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US Aviation Review 2012: Vinay vs. Cranky Flier

by Vinay Bhaskara and Brett SnyderEarlier this month, I had a chance to do a little bit of back and forth with Brett Snyder (a.k.a Cranky Flier) about some of the biggest news stories in US aviation from last year. While the idea was that we’d do a lot of debating, it became mostly a discussion (what was that line about great minds….?).

We started off with the potential US Airways/American merger.

Vinay: From a network perspective I really like this merger more than most for American (and of course for US Air) because it really plugs a lot of holes.

Domestically, there is still a lot of incremental value in secondary NE markets (ALB, ROC, SYR, BDL, et. al) connecting them north to south along the East coast. Philadelphia is a strong and stable origin and destination (O&D) market with limited low cost carrier (LCC) penetration and little room for LCCs to expand b/c of terminal space in the medium term. And Philadelphia is a strong connecting hub with a good European network. It is consistently undervalued as a hub in my opinion, and adding Philly would allow American to flow connections to Europe over Philadelphia, leaving the valuable slots at New York JFK for premium O&D flights.

Charlotte is a unique hub that fills a huge hole for American (even United would highly value a Charlotte hub). From a pure network perspective, there is no other hub in American’s network that can serve the traffic flows that Charlotte can’t; Miami is too far South and Dallas Fort Worth too far west. While Northeast-Southeast flying isn’t high yielding in the aggregate there is some high yield traffic there. Flying from the rest of the country to the Southeast is plenty high yield. Plus, demographic and economic trends point to a rosier future for the South as well as for Charlotte. O&D may be a little low in Charlotte at the moment for a hub its size, but it is fast growing thanks to the banking industry, and more importantly high yield. Some international overlap is present with Miami, but the domestic scale means that Charlotte is a viable hub (or at least 85-90% of its current capacity is).

Do I even need to describe the value of Reagan? It’s the preferred airport for DC business travel and of huge strategic value.

Phoenix has questionable value; cost creep from the merger pushes a lot of its flying to unprofitability. The one good thing is that the main competitor Southwest is facing heavy cost creep as well, but even so it’s heavily squeezed by Dallas Fort Worth to the East and Los Angeles to the West.
The Delta/Northwest merger proves that fleets don’t matter to a merger of this scale.

A lot of synergies in terms of consolidated negotiating of contracts, as well as increased attractiveness to frequent flyers are often ignored. These effects number into the hundreds of millions of dollars annually.

From a labor perspective, it has the potential to be a nightmare, though the toxicity of AMR employees seems mostly directed at Horton and current management. I do like that AMR is waiting to complete bankruptcy before merging; this allows them to merge from a lower cost base and not push up US Airways’ costs too much.

It’s also important to note that US Airways management team is amongst the best in the business. Doug Parker and co. have taken an imperfect and challenging situation and turned it into record profits. Bringing that kind of strategic vision to AA’s more powerful network and customer base can only mean good things.

In summary, I’d say that neither US Airways nor American needs to merge. Rather, it adds a lot of value for both parties and would create a stronger airline.

Cranky Flier: I agree with nearly all of what you’ve said, but I want to focus on that last point.  It might be true that neither American nor US Airways needs to merge, but I would say that US Airways needs it less.

US Airways has found a profitable niche over the last few years.  It has been consistently profitable with a lower revenue base because it has been able to achieve costs to match.  But that is really what the airline is – a niche player.  It can help to complement other larger airlines, as it does in Star Alliance today, but it is not a world leader.

American, on the other hand, is supposed to be one of the big three.  It’s the North American anchor of oneworld and it has powerful partnerships.  But when it comes to being a network carrier that serves the US, it falls short of its competitors.  With mergers, Delta and United have created networks that serve the needs of the US.  They are actively working to build partnerships to make sure that Americans can get anywhere in the world without leaving the family.  American doesn’t have that.

Sure American has good partnerships with strong airlines around the world, but it still can’t get anyone from Providence to Atlanta.  In fact, it doesn’t even fly to Providence.  It has a real lack of connectivity up and down the east coast and that is a big problem for an airline that needs to compete for high dollar traveler loyalty.  And while it dominates Latin America with its partners, its European network is very weak.  Delta and United both have powerful jumping off points in New York that allow for single stop connections from much of the US to much of Europe.  American is forced to double connect people more often than not.

A US Airways merger rectifies these problems.  No, it doesn’t give American a hub as powerful as that of Delta or United in New York, but it does give the airline Philly, a respectable hub which, as you say, has little low cost penetration and a strong local traffic base.  That Philly hub combined with National in DC and Charlotte means that there is tremendous ability to connect small and large towns alike all along the east coast.  Charlotte provides the only natural competitor to Atlanta, and that would give American a rare leg up on United in that region.

And Phoenix, while likely to shrink in a merger, still provides a crucial point for connectivity throughout the West.  Dallas/Ft Worth can’t serve everything west.  That’s very clear in the fact that American no longer serves places like Burbank or Oakland.  This is where Phoenix can make a difference.

