Republic Pilots: Forget the Leaks and Prepare to Change Vessels

Since writing the last blog titled “A Race to the Bottom,” I have received a lot of mail, much of it critical.  Many readers wrote about the ratification votes on tentative agreements for pilots taking place at American Eagle/Envoy and Republic.  After a heavy travel schedule, I finally got around to perusing my e-mailbox.

I have long challenged the approach of the Airline Pilots Association (ALPA) and other collective bargaining agents on the mainline-regional relationship, so the last post should not have come as a surprise.  Simply put, the relationship needs fixing but the fix is not going to come from one pilot group voting down a contract in the false hope that a “pilot shortage” will resolve differences between regional carriers and the unions representing pilots. The only fix will come with a far more strategic effort on the part of many industry stakeholders – management, labor unions, universities, Congress and the regulators.  

Consider the Republic situation. I’m hearing rumors of a concerted “Vote No” campaign intended to put the screws on management and extract more money. Based on my analysis of the industry, Republic pilots should take a step back and think long and hard about that approach. Republic is well-positioned to be a major player in the US domestic airline industry of tomorrow – an industry that will look much different than it does today.  So what is important in the interim is to negotiate the very best agreement – one that addresses the makeup of a carrier’s seniority list today and ensures pilots a seat at the table looking forward.

What I like about Republic’s tentative agreement are things that address the future like an early re-opener.  It calls for a four-year contract, allowing for adjustments when the contract is amendable at just about the time we’ll start to see significant changes in the industry. The TA also paves the way for what appears to be a more open relationship with the company to address scheduling and operations. These issues are critical to running the very best regional airline possible.  American and Envoy took a different approach – an approach some call concessionary whereas Republic is offering improvements.

SENIORITY DIFFERENCES

There are, of course, profound seniority differences between Envoy and Republic. Envoy is a “Legacy Regional” because of its relatively high seniority, while Republic’s seniority makeup is quite different.  Among the many difficulties network legacy carriers faced in negotiating labor agreements in bankruptcy, seniority issues more than any other exacerbated the problem of cutting costs to compete with lower cost carriers.  As I have said over and over, you cannot restructure seniority.  Envoy took one approach in negotiating a way around seniority by significantly improving the flow through agreement with American.

Republic has gone another route by negotiating the very best pilot agreement it believes it can afford over the next four years taking into account the progression through the pay scales.  Affordability matters. Republic is currently performing flying under contracts negotiated with mainline partners before this new pilot agreement was negotiated.  Because those terms are set, increased pilot costs only degrade the airline’s margins.

It’s all about balance.   Capacity purchase agreements are a reality for now, no matter how outdated the model, so the most realistic remedy is to accept that as fact and improve the situation one step at a time.

THE NATIONAL MEDIATION BOARD

I can hear the battle cries now:  the NMB will release us and allow us to strike.  Republic pilots will say that, after seven years of negotiations the agreement is simply unacceptable. But the union(s) should understand that the threat of a strike is not what it was 15 years ago.  The NMB would be hard pressed to make a case to the White House that a sector-leading agreement in many important economic areas is not a good outcome and therefore allow the pilots to engage in a work action.

And, yes, commerce would be disrupted. Regional airlines provide the only air access for hundreds of smaller communities, making it even more unlikely that the NMB would grant a release.  [Being remanded back to mediation only prolongs a process already gone too long] Consolidation in the mainline sector only compounds this factor as there is no longer sufficient capacity to accommodate the disenfranchised demand that would result from a work stoppage.

Yes it may be true that smaller cities could in the future lose air service in part because of a shortage of pilots willing to work for the regional carriers, but that argument would not outweigh the risks of a strike today. Are regional pilot salaries too low? Based on the education and skills required for the job, I think the clear answer is yes. But at a time the administration is focused on truly low wage workers and income inequality, it is highly unlikely that the White House would allow this issue to distract from its efforts to raise the minimum wage and allow a work action that could bring more financial pain to areas already punished by a weak economy.

