US and AA Labor: Stop Hiding Behind the Idea of Consumer Benefits

When it comes to Wall Street analyst commentary on the proposed merger of American and US Airways, I have come to appreciate the work of John Godyn at Morgan Stanley.  He is a pragmatist.  His analysis and commentary are not fraught with emotion and Henny Pennyish ramblings as if the sky is falling if a deal does not get done.  He models the industry assuming a deal does not get done.  Certainly Godyn would prefer a deal versus no deal.  However, he assigns a probability of less than 50 percent of a deal happening, much like this observer.

This week’s Wall Street analysis and media coverage caught my eye.  First US Airways’ Captain Bill Pollack, a man I know and respect, wrote an op-ed in the USA Today in support of the merger. The subtitle reads:  “Airline employees have made concessions to survive. It's time our sacrifices paid off.”  Godyn hosted American’s flight attendant union, APFA, to a lunch to discuss the merger.  Like Pollack, the unions tout what they claim are enormous benefits to the consumer but fail to define them.  Then a note comes across my desk:  “Today, Representatives Marc Veasey (D-TX) and Ed Pastor (D-AZ) and 66 of their Democratic colleagues sent a letter to President Barack Obama calling on the Department of Justice (DOJ) to allow American Airlines and US Airways to move forward with a merger.”

Imagine what Jim Oberstar is thinking now?  Imagine, 68 Democrats supporting a merger of two airlines that will ultimately put 87 percent of domestic supply into the hands of four companies.  A party that prides itself in being the protector of the consumer.  Let’s stop kidding ourselves; this merger is about labor and the notion, and a near-term truth, that a consolidated industry can pay more than a fragmented industry. 

This would-be merger is perhaps the most sophisticated labor deal ever struck in the deregulated airline industry.  But don’t be fooled by the rhetoric. This is not about the consumer.  This is not about small communities.  This is about a very clever strategy by a management team to win over labor in order to achieve an exit strategy for US Airways - a highly performing company in search of an identity in tomorrow's industry.  In my view, Doug Parker’s US Airways was no true competitor to the network giants, even before they merged.  So to get there, he agreed to write a check to the airline unions that US Airways – I mean the “New American” - may not be able to afford . . . now, or in the future.

What’s wrong with this picture?  For one, union interests run contrary to consumer interests even if simply when labor costs go up, consumers pays more.  The unions say the merger is necessary to compete with the Delta and United duopoly. What does that mean? Even Parker agrees that mature industries yield few growth opportunities, so the synergies that the “New American” touts are likely to come from a share shift away from incumbents rather than generating new business.  Do we really think that Delta and United are going to sit back and surrender their market to a “new competitor” without a fight?  I don’t think so either.

But the check to labor has been written.

As Glenn Engel points out in his work, “being important is better than being big.”  This is based on the fundamental economics of the S-Curve in which each capacity share point above 30 percent in a given market drives a greater than 1 percent share of revenue up, at least until some point when the law of diminishing returns takes over.  In a merger that touts little to no overlap, where is the consolidation of two carrier’s positions that results in outsized revenue gains to the tune of $1 billion?

That’s right, the check has been written.

In Godyn’s note he talks with the APFA about the lack of a Plan B: “Consistent with what we heard from the APA, the APFA is universally focused on ‘Plan A’ which is to help management raise the probability that LCC is successful and is not actively pursuing any standalone plan alternative,” he wrote. “They also reminded us that no standalone plan had actually been formally submitted and approved by the creditors. Thus, if the deal does not go through, a new reorganization plan would need to be created and approved by creditors.” 

Godyn continues:  “Why are labor costs omitted from the complaint? The APFA expressed real concern that if a deal did not go through the short-term ramifications could cause existing labor contracts to be revisited and the pension to be put at risk, depending on how the new plan of reorganization is shaped as well as the judge. A restructured labor contract could not only include lower wages but also workforce reduction – not to mention labor discontent.” 

Exactly right because this a labor deal.

It is time that we start thinking about Plan B. Let’s assume that, because a number of senior US Airways’ executives have already moved to Dallas and enrolled their kids in school, Parker et al will run the “New American.”  But he has a track record in this type of case, and that is that the company will likely get smaller before it gets bigger. [An idea that will make Wall Street happy.]  A network considered inferior to others cannot pay its workers the same as can larger competition. The workforce will likely need to get smaller rather than reap the benefits promised. Parker’s conundrum is his exuberance to parcel out the synergies before they were realized.  Remember that share shift idea.

