Campaign Season: Little Substance and Fewer Facts

At least in the race for the US Presidency, a winner will be declared. In the corporate campaigns being run by the American and United pilots against their respective employers, no one wins. 25 years ago, corporate campaigns had some effect as they were new. They are often targeted at individuals, either senior executives or board members in hopes of exposing something “dirty” in exchange for leverage that can be traded at the bargaining table. As we have written here before, this upcoming round of labor negotiations is odd in that neither side has significant leverage and the most important in history since the industry was deregulated.

So the pilots, the “professionals”, the “flying investment bankers”, at United and American have taken to erecting billboards, calling for the heads of their CEO, challenging executive compensation schemes, talking openly about safety and ensuring that each carrier’s operating statistics remain in the press long after they have been reported - all the while hiding behind the veil of improving the product for each carrier's customer base. And hiding behind the financial and still unknown economic condition of the industry. What a laughable approach that promises no more leverage than what they have today as the path to a Presidential Emergency Board is carved.

I could have entitled this blog: The Summer of 2008 Part II.

Presidential Campaign

Like many I talk to, I am disappointed that we have not heard peep #1 of substance from either McCain or Obama on transportation issues generally and nothing on the airline industry specifically as they march toward the November general election. Some band-aid ideas on energy from Obama and the energy solutions suggested by McCain would have a long road to hoe to be implemented. Nonetheless, I am disappointed at this juncture that little is being discussed regarding this battered industry.

Corporate Campaign(s)

My view of the antics undertaken by the Allied Pilots Association and their current leadership, who still can claim that they represent 8,300 airmen at American Airlines, has been well documented in this blog. But most of the unprofessional behavior demonstrated by this current administration has been displayed by leadership of this independent union during every other cycle in the past.

Not so long ago, a desperate grasp for leverage only cost APA’s members $45 million in dues dollars. Today, their inflexible bargaining position based on a dream and actions undertaken against the employer to try and bully the employer to accept their outlandish ask could cost the American pilot membership more. Maybe much more. But they have been there before………. And I am still betting that this one gets put on ice and lands before a Presidential Emergency Board 18 months from now - long after the Delta and Northwest pilots begin to enjoy the improved terms of their new collective bargaining agreement that required the loss of certain legacy mindsets.

One thing that has always perplexed me about this industry, and I was persuaded to pursue the same actions in my past as a union leader: why do this industry’s unions perpetually make deals that minimize the headcount reduction while maximizing the pay cut undertaken by all employees? I have talked about how the industry has always over-expanded in the up cycles and never taken enough uneconomic capacity out in the down cycles. Well the same is true with labor.

The unions choose bigger paycuts to preserve jobs in the down cycles. Stated another way, pay cuts have masked the fact that legacy labor has engaged in bargaining practices that have made them less and less productive in the down cycles. These practices then lead to the airline hiring more employees than needed in the subsequent up cycle. This is a classic example of another inefficiency that has compounded itself over three decades of deregulation. But no, we will try to injure the entire membership to protect 200. Makes a strong cost-benefit analysis case don’t you think?

Corporate Campaign #2: United Pilots Call for Tilton to Resign

I was beginning to believe that the corporate campaign season would be limited to the independent union suspects: APA; and USAPA. But no, we are now joined by the United Airlines chapter of the Air Line Pilots Association. [And anyone that knows a few things about ALPA politics know about the cowboys at United.] First we have a public cry challenging the safe maintenance of their airplanes by the company’s own mechanics. Then we have the claim of an unlawful action on the part of the union by the company. Now we have the pilots at United calling for their CEO’s head.

This Is Nothing New......

A little history would be helpful here. Let’s take a walk down memory lane of United pilot and CEO relationships. In 1981 I believe, the United pilots made a significant concessionary pact in productivity to the company called “Blue Skies”. The subsequent negotiations between the company and the pilots did not return those concessions to the pilots and the result was a six-week strike in May of 1985.

The pilots claimed that Richard Ferris, who remained Chairman and CEO following the strike, was diverting money from the airline to invest in Westin and Hertz, a combination that ultimately became known as Allegis and included United Airlines. The United pilots hire F. Lee Bailey and began a push to buy the company following the end of their strike. Ferris was pushed out and the company sold its interests in Hilton and Hertz along the way. The CEO and Chairman chairs were held warm until Stephen Wolf was named head of the airline in late 1987.

But the pilots at United were exercising their power over being disgruntled with Ferris’s actions and were making headway toward a leveraged buyout until “Black Monday” – the market crash in October of 1987. Yes, the stock market crash in October of 1987 ended their initial bid. A failed attempt where the pilot union still paid its advisors some $16 million. Ever think how much that was in 1987?

Then, in walks Wolf in late 1987, a deal-friendly CEO that had cashed out nicely at each Republic Airlines and the Flying Tiger Line. By late 1989, Wolf was Chairman and CEO, the Allegis name was dropped and the subsidiaries sold. As Wolf’s tenure in the Chairman and CEO chair began, the economics of the industry were generally strong. Then came 1991. High oil prices and a recession. In 1993, Wolf turned to the unions seeking concessions from contracts negotiated in a much better economic period. [What we did not know at the time was that an inside ALPA lawyer would be financially rewarded for being an intermediary to turn these talks from simple concessions to the vehicle that would be used to sell the company to the employees] The company sold the flight kitchens following a near $1 billion loss in 1992.

The 1993 concession negotiations ultimately led to the ESOP structure that was closed in July of 1994. Nearly seven years after their initial attempts, the United pilots had their wish. Wolf was paid off handsomely and in came former Chrysler CEO Gerry Greenwald to head the company and usher in this new era of employee relations. Greenwald was hand-picked by ALPA to head the new airline, as was his number 2, John Edwardson. And the pilot advisors were paid yet another $16 million in the process.

Employee seats on the board were negotiated with unprecedented and unhealthy corporate governance power. Greenwald makes himself a lame duck during this period by announcing half way through that he would only fulfill the initial 5-year term of his agreement. My guess is he fully appreciated that the economics and the governance construct would inevitably lead to a bad outcome. He left in 1999.

During 1998, employees that had made concessions to buy the airline were entitled to begin negotiating interim wage increases. Management recognized that the increases being sought could not be sustained. Then, using their power at the board level, ALPA and the IAM voiced strong opposition to John Edwardson – the chief opponent - and he was ultimately replaced by Jim Goodwin. Goodwin, was another President and COO that needed the blessing of the unions. Then in early 1999, following Greenwald’s departure, Goodwin was named Chairman and CEO.

The ESOP construct ended in 2000. But as the ESOP construct was ending, which meant that United had to negotiate new collective bargaining agreements with all of its bargaining units except the flight attendants, Goodwin began to pursue a merger with US Airways. Labor tensions mounted as the merger now posed many issues that could negatively impact the outcome of their negotiation of a new collective bargaining agreement.

The pilots ultimately won a ransome-like contract, based in part on their actions, that made virtually their entire portfolio of international flying unprofitable. Further the contract established a false market on the rates the industry could afford to pay for pilot labor. Ultimately the US Airways bid was abandoned in 2001. Then the events of September 11, 2001 unfolded, exactly one-year after ALPA agreed to accept its ransome. And surprise, surprise: as the unions still possessed the extraordinary governance powers negotiated during the ESOP transaction, Goodwin was gone by November of 2001. His chair was held warm by board member Jack Creighton until a successor could be found.

Like the rest of the industry, United suffered in the aftermath of 9/11. The company began negotiations with all of its unions seeking an unprecedented give of $2.5 billion annually. Creighton retires, as he was not the one to lead this company through this difficult period. With governance powers still in place, ALPA, the IAM and the board replace the retiring Creighton with Glenn Tilton. The former oil executive will be the one to lead United into, and out of, bankruptcy protection. Remember, it was ALPA that hired Tilton - like many before him citing that it was one expensive hire but definitely the very best of the candidates interviewed.

Concluding Thoughts

Now United is nearing the time to begin negotiations to replace the consensual agreements reached while the company was in bankruptcy. One of Tilton’s strongest attributes upon his hiring was his familiarity with the bankruptcy process so I guess in some ways that makes him a restructuring guy. It did not take him long to recognize that the negotiations with the unions that were concluded prior to the filing on December 9, 2002, were not going to be enough. And I do not think that Glenn believes the work is done at United yet.

