Disequilibrium Everywhere; Stimulus Nowhere

It will be clear soon as to why my writing time has largely been invested elsewhere.

I have been thinking about a theme for this post for a few days as I criss-crossed the country. I started considering “Pigs at the Trough” as a theme as I read story after story about the pork finding its way into the various versions of the stimulus bill. I then moved to something like, “For Organized Labor: Will It Be OHbama or NObama” as it pertains to the controversial “card check” legislation? Then it was something like, “And this Little Piggy Cried Wee, Wee, Wee All the Way Home” after reading about Jim “Hell NO”berstar introducing legislation to block additional immunization of airline alliances and explore ways to undo those that exist.

What a sad state of affairs this country finds itself in. What a sad state of affairs airline labor finds itself in . . . where union leaders have time and again failed to lead because they’ve put politics and self-promotion first rather than face hard truths and labor’s role in improving productivity and helping turn around the long decline of the domestic airline industry. What a sad state of affairs the US and global airline industries find themselves in because of patronizing, parochial protectionists like Oberstar whose antiquated, short-sighted views fly in the face of everything we know about the industry’s current financial challenges and competitive burdens.

I am not only disheartened but dismayed. There is plenty of blame to go around. Some goes to the airline executives that have returned to cutting fares in a misguided stimulus plan to fill seats – and too few controls on the number of cheap seats up for sale. There is little to “stimulate” when you consider that some major portion of historic demand for air travel was created by consumer access to easy credit – whether through the new Mastercard that arrived every few months in the mail or the willingness of Americans to take out a third home equity loan to finance yet another family trip to see Mickey Mouse.

By looking at the traffic, capacity and load factor data for January 2009 it becomes pretty clear that the aligning of supply and demand still requires work. Moreover, a realignment will have to occur in international flying as the economies in Europe and Asia particularly are sick and getting sicker.

What is it going to take to get the politicians – whether those in Congress or big labor– to understand that the US airline industry is headed down the very same destructive path that the US auto industry is headed? Many airlines did the right thing last year when, faced with record fuel costs, cut capacity and made some hard choices about pricing and costs. That was an industry that demonstrated discipline with conviction. But to work for the long term, capacity discipline must be practiced with pricing discipline too. After all, that is the theory at work with the industry’s too little, too late recognition that it is the revenue line holds promise for profits.

In my view, the system should have let the weaker airlines liquidate because, in the longer run, they aren’t strong enough to survive. Just look at US auto industry, which supports too many brands; has too much manufacturing capacity; carries legacy labor costs that can possibly be sustained only by a growing industry; and is modeled on an outdated demand curve built on cheap oil and readily-available capital.

The airline industry, too, has too many brands; too many hubs; a product priced below cost; and a high-cost, inflexible labor construct that limits a company’s flexibility and ability to adapt the size of the operation to economic realities. Current contracts and labor assumptions force airlines to pay nothing short of ransom to make necessary operational changes, and only because that is the way it has always been done. Just like the job bank provision in the auto industry.

To bet on a profitable 2009 just because of the price of oil today is, to me, nothing but an attempt to mine fool’s gold. I get the math..... On the other hand, liquidating an airline or two, and investing the proceeds in gold could be a proposition with some upside for airline shareholders.

The Virtuous Circle of Value Destruction is taxiing into position to prepare for a rendezvous with history – I fear.

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.

Leverage Detoxification: Banks and Airlines

With second quarter earnings releases in full swing and a four-letter word starting with “F” being used to describe the impact on the industry’s earnings at each and every carrier, the discussion turns to the what actions each and every carrier is taking to address the new macroeconomic reality. The unequivocal response for the industry’s carriers, with the exception of one I guess, is the level of capacity that will be taken out of the system beginning later this year.

The Banking Industry

Over the weekend, and in between 4 rounds of competitive golf in 95 degree heat and matching humidity, I was drawn to a series of articles in the July 28, 2008 copy of Business Week. Peter Coy wrote a piece entitled: The Credit Chokehold. Breaking the vicious cycle of tightening will take time, but how much? He writes how the cover story explains how each dollar of loan loss can force commercial and investment banks to reduce lending by $15 or more. He goes further to suggest, that by one estimate, mortgage-related losses alone could cause a trillion dollars in credit to vaporize”.

Think About All Network Industries – Not Just Banks

In the second Business Week story by David Henry and Matthew Goldstein: How Bad Will It Get?, ….the concept of leverage is raised. The authors write: “Traders, investors, bankers and economists are waking up to the possibility that Wall Street’s recovery from the worst financial disaster since the Great Depression could grind on for years. ……its aftermath will weigh on banks, other companies and consumers alike.”

