces.  I expect that there will be more weeks like this one as the European unions come to grips with market realities that could make any number of flag carriers irrelevant in tomorrow’s global airline industry. Unless, that is, those unions instead choose to adapt to the industry’s evolution . . . a story that has played out in the US in the names of Pan Am, TWA and Eastern Airlines to name a few.

It’s not just Europe.  Look at what is happening in Japan where JAL, another legacy carrier with outsized costs relative to revenue, is in bankruptcy.  Following 9/11, more than half of the US airline industry was in bankruptcy at one time.  European airlines – and their respective unions - are not immune to the same market forces.  And there are certainly lessons that can be learned from the US experience. 

“A Flying Pig”

Eric Reguly of the globeandmail.com writes a cutting and provocative piece on the situation at Alitalia. I have been looking for an excuse to write about the Alitalia story as it provides a bit of a reflection of US airline industry tendencies. Particularly when politics and labor stand in the way of economic forces that demand change. Fighting an industry’s evolution seems to ultimately result in the failure of the very entity the entrenched believe somehow will flourish in its status quo state.

Whatever date will decide Alitalia’s fate is nearing. Mr. Reguly writes: “Alitalia, with some 18,000 employees (far too many) and 174 aircraft (far too old and fuel inefficient), has been a flying pig for as long as anyone can remember. It was plastered with bandages when radical surgery was required. Between 1999 and 2005, it lost €2.6-billion. In 2002, it was kept alive only by the emergency injection of €1.4-billion from the government. The bleeding still continued. The airline lost €605-million in 2006 and another €364-million last year. The politically motivated strategy of flying from two hubs - Milan's white-elephant Malpensa airport and Rome's Fiumicino - unnecessarily deepened the losses. Alitalia is too small for a two-hub operation (to its credit, the airline was slowly downgrading Malpensa in favour of Fiumicino)”.

The US airline industry is fast approaching a date where something is going to have to give as well with high oil and an economy in recession on a collision course. Whether consolidation or liquidation, the next 12-18 months promises to be the most challenging period in the industry’s deregulated life cycle. The barriers to exit that have historically existed will be challenged. My guess is that they will not provide the same safety net that has been experienced in the past.

Today, Alitalia is Europe’s sixth largest carrier in terms of revenue. The Big 3 in Europe (Air France/KLM, Lufthansa/Swiss and British Airways) are beginning to dwarf numbers 4-6 in terms of size. It would certainly seem that for Alitalia, being part of the world’s largest airline group is its best case scenario. But when parochial interests get in the way, somehow it becomes an all or nothing game rather than to preserve as much of the legacy as possible.

The US airline industry seems poised to experience some similar scenarios. Maybe the best path for the US is consolidation through liquidation? A path of lesser resistance? Some will say to me in various ways: Swelbar, this will only happen when pigs fly. What we are seeing in Altialia is that pigs can’t stay airborne forever – even in Open Skies.

Pigs don’t fly and neither will an industry that refuses to adapt.

Leaping Into Madness

Only every four years, do we get to write on February 29. But every year the month of March is Madness. One might argue that the month of February 2008 has been maddening as we await some kind of news – and a simple yes or no would work – coming from Delta and Northwest.

So I think it is only fitting that we get the following press release from NYU Stern Professor Robert Lamb and his take on the Delta – Northwest combination on the extra day in February. He suggests that the combination looks great on a map, but is doomed to fail. His reasoning is based on his book, co-authored with Thomas Grubb, Capitalize on Merger Chaos: Six Ways to Profit from Your Competitors' Consolidation on Your Own. While I agree it is a strategy that can be employed by players in a consolidating industry, I thought it might be just "mad fun" to consider the 7 points he makes pertaining to the Northwest – Delta combination:

1. Focusing inward on integration of Delta & Northwest will negatively affect their profit,

Precisely why this deal has not moved forward is because a decision has been made to avoid this very issue. Delta and Northwest can only work through the issues with the pilots because they are both represented by ALPA. Therefore, details can be negotiated as the collective bargaining agent is known. Moreover, by dealing with pilot issues upfront, limitations on how aircraft can be deployed will be settled and the important work of network configuration can begin.

While there will be representation issues to work through with the many non-pilot work groups, the direction of that work will also be decided by the employees. And that is whether there will be a collective bargaining agent or not. But non-pilot employees do not control the essential elements that impact how a network can be reworked.

