US Airline Labor Says Cyclical; Reality Says Secular

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

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

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

The Reality of Today’s Airline Revenue Environment

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

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

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

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

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

The US Airline Industry is Neither Flexible Nor Agile

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

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

Using Pilot Labor as an Example

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

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

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

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

You Cannot Look at Labor Costs without Understanding Productivity and Revenue

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

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

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

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

Simply, Changes Are Secular and Not Cyclic

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

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

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

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

Again Dear Richard: You Are Not A Virgin Anymore

This article is a repost of a piece written last October.  As Virgin Atlantic boss Sir Richard Branson lobbies President Obama and the US Congress to reject antitrust immunity for American Airlines/British Airways/Iberia/Finnair/Royal Jordanian - I find myself well ........ blown away that a British company should have any say in US competition policy.  US airlines cannot operate as true global companies because of parochial thinking lawmakers like Jim Oberstar.  In case you did not read before, see below.

One of the more amusing bumper stickers I have ever seen/read occurred at an intersection of Woodland Avenue and Jean Duluth Road in Duluth, Minnesota. I was a senior in high school and had been driving for a year and a half or so. The bumper sticker read: Virgins: Thanks for Nothin’.

Last week, Terry Maxon of the Dallas Morning News Airline Biz blog wrote a piece discussing the data analysis that Virgin Atlantic is using to frame the antitrust immunity application recently filed by American, British Airways and Iberia. We will touch on a few of those issues later and in future posts. But first, I have held a late August 2008 interview with Branson done by Karl West of the UK's Daily Mail that I would like to speak to.

West writes that “he [Branson] believes an alliance of the two giant airlines, plus BA merger partner Iberia, would allow them to dictate the market, charging higher prices between Europe and America." This makes no sense to me whatsoever because if it is high prices you are worried about, then who better than your own Virgin Atlantic, to offer lower prices and show the air travel consumer that you are the answer to their high air fare plight.

Your business model takes you to only the largest metropolitan areas, so your pricing actions will benefit the lion’s share of US – London Heathrow (LHR) demand. Because of your “network’s presence” in these large markets, you have, and will continue to have, a strong voice in attracting these customers because your product offering is very good and even different.

Whether it is the US domestic market or the transatlantic market, mature/maturing airline markets have 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. Simply, if the US - LHR market shows signs of “price gouging” by BA/AA, then surely Virgin Atlantic is among the best positioned to discipline the behavior.

West’s interview was the first one done with Branson following the BA/AA announcement that they would try for an immunized alliance for the third time. Branson believes the 'monster monopoly' will be bad for passengers, bad for competition, and will result in higher ticket prices. “It patently does not make sense,” he fumes. “Monopolies are good for companies, but they are never good for the consumer.” Branson adds: “BA has improved as an airline as a result of Virgin Atlantic keeping them honest.”

First of all where is the monopoly?

To answer that, I turned to Wikipedia for a definition. In Economics, a monopoly exists when a specific individual or enterprise has sufficient control over a particular product or service to determine significantly the terms on which other individuals shall have access to it. Monopolies are thus characterized by a lack of economic competition for the good or service that they provide and a lack of viable substitute goods. Monopoly through integration: A monopoly may be created through vertical integration or horizontal integration. The situation in which a company takes over another in the same business, thus eliminating a competitor (competition) describes a horizontal monopoly (and that is what you are talking about I believe).

Surely no one believes that a monopoly would exist, or even be created, by granting Anti-Trust Immunity (ATI) to BA/AA/IB between the US and LHR. Branson’s arguments are LHR-centric and totally ignore the fact that the airline industry is a network business today and not the cozy structure protected by Bermuda II when Virgin Atlantic first flew in 1984. Yes, LHR is coveted, and is served, by nearly every major carrier of substance from around the world. Those US carriers that were not permitted to serve LHR are now allowed to serve the market and provide Bermuda II incumbents with significant new competition.

But fundamentally, today’s airline industry is about networks and not city pairs. It is a simple fact that oneworld cannot sit and watch STAR and SkyTeam grow anymore. Air France/KLM and Lufthansa/Swiss have grown into the world’s largest revenue producing airlines. Delta and Northwest [completed] will alter the ranking once their merger is approved but that will probably only last as long as it takes Lufthansa to get its hands on SAS and/or Austrian. Branson mentions his thirst for British Midland (BMI) and its extensive LHR slot holdings, but what about Lufthansa’s option on those LHR slots? Surely Richard you are not implying that with meaningful STAR alliance presence at LHR a oneworld monopoly would exist?

Branson talks in the interview about how AA and BA are using the current difficult economic and operating environment to accomplish what they have not been able to accomplish in two prior attempts. Quite honestly Richard, the entire world is being forced to transform their business models to adapt to the new realities.

US carriers are using this time to make difficult decisions on capacity cuts in order to diversify their route structures away from an over-weighted position in the US domestic market. Maybe you should be questioning whether Virgin Atlantic should be considering something other than LHR. Oh you have with Virgin Blue, Virgin Nigeria (and you might sell your stake in that Virgin) and Virgin America.

Or maybe you should be putting more energy into changing the ownership laws in order that Virgin Atlantic can realize all possible synergies from your family of Virgins. Abstinence from industry realities might be safe in the short-term but potentially lonely over the long term. You talk about the AA/BA/IB’s ability to strong arm travel agents and corporate customers. You are a branding genius and now you are saying that you cannot differentiate your product from AA/BA?

At what point do we take you serious?

Your data arguments are weak as well. It is about the local US – London/LHR market and that does need to be studied just as it is done on other deals. At least AA and BA have performed the best analysis to date using the best data source available to make that assessment. The competition authorities will make the same informed analysis and draw the distinction between local and connecting traffic as well.

So go paint your airplanes and while doing so recognize that Willie Walsh is right. He said broken record and I will not take a shot at another of your brands. What I will say is that your arguments are not virgins anymore and maybe you should be writing letters to Oberstar rather than McCain and Obama [which you have]. If you write to McCain and Obama, the subject should be about changing the ownership laws that stand in the way of allowing the industry to become the global industry that rewards world class competitors like Virgin Atlantic. Because the large and small can cohabitate and as you say, make competitors even better competitors.

Oh and while you are thinking about some new arguments, take a look above London. On a clear day, at 40,000 feet, you will see liveries like Emirates, Ethiad, Qatar and others that do not necessarily believe that a network industry requires London to be the center of the airline universe.

Unless you recognize that 1997's arguments need to change the third time around, thanks for nothin’.

Pondering Southwest’s Potential Play on Frontier

By a multiple, the most widely read swelblog.com post ever read was the piece entitled: Is Republic Changing the Face of the US Domestic Market? I wrote the piece thinking about the regional carrier holding company’s play for each Midwest and Frontier. In that piece, I suggested that technology was a, if not the, most important attribute supporting Republic’s decision to make the play for Frontier: “Now Frontier provides Republic with something it previously lacked: a technology infrastructure that gives it long-term viability in the market. A technology infrastructure not tied to a legacy system.”

Most importantly, the technology would give Republic the opportunity to begin selling tickets directly to air travel consumers, something it does not and cannot do today.

Last week as I was walking off of the eighteenth green at the storied Butler National Golf Club in Chicago with dear friends Jack Ginsburg, Pete Robison and Ro Dhanda, I turned on my iPhone and noted dozens of messages. The news had just broken that Southwest Airlines was considering upping the ante over Republic and will prepare its own bid for Frontier.