“One thing is for sure: The new normal won’t be as fun as the recent past. Banks will be smaller and fewer. Capital will be harder to get for some consumers and companies”. The writers ask: Why hasn’t the healing begun? The answer lies in the mechanics of leverage, or borrowed money, which banks not only provide to customers but also use themselves. Leverage is a powerful but dangerous tool, intoxicating on the way up and devastating on the way down”.

The authors continue: "Banks live on the stuff [leverage]: When they post profits, they borrow money to make more loans and book still more profits. During the boom, bigger mortgage loans pumped home prices until people couldn’t handle the debt and the bubble burst. Then the banks, poorer from the losses, had to cut back their own borrowing, too. Now the damage is spreading. How far? Simplified, for every dollar of bank wealth lost, government-regulated commercial banks must eliminate some $10 of lending; for investment banks, the figure can be $30”.

The article includes a graphic demonstrating “The Leverage Multiplier.” Banks used borrowed money to amp returns in the good times.

1. By borrowing $15 for every $1 of capital – or leveraging up 15 times – an investment bank could turn $10 billion into a portfolio of $150 billion.

2. But leverage also amplifies losses. The authors describe when the value of a bank’s portfolio drops by 2%, or $3 billion, the bank loses 30% of its capital, cutting the original $10 billion to $7 billion.

3. Those losses have ramifications that go beyond the bank. If its leverage ratio remains the same, the firm may have to cut back its lending – in this case by $45 billion ($3 billion X 15). That tightening hurts the economy”.

Airlines: Struggling With Just How Much Capacity to Pull Down – For Many of the Same Reasons

The airline industry that lawmakers, communites, employees and other stakeholders have come to know was born of an industry addicted to leverage.

Whereas banks utilize financial leverage to improve returns, the airline industry employs operating leverage. Each node, or new city added to an airline’s map, benefits multiple other flights on that airline’s network by generating new traffic and revenue. Both of these industries are network industries and leverage is a critical component in sustaining existing, and generating new, scale economics.

As the Business Week piece suggests that traders, bankers and economists are waking up to the fact that the banking industry’s recovery could drag on for years - airline industry consumers, employees and communities of all sizes should be considering the same. The article suggests that the banking industry will be smaller and have fewer players. So too will the US and global airline industries. Air travel consumption will prove harder for many consumers going forward. And yes, there will be some dislocations from the air transportation system.

The leverage of capacity growth since deregulation has been both a powerful and dangerous tool for individual carriers. For the industry, it has been intoxicating on the way up as air travel has been made available to the masses. But we are about to experience some devastation on the way down as networks are deleveraged.

Wright Analysis Still Describes Hub Dynamics

The one thing readers will discover about Swelbar: I have advocated one position or another during a career and have done so with conviction. I have made my conclusions over the years with supporting analysis. In fact, the internet makes it impossible to hide from what you have done and said and honestly, that is good. In 2005, I was retained to assist American Airlines in its defense of the Wright Amendment.

Based on work done earlier in a career (the United-US Airways merger attempt in 2001), American asked for an analysis of what “could” happen to the DFW hub if AA were to match Southwest’s expected three frequencies per day into 15 of the largest US markets from Love Field? It was assumed that these 90 inbound and outbound flights would be operated at Love instead of DFW. The (Eclat Consulting’s findings at the time on this project where I was the lead) conclusion was that if American were to move those 90 operations from DFW to Love, an additional 279 flights at DFW would be negatively impacted. The analysis was a ”bottoms up” analysis of load factor impacts of all flights arriving or departing DFW based on the movement of these 90 operations.

Of course you can question whether all 279 would have been uneconomic as market prices were not considered. The analysis found that a 3:1 leverage ratio existed (one mainline flight from 15 large markets supports 3 other mainline and/or regional flights at DFW). It is not totally unreasonable. Moreover, we are about to witness in real time the delicate cutting of capacity that is being considered by each of the hub and spoke carriers.

I was attacked on the analysis of hub degradation then, but it applies to the industry’s decision to cut back capacity today. Wall Street is saying that 20% is the number that gives the industry pricing traction. I do not disagree. But isn’t it also about a 20% reduction within a carrier’s competitive footprint that matters? Why is it being suggested that each carrier pull down capacity approximating 20% that makes it right in the eyes of the Street?

I have been public in my analysis that the industry needs to be judicious in capacity cuts. There is a leverage ratio for airlines too. Competitor capacity cuts within each airline’s footprint need also to count toward that 20 percent. But Delta’s 20 percent is different than United’s 20 percent is different than American’s 20 percent. Right? By the actions already announced, just how much previous capacity will vaporize based on the deleveraging of the industry? Capital has vaporized and so too will existing capacity – or at least we hope.

The healing for the airline industry will only begin when a sustainably profitable model is found that benefits all stakeholders - and this time it will need to benefit shareholders too.

Congrats to United on a very nice earnings call earlier today.