Suddenly, Plan B gets somewhat complicated even with the Golden Boy in charge.  In the event a merger is blocked, what if another party enters the fray and files a separate plan of reorganization?  That could happen in a Plan B scenario and my guess is capital would likely be treated more favorably than labor in that case.  So it may not be only Tom Horton who ends up on labor’s dart board.

I have long been critical of labor leaders who indulge in the overpromise and under deliver message.  But it is no different than Parker and his merry band buying labor favor without first proving on the battlefield that it can win the revenue necessary to fund those promises.  Remember, this is a labor deal. And US Airways may have reached too far in its assumption that it can accomplish what Delta and United did after being number 4 at the altar.  I am not aware of fourth mover benefits.  Think of the concept of the S-Curve and the idea that being important is better than being big.

The merger’s proponents are right that the “New American” will be able to offer more destinations. They are right that it will be able to offer more services in competition with Delta and United.  But proponents also are right in acknowledging that Plan B would result is something far less than labor has been promised. 

Where the unions get this wrong is in the assumption that because they have been to the table and made concessions they are entitled to the same compensation paid to employees of Delta and United, which have generated the revenues to support higher labor costs.  Other than an expanded network, where/what are the benefits for consumers?  I see many benefits for US Airways’ flyers; I see fewer for today’s American flyers.  Other benefits like investing in a re-fleeting and international growth are being implemented.

The DOJ is right to at least challenge the combination.  It may not win, but it is right to challenge.  The industry’s structure is much more concentrated than when it considered and approved the prior three mergers.  If this is indeed the last big deal in the US airline industry, it deserves a very close look.  Based on the combinations that preceded it and the string of events that have impacted the industry since the first merger was approved, it is really difficult to find any consumer benefits other than the fact that a profitable industry is finally investing in products that the consumer wants and desires.

In advocating for the merger, unions are doing what they should be doing to reap the promises the new management team made.  I would be doing the same.  But they should stop hiding behind the consumer because their interests are not aligned.  It will take customers to pay off Doug’s dubious deal and, as a result, customers will pay more - a necessary fact for decades.  And that’s the reality.

Note to readers:  I am long in the equities of Delta Air Lines, United Airlines, Sprit Airlines and Hawaiian Airlines.  Thank you to many readers that have reached out over the past months encouraging me to return the keyboard.  It is nice to be back.

US and AA: AIRLINE MERGER and SMALL COMMUNITY AIR SERVICE MEET AT LGA AND DCA

Note:  this blog is largely comprised of the text contained in a white paper written by me, William S. Swelbar. I would like to acknowledge Mr. Michael D. Wittman for his data collection efforts and deft analytical work that is included in the white paper. All of the air service related tables included in the white paper have a basis in Mr. Wittman’s research.  The conclusions and implications are William Swelbar’s.  The airports are referenced as large, medium, small and non-hub per the FAA’s definition of airport size.

EXECUTIVE SUMMARY

Small community air service and the structural factors that threaten it are certain to be a topic for policy makers in the immediate future.  The threats begin with the per barrel equivalent price of jet fuel in excess of $120; the fact that there is no replacement aircraft in production or even on the drawing board configured at 50 seats or less (the right size for small community air service) because of the high price of oil and associated capital costs [other than the ATR-42]; a looming pilot shortage that will impact the regional sector of the industry before it impacts other sectors; the new flight time/duty time regulations scheduled to be implemented in 2014 that will only exacerbate a potential pilot shortage; and new legislation that requires 1500 hours of flight time for a regional pilot versus the current 500 hours.

Many of these factors stem from past policymaking decisions. The unintended consequences will be reduced service to the nation’s smaller communities.  As the U.S. nears the end of the airline industry consolidation process, policy makers may be faced with yet another decision that could have a further negative impact on small community air service:  a reallocation of slots at each Washington Reagan National Airport (DCA) and New York LaGuardia Airport (LGA) because of the proposed American Airlines – US Airways merger announcement.

