Fixing the Airlines: Reconfigure or Reregulate

Over the 30 years since airline “de-regulation” Delta (NYSE: DAL) management spent $2.35 on M&A for every $1 worth of value they created. Northwest (NYSE: NWA) spent $1.61 for every $1 worth of value created. Southwest (NYSE: LUV) spent just $0.03 on M&A for every $1 worth of value it created. For the details behind these numbers see my last post: Delta/Northwest: Evaluating Company Performance in a Dysfunctional Industry.

VALUE MIGRATION

The preface to Adrian Slywotzky’s 1996 book Value Migration begins with this declaration:

Value Migration describes an outside-in approach to strategy. It begins with the customer and works its way back. It requires thinking from the environment back into the company’s capabilities and direction.

No surprise Mr. Slywotsky devotes an entire chapter to domestic airlines. In “Migration to a No-Profit Industry” he points to a “hidden competitive advantage” that has become the standard of the day:

Ironically, these highly leveraged carriers had a hidden source of competitive advantage – bankruptcy court. While some carriers … failed completely, the courts often allowed bankrupt carriers to continue operating while they restructured. In 1983, Continental Airlines sought protection and temporarily shut down. A few days later, when it reopened, Lorenzo had voided union contracts, fired more than half the workforce, and dropped more than half his routes, lowering costs significantly (p. 125).

Also, no surprise Mr. Slywotsky had no idea “What if anything, will break the pattern toward zero profits” in the airline industry. I have a few ideas on how to do just that. But, first I offer a new perspective on Competing for Customers and Capital in this dysfunctional industry that gives some support to those ideas.

TWO MARKETS, TWO METRICS

Airline companies, like those in every other industry, compete in two separate but equally important markets. As result of the profound differences in how they operate, the markets for capital and customers are described with entirely different theories. Their performance is based on entirely different metrics. And the gap between the two is big enough to drive an 18-wheeler through.

If there is one take-away from this story it’s this:

To understand how the markets
for customers & capital interact
you must measure that interaction.

A company’s stock market performance is measured by its market cap. Its performance in consumer markets is measured by its sales revenues. Table 1 compares the performance of DAL with NWA and LUV over the period from the close of the 2nd quarter 1994 through the close of the 4th quarter 2007. The starting quarter in this series is the first one in which data were available for all eight domestic airlines included in this analysis.

Table 1

The first row in this table reports the market value of the three companies and the group for the first and last quarter in the series, followed by the percentage changes in each. The second row reports the sales revenues in the same way.

What can one conclude from the market value data in Table 1? For one thing, all three carriers, as well as the group, appear to have performed quite well. In particular, NWA appears to be a standout with a 237% appreciation in its market cap. Almost double LUV’s value creation over the period. Of course, the picture isn’t as rosy when you think back to the opening comment in this article: NWA spent $1.61 on M&A for every $1 of value it created.

What can one conclude from the sales revenue data in this table? Again, all three airlines appear to have done well. Especially noteworthy here is LUV’s 277% increase in sales revenue. But then again, if these revenues were adjusted for inflation, the result would be far less rosy.

The corrections needed to present an “adjusted” picture of performance are easy to make. But we didn’t know till now is how to capture the performance in these two markets with a single metric.

TWO MARKETS, ONE METRIC

Everyone is accustomed to measuring a company’s market share of sales revenue. Before now, few have ever considered measuring a company’s share of market value. Measuring both share of value and share of revenue simultaneously leads to the creation of a single metric that captures the interaction between the market for capital and customers.

Consider Table 2 where market shares of value and revenue are presented for the 2nd quarter of 1994 and the 4th quarter of 2007.

Table 2

In June 1994 DAL created 17.1% of the group’s $16.0 billion market value [from Table 1]. In the same quarter DAL generated 17.8% of the group’s $16.6 billion in sales revenues [from Table 1]. The difference between DAL’s share of value and its share of revenues was -0.7 points. By the close of the 4th quarter 2007 this difference had grown to -1.9 points. NWA’s value-revenue differences went from -5.6 to +1.6 points over the period. While LUV’s differences went from +19.5 to +24.3 points.

There were 53 quarters of data between the beginning and end of the series reported in the Tables above. Almost 14 years. How do you capture the effects of the value-revenue differences between these two points?

