Facebook: Will American Friend US Airways?

Much has changed since I last posted. Summer came and went.  I played some golf and worked some projects. My mom had major surgery.  And the usual drama in the U.S airline industry continued, including breathless speculation about the potential marriage of US Airways and American. 

I was thinking about this watching the dizzying rise and fall of Facebook’s fortunes as part of its Initial Public Offering (IPO).  Based on the price performance of the stock, the IPO has been anything but a success.  Circa 2000, it was thought to be a sure bet for anyone lucky enough to garner those initial shares offered.  Instead shareholders sued Facebook CEO Mark Zuckerberg and a number of banks, alleging that crucial information was concealed ahead of the offering.  At the heart of the lawsuit, according to Reuters news service, was the fact that Facebook and its banks failed to reveal "a severe and pronounced reduction" in forecasts for the company’s revenue growth, as users increasingly access the site through mobile devices. Investors, it happens, were so enamored of the Facebook “story” that too few asked tough questions about the company’s revenues.

I wonder if something similar isn’t happening with the US Airways-American story.  Where are the tough questions?  Or are reporters so taken by the Doug Parker storyline they’ve failed to look behind the pretty wrapping paper.

Mind you, I have not “friended” anyone at the unions representing US Airways or American employees. Not that they would accept the request. But if I were a line employee at American I would be demanding that my elected union officials, at a minimum, be asking the tough questions.

For me, the first question is how many employees are really needed at a combined US Airways and American. In its attempt at a shotgun marriage with American’s union leadership, US Airways suggested that it could hang onto more jobs than American would in restructuring.  That math deserves a second look.  For example, on a pro forma basis a combined American – US Airways network would be 3-4% larger than United – Continental yet it would have nearly 18% more employees.  Granted the number of employees will be reduced under either carrier’s plans, but someone is not telling the whole truth nor is it just found in the outsourcing of jobs. 

Where are the tough questions about airport overlap? Remember that when US Airways was singing the virtues of its proposed merger with Delta it talked about cutting capacity (frequency) in a large number of markets.  Many of those markets would have been smaller communities like Jacksonville, NC.  Today, American and US Airways offer 50-seat or less service in 60 common markets.  Can we honestly believe that all of that service will be maintained?  I think not, particularly when Delta has taken leadership in beginning to wean its system of the inefficient smaller aircraft and adding more 70-seat platforms and B717s.

Criticism of American’s stand-alone plan by the likes of Jamie Baker at JP Morgan point to the fact that a large portion of the proposed revenue synergies will be driven by the Ft. Worth carrier addressing its deficiency in the 70-seat jet arena.  Others cite concern that American would be dependent on a share shift away from incumbent carriers where a renewed AA will compete. 

Given the current significant overlap of the Delta network and the combination of American and US Airways networks, can we really believe that the new combination will stimulate new demand in the US Southeast?  Or will it be a share shift from Delta?  I am betting on the latter and that is a tough synergy to count on as the Delta network has a significant head start and a commensurate first-mover advantage in building presence where it and SkyTeam will compete with oneworld.  And that doesn’t even take into the account the fact that the two networks would be fenced off from one another while the pilots sort out lingering seniority issues?

To underscore the issue of share shift, Baker in his March 2012 report on the proposed US Airways – American combination suggests that a combined Delta – American probably could not pass muster with regulators based on the overlap of the two networks.  Imagine, then, the overlap a combined American and US Airways would have with Delta -- overlap in mature markets that offer little opportunity for significant stimulation of new demand. In that case, any market share model would point to a share shift among existing operators within the city pairs being served.

Where are the tough questions about capacity? This week, United announced it was cutting capacity in the face of weakening economic signals. If US Airways were truthful about their revenue and capacity plans they too would be signaling that the overlap between American service and its own would require a capacity haircut.  And in that case, you have little choice but to idle employees or furlough them.  We know the US Airways plan is designed to appease American’s unions.  What we don’t know is whether US Airways was honest with American’s unions in making clear the unions’ own contracts undermine the carrier’s ability to best manage its network, whether it be a cost disadvantage or restrictive pilot scope clauses.

To give you some idea as to American’s scope disadvantage, in July of 2012 American operated 7,175 70-seat departures or 231 per day.  That sounds like a lot except when you take into consideration what the competition is operating.  Delta offered nearly 36,000 departures with aircraft between 51-76 seats and United offered 26,000.  Hell, US Airways with a tiny network operated 13,000. There is no doubt that the ability to offer two-class service in smaller markets, at the right time of the day, equates improved revenue.

I do not need to be sold on the virtues of consolidation despite the best efforts of US Airways’ public relations firm when they sent me Baker’s report. 

I appreciate that few city pair combinations are overlaps between US Airways and American.  Baker identifies 33 East Coast markets that could gain access to the oneworld network as a result of US Airways becoming a new member of the oneworld alliance.  They range in size from Hartford to Elmira, to Lynchburg to Greenville, NC.  Lovely cities all, but not likely to tip the balance of power to a new combination when compared to Delta and United.  And hopefully a judicious British Airways recognizes this as well. 

The real balance of power is about the West Coast and New York.  US Airways does still operate the Northeast Shuttle but it sorely lacks at New York JFK and Boston.  A much deeper relationship with jetBlue does more for American than does a messy merger with US Airways.   And I am not talking about a merger with jetBlue.  US Airways does not give American what it needs in the West either.  So if this becomes all about Lynchburg and Richmond then I think this is probably not the right deal no matter what Wall Street, Doug Parker and the chorus of reporters tell us. 

Are there alternatives that do not add capacity to the system? The naysayers claim American’s stand-alone plan will add capacity to the system to the tune of 20 percent.  But Delta is replacing 50-seat RJs and bringing on more 70-seat platforms and 717s, and no one is crying foul about what that might mean from a capacity point of view.

My bet is that United and Delta continue to poke at US Airways to keep up the fight for American.  Not because a merger will be a silver bullet to improve the industry but because they would love to compete for traffic and revenue as the two go through a complex integration.  With Non-Disclosure Agreements now in place, I can only expect that the due diligence will spur the tough questions this pairing deserves and yield real answers that might temper the enthusiasm of stakeholders who believe another merger will produce the same results that first movers United and Delta enjoyed.

I have heard from many who question my skepticism about this potential merger when I have been an ardent supporter of consolidation in the past.  My interest is, and always has been, in the economics.  Facebook may have a lot of “friends” but show investors the money.  Can the economics of a US Airways-American marriage create a carrier that can not only compete in the vicious US domestic market but also with the global networks?  I remain unconvinced.

US Airways And American And The Elephants In The Room

I want to talk about the elephant in the room.

Actually, it’s a whole herd of elephants in pink tutus with “Seniority Integration” and “Unintended Consequences” emblazoned in neon lettering across their posteriors. Yet, most media seem too distracted by sexy headlines and hoped for revenue synergy calculations an alleged US Airways – American Airlines tie-up might bring to even notice the elephants.

Maybe they’re right. The customer doesn’t care what uniform the pilot flying the plane wears or what that pilot’s career prospects look like. They just want that pilot to safely get them to where they’re going.

US Airways is a perfect example that ignoring the elephant can work with few external (i.e. passenger) repercussions: it hasn’t fully integrated pilots or flight attendants since merging with America West in 2005. After nearly seven years of flying separate-and-not-nearly-equal crews on two coasts, maybe US thinks the elephant is just a mouse. Heck, company president Scott Kirby said taking over American Airlines would actually solve US’s problem:

"It's ironic but the solution to that issue at US Airways I think it's probably because we're able to get this deal done. The area that people focus on the most is USAPA, our pilots' union. In this case there is a huge benefit for our pilots in getting the deal done.”

Kirby’s comments would also seem to hold true for flight attendants. He even pointed out merging work groups would be subject to the McCaskill-Bond legislation… created in part, by American’s 2001 takeover of TWA and the short-end of the deal those employees received.

And that’s where the elephants start trumpeting.

I’ll concede again that seniority integration doesn’t mean anything to the average customer. But it means everything to airline employees and, because of the very McCaskill-Bond law Kirby mentioned, even to those employees who don’t belong to a union. They, too, will be subject to the law and the vagaries of seniority integration.

If the Allied Pilots Association really believes seniority integration is, as its spokesperson Tom Hoban labeled it, a “faux concern,” then it’s ignoring its own recent past.  If I am an APA pilot and my union is calling seniority integration a faux concern, well I would be concerned.

If the Association of Professional Flight Attendants thinks it will join hands with US and its senior members will either cash out or staple US’s two groups to the bottom of the seniority list – like the APFA did to the TWA flight attendants – its remaining members will have plenty of time to regret that decision when they’re flying Richmond, VA to Greenville, SC via Charlotte for the third time that day.

REAPING WHAT THEY SOWED

The very group APFA leaders either think they will harmoniously bond with or take precedence over (and I’m betting it’s the latter more than the former) is the Association of Flight Attendants.  The AFA represents two distinct groups at US – the flight attendants from the “old” US Airways and former America West FAs – which have never worked under a joint contract. Kirby’s mention of McCaskill-Bond is especially pertinent in this potential combination of three different flight attendant groups, each with its own pay rates, work rules and benefits.

Why? Well, this is what the AFA says about McCaskill-Bond:

“In 2001, American Airlines purchased TWA. The TWA flight attendants, represented at the time by the lAM, were stapled to the bottom of the American Airline's flight attendant seniority list. The AA flight attendants are represented by the APFA. This was grossly unfair to the former TWA flight attendants. The TWA flight attendants fought back. They were unable to right the wrong that had been done to them. But they were able to, with the help of Congress, ensure that it will not happen again.”

Doesn’t sound like the AFA is ready to take a jump-seat to anyone, especially not a group that was “grossly unfair” to other flight attendants. No matter what promises US’s Doug Parker and Scott Kirby have made to the APFA and president Laura Glading. US flight attendants are going to have a say about what part of the pie they get. It’s also important to remember neither AFA group has approved a new contract with US – in fact, they overwhelmingly rejected the last tentative agreement two months ago.

