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Archive for Friday, January 26, 2007

Airline industry seeks elusive profitability

January 26, 2007

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"If capitalists had been present at Kitty Hawk when the Wright brothers' plane first took off, they should have shot it down."

- Warren Buffett

Recently, as an airliner taxied up to a gate, a flight attendant made the usual announcement - thank you for flying with us - but with an unusual coda: "We know you have your choice of bankrupt airlines." Which raises a question: What is wrong with American Airlines?

American is the only one of the six "legacy" carriers (the others are United, Delta, Northwest, Continental, US Airways) that has never been in bankruptcy. Is it irresponsible for American not to use bankruptcy to lighten legacy costs - shredding labor contracts and reducing obligations to retired employees?

Gerard Arpey, American's CEO, replies with a laconic "no." He considers it unseemly and shortsighted - and unnecessary - to seize short-term competitive advantages by reneging on labor contracts freely consented to, and to escape commitments to investors who lent you money in good faith. Furthermore, the damage to employee relations makes bankruptcy more costly than some companies realize when they use it as a routine management tool.

While some of American's competitors use bankruptcy to end medical payments for retirees, Arpey says American continues to pay $250 million a year "for people who are not here." His reward has been helpfulness from American's unions.

JetBlue, a low-cost carrier, will outsource 80 percent of the maintenance of its aircraft to El Salvador and Canada. But because American's unions revised inefficient work rules ("I'm working on this plane in this hangar and when I finish I won't go to the next hangar"), American still does its maintenance in Tulsa, Kansas City and Fort Worth. Other airlines have used bankruptcy to bludgeon unions into financial givebacks; American's unions, says Arpey, "accepted pay cuts in 2003 and we have asked them to keep changing to drive more productivity - and they are answering the call." Still, Arpey says that if American, which has about 9,000 active pilots, had the work rules Continental has after two bankruptcies, "I could run American Airlines with 1,000 fewer pilots."

The U.S. airline industry is in the red since Kitty Hawk and today has three daunting problems. First, fuel costs are beyond any airline's control. However, good (if risky) business practices can help. Southwest has made hugely successful hedges against increased fuel costs, betting on an increase, and has been paying about half as much for fuel as most other airlines. But the hedge advantage is expiring and Southwest, now 35 years old, is acquiring legacy costs.

Second, with large fixed costs - aircraft - and an intensely competitive environment, no carrier could survive being grounded by a protracted strike, which limits management's leverage in bargaining with unions. But, then, unions understand that a strike could kill their employer.

Third, the nation now has a two-tier airline industry - the legacy carriers, and the younger low-cost carriers, the most successful being Southwest, which invented the second tier and now leads the industry in daily departures. The second tier, composed of newer airlines that never put in place huge legacy costs before deregulation unleashed price competition, limits the top tier's ability to pass along costs to customers. Hence the top tier's temptation to bankruptcy.

Two considerations, Arpey says, determine the choices of most air travelers - schedule and price. The Internet has simplified comparing prices over every route, and, he says, a price difference of even $3 will drive people elsewhere, "no matter how strong your brand, or how good your product." As American competes with airlines that got substantial cost relief from bankruptcy, Arpey says, "I hope the companies that do that will have consequences."

He adds, "Our results don't look that different than United's, which was three years in bankruptcy." This, even though post-bankruptcy United has a $1 billion annual labor cost advantage.

Having had an unhappy experience as an airline investor (with US Airways, which has been in bankruptcy twice), Warren Buffett says: "I have an 800-number now that I call if I get the urge to buy an airline stock. I call at 2 in the morning and I say: 'My name is Warren and I'm an aeroholic.' And then they talk me down."

Still, in 2003 American's stock fell to under $2 a share, and the company's market capitalization was under $500 million. As of this writing, the stock is over $37 and shareholders have $8 billion in equity, and in 2006 American had its first annual profit in six years. The Wright brothers' machine might work out after all.

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