07.26.2010 « Time to Sustain to Avoid the Inevitable Pain »
Webster’s defines sustainability as: “of, relating to, or being a method of harvesting or using a resource so that the resource is not depleted or permanently damaged.” I am not talking agriculture; I am talking about the airline industry’s financial performance. Why? Eight of the nine largest US airlines have reported earnings for the second quarter (only Southwest remains). Thus far the industry has reported $2.8 billion in operating income and $1.9 billion in pre-tax income.
The margins (respective profit as a percent of revenue) are impressive. The industry’s operating margin of 9.9 percent and the pre-tax margin of 6.5 percent compare to 2000’s margins of 5.7 percent and 4.7 percent respectively. I compare to 2000 as that was the last profitable year of the last up cycle prior to the restructuring decade of 2001 – 2010. In past times margins like this would provide the industry comfort – whether to negotiate fat labor contracts, continue to deploy regional jets or even to place a sizeable aircraft order. But all that achieved was to begin the process of depleting the key resource, in this case airline earnings, that is critical to the overall sustainability of the industry.
These second quarter earnings are one sign that the difficult restructuring work done over the last decade can and have produced a desired result. Much can also be attributed to a robust revenue environment. Passenger revenue for the first half of 2010 is a healthy 14 percent greater than in 2009. But 2010 first half revenues are 10 percent less than the same period in 2008, albeit on 9 percent less capacity.
The second quarter will mark the first time since the third quarter of 2000 when the entire industry will be profitable on an operating basis. What followed – indeed what began in the second half of 2000 --was significant unit revenue deterioration spurred by low cost carriers and internet pricing that together changed the ticket prices network carriers could command.
Now we must change the focus, away from operating earnings as was common in the past, to pre-tax earnings which matter more for the future. Why? Mostly because of the interest on debt that remains outstanding. Today the eight largest carriers have more than $47 billion dollars in long-term debt and capitalized leases on their balance sheets. That is nearly $20 billion more than the same carriers held in 2000. Whereas the industry borrowed nearly $20 billion over the past decade, the same group of eight carriers holds nearly $12 billion more in cash today than they did in 2000.
Cash balances for the industry are at the comfortable level of 20 percent of revenue – the new norm following the events of 9/11. Given that debt has swelled, there is balance sheet repair to be done. 2010 promises to be a year when the industry produces reasonable levels of free cash flow. But before the carriers purchase new airplanes or increase capacity or agree to rich new labor contracts, I hope that they reinvest in themselves by repairing their respective balance sheets. This way there is sufficient collateral to borrow against when the inevitable next downturn takes place versus the mad scramble to find sufficient collateral – as we saw in 2008 -- to prop up liquidity and live to see another day. Even when the loans were arguably over collateralized in 2008, the costs of borrowing were high by historic standards. Thus credit worthiness must also be repaired.
There is much talk from IATA, ATA and others about the need to create a sustainable industry. Increasing debt while cash balances are not keeping pace is not the way. It can be a short-term strategy, even a necessity to stay alive, but it is not the way to build a resource that so many depend on for their livelihoods.
Speaking of Labor
What is nice to see in the second quarter earnings reports are discussion about earnings before profit sharing. Imagine having a first dollar profit sharing plan in place as the industry recovers from a troubled decade. There is a fundamental financial concept called Net Present Value (NPV). The calculation applies a discount rate to a stream of cash flows in order to define today’s value of future benefits.
Variable earnings are increasingly being offered and negotiated as part of closed collective bargaining agreements. If one believes that the industry is at the commencement of a long and “sustained” profit cycle, then as a union leader I would want to move and close my negotiations. There is an immediate benefit in receiving dollar one sooner rather than later. The NPV of a stream of income beginning today is often of greater benefit to the recipient than holding out for some contractual increase three years from now.