For years, the United pilots have taken to calling for the head of each and every CEO that said no. They were more than willing to put in place those they believed would say yes. But even they had to say no at some point and when they did - they were gone. Tilton has said no and continues to say no so that means that the United pilots should keep with what they know and call for his head. But any good restructuring guy knows when the work is done and when it is not done. Many have stayed too long. I don’t think this will be the case as United works toward righting its operation in anticipation of an alliance with Continental Airlines.

I think some history is important for those looking at the United pilots calling for Tilton’s head as a significant event. It is not significant. It is nothing more than a piece of a tired, three-decade old tactic that the United pilots are using in Corporate Campaign 2008. If the United pilots are serious, as they were in the mid 1980’s, then buy the company again. Otherwise there are two choices: be creative and constructive; or be legacy-minded and destructive. United probably has a liquidation value that shareholders might just view as attractive.

I love how history repeats itself in this industry. This blog was largely written from memory as I have spent a lot of my life at United in these dealings. I am sure that I will be corrected if I have made a mistake on the chain of events.

And further, isn’t it interesting that on the day the pilots call for Tilton’s head, the Delta and Northwest pilots approve a new collective bargaining agreement that will be in place when the merger of the two companies is finally approved. At least at some carriers represented by ALPA there are constructive actions being undertaken to address a changing world.

More to come.

The Summer of 2008 ……..

Rather than proving who is right, can’t we just recognize that much is wrong?

Will it be the sequel to the Summer of 2000? An early opening to “goose season”? Or a leading indicator of what is to come as we enter the post – 9/11 labor negotiations season? Or all of the above? With only a short amount of time to check the news as I continued my tour of the domestic US last week, I am talking about the news that United Airlines filed suit over a perceived abuse of sick leave by its Air Line Pilots Association unit, or some of them.

Between the USAPA; APA and the United pilots, we have the beginnings of something good – in a perverted kind of way. Yes we will have the sympathizers; the empathizers; the hypothesizers; the criticizers; and of course the legitimizers. But the something good is the continuation of extinguishing 50 years of bad labor practices. It is a painful and necessary process begun in 2002. I was addressing a group last Tuesday, and as the talk continued there seemed to be one theme that emerged from those carriers that have better labor relations. [Answer] They were not in existence prior to 1978, or were in a fledgling state, when the industry was deregulated.

Yes you can argue that Continental was a pre-1978 carrier. But by the time the Old Continental finished its second or third trip through the bankruptcy process, the whiteboard of outdated contractual language was virtually clean and it looked very little like its legacy self. And take advantage of the ability to rewrite the construct they did. Management made the effort to be inclusive of its battered work force. Employees were grateful to be acknowledged by a management team that promised to include them and to reinvent the airline; execute on their plan to do so; all the while implementing a better employee relations environment.

Fast forward to the Summer of 2008. Continental now finds itself at the top, or near the top, of total compensation in each class and craft of employee when compared to its network legacy carrier brethren. But they are also a highly productive work force when compared to their network legacy carrier brethren which permits the higher compensation. Somehow the importance of this relationship gets lost on union leadership. It is this relationship that provides Southwest the leeway to improve the earnings of its work force - and I am not suggesting that the hub and spoke carriers with senior work forces can realize the levels of productivity generated at Southwest.

The pilots at American Airlines somehow believe that they gave up amounts similar to the amounts conceded by their counterparts at United and US Airways. Not close. Not even in the zip code. And now they want it all back. The irony is: if the United pilots are actually calling in sick and standing in the way of the most efficient operation that can be run during the peak summer season, then this does smell some of the Summer of 2000 when Dubinsky brought the airline to its knees and the airline gave them an unprecedented contract.

The one subtle difference between the two periods is that the Summer of 2000 was about negotiating a collective bargaining agreement that followed a failed ESOP arrangement. The sad part was that the collective bargaining process was about negotiating a fixed-cost agreement that would somehow compensate for the failure of a risk-based stock ownership regime. It cannot be done but there has to be a hybrid that is good for all stakeholders.

The Summer of 2008 is about preserving a few more jobs against the backdrop of an industry in need of capacity cuts.

The Summer of 2000 collective bargaining agreement lasted all of 15 months before United filed for bankruptcy. First it was wage reductions. Then it was productivity. Then it was the pensions. Pension terminations are where I have sympathy. Relatively unproductive work forces in this environment do not get much sympathy as deregulation was as much about removing the inefficiencies as it was about making air travel affordable to the masses. Would I like to see some wages restored to help ease the rise in the price of fuel and food? Yes, but……….. risk needs to be shared. For both sides, using the collective bargaining process to further complicate contract language that is outdated only serves to make for confrontation over a sense of entitlement.

Are we ever going to ask the hard questions:

1. Are 30+ sections of a collective bargaining agreement really necessary?;

2. Why is it good practice to continually modify and expand on paragraphs that were originally written long, long ago when route networks were vastly different and air traffic control was much less burdened?;

3. Is the seniority system really the best way, or is it time to consider changing the seniority system going forward for those that ultimately hire on and will be the backbone of the US airline industry tomorrow?;

4. As we approach 150,000 lost jobs, isn’t it time to begin planning for the industry of tomorrow? This can be done while preserving much of what the legacy employee has today and creating a compensation system that best reflects the industry’s reality of macroeconomic ebbs and flows;

5. Are we ever going to try and fix it or are we just going to continue to lay blame? And that holds true for both sides. But when I see APA so resistant to a change in their sick leave policy, and in turn file a lawsuit, well, the type of necessary change seems so far away.

So as we read stories about how United and its pilots negotiated a standstill pact at the end of last week, more and more stories will appear about the deplorable labor-management relation in the airline industry. It takes two sides to negotiate. It takes two sides to recognize that writing new language that will somehow “right” the old language is just bad practice. It is 2008, not 1938.

We write about change; we read about change; we recognize that industry conditions change; but somehow the more things change, the more they stay the same. And the more they stay the same, the further we are from finding a successful industry construct.

Leverage Detoxification: Banks and Airlines

With second quarter earnings releases in full swing and a four-letter word starting with “F” being used to describe the impact on the industry’s earnings at each and every carrier, the discussion turns to the what actions each and every carrier is taking to address the new macroeconomic reality. The unequivocal response for the industry’s carriers, with the exception of one I guess, is the level of capacity that will be taken out of the system beginning later this year.

The Banking Industry

Over the weekend, and in between 4 rounds of competitive golf in 95 degree heat and matching humidity, I was drawn to a series of articles in the July 28, 2008 copy of Business Week. Peter Coy wrote a piece entitled: The Credit Chokehold. Breaking the vicious cycle of tightening will take time, but how much? He writes how the cover story explains how each dollar of loan loss can force commercial and investment banks to reduce lending by $15 or more. He goes further to suggest, that by one estimate, mortgage-related losses alone could cause a trillion dollars in credit to vaporize”.

Think About All Network Industries – Not Just Banks

In the second Business Week story by David Henry and Matthew Goldstein: How Bad Will It Get?, ….the concept of leverage is raised. The authors write: “Traders, investors, bankers and economists are waking up to the possibility that Wall Street’s recovery from the worst financial disaster since the Great Depression could grind on for years. ……its aftermath will weigh on banks, other companies and consumers alike.”

“One thing is for sure: The new normal won’t be as fun as the recent past. Banks will be smaller and fewer. Capital will be harder to get for some consumers and companies”. The writers ask: Why hasn’t the healing begun? The answer lies in the mechanics of leverage, or borrowed money, which banks not only provide to customers but also use themselves. Leverage is a powerful but dangerous tool, intoxicating on the way up and devastating on the way down”.

The authors continue: "Banks live on the stuff [leverage]: When they post profits, they borrow money to make more loans and book still more profits. During the boom, bigger mortgage loans pumped home prices until people couldn’t handle the debt and the bubble burst. Then the banks, poorer from the losses, had to cut back their own borrowing, too. Now the damage is spreading. How far? Simplified, for every dollar of bank wealth lost, government-regulated commercial banks must eliminate some $10 of lending; for investment banks, the figure can be $30”.

The article includes a graphic demonstrating “The Leverage Multiplier.” Banks used borrowed money to amp returns in the good times.

1. By borrowing $15 for every $1 of capital – or leveraging up 15 times – an investment bank could turn $10 billion into a portfolio of $150 billion.

2. But leverage also amplifies losses. The authors describe when the value of a bank’s portfolio drops by 2%, or $3 billion, the bank loses 30% of its capital, cutting the original $10 billion to $7 billion.