Currently, the APFA has, in total, the best pay, benefits and work rules in the industry. (A decision on American’s 1113 motion in U.S. bankruptcy court could change that). US Airways are among the lowest compensated. Doug Parker will probably promise his own flight attendants they’ll move up to APFA pay, and with the reported “early out” incentive offered as part of the US-APFA deal (about 80 percent of APFA’s members would qualify under the union’s stated parameters including President Glading), would quickly dominate the seniority lists.

That’s probably not going to be enough for the US flight attendants. They’ll likely – and, perhaps, justly – demand the same early outs, guaranteed seniority and other incentives. McCaskill-Bond calls for arbitration, though US Airways says it is “hoping” for a negotiated settlement. This is the same group hasn’t been able to negotiate contracts with any of its current flight groups in seven years, yet “hopes” for agreements with three different unions all clamoring for top billing?

That doesn’t even take into consideration the lawsuits that will be generated when the remaining APFA members realize they’ve been sold out or either of the AFA groups feel they’ve been shorted.

Speaking of lawsuits, the APA knows a bit about seniority integration court battles. When American took over bankrupt TWA, the APA argued in the Supreme Court of the United States that its members deserved seniority over all Trans World pilots because TWA crews had limited to no future prospects and no reasonable “healthy carrier” would agree to merge if its employees didn’t take precedence. Some call this the “failed carrier doctrine” and it is still applicable with the McCaskill-Bond legislation. The APA won its case in front of the Supreme Court, so it shouldn’t be surprised if USAPA East & West use it against them.

Of course Kirby thinks merging will solve US’s current integration problems. The USAPA pilots are salivating over new planes, APA’s high pay rates and benefits and the chance at more international routes. They’ll happily staple APA to the bottom of the seniority list to get those perks.

Perhaps APA president David Bates really believes the former America West pilots will just give way to the APA’s claims on seniority. He met with USAPA pilots in Charlotte last month and touted the meeting as a beginning of negotiations to resolve the issue.

I don’t believe any “negotiations” are going to resolve this issue quickly or simply… and I see no way APA members come out of this scenario better in the long-term. Union solidarity only goes so far and US pilots have been waiting years for an opportunity like this.

More telling I thought was a quote in The Charlotte Observer from USAPA president Gary Hummell:

"My job, even though we are looking forward to a cooperative effort, is to protect USAPA pilots (and) to ensure our pilots get the best contract they can."

Even if that means it’s at the expense of the APA.  Even if this means making American out to be a failing carrier.

WHITHER TWU?

The Transport Workers Union International and many of the locals haven’t exactly rushed into the arms of US Airways. Unlike APFA, which has thrown itself at US like .... well I won't say it, or APA, with its “studious business” approach, TWU has seemingly shrugged its collective shoulders about the US “deal.”

That’s probably because the US agreement isn’t much different from the one AA recently offered TWU. The Mechanics and Related and Stores work groups rejected American’s proposal, but I doubt they’re holding their breath waiting for US Airways to save them.

The TWU is being realistic. Besides saving some jobs – which the M&R and Stores groups decided wasn’t enough reason to approve the AA offer – there’s not a lot US can do for TWU members. They’ve heard US’s promises of limited job protection and bringing more maintenance in-house, but a quick look at DOT numbers also shows US currently has one of highest percentages of outsourced maintenance in the industry. Hard to believe it would be more cost efficient for US to give that work to TWU.

Plus, the TWU successfully used the failed carrier doctrine against TWA as well. While its 24,000 members at American dwarf the number of ground workers at US, TWU leaders know their own arguments will be used against them in arbitration. The TWU has seen what has happened to ground workers at other failed airlines and, at this point, can only hope to minimize its losses.

TWU also lost a bitter and expensive battle against IAM to represent workers at US and, as any political junkie knows, unseating an incumbent is neither easy nor cheap.

WHAT’S IT ALL MEAN?

I’ve already admitted seniority battles might mean little to nothing to customers and operations. That’s possibly enough for Wall Street types who are bounding after this potential consolidation like dogs chase cars.

There are, though, real concerns for other financial stakeholders.  One complex integration should give them pause - but three battles should/will make them nauseous.

US has touted the synergies merging with American would immediately bring. What happens to those synergies if integrating pilots, flight attendants and ground workers drags on, or as I expect, become overly contentious and litigious?

US Airways’ own track record – now going on seven years - shows it cannot facilitate integrated contracts and is quick to suggest the reason is because of internal union squabbles. “Old” US flight attendants fly with “old” US pilots, segregated from their former-America West peers. If a similar situation develops with a devoured American workforce, those already questionable synergies become even more degraded. In other words, the risk and return calculation might be worth further consideration by AMR’s creditors.

There are also a couple of other elephants standing off in the corner that bear watching. First is US Airways own unions, specifically the AFA and the IAM. None of those three groups (remember, AFA represents two distinct flight attendant units at US) are very happy with Parker and Co. right now. Contract negotiations have dragged on with US holding the line on costs because of its structural revenue underperformance relative to the industry.

Yet the IAM and AFA saw Parker and Kirby promise the moon, stars and assorted planets to American’s union leaders. They have significant leverage, including asking the National Mediation Board for release. With an election quickly approaching, a Democratic White House might be hard put to ignore the treaties of two very influential labor organizations, both of which wield more power than American’s unions. Keep in mind, the current chairperson of the NMB is former AFA president Linda Puchala.

Then there are American’s non-union employees. The CWA is currently trying to organize American’s 10,000 agents and representatives, even though the CWA has publicly admitted the majority of those employees don’t want a union. Well, guess who represents US Airways passenger service representatives? That’s right, the CWA. (It also is partnered with the AFA). In a merger, American’s PSRs would get a union whether they wanted one or not, most likely without a vote and probably find themselves on the bottom of the seniority scale. Their – and the other non-union AA employees not happy about their new seniority “rank” – only recourse might be the courts.

The last elephant is more of a wooly mammoth: extinct, but vestiges still remain. That would be the group of employees the APA, APFA and TWU all made bones off of… the former TWA workers. This could be their last shot to right some wrongs and adding them into the mix exponentially increases the level of difficulty of integration.

"We have a chance for a fresh start here," Roger Graham, a spokesman for the former TWA flight attendants, told Ted Reed of TheStreet.com earlier this month.  At least there is one group of employees who might benefit from this proposed merger.

It’s hard to fathom why no one has really taken notice of the elephants. Maybe because they obscure Wall Street’s desire for a (very) short-term gain despite the longer-term implications. Maybe it’s because American’s unions are simply using US as leverage with no intent to expose their members to the possible risks of actually going through with the merger. Or maybe it’s because ignoring them makes it easier for Parker and Kirby to believe this deal is really as simple as they pretend.

Maybe the court and AMR’s creditors, blinded by pro forma financial reasoning that is, sadly, often divorced from airline industry reality and the notion of competitive response, will embrace the US proposal as the best value for their dollars.

If they do, they should beware that discounts to the pro forma estimate are called for because of the elephants in the room.

APFA, by not making a deal with the company in 1113, should be questioned by its members about its decision to put all of its eggs in the US basket under the failed leadership doctrine.

Finally, the TWA pilots reared their heads last week by filing suit against American Airlines and the Allied Pilots Association. 

Looks to me like -- game on.

US Airways at the Masters: Trying to Win on Thursday?

For those readers who know me well, today marks the beginning of the end of the finest 30 days in sports television.  It starts with the NCAA tournament and culminates with what can often be the best two hours in sports – the back nine at the Master’s Tournament on Sunday. 

Even with the history and the azaleas to occupy my attention, on this tournament Thursday, my mind still wanders to the airline industry and I see similarities in golf, aviation and the games people play.

As is tradition at the Masters, past champions Nicklaus, Palmer and, this year, Gary Player (a.k.a  Delta, United and Southwest) ceremoniously hit the first tee shots to open the playing of 76th tournament at the venerable Augusta National Golf Club. Past champions (multiple winners) at the Masters Tournament enjoy notoriety and historical significance long past their years of playing.

A popular past champion still participating in the Masters Tournament is Ben Crenshaw (American Airlines).  Crenshaw is given little to no chance in this year’s tournament, but the sweet putting stroke possessed by the Texas gentleman keeps Crenshaw a fan (AAdvantage members) favorite. 

Some very good golfers have never attended the Champion’s Dinner. Greg Norman (er US Airways) for example.  Nobody in Masters’ history lost in more heartbreaking fashion than Norman in 1987 when Larry Mize chipped in on the second playoff hole to beat him; or when Norman beat himself in the final round that handed the green jacket to Nick Faldo in 1996.  Norman’s misery is akin to US Airways missing out on consolidation opportunities in 2001(United), 2008 (Delta) and then again in 2010 (United).  US Airways’ strategy to attempt a hostile takeover of Delta while in bankruptcy in 2008 reminds this golf fan of Norman’s collapse in ‘96.

Playing in this year’s field and given a real chance to win are world #1 Luke Donald (Alaska Airlines) and world #2 Rory McIlroy (jetBlue Airways).  The Europeans are also making a strong showing these days, like defending champion Charl Schwartzel and perennial contender Lee Westwood (British Airways and Iberia).

Bunkers, Birdies and Bogeys

Pressure tournaments like the Masters tend to spawn meltdowns even among the very best players. The young McIlroy, in fact, suffered through a sad Sunday in Augusta last year.  Just like airlines have their good years, bad years and critical moments. And just like golfers, the difference between success and spectacular failure in the airline industry depends on how you read the lie. It’s how you think your way around the course, avoiding bunkers like bad decisions, taking advantage of business opportunities (birdies) and minimizing the negatives (bogeys and others) like fuel spikes and bad strategic decisions.

That brings me to US Airways.  

US Airways pursuit of Flight Attendant Hearts and Minds

The Masters is an invitational tournament; you have to be invited by the “committee” [UCC] in order to play.  US Airways is trying to play to the court of public opinion to get an invite to this year’s event.  US Airways had one good round it hoped would help it win an invitation to play in the year’s first major. That was reaching a tentative agreement with its flight attendants.  Unfortunately for US Airways, it couldn’t finish. The flight attendants at the company overwhelmingly rejected that agreement despite the fact it offered significant pay increases.

