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.

Mainline Pilot Scope: Will Regional Carriers Be Permitted to Fly 90+ Seat Aircraft?

Today I had the pleasure of participating on a panel at the 35^th Annual FAA Aviation Forecast Conference, my second consecutive year taking part in one of the breakout sessions.  I shared a dais with the President of the Regional Airline Association, Roger Cohen, and long-time industry consultant, historian and photographer George Hamlin on a panel titled: New Decade......Dawn or Dusk for Regional Carriers?  I had the hotseat – responsible for discussing the reliably controversial subject of mainline pilot scope clauses.

It is my view that there can’t be an honest discussion on the shape or structure of the US domestic airline industry without talking about scope – the contractual clauses pilot unions negotiate to protect certain flying for their members.  I believe that this round of contract negotiations at major carriers will be the most important since deregulation, and scope will play a pivotal role as the airlines take a hard look at economics. And mainline pilot scope agreements are all about economics. 

Today’s industry architecture in which regional carriers fly large numbers of aircraft with 76 seats and less was drawn on the equivalent of vellum paper using compasses, triangles, French curves, triangular scales and protractors.  The working structure did not come about easily. First, earlier era scope clauses were relaxed during the late 1990s and early 2000s to permit carriers to deploy 50-seat regional jets between hubs and markets that could no longer support the economics of a mainline jet.  Delta and Continental had a significant head start on the rest of the industry in using these smaller aircraft because they had few limitations imposed through their pilot agreements.

Other mainline carriers: American, Northwest, United and US Airways, were late to the game.  Scope-relaxed competitors were using the 50-seater to claim traffic that was traditionally the domain of the scope-constrained carriers still limited to feed markets within the turboprop drawn 400 mile radius around a hub.  Now these little jets could overfly hubs, aggressively changing the competitive structure in the US domestic market.

So those carriers that needed the permission of pilots to compete on a level playing field recognized the need to relax restrictive scope clauses that limited what type of aircraft regional pilots could fly.  And that made the scope clause important trading currency for pilot unions that agreed to relax scope protections only in return for improvements in other parts of the agreement.  For example, when United pilots negotiated a new agreement in the Fall of 2000, the union leveraged scope relief to demand a weighted average 23 percent wage increase and two subsequent 4.7 percent increases, as well as a number of other contract enhancements that ultimately contributed to landing the carrier in bankruptcy.

I am convinced that, if not for bankruptcy, we would not be seeing mainline carrier’s regional partners flying aircraft 70 seats and greater in the numbers we are seeing today.  So if today’s architecture was drawn with outdated tools, then tomorrow’s architecture will likely require Computer Aided Design (CAD) software.  That, as old-school architects might say, is equivalent to replacing the pencil with a keyboard -- limiting in that the digital world requires exact inputs rather than the less precise nature of sketching. And that has real implications for pilots and the carriers that employ them. 

Tipping Point

From my perspective this next round of pilot negotiations could be the tipping point for scope:  the critical juncture in an evolving situation that leads to a new and irreversible development.  What if mainline pilots again treat the relaxation of scope as trading currency to make improvements in the collective bargaining agreement? Wouldn’t they ultimately be ceding mainline narrowbody flying in the US domestic market?  I think so. 

This approach would be a mistake for management, too, because scope relief has historically been assigned too much value in bargaining.  There is value in the shift of flying from the mainline to regional partners to be sure.  But the differences in labor rates between the mainline and the regional are nowhere near what they were before the last round of industry restructuring.  Domestic revenues continue to suffer, particularly compared to the revenue environment when values were last ascribed to scope relief.  And with little growth expected in US domestic flying, airlines must question where they’ll find the arbitrage.

I make this projection for domestic flying based in part on a comparison to historic growth rates. Today, the travel spend as a percent of GDP produces $35+ billion dollars less in revenue than did the high water-market in 2001.  Labor rate differentials between mainline and regional carriers are significantly smaller than they were in 2001.  Regulatory oversight of the regional industry will add expense that is not yet known or understood.  Negative media coverage could undermine passenger acceptance and willingness to fly regional carriers.  Most mainline airlines are ordering narrowbody equipment to replace aircraft in their fleets, not expand their fleets. And there are still thousands of mainline pilots on furlough.

Does Scope Produce the Intended Outcome?

In the most simplistic terms, scope is the definition of work for the class and craft of employees governed by the provisions of a collective bargaining agreement.  Its purpose is to provide job security for those employees.  But it is safe to say that most scope clauses produced unintended consequences.  Between 2000 – 2008, legacy carriers reduced the number of narrowbody aircraft they fly by 800, and more than 14,000 pilot jobs have disappeared.

