Time Well Spent; Unchanged Catalysts to Consolidation; and Concerns Surrounding the Delta – Northwest Deal

Time Well Spent

A significant amount of my career has been spent participating in labor negotiations surrounding a distressed situation. There are two principles I always adhered to when advising clients: 1) you can always make a bad deal; and 2) strive to make a deal where either both sides are happy or both sides are unhappy because in both scenarios that probably means you have negotiated the best deal possible. Trying to avoid a scenario where one side is happy and the other side unhappy means you have negotiated a bad deal – and that is precisely what Northwest and Delta are trying to avoid.

Justin Baer of the Financial Times writes an excellent piece describing why seniority is critical for pilots. So it is important to understand just why these discussions are taking so long. Given that we are more than 20 years from the US industry’s last round of consolidation involving multiple carriers, pilots recognize that decisions made today will more than likely impact the majority of their remaining careers. But the always thoughtful and insightful Liz Fedor of the Minneapolis Star Tribune raises the specter of a negotiating clock. Another important negotiating rule is that it is hard to negotiate without a deadline.

Whereas many journalists and pundits are suggesting that the end is near in these negotiations, and as a result the much discussed deal will die, I am not one of them. Ms. Fedor in her opening paragraph writes: “A veil of silence has encircled the pilot leaders at Delta Air Lines and Northwest Airlines who are struggling to integrate their seniority lists -- the lone impediment to a merger announcement”. So why is this important? I typically read no talking as a positive sign. And the only people I have heard say Hell No to this deal before seeing the details is Congressman Jim “Hell NO”berstar and members of his staff.

I am an open proponent of change. I am an opponent of closed mindedness. One of the big points that I think is being missed: if there is concern over a political clock running out to get regulatory approval, then weeks spent today could possibly save months gaining regulatory approval for the deal tomorrow. In concluding her piece, Ms. Fedor raises this very important point that I have not seen written elsewhere as well: “If an agreement is negotiated in advance of a merger announcement, the two pilot groups also would be expected to be political allies for a merger during a regulatory review in Washington”.

The Catalysts to Consolidation Remain Unchanged

This morning, William Greene, analyst at Morgan Stanley writes a research note referencing the widely covered internal Delta memo to employees yesterday. The text of Mr. Greene’s note follows:

Delta Air Lines, Inc.
Quick Comment: CEO Memo Does Not Change Our Views

Impact on our views: The Delta CEO memo made public on Tuesday highlights the difficulties involved in completing airline mergers. That said, we still believe a deal is possible near-term for 2 reasons: (1) Oil prices at $100/bbl and a slowing US economy will keep the pressure on major airlines “to do a deal” and (2) the very substantial pay increases and equity ownership that labor stands to receive should a deal happen will increasingly put pressure on labor leaders to find common ground on seniority issues. Moreover, the economic arguments supporting consolidation are as compelling today (if not more so given the macro backdrop) as they were 6-12 months ago.

What's new: On Tuesday, Delta released a memo from CEO Richard Anderson to employees that outlined guiding principles for Delta in the event of a merger. The memo is intended to allay concerns that Delta employees have regarding a merger. Key concerns for employees include: seniority, job security, career growth and maintaining pensions. The memo indicates that any deal must satisfy these key concerns and a deal that does has not yet been attained (see memo on next page for more details).

Investment thesis: We maintain an Overweight-V rating on DAL primarily due to the company’s positive stance toward consolidation and good position vis-à-vis our key themes (market exposure, strategic actions, and labor risk). We also see relative value in DAL, although we note that we see the group as a whole as overvalued on an absolute basis at current oil prices. This is one reason we continue to recommend that investors sell into strength on news of consolidation. Should the stock run sharply higher from current levels or if the outlook for consolidation changes dramatically, we may need to revisit our rating.

Concerns – And Yes I Have Some

In a post earlier this month, I asked the following question regarding a labor leader’s decision making whether to support a deal or not: is the implementation risk of a merger deal (seniority integration, single collective bargaining agreement etc.) any greater than a leader having to manage the expectations of any employee group that actually believes they can make themselves whole in the next round of Section 6 negotiations?

While I understand the Northwest pilots are not prepared to sign on just because they would work under Delta rates of pay on the day following consummation of a deal. But doesn’t the question beg, as far as career earnings are concerned, just how much would pilots earn at Northwest if the company were to remain a stand alone entity? What are Northwest’s 20 year growth prospects? Will Northwest be able to duplicate organically what it would get fairly quickly in a deal with Delta? Will labor have any better opportunity over the next 5 years to do any better by their members?