The flight attendants said in a press release:  "Since the onset of negotiations, Flight Attendants have been steadfast and determined that an agreement must address the needs identified by the membership. Flight Attendants have subsidized the cost of the merger and rising fuel costs for the 'New US Airways.' Management must recognize that our sacrifices have directly contributed to the success of US Airways," said Deborah Volpe, AFA pre-merger America West President and Mark Gentile, AFA pre-merger US Airways acting President.”

It has been nearly seven years since the “Old US Airways” merged with America West and there is still no done deal with either its flight attendants or its internally troubled pilot group. 

And yet before round one has been completed in Augusta, US Airways has allegedly been courting the president of American Airlines flight attendant union, Laura Glading, who is also a member of the Unsecured Creditors Committee (UCC) in order to get that invitation to the year’s first major… a merger with American?

While it’s hard to know exactly who is chasing who in all of the US Airways merging/consolidating with American talk, Glading and the APFA have been anything but shy in their pursuit of an offer from Doug Parker and company. The APFA has boldly stated it thinks there is a better business plan than the one American is offering… mainly because AA’s will freeze pensions and trigger approximately 13,000 layoffs. (Notice no mention of the finer points; that AA’s plan might finally unshackle the company’s ability to compete with other network carriers who rehabilitated under bankruptcy.)

Someone – probably the APFA - has “leaked” stories to specific media about “suitors” talking to the UCC – even though as far as anyone knows the only UCC members actually listening are the unions themselves.

While both the APA and TWU (who are also part of the UCC) have reportedly had serious discussions with AA – and apparently those negotiations might have saved some TWU jobs – Glading has been stomping her feet and pouting about the unfairness of it all.  She’s on record as stating the UCC (or, at least, one particular UCC member) is open to seeing a “better” business plan, thus leading to the flirtation with US Airways.

“Better” to Glading apparently means giving up nothing and gaining everything. But what “better” will she glean from this dalliance with US Airways?  Not to change sports, but Vince Lombardi, the iconic former coach of the world champion Green Bay Packers said:  “the only place you will find success before work is in the dictionary”.  Do Glading and other leaders of American’s unions honestly think US Airways will not seek to make major changes to American’s archaic work rules and collective bargaining agreements? 

In the tentative agreement, the former America West flight attendants were granted a 22 percent increase and the former “Old US Airways” flight attendants were given an 11 percent increase to even out pay rates – finally, after seven years. What then would US Airways have to do in order to put three groups on par with one another? Would APFA members be willing to work more for less? And if so, why wouldn’t they just stay with their own company? Or entertain commercial opportunities that might not involve a seniority integration process?

Maintaining a Cost Advantage Is Critical for US Airways

US Airways suffers from a stage length adjusted unit revenue disadvantage versus its legacy carrier peers – even more than American. But it also enjoys a stage length adjusted unit cost advantage versus these rivals – much more than American. Despite the revenue generating deficiency of US Airways’ network, the Tempe-based airline is producing very good revenue results relative to the industry.

US Airways’ revenue disadvantage is offset by maintaining its cost advantage – and most of that advantage is very low labor costs relative to the industry. As a result, US Airways’ pre-tax margins are impressive given its structural deficiencies. The cost advantage the carrier enjoys cannot be overstated nor can the company hide behind the fact a significant portion of its profit performance 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. US Airways has not explored what labor peace would cost, probably because maintaining the status quo is more cost effective.  Or did the flight attendants say in their vote that what US Airways could afford was not sufficient to buy labor peace?

US Airways Touting Merger Synergies Before an Invitation is Granted

The most recent version of the US Airways – American merger story leaked to the press suggests the “synergies” of a combination would produce $1 billion in revenue and $500 million in cost savings.  The revenue synergy number stems from the idea other mergers have realized a three margin point improvement in revenue resulting from the combination.  JP Morgan’s Jamie Baker point to the fact American is weak in Albany, Buffalo, Greesnboro, and Richmond to name a few.  What a yawn. In today’s world why are Baker and US Airways not talking about Auckland, Buenos Aires (oh American is positioned there), Guangzhou or Rome?

The strongest example of American’s domestic weakness is that AA is the #4 carrier in the Eastern U.S. in terms of market share and #4 in the highly fragmented Western U.S.  So, the question remains, can AA truly address these structural weaknesses organically or does it need a merger partner?

Problem with adapting previous margin calculation to a US-AA merger is they don’t necessarily apply. Other mergers involved carriers with stronger domestic and – and more important – international networks. US Airways flies to mainly second-tier markets and has little international presence. That might seem like a good thing – each partner filling a need – but there is little synching between the two – but for this observer there is nothing that gets me excited from a network perspective. Domestic calculations are one thing – international are another.  If I were Delta or United, I would be applauding this possible combination because it adds little to what other combinations might add.  And what about the cost savings?  We don’t even know what American will look like once it goes through the full bankruptcy process.  Therefore how can we know what the cost savings will be?

It is just too early to tell because no one knows what AA will be when it gets through the restructuring process.  Stated differently, what if AA wins the ability to have unlimited code sharing in the U.S. domestic market as a result of a changed pilot scope agreement?  Then is US Airways the only choice?  After all, American’s CEO, Tom Horton, has stated publicly he is not averse to a merger, but will only consider such a strategy once the company completes the restructuring process.

US Airways is absolutely not the only option for American.  What about a fully integrated relationship with each Alaska and jetBlue?  These would certainly better address the weaknesses on the west coast and in New York, particularly at JFK – two aspects of American’s not-successful-to-date “cornerstone strategy”. 

The point is, there are options for American beyond US Airways and I might suggest there are better options than the Tempe-based airline – and they do not require a seniority integration process and potentially do not add seats to the capacity fragile U.S. domestic market.  Then again the restructuring needs to be completed in full before we can begin to evaluate options – something that US Airways wants to avoid.  For a company that constantly claims it does not need to merge, it seems to this observer to be incredibly desperate and fearful of not merging with its bigger counterpart.

Concluding Thoughts

As they say at the Masters, and any golf tournament for that matter, you can lose the tournament on Thursday but you cannot win it. It seems to me that US Airways is trying very hard to win the tournament on Thursday.  There is a lot of golf to play in the American Airlines’ bankruptcy case. And until the back nine begins on Sunday, the leaderboard promises to be crowded as American is an important asset to many – most notably employees, British Airways, JAL, the Dallas-Fort Worth Metroplex and Tulsa to name a few. 

If employee members of the Unsecured Creditors Committee are going to believe there is a free lunch (egg salad and pimento cheese sandwiches) with US Airways they are surely mistaken. Simply, if US Airways doesn’t fix many of the structural things wrong with American, then in a few years maybe the “New New US Airways” will have to file for bankruptcy and fix some of the obvious problems their desperate overpromise and sure to under-deliver approach to American’s unions will avoid in order to win the hearts and minds of employees to get a deal done.

Most of the naysayers regarding American’s stated stand-alone business plan have vested interests in the outcome of the game.  Wall Street has made the case that consolidation and strict capacity discipline absolutely need  to be adhered to if the industry is to be stable.  They cite American’s 20 percent stated growth as something to fear.  And it might be.  But what is the 20 percent American has mentioned?  Nobody knows.  What if it is the ability to generate 20 percent more city pairs to sell through code sharing alliances with Alaska and jetBlue that add no new capacity to the system?  Net effect equals zero.  Period. 

Then we have US Airways.  Too big to be small and too small to be big.  Like American, there is a case to be made that their route structure is being marginalized each and every day; therefore a merger is more important to its very success.  For US Airways it’s only shot at a green jacket is to buy one (remember Crenshaw has two and Norman has none) because over a career opportunities to win one have been missed. 

Angst breeds strange bed fellows.  Angst does not win an invite to the Masters Toonament.  And angst does not win an invite to membership.  Yesterday Dustin Johnson had to withdraw from the Masters because of health reasons.  For US Airways this sucks because the Masters does not have an alternate list.  It must earn its way into the 2013 event because angst will not get it into this year’s Masters Tournament.

More to come.

If History Is A Lesson – American’s Labor Cuts Will Be Large

There is much anticipation regarding when American will file its petitions for labor relief under Sections 1113 and 1114 of the US Bankruptcy Code.  The clock is ticking in terms of the airline’s ability to get its network and costs in line generally and its labor costs specifically.  This needs to be done without undue rancor and in time to implement a workable plan. 

Further, the bankruptcy road has many unknown twists and turns as experienced by US Airways (not one filing but two), United (a three year stay and multiple approaches for concessions from labor) and Delta (an unsolicited offer to buy the company from US Airways).  American will face surprises along the way as well.

Let’s consider some facts.   Today United/Continental fly 39 percent more ASMs than American, yet its payroll is only 17 percent higher.  Delta flies 27 percent more ASMs than American, yet its payroll is only 7 percent higher.  US Airways is 53 percent smaller than American in terms of ASMs but its payroll is nearly 1/3 the size of American’s.  Any way you consider it, American pays significantly more for labor to fly its schedule than its network carrier peers.

I concluded a recent blog noting that American’s problems are bigger than any check labor could write outside of bankruptcy, but that employees will pay a much higher cost inside bankruptcy.   And that’s a painful situation that might have been avoided if all of the employee groups had the will and found a way to negotiate cost savings the airline requires to survive and prosper.

As APA President Dave Bates told The Wall Street Journal, "Sometimes in life it's easier to have something imposed upon a person than have them agree to it voluntarily." 

UNITED

The same story played out at United in 2002 and, sure enough, the toll on employees was much higher in bankruptcy than what the company originally sought in direct negotiations. Early that year, the company proposed a package of concessions totaling $9 billion over six years – or $1.5 billion per year.  The unions went back and forth for months and ultimately proposed a give of $5.8 billion over 5.5 years as a package they said employees could live with.  But as with the American negotiations, deadlines kept slipping as the unions sought more time to ratify the agreements. 

