A Walk Across the Last Five Business Cycles

On Monday January 13, 2014 I am pleased to be joining two panels at the 93^rd meeting of the Transportation Research Board in Washington, DC.  On one panel, Airline Consolidation: Impacts on Stakeholders and the Industry, I will be joined by my MIT colleague Mike Wittman to speak to a series of MIT white papers on small community air service.  The panel will be moderated by one of the industry’s good guys, Paul Aussendorf of the Government Accountability Office.

The other panel, Economic Deregulation of Airlines: A Promise Realized?, will have as its moderator another industry good guy in Robert Peterson of Boeing.  Some might say deregulation is a tired topic, but there are many critical lessons to learn from the past 35 years as we anticipate what’s ahead for investors and stakeholders in today’s industry.

ACROSS THE BUSINESS CYCLE

With shareholders now demanding profitability across the entire business cycle, I’ve analyzed the industry since deregulation across five distinct economic rounds.  It was interesting to look back on each of the five cycles and what insiders and observers said about the airline business. Consider Alfred Kahn, the so-called Father of Deregulation, who in 1977 admitted he did not know one plane from another.  “To me,” he said, “they are all just marginal costs with wings.”

Based on that over-arching simplification by the man in charge, the industry was being led down the marginal cost path all the while that a fully allocated cost approach should have been adopted.  Ah, hindsight. It was too late, but the story is a great one.  It’s got colorful characters like Marty Shugrue and Frank Lorenzo, smart guys like Michael E. Levine and Warren Buffet, and current wisdom from the guys now running the big airlines, including Jeff Smisek and Richard Anderson.

A hard look at the financial data shows that the industry actually made a few pennies on a pre-tax basis through the fourth quarter of 2001, the end of the third business cycle.   The average cost of fuel was then $0.62, down from $0.84 during the first business cycle.  On a cost per seat mile basis, labor costs were managed with a deft touch during the entire 35-year period, despite that fact that the average cost per employee grew roughly at the rate of inflation.  Average wage growth outpaced productivity growth.  And any financial or economic efficiencies were competed away in the form of low and lower fares.

Warren Buffet said it best:  “The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines.”

All told, the industry lost $36 billion on a pre-tax basis, or 1.2 cents on every dollar of revenue.  But that is changing.  Load factors are up over 14 points across the last two business cycles as capacity growth slows. The current cycle is producing an operating profit margin that is 1.2 points higher than that earned during the best performing cycle – and after 17 quarters, the macroeconomic indicators are starting to be true tailwinds.

I can’t overstate the effect of load factor and ancillary revenue on unit revenue.  In the current cycle, the increase in unit revenue actually outpaces the increase in the consumer price index – an achievement long overdue.  Yet despite what is described by one prominent analyst as a “Goldilocks economy,” margins remain below the targeted level.

The first four cycles were defined by cost cutting and sheer survival.  Given that there is little low hanging expense fruit remaining on many airline income statements, the current cycle is all about the revenue.  As it should be.

WHAT COMES NEXT?

Whereas the current cycle shows incredible promise for profits, without some technological breakthrough that allows us to fly faster and longer, where will we find the efficiencies on the expense side of the ledger? Spirit and Allegiant are prospering by carrying passengers that the network carriers cannot afford to carry.  So how much more can airfares rise before an Ultra Low Cost Carrier (ULCC) revolution breaks out in the US domestic market?  As we test the limits of price elasticity, cost creep is a reality in labor and non-labor unit costs. 

Near-term, all things point bullish on the airline sector.  However, we know that growth prospects are limited for the higher cost network carriers in the domestic market.  Internationally, the next logical step (or the only step remaining after joint ventures) is to allow cross-border mergers. Is that the answer? I think not, at least if I am a US carrier looking to buy something outright.  Removing barriers is a good thing, but I can’t see too many U.S. carriers buying a European alliance partner that operates at 21 cents a seat mile - a cost that likely goes higher before it goes lower.

With all going so well, why even bring this up?  Because we need to be thinking from the position of financial strength that has taken so long to reach.  I trembled a couple of weeks ago when a headline in the Washington Post read:  GDP Grows an Adjusted 4.1%.  With indifferent macroeconomic indicators in play during the first phase of this business cycle quickly becoming tailwinds today, one hopes that the lessons learned this decade stick.  The cost creep found in some areas of the income statement gives pause particularly if one believes, as I do, that the industry is approaching a passenger revenue inflection point.

Robust periods of past business cycles have led to some bad management decisions.  I hope the leaders of today’s airlines will not repeat them.

Musings From the Last Five Weeks

US Airways - American

$130 here - million I mean.  $100 million there.  Couple hundred here and there.  A chunk of the company for you.  A less than desirable chunk for me.  Hey PBGC, what do you need so we can carry a pension liability on our balance sheet going forward? That’s not a problem since the “old” US Airways terminated its plans!  While we are at it, let’s keep 15,000 more employees than a similar-sized United (each carrier would generate approximately $37 billion in revenue) because, after all, the synergy generation will surely cover it.  It’s the new math - circa 2012.

