United and US Airways: Third Time a Charm? I Say “Do No Harm”

We went to bed last night with the news United and US Airways were in negotiations to merge for a third time.  We awake this morning to the news British Airways and Iberia have finally signed their long awaited merger agreement.  British Airways will change its name to International Airlines after completing the deal with Iberia, expected in December of 2010.  If United and US Airways were to merge, what would they change their name to?  US Domestic Mess?  Ground Hog Air? 

United and US Airways broke off marriage discussion #2 in June of 2008 as oil was on its historic march to  $147+ per barrel.  Ultimately, United settled on a virtual STAR alliance partnership with Houston-based Continental.  The UA/CO relationship makes sense as both companies have an international focus with hubs in the largest U.S. cities where large pools of business travelers avail themselves to airline service across all continents.  A  United – US Airways combination ensures regulatory scrutiny of slot holdings at key east coast airports in New York and Washington, DC.  I don’t get the benefit of United – US Airways today anymore than when I wrote that I did not like the deal on June 2, 2008.

To my eyes, the real United news yesterday was the company reporting its preliminary March traffic results.  “Total consolidated revenue passenger miles (RPMs) increased in March by 3.2% on a decrease of 2.7% in available seat miles (ASMs) compared with the same period in 2009. This resulted in a reported March consolidated passenger load factor of 83.5%, an increase of 4.8 points compared to 2009. For March 2010, consolidated passenger revenue per available seat mile (PRASM) is estimated to have increased 21.5% to 23.5% year over year. Consolidated PRASM is estimated to have increased 3.2% to 5.2% for March 2010 compared to March 2008, approximately 3.0 percentage points of which were due to growth in ancillary revenues.”  Those are not words from a company seeking to do a deal for the sake of a deal – right?

The Delta – Northwest Merger Template

United CEO Glenn Tilton and Continental CEO Jeff Smisek have pointed to the success of the Delta – Northwest merger, citing that combined company’s market capitalization of $11+ billion.  Today, pre-market, United’s market capitalization is $3.2 billion, or nearly 5 times greater than it was a year ago.  US Airways market capitalization is $1.1 billion or nearly 2.5 times greater than it was a year ago. 

Today, Delta’s market capitalization is roughly equal to 40 cents per dollar of its trailing twelve month revenue; United’s market capitalization is equal to 19 cents per dollar of trailing twelve month revenue and US Airways is 11 cents.  If United and US Airways were to be accorded the same relationship of market capitalization to revenue that Delta is today, the market would need to multiply the pro forma market capitalization today by nearly 2.5 times.  An unlikely scenario.

Three of the Reasons Why I Do Not Like the Rumor

1. The Delta and Northwest networks were largely complementary when the two carriers combined.  The size of Northwest and Delta’s network is larger than a combined United and US Airways.  However, the fit of the network is more important than size.  The ability to leverage one network against the other in order to create new city pairs to sell is critical to any network’s success.  Delta and Northwest made for a true “end to end” combination whereas United and US Airways possess some meaningful overlap that would likely require DOJ mandated carve outs.  Any carve-outs would immediately erase some of the perceived benefit of a combined United and US Airways in the eyes of the market.  Simply why do I want DOJ interference in the first place?
2. Today, United has several immunized joint venture applications pending before the regulatory bodies with partners across each the Atlantic and the Pacific.  These relationships are valuable and likely have been recognized by the financial markets as such.  Why would United possibly jeopardize the international potential to merge with a U.S. domestic-oriented carrier?
3. Finally, and possibly most importantly, the Delta – Northwest combination was blessed to have a pilot leader in place that understood consolidation and globalization are not only inevitable but are important to the success of his company and therefore the pilots he represents.  We have talked about Capt. Lee Moak here many times.  The Delta – Northwest combination had a merged seniority list and negotiated collective bargaining agreement in place before the deal was consummated.  This seemingly simple fact allowed the newly merged company to enjoy the ability to reconfigure the combined network from the outset.  The benefits were/are many and could be the subject of another blog post or a master’s thesis or a doctorate.

Whereas Moak and his Northwest counterparts put into place the unthinkable in only five months, the pilots at US Airways and America West continue to emulate the Hatfields and the McCoys five years after their two companies merged.  What has transpired at that company since 2005 is mind-numbing and underscores the broken model of labor language that pervades the U.S. industry today.  Sadly, the professional aviators at that combined company have suffered due to the leadership vacuum that persists on both sides of the argument. 

Combine the dysfunctional relationship between the US Airways and America West pilots with the entitlement mindset of the United pilots (and all United employees for that matter) and you have a mess.  A mess that in no way promises the revenue synergies Delta and Northwest mined almost immediately that facilitated an outsized market capitalization relative to other legacy carriers. 

Don’t get me wrong, I am for any type of commercial relationship benefitting the industry generally and individual companies specifically.  I was a fan of United – US Airways #1 in 2000.  I was not a fan of United – US Airways #2 in 2008.  And I am not a fan of United – US Airways #3 today.  Each company’s fundamentals are improving so I don’t understand the rush – assuming there is one. . 

The third time is not a charm.  I say do no harm to the improving fundamentals at each company.  I do believe the risk of irrelevance in the marketplace is higher for US Airways than it is for United.  There was a time – albeit a short period – when the fundamentals of the U.S. domestic market were outperforming international operations.  That is not the case today and is but one US Airways’ attribute that  will not prove to be a winning scenario over the long term given the cost structures of the legacy carriers.

The one mantra that always lived with me at the negotiating table – you can always do a bad deal.

More to come.

[Note:  the author holds shares in United Airlines]

Dear Southwest: Grab Your Bag of Fiction; It’s On

On Tuesday morning a headline in The Washington Post read “Southwest Airlines Feeling Squeezed Out at National Airport”.  Terry Maxon wrote on The Dallas Morning News blog “Delta, US Airways Maneuver Around Southwest Airlines.”  The headline in Business Week read “Delta, US Airways Sweeten NYC-Washington Plan by Boosting Small Rivals.”

As I prepared to write this piece, I began by reviewing the various comments submitted to the U.S. Department of Transportation (DOT) by the air carriers during the comment period set forth following its tentative decision on the proposed Delta Air Lines – US Airways slot swap deal.  When I got to Southwest’s, I thought I was in a time warp.  A time warp whereby many of the same arguments used in Southwest’s fight to repeal the Wright Amendment were being dusted off and employed again.  Another opportune time for poor, little Southwest Airlines to get something on the cheap from the carriers that have invested hundreds of millions of dollars in their respective infrastructures over the past decades.  But here’s the thing:  Southwest is neither poor nor little.

Background

All of these stories of course pertain to a repackaging of the proposed Delta-US Airways slot swap first announced in August 2009.  In the initial deal made between Delta and US Airways, US Airways would receive 42 slot pairs from Delta Air Lines at Washington’s Reagan National Airport and a route authority to Sao Paulo and Tokyo Narita in exchange for 140 slot pairs at New York’s LaGuardia Airport. 

In February 2010, the DOT tentatively approved the deal between Delta and US Airways. The caveat was each carrier had to sell 14 National and 20 LaGuardia slot pairs to U.S. or Canadian carriers that have less than 5% of the total slot holdings at the respective airports. This stipulation materially impacted the value of the deal, so US Airways and Delta went back to the drawing board.