United, losing millions of dollars a day at a time the carrier was trying desperately to win a loan guarantee from the Air Transportation Stabilization Board (ATSB).  As it was, the ATSB was about the only potential source of capital then available to a company hemorrhaging cash and seemingly unable to control its labor and other costs.

As the clock ticked, the unions finally agreed to the $5.8 billion package, only to have the International Association of Machinists and Aerospace Workers (IAMAW) vote the deal down.  With the ATSB loan imperiled as a result, United filed for court protection 11 days later, on December 9, 2002.

US AIRWAYS

Four months earlier, inside of court protection, US Airways in its first filing asked for $950 million in labor relief per year on a total labor bill of $4 billion.  This was US Airways’ first bite at the labor apple as the company quickly emerged from bankruptcy number one and filed again in 2004 where a subsequent $800 million in concessions were granted.  By the time US Airways emerged from its second bankruptcy and was being merged with America West, the company was half its size in terms of employees and its payroll was 58 percent smaller.

DELTA

On September 14, 2005 Delta Air Lines filed for bankruptcy reorganization.  In the year before Delta’s filing, its payroll was $5.8 billion and it employed nearly 58,000 employees (down from 71,000 in 2000).  Through the bankruptcy stay, Delta shed nearly $2 billion in payroll and reduced the number of employees by an additional 11,000.

WHAT IS THE LESSON FOR AMERICAN?

First, the bankruptcy court proved to be a more effective means to achieving the cost savings than any airline is able to accomplish through traditional collective bargaining.  Remember, United asked for $1.5 billion per year from its labor groups prior to bankruptcy and the unions would agree to about two-thirds of that. Under Section 1113, United asked for, and received, $2.4 billion dollars of an annual labor cost savings over 6 years – for a total of $14 billion in concessions.  And this would only be United’s first of three bites at the labor apple.

The second bite occurred in early 2004 when United filed for relief from paying contractual retiree medical benefits under Section 1114 of the US Bankruptcy Code.  The third bite came in late 2004, with fuel prices beginning their march to $147 per barrel and clear recognition that the company had not cut enough while in bankruptcy, United went back and asked for an additional $725 million per year that would include the employees’ defined benefit pension plans.  These two additional bites at the labor apple cause American to stand out as having benefit packages significantly more rich than the industry and productivity constraints dictated by terms in the existing collective bargaining agreements more onerous.

According to the MIT Airline Data Project, if American’s contract with its pilots union allowed it to match the productivity of Continental’s pilot workforce, American would need 800 fewer pilots to fly its current schedule.  That amounts to $400 million in costs mostly attributable to a labor contract that puts artificially low limits on the amount to hours an American pilot can fly.

If American were to achieve the same flight attendant productivity as Delta, it would require 1,500 fewer flight attendants than it now carries to fly the schedule.

And had American relied even partly as much on outsourcing as does every one of its competitors, American’s maintenance operation, represented by the TWU, would be a fraction of its current size. American today outsources only 24 percent of its maintenance and related work, compared to an average of 40 percent outsourcing among all other carriers.  When United began its restructuring, it outsourced 17% of its maintenance.  By 2007, that had grown to 46 percent.  So it’s not unreasonable to expect something similar when all is said and done in American’s trip through the restructuring process, particularly as its maintenance-heavy Super 80 fleet is retired.

According to AMR, American’s labor cost disadvantage versus the industry now tops $800 million a year.  One of the he main questions outstanding is where the airline cuts, resizes and reconfigures its network to get to a place that it can compete and earn sustained profits.

That plan could, and probably should, contemplate significant outsourcing in the aircraft and traffic servicing department, particularly “under the wing” work in small stations with limited flight activity.

And as the airline rethinks its overall fleet and flight schedule under the watchful eye of its creditors, every position from the flight crews to ground workers to airport agents will be examined to determine how many employees will be necessary to support a resized operation.

How much power do the unions have to “protect” these jobs? If history is any guide, very little. Ultimately, the bankruptcy court will determine the viability of the company’s operating plan based on its ability to balance costs and revenues and return a profit. And if that means fewer jobs, then that’s the reality the court will consider.

This is an admittedly harsh portrait, particularly in light of the $1.8 billion in concessions granted in 2003 by American’s unions – alongside another $2+ billion in non-labor cost reductions that affected employees across the company. 

I have no direct knowledge of what American will ultimately ask of its employees or the other elements of its restructuring plan. But I don’t believe the ask will be light, or easy, and that is more a factor of the economics of the industry and the competitive marketplace than anything American could have done through other means.

American Airlines, Labor Leverage, US Airways and Chicken Little

Labor Leverage and Other Thoughts

Since American’s filing for bankruptcy protection last week, I’ve received many notes asking why I am not writing about American - about a potential combination with US Airways or what I expect the company to win from the unions.  I haven’t written because, frankly, I already talked about the potential consequences of bankruptcy for the airline, unions and the industry in my most recent piece.

On Monday, I intended to write about leverage and how the Allied Pilots Association was seriously misjudging the leverage it thought it had. Tuesday’s filing kind of made that point moot.   As the Sections 1113 and 1114 negotiating process wends its way through a court supervised restructuring, the pilots and all unionized employees will either reach consensual agreements with the company or the company will look to the court to terminate the existing agreements.  Whichever outcome, the new contracts will look nothing like the potential deals the unions could have negotiated at various times over the past five plus years.

I know, I know… “American could have reached a deal if it wanted.” It does take two to tango, but in this round of negotiations, American and its unions were listening to vastly different music. American’s offers provided cost benefits that would be realized over the long-term while still maintaining what can only be described as an industry-best benefits package. That wasn’t going to sit well with analysts and Wall Street types who fervently believed the airline needed immediate gains to remain viable.

The unions, seemingly, wanted everything to magically return to past patterns and routinely called for restoration of the pay and benefits they conceded in 2003 to stave off bankruptcy. A common refrain has been no union members have seen substantial increases in wages since 2001. Peers at other airlines did get raises, but American’s employees were – and are - still better off.  It’s a simple, provable truth and it meant there was no going back to 2003 or 1993. It’s a different industry and a different world.

That’s key to understanding there is no leverage for either side in this round of negotiations. (Are you listening, United pilots?) It’s also why this negotiations cycle has been so difficult. Few agreements have been struck. American will likely get deals well before we see contracts – or even tentative agreements - at United and US Airways.  As the bankruptcy process plays out, the American pilots and flight attendants will no longer have industry leading contracts among the network legacy carriers – Delta will.

And guess who comes up next for negotiation – the Delta pilots.  Like American’s management over the past five years, Delta’s management will have to negotiate improved terms and conditions on the highest cost labor contract in existence. All the while, the United/Continental pilots will spend more time asking who is on first than they will spend at a negotiation table.  Looks to me like all of that “leverage” being created by the United pilots alleging poor safety policies by management is NOT moving the parties quickly toward a deal.

While I expect the Delta pilot negotiations to be complicated and difficult for the company, at least the pilots enjoyed some benefit following the merger with Northwest and the bankruptcy agreements that preceded it.  Delta’s pilots will have the richest compensation package in the industry after American completes its bankruptcy negotiations. That means they won’t have any leverage over the company even as pilots squawk about the liberal scope clause in the current agreement. 

In this process, there is a different kind of “trickle down” theory. Case in point: The TWU employees at American. Talk about no leverage.  The more removed from the flight deck, the more leverage dwindles. American’s below-the-wing employees currently earn a total compensation package of roughly $25 per hour. That work can be outsourced for 40 cents on the dollar.   Add the fact  American outsources the least amount of maintenance work in the industry, and that it has more ground workers than any other airline, well, you get the feeling things are going to change. If you’re a TWU worker, that’s probably no comfort.  

All This Talk About A Merger With US Airways

I am surprised – no, blown away - by just how much attention the US Airways – American merger possibility is getting.  In the first 36 hours after AA filed for protection it seemed the world was suggesting a merger with US Airways was the only viable exit strategy.  I don’t believe it.  American will have the exclusive right to file a Plan of Reorganization (POR) for 180 days – a right that is typically extended multiple times by the presiding judge.

Keep in mind, all three of American’s unions were appointed to the unsecured creditors committee. Any plan of reorganization by a party other than AA will have to convince the committee their plan is better for all stakeholders.  Given the messy labor situation that remains at US – six years after its merger with America West – I sincerely doubt anyone would find a US bid credible… especially American’s unionized workforce.  

That’s why, at least right now, I simply don’t see a merger happening, despite industry analyst Vaughn Cordle’s contention that, “regardless of the ugly nature of merging two suboptimal business models and different unions, American's best option is to merge with US Airways.”  My first question is, why would you even think of merging two suboptimal business models in the first place?  So that you can compete directly against balance sheet and network rich United and Delta?

There is another option I don’t think many analysts have considered.  I could see a competing plan led by British Airways and other oneworld partners that would have the potential to win if the AA case gets to the point where outside parties are free to submit alternative PORs – even at today’s 25% foreign ownership limit.  If you believe AA will become a smaller entity over the coming months, the one sure thing is AA’s network will be optimized to maximize revenue generation with its new joint venture partners.  That’s precisely what STAR is doing through United and SkyTeam with Delta. 

The Sky Is Not Falling

Over at Terry Maxon’s AirlineBiz blog is a letter from TWU President Jim Little decrying American’s filing with $4.1 billion in cash and thus a near term ability to pay its current obligations.  I urge you to read the letter in full and the lack of reasoning throughout.  What did Little expect the company to do when he refused on numerous occasions to step-up and tell his TWU members the cold truth that something is better than nothing?  He has had a number of opportunities over the past five years to negotiate an agreement with American that the company could afford. 

The bottom line is bankruptcy is not a big deal.  This is not the industry’s first rodeo.  American’s problems are bigger than a check labor could write outside of bankruptcy, but sadly, the employees will pay much more inside of bankruptcy.   As APA President Dave Bates told The Wall Street Journal, "Sometimes in life it's easier to have something imposed upon a person than have them agree to it voluntarily."  Sad commentary indeed.

