Unbundling, Rebundling and Now De-Commoditization

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Let the restructuring continue.

Patience and Perseverance: Tilton Walks It Like He Talks It

There is no way to describe United Airline leader Glenn Tilton other than resilient.  He is disliked internally by organized labor and questioned externally by nearly everyone who has an eye on this industry.  He has taken his role as the industry spokesperson seriously, perhaps more seriously than anyone before him.  We listen intently to Giovanni Bisignani, the CEO of IATA.  But we do not listen enough to Tilton. Why? Because Tilton’s is a message of change not cluttered by this industry’s history, and some people don’t like the message.

Tilton was quoted shortly after United ended a three year stay in bankruptcy: “If I were able to draw a visual image of the beginning (of bankruptcy) to today, it would be one continuous experience of knocking down internal and external barriers.”  In his role as chief spokesperson for the US airline industry as Chairman of the Board of the Air Transport Association, Tilton waxes philosophical about the barriers that impede the industry’s natural evolution.

I have a long history at United and knew the “old company” well.  United epitomized all that was wrong with the US airline industry prior to its bankruptcy in December of 2002.  One of Tilton’s predecessors as CEO, Stephen Wolf, did some very good things along the way that provided United with its global roots.  But even Wolf did little to address the company’s bloated cost structure and a management bureaucracy that often resulted in paralysis.  For every cubicle in Elk Grove Village, one could find at least one silo. 

Tilton cares less about the history of United than its future.  His history lesson was a short one – whatever structure in place when he arrived in 2002 did not work and therefore needed to be changed.  If Tilton was wed to preserving United’s legacy, then he likely would not have taken the same course in fundamentally reshaping the company. He would not have taken on the pilot union, ALPA, over its actions to disrupt United’s operations – winning an airtight legal victory for management that ranks among the most significant victories in decades.  Rather he would have permitted bad behavior – or paid the pilots to stop behaving badly - just as prior administrations had done. 

Today United is a lot smaller, with a mainline operation 30 percent smaller than it was 10 years ago.  For this, Tilton takes a lot of heat.  As the pilots union watches its ranks diminish, ALPA constantly reminds Tilton that an airline cannot shrink its way to profitability.  This may have been true in United’s past, but on Tilton’s watch growth will only occur if it is profitable growth.  It is hard to envision a day when United will again have 12,000 pilot equivalents on the payroll.

Tilton and others recognize that the industry is still too big.  In the most read Swelblog article to date, Montie Brewer makes a clear case that the industry’s capacity-lead business model is the number one reason why the airline industry will never be profitable over a sustainable period.  Also weighing in on the subject is Professor Rigas Doganis who writes about over capacity in Airline Business.  According to Doganis, the airline industry is inherently unstable and airlines have only themselves to blame for the constant state of oversupply and the downward pressure on fares that result.

Doganis goes on to discuss how airlines are “spasmodically” profitable, quoting Tilton on the fact that the industry has "systematically failed to earn its cost of capital."  This is a fact that has long bothered the former oilman.  In a recent speech to the Wings Club in New York, Tilton raised the industry’s continuing and daunting challenge: “How to navigate to sustainable profitability in light of our financial instability.”

In London he made the point again and differently:  “Volatility and losses have been the norm for this industry, as has our systemic failure to earn our cost of capital and achieve any level of consistent financial resilience. The industry has lost nearly $50 billion worldwide since 2000 and a staggering $11 billion last year alone.”

Tilton at United – From Hands On to Chief Strategist

One can be sure that when Tilton arrived at United in September 2002, he had little idea just how bad things were.  But he would soon find out.  Three months after his arrival in Elk Grove Village, United landed in a downtown Chicago courtroom for more than three years as the company restructured itself.  There were mistakes along the way.  There was some bad luck along the way particularly as it pertained to rising values in the aircraft market.  There was the decision to terminate employee defined benefit plans, which among other things permanently damaged Tilton’s reputation in the labor ranks, but enabled the airline to get the exit capital it needed to start anew.

As United exited bankruptcy protection in February 2006, oil prices were on the rise.  The company restructured itself around $55 per barrel oil – a price that was fast becoming a memory and a bad assumption in the company’s plan of reorganization.  Company performance – operational, financial or otherwise – was nowhere near expectations set based on an entity that had spent three years fixing itself.  For either right or wrong reasons, Tilton kept many of United’s legacy management team around to complete the bankruptcy process.  What he belatedly came to appreciate is that leadership at the company had to change – and change it did.

United mainline is much smaller today than it was the day it emerged from bankruptcy.  Tilton oversaw its downsizing in bankruptcy and continued the work as oil prices climbed.  But he also recognized that he was not the guy to handle the day to day operations. Like any good restructuring guy, Tilton knew to hand over the operation of the company to others on the executive team, particularly  John Tague, Kathryn Mikells and Pete McDonald.