Late Monday, the two airlines announced a restructured proposal.  Only this time, they included provisions providing slots to competing carriers.  Delta concluded deals with WestJet, AirTran and Spirit to transfer up to five slot pairs each at New York’s LaGuardia Airport (LGA).  US Airways will transfer up to five slot pairs to JetBlue at Washington Reagan (DCA).  The inclusion of WestJet, AirTran, Spirit and jetBlue certainly satisfies the DOT’s requirement that divested slot pairs be provided to a U.S. or Canadian carrier with less than a 5 percent share.

Let’s Get Some Southwest Non-fiction on the Table

In its submission, Southwest complains that at LGA, "instead of an airport balanced among three airlines of roughly equal size, the slot swap would catapult Delta into a dominant position more than twice the size of the nearest competitor."  But Southwest does not ever mention anything pertaining to its size within the U.S. domestic market. In 2008 there were only 6 airport markets with more domestic origin and destination (O&D) traffic than LGA.  Southwest is the largest carrier in three of those six markets.  At the 48 domestic airports where Southwest is the largest carrier of O&D traffic, it is at least twice the size of the next largest carrier in 27.

At Dallas Love Field, Southwest controls 94.3 percent of O&D traffic and the second largest carrier has 2.2 percent.  At Houston Hobby Airport, Southwest controls 86.2 percent of O&D traffic versus 5.2 for the nearest competitor.  At Chicago Midway, Southwest has 79.1 percent control while the next largest competitor has 8.8 percent.  At Love Field, Houston Hobby and Chicago Midway the average fares rose at those airports 36.2 percent, 21.8 percent and 29.4 percent respectively between 2005 and 2008.  In each of the 48 airport markets where Southwest is the number one competitor, fares on average increased 17.5 percent between 2005 and 2008. 

Southwest would have us all believe that their presence at an airport is the ultimate discipline on fares and they claim it in every regulatory filing and certainly on every advertisement.  Despite what Southwest likes to say, it is not the same Southwest that sprinkled the “Southwest Effect” on markets in 1992. The claims of low fares stimulating new demand just do not hold today - because everyone offers low fares. 

During the period between 2005 and 2008, wasn’t Southwest enjoying the benefits of a fuel hedging program that provided the carrier with a most significant cost advantage relative to an industry that had largely restructured itself?  I assumed that cost advantage benefit garnered from a fortuitous bet on the price of oil was being passed on to the consumer.  Instead Southwest was raising fares.  In their filing they actually go as far as calculate the cost saving their low fares would bring to each the DCA and LGA markets.  The calculation is performed after including a $25 bag fee on top of the fare of the competition. 

Fiction Fatigue

If Southwest wants to gain entry to the few remaining slot controlled airports, then it should make the incumbents an offer – one that provides the slot holder a return on that carrier’s prior investment.  In a 2006 regulatory filing, Delta described how it took 22 years to build its slot portfolio at LGA.  The Buy-Sell Rule is a mechanism in place permitting such purchase.    

The filing states, “In sum, Delta acquired the right to operate most of the 243 LGA slots it currently operates at LGA through market-based transactions.  Delta acquired them through diligent investment in private market transactions, not by regulatory fiat. Delta has also invested hundreds of millions of dollars in expanding its service at LGA because Delta valued the right to expand its service at the airport, believing it would be profitable to make such investments.  Delta’s decisions to acquire slots in market-based transactions and develop its landside infrastructure at LaGuardia over three decades have permitted Delta to grow steadily and to offer greatly expanded services there to meet consumer demand.”

Carriers that purchased slots at the controlled airports did so expecting they would earn a commensurate return on their expended capital.  Of course that would mean average fares would more than compensate the cost of operating at those airports.  The average fare at LGA in 1990 was $150; by 2005 the average fare had fallen to $136; and in 2008 that fare was $159.  A similar trend can be found at Washington National, although fares in 2008 were higher.

Southwest Is Not Special

Southwest’s growth has caused/forced the industry to reduce costs in order to match the fare offerings from it and the so-called low-cost carriers it helped spawn.  Today, however, Legacy carriers with iconic names like American, Continental, Delta, United and US Airways are also offering low fares to passengers.  Low fares to air travel consumers in smaller communities that the Southwest operating model ignores.  It is these legacy carriers that have invested hundreds of millions of dollars at slot controlled airports. 

If Southwest wants to play, it should have to write the same type of check.  They won’t because the low fare structure at either of these airports will not produce adequate revenue streams to justify the investment.  Instead Southwest somehow believes it is “entitled” to the slots being divested by US Airways and Delta.

Southwest is no longer the only game in town.  It talks about all the money consumers will save as a result of Southwest’s entry into DCA and LGA, subtracting its entry level fares from average fares plus bag fees for the incumbents. Once Southwest is imbedded, there’s a new “Southwest Effect.” As mentioned above, in markets where Southwest is the largest carrier, fares increase the fastest.

Ted Reed at TheStreet.com wrote “Southwest Blasts Revised Slot Deal.”  In his story, Reed quotes Southwest, "Allowing two of the country's largest airlines to collude on trading assets in a way to reduce competition while dramatically increasing their market dominance at two of the United States' most important airports is, on its face, an alarming prospect that should not be permitted."

Who is the largest US domestic airline?  Southwest.

To me the more alarming prospect is allowing Southwest to get something for free – yet again.  Think Wright Amendment and the undoing of a deal because the market had changed and they needed to find a new way to grow.  Simply you have to pay to play, Southwest.  You have the cash.  Make someone an offer they cannot refuse.  The rules to do so are in place.  I have every confidence that neither LGA nor DCA absolutely needs Southwest.  I am confident that JetBlue, AirTran, Spirit and WestJet can do just fine.

It’s On. 

Pondering Washington Politics and Dilemmas over Airline Strikes

Things just happen when things move too far too fast.

Wow.  All I could say after Tuesday night’s victory for Scott Brown in Massachusetts was wow.  I am still in a head shaking wow mode as is much of the country.  Then again, this has been one amazing 40 days for the country when it comes to politics.  Much of the political power grabs have been occurring within the health care reform debate arena where the “Cornhusker Kickback” and the unions wringing a “Cadillac Plan” tax exemption out of the White House emerged.   

During these amazing 40 days, the airline industry was not immune from political meddling and arrogance that somehow manage to turn politicians into CEOs and airline route planners either.  Nevada Senator Harry Reid went so far as to write a letter to US Airways CEO Doug Parker expressing concerns about the airline’s decision to significantly downsize operations at Las Vegas’ McCarran International Airport.   Reid’s letter provides a lot of fodder for comment, but there are a few I want to highlight.

Reid writes, “As I am sure you are aware, Nevada has been particularly hard hit by the recession affecting our nation.”  Hey Harry, have you noticed the U.S. airline industry lost nearly $60 billion during the 2K decade.  Or that airlines shed 150,000 jobs because of economic conditions that plague the country and, thus, this industry which is inextricably tied to the health of the economy?  Or that taxes and fees on airlines increased while the revenue environment deteriorated?  Or that you chose to pursue, and fund, a railroad serving a few rather than funding an air traffic control system and equipping an industry now serving the masses?  I suppose not.

