« 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?

Comments

[JohnQ]

I understand you get paid to analyze the stastical data and "look for money". Just let me say that the are currently a lot of tired pilots flying airplanes right now and moral at many airliines is at historical lows. The guys/gals who operate the airplanes are in fact so tired and fed up they are are making mores mistakes (I have seen it first hand) and tend to push back against being away from from home/family by burning brakes/fuel etc. You should try to weave that into the cost of running an airline.

[TommasoW]

The 400 pound gorilla in the discussion about commercial aviation is the fact that operating cost and ticket prices often have little in common. How many other industries routinely allow price dumping, where a good is sold at a price that is significally below cost? At this very moment the cheapest coast to coast roundtrip ticket is sold at less than the coast of the FUEL used to take you there. Price dumping is illegal in the manufacturing world, why is it not in commercial aviation?

Also, how significant are the breaks that startup airlines get with their leases, their maintenance costs for new ac etc, in their cost structure? and how does that impact their ability to underbid established carriers?

[malcontent]

The word "bleak" comes to mind most when thinking about the state of this once great industry these days.

Price dumping is a big issue, but the bigger issue is the diversity of cost structures in the industry that are competing at the same price points. JetBlue's cost to operate an A320 from LA to Washington DC is far less than United's cost on the same route. Why? Older (higher paid) employees at United, along with their pension and health costs, older aircraft, etc. So while it may not be a price dump for JetBlue, it is for United if they want to compete on price (and often do).

These new market entrants have gained almost all pricing power in the industry and are keeping fares low. That in turn in pushing wage growth down (negative in many cases this decade) and will continue to do so for the forseeable future. Sad to say it, but the "glory days" of the industry for employees are history. Bare survival and anemic growth are the future, if not more bankruptcies and outright failures.

[Evan]

Whenever you have divergent incentives, you will see this sort of challenge.

In most companies, employees want the firm to prosper since that means job security and more long-term wage improvement. But airline unions have not planned for the long-term, they have sought "wealth transfer" of the highest amount. Literally: How many dollars can I get the airline to pay my members in total this year.

That metric is completely at odds with management, who is actually thinking the opposite: How few dollars can I pay my pilots to fly this year?

Perhaps in a non-cyclical industry where all boats always float up, this could work. But airlines are the antithesis of that -- they are extremely cyclical and this system virtually guarantees they cannot adjust as fast as required.

As a final note -- I agree with your assessment that Republic may be onto something. One size does not fit all in nearly any other industry, why should it in aviation? Southwest is now in uncharted territory of expanding beyond their very large niche (e.g. LGA, BOS, Mexico). Perhaps they too will learn their lesson? But Republic seems to understand that synergy from ownership doesn't have to come at the expense of niche brands and single-market control. I look for them to be the leaders of a new model.

I'll hazard that the piece of the GDP is getting smaller not because of a lack of demand or cost, but because of over-competition. Most industries self-regulate, but the massive boom and bust cycles of the airlines combined with their lack of ability to adjust fast to anything means self-destruction is the more likely outcome.

Now let's see what "recovery" will do to the industry...