2. The skills of employees from each company are not necessarily transferable,

The class and craft system of employees in the airline industry can be applied across the many companies that comprise the airline industry. The airline industry is made up of a lot of smart people. After some differences training, I feel confident that all employees performing a function at Northwest can perform the same function at Delta. So, I do not think this issue does much to stand in the way of a successful merger.

3. The lack of a strategically powerful merger plan will lead to chaos and uncertainty, and both companies’ most valuable resources—their best people—will probably flee,

Let’s think about this for a minute. We have a $20 billion deal sitting on ice while we await word as to whether a consensual integration of seniority can be accomplished between the two pilot groups. In an industry where seniority rules how employees work, there is a very long history of why employees do not leave one company for another in this industry.

4. The size of these two airlines combined creates the largest US airline, which poses a threat, according to studies indicating that larger companies are historically the least successful in mergers,

And today, the two largest airlines in the world are arguably among the most successful. And they are the byproduct of merger activity: Air France and KLM; and Lufthansa and Swiss. The economies of scope and scale are important in a network industry. And to continue the debate about size of an airline in the context of a US only industry ignores the economic forces of globalization. What was most refreshing for me on my trip to Dubai was to have multiple discussions where perspective was only considered in the global context and not on a regional scale. And the US is merely a region that is part of the global economy.

5. Most companies don’t know the statistics on merger failure and let egos alter their judgment when determining how much the enterprise can afford to pay and how much they will recoup,

Northwest and Delta are working hard to address the known issues that have stood in the way of successful attempts in the past. I think each company involved along with knowledgeable industry watchers is well aware of the statistics on merger failure in the airline industry. I guess the fact that the senior management team has already been decided does not suggest that egos have been put down in order to forge a combination that each company believes is in the best long term interest of their respective companies. And finally in a stock swap deal and given the certainty over oil prices and economic conditions, how much can be recouped is a fairly straight forward exercise.

6. Union issues may delay the merger, causing airline executives to focus too much on internal operations, and not enough on competitors,

I believe that this was answered in #1 above. Further without an agreement from the one similar, and known, union on the property, there is no deal based on what we know today.

7. A significantly more profitable merger would result from a joint venture between either Delta or Northwest and a strong foreign airline.

Now finally a point I can begin to embrace somewhat. But in some ways doesn’t Northwest already have a joint venture with KLM and Delta a joint venture with Air France and Northwest/Delta with Air France/KLM? This loose joint venture will be cemented by the equity investment the non-US group plans to make in the Northwest-Delta combination. I hope the combination results in a more profitable entity as today’s profit levels are not sufficient to enable the reinvestment in the business that is necessary.

Concluding Question

Is this delay in time good for the deal, bad for the deal or indifferent to the deal?

Concluding Thought

If nothing else, the delay brings with it many interesting nuance and analysis that is just simply not applicable. I do expect more from a prestigious academic institution than to think about mergers in a parochial US-centric way. Ignoring the forces of globalization is well…….

Where is Swelbar? Thinking About US Airline Industry Structure in Zurich

Well Swelbar is sitting in a lounge in Zurich on his way to Dubai. But the day is no different than any other day. I wake up from my sleep, only this time I awakened in the comfort of United’s new business class interior. The new first and business class interior is a significant improvement over the previous offering and a product worth trying. (Now remember I remain a United shareholder). But, lie flat in business class is a nice seat and of course the video and audio entertainment is much improved as well if you are into that stuff.

But I am not a guy that plans to write much on aircraft interiors. I am a guy interested in the competitiveness of US carriers in the global marketplace. Whereas it has been said that the new interiors being installed by United and American may be an iteration old when compared to the interiors of the major global players, it is a start.

Theories Behind Consolidation

While I do not have much time to write this morning, Barney Gimbel of Fortune Magazine writes an interesting take on the Delta – Northwest deal. As I have written about this expected deal, the devil is in the details, but…… The stories to date suggest that labor stands to make gains in the neighborhood of 30%, at least in the case of the pilots. Further the stories suggest that very little flying will be cut, hubs will be maintained and in fact new service may be offered. No, that does not sound like consolidation or what I call phase 2 of the industry’s restructuring started in 2002.

But if ensuring that one group of employees does not have rates of pay less than another group of employees, those rates need to be adjusted to address the known internal strife that will be generated if not addressed up front. Moreover, strife that will stand in the way of achieving synergies in the many areas of the operation that are certain to be addressed.

