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Why hasn't the US industry undergone "creative destruction"? Jan/Feb 2005 Download PDF

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The US industry remains in the midst of a structural battle between two sectors following vastly different business models.

This competitive battle has been well understood by industry observers for many years (see Aviation Strategy, July/August 2002 for example) but few expected that there would still be no sign of an industry shakeout more than seven years after the battle began and, four years after the financial collapse of the Legacy/Big Hub sector (American, United, Delta, Northwest, Continental and USAirways have lost $27bn since 2000). Industries in the midst of structural change — the "creative destruction" of free markets — usually create profit opportunities for those driving the innovation and restructuring. The extended stalemate in US aviation has had the opposite effect — wiping out profits, growth prospects and access to capital for everyone.

In his article, Hubert Horan explores the causes of the current stalemate, the types of restructuring that could drive a shakeout to restore a more stable equilibrium, and the major factors blocking needed reform.

Disequilibrium: structural LCC-Legacy battles

Ten years ago, the Low Cost/Quasi–Network sector operated 7% of industry capacity, heavily concentrated in short–haul market niches (such as intra–California/Texas) and did not directly compete with any of the large Legacy hubs. Today’s structural battle began in the late 90s when the Legacy carriers bloated both their fare and cost structures allowing the LCCs to rapidly expand into the core of traditional Legacy markets. Now the LCCs operate more than a quarter of all domestic capacity, and compete with the Legacy business model from coast to coast.

The six Legacy mainline carriers have not only lost share to the LCCs, but have also been steadily shifting operations to the smaller aircraft of their regional partners. There is no hope of sustainable industry profits until the market share battle between the two sectors has been played out, and a new competitive balance emerges.

The underlying economics of the Legacy/Big Hub business model suggest it could have profitably captured the dominant share of US traffic. The vast majority of O&D markets are small,and the Big Hub business model is expressly designed to serve a diverse range of low volume flows. However, the Legacy carriers extended the Hub model well beyond the markets where it had clear advantage, attempting to provide nearly universal coverage of all US–based O&Ds, large and small, hub and non–hub. The Low Cost/Quasi- Network model deliberately avoided both ubiquitous networks and the costs and complexity of large connecting hubs, in order to serve the largest O&D markets at the lowest possible cost. The structural battle, and today’s unprofitable disequilibrium will be resolved when the Legacy sector restructures around sustainable capacity levels in the markets where they have competitive advantage.

The underlying strengths of the Legacy/Big Hub model have been badly damaged by the $27bn in losses, and the related damage to balance sheets and brand reputations.

One internal Legacy carrier analysis from the early 90s found that if LCCs (then serving 3% of national demand) expanded to serve all markets where they had an inherent competitive advantage, they could grow to perhaps 20% of the industry, with the inherent advantages of the Big Hubs allowing them to profitably serve the other 80%. Had the Legacy group fully reformed costs and network approaches several years ago, it might have profitably retained 65–70% of the market. Without rapid cost and network restructuring, the profitable Legacy share of a post–shakeout industry could easily fall below 50%. None of the six Legacy carriers are viable going concerns if the current stalemate continues indefinitely.

Comparisons between industries are always imperfect, but there are many analogies between the US Legacy airlines and other industries where old–line companies survived but permanently lost share to newer business models: e.g. the business model of the large retailers (Sears, Macy's) focused on serving all possible market segments, rather than maximising efficiency in any specific segment, and struggled to respond to new models (Wal–Mart, Target) that targeted narrower segments at much lower cost. In each case, the "legacy" companies remained in denial about the inevitable loss of market share, allowing the new competition to capture much more of the market that they might have otherwise.

