Republic Pilots: Forget the Leaks and Prepare to Change Vessels

Since writing the last blog titled “A Race to the Bottom,” I have received a lot of mail, much of it critical.  Many readers wrote about the ratification votes on tentative agreements for pilots taking place at American Eagle/Envoy and Republic.  After a heavy travel schedule, I finally got around to perusing my e-mailbox.

I have long challenged the approach of the Airline Pilots Association (ALPA) and other collective bargaining agents on the mainline-regional relationship, so the last post should not have come as a surprise.  Simply put, the relationship needs fixing but the fix is not going to come from one pilot group voting down a contract in the false hope that a “pilot shortage” will resolve differences between regional carriers and the unions representing pilots. The only fix will come with a far more strategic effort on the part of many industry stakeholders – management, labor unions, universities, Congress and the regulators.  

Consider the Republic situation. I’m hearing rumors of a concerted “Vote No” campaign intended to put the screws on management and extract more money. Based on my analysis of the industry, Republic pilots should take a step back and think long and hard about that approach. Republic is well-positioned to be a major player in the US domestic airline industry of tomorrow – an industry that will look much different than it does today.  So what is important in the interim is to negotiate the very best agreement – one that addresses the makeup of a carrier’s seniority list today and ensures pilots a seat at the table looking forward.

What I like about Republic’s tentative agreement are things that address the future like an early re-opener.  It calls for a four-year contract, allowing for adjustments when the contract is amendable at just about the time we’ll start to see significant changes in the industry. The TA also paves the way for what appears to be a more open relationship with the company to address scheduling and operations. These issues are critical to running the very best regional airline possible.  American and Envoy took a different approach – an approach some call concessionary whereas Republic is offering improvements.

SENIORITY DIFFERENCES

There are, of course, profound seniority differences between Envoy and Republic. Envoy is a “Legacy Regional” because of its relatively high seniority, while Republic’s seniority makeup is quite different.  Among the many difficulties network legacy carriers faced in negotiating labor agreements in bankruptcy, seniority issues more than any other exacerbated the problem of cutting costs to compete with lower cost carriers.  As I have said over and over, you cannot restructure seniority.  Envoy took one approach in negotiating a way around seniority by significantly improving the flow through agreement with American.

Republic has gone another route by negotiating the very best pilot agreement it believes it can afford over the next four years taking into account the progression through the pay scales.  Affordability matters. Republic is currently performing flying under contracts negotiated with mainline partners before this new pilot agreement was negotiated.  Because those terms are set, increased pilot costs only degrade the airline’s margins.

It’s all about balance.   Capacity purchase agreements are a reality for now, no matter how outdated the model, so the most realistic remedy is to accept that as fact and improve the situation one step at a time.

THE NATIONAL MEDIATION BOARD

I can hear the battle cries now:  the NMB will release us and allow us to strike.  Republic pilots will say that, after seven years of negotiations the agreement is simply unacceptable. But the union(s) should understand that the threat of a strike is not what it was 15 years ago.  The NMB would be hard pressed to make a case to the White House that a sector-leading agreement in many important economic areas is not a good outcome and therefore allow the pilots to engage in a work action.

And, yes, commerce would be disrupted. Regional airlines provide the only air access for hundreds of smaller communities, making it even more unlikely that the NMB would grant a release.  [Being remanded back to mediation only prolongs a process already gone too long] Consolidation in the mainline sector only compounds this factor as there is no longer sufficient capacity to accommodate the disenfranchised demand that would result from a work stoppage.

Yes it may be true that smaller cities could in the future lose air service in part because of a shortage of pilots willing to work for the regional carriers, but that argument would not outweigh the risks of a strike today. Are regional pilot salaries too low? Based on the education and skills required for the job, I think the clear answer is yes. But at a time the administration is focused on truly low wage workers and income inequality, it is highly unlikely that the White House would allow this issue to distract from its efforts to raise the minimum wage and allow a work action that could bring more financial pain to areas already punished by a weak economy.

So Republic pilots should perhaps think twice about the conditions for this particular battle and instead focus on the bigger picture and positioning for the future.

A SECTOR IN FLUX WITH THE POTENTIAL TO BE SIGNIFICANT

I’ve been putting a lot of thought into this subject, in part to prepare for a presentation I gave last week on what the North American airline industry will look like in 2025.  Projections this far out are never easy, particularly in a business in which long-term planning is too often viewed as planning for the next month.  I gave it a go, however, and came down on the side of today’s freight railroad industry.  This is an industry that has a created a blueprint for sustainability that began with the passage of the Staggers Act and the departure of large railroads from their non-core businesses like passenger rail. 