FORT WORTH, Texas: The Longer It Goes, The Worse It Will Get

Another Sunday in the Washington D.C. area means being forced to watch the Redskins if you want to watch some football.  I wanted to watch some football, but catching up on my reading was much more interesting.  As is typically the case, my starting point is Terry Maxon's Airline Biz Blog.  Three of Maxon’s last four posts pertain to the negotiations between American Airlines and the Allied Pilots Association.

Each of the parties issued a statement regarding the decision not to negotiate over the past weekend with both pointing fingers at each other.  The understanding, at least for those of us on the outside looking in, is the company is seeking to reach an agreement in principle with pilots before this week’s regularly scheduled AMR Board of Director’s Meeting. 

I have participated in numerous troubled negotiations between management and labor, and taking time off because someone is tired prior to a deadline just does not make any sense.   Maybe the APA doesn’t think it is negotiating against a deadline.  I am also someone who knows a little bit about Board of Directors meetings and fiduciary duty, so if I was the APA, I would be taking Wednesday’s meeting seriously.

After all of the news, reviews and Wall Street’s muse over American’s financial blues I am guessing that AMR’s Board of Directors is feeling under pressure.  And Boards under investor pressure often feel the need to act.  As I wrote in American: Limited Options, Pain Likely, something at the Fort Worth, Texas carrier likely needs to give if no labor deals are reached – particularly a pilot deal that could serve as a template for other work group agreements.  The potential scenarios are, of course, bankruptcy, getting significantly smaller outside of bankruptcy or getting smaller inside of court-assisted restructuring.

Some of the messages I received on that piece suggested bankruptcy is an acceptable solution for American’s situation, particularly when dealing with the current management.  I think all of American’s union groups, and especially the pilots, should be very careful what they wish for.  Never forget the truism that it is probably best to deal with the devil you know.

The fact is employees at American still have their benefits, including pensions, because CEO Gerard Arpey chose not to use bankruptcy proceedings to cut costs the way everyone else in the industry did. Whether the unions like or dislike Arpey, though, is moot. If American files Chapter 11, creditors and the courts probably won’t let Arpey guide the airline during its time in bankruptcy.  They’ll want a restructuring guy, possibly in the mold of United’s Glenn Tilton, who turned his back on company history and acted in the best interests of financial capital, not employees to reposition the enterprise. That caused some serious labor/management relationship wounds.

American can survive labor discord as it has since Robert Crandall was in charge. I’m not as sure American comes out of bankruptcy unscathed – at least, not the American Airlines that we’ve known for the last 85 years. A much different airline would likely emerge, if at all, so emotionally-charged employees might rue their actions today.

Let’s review a few facts about bankruptcy and North American airlines.  Since 1991 there have been 14 airline bankruptcies and only one carrier remains a stand-alone airline today – financially troubled Air Canada.  Eight of the airlines have been liquidated or ceased operations:  Pan Am, TWA, Aloha, ATA, Skybus, EOS, Arrow and Mexicana (Eastern filed for bankruptcy in March of 1989 and ceased flying in January of 1991).  The remaining five airlines have been merged:  US Airways, United, Delta, Northwest and Frontier.

While the merged companies are stronger, they lost most – if not all - of their individual identity.  A merger partner with American in its current financial and labor condition is unlikely.  Private equity would only be interested in American after a deep cleansing of labor contracts in bankruptcy.  After all, even private equity wants clean fingernails when the entity emerges from court protection.

Union groups need to think long and hard about what that means for them. For American’s flight attendants and ground workers, a Chapter 11 filing would be the end of the world as they know it.

American’s flight attendants fly the least of any cabin crew in the U.S. airline industry. They currently pay less for medical coverage than their peers and still have pensions and retiree medical that are but faded memories for flight attendants at other carriers.

There are roughly 25,000 TWU members employed at American – mechanics, baggage handlers, cabin cleaners. A bankrupt American would dramatically slash that number, outsourcing a majority of jobs as much of the industry already does. Pensions, retiree medical – all gone. The reverberations would shake big cities like Miami and communities like Tulsa where the American maintenance base is the largest private corporate taxpayer.

Pilots like to think they’re different, more crucial to the operation, more prepared to handle anything that arises. That’s their job, and most are very, very good at what they do. The members at the Allied Pilots Association, though, should use the same reasoning and spend some time rethinking their position.

As MIT’s Airline Data Project shows, on average, American’s pilots are already making about two-percent more than their peers. The thing that should make pilots uneasy, though, is when you look at their benefits, which are worth about 40+ percent more than what pilots at other network carriers make. There is not a bankruptcy judge in the country who won’t immediately allow the company to toss all of that out the window.  It is not the wages per se; it is the benefit package and relatively poor productivity that makes the American pilot agreement uneconomic when compared to peer carriers. 

I’m not privy to what’s being talked about at the table between pilots and American, but the company is posting all of its proposals on its public web site, AANegotiations.com. From what I’ve seen, American’s current offers don’t dramatically change pilot benefits… they would still be significantly better than other carriers. What hasn’t been posted is any item on scope, and I’m sure the pilots would vehemently oppose any changes, no matter how necessary or warranted they might be.

If anyone on the APA Board foolishly thinks bankruptcy wouldn’t be so bad, they should review those facts I mentioned earlier. Besides the loss of pensions and work rules, a post-bankruptcy American would either be much smaller – meaning fewer pilots needed-- or prey to other airlines circling its carcass. If it’s plucked as a weak-sister acquisition, those APA pilots would most likely lose their seniority taking a backseat – or right seat – to their new colleagues.  And that assumes that acquiring airlines would even want former American employees – particularly in seniority order.

I could absolutely envision a U.S. airline industry without American.  Think of the value of the Heathrow slots, the LaGuardia slots, the JFK slots, the Washington National slots, the related real estate at each of the former, a ready-made Deep South America operation in Miami and an opportunity for network and low-cost carriers alike to finally get necessary real estate at Chicago O’Hare to mount a competitive operation.  American’s parts could be worth more than its whole to creditors and other airlines.

From a Board of Directors perspective, there are some basic facts to contend with. You cannot restructure the price of jet fuel.  Most, if not all, of American’s assets are pledged as collateral so little might be achieved in the airplane area other than rejecting certain leases on the oldest and most inefficient narrowbody fleet in the industry.  The company faces significant loan repayments and pension contributions.  In other words, AMR has every reason to file.

The pilots and the APA can belay that. They can be the leaders they think they are; not just for themselves, but for every other employee at American. Negotiating a deal now sends a signal to Wall Street, creditors and even consumers that things really can change. It also lessens the pressure on AMR’s Board of Directors to take a more active role in the company’s day-to-day dealings. Without it, the only pragmatic course for the Board would be to seriously examine its next steps. It can’t wait on the promise of a labor deal, especially if the APA mistakenly believes it has leverage and wants to try and use it.  Even if an agreement were reached today, it will be sometime in the first quarter of 2012 before the voting on a new agreement is concluded - that is why time is not on the side of the pilots and why AMR's Board is likely to grow restless if something does not happen soon.

Should a Chapter 11 restructuring end in Chapter 7 for some reason (a probability greater than 0 given that the company may be forced to cede control of its right to file a plan of reorganization), one can envision U.S. air transport system without American Airlines.  History suggests that the capacity void left will be filled in short order by the remaining players.  If a profitable hub opportunity exists for a remaining airline, it will be filled.  Will there need to be a hub at DFW?  No.  But there is plenty of local traffic to fill new service from existing airlines as well as Southwest at Love Field.  American’s aircraft order will likely be absorbed by the remaining carriers over the coming years to help fill the void left.

I just wrote “An Unpleasant Situation That Continually Repeats” last week that focused on unions thinking they know what is best for the company at both Qantas and Air Canada.  Maybe American was the sequel I was thinking about when I wrote that piece.  If that sequel includes bankruptcy, I know the story ends badly for the working men and women at American.  The rest of the industry will applaud the demise.

American: Limited Options, Pain Likely

Many readers have let me know that they are not as encouraged about the financial prospects of American Airlines with its massive aircraft order as I was in this piece. After all, the folks at AMR have problems beyond an ancient fleet, including an anemic revenue performance relative to the industry, high labor costs and all the other economic misery inflicted on many airlines in the past ten years.

I believe that AA’s aging fleet contributes some to the competitive disadvantage it suffers, and bright, shiny, fuel-efficient new planes will help impress customers and cut fuel and maintenance costs.  But what comes next?

Anxious analysts point to the fact that the price of oil impacts everyone, yet AA’s performance lags quarter after quarter. And there’s seemingly no significant movement yet in the airline’s labor negotiations, despite years at the bargaining table. With contract costs higher than anyone else in the industry, the company wants more productivity and smarter work rules in exchange for enhancements. All the while the unions have dug in either thinking or pretending that their righteous indignation will somehow turn the global economy and thus the industry around and recoup for labor all of losses in recent years.

American is one of the few carriers out there that didn’t turn to bankruptcy to shed some of these costs. In bankruptcy you cannot restructure the price of oil, but you can shed the leases of the least desirable aircraft, work with creditors to reduce debt and make changes to the labor agreements. But bankruptcy is probably not a realistic option now.

This is not 2002 with the shadow of 9/11 cast over the proceedings. This is not 2005 when the price of oil began its march upward and served as a catalyst for the bankruptcy filings of Northwest and Delta on the same day. 

No it is 2011, 10 years past the date that the country would like to forget.  Now, many airlines are flush with cash and don’t have the liquidity scares that were present when others filed. Many U.S. airlines are making money or at the very least are cash positive, despite jet fuel prices at the equivalent of a barrel of oil at $130. 

American, however, is on the wrong end of the industry today and some smart people question whether it will survive to see it’s much talked about long-term plans take wing.

So, let’s assume that Avondale Partners’ airline analyst Bob McAdoo was right in his May 16, 2011 analysis that American simply needs to shed capacity.  McAdoo cited US Airways as an example, where new management culled 20 percent of jet capacity.  But what he did not figure in is the likely relief American would need from its pilots union to make that kind of correction possible. More on that later.