Then Reid has the audacity to write, “Because of the commitment you have shown to Nevada, I have been a longtime supporter of your airline.  From the merger with USAir to accessing additional slots on the East Coast, we have worked together to build the airline into one of the premier national carriers.”  Wow, how arrogant is that?  Does that mean if US Airways pulls down Las Vegas, Reid will stand in the way of a commercial arrangement that would make US Airways stronger?  Then again, that line of thinking is more typical than atypical of this Congress and its view of an industry that facilitates commerce.

Politics are the rule of the day even with quasi-government agencies charged with minimizing instability within those very industries. The way the National Mediation Board is going about changing a 75-year rule that worked until organizing possibilities presented themselves at Delta Air Lines is another example of politics run amuck.

Speaking of the National Mediation Board

There is a lot of talk in the mainstream and industry press about airline strikes.  The process by which airline and railroad unions can strike is quite different than other industries – and it all runs through the National Mediation Board.  It is explained better by some reporters than others. 

This round of negotiations is the first since the restructuring negotiations of 2002 that resulted in significant salary and work rule provisions being stripped from many collective bargaining agreements.  Some of those negotiations were done under Sections 1113 and 1114 of the U.S. Bankruptcy Code and others were not.  The current round of talks will involve the National Mediation Board in many, if not most, instances.  Complicating matters is the sheer number of cases already being negotiated under the auspice of the NMB.   And there are more cases on the way. 

As I write, all organized groups at both American and United Airlines (per a reader: except the IBT, PAFCA and IFPTE) are in mediation.  At some point, certain of those negotiations will have gone as far as they can before the NMB determines the two sides are at an "impasse".  Once an impasse is declared, then the parties are put into what is known as a “30 day cooling off period.”  If no agreement is reached inside that 30 day period, then either side is free to engage in “self help.”  Self help permits management to either “lock out” employees or to "impose its last offer" on the work force. The union can choose to withdraw its services – otherwise known as a strike - - or utilize other “work actions.”   The parties can mutually agree to continue talks until such point that further discussions are deemed fruitless by either side.

Dilemmas for Obama As He Considers a Request from Airline Workers to Strike

Going into this negotiating period and suspecting difficult, if not impossible, negotiations, I wondered aloud about how decisions would be made to release parties into a cooling off period.  I wondered aloud if strikes would be more prevalent than they have been in the past.  I have wondered aloud about who might be this decade’s Eastern Air Lines.  I have wondered just how the NMB is possibly going to manage this work load all the while promising a more speedy negotiating process as part of its new charge.  And recently I have been wondering how politics might affect NMB thinking when it comes to releasing parties from mediation. 

In my prior thinking I believed that this round would result in more Presidential Emergency Board proceedings to ultimately decide the terms of a contract.  A Presidential Emergency Board?  Yes, as the 30 day cooling off period expires and, more often than not, the union decides to engage in self help, there is a parallel decision that must be reached by the White House. 

The White House must determine how commerce might be disrupted if a certain airline were to go on strike.  That calculus involves, at a minimum, the level of unaccomodated demand in certain markets if one carrier were to strike.  Or said another way, can the remaining service in the market accommodate the passengers that cannot travel on the carrier they booked on due to the strike? 

In the era where 80+ percent load factors are the norm, the case for suggesting that demand can be accommodated by the remaining service is increasingly difficult.  It was already starting to get difficult when the Northwest pilots decided to strike in August of 1998.

So if Obama, in this case, determines that a strike would provide too much harm to certain air travel markets, he could stop the strike and order a Presidential Emergency Board to be convened… just like President Clinton did in 1997 when the American pilots chose to strike.  In the case of a PEB, a panel of neutrals, usually arbitrators, is formed to hear the economic case presented by each side.  If the parties cannot agree, then the panel will suggest a "non-binding" settlement.  There is still the possibility of a strike and also the possibility that Congress could legislate a settlement to avert such strike – more than likely the settlement offered by the PEB.

But that is a long way down the road.  I only raise the issues in this piece because politics prior to Massachusetts at least would seem to be nothing more than promises made to special interests (unions) in a dark room in order to garner their support for Obama.  And it worked and has worked.  But might things change?

Compunding the complexity of White House decisions in this round is the possibility of interstate commerce disruption when government stimulus money is in play.

Dilemmas for Airline Labor As They Decide to Strike

About the only thing that you can predict is that a strike at a major, legacy airline will more than likely result in yet another tombstone in the airline graveyard.  Said another way, if a union wants to strike one of today’s legacy carriers, I can see a lock out, use of replacement workers or the sale of assets to another airline that does not include employees.  Ultimately, the majority of the flying done by the striking airline will be replaced. Should a strike result in the liquidation of an airline, the flying will be done by companies that can do it more efficiently – which means fewer jobs.  And that cuts against this administration’s agenda too – doesn’t it?

As hard as it might be for unions to understand, not enough was done on the productivity side of the equation during the restructuring negotiations.  Yes, a judge presided over most of the restructuring negotiations.  But the unions were largely permitted to “pick their poison” when it came to making contractual changes with pensions being the exception.  The poison chosen was to reduce pay more than it needed to be reduced in order to preserve work rules. The tenet that rules the day in any union caucus room is that you can never get work rules back.

In order to get more money in the pockets of workers, more efficiencies need to be found in this industry.  For unions, that will mean fewer dues paying members.  But, this smaller work force would be earning more cash compensation.

One can only hope that a Presidential Emergency Board fully understands the tradeoff between pay, benefits and productivity.

“Go Ahead, Bite the Big Apple; Don’t Mind the Maggots”

Yesterday, as I was awaiting a report from the Institute of Supply Management on August manufacturing activity, I was working on a piece I titled:  “Government Buys Junk; Consumer in Funk; Airline Recovery No Slam Dunk.”  But after reading Ann Keaton’s piece in the Wall Street Journal on how jetBlue and Lufthansa are looking for a code share deal, I started thinking about all the pieces in play in the New York market and, as it happens, of the 1977 Rolling Stones tune “Shattered.”

Was it US Airways’ that said “my brain’s been battered, splattered all over Manhattan?”  Or AirTran talking about “rats on the west side, bed bugs uptown?”  Was that Continental murmuring something about “all this chitter-chatter, chitter-chatter, chitter-chatter ‘bout shmatta, shmatta, shmatta -- I can’t give it away on 7th Avenue?”  [But I can in Newark]  I do think I heard Delta saying, “to live in this town you must be tough, tough, tough, tough, tough!”  And I am sure I will hear from American “don’t you know the crime rate is going up, up, up, up, up” if it is not granted an immunized alliance with its transatlantic partners.

A Long and Overdue Reshaping of the Competitive Environment Gets Underway

It began on August 11, when AirTran Airways announced a deal with Continental to vacate Newark and give its slots and one gate there to Continental in return for slots at New York’s Laguardia and Washington Reagan.  A day later, Delta and US Airways announced a monster deal in which US Airways will give up 125 pairs of Express slots at Laguardia in exchange for 42 pairs of slots at Washington Reagan and rights to fly to Tokyo and Sao Paulo.  Both swaps involve no cash and have no impact on the Northeast Shuttle operations run by each US Airways and Delta.