One way is to calculate the standard deviation of the value-revenue differences over the entire series. This is a measure of volatility commonly used in finance to create discounted rates of return. The standard deviation in DAL’s value-revenue differences over the 55 quarters was 6.9 points. The standard deviation in NWA’s value-revenue differences was 5.2. LUV’s standard deviation was 21.2. Call these a measure of the risk associated with each company’s relative performance in both capital and customer markets.

Dividing the value-revenue differences in each period by their risk yields the “risk-adjusted” differences. DAL’s risk-adjusted differences went from -0.1 to -0.3; NWA’s went from -1.1 to +0.3; LUV’s went from +0.9 to +1.1 over the 55 quarters. What do these numbers mean?

The risk-adjusted differential [RAD] is a measure of the interactions between capital and customer markets. In technical terms, within a strategic group, RAD is a standard normal variable with mean zero and standard deviation one. If you are interested in the theory and analytical details behind this metric you can find out in the audio slide show Y’all Buckle That Seat Belt. It runs about 18 minutes.

Think of RAD as a control variable. Companies with risk-adjusted differentials greater than zero are value creators. Those with RADs less than zero experience value migration. Since the standard deviation is one, a company that posts RADs greater that +2.0 is creating significantly more value than its peers. A company that posts RADs less than -2.0 is experiencing significant value migration.

DELTA’S ERRATIC GLIDE

Chart 1 reports the value creation & migration pattern for Delta Air Lines over the same 55 quarters.

Chart 1

Through the first 29 quarters ending in June 2001 Delta's pattern of value creation and migration was erratic, reaching a high point of +1.6 in September 1999. Delta clearly was tipped into decline by the attacks on the World Trade Center and the Pentagon. And the company continued to shed value right through December 2007.

NORTHWEST’S LONG SLIDE

Chart 2 is a plot of Northwest’s value creation and migration in each quarter. The series opens with three negative RADs beginning with the 2nd quarter of 1994. Then the company moves through a run of nine quarters of value creation peaking at +1.7 in December 1995.

Chart 2

In June 1997 NWA entered into a period of continuous value migration that lasted through the 4th quarter of 2006. This value migration had nothing to do with the attacks on the World Trade Center and the Pentagon. Investors continued to shift progressively more value away from NWA for years, finally culminating in bankruptcy.

SOUTHWEST’S HIGH RIDE

As Chart 3 shows, the value that migrated from its competitors went largely to Southwest. The company posted positive risk-adjusted differentials in every one of the 55 quarters in this study.

Chart 3

Beginning in March 2000, Southwest posted value creation numbers greater than 1.0 in every quarter but March 2007. This performance is extraordinary. Chart 4 shows why.

Chart 4

This is a plot of the distribution of risk-adjusted differentials for a large sample of companies in the study of Marketing’s Impact on Firm Value published by the Marketing Science Institute in 2003. Only 12 of the 337 companies in this study posted risk-adjusted differentials greater than +2.0 in all ten years between 1991 and 2000. Southwest Airlines did that for 18 quarters during, arguably the most turbulent period in domestic airline history.

RECONFIGURE OR RE-REGULATE

Given this history, and the failure of virtually all large scale mergers, there are two ways to fix the airlines.

One is to break them up and reconfigure the parts. For example, spin off Northwest’s Asian routes along with Delta’s European routes and combine them in a public company that would offer formidable competition to Air France KLM, British Airways, and Lufthansa. Since all the air craft in this new international airline would be big, this reconfiguration might go a long way to solving the union's seniority problem. Then the domestic routes of both companies not required for international operations could be merged in a point-to-point/multiple-hub network. Then the aircraft, routes, landing rights, and gates that don’t fit the reconfigured domestic network could be auctioned off to the highest bidders. No doubt Southwest would buy more than a few of these and hire most of their employees too.

What's the other way to fix the airlines? Reregulate the supply side of the industry. What do you think of these options?

Comments

[airbusdriver]

Spinning off the international aircraft and routes of Delta and Northwest into a separate airline just wouldn't work. International only airlines just don't work - they need the domestic network to feed them. Take for example Pan Am which lacked a domestic structure and died a slow death. NWA merged with Republic for this same reason. In addition, the labor issues that arise from such a deal are worse than a full scale merger. Who who go with the part of the airline that is spun off and who will stay to be hired at the bottom of someone else's list. The sell off of Pan Am's pacific routes to United is an example of the difficulties that arise in this regard. You're right about the use of bankruptcy as a business tool by management in the industry. There used to be a stigma associated with filing but not so anymore. The fact that the recent round of bankruptcies has produced larger than otherwise pay days for emt's at the airlines just made the decisions even easier.