So Republic pilots should perhaps think twice about the conditions for this particular battle and instead focus on the bigger picture and positioning for the future.

A SECTOR IN FLUX WITH THE POTENTIAL TO BE SIGNIFICANT

I’ve been putting a lot of thought into this subject, in part to prepare for a presentation I gave last week on what the North American airline industry will look like in 2025.  Projections this far out are never easy, particularly in a business in which long-term planning is too often viewed as planning for the next month.  I gave it a go, however, and came down on the side of today’s freight railroad industry.  This is an industry that has a created a blueprint for sustainability that began with the passage of the Staggers Act and the departure of large railroads from their non-core businesses like passenger rail. 

I see the Big Three airlines soon shedding small market service as it becomes less and less a part of their core business.  If Southwest can influence more than 95 percent of demand by serving just a fraction of the markets served by the network carriers, so too can American, Delta and United who will concentrate their service on the nation’s top 100 or so markets along with transoceanic flying. 

As costs creep up at the largest airlines, serving more markets won’t make economic sense, whether they do it themselves or in conjunction with a partner airline. Capacity purchase agreements won’t go away, but it is likely that carriers in today’s regional sector will become hybrid carriers that offer service to many markets the mainline carriers vacate.

THE NAYSAYERS

I fully expect that naysayers will take a page out of an antiquated playbook to say that the economics will suddenly improve because the network carriers will “fix” agreements in place with their regional partners.  As Lee Corso says every Saturday on ESPN’s College Gameday as the group picks winners and losers:  “Not so fast.”  You won’t hear it from the network carriers because it wouldn’t be politically astute for them to say it out loud, but my guess is that they would be very happy to begin exiting many of the small markets they now serve.

You don’t have to look too far to appreciate this fact as nearly every hub that has, or had, regional fleets as the backbone of its flying are now disbanded.  Delta is trending away from 50-seat aircraft as quickly as it can in exchange for larger 76-seat and B717 aircraft for service to its smaller markets.  Whereas in the past the network carriers would participate in subsidized Essential Air Service flying, that trend is dying. American will surely park the “scope-buster fleet” at Envoy.  That leaves United which, in the midst of a $2 billion cost-cutting exercise, will certainly be looking hard at the billions of dollars it spends on regional lift and questioning how much is too much.

There is nothing in the data or the trend lines to suggest that legacy carriers will be willing to change the terms of existing capacity purchase agreements just because the economics of regional carrier labor agreement need fixing. These trends do, however, suggest that the regional sector as we know it will be smaller and that will mitigate some of the pilot shortage concerns in the short-term.  The medium and long-term are another story but that is not going to get fixed in this round or address the pending problem of putting a qualified supply of pilots into the commercial airline pipeline. 

SURVIVORS AND LOSERS

I see two big winners in the regional sector in 2025: Republic and SkyWest, in part because of their commitment to running the very best regional airlines.  Yes, Envoy and the former US Airways’ wholly-owned carriers may evolve as stand-alone airlines, but their success is uncertain.

Republic and a SkyWest, by contrast, can successfully transition as hybrid carriers, much like Class II railroads did.  Think airlines with multiple code share agreements on the same flight.  At-risk flying will be more the norm. There will be capacity purchase agreements with the network carriers, albeit fewer, but only for those who demonstrate a track record of reliable service. Republic and SkyWest have that record where a carrier like Mesa does not. Ultimately, it will be Republic – assuming it can move forward with a new pilot agreement - and SkyWest who command the markets too small to be big enough for network carrier’s mainline aircraft.

CONCLUDING THOUGHTS

Warren Buffet said:  “In a chronically leaking boat, energy devoted to changing vessels is more productive than energy devoted to patching leaks.”  Republic pilots who vote “no” on the current tentative agreement to protest realities of the market are doing nothing more than trying to patch leaks, and not successfully. The sector is changing and will change and the best energy now should be spent looking ahead to the next contract with greater clarity about what the business will be four years from now. 

