Unbundling Our Way On The Search To Find The Inelastic Demand

I am beginning to believe that there is a silver lining in the high price of oil.

Last month, I wrote a piece entitled The Elastic Induced Ride to Inelasticity. With seat belts on, seat backs and tray tables up, we are ready for takeoff. Yesterday, while American and Southwest were holding their Annual Meetings of Shareholders, I was on an airplane back from Honolulu. So I missed the news flying out of those meetings that found its way onto the wires as rapidly as it could be transcribed. I missed the latest $4 per barrel rise in the cost of crude oil that now equates to $4+ per gallon of jet fuel. I missed …….. or, did I really miss anything?

Oh, I missed something all right. Whereas I believed the industry would transform itself more through merger and acquisition activity, I am now a believer that the price of oil, and the market, is truly what is needed to fully address the many structural ills that have plagued this industry for years. I would like to return to a few paragraphs I wrote in an Airline Business piece earlier this year: Are US carriers really ready for competition?

Despite claims to the contrary, nothing is new in the US. The same old ways of doing business remain intact, which calls into question whether the industry’s fabled “restructuring” has made any meaningful changes in the competitive profile of the US airline business. Despite deep cuts, many outmoded, and troubling, business practices remain.

Following an industry life cycle of value destruction, US legacy carriers now face a dilemma: whether to invest in their core businesses or not? Certainly the tendency to legislative and regulatory gridlock did not get restructured. An inflexible labor construct did not get restructured. The fragmentation of the US domestic market did not get restructured. The infrastructure, whether it be ATC or the airport system, did not get restructured. And the historic mindset that capital will be forever recycled among manufacturers, vendors, labor and government imposed actions did not get restructured.

Little has changed when it comes to labor and regulator views on consolidation. The mindset among the 535 decision makers on Capitol Hill still assumes that any congressional district with a runway, a terminal building and security is entitled to air service. Compounding this sense of entitlement is labor’s sense that the industry will return to its previous “pattern bargaining” – a supposition that fails to recognize the structural change in markets, labor and city pair.

Gerard Arpey’s Words

The full text of Mr. Arpey’s comments to his shareholders can be found here: Remarks Of Gerard Arpey At American Airlines Shareholders Meeting. As we approach the 30th birthday of US Airline Deregulation, it is the price of oil that is demonstrating its power to force the industry to address the many legacy mindsets that did not get restructured during the post 9/11 period. Among many, it includes the customer’s assumption that they actually pay the “all-in” price of the service and are therefore entitled to multiple access points to the air transportation system. NOT.

In this morning’s Wall Street Journal front page, column six, story by Susan Carey and Paulo Prada, they wrote: “If oil prices keep climbing, rising fares could start to push a significant percentage of travelers away from flying entirely. That could reverse one of the most dramatic effects of the industry’s deregulation in 1978, which led to a huge increase in flights, and brought intense fare competition, opening the world of air travel to millions of people”.

Ms. Carey and Mr. Prada are right. And the industry is right to evaluate the cost of providing the product at every juncture. And the industry is absolutely right to charge what it costs to produce the product. From the time the customer logs onto the internet to consider purchasing the ticket; to the actual purchase of the ticket; to the airport experience including check-in; the trip through security; down the jetway; taxi out; inflight service; taxi in; deplane; and collect luggage. Everything has a cost. And the management teams of each and every airline are being forced to “drill down” as never before in order to fully calculate those costs. And after calculating the costs of provision, many, many difficult decisions are being made.

Now this does not make any CEO popular. But being a CEO today is not a popularity contest during these difficult times. [And the most popular CEO of all time, stepped down from a 40+ year career BOD position yesterday] Being a CEO today means having the fortitude to say no. Being a CEO today means questioning anything and everything just because that is the way it has always been done. Being a CEO today means making the tough decisions even though dislocations of certain stakeholders might occur. And being a CEO today means having the guts to say out loud what CEOs knew before them but failed to act.

Mr. Arpey said and the WSJ highlighted: “The airline industry will not and cannot continue in its current state”.

Concluding Thoughts

With all of the actions being taken by the industry to charge for things that were never charged for before, what is interesting is how each carrier is sure to ensure that their most important customers will not pay those fees. Loyalty programs have just become a/the most important asset to an airline – not that they were not before – but rather it is this “inelastic” air traveler that the industry needs to rediscover. And cater to. And build for. And so on. And maybe this is why Mr. Arpey suggested that it was just not a good idea to sell its AAdvantage program. And maybe the market will begin to rethink how it values these currently undervalued assets.

This industry is now recognizing that it cannot be everything to everybody. Yes the industry has met its match – and it is not labor, government, or the macro economy. It is the high price of fuel that is causing the industry to continue the process of fully transforming the way business is done. My guess is that if we had not faced this potentially murderous economic period, then the industry would not have been forced to fully examine itself. The current industry architecture is a picture of what the deregulators envisioned – and the industry delivered. But the architecture produced does not work.

So Mr. Arpey, as your unions marched, I for one am glad you spoke. And you spoke clearly as to how American is moving forward. Your message was not popular. Your message pushed the envelope a little further and added to the debate significantly. No one knows how all of this will really play out. There has to be recognition before there is action. The industry is taking action and one can only hope that labor and government begin to recognize that we are not going back to the same old, same old.

Except for the fact that each airline will "return their attention" to those core, “inelastic”, customers that are willing and able to pay for the service being provided. And those customers will complain less over time. As for the rest of the traveling public and lawmakers that believe they are entitled to air service - well you are not.

More to come.

Pondering the Next Move; But Before I Do…….