3. Those losses have ramifications that go beyond the bank. If its leverage ratio remains the same, the firm may have to cut back its lending – in this case by $45 billion ($3 billion X 15). That tightening hurts the economy”.

Airlines: Struggling With Just How Much Capacity to Pull Down – For Many of the Same Reasons

The airline industry that lawmakers, communites, employees and other stakeholders have come to know was born of an industry addicted to leverage.

Whereas banks utilize financial leverage to improve returns, the airline industry employs operating leverage. Each node, or new city added to an airline’s map, benefits multiple other flights on that airline’s network by generating new traffic and revenue. Both of these industries are network industries and leverage is a critical component in sustaining existing, and generating new, scale economics.

As the Business Week piece suggests that traders, bankers and economists are waking up to the fact that the banking industry’s recovery could drag on for years - airline industry consumers, employees and communities of all sizes should be considering the same. The article suggests that the banking industry will be smaller and have fewer players. So too will the US and global airline industries. Air travel consumption will prove harder for many consumers going forward. And yes, there will be some dislocations from the air transportation system.

The leverage of capacity growth since deregulation has been both a powerful and dangerous tool for individual carriers. For the industry, it has been intoxicating on the way up as air travel has been made available to the masses. But we are about to experience some devastation on the way down as networks are deleveraged.

Wright Analysis Still Describes Hub Dynamics

The one thing readers will discover about Swelbar: I have advocated one position or another during a career and have done so with conviction. I have made my conclusions over the years with supporting analysis. In fact, the internet makes it impossible to hide from what you have done and said and honestly, that is good. In 2005, I was retained to assist American Airlines in its defense of the Wright Amendment.

Based on work done earlier in a career (the United-US Airways merger attempt in 2001), American asked for an analysis of what “could” happen to the DFW hub if AA were to match Southwest’s expected three frequencies per day into 15 of the largest US markets from Love Field? It was assumed that these 90 inbound and outbound flights would be operated at Love instead of DFW. The (Eclat Consulting’s findings at the time on this project where I was the lead) conclusion was that if American were to move those 90 operations from DFW to Love, an additional 279 flights at DFW would be negatively impacted. The analysis was a ”bottoms up” analysis of load factor impacts of all flights arriving or departing DFW based on the movement of these 90 operations.

Of course you can question whether all 279 would have been uneconomic as market prices were not considered. The analysis found that a 3:1 leverage ratio existed (one mainline flight from 15 large markets supports 3 other mainline and/or regional flights at DFW). It is not totally unreasonable. Moreover, we are about to witness in real time the delicate cutting of capacity that is being considered by each of the hub and spoke carriers.

I was attacked on the analysis of hub degradation then, but it applies to the industry’s decision to cut back capacity today. Wall Street is saying that 20% is the number that gives the industry pricing traction. I do not disagree. But isn’t it also about a 20% reduction within a carrier’s competitive footprint that matters? Why is it being suggested that each carrier pull down capacity approximating 20% that makes it right in the eyes of the Street?

I have been public in my analysis that the industry needs to be judicious in capacity cuts. There is a leverage ratio for airlines too. Competitor capacity cuts within each airline’s footprint need also to count toward that 20 percent. But Delta’s 20 percent is different than United’s 20 percent is different than American’s 20 percent. Right? By the actions already announced, just how much previous capacity will vaporize based on the deleveraging of the industry? Capital has vaporized and so too will existing capacity – or at least we hope.

The healing for the airline industry will only begin when a sustainably profitable model is found that benefits all stakeholders - and this time it will need to benefit shareholders too.

Congrats to United on a very nice earnings call earlier today.

Speculation, Consternation and Regurgitation

First, the regurgitation. In writing this blog, I am often amazed at which posts receive the most attention and the posts that do not. The one post that continues to amaze me in its interest by readers around the world is the piece I wrote in March of this year entitled: Invoking the Force Majeure Clause: Oil Taking Its Toll.

In that post, my primary intent was to challenge the contracts between the mainline carriers and their respective regional partners. Some took it that I was taking a swipe at labor contracts and implied that was the sole reason I wrote the piece. It is the contracts between the mainline and regional partners that are beginning to receive a lot of attention. I will say that I am happy to see significant cuts being undertaken by those carriers that makeup the regional sector of the US industry as they largely received a free ride as the industry restructured post-9/11.

Consternation

Just what to do at Midwest? This is a most difficult decision for labor as well as the private equity in the deal. What is true for Midwest is that it fits the mold of those carriers that have liquidated thus far. Labor is being asked to give amounts similar to what their legacy brethren gave during the bankruptcy period relative to their current payroll. This really does seem to be a tired attempt by restructuring firm, Seabury, to employ the same tactics that it tried at America West, US Airways, Northwest and Air Canada with moderate success. But those carriers possessed some scale before the cuts ultimately won and Midwest does not.

If Midwest does file for Chapter 11 protection, can the company prove that its labor rates are non-competitive and therefore require immediate relief to implement a successful plan of reorganization. I am just not sure that they can as the labor bill at Midwest is just simply not big enough to offset the increase in the price of fuel. Can Midwest cut back to a skeleton of its current self and find a profitable core that can survive oil’s assault on the meek? From what I can tell, it is going to take a hell of lot more than trying to trot out the same old playbook that was used when oil was $30-40 per barrel.

Seabury’s tactics lack for creativity in an environment that is entirely different. Unlike the prior restructuring period, labor is not the only issue at Midwest. In fact labor may be only a very small issue, if an issue at all. I will let you draw your own conclusions based on the analysis of US carriers just completed by MIT’s Airline Data Project by assessing stage length adjusted labor unit costs and stage length adjusted non-labor unit costs.

Can Spirit be far behind?

I am of the view that this period’s force majeure will be liquidation.

Speculation

It has been interesting to see how various organizations, writers, bloggers and keen observers have come down on ATA’s campaign to rid the markets of possible rampant speculation when it comes to oil prices. For one who firmly believes in markets over the long term, there is some trepidation regarding which side is right as both sides make very compelling arguments regarding their views.

But I do not believe that ATA and the industry is suggesting that speculation is the sole cause of the rise in the price of oil. I do not believe that ATA and the industry discount the enabling issues surrounding demand; I do not believe that ATA and industry discount supply issues or infrastructure issues; nor do I believe that ATA and the industry discount that certain world economies and organizations that produce oil have every incentive to do very little as it is simply not in their best interest.

A friend, Frank Gretz of Shields and Company in New York writes a weekly letter to his clients entitled: Equities Perspective. I am fortunate to get to read Frank each week and I found his comments this week on commodity stocks and oil most interesting.

“When it comes to the Commodity stocks, and Oil especially, even the likes of Warren Buffett tell us that prices are being driven by demand, not speculation. Certainly, the demand is there, but so too it would seem the speculation. From a demand standpoint, China has accounted for roughly 80% of the world’s incremental oil consumption over the past couple of years, a time during which the commodity climbed from $50 a barrel. Clearly there is something to the idea of “China-driven commodity demand.” But similarly, back in 2000 there was a real demand for Cisco’s routers and, more recently, a real demand for housing – the poor immigrants and all. But we all know that there was plenty of speculation in Cisco at $84 and no money down housing, and the same seems true now of commodities. An environment of negative real interest rates is particularly conducive to the speculation we have seen in different sectors of the economy and asset markets – NASDAQ in 2000, housing in 2006 and commodities now. Of course no one complained when speculation was driving up the NASDAQ stocks or the price of their house, but when the price of food and gas goes up, we’ll have none of that speculation.”

Just like consolidation activity was never going to be the only answer to the airline industry’s ills, defusing speculation is not the only answer to the steep, upward trajectory of the price of oil. But it just may be a part of the problem that leads to focused action on other aspects of the energy issue as well, like: alternative sources of energy; increasing supply by considering actions previously thought as taboo; better understanding the demand for oil; make a priority of addressing infrastructure needs in order that supply might better match demand.

I do not even pretend to know of the necessary solutions here. But I am confident that there are many forces at work and if highlighting one might lead to progress on other fronts, then it is an approach worth taking. But I sure wish we did not have to ask Congress for their help as I fear that the ask might bring into play a less than desired outcome. On that note ………

Energy and Air Service to Markets of All Sizes

On Thursday of this past week, I was asked to participate on a panel that was moderated by Will Ris, American Airline's Senior Vice President of Government Affairs at the American Assocition of Airport Executives (AAAE) Summit on Energy and Air Service. The timeliness of the topic could not have been better and the quality and scope of speakers was first rate.