An early re-opener allows time to do just that: change vessels and improve the economics for those who want to stay and have a career at Republic [and Envoy].  Voting “no” does a disservice to the pilot profession because the problem is simply bigger than one carrier’s collective bargaining process.  Voting “no” may feel good for a moment, but the long-term impact leaves Republic pilots with no seat at the table or real influence in fixing the industry’s medium and long-term economics. Does voting “no” send a signal?  Perhaps, but in my view its equivalent to throwing the life preservers out of a leaking boat in a futile protest of reality.

If It Doesn’t Add, Let’s Begin the Subtraction Process

What Is Wrong With US Regional Industry Attrition?

It is increasingly clear that, in addition to fuel, regional airline industry overcapacity – a “bubble” in this writer’s opinion - may be the second most important catalyst to consolidation in the US airline industry.

Today, USA Today wrote about the capacity issue in an article about cuts in airline schedules across the industry, even in the face of strong demand click here. Maybe this is a precursor of things to come.

When domestic market overlap is evaluated, it is the respective regional network webs that will give pause to regulators and legislators, particularly considering the extent to which consumers may be disadvantaged as the result of consolidation. This is where network overlap occurs, not on the densest routes replete with competition from all sectors of the industry.

At last week’s ACI-NA International Aviation Issues Seminar in Washington DC, I tried to come up with a politically astute answer when asked a question on consolidation. But given my inclination to tell it how it is, I ultimately acknowledged that, on this subject, there is no “politic” answer.

I think Doug Parker had it right. I’m in no position to make that call, but looking at Parker’s blueprint for US Airways, he was suggesting some smart decisions. Why does Jacksonville, NC need nine flights a day to connect its airport to the US air transportation system when six are sufficient? Why does Greenville-Spartanburg need 25 choices for 100 or so passengers a day to and from Los Angeles?

The US industry is now struggling to shed fixed costs in an era when many airlines already have achieved significant cost savings from labor; fuel costs are outside anyone’s control and therefore not an option; and most of the cost reductions already have been wrung out of the distribution area

Since 2002, transport related expenses as reported by the mainline carriers – the vast majority representing the purchase of capacity from regional partners - increased more than fourfold to more than $17 billion in 2006 click here. If there is a cost area that deserves, and needs, reevaluation it is regional capacity deployment.

To put it in perspective, the $17 billion in expense spent by the mainline carriers on regional capacity exceeds the market capitalizations of United, American, Northwest and US Airways combined.

A Contrarian View of American’s Decision to Shed Eagle

Since American announced its intention to spin out its wholly owned American Eagle unit, I am troubled by some of the analysis. This is not about American or even about the FL Group, an activist AMR shareholder that has pushed the company to divest assets. This is about a sector of the industry with failing economics – the regional sector. And this surely is not about mainline pilot scope clauses. This is about economics: pure and simple. This is about American continually persuing the cleanup of its balance sheet.

If Southwest is continually revising downward planned capacity, then this relatively expensive capacity is surely difficult to maintain, yet alone grow.

As I have written here before: there are too many network carriers; too many low cost carriers; too many hubs and too many regional carriers. Already, we are seeing some signs of a pilot shortage. And the growth of the regionals – much of it built on labor arbitrage and an over-reliance on regional jets over mainline narrowbodies – is now slowing to a crawl. So why shouldn’t we begin to shrink the regional sector? Delta has Comair up for sale or some other transaction, which has been public knowledge for some time.

Financial engineering the AA deal is not. Pinnacle was the last financial engineering attempt using a regional platform and in the end the market correctly valued the expected revenue streams based on activity in the industry at the time. Mainline carriers began paying lower margins based on reduced revenue flows as the bankruptcy parade commenced. If AA were looking to enhance shareholder value, they have two or three other options that surely would have been announced before this one.