I understand that labor values variable earning less than a fixed increase to an hourly rate. But some adjustment to the hourly rate plus the opportunity to participate in a first dollar profit sharing plan could prove quite interesting if this indeed the beginning of an economic up cycle for the industry. But we know that this recovery is a jobless one and that the full impacts of housing and commercial real estate are yet to be felt. Nonetheless, the difficult decisions for labor to grant concessions early in the decade and the wrenching decision for management to aggressively cut capacity in 2008 are pieces of the puzzle that are contributing to profits thus far in 2010.
Concluding Thoughts
Past managements have ultimately caved to stakeholder interests – those other than shareholder interests, that is -- during profit cycles. I abhor any talk of significant capacity increases at this point in the cycle. The industry has come too far to begin a renewed growth spurt particularly in the domestic market. Thus far capacity discipline has been has been the rule, with the exception of Delta later in 2010 and jetBlue. [This morning I sold my jetBlue stock].
So the next hill to climb is balance sheet repair. It is time to educate employees on the importance of a healthy balance sheet and why it is in employees’ interest to cut debt rather than pay higher and ultimately unsustainable wage rates. Improving employee relations in the airline industry will be much easier if carriers aren’t in the position of requesting concessions during the inevitable next down cycle. Wouldn’t it be healthier to see employees share in the up cycle and keep what they have in a down cycle? Now that sounds more like a sustainable plan than any other plan we’ve seen over the past 30 years.
And the NPV would undoubtedly be higher.
Reader Comments (5)
Just curious, why did you sell JetBlue stock now? Why not a year ago? 3 years ago?
Load factors have been VERY high lately. How high should load factors be before the industry starts to increase capacity so they don't lose business they might otherwise have had?
I realize that load factors can be controlled by pricing but there has to be an optimal level, doesn't there?
I believe AMR's CEO Arpey said it best....
"And again, our hypothesis is that we’re going to continue to work in good faith, cut responsible agreements with our unions and that all of the network carriers in the next 24 months are going to go through the same funnel. And that when we all come out of that funnel, ultimately the market is going to be brought to bear on all of these companies and the market will determine wages and benefits in this industry just like it largely does other industries."
So we're all gonna go through the SAME funnel? Ok!
Analysts would need to look at the wage rates of SWA/FEDEX/UPS and now Spirit to see what the FREE MARKET FUNNEL has in store for the pilots.
Keep in mind that the pilots didn't create the goofy strategic plans that created bloated capacity industry wide. We have no say over these plans.
Nor do we have much say over poor government policies that seek to impose "unfettered competition" on an industry where that simply doesn't work very well. (Crandall)
No....if this past decade has taught pilots anything it has taught us that industry executive do NOT see us as business partners but as adversaries with targets our backs.
This is the lesson of the 9/11 decade we will take forward with us.
Variable compensation?? That implies that you think I trust airline executives to treat me fairly. There behavior over the past decades clearly shows that they can't be trusted, and you want me to buy-off on a scheme where they CONTROL the data?
AHAHAHAHAHAHAHAHAHAHHAAHHAA!
You're out of your mind! Ain't gonna happen.
You got your "convergence" with Low Cost Carriers like SWA and we know make less than cargo pilots with considerably more responsiblily.
No....you're going through the FUNNEL and you're gonna PAY for my skills and experience just like the rest of the industries in this country do.
You can't hide behind the NMB/RLA skirt forever!
Variable compensation is just another insult you think I'll accept.....WRONG!
You have heard of the Modigliani Miller Theorem right?
You seem to be on a campaign to recruit employees to pay down AMR's debt. That somehow this will be a well spring of increased profit.
M&M's Theorem shows us that the captial structure of a firm is irrelevant. Regardless of how it is financed the operation will only throw off a given level of dollars. Whether you use 100% debt or 100% equity. Operational profits are the same.
These dollars are shared by the holders of capital (debt or equity) Changing the capital structure will not allow the firm to generate more dollars. It only allows for the redistribution of a given amount of dollars.
But nice hoax you're playing...but let's see if the employees are stupid enough to fall for it.