If slot divestiture is decided to be necessary, there are important facts to keep in mind:

1. It is the network carriers that are the air service lifeline to small community markets keeping them connected to the national and global air transportation grids – not the low cost carriers;
2. In 2012, US Airways offered service to 40 small and non-hub markets from Washington – DCA while all the low cost carriers combined served 2 such markets;
3. In 2012, Delta Air Lines offered service to 25 small and non-hub markets from New York – LGA while all the low cost carriers combined served 3 such markets;
4. Even before any slot divestiture, service to small and non-hub markets from each DCA and LGA is less than 20 percent of the total service offered from each respective airport.  To disenfranchise these small markets from one or two of their largest passenger demand markets would not be good policy; and
5. Today’s perceived low fare carrier is not yesterday’s low fare carrier:  Between 1995 and 2011, average fares for the low cost carriers as measured by yield increased 45%, average fares for Southwest increased 41% and average fares for the network carriers increased only 14%.

Small community air service faces numerous headwinds just to remain viable over the medium and long-term.  Some of those headwinds cannot be controlled while others stem from policy decisions already put in place.  To exacerbate a situation where small community air service would certainly suffer if slots were to be required to be divested at each DCA and LGA would not be good policy at this late stage of industry consolidation.

BACKGROUND

There is little dispute among the analyst community that the announced intent on February 14, 2013  to merge American Airlines and US Airways will result in the last “big deal” among U.S. airlines.  In the final analysis, the four largest U.S. airlines (American/US Airways, Delta, United and Southwest) would possess more the 85 percent of the capacity flown domestically.  While there may be some consolidation among carriers comprising the remaining 15 percent, no remaining transaction will be the size of American and US Airways or the three transactions that preceded it. 

American Airlines and US Airways have networks that are largely complementary—there are only twelve domestic city-pairs that receive duplicate service by both airlines out of nearly 900 routes in the combined AA-US network.  However, the combined slot holdings of the merged airline at each Washington Reagan National Airport (DCA) and New York LaGuardia Airport (LGA) will undoubtedly receive scrutiny by the US Department of Transportation (DOT) and the US Department of Justice (DOJ).

We don’t have to look too far back in time to find a transaction that involved slots at DCA and LGA.  In August of 2009, US Airways and Delta Air Lines entered into an agreement to swap slots with each other at each DCA and LGA.  In the initial transaction, US Airways agreed to transfer 125 slots at LGA to Delta in exchange for 42 slots at DCA.  Delta was seeking to expand its presence at LGA to establish a domestic hub just as US Airways was looking to augment its position at DCA and bolster connectivity for an increasing number of small communities it proposed serving from National. 

Per the initial transaction, “US Airways would raise its share of departures at DCA from 47 to 58 percent. US Airways' share of slot interests at DCA...would increase from 44 percent to 54 percent...Delta would ascend to a dominant position at LGA, raising its share of departures from 26 percent to 51 percent. Delta's share of slot interests at LGA would more than double, growing from 24 percent to 49 percent.”  To protect the “public interest”, the FAA proposed a divestiture of slots.  The slots would largely be made available to Southwest Airlines and other so-called low cost carriers (LCCs).  This was found to be unacceptable by each Delta and US Airways.

In 2011, a compromise deal was reached between the two carriers and the FAA.  The compromise deal shifted about 20 percent of the LGA slots from US Airways to Delta where about 3 percent of those slot holdings were divested.  At DCA, about 8 percent of the slots were transferred from Delta to US Airways and 2 percent of the slots were divested.  Ultimately this framework was approved and a final order was issued permitting the transaction to move forward.

If slot divestitures are ultimately required at DCA and/or LGA as a result of the combination of American and US Airways, then the same type of analysis of the “public interest” is necessary.  Some regulators, as well as Southwest and other so-called LCCs, will likely suggest using the AA-US merger as an opportunity to reexamine the service makeup of these slot controlled airports. They are likely to claim that at this late stage of consolidating the U.S. market structure to be one of the last opportunities to readjust the competitive profiles at LGA and DCA.  However, an important tradeoff exists between allocating slots to LCCs instead of network carriers: while additional LCC slots may contribute to more robust frequency competition in highly-served city-pair markets or to vacation destinations, it is unlikely to bolster service to struggling small community airports.  On the other hand, further network carrier service allows for small communities to remain connected to the strategically and economically important Washington and New York markets. 

While the network carriers have invested hundreds of millions of dollars in their respective operations to ensure that these smaller markets have access to the nation’s and the globe’s air transportation grid, LCCs have traditionally shown very little interest in serving smaller U.S. markets

In 2012, 44 small and non-hub sized markets received nonstop service at DCA.

In 2012, 35 small and non-hub sized markets received nonstop service at LGA.  