A merger doesn’t solve everything, but no merger can.  Sure, it fails to give American a Pacific presence, but that’s not the point.  The point is that it brings American so much that there’s no need to focus on what it can’t deliver.

Will there be labor unrest in a merger?  To some degree, sure.  Are mergers all difficult?  Yes, of course.  But if American really wants to compete with Delta and United, then it needs more strategic heft.  And a US Airways merger gives the airline exactly that.

We then moved on to the IT issues with the United/Continental merger.

Cranky Flier: I don’t know that they [United] did anything wrong with the original physical integration itself.  There were some minor issues but in the end, it went fairly smoothly.  The problems that followed were two-fold.

First, they just couldn’t be bothered to wait until they had a graphical interface for SHARES.  Instead, they forced all the United folks who used graphical interfaces before to learn command-driven SHARES.  From what I can tell, training wasn’t adequate, so you have a lot of agents that just didn’t know what to do.  I believe the new graphical interface has been introduced (or is in process), but there was a lot of unnecessary pain just because they were in too much of a hurry.

The other problem is that they didn’t bother to find out if SHARES could handle everything it needed to do.  Upgrades became a nightmare early on.  Then there have been all kinds of issues with reservations not ticketing, especially with partner airline awards.  It simply doesn’t seem like it can handle the tasks that it needs to handle.  This seems very surprising because US Airways seems to be running alright on SHARES.  Granted, it’s not exactly the same system, but you would really hope these problems would have been discovered before making the switch.

The end results is that customers are very uneasy.  You have people wanting to reconfirm everything multiple times because of how many problems there have been.  And the problems seem to have gotten worse over the last couple months, at least for our clients.  This can’t continue.  People will keep having miserable experiences due to tech problems and they won’t keep flying the airline forever.

Vinay: I don’t really have much more to add. I find it interesting that it was a training malfunction in that they didn’t give the United employees either sufficient training to work with Continental’s interface or didn’t wait for the new interface; I think that’s on United management for not planning properly.

Empirically, I can empathize with everybody who had to go through some trouble with the whole United reservations mess. This past summer, my father and I were flying out to Kansas City and there was a thunderstorm that turned Newark into a mess. There were literally hundreds of disaffected elites (let alone customers as a whole) packed into Terminal A where United has less than 60 flights a day, and I can only imagine how bad it was over in Terminal C. And it was taking the United customer reps 20-25 minutes just to deal with each customer and so we got in line at around 9 pm, and didn’t get rebooked till closer to 1 am.

But the more interesting question  is how much this affects revenue and profitability for United. Their Q3 and Q4 financial performance was rather poor from a revenue and margin perspective. Even while the aggregate operational performance has gotten better over Q4, as you’ve mentioned the issues have not completely subsided. When as a corporate customer/business traveler do you start to book away from United because you’re afraid of a lack of reliability? Because even if they only lose a few such customers at the margin, it has a tangible impact on PRASM and profitability.

Cranky Flier: I think any bookaway will be temporary.  They will get this fixed and they will start firing on all cylinders.  It’s just taking longer than it should have.  And longer than it did with Delta/Northwest.

Our focus then shifted to the Delta/Southwest deal for 717s

Vinay: Shifting gears a little bit, I’d like to talk a little bit about the Delta/Southwest 717 deal.
First, from a Delta perspective, it’s pretty much a continuation of the same strategy that brought them the MD-90s (and before that with Northwest the DC-9s and DC-10s) at dirt cheap rates. I know you described it as a “Moneyball” style of strategy earlier this year, and I’d agree. Delta is taking assets (airplanes) that are undervalued and thus relatively cheap on the world market, and then using them profitably. The strategy to minimize capital costs makes a lot of sense in the current environment and Delta is happily paying off its debt, even as the other US carriers commit to huge capital commitments in the form of massive aircraft orders (even Southwest). I also wonder if Delta will apply this strategy to A320s and 737NGs as those end up on the used market and their valuations fall in the face of the re-engined products? I know that the 737-900ER order is ostensibly supposed to partly replace the A320 fleet, but there is a chance that a deal too good to pass up on A320s will arise at some point over the next 3-5 years. Because of current trends in US and global oil production, especially the rise of alternative sources like shale oil and tar sands, the long run trend in oil prices looks to be declining, though oil prices are obviously quite volatile and there’s always the potential of environmental regulations driving up prices. So the downside risk for Delta of having a fuel inefficient fleet and being hit with a huge oil spike is relatively low in my opinion. From a network perspective, the 717s slot right in. They help backfill some of the lost capacity from the 50 seat regional jet reductions, and I think they’ll be especially useful for larger markets from La Guardia.