Financial collapse of the entire Legacy sector

The Legacy sector’s financial collapse resulted from the convergence of four factors:

  • Massive over–expansion in the late 90s, when 750 mainline and 575 regional jets were added; any capacity growth was foolhardy given the inevitable loss of Legacy share, and few of the expensive new aircraft arrived before the dotcom economic boom had faded.
  • Excessive focus on boosting short–term earnings, leading to astronomical increases in business fares, and a major breakdown of cost discipline as employees demanded permanent raises in line with the temporary growth in quarterly earnings and management compensation.
  • Accelerated competition from LCCs anxious to exploit the growing Legacy cost and pricing disadvantage, and the breakdown of Legacy customer loyalty.
  • Normal cyclical demand weakness after the dotcom boom ended in 1999/2000, exacerbated by the impact of the late 2001 terrorist attacks, and internet distribution channels that intensified the pace of normal price competition.

The Legacy cost and pricing structures of the mid–90s gave them a natural (but modest) advantage in serving many medium–sized markets (Cleveland–Phoenix, Boston- San Diego) via their hubs. These four factors destroyed that advantage, creating the opportunity for expanding LCCs to profitably capture a sizeable share of those flows.

Legacy over–expansion cannibalised existing traffic, and added huge costs but very little new revenue. Fare increases (to cover the cost of expansion, and to boost quarterly earnings) allowed LCCs to easily capture the largest of these markets. The strong customer loyalty Legacy carriers had developed in the 80s and early 90s collapsed in the face of superior value offered by the LCCsand the weakening of frequent flyer and travel agency programmes by carriers focused on short–term cash preservation.

As traffic fell, Legacy carriers shifted more and more hub routes to 50–seat RJs, which required even higher fares in local markets and could not provide the large volumes of connecting revenue needed to cover high hub infrastructure costs.

Continued LCC growth and the huge supply/ demand imbalance ensured that low fares rapidly spread beyond the small number of traditional high–volume point–to–point markets, undermining hub pricing nationwide, and permanently reducing the Legacy revenue base.

The LCC growth crisis

The Low Cost/Quasi–Network group operated just under 900 jet aircraft at the end of 2003, and anticipating strong, profitable growth, had 488 aircraft on firm order (equivalent to 55% of their current fleet) and options for several hundred more.

Most of this growth assumed steady ongoing share shift from the Legacy carriers — markets they expected the Legacy group to lose because of either natural disadvantage or financial mismanagement. These plans have been frustrated as that hopelessly unprofitable capacity shows no sign of exiting the market.

LCC profits will collapse if they cannot use their new aircraft profitably, and the added capacity drives industry–wide fares down to even less economic levels.

Atlantic Coast Airlines (rebranded as Independence Air) targeted United’s unprofitable Washington Dulles hub as a market that would never be viable as a Legacy operation, and that they thought they could successfully serve under an LCC model.

While there were a number of problems with Atlantic Coast’s strategy (including excessive reliance on 50–seat aircraft), United has not only refused to withdraw its unprofitable capacity, but actually increased capacity (acknowledged in Court documents to also be unprofitable) in an attempt to weaken Atlantic Coast’s new service. While it is normal and proper for airlines to respond to competitive attack, there is no evidence that United could ever operate a sustainably profitable hub at Dulles in an LCC–dominated industry, and United’s short–term response while under bankruptcy protection hardly reflects normal marketplace competition. Whatever the outcome at Dulles, these 488 aircraft could become a major financial drain for the LCCs if the Legacy sector continues to lose billions on its current hubs and capacity. Expansion capital, which LCCs had ready access to in 2003, is no longer available, and all plans for new entrants (such as Virgin America) have been moved to the back burner. Even the LCCs that are best positioned for any eventual industry shakeout such as Southwest, have seen their share prices punished by investors who see poor (and excessively volatile) short–term yield and growth prospects.

