Re-Regulation

Despite recent changes in expectations that now forecast a return to profitability in 2010 following two years of multi-billion dollar losses, the airline industry faces enormous financial and structural obstacles. The challenges faced by the lack of a regulated pricing system and outdated labor and bankruptcy laws, which contributed to the industry’s downfall, remain largely unresolved.

In a state of financial necessity, many airlines trimmed domestic schedules, reduced fleets and cut jobs resulting in inconsistent ticket prices, crowded airplanes, decreased customer satisfaction, and flight delays and cancellations. According to the Air Transportation Association, U.S. domestic capacity fell last year to its lowest point since 1999, and the U.S. has declined by nearly 700 aircraft since 2000. The Bureau of Transportation Statistics confirms that U.S. scheduled passenger airlines employed 4.1% fewer workers in April 2010 than in April 2009. This is the 22nd consecutive decrease in full-time employee levels for a 12 month period. The pool of U.S. travelers is greatly diminished from just two years ago, when McGladrey Capital Markets first called for the re-regulation of the airline industry.

It is no coincidence that the airline industry is deteriorating simultaneously to the downturn of the U.S. economy. While the struggles 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. Two years ago in Farnborough, McGladrey Capital Markets, the investment banking arm of RSM McGladrey and H&R Block, called on Congress to re-regulate the industry. There continues to be fear in the word “re-regulation.” Yet, time has only strengthened this call to action as evidenced by losses of $12.3 billion in North America alone over the last two years. If action is not taken to re-regulate the airline industry, we will continue to see airlines cutting corners and implementing more surcharges in order to become profitable. The airline sector is a vital segment of the U.S. economy and McGladrey Capital Markets strongly believes that industry re-regulation is long overdue. Congress must stop discussing and act promptly to avoid further negative results which impact the airline industry and thus the U.S. economy as a whole.

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

Direct Employment – According to the U.S. Department of Transportation, the seven largest U.S. airlines each employed between 30,000 and 75,000 workers, with salaries, wages, and benefits totaling nearly $23 billion last year.
Communities and Indirect Jobs – Each airline creates a significant amount of indirect local jobs, including local retail jobs at or near the airport, construction and service jobs. According to Los Angeles World Airports, LAX employs roughly 50,000 people, but its aggregate employment totals over 400,000 with an annual economic impact of nearly $60 billion. One in 20 jobs in Southern California is attributed to LAX operations.
Purchases from Suppliers – Financially struggling airlines are less likely to meet their purchasing commitments to aircraft manufacturers, as well as other domestic aerospace companies supplying various parts and services to the airlines.
Tourism – As many manufacturing jobs have been outsourced overseas, the United States turned to tourism to help fill the void. Higher fares, along with reduced domestic capacity and frequent delays and cancellations however, drive away passengers.
Logistics and Supply Chain Management – Aside from passengers, airlines carry a variety of cargo, ranging from manufacturing parts to food.
Business Activity – The ability of businesspeople to travel wherever is essential for economic expansion. With a down cycle in airline activity comes a down cycle in business activity. Premium passengers and business travelers are vital to the recovery of the airline industry.
Tax Revenues – A decrease in air travel adversely impacts federal, state and local tax revenue.
Government Outlays – The BTC believes that adversely affected employees, businesses and jurisdictions increase the demand for scarce public funds through unemployment compensation, retraining programs, and public hospitals and healthcare resources.
U.S. 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. Further, international visitors to the U.S. decreased five percent in 2009 from 2008, which resulted in a 15% drop in spending by these visitors according to the International Trade Administration.

It’s difficult to open a newspaper or turn on the television without hearing experts and pundits championing the successes of airline deregulation. However, Demos, a non-partisan public policy organization, argues just the opposite. While deregulation made air travel more accessible to the general public, it facilitated the erosion of the airline industry. In 1978, there were about 150 low-cost airlines, but fewer than a dozen of these remain in operation today. The authors of the Demos’ report state, “Today’s industry is more concentrated than ever, yet lacks the resources and motivation to make crucial investments in equipment, technology, and human capital.” The authors, James Lardner and Robert Kuttner, do not believe the major airlines have a long-term strategy that can adapt to our ever-changing world. They maintain that the major airlines are static, content with continuing to cut back on service, ship jobs overseas, reduce benefits and hiding surcharges.

On one hand, Demos concedes that deregulation produced lower airfares which increased accessibility to air travel for millions of Americans. This benefit, however, is believed to be a double-edge sword. Demos considers “low airfares are as much a problem as an achievement if they leave an industry without the resources to maintain service standards and make crucial investments in equipment, technology, and human capital.” The public policy organization, founded in 2000, is calling for Congress to create a task force to investigate the industry’s problems and recommend solutions.