Wednesday’s Hearings: “Forgetting About History”

If there is another “something” in the works, surely no one really believed that anything would be announced before yesterday’s House hearings on Delta – Northwest? Jim “Hell NO”berstar was anything but “Hell No” in yesterday’s hearings. To be sure, he was anything but Hell Yes. He seemed to save his “powder” for the testimony of the Departments of Justice and Transportation. But even that was dry and in the end about all we could do was “take heart” that the investigation would be thorough.

I am not one that is going to give a protectionist much slack. But I kind of felt sorry for him when it became clear that he had not quite grasped that Phase I of the US-EU liberalization deal was in effect and that all six US legacy carriers could fly to Heathrow. But where I really struggled was with the continued pointing to American Airlines and their purchase of TWA’s assets. Remember, not a merger but rather, an acquisition of assets. There was much discussion about how St. Louis was reduced from 500 flights per day to 250 flights per day.

When American made the decision to purchase TWA’s assets, congestion was the rule/industry fear of the day. The “Summer from Hell”, or the Summer of 2000, was in the books. Chicago O’Hare was in the headlines most days during that summer. Delays in Chicago were either based on thunderstorms or Rick Dubinsky choking the golden goose. From American’s strategic perspective, St. Louis could potentially be that reliever of congestion in Chicago as connecting traffic is well connecting traffic and can be accomplished in either city.

But “NOberstar and the Fear Mongers” sang the tune that American sat in the very same hearing room and vowed to keep St. Louis whole. We heard it over and over. If we forgot about Phase I being in place; surely we did not forget about September 11, 2001 and the effects it had on the US domestic airline industry in general and the network legacy carriers specifically. Yes, St. Louis was downsized and most non-hub flying was eliminated. Pittsburgh was carefully eliminated. Atlantic Coast died under its own lack of weight. And an over-exhuberant industry replaced mainline flying with regional flying.

St. Louis was a dying hub. McDonnell Douglas was gone. Its local economy was built on reputation and not on strong underlying economic attributes. American made the only decision that was in its best corporate interest. Remove capacity from a weak point and focus on a strong one – Chicago. Nuff’ said.

Pondering the Next Move

My guess is Jim “Hell NO”berstar is keeping his powder dry until the next move is announced. The next move will face more intense scrutiny based on the “I told you so” line that was most prevalent yesterday. Honestly, I do not know of another deal scenario that is interesting – let alone transformational – and provides the kind of investment thesis that helps this period come alive.

We have United and US Airways merger discussions being tossed around by “those close to the situation”. Now we have a United and Continental alliance in the news. Readers know I like what Tilton says as he talks about the industry from 40,000 feet – and I am in fundamental agreement that the current construct is good for no stakeholder group.

If I lean to one of the two scenarios being painted in today’s mainstream press, I lean to a United - Continental alliance. Gravity takes me there because it differentiates the combination from Delta and Northwest. Delta and Northwest individually, and collectively, are/will be highly reliant on connecting traffic as their hubs are located in smaller population centers. [And this is why their commitment to maintaining the most extensive network possible is absolutely factual] United and Continental would be building around hubs/gateways where core onboard traffic would be largely local.

Now, I understand that the transatlantic onboard traffic mix can be different based on other competitors in the market. We do not have to look much further than Washington Dulles and the fact that Lufthansa carries more Washington local traffic to Germany and beyond than United. United’s airplanes are filled with more behind and bridge traffic based on the connection to its US domestic network at Washington Dulles.

But doesn’t this also suggest intra-alliance competition for traffic that is being bastardized by comments from the fear mongers that the transatlantic will soon face a scenario where barriers to entry are much too high?

LIQUIDITY AND SOUTHWEST AND UNITED

Over the last couple of months, this blogger has written about how liquidity will be back in the headlines just as it was following the events of September 11, 2001. American has looked to relax fixed charge covenants. Delta and Northwest are looking to a combined balance sheet. United has worked to relax covenants in its loan agreements. US Airways balance sheet is actually in pretty good shape for the moment. Southwest recently borrowed $600 million against owned aircraft to bolster an already strong liquidity position. jetBlue has sold aircraft and sold equity to Lufthansa to bolster liquidity. AirTran has sold delivery positions and just completed a convertible to bolster its liquidity. And the market yawns.

Holly Hegeman of Planebuzz.com asks the question: PlaneBuzz: Follow up on Southwest Nuts: Why Do They Need More? If she had not written before I had a chance, I would have asked the same question but probably not as eloquently. Me thinks, Southwest plays a meaningful role in the next move. These guys – and sorry Laura – are smart. Based on their model, there are just simply not many markets left in the US.

Now, I have no clue as to what the plans are – or if there are any - as I am not a source close to the situation. But I am willing to bet that the next move involves Southwest purchasing assets. Whether they are Washington National assets; Laguardia assets; or something else they are the only name that can assure “NOberstar and the Fear Mongers” that competition will remain robust. If Southwest is involved, the strategy is brilliant. And I am not one that will discount Tilton.

I am the guy that has lived a life liking and rooting for: Illie Nastase; Jimmy Connors; Derek Sanderson; Craig Stadler; well you get the picture.

As I have said, this time is cruel but it will lead to something better. Simply because the current construct just does not work for anyone. So for the consumer groups: you will pay more and it is not because of a changing industry structure, rather it is an industry that must simply charge at least as much as it costs to produce the product. And for labor, the best bet to recapture what you think is entitled is to bet on the future. It just might be good.

Just Wondering, Or Am I Wandering?