If part of the increase includes future pay raises granted under a single collective bargaining agreement, then the question becomes over what term? Is commensurate productivity to be gained in return for those wage increases? And what period of time does a new collective bargaining agreement cover? These are important issues and questions to ask – and the devil will be in the details.

My take on the facts gathered from known good sources of reported information is that Delta will first try to maximize revenue from a "network rework" then turn to difficult cost cutting issues as they evaluate the top line performance of the "reworked network". The US Airways – America West merger did produce revenue synergies as the networks were combined. Pittsburgh has in effect been closed. But few, if any, meaningful other cost synergies have been realized. And this is partly the result of the labor divisions that stand in the way of full operational integration.

Mr. Gimbel raises a point that I have been raising on this blog since the beginning – and that is about finding a sound and sustainable industry structure. Yes the industry is made up of individual carrier and other disparate interests, but the key to a better tomorrow has to be in addressing the known fragmentation of the home market. And that involves tough and painful decisions otherwise we do just continue down the path of attrition that will be disproportionately painful for many.

It is widely assumed that when a Delta – Northwest deal is announced, others will follow. If United is involved, we know there is a management team that will pursue both a revenue maximizing and cost- minimizing approach and this may change the thinking of all carriers considering combinations.

Banking on revenue alone is a dangerous approach given that we still do not know the real underlying condition of the US economy or what effects the condition of the US economy will ultimately have on the global economy. Combined networks will result in the ability to sell city pairs tomorrow that one cannot sell today. But the health of city pairs are still impacted by the underlying economic forces.

So let’s wait on the details. Let’s acknowledge that there are many ways to address less than adequate financial performance. I do not believe that consolidation is a panacea by any means, but what I do know is that today’s industry construct does not work.

The debate on approach can only begin in earnest once we know how all of the "new" pieces will fit together. Mr. Gimbel raises good points. But, even he is early in the game to declare that it just does not work. It took a long time to create these structural inefficiencies and they cannot be erased with one deal. It will take more than one and a piece here, and a piece there. Otherwise we just perpetuate the status quo.

More to come.

First Labor Hurdle Cleared in Delta – Northwest Deal?

The Devil Will Be In The Details

As Delta Air Line’s Board of Directors prepares to meet tomorrow in New York, Nathan Hurst of the Detroit News reports that the pilots of each Delta and Northwest have tentatively agreed to a framework of a deal. As in all things difficult, the devil is in the details. But the story suggests that an agreement on seniority integration has been reached subject to membership ratification.

There is no mention of a construct of a single collective bargaining agreement but the article does suggest that the pilots will receive an equity stake and a voting board seat in the combined entity. In the event the tentative agreement is not ratified by the membership, a binding arbitration mechanism has been put in place.

Susan Carey and Paulo Prada report in today's Wall Street Journal that a number of other “deal issues” still need to be finalized including the size of the Air France/KLM stake, compensation for non-pilot employees, a premium for Northwest shareholders among other items.

In the Journal story, Carey and Prada write “Some industry executives have worried privately how zero capacity reductions and higher labor rates would hurt the rest of the industry”? I am an analyst that wonders the very same thing but as mentioned above, the devil is in the details.

But it sure looks like tomorrow’s Board meeting is important and maybe we can start to look at the details instead of wondering what they might be. Or, maybe we will hear as soon as today or tomorrow according to the Atlanta Journal-Constitution.

Thinking about This Week’s Airline News: Industry Structure; Labor; and the Customer

Setting the Table

On October 8, 2007, I wrote the following in a post: “Some want to believe that the cost cutting is done. It is not. Some want to believe that it cannot get worse and it likely will . . . at least for some carriers. The low hanging fruit has been picked from the expense tree which only means that the hardest work is still ahead”.

“Over the next 2-3 years the winners of this war of attrition will begin to emerge. I am not alone in my belief that there are simply too many airlines– mainline and regional -- too many hubs and too many parochial interests among the stakeholders to make this market work for everyone”.

In a post on October 21, 2007, I wrote a piece where I was addressing employee and community entitlement to employment and air service. “Defining Entitlement Economics: all are conferred a lifelong right to employment and/or abundant service despite the fact that the economics of the US airline industry, particularly its domestic operations, have changed significantly since the early 1990’s”. Nobody is entitled to a lifelong right of anything.