The Delta – US Airways swap all but ensures that Delta will surpass American as the largest carrier at Laguardia.  By any measure of market concentration, LGA will continue to have ample competition.  For Delta and US Airways, the deal gives each carrier the tools to build out markets they believe are market strongholds.  Some say that a split operation (Laguardia and JFK) for Delta is a mistake.  But I disagree.  Winning passenger loyalty from offering expanded domestic services at LGA should translate into making Delta a clearer choice for passengers to choose the carrier when traveling to international destinations from its operation at JFK.

Absent this kind of deal, there is not much that can be done to increase domestic flying at any of New York’s three major airports.  Applying US Department of Justice standards to determine market concentration, Laguardia, JFK and Newark would be considered concentrated or moderately concentrated per the Herfindahl-Hirschman Index.  And JFK has limited space to for an airline to run a large domestic operation because of the extensive international operations that occupy the critical late afternoon/early evening hours.

Given all of the constraints of the New York aviation infrastructure, the airlines involved in the slot swaps have taken a proactive approach to advance their competitive strategies.  By recognizing their individual strengths and weaknesses, the airlines involved will be better positioned when a recovery gets underway.  If the government says you cannot merge, then engage in binge and purge. 

Today’s environment does not afford any carrier the luxury of presence everywhere and pricing power nowhere.

Congress and the Regulators

Because these transactions require regulatory approval, I fear that critics will claim that the deals would give the carriers excessive pricing power in those markets. 

But look at the data. According to the Airline Transport Association, system passenger revenue is down 21 percent, or $12.5 billion when comparing the first seven months of 2009 to 2008.  Add in the $3.1 billion the industry has brought in from those damn fees that everyone likes to write about, and that means revenue is down $9.4 billion. 

Where is the pricing power?  Where is the gouging?  And when will the politicians and regulators take airlines at their word when they say they need change?

“People dressed in plastic bags.  Directing Traffic.”

US Airline Labor Says Cyclical; Reality Says Secular

Last week, the Labor Department reported preliminary unit labor cost and productivity numbers for the second quarter. It reported that non-farm productivity increased at an annual rate last quarter of 6.4 percent and unit labor costs decreased 5.8 percent. The increase in productivity was the highest since the third quarter of 2003 and the decrease in unit labor costs was the most since the second quarter of 2001.

In theory and in practice, highly productive work forces give companies flexibility in economic upcycles as well as downcycles. That means flexibility that helps companies meet demand – including flexibility to increase wages in return for greater productivity as higher product output can be achieved with less labor input. During this difficult economic period, second quarter corporate earnings results generally exceeded expectations.  Some amount of corporate success in the quarter can be attributed to increased workforce productivity, as many jobs left unfilled meant more work for those on the payroll.

But this is not, sadly, the case in the airline industry.

The Reality of Today’s Airline Revenue Environment

This morning, The Wall Street Journal carried a piece by Susan Carey entitled: “Airline Industry Sees Pain Extending Beyond the Recession.” In this critically insightful piece, Carey examines the relationship of airline revenue to US Gross Domestic Product. “For decades,” she writes, “U.S. airlines could rely on a remarkably stable relationship between their revenue and gross domestic product. Year after year, domestic revenue came in at 0.73% of GDP on average, and total passenger revenue was equal to 0.95% of GDP. For the year ended March 31, domestic revenue was 0.54% of GDP, while total passenger revenue was 0.76% of GDP.”

In the article, Carey cites US Airways President Scott Kirby and his view that the rapid growth of discount airlines is the primary culprit behind what he called "a long-term secular decline" in the revenue-to-GDP relationship.

“Since [before] Sept. 11, low-cost airlines have grown rapidly, putting downward pressure on fares, while travelers increasingly shop for the cheapest tickets on the Internet.” Carey writes. “The Transportation Department estimates that budget airlines now account for 40% of the domestic market, up from 22% in 2001. While lower fares stimulate demand, Mr. Kirby said, airlines still wind up losing revenue overall.”

Carey also offers props to the Massachusetts Institute of Technology Airline Data Project, citing data there that “if the revenue-to-GDP ratio had stayed where it was pre-2001, the airlines would have raked in an additional $27 billion in revenue in the year ended in March.”

She continues,”if thrifty consumers and cost-cutting businesses are this recession's legacies, airlines will be forced to shrink even more. Growing smaller means parking planes, laying off workers and dropping destinations, meaning potential customers have fewer reasons to book. Earlier this month, Delta Air Lines Inc. cited a gloomy revenue outlook for the rest of the year in its plans to cut more management jobs. If passengers don't return to the skies and fares don't rise, some airlines could run low on cash, raising the specter of additional bankruptcies.”

The US Airline Industry is Neither Flexible Nor Agile

An industry governed by a seniority system is virtually assured of decreased productivity as capacity (productive output) is reduced. We’ve recently posted our analysis of 2008 US airline employee compensation and productivity on the Airline Data Project. And that data paints a very clear picture: by the end of last year, US airlines showed neither increased productivity nor decreasing wages, despite an industry beset with very sick revenue generation.

What the data does demonstrate is the industry’s difficulty in its efforts to shrink and realize immediate labor cost benefits. To get smaller, legacy airlines lay off employees – those, of course, with less seniority -- and end up retaining those employees that have accrued more time off. Therefore, more labor is necessary to do the that reduced level of flying. Compounding the problem, the employees that remain are paid at higher hourly rates, trending the average wage for employees upward.

Using Pilot Labor as an Example

Overall, the industry has made tremendous progress in increasing the average number of flight hours per month per pilot – a necessary increase over the artificially low “monthly maximums” that pilot unions protected through collective bargaining agreements since the early years of this decade. [This trend was generally the case across all airline employee groups as well.] But what I find most interesting is this: after years of sequential progress, each of the network carriers nonetheless experienced a decline in pilot productivity in 2008.

I think it important to mention the Delta and Northwest pilot productivity data appears to be affected negatively by their merger completed in 2008’s fourth quarter. But the declines in United’s pilot labor productivity appear to me to highlight the conundrum a unionized airline industry faces – the inability to reduce workforce in concert with capacity.

With productivity in decline, average salaries per pilot equivalent generally increased in 2008 versus the prior year. On the other hand, average salary and benefit costs per pilot equivalent show mixed results. But there are a lot of factors in that calculation, including the costs driven by defined contribution pension plans as companies made historically high contributions; modest increases in compensation negotiated during the restructuring periods; and uneven financial results as many airlines attempt to reduce health care costs and other efforts related to restructuring.

Most disturbing are the trends in output per dollar of total pilot labor cost. The most important metric to me is the marginal cost of a unit of output. Consider the trends in Available Seat Miles per dollar of pilot cost, where labor costs are increasing faster than capacity is being produced. The same downward trend is evident when looking at output per dollar to all employee compensation – which amounts to a steady and stubborn increase in labor costs to productivity that could have a particularly negative impact on Southwest and American over the long term absent a significant new source of revenue.

