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.

The United and Continental Pilots Engage In MISInformational Picketing

Today in Newark; tomorrow in Houston; and on December 1 in front of UAL Headquarters in downtown Chicago the United and Continental pilots have announced they will engage in “informational picketing” regarding the new company’s decision to redeploy certain United 70-seat regional jet flying into former Continental hubs Newark, Cleveland and Houston.  In return for that redeployment, certain Continental 50-seat jets will replace the United 70-seat jets flying out of certain former United hubs.  Note the tradeoff:  no one loses flying; no one loses a job; no mainline flying is impacted; and everyone benefits from a network made stronger by matching the right-sized aircraft to routes that either need a larger or smaller aircraft.

Yet the message from the "informational picketing" will deflect what has been going on between the United and Continental pilots of late and make the company the villain.

Seems so simple.  Just like the combined Delta and Northwest networks moved quickly to best match aircraft size to markets with commensurate demand, Continental and United are moving to do the same. 

Part of the Continental and United pilots message to the public will be that the combined company is violating their respective collective bargaining agreements, in particular the section called scope that swelblog has covered so extensively..    In a November 12, 2010 Continental pilot communiqué, the call to arms read as follows:  “It’s time to get serious and stand united against outsourcing. In response to management’s attack on our current scope provisions, and their clear leveraging of it in negotiations for a new JCBA, the CAL SPSC, in cooperation with the UAL SPSC, will jointly organize informational picketing at both Newark and Houston airports as well as United world headquarters in downtown Chicago. It is time to show the new United management and the public that ideas and plans to violate our contract and outsource our jobs to the lowest bidder will NOT be tolerated by pilots.”

OUTSOURCING

The pilots first fallacy is ‘outsourcing”.  The fact is that the pilots’ union, ALPA, has played a major role in creating the labor Ponzi scheme that survives at the legacy airlines. Over the past 15 years, how did ALPA find a way to pay mainline pilots more?  By agreeing to allow another group of pilots to fly where mainline flying is no longer economic and to be paid less to do so in order to buy “better” contracts for the mainline pilots they represent. 

What the Continental and United pilots fail to share is ALPA’s dirty little secret: that the wage rates, working conditions, training provisions and other particulars they criticize at the regional carriers were negotiated by their very own union. ALPA represents the majority of regional pilots flying in the US today.  So maybe ALPA needs to step up and take some responsibility for its contribution to building the regional sector of the industry that they now deprecate.  Only by agreeing to lower rates of pay and more flying time at the regional carriers can ALPA justify and sustain the generous pay, benefits and work rules that benefit pilots at the mainline airlines. 

Look at any significant relaxation of the scope clause at the mainline carrier that allows the airline to increase its use of jets 70 seats or less. In just about every case the mainline pilots received a significant pay boost – or were able reduce the level of concession - in return for that “concession” as they were given economic credit for allowing the deployment of regional jet flying by regional partners.

Stop calling it outsourcing.  It is not.  It is a convenient word to use given the disdain for the practice by the now lame duck Chairman of the House Transportation and Infrastructure Committee.  The practice of relaxing scope to permit regional partners to perform uneconomic flying has kept more mainline pilots on the payrolls than it has cost jobs as the network has been kept largely intact when routes would have needed to have been cut because it was not economic for 100+ seat aircraft to perform the flying.

SOME FACTS

This redeployment, or better said a swap of one-sized regional jet for another, has gone so far that an expedited grievance has been filed by the joint Continental and United pilots.  On November 15, 2010 the union filed grievance:  File 11.10.041CG.  “Pursuant to the Collective Bargaining Agreement (CBA) between Continental Airlines, Inc. and the airline pilots in its service, as represented by the Air Line Pilots Association, International, (ALPA) the undersigned hereby files this grievance, on behalf of all affected pilots, protesting the Company’s violation of Section 1 (Scope) and all related sections of the CBA by placing and planning to place the CO code on United Express flights using jet aircraft with an FAA certification of fifty-one or greater seats to and from CLE, EWR and IAH.  As a remedy, ALPA requests that the Company cease and desist advertising and placing the CO code on such flights, and all other relief that may be appropriate.”