And the plan seems to be finally working.  United is starting to produce some good results.  There might be a lesson here for others in the industry, including the consideration of whether CEOs should delegate the day-to-day functions and concentrate on their role as the company’s chief strategist.  Just as pivotal, in United’s case at least, was Tilton’s decision to focus on tearing down the barriers to change – something all industry CEOs should consider in improving the financial prospects for a once proud industry relegated to underperformance, in part by the stakeholders who benefit from its inefficiency.

Tilton and Government

In one way or another, Tilton delivers the message that “no matter how well United or any U.S. carrier transforms its business, none of us will be as strong as we should be - much less in a position to compete in the emerging global aviation industry - if there's no change to the regulatory environment in which we operate.” Without a coherent U.S. aviation policy that “reverses the bias against airline size and removes the barriers that prevent us from constructive consolidation, U.S. carriers will be unable to compete on a global scale and we risk being marginalized,” Tilton said.

Among the questions for the industry, as Tilton outlined in a talk to the UK Aviation club, is what motivates the protectionists’ view of the industry.  “What is it that they are “protecting? A chronically underperforming industry?” he asked.

Concluding Thoughts

For what it’s worth, I focus on Tilton not because of his work at United but because of the message he delivers and its relevance to the rest of the industry.

As I predicted in my last post, February 2010 has been a significant month for airline news – some of it good and some of it bad like government’s call for slot divestitures in the USAirways – Delta slot swap.  It appears likely that oneworld will get permission to compete on an equal footing with the STAR and SkyTeam alliances.  This is the necessary next step to ensure inter-alliance competition as we think and talk about the industry’s structure going forward.   Tilton is a huge proponent of alliances who quickly recognized that one airline cannot be everything to everybody and that network scope and scale can be economically garnered through partnerships that leverage each member airline’s strengths.

Tilton also remains a proponent of consolidation.  His voice is growing increasingly louder on the subject of cross-border mergers and the flow of capital based his belief that the US and the European Union should move forward on Phase II of a transatlantic agreement and pave the way to permitting cross border commercial activity in the airline industry.  As Tilton noted in his UK speech, “capital is global and doesn't have sovereign inhibitions."

Like him or not, Tilton rarely shies away from stating his views, even at the risk of ruffling some stakeholder’s feathers.  For Tilton, too many people focus on the past rather than the future and what needs removed in order that the industry can continue to evolve. That evolution may continue to prove painful for some in the industry as Open Skies and re-shaped alliances bring new competition all the while presenting new opportunities for agile and nimble operators.

Tilton’s role, like that of the Anderson, Arpey, Smisek , Parker and other airline CEOs, is to serve as agents of that change and find a way to balance the demands and interests of labor, shareholders and other stakeholders that depend on a robust, profitable industry.

Note:  I hold stock and options in Hawaiian Holdings, Inc. as a result of my Board position.  I also hold stock in United Airlines accumulated at various points in time since the company emerged from bankruptcy.

Memorializing Yet Another Date in 2008

Black Monday III (1929, 1987 and now 2008)? Another example of how money and politics just do not, and cannot, mix? I do not like government intervention into private matters. But on this bank bailout I was resigned to the fact that it was/is a necessary action. Was it politicians protecting themselves at all costs? What should be bipartisan becomes partisan? What should be about the good of the American people becomes about what political party is more responsible for success or failure?

I woke up in Jacksonville, FL this morning to the news about Citi and Wachovia. I actually had the pleasure to speak to an enlightened Jacksonville Aviation Authority Board of Directors about happenings in the airline industry and the resultant effects on their business.

By the time I landed back in Washington, the Dow had closed down 778 points, its biggest one day drop in history, or 7%; the Nasdaq was down 200 points or 9%; and the S&P had closed down 107 points or 8.8%. All the while, oil had dropped to $95 per barrel and gold prices surged. The US House of Representatives had voted down the bailout package in a roll call vote of 228-205. The markets, anticipating passage of the bill, were looking for anything to suggest an end to the psychological unease and the resultant turmoil in the US and world markets. The volatility present in the markets when the wheels went up only continued.

Like a lot of things that seem obvious when politics become intertwined with logic, we probably should not have expected a “yes vote” on the bailout package in the first version offered to a vote of the US House of Representatives. After all, it is a presidential election year. A plum job that might be better suited to a resume of a funeral director.

The fallout was not limited to the US. Bailout activity took place in the United Kingdom, Belgium, Germany and Iceland. Asia is not immune. Given less than full information on this region we really cannot know just what might be ahead there. Like in the US, big name banks were in the news around the world. Europe’s stock market suffered its second worst day in trading activity.

Some are declaring Wall Street dead as we know it. I do not know what to make of the elected representatives in the US House. Paul Krugman writes: "So what we now have is non-functional government in the face of a major crisis, because Congress includes a quorum of crazies and nobody trusts the White House an inch. As a friend said last night, we’ve become a banana republic with nukes."