You Cannot Look at Labor Costs without Understanding Productivity and Revenue

The Journal piece could not have come at a more important time as it provides the revenue backdrop against which all labor negotiations are set. The economy may not continue to shrink, but reality for the airline industry is that its piece of the economic pie is shrinking. While it’s hard to know if the continued sequential relationship of revenue as a percent of GDP will continue, it is increasingly evident that the relationship is not returning to that of the 1980s and 1990s heyday upon which historic labor negotiations patterns were built.

Labor needs to grasp that revenue premiums generated by the legacy carriers are largely gone. When all pricing is transparent and any Internet user can compare any airlines’ fare on any route, there is little room to cross-subsidize, or any grounds for expectations that the industry can repay concessions granted in the past. The revenue environment absolutely underscores that this is the right time in the industry’s maturation cycle to rethink how employees are compensated.

The National Mediation Board is not the answer. There is little logic to the notion that the company and the unions can come in with wide disparities in their respective positions and the Board will merely split the difference. Not unless either party is willing to accept the inevitable result: that this type of decision in today’s world would likely force another carrier into, or back into, bankruptcy court.

Historically, “pattern bargaining” has created an inflationary cycle in which labor groups chase best contracts among other labor groups in the industry. This practice, however, ignores the competitive mix and thus the revenue environment in which any carrier operates.. The only relationship that matters is an airline’s unit cost relationship to its unit revenue. And that is different for every airline.

Simply, Changes Are Secular and Not Cyclic

This is a subtle point. Cyclical and seasonal changes in a longer-term trend line are generally easy to identify and explain and are supported by historic patterns. However, when the changes in a trend line cannot be easily explained in line with historic patterns, then the pattern is broken. We know that the US airline industry’s revenue relationship since the fourth quarter of 2000 has been in decline. We know that the trend cannot be fully attributed to either seasonal patterns or cyclic economic variations. So, those variances that we can’t explain usually point to a permanent or secular change in the industry – and in the airline industry the change has been underway for some time. A return to the past is, quite simply, unlikely.

Therefore airlines will be forced to either adapt their operations to the new environment or to accept their fate in the airline graveyard. A revenue environment that has atrophied to this level can only support so much cost. Therefore as labor negotiations continue into the fall and winter months and become a bigger airline industry story, it is important to acknowledge this change. If I am a union leader, I would bet on smaller fixed wage increases and include a bet on an improving revenue environment as the economy improves in return for flexibility in order that companies can quickly adjust their respective operations.

This is one reason I like what Republic Airlines has accomplished with multiple brands under one umbrella that can succeed in an industry where one size no longer fits all. In some ways, it is not dissimilar to what the successful mega carriers in Europe have been doing all the while the US wallows in the unsustainable cost structure of its past. In this industry, wallowing is a secular trend to be sure.

Is US airline labor ever going to get that featherbedding their own membership roles is actually hurting a smaller number of employees necessary to support a struggling industry?

Neither Ponzi nor Pyramid, but an End Game Nonetheless?

Liquidations and/or Use of the Failing Carrier Doctrine?

On the day when Bernie Madoff gets sentenced to 150 years for orchestrating the financial fleecing scheme that put its namesake, Charles Ponzi, to shame, I am pondering the balance sheets of airlines. And it comes down to this: some carriers have little room to maneuver. Investors (read: credit) are not lining up to provide new capital without demanding ransom in terms of collateral or sky-high coupon rates well above those paid in other industries.

Ponzi and pyramid schemes work by gathering proceeds from one group of investors to pay off earlier investors. It is no small irony, then, that much the same has been happening in the airline industry for years. The financial scams fall apart when they run out of money to pay new investors. In airlines, the end result is pretty much the same. Airlines continue to seek new capital even as previous investors fail to earn a respectable return on their investment. It’s not illegal, but neither is it sustainable. Indeed, it is fast becoming apparent that capital is quickly tiring of this industry and its inability to sustain profits, return its cost of capital and thus reinvest in itself at market rates.

In an industry that has succeeded mainly in destroying decades of capital, the end game for some airlines may be near. To inject new funds into its operation, United Airlines’ required collateral was reportedly three times the $175 million in cash it raised. More troubling yet -- the coupon rate on the new debt was 12.75 percent. Even with exorbitant collateral demands and above-market interest rates, new investors were willing to pay only 90 cents on the dollar for the security, which equates to an effective return to the investor closer to 17 percent.

At the same time, American announced it will sell $520.1 million in debt . American’s collateral requirements will be hefty, but slightly less than twice the amount it plans to raise. According to the Associated Press, American’s debt is investment grade based in part on the assets pledged as collateral. Therefore, American will pay significantly less for its capital than will United, even if the investor interest level is on par. But with corporations of this size, and of this importance to the US economy, “investment grade” ought to be the baseline, not the high bar. That’s not the case today. Earlier in the year, Southwest -- the industry’s only capital-worthy airline -- was forced to pay in excess of 10 percent on its loans. Wow. In other circumstances, that might be considered usury.

Data Points

Market perceptions, and cold, hard cash, demonstrate a new industry pecking order is emerging. Allegiant, AirTran, Alaska and SkyWest – airlines many Americans have never flown -- each today have a market capitalization greater than that of either United or US Airways.

In Spring 2009, Fitch’s Airline Credit Navigator outlined current liquidity and expected debt maturities for airlines over the next three years. It found “most of the biggest U.S. airlines ended the first quarter in "unfavorable liquidity positions.”

For three of the top seven carriers (US Airways, American and United), this liquidity ratio fell below 15 percent of trailing twelve month revenues - a benchmark commonly used to target an optimal amount of cash to be held on the balance sheet.

According to Fitch’s data, American, Continental, Delta, United, US Airways, Southwest and jetBlue held nearly $17 billion in liquidity at the end of the first quarter of 2009 (and with a market capitalization of $13.7 billion for the same group of carriers, the market says that a dollar today is not a dollar tomorrow). Southwest and Delta constitute two-thirds of the group’s market capitalization.

Assets are only one part of the disturbing picture the Fitch data paints. The other half is liabilities. Together, the carriers have debt obligations of nearly $12 billion due by the end of 2010. And these obligations come at a time where negative free cash flows are anticipated for the foreseeable future.

Take as one example Delta, which claimed title as the world’s largest airline following its merger with Northwest. While in the first quarter of this year Delta did not fall below Fitch’s relatively arbitrary liquidity rating. Fitch nonetheless downgraded the debt ratings of Delta and Northwest on June 25 to reflect “intense revenue pressure” and expected negative cash flows. As a result of its combined balance sheet with Northwest, Delta has a stronger absolute cash balance relative to the industry, but still faces nearly $5 billion of fixed debt obligations through 2011.

The shift of capacity by the U.S .legacy carriers to international markets has suffered from poor timing. For United, its exposure to once lucrative trans-Pacific markets is even more painful as the geographic region is closest to intensive care. By comparison, American and US Airways are fortunate to have little relative exposure in the Pacific. But the winner is likely the new Delta which, with lots of eggs in all international baskets. This diversification will certainly produce better results than either Northwest or Delta would have achieved individually.

Renewed Consolidation Focus Based on an Old Tool?

In prior eras, the airline industry has relied on the “failing carrier doctrine” to combine companies on the verge of collapse or unable to meet debt obligations. That doctrine might be dusted off and used again during the next 12 months. Precedent shows mergers and acquisitions are viewed more favorably – with fewer concerns about competition – when the economy is in a swoon and airlines are at greater risk of going under.