But to be truthful, the impact of airline capacity cuts will not be fully realized by communities of all sizes until the clocks change in early November. That is when the reduced schedules will be fully implemented - or at least the schedule changes that have been announced thus far.

REMARKS OF WILLIAM SWELBAR
AAAE ENERGY AIR SERVICE SUMMIT
July 10, 2008

My top ten list, but before I go there……..

I am pleased to have been invited today to participate in this most important summit. My guess is that there will be even more questions than answers at the conclusion of the day’s program just as there are few answers to confront the most difficult economic environment facing the US and global airline industries today.

As I stand here today, I certainly have lots of questions with few answers.

This industry has been morphing since it was deregulated nearly 30 years ago. Its work is far from done. Along the way, the airlines have learned to operate more efficiently, but at the same time, as carriers competed their way to low and lower ticket prices, they didn’t reap the financial benefits from the efficiencies they found and implemented.

Despite the cyclical noise emanating from the headlines regarding airline labor issues, this industry have actually managed total labor compensation very well as it relates to inflation. Compared to other legacy industries – autos and steel and their respective unions – airline labor can say that they preserved many high-paying jobs. That said, and given the magnitude of the labor cost reductions in the past restructuring period for many, reducing labor rates is probably not an answer and could not be sufficient to turn the expected earnings deficit positive.

When it comes to distribution costs: it is hard to imagine any other area where costs have come down so significantly through the use of technology and business practices, yet the $5 billion in run-rate savings have largely been competed away in the name of lower fares.

In the latest round of restructuring, airlines began to challenge the historic practice of performing heavy maintenance work in-house. Outsourcing has long been a practice at airlines like Southwest and others but less so for the legacy carriers. During the recent bankruptcy period, carriers began to make the transition from in-sourcing to outsourcing and the financial advantages are unclear at this point.

One of the difficulties of the transition has come in the cost of materials. Since late last year, materials costs to the industry grew at double digits, driving maintenance expenses to rise beyond budgeted forecasts. Aging fleets and repairs go hand in hand. Isn’t it ironic that another input in the airline profit equation has commodity pricing attributes as well? There are many industries competing for the metals and composites that are necessary to make airplane parts.

There just are not any line items on an airline’s income statement left that can be cut or restructured to produce sufficient revenues to offset the high cost of fuel . . . Except for the cuts in capacity most airlines have begun.

It has been and remains my view that the industry was over-exuberant in its use of small jets. While the economics of small jet operations were challenging at $50 per barrel, there is no question what today’s economic reality of oil at $140 per barrel means to air service for many communities represented in this room.

Much was made about mainline capacity reductions over the past 5 years, but much of that flying was replaced by the regional sector. So in reality, the industry failed to do much other than to control the supply going forward.

What’s responsible for too much capacity in the industry? Some say it is the legacy carrier’s decision to outsource growth to the regional segment, creating networks that are simply “over-connected” and not profitable. Some say, as I do often, that the barriers to entry in the airline industry are too low, and barriers to exit too high. Clearly several factors are at work including the incursion of the LCC sector in the US industry.

So before I go to my top 10 List, let me say that I see this new era as one of the most exciting periods for airlines in recent history. There is a lot more change in the works and work to be done, because in the past few decades, strong economic times have simply masked the fact that the airlines haven’t done enough to restructure or rethink a business model that was increasingly being held together by chicken wire and duct tape.

This industry is now recognizing that it cannot be everything to everybody. Yes, the industry has met its match – and it is not labor, government, or the macro economy. It is the high price of fuel. Most analysts believe that high fuel prices are here to stay, and that is causing the industry to continue the process of fully transforming the way business is done. Without this trigger, it is likely that the industry would not have had the will or the necessary pressure to make some of the changes underway, perpetuating the long-running boom and bust cycles that characterize an unhealthy industry.

The current industry architecture is a picture of what the deregulators envisioned – and the industry delivered. The problem? The foundation won’t hold.

10 Items That Were Top of Mind As I Was Preparing to Speak Today

1. In the name of competition. Aircraft technologies; airline marketing strategies; and one could even say airport strategies (think LAX) have all been designed in some way to fragment markets. A question to be asked: does the policy and practice of fragmentation lead to healthy or destructive competition? At current fuel prices, fragmenting markets cannot be sustained -- which is one big reason why capacity must be cut.

2. The “boom and bust” cycle that characterizes this industry’s financial performance is good for no stakeholder group.

3. We finally can define over-capacity. The correct term should be uneconomic capacity, an inherent weakness that is compounded by an industry practice that emulates other capital intensive, commodity industries. The US airline industry has too often expanded too much during the up cycles and kept uneconomic capacity in place in the down cycles - all in the name of market share.

4. In 2003, I made a presentation in Washington entitled: The LCCS: Thou Shall Not Inherit the Earth. There are few profitable growth opportunities remaining for the low-cost sector absent contraction in the largest US markets. LCC’s own 26+ percent of the domestic market today. How much tomorrow after attrition? Is this what the consumer wants? I believe that we will begin to test not only the elasticity of demand but also test the true needs and wants of the air travel consumer.

5. Will we ever talk about fundamentals in this industry? Will we finally make route profitability the rule and network contribution the excepting practice? Will we ever talk again about profitability and the income statement or will we continue to assess survivors by relying on the cash flow statement and the balance sheet?

6. Attributes of a successful US airline industry are no different for an airline than for an individual investor or a portfolio manager. Instead of diversifying a portfolio of financial assets, airlines hold a portfolio of routes. Modern Portfolio Theory suggests how investors employ diversification to optimize their portfolios. The model that proposes this diversification assumes that investors are risk-averse, meaning that if the expected rates of return on two separate investments are equal, the investor will choose the one with the least risk. On the other hand, an investor will not accept more risk without a commensurate increase in the expected rate of return.

This characterizes current airline thinking. Parochial-thinking on the part of lawmakers like Oberstar, regulators and the Business Travel Coalition promote the notion that the US airline industry should continually accept more risk while accepting a commensurately lower expected rate of return . . . Much of it driven by policy and entitlement and preservation of uneconomic competition. This is bad economic thinking.

7. Rather than scare people about losing air service to small communities, maybe it is time to design an Essential Air Service program that actually works for airlines, airports and air travel consumers. This means a program based in commercial reality. Networks have evolved, but policy has failed to morph along with the changed network architecture.

8. Reconnecting the virtuous circle of airline industry prosperity because the current circle has a disconnect. You know how it goes: liberalization leads to new and better services which fuels traffic growth which contributes to economic growth which facilitates job growth. Then we start all over again. My question: when will we start?

9. Revenue management – the “Dark Science” adapts but will it subtract? The days of 10-30 seats per flight being sold below cost are over. Will the concept of cross-subsidization be over as it takes place everyday across a network and across each flight segment?

10. As we approach the 30th birthday of US Airline Deregulation, it is the price of oil that is demonstrating its power to force the industry to complete the resetting of the legacy mindsets that have remained in existence for too long. And this includes customers’ belief that they actually pay the “all-in” price of the service and are therefore entitled to multiple access points to the air transportation system. And the concept of entitlement is not limited to just the consumer.

Here in this room, we have representatives from nearly every airline industry stakeholder group. The truth is, only one stakeholder group has been a winner since deregulation, and that is the air travel consumer. Consumers have won on price and have come to consider safe and affordable air travel as an entitlement. I would expect to hear an argument regarding reliable air transportation however.

But the industry can’t and won’t succeed in its current state while confronting the fuel price headwinds, and that is something we can all agree on and that needs to be addressed as we move forward. Because there are no stakeholders if there are no airlines.

Thank you.

Are We Beginning to Define US Airline Industry Survivors?

All Sectors Present and …. Discounted

As the day ends and I finally get my thoughts away from preparing for tomorrow’s AAAE Energy/Air Service Summit to be held in Washington, D.C., I turned to Holly Hegeman’s blog Planebuzz. As she often does, Holly chronicled the day’s events on Wall Street. The drops in stock prices for AirTran, Continental, Northwest, Delta and Mesa are disturbing. But then again, why is today any different?

