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.

Let’s Make Today’s Unions Tomorrow’s Source for Labor

A Challenge to ALPA Captains Paul Rice and John Prater

On the last day of 2009, Caroline Salas of Bloomberg (edited) wrote an article on the regional airline industry titled:  Pilot Complaints Highlight Hazards of Regional Airlines.  In it were references to Gulfstream International (a training academy and airline) that were first reported by Susan Carey and Andy Pasztor of the Wall Street Journal on December 1, 2009. Salas quotes Captain Paul Rice, First Vice President of the Air Line Pilots Association (ALPA) alleging that the industry contracts flying to regional carriers to circumvent pilot agreements at the mainline carriers. 

Rice says: "The way the industry is structured is that management will go out and find a new airline and start siphoning off the business to whoever will fly for cheaper.  The American public is only just starting to wake up to that. What they are buying is the lowest-cost operation that's available."

This is a gross misrepresentation of the truth. What Rice does not say is that his very own union is a primary reason why the industry is structured the way it is. ALPA and others negotiate contracts with mainline carriers that proscribe the terms on which an airline can outsource flying to its regional partners.  Under the restrictive collective bargaining agreements common in this industry, most airlines can’t even make these important business decisions without the authorization of the pilot unions.

It is high time for ALPA and Captains Prater and Rice to tell the truth and take some responsibility for the current structure of the industry, even when it doesn’t necessarily serve the interests of big labor and its members. 

In a recent post, Sacred Cows and Fatigue, I referenced a thought-provoking column by Michael E. Levine in Aviation Daily that took on some of the debate over regional flying today.  In it, Levine noted that the February 2009 Colgan Air crash near Buffalo raised issues about pilot experience, fatigue and performance that “underscore the need to revisit negotiated seniority rules and pay scales that pay pilots more to fly bigger aircraft, leaving some of the least experienced pilots to do some of the most demanding flying.”

Earlier, in US Pilot Unions’ Dirty Little Secrets, I discussed the complex structure of airline networks that have developed over time through mergers; acquisitions; regulation and, importantly, union influence. And one place that labor influence plays out is in pilot contract “scope” clauses that too often hamstring an airline’s operations in the name of job protection for pilots.  The question we in the industry should be asking is whether those scope clauses really serve that purpose or, rather, whether some union leaders use scope in a way that is both misguided and ultimately harmful to the pilots they represent.

My Challenge to Captains Rice and Prater

Based on the testimony of ALPA since the Colgan accident, there has been nothing said that makes me think that the nation’s largest pilot union is ready to take responsibility and become part of the solution. Yes, regulatory barriers play a role in many airlines’ ability to serve certain markets profitably.  But at the same time scope clauses also contribute to a situation in which airlines are forced to outsource flying to their regional partners when mainline economics cannot support that flying. This fact is as true today as in the late 1980’s when the architecture of the network carrier's relationship with the regional airline industry was being drawn.

How about this resolution: Beginning in 2011, ALPA and other unions that hold collective bargaining rights for airline workers actually employ the members they now represent. Let’s use pilots as the example:

Let’s say Airline X needs pilots for 1.7 million block hours of mainline flying.  Of that, the airline needs .6 million hours of 777 flying; .2 million hours of 767 flying; .5 million hours of 737 flying; and .4 million hours of 757 flying.  Based on its projections of the revenue it can earn to fly these routes, Airline X is willing to pay $1.2 billion for pilot labor. In addition, and a result of the current industry structure, Airline X will require .5 million hours of CRJ flying and .5 million hours of EMB70 flying for which it can pay $500 million.  So, in total, Airline X needs pilots to perform 2.7 million hours of flying and is willing to pay $1.7 billion for those services.

Based on calculations compiled in MIT’s Airline Data Project and an assumed split for captains and first officers, on average, the industry pays a captain cost per block hour of $325 and a first officer cost per block hour of $225 for small narrowbody flying.  For 757 flying, the cost per captain block hour is $350 and $250 per first officer hour.  And for widebody flying, captains cost $563 per block hour and first officers earn $400 per block hour.