[Waves]

All of these statistics and graphs are fine, but had SW not been heavily fuel hedged, they would have lost money just like the rest of the airlines. Many airline analysts mistakenly imply that SW should be the model for all airlines to use. Yes, they are well managed, but when, or if, their fuel hedging program ever lapses, we shall all see the flaws in their type of operation.

Due largely to their lower fuel costs, throughout the years, SW has been able to charge much less for a ticket than their competitors. The so called "loyal customers" that airline management teams imagine, have obviously migrated to SW to save dollars. This trend of losing "loyal customers" has been taking place for a couple of decades, and cannot be reversed over night. Other airlines such as Jet Blue, and AirTran, have had similar success charging lower fares by paying their employees lower wages, and also having substantially lower aircraft maintenance costs.

Delta's prior management team (more specifically, CFO Michele Burns, under CEO Leo Mullin) decided to sell most of their fuel hedges, because, "everyone knew that fuel was going down to $28 per barrel." Great foresight, huh? With fuel topping $111 per barrel, is it any wonder why airlines cannot stay in the black?

Interesting read, keep um coming, Victor.

[Waves]

P.S. I agree with the Airbus driver! A good domestic route feed to an international operation is the way to go. SW has neither. If I'm not mistaken, United paid $120 mil for Pan Am's South American routes, and the operation paid for itself within one year. Delta's management team (under Ron Allen) didn't want the SA routes because they said there was no money to be made in SA. Instead, they purchased the European route structure, lost huge amounts of money there, and then abandoned most of that route structure. Those decisions didn't seem to phase management; however, many employees took it in the shorts.

All for now

[Victor J. Cook, Jr.]

Airbusdriver,

I spent the better part of the last hour reading posts on your web site at flightdeckview.blogspot.com /. I found from your earlier comments on my SA posts that you knew a lot about the airline industry. But I didn't realize how deep that knowledge actually is. Quoting from your site:

"I've been flying for 25 years and have been an airline pilot for over 18 years. - Engineer for a major airframe manufacturer - Licensed aircraft mechanic - Accident investigator - Airline Industry Safety work."

If it's okay with you I would like to have your opinion on future posts containing ideas about how to fix the airlines before they're published!

Thanks for your thoughtful and informed comments.

~V

[Victor J. Cook, Jr.]

Waves,

Yes, if Southwest had not been "heavily fuel hedged" they probably would have lost money. I'm not sure their losses would have been as large as the others carriers, but as a percent of revenues they certainly could have been.

I don't have the numbers at hand but I recall Southwest saved a significant amount over the past several years as a result of their successful fuel hedges. Do you happen to know how large those savings were year-by-year? Can this information be found in footnotes to their balance sheet?

Thanks for your thoughtful and informed comments.

~V

[Captain]

Reregulate.
I, for one, am sick and tired of fighting, through my union, for not only a reasonable return on my investment in education and experience, but for the safety of the flying public! My, and I am sure every other, airline would fly every airplane they have with the absolute minimum amount of attention if they could get away with it. Air Traffic Control is getting weaker every day. The skies and airports are over crowded much of the time. Terrorism still lurks. These are serious safety issues for passengers which should be addressed by government, not airline employees.
Reregulation is the answer. For safety's sake, bring sanity and order back to the skies!

[TheOnlyWayToFly]

Prior to the "ivory towered" inspiration for the tragically flawed congressional decision to deregulate the nations airlines, they operated as de facto utilities. They were publicly owned, but controlled by the Civil Aeronautics Board. It wasn't a condition of complete utopia, but the CAB did provide significant resistance to airline managerial ineptitude. I'm not a proponent of increasing governmental control, however, in the interest of preventing a "new wave" of airline operators from "eating their young", re-regulation is a consideration.

[AV8R]

It should be apparent now that airlines are a public utility and not a commodity market. Unbridled and needless growth has grossly overburdened the finite amounts of sky and concrete available. The saturation of regional jets and small turboprops is strangling an already choking industry. The woes of the industry can be solved by applying this basic principle: raise fares to more accurately reflect the cost of doing business and limit excess capacity to make the product more demand based. Since the airlines won't do this voluntarily or in concert the decision will have to made for them.

