A Recent Swelbar Interview

The ANALYST is the flagship publication of ICFAI University Press* which caters to a niche segment comprising finance professionals, bankers, academicians, economists, corporate executives and students. Just published.

The ANALYST: Delta Air Lines and Northwest Airlines have recently agreed to merge in a $3.1 billion deal. How do you see the deal?

Swelbar: I see the deal as the real beginning of the second phase of the restructuring of the US airline industry. The first phase began with the bankruptcy filings in 2002 and concluded with the emergence from bankruptcy of Delta and Northwest in early 2007. The industry (largely the legacy carriers) shed nearly $20 billion of cost during this period with nearly 60% of that being reductions in employees, rates of pay and benefit reductions. But the necessary cost reductions were designed to address a revenue environment that was increasingly influenced by the low cost carrier sector of the industry that had grown to nearly 30% of industry capacity. This created more competition with an industry that was producing $30 billion less in revenue as the relationship of revenue to GDP fundamentally shifted beginning in early 2001. The restructuring cuts were not made with the idea that oil would increase from $45 per barrel to $117 per barrel today. And it is the cost of oil today that is the catalyst underscoring that the restructuring work to make the industry sustainably profitable is far from done.

The ANALYST: What are the parameters considered at arriving at the deal?

Swelbar: I will answer this as the catalysts to consolidation: high oil; a softening economy both domestically and globally; increased global competition; and tightening credit conditions to name a few. The US domestic market, where all US carriers have the strong majority of their capacity deployed, remains a highly fragmented and hypercompetitive market. Therefore it is a most difficult space to realize higher fares absent the push from higher fuel. Today fares are on the increase domestically but not near enough to offset the cost of higher commodity prices. Therefore the industry is exploring two different paths: 1) consolidation of industry capacity through merger and acquisition activity; 2) consolidation through liquidation of airlines; and 3) consolidation of industry capacity by removing uneconomic capacity. Both strategies are being employed simultaneously and can be expected.

The ANALYST: What are the expected synergies of this deal?

Swelbar: Delta and Northwest, while announcing some capacity cuts prior to announcement of the deal, are betting that the linking of two end-to-end networks is the way to drive increased revenues without increasing flying expense. This is possible through a larger network providing for an increased number of new city pairs to sell. On the cost side, the combined carriers see that the ability to best match aircraft size to city pair markets will provide a cost savings going forward. As to other benefits, the North Atlantic alliance with Air France, KLM, Alitalia and CSA will remain and can only become more robust. Obviously Northwest's delivery position for new transoceanic equipment is a benefit. But most of all this is a step, among many, to continue to work toward finding a more stable platform for employees, communities and stockholders that stand alone plans cannot begin to guarantee. Is there risk? Yes. But there is arguably more risk with a stand-alone plan.

The ANALYST: What could be the challenges to this merged entity?

Swelbar: The obvious challenges are the age old challenges that present themselves when the US airline industry looks to consolidate: the regulators and organized labor. Change is difficult but an industry that took $20 billion of cost out of their combined operations and produced only two years of industry profitability underscores that the current industry structure is far from healthy. In addition the Congress is sure to raise consumer issues. But concerns that consolidation will raise prices are muted by the industry's fuel bill increasing by nearly $20 billion in 2008 versus 2007. Fares have to go up, otherwise we will have a bankrupt industry rather than a few bankrupt carriers. And the US market under deregulation has proven time and time again that if one carrier tries to gouge consumers in certain markets, there will be a lower cost provider ready and willing to exploit that market opportunity.

The ANALYST: How do you see the future of US airlines industry?

Swelbar: Honestly, I am concerned. Our market remains the most regulated, deregulated market in the world – or so it seems to me. And some of that regulation stems from parochial interests on Capitol Hill that somehow believes that if there is a runway, a terminal building and security that the airport is somehow entitled to air service – not whether the economics make sense. Consolidation along the lines of Delta and Northwest and others that might follow is but one step along the way. Globalization is an economic force that cannot be ignored. Recognition that the airline industry is a global industry would be a good start for the US policy makers. Recognition that US airlines need to be freed of the shackles that largely tie them to the US market need to be unlocked. Unless labor and policy makers can move their mindset away from believing that the US airline industry can support jobs and remain US-centric will only ensure that we continue to experience the boom and bust cycles that have been the rule for the industry over the last 30 years. And that has not proven to benefit anyone.

The ANALYST: Any other comments?

Swelbar: Unless something changes along the way that paves the path for a more globally focused US industry, I am afraid that we will see another icon like Pan Am or TWA disappear from the US landscape. Thank you for the opportunity to talk with you.

*this interview was done $20 per barrel ago.

Rambling, Musing and Pondering on Airline Industry Issues

In past years, the industry’s trade associations have not always been strong voices for issues, particularly economic issues, impacting the industry, whether it is the global industry or the US industry. In recent years that has changed. Each respective organization is fortunate to have two very capable Chief Economists: Bryan Pierce with the International Air Transport Association; and John Heimlich with the (US) Air Transport Association. The data and analysis provided by each should be a link on every serious industry watchers favorite list. And watch them daily, as meaningful insight is provided by each man.