So, one could argue that scope is just another example of protectionism that failed. As economist Henry George, a sharp critic of protectionist policies, once said: “Protectionism teaches us is to do to ourselves in times of peace what enemies seek to do to us in times of war.” 

Scope negotiations have been divisive not only between labor and managements but just as much between the unions representing mainline pilots and those representing regional pilots. Ultimately airlines must determine whether the 90-125 seat flying of tomorrow should go to the mainline or be flown by their regional partners. To arrive at the right economic solution, it is time for organized pilot labor and management to stop putting a Band-aid on problems.

The Boyd Group International recently released an interesting fleet forecast that looks in part at new aircraft orders. So far, the only area of real growth is in the 75-125 seat category.  Orders in other seat ranges are forecast simply as replacements from now until 2015.

Ironically, 2015 is when many regional contracts expire, primarily those for 50-seat flying.  These expirations could eliminate nearly 500 existing airplanes currently under contract between now and 2016; with the lion’s share coming off contract in 2015.  This is a conundrum for the regional industry for sure.  There will be a thirst for new flying.

It Is All About the Economics

Perhaps a better way than scope for pilot unions to think about job protection is to find the economics that will employ the most pilots at the mainline.  That challenge must acknowledge the fact that today’s industry is not the industry of yesteryear.  If the regional industry has been used as currency to cross-subsidize pilots at the mainline; and assuming that the trading currency is not what is was as we engage in this round of bargaining, then something has to give. 

There are two solutions as I see it:  1) relax scope in order to win bigger increases in wages, benefits and working conditions for pilots that remain at the mainline; or 2) embrace the absolute fact that contractual rates, work rules and benefits need to be lower for US domestic mainline flying.  That type of carve out can be negotiated.  Domestic market flying differentials can be the new trading currency used to adapt any pilot contract to the market realities of today.  There is no way to “perfume the pig” here; the mainline did something similar in 1984 in order to average down labor costs to facilitate growth.  When it was decided that the concept was not internally healthy, mainline pilot labor made the regional industry the new vehicle for cross-subsidization of mainline pilot terms of employment.

One trend is clear:  the industry’s pricing structure cannot now support labor rates that keep pace with inflation.  An unpopular message -- yes.  But there needs to be a structure in place that recognizes the different conditions in the US domestic market versus international markets.  This structure must recognize that not all flying is created equal, just as the airlines are coming to appreciate that a one size fits all operation is not financially sustainable.  There is a tremendous opportunity to put in place something better – if only the players at the table can let go of the past and come to terms with a new era in the airline industry.

Where Do I Come Out?

I recently saw a piece by Lori Ranson on the Airline Business blog titled:  “A New Line In the Sand” that cites comments by long-time Raymond James analyst Jim Parker on the future of scope: “As employee groups seek to regain some concessions made early last decade as a host of carriers spent time in Chapter 11, there could be some leeway in the size of jets flown by mainline regional partners,” according to the analysis.  James sees the potential to renegotiate current scope clauses, moving the dial from 70-seats to 90-seats.

I am not one to be on the other side of Parker often, but on this one I am.  I do not believe that the mainline pilot unions can afford to make another mistake.  Their arrogance toward regional jet flying led to their current predicament.  The economics of US domestic flying is simply much more difficult now for the legacy carriers.  If labor can’t let go of their memories of what the industry was 20 years ago to focus instead on where it’s going over the next 20 years, then they will have no one to blame but themselves if they fail to help position airlines – and the pilots they represent  – for success.  John Kennedy once said:  “Change is the law of life. And those who look only to the past or present are certain to miss the future.”

It won’t be easy for pilot union leaders to find a solution for a problem that they helped to create.  Just as the US Airways East scope clause defines small, medium and large regional aircraft, it is time to define small, medium and large narrowbody equipment necessary to profitably serve the domestic market. 

Once again, a call for pilot union leadership.  My view is that management is indifferent as to which pilot group does the flying.  I am thinking we are at that critical juncture in an evolving situation that leads to a new and irreversible development – mainline legacy carrier pilots performing narrowbody flying in the US domestic market 20 years from now – or NOT.

Swelblog’s 12 Airline Industry News Items of 2009

It is that time of the year again when it is time to put the packages under the tree. The packages represent my 12 days of Christmas, or the 12 airline industry issues that took place in 2009 that I find important. I have placed my packages under the tree in descending order of importance.