If it wasn’t so serious, it would be really funny. This is the macro economy’s watershed. People got tired of the airline industry traipsing about Capitol Hill after 9/11. This is much more serious for even the airline industry. You know how it goes, the airline industry is inextricably linked to the health of the US and global economies. Well, with little health in the macroeconomy, we just may not need all of those airlines anyway. Oil remains a concern, but these economic headwinds may be greater than anything the industry has faced thus far.

As for all of those grossly overpaid senior managers in the airline industry, they are looking pretty damn smart for their decisions three months ago to bolster the liquidity positions of their respective companies. The window can be declared closed for the immediate future and as a result of their actions companies can manage their businesses with a focus on internally generated capital because that is all that will be available for awhile.

Nancy Pelosi spoke, but I do not think the fat lady has sung on this one just yet.

These Really Are Dynamic Times

In my most recent blog post, I postulated that we are not we are not out of the woods by any measure as oil had been closer to $90 per barrel than $100 in the past week. I am sure that there were some that scratched their heads over that post. Part of my reasoning for drafting the piece was that the markets had turned their attention to the banking crisis and away from the commodity world. The market's lack of attention typically makes me nervous.

I am not going to say I said I told you so, but today, oil spikes $25 amid anxiety over bailout news. The October contract ultimately settled near $121 per barrel, up more than $16 per barrel, far surpassing the one day record increase of $10.75 in early June 2008. The November 2008 contract is trading at more than $109 per barrel as I write.

Remember, these numbers do not reflect the crack spread price equivalent per barrel that needs to be included when considering the airline industry's cost of jet fuel. At last look it was $24 per barrel since falling from $44 per barrel as the hurricanes made their way toward our shores. Fundamental to the message in my previous post was the concept that this industry, and virtually all industries, will be facing volatile times that require the ability to remain nimble in order to navigate the ebbs and flows that we are sure to face. Remember, we have not started to discuss just how cold, or warm, it might be this winter.

Many of our parents speak about the gold standard. Today the price of an ounce of gold increased more than $44 per ounce for those that doubt the market’s view of our world. In the article linked to above, analysts interviewed cited a weakening dollar and short positions. Sounds familiar doesn’t it?

In my previous post, I suggested that this industry is just not in the position to accept a fixed cost, fixed fare or fixed anything environment given the dynamic nature of input costs that face this industry. I suggested that the boom and bust cycle that has plagued this industry must be addressed as the cycle is not good for any one stakeholder group.

We really do need to think about this.

More to come.

Begging ……. The Questions

I don’t know about you, but the Air Transport Association’s prediction of a 6 percent slump in Labor Day travel caught me a little off guard. Sure I did expect a decline, but not on that order of magnitude. Demand is impacted by both price and service. Moreover, we will not begin to feel the reductions in service until after Labor Day. Is this a sign of things to come and why most of the US’s largest carriers are targeting capacity reductions in the 10-13 percent zip code?

If this is the case, can we as an industry not lose sight of some very fundamental and important issues during this slowdown as we have in the past?

1. Immediately after 9/11, somehow we all forgot that the nation’s air traffic system was a national embarrassment and remains so. What should be transparent in its role everyday was made a daily headline. When capacity was being reduced and demand slowed, there was an opportunity to continue work to address this fundamental issue. This is not about slot auctions and other band-aid approaches; it is high-time that we address what is fundamental to the efficiency of the nation’s commercial airline industry that impacts nearly every cost center. Embedded inefficiencies that burn more fuel can no longer be ignored - let alone tolerated.

2. Just because the price of oil has come down off of its July 11, 2008 high, does not mean that the network surgery planned for the fall and winter should become an elective surgery. Rather it is mandatory surgery that has been put off too long. I share Bill Greene’s [Morgan Stanley’s airline equity analyst] concern that the oil price drops will somehow cause some airlines to vacate the announced capacity reduction intentions.

3. The US airline industry has been forced to address multiple macroeconomic issues throughout its deregulated history. This time, can we put the customer at the top of the list and make air travel a value proposition again? It is not just about price and now is the time to demonstrate that fact and begin the process of affecting consumer attitudes and expectations – in the right direction. Simply, make them feel that they are getting more for more, not less for more.

4. In keeping with that theme, can we please recognize that the air travel experience begins and ends at an airport. We talk ad nauseum about airline alliances. Shouldn’t there be an unstated airline-airport alliance? If airlines are going to reduce service, then the service at the remaining airports should match the product that the airline(s) serving that airport market are trying to sell. It will increasingly be in the best interest of both the airline and the airport to make the customer experience the very best it can be otherwise accept the fact that the customer will access the air transportation system via the highway and fly another airline.

5. Whereas I understand the need to be judicious with cash and liquidity, non-existent non-aircraft capital expenditures by the US industry need to exist again. Honestly, if there was going to be foreign capital employed in any of the transactions being considered, it was my fervent hope that the capital would have been dedicated to upgrading the product. If the industry is to justify higher prices, then we really need to invest in the product. Sitting in a ratty airport holding area to board a flight with coke for sale and no movie to watch just does not seem to be the long-term solution.