In its quest to acquire American Airlines, US Airways sounds like a teenager with its first credit card, spending money it doesn’t have.  Paper wealth.  What cracks me up about this “plan” is the new math I mentioned. Critics pan AA’s goal of creating $1 billion in new revenue as bogus because, among other issues, it assumes no competitive response.  Does anyone really think United and Delta are going roll over and let US Airways improve its revenue generation at their expense? Not a chance.

UAL CEO Jeff Smisek said last month a US merger "net, net, that would be good for us." Will there be more competition on certain city pairs?  Yes.  But neither United nor Delta are afraid of competition much less the threat posed by the paper tiger US Airways/American combination.   Smisek and Delta’s Richard Anderson are smart. They know the synergy formula US has seduced some media and AA’s unions with is but a calculation at this point.  Even American’s own pilots admitted in bankruptcy court this week its faux “deal” with US doesn’t include cost assumptions or valuations.

In other words, US is spending money it has no idea whether it will actually have. It is one thing to have a term sheet and quite another to have written contractual language.  My bet is United and Delta see that the first mover advantages created by mergers have already been mined.  For AMR’s creditors – including the labor unions – there are a host of other issues with this proposed takeover.  It is my opinion that US’s new math adds up to the likelihood that they may need to visit out-of-court cost cutting exercises within a very short time to finish the job that they are choosing not to finish during the courting stage – particularly if exogenous shocks again plague the industry.

Showdown in Houston

Most readers of www.swelblog.com know I was asked by United to help study the findings of the Houston Airports System (HAS) report about Southwest flying internationally from Houston Hobby Airport.  HAS and its consultants originally claimed that 23 flights by SWA from Hobby would create in excess of 18,000 jobs and generate more than $1.6 billion in new economic activity for the City of Houston. 

Stratospheric numbers like those don’t pass the sniff test, yet Southwest executives Gary Kelly, Bob Montgomery and Ron Ricks reference the HAS findings as if they were they were gospel.  More on this later.

I believe the HAS study is seriously flawed and is based on what has become known as the “Southwest Effect.”  Problem is, the “Southwest Effect” is a largely a thing of the past.  It got its name from a study completed more than 20 years ago by the U.S. DOT when jet fuel was the equivalent of $30 per barrel.  The fundamental premise is lowering fares will create a disproportionate level of “new” demand in a market. 

Despite the fact Southwest has no experience in flying to international markets, the HAS study assumes traffic will increase 180 percent.  Relevant empirical data shows Southwest’s (135 city pair markets entered since 2006) entry into new markets over the past five years resulted in traffic stimulation of only 10 percent. The latest data shows fares in those markets have actually increased – not decreased.  The HAS study, at a minimum, grossly exaggerates the benefits of a Southwest entry into duplicative markets and is based on a host of unrealistic assumptions. Publicly available cost data shows international flying done by Southwest from HOU would lose more than $76 million per year.  Even Southwest is not flying markets that lose that kind of money despite its self-proclaimed benevolence toward the air travel consumer.

The economic stimulation predicted by the HAS study claims that prices will decrease 55 percent lower than United’s fares.  The truth is, what Southwest calls “stimulation,” is comprised mostly of the cannibalization of IAH traffic which adds nothing to the Houston economy.

The “Southwest Effect” does not drive benefits to local economies as it once did.  Even Gary Kelly agrees.  When pinned down by the Houston City Council on the number of jobs that would be created at Southwest from its limited entry to routes already served, Kelly admitted that total number (nationally) would be 700 and direct Southwest jobs created in Houston would be 50-100. Kelly went on to say that even these 50-100 jobs would be achieved only if Southwest flies the maximum number of flights in its projections several years after entry.  

Even with outrageous multipliers, the number of direct, indirect and induced job creation cannot even begin to approach 10,000 – let alone 18,000.  Not even by relying on the long-obsolete conclusions of a 20 year old study.

The United Pilots

The United pilots are at it again.  While the Delta Air Lines' pilots reached an agreement seven months early, the United pilots are busy building websites whining about outsourced jobs (their term, not mine) and the salaries of United Airlines’ executives. 

Labor leaders in the pilot ranks would have you believe this “outsourcing” (international code sharing and the use of regional flying within the network) is all about management abusing provisions of their collective bargaining agreements to enrich their shareholders. In fact, reducing costs through the relaxation of scope provisions has been labor’s “quid” in return for increases in compensation (or to give less in a concessionary contract) and benefits for 20+ years [the “quo.”]

Among many myths portrayed on the website, United ALPA (Air Line Pilots Association) claims that after the tragedy of September 11, 2001, the management of United Airlines launched a strategic plan to offshore and outsource jobs in an effort to cut costs.  Look no further than the unaffordable contract negotiated between United and its pilots in 2000.  The pilots significantly relaxed scope provisions in return for increased wages, work rules and benefits.  I rest my case.

First of all, the fundamental economics underlying the health of the U.S. airline industry began deteriorating during the second half of 2000.  September 11 ensured that there would be no return to prior industry conditions particularly on the revenue line.  The incursion of the low cost carriers and the use of the internet for airline ticket distribution were every bit as powerful forces as 9/11 in compelling the industry to restructure.  The operating models sought by the network carriers were to find cost savings much like the low-cost carriers – a sector that outsourced a significant portion of its maintenance.  The advent of the regional jet in the mid-1990s was the catalyst driving a reduction in pilot and other costs.  Pilots at all network carriers permitted extensive use of the regional jet well before September 11, 2001.