Yesterday, The Economist ran two separate articles that are a must read from my perspective. The first opinion piece entitled The Need to Shrink picks up on the very themes that have been written in this blog since its inception. The second, entitled Aviation A normal industry? cites the many catalysts for consolidation that we have discussed here as well.

But more importantly the article raises the specter that US aviation is anything but a normal industry due to the protectionist policies in place as well as the entitlement issues that the various industry stakeholders possess. The article also offers the global view that success for commercial aviation needs a healthy US market – a theme that this blogger believes firmly lies at the foundation of US carrier secondary status in the global marketplace today.

Labor and Expectations in Consolidation Scenarios

I am encouraged by the involvement of labor by each Delta and Northwest. There have been numerous news stories throughout the week on the subject. We should not be discouraged by the delay in announcing the deal as they engage labor in the discussion. A delay in the announcement measured in weeks could potentially take months off of the time it takes to get a deal approved.

What I am discouraged about is the sense by some that labor will be able to reclaim a significant level of concessions granted in return for agreeing to a deal. If we are looking for a merge lane back onto the virtuous cycle of value destruction that has plagued the industry since it was deregulated, let’s just stop the process and continue the war of attrition. If this is to be the transformational period that can hopefully address many of the remaining structural deficiencies that exist, this simply cannot happen.

As in any negotiations, there were more than likely some changes made to respective collective bargaining agreements that have not yielded the desired results for either management or labor. Those are the types of things that can be fixed.

Commercial transactions like these are not undertaken lightly. Consolidation for the sake of consolidation is not what this is about nor should be about. Rather, this is a careful examination of what continues to stand between the status quo and what is necessary to create sustainable, investable enterprises. Increasing costs for the sake of peace does not create a pathway to a sustainable and investable business.

All airline labor should explore other means of wealth creation rather than increases to base wages. It is called at-risk compensation. Sure your buy-in to any proposed deal is critically important. The industry just does not have the ability to pay today – not that it ever did.

But as The Economist article suggests: today’s managers are focused on the business of cost cutting that is necessary to adapt the business to the rough and tumble operating environment of today and prepare it for heightened competition tomorrow. Like it or not, these very same managers will make many tough decisions that their “nicer” predecessors did not address in the spirit of harmony. And in the end, those that acknowledge the need for change and that a continued restructuring and transformation is necessary will reap benefits that today’s structure simply cannot produce.

The Customer

In all of our talk here and elsewhere about the need for fundamental and transformational change, I am in hopes that the customer finds its way to the very top of the list. We spend lots of time discussing employees, communities, shareholders, Congress and industry vendors. Each of these stakeholder groups believe that they have some entitlement to reap from this industry.

Unlike in the bankruptcy process when the customer barely got mentioned as important to a plan of reorganization, the only stakeholder that is truly entitled to a better tomorrow is the customer. There are no other stakeholders without customers. The investment in the business needs to be in the customer and to demonstrate over time that airlines can regain their confidence. Continental, beginning in the mid 1990s, invested in gaining customer confidence in their product and it translated into higher revenue. It can be done.

Continuing to Ponder a Northwest – Delta Combination

Over the past weeks, I have written about what I see as catalysts behind the current consolidation talk/activity that is enveloping the industry. In addition to the catalysts I have talked, as have many others, that the two biggest hurdles to a deal are labor and the regulators. Further I have addressed an influential member of Congress that supported open skies and increased competition in the name of consumer benefits but fails to recognize that a healthy US industry lies at the core of delivering those very consumer benefits.

The Labor Hurdle

Unlike the naysayers who continually point to labor issues as likely to derail any potential deals, I actually see labor as a catalyst to the current activity. Why you may say? Because simply, any enlightened leader understands that the next round of Section 6 negotiations cannot, and will not, make their respective members whole following the restructuring round of negotiations.

The industry is no position to return to labor the $11 billion in concessions made over the period particularly when faced with a fuel headwind of $14 billion over the same period. What labor can do in a consolidation scenario is to position themselves in multiple ways to address their most pressing near term concerns while doing their best to ensure that their members will survive the ongoing Darwinian Struggle.