For Southwest, the Best Offense Is a Good Defense

History is not clear whether someone actually said that the best offense is a good defense. It is believed to be a misstatement of a quote attributed to Carl van Clausewitz, military strategist and the author of On War, a book, published in 1832, that was required reading for me in a graduate school marketing class. Clausewitz was quoted as saying the best defense is a good offense. Either way, Southwest’s motives for this deal had me thinking.

If Republic is successful in gaining control of Frontier, it would produce, overnight, a new and potentially threatening competitor to Southwest’s domestic dominance. This past April, I made a presentation to the 34th Annual FAA Forecast Conference entitled: Cost Differences Suggesting a New Mid-Term Structure. There, I warned of the difficulty of analyzing cost differences between carriers, particularly in light of Southwest’s unique influence on the market. I believe it is now wrong to include Southwest among the group traditionally known as “low cost carriers” because its sheer size distorts the results. It was clear to me then, as it is more so now, that Southwest is losing the significant cost advantages that have historically been its primary competitive weapon and driver of its organic growth.

My analysis relied on MIT's Airline Data Project. When I prepared the analysis for the FAA Conference, final fourth quarter 2008 data had not been filed but has now been updated. The story remains the same. In order to make an apples-to-apples comparison of cost per available seat mile, adjustments must be made.

First, transport-related expenses (largely the fees paid to regional carriers for capacity) must be removed as there is an offsetting revenue account. Second, fuel cost per available seat mile should be removed as varying hedging strategies make for distorted comparisons. This is particularly true of Southwest where I estimate that its fuel hedging strategy accounted for 53 percent of its cost advantage versus the network carriers for the first nine months of 2008.

I also compared unit costs of the network carriers (American, Continental, Delta/Northwest, United and US Airways) to Southwest and a group of carriers I refer to as Midscales (AirTran, Frontier and jetBlue). Absent removing transport-related and fuel expenses, Southwest has a cost advantage versus both groups of carriers –in the case of the network carriers, a 6.4 cent advantage. When transport-related expenses are removed, then Southwest’s cost advantage is nearly halved. When fuel expenses are removed, the advantage versus the network carriers shrinks to 1.6 cents.

Now consider this: When transport related and fuel expenses are removed Southwest has a cost disadvantage versus the Midscale group. Just imagine what Southwest’s cost disadvantage could be if Republic were to get its hands on Frontier? Southwest non-labor costs are the envy of any carrier, and it still has an advantage versus the network and Midscale carriers. But Southwest now has a labor cost disadvantage against those carriers. In fact, the unit labor costs of the Frontier, AirTran and jetBlue sub grouping are nearly a full penny per seat mile lower than the unit labor costs at Southwest. Pennies in this instance can quickly add up to tens of millions of dollars in cost to Southwest when competing directly.

Adding To the Speculation

Many observers already question whether Southwest would be adding to its burdens and its costs in acquiring Frontier’s airplanes and thereby introducing different aircraft to its famously one-sized-fits all fleet. That can be addressed.

Can the labor issues also be managed? In my view yes, even if that means Southwest buying labor’s favor. Independent unions represent the pilots at each airline, so the always-difficult task of integration would be made easier by the fact there is no national union constitution and bylaws to deal with. Frontier, through its bankruptcy, has moved toward more maintenance outsourcing and that fits Southwest’s current model. And because the Frontier flight attendants are not unionized, there are minimal labor hurdles there.

No doubt, the financial transaction would be accretive to whichever airline ends up making the play. I believe, though, that the most value from Frontier would be garnered only by another airline that could leverage its assets - a local market following and its IT platform – not by financial players that won’t see the same advantages.

Frontier would provide Republic a tremendous opportunity to transform not only itself but the US domestic market. For Southwest, the Frontier play is not so much transformative as it is defensive, by:

1. Removing a local market competitor for a company struggling to find new markets (and there are no profitable 3-carrier markets in today’s revenue environment)
2. Providing a solid technology foundation and expertise in value-added pricing
3. Thwarting future competition by ensuring that Republic remains a capacity provider to the nations’ legacy carriers – at least in the near term.

Ding: The “Southwest Effect” is Dead

The Denver market is unique in that there are few alternative modes of transportation that can compete with air travel because of sheer distances in the western US. Boulder, Colorado Springs and other surrounding cities’ traffic already access the air transportation system through Denver. The truth is today’s stimulation is largely diversion from another market or another carrier.

Many point to the pain a Southwest takeover would impose on United. But there are two sources of traffic: local and connecting. United runs a large connecting operation in Denver. Onboard United airplanes is a traffic mix of 1/3 local passengers and 2/3 connecting passengers.  On the other hand, each Frontier and Southwest are highly reliant on local passengers.  Before we count United dead in Denver as a result of this combination, this fact needs to be examined. 

Fares for local traffic in the Denver market are largely dictated by the competition between Southwest and Frontier. Publicly available data would show that nearly half of Frontier's traffic at Denver is local and Southwest's is near 70 percent. Therefore which direction do you think fares will go if Southwest is successful in taking out an important competitor for Denver local traffic? And after reducing certain duplicative Frontier capacity?  Southwest’s fares will prevail, even though Southwest is not always the low fare provider in each market.

Southwest Showing Its Age

Southwest built its Denver operations quickly at a time when Frontier’s future was in doubt and United was struggling. As Southwest’s organic growth slows because of the anemic revenue environment in the US domestic market, then buying the carrier that competes largely for the same local traffic makes good sense. With a cost structure that no longer sets them apart from the crowd, it is clear why Southwest continually talks of the need to augment its revenue streams.

To be fair, some will say that analysis of Southwest’s cost advantage shrinkage is flawed because it does not account for stage length -- the length of the average flight. But in comparing one airline’s performance and costs to another, adjusting for stage length is somewhat arbitrary.

Rather, what is most important is the relationship of [system] cost per available seat mile to [system] revenue per available seat mile. It is this relationship that finds Southwest struggling at Denver where load factors have been in modest decline as the airline has grown and has been increasing fares from the carrier’s initial offerings. The net effect has been a modest decline in RASM - as CASM has been increasing.

The network carriers are challenged in this regard because of the black revenue hole created by the downturn in first and business class travel on international routes. Just as the network carriers have to adapt for shrinking revenue relative to costs, so does Southwest – without the magic of stimulating a mature market replete with competition from low cost and network carriers alike.

Southwest just celebrated its 38^th birthday. It is a mature and maturing carrier operating in a mature domestic environment where it is no longer an innovator. What I find most interesting in Southwest’s potential bid for Frontier is that the carrier is being forced to act just as the network legacy carriers. Southwest is seeking a consolidation scenario that could and should lead to an improved revenue line in Denver where it has significant capacity deployed and where Frontier, a beloved (not LUVed) carrier in the region is all but assured of emerging from bankruptcy protection with its loyal local following in tow.

Keep tuned. I can’t wait to hear the arguments Southwest uses in Washington to gain regulatory approval, particularly as it will be hard pressed to make the argument that acquiring Frontier would lower airfares in the Denver region.

Funny how things change.

Propagating Harm: Senators Boxer and Snowe; and Kate Hanni

The festering issue of whether to enact a Passenger Bill of Rights is on its most aggressive track, both publicly and in Congress. Last week the Senate Commerce Committee approved its version of the FAA Reauthorization Bill. Tucked inside was the Boxer-Snowe amendment, which resurrects the Airline Passenger Bill of Rights nearly two years after it first reared its ugly head on Capitol Hill.