Perpetuating myths to a public that largely doesn’t care (pilots are much better compensated than the average passenger) is probably a disservice to United’s ALPA members.  Put energy into negotiations like the Delta pilots and you might actually get somewhere.  That requires leadership and telling the entitled pilots at the old United that things are not going to return to the days when the company negotiated contracts it couldn’t afford.  It is just not going to happen.

Concluding Thoughts

Delta Air Lines just continues to do things a little differently.  When it merged with Northwest, Delta made the pilots “buy in” to the concept that consolidation was inevitable and that it was in their best interests to participate.  Delta’s financial performance relative to the industry has been very good quarter after quarter.  Then it buys an oil refinery and negotiates a deal with pilots seven months before the amendable date.  Hell, most negotiations have just completed the uniform section at this point in the proceedings – maybe.

It is clear Delta’s largest unionized group understands industry realities.  That’s a rare thing these days when, too often, reality is sacrificed for political expedience.  Simply look at how much has been made in the media about American’s unions joining hands with US Airways.  That was the easy part.  Which union wouldn’t agree to give up less and suffer fewer job losses?  It sounds great to members and union leaders can knowingly smile and say, at the very least, they’re putting pressure on management.  But reality says they’re weakening their own position, opening themselves up to my favorite term – unintended consequences and simply ignoring the truth that US Airways would have to carry 15,000 more heads than United, while generating the same level of revenue.  That’s not reality; that’s fantasy.

There is little doubt industry consolidation has helped catapult financial results beyond what could have been imagined for the industry based on past performance.  In that reality, my guess is Delta just made it more expensive for US Airways - and United - yesterday by negotiating yet another joint collective bargaining agreement.  US Airways needs those lower labor rates because its network produces below industry unit revenues. So now US is in the position of not only promising American’s pilots increased pay, but having to actually pay its own pilots at Delta +.

But hey, what is a couple of hundred million here and a couple of hundred million there?  After all, the margins for the US airline industry are plentiful.  Right?

Scope Yet Again; Commenting to a Commenter

There is often some very good reading over at www.airliners.net inside their civil aviation forum with some very good commenters and very interesting threads to follow.  This week, one asked:  “United/Continental Conceding Domestic Market?”  Another speculated about the future of the Air Line Pilots Association (ALPA).  Another asked which is the next US carrier to file for bankruptcy? That speculation is rightfully focused on the regional sector of the industry.  But much of the discussion fails to recognize the tangled web called the domestic network business, which includes mainline carriers, regional carriers and the unions. The players in this web are inextricably intertwined - but too often discussed in silos. 

United-Continental Holdings’ CEO Jeff Smisek once said something I now quote in every presentation I make. Of the world’s now largest airline, he said:  “We’ll have the domestic operations sized solely to feed the international traffic.”  That quote and its derivatives are sprinkled throughout the airliners.net thread focusing on whether United/Continental is conceding the domestic market.

In my view, the US domestic business is at a crossroads.  Do iconic names like United, Delta, American and US Airways continue to make pure domestic flying a significant portion of their route portfolio, or do they continue to attrite pure domestic operations away because cost structures can no longer support mainline flying in what has become an ultra low fare market?

Some in the thread note that Smisek’s words worry some pilots, as they should. And those concerns shouldn’t be limited to the flight deck.  In a ‘be careful what you ask’ for scenario, there are forces at work that ensure the regional sector of the business as we know it today will be smaller tomorrow.

There is a virtuous circle of events at play:  with in the wing oil in excess of $100 per barrel; no 50 seat and less replacement aircraft in the pipeline; regional flying under contract that won’t be renewed because of economics; the prevalence of low cost carriers in the primary and secondary catchment areas of small and non hub airport markets; a pilot shortage that will impact the regional sector; flight time/duty time regulations that will require more regional pilots to perform the same level of flying being performed today; a new law requiring 1500 hours of flying for new pilots; and the fact that the smallest aircraft coming to market will be at least 100 seats. 

And so the circle spirals downward for the regional sector of the business.

I think scope is a cancer because it has been used as a bargaining chip.  It has been, and is, a Ponzi scheme as I wrote in US Pilot Unions’ Dirty Little Secrets.  There has been a B-Scale in place supporting the rich mainline contracts since 1984 when new hires were offered positions at lower rates of pay.  When it was deemed wrong for unions to do such a thing, regional airline code sharing relationships were formed.  This “outsourcing” was agreed to by the union in return for higher wages and benefits for incumbent mainline pilots.   

After my last two posts on scope I expected, and received a lot of interesting mail.  Much of it emotional but some as ugly as the commentator who suggested “a certain poetic irony to the image of you[Swelbar] in a smokin' hole and another Captain Renslow at the controls.  Be careful what you ask for.”

Now it is my turn to say:  Be careful what you ask for.  If no B-Scale for domestic flying is possible and a phasing out of regional jobs is the goal in this round of negotiations, then what is going to cross-subsidize the wages, benefits and work rules at the mainline? By my calculation then, there is even less money to go around to for mainline pilots to win in a new contract.  And with the loss of feed traffic from a smaller regional sector, the real question is just how many mainline narrowbody aircraft does a carrier need?  In a point-to-point world, the answer is a whole lot less. If 14,000 mainline pilot jobs were lost in a decade of downsizing then more job losses are on the way from a loss of feed.  And the effects of a pilot shortage are even less.