The three most significant issues facing labor in any consolidation scenario are: 1) determining labor representation; 2) seniority integration; and 3) negotiating a single collective bargaining agreement. I recently wrote a post on the first two items which discussed the nuances of potential Delta merger scenarios. The next day, Susan Carey and Paulo Prada of the Wall Street Journal filed a story in which they write “Executives at Delta Air Lines Inc. and Northwest Airlines Corp. are trying to build a common labor contract for the 11,000 pilots at both airlines before they complete a merger deal, according to people familiar with the matter”.

Further they write, “Delta and Northwest want to quickly achieve the synergies that would flow from a merger and avoid a messy, protracted labor wrangle that could arise if they wait to get pilots' agreements after a merger were announced or consummated.”

What is encouraging with all of this news is that the current industry is working hard to address many of the issues that the talking heads of the industry like to use to create doubt. If a single collective bargaining agreement construct is agreed to, Delta and Northwest have placed a high hurdle for any deals that might follow. I guess Delta and Northwest are redefining what conventional wisdom has come to accept as a labor hurdle.

The Regulatory Hurdle

If the current “odds on favorite” deal plays out, nearly 14 months to the day after Delta began its work to fend off a hostile bid from US Airways, Delta will be put in the position of defending why a consolidation scenario makes sense for the carrier, and the US industry, versus pulling out the guns to explain why a deal makes no sense. Ironic, yes. Surprising, no. Aside from Atlanta and a good market position in New York, the Delta network is anything but an envy of the industry. As for Northwest’s network with it hubs in Detroit and Minneapolis/St. Paul, the best description of their domestic network remains – it is cold, it is dark and it is ours. Just not high traffic volumes to Fargo and my Duluth home.

In the link to the powerpoint presentation entitled “Proposed US Airways/Delta Merger Would Be Highly Anticompetitive” above, it is easy to see how Delta played on the small community air service fear. It is also true that a combination with Northwest will result in a very different competition analysis given the more end-to-end attributes of the two networks. My guess is the combination will be looking for similar synergies that US Airways recognized -- read fixed cost savings while not undermining the pro forma revenue line of the merger scenario.

It is true that the Atlanta and Charlotte hubs have significant overlap. It is true that Salt Lake City overlaps with Phoenix and Las Vegas. It is true that Cincinnati overlapped with Pittsburgh (particularly before the downsizing). I am not going to acknowledge the suggested cited competitive overlap between New York JFK and Philadelphia as problematic.

There have been some reports suggesting minimal reductions can be expected at any of the hubs utilized by either Northwest or Delta. Look at page 6 of the powerpoint presentation. If Charlotte and Atlanta served 90 similar points, just imagine what percentage of cities served at tiny Memphis are served by Delta’s Atlanta megahub? The same statement would apply between Cincinnati and Northwest’s megahub at Detroit. And this is before we throw Midwest into the network mix.

Yes the restructuring that just recently concluded removed some of the redundancies between the Delta and Northwest networks. When US Airways made that hostile play for Delta, traditional anti-trust analysis would have shown this combination (DL/NW) to drive a higher concentration of market power than most other possible combinations. And a Continental – United combination would create a relatively low measure of market power across their respective networks.

But Is This What Is Really Important?

I am actually troubled by my own post. I have just spent 1000 words talking about what happens inside the 48 contiguous states and not what is transpiring around the globe. I am not talking about competition for China traffic between US carriers with authority today and what Korean Airlines carries over its global hub at Seoul. I am not talking about the global elite carriers that have prospered while our carriers have languished in a fragmented and hypercompetitive home market. I am not talking about the prospects of Singapore serving London Heathrow and New York with a far superior product.

No, I just did what many will try to do and limit the analysis to competition at home and not around the globe. And isn’t it the economic forces of globalization that are really at the heart of change? The naysayers will continue to fight those forces. In the end the forces always win. And in the end it really is about what structural changes need to be made to ensure that the US is in best position to regain a world leadership position. Let’s really think this through before dismissing it out of hand like Congressman Oberstar.

More to come.

F + E = LPP^DL: Fairness and Equity; Seniority Integration; Union Representation; and Lee Moak Again

In a Delta Air Lines Deal, Labor Protective Provisions Were Board Approved Before the Law Was Passed

Well, leave it to Susan Carey, along with Dennis K. Berman and Paulo Prada, of the Wall Street Journal to again write, and break the most recent period of silence surrounding a potential deal between Delta Air Lines and Northwest Airlines. In the same story, she reports that the preliminary talks that have taken place between United Airlines and Continental Airlines “have grown more serious”.