So, in our example, simple math produces a mainline cost that is $85 million more than what Airline X can pay based on projected revenue for that flying.  As an employer, ALPA would either have to agree to reduce the rate charged for each pilot or find another way to get the flying done at that cost.  That might mean increasing pilot productivity beyond the average 40-50 hours per month most network pilots now fly.  Or expanding the arbitrary and artificially low limit most unions put on pilot duty time. Or rethinking the level of benefits provided.  But the exercise itself – one not dissimilar to what most airlines are trying to do through labor negotiations to correct for bloat and inefficiency in current contracts – would be an eye-opener for labor leaders who don’t now have to trouble themselves with the hard work of making the airline’s budget actually balance.

The Math Is the Math

Now ALPA has to decide if it is in their best interest to maintain a greater number of pilots (today’s practice in which younger pilots ultimately subsidize the generous pay provided more experienced flyers) or fewer pilots who would earn more based on what the market is willing to pay. 

That decision must include many considerations, including:

• Is there really a difference in the cost of a life flying on a 50-seat regional jet versus a 250 -seat B777?;
• As market economics have made mainline narrowbody flying uneconomic in a large number of markets, is it good practice for a union to negotiate lower rates and different work rules for pilots at one carrier in order to support higher wages and more time off for pilots at another carrier?;
• Is it the case, as Prater testified before Congress, that “a safety benefit is derived from all flying being done from a single pilot-seniority list because it requires that first officers fly with many captains and learn from their experience and wisdom before becoming captains themselves”?; 
• If ALPA actually employed all pilots, then wouldn’t the creation of a single pilot seniority list facilitate the implementation of a system to address the experience problem at the regionals where, as Levine suggests,  a  30-year 737 captain might actually be assigned by ALPA to fly the demanding flying that today is performed by 50 seat CRJ pilots?; and
• Does a system of pilot promotion from right seat to left seat; from regional to mainline in a market that promises only a growth rate roughly equal to the rate of attrition at best, really work anymore?

As employers, the unions might be forced to make decisions like management must – based on what is in the long-term best interests of the airline and all of its employees.  From that position, it is much harder to throw stones or seek job protections and wages that don’t recognize market realities. ALPA and the unions would have to answer some really tough questions.  

Given that the market offers little promise for growth like that experienced between 1978 and 2001, it is time for a new compensation and work rule model.  Perhaps it is time to put the most experienced pilots on trips that include the most demanding flying. 

And it is time that organized labor, particularly ALPA, to step up to the plate and become part of the solution rather than continue to contribute to a troubled industry’s troubles by not accepting any responsibility for today's structural predicament.  ALPA can put its dues money where its mouth is and truly promote safety.  But that might just mean a total overhaul of the way pilots are compensated.  

Sacred Cows and Fatigue

Last week, I was in Boston listening to the students in MIT’s Airline Industry class make group presentations on six US airlines.  It is always refreshing to hear the analysis, reflection on strategies and recommendations from really smart kids who aren’t burdened, like me, by three decades of taint or cynicism. 

Do We Have a National Aviation Policy?

The student presentations got me thinking about the role of national policy on the U.S. airlines. Michael E. Levine, now a Distinguished Research Scholar and Senior Lecturer at  the New York University School of Law, wrote an op-ed in the December 1, 2009 Aviation Daily titled:  “We Have a National Aviation Policy.”  Many will remember Levine as one of the minds behind and framers of the Airline Deregulation Act of 1978.  Levine went on to serve in numerous senior management positions at a number of airlines along the way.  To the serious industry observer, Levine is a must-read.  You may not always agree with his viewpoints, but you always know that the work will be well researched, thoughtful and provocative.