Only the Northwest MEC can answer these questions. Where I am concerned is that the Northwest MEC is being advised by counsel in the Northwest – Republic seniority integration and in the most recent US Airways – America West pilot seniority integration (also reported by Ms. Fedor). By now everyone is aware that there are few, if any, success stories in either of these two cases. I just hope that decision making is not being clouded by the prospect that somehow past wrongs can be righted through this deal. But only those that know, know.

So hopefully either all will be happy or all will be unhappy. Otherwise just go ahead and say "Hell No". At least someone will be happy.

Where is Swelbar? Thinking About US Airline Industry Structure in Zurich

Well Swelbar is sitting in a lounge in Zurich on his way to Dubai. But the day is no different than any other day. I wake up from my sleep, only this time I awakened in the comfort of United’s new business class interior. The new first and business class interior is a significant improvement over the previous offering and a product worth trying. (Now remember I remain a United shareholder). But, lie flat in business class is a nice seat and of course the video and audio entertainment is much improved as well if you are into that stuff.

But I am not a guy that plans to write much on aircraft interiors. I am a guy interested in the competitiveness of US carriers in the global marketplace. Whereas it has been said that the new interiors being installed by United and American may be an iteration old when compared to the interiors of the major global players, it is a start.

Theories Behind Consolidation

While I do not have much time to write this morning, Barney Gimbel of Fortune Magazine writes an interesting take on the Delta – Northwest deal. As I have written about this expected deal, the devil is in the details, but…… The stories to date suggest that labor stands to make gains in the neighborhood of 30%, at least in the case of the pilots. Further the stories suggest that very little flying will be cut, hubs will be maintained and in fact new service may be offered. No, that does not sound like consolidation or what I call phase 2 of the industry’s restructuring started in 2002.

But if ensuring that one group of employees does not have rates of pay less than another group of employees, those rates need to be adjusted to address the known internal strife that will be generated if not addressed up front. Moreover, strife that will stand in the way of achieving synergies in the many areas of the operation that are certain to be addressed.

If part of the increase includes future pay raises granted under a single collective bargaining agreement, then the question becomes over what term? Is commensurate productivity to be gained in return for those wage increases? And what period of time does a new collective bargaining agreement cover? These are important issues and questions to ask – and the devil will be in the details.

My take on the facts gathered from known good sources of reported information is that Delta will first try to maximize revenue from a "network rework" then turn to difficult cost cutting issues as they evaluate the top line performance of the "reworked network". The US Airways – America West merger did produce revenue synergies as the networks were combined. Pittsburgh has in effect been closed. But few, if any, meaningful other cost synergies have been realized. And this is partly the result of the labor divisions that stand in the way of full operational integration.

Mr. Gimbel raises a point that I have been raising on this blog since the beginning – and that is about finding a sound and sustainable industry structure. Yes the industry is made up of individual carrier and other disparate interests, but the key to a better tomorrow has to be in addressing the known fragmentation of the home market. And that involves tough and painful decisions otherwise we do just continue down the path of attrition that will be disproportionately painful for many.

It is widely assumed that when a Delta – Northwest deal is announced, others will follow. If United is involved, we know there is a management team that will pursue both a revenue maximizing and cost- minimizing approach and this may change the thinking of all carriers considering combinations.

Banking on revenue alone is a dangerous approach given that we still do not know the real underlying condition of the US economy or what effects the condition of the US economy will ultimately have on the global economy. Combined networks will result in the ability to sell city pairs tomorrow that one cannot sell today. But the health of city pairs are still impacted by the underlying economic forces.

So let’s wait on the details. Let’s acknowledge that there are many ways to address less than adequate financial performance. I do not believe that consolidation is a panacea by any means, but what I do know is that today’s industry construct does not work.

The debate on approach can only begin in earnest once we know how all of the "new" pieces will fit together. Mr. Gimbel raises good points. But, even he is early in the game to declare that it just does not work. It took a long time to create these structural inefficiencies and they cannot be erased with one deal. It will take more than one and a piece here, and a piece there. Otherwise we just perpetuate the status quo.

More to come.

Thinking about This Week’s Airline News: Industry Structure; Labor; and the Customer

Setting the Table

On October 8, 2007, I wrote the following in a post: “Some want to believe that the cost cutting is done. It is not. Some want to believe that it cannot get worse and it likely will . . . at least for some carriers. The low hanging fruit has been picked from the expense tree which only means that the hardest work is still ahead”.