Whereas news on the deal side has been quiet, I have also noted the deafening silence from Lee Moak, the Chairman of the Delta chapter of the Air Line Pilots Association. My guess is Captain Moak is doing what all labor leaders should be doing and that is preparing for what is arguably going to be the most important period for organized labor since the passing of the Airline Deregulation Act.

A Recent Law Was Passed…..but the tenets had already been adopted by the Delta Board of Directors

SEC. 117. LABOR INTEGRATION. (a) LABOR INTEGRATION- With respect to any covered transaction involving two or more covered air carriers that results in the combination of crafts or classes that are subject to the Railway Labor Act (45 U.S.C. 151 et seq.), sections 3 and 13 of the labor protective provisions imposed by the Civil Aeronautics Board in the Allegheny-Mohawk merger (as published at 59 C.A.B. 45) shall apply to the integration of covered employees of the covered air carriers; except that--
(1) if the same collective bargaining agent represents the combining crafts or classes at each of the covered air carriers, that collective bargaining agent's internal policies regarding integration, if any, will not be affected by and will supersede the requirements of this section; and
(2) the requirements of any collective bargaining agreement that may be applicable to the terms of integration involving covered employees of a covered air carrier shall not be affected by the requirements of this section as to the employees covered by that agreement, so long as those provisions allow for the protections afforded by sections 3 and 13 of the Allegheny-Mohawk provisions.
(b) DEFINITIONS- In this section, the following definitions apply:
(1) AIR CARRIER- The term `air carrier' means an air carrier that holds a certificate issued under chapter 411 of title 49, United States Code.
(2) COVERED AIR CARRIER- The term `covered air carrier' means an air carrier that is involved in a covered transaction.
(3) COVERED EMPLOYEE- The term `covered employee' means an employee who--
(A) is not a temporary employee; and
(B) is a member of a craft or class that is subject to the Railway Labor Act (45 U.S.C. 151 et seq.).
(4) COVERED TRANSACTION- The term `covered transaction' means--
(A) a transaction for the combination of multiple air carriers into a single air carrier; and which
(B) involves the transfer of ownership or control of--
(i) 50 percent or more of the equity securities (as defined in section 101 of title 11, United States Code) of an air carrier; or
(ii) 50 percent or more (by value) of the assets of the air carrier.
(c) APPLICATION- This section shall not apply to any covered transaction involving a covered air carrier that took place before the date of enactment of this Act.
(d) EFFECTIVENESS OF PROVISION- This section shall become effective on the date of enactment of this Act and shall continue in effect in fiscal years after fiscal year 2008.

As we move forward there will be lots of stories about labor issues, air service to communities of all sizes, domestic issues, international issues, consumer issues and of course the horror stories of past deals gone bad to name a few. I sincerely believe that “smart labor” recognizes that the current speculation of possible combinations is not just talk but may be their best hope to position themselves for the future. Naïve thinking that Section 6 bargaining will return to its historical nature – well it is just naïve.

As we have written here many times and in many different ways, the current industry construct does not work for many, if any, major industry stakeholder(s). Any concept of change is difficult to accept on both the emotional and rational levels for sure. Short- term displacements and pain for some -- yes. Being forced to step back and accept that tomorrow will be significantly different -- absolutely.

But the burning question for me is: is the implementation risk of a merger deal (seniority integration, single collective bargaining agreement etc.) any greater than a leader having to manage the expectations of any employee group that actually believes they can make themselves whole in the next round of Section 6 negotiations? I do not think so with the industry facing an oil environment that was imagined by only a few, a weakening economy, increased global competition, general lack of an investment thesis, presence everywhere and pricing power no where -- no matter who you are.

My guess is Captain Moak has taken the basic tenets (fairness and equity) of the Allegheny-Mohawk merger protection provisions to heart and is studying the same merger scenarios that his management is. The primary difference in his due diligence is that he is focused on seniority lists and not EBITDAR. In his diligence process, I am sure he is figuring how to best analyze and “game out” the combination that treats each his own pilots as well as all pilots of a combined entity fairly and equitably. That is what leaders do and in this case it is leaders from both management and labor.

The integration process has evolved over the years since the Allegheny-Mohawk Labor Protective Provisions were originally enacted. There have been more failures at adopting fairness and equity than not to be sure. But it is incumbant for labor and management leadership this time to ensure that career expectations are met for all employees. Simply this concept means that the relative seniority of a combined list is not significantly different for a respective employee in a combined entity than it is for that employee today.