Among other things, the Boxer-Snowe version requires airlines to let passengers off of an aircraft that is delayed on the tarmac for three hours or more.

I ask, is this really a cause for Congress? Is this “issue” worthy of all the angst we see in articles like in the USA Today, which is to my eye drafted to drum up controversy replete with anecdotes and devoid of the relationship to the sheer number of flights consumers enjoy.

It is anecdotal and emotion driven by a populist appeal that seems to be driving this debate. With the airline industry already in fierce competition for customers and revenue, my bet is that the industry is more than capable of addressing this issue on its own as evidenced in the recent focus on operational results. But Congress too often seeks a legislative solution where the private sector should prevail, as we’ve seen before and will unfortunately see again. And in these cases, it is clear that the law of unintended consequences is alive and well.

At MIT, I am fortunate to work with learned academics and industry experts who produce a volume of impressive research on airline operations and performance and schedule recovery. Among it is some interesting data that shows airline schedule planning may actually propagate the kind of air travel delays that has some in Congress pushing bills that very likely will add to, and not ameliorate the problem.

Professor Amy Cohn of the University of Michigan is a Sloan Industry Studies Fellow researching the passenger airline industry. Her research illustrates that plans that look good on paper often do not perform well in practice. Cohn argues that, with the complex nature of airline networks, a little “slack” built into the schedule actually improves performance – but offsets the benefits of system optimization. Much good work has been done to make this capital and labor intensive industry as efficient as it can be, particularly given the many variables that affect performance – from a crew member calling in sick, to a mechanical problem, to a geopolitical event, or to the weather.

Consumer Benefits of Airline Schedules Have Been Significant

Schedule planning has provided a wide range of benefits – primarily for consumers. Over the past 20 years, passengers have seen connecting times fall significantly – which is particularly important to those who do not live in hub cities and face a combination of flights to get to their desired destinations. This opaque airline practice has resulted in more productive time for the airline passenger. It has helped to make airlines significantly more efficient because time saved on the ground translates into money saved for the airline. These cost savings have also been passed along to consumers in the form of lower fares

In addition, schedule optimization has permitted added frequencies to non-stop destinations, providing consumers a wider array of departure times and, in some instances, a wider choice in carriers and hubs.

All Anecdotes, Few Facts and Little Analysis

Federal legislation like the Passenger Bill of Rights proposal could significantly undo the progress the airline industry has made. And the real shame is that the legislation borne of one unfortunate delay and an angry but media darling passenger activist named Kate Hanni is the product of anecdotal, and often unsubstantiated evidence rather than serious analysis. Anecdotes produce sensationalist stories like the one in the USA Today. But real research tells a different story. According to the Air Transport Association and the US Bureau of Transportation Statistics, all but one of the airline efficiency metrics are at their best levels since 2000, including flight cancellations as a percent of domestic departures, on- time arrival rates, mishandled bags, customer complaints, and taxi-out times in excess of three hours.

So why the focus on an arbitrary three hour time limit? Why not two hours? Why not three hours and 17 minutes? As it is, the legislation now in Congress is designed to affect no more than .014 (1q’09 according to ATA) percent of domestic passengers. Of that small subset of passengers, who, if anyone will actually benefit from the legislation? Well that depends on how many of those passengers would rather wait a little while more in hopes of getting clearance to take off, and how many would prefer to return to the gate and call it a night and risk the ultimate arrival. Now I will add that in order to wait out a delay, there is a rightful expectation of a fully functioning aircraft and onboard amenities that allow a bearable experience.

Who Wins?

The truth is, you can’t legislate smooth travel conditions. Weather is a reality and weather causes delays. And yes, delays add to the angst of travel and wets the appetites of those in the media that thrive on the travails of travel. In those cases of severe weather and flight irregularities, some fliers may be happy just to wait out the delay if it means getting to their destination. A return to the terminal, after all, just adds to the chaos for later flights as the airline struggles to get crews on planes and passengers on their way. And the issues propagate. Imagine the mood on a plane queued to take off following a weather delay if the pilot suddenly announces that they are headed back to the terminal because Congress says they have to. Whose “rights” does that protect?

What Does This Have to Do With Reauthorization?

Of the .014 percent, or the .01 percent of domestic departures during the first quarter of 2009, of domestic passengers impacted by tarmac delays greater than three hours, shouldn’t we also be asking how many of those delays could possibly be laid at the feet of Congress and the government because they did not keep their promise of upgrading the air traffic control system? That’s a legislative solution that would benefit all airline passengers, every community and the industry itself. Whereas the USA Today article was largely sensationalistic with its statistical story and included vignettes about crying babies and the like, at least the reporter talked to an airline and a knowledgeable consultant about the old and inefficient air traffic control system.

The USA Today article rightly makes this case. "Because of the antiquated air-traffic-control system in which we — and every airline — operate, we're restricted as to the operational improvements we can make," Bryan Baldwin, spokesman for JetBlue Airways, told the newspaper

Aviation consultant Michael Boyd said airline CEOs "should form a conga line" to the FAA and demand the country's air-traffic system be modernized. That could increase airspace capacity and reduce the number of waiting planes.

That alone would do far more to reduce congestion and delay than would a phony and likely counterproductive passenger “bill of rights.”

Don’t get me wrong. The airlines deserve some blame here. We would not be facing the prospect of such a ludicrous proposal if the airlines did not fail their passengers and fail them more than once. But remember, they do operate nearly seven million flights per year - significantly more than when competition was born. Their failures pale in comparison. Passengers could, and have, experience serious repercussions from a prolonged wait on the tarmac – whether from lack of food, water, medicine or simply the need to get off the plane and attend to personal matters. But that is an issue that can be solved with a directive, a renewed focus on customer service and basic human comforts, not a piece of legislation that certainly will result in unintended consequences. Airlines and airports are making progress on that front and addressing delays that they can control. But last I checked, weather was not among them.

This issue needs study – a very detailed study – and it sure as hell is not the 2008 ARC study - on the issues . There is a solid foundation of scholarly work to build on and adapt that work to this particular issue. Those that perform the study need to understand how airline operations work and then determine how an airline can best address the anecdotes (outlier events) given the unique constraints placed on airlines, airports and the air traffic system each and every day as there is no one size fits all solution that seems to be called for in the ill advised Boxer-Snowe legislation.

The real issue is in the root cause of airline delays, and the answer will be found to incubate in the air traffic control system. The FAA reauthorization bill comes around only once every so many years. Is Congress going to use this opportunity to pass a meaningless “protection” for a few passengers, or take a bold step and do what it takes to build a better air traffic control system for the good of all?

I thought the administration was going to take parochial interests out of legislation. This legislation should be about funding the FAA in order to modernize the air traffic system and increase its safety – not tarmac delays; not propping up a non-essential Essential Air Service program; and certainly not about anti-trust immunity.

More to come on these issues.

The next post will examine the baseline of pay and productivity issues the airlines face as labor seeks to return compensation lost from past negotiations.

Let’s Just Get It Out There: Would You Loan To a (Union) Labor Intensive (Airline) Industry?

In a post two weeks ago, a reader asked: “… are [you] just forgetting one thing about the "usury" that is the interest rate charged to United on what is in theory a very secured loan? The Obama administration pretty much threw out of the window centuries of legal precedent and destroyed the notion of secured credit with the Chrysler bankruptcy. Collateral is useless if you are not able to collect it in the event of a bankruptcy because someone in power favors the unions, and so the natural result is for all companies, across all industries, to pay higher interest rates (the law of unintended consequences is a pain in the ass, isn't it?). Frankly, 12.75% is a bargain for unsecured credit in a company with the creditworthiness of United.”