A Few Issues in the Press

1. With the Euro reaching an all time high relative to the dollar yesterday, how will this impact international travel? Can the potential loss of US-origin customers that now deem an EU trip unaffordable because of the currency relationship be offset by EU-origin demand that will find the US cheap?

a. Headline in today’s Wall Street Journal: "Lufthansa Expects Growth in 2008". As the company’s net profit doubled in 2007 v. 2006, the company cites its broad business model that includes aviation services, catering, airports and other areas as a mitigation of downside macro risks. For the US, that might mean increasing the foreign ownership limits?

2. In late 2007, United warned of the potential to “put down” as much as 10 percent of its capacity if oil prices stayed above $100 per barrel. Well, yesterday oil actually traded over $110 per barrel. The $100 price point has become a level that most oil watchers expect to be sustained. My question for the politicians is: will there be more industry capacity removed as a result of oil prices or consolidation?

a. My suggestion to the "know all" politicians: Be very careful for what you say no to.

3. Yesterday, Jamie Baker of JP Morgan downgraded the US airline industry for all intents and purposes. Terry Maxon of the Dallas Morning News blogged on Baker’s research note that suggests a best case scenario, based on current oil prices and a minimal demand loss due to an economic slowdown, is for the US industry to lose $4 billion. The worse case scenario calls for an industry loss of $9 billion.

a. So much for the robust, and sustainable, industry turnaround we hear from labor leaders and others.

4. Speaking of labor, Baker makes a very powerful point, and one that I have used a number of times. He says that since 2002, the industry’s fuel cost will have increased in the neighborhood of $25 billion. This contrasts with his estimate of labor savings over the same period of $7 billion.

a. Will we ever hear the end of the refrain that the industry recovery has been built on the backs of labor? First, and again, what recovery? Then, and again, what is the industry’s ability to repay that $7 billion? This just underscores what will prove to be the most difficult labor negotiations cycle since deregulation.

5. As if the industry needs more weighty issues to test its resolve, the story at Southwest over maintenance practices is most troubling. I am in no way going to suggest anything regarding this situation until all of the facts are known. But, this story will not be going away for awhile.

a. If the economy can be expected to have a dampening effect on demand, will concerns over maintenance have a compounding effect?

b. Jim “Hell NO”berstar gets yet another bully pulpit issue.

6. On another labor issue. I find it interesting that, included in labor’s chants against consolidation of the industry it says it will be looking out for its members (OK, that is their job) and the traveling public?

a. I guess the threats from labor of a strike, or a slowdown, are beneficial to the consumer because the system can quickly reaccomodate demand and there will be minimal disruption to the affected consumer? NOT

7. Yesterday the Continental pilots rallied in Battery Park along with other ALPA carriers and independent unions to call for the repayment of the concessions that the Continental group calls a loan made to the company in 2005.

a. What loan? Did you negotiate terms like those negotiated when money is borrowed?

b. Isn’t it ironic that the labor groups chose Wall Street as the venue for their rally? There must have been a lot of sympathetic observers given that Wall Street employees largely rely on variable earnings to comprise their total compensation and not fixed rates of pay? Oh I digress.

8. The Allied Pilots Association have told us many times and through many different mediums that just a modest increase in passenger fares will pay for one of the most outrageous asks made by a union of a company in my career. NOT

a. In the face of current oil prices, at what point do “pass throughs” of increased fuel costs negatively impact demand? At what point do the US macro economic issues negatively impact demand as consumer disposable income is negatively impacted from a long list of possible reasons?

b. If demand begins to weaken, I do not think fare increases will be the tactic employed by the industry to address the issue.

b. Maybe the CR Smith Museum should be enlarged rather than being refurbished?

9. Politicians and labor should think real hard about the fallout that could stem from the current economic environment versus what the perceived fallout could be in a consolidation scenario.

More to come.

Dear US Government: I hope you are reading the newspaper

Thinking About Three Headlines from January 24, 2008

So much of the current discussion surrounding US airline industry consolidation scenarios involves only the Network Legacy Carrier (NLC) sector. In an earlier post this week, I wrote about the catalysts for consolidation. In that post the importance of economies of scope, scale and density is discussed and how they are a most important ingredient to a healthy industry structure. These economies are critical to all players – even the LCCs.

Three headlines in yesterday’s news underscore the negative effects of a highly fragmented and hypercompetitive US domestic industry structure – and those negative effects are not limited to the sector of the industry that is forever blamed for the industry’s woes – the NLCs. Yes, there is even bad news emanating from the Low Cost Carrier (LCC) sector. The very sector that many policymakers believe is solely responsible for the consumer benefits that the entire industry delivers each and every day - NOT.

First off, Holly Hegeman writing in her blog Planebuzz reports the first credit downgrade of the period. No it is not one of the NLCs, it is Southwest Airlines. Not that this is anywhere near the end of the world for the carrier with the industry’s best credit rating – even after the downgrade – but noteworthy in my view.

Second, Terry Maxon in his Airline Biz blog writes about additional stock sales by David Neeleman, founder and non-executive Chairman of jetBlue. Whereas there are always multiple reasons for stock sales, Neeleman has sold nearly 30% of his holdings since May of 2007. This particular announcement comes just days after jetBlue finalized a stock sale to Lufthansa that was designed primarily to address some near term liquidity concerns.

Third, last night Reuters reported out on Frontier’s earnings. The short article was entitled: Frontier reports wider loss, to sell four jets. Enough said.

For government regulators generally: the bad news regarding the industry’s financial performance is not limited to one sector. If you were right, and I was wrong, that the LCCs were/are the sector that will keep the US industry in a global leadership position, then it is time to step back and recognize that even this sector is beginning to show signs of troubled economics. And given that this sector is largely confined to the 48 contiguous states, that would be a good place to start your analysis of the industry’s structure.