US Airways chief Doug Parker is not alone in making a case for consolidation. United’s Glenn Tilton is also in the chorus. Both carriers are on Fitch’s list of those in the “liquidity danger zone.” United and US Airways still have some room to maneuver, but recent attempts to raise capital have proven, in the airline industry particularly, money is getting increasingly expensive.

We may be entering a new era in which the “failing carrier doctrine” no longer applies. Instead, we are now facing the “failing industry doctrine.”

On Second Thought

One of the big issues related to mergers not discussed enough is the preservation of the tax loss carry forwards that each airline has accrued (accrued losses can be used to offset profits in future years). So in the short to medium term, the industry may resist the urge to merge because a change of control could or would have significant tax ramifications. If this is the case, why not apply the failing carrier doctrine to anti-trust immunity?

First, there is no doubt we will see additional capacity cuts, with the next round showing up in the schedules for fall of 2009. This industry is not shrinking because it wants to, but rather because it has to. By the time airlines cut further at the end of the summer travel season, the industry’s two decades of economics-be-damned growth may be nothing but a memory of bad decisions gone by. Then the U.S. airline industry can finally get down to the business of being a business. Or be resigned to failure.

As I have written time and again, in this economy, capital will determine the survivors. Access to capital is the lifeline airlines need now. Those who control that capital are sending a message to legacy carriers, and that is they will pay dearly for funding until they can demonstrate a sufficient return for investors.

Republic Airways Holdings, Inc.

Recognizing the importance of that lifeline might shape the airline industry of the future. Republic Airways CEO Bryan Bedford seems to already be moving that way. As a result of his purchase of Midwest, Bedford now has investment firm TPG on his board - - basically, capital now in is the role of decision maker.

Whether other carriers can accept that kind of change might very well decide the future of the industry and whether some airlines even survive. Right now, that future for many airlines and the hundreds of thousands of people they employ is anything but bright.

Keep in mind, the next industry shakeout is not reserved for the big players alone. Look for entities other than the five legacy carriers (American, Continental, Delta, United and US Airways) to have input into any new architectural renderings of network structure. And input will not only come from Alaska and from the so-called low cost carriers, (Southwest, jetBlue and AirTran) but also some regional carriers like SkyWest.

And I keep coming back to Republic.

Former America West Pilots Prevail in Phoenix District Court

A group of former America West pilots prevailed this afternoon in a Phoenix, Arizona courtroom.The jury ruled that the US Airline Pilots Association failed to uphold its Duty of Fair Representation. Read the story by Dawn Gilbertson of the Arizona Republic.

Nobody should be terribly surprised by the outcome. Unfortunately, it is only the fifth inning of a scheduled nine inning game for the US Airways pilots to agree to a merged list. The right decision was reached by the jury in this case.

Are represented employees ever going to learn that the grass is never greener when AMFA ideology is utilized? Their approach is simply to over promise and under deliver.

What no one will say publicly at least: without the plan of reorganization for the former US Airways that included a merger with America West, the former US Airways [East] pilots would likely have landed in the unemployment line.  And someone other than "Sully" Sullenberger would have been the captain on the flight that successfully landed on the Hudson.

It really is high time to put together a national seniority list in order that transactions like mergers can take place without labor diversions. 

1st Quarter Earnings Calls: Unbungling; Unbundling But Not Unshackled

Three legacy carrier earnings calls down, two to go. Southwest and Allegiant have reported. So has SkyWest. But the clear takeaways are difficult to discern. Everyone wants to know if the industry has reached a bottom. But there are no clear answers while we are still in the middle of an economic tsunami. For all those who have said the domestic market is stabilizing (me among them) the only hard evidence on our side right now is that the environment is not getting worse.

Every carrier is supremely focused on unbungling their operations. Yes, unbungling. Because we all know that operations at many carriers have been a mess, with many factors to blame. And, as painful as the process has been, many carriers are making progress getting their operations and costs in order. US Airways led an amazing turnaround focused on its once-troubled Philadelphia hub. Many very good reforms are underway at United. And all things operational are improving at American, albeit at a slower pace than at some of their legacy peers.

Moreover, virtually every carrier – except for Southwest – remains committed to continuing the unbundling process and to maximizing secondary revenue sources. Today, Delta went so far as to announce a fee for the second checked bag on international flights -- becoming the first in the industry to do so. The industry is unequivocal that the fees will stay and that where opportunities are present to do more, they will. Further, a heartening storyline has emerged regarding distribution, where carriers increasingly see opportunities to move away from paying intermediaries to sell their tickets and to turn that model on its head so that airlines get a fee from the middle man for the right to sell their product.

The United Call

I do not have the transcript of this call in front of me, but this was a most interesting listen. My favorite part was when Morgan Stanley’s Bill Greene posed a very fundamental question that went something like this: With planned capital expenditures less than depreciation, how are we supposed to think about United, or the industry, on a going forward basis from an investment point of view?

Or, as Helane Becker of Jessup and Lamont put it: Should UAL have public equity at all, or instead raise only debt capital from the public markets? Then there was Ted Reed of TheStreet.com, who was blunt in asking whether, just maybe, United had “shrunk too much.”

Good questions. Unfortunately, they are ones that the current environment makes very difficult to answer with conviction.

In my last post, I questioned the airline industry’s access to capital given fragile economic fundamentals in an industry that, over its long history, has failed to produce so much as a dime in retained earnings. In my view, the industry is at a tipping point in which smart investors should question the structural integrity of some carriers and networks during what amounts to a market stress test . . . one that just might reveal which airlines have few moves left to shed uneconomic capacity.

This is the “new and irreversible development” I referred to, a trajectory that might change only through serious effort to remove the many regulatory shackles around this industry. Some necessary changes might not be politically popular -- increased foreign ownership of US airlines comes to mind – but the industry’s options are narrowing when you consider that revenue trends do not hold out much immediate promise.

Looking ahead, with credit tight, where will capital – affordable capital – be found unless it is from another participant in the same industry? If companies are struggling to realize any return on invested capital today, then what happens as interest rates continue to increase in lockstep with capital scarcity? As standalone companies, there is just not enough room for individual carriers to maneuver around an income statement that holds little promise of further significant reductions in the short-term. Based on Greene’s point, even United seems reluctant to reinvest much of its own, and limited, capital into a business that does not hold promise of a reasonable return.

This is not just about United. This is an industry issue. And not just a US industry issue . . . it is fast becoming a global industry issue.

In North America, Air Canada has long been the poster child of an airline that needs an influx of foreign capital necessary to keep the company relevant in the global market place. Air Canada faces some unique challenges: namely that nearly two-thirds of Canada’s air travel demand is found in just eight markets.

Meanwhile, the Delta/Northwest merger is fast proving that the combined entity is far less vulnerable than either of the two carriers would have been had they not merged. Just think about the vulnerability of each Delta’s and Northwest’s respective hubs to the economies in the interior of the US footprint.