A Great Point

Similar questions were asked in recent months as Chrysler and General Motors teetered toward bankruptcy. In Chrysler’s case, the United Auto Workers ended up owning 55 percent of the company in a retiree trust following the automaker’s 42 day-stay in bankruptcy. Italian automaker Fiat ended up with 20 percent of Chrysler -- a stake that could grow to 35 percent under certain conditions [didn't the US Government insist on this foreign owner as part of the plan of reorganization?], while the United States and Canadian governments own the rest.

Was that deal fair to those who had loaned money to Chrysler thinking that their loan was secure?

In the final chapter of GM’s emergence from bankruptcy, the US government put $50 billion into the restructuring. In return, the US government got a 60.8 percent share of the new company, while the governments of Canada and Ontario hold 11.7 percent and a UAW retiree health trust holds 17.5 percent.

Was that deal fair to GM’s capital providers that thought their loan was secure?

What is wrong with this picture? How about the fact that secured debt is being relegated to Third World status to pay yesterday’s unsecured obligations before tomorrow’s capital providers and new shareholders get paid?

A similar story may be playing out in the airline industry, where unions are crying foul, demanding a return on the “investment” they made in concessions during restructuring in recent years.

And while several major carriers are already in negotiations with unions grappling with contracts that impose legacy costs and job protections that constrain their ability to compete, Teamsters President James Hoffa is marching on Continental, trying to convince the airline’s fleet service workers the Teamsters can offer them job security in an industry in the midst of a major competitive shakeout.

Will We Ever Understand?

Before long, the leaders of the major US airline unions will need to come to terms with the very financial realities faced by the US auto industry: a tapped out balance sheet isn’t going to provide much juice. For unions, the “unsecured debt” comes in the form of a two-tiered workforce in which younger or less-experienced members stagnate – unable to advance in the ranks – to protect the inflated wages, and generous benefits and working conditions bestowed upon senior employees at mainline carriers. Like all good Ponzi schemes, it works for awhile. But the bill is soon to come due. Airplane seating configurations have been downsized to the maximum extent and are now increasing. Furthermore, it is clear that the industry is not finished calibrating the right balance between mainline and regional flying, a necessary task for airlines that can only serve unprofitable routes for so long.

“Obamanomics” has been at play in the US airline industry since deregulation – manifest in the belief that the industry can continually borrow from tomorrow to pay for yesterday. First the “trunk” airlines bought up regional carriers – an easy decision given the better economics of flying smaller planes to smaller markets and in the process consolidating duplicated capacity that helped build regional dominance. Along the way, a pattern of cyclical bargaining played out, abetted by the Railway Labor Act which permits contract negotiations to continue for months and years.

Time and again, airlines would make unions “whole” for past concessions necessary in downturns, perpetuating an imbalance in which airline labor costs rose higher and higher – above the industry’s ability to bring in revenues to pay for them. As small jet technology improved, a new regional air industry took hold, creating a labor arbitrage game that made it all but impossible for legacy carriers to compete with labor costs too high to serve many markets. Finally, the lower-cost “upstarts” played their own arbitrage – taking advantage of their lower costs and workforce seniority to keep their costs down, and put yet more pressure on the legacy carriers.

We are soon approaching Judgment Day for airlines and their awkward and delicate relationship with the airline unions. In the airline industry, the “virtuous circle” that rewards success with more success has had a break in it for some time.

Something Different

I believe that we should be looking at this period of labor negotiations as an opportunity to find a better model. Employee morale is low, and that presents a real barrier to industry success in transforming today’s labor construct. But rather than trying to resurrect airline economics and models that are no longer relevant to the modern industry, labor should be working with airline management to find a way to rewrite legacy provisions that aren’t sustainable and won’t serve the long-term interests of their members.

Management Is At Fault

I’m tough on unions here, but you won’t find me congratulating management for labor's entitlement mindset created by decades of ill-conceived capacity growth. In the early 1990’s, American’s Bob Crandall began to close hubs at Nashville, San Jose and Raleigh/Durham, noting the important economic concept of fully allocated cost versus marginal cost of growth. In doing so, he acknowledged the error of his ways based on American’s growth during the 1985 – 1991 period in which growth was funded largely by lower marginal labor costs.

The recession of 1991 gave American and others pause. But it did not stop the growth. When the recession ebbed, that economic lesson was quickly forgotten and the industry continued to add capacity into early 2001.

By my calculation, until we get back to 1991 capacity levels, we’ve got another five years of shrinkage ahead.

Spreadsheet Analysis

It is a hard fact that, in its current construct, this industry only works for labor when it’s growing. Few airlines will be fortunate enough to avoid more labor trouble to come as they try to balance new industry economics against the expectations and demands of organized labor. It’s already messy at American, United, US Airways and Continental. Delta will only buy so much labor peace following its largely-successful integration of the Northwest operations, and Air Tran will be a new test now that its pilots have joined ALPA.

If I had money to invest, I would be staying far away from this industry unless a construct is put in place that will begin to allow airlines to manage the workforce with needed flexibility to match the direction of the business cycle.

Obama has promised airline labor that releases from mediation will be forthcoming – thus making the possibility of strikes a reality. Adding labor instability to today’s mix of economic, commodity and competitive instability should make any lender nervous. Then again, capital is already nervous about lending to this legacy industry as evidenced in the recent terms and conditions demanded for capital provided. What will labor instability, aided by this administration's promises to labor, add to the terms and conditions necessary to borrow scarce capital?

In any industry, there is no need for either labor or management if there is no capital.

Are Some US Airlines Too Big to Fail? Hell No!

Holman W. Jenkins Jr., writing in the July 8 Wall Street Journal gets it right: "The new administration seemingly won't let companies fail, and won't let them succeed either," Jenkins wrote of Justice Department opposition to antitrust immunity for Continental Airlines and the Star Alliance. Such alliances, he argues, are the industry's "self-help solution" for companies looking "to share losses and preserve capacity in a downturn." By denying that option to struggling carriers, Obama may soon be forced to "add the airlines to the collection of failed industries being run out of the White House."

Sadly, What is Good for One is Not Good for the Other Two

Congress, of course, has a long-held penchant for meddling in the affairs of industries and organizations. This week, the Senate Judiciary Committee Subcommittee on Antitrust, Competition Policy and Consumer Rights spent taxpayer money to hold hearings on college football’s selection process for placing teams in its Bowl Championship Series. So we should not be surprised to see a growing government role in an industry that has managed to lose more than $30 billion over the past nine years.

If government oversight of the airline industry is going to stand in the way of corporate success, then there is no airline too big to fail. So why not let them fail? Airlines are criticized for not being innovative. True - and for the most part their innovations over the past 10 years amount to little more than finding ways to maximize revenue within a system of constraints.

Delta/Northwest is the largest carrier in the world, and even it commands less than a 5 percent share of the global airline market. No other U.S. airline claims more than a 3 percent share. Yet the government continues to treat the U.S. airline industry as if it is a threat to competition and slap the hands of airlines that attempt to improve/augment their business models through partnerships and alliances with foreign carriers.

Antitrust laws are designed to protect consumers from corporate power. Does a well-established trend line of fares falling at rates greater than inflation for three decades demonstrate corporate or industry pricing power? A passenger traveling from Greenville/Spartanburg to Los Angeles has a choice between more than 20 flight combinations to get from California and back.  Does that demonstrate corporate or industry power? Does an industry that makes the price of its product fully transparent to the buyer sound like an abuse of the consumer?