... read more

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Grab a Big ‘Ol Cup of Jo, and Let’s Talk Airline Service Cuts

Starbucks, Airlines and Air Service Cutbacks

This morning’s headline in the Wall Street Journal on B1 reads: Starbucks to Shut 500 More Stores, Cut Jobs. The story by Janet Adamy offers many insights as to what is plaguing the airline industry, at least from this observer’s perspective. The announced shutdowns will occur throughout the remainder of 2008 and will continue into early 2009. The 500 store closures announced yesterday are in addition to the 100 the coffee proprietor announced earlier this year. I will highlight some of the points made by Adamy in her story:

· “The pullback is a sign that the Seattle-based coffee giant is continuing to see weak sales as high gas prices and other pressures on consumer spending prompt Americans to cut back on extras.”

· “It also shows how badly the specialty-coffee business is struggling just as mainstream companies, such as fast-food giant McDonald’s Corp., are beginning to invest in it.”

· “Starbucks didn’t disclose which of its about 11,000 stores U.S. stores it will shut, but said the affected stores are spread across all major U.S. markets. About 70% of them have opened since the Fall of 2005, it said”.

· “The purpose of its rapid expansion (2,500 stores globally during the last fiscal year) was to boost sales growth and siphon traffic away from some of its stores where long lines were driving away customers. Also fueling the push was company research that showed people sometimes weren’t willing to cross the street to buy a cup of coffee.”

· Last year, as Starbuck’s sales began to soften, it became clear that the company’s expansion was cannibalizing its sales in a way that was threatening the chain’s success, as well as causing the quality at its existing locations to slip”.

The Ubiquitous Airline Industry

Adamy mentions ubiquity in her story and it absolutely applies to the US airline industry as well. You know: the seeming need to be present everywhere. As we have written here many times: presence everywhere and pricing power nowhere. Ubiquity is synonymous with fragmentation. Fragmentation best describes the US airline industry’s domestic market. [In fact, IATA suggests that fragmentation describes the construct of the global industry’s marketplace.] The US airline industry’s domestic market lies at the heart of the US airline industry’s woes. Hyper-competition has led/contributed to the non-economic prices that persist. So if fragmentation is present and structurally undermining your performance, consolidate around your strengths – right?

Based on the story about Starbucks closing stores let’s talk about the US airline industry and the planned capacity cuts that are known and those that might not be known. We have heard about some airlines either discontinuing service altogether or reducing frequencies to large markets like Ft. Lauderdale and Oakland. Will Ft. Lauderdale and Oakland passengers suffer as a result? My answer is NO as they will have other options available like Miami or on other carriers, mainly those with the outdated low cost carrier moniker, continuing to serve the market. Will Oakland customers suffer? My answer is NO as they will have access to remaining service at OAK and will have a menu of offerings available at alternatives like San Jose and San Francisco. So customers will continue to have options, and options with low cost carrier presence, just as they have before.

Just like Starbucks realizes it cannibalizes traffic with certain store openings, the US airline industry cannibalizes itself with nearly every new service in some way it seems. My numbers may be off a bit here, but hear me out. At one point I was looking at the Greenville-Spartanburg, SC (GSP) to Los Angeles market. At that time there were 100 passengers per day each way (PDEWs) in that market. Those 100 passengers had a choice of 24 nonstop flights to access the air transportation system over 15 different hubs.

So I have 24 nonstops competing for four passengers per flight. As oil skyrockets, how can I possibly raise fares enough to cover the cost with that many consumer choices in the market? Simply, you cannot. Another question should be: how many choices is too many choices for a mid-size market like GSP?

To make matters worse, it can actually be said that carriers competing in that market actually compete with themselves. Delta carries traffic in this market over each its Atlanta and Cincinnati hubs. There are a multitude of examples just like this one where consumer choices to get from A to B are much more than the market can economically support. Unfortunately, it has taken the price of oil to demonstrate that the choices provided air travel consumers over the years cannot be economically sustained in many instances. So just like Starbucks, the US airline industry will pare back choices and consolidate that demand around markets that are, or can be made, economic by consolidating traffic.

So as the Business Travel Coalition paints the landscape with scare tactics, their back of the envelope analysis tells us very little. The BTC fails to mention that in the vast majority of service reduction announcements thus far, passengers demanding service to a particular destination will still be accommodated albeit by fewer frequencies or over fewer hubs – and few will be disenfranchised from the air transportation system.

Another Question I Have: Why Is It OK for Southwest and No One Else?