The union’s position “is that Section 1, Part 3-A of the CBA clearly prohibits the Company action, unless it is authorized by some other Part of Section 1. No other Part of Section 1 authorizes the Company course of action, as none of the express carriers performing the work is a Company affiliate; only 50-seat and turboprop flying, not 70-seat jet flying, is permitted by Part 4; and flying to a Company hub (if not to or from a hub of the other carrier) is not permitted by Part 5.”

The union says that the Company’s position relies on Part 7, arguing that it is flying by another air carrier while participating in a Complete Transaction in accordance with Part 7. The union suggests, however, that while Part 7 specifies rules for separation and merger of mainline operations, Part 7 does not change the rules in Parts 4 or 5 for operation of Express carriers or Complementary Carriers. Nor does Part 7 license Continental to permit United Express carriers SkyWest or Shuttle America to carry the CO code without observing the limits in Parts 4 or 5, because neither of them is a "participant" in a Complete Transaction. Neither express carrier is acquiring any part of Continental, nor is it becoming a Parent of the Company. Nor is Continental acquiring Control of assets of either carrier. Further, if either of these air carriers were participating in a Complete Transaction with the Company, that participation would trigger a series of obligations that the Company has not applied.

Note to self:  Then what comprised the United network at the time the combination was contemplated?  and the transaction closed?  Mainline flying only?  I think not.

The union says the Company also argues that following the merger closing, United and Continental will each continue to operate as an air carrier, but they are not prohibited from integrating their marketing, reservations systems and livery, ultimately marketing and operating their service under a blend of the United name and Continental livery. But this argument relies on general actions associated with a merger to dissolve specific protections at the heart of the CBA, as well as mixing those actions which the Company can undertake now with those that must wait until after a JCBA (and integrated seniority list) are reached.

Note to self:  Why should the company wait to maximize revenue when it can do so today?

The union concludes, their [the company’s] actions are not an effort to transition Continental and Continental Express operations to the single UA code, but to replace 50-seat jets in Continental hubs with 70-seat jets and to connect them with Continental flights, branded as Continental flights under the CO code, strictly as a way of carrying more passengers and thus making more money.

A Paper Tiger

A paper tiger is seemingly dangerous and powerful but is in fact timid, or as Frederick Forsyth put it: "They are paper tigers, weak and indecisive."

Sometimes the actions of pilots and scope are like that of a paper tiger – a mighty roar but no real threat. I thought the pilots of the combined carrier were looking to share in the synergies of the combined carrier.  In this instance, they talk about the company redeploying regional lift – remember no loss of jobs – as a way of carrying more passengers and thus making more money.  If the carrier makes more money, then don’t the UA and CO pilots potentially make more money?

The pilots claim that this is about the company trying to gain leverage in negotiations.  Let’s not forget that on August 27, 2010, the United and Continental pilots made a proposal to management to end outsourcing to regional airlines.  This is the issue pure and simple.  The joint UA and CO pilots are fishing for ways to block the carrier from finding the most economic way to serve cities of all sizes all the while somehow making the case that the same network economics can be achieved at the mainline level for performing tomorrow the regional flying of today.  It cannot be done absent significant concessions at the mainline level.

Finally, the joint bargaining teams have been publicly lobbing grenades at one another over compensation proposals that might favor one group over another during the seniority list integration process.  This is a group that has said publicly that they will first negotiate a joint collective bargaining agreement before engaging in the seniority list integration process, just like the Northwest and Delta pilots did so successfully.  If memory serves me, the Delta – Northwest negotiation was not without its disagreements and wrinkles.  That said, the Delta – Northwest agreement ultimately paved the way for sufficient numbers of 70+ seat flying to be performed by a number of regional partners. 

At least in Delta’s case, the union recognized that the regional flying being performed today was critical to supporting mainline jobs.  Regional carriers were contracted to perform domestic flying in markets where the poor underlying domestic economics remain.  The Continental and United pilots should be looking at the very same thing.  The unintended consequence of undoing the regional relationships today will be a smaller mainline tomorrow.  Smaller network architecture does not produce the synergies promised by a combined United and Continental.

Less in generated synergies means less to be shared among the pilots of the combined company.  Less in generated synergies means that the collective bargaining agreement ultimately reached will have less upside and will look more like the agreements that would have been ultimately reached if the companies remained as standalone entities. Less in generated synergies means that the combined entity will likely not attain its status as the world’s best airline.