The fact is that most U.S. air travelers still have plenty of choices when it comes to flying – albeit in an industry that still carries more capacity than it needs.

Southwest: The Wolf in Sheep’s Clothing

Let the record show that I have not joined the chorus of analysts and observers who predict rising fares by Fall. The recession holds. Many consumers are tapped out. Enter: Southwest Airlines.

Southwest has a long history of leveraging difficult financial times -- profiting at the expense of competing airlines because it could. It profited because of the chasm in its CASM versus it competitors; it profited because of the chasm in the RASM charged by competitors; it profited because it smartly used its balance sheet to make a wildly successful bet on the future of fuel prices . . . Southwest profited because it could. So this week’s fare sale in which the airline is selling tickets at $30, $60 and $90 says one of two things: either Southwest is struggling mightily with the forward booking curve, or the airline smells blood. I think the answer is both, but more the latter.

Southwest is now the big dog in the US domestic market and a player that must be reckoned with in any discussion of domestic market competition. If the nation’s lawmakers and policymakers continue to equate low fares with sufficient competition and consumer benefit, then deregulation has clearly come full circle.

Southwest is not now the big dog to those in Greenville/Spartanburg, Knoxville or Duluth. But most travelers can get in a car and drive less than a few hours to fly Southwest from these markets or more than 280 others not now served by LUV.

If this is what the regulators and policymakers really want, then that’s what they’ll get. Therefore, there is no reason to think that any airline flying today is too big to fail.

With Southwest adding the dots of the largest population centers where it did not previously fly to its route map, the industry could be at a tipping point. These markets also represent large sources of feed revenue to many legacy carrier hubs, and with Southwest offering fares too low for some legacies to match, this fall and winter may be a long, cold one for the traditional carriers.

Will the government continue to stand in the way of airlines that are desperately seeking new revenues? If so, no bailout will save an airline – not until U.S. airlines are allowed to act like other multinational industries serving a global economy. There already is enough taxpayer money bailing out other industries with similarly troubled attributes – adding airline rescues to the mix would only throw more good money after bad.

Union Rhetoric

What’s behind Congressional opposition to these common-sense alliances? The loudest voice in the room is labor. Even at this financially treacherous time, the industry is split from within, the result in part of union leaders that refuse to recognize economic trends and realities when they don’t serve the union’s objectives. When are the unions going to recognize that the transfer of domestic market wealth from the incumbent carriers at the time of deregulation to the new wave of carriers that followed is largely complete? And that tomorrow’s opportunities do not reside inside the 48 contiguous states?

Now, in the years since airlines sought and won aggressive cuts in labor costs during restructuring, it is increasingly clear to me that continual change/modification to outdated collective bargaining agreements cannot overcome the structural seniority chasms that exist between the legacy carriers and their lower-cost, younger competitors – at least in the domestic market. For decades, as the network carriers have been forced to compete for ways to average down labor costs through protracted bargaining, the low-cost carriers simply use seniority arbitrage to facilitate their growth. And I think we are about to see another run of growth by the LCC sector.

When it comes to the airlines seeking immunity to maximize revenue and, in the case of United/Continental/Air Canada, address certain cost efficiencies as well, the strategy is to maintain as much of the current operation as is financially feasible. Unlike the US steel industry that lost nearly 400,000 jobs because producers in other countries could do it significantly cheaper, blame for the next round of airline job cuts most go in part to the airline unions that have been busy trying to convince the dinosaurs at the Department of Justice and on Capitol Hill that alliances will result in job loss and a further deterioration of wages and working conditions.

Between the time Eastern Airlines and Pan Am died and 2000, the industry’s high-water mark for employment, U.S. airlines added nearly 100,000 jobs. Since 2000, the industry has lost nearly 140,000 jobs - and it should have been more -  mostly because nearly all the airlines and virtually all the existing hubs have been protected in one way or another by patrons on Washington. Indeed, many of the jobs lost from a failure of one or two of today’s carriers likely will be replaced as market positions in the largest cities are filled by new and more efficient carriers.

Let Some Airlines Die – And Then Let DOJ and Congress Rethink

At this point no one US airline is too big to die. Competition remains plentiful whether that competition comes from another ticket counter at the same airport or cheap fares at a nearby airport. Either way, the industry is still too big – with too many network carriers, too many regional carriers and too many hubs.

And, except for a few “up cycles” along the way, revenue has not supported the industry’s growth or size. The time is right for lawmakers to hear the new reality in the industry – one focused not on a false threat of monopolies and price gouging, but the very real threat in an industry so bloated, burdened and inefficient that it fails to provide the very thing a business must: a reliable return for investors and real job security for employees.

In the Spirit of LAN: Another Emerging Strategy?

Airline and Air Service Thoughts -- Again

Never did I think I would write about LAN Airlines and Spirit Airlines in the same story, let alone refer to them in the same title. Never! On Sunday, Benet Wilson with Aviation Week’s Things With Wings blog asked: Has Spirit Airlines bought Air Jamaica? Benet was following through on an Associated Press story reporting that Spirit had indeed bought forever-struggling Air Jamaica, albeit citing unnamed sources. Today, it appears true.

Ms. Wilson first reported on the bizarre nature of Air Jamaica’s privatization in December 2008. On July 4, 2009, The Gleaner in Jamaica went so far as to suggest the new name for Air Jamaica might be the Spirit of Jamaica. Then I started thinking.

LAN

An airline that I rarely mention, but have a deep admiration for, is LAN based in Santiago, Chile. LAN’s strategy of taking equity stakes, and in effect becoming a surrogate flag carrier for a country in a continent’s economic woes by filling the gap left by an airline's corporate failure in South America, has been brilliant. The strategy has allowed the former Lan Chile to diversify its traffic base away from Chile-only, and grow to become the defacto flag carrier for other countries in the continent. LAN’s ability to take advantage of non-Chilean country bilaterals has produced growth opportunities where a reliance on Chile-only would have only led to diminishing returns – much like the US carriers are realizing today.

The carrier began as Línea Aeropostal Santiago-Arica in 1929 before becoming Línea Aérea Nacional de Chile (Lan Chile) in 1932. The Chilean government privatized Línea Aérea Nacional de Chile in 1989, and the carrier absorbed Chile’s second carrier, Ladeco, in 1995. Today, the LAN umbrella covers LAN Chile; LAN Peru; LAN Dominicana; LAN Ecuador; LAN Argentina; LAN Cargo; and LAN Express, among others. Some said LAN refers to Latin American Network. LAN is a brand!

Spirit’s L-A-N (Local Area Network?)

Born during the global recession in the early 1990’s, Spirit, a perpetual “bottom feader”, then based in Detroit, focused on providing ultra cheap flights to popular leisure destinations and gambling meccas. It took advantage of the failures of Eastern, Pan Am and others to build a cheap fleet staffed by cheap labor, offering few amenities in exchange for fares that were often 70 percent or lower than those offered by the competition.

As many legacy carriers began to recover in the mid 1990’s and the wave of new low cost carrier growth accelerated, Spirit had several brushes with financial disaster. Written off for dead many times, the company pushed ahead and adapted its strategy to the competitive environment. It moved from Detroit to South Florida in 1999 and pursued new growth built on its ultra low-cost roots. Like most of the industry, Spirit struggled after 9/11. But in the process of adapting and taking advantage of its new home base, Spirit received an important injection of $125 million from OakTree Capital and landed as its CEO Ben Baldanza, who previously held executive posts at US Airways, American, Continental and Northwest.