“Over the next 2-3 years the winners of this war of attrition will begin to emerge. I am not alone in my belief that there are simply too many airlines– mainline and regional -- too many hubs and too many parochial interests among the stakeholders to make this market work for everyone”.

In a post on October 21, 2007, I wrote a piece where I was addressing employee and community entitlement to employment and air service. “Defining Entitlement Economics: all are conferred a lifelong right to employment and/or abundant service despite the fact that the economics of the US airline industry, particularly its domestic operations, have changed significantly since the early 1990’s”. Nobody is entitled to a lifelong right of anything.

Yesterday, The Economist ran two separate articles that are a must read from my perspective. The first opinion piece entitled The Need to Shrink picks up on the very themes that have been written in this blog since its inception. The second, entitled Aviation A normal industry? cites the many catalysts for consolidation that we have discussed here as well.

But more importantly the article raises the specter that US aviation is anything but a normal industry due to the protectionist policies in place as well as the entitlement issues that the various industry stakeholders possess. The article also offers the global view that success for commercial aviation needs a healthy US market – a theme that this blogger believes firmly lies at the foundation of US carrier secondary status in the global marketplace today.

Labor and Expectations in Consolidation Scenarios

I am encouraged by the involvement of labor by each Delta and Northwest. There have been numerous news stories throughout the week on the subject. We should not be discouraged by the delay in announcing the deal as they engage labor in the discussion. A delay in the announcement measured in weeks could potentially take months off of the time it takes to get a deal approved.

What I am discouraged about is the sense by some that labor will be able to reclaim a significant level of concessions granted in return for agreeing to a deal. If we are looking for a merge lane back onto the virtuous cycle of value destruction that has plagued the industry since it was deregulated, let’s just stop the process and continue the war of attrition. If this is to be the transformational period that can hopefully address many of the remaining structural deficiencies that exist, this simply cannot happen.

As in any negotiations, there were more than likely some changes made to respective collective bargaining agreements that have not yielded the desired results for either management or labor. Those are the types of things that can be fixed.

Commercial transactions like these are not undertaken lightly. Consolidation for the sake of consolidation is not what this is about nor should be about. Rather, this is a careful examination of what continues to stand between the status quo and what is necessary to create sustainable, investable enterprises. Increasing costs for the sake of peace does not create a pathway to a sustainable and investable business.

All airline labor should explore other means of wealth creation rather than increases to base wages. It is called at-risk compensation. Sure your buy-in to any proposed deal is critically important. The industry just does not have the ability to pay today – not that it ever did.

But as The Economist article suggests: today’s managers are focused on the business of cost cutting that is necessary to adapt the business to the rough and tumble operating environment of today and prepare it for heightened competition tomorrow. Like it or not, these very same managers will make many tough decisions that their “nicer” predecessors did not address in the spirit of harmony. And in the end, those that acknowledge the need for change and that a continued restructuring and transformation is necessary will reap benefits that today’s structure simply cannot produce.

The Customer

In all of our talk here and elsewhere about the need for fundamental and transformational change, I am in hopes that the customer finds its way to the very top of the list. We spend lots of time discussing employees, communities, shareholders, Congress and industry vendors. Each of these stakeholder groups believe that they have some entitlement to reap from this industry.

Unlike in the bankruptcy process when the customer barely got mentioned as important to a plan of reorganization, the only stakeholder that is truly entitled to a better tomorrow is the customer. There are no other stakeholders without customers. The investment in the business needs to be in the customer and to demonstrate over time that airlines can regain their confidence. Continental, beginning in the mid 1990s, invested in gaining customer confidence in their product and it translated into higher revenue. It can be done.

Continuing to Ponder a Northwest – Delta Combination

Over the past weeks, I have written about what I see as catalysts behind the current consolidation talk/activity that is enveloping the industry. In addition to the catalysts I have talked, as have many others, that the two biggest hurdles to a deal are labor and the regulators. Further I have addressed an influential member of Congress that supported open skies and increased competition in the name of consumer benefits but fails to recognize that a healthy US industry lies at the core of delivering those very consumer benefits.

The Labor Hurdle

Unlike the naysayers who continually point to labor issues as likely to derail any potential deals, I actually see labor as a catalyst to the current activity. Why you may say? Because simply, any enlightened leader understands that the next round of Section 6 negotiations cannot, and will not, make their respective members whole following the restructuring round of negotiations.