You know the story. Everything Southwest does is somehow the best and always in the best interest of the consumer. Southwest, circa 1995, enters a market. Fares go down and significantly in some cases. Traffic at that airport market is stimulated. Southwest’s success in entering a market had much to do with expanding the catchment area of that airport market. So while the carrier still only serves less than 65 airport markets in the US, if one were to draw a circle equivalent to a 2-hour drive to that airport, the carrier impacts more than 90% of US domestic air travel demand.

But the question should be: how much of that demand is/was created because air travel was made affordable to some new segment of the population and how much is/was diverted from airport market(s) located within that 2-hour catchment area? It is some combination of the two. Is that stimulation or diversion? The answer is diversion.

There are many examples of airport markets that have suffered as the Southwest’s, jetBlue’s and AirTran’s and other “bottom fishers” entered markets across the US. Their lower costs at the time allowed them the “freedom” to price aggressively while exploiting the bloated cost structures at the legacy carriers that existed. The low fares worked to stimulate new demand all the while diverting traffic from smaller airports with higher prices enveloped by the catchment area. It is the sum of the two - not one or the other.

But why is it OK for Southwest to offer service at an airport and rely on the highway system to be the first leg of access to the air transportation system – all in the name of low fares?

Why is it not OK for the remainder of the industry to cutback frequencies that may result in the highway system being the first leg of access for some – in the name of preserving as much of the network architecture that has been built and can be made economically viable?

The existing network architecture has provided more than sufficient choice for air travel customers in cities of all sizes, not just the largest metro areas that have secondary airports that are the backbone of Southwest, and its LCC brethern, service.

There Is a Lesson Found In Starbucks’ Decisions That Apply

At some point Congress, BTC and others may actually realize that the industry has grossly overbuilt through the over exuberance in the use of regional jets. For many markets it means you will still not have to walk across the street to get a cup – or access in airline vernacular. For others, it will mean having to walk three blocks for a cup. But in any case, you will pay the “all in” cost of that cup. Like Starbucks, you will go for that first or even second cup. The trick for the US airline industry will be the demand for that third cup or the iced cup that lies the heart of the demand equation and the ultimate decision on how much capacity to cut is right.

More to come.

If It Doesn’t Add, Let’s Begin the Subtraction Process

What Is Wrong With US Regional Industry Attrition?

It is increasingly clear that, in addition to fuel, regional airline industry overcapacity – a “bubble” in this writer’s opinion - may be the second most important catalyst to consolidation in the US airline industry.

Today, USA Today wrote about the capacity issue in an article about cuts in airline schedules across the industry, even in the face of strong demand click here. Maybe this is a precursor of things to come.

When domestic market overlap is evaluated, it is the respective regional network webs that will give pause to regulators and legislators, particularly considering the extent to which consumers may be disadvantaged as the result of consolidation. This is where network overlap occurs, not on the densest routes replete with competition from all sectors of the industry.

At last week’s ACI-NA International Aviation Issues Seminar in Washington DC, I tried to come up with a politically astute answer when asked a question on consolidation. But given my inclination to tell it how it is, I ultimately acknowledged that, on this subject, there is no “politic” answer.

I think Doug Parker had it right. I’m in no position to make that call, but looking at Parker’s blueprint for US Airways, he was suggesting some smart decisions. Why does Jacksonville, NC need nine flights a day to connect its airport to the US air transportation system when six are sufficient? Why does Greenville-Spartanburg need 25 choices for 100 or so passengers a day to and from Los Angeles?

The US industry is now struggling to shed fixed costs in an era when many airlines already have achieved significant cost savings from labor; fuel costs are outside anyone’s control and therefore not an option; and most of the cost reductions already have been wrung out of the distribution area

Since 2002, transport related expenses as reported by the mainline carriers – the vast majority representing the purchase of capacity from regional partners - increased more than fourfold to more than $17 billion in 2006 click here. If there is a cost area that deserves, and needs, reevaluation it is regional capacity deployment.

To put it in perspective, the $17 billion in expense spent by the mainline carriers on regional capacity exceeds the market capitalizations of United, American, Northwest and US Airways combined.

A Contrarian View of American’s Decision to Shed Eagle

Since American announced its intention to spin out its wholly owned American Eagle unit, I am troubled by some of the analysis. This is not about American or even about the FL Group, an activist AMR shareholder that has pushed the company to divest assets. This is about a sector of the industry with failing economics – the regional sector. And this surely is not about mainline pilot scope clauses. This is about economics: pure and simple. This is about American continually persuing the cleanup of its balance sheet.

If Southwest is continually revising downward planned capacity, then this relatively expensive capacity is surely difficult to maintain, yet alone grow.