American still relies on its regional partners to fly 37 and 44 seat jets because they are part of the pilot contract’s “scope” equation that determines the number of larger regional jets American can fly.  A 20 percent reduction in flying, much of it on long haul wide body routes flown by senior crews, would likely result in a furlough of up to another 1,500 pilots.  But American can’t do that either because of the same contract provisions that say American cannot drop below 7,200 pilots on the active roster.  And that doesn’t even take into consideration what the other union groups may have in their contracts that prevent the company from making the kind of changes that may be necessary to save the airline.

So what choice does American Airlines have?  Cutting that much capacity will be extremely painful for employees, and could put at least an additional 11,000 other American Airlines workers on the furlough list and in the unemployment line.  Cutting that much capacity would also redraw American’s network and route structure as we know it, giving its competitors greater strength in some cities and markets where American’s presence would dwindle or disappear.

McAdoo’s analysis calls for American to pull down certain Chicago to London flying; cut flights to Buenos Aires from multiple AA gateways; eliminate service to India;  reduce by half the flights from Chicago to China; and trim transcon service between JFK, Los Angeles and San Francisco.

McAdoo also challenges American’s “Cornerstone Strategy.”  In addition to flying a money-losing route between London Heathrow and Los Angeles, American is building its LAX presence using those inefficient, small regional jet aircraft. The same is true at Chicago and New York JFK.  In McAdoo’s view, Chicago is too dependent on connecting traffic at fares that are not compensatory.  Further he claims that in many instances, Chicago and Dallas/Ft Worth compete for many of same passengers connecting to points east and west and internationally and therefore are redundant service. 

Maybe it is time to de-emphasize LAX because the mix of traffic makes profitability difficult.  Maybe it is time to pull out of O’Hare because de-leveraging a hub is tricky particularly with an aggressive United hubbing in the same market.  Honestly, the only real big bang [removing fixed costs] American may have left is to massacre a hub like Chicago the way US Airways did to Pittsburgh and Delta did to Dallas/Ft. Worth.  The bigger the hub takedown, the bigger the fixed cost savings.

As for New York, American is now third in the market behind Continental at Newark and Delta at JFK and offers less connecting service than does Delta at JFK.  American’s relationship with jetBlue was supposed to address some of these competitive disadvantages but, as McAdoo points out, one can look a long time before finding many jetBlue to American connections in the various distribution systems. 

In the local New York market, AMR’s revenue per seat mile is underperforming when compared to peers at JFK and Newark.  Maybe it is time for American to pull out of JFK except for some select Trans-Atlantic flying, select transcon flying, and turn the rest of the region’s feed over the jetBlue.  But oneworld is depending on American to make New York the best market it can be for the alliance so this would be harder to do.  In fact with more 70-seat aircraft American could actually become more competitive there.  That would, again, depend on the pilot union’s willingness to do the right thing.

There is no doubt that a 20 percent cut in capacity would cause significant pain at American, even if it might be absolutely necessary to address the airline’s structural problems. But what if the cuts go even deeper?  What will be the impact on necessary American Eagle capacity that American has contracted for in the new Air Services Agreement?  If there is no Eagle feed, then there is no need for many mainline aircraft now dependent on the flow from points of all sizes behind and beyond the hub.  The virtuous circle spirals downward. 

At that point, American’s Cornerstone Strategy will be more about Dallas/Ft Worth, Miami and a little New York JFK and Los Angeles.  And the labor savings will come simply by cutting headcount.

To be clear, McAdoo says very clearly that labor costs are not the main driver of American’s weak results.  “Stopping the long haul bleeding has more direct leverage than trying to offset the losses by squeezing labor,” he said.  But in this scenario, labor is a large component of the fixed costs shed.

And on a strict profitability analysis, McAdoo may be right.  But contractual restrictions like pilot scope clauses – and American’s pilot scope clause is the most restrictive of network carriers – hamstring the company from making necessary tactical and strategic decisions. It is pretty clear that that American would not be flying as many mainline 136-seat aircraft today if it were able to utilize 70 seat aircraft like its competitors.  If that were the case, we may not be having this discussion.  And American Eagle would certainly not be flying 37 and 44 seat configurations in today’s fuel environment if not for the mainline pilot scope clause.

These small aircraft, “scope busters” to their critics, are used for many reasons and in this case they are used to average down the seat size of the regional fleet so that larger aircraft can be flown.  By the way, the competition flies 70-seat aircraft at will, primarily with the borders of the contiguous United States.  They can compete on frequency because they have right sized aircraft.  American does not.  Remember CALite?

Those who suggest that there is no labor problem at American should look no farther than the pilot agreement.  Among other common-sense adjustments, either American needs relief from that scope agreement in order that it can compete on equal footing with its domestic peers and provide the U.S. network feed to its oneworld partners that they demand, or the Allied Pilots Association needs to negotiate a regional-like contract for domestic flying as the A319s are delivered.  I wrote about these two options in March 2010 when I asked:  Mainline Pilot Scope: Will Regional Carriers Be Permitted to Fly 90+ Seat Aircraft?

It is unlikely that management at other airlines are going to make any deals that drive up their own labor costs only to have to go back and ask for relief later.

So there is not likely going to be the kind of labor cost convergence American hopes for in this round of negotiations; therefore, American may still have a labor cost disadvantage relative to the industry, particularly on productivity and benefits and scope.  This coupled with continuing economic challenges and pressure from investors and analysts will necessarily limit the extent to which American can sweeten its contract proposals to buy labor peace.  Purchasing labor peace only exacerbates the Ft. Worth carrier’s problems.

By all appearances, even the National Mediation Board recognizes that American does not have the money to satisfy the inflated demands of the unions that seem unwilling to discuss anything that smacks of a concession.

The upshot is that the unions at American may want to think hard about a draw-a-line-in-the-sand strategy that has done nothing but contribute to the airline’s under-performance. The contracts have to be part of an overall plan to get American out of the financial doldrums if the company is going to be able to execute the kind of financial and operational maneuvering that is absolutely necessary to win back the hearts and minds of the investment community – let alone customers and alliance partners.

A failure to make strategic, forward-looking agreements at the negotiations table now could have ramifications well beyond the individual contracts.  And there’s not a lot of time to waste in the process.  With limited options, the structural changes will prove painful.  

Global Distribution Systems and the Pretense of Consumer Protection?

This past weekend, I found myself immersed in the messy divorce between airlines and the Global Distribution Systems (GDS) that used to be their “partners”.

In this case, I was looking at complaints filed by American Airlines and US Airways against Sabre and related companies, and then Sabre’s and Travelport’s complaints against American Airlines.  Readers know that I believe this is one of the more transformational events in the industry and I finally found the time to read in detail each party’s take on an increasingly tense situation.

In coming weeks, this fight is likely to again come to the fore.  The story is about monopolies and not market power. 

There is no elevator speech on this topic.  Within the industry, it’s all inside baseball. To the outsider, it’s incredibly obscure. But here’s the crux of the matter:  American, US Airways and other airlines are trying to retake their inventory from the GDSs that have for years listed their flights and taken a piece of the ticket price. 

What the airline’s want, in other words, is broader competition through an alternative mechanism to sell airplane seats and other travel related products – not to eliminate the GDSs.  

After all, airlines understand competition. Airlines understand fragmented markets.  Airlines understand pricing dictated by competition and macro economics, and monopolies and duopolies of vendor industries.  There is no global airline company with more than a 7 percent market share.  Even the top 10 airlines in the world together have less than a 40 percent share of global capacity. 

But when it comes to the GDSs, it is a different story.  Sixty percent of airline tickets are sold through travel agents and it is this sector of the industry that is ripe for competition.  According to MIDT data today, three players dominate the field in the U.S.: Sabre with 58% of the market; Travelport with 33%; and Amadeus with 10%. 

Travel agents make money by using the GDSs. The contracts between the vendor and the agent impose such significant switching costs that the financial penalty is too steep for most agents to consider an alternative booking channel.

As US Airways wrote in its complaint, the American Society of Travel Agents confirms the industry’s dependence on the legacy GDSs.  As of the end of 2009, 85.7 percent of travel agencies use only one GDS.  94.9 percent of travel agents using a GDS have not changed their GDS provider in the last two years and a remarkable 86.7 percent of agents are using the same primary GDS that they were seven years ago when the GDS industry was deregulated.    

As a business model, the GDSs are more about suppressing competition than spurring innovation.  Seven years after deregulation, barriers to entry in the GDS space have blocked all new competition. Contrast that with the domestic aviation market where low cost carriers now fly more than 31 percent of ASMs flown.

Market power is a seller's ability to exercise some control over the price it charges. In our economy, few firms see perfectly elastic demand. All products have a differentiation, whether due to consumer tastes, seller reputation, or location, as with airlines that convey upon a seller some degree of pricing power. Thus, a small degree of market power is common and understood not to warrant antitrust intervention.

Market power and monopoly power are related but not the same. The Supreme Court has defined market power as "the ability to raise prices above those that would be charged in a competitive market," and monopoly power as "the power to control prices or exclude competition."  In many markets, but not all, airlines do have market power in that they are able to set revenue in excess of marginal cost.  The last thing they are is monopolists as they have no ability to control prices or exclude competition.

In its complaint against American, Sabre makes a feeble and even laughable attempt to point to American’s monopoly power over certain routes at Dallas/Ft. Worth, Chicago O’Hare and Miami.  Sabre goes so far as to name non-hub cities like Abilene,TX; Augusta, GA; Brownsville, TX; Champaign, IL; and Dubuque, IA as city pair markets where American has monopoly power.  But it is simply wrong to suggest these cities are examples of monopolies, when each is blessed (given their population and underlying demographics) to have entry into the nation’s air transportation grid and each faces some direct or indirect competition. It is just as wrong to suggest that American has no competition on its Augusta GA to Dallas/Ft. Worth route when Delta flies those skies multiple times a day. 

This is a network business and American Airlines holds a 15.2 percent share and US Airways 9.6 percent of capacity in the domestic network market. In fact, the top five airline competitors hold an 80 percent market share in the U.S. domestic market, with the largest carrier, Delta, garnering a 20.1 percent share of ASMs.  This is a far cry from Sabre’s 58 percent share of the U.S. GDS market and that three firms have 100 percent of the U.S. domestic market.