And so the virtuous circle spirals downward for the mainline sector of the business.

Commenting on a Commenter

I received the following private email from John, which encompasses the views of many other commenters (public and private). He writes:

I read your blog because I know management does, I’m not your biggest fan.  However, I would like to see your opinion on the consolidation of regional carriers.  To me, scope is synonymous with outsourcing, which you say allows for flexibility.  But the real advantage of outsourcing is the low cost entry into markets (and exit). 

Things have changed, wouldn’t you agree?  Cash strapped regional airline are a thing of the past because consolidation has honed the market down to three: Republic, Skywest, and Pinnacle.  With size came assets, more loan opportunities, and market dominance.  In my opinion, I believe that regional airlines have reached a size where they have serious power over code sharing agreements or have the option to go many markets alone, Skywest is already considered a major airline with a MC of $6B.

I know you love to blame labor, because your audience isn’t.  I understand you have to make a living, and the ATA may not want to hear this, but they are screwing up.  The majors better start thinking of in-sourcing or face another round of upstart airlines entering the market with low cost structure and plenty of established routes thanks to the majors giving them business.

After all, outsourcing worked so well on the 787 it aught to do equally well for the airlines…right?

For the record, I do not see scope as outsourcing as it was agreed by both parties that a certain number of smaller jets can be used within the domestic system carrying a certain airline code.  After all, the mainline pilots did not want to be bothered with those little jets.  As for John, the real advantage of deploying small jets under the airline code is to maintain presence in feed markets that the mainline cost structure could no longer support.  Mainline aircraft in markets like Charleston, WV is a thing of the bygone years that immediately followed deregulation, yet they unfortunately still comprise a disproportionate size of the memory bank called entitlement. 

Yes, things have changed and are changing.  There are haves and have nots within the regional industry today as there were in mainline industry of yesterday.  There is one airline, SkyWest, which stands alone in the industry because of stellar management that understands the carrier’s place in the industry and their role in building a balance sheet that ensures Skywest will be part of the discussion for years to come. While I am sure that SkyWest would love to have a market capitalization of $6 billion that you make fact – on Friday the market capitalization of SkyWest was less than $650 million.

To make a valid argument, John would need to produce economics at the mainline that allow the company to serve Ft. Wayne, Indiana with non-regional (77 seats and more) equipment.  And my guess is that he could not. How many of those 737s/A320s/MD80s are filled with traffic coming from 50 and 70 seat jets?  How could he produce the same economics on the flying without having to make wholesale changes to his existing collective bargaining agreement in order to keep the flying in house? 

I get this argument often from other commenters that look back before looking ahead. Yes you can bring the flying in house - but not until the terms of the collective bargaining agreement reflect the B-Scale terms and conditions the mainline pilots found, and find, appropriate for their regional brothers and sisters.

Many claim I am too quick to blame labor.  In this case, it is the unions that create this purported “outsourcing” to support bloated mainline salaries, benefits and work rules.

John is right in his comment that “the majors better start thinking of in-sourcing or face another round of upstart airlines entering the market with low cost structure and plenty of established routes thanks to the majors giving them business”  -- at least on one front.  Today, the use of the regional industry is a defensive weapon used by networks to curb encroachment into mainline markets.  By forcing regional carriers to fly fewer 76-seat aircraft and less as well as limit their ability to fly anything bigger (again assuming the pilot unions would not change their collective bargaining agreements to meet or exceed the terms available from the regional provider), any airline network will begin to vacate certain markets that may then become an opportunity for a start up or an inroad for an incumbent like Southwest or jetBlue. 

Scope is as much as regulator of the business as is government at a time this industry does not need any more regulation.  Regulation often results in unintended consequences, one of which will be to create market vacuums that an upstart might willingly fill. Nature abhors a vacuum.

And John and many of his fellow mainline pilots end up over-regulating the business of feeding the aircraft they fly.  No feed – assuming that airlines cannot get to the right economics to fly certain routes – will likely result in significantly less mainline narrowbody flying – perhaps just enough to support the international operation.  And that may not be the consequence that mainline pilots have intended.

It Shouldn’t Be About Scope This Time – Rather Benefiting More Than One Stakeholder Is Key

It is Friday, August 26, 2011 and I am aboard United flight #701 bound for Albuquerque to participate in the 16^th Annual Boyd Group International Aviation Forecast Summit.  Many third rail issues get addressed at this widely attended conference and this year promises to be no exception.  The conference will address what Boyd refers to as futurist issues that will ultimately result in structural change to the architecture of the industry.  And I have been asked to help Mike open the conference along with Captain Michael Baiada.  I cannot wait.

What is significant about United flight #701? Seven years ago, a significant part of my career was assisting communities to attract airlines to begin new service. I was working with a talented air service development team at the Metropolitan Washington Airports Authority and my former firm, Eclat, and at the time there was very little domestic service to relevant markets that Washington Dulles did not have, whether regionally, mid-con or trans-con. 