The IATA Annual General Meeting opened today in Istanbul and IATA CEO Giovanni Bisignani warned that the global industry is on course to lose $2.3 billion if oil should average $107 per barrel and $6.1 billion if oil should average $135 per barrel. Less than a year ago, IATA was forecasting a global industry profit in excess of $10 billion. Bisignani has been a loud voice on the need for consolidation in the global industry citing important facts regarding this industry’s unhealthy and fragmented state. I really like this guy and I particularly like his call for a clean whiteboard as this blogger has wanted the UPS whiteboard guy to redraw the global map for some time.

United; United-US Airways; American; and Jim “Hell NO”berstar

I don’t know about you, but I am very happy that United said “NO” to walking down a road toward a formal combination with US Airways last week. Something just did not feel right about that one. Yes the labor issues were significant. The IT issues were significant. The combined networks left a bit to be desired from my perspective as the regulators would surely have required some auctioning off of valuable airline real estate. United has more than its share of problems to be sure, but the deal was far better for US Airways’ stakeholders from my perspective as there is little the Phoenix-based carrier could offer in terms of route portfolio diversification.

It took us 30 years to get into this mess and it will take time to get us out.

Despite industry consensus, Tilton did not pursue a deal for deal’s sake. Instead he said "NO" – at least from public reports. The historic US industry leaders – American and United – both began the process of battening down the hatches last week. Each carrier began to make announcements and pronouncements that their respective businesses would be managed in the near-term as stand-alone entities. So Jim “Hell NO”berstar looks less like a soothsayer as the wave of industry deals he suggested has come to a halt.

I like the decisions. I particularly like United’s decision because Tilton has been saying that the industry needs to restructure. Consolidation is part of the restructuring he has suggested. Consolidation has been the operative word used for mergers in the industry – but mergers rarely consolidate much if anything. Consolidation has been the scare word used by the naysayers to signal that consumers will get hurt. Consolidation has been used by labor to extract monopoly rent only to return to the bargaining table to give most of the rent won back to the respective company. Consolidation has been used by those on Capitol Hill to suggest that service will be lost.

Well, we are about to begin a real consolidation of the industry and it cannot be laid at the feet of a merger and acquisition proposal/era. Capacity will be cut because it is not economic to run individual networks of the scope that are operated today. Prices will go up, but not because of a merger and acquisition proposal but rather because a business that needs to pass on the costs of providing the service. Labor will negotiate their next contracts just as they have before, except for the Delta pilots that recognize that certain scope restrictions standing between revenue and principal are not in anyone’s interest. And the condition of the economic environment will be taken into account in either direct or mediated talks or whether the case lands in front of a Presidential Emergency Board.

American and United are, and will be making some tough decisions. Delta and Northwest have made a tough decision to join hands. But that decision is in the best interest of two companies that are so dependent on network scope to maintain service to a maximum number of points. Northwest would be particularly hard-pressed to maintain all of the service it provides. Continental is blessed by geography but still has fragility in its financial position. And the question becomes for the remaining legacy carrier, is US Airways’ cursed?

As for the sectors incorrectly referred to as Low Cost and Other Carriers: Southwest is blessed with capital and well all that is-Southwest; Alaska, jetBlue and Virgin America are arguably blessed with a brand; and AirTran is blessed – in the near-term with flexibility of selling off delivery positions to help it today - but could hinder it tomorrow when the market does make a turn for the positive.

This really is a cool time in the industry’s history. A time that will be embraced by the survivors. The "oil era" will be sure to have its place in history. And for some the slippery slope caused by the commodity will land some in airline oblivion; for others it will end on a path toward something much better than today.

The Price of Oil and Attributes of a “Bubble”

Over the weekend, a number of articles appeared suggesting that the oil chart replicates some of the stock – or shall we call them commodities’ – charts of the late 90’s. One thing I have learned from years in this industry is not to second guess the markets and not to try and predict the price of oil. Do today’s oil prices have “bubble” attributes in the traditional sense – yes. Does history suggest that anything that is market influenced will remain on this trajectory – no. And this is yet another reason why, if I am labor, I would be putting some chips with insurance on the come line. Leverage with the business is the only hope of coming close to replacing a majority of what was given up during the restructuring period. Only it will be in a one-time payment and not a legacy payment embedded in a contract.

CEOs, Policy Makers and Shareholders

I like to refer to today’s CEOs as “Agents of Change”. Popular? – no. Hell bent on change – yes. Standing in the way of preventing the past practice of doing business – yes. Concerned about their place in history – yes. Afraid to get dirt thrown their way in the process – no. Bringing the shareholder into the “virtuous circle” of airline industry prosperity – yes.