The industry is no position to return to labor the $11 billion in concessions made over the period particularly when faced with a fuel headwind of $14 billion over the same period. What labor can do in a consolidation scenario is to position themselves in multiple ways to address their most pressing near term concerns while doing their best to ensure that their members will survive the ongoing Darwinian Struggle.

The three most significant issues facing labor in any consolidation scenario are: 1) determining labor representation; 2) seniority integration; and 3) negotiating a single collective bargaining agreement. I recently wrote a post on the first two items which discussed the nuances of potential Delta merger scenarios. The next day, Susan Carey and Paulo Prada of the Wall Street Journal filed a story in which they write “Executives at Delta Air Lines Inc. and Northwest Airlines Corp. are trying to build a common labor contract for the 11,000 pilots at both airlines before they complete a merger deal, according to people familiar with the matter”.

Further they write, “Delta and Northwest want to quickly achieve the synergies that would flow from a merger and avoid a messy, protracted labor wrangle that could arise if they wait to get pilots' agreements after a merger were announced or consummated.”

What is encouraging with all of this news is that the current industry is working hard to address many of the issues that the talking heads of the industry like to use to create doubt. If a single collective bargaining agreement construct is agreed to, Delta and Northwest have placed a high hurdle for any deals that might follow. I guess Delta and Northwest are redefining what conventional wisdom has come to accept as a labor hurdle.

The Regulatory Hurdle

If the current “odds on favorite” deal plays out, nearly 14 months to the day after Delta began its work to fend off a hostile bid from US Airways, Delta will be put in the position of defending why a consolidation scenario makes sense for the carrier, and the US industry, versus pulling out the guns to explain why a deal makes no sense. Ironic, yes. Surprising, no. Aside from Atlanta and a good market position in New York, the Delta network is anything but an envy of the industry. As for Northwest’s network with it hubs in Detroit and Minneapolis/St. Paul, the best description of their domestic network remains – it is cold, it is dark and it is ours. Just not high traffic volumes to Fargo and my Duluth home.

In the link to the powerpoint presentation entitled “Proposed US Airways/Delta Merger Would Be Highly Anticompetitive” above, it is easy to see how Delta played on the small community air service fear. It is also true that a combination with Northwest will result in a very different competition analysis given the more end-to-end attributes of the two networks. My guess is the combination will be looking for similar synergies that US Airways recognized -- read fixed cost savings while not undermining the pro forma revenue line of the merger scenario.

It is true that the Atlanta and Charlotte hubs have significant overlap. It is true that Salt Lake City overlaps with Phoenix and Las Vegas. It is true that Cincinnati overlapped with Pittsburgh (particularly before the downsizing). I am not going to acknowledge the suggested cited competitive overlap between New York JFK and Philadelphia as problematic.

There have been some reports suggesting minimal reductions can be expected at any of the hubs utilized by either Northwest or Delta. Look at page 6 of the powerpoint presentation. If Charlotte and Atlanta served 90 similar points, just imagine what percentage of cities served at tiny Memphis are served by Delta’s Atlanta megahub? The same statement would apply between Cincinnati and Northwest’s megahub at Detroit. And this is before we throw Midwest into the network mix.

Yes the restructuring that just recently concluded removed some of the redundancies between the Delta and Northwest networks. When US Airways made that hostile play for Delta, traditional anti-trust analysis would have shown this combination (DL/NW) to drive a higher concentration of market power than most other possible combinations. And a Continental – United combination would create a relatively low measure of market power across their respective networks.

But Is This What Is Really Important?

I am actually troubled by my own post. I have just spent 1000 words talking about what happens inside the 48 contiguous states and not what is transpiring around the globe. I am not talking about competition for China traffic between US carriers with authority today and what Korean Airlines carries over its global hub at Seoul. I am not talking about the global elite carriers that have prospered while our carriers have languished in a fragmented and hypercompetitive home market. I am not talking about the prospects of Singapore serving London Heathrow and New York with a far superior product.

No, I just did what many will try to do and limit the analysis to competition at home and not around the globe. And isn’t it the economic forces of globalization that are really at the heart of change? The naysayers will continue to fight those forces. In the end the forces always win. And in the end it really is about what structural changes need to be made to ensure that the US is in best position to regain a world leadership position. Let’s really think this through before dismissing it out of hand like Congressman Oberstar.

More to come.