With capital raised, a fleet renewal plan in place, and a new CEO, Spirit began to think less about Detroit, Flint and Atlantic City and more about the Caribbean and Latin America. The carrier continues to seek route authority into many of the northern South American countries like Colombia and Peru. Today the company boasts that it is the leading low cost carrier to the Caribbean, the Bahamas, Central and Latin America. In fact, more than half its 43 destinations served are to the Local Area Network called loosely – Latin America. Its model looks more like RyanAir and Air Asia and Allegiant than it does the more traditional carriers serving North America.

Air Jamaica?

The Local Area Network of Latin America is highly dependent on tourism. Most island economies are incapable of raising sufficient capital to fund their own airlines. If Air Jamaica is losing tens of millions of dollars then imagine what airlines in other, less developed, island economies must be experiencing.

In Ms. Wilson’s first piece, she quotes an economist friend’s take on why would anyone want to buy Air Jamaica, noting that the carrier was "the classic case" of an airline’s importance to a region’s economic health.

"From a pure privatization play, Air Jamaica has a value of zero," Wilson said, quoting the economist. Yes there are short-term gains to bolster [Air Jamaica’s] the bank account, but in the long term, a perpetually losing airline stands a high risk of becoming extinct as it holds little to no value for any financial player. The value of Air Jamaica to me seems to only lie with the Jamaican government and the Jamaican tourism industry.”

I concur. And the Jamaican government might finally be realizing just that. Island economies absolutely need airline(s) service to enable economic activity. In a piece I wrote last October, I challenged whether airlines should be bearing the cost of providing service to certain communities, or the other way around.

As an example - and let's think for a moment - (these are not actual numbers), if Air Jamaica is losing $100+ million per year and yet is responsible for enabling $1 billion in economic activity, then what amount of the sum total of direct, indirect and induced economic activity should the Jamaican government be willing to spend to keep critical airline service? The answer lies somewhere between $0 and $100+ million – at any figure a good investment to keep a billion dollars in economic activity that supports the island economy. But total cash outflow is not directly timed with direct, or even indirect, let alone induced inflows.

Without a doubt, Spirit can be that airline at significantly lower cost than Air Jamaica is today with its legacy issues.

Spirit Could be On to Something

Like many other industry observers, I have serious doubts about Spirit’s future as a sustainable enterprise in its current form. On the other hand, LAN discovered there are many opportunities within the Local Area Network of Latin America where a Spirit of Jamaica brand could be duplicated if successful.

Island Economies and US Small Community Air Service

In the US, small community air service is a lot like small island economy air service. It is not for the faint of heart.

Not unless, and until, island nation governments appreciate the fact that if I have a runway, a terminal building and security that I am forever entitled to receiving air service. No one is entitled.  Moreover it is wrong to think that a country can support an airline because that country has a flag; a currency or a dialect.

Just ask the people in Peru, Argentina, Dominican Republic and Ecuador if the air service they receive from the LAN brand leaves them disadvantaged on the global map. My guess is that they have been enhanced from a service provider that can do it better. May(be) the Spirit be with those island economies dependent on tourism to find a similar alternative to their own fledgling flag carrier. Or maybe Spirit has finally found a niche.

I only hope that Spirit, and its investors, are being supported in this Jamaican investment by a government that understands the correlation between direct cash outflows and economic activity. If not, run Spirit run.

Why not the Spirit of Aruba? Why not the Spirit of Trinidad and Tobago? Why not ……… ?

Neither Ponzi nor Pyramid, but an End Game Nonetheless?

Liquidations and/or Use of the Failing Carrier Doctrine?

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

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

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

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

Data Points

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

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

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

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

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

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

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

Renewed Consolidation Focus Based on an Old Tool?

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

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

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

On Second Thought

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

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

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

Republic Airways Holdings, Inc.

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

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

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

And I keep coming back to Republic.

Is Republic Changing the Face of the US Domestic Market?

On June 22, Reuters reported that Republic Airways Holdings Inc. (RAH) will sponsor Frontier Airlines’ exit from bankruptcy, noting that the “US regional carrier” would pay $108 million for 100 percent of the equity in the reorganized entity. The next day, Republic announced that it will buy the remains of Midwest Airlines for a mere $31 million (only $6 million in cash), from TPG, the private equity group that has had some success in the US airline industry. While the story got some play in the mainstream press, the possibilities are much bigger than many may realize.

Think About It

Prior to these announcements (and keeping in mind that the Frontier deal is subject to Bankruptcy Court approval), Republic Airways Holdings was soley in business as a provider of “regional airline” capacity. The holding company offers potential purchasers three brands: Chautauqua Airlines, Shuttle America, and Republic Airlines. Under this model, Republic Airways Holdings operates under the flags of its contractual partners, including United Express; US Airways Express; Delta Connection; AmericanConnection; and Continental Express. Therefore it has its fingers into each of the five legacy carrier networks

RAH’s CEO, Bryan Bedford has been in this industry a long time. And he is smart, really smart. Bedford makes this move in an environment in which it is increasingly clear that the legacy carriers do not – and cannot – now operate under a cost structure that will support the number of airlines trying to survive in the hypercompetitive domestic US airline business.

Through May of 2009, airlines have cut capacity another 11 percent. At the same time, passenger revenue is down 21 percent versus the first five months of 2008. When compared to the heyday of 2000, mainline capacity is down 28 percent in the domestic market and passenger revenue is down 33 percent. Despite all of the work done by the legacy carriers to reduce costs – whether through the hammer of the bankruptcy court or not – these revenue trends illustrate an industry all but unsustainable in its current form. And while much has been made of the shift of capacity from domestic to international markets, those revenue trends are even worse in recent months.

Back to Republic

So what‘s behind Republic Airway’s maneuver? Consider this. Chautauqua is a carrier with relatively senior workforce and a fleet that offers little in terms of improvement in technology or scale. Shuttle America is much the same. And parts of Republic Airline’s fortunes are tied to United and US Airways where it operates the latest and greatest 70-seat technology. Happily for Republic, no other carrier is better positioned to capture this flying, in part because it owns its fleet rather than leases it from its mainline partner.

RAH’s structure allows it the necessary flexibility to provide a range of services for a range of clients. It has the flexibility to move from one segment of the business to another. The holding company is designed to work around pilot scope agreements. Nobody does it better. As a result, Republic and Bedford have built a business that provides them with a capital base that allows them to “pay to play.”

Indiana Hold 'em

Bedford “played the river” and now, in this observer’s view, has won enough chips to move to the final table. Providing debtor-in-possession financing is among the safest bets in restructuring. It results in little to no loss of capital in return for increased business. The result is a widely diversified portfolio of flying at increasing revenues as aircraft have gotten larger. Based on the cash flows, Republic has a fleet of aircraft well suited for tomorrow’s US domestic market. For Republic, the next move is building fleets in the 90-120 seat range and that will only augment its cost advantage.

The Frontier Card

Now Frontier provides Republic with something it previously lacked: a technology infrastructure that gives it long-term viability in the market. A technology infrastructure not tied to a legacy system. Today’s “regional carriers” are merely a wet lease of capacity to fly to small markets where mainline aircraft and crews cannot operate economically. They don’t sell tickets. Their purchased capacity merely moves people onto a mainline aircraft at a hub. With Frontier, Republic could change the game.