With the exception of Delta-Northwest, the litmus test is underway. Each of the legacy carriers is on a path toward restructuring their respective businesses. The naysayers should be happy. Of the six legacy names, the current construct will preserve five. Yet service will be cut and prices will go up – and it will not be because of consolidation in its historic definition. It will be of business decisions necessary to preserve the capital of the day’s stakeholders. Not all of them. But….. Today’s CEOs will do that as their fiduciary duties begin and end with that fundamental charge.

Labor will be tested and will probably say on some Monday morning: “Man, that merger proposal may have been better than riding out a business that has to make these decisions to cut, cut, cut”. Congress will ask: “Maybe this business is not a utility that serves my region’s airport? Some sort of rethinking the emotional issues may have provided my constituents with something better?” Regulators will say: “I knew if we kept our hands off the US market would be better served”. And hopefully the Executive Branch policy makers will say: “this boom and bust is good for no one, so let’s give them a clean whiteboard and if it gets out of hand will step up. But the way we are doing this just does not work”.

And the shareholders will finally say: “the barriers – oh I mean excuses – have been removed and if this guy cannot do it now then let’s find another guy”.

Contrasting the APA Message with the APFA Message

American Airlines Negotiations. As flight attendant negotiations begin at American, please read the following message on the AA negotiations site. My guess is that this did not go online without some agreement on words and message. What a difference a day makes. (edited 5/29)

American Airlines and the Allied Pilots Association: A $3 Billion Question

On October 26, 2007, I wrote Just Put It On Ice: American’s Ability to Pay ≠ APA’s Expectations. I followed on in December of 2007 when I wrote Maybe the Allied Pilots Association Is Really Onto Something where I attempted a cynical response to address the union’s scope proposal. Today, May, 27, 2008, American management put a number to the cost of the APA’s numerous proposals and discussed it on their negotiations website.

When I made a back of the envelope attempt to price out the opener based on the proposals on the table in October (no new scope or new pension proposals had been made by APA at that time), I made the comment that this was one rich deal. And that the cost would be a three-comma number. And for making that educated guess, I received many comments from certain APA members (and I encourage you to (re)read them). Well, American estimates that the “all-in” number including wage increases, productivity improvements, scope standing in the way of revenue earned today that would be prohibited tomorrow and further improvements in the network carrier’s best pension program is: a cool $3 billion.

Yes, $3 billion annually as the number excludes the one-time payment of a signing bonus proposed by the APA . Whereas there may be some issue with the company’s costing, the number dwarfs even the “unaffordable” $700-800 million estimated by the Allied Pilots Association of its proposal. Based on a career spent around labor negotiations, the $3 billion zip code sounds about right.

A Failure In Leadership

And please do not write that a company gets the union it deserves.

I too listened to the APA podcast referenced by American in its statement today. I smiled as I listened to the enlightened Lloyd Hill suggest to Jason Goldberg in the canned interview that significant contractual improvements can be made during difficult economic periods. In fact, Hill referenced the contract won in the early 90’s. I guess he was suggesting that today’s issues are easier to navigate than the slowdown in the economy and the outbreak of the Gulf War at that time. NOT.

If I am a 50 year old American Airlines’ pilot today, I would be starting to get a little nervous. Erecting billboards; picketing the Board of Directors, Wall Street, and the airline's best customers; spreading misinformation across every available medium; may seem to have an effect and help to generate leverage. These reckless actions haven’t increased the union’s leverage and they won’t. All they are doing is cleaning the lens for everyone to better evaluate the APA’s asks and truly question their motives. This time, APA and all airline labor will learn that the leverage they are seeking to gain is held by capital and oil.

It has been said on this blog’s comments that I have a disdain for airline employees. My response is that I have nothing against airline employees, but I do have a disdain for reckless union leadership. And while reckless leadership can be found at many airlines today, there is none more reckless than the Allied Pilots Association. And every day that there is a new public action undertaken or announced by them, I am reminded of Eastern Airlines and the actions of one Charlie Bryan.

There Is Nothing to Mediate

When I wrote Just Put It On Ice last October, my back of the envelope calculations suggested that American management is faced with a pilot contract that should be cut by $500 million. Therefore based on the APA ask, my best guess is that the company and the union were $1.5 – 2 billion apart. But the company was not, and has not been, asking for reductions. So let’s call it $1.0 – 1.5 billion apart at the time. I certainly appreciate that my estimates have no weight. But if the company’s estimates discussed today are remotely close, what is there to mediate?

With differences of this magnitude, there is little to discuss and nothing to mediate. Even with the best one-sided economic analysis that the union can make, the gulf between APA’s ask and AA’s ability to pay cannot be closed sufficiently to even consider a meaningful mediation process. Other than mediating our way to a Presidential Emergency Board in 2 years or so I see little to be gained. And we still have not even discussed how we might improve the earnings of the vast majority of American’s employees.

As I wrote earlier, I am beginning to think that there is a silver lining in the high cost of fuel in that it will force a changed industry structure. Maybe there is the same silver lining in reckless union leadership at certain carriers during this fragile period in that the collateral damage would be limited. And the opportunities for the remainder of the industry to pick up the pieces will be greater – and in an American-less US industry, much greater.