[Captain]

In my comment, I made the assumption everyone realizes safety costs. Maybe I shouldn't have. To tie into the article, if airlines were not allowed to sell tickets at or near cost then perhaps they would have enough money to not only reward management with multi-million dollar bonus payouts (which should be curtailed as well), but they would be able to invest a little more in the above mentioned safety items. Regulation would provide the ability, and should require the compliance. A side benefit would be an improvement in overall customer service as well since this would then become the primary area of competition among airlines.

Cutting corners on production to sell cheap may work on widgets, but is ludicrous in the airline industry. Although the airlines (read, their employees) make it look easy now days, flying is still a precarious, demanding, and unforgiving endeavor. Technology is a great help, but it is still the people who make it work. The way people, technology, and equipment are being pushed to their limits cannot continue to expand, there is an end point. We need to stop before it is reached. Although I will be the first to admit regulation had it's drawbacks as well, a reduction in safety was not one of them. I have been flying for over 32 years and have seen the difference. As one of the last lines of defense in my passengers safety, this is my primary concern. If it puts a small crimp in the free market, so be it.

[Pundit]

As your analysis indicates, the airlines are a poor financial bet. The reasons for this are inherent in a flawed business model and can be summed up as follows:

1. Flawed pricing. The airlines are the only major industrial enterprise that consistently sells its product below cost. The airlines have been doing this since "deregulation" in the erroneous belief that they could make up in volumn what they loose in lack of revenues net of costs.

2. Cost. The cost structure of all airlines is high and part of the failure of the model is that they grow inexorably higher while unit revenues are flat. The airlines have vastly increase capacity and gross revenues, but as you pointed out, net profit, where there is any at all, is a very small percentage of revenue.

3. Infrastructure. The Airline Deregulation Act did not fully deregulate the airlines, and a prime example is in access to airport infrastructure. The airlines covet and hoard prime airport space, some of the most expensive real estate in commerce. New entrants can't get access to the airports, except at exhorbitant cost, often paid directly to their competitors.

4. Labor and seniority. The news on any given day chronicles the rancorous and never-ending relationships airlines have with their key labor groups. At the core of this problem is the historial and anachronistic veneration of seniority above all else in determining remuneration and benefits. For this reason alone, the airlines labor model is horribly inefficient, and the more so the higher up one looks on the labor hierarchy. An example is pilots, who are at the top of the economic scale in terms of labor cost. The goal of the pilot's collective bargaining is to work as little as possible for the highest possible gain in pay and benefits. Yet pilot collective bargaining agreements are merely totemic of an inflexible structure that doom the airlines to low- or no-profitability long term.

5. Managerial Overhead. Few industrial enterprises have the bloated overhead typical of all airline companies. A huge and disproportional amount of cost resides in the executive and senior- to mid-managerial suites. Much of this inefficiency exists as the result of "empire building" and outmoded industry conventions, and some is there due to highly inefficient industry regulation, bt the dead wood is there, nonetheless.

6. Dogma. Airline managements are not populated by great thinkers. Much of airline management theory is horribly out of date and out of touch with economic realities, and this is perhaps the biggest flaw in the airline business model today. Airline management is still fixated on quaint theories of customer "loyalty" and "customer service" and the notion that passenger cabin gimmickery will compel future purchasing decisions. As the airlines have proven, there is no "loyalty" beyond today's price point. Volumn can't make up for this. See item "1" above.

7. Technology. Innovative companies use technology to increase efficiency and profit. Airline companies deploy technology to increase costs. While it cannot be disputed that certain technological advances have vastly increased the safety of air travel, much of the high technology in todays air and ground operations fails to deliver a return on investment. The eight- and nine-figure costs of todays aircraft are an example of this.

As comments to your article indicate, there is no shortage of hidebound thinking in commercial aviation. All these chickens are now coming home to roost as energy costs no tip the airline model beyond the point of no return.

[Victor J. Cook, Jr.]

Waves,

I tracked down Southwest's gains from fuel hedging from 2004 through 2007 in a New York Times article: www.nytimes.com/2007/11/29/business/29he... . The 2007 number was for the first 9 months, so I adjusted upward by (9/12).

Combined with the company's Before Tax net, here's how it worked out:

LUV Gains BT Net Difference
2007 $585 $1,058 $473
2006 $675 $790 $115
2005 $892 $779 -$113
2004 $455 $339 -$116
Sum $2,607 $2,966 $359

Over the four years $2.6b gain from fuel hedging compared wiht $3.0b before tax net gave them a $359m profit. But they lost money in 2004 and 2005 as you guessed.