To read the GDS’ complaints, you would think that we’re back in 1978 when schedule and price were the only consumer consideration. Thirty-three years later the GDSs still force the airlines to compete only on two factors; schedule and price. By limiting how airlines compete, the product is the definition of a pure commodity.  

After all, Southwest does not turn its inventory over to the GDSs. How can you have a discussion on price and service without Southwest – which now competes in markets that account for 95% of domestic demand – as part of the dialogue?

GDS advocate Kevin Mitchell, Chairman of the Business Travel Coalition (BTC) has a questionable take on the issue.  In Sabre’s complaint, Mitchell says: “The stakes in this conflict are clear: either an improved airline industry and distribution marketplace centered around the consumer, or one that subordinates consumer interests to the self-serving motivations of individual airlines endeavoring to shift costs and impose their wills on consumers and the other participants in the travel industry.”

He’s right on one point: the stakes are clear.  This is a battle about an improved airline industry – one that is sustainable over the long term; and a distribution marketplace centered on the consumer. But that’s only going to happen when the airlines have control over their own inventory.  Only when airlines have the ability to package their product based on their knowledge of consumer behavior will it become all about the consumer.  To protect and advocate for the GDSs in fact subordinates consumer interests because this legacy distribution vehicle does nothing but thwart competition and stifle innovation. 

Perhaps it is OK with the GDSs and the BTC that shifting (cutting) labor costs in bankruptcy was an appropriate strategy as long as the annuity from the airlines to the GDSs to the travel agents was not affected.  But that assumes an annuity in perpetuity, and fewer and fewer of those exist in today’s airline business. The business of the GDSs can be done cheaper and better by those with technology younger than 1960.  What the GDSs and the BTC claim is an entitlement is anti-competitive at its core.

Mitchell also proclaims to be a consumer advocate.  Remember it was he and Kate Hanni who teamed to advocate for the three hour tarmac delay rule which, with the help of the gullible Secretary of Transportation Ray LaHood, purported to “protect the rights” of some fraction of one percent of all passengers.  Today he supports a monopoly making its money off of 60 percent of air travel consumers.  Now it is Mitchell who rails against what he calls “Hidden Fees” like seat upgrades, baggage fees, and charges for pillows and blankets to name a few of the 16 specific revenue items the Department of Transportation wants the airlines to report.

This, keep in mind, 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 in the first place.

The airline industry already pays more than its share of taxes and fees.  But if it is transparency of “hidden fees” that the regulators (and Mitchell) want, then I as a passenger also want to know how much of my ticket price goes to the GDSs just as I want to know how taxes on my airline ticket are disseminated to various government agencies. 

To me GDS fees and taxes are similar as they both support legacy interests/ideals – some might argue outmoded models -- without any meaningful return to the airlines. That said, there remains an ongoing need for GDSs, particularly with respect to the support they provide to the thousands of travel agencies worldwide and to their international reach.

Today, the GDS industry earns $7 billion in revenue with no product other than the airlines own schedules and prices.  Is that innovation?  Some estimate that the work of the legacy GDSs could be done for 20 cents on the dollar.  That’s a lot of money spent on something that belies innovation.

The GDS role was relevant until about 2002 when market share was the name of the game.  Now the industry is focused on profits.  In fact, this is an industry that would have lost money in 2010 if not for the fees that Mitchell decries.  The GDSs need time to develop the software necessary for it to “up sell” better seats on US Airways.  Imagine how long it will take for the legacy GDS systems to account for 16 fee buckets as defined by the Department of Transportation (a potential new regulatory requirement).

But Mitchell bangs the consumer drum while advocating for an industry serving the airline industry that has monopoly powers over the very companies it calls customers.  

Concluding Thoughts

According to the U.S. Department of Justice (DOJ), “U.S. antitrust laws reflect a national commitment to the use of free markets to allocate resources efficiently and to spur the innovation that is the principal source of economic growth.”  Today’s GDS industry, circa 1960, represents anything but free markets or innovation.  Rather is about protecting a monopoly revenue stream at the expense of allowing the consumer to customize the travel experience depending on their wants and needs.

According to the US Airways complaint, the DOT made four assumptions when the GDS industry was deregulated: 

1) Airline divestiture of their interests in the GDSs made it less likely that a GDS would favor one airline over another;

2) Forthcoming technological changes – including online, direct-to-consumer ticket sales – would operate as a check on the market power of the GDSs;

3) Airlines’ ability to control access to their own content, including webfares and other discounts offered through an airline’s own website or select distribution channels – would reduce the GDSs market power; and

4) Vigorous anti-trust enforcement would help ensure competitive markets.

No matter how well-meaning those assumptions, they haven’t held water largely because of the power of the legacy GDS industry. So perhaps it is high time that the DOJ file suit against the GDS industry.  Why is it OK that Amazon.com is able to offer recommended products to consumers based on past purchase behavior and the airlines cannot?  Why can the consumer pick from a variety of offerings when picking a cable television or cellular phone plan but is so limited in options for air travel purchases?   

Today, all the consumer can do when buying from a travel agent is to make the purchase decision based on service and price.  Limiting indeed.

We desperately need an industry correction that allows a natural evolution in business practices so the free market can work.  A DOJ suit may achieve that.  Free competition will spur the innovation that anti-trust laws are designed to promote.  A DOJ suit may do that.  When competition wins, the consumer wins.  When innovation is allowed, the consumer wins.  Don’t be fooled by the GDS industry and its supporters hiding behind hidden fees; the consumer has no idea how much it already pays to an industry that stifles competition each and every day.   The biggest thing hidden there is the opportunity cost imposed by the GDS industry that would rather direct consumer’s attention elsewhere.

Thinking About American’s Contrarian Path to Transformation

The list is long of those kicking American Airlines for not producing near-term results because that is, after all, what Wall Street wants and needs.  Wall Street’s lead striker and headline maker has been Jamie Baker, airline equity analyst at JP Morgan Chase.  Baker was quoted in a Wall Street Journal story last week saying AMR's poor financial results and worsening margin deficit raises questions about the wisdom of a giant aircraft purchase. He said,  “We cannot reconcile spending incremental capital while failing to earn returns on [the] existing capital base.”

It was Baker who, on a company earnings call that outlined some near-term strategies to address American’s underperformance, first asked AMR executives, “Is that all you got?”  In the WSJ story referenced above, Baker stated “we think the best thing AMR can do is figure out a way to generate more profitable flying with the current fleet." 

Jamie, is that all you got?

Baker and much of Wall Street’s short-sightedness is perplexing, even for a group that has a hard time seeing six months ahead.  I agree American’s quarterly revenue performance relative to peers was disappointing and concerning, as pointed out by Bank of America/Merrill Lynch analyst Glenn Engel. The point I think the Street is missing is American’s re-fleeting isn’t about six months from now or even next year. It’s about transforming a Robert Crandall vintage 1983 airline spending nary a dime. 

American’s MD80 fleet has basically been around since the earth cooled.  And it shows.  American flies more small narrowbody aircraft (150 seats and less) than any network carrier except for Southwest.  In 2009 (2010 data incomplete/incorrect) it’s the fuel guzzling, maintenance intense 140 seat per aircraft fleet flies about 9.7 hours per day (less than its peers); with an average stage length of 870 miles (about the same as its peers); and less than 4 departures per day (less than its peers).  More importantly, on those missions, the fleet burns 957 gallons of jet fuel per block hour – the same amount of burn as in 1995 when jet fuel was 56 cents per gallon – not $3.00+ per gallon.  No airline, except for maybe portions of Delta’s fleet, has to keep more spares available to maintain some sort of schedule integrity and thus have the potential for more operating leverage than American from a re-fleeting order.

And yet Baker and Wall Street want American to do more with less than its industry peers?  Maybe – and this isn’t a stretch - that aging fleet contributes to some to the airline’s under performance?  I’d say yes even though it’s difficult to quantify and I like my numbers cold and hard.  Perhaps most puzzling is the Street never offers a better time to re-fleet. When was it supposed to take place?  When it was too late and even more spares would have been required to maintain some semblance of a schedule?  That might have slaked some analysts’ thirst for capacity cuts, but that type of cutting is eerily close to shuttering an airline… and more expensive than marginal revenue improvements might lead you to believe.

Let’s Think About This Aircraft Order

American is not alone.  All of the industry, especially the more mature United, US Airways, Delta and Southwest – yes Southwest - all face some sort of replacement order.  It is just that American has a more real-time issue than do those that effectively used bankruptcy – not Southwest - and other means to get rid of aircraft with poor operating economics.  I am not being self-righteous… bankruptcy was necessary to address many legacy issues that would have buried others in the airline graveyard.  Fleet replacement is not like going to the store and grabbing something off the shelf.  Long lead times define aircraft purchases. 

What is wrong with placing an order at the bottom of the cycle versus the top of the cycle? It's a long-standing industry practice to do the opposite. It’s been a proven recipe for bad economics by adding capacity during a weakening economy that only leads to even poorer results. This quarter was less about writing down results than communicating a contrarian message – a re-fleeting announcement.  The rest of the industry, along with American, has been engaged in balance sheet repair over the past two years. 

The Street immediately pointed to the increased financial leverage associated with the new order and the fact that even though American will finance the first 230 aircraft with operating leases there will be a need to adjust upward the Fort Worth carrier’s debt by seven times the lease cost to reflect the long term commitment stemming from the lease financing negotiated with Boeing and Airbus. American’s hard won terms with the manufacturers does little to nothing to impact the company’s near term liquidity.  There is nothing to stop American from further balance sheet repair should operating results improve over the next five years as the first 230 aircraft are delivered.

Keep in mind, this order isn’t just about American. It’s also very much about Boeing and Airbus. They’ve thrown their balance sheets on the table as well, betting on American’s strategy and willing to take on the cost of building planes with no cash up front. That doesn’t normally happen in the airline industry. That’s serious backing and just how much of a deal both manufacturers gave American could very well be a game changer.

