United and US Airways: Third Time a Charm? I Say “Do No Harm”

We went to bed last night with the news United and US Airways were in negotiations to merge for a third time.  We awake this morning to the news British Airways and Iberia have finally signed their long awaited merger agreement.  British Airways will change its name to International Airlines after completing the deal with Iberia, expected in December of 2010.  If United and US Airways were to merge, what would they change their name to?  US Domestic Mess?  Ground Hog Air? 

United and US Airways broke off marriage discussion #2 in June of 2008 as oil was on its historic march to  $147+ per barrel.  Ultimately, United settled on a virtual STAR alliance partnership with Houston-based Continental.  The UA/CO relationship makes sense as both companies have an international focus with hubs in the largest U.S. cities where large pools of business travelers avail themselves to airline service across all continents.  A  United – US Airways combination ensures regulatory scrutiny of slot holdings at key east coast airports in New York and Washington, DC.  I don’t get the benefit of United – US Airways today anymore than when I wrote that I did not like the deal on June 2, 2008.

To my eyes, the real United news yesterday was the company reporting its preliminary March traffic results.  “Total consolidated revenue passenger miles (RPMs) increased in March by 3.2% on a decrease of 2.7% in available seat miles (ASMs) compared with the same period in 2009. This resulted in a reported March consolidated passenger load factor of 83.5%, an increase of 4.8 points compared to 2009. For March 2010, consolidated passenger revenue per available seat mile (PRASM) is estimated to have increased 21.5% to 23.5% year over year. Consolidated PRASM is estimated to have increased 3.2% to 5.2% for March 2010 compared to March 2008, approximately 3.0 percentage points of which were due to growth in ancillary revenues.”  Those are not words from a company seeking to do a deal for the sake of a deal – right?

The Delta – Northwest Merger Template

United CEO Glenn Tilton and Continental CEO Jeff Smisek have pointed to the success of the Delta – Northwest merger, citing that combined company’s market capitalization of $11+ billion.  Today, pre-market, United’s market capitalization is $3.2 billion, or nearly 5 times greater than it was a year ago.  US Airways market capitalization is $1.1 billion or nearly 2.5 times greater than it was a year ago. 

Today, Delta’s market capitalization is roughly equal to 40 cents per dollar of its trailing twelve month revenue; United’s market capitalization is equal to 19 cents per dollar of trailing twelve month revenue and US Airways is 11 cents.  If United and US Airways were to be accorded the same relationship of market capitalization to revenue that Delta is today, the market would need to multiply the pro forma market capitalization today by nearly 2.5 times.  An unlikely scenario.

Three of the Reasons Why I Do Not Like the Rumor

1. The Delta and Northwest networks were largely complementary when the two carriers combined.  The size of Northwest and Delta’s network is larger than a combined United and US Airways.  However, the fit of the network is more important than size.  The ability to leverage one network against the other in order to create new city pairs to sell is critical to any network’s success.  Delta and Northwest made for a true “end to end” combination whereas United and US Airways possess some meaningful overlap that would likely require DOJ mandated carve outs.  Any carve-outs would immediately erase some of the perceived benefit of a combined United and US Airways in the eyes of the market.  Simply why do I want DOJ interference in the first place?
2. Today, United has several immunized joint venture applications pending before the regulatory bodies with partners across each the Atlantic and the Pacific.  These relationships are valuable and likely have been recognized by the financial markets as such.  Why would United possibly jeopardize the international potential to merge with a U.S. domestic-oriented carrier?
3. Finally, and possibly most importantly, the Delta – Northwest combination was blessed to have a pilot leader in place that understood consolidation and globalization are not only inevitable but are important to the success of his company and therefore the pilots he represents.  We have talked about Capt. Lee Moak here many times.  The Delta – Northwest combination had a merged seniority list and negotiated collective bargaining agreement in place before the deal was consummated.  This seemingly simple fact allowed the newly merged company to enjoy the ability to reconfigure the combined network from the outset.  The benefits were/are many and could be the subject of another blog post or a master’s thesis or a doctorate.

Whereas Moak and his Northwest counterparts put into place the unthinkable in only five months, the pilots at US Airways and America West continue to emulate the Hatfields and the McCoys five years after their two companies merged.  What has transpired at that company since 2005 is mind-numbing and underscores the broken model of labor language that pervades the U.S. industry today.  Sadly, the professional aviators at that combined company have suffered due to the leadership vacuum that persists on both sides of the argument. 

Combine the dysfunctional relationship between the US Airways and America West pilots with the entitlement mindset of the United pilots (and all United employees for that matter) and you have a mess.  A mess that in no way promises the revenue synergies Delta and Northwest mined almost immediately that facilitated an outsized market capitalization relative to other legacy carriers. 

Don’t get me wrong, I am for any type of commercial relationship benefitting the industry generally and individual companies specifically.  I was a fan of United – US Airways #1 in 2000.  I was not a fan of United – US Airways #2 in 2008.  And I am not a fan of United – US Airways #3 today.  Each company’s fundamentals are improving so I don’t understand the rush – assuming there is one. . 

The third time is not a charm.  I say do no harm to the improving fundamentals at each company.  I do believe the risk of irrelevance in the marketplace is higher for US Airways than it is for United.  There was a time – albeit a short period – when the fundamentals of the U.S. domestic market were outperforming international operations.  That is not the case today and is but one US Airways’ attribute that  will not prove to be a winning scenario over the long term given the cost structures of the legacy carriers.

The one mantra that always lived with me at the negotiating table – you can always do a bad deal.

More to come.

[Note:  the author holds shares in United Airlines]

Continental Makes a Most Interesting Proposal to Its Pilots: Delta plus $1

Happy St. Patrick’s Day to all.  The pattern on this holiday is all things green.  And maybe the luck of the Irish will make this St. Patrick’s Day a lucky one for Continental pilots as the company presented the Air Line Pilots Association (ALPA) with a new contract proposal. The pattern for collective bargaining in the airline industry is to secure all things deemed as best in class.  As I see it, Continental made an offer to its pilots that actually addresses pattern bargaining.  Not quite sure if I love it, but it is interesting.  Most interesting.  

The two sides have been in discussions for more than two and one-half years.  The amendable date has come and gone, yet the parties have not filed for mediation.  There’s been some movement on the non-economic issues, but little progress has been made on the economic ones. 

Sounds familiar doesn’t it?  This week, that’s what much of the talk from American Airlines’ flight attendants centered on as they asked for release from the National Mediation Board.  Several unions at American and United increasingly point to the long periods of time it is taking to reach an agreement. 

In its letter to Capt. Jay Pierce, President of the Continental ALPA Master Executive Council, Continental Airlines addresses how long it might take to negotiate an agreement:  “We have weighed the fact that it has taken ALPA two and a half years to compile and propose an exceptionally complex and comprehensive opening economic proposal that nonetheless still has a number of substantive items open. Despite its complexity, that proposal remains only conceptual, lacking specific contractual language. We have also considered the considerable period of time it would take to negotiate and craft specific contractual language that is fair to the pilots and fair to the Company. Even if we had no significant disagreements over terms of that opening proposal (a highly unlikely circumstance given the excessive increase in costs it contains), negotiating and refining ALPA's current proposal into to a final executable agreement is a task that would clearly take a very long time.”