For government officials in smaller US communities: the bad news is that the LCC sector of the industry is not your answer. The bad news is that industry economics do not support all of the service currently being provided. The good news is there is an opportunity to look at the current industry structure and allow it to make necessary commercial changes. Scrutinize the proposed changes for sure. But, changes that keep your airport market connected to the US air transportation system is much better than being the subject of attrition from the airline map.

For government officials in cities that serve as corporate headquarters: keeping your city as a critical dot on the global airline and trading map is much more important than housing a few thousand workers. It is simple economic impact math.

Much more to come,

Converging Catalysts Making a Case for Consolidation?

Don’t look now…….

…..but there is something that feels different to me. In the vial, mix:

1. a lot of anxiety with commensurate posturing
2. non-traditional capital sources with skeptical labor
3. parochial tendencies against global economic forces
4. a weak dollar relative to foreign currencies
5. a weakening US economy and record high oil prices that appear to be the new standard

What do you get? Consolidation chatter that has the feel that it is real. Not talk; not speculation . . ..the real deal.

The US Home Market

The last meaningful airline consolidation period that involved multiple players began in the mid-1980s. Piedmont bought Empire; American bought AirCal; Northwest bought Republic; TWA bought Ozark; United bought Pan Am’s Pacific Division; Delta bought Western; USAir bought PSA; USAir and PSA bought Piedmont; United bought Pan Am’s London Heathrow authority; and American bought TWA’s London Heathrow authority. And that’s only the larger transactions of the period.

It is these transactions that formed the commercial backbone of the industry today. Nearly 20 years have passed since the industry recognized that economies of scope, scale and density would prove important to survival in a deregulated network industry. And it brought a significant regional concentration of services. Two Minneapolis hub carriers merged; two St. Louis hub carriers merged; and two predominantly East Coast carriers merged. Arguably, only Delta and Western represented an “end to end” merger of carriers.

In the years since, there have been periods of mainline capacity cuts, mainline capacity growth and regional carrier growth – explosive at times and largely facilitated by technological change and a disparity in labor rates. And by the late 1990s, we also had the explosion in new capacity by low-cost carriers, and not just Southwest. The growth by the LCC sector was largely driven by the gap in the cost structures between the upstarts and the legacy carriers.

That Was Then, This Is Now

We have talked on Swelblog.com about how the barriers to exit are greater for this industry than are the barriers to entry. We learned the latest lesson on this topic during the bankruptcy era when more-than-sufficient capital was available to fund each of the respective plans of reorganization.

I would be surprised if one serious analyst did not question the virtues of the reorganization plans. Costs were cut and network changes were made, to be sure. But now, compounding the price of fuel is a weakening economy. Airline share prices plummeted throughout the month of December. Thus far in 2008, virtually every market is off to one of the worst starts of any year on record. The markets know something. The only time I want to see the highs getting lower, and the lows getting lower, is in my golf score.

At some point, the current credit crisis, increasing food prices and the impact of rising fuel on the consumer pocketbook will begin to put real pressure on consumer disposable income. And this will impact airline travel. Consumers will simply be less inclined to travel, even if the ticket price is right. From everything I read, it is clear that planned capacity for 2008 has not factored in any meaningful loss of consumer disposable income, nor should it as the macro economic indicators continue to provide us with mixed signals at every turn.

The Catalysts for Consolidation

1. The price of fuel: Consolidate this time will mean consolidate, or risk getting smaller. Consolidate means eliminating any and all duplication of service and costs associated with providing that service. And no, it does not have to harm the consumer as I believe that the leadership of the US airline industry may actually be more concerned about further erosion of consumer confidence in the industry than the health of the economy and oil threats.

2. The US domestic economy: A weakening economy will only shine a harsher light on service to communities that can’t be operated at a profit. The US airline industry made a good bet on 50 seat capacity during the latter half of the 1990s. That bet helped the industry to remain connected during the dark days of 2001 – 2004. But if that capacity was not economic at $50 oil, then it certainly is not economic at $90 oil. I do not think the industry has any overt intentions to disenfranchise entire communities from access to the US air transportation system. Rather, the industry will rightly ask if the same revenue can be generated with six frequencies instead of nine or three frequencies instead of five.

3. Hyper domestic competition: If anyone on Capitol Hill ignores the simple fact that US airline industry growth has slowed at home because few profitable opportunities remain, then we will just keep having the circular conversation – mostly driven by parochial concerns – that rejects consolidation out of an irrational fear that it will limit competition.

4. Increased international competition: If not a catalyst today, incursions into our market from foreign carriers promise to become a pressure point in the near term. The immediate impact of the US-EU deal is not much more than a change of the three letter airport code from LGW to LHR. But LHR, like JFK, is important airline real estate. Given this fact, what will bmi do? It has significant slot holdings that are sure to be bid on by any number of carriers like BA, Virgin, Lufthansa (with rights to exercise), Singapore, Emirates or any one of the Indian carriers. Any one of these carriers can force a changed transAtlantic environment overnight if LHR slots land in their portfolio. And we will sit and watch just how BA will compete with its Open Skies subsidiary from non-LHR points on the continent. Game on.

5. Foreign Capital: Just as plenty of money was available from many sources to fund bankruptcy exits in the US, foreign capital will prove to be plentiful as the US considers merger partners and deal structures. I am not convinced that all alliance structures are set in concrete. This being said, the alliances are sure to be most interested parties in how the network structures might evolve. In fact, some of the competition among the alliances to secure their place at a preferred table may be the catalyst to satisfy the many currently unsatisfied shareholders in US airlines today.