This Order Is About Both Finance and Competitive Positioning

When comparing American’s small narrowbody economics with Continental’s, American burns 262 more gallons per block hour than does the newly Chicago-based carrier.  I use Continental because its fleet is the most modern among the network carriers. Let’s not forget Continental began its re-fleeting project at the bottom of a profit cycle beginning in 1995 upon exiting bankruptcy #2. At 10 hours per day per month and with fuel assumed to be $3 per gallon, American’s new planes would immediately save $236,000 per month per airplane in fuel costs versus its MD80 fleet.  For every 10 cent increase in the cost of jet fuel, American would save an additional $8,000 per month per aircraft.

Few fleets have realized maintenance cost increases like American’s narrowbodies over the past decade.  I appreciate there are many ways to pay for maintenance expenses across the life of an aircraft, but during the honeymoon period of 5-10 years, American will, at least, not be paying $600 per block hour just to keep its MD80s in the air.  Instead it will likely save about $400-450 per hour.  Using the same calculus as in fuel savings, that saves the company another $135,000 per month per aircraft.

Yes, American still has to pay for the airplanes. As a general rule, the lease cost of an airplane is one percent of the sticker price.  If the retail cost of the various airplanes is $40 million per copy, then the lease cost is somewhere around $400,000 per month.  The fuel and maintenance savings are estimated at $370,000 per airplane per month. 

But wait a minute. We know that American did not pay retail for the airplanes.  Reuters reported American will only pay 70 percent of the list price on the Airbus equipment.  Airbus disputes that and I normally don’t believe numbers bantered around in the press, so let’s split the difference. Assume American is paying 85 percent of sticker price.  That brings the operating lease cost of the first 230 airplanes to $340,000 per month.  Even Wall Street can do this math.  If the planes cost $340,000 per month and the potential exists to save $370,000 per plane per month (and we haven’t talked about ancillary revenue possibilities from IFE, crew cost efficiencies from a simpler fleet once complexity costs are addressed, crew cost savings from a more reliable fleet, new passenger acceptance of a modern fleet etc), all of a sudden, American’s income statement and thus its balance sheet looks much different.

Is The Fleet Order Itself Transformational?

In a word, no.  Or maybe, sort of. The fleet is transformed, but that alone doesn’t necessarily transform the way American works today.  What would make this order even more exciting is to see a pilot agreement that really is transformational and recognizes the sub optimum economics of the U.S. domestic market.  What if the pilots were to negotiate pay banding, training language that does not create a bubble and benefit packages better resembling what corporate America provides its employees?  That would really make things interesting.  Problem is, those are all long-term realizations, which makes no one in New York any happier than they are today.

Another benefit from a pilot deal that could be labor transformational is to break the current regional – mainline mold.  If the economics of the smaller mainline airplanes (pilots, flight attendants and airplane) just ordered can match the economics of the largest regional jet airplanes out there, then much of the discussion over scope just might be over.  American needs access to more 76 seat aircraft (existing scope relief) with two class service, but the ask of the mainline pilots would not be further relief into the 90 and 120 seat range – unless of course there is no headway with APA making necessary changes.

Another thing to consider is, if some of the new planes are less efficient than even newer models or the price of oil goes significantly higher, the leasing options let American re-fleet the re-fleet.

Odds and Ends

Some say that American’s transatlantic partners are not the same airlines today as they were in yesteryear – namely British Airways.  That may be true in some respects, but either way, 1 + 1 is greater than 1 and that addresses those that believe American and their London counterpart are but half of their previous selves.  It was nice to read BA’s earnings release Wednesday morning citing improved traffic flows from American.  That will only continue to get better.  Realizing the full benefits of the joint business agreements is transformational for American as it evolves from a single entity into a much broader network.

But the most important fight taking place to transform American – and the industry for that matter – is the fight with the Global Distribution Systems.  Imagine the revenue benefits that will accrue to American in addition to just passenger revenue if they are able to package the product for the individual consumer.  If they are successful in breaking the monopolistic practices and reclaim their inventory – now that is transformational.

Taken together, there are some interesting possibilities taking shape in Fort Worth, Texas.  What needs to take shape immediately are the unit revenue benefits supposedly coming from the cornerstone strategy.  As analysts have correctly pointed out, that hasn't happened yet, which might explain the Street’s shortsightedness about other things American.

Look, I’ve been teasingly picking on Baker, Keay (indirectly) and Wall Street types. I realize their job is gauging the near-term forecast for clients.  But we’ve gotten so wrapped-up in Street predictions and instant opinions we’ve forgotten long-term, especially in the airline industry, like January 2015. American is resetting itself with a bold move that, honestly, shocked competitors and analysts. It deserves credit for making an astounding and first comer economic deal. Whether it works won’t be known 24 months (or five years given the jet fuel price) from now or even possibly 72 months.

But I doubt anyone is going to be asking if that’s all American’s got anytime soon.

To The GDS's: Either Evolve Or Dissolve -- It's That Simple

In the March 12 Economics column of The New York Times, University of Chicago economist Richard Thaler correctly titles his piece as it pertains to the airline industry:  “This Data Isn’t Dull. It Improves Lives.” The column then goes on to distort the intentions of the airline industry. 

At the heart of the matter is the relationship of the airline industry to the Global Distribution Systems (GDS).  Every time an air travel consumer works with a travel agency, the information being supplied by the agent is likely provided by a GDS.  The data necessary to enable the agent is supplied by the airlines to the GDS.   

In the early years following deregulation of the airline industry, GDS were largely owned by airlines and used to provide information to intermediaries to sell tickets on particular carriers.  The systems were biased toward the airline(s) providing the technology to the travel industry community.  These massive networks were built using the technology prevalent at the time – prior to the advent of the internet – and GDS were compensated for providing and maintaining vast private networks and for acting as gatekeepers between agents and airlines.

In fairly short order, the government stepped in to regulate the bias.  As a result, the GDS were no longer a distribution tool aiding the airline(s) that invested in the technology directly; rather they became a tool of the travel industry to sell a service.  Today, the airlines pay an intermediary to distribute their product – and they are paying a price much higher than the prevalent transaction costs. The airlines’ costs reflect an outdated model replete with older and more expensive technology as the GDS fight to sustain their large networks and maintain their role as gatekeeper.

But the intermediaries don’t pay the airlines for the airline-created content they use to lure customers to their respective websites so they can sell hotel stays and rental cars.  It makes no sense.

Name a financially successful industry that turns over control of its inventory to an intermediary. I can’t think of one either.

Airline travel is now available for purchase on multiple channels via the internet, including through the airlines’ own websites. Those sites typically provide carriers with the most control over the shopping experience while also being the lowest cost channel for the transaction. It is simply much cheaper and more efficient to use newer, internet –based technology to distribute tickets without the need for a “gatekeeper” between airlines and agents.   

Now the airlines also want to be able to go directly to their customers via their own channel.  Not that the airlines do not value the higher yield business that comes from agencies.  The motive is not, as some detractors have said, because airlines want you only to shop at their sites or not reveal what the cost of a trip is if you check two bags.  Rather, airlines are looking for ways to differentiate themselves by offering additional products and services to their customers that enhance the travel experience. This information is something the GDS cannot provide today without a significant investment in their systems.

Duopolists are typically reluctant to invest new capital unless it is absolutely essential to protect its cash cow

The airlines don’t necessarily want - or need – to drive all transactions to their sites and there is still a role GDS can play in this process. GDS could be content aggregators, allowing customers to easily compare fares. Right now, though, that’s a role GDS seems unwilling to take on perhaps worried about risking their fees.  

There are other factors at play here as well. First, airlines know their particular customers better than the government or the GDS. Plus; the GDS haven’t evolved as the industry has dramatically changed.  

Today’s GDS force the airlines to compete only on two factors; service and price. By limiting areas how airlines compete, the product offered is the definition of pure commodity. This was true in 1983 just as it is today. 

Despite the airline industry’s efforts to remove more than $20 billion in expenses over the past decade, the price of another commodity essential to its business increased more than fourfold – oil.  The airline industry is left with little choice, if it is to ever be a sustainable business, but to begin the process of de-commoditizing its product and finding new revenue sources.  To do so, means fundamentally altering its legacy relationship with the GDS and recapturing control over its inventory.

The airline industry has found new ways to generate revenue by offering customers products they value and are willing to pay for, including seat upgrades, passing through security faster or day passes to airport clubs. Bag fees, now charged by the majority of U.S. carriers, reflect a more accurate way to pay for what you use. In other words, customers that don’t check bags no longer subsidize the cost of those who do.  

Yet the GDS and supporters claim airlines aren’t being “transparent” in their pricing that they do not want to reveal the total cost of trip to a passenger.  Few industries have price transparency like the airline industry – compare it to cell phone contracts – and the majority of customers know exactly what they’re paying for when they travel.

Thaler is right; the data supplied to the GDS is anything but dull and service and price competition have benefited many by making air travel affordable to the masses. This will certainly continue as the competition is as hungry today as ever.

This is not a fight about defending the purity of data or somehow withholding it from those whose only aim is to presumably help customers. No one, including the GDS, can really dispute that this information comes from the airlines.

Despite the rhetoric, it’s also not about protecting customers from an industry desperate to reach more. This is about protecting an outdated mode of operation and stifling innovation.  The GDS duopoly cannot move fast enough for an industry that sells “time saved”.  The GDS doesn’t want its revenue tap turned off. It’s time the GDS recognizes it can’t support interests other than their ultimate customer – the airlines.  The airlines are simply looking to adapt to new economic realities and help their ultimate customer – the person who actually buys a ticket.

Duopolist.  Monopolist.  Neither is accepted in the airline business.  Now the airline business says it is time that vendors servicing the airline industry cannot be duopolists or monopolists either.  It is all part of the evolution of the business that began in 2002. 

Unbundling, Rebundling and Now De-Commoditization

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Let the restructuring continue.

Time to Rethink the Virtuous Circle

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

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

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

Industry Eyes on American

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

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

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

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

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

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

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

Concluding Thoughts

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

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

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