Unbundling Our Way On The Search To Find The Inelastic Demand

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

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

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

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

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

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

Gerard Arpey’s Words

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

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

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

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

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

Concluding Thoughts

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

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

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

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

More to come.

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

Wednesday’s Hearings: “Forgetting About History”

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

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

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

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

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

Pondering the Next Move

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

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

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

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

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

LIQUIDITY AND SOUTHWEST AND UNITED

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

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

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

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

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

Now This Is A Little More About What I Have Been Talkin' About

Reuters reports today on US position as Phase II of US-EU liberalization talks set to begin in Slovenia later this week: UPDATE 2-US suprises EU with global airline ownership plan.

More to come.

Back to the Future?

In a comment to my most recent, and only, post thus far in May a reader asked if I was suffering from Airline Fatigue Syndrome? I am thinking yes. I look at the news today and I see that Frontier is going to start flying to Fargo. WOW. And Virgin America is going to start flying to Chicago. WOW again. And Sun Country did Mother’s Day with flowers. Double WOW.

I admit I am hung up on wanting a real transformation of the industry – or at least a sense that one is underway. I want the UPS guy to redraw the lines without labor or political interference and present us with a way to work toward making each of those stakeholders more secure in tomorrow’s rendering of the US and global airline architecture.

I do not remember a time when more balance sheet risk presented itself. In the past there was typically a carrier or group of carriers that you were sure would emerge from the trials of a particular period. This time you give a nod to Southwest given the health of their balance sheet and their current hedge positions. After that, it is clear as mud.

I lectured today on issues confronting the industry and its evolution. We talked about the current actions being undertaken that feel like recycled ideas. We talked about Phase I of the US-EU deal and its lack of transformational attributes – unless Phase II is successfully negotiated. We talked about Delta – Northwest and the revenue synergy concept that they are employing -- and how it looks and feels a bit like the combinations of Air France/KLM and Lufthansa/Swiss. We talked about a potential United – US Airways deal and asked if the third time might be a charm?

We talked about the fragility of networks. At some point, the downsizing of a network collapses under its own weight. We talked about the dollar versus foreign currencies and the competitive advantage currently being enjoyed by our non-US competitors in reinvestment, growth and in the purchase of fuel. We talked about the need to raise fares, cover input costs and the need to emerge from the long-term value destruction cycle that has described this industry. We talked about the drive to find the inelastic demand component.

We talked about the difficulty of placing meaningful raises into the pockets of labor given all of the externalities impacting the industry – and we barely talked about the infrastructure. We talked about politics and their impact on the current industry structure. We talked about how the US does not have a strong bearer of the flag in foreign markets. We talked……..

Back to the Future

Maybe we do need to look back before we can go forward. Remember when we talked about yield and not RASM? Remember when we had turboprops with limited range that married them to a geographically centered hub market? Remember when we actually talked more about operating profits than EBITDAR? Remember when load factor was a data point and not the mantra?

Not that there was ever structural stability during these points in time either, but fuel is the real deal. It just might be that catalyst for change that has been missing during the deregulation experiment. And if the change causes an industry to be disciplined enough to charge the passenger "all-in plus some return on capital", then we just might look back and call this time the best thing that happened to the US airline industry.

Let's get smaller (whether by commercial choice or by market forces); focus on yield and not RASM; get rid of duplicative hub feed (whether by commercial choice or by market forces); and forget about load factor that is won largely by not charging anywhere near enough for those final 10, 20, 30 or even 40 seats. Surely these actions would lead us to some capacity level less than today and approaches an economic level.

As cp5000 commented on the previous post: “And assuming the industry is successful in raising fares (which they must), what alternatives will benefit? More teleconferencing, more driving, more conference calls? I don’t know. That question at least is new and fresh. Better than the same old, same old”.

“The market place is working. It is not pretty, nor should it be. More change has to come – hard to say what it is going to be. Stay tuned”.

Yawn

This post represents the longest period between pieces for me since I started swelblog.com in October of 2007. Change has been the theme to date. Change will continue to be a theme. Bloggers typically are not sources for news. Instead we rely on reports from the Wall Street Journal, the Financial Times, Bloomberg and other trusted sources for the news and views.

Last Monday, Susan Carey and Melanie Trottman wrote: Continental Rejects Merger Overtures. The subtitle read: Move Marks Rebuke to Rival United; Shifting Alliances? OK. That story ran on A1. Today Susan Carey writes a piece entitled: UAL Merger Discussions With US Airways Intensify. The subtitle reads: Companies See $1.5 Billion In Savings, Synergies; Decision Within 10 Days. Yawn. This story ran on B1. And of course the story comes replete with the now familiar disclaimer: “according to people familiar with the matter”.

In the past, news of airline mergers and potential structural changes in the industry had an air of intrigue and suggested something new in the age old debate was about to emerge. Not this time. Throughout this current period of M&A discussion, I have hoped for something that suggests a path toward transforming of the industry. Something different. Something that tests the current shackles that tie the industry to the same old, same old.

