It’s difficult to open a newspaper or turn on the television without hearing about the downward spiral of the U.S. airline industry.  In a state of financial panic, many airlines are trimming schedules, grounding jets and eliminating jobs, resulting in higher ticket prices, congested airports and delays and cancellations for consumers.  According to the Bureau of Transportation Services, the group consisting of the seven largest U.S. airlines (Continental Airlines, Delta Air Lines, Northwest Airlines, American Airlines, US Airways, Alaska Airlines and United Airlines) reported a combined operating loss of $1.3 billion for the first quarter of 2008, a 5.2 percent decrease from the previous quarter.  This loss was the group’s largest quarterly loss since the fourth quarter of 2005.  The bad news for airlines has continued into the second and third quarters, with Wall Street analysts downgrading several airline and aerospace stocks during the last month.

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While this downward spiral of the airline industry did not create the nation’s current economic turmoil, a strong correlation exists between the two, and there will be additional burdens on the nation’s economy unless immediate action is taken to address the health of the domestic airline industry.  As such, McGladrey Capital Markets, the investment banking arm of RSM McGladrey and H&R Block, is calling on Congress to re-regulate the industry.  McGladrey Capital Markets recognizes that the airline sector is a critical segment of the U.S. economy, and believes re-regulation of the industry is long overdue.  In the midst of a recession, Congress must act promptly to avoid further negative issues impacting airline industry and therefore the U.S. economy as a whole.

McGladrey Capital Markets is not alone in its beliefs that a healthy U.S. airline industry is necessary for an overall healthy national economy.  Kevin Mitchell, chairman of the Business Travel Coalition, states, “The airline industry stimulates so much economic activity – much more than people currently understand.”  A recent press release from the BTC notes how the following nine economic areas become impacted during a down cycle in the airline industry:

• Direct Employment – According to the U.S. Department of Transportation, each of the seven largest U.S. airlines employs between 30,000 and 75,000 workers, with salaries, wages and benefits totaling over $26 billion in 2007.
• Communities and Indirect Jobs – Each airline job creates a large number of indirect local jobs, such as local retail jobs at or near the airport, construction jobs and service jobs.  According to BTC, Los Angeles World Airports, for example, calculated that while roughly 59,000 people work at LAX, its aggregate employment totals over 400,000, with an annual economic impact of $61 billion.
• Purchases from Suppliers – Financially struggling airlines are less likely to meet their purchasing commitments to aircraft manufacturers, such as Boeing and Airbus, as well as other companies supplying various parts and services to the airlines.
• Tourism – As many manufacturing jobs have been outsourced overseas, the United States has turned lto tourism to help fill the void.  According a survey performed by the Travel Industry Association, frustrations among air travelers, resulting from higher costs, delays and cancellations, led them to avoid an estimated 41 million trips from May 2007 to May 2008.  Roger Dow, the TIA’s president and chief executive, estimates that this statistic “represents a $26 billion loss in consumer spending to the U.S. economy, including $9.4 billion in lost airline revenues, $5.6 billion in lost hotel receipts, $3.1 billion in lost restaurant income and $4.21 billion in lost federal, state and local taxes."
• Logistics and Supply Chain Management – Aside from passengers, airlines carry a variety of cargo, ranging from manufacturing parts to food.  Airline failures would result in increased shipping and postage prices for these items and, therefore, higher prices for the consumers.
• Business Activity – The ability of businesspeople to travel from point A to point B is essential for economic expansion.  With a down cycle in airline activity comes a down cycle in business activity.  According to Reuters, business travel in March 2008 declined its largest amount since 2003.
• Tax Revenues – As noted in the TIA survey mentioned above, a decrease in air travel can have a major impact on federal, state and local taxes.
• Government Outlays – The BTC believes that affected employees, businesses and jurisdictions would place demands on public funds through unemployment compensation, retraining programs and public hospitals and healthcare resources.
• US Competitiveness – Because most U.S. airline growth over the past decade has been in international markets, a major U.S. airline failure could have both economic and political implications overseas.  According to the BTC, international arrivals into the United States declined 17 percent after September 11, 2001.  If another drop this size occurred, the impact would be an estimated  financial loss of $17 billion annually from international travelers.

Because the overall health of the U.S. economy relies on the success of the airline industry, finding a solution to the problems currently facing the industry is of the utmost importance.  These sentiments were echoed when Robert Crandall, former American Airlines chief executive, took the stage at New York’s Wings Club on June 10 to discuss the failure of deregulation in the airline industry.  Once a strong proponent of industry deregulation, Crandall declared, “Our airlines, once world leaders, are now laggards in every category, including fleet age, service quality and international reputation.  Meanwhile, the financial health of the industry, and of the individual carriers, has become ever more precarious.  Most have been through the bankruptcy process at least once, and some have passed through on multiple occasions.”

Crandall believes that the airline industry is one in which unfettered competition doesn’t work very well.  In the sense that the U.S. airline industry provides an essential commodity or service to the public and is an infrastructure requiring significant investment, Crandall states, “It is time to acknowledge that airlines look and are more like utilities than ordinary businesses.”  Other utilities, such as electricity and natural gas, have also had adverse outcomes with deregulation efforts and currently have consumers in many states calling for re-regulation.

Hector J. Cuellar, president of McGladrey Capital Markets, shares this belief, adding, “It is this utility-like characteristic that the U.S. Congress must appreciate so that we can re-harness its value and protect it.”  Cuellar’s career in the airline industry has spanned the profitable 1980s and 1990s as well as the apparent unprofitable new millennium.  While a managing director and industry head of Banc of America Securities’ Airline and Aerospace division, and subsequently the more profitable Aerospace and Defense Division, Cuellar saw a number of airlines, including Air Midwest, Air Wisconsin, Midway Airlines and Braniff International Airways, file for bankruptcy.  He also was called as an expert witness during the MarkAir and United Airlines bankruptcies. During his career, Cuellar also oversaw portfolio responsibility for Latin American and European airlines.