I see the Big Three airlines soon shedding small market service as it becomes less and less a part of their core business.  If Southwest can influence more than 95 percent of demand by serving just a fraction of the markets served by the network carriers, so too can American, Delta and United who will concentrate their service on the nation’s top 100 or so markets along with transoceanic flying. 

As costs creep up at the largest airlines, serving more markets won’t make economic sense, whether they do it themselves or in conjunction with a partner airline. Capacity purchase agreements won’t go away, but it is likely that carriers in today’s regional sector will become hybrid carriers that offer service to many markets the mainline carriers vacate.

THE NAYSAYERS

I fully expect that naysayers will take a page out of an antiquated playbook to say that the economics will suddenly improve because the network carriers will “fix” agreements in place with their regional partners.  As Lee Corso says every Saturday on ESPN’s College Gameday as the group picks winners and losers:  “Not so fast.”  You won’t hear it from the network carriers because it wouldn’t be politically astute for them to say it out loud, but my guess is that they would be very happy to begin exiting many of the small markets they now serve.

You don’t have to look too far to appreciate this fact as nearly every hub that has, or had, regional fleets as the backbone of its flying are now disbanded.  Delta is trending away from 50-seat aircraft as quickly as it can in exchange for larger 76-seat and B717 aircraft for service to its smaller markets.  Whereas in the past the network carriers would participate in subsidized Essential Air Service flying, that trend is dying. American will surely park the “scope-buster fleet” at Envoy.  That leaves United which, in the midst of a $2 billion cost-cutting exercise, will certainly be looking hard at the billions of dollars it spends on regional lift and questioning how much is too much.

There is nothing in the data or the trend lines to suggest that legacy carriers will be willing to change the terms of existing capacity purchase agreements just because the economics of regional carrier labor agreement need fixing. These trends do, however, suggest that the regional sector as we know it will be smaller and that will mitigate some of the pilot shortage concerns in the short-term.  The medium and long-term are another story but that is not going to get fixed in this round or address the pending problem of putting a qualified supply of pilots into the commercial airline pipeline. 

SURVIVORS AND LOSERS

I see two big winners in the regional sector in 2025: Republic and SkyWest, in part because of their commitment to running the very best regional airlines.  Yes, Envoy and the former US Airways’ wholly-owned carriers may evolve as stand-alone airlines, but their success is uncertain.

Republic and a SkyWest, by contrast, can successfully transition as hybrid carriers, much like Class II railroads did.  Think airlines with multiple code share agreements on the same flight.  At-risk flying will be more the norm. There will be capacity purchase agreements with the network carriers, albeit fewer, but only for those who demonstrate a track record of reliable service. Republic and SkyWest have that record where a carrier like Mesa does not. Ultimately, it will be Republic – assuming it can move forward with a new pilot agreement - and SkyWest who command the markets too small to be big enough for network carrier’s mainline aircraft.

CONCLUDING THOUGHTS

Warren Buffet said:  “In a chronically leaking boat, energy devoted to changing vessels is more productive than energy devoted to patching leaks.”  Republic pilots who vote “no” on the current tentative agreement to protest realities of the market are doing nothing more than trying to patch leaks, and not successfully. The sector is changing and will change and the best energy now should be spent looking ahead to the next contract with greater clarity about what the business will be four years from now. 

An early re-opener allows time to do just that: change vessels and improve the economics for those who want to stay and have a career at Republic [and Envoy].  Voting “no” does a disservice to the pilot profession because the problem is simply bigger than one carrier’s collective bargaining process.  Voting “no” may feel good for a moment, but the long-term impact leaves Republic pilots with no seat at the table or real influence in fixing the industry’s medium and long-term economics. Does voting “no” send a signal?  Perhaps, but in my view its equivalent to throwing the life preservers out of a leaking boat in a futile protest of reality.

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.

Just Who Will Inherit the US Domestic Market? Don’t Forget Today’s “Regional Carriers”

Will the legacy carriers today be the domestic providers tomorrow?

This post has been partially written for about six weeks. The US domestic market presents us with many things to consider as it evolves. “Darwinists” will say it will be the “survival of the fittest”, or the strongest competitor will be the last standing. In October 2002, Eric A. Marks wrote a book: Business Darwinism: Evolve or Disolve: Adaptive Strategies for the Information Age. Marks was writing on the critical importance of information technology in accelerating the necessary grab for global market share. He used the phrase the “survival of the fastest”.

Whether it applies to the US airline industry and its participants or not, the use of a phrase like “evolve or disolve” certainly applies to the current carriers of all ilk providing service to customers within the US domestic airline market. So as we move into the season of capacity cutting in a significant way, one could ask if we are dissolving or simply engaged in a practice of attrition of uneconomic capacity? No matter how we choose to refer to this period, it is an evolution of an industry structure that is unknown.