There is a financial concept lost on union leaders today:  Net Present Value or NPV.   It means simply that cash flows realized in the short term have more value to the firm (or individual) than cash flows generated years down the road.  Captain Jay Pierce, the head of the Continental ALPA unit, argues rightly that the company’s action of swapping five 70 seat jets in Continental’s hubs for five 50 seat jets is strictly a way of carrying more passengers and thus making more money.  It is what companies should be doing - maximizing the revenue earning power of the network.

The benefits to the new United’s actions in this limited case are obvious.  The risks are, well,  timid and weak as no jobs are being lost.  Energy spent during one of the most traveled weeks of the year should be spent negotiating a joint collective bargaining agreement and not preparing for an arbitration that in reality is nothing more than a desperate grab of leverage that - if the pilots prevail - will result in fewer jobs, less mainline flying, fewer synergies to be shared among pilots and a degradation of the combined carrier’s status within the STAR Alliance.

Analyst Engel Does RJ Math; Swelbar Opines

Bank of America/Merrill Lynch airline equity analyst Glenn Engel could not have been more timely in his report published yesterday: “Regional Jet Analysis:  A Look at Profits Per Plane.”  Given the industry-wide focus on the future of the regional jet industry, Engel’s analysis cuts to the heart of the economics of RJs, particularly as to how they are used by network carriers and what effect changes may have on those carrier’s route systems. I do not read the report as having investment implications but rather as an analysis of the economics of regional jets utilized inside of each network carrier’s route system.

A Note on Engel’s Methodology

Engel notes up front the limitations of the analysis:  “1) Disclosure and accounting for regional revenues and costs are inconsistent across the carriers. 2) Differing fleet ownership and usage complicates comparisons; Pinnacle and ExpressJet sublease planes and as a result show lower nonfuel costs relative to SkyWest and Republic. 3) Mainline operations and regional feed mutually benefit each other, which can help cross-subsidize losses.”  In my mind, I acknowledge the importance of accounting but it is the network effects that are most difficult to discern.

Engel’s analysis is done on a per plane basis.  In order to counter the underlying differences in airplane size and the subsequent effect on traditional metrics used to compare like per seat mile costs, he normalizes regional jets operating on behalf of mainline partners into 737 equivalents.  He then assesses efficiency and profitability without structural distortions that are inherent across the entire spectrum of RJ usage.

Engel’s Analysis  

Based on Engel’s analysis, United enjoys the highest profit per regional unit by a factor of three over US Airways, which has the second-highest profitability.  American Airlines is the least profitable, losing $3.1 million per RJ equivalent.  It is no coincidence that the most profitable is the carrier that has among the most liberal mainline scope clause agreements, while the least profitable has the most restrictive contractual rules governing RJ deployment.  According to Engel, Continental, Delta and American each lose money on their RJ operations in that order before network synergies are accounted for.

Today, according to Engel, American is limited by its collective bargaining agreement with the Allied Pilots Association to flying no more than 47 70-seat regional jets.  At Delta, with the most relaxed scope clause, regional partners fly 284 70 and 90 seat jets; at United, regional partners are flying 153 70-seat jets; and at US Airways, regional partners are flying 110 70 and 90 seat jets.  [US Airways is the only network carrier permitted by the mainline agreement to fly regional aircraft larger than 76 seats.] Continental is not permitted to fly any regional jet larger than 50 seats.

Engel estimates that the mainline today flies 5.1 seats to every seat flown by the regional partners compared to 5.8 seats in 2006.  At that time, Delta and Northwest had not completed their restructuring in bankruptcy and United had just aggressively begun replacing unprofitable 737 flying with 70 seat regional jets.  United was able to replace the unprofitable flying only by negotiating the right to relax the scope clause during its bankruptcy restructuring.

At the Core of RJ Profitability:  FUEL

Ultimately, Engel’s analysis underscores the critical role fuel plays. “When fuel prices doubled in 2004, regional jets, especially 50-seat planes that have high fuel consumption per seat, became less attractive relative to mainline flying,” he wrote. Since 2004, mainline airlines have made $1.72 million per 737-equivalent (or $580,000 per CRJ-200 equivalent) more on their mainline aircraft than their regional fleet. The mainline-regional spread peaked at more than $3.20 million per 737-equivalent (or $1.09 million per CRJ-200) when oil prices spiked in 2008.”