Given the strength of the small community air service network provided from both DCA and LGA and US Airways’ concerted effort to build a connecting hub at Washington National to connect northeastern and southeastern U.S. cities, a comprehensive slot divestiture program at these slot controlled airports as a result of the AA-US merger would likely have a detrimental effect on the nation’s smallest airports that have already been negatively affected by network carrier capacity reductions over the last six years.

TRENDS IN SMALL COMMUNITY AIR SERVICE ACROSS THE ENTIRE U.S. TRANSPORTATION NETWORK

Small community air service as a whole has suffered in the last six years. As a result of the rampant increase in the price of jet fuel and the prolonged economic downturn, U.S. airlines—in particular, the network carriers—began to rethink their service strategies. As a result, the entire U.S. air transportation system has seen a wide-scale reduction in both departures and seats since 2007. Between 2007 and 2012, nearly 1.7 million yearly departures have been removed from the US domestic system in response to the economic shocks mentioned above.  While most U.S. airports were affected by this newfound “capacity discipline,” a disproportionate share of the cutbacks occurred in the non-large hub airports.  In 2012, only 40.6 percent of US domestic departures were flown in non-large hub markets as compared to 44.2 percent in 2007 when there were 1.7 million additional departures.  A large percentage of this reduction in service was due to network carriers—on average, network carrier flights were cut by 27.2% at smaller U.S airports.

However, it was not just the network carriers that were reducing service at the nation’s smaller airport markets.  Southwest Airlines, the carrier hailed as the archetypal LCC, has also started to behave like the network carriers by practicing “capacity discipline” across its network.  In addition to reducing capacity in smaller markets, Southwest also made a decision to vacate 13 small community markets previously served by merger partner AirTran Airways:  Allentown, PA; Asheville, NC; Atlantic City, NJ; Bloomington/Normal, IN; Charleston, WV; Harrisburg, PA; Huntsville, AL; Knoxville, TN; Lexington, KY; Moline, IL; Newport News/Williamsburg, VA; Sarasota-Bradenton, FL; and White Plains, NY.  Southwest flights at smaller airports have been cut by 9.8% since 2007.

On the other hand, other LCCs and ultra-low cost carriers (ULCCs) generally increased service over the analysis period. 

Yet other than jetBlue and Frontier, none of the other LCC and ULCCs operates a hub and spoke system per se; Spirit Airlines is an opportunist with low fares and no frills, Virgin America is struggling to be profitable and Allegiant Air is a travel company that provides only infrequent service to vacation destinations.  While they may offer low fares, these airlines do not offer their passengers high-quality connecting service to the global air transportation network.

Of course, the replacement of traditional network carrier service with LCC/ULCC service to high-frequency markets already served or to vacation destinations does indeed boost airline activity at an airport.  To be sure, many small communities are today relying on carriers like Spirit or Allegiant or Sun Country as their primary/sole provider of commercial air service.  However, is infrequent service to vacation destinations on a ULCC as valuable to air travel consumers as frequent service from a network carrier to a hub airport, from which connections can be made to other destinations within the U.S. and throughout the world?  This would seem to be a paramount policy question to consider if slot divestitures are mandated.  A small community with a nonstop flight to a single network carrier hub can open up hundreds of potential domestic and international connecting itineraries.  However, low-frequency service from an ULCC will have a limited impact on improving airport connectivity. 

Mandatory slot divestitures would cause network carriers to potentially drop direct flights from these small community airports to LGA and DCA—limiting the connecting potential for passengers at these airports and hurting small community residents’ access to the global air transportation network.  Replacing network carrier service with LCC or ULCC service is often a poor substitute due to comparatively inferior options for nonstop and connecting destinations. Already, a small percentage of domestic airport markets served by the LCCs are small and non-hub sized airports versus the network carriers where nearly two-thirds of airports served are small community markets.

On the other side of the policy aisle, the DOJ continually points to a tired argument that the entry of LCCs results in lower fares and stimulates new demand.  That may have been true in 1993, but it is less true today.  Again using Southwest Airlines as the archetypal LCC, in the markets entered by the carrier between 2006 – 2011, fares increased 4 percent and traffic increased but 10 percent.  To demonstrate the fact that the LCCs behave a lot like the network carriers today and vice versa, let’s examine system passenger yield growth for the LCCs, Southwest, and the network carriers between 1995 – 2011.  Since 1995, Southwest passenger yields have increased 41 percent on a stage length adjusted basis; all LCC adjusted yields have increased 45 percent and network carrier yields have increased only 14 percent.