Republic Airways, SkyWest and Possibly Others

In the past weeks, Republic Airways, a “US Regional Carrier”, has made some aggressive financial plays at each Frontier and Midwest. Both carriers have strong local market followings and that could be described as an understatement. Warren Buffett likes brands. Are hub markets brands? And if these hubs are joined?

Pilots at Midwest might say that the current ownership is using the Indianapolis-based carrier as a stalking horse to win pay and productivity relief from current contracts. In Frontier’s case, Republic is part of the group that provided the “Debtor In Possession” financing necessary for the Denver-based carrier to construct its plan of reorganization.

Neither Frontier nor Midwest are vital to tomorrow’s US domestic air transportation system - as we know it - and they are joined in that regard by Sun Country in Minneapolis. Whereas this observer has been vocal of a need to consolidate carriers in the “regional space”, I am thinking that there just might be something more to consider. I refer from time to time to a piece I did in 2003 entitled: Low Cost Carriers: Thou Shalt Not Inherit the Earth.

Not so much that there is a need to consolidate carriers in the regional space as many of them will simply dissolve as hubs are closed in the face of high oil; an overall slowing of demand; and less reliance on domestic traffic flows for the network legacy carriers. But I am thinking that carriers like Republic, under it visionary CEO, Bryan Bedford (who should have been a CEO at a legacy carrier already – but then again why would you want to do that?), and SkyWest just might be tomorrow’s US domestic capacity providers. Carriers like Republic and SkyWest just might be the competition for the surviving “Low Cost Carriers” like Southwest, jetBlue, AirTran and possibly Virgin America.

It is Republic and SkyWest that are buying the right-sized aircraft for a market with higher prices and slowing demand. It is Republic and SkyWest that are building fleet scope that provides each of them with the economies of scale that are critical to manage any and all associated costs. It is Republic and SkyWest that have aircraft to serve communities of all sizes that will make "narrow-minded" lawmakers happy. It is Republic and SkyWest that will be looking for "natural partners" to code-share with as they will need international network scope in order to maximize onboard revenue. Republic and SkyWest have learned the lessons from Independence Air and ExpressJet (edited) that built failed models focusing only on the US domestic market.

SO……….

Hey Bill, what are you saying? I guess what I am saying very simply is that this labor negotiating period remains the most critical since deregulation – just as I have been saying for the past couple of years. As Aristotle first said, and was recently used by my dear friend Jon Abbet on the putting green when comparing the banking industries to the airline industry, “nature abhors a vacuum”. The US domestic airline system presents the greatest potential for a vacuum. Controllable costs have converged. But that will not last. Service from Lubbock to London would produce a vacuum if American were to leave and that will be filled. Lansing to Lagos would produce a vacuum if Northwest/Delta were to leave.

Carriers like Republic and SkyWest have the opportunity to take advantage of technology that ensures a “survival of the fastest” path. Remember the UPS whiteboard guy and the cargo industry - no real legacy impediments. Tomorrow they will be the carriers that deal more with an inefficient air traffic control system. STAR, SkyTeam and oneworld will only want to ensure that international connections arrive on time. Northwest and Delta have committed themselves to the US domestic market. But I am not sure that United, Continental, US Airways and American have. In the case of the latter two, they have more commitment today.

Whether it is seniority or a different compensation scheme for tomorrow’s "seniority" that works best for the future industry, never overlook a potential competitor - as it is present. That competitor is not the obvious but rather the well managed companies that have been tasked to adapt to the network model. Republic and SkyWest have.

So in this negotiation, labor will either figure it out or they will not. The US domestic network still provides the most jobs to the labor organizations representing the employees at the legacy network carriers. Will that be the case tomorrow? I am not sure. This is a time to negotiate a construct that rewards blood, sweat and tears. This is also a time to negotiate a construct that recognizes that tomorrow is different. And in the course of doing so, membership numbers can be protected, and possibly augmented.

So ask Boeing and the IAM if a strike is worth it? I am not sure. Ceding competitive advantage to Embraer and Bombardier and others in tomorrow's narrowbody market is the ultimate question. The same is true for airline labor. Domestic economics are different from international economics. Beware of the underdog as is it not the LCCs to fear, it is Republic and SkyWest. Attrit and dissolve; attrit and resolve. That is the question?

Never doubt that nature abhors a vacuum. For ALPA and pilot's unions this is a watershed issue as you represent both sectors. For the flight attendants, membership numbers might not grow but at least you will protect what you have. This is big. Really big.

More to come.