Legacy restructuring needs

The return of stable industry profitability will require major new progress in at least the following five areas:

  • Further large cuts in Legacy capacity serving high volume connect markets, (especially at the weakest hubs) where far too much expensive hub infrastructure is chasing very low yield traffic, and in non–hub (point–to point) markets that are most vulnerable to oversupply and uneconomic pricing
  • A much more rigorous segregation between operations and network strategies in LCC/Quasi–network markets, traditional high–demand hub markets (potentially exposed to LCC pricing), and very low–volume "regional" markets that will never be exposed to LCC pricing. No carrier has yet demonstrated an ability to compete successfully in all three sectors, and mixed approaches tend to reduce competitiveness in each. The desire to be all things to all people usually reflects much greater concern for market share than for profits.
  • Network (pricing/capacity) models must be completely restructured around more realistic, longer–term views of competitive supply/ demand/pricing dynamics and the mature aggregate industry revenue base, and around simpler and more stable approaches that can consistently provide a standard of value that customers can appreciate and rely on. Carriers must abandon models where exogenous economic factors justify capacity and revenue growth.

Carriers must abandon traditional approaches designed to aggressively exploit "market power" or short term market fluctuations.

  • Further large cuts in overly complex operational and marketing systems, usually supporting connecting traffic or small traffic niches where the marginal revenue is more than offset by the marginal costs.
  • More aggressive movement to the routes, capacity levels and pricing approaches that are clearly sustainable over the longer term in a post–shakeout environment, that can generate returns sufficient to cover higher fuel prices, and the ongoing replacement of fleet, computer systems and other capital.

In simplest terms, costs must be reduced, most importantly in areas where they do not add value that customers are willing to pay for. Capacity must be carefully aligned with the Legacy sector’s future revenue base and must be eliminated from markets where its costs are uncompetitive.

Changes of this nature would raise industry revenues by eliminating the pricing pressure created by excess capacity and carriers focusing on short term cash. It would eventually stabilise the LCC–Legacy market share battle, as Legacy carriers demonstrate sustainable profits at reasonable profits in their natural markets. The industry would regain access to capital once market stability allowed carriers to plausibly plan on returns from sensible investments.

Clinging to 80s/90s Legacy strategies

Each of these issues have been widely recognised, but no Legacy carrier has made substantive progress in more than one or two areas, and most have clung desperately to the competitive thinking developed ten to twenty years ago. Some carriers recognised the longer–term need for change, but kept high fares and excess capacity in place to protect short–term cash. This simply created unrealistic employee expectations about the level of jobs that could be sustained, and like US Airways at Philadelphia, made it easier for new competition to attack and cause much more lasting damage.

After inflation, the Legacy passenger revenue base fell 22% between 1997 and 2003 while ASMs fell only 9%.

Given billions in ongoing losses and the inevitable further expansion of LCC competition and pricing, the sustainable revenue base is obviously a much lower level.

Instead of shrinking capacity to sustainable levels, the Legacy carriers actually added 6% capacity in 2004. Most recent Legacy cuts occurred as a reaction to either a serious liquidity squeeze, or bankruptcy–process driven lease terminations, rather than any serious attempt to optimise long–term capacity. Rather than fixing the mistakes of the past, many Legacy carriers continue to play a dangerous game of "chicken", making as few painful changes as possible, hoping that someone else liquidates first.

The Legacy carriers operated 24 large hubs throughout the 1990s. Only two small hubs have been completely abandoned (see table, opposite), although several others have been transferred to the regional partner.

However it is possible that as few as seven hubs are sustainable in the long–term, with the hubs at the largest cities (ORD, ATL, DFW) and the least vulnerable to LCC competition (EWR, MSP) among the most likely survivors. It is unclear how hubs based predominately on high cost 50–seat aircraft can survive at any large scale, especially in markets like PIT, CLE, CVG IAD or STL that are heavily exposed to very low prices.

Some level of regional service will undoubtedly continue in those markets, but it cannot support any significant volume of connecting traffic, and would provide very little synergy with hubs in other cities.