It’s the Southwest side of things that’s much more interesting in my opinion. Right after the merger, the thought was that AirTran’s international ops and the 717s would open up new windows of expansion for Southwest in international flying and smaller domestic markets. We’re finally seeing some of the international flying, but the smaller cities have been a bust. In fact much of AirTran domestic has been culled. Atlanta is more than 40 daily departures off its AirTran Pre-merger levels. The 717s are cheap, paid off, and more fuel efficient than the 737-500s. Yet Southwest could not make them work because the CASM rose too high. And I think that comes back to Southwest’s rising labor costs. For the past 30 years they’ve been granting steady pay and benefit increases to front line workers and offsetting that with steady growth and high productivity as well as fuel hedges. But now they’ve saturated the US, the hedges have expired, and productivity has slipped. And the end result is a rising cost base to such a degree that Southwest is now being forced to jack up fares; they aren’t really an LCC anymore. And there’s no real easy solution either. they could do what US legacies did and force wage freezes and benefit cuts down the unions’ throats, but Southwest has extremely good labor relations and it’s employees do tend to enhance service more than those at most US airlines (empirically). Another answer might be more fees a-la the legacies; but given Southwest’s marketing strategy that’s a no-go in the short term. More international flying and Hawaii flying will help buoy revenues but overall, the 717 deal points to broader structural issues within Southwest. Your thoughts?

Cranky Flier: Yeah, if we look at Delta, this acquisition really is just a continuation of a successful policy.  But I would argue that the 737-900ER is more of the same.  It’s a new airplane but it’s not the MAX, so I bet they were able to get a good deal simply because of that.  Delta really is opportunistic.  If the ability to pick up other airplanes for cheap arises, I’m sure it’ll pounce.  But I would be shocked if they found something as sweet as this 717 which allows them to ditch a bunch of fuel inefficient 50-seaters and bring more flying in-house making employees happy.  The cherry on top is that Southwest is paying to outfit them in Delta’s configuration, doing all maintenance, and painting them.  They’ll be delivered like new to Delta ready to go.  Beautiful plan.

As for Southwest, I just don’t know what to think.  I was excited about the possibility of Southwest being able to service smaller cities – it could open new opportunities I thought.  But Southwest pulled out of nearly every small city AirTran served.  It also went and ditched the 717, paying dearly for the privilege, effectively saying it can’t do it at all.

So that puts all of Southwest’s eggs in the international basket.  There is limited opportunity in the US for the airline.  Hawai’i and Caribbean/Latin are really the only growth opportunites that are big enough with high enough fares to support Southwest’s higher costs.  That can tide them over for awhile, but it’s sad to think that’s the only thing out there.

You would imagine that Southwest would have to start adding new fees seriously at some point.  They have danced around that point with some minor fees like charging you if you no-show for a flight, but they haven’t touched bag fees and change fees.  They’ve really dug themselves a hole if they even try at this point because marketing has really drilled it into people’s heads.  I think they can still get away with charging for a 2nd bag, so that would be something.  But they are in a very sticky situation now.

Editors Note: After I wrote about Delta getting used A320s/NGs, Richard Anderson on Delta’s Q4 earnings call:

“Given the glut of narrow-bodies coming on the market right now, we think that there is going to be significant opportunities because residual values on eight to ten year old narrow-body airplanes are on a significant downward slide. And we will continue to be with the glut of airplanes there.”

And we finished up by discussing the drama surrounding United, Southwest, and the fight for international service at Houston Hobby.

Cranky Flier: The whole thing seemed absurd to me.  Southwest only flies to Hobby in Houston and it wants to push internationally.  It stands to reason that it would want to operate those flights out of Hobby instead of splitting its operation into two airports.  That would just be stupid.  But the response United gave to this plan was simply absurd.  It trotted out all these consultants to do studies saying how it would ruin the entire Houston area and United would have to slash and burn everything.  Oh please.  Southwest might do some Caribbean and Latin flying but that’s about it.  Yet United acted like it would have to lay everyone off and stop flying to Houtson altogether.  (Yeah, that’s only a slight exaggeration to how silly they sounded.)

Even after Southwest won the battle, United tried to blame flight cuts and staff lay offs that were in the works on the decision.  Southwest isn’t even starting to fly for some time and nobody knows exactly where they’ll go.  To blame the addition of a customs/immigration facility at Hobby for the cuts is just a joke.  I imagine United might pay for this for quite some time with local Houston politicians.  I don’t think they should be expecting any favors.

Vinay: I agree that it was very much a knee-jerk reaction from United, and probably a bad one in terms of the Houston market moving forward. But it is important to point out that United is far and away the leader in the US-Latin America market in terms of profitability, with a superb 29.9% net margin (though American has the highest yields thanks to its Miami hub) as per DOT data for Q3. And for the most part, United’s Latin American network is through Houston. They command extremely high fares on some of the O&D monopoly markets to and from Latin America. When you throw Southwest into the equation, it takes away a lot of the VFR and leisure volume, as well as potentially some of the incremental business travel. And some of the connections to Mexico that are very competitive through Houston will be lost to Southwest at Hobby.  Will all of this kill United? No. But it is a significant threat to what is one of their cash cows. I think we all saw with the annual results last week that United is not in tip top financial shape. Regardless of their methods, I think it is understandable that United would strike out and try to shunt this in whatever way possible. Houston is a large and growing city with a large enough O&D base to sustain these two operations simultaneously. And we’ll likely see United manage its capacity allocation to Latin America better; large RJs versus mainline to Central American and Mexico for example. And all of this assumes that Southwest is able to get an international operation with all related reservations infrastructure in place by 2014; far from a sure bet.

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