SLOT DIVESTITURE AND SMALL COMMUNITY AIR SERVICE AT DCA AND LGA

In the initial Delta – US Airways slot swap comment period, Southwest spent inordinate time and resources claiming that the two carriers needed to surrender more slots than originally proposed because the transaction would “permanently lock out” low fare competition.  But each Delta and US Airways were promising more than low fare competition—the two applicants were offering to build and augment their respective connecting complexes at each DCA and LGA. 

The timing of Delta’s and US Airways’ claim could not have been better as small community markets had seen hub access and connectivity at Pittsburgh and St. Louis virtually disappear.  Hub access at Cincinnati and Memphis was being eroded in a significant way as service cuts at those secondary hubs was proving necessary in the face of high oil prices and a damaged economy.  Now there were two new alternatives for improved connectivity in the name of DCA and LGA.  Even more important was the fact that DCA and LGA are among the largest origin and destination (O-D) markets for many communities in the U.S. – big and small. Hence, DCA and LGA provided the opportunity to build connecting hubs at airports with significant existing local demand – a particularly important ingredient for sustainable air service.

The DOT listened and wrote:  “While we acknowledge Southwest’s claims regarding potential inefficiencies resulting from hub development at slot controlled airports, we must consider both potential operating inefficiencies and expected network benefits typically resulting from hub development or expansion. The Joint Applicants [Delta and US Airways] claim that numerous benefits will accrue to consumers as a result of their transaction. Among the more compelling benefits that they articulate, we are most convinced by their arguments that development of a LGA hub will lead to enhanced service to small communities (even with the small aircraft that Southwest contends would be used) and improved competition versus other east coast hubs, including United’s Newark hub and US Airways’ hub in Philadelphia.”

In that case, the carriers asserted that primary benefits of the transaction will include enhanced service to smaller communities on an overall basis.  And that is exactly what has happened. 

During 2012, US Airways served 69 airports from DCA—the beginning of a true connecting hub.  40, or 58 percent, of those cities served were small and non-hub markets. 

At LGA, Delta served 58 airports during 2012, including 25 (43.1%) small or non-hub markets.

CONCLUSIONS

Despite the growing connecting hubs being built by US Airways and Delta at DCA and LGA respectively, it is important to note that as a whole, small community air service at these airports is already becoming a rare commodity. Today, only about 17 percent of service offered from New York’s LaGuardia Airport is to small communities—down from about 25 percent of all departures just six years ago.

Small community service is also already limited at DCA. Today, small community air service makes up only about 19 percent of service offered from Washington’s Reagan National Airport.

An important and fundamental question to ask is:  Does it really make good policy sense, assuming that slots are required to be divested, to make a slot pair available to a carrier proposing to serve Orlando, Tampa, or Ft. Lauderdale – all markets with metropolitan area nonstop service and a plethora of connecting options by each major carrier with hub choice as well?  Or, does it make better policy sense to maintain slots for small community access to some of the nation’s largest local O-D markets that offer connections as a result of the recent US Airways – Delta Air Lines slot swap?

One more nonstop from a large market to a large market does very little in improving the quality of service for airline consumers on either end of the itinerary.  Whereas the loss of a nonstop service from a smaller community to a large O-D market that offers connections would have a significant negative impact on that smaller community’s connectivity to the global air transportation network.  It is simply intuitive.

DCA and LGA already have excellent service to the nation’s largest markets from both network and low cost carriers.  Maintaining at least the status quo of slots for small community air service at this late juncture in market consolidation helps to maintain quality air service at some of the nation’s smaller markets at a time when service is being cut and hubs are being eliminated for reasons beyond the industry’s control.

THE END GAME: IT’S ULTIMATELY ABOUT RETAINING THE CUSTOMER

Paint me a skeptic.  Paint me a contrarian.  Paint me stupid.  I’ve been painted with worse colors. I’ve been one of the lone voices really challenging the proposed merger between American and US Airways – one that any read of the newspapers makes clear will likely go forward. And to be honest, many of the concerns I have raised about the merger have been addressed in the talks underway.

By all accounts, the deal is done but for a decision about who will lead the new airline. The analysts and the unions are betting on Doug Parker in the leadership beauty contest between American’s Tom Horton and the US Airways’ CEO.  It’s the nature of this kind of deal to want to crown a winner.