Levine’s Aviation Daily piece has its roots in the recent comments by former American Airlines CEO Robert Crandall and Business Travel Coalition President Kevin Mitchell suggesting that the U.S. lacks an effective  aviation policy.

Levine disagrees:  “Our government has an excellent aviation policy:  continuously improve safety, promote environmental goals, maintain consumer choice, and allow the general public access to a system not run specially for the benefit of stockholders, banks, elite purchasers, aircraft manufacturers and workers more privileged than they are,” he writes. “We even have a mechanism in place to make sure that service is provided where social policy demands it and the market won’t pay for it.”

In Levine’s view:

• Profit is the job of managements and shareholders, not government
• Air transportation must be safe
• Government’s job is to ensure that aircraft are safe, not new
• Airline wages and career options should be no more or less a government concern than they are for workers in general
• US airlines should compete in world markets, and our government should eliminate impediments put in their way by other governments
• The terrible accident in Buffalo raises issues about pilot experience, fatigue and past performance that underscore the need to revisit negotiated seniority rules and pay scales that pay pilots more to fly bigger aircraft, leaving some of the least experienced pilots to do some of the most demanding flying
• Pilot fatigue comes not only from duty assignments but also from lifestyle choices that have pilots commuting to work from homes that may be thousands of miles from their jobs.

I encourage readers to find a copy and read Levine’s piece in its entirety.  It is good.  And of course many of the ideas are those espoused here at swelblog.com.  If I have a quibble at all with Levine’s piece, I would say that the US government and the narrow-minded thinkers in Washington who are in power positions on committees overseeing US commercial aviation produce at least as many impediments as do other governments. 

Levine’s analysis is also well timed to the formation of Transportation Secretary Ray LaHood’s Blue Ribbon panel to study the industry. A mind like Levine’s would serve the industry well because unlike Crandall and Mitchell, he does not have a dog in the fight.  Furthermore, his writing reflects the need to cut to core issues that govern US aviation today and fix the things don’t work – even if those things include some sacred cow(s).

Pilot Fatigue

Last week, FAA Administrator Babbitt testified before the Senate Commerce Committee’s Aviation Subcommittee on a variety of safety issues including pilot fatigue. As I have written here many times, there can be no productive discussion on pilot fatigue until the issue of commuting is included in that discussion. 

Until last week, any Congressional testimony fatigue or flight time/duty time regulation changes centered on the work of an FAA Advisory panel that met during July and August to recommend changes to existing rules.  But that committee -- comprised of labor, management and other stakeholder groups  -- decided that commuting was “outside the boundaries” of their mission.  So it is left to Babbitt and the FAA to seek comment on commuting with respect to the proposed rule changes.

Commuting, of course is among the industry’s most sacred cows. I don’t know how many airlines would be willing to go first in telling a pilot, or a flight attendant, that they cannot commute or that they have to live within X miles of their assigned domicile.  Clearly,  Babbitt is not convinced that commuting is the only major factor in the fatigue question. So for now, Babbitt’s mantra is the right one:  Show up fit to work.

But commuting is a management issue as well.  Back in the day when I was flying, pilots were paid moving expenses and had the company buy their house (in the event it could not be sold) if they were displaced to another domicile.  As the industry began to grow and merge and create new hubs and thus new crew domiciles, the moving expense issue was a big one for companies to consider.  Lo and behold, it was one of the early concessions airlines sought from pilot contracts in their efforts to cut costs and the industry structure began transforming itself.

I am glad that we are looking at fatigue and flight time/duty time regulations with a learned eye to make fixes where science suggests fixes need to be made.  What doesn’t make sense is this hue and cry that fatigue is an issue because airlines have worked to improve productivity by getting their pilots to fly an additional eight hours a month.

Autos & Airlines: Similarities are Frightening

The auto industry faces many of the very same issues that the airline industry faces, and faced, albeit the inherent inefficiencies were exposed by different exogenous events. Today’s credit crisis has exposed decades of leveraged inefficiencies...

Click to read more ...