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.

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.

Ironical Catalysts; Seniority No More?; and One Last Comment on Force Majeure

Ironical Catalysts

Isn’t it ironic that the number one catalyst cited as driving a consolidation phase for the US industry is now being discussed as the number one reason that consolidation is being put on the back burner – or even being pulled off of the stove? Ted Reed of the Street.com writes a column offering the Northwest pilot’s take on the industry at $110 per barrel oil as well as their views on how oil might stand in the way of executing what the pilot leaders termed as “an aggressive business plan” by the other carrier [read Delta even if not mentioned by name].

On the surface, Mr. Reed’s story might be read as the Northwest pilots pointing to anything and everything rational that could provide cover for not reaching agreement over an emotional issue. On the other hand their counterparts at Delta, whether ALPA or management, are not suggesting much compromise, let alone capitulation, either. So we have a stand off. The Northwest pilots have a bird in the hand, assuming that no adjustments are made to the terms of the single collective bargaining agreement, versus Section 6 negotiations in 2011. And as I have written here, only the MEC can decide that issue.

What is encouraging about the industry today is its willingness to address some difficult issues with swift and decisive actions – like making the hard choice to further reduce capacity. But these decisions are not limited to Delta. We now have CEOs in the industry that are willing to address these tough issues that prior management teams would have decided to “fly through”. And in the last week, jetBlue, AirTran and Frontier have all sold aircraft or delivery positions largely to augment their respective liquidity positions.

When I first read Mr. Reed’s column this morning, fresh off of a 24 turn between Los Angeles and Washington, I interpreted it to suggest that consolidation is dead. That is not what he is saying at all. But US Airways sure views the lull in the action as a potential entry point to get back in the game as Mr. Reed reports.

Seniority No More?

Let’s segue from seniority integration into seniority. Today, the Washington Post’s Steven Pearlstein writes in his column about industry woes, commercial airline pilot careers and questioning seniority generally.

He concludes with the following two paragraphs: “The reason it's so hard for airlines to find a fair and rational way to combine pilot seniority lists is there is nothing fair and rational in the way seniority is used. It causes a disconnect between performance and reward, discourages movement of employees between and within companies, creates a corrosive caste system that breeds resentment among junior employees and an overblown sense of entitlement among those who are most senior”.

“Airline customers, employees and shareholders would all be better off if the industry spent less time and energy figuring out how to combine seniority lists and more time on how to eliminate them”.

Back in December, two days before Christmas in fact, swelblog.com questioned whether seniority worked for each airline management and labor. Now two days before Easter, a similar question is being raised by Mr. Pearlstein. While some of what Mr. Pearlstein suggests is impossible given equipment qualifications, he raises a fair issue. It is fair particularly when an industry is in serious need of a total overhaul.

While I am confident that any suggestion of seniority will raise the ire of organized labor, this is the time to explore such issues. It is time because many of the legacy constructs within this industry are prohibiting it from moving forward – and seniority is but one. And based on the many issues burdening the industry that are not of its own doing, everything should be on the table and everything explored.

A Little More on Force Majeure

Clearly my prior post generated some comments and most were not in agreement with what I had written. I knew that when I wrote the piece it would not be embraced by all. I certainly expected the note from the American pilot. I did not expect the “call out” by Blackbook, who is one this blog’s most astute commenters. Blackbook's fair questions and comments, and my answer to Blackbook, are available for all to read in the comment section.

While Force Majeure has many, many legal issues surrounding its use and I, admittedly, am not qualified to answer those questions, my intent was to raise a number of issues out there that bother me and to look at pools of expense that could be explored for cost savings. On Thursday of this week, Suzanne Marta of the Dallas Morning News blogged on research notes written by Kevin Crissey at UBS and Jamie Baker at JP Morgan.

Mr. Baker writes: "We would note that with the exception of the immediate aftermath of 9/11, the only time the industry even approached a single-year capacity correction of this magnitude was during the Gulf War I recession - and it required the failure of Eastern, Midway, Pan Am, several discount airlines, and bankruptcies at America West, and Continental to get there."

Immediately following 9/11, certain force majeure clauses were invoked. While force majeure may not be the effect - or even the right action - stemming from today’s environment, the macro environment has many attributes of a cause.