As demand slows, it is a perfect time to assess the passenger experience from beginning to end. Different approaches and processes can be tried in a less-taxed environment. Airlines could even begin the process of differentiating their product from another. Maybe we could even begin to recognize the difference of services and amenities in a STAR alliance-dominated airport from a SkyTeam-dominated airport from a oneworld-dominated airport from a Southwest-dominated airport.

I do not pretend to have all of the answers because I do not. But I do believe in the adage that says where there are problems, there are opportunities. In the past, opportunities have been missed. This time, any opportunities missed may result in something significant being lost. No matter what we do, it all comes back to the fundamentals. The fundamental product this industry sells is the seat that carries an air travel consumer from A to B.

So, I guess I am begging that we address the fundamentals while facing the problems at hand - and there are many and my short list is not intended to be exhaustive. But, without customers there is no industry - or at least one that we can all be proud of.

Unbundling Our Way On The Search To Find The Inelastic Demand

I am beginning to believe that there is a silver lining in the high price of oil.

Last month, I wrote a piece entitled The Elastic Induced Ride to Inelasticity. With seat belts on, seat backs and tray tables up, we are ready for takeoff. Yesterday, while American and Southwest were holding their Annual Meetings of Shareholders, I was on an airplane back from Honolulu. So I missed the news flying out of those meetings that found its way onto the wires as rapidly as it could be transcribed. I missed the latest $4 per barrel rise in the cost of crude oil that now equates to $4+ per gallon of jet fuel. I missed …….. or, did I really miss anything?

Oh, I missed something all right. Whereas I believed the industry would transform itself more through merger and acquisition activity, I am now a believer that the price of oil, and the market, is truly what is needed to fully address the many structural ills that have plagued this industry for years. I would like to return to a few paragraphs I wrote in an Airline Business piece earlier this year: Are US carriers really ready for competition?

Despite claims to the contrary, nothing is new in the US. The same old ways of doing business remain intact, which calls into question whether the industry’s fabled “restructuring” has made any meaningful changes in the competitive profile of the US airline business. Despite deep cuts, many outmoded, and troubling, business practices remain.

Following an industry life cycle of value destruction, US legacy carriers now face a dilemma: whether to invest in their core businesses or not? Certainly the tendency to legislative and regulatory gridlock did not get restructured. An inflexible labor construct did not get restructured. The fragmentation of the US domestic market did not get restructured. The infrastructure, whether it be ATC or the airport system, did not get restructured. And the historic mindset that capital will be forever recycled among manufacturers, vendors, labor and government imposed actions did not get restructured.

Little has changed when it comes to labor and regulator views on consolidation. The mindset among the 535 decision makers on Capitol Hill still assumes that any congressional district with a runway, a terminal building and security is entitled to air service. Compounding this sense of entitlement is labor’s sense that the industry will return to its previous “pattern bargaining” – a supposition that fails to recognize the structural change in markets, labor and city pair.

Gerard Arpey’s Words

The full text of Mr. Arpey’s comments to his shareholders can be found here: Remarks Of Gerard Arpey At American Airlines Shareholders Meeting. As we approach the 30th birthday of US Airline Deregulation, it is the price of oil that is demonstrating its power to force the industry to address the many legacy mindsets that did not get restructured during the post 9/11 period. Among many, it includes the customer’s assumption that they actually pay the “all-in” price of the service and are therefore entitled to multiple access points to the air transportation system. NOT.

In this morning’s Wall Street Journal front page, column six, story by Susan Carey and Paulo Prada, they wrote: “If oil prices keep climbing, rising fares could start to push a significant percentage of travelers away from flying entirely. That could reverse one of the most dramatic effects of the industry’s deregulation in 1978, which led to a huge increase in flights, and brought intense fare competition, opening the world of air travel to millions of people”.

Ms. Carey and Mr. Prada are right. And the industry is right to evaluate the cost of providing the product at every juncture. And the industry is absolutely right to charge what it costs to produce the product. From the time the customer logs onto the internet to consider purchasing the ticket; to the actual purchase of the ticket; to the airport experience including check-in; the trip through security; down the jetway; taxi out; inflight service; taxi in; deplane; and collect luggage. Everything has a cost. And the management teams of each and every airline are being forced to “drill down” as never before in order to fully calculate those costs. And after calculating the costs of provision, many, many difficult decisions are being made.

Now this does not make any CEO popular. But being a CEO today is not a popularity contest during these difficult times. [And the most popular CEO of all time, stepped down from a 40+ year career BOD position yesterday] Being a CEO today means having the fortitude to say no. Being a CEO today means questioning anything and everything just because that is the way it has always been done. Being a CEO today means making the tough decisions even though dislocations of certain stakeholders might occur. And being a CEO today means having the guts to say out loud what CEOs knew before them but failed to act.

Mr. Arpey said and the WSJ highlighted: “The airline industry will not and cannot continue in its current state”.