But there were unserved markets like San Antonio and Albuquerque that were made interesting with regional aircraft service.  We approached United about a regional service from Dulles to the Land of Enchantment starting with a regional jet.  United agreed that the market could support a 50-seat aircraft on that route.  Over time, that route could support a 70-seat plane. Tonight I sit aboard a United mainline A-319 flown by a United mainline crew. 

If not for the ability to initiate a route that had fledgling demand with a right-sized aircraft, there would not be a mainline flight today that would get passengers from Washington Dulles to New Mexico in three hours and nineteen minutes. And this is but one example of many similar stories.

Today's pilot unions might look at this through a different lens.  How can we talk about any positive development stemming from the relationship between a mainline carrier and a regional partner?  In the view of many, any flight flown under the flagship name should be flown by mainline pilots. That's why unions negotiate scope clauses. That's job protection.

Or is it?

Ahh -- the law of unintended consequences rears its head in union halls.  Scope language is negotiated – in the mind of the pilot unions - to protect jobs.  But it does not.  Just note the loss of more than 800 mainline narrowbody shells and nearly 15,000 mainline flight crew members over the past decade and ask how successful the pilot unions have been at protecting jobs. 

More cuts will come if management negotiates the wrong scope language this time – language that limits their ability to remain agile when responding to competitive threats.  Domestic mainline network attrition will occur by 300-400 additional paper cuts per airline if done otherwise.  Nothing can artificially alter market forces.  Airlines have found ways around regulations governing international air transport and they have found ways around the biggest regulator of all – unions and scope language.

All I hear from negotiations at United/Continental, American and a renegade wannabe union challenging ALPA at Delta is that this round is about Scope, Scope and more Scope.  And I smile and wonder where the magic will come this time as lower cost competition remains keen to take full advantage of its labor and other cost advantages to find future growth opportunities.

Jeff Smisek, President and CEO of United Continental Holdings, recently lambasted the federal government - the other regulator - in a presentation at the Global Business Travel Association Convention in Denver.  Where might the U.S. look for a model of more effective air policy? Dubai, Smisek said, according to an article by Fred Gebhart in Travel Market Report.

“Emirates is a good example of an airline with a government that has good aviation policy,” Smisek said.
“Dubai recognizes the importance of air. It has an intelligent policy with a government that cares about the success of the air sector. It doesn’t throw up roadblocks, doesn’t over-tax it, and doesn’t beat it down at every opportunity. The U.S. government does all those things every day.”

 As usual, Smisek is spot on.

He talked of wanting to make United an airline that customers want to fly and investors want to invest in.  But while he spoke, Gebhart reports, nearly three dozen pilots and staffers picketed Smisek outside the conference, claiming that the company was "outsourcing jobs while creating unsafe working and flying conditions for employees and passengers.”

Nothing, and I mean nothing, disgusts me more than the actions of the US Airways and United/Continental pilots playing the safety card to create leverage in negotiating a collective bargaining agreement.  Is it really useful to try to frighten passengers? The vast majority of employees recognize that the best job security is a successful company and successful companies need customers to provide the revenue and shareholders to provide the capital.

Keep in mind that the pilots doing the picketing agreed to the language that allows the outsourcing of certain flying.  If not for the regional partners as a lower cost alternative, United, Continental, Delta and US Airways mainline operations would be but a shadow of the shadow they are today.

The United/Continental and US Airways pilot groups should get out of the court room and the arbitration tribunal business and get back to the bargaining table and negotiate an agreement that takes into account their companies' unique strengths and weaknesses.

Scope is not their problem.  Global competition is the challenge, and no scope language is going to protect them from that.  Any attempt to hamstring the airlines from making decisions that are in the best interests of all employees/stakeholders will only weaken the companies down the line. When it comes to United/Continental and US Airways ability to survive, Smisek and Parker are not the enemy; Emirates and Southwest/AirTran and Air Asia are.

Qantas Compared to the US Network Carriers

Speaking of being hamstrung by labor - the Qantas story playing out has strong parallels to the US network carriers that used the bankruptcy process to remake their operations during the 2002 – 2007 period.  The only real difference is that Qantas is quickly losing its competitive advantages to the emerging international “low cost” network carriers whereas the US network carriers lost their competitive advantage to the emerging domestic low cost carriers.

Last week Qantas outlined for the world the initial phase of an intended restructuring in its international operations designed to get its operating costs down – beginning with a new, high end, narrowbody intra-Asia operation with 11 Airbus aircraft.  Needless to say, Qantas CEO Alan Joyce’s decision to embark on such a strategy only poured more fuel on the fire burning between the kangaroo and its unionized pilots. 

Joyce is one tough leader.  Last week, Qantas announced that its profits doubled.  You know if you are making money why would you need to possibly embark on a radical, non-Australia based operation?  Because the international operation is under fire from Emirates and Air Asia and Virgin Australia and . . . Qantas announced that the mainline domestic and international – not subsidiary JetStar - made AUD 228 million, an improvement of 240 percent over the prior year period.  So what’s the problem?  The international operation lost AUD 200 million, meaning a very small domestic operation made a staggering AUD 428 million.  Therein lays the problem.  A money losing international operation, given the large fixed investment made, could quickly land a smallish carrier like Qantas in the memory bank.