On the labor side, rigorous analysis of seniority lists can be done ahead of an announcement. My only hope is that Moak is being joined by his counterparts in Chicago, Minneapolis/St. Paul, Houston and other airline corporate homes. From what I read, Moak understands that a short implementation period is a friend of the deal and a long implementation period is well – just look at US Airways. Moreover, if pilots and other employees are seriously interested in a piece of equity ownership of the new entity, labor should absolutely want a short implementation period too.

Yes, There Are Employees Other Than Pilots

What makes any Delta combination interesting is the fact that other than the pilots and dispatchers, the company is non-union. Delta is a company that has trumpeted the idea of fair and equitable throughout its existence whether in union avoidance strategies directly or in the day to day management of its various class and crafts of employees. Whether conscious union avoidance or not, along the way you have to walk the walk and not just talk the talk. And in Atlanta there has obviously been more walkin’ the talk than talkin’ the walk.

Just How Might Delta’s Current Non Union Workforce Play Out

Any deal led by Delta, or involving Delta, opens up a potential union representation box. Stated otherwise, if a combination of any class and craft of employees involves two different unions, then more than likely there will be an election; and if there is a combination of any class and craft of employees where one is union and the other non-union, and the unionized group comprises 35% or more of the total employees, then there would likely be an election.

In the Delta combinations being discussed, in each case the pilots are organized and members of the same union so no representation elections are expected.

But the flight attendants are a different story. The Northwest and United flight attendants are represented by the Association of Flight Attendants, AFA-CWA. And given that a combined entity would be comprised of 35% or more union represented employees, a representation election would likely occur. In that election the flight attendants could either vote for AFA-CWA, another flight attendant union or for no representation in either merger scenario.

AFA-CWA has an organizing campaign underway at Delta. The decision point for the combined work force would be simply: am I better off working under a collective bargaining agreement or under the wage and working conditions employed by Delta with its current flight attendant work force.

As for the mechanics, this one also has some interesting nuances to it as well. Delta’s in house maintenance work force is unorganized and the company has begun to increase its insourcing of maintenance work. Each United and Northwest have been outsourcing an increasing amount of their maintenance work albeit for different reasons. Northwest’s mechanics were in effect disenfranchised by AMFA’s poorly conceived decision to strike Northwest and therefore, based on my read of the LPPs, the mechanics of a combined Delta – Northwest entity would not trigger a representation election. In a United - Delta combination, an election would be triggered but who the incumbent union would be is not known at United because currently the Teamsters are challenging AMFA. Got that?

As for the ground and related employees, the scenarios for either a Delta and Northwest or a Delta and United combination are the same. An election would more than likely be triggered given that the International Association of Machinists and Aerospace Workers (IAM) represent the various class and crafts of employees in this broad group at each Northwest and United. The definition of class and craft here will be a story to watch and they include ramp, customer service and reservations.

And more than likely, a representation election would be triggered by combining the dispatch groups. Although small in number, they are governed by the same rules as well.

Bigger Concerns than Unionization

In addition to the capable leadership of Moak, Delta management is led by Michael Campbell, their EVP of Human Resources, Labor Relations and Communications. Campbell was Gordon Bethune’s head of labor at Continental. The issues of representation and combining collective bargaining agreements are complicated for sure - but in capable and professional hands.

Should the investment community be concerned of union representation at Delta? No. The investment community should be more concerned with seeing that labor integration is done as quickly as possible, whether it involves unions or not, as this provides the shortest pathway to realizing merger synergies. For Delta, fairness and equity has been adopted at the Board level. Now it is law and this is important for many to consider when the naysayers repeatedly and continually tell us all to remember the menu of historic disasters.

At the end of the day, what was important for Delta yesterday will carry the same weight for Delta tomorrow. Given the current lack of unionization at the carrier, some might say that something was done right. Delta has historically understood that higher wages in return for commensurately higher productivity has served its employees and the company well. This concept is a most important model for the industry to sustain and will promise to be a most important theme in any upcoming negotiation. Further, it will be important for any combination to maintain - and sustain - the highest productivity possible as the industry needs to continue to shed fixed costs and not add to them.

Isn’t that really the issue behind today’s consolidation push anyway? I think Delta and others have learned from past mistakes.