Concluding Thoughts

With all of the actions being taken by the industry to charge for things that were never charged for before, what is interesting is how each carrier is sure to ensure that their most important customers will not pay those fees. Loyalty programs have just become a/the most important asset to an airline – not that they were not before – but rather it is this “inelastic” air traveler that the industry needs to rediscover. And cater to. And build for. And so on. And maybe this is why Mr. Arpey suggested that it was just not a good idea to sell its AAdvantage program. And maybe the market will begin to rethink how it values these currently undervalued assets.

This industry is now recognizing that it cannot be everything to everybody. Yes the industry has met its match – and it is not labor, government, or the macro economy. It is the high price of fuel that is causing the industry to continue the process of fully transforming the way business is done. My guess is that if we had not faced this potentially murderous economic period, then the industry would not have been forced to fully examine itself. The current industry architecture is a picture of what the deregulators envisioned – and the industry delivered. But the architecture produced does not work.

So Mr. Arpey, as your unions marched, I for one am glad you spoke. And you spoke clearly as to how American is moving forward. Your message was not popular. Your message pushed the envelope a little further and added to the debate significantly. No one knows how all of this will really play out. There has to be recognition before there is action. The industry is taking action and one can only hope that labor and government begin to recognize that we are not going back to the same old, same old.

Except for the fact that each airline will "return their attention" to those core, “inelastic”, customers that are willing and able to pay for the service being provided. And those customers will complain less over time. As for the rest of the traveling public and lawmakers that believe they are entitled to air service - well you are not.

More to come.

Still Pondering a Northwest – Delta Combination

Swelblog.com: The First 183 Days

Time flies. Never did I think I would write anything with a title, “A Flying Pig”. Never did I think that this year’s four number 1 seeds would make it through the Regionals only to meet at the 2008 Final Four in San Antonio. Never did I think that it was possible for one man to dominate the game of golf as we get to witness Tiger Woods’ rewrite of the record books before he is 35. Never did I think that writing could be this much fun as it comes quite hard for me.

I did think that some of what I would write would not be popular with all. I did think, and do think, when I began to write this blog that we were about to embark on one of the most important and necessary journeys along the path of change since the industry was deregulated.

Still Pondering a Northwest – Delta Combination

Pardus Capital, the activist hedge fund, arguably started the consolidation ball rolling with its expressed interest in seeing a Delta and United combination. Today, $2 bln hedge fund Pardus suspends withdrawals just as we begin to think about a Northwest – Delta combination yet again. Capital preservation.

Where to start when pondering a Northwest – Delta combination sans an agreement on pilot seniority? And speculation of a reworked pilot deal? And announced capacity cuts in the face of oil price realities and macro economic weakness? And with CEOs that have spent considerable amounts of personal and political capital since this deal first became news in January 2008? Capital preservation.

I simply do not know where to start on this one. It made sense before and it makes sense today. My thoughts concerning this deal have me stuck on the negotiating positions of all involved. A lot has been said by the CEOs and the MECs that is going to be – and I am assuming that there will be another attempt to revive the deal – most interesting this go around. Some compromise will be necessary.

Labor versus Capital

Just as the Pardus play was summarily dismissed by Captain Moak, Pardus’ interest along with the interest of all capital are watching this deal. The patience of many was tested as Delta and Northwest tried to forge a deal along the path of least resistance and give labor the say that they demanded following the Pardus play last fall. Well labor had their shot to act in the shaping of the deal and there were many cheerleaders, including me.

But not everyone was a fan of the deal cut, including me. I am all for employees having a piece of the deal as it gives them skin in the game and begins to mitigate some of the us versus them mentality that is all too prevalent in the management and labor worlds today. I am not for negotiating significant fixed increases in rates of pay that will stand in the way of capital appreciation. Particularly in today’s economic world where revenue generation is sure to be challenged.

I am encouraged by the decisions of respective players in the industry to begin the process of cutting capacity. This was another area of the first deal that was troubling. But again, economic forces prevail.

The catalysts driving consolidation have been identified and all remain. But another catalyst, capital, is about to emerge and retake the top spot. And on a day when Pardus Capital is in a capital preservation posture.

Just another irony in this deal. And on a day where we liquidate the first US airline in this cycle. And on a day when Champion Air announces it will cease flight operations on May 31, 2008. And.......

Invoking the Force Majeure Clause: Oil Taking Its Toll

...and Thinking About Northwest - Delta

As I prepared to write this week, I had outlined a piece around the NCAA basketball tournament generally and Selection Sunday specifically. I was going to talk about how the Delta-Northwest deal, destined for a #1 seed a month ago had become a “bubble” deal over the past month because of a less than stellar end to the conference schedule and “one and done” in the conference tournament. And then I was prepared to place them in the last 4 teams out group.

But rather than just isolate Delta-Northwest, I think it is time for the industry to think about consolidation in yet another way. Typically we think about consolidation as two entities combining through merger activity. But there is financial consolidation as well. It is similar to what we experienced during the 2002-2006 period where an industry contracts on its own volition. It is probably time to begin another round of contraction as the price of oil makes it very difficult for the industry to maintain its current service offerings.