Not only does Qantas suffer a structural geographic disadvantage of being at the end of a network system easily making its markets captive by the competition, it also suffers from a labor cost disadvantage, particularly in its international operations.  With successful competitors springing up in all sectors of Asian commercial aviation, the Qantas brand is potentially isolated and damned for extinction unless the network procreates outside of Australia.

This is why Joyce is making his move and doing so before it is too late.  And that is what the unions do not understand.  Scope is only as valuable as a met condition makes it.  Scope is negotiated before the future landscape is fully known and understood.  Airlines overpay for scope because the opportunity costs to shareholders are disregarded.  And this must come to an end because it only hurts the bottom line and job protection in the future.

Smisek, Anderson, Parker and Arpey (and maybe even Kelly as his airline gets more complicated) should take a long hard look at the history of scope.  Has it produced the desired consequences for employees, shareholders and the company?  Has it produced the kind of goodwill a company might expect from negotiating job protection measures in collective bargaining agreements?  Has it stopped unions from using the "safety card" to attack their own airlines by making customers leery of flying?

I challenge each of the US CEOs to resist caving into union demands for scope language in negotiations with the unions. There is no job security for any employee if the company is made weaker because management tried to buy labor peace with short-sided, limiting "job protection" clauses designed to make one employee group feel better.  In today's airline industry, the root of job security is the ability to fly profitably and with the flexibility to fly the right aircraft with the right costs on the right routes for the network.

More to come later this week.

In The Airline Business We Just Do Not Talk About Balance Sheets Enough

In the Gulf States, we have Qatar CEO Akbar Al Baker saying to Gulf Business Nothing Can Stop Us Now.  In the article Al Baker talks about the high cost and inefficient airlines in the west.  In the U.K., a headline in The Independent reads:  More Carriers Could Fold Warns IAG’s Willie Walsh.  Bruce Smith, writing for the Indianapolis Star publishes a story on hometown Republic Holdings titled:  Republic Emphasizes Cost Cuts As It Fights To Compete.  Like a lot of airlines these days, Republic’s branded carriers – otherwise known as Frontier and Midwest  – are not only fighting to compete, they’re fighting to simply stay alive.

It’s easy to forget Republic now flies its own airline flag. Prior to purchasing Frontier and Midwest out of bankruptcy, Republic Holdings’ predominately did fee-for-departure flying for U.S. network carriers.  In October 2008, I asked:  Just Who Will Inherit the U.S. Domestic Market? Don’t Forget Today’s “Regional Carriers”.  Nearly two years ago, after Republic staved off Southwest from sponsoring Frontier’s exit from bankruptcy, I asked,  Is Republic Changing the Face of the US Domestic Market?   

In each of the Swelblog.com articles referenced above, I talked about how smart Bryan Bedford, CEO of Republic Holdings (RJET) is.   Bedford made the move to acquire Frontier and Midwest in an environment where it was increasingly clear the legacy carriers did not – and cannot over the long-term – operate under a cost structure that will not support the number of airlines trying to survive in the hypercompetitive U.S. domestic airline business.  Since then, consolidation among U.S. carriers has taken off – for network, low cost and regional airlines alike.

Smart or not, the price of jet fuel puts pressure on Bedford’s balance sheet more so than other carriers given Republic’s incipient fragility.  I have written time and again the most important financial statement for any airline today is its balance sheet.  As Republic Holdings trades near a 52 week low, many analysts are jumping off the RJET bandwagon.

Mike Linenberg, equity analyst at Deutsche Bank, wrote following Republic’s first quarter results, “Republic ended the March quarter with $467 million in total cash, $37 million higher than at the end of the December quarter. While the company’s restricted cash balance increased $87 million to $226 million, driven by the seasonality of its Frontier business, unrestricted cash declined $50 million to $241 million, impacted by the company’s relatively high credit card holdback provision of 95%. Regarding additional sources of cash, Republic indicated that it had some collateral-backed debt that could be refinanced to produce an additional $70- $80 million of net cash to the company.”

In the airline business, cash is king and fuel is the wildcard. With its fee-for-departure contracts, Republic left the fuel risk to its mainline partners.   (Of course the price of fuel affects the decision of the mainline carrier as to whether to buy regional capacity).  Now Bedford has to buy fuel for his Frontier and Midwest subsidiaries… that helps to explain why RJET’s unrestricted cash declined by some $50 million.

Why I was bullish on the Republic – Frontier combination in the early days was because the Indianapolis based holding company had bought a brand, one that came with a vibrant flying community – Denver.  With a community comes inherent demand.  With demand comes revenue.  But Last month, Ann Schrader of the Denver Post reported Southwest had jumped over Frontier in terms of market share at DIA.    

Republic announced the acquisition of Frontier on June 22, 2009.  On that date, the price of a barrel of West Texas Intermediate (WTI) crude oil was $64.58 and the price of a gallon of jet fuel was $1.78.  In 2011, WTI has traded in excess of $100 per barrel and one gallon of jet fuel tops $3.  It is one thing to be in the regional business when the cost of fuel doesn’t directly affect you. It’s another when you actually have to pay for the gas.

Southwest

On the flip side, I think that Southwest’s purchase of AirTran is brilliant.  In many catchment areas around the contiguous 48 states most populated and wealthy areas, the combined carrier has at least two beachheads.  While I still don’t believe Southwest, jetBlue, Frontier and Spirit will inherit the domestic U.S. marketplace; I am increasingly convinced the not-so-meek Southwest will inherit more earth than any of the others.  The U.S. domestic market has always been about the survival of the fittest. 