Northwest and Continental have rigorously avoided LCC–type operations and markets, following strategies established in the early 90s.The other Legacy carriers continue to operate a somewhat muddled mixture of hub and point–to–point routes, and continue to experiment with "airlines–within the airline" (Delta’s Song, United’s Ted) that attempt to mimic LCC practices. The net result has been scheduling and pricing practices that are confusing for customers and do not make money in either type of market.

Most of this appears driven by the desire for ubiquitous national networks, and the desire to serve every category of airline traffic that became common in the late 80s when LCC competition was insignificant and the Legacy carriers had a 97% market share.

Delta recently introduced a much lower and simpler pricing system (see SimpliFares analysis, this issue), the only major Legacy attempt to move to the type of approach that will likely emerge in a "post–shakeout" industry environment (Alaska and America West converted to this approach some time ago).

However pricing approaches can only succeed when carefully aligned with all other elements of network strategy. Delta’s network remains a mish–mash of ultra–competitive point–to–point markets (Transcon, Northeast–Florida), a classic Big Hub (Atlanta) and high–cost regional operations (Cincinnati, Salt Lake City). There is no obvious link between Delta’s network and its new pricing approaches, and it is unclear how any single pricing approach could serve the needs of the different types of routes it operates.

Northwest and Delta publicly argued over the initiative, illustrating two different perspectives on Legacy competitive incoherence.

Northwest has carefully managed its network to minimise LCC price competition, and argues that its traditional (high–fare) pricing approach (which Delta is undermining) is the best way to maximise revenue.

Thus Northwest has sensibly aligned its network and pricing approaches, but may have been unrealistic about its ability to sustain the high fare environment its network needs. Delta understands the need to deal with the future of airline pricing but doesn’t seem to have figured out how its 300 high–cost regional aircraft can make money in that environment.

Excessive Legacy focus on cost cuts

Carriers have made multiple rounds of large labour cuts since 2002.

Large cost cuts are a necessary part of any eventual restructuring but have clearly been inadequate.

They failed because carriers have been focusing narrowly on the labour cost of operating their late–90s network strategies, without addressing the shortcomings in those strategies, including the industry–wide oversupply they create. Labour cuts alone are also not sufficient to address the full magnitude of the Legacy late–90s cost bubble, when a 22% CASM increase added nearly $10bn of annual costs with little offsetting benefit. While new union contracts were a huge factor, there were also many aircraft, facility, financial and other new obligations that are even more difficult to reverse.

Legacy unit labour costs fell 7% in the first six months of 2004, driven by 11% declines at United and American. When financial performance continued to deteriorate, United and US Airways triggered another round of labour cuts by filing petitions with their respective Bankruptcy Courts, asking them to impose the lowest wages in the industry on their workforce*.

1 Alaska $184,392 128%
2 Southwest $170,352 118%
3 Northwest $168,480 117%
4 Continental $167,544 116%
5 Delta $161,928 112%
6 Frontier $146,952 102%
7 American $146,016 101%
8 AirTran $143,208 99%
9 Hawaiian $138,528 96%
10 Aloha $136,656 95%
11 ATA $135,720 94%
12 Midwest $134,784 93%
13 jetBlue $130,104 90%
14 America West $129,168 90%
15 Independence $123,552 86%
16 United $117,000 81%
17 US Airways $117,000 81%
  Average $144,199 100%
Note: table assumes an average of 78 hours per month
Source: Airline Forecasts

The other Legacy carriers initiated their own efforts to negotiate further cuts. Vaughn Cordle of Airline Forecasts, who has become one of the leading analysts of industry financial trends, estimated the annual wage cost for a senior narrowbody Captain (see table), assuming the proposed Legacy cuts are fully implemented. After decades where Legacy workers enjoyed a huge wage premium, United and US Airways would become the low–wage airlines, while Southwest pilots would be nearly the highest paid in the industry.

Yet Southwest remains profitable, with significant long–term growth potential, while there is no clear evidence of anyone willing to finance United’s or USAirways' emergence from Bankruptcy.