Something like British Airways testing the ownership limits and investing in American and/or Continental. Deal is intended to highlight the importance of the subject as the US and EU negotiate Phase II. Or, labor agrees to a single collective bargaining agreement that makes changes to scope that opens up the globe to new revenue sources all the while protecting US jobs and ensuring that growth will largely remain with the US carriers involved. In return, labor wins meaningful equity in the deal and ties compensation to the same metrics as management. The changed compensation structure begins the process of aligning interests in the company's success.

But I think the market will be the ultimate driver of change. Not the carriers themselves. But maybe that is the good news in all of this and honestly, the only way it can get done.

Transition v. Transformation (Labor Actions Hold A Key)

No matter what direction the industry was going to fly following the emergence of Delta and Northwest from Bankruptcy in early 2007, the subsequent five years or so was going to be a period of transition. The era was sure to be marked by increased competition from non-US carriers; higher oil prices; an economy that was tiring; and more than likely a recognition that no carrier that filed for protection probably had done enough, or tried to preserve too much, given the trajectory of the oil curve.

Then we were going to be faced by the demands of labor to return what was conceded during the restructuring period. Because that is the way it has always been. Right? So maybe it is labor, and their ultimate actions, that is the transition. The transition to transformation? And this transition holds a high probability of the death of an icon.

We already schooled on the many labor issues surrounding Delta and Northwest. But United and US Airways provide their own interesting twists. And those twists begin with the pilots.

No group of pilots has even approached the unrealistic and "head shaking" behaviors of the American Airlines’ pilots except for the former US Airways pilots (US Airways East). These are the pilots that chose to form an independent union by selling an unachievable (from this writer’s opinion, anyway) overturn of an arbitrator’s decision regarding seniority integration of the former America West and US Airways pilots.

But if United and US Airways do decide to join hands, some very interesting possibilities come to the fore. With 5,000 United pilots represented by ALPA; 2,200 former America West pilots that largely voted for ALPA I would guess; and the 2,700 or so former US Airways East pilots that bought the pipe dream sold by the USAPA upstart – an election for representation is all but ensured. And ALPA would likely win. The integration would more than likely get done - yet again. This is the best hope for the former US Airways' East pilots who should recognize that they were fortunate to have found a way out of Chapter 22.

As for the concept of rent sharing discussed in the previous post, a combination of United and US Airways would result in less transfer of capital from the deal and into hush money paid to labor given the relative proximity of average salaries and productivity levels of the two groups.

A United – US Airways combination would also prove most interesting for the flight attendant group as the AFA-CWA represents not only the United class and craft but each the former US Airways and former America West flight attendants as well. From my perspective, this could very well become a “game changer” in the AFA’s attempt to organize the current Delta flight attendants. AFA will be put under the spotlight as to how the union will deal with the integration of its own members that are sure to have varied interests.

As for the other represented groups in the United – US Airways combination, labor stories exist but they are less headline making than what could go on with each the pilots and flight attendants in this scenario.

Over The Weekend, A Comment From a Reader

In my most recent post, Swelblog.com: Let’s Just Continue the War of Attrition, cp5000 commented: “Bottom line is that in a free market, management and labor are free to do whatever they please and capital should be able to make its way to those companies that make arrangements with their work groups that make sense to the providers of capital. Letting the market place sort this all out is difficult for a politician, particularly for a politician from an area that will lose jobs due to the workings of the market. However, our political leaders should be able to see that the pain experienced by some in the past has led to many benefits today”.

cp was speaking to events like the loss of TWA that arguably provided for the opportunity for jetBlue to be granted the slots necessary at JFK that were instrumental to its successful start. The demise of Pan Am was critical to United building Asia and gaining early access to London Heathrow. It could be said that the loss of Eastern ultimately created the vacuum for AirTran today as it has morphed from its prior incarnation as ValuJet. And Southwest has just “triangulated” its way through it all and now has its footprint in all four corners of the US domestic market..

Charlie Bryan’s Tombstone Would Probably Like Some Company

Whether it be the integration of seniority, the overreach for corporate rents by various stakeholder groups, or the failure to recognize that the historic patterns of bargaining and capital recycling are over – labor will definitely play a role in this transition period.

In a post on October 21, 2007, I wrote a piece where I was addressing employee and community entitlement to employment and air service. “Defining Entitlement Economics: all are conferred a lifelong right to employment and/or abundant service despite the fact that the economics of the US airline industry, particularly its domestic operations, have changed significantly since the early 1990’s”. Nobody is entitled to a lifelong right of anything.

Why this period is not viewed as an opportunity by labor and policymakers, I just do not know. Instead opponents will point to executive compensation; service problems; loss of service; a menu of potential dislocations; and just plain ignore the economic reality that this industry needs to figure out how to make money. Period. That is the only thing that will benefit everyone.