Might we be headed for another round where Southwest captures five points of domestic market share?  Possibly. What’s different this time versus the 2001 – 2006 period when Southwest and the other LCCs captured nearly 20 points of domestic market share is the airlines losing ground won’t be the network carriers.  More will come from weak competitors – like Frontier, Midwest and Spirit. .  There should be little surprise that Spirit sold a fraction of its intended shares at 25 percent less than desired price in its Initial Public Offering (IPO). 

Frontier is quickly losing pricing power in the very place it called home.  Presumably the value in the Frontier franchise was its cult following in the Denver local market. Without a meaningful, and growing, share of the local market, pricing power is compromised.  No pricing power in a high jet fuel cost environment does little to bolster a fragile balance sheet.  Southwest has the time and the financial wherewithal to whittle Frontier's following and, thus, its franchise value.

Southwest isn’t Frontier’s (and Bedford’s) only headache. United has a presence in Denver as well, one that’s not necessarily focused on local traffic. That makes Denver somewhat different than other cities where three carriers have tried to hub.  My guess is something is going to give in Denver because, at some point, the law of diminishing returns is sure to play out for any one of the three competitors.  And I’ll bet on Southwest’s balance sheet winning the war.

Southwest is an opportunistic competitor.  I expect Southwest to fill any voids left by either Frontier or United in Denver.  Where United or Frontier might be vulnerable, Southwest will likely exploit that weakness by adding capacity.  It can be patient because Southwest has a balance sheet that is far stronger than either of its two Denver competitors.  Frontier is, by far, the weakest. The high cost of fuel is its immediate enemy and Frontier has fewer options than either Southwest or United.

Labor - It Really Is About The Balance Sheet

The one thing that the pre-Frontier/Midwest Republic did not have to worry about was earnings as long as it delivered the product promised to the mainline carriers.  Today, the branded operation is suffering losses and is forecast to lose money going forward while most major players are going to make money.  As Linenberg’s analysis suggests, Frontier needs to generate cash internally because it has limited borrowing capability.

The strong get stronger.  The weak get weaker.  Survival of the fittest at its most emblematic. As Bryan Bedford told his shareholders – and the world - he needed to find $100 million in cost savings, his pilots protested outside.  No earnings and a weak balance sheet usually do not equal wage increases. It’s not about whether pilots deserve increases – that’s not what I’m talking about.  Balance sheet repair is not sexy.  Balance sheet repair does not add to earnings.  Balance sheet repair does not produce wage increases and work rule changes that resemble 2001.

What balance sheet repair does is keep airlines flying. If struggling carriers don’t find ways to fix their sheets, they won’t be around. I don’t mean they’ll file Chapter 11 and hope to reorganize or sell themselves off at the last minute. I mean they will cease to exist. Their one-time employees will be out of work, their assets will be auctioned off. No one is going to pump capital into an airline whose balance sheet is out of whack, whether that’s because of fuel, diminished market share or labor costs.  

It really is why pattern bargaining should be a thing of the past.  Every airline is different.  Every airline competes in different geographies, with different goals and has labor needs that other carriers don’t. 

The more I think about it, US Airways pilots – and whichever union/group is currently representing them - are really doing the company a favor by not coming to grips with reality.  US Airways is more exposed in the U.S. domestic market than any other network carrier.  The U.S. domestic market is a low-fare environment and requires lower labor costs than, say, a United or a Delta that have more capacity in international markets.  The same holds true for flight attendants and below-the-wing personnel. More to come on this one.

I see employees picketing and I scratch my head.  This industry lost nearly one in every four jobs during the past decade, yet still has more than 350,000 employees with wage and benefit packages in excess of $85,000.  This is an industry of good paying jobs despite the economic environment it operates in. Yet many labor groups refuse to recognize the need for balance sheet repair… and that labor costs have to be part of the fix. You can’t just tweak revenue or fuel costs or charge more for a ticket. Shoring the balance sheet requires a holistic approach.

Without that type of approach, as Willie Walsh recently said, more airlines will fold.  I’ll even venture more could merge. Frontier is a classic example of why this industry is not out of the woods.  And why even the network carriers are not done.  And why the regional carriers are not done.  Isn’t it interesting that Sean Menke, the former head of Frontier just joined Pinnacle Airlines – a truly regional carrier at this point in the industry lifecycle?  What does he know that the rest of us do not?  Me thinks that the domestic market will also be made up of today’s regional carriers; today’s low cost carriers and of course; today’s network carriers as Jeff Smisek, CEO at the new United said, "A domestic operation sized solely to feed our international traffic".  It will be different no matter what pilot scope clauses suggest.

Pithy Ramblings On The Past 24 Days

In the 24 days since I last wrote, I have given multiple lectures, participated on a panel at the EU Forum on Transatlantic Competitiveness, prepared to present at Atlantic Southeast Airlines' Spring Leadership Conference and am working with two MIT students, Kari Hernandez and Joe Jenkins, on what I believe will be an insightful and important study on airline industry efficiencies and community access to the nation’s air transportation grid.