The larger problem is illustrated by the next table which compares actual labour and overall unit costs for the year ending 2Q2004 with and without the unit costs the Legacy carriers might achieve if they operated that level of capacity at the lower wage rates they are currently pursuing.

YE 2Q 2004 Labour CASM index-HP Total CASM index-HP
Legacy actual avg. 3.99 165 11.10 135
Legacy with cuts 3.29 126 10.41 127
WN 3.32 137 8.50 103
LCC (avg.) 3.01 124 8.58 104
FL 2.44 101 9.03 109
HP 2.44 100 8.22 100
B6 2.04 84 7.01 85

While the current round of Legacy labour cuts, if fully implemented, would reduce unit labour costs by 18%, overall unit costs would only fall 6%. Even if UA and US achieve the lowest wages in the industry (and with all Legacy carriers paying less than Southwest), overall costs would still be 25- 30% higher than Southwest and the LCC sector as a whole. Legacy and LCC costs are beginning to converge but there is still a sizeable gap. Wage cuts alone are simply not enough to make the Legacy carriers competitive.

Paralysis because the whole sector is bankrupt

In past airline crises, and in most analogous cases of business model battles in other industries (retailing, freight railroads) there was always a split between companies that suffered, but remained relatively strong and well–run (Dayton–Hudson, Union Pacific) and competitors on the verge of collapse (Montgomery Ward, Penn Central).

Having a core of strong survivors accelerated the process of reallocating industry assets from weaker to stronger uses, and replacing failed management practices with better ones. Better run companies can acquire worthwhile assets at a discount, and immediately make them much more productive.

Companies can spur financial recovery by copying practices and hiring managers from the better companies.

Following the early 90s airline downturn, major network assets that were struggling at Eastern, TWA and Pan Am, flourished after being acquired by United and American.

Northwest and Continental became much more profitable after a major influx of new, outside management talent. But today there are no strong companies in the sector capable of financing assets shifts, or sharing profitable practices. LCCs have money and capable managers, but have no use for any Legacy assets, and LCC practices cannot be readily transferred to Legacy networks.

Legacy carriers desperately need, but cannot afford the major management shakeups that NW and CO achieved ten years ago. Legacy management cultures remain dominated by the same thinking (and, with the exception of US Airways, by many of the same individuals) that destroyed Legacy competitiveness in the late 90s. Despite $27bn in losses, Legacy sector management seems far more focused on self–preservation than on the changes needed to restore profitability.

No profitable opportunity for outside investors

The early 90s US airline recovery was driven by outside investors attempting to profit from the restructuring process.

While the magnitude of new equity investment in the early 90s was not very large, without outside money (such as from KLM, Texas Pacific and Air Canada) driving the process, the industry might have taken many more years to recover from the 90–92 downturn.

The returns needed to justify major turnaround investments normally comes from either the potential for dramatic near–term equity appreciation or from a merger/consolidation opportunity that management could not exploit on its own (in the 1993 Northwest case, KLM’s small added equity investment led to the first (and most profitable) immunised transatlantic alliance, and to an option to acquire controlling ownership).

Today, new investors not only face a huge challenge figuring out how to rapidly improve the airline’s financial performance, but also face an environment where equity appreciation is more difficult, and they must also overcome serious obstacles to establishing control over management and the new capital structure. None of the current Legacy Board/management groups have developed plausible plans and most appear actively hostile to any steps that would threaten their full control (for example, Delta and American’s fierce resistance to Chapter 11 filings).

Investor returns will be limited by the magnitude of unpayable Legacy obligations; creditors will demand as much equity and future cash flow as possible.

And years of disastrous losses have seriously weakened the potential for near–term equity appreciation. Airline stocks continue to provide a speculative vehicle for day traders, but broad–based investor interest is gone, and without that interest it would be much more difficult to realise the type of rapid equity appreciation achieved at NW and CO in the 90s. Broad–base investor interest would return if the industry went through the restructuring and shakeout it needs, and demonstrated several years of improved performance. This equity appreciation problem would significantly increase the (already huge) risks any new airline investor would face.