Given that the Delta pilot agreement had become a template for the Continental pilots in their negotiation of a new agreement, Continental simply said that they would offer their pilots the Delta pilot contract except for a seat on the Board of Directors and by adding $1 to the pay rates included in the Delta Pilot Working Agreement (PWA).  The offering includes the Delta pension and benefits section as well.  This is important – very important – because benefit costs go into the calculation of the cost of an agreement.  We are finally at the point where we talk about the all-in cost – not just hourly rates of pay.

Capt. Pierce responded:  “the proposal is no surprise and much of the bargaining agenda that we have already presented is based on the Delta PWA. Hence, our Negotiating Committee is very familiar with that agreement and has referred to it often. Notwithstanding this fact, any such transition would be a very complex matter and there is much to consider before we commit ourselves to such a process. We will be carefully reviewing the ramifications of this proposal with respect to our bargaining objectives over the coming days. However, while we must proceed with caution and based on a complete understanding of the Delta contract, we are obviously interested in any process by which we can legitimately avoid extended negotiations during which a concession agreement will remain in place.”

Pattern Bargaining

This is the second time this week where I’ve see pattern bargaining embraced by management. First, it was American and how it structured pay increases for flight attendants in the last offer.  Now it is Continental adding $1 to the pay rates included in the Delta pilot agreement.  I hate pattern bargaining.  I think it is counter-productive as no one airline is the same.  Just because Delta negotiates an agreement with rates and working conditions it believes it can afford, that does not mean Continental’s network can afford the same. But this pattern is a little different than pattern bargaining of the past – and deserves a closer look.

Pattern bargaining typically resulted in best-in-class provisions being included in the union’s opening proposal.  It was/is a cherry picking exercise. Whether the unions want to believe it or not, the cherry-picking of agreements also contributes to negotiations taking longer than a party might wish.  Why?  Because each and every collective bargaining agreement has sections that work in tandem with another section.  As one section was made more complex, other sections of the agreement were impacted.  Simply, the interdependencies within a collective bargaining agreement must be analyzed, understanding a change in Section 7 affects Sections 11 and 14 and so on.  It’s a process that has become increasingly complex over the years.  Circular logic can be hard to avoid for you excel users.

What is interesting about Continental’s offer is the idea of a single collective bargaining agreement – one where the interdependencies are understood and identified – avoids many of the pitfalls of traditional pattern bargaining.  What the company points out in its submission letter is the Delta PWA “is a post-merger, post-concessionary pilot agreement at a legacy carrier that is also the world's largest airline, it will likely set the pilot contract standard for years to come.”   

For me, what the company seems to be saying, is if we are going to engage in pattern bargaining, then no more picking what you want from that agreement and from this agreement.  The same agreement produces no need to distinguish between pilot rates of pay; rules governing work; and benefits (to be determined).  Presumably, the work rules when applied across a respective network would yield the same hours of productivity except for structural seniority differences.  Differences in pension plans and retiree health insurance are company specific and therefore may be or may not addressed by this type of a proposal exchange.  Talk about a way to speed the process.

The Delta Nuance

The Delta PWA was negotiated under the watchful eye and focused leadership of Captain Lee Moak.  I have written about Capt. Moak many times. What seems to set Moak apart is an understanding the industry has undergone significant structural change and the Delta agreement needs to embrace that change.  For example, because Delta serves many small and medium-sized markets in the U.S., there are few limits on the use of regional jets 76 seats and smaller.  Continental is the only legacy carrier that does not permit use of regional jets with more than 50 seats.  This line in the sand keeps Continental at a domestic competitive disadvantage relative to the industry.      

Mainline pilot scope has been quite the topic here at www.swelblog.com over the past week.  Some have suggested I drew the line – or heard what they wanted to hear - at 50 seats.  I did not.  To me the line begins with the next generation of small jets that are bigger than the current aircraft platforms doing 76 seat-and-less flying within networks.  The domestic scope issue is but one scope concern at Continental.  The real issue of significance is that Continental cannot implement the joint venture with United, Air Canada and Lufthansa without the relaxation of language contained in the existing Continental pilot agreement.  There is a regulatory deadline to complete aspects of the joint venture and anti-trust immunity agreements.  Scope is not just domestic.

This is where the Continental situation gets a little murky.  Moak understands that the globalization of the airline industry will drive his carrier’s success.  Further, he demonstrated his understanding of such when he negotiated a new collective bargaining agreement for the merged Delta and Northwest pilots.  Moak accomplished something extraordinary in the history of merger negotiations in the U.S. airline industry. 

Ted Reed of TheStreet.com wrote about the Continental situation last month.  Reed wrote and quoted Continental’s pilot leader Jay Pierce, “Among the network carriers, two models exist for pilot relations. Pilots at Continental and Delta have generally enjoyed positive relationships with the carriers. Pierce said he is an admirer of Lee Moak, chairman of the Delta ALPA chapter; the two talk frequently. "We both recognize that our airlines need to be profitable," he said.”

Depending on how you look at it, the Continental pilots are searching for leverage and public pronouncements seem to suggest they have found the leverage in their scope section.  Now the company counters by offering pilots the agreement they have held out as "industry leading".  The difference being the Delta contract negotiated by Moak allows 76 seat-and-less flying and embraces the direction of international joint ventures.  [All sections of an agreement have interdependencies with other parts of the agreement]

In his interview with Ted Reed, Pierce says he recognizes the need for his company to be profitable.  The pilots also say their current proposal would only cost the company $500 million. [Note:  the $500 million is an ALPA cost estimate, and not a company estimate.] When was the last time Continental reported net income in a year of more than $500 million?  But the ask is not just $500 million.  The $500 million would compound in perpetuity.  And that is before contractual improvements are offered to other Continental employees.

Why I Like the Continental Approach 

• What I like about this offer from Continental is it does some tearing down of the cancerous practice in the airline industry of pattern bargaining. 
• It challenges both sides to come to terms in a more expedient manner than the current construct produces. 
• It embraces Delta’s long-time approach to pay commensurately well in return for operational flexibility and productivity. 
• Most of why I like the approach is that it is different.  As I say too much for some on this blog, the old way just does not work. 

As I wrote in the last piece on pilot scope, my real fear is for management to again overpay for scope.  That makes me nervous this time.

The more I think about it though, I am starting to like it because it addresses the real issue of how long it takes to get a deal done under the Railway Labor Act.  Whereas I have defended the RLA in the past, maybe the time issue does need to be discussed.  But to do that, we would have to limit the number of issues that require mediator expertise?

And another reason I like it -- maybe this will build the stage where the legacy carriers can compete on service and price and not on a labor cost differential?

“Go Ahead, Bite the Big Apple; Don’t Mind the Maggots”

Yesterday, as I was awaiting a report from the Institute of Supply Management on August manufacturing activity, I was working on a piece I titled:  “Government Buys Junk; Consumer in Funk; Airline Recovery No Slam Dunk.”  But after reading Ann Keaton’s piece in the Wall Street Journal on how jetBlue and Lufthansa are looking for a code share deal, I started thinking about all the pieces in play in the New York market and, as it happens, of the 1977 Rolling Stones tune “Shattered.”

Was it US Airways’ that said “my brain’s been battered, splattered all over Manhattan?”  Or AirTran talking about “rats on the west side, bed bugs uptown?”  Was that Continental murmuring something about “all this chitter-chatter, chitter-chatter, chitter-chatter ‘bout shmatta, shmatta, shmatta -- I can’t give it away on 7th Avenue?”  [But I can in Newark]  I do think I heard Delta saying, “to live in this town you must be tough, tough, tough, tough, tough!”  And I am sure I will hear from American “don’t you know the crime rate is going up, up, up, up, up” if it is not granted an immunized alliance with its transatlantic partners.