The worst NCAA national championship game in history ended three painful weeks made more so by my abysmal picks for the tournament.  And the Master’s golf tournament began and ended with no American at the top of the world ranking, just as no US airline can be said to be atop of the global airline industry.

With earnings and proxy season in full swing, it’s clear that most airlines are scrapping their way to respectable results even as high fuel costs depress their performance and executives continue to get paid executive salaries even at the sharp objections of unions.

And with so many union contracts still under negotiation, labor disputes continue to dog the industry, here and at airlines around the world.  I looked with hope to the pilot negotiations at Air Canada, where it appeared that the union was willing to consider less onerous restrictions on domestic flying in recognition of economic difficulties in the domestic Canadian market.  But rather than put an agreement out to vote, the union instead recalled its Chairman, doing little to strengthen the airline for the future. In response, the Centre for Pacific Aviation said it best: “That Air Canada needs something dramatic to make it sustainable is as obvious as the maple leaf on the national flag.”

I made the same suggestion in my presentation to the FAA's 35th Annual Aviation Forecast Conference.  But in doing so I often feel much like the Chairman of the Air Canada pilots union with plenty of readers who want to recall me when I look economic reality in the eye and recommend dramatic change.  One reader warns of a looming pilot shortage citing the law of supply and demand.  But that law will apply only by depressing the demand for pilots as the industry in the US will get smaller yet before it gets bigger.

At most of the US network carriers, cost structures are still too high to continue domestic flying at current levels.  And those high cost structures make it hard to justify investment in the hundreds of new narrowbodies necessary to replace fleets performing domestic flying today, particularly if today’s managers are truly serious about achieving a return on capital that actually exceeds the cost of capital.

Speaking at a CERA Conference in March, United-Continental Holdings CEO Jeff Smisek acknowledged that United-Continental, the product of the merger of United and Continental, will shrink in the U.S.  “We'll have the domestic [operations] sized solely to feed the international traffic," Smisek said.

Warring words between pilots and management have been increasing in volume in Australia too. Qantas had it relatively easy domestically once Ansett, the largely domestic carrier, was liquidated in 2002. When Virgin Blue grew to replace Ansett, Qantas responded by forming Jetstar, an airline within an airline.  But then came Tiger Airways Australia which now leads pricing in the Australian domestic market.  So legacy Qantas, with a cost structure once supported by a near monopoly in its domestic market, has now lost its competitive way.  Add to that pressure from the Middle East carriers internationally, a route system that is nothing more than a spoke to the world’s hubs is under challenge from all directions.

We can expect to hear similar noise from union halls in Germany, France, the Netherlands and the United Kingdom.  This is a region with social cost structures that look more like that of the state bureaucracy in Wisconsin than what will be needed to compete for tomorrow's global traffic.  I increasingly believe that what is being built in the Middle East will challenge the competitive integrity of each of the three global alliances.  Given that these alliances are nothing more than Band-Aid solutions to maneuver around archaic rules and regulations governing air transport, the bandages will begin to lose their adhesion one by one.  Global airlines built organically, particularly through cross-border mergers that build a brand, will begin to win the day. 

Not surprisingly, the response to the Middle East carriers from Canada, Germany, France and elsewhere has been protectionist at best. First the world wanted to open the skies.  Now that the skies are largely open for some, the talk has turned to restricting access to markets from new, innovative and vibrant competition.  I agree that the new competition should not be allowed to access cheap capital that is not available to all.  But to limit access because of presumed subsidy, cheap fuel, little or no airport costs and whatever other excuse to limit the growth of Middle East carriers is just plain wrong. Until a forensic accounting of Middle East carrier finances is available, it is all heresay to me.  Even Willie Walsh speaking at the EU Forum said he sees nothing abnormal in the numbers being reported today.  

In my mind, the US network carriers already have faced this type of competitive challenge to their domestic operations from upstart airlines with a labor cost advantage, new, more efficient aircraft and a cost structure that reflects the realities of today’s market in part by doing things like outsourcing ground services.  Why was it OK for the low cost carriers in the US to take 20 points of domestic market share away from incumbents and it is not OK for more efficient operations in other parts of the world to challenge incumbents in Europe and Canada?  Let’s not forget that one of the benefits of LCCs in the US was stimulating new demand that filled airplanes painted with new and old liveries. 

Finally, a few words on the battle between American Airlines and the global distribution systems/online travel agencies. We cannot talk about the airline ticket distribution system without mentioning the Business Travel Coalition – the advocacy group that tells the world it is all about protecting consumers when it is doing nothing more than to ensure the sustainability of its business with cash flows from the distribution duopoly.  In the past month alone, the BTC News Wire put out communications that, among other things, suggested that airlines are lying to Congress, railing against airline fees and urging consumers to write Congress in protest.

As I wrote 24 days ago,  despite the rhetoric from BTC and the constituents it represents, the coalition is doing more to protect an outdated mode of operation and stifle innovation than support a strong airline industry.  The GDS duopoly cannot move fast enough for an industry that sells “time saved” no matter how painful it is for the BTC and the online travel agencies to have the revenue tap turned off.  It’s time for the GDS to recognize they can’t support interests other than their ultimate customer – the airlines that actually do serve the air travel customer.

Much more to come.