Mergers and consolidations hold even less prospect for potential investors. The models and theories that were used to justify consolidations in the 90s have been fully discredited.

There are no cost or marketing synergies in any hypothetical intra–Legacy merger that would justify transaction costs, much less an acquisition premium. There continue to be occasional reports of consolidation talks between Delta, Northwest, and Continental but, aside from the payoffs individual managers and investment bankers might pocket, there is no reason to think consolidation would create any broader economic value. Remember that United pursued a $60 per share acquisition of US Airways until 2002, a transaction that would have made millions for a few individuals but would have completely destroyed both companies.

Chapter 11 process can’t cope

The US Chapter 11 bankruptcy laws are designed to keep as many assets profitably employed as possible, and to maximise financial recovery for the creditors whose contracts have been broken. It deliberately protects interim operations, since a company that can be profitably restructured will almost always provide greater returns for creditors than liquidation. The laws are not designed to protect employment or optimise industry conditions, and cannot be criticised merely because competitors find the process slow or the results inconvenient. The law relies on concrete reorganisation plans, and the self–interest of competing stakeholders to force the process to the best possible outcome for creditors in a reasonably timely manner.

Unfortunately, the current Chapter 11 process appears to be failing its primary missions of protecting creditors and maximising the base of assets that can be returned to profitable operations. Neither US Airways nor United have plausible turnaround plans or financing. Absent financeable plans, the two Courts lack the normal basis for deciding whether creditors will receive adequate compensation in aggregate, or whether each class of creditors will be treated fairly under the law. If nobody puts forward a reorganisation plan, and the airline’s cash generation can cover its out–of–pocket costs, then interim operations could continue for years. But if the airline remains fundamentally unprofitable, this results in a de–facto slow liquidation process — the worst possible result for creditors whose repayment depends on either capturing the value of liquidated assets, or future profits from a successful reorganisation. Slow liquidation involves "burning the furniture to heat the house"- destroying asset values and making an eventual turnaround much less likely.

If there are no outside investors, the peculiar creditor mix at large airlines can undermine the Chapter 11’s ability to maximise total creditor returns. Key creditor groups (labour, management, certain suppliers), and bankruptcy lawyers and consultants have limited interest in protecting capital assets or long–term going–concern value, and a huge incentive to prolong the status quo as long as possible, especially in cases like these where successful reorganisation would require deep, painful cuts. Certain creditors (such as aircraft lessors) may not wish to risk long–term marketing relationships by aggressively challenging the types of large airlines their business depends on.

These interests can hijack the Court process, run the airline on a short–term cash basis, and fund status–quo losses by eroding the value of other creditor assets. Unless an outside investor or creditor group is willing to file a competing, financeable plan, (tantamount to mounting a hostile takeover bid) there may be little the Court can do.

The Continental, Northwest and America West recapitalisation processes in the 90s and this year’s Hawaiian case were expeditious and successful as there were serious investor plans driving the process.

But Eastern, TWA and Pan Am lacked investors, and many creditors suffered as the Court was unable to force either viable reorganisation plans or final liquidation while interim operations dragged on and on.

United has been under Bankruptcy Court protection for 26 months and would have presumably filed many months earlier had $2bn in taxpayer (ATSB) funding not been on offer throughout 2002.

It is currently working on the sixth major iteration of its business plan. There has been no evidence of any serious new equity from investors using private sector criteria, and the ATSB found that two of the earlier versions of United’s plan did not even meet more lenient public sector standards. Each plan version to date has kept the basic United network strategy of the 90s (hubs, fleet mix, pricing, ubiquitous national network coverage) and United’s 2003 capacity levels completely intact. Profit recovery in each plan is primarily driven by enormous, rapid growth in unit revenue (including a return to dotcom era business fares) that are hard to comprehend given the industry changes of the last seven years.