A Long and Overdue Reshaping of the Competitive Environment Gets Underway

It began on August 11, when AirTran Airways announced a deal with Continental to vacate Newark and give its slots and one gate there to Continental in return for slots at New York’s Laguardia and Washington Reagan.  A day later, Delta and US Airways announced a monster deal in which US Airways will give up 125 pairs of Express slots at Laguardia in exchange for 42 pairs of slots at Washington Reagan and rights to fly to Tokyo and Sao Paulo.  Both swaps involve no cash and have no impact on the Northeast Shuttle operations run by each US Airways and Delta.

The Delta – US Airways swap all but ensures that Delta will surpass American as the largest carrier at Laguardia.  By any measure of market concentration, LGA will continue to have ample competition.  For Delta and US Airways, the deal gives each carrier the tools to build out markets they believe are market strongholds.  Some say that a split operation (Laguardia and JFK) for Delta is a mistake.  But I disagree.  Winning passenger loyalty from offering expanded domestic services at LGA should translate into making Delta a clearer choice for passengers to choose the carrier when traveling to international destinations from its operation at JFK.

Absent this kind of deal, there is not much that can be done to increase domestic flying at any of New York’s three major airports.  Applying US Department of Justice standards to determine market concentration, Laguardia, JFK and Newark would be considered concentrated or moderately concentrated per the Herfindahl-Hirschman Index.  And JFK has limited space to for an airline to run a large domestic operation because of the extensive international operations that occupy the critical late afternoon/early evening hours.

Given all of the constraints of the New York aviation infrastructure, the airlines involved in the slot swaps have taken a proactive approach to advance their competitive strategies.  By recognizing their individual strengths and weaknesses, the airlines involved will be better positioned when a recovery gets underway.  If the government says you cannot merge, then engage in binge and purge. 

Today’s environment does not afford any carrier the luxury of presence everywhere and pricing power nowhere.

Congress and the Regulators

Because these transactions require regulatory approval, I fear that critics will claim that the deals would give the carriers excessive pricing power in those markets. 

But look at the data. According to the Airline Transport Association, system passenger revenue is down 21 percent, or $12.5 billion when comparing the first seven months of 2009 to 2008.  Add in the $3.1 billion the industry has brought in from those damn fees that everyone likes to write about, and that means revenue is down $9.4 billion. 

Where is the pricing power?  Where is the gouging?  And when will the politicians and regulators take airlines at their word when they say they need change?

“People dressed in plastic bags.  Directing Traffic.”

Are Some US Airlines Too Big to Fail? Hell No!

Holman W. Jenkins Jr., writing in the July 8 Wall Street Journal gets it right: "The new administration seemingly won't let companies fail, and won't let them succeed either," Jenkins wrote of Justice Department opposition to antitrust immunity for Continental Airlines and the Star Alliance. Such alliances, he argues, are the industry's "self-help solution" for companies looking "to share losses and preserve capacity in a downturn." By denying that option to struggling carriers, Obama may soon be forced to "add the airlines to the collection of failed industries being run out of the White House."

Sadly, What is Good for One is Not Good for the Other Two

Congress, of course, has a long-held penchant for meddling in the affairs of industries and organizations. This week, the Senate Judiciary Committee Subcommittee on Antitrust, Competition Policy and Consumer Rights spent taxpayer money to hold hearings on college football’s selection process for placing teams in its Bowl Championship Series. So we should not be surprised to see a growing government role in an industry that has managed to lose more than $30 billion over the past nine years.

If government oversight of the airline industry is going to stand in the way of corporate success, then there is no airline too big to fail. So why not let them fail? Airlines are criticized for not being innovative. True - and for the most part their innovations over the past 10 years amount to little more than finding ways to maximize revenue within a system of constraints.

Delta/Northwest is the largest carrier in the world, and even it commands less than a 5 percent share of the global airline market. No other U.S. airline claims more than a 3 percent share. Yet the government continues to treat the U.S. airline industry as if it is a threat to competition and slap the hands of airlines that attempt to improve/augment their business models through partnerships and alliances with foreign carriers.

Antitrust laws are designed to protect consumers from corporate power. Does a well-established trend line of fares falling at rates greater than inflation for three decades demonstrate corporate or industry pricing power? A passenger traveling from Greenville/Spartanburg to Los Angeles has a choice between more than 20 flight combinations to get from California and back.  Does that demonstrate corporate or industry power? Does an industry that makes the price of its product fully transparent to the buyer sound like an abuse of the consumer?

The fact is that most U.S. air travelers still have plenty of choices when it comes to flying – albeit in an industry that still carries more capacity than it needs.

Southwest: The Wolf in Sheep’s Clothing

Let the record show that I have not joined the chorus of analysts and observers who predict rising fares by Fall. The recession holds. Many consumers are tapped out. Enter: Southwest Airlines.

Southwest has a long history of leveraging difficult financial times -- profiting at the expense of competing airlines because it could. It profited because of the chasm in its CASM versus it competitors; it profited because of the chasm in the RASM charged by competitors; it profited because it smartly used its balance sheet to make a wildly successful bet on the future of fuel prices . . . Southwest profited because it could. So this week’s fare sale in which the airline is selling tickets at $30, $60 and $90 says one of two things: either Southwest is struggling mightily with the forward booking curve, or the airline smells blood. I think the answer is both, but more the latter.

Southwest is now the big dog in the US domestic market and a player that must be reckoned with in any discussion of domestic market competition. If the nation’s lawmakers and policymakers continue to equate low fares with sufficient competition and consumer benefit, then deregulation has clearly come full circle.

Southwest is not now the big dog to those in Greenville/Spartanburg, Knoxville or Duluth. But most travelers can get in a car and drive less than a few hours to fly Southwest from these markets or more than 280 others not now served by LUV.

If this is what the regulators and policymakers really want, then that’s what they’ll get. Therefore, there is no reason to think that any airline flying today is too big to fail.

With Southwest adding the dots of the largest population centers where it did not previously fly to its route map, the industry could be at a tipping point. These markets also represent large sources of feed revenue to many legacy carrier hubs, and with Southwest offering fares too low for some legacies to match, this fall and winter may be a long, cold one for the traditional carriers.

Will the government continue to stand in the way of airlines that are desperately seeking new revenues? If so, no bailout will save an airline – not until U.S. airlines are allowed to act like other multinational industries serving a global economy. There already is enough taxpayer money bailing out other industries with similarly troubled attributes – adding airline rescues to the mix would only throw more good money after bad.

Union Rhetoric

What’s behind Congressional opposition to these common-sense alliances? The loudest voice in the room is labor. Even at this financially treacherous time, the industry is split from within, the result in part of union leaders that refuse to recognize economic trends and realities when they don’t serve the union’s objectives. When are the unions going to recognize that the transfer of domestic market wealth from the incumbent carriers at the time of deregulation to the new wave of carriers that followed is largely complete? And that tomorrow’s opportunities do not reside inside the 48 contiguous states?