This has been a "Death March" that ends with the inevitability of structural attrition. It is unlike the loss of value experienced immediately post-9/11 in that nearly every airline has been punished by Wall Street. Post-9/11 actually saw some carriers be ascribed significantly higher equity values relative to other carriers based on the condition of their balance sheets and the view of their respective cost structures at the time. With exception of Southwest (do they run a trading desk or an airline?), every carrier has been hit very hard by the Street. Yes, airline equities are an option on the price of oil.

In her post referenced above, Holly ponders the Street’s view of AirTran. Yep, there is something going on here, and in hindsight, the bears have been leaving crumbs along the downward trajectory of its stock chart for months. Many question Northwest Airlines viability as a stand-alone entity. Today, Northwest put some specifics to its capacity reductions. And Northwest made that decision to charge for the first bag (that this blogger really dislikes).

Yesterday, we had the announcement that ExpressJet would terminate its branded flying. And today we have Mesa trading at 37 cents.

Renewed Bankruptcy Talk and My Blunt Talk on Private Equity

Over the past month or so, virtually every major airline reporter has written something on bankruptcy. But my fundamental question is: how do you restructure a market-driven commodity cost? Or is another bankruptcy period being created so that private-equity firms can finally buy what they determined they did not want to buy during the last round of Chapter 11 filings? Are we not watching this play out at Midwest where private equity holds a “passive stake” and is asking labor to make untenable concessions. Yep, they will probably file too and nope labor should not play as the outcome would remain fragile at best.

Private equity is smart money – right? Smart in that they did not play in the first round because they recognized that the work was not done. Smart because they knew the subsequent round of labor negotiations would result in dirty fingernails – particularly given the pension terminations and freezes that took place. So now we are down to the final act: removing capacity from the system and trying to educate lawmakers, communities and airports of these unpopular actions. As we make the final push to clear the last ten acres of 30 year-old underbrush, what a perfect time for private equity, right?

The right form of capital during this time is “internal stakeholder capital” and not external “private equity”. This can only be prevented absent a bankruptcy filing I fear, except for American I guess. As difficult as it may be, labor and management had best figure it out in a hurry. Think back to the early days of Southwest Airlines when the carrier was struggling mightily to stay alive. Southwest management put equity in the hands of the small number of employees that existed. History refers to them as the “North Dallas 40”. Millionaires, who would not have become millionaires, were made.

I am not saying that employees will be millionaires, but I can say with conviction that equity in lieu of hourly rate increases at this fragile time holds the promise of appreciation once this storm passes. And the long-term trend line of equity appreciation runs along a higher line parallel to inflation. So if I am labor and management, each of you has interests to protect. This is not about management compensation for god’s sake, it is about employee compensation and preserving as much of the enterprise that the macroeconomic environment allows. If labor believes it has somehow been wronged by management compensation structures of late, just wait until you lose control in bankruptcy the next time, or even for the first time, and the owner is Blackstone, TPG, or Pardus to name a few.

Thinking About Capacity Cuts and Industry Structure

Have you ever stopped to think that this is IT? Will the capacity reductions be an acclamation or an eulogy? There really is not much left to cut. As we raise fares, we will test 30 years of consumer attitudes in the making that air travel is among the greatest bargains ever delivered by a government’s action on an industry. As we cut capacity we will test the resolve of lawmakers to recognize that the airline business is a business and needs to earn a return on capital just like other industries. As we cut capacity, we will ultimately test organized labor’s mindset about pattern bargaining.

So as we march toward the airline graveyard, who will live to eulogize? Delta and Northwest have made their arrangement and it holds promise. Continental and United could prove to be a real powerhouse serving the largest US cities to metro areas around the globe. American will live because it has the “B” card to play where I fear others do not and it has the opportunity presented by an immunized alliance to generate revenue that has been limited because of regualtion. As for US Airways, labor got onboard too late for this one and I fear its ultimate death.

Turning to government’s beloved and answer to all industry ills: the LCCs. Isn’t it interesting that this sector has been rocked like no other sector. The price of oil has mitigated its previously inherent cost advantages. Yes, Southwest lives but it was really the only LCC to grow and prosper under deregulation anyway. jetBlue is taking on more characteristics of a network carrier recognizing the importance of local traffic in large metropolitan areas. ATA and SkyBus are gone. Spirit holds many of the attributes that characterize those carriers that have liquidated thus far: small footprint; private capital; market strength nowhere.

AirTran is the enigma. But there is something fundamentally wrong here despite a very strong management team. Maybe it comes down to that simple diversification thing that I like to write about. It has a presence in Atlanta. And Orlando I guess – and that market will prove to be a friend of a few that live to see another tomorrow. Oh, and Frontier. It too suffers from that diversification thing and my guess is the aircraft are much more valuable than the carrier’s value to the US air transportation system.

From this blogger’s perspective, what is missed on the regional sector is that there are legacy-regionals and LCC-regionals - for lack of a better descriptive term. It has much to do with labor rates as they are the only cost centers that allow this sector to differentiate their delivery of flying - at least under the current capacity purchase agreement construct. Republic and SkyWest are safe as each has been able to grow their jet-flying subsidiaries faster than their subsidiaries laden with employees that were in place when turboprops were the only game in town.

When it comes to rest of the regional sector, I just do not believe that the remaining carriers have been able to effect a business plan that transforms their structural beginnings.

So in the end, are we left with: United/Continental; Delta/Northwest; American/British Airways; Southwest; jetBlue; Virgin America (because of capital and branding); Allegiant; SkyWest; and Republic? I just do not know, but I am thinking that we are closing in on it.

Grab a Big ‘Ol Cup of Jo, and Let’s Talk Airline Service Cuts

Starbucks, Airlines and Air Service Cutbacks

This morning’s headline in the Wall Street Journal on B1 reads: Starbucks to Shut 500 More Stores, Cut Jobs. The story by Janet Adamy offers many insights as to what is plaguing the airline industry, at least from this observer’s perspective. The announced shutdowns will occur throughout the remainder of 2008 and will continue into early 2009. The 500 store closures announced yesterday are in addition to the 100 the coffee proprietor announced earlier this year. I will highlight some of the points made by Adamy in her story:

· “The pullback is a sign that the Seattle-based coffee giant is continuing to see weak sales as high gas prices and other pressures on consumer spending prompt Americans to cut back on extras.”

· “It also shows how badly the specialty-coffee business is struggling just as mainstream companies, such as fast-food giant McDonald’s Corp., are beginning to invest in it.”

· “Starbucks didn’t disclose which of its about 11,000 stores U.S. stores it will shut, but said the affected stores are spread across all major U.S. markets. About 70% of them have opened since the Fall of 2005, it said”.

· “The purpose of its rapid expansion (2,500 stores globally during the last fiscal year) was to boost sales growth and siphon traffic away from some of its stores where long lines were driving away customers. Also fueling the push was company research that showed people sometimes weren’t willing to cross the street to buy a cup of coffee.”

· Last year, as Starbuck’s sales began to soften, it became clear that the company’s expansion was cannibalizing its sales in a way that was threatening the chain’s success, as well as causing the quality at its existing locations to slip”.

The Ubiquitous Airline Industry

Adamy mentions ubiquity in her story and it absolutely applies to the US airline industry as well. You know: the seeming need to be present everywhere. As we have written here many times: presence everywhere and pricing power nowhere. Ubiquity is synonymous with fragmentation. Fragmentation best describes the US airline industry’s domestic market. [In fact, IATA suggests that fragmentation describes the construct of the global industry’s marketplace.] The US airline industry’s domestic market lies at the heart of the US airline industry’s woes. Hyper-competition has led/contributed to the non-economic prices that persist. So if fragmentation is present and structurally undermining your performance, consolidate around your strengths – right?

Based on the story about Starbucks closing stores let’s talk about the US airline industry and the planned capacity cuts that are known and those that might not be known. We have heard about some airlines either discontinuing service altogether or reducing frequencies to large markets like Ft. Lauderdale and Oakland. Will Ft. Lauderdale and Oakland passengers suffer as a result? My answer is NO as they will have other options available like Miami or on other carriers, mainly those with the outdated low cost carrier moniker, continuing to serve the market. Will Oakland customers suffer? My answer is NO as they will have access to remaining service at OAK and will have a menu of offerings available at alternatives like San Jose and San Francisco. So customers will continue to have options, and options with low cost carrier presence, just as they have before.

Just like Starbucks realizes it cannibalizes traffic with certain store openings, the US airline industry cannibalizes itself with nearly every new service in some way it seems. My numbers may be off a bit here, but hear me out. At one point I was looking at the Greenville-Spartanburg, SC (GSP) to Los Angeles market. At that time there were 100 passengers per day each way (PDEWs) in that market. Those 100 passengers had a choice of 24 nonstop flights to access the air transportation system over 15 different hubs.