Yawning at United – US Airways and the drumbeat in anticipation of it. Not sure if I am just weary of the tired refrain of executive compensation and entitlement of economics and seniority; or if bored because the arguments and scare tactics remain the same all the while the world around the arguments continues to change; or if oil is just sucking the oxygen out of the industry and limiting the interesting things that could be done proactively. But I will be patient as some great stories and perspective will emerge.

Or maybe it is simply because I celebrate five decades of life on Thursday. I probably should have written this piece on Mayday. But it is Cinco de Mayo.

Let’s Just Continue the War of Attrition

Considering the Concept of "Rent Sharing"

Maybe the best answer to US airline industry woes is the same path followed in the early 1990’s when iconic names like Pan Am and Eastern liquidated.

I understand Continental’s thinking, I think. They have many attributes that are viewed in previous consolidation periods as positives: youngish fleet; decent, if not good, labor relations; hubs/gateways in markets with strong underlying local demand; hubs/gateways in markets that have interest not only to those in the US but around the globe; and a respected management team that has not only devised a plan but has acted on it. But they still have a fragile balance sheet just like the rest of the US industry.

Kevin Crissey at UBS writes this morning on Continental’s attitude toward consolidation: “We believe CAL mgmt view consolidation as beneficial over the long run but much less so in the short run as labor would take a big cut of the synergies. With fuel and demand draining life from the sector, mgmt appears to be focusing on CAL's survival and likely views a merger as increasing bankruptcy risk”. Continuing to beat that fuel issue to death, my only question is what is the short-term and what is the long-term for the US industry? Is the short-term six months or is it two years?

Mr. Crissey was right to raise the labor situation and the negative impact on any short-term synergies that might be gained from the overall deal. In last week’s congressional hearings on the Delta-Northwest hearings, I believe that Dr. Clifford Winston of the Brookings Institute referred to the topic as “rent sharing”. The negative synergies in "rent sharing" between labor and the deal in the case of Continental and United are somewhere in the $300 – 400 million range, or double those in the Northwest – Delta case.

But rates of pay are only half of the story. Continental’s pilots are more productive than United’s pilots per month based on publically available data in 2006. If that were to be the case, the Airline Data Project estimates that the increase in productivity to Continental levels would mean that 460 fewer United pilots would be needed. While final 2007 numbers will not be available for another six weeks, rate and productivity calculations underscore just one of many difficulties faced in estimating the offset of overall network synergies by the “rent sharing” calculation between management and labor.

On both the compensation and productivity calculations included in the Airline Data Project, please read the footnote that suggests problems with the US Airways and America West calculations for 2006. Further, and based on the calculations there should be no secret as to the difficulties American has in considering whether to play in this round of consolidation or not. The math for them is particularly difficult.

So maybe we just will not be able to get there. Bankruptcy is less an option unless it is a liquidating bankruptcy like we saw most recently with American and TWA where American purchased the assets of TWA. The few combinations left to consider do little to address the immediate need to minimize exposure to the US domestic market unless the opponents to change recognize that the current structure is simply not healthy. US Airways has too many eggs in the US domestic market basket. Hell, everyone has too many eggs in that basket.

Maybe we should start thinking about consolidation as the world thinks about our marketplace and engage in a consolidation of North America and bring Air Canada and Mexico fully into the conversation. This idea would address the US centric mindset that seems to dominate the conversations among the naysayers.

Talk about a bad time to be a CEO in the airline industry. Someone has to get their fingernails dirty. To be sure, private equity would not want to touch the issues left for the industry to work through. Last night, United said in a statement following the Continental Board’s decision: "Ensuring you have the right partner is everything,"

As the late Johnny Cochran might have said: If it doesn’t fit, you must attrit. And in the long run the survivors will benefit.

Reflecting on Today’s Congressional Testimony in the DL-NW Deal

I did my best to listen to as much of each hearing as I could today. I certainly found the Senate hearing much more interesting than the House hearing. The only players to testify in each hearing were Delta CEO Richard Anderson and Northwest CEO Doug Steenland. For the most part, similar testimony was offered in each the House and Senate hearings.

I did think both CEOs were much better and much sharper in the Senate give and take. But I sure did feel the pain for Anderson as he tried in many ways to describe how networks work and how networks can create new product as the nodes are leveraged post-deal. Both were particularly good in the afternoon discussing the fuel issue and Steenland finally reminded everyone of the fact that the weak dollar versus virtually any world currency is just another issue weakening the competitive posture of US airlines today.

But the other two panelists in the Senate session?………And for me the most interesting testimony was from Kevin Mitchell of the Business Travel Coalition.

12 Mitchellisms

I just cannot help myself and will spend a little time picking out some of my highlights from the testimony of each Kevin Mitchell of the Business Travel Coalition and Dr. Darren Bush of the University of Houston Law Center -- and I am just not sure what he was saying. No, I will spend virtually all of my time with Mr. Mitchell’s testimony as he has been around this industry a long time, and well…….should know better on many points.