Introduction to Force Majeur for Those on Capitol Hill
and a Refresher for US Airline Labor

From where I sit, the NCAA tournament will make great theater as always but will pale in news as to what I see coming for the US airline industry. In my last blog post, I purposefully left the piece hanging on an issue for labor and the politicians to seriously consider: “Politicians and labor should think real hard about the fallout that could stem from the current economic environment [read to include high oil prices] versus what the perceived fallout could be in a consolidation scenario”.

As the market opened this morning, oil traded near $112 per barrel. Whereas the price has pulled back from those highs, it is becoming clearer that oil is going higher as the highs get higher and the lows get higher. Heeding warnings from the industry that capacity will be closely examined at these prices, I began to write this piece.

Then as I was writing, I did my usual check of the headlines as the day wore on. In one check of the day’s news, I read, as everyone should when you are not reading here to steal a Maxon line, a blog post by David Field of Airline Business on his blog named appropriately Left Field. Mr. Field cites quotes directly from Delta’s Anderson, Northwest’s Steenland and Continental’s Kellner each questioning the size of their respective networks in the face of $105 per barrel oil.

Defining Force Majeure

Typically we do not like to talk about force majeure issues in the industry, but I am thinking it is time. Wikpedia defines force majeure as:

Force majeure (French for "greater force") is a common clause in contracts which essentially frees both parties from liability or obligation when an extraordinary event or circumstance beyond the control of the parties, such as war, strike, riot, crime, act of nature (e.g., flooding, earthquake, volcano), prevents one or both parties from fulfilling their obligations under the contract. However, force majeure is not intended to excuse negligence or other malfeasance of a party, as where non-performance is caused by the usual and natural consequences of external forces (e.g., predicted rain stops an outdoor event), or where the intervening circumstances are specifically contemplated.

Time-critical and other sensitive contracts may be drafted to limit the shield of this clause where a party does not take reasonable steps (or specific precautions) to prevent or limit the effects of the outside interference, either when they become likely or when they actually occur. A force majeure may work to excuse all or part of the obligations of one or both parties. For example, a strike might prevent timely delivery of goods, but not timely payment for the portion delivered. Similarly, a widespread power outage would not be a force majeure excuse if the contract requires the provision of backup power or other contingency plans for continuity.

A force majeure may also be the overpowering force itself, which prevents the fulfillment of a contract. In that instance, it is actually the Impossibility defense.

The understanding of force majeure in French law is similar to that of international law and vis major as defined above. For a defendant to invoke force majeure in French law, the event proposed as force majeure must pass three tests:

Externality

The defendant must have nothing to do with the event's happening.

Unpredictability

If the event could be foreseen, the defendant is obligated to have prepared for it. Being unprepared for a foreseeable event leaves the defendant culpable. This standard is very strictly applied.

Irresistibility

The consequences of the event must have been unpreventable.

A Non-Lawyer Discussion of Force Majeure

Force majeure (French for "greater force") is a common clause in contracts which essentially frees both parties from liability or obligation when an extraordinary event or circumstance beyond the control of the parties, such as war, strike, riot, crime, act of nature (e.g., flooding, earthquake, volcano), prevents one or both parties from fulfilling their obligations under the contract.

Name any airline that spent time in bankruptcy and was required to file a plan of reorganization that correctly estimated the price of oil in that plan. United assumed $55 per barrel and that was $50+ per barrel ago. Northwest just recently emerged and it assumed oil $40+ per barrel ago.

Based on the assumed price per barrel of oil, contracts were entered into with the regional affiliates of the major carriers. The price of oil has long been described an uncontrollable expense for the airline industry. Is this an act of nature, I do not know. What I do know, is that this rise in the price of oil is beyond the control of the industry. Moreover, this recent price push makes oil more expensive than it was on an inflation adjusted basis in the early 1980’s and we know that the period will always be defined as an oil crisis.

However, force majeure is not intended to excuse negligence or other malfeasance of a party, as where non-performance is caused by the usual and natural consequences of external forces (e.g., predicted rain stops an outdoor event), or where the intervening circumstances are specifically contemplated.

There is no negligence here by the industry or malfeasance by anyone. This is the market at work. The causes for the oil price increases are many but cannot be isolated to any one catalyst. And none of this is as predictable as rain on a hot summer night.

Time-critical and other sensitive contracts may be drafted to limit the shield of this clause where a party does not take reasonable steps (or specific precautions) to prevent or limit the effects of the outside interference, either when they become likely or when they actually occur.

To say that the industry has not taken reasonable steps to prevent or limit the effects of the outside interference would ignore the painful attempts to address cost structures that were simply not sustainable. As Jamie Baker pointed out last week in his research note, since 2002, the price of oil will have increased some $25 billion for the US industry while savings from labor over the same period amounts to $7 billion.