So I have 24 nonstops competing for four passengers per flight. As oil skyrockets, how can I possibly raise fares enough to cover the cost with that many consumer choices in the market? Simply, you cannot. Another question should be: how many choices is too many choices for a mid-size market like GSP?

To make matters worse, it can actually be said that carriers competing in that market actually compete with themselves. Delta carries traffic in this market over each its Atlanta and Cincinnati hubs. There are a multitude of examples just like this one where consumer choices to get from A to B are much more than the market can economically support. Unfortunately, it has taken the price of oil to demonstrate that the choices provided air travel consumers over the years cannot be economically sustained in many instances. So just like Starbucks, the US airline industry will pare back choices and consolidate that demand around markets that are, or can be made, economic by consolidating traffic.

So as the Business Travel Coalition paints the landscape with scare tactics, their back of the envelope analysis tells us very little. The BTC fails to mention that in the vast majority of service reduction announcements thus far, passengers demanding service to a particular destination will still be accommodated albeit by fewer frequencies or over fewer hubs – and few will be disenfranchised from the air transportation system.

Another Question I Have: Why Is It OK for Southwest and No One Else?

You know the story. Everything Southwest does is somehow the best and always in the best interest of the consumer. Southwest, circa 1995, enters a market. Fares go down and significantly in some cases. Traffic at that airport market is stimulated. Southwest’s success in entering a market had much to do with expanding the catchment area of that airport market. So while the carrier still only serves less than 65 airport markets in the US, if one were to draw a circle equivalent to a 2-hour drive to that airport, the carrier impacts more than 90% of US domestic air travel demand.

But the question should be: how much of that demand is/was created because air travel was made affordable to some new segment of the population and how much is/was diverted from airport market(s) located within that 2-hour catchment area? It is some combination of the two. Is that stimulation or diversion? The answer is diversion.

There are many examples of airport markets that have suffered as the Southwest’s, jetBlue’s and AirTran’s and other “bottom fishers” entered markets across the US. Their lower costs at the time allowed them the “freedom” to price aggressively while exploiting the bloated cost structures at the legacy carriers that existed. The low fares worked to stimulate new demand all the while diverting traffic from smaller airports with higher prices enveloped by the catchment area. It is the sum of the two - not one or the other.

But why is it OK for Southwest to offer service at an airport and rely on the highway system to be the first leg of access to the air transportation system – all in the name of low fares?

Why is it not OK for the remainder of the industry to cutback frequencies that may result in the highway system being the first leg of access for some – in the name of preserving as much of the network architecture that has been built and can be made economically viable?

The existing network architecture has provided more than sufficient choice for air travel customers in cities of all sizes, not just the largest metro areas that have secondary airports that are the backbone of Southwest, and its LCC brethern, service.

There Is a Lesson Found In Starbucks’ Decisions That Apply

At some point Congress, BTC and others may actually realize that the industry has grossly overbuilt through the over exuberance in the use of regional jets. For many markets it means you will still not have to walk across the street to get a cup – or access in airline vernacular. For others, it will mean having to walk three blocks for a cup. But in any case, you will pay the “all in” cost of that cup. Like Starbucks, you will go for that first or even second cup. The trick for the US airline industry will be the demand for that third cup or the iced cup that lies the heart of the demand equation and the ultimate decision on how much capacity to cut is right.

More to come.

The Reality Show Called Airlines

The Biggest Loser(s)

Reality shows have become a fixture on American television. Like them or not, the ratings of many are hard to ignore. So at a time when US carriers consider whether charging by the pound would be good practice, the title today seems appropriate. 2008’s second quarter comes to a close today. Red ink will again be the color to describe the financial results for the US airline industry. Red will also be a color prevalent in calculating changes in liquidity positions for many of the US carriers.

Red should also be the color of the faces of analytical team employed by the Business Travel Coalition as they made public their latest of a long list of scare tactics. It is has been nice to see other bloggers and observers make their views known regarding the information and “analysis” that has been emanating from this group. There are many smart observers of this industry. To even allow BTC’s latest missive find its way from the idea table is head scratching enough. To allow a piece into the public domain without the supporting data and analysis underlying the “findings” is even more bothersome.

My guess is the BTC’s leader is nothing more than a pawn for Jim “Hell NO”berstar and the socialist ideals he thinks are best for the US airline industry.

Closer To Another Method of Treatment, Than A Cancer

Many times I have written about Willie Walsh, British Airways’ Chief Executive and his views on US regulation and its hindrance to the natural evolution of the global airline industry. Today, Mr. Walsh’s views were expanded upon by Martin Broughton, the Chairman of British Airways PLC in an interview in the Wall Street Journal by Daniel Michaels. Some of Mr. Broughton’s comments that I found to be spot on are as follows:

· An eventual relaxation of US airline-ownership rules would spark a world-wide wave of cross-border deals over the next five to 20 years. That would help the troubled aviation sector function more like other industries.
· Mr. Broughton still sees it [US – EU Open Skies Phase I] as a lousy deal because it opened Heathrow, but only opened a small crack in the US market for EU carriers.
· Mr. Broughton hopes economic pressures will do what diplomacy couldn’t. It could be the financial exigencies of the day that finally make for a breakthrough.
· In Europe he cites two cross-border mergers that have shown the potential of multiairline groups: Air France/KLM; and Lufthansa/Swiss. In Latin America, he cites the tremendous success of Chile’s LAN Airlines SA. In Asia he points to the success of Kuala Lumpur-based budget carrier Air Asia.
· Mr. Broughton points to the frustration of Lufthansa’s Chief Executive Wolfgang Mayrhuber with airline-ownership limits. He quotes Mr. Mayrhuber as saying this industry shouldn’t be treated like railroads. It should be like car makers or chemical companies and operate globally.
· Mr. Broughton called America the biggest impediment to relaxing the aviation industry’s ownership and nationality rules. He suggests that if you break US resistance then you have made a big breakthrough on a global scale.
· Broughton believes that financial considerations may soon overtake nationalistic ones. He suggests that even labor should welcome the changes because foreign investment is investment and that is something US carriers have lacked in recent years.

So as we carefully dismantle/deleverage the last 30 years of network architecture as a method to discover individual carrier’s profitable cores, I long for the day when we begin to grow again whether organically or through other means. The combinations cited by Mr. Broughton are those carriers that are leaders in a global context as far as return on invested capital; growth in virtually any measure; and in market capitalization. Moreover they are proof of successful models of cross-border combinations that are producing the right kind of returns for many stakeholders, not just a few.

US Airlines and Portfolio Theory

Attributes of a successful US airline industry are no different than an individual investor or a portfolio manager. Instead of diversifying a portfolio of financial assets, airlines hold a portfolio of routes. Modern Portfolio Theory (MPT) proposes how investors will employ diversification to optimize their portfolio of assets. The model that proposes this diversification assumes that investors are risk averse meaning that if the expected rates of return on two separate investments are equal, then the investor will choose the one with the least risk. On the other hand, an investor will not accept more risk without a commensurate increase in the expected rate of return.

Parochial-thinking lawmakers, regulators and aforementioned observers somehow think that the US airline industry should continually accept more risk all the while accepting a commensurately lower expected rate of return largely driven by policy -- all in the name of competition I guess. For the largest US carriers, the portfolio is simply made of up too many domestic routes. This is how you can characterize the first 30 years of deregulation. Now it is time to break the boom and bust cycles that have characterized this industry.

During the down cycles: Unhealthy competitors remained due to high barriers to exit; new entrants emerged, because of the very low barriers to entry, looking to exploit weaknesses; leading one to argue that this has led to the overcapacity situation that will begin to be addressed immediately after Labor Day. Compounding the “excess capacity” issue, the airline industry emulates other capital intensive, commodity industries by over-expanding during the up cycles.

Surely the Naysayers Recognize that Something Is Wrong?

So here we sit. With nowhere to run, nowhere to hide, and few options to find new capital to invest in a lacking product that will require the consumer to pay more for as a result of high oil prices over the coming months – it will get interesting. Moreover, the consumer will surely have an expectation that increased prices sure as hell better produce an improved product.