The Exception is United

While the US Airways regional jet operation has been the most consistently profitable and American the least profitable, Engel finds that United earns the most per regional jet and is the only carrier where the regional jet operation is more profitable than the mainline operation. According to Engel, United does much less non-hub flying with its regional jets than its peers, operates a higher percentage of larger regional jets (more than half have more than 50 seats) and leverages its powerful domestic and international connections to increase profits.

Engel makes other points:

-          United has the highest utilization of RJs; Delta the lowest primarily because of a disproportionate number of 50-seat RJs.  Delta’s utilization should improve as it goes forward with plans to remove 10 percent of the RJs it operated in 2009. 

-          Legacy carriers fly RJs less but generate more revenue per plane.  United generates 41% more revenue per 737-equivalent from its regional fleet than the industry as a whole, and Delta produces 16% less revenue per regional plane.

-          United pays least for its feed while American pays most.  United spends 27% more per equivalent regional plane while garnering 41% more seat-miles and revenues. In contrast, American spends 10% more per regional aircraft while obtaining 4% fewer seat-miles and revenues.

Engel goes on to break down metrics between Republic, SkyWest, Pinnacle and ExpressJet – the publicly traded regional providers.  My read is that Republic and SkyWest are in the best position to weather the shakeout.  Pinnacle enjoys some strong attributes and SkyWest subsidiary Atlantic Southeast Airlines has announced its intention to purchase ExpressJet. A consolidation phase is playing out inside the regional sector as carriers look to create economies of scale.

What about the Regional Business?  Scope Negotiations?  Small Community Air Service?

New rules and regulations facing the industry will likely layer new costs upon costs, which could change this analysis looking ahead. Already regulators are suggesting that mainline carriers take a much more active role in overseeing their regional operators, which would impose upon them new responsibilities and potential liabilities. One question is whether new costs will tip the balance for Continental, Delta and American in terms of keeping the regional operations profitable.

As we add additional costs on top of already unprofitable flying (absent network effects), there are calls by the American and the United/Continental pilot unions to, in effect, bring all regional flying in-house.  Can the mainline pilots possibly do the flying with better economics?  In an earlier blog, Mainline Pilot Scope: Will Regional Carriers Be Permitted to Fly 90+ Seat Aircraft? I argued that pilot unions should find a more effective way than scope to think about job protection, focusing instead on 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.

 As I see it there are two options:  Either 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.   Domestic market flying differentials may be the new trading currency to adapt pilot contracts to the market realities of today.

It won’t be easy for pilot union leaders to agree upon a solution to 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.   As for the American and United/Continental pilots who believe that all flying should be done by mainline pilots, Engel’s analysis makes clear that United did a very good job in trading out 737’s for EMB 170’s.  The fact that United’s regionals outperform all of their industry peers in efficiency and profitability underscores how difficult it will be to undo the language that they negotiated in the first place.

With Congress’ influence being felt at every corner when it comes to what is best for the regional industry, it is time to discuss the unintended consequences.  As we layer on regulatory costs, it is certain that some of regional flying being done today will no longer be profitable.  Today’s carriers seem to be hell bent on removing unprofitable flying from their networks.  Won’t it be interesting when the next commercial air service airport is disenfranchised from the air transportation grid because the market cannot make money as a result of the new costs?

Then we will hear that the Essential Air Service program – a program that benefits a few at the expense of many taxpayers -- needs more funding.  Will anyone have the political mettle to acknowledge that the program has outlived its intended consequence? Today, 97 percent of US domestic demand is found at the 200 largest commercial airports. Given the razor thin margins in the regional industry Congress and the regulators should be careful for what they ask for. 

What is wrong with the highway being the first point of access to the air transportation system for markets that cannot support direct air service?  Customers seeking low fares have already proven they are willing to drive to whatever airport offers them. But when it comes to NIMBY (Not In My Backyard) Congressional Representatives, lawmakers who support policies that add costs to regional flying must realize that there are consequences to their actions.  Oil has made the 50-seat jet largely unprofitable.  With no replacement aircraft that size in sight, what happens to small community air service when leases are not renewed because small jet aircraft are just too expensive to operate?

Between the price of oil, scope, the legislators and the regulators, I fear that there will be many communities that lose service over the next decade.  And of course no one will take the blame.