Now, in the years since airlines sought and won aggressive cuts in labor costs during restructuring, it is increasingly clear to me that continual change/modification to outdated collective bargaining agreements cannot overcome the structural seniority chasms that exist between the legacy carriers and their lower-cost, younger competitors – at least in the domestic market. For decades, as the network carriers have been forced to compete for ways to average down labor costs through protracted bargaining, the low-cost carriers simply use seniority arbitrage to facilitate their growth. And I think we are about to see another run of growth by the LCC sector.

When it comes to the airlines seeking immunity to maximize revenue and, in the case of United/Continental/Air Canada, address certain cost efficiencies as well, the strategy is to maintain as much of the current operation as is financially feasible. Unlike the US steel industry that lost nearly 400,000 jobs because producers in other countries could do it significantly cheaper, blame for the next round of airline job cuts most go in part to the airline unions that have been busy trying to convince the dinosaurs at the Department of Justice and on Capitol Hill that alliances will result in job loss and a further deterioration of wages and working conditions.

Between the time Eastern Airlines and Pan Am died and 2000, the industry’s high-water mark for employment, U.S. airlines added nearly 100,000 jobs. Since 2000, the industry has lost nearly 140,000 jobs - and it should have been more -  mostly because nearly all the airlines and virtually all the existing hubs have been protected in one way or another by patrons on Washington. Indeed, many of the jobs lost from a failure of one or two of today’s carriers likely will be replaced as market positions in the largest cities are filled by new and more efficient carriers.

Let Some Airlines Die – And Then Let DOJ and Congress Rethink

At this point no one US airline is too big to die. Competition remains plentiful whether that competition comes from another ticket counter at the same airport or cheap fares at a nearby airport. Either way, the industry is still too big – with too many network carriers, too many regional carriers and too many hubs.

And, except for a few “up cycles” along the way, revenue has not supported the industry’s growth or size. The time is right for lawmakers to hear the new reality in the industry – one focused not on a false threat of monopolies and price gouging, but the very real threat in an industry so bloated, burdened and inefficient that it fails to provide the very thing a business must: a reliable return for investors and real job security for employees.

Neither Ponzi nor Pyramid, but an End Game Nonetheless?

Liquidations and/or Use of the Failing Carrier Doctrine?

On the day when Bernie Madoff gets sentenced to 150 years for orchestrating the financial fleecing scheme that put its namesake, Charles Ponzi, to shame, I am pondering the balance sheets of airlines. And it comes down to this: some carriers have little room to maneuver. Investors (read: credit) are not lining up to provide new capital without demanding ransom in terms of collateral or sky-high coupon rates well above those paid in other industries.

Ponzi and pyramid schemes work by gathering proceeds from one group of investors to pay off earlier investors. It is no small irony, then, that much the same has been happening in the airline industry for years. The financial scams fall apart when they run out of money to pay new investors. In airlines, the end result is pretty much the same. Airlines continue to seek new capital even as previous investors fail to earn a respectable return on their investment. It’s not illegal, but neither is it sustainable. Indeed, it is fast becoming apparent that capital is quickly tiring of this industry and its inability to sustain profits, return its cost of capital and thus reinvest in itself at market rates.

In an industry that has succeeded mainly in destroying decades of capital, the end game for some airlines may be near. To inject new funds into its operation, United Airlines’ required collateral was reportedly three times the $175 million in cash it raised. More troubling yet -- the coupon rate on the new debt was 12.75 percent. Even with exorbitant collateral demands and above-market interest rates, new investors were willing to pay only 90 cents on the dollar for the security, which equates to an effective return to the investor closer to 17 percent.

At the same time, American announced it will sell $520.1 million in debt . American’s collateral requirements will be hefty, but slightly less than twice the amount it plans to raise. According to the Associated Press, American’s debt is investment grade based in part on the assets pledged as collateral. Therefore, American will pay significantly less for its capital than will United, even if the investor interest level is on par. But with corporations of this size, and of this importance to the US economy, “investment grade” ought to be the baseline, not the high bar. That’s not the case today. Earlier in the year, Southwest -- the industry’s only capital-worthy airline -- was forced to pay in excess of 10 percent on its loans. Wow. In other circumstances, that might be considered usury.

Data Points

Market perceptions, and cold, hard cash, demonstrate a new industry pecking order is emerging. Allegiant, AirTran, Alaska and SkyWest – airlines many Americans have never flown -- each today have a market capitalization greater than that of either United or US Airways.

In Spring 2009, Fitch’s Airline Credit Navigator outlined current liquidity and expected debt maturities for airlines over the next three years. It found “most of the biggest U.S. airlines ended the first quarter in "unfavorable liquidity positions.”

For three of the top seven carriers (US Airways, American and United), this liquidity ratio fell below 15 percent of trailing twelve month revenues - a benchmark commonly used to target an optimal amount of cash to be held on the balance sheet.

According to Fitch’s data, American, Continental, Delta, United, US Airways, Southwest and jetBlue held nearly $17 billion in liquidity at the end of the first quarter of 2009 (and with a market capitalization of $13.7 billion for the same group of carriers, the market says that a dollar today is not a dollar tomorrow). Southwest and Delta constitute two-thirds of the group’s market capitalization.

Assets are only one part of the disturbing picture the Fitch data paints. The other half is liabilities. Together, the carriers have debt obligations of nearly $12 billion due by the end of 2010. And these obligations come at a time where negative free cash flows are anticipated for the foreseeable future.

Take as one example Delta, which claimed title as the world’s largest airline following its merger with Northwest. While in the first quarter of this year Delta did not fall below Fitch’s relatively arbitrary liquidity rating. Fitch nonetheless downgraded the debt ratings of Delta and Northwest on June 25 to reflect “intense revenue pressure” and expected negative cash flows. As a result of its combined balance sheet with Northwest, Delta has a stronger absolute cash balance relative to the industry, but still faces nearly $5 billion of fixed debt obligations through 2011.

The shift of capacity by the U.S .legacy carriers to international markets has suffered from poor timing. For United, its exposure to once lucrative trans-Pacific markets is even more painful as the geographic region is closest to intensive care. By comparison, American and US Airways are fortunate to have little relative exposure in the Pacific. But the winner is likely the new Delta which, with lots of eggs in all international baskets. This diversification will certainly produce better results than either Northwest or Delta would have achieved individually.

Renewed Consolidation Focus Based on an Old Tool?

In prior eras, the airline industry has relied on the “failing carrier doctrine” to combine companies on the verge of collapse or unable to meet debt obligations. That doctrine might be dusted off and used again during the next 12 months. Precedent shows mergers and acquisitions are viewed more favorably – with fewer concerns about competition – when the economy is in a swoon and airlines are at greater risk of going under.

US Airways chief Doug Parker is not alone in making a case for consolidation. United’s Glenn Tilton is also in the chorus. Both carriers are on Fitch’s list of those in the “liquidity danger zone.” United and US Airways still have some room to maneuver, but recent attempts to raise capital have proven, in the airline industry particularly, money is getting increasingly expensive.

We may be entering a new era in which the “failing carrier doctrine” no longer applies. Instead, we are now facing the “failing industry doctrine.”

On Second Thought

One of the big issues related to mergers not discussed enough is the preservation of the tax loss carry forwards that each airline has accrued (accrued losses can be used to offset profits in future years). So in the short to medium term, the industry may resist the urge to merge because a change of control could or would have significant tax ramifications. If this is the case, why not apply the failing carrier doctrine to anti-trust immunity?