6. Labor: In a recent post here (no, not the one where the Terrapins beat the Tar Heels), I wrote about the emerging leadership of Lee Moak, ALPA MEC Chairman at Delta. Since that posting, the leadership of the pilots at United and Northwest have also spoken. Why the rising volume in the union leadership ranks? Because I am increasingly convinced that the industry is moving beyond recognition that structural change is about to occur -- and with that recognition comes preparation. Unions representing pilots and the flight attendants signal that preparations are underway to address respective issues in any consolidation scenario. They are seeming to believe, as do I, that with a seat at the table comes opportunity.

7. Management: In their public statements, the leadership at each of the airlines is increasingly more resolute in their comments regarding consolidation. United’s Tilton and US Airways’ Parker have been joined in recent weeks by Delta’s Anderson and Northwest’s Steenland speaking out in support of consolidation. Keep watching – it appears that Continental’s Kellner and Southwest’s Kelly may not be far behind.

With jetBlue partnering with Lufthansa; Frontier under increasing competitive pressure in Denver; and AirTran certain to be challenged by a growing and more vibrant Delta footprint, this discussion is not confined to a single sector of the industry.

A Few Concluding Thoughts

There is just something different this time. If after taking billions of dollars of cost out of the industry’s operations, all we get is a two-year profit cycle, then there will have to be something different this time. Yes, we might get three years of profitability, but that’s not where the smart money is now. Already profit estimates for 2008 are being reduced by 40 percent versus what the industry earned in 2007.

The fact is, the industry already has used most of the rabbits in its hat. In 1985 the industry was in its infancy and the focus was on the domestic market as network size could not be built organically in the face of deregulated pricing. The same is true in 2008, but now we’re talking about network size in the global marketplace. Like in 1985, the networks that are necessary to survive cannot be built organically, not when airlines lack critical pricing power that stems from a fragmented and hypercompetitive home market.

Some very good things came out of that merger period in the 1980s. Some very good things will come out of this merger period as well. Yes, there will be dislocations and the loss of an icon or two. But we should embrace the change. It may be the last shot for many airlines. And it is a risk worth taking because the current model will only produce the same deaths by a thousand paper cuts.

01-02-08: Manufacturing Sector Disappoints + $100 Oil = Continued Airline Stock Carnage

Just thought I would memorialize a few facts from the first trading day of 2008. Crude oil trades at over $100 per barrel for the first time. [Crude oil actually traded at less than $11 per barrel in December of 1998.] Gold trades at a 27 year high. 1 Euro can buy 1 US Dollar and 47 cents. A report issued by the Institute of Supply Management suggested a contraction in the manufacturing sector which is an important barometer of US economic activity.

Airline stocks continued their downward drift in the face of more and more signs pointing to a weakening US economy. Most experts I heard interviewed today suggested that they see little in the way of oil price relief unless there is a significant global economic slowdown.

Now some stock facts on select US airlines…….

Of the 9 US publicly traded US stocks I consider significant, 8 set new 52-week lows: American, Continental, Delta, Northwest, US Airways, Southwest, jetBlue and AirTran.

United closed 37 cents above its 52-week low.

For these stocks setting new 52-week lows; American, Continental, Delta, Northwest, US Airways and Southwest all traded at least 3 times their average daily volume.

jetBlue’s market capitalization closed the day at less than $1 billion. The carrier’s stock still trades at 61 times its forward earnings suggesting there still may be more stock price damage ahead.

Of the 9 airline equities analyzed, the three largest in terms of market capitalization are: Southwest, $8.7 billion; United and Delta, $3.7 billion each.

Southwest trades at 20 times its forward earnings and United trades at 14.5 times. American, Continental and US Airways all trade at, or below, 7.5 times forward earnings.

The market capitalization of the 6 US network carriers combined ($17.3 billion) is the equivalent of 17.5 cents per dollar of revenue ($98.9 billion).

The LCC carriers: Southwest, jetBlue and AirTran would cost considerably more as their combined market capitalization ($10.3 billion) is the equivalent of 70.9 cents per dollar of revenue ($14.5 billion). Southwest comprises nearly 85 percent of the three carrier's market capitalization. Southwest’s market capitalization is the equivalent of 90 cents per dollar of its revenue.

Ringing Out the Old, Ringing In the New. NOT

It is the last day of 2007, and as I prepare to write my final blog post for the year, I want to say something positive about where I see the industry – particularly the US industry. There are plenty of encouraging things happening in Latin America, Europe, Asia and the Middle East with carriers like LAN, Air France/KLM/Alitalia, Lufthansa/Swiss, Singapore, Cathay and the Chinese airlines. The global marketplace is where it is happening

In the US, however, we seem stuck with the old and little hope for new – with only a few exceptions.

While CEOs are speaking to the structural deficiencies plaguing the US airline industry, there is little “public” effort being exerted to address those deficiencies. I am encouraged at what seems to be the beginnings of US carriers like United and American, who have been sitting on the sidelines for too long, again investing in their product. But my excitement is muted by the endless news accounts of poor customer service and flight delays that work only to chase travelers away.

There should be a connection between product and customer and revenue – right? Gary Kelly at Southwest sure seems to be focused on product; the one word that never leaves the LUV vernacular is “customer.” Many are questioning Southwest’s recent actions to expand its customer base. Not me. This is a great story unfolding– the low cost leader and low fare provider now openly discussing its need to change. This means a need to find new revenue and a need to make its product attractive to a wider range of customers. And they are actually doing something about it.

I encourage readers here to visit the Dallas Morning News’ blog click here and read Terry Maxon’s take on the top 10 aviation issues in 2007, and the Air Traveler’s Association’s Top 10 issues for 2008 click here. Finally, click here to read an interview with Herb Kelleher, Southwest Airline’s departing Chairman, in the Southwest Economy published by the Federal Reserve Bank of Dallas. Kelleher’s comments on globalization are particularly interesting.