With US Airways the exception among the legacy carriers as to international market exposure, we as a nation should at very least acknowledge the reality that globally-oriented airlines need to be just that. I’m not talking about domestic airlines with global extensions -- we tried that, in a way, with TWA, Eastern and Pan Am . But absent any real alliances that left each of them dependent only on US-origin traffic, those carriers suffered a common fate -- shut down in sagging economies as capital became tight.

Concluding Thoughts

Following an industry life cycle of value destruction, US legacy carriers now face a dilemma: whether to invest in their core businesses or not?

As the US airline industry is now six full years into a major restructuring, the tendency to legislative and regulatory gridlock did not get restructured. An inflexible labor construct did not get restructured. Policies promoting the fragmentation of the US domestic market did not get restructured – until the airlines themselves took on this task through capacity reductions in redundant markets out of necessity. 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.

In truth, the US market should not fear individual carrier failures or consolidation. Indeed, this market has demonstrated time and time again that where competition is vulnerable, a new entrant will exploit that vulnerability. Where there are market opportunities, there will be a carrier to leverage that opportunity. Where there is insufficient capacity, capacity will be sure to find the insufficiency.

At a minimum, government should take a very serious look at where this industry sits. The US airline industry is not asking for government handouts. Rather it is my view that this industry seeks nothing more than the same rights to operate as virtually every other successful US industry selling to the global marketplace is permitted.

Few shackles unless consumer harm can be proven. Going backward will result in significantly more dislocation for virtually every stakeholder remaining in the industry today as it begins with an industry even smaller than today’s.  It would be a shame to waste six years of some very good work.

Empathy for Ron Gettelfinger

What, Swelbar showing empathy for a labor leader? Yes. In fact, my feelings are not dissimilar to the emotion I felt for airline labor leaders a few years back, when the solvency of so many carriers was in question and some of the biggest went on to file bankruptcy. Trust me, no one wanted to be a labor leader in the airline industry following 9/11. Today, I’d bet that there is no human being that wants to sit in for Ron Gettelfinger, the damned-if-you do, damned-if-you-don’t President of the United Auto Workers (UAW).

On Tuesday, Fox.com posted a piece entitled: With GM's Wagoner Ousted, Should Union Head Have Met the Same Fate? In my view, absolutely not. In the early days of Swelblog.com I wrote a piece entitled Self Help in which I praised the negotiating strategy of the UAW. This was on October 11, 2007, long before the spike in oil prices, the freeze in credit markets and the downturn in the economy that has left consumers with little to no confidence in the future and contributed to a decline in consumer spending.

The contracts Gettelfinger negotiated at GM 18 months ago attempted to address many of the competitive disadvantages the US auto industry faced. Those negotiations resulted in, among other items: 1) freezing base pay for 4 years; 2) shifting a significant share of the burden of retiree health care from GM to the union; 3) creating a two-tier compensation structure in return for job protections for the current workforce.

Think about these terms. Unpopular? Anti-worker? Unsuccessful? Yes to all. But the new contract made significant ground in bringing about some of the necessary changes to a collective bargaining agreement born of decades of negotiation between the UAW and the Big Three carmakers and costs that had spiraled out of control. These were well-intended fixes to contractual language written when times were different – but the fixes allowed some historical language to remain. This was well-intended language that would only produce real benefit if the industry grew.

It is like pilot scope clauses: there is only value in the language when it happens. Some might argue this point – don’t scope clauses restrict airlines from even considering new routes/planes/partners when it would potentially violate scope – even when company growth presents itself? Only growth is not in the cards for U.S. auto industry, - or the US airline industry - at least not unless, and until, there is real change.

Just like the automakers, the legacy airlines continue to negotiate from outdated language. Most of these contracts were written when technological changes facilitated productivity improvements that could offset pay increases, and when targeted capacity growth would build airline markets where there was no evidence that the market could support new air service. At the time, collective bargaining agreements did more to ensure that labor would take advantage of technology change rather than to adjust work rules and expectations to account for the advantages new technology brought.

Unfortunately for the airline industry, there is no techological change on the horizon that will increase the speed of the aircraft in a meaningful way.

I have written many times here that the auto industry cannot make the necessary changes without a court-assisted restructuring. The same was true for the airline industry. The problem is that, even in bankruptcy, the airline industry still left decades-old and largely irrelevant language in their collective bargaining agreements. Bankruptcy was effective in dealing with the low-hanging fruit, but did not do enough to position the airlines for long-term success.  Simply, the flexibility to match the work force to the demand environment was not negotiated.

So here we sit with significant negotiations to be done at United, American, US Airways, Continental and AirTran. No labor leader at any of these carriers has stepped up the way Gettelfinger did 18 months ago when he was willing to challenge decade’s worth of old-labor ideas and ideals in return for better positioning GM in tomorrow’s world.

Lee Moak, the head of the pilots’ union at Delta, came closer than any other union leader in acknowledging that change was inevitable as the Delta-Northwest merger moved forward. Moak did what any first-mover in a merger world would do and negotiated the best deal for his members. The problem is that Moak did too good of a job given the state of international markets. I only hope he can hang on to what he negotiated.

We have new contracts getting done across the industry. Interesting and different mindsets at Alaska and Hawaiian have produced some very different agreements. Southwest ground workers have ratified a deal. Southwest has announced a tentative agreement with its flight attendants.

And Southwest this week revealed details of an agreement with its pilots that in my view will prove to be a mistake – with the company caving to the union and giving pilots too much specificity in scope. Southwest did show amazing restraint in agreeing to wage increases, but I had expected it to come without “handcuffs” on code sharing. With this contract, we can see quite clearly how Southwest is aging and facing many of the very same labor struggles that have long dogged the legacy carriers.

I feel for those employees that have “given back,” whether through concessionary contracts or at the demand of a bankruptcy court. But that doesn’t change the fact that the give back was from a level that was unsustainable and would have occurred, eventually, come hell or high water.

This current negotiating period is important to both management and labor. Hopefully, the airline industry will produce leaders like Gettelfinger that recognize that tomorrow has different challenges than yesterday, and that labor leaders have a crucial role in negotiating contracts that protect the workers who helped build the industry, while at the same time ensuring that US aviation can be competitive in the future.

Some call this approach “eating their young”. I call it smart. Because there is nothing that Gettelfinger and the UAW can do today to fix what was done 20 years ago. But labor leaders in the airline industry should do everything in their power to avoid the situation automobile labor now faces. Labor leaders who succeed in the long term will be those who set realistic expectations for their members, resist the urge to overpromise and, like Gettelfinger, recognize that change is inevitable and that labor can and should be a key player in making it work.

More to come.

Thinking about the Federal Reserve’s Beige Book

A couple of headlines in the past days got me thinking. The first is: "Emirates to pull A380 from NY routes on downturn". The second story is based on analyst reports from Kevin Crissey at UBS and Bill Greene at Morgan Stanley on the declines in unit revenue at Continental Airlines in February and the expectations that March revenue will come in even lower.

Think about it. New York is the first US gateway city for almost every airline. Emirates is not vacating the route but, is downgrading from the flagship A380 aircraft it flies in the world’s largest O&D market after just months in the market with the aircraft.

Add to that the report that Continental, which over the years has established itself as the bellwether on the direction/trajectory of US carrier unit revenue, announced unit revenue declines of 12 percent in February and an estimated 18 percent decline in March, which makes me wonder what’s coming from other carriers.