I’m not going to weigh in on the relative merits of Parker over Horton or make this about personalities or executive legacy, which misses the point. In my view, the most successful mergers focus not on the victor to whom goes the spoils, but rather focus on building a leadership structure that brings the experience necessary to maximize the synergies and fulfill promises made to stakeholders.

So for that reason and many others, it would be an error to approach a merger of AA and US as another notch in Parker’s bedpost so he can impose his personal style on the combined airline. US Airways has done a very good job of running the airline it is, but it will take a breadth and depth of experience to a run the airline the new American would be. This is the case because this merger perhaps more than any others will require a delicate marriage of cultures and operating styles.

There is little comparison to the three big mergers that have preceded it:  Delta – Northwest; United – Continental; and Southwest – AirTran.  All three had some international angle to the redrawn networks. Northwest brought the Pacific to Delta and Delta brought some Latin America to Northwest; United brought the Pacific to Continental and Continental brought Latin America to United; and AirTran brought international capabilities to Southwest, providing Southwest the ability to “take out” a potential long-term nemesis in the lower cost AirTran. 

Other than strengthening American’s presence in the northeast US and along the eastern seaboard, US Airways brings little to American from a network perspective. US Airways will transfer a nice chunk of international revenue away from the STAR Alliance to oneworld, and, of course, the sheer size of the combined carrier would return the new American to the number one spot American lost when Delta and Northwest merged.

But to effectively run the combined airline, the new American can’t alienate its high-value business customers who won’t put up with the growing pains we’ve seen with United-Continental. And if the new airline is uncertain in its pace or fails to impress those most valuable customers – many of them the core of American’s revenue base – then a successful merger is far less certain.

The award for the biggest network airline merger failure should go to the team that put together the 1987 deal to combine PEOPLExpress, Frontier and New York Air into Continental Airlines.  The idea was to merge Texas Air Corp.’s holdings to form the nation’s third largest carrier.  But instead of creating a worthy competitor for the two largest airlines at the time, the combination resulted in a balance sheet bloated with debt, unit revenue deficiencies in every corner of the network and no commonality in the combined fleets.  The merged company ultimately filed for bankruptcy protection in in 1990, emerging three years after that.  Ultimately a new management was put in place and the turnaround is legend.  

An American – US Airways combination would not be Continental circa 1987. American is simply too good of an asset.  Nor do I think it will be Delta–Northwest circa 2008, in part because the execution risk strikes me as very high, particularly considering disparities between each airline’s model and culture. One flies to China, the other to Chattanooga.  As a result, they bring two very different customer bases to the entity as well, so customer expectations will differ, too. 

Many analysts have focused on US Airways’ deft courtship of American’s labor leaders as evidence that the US Airways culture is a superior model. But I believe that analysis focuses on the wrong stakeholder group.  At this late stage of the consolidation process, American’s ability to retain existing customers and win new ones is critical to the success of the new airline. A culture transplant alone won’t get the job done. The highest barrier to success would be the one set by a new leadership team that insisted upon its way or the highway in running a combined airline.

Collaboration is critical. That doesn’t mean Tom Horton must be a part of the new American if the architects of any deal determine he’s not welcome. Nor does it mean that the entire American team in place today is necessarily the best choice.  But if the leadership crown goes to Parker’s Phoenix posse, they would be making a grave error to impose the US Airways style on the new American without leveraging American’s successes and cultural assets.

American has proven adept at managing its regional affiliations, code share partners, joint ventures with British Airways and JAL and a loyalty program that arguably is more valuable than US Airways itself.  Its marketing and IT capabilities exceed anything US Airways has ever tried. And American knows far better than its potential new partner how to treat the premium customer who wants warm nuts and lie-flat seats in first class.

I can only hope that the “best of the best” of the two companies will be a part of any new one, because that’s the only way the new airline will compete effectively with first movers Delta, United and Southwest.

Stuffing the Turkey

The drum beat is growing louder now that we may soon see the outcome of all those merger talks between American Airlines and US Airways.  As Ray Neidl of the Maxim Group wrote in a November 20 research note this morning:  “We believe a merger would definitely benefit the industry since it would promote further consolidation and enhanced pricing power for the carriers in general. However, we also believe that an AMR/US Airways merger, if it were to happen, would not be an easy endeavor to manage (as was Delta/Northwest merger, even with AMR union support). We believe that the benefits in market mass would not be as great as either the Delta/Northwest or UAL/Continental merger are proving to be.”