When it comes to changing the way consumers buy airline tickets, few see Air Canada as the bellwether - they were. But Frontier’s CEO, Sean Menke, came from Air Canada and brought with him the concept and a blueprint of giving consumers a choice of the services and amenities they want at a price they were willing to pay. There, he was recently joined by Air Canada’s Daniel Shurz, a marketing/strategy visionary wunderkind who has further strengthened the Frontier management team.

Frontier may well be the next new thing in the market. It’s not the Independence Air model or just another regional carrier. It is tomorrow’s solution for outdated domestic capacity. Bedford could now buy an Airbus fleet for a song. Bedford could now buy Milwaukee at a bargain. Who cares about Milwaukee? Only Southwest and AirTran and each and every legacy carrier that depends on Milwaukee traffic to feed operations at their hubs.

Imagine This Scenario. . .

1. Republic continues to collect revenue per departure for the feed it provides to each of its five current clients.
2. Republic maintains a financial interest in cities with three carriers trying to maintain or obtain market dominance. There is little evidence to suggest that many cities can support three aggressive carriers vying for market share. It’s been tried at DEN and it sure as hell cannot work at MKE.
3. Come Fall, as mainline carriers realize that previously announced capacity cuts are not sufficient, they turn to Republic and attempt to renegotiate their contracts. Republic says “Hell No” and instead makes a move to turn to develop its holding company portfolio into an airline that will compete for the very same traffic.
4. Maybe it then becomes apparent to one of those competing airlines that flying to DEN– largely reliant on feed traffic –no longer makes sense and it negotiates with Republic to replace its capacity there? Certainly, labor issues abound, but economic realities could prove persuasive.

All of this comes at a time of seachange for the big players in the US market. Ultimately, there is little left for the legacy carriers to restructure. There is no way to restructure zero demand. There is no way to restructure free-falling fares. There is no way to restructure rising fuel costs. And under current labor contracts, there is no way to restructure labor costs other than to get rid of minimum employment requirements.

That given, and with liquidations possible if conditions don't begin to quickly improve, Republic is well positioned to take advantage of vacuums in the domestic market. And we all know that nature abhors vacuums.

We’re entering a new era in the US airline industry. Change likely won’t depend on the kind of calamity or crisis that triggers the “force majeure” clause that allows airlines to suspend or break contracts. Instead, new market economics may force a restructuring of the industry in which the victors are those, like Republic, which simply have a better business model - a flexible and agile model. The top domestic airlines of tomorrow might be Southwest, jetBlue, Republic and maybe two of the five current legacy carriers.

Hubs will remain in the largest metro areas because that is where the population is gravitating. Thus, the focus of air service providers is no different today than it was in the early 1990’s when we lost Eastern and Pan Am. And once again, the industry will discover that presence in all the big markets doesn’t give them pricing power anywhere. Republic’s move demonstrates that the major carrier’s reliance on feed markets to cross subsidize this fact could be over. Air travelers want low fares and, time and again are showing they’ll drive to whatever airport – and airline -- offers them.

In the very near future, it might be a very different set of carriers that dominates the US domestic landscape.

Meanderings on US Open Golf and the US Airline Industry

I started writing this on Thursday as the 109^th US Open golf championship got underway on the vaunted Black Course at Bethpage State Park on New York’s Long Island. At 10:17am on Day 1, play was suspended due to heavy rains that added to the overnight rain resulting in standing water on numerous parts of the course.

As the tournament played out, the weather - and what side of the draw you were on - was as much the story as the winner. For golf fans, the US Open annually represents a most stern test designed by the United States Golf Association to identify the world’s best player.

The US Open is as much a test of mental strength as it is physical skill. There is not one player that would enjoy being subjected to US Open conditions week in and week out. Well, maybe one, and I am not sure he enjoyed this year’s version either.

It seems as if the US airline industry has been playing under this year’s US Open conditions every week since October 2000. But the airline industry does not get play suspended when conditions are less than ideal. Rather, the industry has been forced to adapt to one economic and geopolitical event after another. And there is no end in sight.

There have been a number of good stories over the past few weeks that have looked at individual carrier’s fates. During that time, I have been on a speaking tour where it is clear that, whatever the audience, the question of airlines’ survival is top of mind.

And congratulations to Lucas Glover on winning his first golf major.

Meanwhile, I have just completed updating the 2008 analysis in the MIT Airline Data Project that puts a klieg light into the cost side of the US airline world. At the same time, I got a glimpse of the new revenue report from the Air Transport Association and together, the picture for the industry is pretty ugly.

The ATA report reminds me of the impossible lie David Duval encountered Monday morning on his first shot after Sunday’s suspension due to darkness that led to an undeserved triple bogey.

While the US airline industry has endured much bad luck over the past eight years, it, like Duval, has continued to persevere and take advantage of what the course offers. But in an Open, it is next to impossible to win after making such a score on an individual hole. Fight as he did, Duval ultimately finished two shots out of what would have been a most unlikely – and welcome - win. The same just may be true for some carriers out there that may be near the point where one more misstep – or one more bad bounce - will eliminate any chance of competing as well.

For long-time readers, you know I love the game of golf because of what it exemplifies and what it represents. You can find me glued to a television during any of the season’s four majors. The sadistic side of me appreciates the course set up of US Open’s as it challenges the world’s best players in ways that weekly tour stops rarely inflict.

But you always know that it is only a few days each year that golfers face this brutal test. The US airline industry has endured the unthinkable since late 2000. With rare exception, there is not one year that can be described as a whole, but rather a tale of two halves. Even the year 2000 was that way when the first half had all stars aligned and the second half was the beginning of a revenue decline that still continues.

As fuel marched from $90 per barrel in early 2008 to $147 on July 11, unit revenues were on the rise. Ancillary fees became a part the industry vernacular. Then in late summer of that year, as fuel prices dropped nearly as fast as they rose, unit revenues began to freefall. And they continue.

The Airline Data Project demonstrates that passenger revenue for the airlines covered increased $3.8 billion in 2008 while fuel expenses increased some $11 billion. Year-to-date passenger revenue in 2009 is down some 20 percent thus far, while capacity has dropped 8 percent.

Generally, I care a hell of a lot less about the relationship of traffic to capacity as I do about the relationship of revenue to capacity. The trends defy the usual rule of thumb that a drop in capacity leads to pricing traction. That simply is not happening. And that tells me that this industry should be even smaller than it now is.

The Airline Data Project also shows that legacy carrier capacity is now roughly equivalent to what it was in 1997. But the combined capacity of legacy carriers and “low cost” carriers is 15 percent larger than it was in 1997, and that excludes the affiliated regional carriers like Republic, SkyWest, Pinnacle et al and includes Alaska, Hawaiian and Midwest Airlines. So the industry is not smaller – it is bigger. The legacy carriers simply have a smaller slice of the pie.

The MIT data will show that the legacy carriers spent more than $20 billion in 2008 on their contracts with regional partners – an expense largely contained in transport-related expenses. American spends the least on regional flying, while Delta/Northwest spends double plus 20 percent more than number two on the list -- United. What does this tell me? We have to cut back. We have to cut back!

At least the US Open sets strict boundaries on how many players qualify for a national championship. The same is not true for the US airline industry. As I say often, if you have a dollar, have an aircraft, and find an airport with security, you too can have an airline. There’s a lesson in that data. It’s time for limits on entry unless and until there is real change to the industry’s business model and structure. I am no protectionist, but anyone who challenges – or even suggests– that a lack of completion exists in the US airline industry fails to acknowledge the bottom line.