Through the restructuring period and practices that continue today, the industry cut costs to combat a declining revenue environment and to address the rising cost of oil. The industry has used hedges; pared domestic capacity as a way to reduce exposure to an unhealthy domestic market; increased international capacity as a way to increase revenue; cut back on amenities; cut distribution costs to a minimal level; reduced ownership costs; cut employee wages; improved employee productivity; improved asset utilization; terminated pensions; outsourced flying; outsourced maintenance; outsourced administrative activities; and experimented with hub structures to name a few of the hundred of cost cutting activities that have been employed.

Most, if not all, reasonable steps have been taken to prevent or limit the continued losses for the US industry – except for that outside interference called oil.

Included in the definition: A force majeure may also be the overpowering force itself, which prevents the fulfillment of a contract. In that instance, it is actually the Impossibility defense. As for the externality, the industry has nothing to do with the event’s happening. As for unpredictability, this industry has done everything it can do to counteract its influences. As for irresistibility, the consequences of the oil price rise were not preventable.

Delta and Northwest

About one month ago, I remember Bob Fornaro, CEO of AirTran Airways, referring to proposals made to his pilots in an oil-denominated way. Like Fornaro, Messrs. Anderson and Steenland I only hope that you tell your pilots and all other employees that the terms of the agreement you made in order to have a single collective bargaining agreement in place are now off of the table. You made an agreement where some of your pilots would receive 30% pay increases at $85-90 oil, surely those agreements should not be made at $105 oil. Invoke force majeur.

$20 per barrel ago, you said that your networks would be largely kept intact. Now today you seem to be hinting that the size of your networks may need to be reconsidered. Let’s just face the fact that there are too many regional carriers and too many hubs and as a result too much money being spent on serving communities that cannot economically support the frequency of access to the air transportation system today. Cutbacks like those Doug Parker of US Airways suggested were probably unavoidable at some point and at $105 oil, well……invoke force majeur.

In each case, these suggested actions seem prudent and can easily be explained by an unpredictable externality whose consequences could not have been predicted by you. Invoke force majeur.

Consolidation is still right. But as everyone has said it has to be the right deal for all stakeholders and given the externalities facing the industry, much harder choices will now have to be made.

More to come.

Just Wondering, Or Am I Wandering?

A Few Issues in the Press

1. With the Euro reaching an all time high relative to the dollar yesterday, how will this impact international travel? Can the potential loss of US-origin customers that now deem an EU trip unaffordable because of the currency relationship be offset by EU-origin demand that will find the US cheap?

a. Headline in today’s Wall Street Journal: "Lufthansa Expects Growth in 2008". As the company’s net profit doubled in 2007 v. 2006, the company cites its broad business model that includes aviation services, catering, airports and other areas as a mitigation of downside macro risks. For the US, that might mean increasing the foreign ownership limits?

2. In late 2007, United warned of the potential to “put down” as much as 10 percent of its capacity if oil prices stayed above $100 per barrel. Well, yesterday oil actually traded over $110 per barrel. The $100 price point has become a level that most oil watchers expect to be sustained. My question for the politicians is: will there be more industry capacity removed as a result of oil prices or consolidation?

a. My suggestion to the "know all" politicians: Be very careful for what you say no to.

3. Yesterday, Jamie Baker of JP Morgan downgraded the US airline industry for all intents and purposes. Terry Maxon of the Dallas Morning News blogged on Baker’s research note that suggests a best case scenario, based on current oil prices and a minimal demand loss due to an economic slowdown, is for the US industry to lose $4 billion. The worse case scenario calls for an industry loss of $9 billion.

a. So much for the robust, and sustainable, industry turnaround we hear from labor leaders and others.

4. Speaking of labor, Baker makes a very powerful point, and one that I have used a number of times. He says that since 2002, the industry’s fuel cost will have increased in the neighborhood of $25 billion. This contrasts with his estimate of labor savings over the same period of $7 billion.

a. Will we ever hear the end of the refrain that the industry recovery has been built on the backs of labor? First, and again, what recovery? Then, and again, what is the industry’s ability to repay that $7 billion? This just underscores what will prove to be the most difficult labor negotiations cycle since deregulation.

5. As if the industry needs more weighty issues to test its resolve, the story at Southwest over maintenance practices is most troubling. I am in no way going to suggest anything regarding this situation until all of the facts are known. But, this story will not be going away for awhile.

a. If the economy can be expected to have a dampening effect on demand, will concerns over maintenance have a compounding effect?

b. Jim “Hell NO”berstar gets yet another bully pulpit issue.

6. On another labor issue. I find it interesting that, included in labor’s chants against consolidation of the industry it says it will be looking out for its members (OK, that is their job) and the traveling public?

a. I guess the threats from labor of a strike, or a slowdown, are beneficial to the consumer because the system can quickly reaccomodate demand and there will be minimal disruption to the affected consumer? NOT

7. Yesterday the Continental pilots rallied in Battery Park along with other ALPA carriers and independent unions to call for the repayment of the concessions that the Continental group calls a loan made to the company in 2005.

a. What loan? Did you negotiate terms like those negotiated when money is borrowed?

b. Isn’t it ironic that the labor groups chose Wall Street as the venue for their rally? There must have been a lot of sympathetic observers given that Wall Street employees largely rely on variable earnings to comprise their total compensation and not fixed rates of pay? Oh I digress.