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 are echoed by Robert Crandall, former American Airlines chief executive. Once a strong proponent of deregulation, he recognized that “our airlines, once world leaders, are now laggards in every category, including fleet age, service quality and international reputation.”

Crandall believes that the airline industry is one in which unfettered competition doesn’t work well. Because 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 natural gas and electricity, 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 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 numerous airlines file for bankruptcy. He served as an expert witness during many bankruptcy trials, most notably United Airlines in 2003. After this experience, Cuellar concluded that limited government regulation is necessary to help the industry survive. He adds, “Government must act now – before our airline transportation infrastructure is depleted. Waiting further will limit our country’s ability to grow and negatively impact the aerospace sector as airlines press hard for lower prices and PMA (generic) parts.”

Currently, the volatile price of fuel is causing one of the greatest concerns for airlines. The six network airlines (Delta, American, United, US Airways, Continental, and Alaska) spent an average of 23.3% of their operating expenses in the first quarter of 2010 on fuel, compared to just 19.4% in the first quarter of 2005. However, the unpredictable price movements for fuel aren’t the only obstacle facing the airline industry. 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 deterioration.

With inefficient 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 demonstrated that it cannot operate efficiently without a regulated pricing structure,” Cuellar adds. He believes a structure in which a commission is established to review airline prices is vital, 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.

Helane Becker, analyst for Dahlman Rose & Co., agrees that the rules must be changed in regards to the airline industry. She believes that the pricing model must be changed so that airlines cannot be allowed to price below full cost and that new entrants into the industry should have larger minimum capital requirements. These practices, which would raise the barrier to entry into the airline industry, would detract from airlines pricing each other into bankruptcy. Crandall concurs 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. Such was the model in the pre-deregulation era.

Aside from jet fuel costs, another cost item wreaking havoc on airlines’ balance sheets is labor. Many legacy airlines (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, low-cost airlines such as JetBlue and Southwest. There are enormously imbalanced negotiating strengths between organized labor and the airlines themselves, with labor enjoying leverage from the nature of the industry. Since the airlines are in a service-oriented business, they have no product to sell during a strike. Even the threat of a strike can scare consumers away, and air traffic takes time to return to normal after a strike is resolved or averted. This is why Cuellar is urging Congress to amend current labor laws to enable resolutions to be reached in a timelier manner. Although a quicker binding arbitration process may deprive organized labor of its leverage, it will assist in stabilizing the currently imbalanced system.

With regard to current bankruptcy laws, government intervention is necessary to stop failing airlines from remaining in operation while under protection. Becker echoes this thought by recommending that the barriers to exit the airline industry are too high. Tom Plaskett, former chief executive of Pan Am, states, “It takes a lot 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 operation. For instance, Congress passed $7.5 billion in emergency aid to the industry after 9/11. Furthermore, 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.” Cuellar believes that the ability of failed carriers to use lower costs to undercut the fares of financially stable carriers should be disallowed. He continues to suggest that 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,” Cuellar stated.

The topic of airline re-regulation taboo is no longer taboo in today’s environment, as it is gathering Congressional attention. Recently, Congressman James Oberstar (D-Minn.), chairman of the House Transportation and Infrastructure Committee, and Congressman Jerry Costello (D-Ill.), chairman of the Aviation Subcommittee, held hearings on Capitol Hill discussing the possibility of re-regulating the airline industry. Oberstar says, “Hardly a day passes where I don't walk out on the (House) floor that someone asks me, 'When are we going to re-regulate the airlines?’”. He wishes to propose legislation that would create “federal regulation of airline pricing and re-establish a government gatekeeper role similar to that played by the old Civil Aeronautics Board prior to deregulation in 1978.”

McGladrey Capital Markets takes a strong stance on this issue because re-regulation is the best, and only, course of action. As a thought leader in the aerospace industry, MCM believes the current airline business model is not sustainable, and the evidence of this is overwhelming. These airlines use dangerously old fleets, have decreased capacity, cut thousands of jobs, and have had cumulative industry losses of near $13 billion since deregulation took effect in 1978. If the airline industry continues along its current path, it will have a far-reaching, disastrous impact. The nation’s infrastructure will suffer, consumer’s safety will be at risk because of the antiquated fleets, which opens the potential for foreign ownership. Furthermore, as the US airline industry suffers, so will the aerospace suppliers, creating a ripple effect. Unless this is resolved, we will welcome in the era of PMA on an accelerated basis. The answer lies in not permitting another 30 years of failure, and consolidation is a poor excuse when the nation has far too few carriers to compete. McGladrey strongly believes that utility-like treatment by Congress will avoid further consolidation and will improve the financial health of carriers allowing them to pay their employees, fund their pension plans and create jobs through capacity increases. Re-regulation will ensure consumer safety, long-lasting competition among the airlines and a healthy industry that will support our nation’s growth.