As I have written here before: there are too many network carriers; too many low cost carriers; too many hubs and too many regional carriers. Already, we are seeing some signs of a pilot shortage. And the growth of the regionals – much of it built on labor arbitrage and an over-reliance on regional jets over mainline narrowbodies – is now slowing to a crawl. So why shouldn’t we begin to shrink the regional sector? Delta has Comair up for sale or some other transaction, which has been public knowledge for some time.

Financial engineering the AA deal is not. Pinnacle was the last financial engineering attempt using a regional platform and in the end the market correctly valued the expected revenue streams based on activity in the industry at the time. Mainline carriers began paying lower margins based on reduced revenue flows as the bankruptcy parade commenced. If AA were looking to enhance shareholder value, they have two or three other options that surely would have been announced before this one.

Prior to its Chapter 11 filing, Delta sold ASA to Skywest for a fraction of the price it paid for the regional carrier. Skywest negotiated certain terms in the event of a bankruptcy filing by the parent. More importantly, the broken carrier Skywest bought at a deep discount also came with a 15-year Air Service Agreement with Delta on pay out terms that are believed to be significantly better than newcomers to Delta’s regional stable receive.

This is the type of deal I would expect in the case of AA and Eagle. American has signaled to the market that it plans to maintain the current lift being purchased from Eagle. Yes, a new Air Service Agreement would have to be negotiated along with the transaction. What will be different with this deal is that aircraft will begin to come “off lease” over the term so the “buyer” may be purchasing reduced cash flow streams going forward. This is not financial engineering but economic reality. But they will be buying cash flow streams nonetheless – and that revenue is what matters to the analysis, not scope clause limitations.

Some Concluding Thoughts

Maybe this deal could be a catalyst to begin a long and overdue attrition of the regional industry as we know it. If there is a pilot shortage, then you are buying pilots. If you are looking to build a capital base that could be leveraged in other areas, this could be an economical means to buy what you could not build organically – particularly in this environment.

Growth is not occurring with 50 seat flying; that has been a well- documented fact for the past two years. But it takes the same number of crews to fly a 70 or a 76 seat plane as it does to fly a 37, 44 or 50 seater. Carriers participating in new flying with mainline partners are now purchasing their own aircraft. The purchase of new aircraft requires both cash flow and a sufficient capital base. The inclusion of Eagle assets and cash flow will surely provide a regional provider with more long-term staying power to withstand the necessary changes within this sector.

Just as we have talked about a domestic airline industry that could ultimately shrink to three or four legacy carriers, then it also is safe to say that three or four regional carriers are more than sufficient to meet demand. Skywest and arguably Republic will be there in the end. The question is who will join them in supplying capacity to the mainline carriers. The regional carrier space needs multiple providers, not only to ensure the competition for feed that the buyers want in the marketplace, but also to avoid the labor disruptions possible when a carrier is dependent on feed from just one provider.

Concluding Thoughts For Government

This is not a time to be “knee jerk” in a federal response to U.S. carriers that are struggling to be profitable at home while quickly being relegated to secondary status in the global arena. Just because there is an airport in a congressman’s district does not necessarily mean it makes economic and financial sense for airlines to offer service.

Yes, the government should ensure access to the US and global air transportation systems for as many communities as possible. But it is not commercially viable to offer each of those airports around-the-clock service. This bubble has raised unrealistic expectations for air service. Now we need to relieve pressure on an industry before it breaks.

Heeding the Divestiture Cry? American to Spin Off Its Eagle Unit

This afternoon, American announced its intention to spin off its American Eagle unit click here. Given the talk surrounding the company to consider spinning off AAdvantage, American Beacon Advisors, American Eagle and its maintenance unit, this announcement should come as no surprise.

Calls for American to spin off AAdvantage were first made by Reykjavik-based FL Group, which owns 9.1 percent of American in September. All US carriers, and not just American, are considering means to respond to increased shareholder pressure as airline shares have significantly underperformed the Standard & Poor's 500 Index this year.

One might say that AA is considering the divestiture of a regional carrier late in the cycle when growth has slowed considerably. On the other hand, if you believe that the regional sector of the US airline industry is not immune from consolidation, it just may be the right time to participate in the purchase of a carrier with a $2+ billion revenue stream that American says will remain intact as the parent plans to maintain all current feed provided by Eagle.

That revenue stream and an increased capital base will certainly have some attraction to regional sector’s biggest players: Republic, SkyWest, Pinnacle and others looking to assure their survival as its sector of the industry matures as well. American suggests the transaction will be a 2008 event with all the necessary caveats. No details have been provided on a deal structure other than a blank whiteboard.