First, there is no doubt we will see additional capacity cuts, with the next round showing up in the schedules for fall of 2009. This industry is not shrinking because it wants to, but rather because it has to. By the time airlines cut further at the end of the summer travel season, the industry’s two decades of economics-be-damned growth may be nothing but a memory of bad decisions gone by. Then the U.S. airline industry can finally get down to the business of being a business. Or be resigned to failure.

As I have written time and again, in this economy, capital will determine the survivors. Access to capital is the lifeline airlines need now. Those who control that capital are sending a message to legacy carriers, and that is they will pay dearly for funding until they can demonstrate a sufficient return for investors.

Republic Airways Holdings, Inc.

Recognizing the importance of that lifeline might shape the airline industry of the future. Republic Airways CEO Bryan Bedford seems to already be moving that way. As a result of his purchase of Midwest, Bedford now has investment firm TPG on his board - - basically, capital now in is the role of decision maker.

Whether other carriers can accept that kind of change might very well decide the future of the industry and whether some airlines even survive. Right now, that future for many airlines and the hundreds of thousands of people they employ is anything but bright.

Keep in mind, the next industry shakeout is not reserved for the big players alone. Look for entities other than the five legacy carriers (American, Continental, Delta, United and US Airways) to have input into any new architectural renderings of network structure. And input will not only come from Alaska and from the so-called low cost carriers, (Southwest, jetBlue and AirTran) but also some regional carriers like SkyWest.

And I keep coming back to Republic.

Aboard UA #2: Reading Captain Wallach’s Latest Half Truths

I have a long institutional history at United, primarily working on behalf of the Association of Flight Attendants. In this role, I worked with the flight attendants through every concessionary period, the ESOP attempts, and Phase One of bankruptcy -- a long association that ended when I spoke my mind in a media interview on the vulnerability of defined benefit pension plans and, in doing so, angered some in the union leadership with my candor. .

All by way of saying that there is very little in United’s recent history, at least between 1985 and 2003, that I did not witness up front and personal.

The Recent Spat

The latest static at UAL involves a war of words surrounding United, Continental, Air Canada and Lufthansa in their application for anti-trust immunity to operate an international alliance. This debate is creating much more noise in Chicago than it is in either Washington or Brussels and that’s for one reason: the noise comes from a desperate union leader who waited ten months to voice concern about any potential impact on United workers.

This is the very same union leader who sits on United’s Board of Directors. His administration was subject to a federal court injunction to end what Judge Joan H. Lefkow ruled was a job action in clear violation of federal law. This, in fact, is a union leader who fancies himself as the second coming of ALPA boss Rick Dubinsky – the legendary golden goose hunter that worked more than 15 years to create many of the problems that still plague United. But, Mr. Wallach, you are no Rick Dubinisky.

Sometime after Wallach’s anti-trust immunity concerns were made known via the press, United COO John Tague, sent a letter to employees explaining United’s successful alliances with ten airlines over the course of the past ten years – none of which had led to problems or complaints with the carrier’s unions. A day later, Wallach responded with an open letter to Tague and copied all United employees – a tirade he then shared with the media as demonstrated by this submission to Forbes.com.

Wallach’s Letter

Wallach opens citing what he calls blatant mischaracterizations and outright falsehoods contained in Tague’s letter. But after reading Wallach’s letter, I am of the mind that it is he who is guilty of blatant mischaracterizations and outright falsehoods.

In building his case, Wallach attempts to blame United’s role in the STAR Alliance for the airline’s trouble today . . . a dubious case he makes by comparing the size of United in 1997 when it first joined STAR to the carrier’s size today. That argument conveniently fails to note that 1997 marked the middle of the greatest up cycle in US airline history, and then neglects to account for all the industry trouble that has transpired since. But that’s what the industry has come to expect from unions that spend more time and capital attacking companies through half truths and blatant misinterpretations rather than working to address the economic and competitive realities at the root of the industry’s struggles.

A more honest analysis would take into account the full breadth of events that have had a profound impact on the airline industry since 1997, including but not limited to SARS

1. SARS
2. The growth of the US low cost carriers
3. The rapid deflation of the IPO bubble
4. The puncture of the stock market bubble
5. The advent of internet distribution and pricing (transparency that contributes to lower ticket prices
6. The Summer of 2000 (where actions by UA pilots to “work to rule” impacted service)
7. Ratification of a new pilot contract with rates far higher than the rest of the industry
8. September 11, 2001
9. US Airways bankruptcy filing that led to significant reductions in labor rates
10. United bankruptcy filing
11. Oil prices begin increase to historic levels; crack spreads depart from historic norms
12. Delta and Northwest bankruptcy filings
13. Oil reaches $147 per barrel, driving run up of other commodity prices
14. New rash of airline industry oil hedges in anticipation of further price spikes,
15. Followed by plummeting prices that put many hedge contracts underwater
16. Credit crisis takes hold
17. Consumer confidence falls
18. Economy enters recession in late 2007
19. Recession deepens to become worst on record since 1930’s with global reach into Asia and Europe
20. Pandemic flu outbreak with hardest initial impact in Mexico.
21. United pilots in negotiations over new contract for first time since bankruptcy agreement.

The real lesson is in the extent to which the entire industry has changed over the past 12 years with a permanent impact on the legacy carriers. Wallach weakens his own case by suggesting that alliances have hurt US airline employment without identifying the many factors in the equation.

In fact, I would argue that without the alliance partners United works with today, the airline would be even smaller.

Has the management at United made some mistakes along the way? Of course. The current UAL leadership has no compunction about forgetting the past other than to recognize that the carrier’s past was largely a dysfunctional disaster. But that recognition led to many of the changes to United’s structure and operations in place today. As CEO Glenn Tilton often makes the case, the industry has to earn its cost of capital – something the global industry has rarely achieved over its long history.

Corporate Campaigns and Organized Pilot Labor

The airline unions – particularly those now in contract negotiations, have not shied away from full-barrel attacks on the carriers as one method of soliciting support during labor talks. Ginning up opposition to airline alliances seems to have become the latest tactic in this long-running campaign. But it should not be lost on any industry watcher that the loudest rhetoric comes from the union halls of the pilots at United and American. Ironically, the least noise is coming from the most successful US legacy carriers – Continental and Delta. I’ll leave it to the readers to weigh in as to whether there’s a connection.

But outside the rhetoric there’s a pretty clear case for the benefits of these alliances, particularly for an industry that needs desperately to hold on to its customer base. Maintaining and expanding the current alliance structure is one sure way to do so.

Concluding Thoughts

It is important to filter the daily missives fired from the labor bunker with the understanding that many in the industry are understandably frustrated by the changes and challenges in the airline industry. At some level, the best labor leaders recognize that the industry will not return to the unsustainable bargaining patterns and demands of yesteryear. Captain Wallach should take a very careful look at his union’s history at United and role in contributing to the precarious position the airline now finds itself in.  In other words, make yourself relevant in shaping United's tomorrow.

That history lesson should begin with the pilot-led majority purchase of the company in 1994, a process that began following a strike in 1985. With that purchase, the unions had unprecedented power in the governance structure and influence so strong it included hiring and firing power. But as the ESOP sunset, there was no transformation – no new culture or structure that prepared the airline to weather the trials to come. Instead, the transformation has come as the result of seismic economic factors that are redrawing the global airline industry map. And that map includes alliances – a necessary partnership in an industry in which US airlines aren’t permitted to act like other global businesses and merge.