I like the idea of foreign capital for this very reason – the need to invest in product that facilitates a new cycle where the ultimate US flag bearers in the global industry begin to differentiate themselves from the local service carriers (formerly called Republic, Ozark and Western) – or today’s equivalent (Southwest, jetBlue and AirTran) – tomorrow. But if I had capital I would not make that investment without commensurate voting power either.

So over the next 12 months or so, it will be interesting to see just who gets voted off of the show.

Is Oil A Cancer Or A Cure?

As I write this morning, I am without an internet connection. On Monday and Tuesday of this week I was in Chicago speaking to, and participating in a roundtable discussion with senior executives of the International Association of Exhibitions and Events. A most enlightened group that depends heavily on the airline industry to deliver people and goods to the large trade shows they run. Rather than run from the issues plaguing this industry and others, this group was meeting to strategize on proactive stances and rethink their many successful approaches – many of which were designed around a low fuel environment.

Today, I sit in rural Maryland as the coolest, little guy in my world, Sam, plays in his first Titleist Tour event. Not being the doting one, I watched him hit a very good tee shot down the right side of the first hole then strap his bag on his back and begin play. And I found a quiet spot under a tree to write. In case you have not figured it out by now, the game of golf is a passion and it is way cool to watch Sam embrace the game and pay respect to the many traditions that make the game so great.

I Think We Are Beginning to Actually Define Overcapacity

The naïve notion that high load factors somehow suggested that there is no overcapacity is in the process of being put to bed. A better term to have used would have been uneconomic capacity because we know that on many flights that there are somewhere between 10 – 30 seats that too often get sold for less than the cost to carry the passenger occupying one of those seats.

My guess is some readers here have also been questioning my lack of writing over the past 4-5 weeks. For the same reason that I got out of the day to day grind of the consulting business where I devoted an inordinate amount of time to restructuring airline labor agreements. How many ways can you tell someone or a work group that their collective bargaining agreement has cancer? How many ways can you write that the treatments being recommended may/or may not work? Another attribute of cancer survivors is attitude – a positive attitude has proven time and time again to transcend many things that require wholesale change. And it does not take an Oncologist to tell anyone that.

Is the price of oil a cancer or a cure for the industry’s ills? I do not know the answer and the question is probably best left to the individual. For some, the price of oil is a cancer in that its very presence will prevent certain stakeholders from achieving what they somehow believe they are entitled to. More than likely a positive outcome will be prevented by the lack of acceptance that additional treatment is necessary and succumb to the “woe is me” attitude. For others, they will accept that the treatments taken over the past 5 years are simply not enough and that more has to be done – and the only path left is invasive. [for those that will comment that I am suggesting more concessions, I am not]

Already this week, labor news surrounding the industry has been plentiful. I wake up in Chicago on Tuesday morning to the headline on the front page of the Chicago Tribune that United will furlough 950 pilots between now and the end of 2009. Later that day, the Delta and Northwest pilots announce that they have reached a tentative agreement on a joint contract covering both the Delta and Northwest pilots. In addition, a protocol agreement has been put in place to merge the seniority lists prior to closing of the transaction. Today American Airlines began to detail its previously announced service cuts. And New York is prominent on that list.

The United news of pilot furloughs is the first real indication just how far that carrier is willing to go to find its profitable core. Clearly, the carrier recognizes that major changes/treatments are necessary. United has been quite busy of late announcing an alliance with Continental; making a number of fare rule changes including bringing back the unpopular Saturday night stay provision; being so bold that it would put down 100 aircraft units; and entertaining any and most of the ideas – including some of their own - regarding charging for most unbundled services.

Layoffs associated with aircraft retirements will be many as we work toward the fall and winter months of 2008. But I do not see the numbers of jobs lost approaching the 125,000 jobs lost post 9/11. Unless we liquidate a large airline or two.

The Confused Business Travel Coalition

On the heels of the Business Travel Coalition testifying against the proposed Delta and Northwest merger on two separate occasions, the confused advocacy group underwrites a study suggesting that the current crisis (the price of oil) facing the industry is leading to a catastrophe. A crisis for some stakeholders to be sure. But a catastrophe?: absolutely not. Why is it a catastrophe if inefficient players are finally removed from the industry? Or if uneconomic capacity is finally removed from the system?

This industry will be here after this storm has passed. Only the liveries on the tails will be different unless invasive treatment is accepted, implemented and met with a survival attitude. Based on this group’s track record, I thought it was a catastrophic event if carriers merged. Now everything is a catastrophe. Maybe the upcoming lesson on network economics in the fall will shed some light on approaches other than the group's tired refrain that the “sky is falling”.

In this environment combined networks, whether it is through merger activity or through the formation of an alliance, promise to preserve more capacity than if carriers operated individually. As carriers begin the process of weaning capacity, the industry will get a real live lesson on the interdependencies between nodes that exist within network industries. We will take a cue from consumers as to whether the Southwest’s, jetBlue’s and AirTran’s can satisfy all consumers wants from air travel in the domestic industry. I am prepared to bet that all consumers will not be happy with their limited services - but we will see.

So while the news is bad and additional dislocations are all but assured, I see the price of oil as a cure to 30 years of cancer that never received the proper treatment. When we come out of the other side, however long it takes, it will be better as many bad business practices that have plagued this industry will have been eliminated. And not thought to have been eliminated when they were actually in remission.

Continental, United and the STAR Alliance

One hour ago, Continental Airlines and United Airlines Announce Comprehensive Plan for Global Cooperation; Continental Plans to Join Star Alliance. There will much to learn about this one as it goes forward, but this is one interesting combination with a myriad of strategic and tactical opportunities.

Last month I wrote about the possibility of a United – Continental combination in Swelblog.com: Pondering the Next Move; But Before I Do…….. The piece was written as United – US Airways possibilities were being thrown about. Then the idea of a United – Continental alliance was being tossed about. I wrote a couple of paragraphs where I contrasted these combinations with the Delta – Northwest combination that is on the table. And I wrote……

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

Now we have a United and Continental alliance in the news. Readers know I like what Tilton says as he talks about the industry from 40,000 feet – and I am in fundamental agreement that the current construct is good for no stakeholder group.

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

I for one look forward to hearing more about this combination.

More to come.

10 Airline Issues That Have My Attention

Note: at 634pm I made some minor edits to the orginal post. Immediately after posting, a personal issue arose that required immediate attention. I apologize.

But before we go there I will share my favorite headline of the week gone by: Congress, get off your gas, and drill!

1. Crandall

It is interesting to me that Gordon Bethune has gone quiet for the most part and has now been replaced by Crandall. The entire industry recognizes what Crandall recognizes and that there is little obvious cost cutting that remains other than capacity cuts and that the revenue line must become the focus for the industry. The interesting note to all of Crandall's suggestions for some form of reregulation is how US airline labor generally, and American Airlines' labor specifically, are hanging on his words of late. Is it Crandall the leader or the suggestion of reregulating the industry? Crandall the leader would not be handing out big increases in compensation in this fuel environment; yet Crandall the re-regulator is the silver bullet that would enable the industry to charge enough for an airline ticket to offer a return of the concessions and still employ all 400,000+ people that remain in the industry?

2. IATA Annual General Meeting

Mark Pilling of Airline Business writes Airline bosses call for strict capacity discipline following IATA’s Annual General Meeting last week in Istanbul. This piece is good reporting on the differing levels of cuts being considered around the globe. With the US undertaking the most aggressive actions: Europe is now beginning the process of how to react; the Asia-Pacific carriers are exiting some routes but redeploying capacity to other more promising routes; and the Middle East is continuing on their aggressive growth path. Is the industry serious about capacity discipline this time and will we really put capacity down as a reaction to outside forces and inherent inefficiencies? Or is this just a time out?

3. Labor PR and of Course Fuel Does Not Matter

I did not think I would see ALPA take a page out of APA’s tired play book, but they have. On Sunday night, the following appeared: labor Relations Darken at Hawaiian Airlines. But my favorite story in this topic area was written last week as Continental pilots picket for higher pay, benefits. I have no issue regarding a union’s right to picket. But I do have an issue with yet another irresponsible statement from a labor leader. In the Continental story, Captain John Prater, President of ALPA is quoted as saying: “Don't try to use the price of gas," said Prater. "The industry is unstable, and the only way to add labor stability is through a solid contract." What does that mean? Of course the price of gas will have absolutely nothing to do with the outcomes of negotiated agreements John [emphasis added]. With so many things happening in the interesting Hawaii market, I only wish I could write on some of them.