United’s bankruptcy professionals have charged over $132m to date, making it one of the most expensive cases in US bankruptcy history, with no end in sight. United’s expert Court witness testifying to the causes of United’s current financial difficulties did not cite any problems with its basic business model or competitive strategy, or any problems created by any past United management decisions. United management has aggressively fought to maintain full control.

It attempted to contractually link union pay cuts to control by current management, and recently announced a preference for debt financing over new equity investors (who would require control). The Judge overseeing United’s case did not approve the contractual pay cut/control link but has blocked all outsiders from offering any competing reorganisation proposals.

In contrast, US Airways moved aggressively at the outset of the bankruptcy process to cut capacity, replace previous management, actively communicate with their workforce about the painful changes the bankruptcy process would require, bring in new equity financing and to emerge from bankruptcy as quickly as possible.

The process was arguably distorted by the availability of non–market (ATSB) financing in the immediate aftermath of the 2001 terrorist attacks, but this was not an inherent flaw in the bankruptcy process. While it can be argued that US Airways made more substantive changes in 2002/03 than the other five Legacy carriers put together, they unfortunately did not go far enough.

Their plan did not come to grips with magnitude of the Legacy–LCC market shift, tried to protect the many unsustainable pockets of high–fare markets they still enjoyed, and failed to rethink their hubs and pricing in post–shakeout terms. They re–filed for Chapter 11 protection in September 2004, and have begun new rounds of capacity and cost cuts, but they do not appear to have anything resembling a plausible turnaround plan.

As noted earlier, both carriers asked their Courts to forcibly terminate all labour contracts and impose new long–term contracts with wages below those of most LCCs.

While the current contracts at these two airlines are not sustainable, this raises serious legal issues, and the precedent could seriously distort the industry shakeout process.

The new lower contracts would run for the rest of the decade, but have absolutely no link to an actual reorganisation plan with actual financing.

The legal requirement of a financeable plan is critical to ensuring the timely resolution of any Chapter 11 case — the company either develops a plan that can meet full creditor and Court scrutiny, or (if there is no hope of reorganisation) moves to liquidate.

By periodically imposing permanent cost cuts despite the absence of a plan, the Court undermines the legal pressure for timely reorganisation, and encourages the case to drag on and on. It also endangers basic creditor rights. In this case it seriously undermines the ability of the employees (perhaps the largest creditor group) to negotiate terms under any final reorganisation plan (such as equity or other consideration for their concessions).

Instead of focusing on the rights of creditors, the Courts appear to be giving higher priority to helping management sustain interim, status–quo operations.

The two airline’s requests for labour contract termination were based very narrowly on the argument that (a) other airlines have lower labour costs and (b) no one has offered to finance management’s current plan at the old contract rates. There was no evidence that profits (or financing) would materialise under the new lower contract rates.

Since none of the normal Chapter 11 safeguards apply (concrete plans that creditors can review and challenge, opportunities for competing plans) there has been no Court review of the planning models used to justify the cost cuts. Instead of terminating a contract to support the best overall plan for all creditors (as the law allows), United and US Airways are using contract termination process to strengthen the interim position of certain creditor groups at the expense of others, while prolonging current management’s ability to maintain control without having a financeable reorganisation plan.

This precedent creates the potential for every other Legacy carrier to file Chapter 11 and impose rock bottom wages on their work force. All they would need to demonstrate is the presence of competitors with lower wages, and the absence of investors anxious to finance management’s preferred plan under the old, higher wages. If lower section 1113–driven wages allow the United/US Airways slow liquidation process to drag on longer, Delta, Northwest, American and Continental may have no choice but to follow suit, and the larger Legacy stalemate could remain in place for many years.

All six carriers could be under Court protection, but with management still in full control and under little pressure to make the needed capacity cuts or painful changes in a timely manner.