There is not one legacy carrier in the US today that could stand alone and compete on a global scale. To stand in the way of market evolution is to stand on a dangerous path.

Empathy for Ron Gettelfinger

What, Swelbar showing empathy for a labor leader? Yes. In fact, my feelings are not dissimilar to the emotion I felt for airline labor leaders a few years back, when the solvency of so many carriers was in question and some of the biggest went on to file bankruptcy. Trust me, no one wanted to be a labor leader in the airline industry following 9/11. Today, I’d bet that there is no human being that wants to sit in for Ron Gettelfinger, the damned-if-you do, damned-if-you-don’t President of the United Auto Workers (UAW).

On Tuesday, Fox.com posted a piece entitled: With GM's Wagoner Ousted, Should Union Head Have Met the Same Fate? In my view, absolutely not. In the early days of Swelblog.com I wrote a piece entitled Self Help in which I praised the negotiating strategy of the UAW. This was on October 11, 2007, long before the spike in oil prices, the freeze in credit markets and the downturn in the economy that has left consumers with little to no confidence in the future and contributed to a decline in consumer spending.

The contracts Gettelfinger negotiated at GM 18 months ago attempted to address many of the competitive disadvantages the US auto industry faced. Those negotiations resulted in, among other items: 1) freezing base pay for 4 years; 2) shifting a significant share of the burden of retiree health care from GM to the union; 3) creating a two-tier compensation structure in return for job protections for the current workforce.

Think about these terms. Unpopular? Anti-worker? Unsuccessful? Yes to all. But the new contract made significant ground in bringing about some of the necessary changes to a collective bargaining agreement born of decades of negotiation between the UAW and the Big Three carmakers and costs that had spiraled out of control. These were well-intended fixes to contractual language written when times were different – but the fixes allowed some historical language to remain. This was well-intended language that would only produce real benefit if the industry grew.

It is like pilot scope clauses: there is only value in the language when it happens. Some might argue this point – don’t scope clauses restrict airlines from even considering new routes/planes/partners when it would potentially violate scope – even when company growth presents itself? Only growth is not in the cards for U.S. auto industry, - or the US airline industry - at least not unless, and until, there is real change.

Just like the automakers, the legacy airlines continue to negotiate from outdated language. Most of these contracts were written when technological changes facilitated productivity improvements that could offset pay increases, and when targeted capacity growth would build airline markets where there was no evidence that the market could support new air service. At the time, collective bargaining agreements did more to ensure that labor would take advantage of technology change rather than to adjust work rules and expectations to account for the advantages new technology brought.

Unfortunately for the airline industry, there is no techological change on the horizon that will increase the speed of the aircraft in a meaningful way.

I have written many times here that the auto industry cannot make the necessary changes without a court-assisted restructuring. The same was true for the airline industry. The problem is that, even in bankruptcy, the airline industry still left decades-old and largely irrelevant language in their collective bargaining agreements. Bankruptcy was effective in dealing with the low-hanging fruit, but did not do enough to position the airlines for long-term success.  Simply, the flexibility to match the work force to the demand environment was not negotiated.

So here we sit with significant negotiations to be done at United, American, US Airways, Continental and AirTran. No labor leader at any of these carriers has stepped up the way Gettelfinger did 18 months ago when he was willing to challenge decade’s worth of old-labor ideas and ideals in return for better positioning GM in tomorrow’s world.

Lee Moak, the head of the pilots’ union at Delta, came closer than any other union leader in acknowledging that change was inevitable as the Delta-Northwest merger moved forward. Moak did what any first-mover in a merger world would do and negotiated the best deal for his members. The problem is that Moak did too good of a job given the state of international markets. I only hope he can hang on to what he negotiated.

We have new contracts getting done across the industry. Interesting and different mindsets at Alaska and Hawaiian have produced some very different agreements. Southwest ground workers have ratified a deal. Southwest has announced a tentative agreement with its flight attendants.

And Southwest this week revealed details of an agreement with its pilots that in my view will prove to be a mistake – with the company caving to the union and giving pilots too much specificity in scope. Southwest did show amazing restraint in agreeing to wage increases, but I had expected it to come without “handcuffs” on code sharing. With this contract, we can see quite clearly how Southwest is aging and facing many of the very same labor struggles that have long dogged the legacy carriers.

I feel for those employees that have “given back,” whether through concessionary contracts or at the demand of a bankruptcy court. But that doesn’t change the fact that the give back was from a level that was unsustainable and would have occurred, eventually, come hell or high water.

This current negotiating period is important to both management and labor. Hopefully, the airline industry will produce leaders like Gettelfinger that recognize that tomorrow has different challenges than yesterday, and that labor leaders have a crucial role in negotiating contracts that protect the workers who helped build the industry, while at the same time ensuring that US aviation can be competitive in the future.

Some call this approach “eating their young”. I call it smart. Because there is nothing that Gettelfinger and the UAW can do today to fix what was done 20 years ago. But labor leaders in the airline industry should do everything in their power to avoid the situation automobile labor now faces. Labor leaders who succeed in the long term will be those who set realistic expectations for their members, resist the urge to overpromise and, like Gettelfinger, recognize that change is inevitable and that labor can and should be a key player in making it work.

More to come.

Thinking about the Federal Reserve’s Beige Book

A couple of headlines in the past days got me thinking. The first is: "Emirates to pull A380 from NY routes on downturn". The second story is based on analyst reports from Kevin Crissey at UBS and Bill Greene at Morgan Stanley on the declines in unit revenue at Continental Airlines in February and the expectations that March revenue will come in even lower.

Think about it. New York is the first US gateway city for almost every airline. Emirates is not vacating the route but, is downgrading from the flagship A380 aircraft it flies in the world’s largest O&D market after just months in the market with the aircraft.

Add to that the report that Continental, which over the years has established itself as the bellwether on the direction/trajectory of US carrier unit revenue, announced unit revenue declines of 12 percent in February and an estimated 18 percent decline in March, which makes me wonder what’s coming from other carriers.

The Federal Reserve’s Beige Book

This brings me to the Beige Book, in which each of the 12 Federal Reserve districts (Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco) publish a report on current economic conditions eight times a year.

According to the Federal Reserve, the report is based on “anecdotal information” on economic conditions in each district based on reports from bank and branch directors and interviews with business contacts, economists, market experts, and other sources.

So What Does This Have to Do With Anything?

Now think for a moment about where airline hubs are located. For example, Continental’s Houston and New York hubs no longer provide the carrier the same geographic advantages they did even a year ago. Why? Because in the first part of 2008, the Houston economy was still soaring on oil priced at $100+ per barrel, and the New York hub served a still-humming community of investment bankers and financiers. One year later, the price of oil has plummeted by $95 a barrel and the government now rules the canyons of Wall Street.

I’m not saying that the Beige Book provides certain insight into the regional economies that house major airline operations, but there is a clear correlation between the Fed’s primary districts and the hub cities that define commercial air travel. I believe that individual airline financial performance in 2009 will be largely predicated on the strength of these local and regional economies. And they will be different -- and uneven results will occur.

That may be good news for US Airways. The January 2009 Beige Book reports deteriorating economic conditions in the U.S. Southwest, which should have a significant - negative -  impact on the carrier based in Phoenix. On the other hand, US Airways is the least exposed to international markets that were, until recently, considered the most lucrative revenue opportunity for US airlines. Isn’t it interesting that the legacy carrier most exposed to the rigors of the US domestic markets is seeing a different picture?