Unlike the US Open, the open market in the US airline industry does not identify the best. Rather it just keeps expanding the field until someone less than the best is crowned the best because they are younger - if only on a quarterly basis based on our fixation with results. Labor leaders should look at seniority as the only real weapon the upstarts have to whipsaw you. Management must make the best business case it can to stop the madness of continually having to average down labor costs as the only controllable means to manage overall costs.

The US airline industry, like the US Open, should be an examination of competition between the best. Instead it is about luck – and timing. It is about playing the “river.” I don’t know which airlines will survive. But I do care about the integrity of the field – something that is fundamental to the rules of golf. Like in the US Open, the field should be the best. Many are fit but few can deliver the full range of consumer service that established airlines offer.

Lucas Glover, David Duval, Ross Fisher and Soren Hansen earned finishes that may get them named to a Ryder Cup team. In that event, they’ll be required to play team events like 4-ball and Foursomes.

Too bad that, in the US, too many politicians view team events like consolidation and alliances as a threat to competition and the sure path to domination. Who has won the majority of the last two decades Ryder Cup matches? Not the US. And the same will be true of survivors in the global airline industry if we do not change our thinking about global competition.

Frontier and Republic; Republic and Frontier

Last October, I penned a piece on swelblog entitled: Just Who Will Inherit the US Domestic Market? Don’t Forget Today’s “Regional Carriers”. I thought it appropriate to repost the piece based on the news that Republic has offered to buy 100 percent of Frontier's equity for $108.8 million upon its emergence from bankruptcy protection.

Aboard UA #2: Reading Captain Wallach’s Latest Half Truths

I have a long institutional history at United, primarily working on behalf of the Association of Flight Attendants. In this role, I worked with the flight attendants through every concessionary period, the ESOP attempts, and Phase One of bankruptcy -- a long association that ended when I spoke my mind in a media interview on the vulnerability of defined benefit pension plans and, in doing so, angered some in the union leadership with my candor. .

All by way of saying that there is very little in United’s recent history, at least between 1985 and 2003, that I did not witness up front and personal.

The Recent Spat

The latest static at UAL involves a war of words surrounding United, Continental, Air Canada and Lufthansa in their application for anti-trust immunity to operate an international alliance. This debate is creating much more noise in Chicago than it is in either Washington or Brussels and that’s for one reason: the noise comes from a desperate union leader who waited ten months to voice concern about any potential impact on United workers.

This is the very same union leader who sits on United’s Board of Directors. His administration was subject to a federal court injunction to end what Judge Joan H. Lefkow ruled was a job action in clear violation of federal law. This, in fact, is a union leader who fancies himself as the second coming of ALPA boss Rick Dubinsky – the legendary golden goose hunter that worked more than 15 years to create many of the problems that still plague United. But, Mr. Wallach, you are no Rick Dubinisky.

Sometime after Wallach’s anti-trust immunity concerns were made known via the press, United COO John Tague, sent a letter to employees explaining United’s successful alliances with ten airlines over the course of the past ten years – none of which had led to problems or complaints with the carrier’s unions. A day later, Wallach responded with an open letter to Tague and copied all United employees – a tirade he then shared with the media as demonstrated by this submission to Forbes.com.

Wallach’s Letter

Wallach opens citing what he calls blatant mischaracterizations and outright falsehoods contained in Tague’s letter. But after reading Wallach’s letter, I am of the mind that it is he who is guilty of blatant mischaracterizations and outright falsehoods.

In building his case, Wallach attempts to blame United’s role in the STAR Alliance for the airline’s trouble today . . . a dubious case he makes by comparing the size of United in 1997 when it first joined STAR to the carrier’s size today. That argument conveniently fails to note that 1997 marked the middle of the greatest up cycle in US airline history, and then neglects to account for all the industry trouble that has transpired since. But that’s what the industry has come to expect from unions that spend more time and capital attacking companies through half truths and blatant misinterpretations rather than working to address the economic and competitive realities at the root of the industry’s struggles.

A more honest analysis would take into account the full breadth of events that have had a profound impact on the airline industry since 1997, including but not limited to SARS

1. SARS
2. The growth of the US low cost carriers
3. The rapid deflation of the IPO bubble
4. The puncture of the stock market bubble
5. The advent of internet distribution and pricing (transparency that contributes to lower ticket prices
6. The Summer of 2000 (where actions by UA pilots to “work to rule” impacted service)
7. Ratification of a new pilot contract with rates far higher than the rest of the industry
8. September 11, 2001
9. US Airways bankruptcy filing that led to significant reductions in labor rates
10. United bankruptcy filing
11. Oil prices begin increase to historic levels; crack spreads depart from historic norms
12. Delta and Northwest bankruptcy filings
13. Oil reaches $147 per barrel, driving run up of other commodity prices
14. New rash of airline industry oil hedges in anticipation of further price spikes,
15. Followed by plummeting prices that put many hedge contracts underwater
16. Credit crisis takes hold
17. Consumer confidence falls
18. Economy enters recession in late 2007
19. Recession deepens to become worst on record since 1930’s with global reach into Asia and Europe
20. Pandemic flu outbreak with hardest initial impact in Mexico.
21. United pilots in negotiations over new contract for first time since bankruptcy agreement.

The real lesson is in the extent to which the entire industry has changed over the past 12 years with a permanent impact on the legacy carriers. Wallach weakens his own case by suggesting that alliances have hurt US airline employment without identifying the many factors in the equation.

In fact, I would argue that without the alliance partners United works with today, the airline would be even smaller.

Has the management at United made some mistakes along the way? Of course. The current UAL leadership has no compunction about forgetting the past other than to recognize that the carrier’s past was largely a dysfunctional disaster. But that recognition led to many of the changes to United’s structure and operations in place today. As CEO Glenn Tilton often makes the case, the industry has to earn its cost of capital – something the global industry has rarely achieved over its long history.

Corporate Campaigns and Organized Pilot Labor

The airline unions – particularly those now in contract negotiations, have not shied away from full-barrel attacks on the carriers as one method of soliciting support during labor talks. Ginning up opposition to airline alliances seems to have become the latest tactic in this long-running campaign. But it should not be lost on any industry watcher that the loudest rhetoric comes from the union halls of the pilots at United and American. Ironically, the least noise is coming from the most successful US legacy carriers – Continental and Delta. I’ll leave it to the readers to weigh in as to whether there’s a connection.

But outside the rhetoric there’s a pretty clear case for the benefits of these alliances, particularly for an industry that needs desperately to hold on to its customer base. Maintaining and expanding the current alliance structure is one sure way to do so.

Concluding Thoughts

It is important to filter the daily missives fired from the labor bunker with the understanding that many in the industry are understandably frustrated by the changes and challenges in the airline industry. At some level, the best labor leaders recognize that the industry will not return to the unsustainable bargaining patterns and demands of yesteryear. Captain Wallach should take a very careful look at his union’s history at United and role in contributing to the precarious position the airline now finds itself in.  In other words, make yourself relevant in shaping United's tomorrow.

That history lesson should begin with the pilot-led majority purchase of the company in 1994, a process that began following a strike in 1985. With that purchase, the unions had unprecedented power in the governance structure and influence so strong it included hiring and firing power. But as the ESOP sunset, there was no transformation – no new culture or structure that prepared the airline to weather the trials to come. Instead, the transformation has come as the result of seismic economic factors that are redrawing the global airline industry map. And that map includes alliances – a necessary partnership in an industry in which US airlines aren’t permitted to act like other global businesses and merge.

There is not one legacy carrier in the US today that could stand alone and compete on a global scale. To stand in the way of market evolution is to stand on a dangerous path.