The Federal Reserve’s Beige Book

This brings me to the Beige Book, in which each of the 12 Federal Reserve districts (Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco) publish a report on current economic conditions eight times a year.

According to the Federal Reserve, the report is based on “anecdotal information” on economic conditions in each district based on reports from bank and branch directors and interviews with business contacts, economists, market experts, and other sources.

So What Does This Have to Do With Anything?

Now think for a moment about where airline hubs are located. For example, Continental’s Houston and New York hubs no longer provide the carrier the same geographic advantages they did even a year ago. Why? Because in the first part of 2008, the Houston economy was still soaring on oil priced at $100+ per barrel, and the New York hub served a still-humming community of investment bankers and financiers. One year later, the price of oil has plummeted by $95 a barrel and the government now rules the canyons of Wall Street.

I’m not saying that the Beige Book provides certain insight into the regional economies that house major airline operations, but there is a clear correlation between the Fed’s primary districts and the hub cities that define commercial air travel. I believe that individual airline financial performance in 2009 will be largely predicated on the strength of these local and regional economies. And they will be different -- and uneven results will occur.

That may be good news for US Airways. The January 2009 Beige Book reports deteriorating economic conditions in the U.S. Southwest, which should have a significant - negative -  impact on the carrier based in Phoenix. On the other hand, US Airways is the least exposed to international markets that were, until recently, considered the most lucrative revenue opportunity for US airlines. Isn’t it interesting that the legacy carrier most exposed to the rigors of the US domestic markets is seeing a different picture?

Concluding Meanderings

As is so often the case, macroeconomics rule airline markets. And geographic macroeconomics likely will have significant impact on individual airlines in 2009. Those carriers with a disproportionate presence in the Northeast U.S. may have a better year than those with a similarly situated route portfolio in the Southwest U.S.. Those with a US domestic presence may do better than those with an international presence. Those with a dominant Pacific presence may do worse than those with a dominant Latin presence. You get the picture.

The only thing that is increasingly clear to me is that some of today’s carriers are going to do distinctly better than others, thus making themselves better short-term credit risks. Those with better access to credit may be able to grow or acquire assets and take advantage of opportunities not available to competitors with riskier credit. And those with geographic advantages -- whether domestically or internationally -- may be best positioned to gain market share and competitive advantage this year. In this economy, the Beige Book might just provide a roadmap not historically relied upon.

Mumblin’, Bumblin’ and Stumblin’ for Something to Write

It’s pretty sad when . . .

. . . the reports that US Airways will discontinue charging for water and soft drinks is the best news out there. Not just in the airline industry, but in any industry for that matter. Water for nothin’ and cokes for free.My guess is Southwest was more than happy to have US Airways charging for water and soft drinks. And that is the nature of a competitive market– what is good for someone in this industry may not be good for another.

For me, the best news out there are reports that the government is telling the automotive industry that its turnaround plans do not go far enough in addressing the structural problems of Detroit’s automakers. The Big 3 is about to become the Big 1.75.

What will that mean for the airline industry which already is suffering from a sharp decline in business travel?For one, it will probably throw a klieg light on the fact that U.S. airlines have too many hubs in the middle part of the country. That might provide incentive for the industry to actually rid itself of marginal hubs that have outlived their useful lives. And that could portend well for the underlying economics of the industry once the toxins are extinguished from the macro economy.

In other news, Delta flight attendants have come up with a seniority list they say embraces the important tenets of equity and fairness for the former Northwest flight attendants who joined their ranks following the merger. The problem is that the Association of Flight Attendants, which represents the former Northwest cabin crews, does not yet recognize the combined airlines as a single carrier. It is no surprise that the AFA is digging in its heels – after all, Delta flight attendants are not unionized and in fact twice voted down the union’s organizing efforts -- in 2008 and in 2002. Merging workforces is never easy and anxiety over relative seniority will only grow if further capacity reductions become necessary. Expect a tough battle when the AFA goes back for yet another unionization vote.

Speaking of capacity, we are now seeing more impact from the transfer of industry capacity from domestic markets to international that began in 2004. All trends point to a very tough international environment, particularly for transatlantic services. Deteriorating fundamentals at British Airways have been in the news off and on for the past year. Now even Air France and KLM are cutting capacity. Lufthansa just keeps shopping but being the smart carrier it is – a deal is a deal and they will not pay too much.

Pacific region fundamentals are holding up, but China could change that equation. At a time that the West really needs China to increase consumption, that trend now is on hold as the Chinese economy continues to sicken. Economic problems in India that took route last fall continue to grow. Now the economic weakness is beginning to impact airlines throughout the region. Japan Air Lines is looking to its government for a $2+ billion dollar handout and economic ills already are beginning to hurt financial performance at Singapore and Qantas and Cathay Pacific.

The Middle East is perhaps the only economic bright spot for the airline industry, where both fledgling and well-financed carriers continue to grow and take delivery of new equipment, although not without occasional talk of potential mergers. And while Latin America shows pockets of strength, don’t forget that more than half of that region’s demand is focused on Mexico and Brazil.

In the US, we actually have some labor deals getting done. Earlier this year, Southwest ratified an agreement with its mechanics and announced an agreement in principle with its pilots. This month, Alaska Airlines announced a tentative agreement with its flight attendants with a vote scheduled for March. In each case, the contracts demonstrate the difficult state of labor negotiations in the industry. A prime example is the Southwest pilot agreement that attempts a delicate mix of pay increases, productivity measures and new scope restrictions.

Finally stock prices seem to be suggesting that another round of bankruptcy filings might just be around the corner. It is hard to totally discount what market values seem to tell us. Air Canada finds itself back in the news as a bankruptcy possibility following the financial engineering done in the prior bankruptcy that leaves the airline with nothing to fall back on this time around. At this point it looks like the only potential safety net is the Canadian government, which seems intent on increasing the ownership limit to 49 percent, but it is too soon to say how that will ultimately play.

Maybe the current economic Armageddon will generate interests in increasing the ownership limit for U.S. airlines– which could provide them a source of new capital and the opportunity to minimize expenses and leverage economies of scale. Most important, such a change would force recognition that competition for competition’s sake at home does not make for an industry structure that can grow and prosper.

Last week I had the opportunity to speak to the Aero Club of Washington and addressed the legislation limiting airline alliances that sponsors -- visionary Rep. James Oberstar among them – support based on misguided arguments of anti-trust issues. To make the point, I quoted economist Henry George who said:“What protectionism teaches us is to do to ourslves in time of peace what enemies seek to do to us in time of war”. George is absolutely right when it comes to those regulating the U.S. airline industry, which in their protectionist views have largely done what George suggests.

This time is different. Very different. The past is less prologue. Those companies that revise history will be best served because simply, you cannot do business today with yesterday’s mindset and practices and hope to be in business tomorrow. This will prove to be true in the airline industry over the next 18 months.

03. It’s Airline Deregulation Bday Week: Management & Labor; Boom & Bust

Earlier this week, I promised to write my views on 30 years of deregulation, with a focus on where deregulation got it right; wrong; backwards and indifferent. One area where the industry had it wrong and continues

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