While acting as an expert witness during the United Airlines bankruptcy trial in 2003, Cuellar concluded that limited government regulation may be necessary to help the industry survive.  As such, he views Crandall’s recent statements as a catalyst for the re-regulation of the industry and is calling on Congress, the Federal Aviation Administration and other government entities to act promptly.  Cuellar adds, “Crandall’s views should not be limited to a sound bite for the Wings Club.  Government must act now -- before our airline transportation infrastructure is depleted.”

Currently, the soaring price of jet fuel is causing the greatest concern for airlines.  The issue is hard to ignore:  the Bureau of Transportation Statistics states that the top seven U.S. airlines spent an average of 29.4 percent of their operating expenses on fuel during the first quarter of 2008.  According to the Air Transport Association, the change in jet fuel prices from a year ago will result in an additional $24.6 billion in jet fuel expenses for U.S. passenger and cargo airlines.  As a reference point, 1999 was the best year in terms of earnings for U.S. passenger and cargo airlines and yielded profits of $5.3 billion -- nearly five times less than what the aforementioned annual increase in jet fuel will cost.

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The rapid increase in jet fuel prices has certainly added to the airline industry’s financial distress.  Several airlines are asking for legislation to add more transparency and disclosure in the oil markets.  However, Cuellar and Crandall agree that the rising cost of fuel is not the only obstacle the industry must overcome if it is to regain its once-elite status.  Airlines have gone bankrupt during periods in which the industry was paying much less for jet fuel.  Other issues, such as the lack of a regulated pricing system and outdated labor and bankruptcy laws, have been even more influential in the industry’s downfall.

With airlines pricing each other into bankruptcy, both Cuellar and Crandall agree that a government-supervised floor on pricing is necessary.  “The U.S. airline industry cannot operate efficiently without a regulated pricing structure,” Cuellar says.  He believes a structure in which a commission is established to review airline prices is essential, given the utility-like characteristics of airlines, and that if anything is to come out of possible industry re-regulation, it should be an updated pricing model.  While Crandall does not get into pricing structure specifics, he agrees that a structure that enables airlines to recapture full costs and earn the profits needed to sustain the large investments required for industry growth is necessary.

Aside from the obvious jet fuel costs, another cost item that wreaks havoc on airlines’ balance sheets is labor.  Many legacy airlines (i.e., those in place before deregulation) have an older workforce with employees who earn higher salaries as well as more retirees collecting pension benefits.  Legacy carriers tend to have dated union contracts in place, making it difficult to compete from a labor cost perspective with newer airlines such as Southwest and JetBlue.  There are enormously imbalanced negotiating strengths between organized labor and the airlines themselves, with labor enjoying leverage from the nature of the industry.  Crandall explains, “Unlike industries with a tangible product, airline seats cannot be stockpiled.  Thus, an airline has no product to sell during a strike, loses business when a strike is threatened, and suffers from reduced traffic for months after a strike is settled.”  Cuellar agrees with this assessment and is urging Congress to amend current labor laws to enable resolutions to be reached in a more timely manner.  “Amending our labor system to quickly resolve issues is the key.  The current system, in which labor disputes can last for several months or even years, does not work,” Cuellar says.  Although a quicker binding arbitration process may deprive organized labor of its leverage, it will assist in stabilizing the currently imbalanced system.

Finally, Cuellar and Crandall agree that government intervention is necessary in the nation’s current bankruptcy laws, which allow failing airlines to remain in operation while under protection.  Tom Plaskett, former chief executive of Pan Am CEO, states, “It takes a lot to and a very long time to kill an airline.  They [airlines] live from paycheck to paycheck, always scrambling to find a little cash here or there.”  In the nation’s current system, the government seems to be dedicated to keeping these financially distressed airlines in business.  For example, Congress delivered $7.5 billion in emergency aid to the industry after 9/11.  Additionally, the Air Transportation Stabilization Board, created in 2001, is authorized to issue $10 billion in federal loan guarantees where “such agreement is a necessary part of maintaining a safe, efficient and viable commercial aviation system in the U.S.”  Under proposed revisions of current bankruptcy laws, the ability of failed carriers to use lower costs to undercut the fares of financially stable carriers should be disallowed.  Additionally, Cuellar believes the government should set a more stringent time limit during which airlines can operate under bankruptcy protection.  “If failed airlines are unable to get their affairs in order within one year, they should die,” he says.

Regarding re-regulation, Crandall also calls for slot controls at congested airports, more stringent financial standards for new carriers, and a more accommodating stance towards industry collaboration.  McGladrey Capital Markets, on the other hand, believes that once a properly regulated pricing structure is implemented, the marketplace will alleviate concerns surrounding airport efficiencies and services.  Additionally, the firm believes strict financial standards for new carriers are unnecessary, since investors will determine the feasibility of new industry participants based on the natural obstacles associated with entering the market.

McGladrey Capital Markets strongly believes that prompt government intervention over a universal pricing structure, labor systems and bankruptcy laws are necessary for the success of the airline industry.  With the industry losing a collective $13 billion since deregulation in 1978, including the profitable years in the 1980s and 1990s, it is evident that airlines have characteristics incompatible with a completely unregulated environment; market forces alone cannot product a satisfactory industry.  A limited amount of regulation has the potential to provide the industry with much-needed financial stability.  Since the health of the airline industry has a significant impact on the U.S. economy as a whole, re-regulation is necessary for the nation itself.