In his first full paragraph of his overview, Mitchell rightfully discusses the importance for the Department of Justice to evaluate competition from both a city pair and network perspectives. Then the 5 minutes of scare tactics begin. Mitchell #1: “Moreover, Congress needs to understand the total consumer costs resulting from massive service disruptions and the degradation of the reliability of the system. The direct, indirect and opportunity costs for mid-size communities that lose efficient connectivity to important business centers around the country and globe need to be quantified”.

The reliability of the system? Don’t you think that the government has a significant stake and has failed the consumer, and small and mid-size communities, by failing to upgrade the very air traffic control system within which the carriers operate? It seems to me that even without these high fuel costs that the industry may not be in such “dire straits” if it did not need to add time to the schedule each quarter because of the system’s inefficiency. “money for nothin’”.

If the economics are not there, just because an airport has a runway, a terminal and security does not mean that the airport market is entitled to air service. Maybe another question could be: how have global forces impacted that community and possibly moved much of the economic base away because they were simply not competitive? A fair question to ask before laying it all at the feet of the industry. More simply, if those customers are willing to pay the cost for the service, then they will continue to receive the service.

Mitchell #2: “The managements of Delta and Northwest drove their companies into painful bankruptcies”. Based on what we know about Gerry Grinstein, my guess is bankruptcy was the last arena he preferred to visit. As for Northwest, they along with their labor, worked arduously to avoid a trip to a court-assisted restructuring and stood with labor on the pension issue along that troubled road. Management did not drive anyone in. Market forces did. And each carrier had very different competitive reasons for filing.

Mitchell #3: “With respect to Delta / Northwest, how can one accept that there are billions of dollars in revenue synergy when there are no plans to restructure either network? Unless Delta can convince expert outsiders of something on the order of $5 billion dollars in readily achievable synergies, there is no possibility that this merger could benefit consumers or the public interest”. No plans to restructure either network? Why did they want a complete pilot deal done first? So they could immediately begin to move aircraft around the network to best match aircraft to market sizes I thought. $5 billion in achievable synergies? Well you must have been much more a fan of the US Airways hostile as it did involve capacity cuts that would have been much greater than anything considered here even with the announcements made on each of the carrier’s earnings calls.

Mitchell #4: “The Delta / Northwest proposal emphasizes all of the features of past mergers that have consistently failed and doesn’t exploit any of the synergies of the rare mergers that did produce positive returns, e.g., TWA / Ozark and Northwest / Republic”. You did forget Delta-Western. What I find most interesting about your statement is that each of these mergers, except Delta-Western removed a competing carrier sharing the same hub. Talk about anti-competitive!? My flip comment on the mergers in the mid 80's was if they approve these, then anything goes.

Mitchell #5: “Megamergers create a risk of an operational meltdown that could cripple the nation’s aviation system". Fuel prices and the lack of merger-related synergies would create huge pressures to cut corners on implementation spending, creating pressures that would exacerbate conflicts with (and among) employee groups”. You are right, economic forces, competitive forces, antiquated air traffic control systems and uncontrollable crude and refining costs have no effect at all – so blame it on M&A activity [please read with tongue in cheek].

And further each carrier today, operating as a stand alone, will avoid the fates of Aloha, ATA, Skybus and Frontier? For someone that has made fares a career, do not forget that it is an accepted principle that volatile prices are most unsettling on commodity industries – and the US airline industry has become a commodity industry. Any one of your members should do a net present value calculation on travel expenditures and compare it to other input costs that they have paid.

Mitchell #6: “Merged mega airlines will leverage their route structures to dictate terms and conditions (pay more for less) to corporate buyers, even for those airline pairings without significant route overlap”. Mr. Mitchell, consumers are going to pay more. And if they don’t, labor is part of your constituency and they would not get anymore either. On the more for less issue. Short-term maybe. But this industry knows it has been lacking in making both aircraft and non-aircraft capital expenditures in the business and the most recent earnings announcements suggest they will get further cut back. For virtually every carrier, another trip to bankruptcy is not an option – and Southwest, jetBlue and AirTran are not the option for the constituency you represent.

Mitchell #7: “Coordinated Effects. Going from 6 to 5 airlines would make fare increases easier to stick, especially if Northwest were absorbed into another large carrier because this carrier has often played the role of the “spoiler.” And of course, the problem with fare increases is even more enormous if the industry goes from 6 to 3 super major carriers. United Airlines recently brought back the infamous Saturday Night Stay requirement that will virtually fence-off lower-priced fares for business travelers increasing ticket prices by hundreds of dollars”. Market forces are the catalyst. All sectors of the industry are affected by the current environment. No more free lunch. But again I impress on you to do that net present value analysis I suggested earlier.

Mitchell #8: “Congress should be concerned with the market power of super-mega airlines and their incentive and means to frustrate new airline entry at hub airports”. With the low cost carriers approaching 30% of US domestic market share, your scare tactic that suggests low barriers to entry are simply not true. The US market should not fear individual carrier failures or consolidation. Indeed, this market has demonstrated time and time again that where competition is vulnerable, a new entrant will exploit that vulnerability. Where there are market opportunities, there will be a carrier to leverage that opportunity. Where there is insufficient capacity, capacity will be sure to find the insufficiency.