Prior to its Chapter 11 filing, Delta sold ASA to Skywest for a fraction of the price it paid for the regional carrier. Skywest negotiated certain terms in the event of a bankruptcy filing by the parent. More importantly, the broken carrier Skywest bought at a deep discount also came with a 15-year Air Service Agreement with Delta on pay out terms that are believed to be significantly better than newcomers to Delta’s regional stable receive.

This is the type of deal I would expect in the case of AA and Eagle. American has signaled to the market that it plans to maintain the current lift being purchased from Eagle. Yes, a new Air Service Agreement would have to be negotiated along with the transaction. What will be different with this deal is that aircraft will begin to come “off lease” over the term so the “buyer” may be purchasing reduced cash flow streams going forward. This is not financial engineering but economic reality. But they will be buying cash flow streams nonetheless – and that revenue is what matters to the analysis, not scope clause limitations.

Some Concluding Thoughts

Maybe this deal could be a catalyst to begin a long and overdue attrition of the regional industry as we know it. If there is a pilot shortage, then you are buying pilots. If you are looking to build a capital base that could be leveraged in other areas, this could be an economical means to buy what you could not build organically – particularly in this environment.

Growth is not occurring with 50 seat flying; that has been a well- documented fact for the past two years. But it takes the same number of crews to fly a 70 or a 76 seat plane as it does to fly a 37, 44 or 50 seater. Carriers participating in new flying with mainline partners are now purchasing their own aircraft. The purchase of new aircraft requires both cash flow and a sufficient capital base. The inclusion of Eagle assets and cash flow will surely provide a regional provider with more long-term staying power to withstand the necessary changes within this sector.

Just as we have talked about a domestic airline industry that could ultimately shrink to three or four legacy carriers, then it also is safe to say that three or four regional carriers are more than sufficient to meet demand. Skywest and arguably Republic will be there in the end. The question is who will join them in supplying capacity to the mainline carriers. The regional carrier space needs multiple providers, not only to ensure the competition for feed that the buyers want in the marketplace, but also to avoid the labor disruptions possible when a carrier is dependent on feed from just one provider.

Concluding Thoughts For Government

This is not a time to be “knee jerk” in a federal response to U.S. carriers that are struggling to be profitable at home while quickly being relegated to secondary status in the global arena. Just because there is an airport in a congressman’s district does not necessarily mean it makes economic and financial sense for airlines to offer service.

Yes, the government should ensure access to the US and global air transportation systems for as many communities as possible. But it is not commercially viable to offer each of those airports around-the-clock service. This bubble has raised unrealistic expectations for air service. Now we need to relieve pressure on an industry before it breaks.

Heeding the Divestiture Cry? American to Spin Off Its Eagle Unit

This afternoon, American announced its intention to spin off its American Eagle unit click here. Given the talk surrounding the company to consider spinning off AAdvantage, American Beacon Advisors, American Eagle and its maintenance unit, this announcement should come as no surprise.

Calls for American to spin off AAdvantage were first made by Reykjavik-based FL Group, which owns 9.1 percent of American in September. All US carriers, and not just American, are considering means to respond to increased shareholder pressure as airline shares have significantly underperformed the Standard & Poor's 500 Index this year.

One might say that AA is considering the divestiture of a regional carrier late in the cycle when growth has slowed considerably. On the other hand, if you believe that the regional sector of the US airline industry is not immune from consolidation, it just may be the right time to participate in the purchase of a carrier with a $2+ billion revenue stream that American says will remain intact as the parent plans to maintain all current feed provided by Eagle.

That revenue stream and an increased capital base will certainly have some attraction to regional sector’s biggest players: Republic, SkyWest, Pinnacle and others looking to assure their survival as its sector of the industry matures as well. American suggests the transaction will be a 2008 event with all the necessary caveats. No details have been provided on a deal structure other than a blank whiteboard.