For another barometer of how the financial markets view the US airline industry, consider select carrier’s stock price performance over the course of this past year. As of December 28, 2007, US Airways, jetBlue and American share prices have dropped by more than 50 percent; Continental, AirTran and Alaska shares have all declined between 30-50 percent; and Frontier, Southwest and United shares have fallen between 20-30 percent.

In the six months after coming out of bankruptcy, Northwest shares are down 36 percent, while Delta’s shares fell 26 percent.

Suffice it to say that I’m joined by many other industry watchers in failing to find many positives in the US airline industry space. Let’s hope that in 2008, the US industry makes some positive steps toward reclaiming a leadership role in this critical sector.

2007: Looking Back.

1. Crowded Skies: This was the (another) year of air traffic congestion and its troubling impact on airlines. Authorities have now enacted limits on air traffic in both New York and Chicago – an approach that can only be viewed as a Band-Aid solution to a much more serious problem. It’s time for Washington to get serious.

2. Consolidation: US Airways’ “hostile” play for Delta took talk of industry consolidation from a murmur to a roar. It was the right idea for the right reasons, only to again be thwarted by labor, the regulators and the legislators. At what point are the naysayers going to accept the fact that the current industry structure does not serve the best interests of the airlines, employees the transportation infrastructure or any stakeholder for that matter?

3. Fuel: The eye-popping price of fuel underscores the ongoing need for the industry to identify ways to cut fixed costs, despite the fact that most of the low-hanging fruit is already plucked. And that’s before we even begin to calculate the price tag of anticipated environmental mandates on an industry already groaning from the weight of taxes and fees.

4. Labor Voice: Lee Moak, Chairman of the Delta ALPA Master Executive Council, emerged as a new voice in the industry labor front with his nod to the need for structural change in the industry. Because he combined straight talk with a serious commitment to representing his pilot members when faced with an unwelcome advance to Delta from Pardus Capital, Mr. Moak demonstrated real leadership by suggesting that he will play a significant role in structuring any deal that impacts his constituents when his carrier is put in play.

5. Foreign Capital: Lufthansa’s investment in jetBlue appears pretty benign on the surface. But Lufthansa, with this investment, has put its money behind carriers housed in two of the most important airport markets in the world – jetBlue at JFK and bmi British Midland at LHR. At the end of the day, this business is nothing more than a real estate game connected by sexy things with wings. No real estate, no access. Ultimately, foreign capital in US carriers only ensures that the weak market structure surrounding the US industry remains intact. These investments are no different than the good money chasing bad business plans that allowed US carriers to fund their exits from bankruptcy.

6. Staffing Woes: The Northwest Airlines system breakdown that followed its emergence from bankruptcy was the fault of productivity changes that were too fast, too aggressive, and resulted in a staff shortage that wreaked havoc on its flight schedule. The only good news was the negotiation between ALPA and the company that provided incentives for flight crews as a way to man the planes. This may be one of brightest spots in the labor arena in 2007.

7. Capacity Chokehold: The sharp slowdown in capacity deployed by the low cost and regional sectors offers important perspective for regulators as consolidation talk continues. Too bad Congress remains convinced that every congressional district is entitled to air service, no matter whether the industry can fly all of these routes profitably.

8. Labor Leading with its Chin: The extraordinary opening proposal made by the Allied Pilots Association as it begins its Section 6 negotiations with American Airlines sought pay increases some estimate at more than 50 percent -- and that is before we even try to incorporate the headcount increases with the remainder of its initial demands. While the aggressive proposal underscores the deteriorating relationship between labor and management at the airline – and in the industry overall -- the question remains whether the APA’s gambit will be a bellwether for the industry or the first in a long line of mediation cases making their way to a Presidential Emergency Board.

9. Capital Connections: In an administration that has not had much to cheer, the US Department of Transportation has served the airline industry well under the leadership of Assistant Secretary’s, Andy Steinberg and Jeff Shane. Unfortunately, these two soldiers of change will be moving on this year at a time when their skill and expertise will be sorely needed.

10. Detroit’s Deal: The agreement forged between the United Auto Workers and the Big Three automakers click here, illustrates the many similarities between the auto and airline industries. Will we see these kind of talks at the airlines? No sign of it yet. Leaders please step forward.

11. Integration Frustration: That US Airways' East pilots believe a new, independent union will right the wrongs of an arbitrator’s decision and do better by pilots than ALPA, demonstrates the triumph of hope over experience. Experience shows us that there is no entitlement clause that applies in these situations. Under globablization, there will be fewer and fewer entitlements left in an increasingly competitive marketplace. But there is opportunity, and the US Airways' pilots should be working together to figure out how to make their airline stronger, and their members better off, rather than fight among themselves.

A Toast to the Customer

Some readers may interpret my views as unrealistic – that I’m looking for some incarnation of Air Nirvana without any of the usual industry friction – but neither is true. I know that structural change will inevitably lead to friction. And some of that friction will come as part of the reality that the airline industry will look very different in a few years, with some carriers no longer in the picture.

My real fear is not the loss of a carrier or carriers – it is the complete loss of customer confidence in an industry that relies on its reputation. Both labor and management should stop pointing fingers regarding customer issues and instead focus energy there first.

Richard Branson Gets the Final Word Here in 2007

As Virgin Atlantic faces a potential job action by its flight attendants, Richard Branson, the carrier’s flamboyant leader writes the following letter to his employees click here. The closing paragraphs state very clearly where I think we are headed and the words that will need to be spoken.