US Airways and others tout the benefits of synergy – relying mostly on the experience of recent mergers that may not apply in this case. Proponents are less likely, however, to spotlight dis-synergies. The fundamental question: What are the net synergies?

This question is particularly relevant in the case of a potential merger that creates an unstable labor situation.  I tried to address this before in the most-read blog in swelblog history:  US Airways and American and the Elephants in the Room.

The labor issues we’ve seen recently at several airlines offer a big window into the risks of brand and service degradation. But let’s focus just on pilots.  What’s most important to a pilot’s career, flying opportunities and pay? Seniority. What is for pilots at most risk in a merger?  Seniority.

We already know what can happen when pilots are unhappy . . . they uniquely have the means to affect the operation by something as minor as a slow taxi to the gate.  Look no further than American’s on-time performance in September and October. .

Difficulty in merging seniority lists is likely the rule, not the exception. Even MaCaskill-Bond, legislation designed to make the process fair for each side, does nothing to ensure a smooth integration. 

So imagine for a moment the seniority integration monster a merger between American and US Airways could create because there are not two but FOUR pilot groups involved: American’s pilots represented by the APA, US Airways pilots and former America West pilots both represented USAPA but working under separate contracts, and former TWA pilots who have never been very happy about their treatment when American acquired TWA’s assets in 2001.

By the time you involve management in that equation, it could be a 5-way or 6-way conversation..  We have seen enough cases of difficult outcomes with three parties at the table, let alone more.

Enter arbitration.

At US Airways, an arbitrated seniority award under ALPA merger policy resulted in the decertification of the union by a majority of US Airways pilots because some more junior America West pilots were placed ahead of them on the combined list. This happened in part because America West pilots had more certain career expectations than the original US Airways’ pilots whose carrier was in bankruptcy for a second time with little hope of surviving as a stand-alone carrier.

If an AA-US merger were to occur before American exits bankruptcy, the two pilot groups at US might successfully argue that AA is a failed carrier and that, as pilots for a successful carrier they deserve super-seniority consideration.  This scenario, known in the industry as the Failed Carrier Doctrine, has long played a role in combining seniority lists in mergers involving a profitable carrier and a bankrupt carrier

Former TWA pilots at AA won a recent court case arguing that ALPA did not meet its “duty of fair representation” in the AA-TWA integration. The APA was originally part of this litigation but was dismissed because the court found that APA did not yet represent the TWA pilots at the time the lists were merged.  Now, the TWA pilots working at AA may demand that wrong be undone as part of their support for a merger with US Airways.

Now consider this: If an integration list is created using a pilot’s date of hire (the most common method of determining seniority) then it is likely that many US Airways East pilots would be placed at the top of the new list. And you can be sure that would not be received well by the AA pilots or the former TWA pilots who could argue that the AA list should be adjusted to reflect their hire date at TWA.

Fences (an industry term for isolating respective operations from another) can fix some of the seniority concerns but also add complexity and unknown costs to the merged operation. At the end of the day, what usually makes pilots happy is a big check from the company.

Bottom line: A merger between American and US Airways would likely be the most difficult seniority integration in history. Some or all pilots will feel disenfranchised as a result because integration results in winners and losers - perceived or real.  Could the pilot unions work together to negotiate integration?  Maybe, but given the history of these pilot groups not without a lot of blood on ground.

Therefore the most likely path to integration is one in which every pilot at AA and US would put their future in the hands of an arbitrator with no guarantee of a positive outcome. There is plenty of precedent for the arbitrator to consider, but very little that indicates an outcome that would be acceptable to a majority of the combined pilot group.

Moreover, it could take years to work out the implementation of a new seniority list. During that time Delta and United would do everything possible to gain a competitive advantage. These carriers already have a first mover advantage over American and US Airways.  So put me in the C-Suite in Atlanta and Chicago and I’m cheering this proposed merger on with a megaphone because there is nothing but opportunity for Delta and United, not only from improved domestic market fundamentals but also from any fallout that occurs should the new American fail to produce.

No valuation of the merger is complete without consideration of this factor during what will be a critical transition period that could make or break the value equation.   And no shareholder should buy the optimistic prospectus from Doug Parker without taking into account this very real risk.

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.