8. The Allied Pilots Association have told us many times and through many different mediums that just a modest increase in passenger fares will pay for one of the most outrageous asks made by a union of a company in my career. NOT

a. In the face of current oil prices, at what point do “pass throughs” of increased fuel costs negatively impact demand? At what point do the US macro economic issues negatively impact demand as consumer disposable income is negatively impacted from a long list of possible reasons?

b. If demand begins to weaken, I do not think fare increases will be the tactic employed by the industry to address the issue.

b. Maybe the CR Smith Museum should be enlarged rather than being refurbished?

9. Politicians and labor should think real hard about the fallout that could stem from the current economic environment versus what the perceived fallout could be in a consolidation scenario.

More to come.

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.

Hell Yes, Going It Alone Remains an Option

In Washington, D.C., Congressman Oberstar says “hell no” before hearings are held on significant issues important to the US airline industry. In Atlanta, Delta Air Lines is reminding us that there is some probability that “no” to a deal just might be the right answer at this time after the company and its board carefully review possible merger combinations.

Russell Grantham, in this morning’s Atlanta Journal-Constitution offers a clear line of sight to the issues Delta views as critical tenets of any combination. Delta’s #2 executive, Ed Bastian, is quoted in the story as saying that “any merger must meet three major goals. He said Delta won't agree to a deal unless the proposed merger: creates a global network that "fills holes" in Delta's operations; avoids burdening the combined airlines with excessive debt; and treats employees fairly and assures them of job and seniority protections”.

We seem to be hung up on the political clock. Yes it is ticking. But with vigilant focus on satisfying certain labor issues, is the time on the clock of critical importance? Personally, I would rather see the industry address those issues it knows will be important to all stakeholders before the spotlight is turned on. It seems to me that by learning from past mistakes, the political clock may be less important. And can something really be completed in 10 months?

The airline industry is not the only industry that is carefully studying and proposing possible acquisitions. Yesterday Microsoft said Yahoo - and not hell no - to a possibility of diversifying its business and in turn creating a stronger competitor to Google. Last time I checked, the internet was a global network business just like the airline industry. And we are proud of the iconish names that carry the US flag in the technology space. But I digress……

More to come.

Dear US Government: I hope you are reading the newspaper

Thinking About Three Headlines from January 24, 2008

So much of the current discussion surrounding US airline industry consolidation scenarios involves only the Network Legacy Carrier (NLC) sector. In an earlier post this week, I wrote about the catalysts for consolidation. In that post the importance of economies of scope, scale and density is discussed and how they are a most important ingredient to a healthy industry structure. These economies are critical to all players – even the LCCs.

Three headlines in yesterday’s news underscore the negative effects of a highly fragmented and hypercompetitive US domestic industry structure – and those negative effects are not limited to the sector of the industry that is forever blamed for the industry’s woes – the NLCs. Yes, there is even bad news emanating from the Low Cost Carrier (LCC) sector. The very sector that many policymakers believe is solely responsible for the consumer benefits that the entire industry delivers each and every day - NOT.

First off, Holly Hegeman writing in her blog Planebuzz reports the first credit downgrade of the period. No it is not one of the NLCs, it is Southwest Airlines. Not that this is anywhere near the end of the world for the carrier with the industry’s best credit rating – even after the downgrade – but noteworthy in my view.

Second, Terry Maxon in his Airline Biz blog writes about additional stock sales by David Neeleman, founder and non-executive Chairman of jetBlue. Whereas there are always multiple reasons for stock sales, Neeleman has sold nearly 30% of his holdings since May of 2007. This particular announcement comes just days after jetBlue finalized a stock sale to Lufthansa that was designed primarily to address some near term liquidity concerns.

Third, last night Reuters reported out on Frontier’s earnings. The short article was entitled: Frontier reports wider loss, to sell four jets. Enough said.

For government regulators generally: the bad news regarding the industry’s financial performance is not limited to one sector. If you were right, and I was wrong, that the LCCs were/are the sector that will keep the US industry in a global leadership position, then it is time to step back and recognize that even this sector is beginning to show signs of troubled economics. And given that this sector is largely confined to the 48 contiguous states, that would be a good place to start your analysis of the industry’s structure.

For government officials in smaller US communities: the bad news is that the LCC sector of the industry is not your answer. The bad news is that industry economics do not support all of the service currently being provided. The good news is there is an opportunity to look at the current industry structure and allow it to make necessary commercial changes. Scrutinize the proposed changes for sure. But, changes that keep your airport market connected to the US air transportation system is much better than being the subject of attrition from the airline map.

For government officials in cities that serve as corporate headquarters: keeping your city as a critical dot on the global airline and trading map is much more important than housing a few thousand workers. It is simple economic impact math.

Much more to come,