“There comes a time in any negotiation when a good management team has to draw a line in the sand and I agree with them that time has come. To go further would result in unacceptable risks and would set a dangerous precedent to the company as a whole. It would be irresponsible of our management and they, rightly, are not going to take that risk.

For some of you more pay than Virgin Atlantic can afford may be critical to your lifestyle and if that is the case you should consider working elsewhere. For the vast majority of you, the pay rise you were offered was the best in the industry this year, which is why the union strongly recommended it. I’d urge you not to put at risk our ability to solve this dispute by messing up our customers’ travel plans.

We all want to resolve this situation and give the best pay increase that the business can afford. The best way to achieve this is by keeping all of our planes flying and delivering what we do best - making sure that all of our passengers leave with a smile”.

Thank you for making Swelblog.com a read for you. Much more to come as the final chapters are a long way from written.

Maybe the Allied Pilots Association Is Really Onto Something

As I have written often and recently, the competitive position of the US legacy carriers in the global arena is a major concern to me. My thoughts on this topic are largely contained in a talk I gave at the ACI-NA International Aviation Issues Seminar in late November click here.

With the combined market capitalizations of the Big 3 EU legacy carriers (Air France/KLM, Lufthansa and British Airways) exceeding the market capitalizations of the Big 6 US legacy carriers (American, Continental, Delta, Northwest, United and US Airways) combined by nearly 33%, something clearly needs to change. And if Air France/KLM is successful in integrating troubled Alitalia into its fold, then the margin will become even more embarrassing for airlines carrying the US flag.

What a Cool Job

If there is a job I want in the airline space today, it would be the UPS whiteboard guy click here. Why? Because the UPS model, and the way they talk about it in their whiteboard campaign, demonstrates the futility of US carriers trying to operate successfully under collective bargaining provisions that are at least 35 years old. The UPS guy is not encumbered by existing lines or parameters as he connects UPS’s dots on the map. More importantly, the company actually connects the product to what customers want and demand –a novel concept! If there is a time to throw the past away (erase) and look to the future (redraw), it is now.

So maybe, just maybe, the Allied Pilots Association is on to something in its latest proposal to American Airlines. While I would never suggest that the APA “one liner” scope provision click here makes sense for the AA network as we know it today, anything that simplifies the ability of US airlines to implement commercial, tactical and strategic decisions to react to a changing domestic and global landscape makes very good sense to me. More importantly, anything that gets the mainline growing again is the best solution to some of the labor-related hostilities in the industry today.

Whiteboard Analysis – Regional and Codeshare Flying

What I like about the simplicity of the APA proposal is that it provides a starting point to begin serious negotiations – something the American Airlines negotiations are sorely lacking.

Given that scope defines who can do what flying necessary to operate the network, AA would get to go to the “whiteboard” and lay out for the APA the cost for feeder flying relative to the revenue generated by that flying, as well as the traffic and revenue contributions to its mainline domestic and international routes. As part of AA’s whiteboard exercise, they also get to demonstrate the value of revenue and traffic contribution the international codesharing partners now contribute.

If APA puts forward a scope proposal that reserves all flying for its member pilots and that makes economic sense, then there would be no need to scale back the current size of the network – all other things being equal. On the other hand, if APA is not willing to agree to terms – pay rates and work rules – that, when the interdependencies of all contractual issues are understood and at least match what AA pays today for this business, then the company would need to make some decisions about how much to shrink the current network.

Whiteboard Analysis – Mainline Flying

Let’s take it further.

The cost of the APA flying will ultimately determine the size of the network for regional and codeshare flying. The next calculation is the cost of operating the existing, or remaining, mainline network. If the network can sustain the 50+ percent increase in rates and all other items included in the union’s current proposal, then the APA will have realized its goal of restoring lost earning power to their members and establishing the pattern for the rest of the industry to follow.

Based on the cost of operating the mainline network under the APA proposal, there are two paths to explore on the decision tree: 1) if the remaining network cannot incorporate the cost of the entire APA proposal, then determine what portions can be operated profitably and the remaining network would need to be dismantled; or 2) determine how much increase in pilot cost the network could absorb and then ask the APA to adjust its proposal downward.

Whiteboard Analysis – What Is the Right Formula for US Legacy and LCCs?

This conversation is underway not only in union halls, but also on Wall Street and in corporate boardrooms. It is a topic on the Dallas Morning News’ airline blog click here. While Mr. Maxon sees the APA proposal is a bombshell, I see it as a starting point for negotiation that appears to be stuck. Historically, scope language is among the last issues negotiated in pilot contracts. Let’s switch it up this time and figure out exactly what unions want their respective companies to be - global leaders or niche players?

We talk a lot here about CEOs that are genuinely concerned about value creation versus value destruction – Glenn Tilton at UAL, Doug Parker at US Airways and Richard Anderson at Delta. But another CEO has been hard at work totally rethinking his business as well: Gary Kelly at Southwest. This past week, Kelly spoke directly to the “perils” facing the industry click here. Kelly and his pilots are also engaged in a discussion of scope language as their business is about to get more complicated with proposals for international flying and code shares as a way to boost revenue production.

With little to no clear investment thesis in the core business of airlines, UAL this week declared a special dividend to its shareholders click here, much to the chagrin of its employees and a very passionate Holly Hegeman who writes about the action in her blog, Planebuzz click here. If nothing else, Tilton and UAL are consistent in their focus on the shareholder – often the most ignored of stakeholders in the airline industry. While I can see the employee view, at-risk compensation is a way around this angst.

So unless the business of the business starts to have a clearer line of sight to the customer – meaning delivering a product that the customer is willing to pay more for – then the payment of special dividends, the selling of wholly owned subsidiaries, consolidation and/or a slow liquidation of US flag airlines will continue. You know, money talks and #$*&! walks.