Ending the stalemate

Hypothetically, independent action by each Legacy carrier could be sufficient to drive the needed shakeout. Rather than hanging on to weak capacity in the hope that competitors liquidate, each could unilaterally shut down weak hubs and other hopeless routes, restructure prices and continue to drive the current round of cost cutting.

It would be possible for all current Legacy airlines to survive under this approach, but it is totally inconsistent with recent Legacy behaviour and it is unlikely to be embraced anytime soon.

The involuntary liquidation of US Airways in the second half of 2005 remains possible, but the latest round of Section 1113 labour cuts may provide enough of a cash cushion to sustain operations longer.However, US Airways only operates 6% of industry capacity, most with a narrow geographic area, and its liquidation would not be sufficient to trigger an industry turnaround.

While Southwest and others would backfill some of US Airways current Philadelphia operations, there would not be other opportunities for carriers to reallocate large blocks of unprofitable capacity to US Airways routes. Regional jets would rapidly fill US slots at La Guardia and Washington National, but this would not address the larger problems of high prices in the Northeast or excess RJ capacity nationwide.

In the longer term, the traditional US Airways, based on connecting hubs, has no hope of survival, and any hub–based plan will eventually fail. US Airways’ only long term hope would appear to be a much more radical restructuring, such as creating a short haul LCC based on its current slot portfolio at LGA, DCA, PHL and BOS, and its new LCC–level labour costs.

All of current management’s recent planning has been firmly based on 90s connecting hub approaches and it would probably require a strong outside investor to pursue this opportunity. A true Northeast LCC would primarily compete with high–fare, high–cost RJs, and would easily trigger major changes throughout the industry.

The United bankruptcy case will probably be the single biggest driver of industry conditions in the near–future.

Involuntary liquidation of United (20% of industry capacity) appears highly unlikely at the moment, but if it occurred it would rapidly trigger several rounds of constructive changes. All of the other Legacy carriers would have the opportunity to move sizeable blocks of hopeless capacity to stronger positions (such as Tokyo, Heathrow and Chicago) as would certain LCCs (Dulles, Los Angeles).

Excess capacity–driven pricing pressure would disappear overnight. Assuming United is not likely to self–destruct, this process could still be driven by outside investors willing to submit a breakup plan to the Bankruptcy Court.

Industry consolidation only makes economic sense under this type of controlled liquidation approach, where carriers acquire a portion of a bankrupt carrier and shut down the rest.

Alternatively, an outside investor could also propose a plan keeping United intact, presumably with different managers and network thinking than United’s current plan.

However if United survives (as most assume is likely), 20% or so of other Legacy capacity would need to be liquidated before the needed industry shakeout can occur.

A credible, well financed United plan would certainly force others to consider long overdue cuts in their own system, but the actual cuts might proceed very slowly.

Any plan that does not rapidly trigger a major shakeout would not offer investors rapid revenue and profit improvements, and as noted earlier, investors may not be able to count on the type of equity appreciation seen in past industry turnarounds.

Any outside plan could force the Court to consider alternatives to the current slow liquidation process, and could eventually lead to a final resolution of the United case one way or another. However, any new investors will face the huge expense and risk of overcoming the resistance of the groups (including management, labour, and their large army of lawyers and consultants) benefiting from the status–quo.

Industry restructuring will only take place if airlines and/or outsiders with major financial resources propose major changes to today’s unprofitable Legacy capacity and practices. Any such effort would face major obstacles, and might never justify the financial risk required. Unless outside force is brought to bear, the slow liquidation process at United could easily drag on, and other Legacy carriers (possibly all of them) could begin using Chapter 11 to sustain their status- quo and management control. The bankrupt Legacy carriers would steadily shrink, but there would be no industry recovery, and capital markets would remain totally alienated. If an extended stalemate keeps uneconomic capacity and practices alive, even the airlines with lower costs, motivated staff, smarter marketing, satisfied customers and other strong fundamentals would struggle to make money.

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