Mitchell #9: “Congress should also view with great concern the increased joint purchasing power of the global alliances (buying groups) with respect to their ability to exercise monopsony power and drive supplier prices below competitive levels”. To suggest the current laws and regulations even permit this type of action by US airlines is yet another scare tactic. Yes the world will evolve. And alliances are nothing but a band-aid to access the world.

Mitchell #10: “The primarily objective and dirty little secret of these megamergers is the permanent end to meaningful competition between the U.S. and Continental Europe—two airline competitor groupings would control 90-95% of a profitable, growing market of over 30 million people, where there would be zero possibility of new competition”. This is among the more laughable suggestions. Whereas the European-based carriers are healthy today, have you noted the downgrades on British Airways; the story surrounding the continent’s sixth largest carrier, Alitalia; continued moves toward further consolidation that make the Europeans stronger? Further have you noted that Europe’s next competitor originates in the Middle East? To suggest that the game’s conclusion is now decided is another unfortunate scare tactic.

Mitchell #11: “All of the potential external funding for Northwest / Delta and United / Continental would come from the European airlines that would be the leaders of this two-airline duopoly, Air France and Lufthansa”. Interesting comment. Most interesting, as they are not participating in the deal that has been presented. I am not saying that Air France will not, but interesting. And Lufthansa invested $300 million in jetBlue but you did not mention that.

Mitchell #12: No comments on your conclusion.

Thank goodness, Cliff Winston of the Brooking Institution testified today so that market forces could get entered into the record. Not sure what the unions were trying to accomplish as you cannot have a seat at the table until you set the table. My guess is you will have a seat once you have made it clear that that a collective bargaining agent outweighs other options.

Much more to say. Much more to come.

The Elastic Induced Ride to Inelasticity

I do not know what you have been doing this morning, but I have been listening to the earnings calls at AirTran Airways and United Airlines. Last week I listened to both American Airlines and Continental Airlines talk to the analysts. It is an accepted principle that volatile prices are most unsettling on commodity industries – and the US airline industry has become a commodity industry.

Beginning in late 2000, volatile prices came in the form of decreasing fares. Today, volatile prices come in the form of rising oil prices.

The initial ride down in fares resulted in the growth of the low cost carrier segment of the industry. That sector's rise occured commensurately with the shrinkage of the network legacy carrier capacity in the US domestic market. The new world of lower ticket prices forced necessary cost changes on the network carrier segment, altered the demand calculus and led many observers to conclude that high load factors demonstrated that there was no overcapacity in the market.

Ah, that elasticity of demand thing. The notion that an airline could fill every seat – but at some price that does not cover the cost -- underscores this shallow approach to the analysis of overcapacity.

Well, the rubber band is about to snap.

In a post last week,: This Week’s Conversation Will Be In Words that Start With “C”, I discussed capacity issues and a whole lot of other “C” words we’re going to be hearing more of as US airlines unveil their financial performance for the first quarter of this year. Covenants; credit card holdbacks; cash; capacity cuts; capx spending plans . . . all are being discussed as liquidity concerns are again top of mind for the industry just like they were in late 2001 and 2002. And I’m not even including consolidation. Based on the market’s embrace (or lack thereof) of the proposed Delta and Northwest merger, there are bigger and more fundamental questions to answer.

And every company has been asked how they might raise cash down the line if needed.

The unhealthy revenue environment that began to form in late 2000 is simply not capable of offsetting the daily spikes in fuel costs that began in 2004. Therefore the industry is left with difficult decisions regarding capacity reductions – a recurring theme as carriers announce additional cuts and slowdowns. Today United, keeping with its aggressive posture, announced the most aggressive capacity cuts of any carrier reporting to date. But say what you will about aggressive management actions, United’s first quarter numbers are hard to swallow.

Capacity reductions will ultimately lead to finding that demand which is inelastic. An elastic demand is one in which the change in quantity demanded due to a change in price is large. An inelastic demand is one in which the change in quantity demanded due to a change in price is small. Volatile changes in price need to be addressed/minimized for this industry to be healthy again – or at least produce that level of supply where costs can be passed on to the consumer. That is where we are headed and it is the right direction. Furthermore, I heard United make it clear on their call that unitary elasticity is not in their interest until it applies to a much smaller segment of their ridership.

Concluding Thoughts

Believe as we might, this industry is not impervious to outside influences that impact every industry. Those influences come in different ways. There will be some consumers displaced by some of these necessary pricing actions. There will be some consumers put out by the sense that they are being nickled and dimed for a change policy, a preferred seat, a second bag that consumes fuel by its weight, or even a meal. There is no free lunch as life teaches us everyday. And for the US airline industry, finally we are saying that no one is entitled to a free ride or at least a ride where the consumer does not pay for the cost of that carriage.

And I wrote this without mentioning force majeur or the need to craft a Failing Industry Doctrine.