Concluding Thoughts

I really think the APA is on to something with its scope proposal. Let’s talk about scope first among the tough questions that will determine the future shape of the US airlines. Once that question is answered we can move on to a meaningful discussion about how to better compensate a workforce because the current seniority-based, hourly rate system simply is not effective in the modern market.

Structured properly, this round of negotiations may just lead to finding the right network architecture to make the US carriers global leaders again. Or not. But doing business circa 1970 is not going to get it done. So let’s remove the clutter and the underbrush and start with a clean whiteboard. Maybe even do what the European carriers do and create business units that carry cost structures to match the sub markets they serve because they recognize that a one size fits all just does not work. And this approach could indeed be done with pilots on the APA list – just ask Northwest and US Airways.

Let’s stop saying it just cannot happen. It can.

All Eyes on Texas

As the airline industry turns away from the round of labor restructuring that began in 2002, it is now at a crossroads. Pilot negotiations now underway, or about to begin, at each of the Texas carriers underscore how difficult this next round will be. And depending on which side of the table you sit, these negotiations are blessed and cursed in many ways.

In each case, fragility rules the day, whether by the condition of airline balance sheets, relationships, expectations, competition, over promising, under delivering. What is clear at the outset is that U.S. airlines need to seriously reexamine their communications to employees and shareholders if they are going to successfully negotiate this treacherous path.

I rank upcoming negotiations at the Texas-based airlines from easiest (nothing will be easy) to most difficult (requiring a new prescription in the rose colored glasses) in this order:

1) Continental, in that the company and its pilots negotiated a protocol agreement that will help preserve effective communications and a productive process.

2) American, in that, by virtually any metric, its pilots are already at the top of industry in terms of total compensation but have the ability to create currency through improved productivity that might be used to subsidize other parts of a new agreement; and

3) Southwest, in that the company and its pilots already lead the industry in productivity click here and as a result do not have much “give” on that front;; have the highest average wages click here; and face slower growth. Man, I would not want to be in Gary Kelly’s shoes on this one.

A case can be made that this upcoming round of negotiations with airline unions may be the watershed event since deregulation. It could go far in determining tomorrow’s airline winners, losers – and mere survivors. Remember Eastern and Pan Am. Every 15 years or so something happens that changes the game.

So why are all eyes on Texas?

Continental and the Air Line Pilots Association’s negotiating protocol paves the way for them to begin bargaining early in an attempt to complete negotiations by the scheduled amendable date of December 31, 2008. American’s contract with the Allied Pilots Association is amendable in April of 2008. And Southwest and its pilots are currently working under an extended agreement that is currently amendable

In my view, Continental has one of the best – if not the best -- management teams of all the network legacy carriers. They were first in signaling the end of the small regional jet euphoria – or, as the former Chairman of the Federal Reserve Bank, would call it “exuberance.” Continental has leveraged its Newark hub to grow transatlantic flying (a model others are trying to emulate but with population bases one-sixth the size of the New York CMSA – but I digress); and they have continued an open communication with all of their employee groups that evolved after the airline emerged from bankruptcy hell in the mid 90s and has clearly led to a good internal operating environment.

In Continental’s case, neither the management side nor the labor side negotiate agreements that prohibit the goose from laying “golden” eggs for all stakeholders. They, too, negotiated concessionary agreements outside of filing for court assistance but they did not have to go near as deep given the competitive pay rates and productive work rules in the collective bargaining agreement.

Between the two Texas network legacy carriers (NLCs as we refer to them at MIT), American faces the toughest negotiations. Its cockpit crew members currently have the highest total compensation per pilot in the sector. More importantly, when total compensation is calculated (wages, pension and benefits and personnel expenses as dictated in the contract) AA has the highest pilot cost per block hour of any carrier in the industry click here.

Given this unenviable cost disadvantage, is it any wonder why American did not immediately agree to the whopping 30.5% pay increase and other sundry contract enhancements demanded by the APA’s prior administration – and now we wait on a new proposal that is speculated to be even more? In fact, that number is uncomfortably close to the number sought by then-Chairman of the United Pilot MEC, Rick Dubinsky during the dreaded summer of 2000, which all but killed the UAL “golden goose” and forced the carrier into bankruptcy. It was said to me at the time that the tentative agreement made nearly two-thirds of United's international flying unprofitable. Now, as a result of the extended trip through bankruptcy, UAL's pilots are among the lowest paid versus the highest paid in the industry.

American’s pilots today enjoy a cost per block hour advantage against no major competitor in the industry click here whereas Continental enjoys a cost per block hour advantage against four of its six NLC competitors.

But it is American’s cross-town competitor, that faces the toughest labor situation of all, at least to this observer. Yes, I mean Southwest -- the envy of the industry in terms of pilot/employee productivity. And therein lies the rub. The magic in collective bargaining – and historically for Southwest - is to find a way to trade productivity for higher wages. When you have a pilot group that flies an average of 65 hard hours per month against a mandated industry maximum of 1000 hours per year, there is not much room to move. This, on top of the fact that Southwest pilots are already the highest compensated in terms of average salary per pilot along with an arguably rich benefit package – begs the question: where do they go from here? As growth slows, it will be increasingly difficult to move the “productivity needle” through operational changes click here. And don’t look now, but Southwest pilots fly the least number of available seat miles per dollar of total compensation than even the network legacy carriers – output per labor dollar has declined more than 25% since 1995 click here.

So as we watch the airline labor negotiating world begin the contract kabuki dance, all eyes should be on Texas. Like it or not, the concept of pattern bargaining still is alive and well in the industry and it is just as much of who’s on first (industry leading) as it is who is going to go first – and set the pattern?