4. European Carriers

Over the last few months, stories have been appearing that suggest the underlying fundamentals in the European market are weakening. Austrian Airlines has suggested the carrier will seek a strategic partner. We all know of the woes at Alitalia. Among the Big 3 in Europe, British Airways has been warning of turbulence ahead for the carrier in the face of high oil prices and the carrier’s exposure to the weakening US market. And now there are even rumblings from Lufthansa and Air France/KLM. For each of those two carriers the revenue synergies have been captured through their acquisitions. Now there will be a renewed focus on costs. Finally, the US is not alone.

5. Asian Carriers

For me, things were starting to get interesting in this critical world region immediately following Singapore’s earnings announcement in February that was less than stellar. Then Cathay Pacific suggested it would begin to curb capacity growth. Then Qantas. Each of these carriers has a place on the list of global elite airlines and are not immune from the environment either. AFP reports that Oil costs will push some Asian airlines under: analysts. Thinking about it, this region’s airlines carry passengers long distances and we know that the price of fuel and long-haul flying are not in concert today in all markets. In the article it is suggested that the region’s airlines are not close to doing enough and that SARS-like capacity actions should be considered in some cases. With or without high oil prices though, this region is certain to lose airlines along the way given its early stages of development.

6. Boeing and Airbus – A Couple of Things

Julie Johnnson of the Chicago Tribune writes that Foreign carriers' woes could hurt jetmakers. I have heard that some deliveries will be deferred. Certainly today’s issues will only prolong the needed replacement programs for the US industry, except for Southwest, Continental, AirTran and others. The manufacturers and lessors cite the fact that aircraft can be quickly placed into another carrier’s portfolio if positions or newer generation aircraft come available. But we still have not felt the full effects of the economy’s headwinds in my judgment.

At the same time the manufacturers are doing the industry no favors by perpetually delaying the delivery of the new generation aircraft that promise significant efficiencies and fuel savings. I found it most interesting in Continental’s announcement last week that it would park its older aircraft but continue to take delivery of new aircraft. This will be a story to watch.

7. Liquidity and US Airline Equities

Bill Greene, Morgan Stanley’s airline analyst, published another very good piece of research today where he continued to write on his tipping point theme. He writes: Too soon to begin buying US airlines, in our view. "As we’ve written in the past, we believe that amid the current macro backdrop, airlines will not become attractive investments until the industry reaches a Tipping Point - when extremely bearish fundamentals trigger broad, acute financial distress and restructuring that leads to significant capacity reductions (beyond current announcements); thus, serving as a very bullish catalyst for shares in surviving airlines. After updating our estimates for $130/bbl oil, it appears that a Tipping Point catalyst is more a question of when rather than if."

In Greene’s liquidity analysis of his tipping point theory, some very interesting findings are expressed. I have written often of liquidity concerns and that this period’s focus will remain firmly on the balance sheet and the cash flow statement. Yes we are in a cash burn scenario yet again. As Greene analyzes the airlines he covers, he points to the steeply downward sloping liquidity positions for each of the carriers assuming $3.81 jet fuel and taking into account all fixed obligations between now and the end of 2009.

Through 2009, he ranks the US airlines he covers from worst to best in terms of liquidity: US Airways, and a need to raise $1.5 billion to maintain a liquidity balance equal to 10 percent of last 12 month revenues; American, and a need to raise $2.6 billion to maintain a liquidity balance equal to 10 percent of last 12 month revenues; Northwest, and a need to raise $856 million to maintain a liquidity balance equal to 10 percent of last 12 month revenues; Continental, and a need to raise $260 million to maintain a liquidity balance equal to 10 percent of last 12 month revenues; United, and a need to raise $290 million to maintain a liquidity balance equal to 10 percent of last 12 month revenues; Delta with no need to raise cash; and jetBlue, with no need to raise cash.

8. Continental's Announcement of Capacity Cuts

Last week, Continental described in detail its planned capacity reductions. Can we learn anything from their list as we look toward the detailed cut announcements to be unfurled by United, American, Delta, US Airways and others as we approach fall? Markets with leisure attributes that demonstrate little to no hope of being able to charge for the full cost of fuel, let alone all other expenses associated with carrying a passenger from A to B will either be eliminated or cut back significantly. Long-haul regional jet flying will be scrutinized, and reduced, as Continental cut a number of these city pairs. City pair routings of a highly seasonal nature might be totally eliminated during the shoulder season. And while much has been made of the shift to international flying, Continental certainly demonstrated that underperforming international markets will be cut as well. Finally, the elimination of service to certain cities that offer little hope of ever being profitable were dropped from their network map. Distinct patterns will develop as other carriers make their announcements.

9. The Mixed LCC Bag

Samer A Majali from Royal Jordanian was named the new Chairman of IATA. In an interview where he discussed issues confronting the global airline industry, he stated that fuel prices to hit budget airlines the hardest. In the US we have witnessed this very issue. We have seen ATA liquidate; Skybus liquidate; Frontier file for Chapter 11 reorganization and still searching for capital; and just recently Sprit announced that it will begin to cut capacity and headcount. This is not a very good time to be a "bottom fisher". AirTran and jetBlue have each sold aircraft and/or delivery positions to bolster liquidity. A question to ask: what will Southwest do when it has to run an airline instead of a trading desk? Will Southwest become the savior for big leisure-oriented markets like Las Vegas and Orlando and will these will be the markets that “fuel their growth”? Southwest is the one that scares me on the capacity discipline issue.

10. Those Frothy Commodity Markets

Today, the Air Transport Association called on Congress for U.S. curbs on oil speculators. I just get nervous when this industry calls on Congress for anything as it seems to be an invitation for layering on more favors that tend to make this industry even more inefficient than it is. But I do understand the need to investigate anything and everything that could help in the jet fuel area.

Finally and based on my previous post, the world’s best golfer was crowned yesterday. Only issue is - he had already been identified.

Identifying the World’s (the US’s) Best

For the last 4 weeks, I have been preparing presentations, traveling to give presentations; only to fly home and do it again. And in that circle of overcommit, the blog received less than my full attention. I often thought about writing, but what to say? So, as I sit on another flight home with not a presentation due until a week from Tuesday, I get to play Caves Valley tomorrow in Baltimore. With a caddy in tow and good friends to catch up with, I look forward to playing one of the best golf venues in the Washington Metro area.

Speaking of golf, it is US Open Week. Play teed off at Torrey Pines on the South Course this morning. I had played Torrey many times before its recent refurbishment. Finally I played the redo last September and it is hard. Really hard. From the tees the tournament will be played at, the course is really long. The US Open is that one golf tournament played each year where the best in the world shoot scores (relative to their averages) and struggle like we do playing a nassau on the weekends. When asked why the United States Golf Association sets up Open courses so difficult, I believe it was David Fay that said: “we are not trying to embarrass the world’s best golfers, just identify them.”

The Open and Oil

My question today: is oil trying to embarrass the US and global industries, or just trying to identify the survivors?

I think the latter as the industry is being forced to try things not previously imagined: like charging for the first bag. American was the first to announce the idea and finally today someone (United) announced it would match – oh I mean follow American’s lead. And then in true lemming fashion, US Airways quickly announced its similar intention. I really do not like this idea at all. I understand it, but I don’t have to like it. The boarding process is already a goat rodeo and now we are going to herd cats at the same time.

I am fine with the second bag and I will just have to live with the cost of toting my golf clubs around the country and world to play the game because that is what I really love to do. I am fine with premium seating charges for the most part. I am fine with buying food on board. I am fine with fuel surcharges. But I would be most fine if the true cost of the trip ... fuel and other direct operating costs ... indirect operating costs ... and some reasonable rate of return ... could be reflected in the single price of a ticket. But transparency within each of the distribution channels, that just is not going to work ... I guess.

But what happens when the bag(s) the passenger paid to check do not arrive at the same time or the same destination? Passengers are angry when they do not arrive on time and we know that the traveling public has not paid the full cost for the service received since the beginning of time. So now they will pay for what will surely be perceived as an expected service. How will the air travel consumer’s expectations be affected by all of this? Will the industry deliver the service sold and thus fulfill the value proposition that is imbedded in the consumer’s purchase of other goods and services?

Just as the USGA says it is not looking to embarrass, there will be certain carriers in the industry that will be embarrassed by their inability to deliver. The value proposition needle is moving. Those that are embarrassed will have little to no chance of being identified as the world’s best as they will have played themselves out of contention in the first round.