Concluding Meanderings

As is so often the case, macroeconomics rule airline markets. And geographic macroeconomics likely will have significant impact on individual airlines in 2009. Those carriers with a disproportionate presence in the Northeast U.S. may have a better year than those with a similarly situated route portfolio in the Southwest U.S.. Those with a US domestic presence may do better than those with an international presence. Those with a dominant Pacific presence may do worse than those with a dominant Latin presence. You get the picture.

The only thing that is increasingly clear to me is that some of today’s carriers are going to do distinctly better than others, thus making themselves better short-term credit risks. Those with better access to credit may be able to grow or acquire assets and take advantage of opportunities not available to competitors with riskier credit. And those with geographic advantages -- whether domestically or internationally -- may be best positioned to gain market share and competitive advantage this year. In this economy, the Beige Book might just provide a roadmap not historically relied upon.

Continental, United and the STAR Alliance

One hour ago, Continental Airlines and United Airlines Announce Comprehensive Plan for Global Cooperation; Continental Plans to Join Star Alliance. There will much to learn about this one as it goes forward, but this is one interesting combination with a myriad of strategic and tactical opportunities.

Last month I wrote about the possibility of a United – Continental combination in Swelblog.com: Pondering the Next Move; But Before I Do…….. The piece was written as United – US Airways possibilities were being thrown about. Then the idea of a United – Continental alliance was being tossed about. I wrote a couple of paragraphs where I contrasted these combinations with the Delta – Northwest combination that is on the table. And I wrote……

My guess is Jim “Hell NO”berstar is keeping his powder dry until the next move is announced. The next move will face more intense scrutiny based on the “I told you so” line that was most prevalent yesterday. Honestly, I do not know of another deal scenario that is interesting – let alone transformational – and provides the kind of investment thesis that helps this period come alive.We have United and US Airways merger discussions being tossed around by “those close to the situation”.

Now we have a United and Continental alliance in the news. Readers know I like what Tilton says as he talks about the industry from 40,000 feet – and I am in fundamental agreement that the current construct is good for no stakeholder group.

If I lean to one of the two scenarios being painted in today’s mainstream press, I lean to a United - Continental alliance. Gravity takes me there because it differentiates the combination from Delta and Northwest. Delta and Northwest individually, and collectively, are/will be highly reliant on connecting traffic as their hubs are located in smaller population centers. [And this is why their commitment to maintaining the most extensive network possible is absolutely factual] United and Continental would be building around hubs/gateways where core onboard traffic would be largely local.

I for one look forward to hearing more about this combination.

More to come.

Let’s Just Continue the War of Attrition

Considering the Concept of "Rent Sharing"

Maybe the best answer to US airline industry woes is the same path followed in the early 1990’s when iconic names like Pan Am and Eastern liquidated.

I understand Continental’s thinking, I think. They have many attributes that are viewed in previous consolidation periods as positives: youngish fleet; decent, if not good, labor relations; hubs/gateways in markets with strong underlying local demand; hubs/gateways in markets that have interest not only to those in the US but around the globe; and a respected management team that has not only devised a plan but has acted on it. But they still have a fragile balance sheet just like the rest of the US industry.

Kevin Crissey at UBS writes this morning on Continental’s attitude toward consolidation: “We believe CAL mgmt view consolidation as beneficial over the long run but much less so in the short run as labor would take a big cut of the synergies. With fuel and demand draining life from the sector, mgmt appears to be focusing on CAL's survival and likely views a merger as increasing bankruptcy risk”. Continuing to beat that fuel issue to death, my only question is what is the short-term and what is the long-term for the US industry? Is the short-term six months or is it two years?

Mr. Crissey was right to raise the labor situation and the negative impact on any short-term synergies that might be gained from the overall deal. In last week’s congressional hearings on the Delta-Northwest hearings, I believe that Dr. Clifford Winston of the Brookings Institute referred to the topic as “rent sharing”. The negative synergies in "rent sharing" between labor and the deal in the case of Continental and United are somewhere in the $300 – 400 million range, or double those in the Northwest – Delta case.

But rates of pay are only half of the story. Continental’s pilots are more productive than United’s pilots per month based on publically available data in 2006. If that were to be the case, the Airline Data Project estimates that the increase in productivity to Continental levels would mean that 460 fewer United pilots would be needed. While final 2007 numbers will not be available for another six weeks, rate and productivity calculations underscore just one of many difficulties faced in estimating the offset of overall network synergies by the “rent sharing” calculation between management and labor.

On both the compensation and productivity calculations included in the Airline Data Project, please read the footnote that suggests problems with the US Airways and America West calculations for 2006. Further, and based on the calculations there should be no secret as to the difficulties American has in considering whether to play in this round of consolidation or not. The math for them is particularly difficult.

So maybe we just will not be able to get there. Bankruptcy is less an option unless it is a liquidating bankruptcy like we saw most recently with American and TWA where American purchased the assets of TWA. The few combinations left to consider do little to address the immediate need to minimize exposure to the US domestic market unless the opponents to change recognize that the current structure is simply not healthy. US Airways has too many eggs in the US domestic market basket. Hell, everyone has too many eggs in that basket.

Maybe we should start thinking about consolidation as the world thinks about our marketplace and engage in a consolidation of North America and bring Air Canada and Mexico fully into the conversation. This idea would address the US centric mindset that seems to dominate the conversations among the naysayers.

Talk about a bad time to be a CEO in the airline industry. Someone has to get their fingernails dirty. To be sure, private equity would not want to touch the issues left for the industry to work through. Last night, United said in a statement following the Continental Board’s decision: "Ensuring you have the right partner is everything,"

As the late Johnny Cochran might have said: If it doesn’t fit, you must attrit. And in the long run the survivors will benefit.

The Elastic Induced Ride to Inelasticity

I do not know what you have been doing this morning, but I have been listening to the earnings calls at AirTran Airways and United Airlines. Last week I listened to both American Airlines and Continental Airlines talk to the analysts. It is an accepted principle that volatile prices are most unsettling on commodity industries – and the US airline industry has become a commodity industry.

Beginning in late 2000, volatile prices came in the form of decreasing fares. Today, volatile prices come in the form of rising oil prices.

The initial ride down in fares resulted in the growth of the low cost carrier segment of the industry. That sector's rise occured commensurately with the shrinkage of the network legacy carrier capacity in the US domestic market. The new world of lower ticket prices forced necessary cost changes on the network carrier segment, altered the demand calculus and led many observers to conclude that high load factors demonstrated that there was no overcapacity in the market.

Ah, that elasticity of demand thing. The notion that an airline could fill every seat – but at some price that does not cover the cost -- underscores this shallow approach to the analysis of overcapacity.

Well, the rubber band is about to snap.

In a post last week,: This Week’s Conversation Will Be In Words that Start With “C”, I discussed capacity issues and a whole lot of other “C” words we’re going to be hearing more of as US airlines unveil their financial performance for the first quarter of this year. Covenants; credit card holdbacks; cash; capacity cuts; capx spending plans . . . all are being discussed as liquidity concerns are again top of mind for the industry just like they were in late 2001 and 2002. And I’m not even including consolidation. Based on the market’s embrace (or lack thereof) of the proposed Delta and Northwest merger, there are bigger and more fundamental questions to answer.

And every company has been asked how they might raise cash down the line if needed.

The unhealthy revenue environment that began to form in late 2000 is simply not capable of offsetting the daily spikes in fuel costs that began in 2004. Therefore the industry is left with difficult decisions regarding capacity reductions – a recurring theme as carriers announce additional cuts and slowdowns. Today United, keeping with its aggressive posture, announced the most aggressive capacity cuts of any carrier reporting to date. But say what you will about aggressive management actions, United’s first quarter numbers are hard to swallow.

Capacity reductions will ultimately lead to finding that demand which is inelastic. An elastic demand is one in which the change in quantity demanded due to a change in price is large. An inelastic demand is one in which the change in quantity demanded due to a change in price is small. Volatile changes in price need to be addressed/minimized for this industry to be healthy again – or at least produce that level of supply where costs can be passed on to the consumer. That is where we are headed and it is the right direction. Furthermore, I heard United make it clear on their call that unitary elasticity is not in their interest until it applies to a much smaller segment of their ridership.

Concluding Thoughts

Believe as we might, this industry is not impervious to outside influences that impact every industry. Those influences come in different ways. There will be some consumers displaced by some of these necessary pricing actions. There will be some consumers put out by the sense that they are being nickled and dimed for a change policy, a preferred seat, a second bag that consumes fuel by its weight, or even a meal. There is no free lunch as life teaches us everyday. And for the US airline industry, finally we are saying that no one is entitled to a free ride or at least a ride where the consumer does not pay for the cost of that carriage.

And I wrote this without mentioning force majeur or the need to craft a Failing Industry Doctrine.

Not Time For “Hush Money”

The Status Quo Is the Issue; Not Firing CEOs

Today I received a comment from Carmen on my latest blog post. Carmen is a frequent reader here, student of the industry and a person that is not afraid to say and write what he believes. Even if it means that he is not the first person other pilots seek out in the crew room when he checks in for his trip. He suggests that invoking force majeure might incite a revolution – and I paraphrase.

Carmen is not a current member of his union and his philosophical differences with his union have been written here and on multiple blog sites that cover the industry. Carmen, like others, point to the lack of a people element in the US airline business today is what stands in the way of a successful and sustainable industry when contrasted to the industry we know that perpetually teeters on the edge.

I Said I Would Not Acknowledge

Regarding Carmen’s comments, I responded in a pretty matter of fact tone. After responding, I started thinking back to Bob Reed's piece in Business week last week entitled: It's Time for United's CEO to Go; UAL should keep United Airlines in Chicago—but send Glenn Tilton, its deal-hungry CEO, packing. OK, for those that know me, you know that I have an affinity for Tilton. Do I agree with everything that has been done at United under his watch? No, I do not. Where I absolutely agree with Mr. Tilton is that the status quo does not work for any stakeholder group. Period.

So Mr. Reed, my question to you: are you singling out Tilton or are you joining hands with certain industry stakeholders that are looking for any leverage to maintain the status quo and perpetuate the self-imposed gridlock toward change which afflicts the US industry? It seems to me that any question you asked in your article could have been asked of Richard Anderson at Delta, Doug Steenland at Northwest, Doug Parker at US Airways and yes, even Larry Kellner at Continental. And I am going to include Gerard Arpey of American and I will discuss that later.

And Mr. Reed, I am sure glad you mentioned Continental and its transformation. From my read, about the only thing in your article that comes close to even describing the competitive reality that faces this industry each and every day is the fact that Continental survived the “controversial and oft-despised” Frank Lorenzo era. And I quote further: “the airline survived his tenure (along with two bankruptcies) and eventually morphed into one of the country's most successful large carriers. Now Continental is enjoying solid financial returns, improved customer satisfaction, and stronger employee relations. What's more, its CEO doesn't want to merge and is even ordering new planes”.

Pretty bold statement on the intentions of Continental’s current CEO who has done anything but rule out merger efforts should other carriers in the industry decide to join hands. Then again, it is hard to talk about joining hands when you are encumbered by a golden share that also serves as golden handcuffs. And even bolder to insinuate that other airline CEOs would not want to achieve the same thing that took Continental 10 years to begin fully realizing. And for that matter, that type of success is what CEOs want to be paid for. But the type of transformation that continues at Continental is more akin to a marathon than a sprint.

Where This Whole Post Started

Like today, the industry then was engaged in a shakeout and survival of the fittest when Continental began its transformation. For any Continental, PEOPLExpress, Frontier, New York Air, Texas International (see comment section) and Eastern (did I leave any carrier out?) employee of the time there are plenty of horror stories. But 20+ years later, we continue to witness the legacy carrier that first underwent necessary quadruple bypass surgery to transform itself to a US industry leader.

The only thing different today is that the transformation is more difficult. In the 1980s it was important to build a network, with a cost structure, that gave a carrier some form of presence/dominance within a particular US geographic region. Today it is about building an entity that maintains is preeminence in the US domestic market while spreading its reach to all world regions with a cost structure that allows it to compete where external forces are increasingly complex. Mr. Reed, airline labor, airline consumer activists and Rep. Oberstar would all have us believe that today’s airline world should remain focused on Altoona rather than Auckland; Duluth rather than Dubai.

Carmen in his comment to me mentions pandering and appeasement against a backdrop of a leadership void. Where I am stuck, is that I think there is finally leadership within the industry and there is a vision as to where this industry needs to morph to. When there is leadership and vision, there will be reasons to say no. And today’s CEOs are saying no to a return to the way things have been. They are saying very clearly and in their own way, no to the various issues that led each of their respective entities into bankruptcy or restructuring.

Definitely Not the Time for Hush Money

I asked Carmen in my response: “but isn't what labor wants is an historical return to pandering and appeasement? Throwing good money at the age old problems only makes people happy in the short term. Then the industry has to return and ask for concessions because they can no longer afford the hush money that was negotiated. I am all for saying no and trying to find a way to break this age old pattern. And I think finally this industry has a group of CEOs that can and will say no rather than push off the tough decisions that have been deferred over the past 3-4 negotiating cycles. Popularity contest -- NO. Necessary action – YES”.

It seems that the Northwest employees were more than willing to vote Steenland out in the event of a Northwest – Delta deal. And apparently he was willing to drop his “ego” and step aside in the event of a transaction that he and his board deemed in the best interests of all stakeholders.

My bet is Mr. Tilton and others would/will do the same in return for a deal that satisfies a vision. United has been out front in the consolidation view to be sure. But, United has been out in front suggesting they would put down capacity in the event of high oil prices also. And that simply sounds like managing the business to me. Mr. Reed pleads with United’s Board to “give Tilton his due, provide him fair compensation for time served—and begin the hunt for an executive who can build on his accomplishments and take an independent airline to greater heights”.

But Tilton’s work at United is not yet done and therefore the United Board should no more pay Tilton his hush money to walk today anymore than the prior United administration should have paid the United pilots the hush money to end the dreaded “Summer of 2000” that ultimately landed the carrier in bankruptcy. And certainly Mr. Arpey should not be paying his pilots, flight attendants or any other employees the amounts of hush money they are seeking over an executive compensation plan designed by American's Board. A compensation plan that could have been altered by the Board, not by Mr. Arpey and his management team.

Breaking the boom-bust cycle is much more important than perpetuating the status quo. Maybe we should invoke the force majeure clause on the self-imposed gridlock toward change which afflicts our industry …

To call for one CEO's head when an entire group of industry CEOs recognize that the status quo just does not work is well.......unfortunate.

More to come.