According to the NYT article LUV is hedged through 2009.

~V

[RB Ops]

Not desiring to enter into a fulisade of rhetoric designed to intimidate rather than inform, as some, I feel that the statement that the Airline Industry should be treated as another utility is worthy of sincere consideration. AND the Oil/Fuel Industry is the other shoe that should be dropped into the same catagory.

[Waves]

Dr. Cook,

I applaud and appreciate your articles and in depth research. Being employed in an industry that is sooooo full of annalistic experts that think they know all of the answers, but really don't have a clue, it is refreshing to read someone that DOES HAVE A CLUE.

At the risk of sounding self important, I continue. As a seasoned pilot, I have an ego to maintain, so please read on. ha I have been flying airplanes (GA, Navy fighters, Airlines) for over 32 years. Man I"m getting old. I am an FAA and military instructor pilot. I have also been maintaining aircraft with an A&P and IA (Inspection Authorization) for over 25 years. I have a Bachelor's degree in Aviation Maintenance and Management. What does this all mean? Nothing at all really, except that I, like many fools, love aviation and have a vested interest in it. Unfortunately, my wife and I have both devoted our lives to it. How smart is that? ha I knew I should have gone to med school. Damn! Orthodontics is where it's at. ha

I would like to comment on all of the above comments, or even better, I would love to discuss in person with each and every commentator, and each and every point. Many of them have valid points, while many of them unfortunately do not really understand the dynamics of the entire airline industry. They may think they do, but they really don't. PUNDITS hits on a few of the airline's problems, but he or she still seems like an outsider that really is shooting from the "investor" sidelines. I'm glad that various people take interest in the airline industry, but I sometimes wonder why.

The true bottom line is that the airlines are a unique business that is highly governed and regulated, extremely highly taxed, highly leveraged, requires HUGE capital to operate, and consumer expectation is always perfection (100% safety) with very little cost.

As far as safety goes, management cannot afford to pay (customers don't want to pay) for top of the line experienced pilots (ie. ex military or high time GA pilots) so who do you think are flying those regional jets? I had a co-pilot once tell me that he would never put his family on a regional jet. I asked why not? He said," I know who's flying those jets, because I used to be one of them. They have no idea of what they are doing." Great warm and fuzzy, huh? The good news is that most of the latest and greatest aircraft technologies, make up for pilot in-experience. Aircraft, navigation systems, redundant mechanical systems, and problem alerting systems, have reduced pilot workload and experience necessary to handle most catastrophic events.

I would like to continue, but must run.

Thanks, Dr.Cook.

[Whitespiral]

Government intervention always and everywhere causes market dislocations. There are far more problems caused by the fact that governments do not allow airlines to fail, then there are by allowing them to "overcompete". There are far more problems caused by governments now allowing airlines to price freely, then there are by the price of jet fuel today.

Dr.Cook's insight into capital/customer markets is profound, but I disagree with the suggestion to re-regulate airlines, or impose top-down solutions on them.

Airlines are faced with the reality of very elastic and very finely divisible demand, while their supply is mostly inelastic, and with very little ability to adjust to short-term or medium-term demand.

As such, they are a very low margin business, even in good cases. However, what almost nobody realizes is that airlines have very high asset turns and due to the capital intensity of the industry, are almost in all cases very heavily leveraged.

This creates a recipe for very high returns on equity, even with 5-6% margins, but only if you can control or successfully adjust to one variable: uncertainty.

Uncertainty in this case is manifested in the cyclical nature of the industry, which in turn is generated by the cyclical nature of the economy. The whole industry is usually coupled by a factor of 2 with the broader economy.

So now, where lies the root cause of business cycles? In one domain, and one domain alone. Fractional Reserve Banking, Fiat Currencies and Central Banking. (Yes, all that's just one).

But even if you were to leave this deeply nonsensical and dangerous system intact, airlines could still make money, if you really let them compete freely. In my book, open competition means the ability to do just about anything Anti-Trust regulators say you can't do, because their HHI and other models tell them you can't.

What do you think would happen if airlines were allowed to consolidate, collude, collaborate, and undercut any competitors freely and globally? Some would thrive, and some would not. (As opposed to all dying a slow death). And what if they overdid any of the above? Well then they'd pay the price by signaling "excess profits" to potential new competitors, making alternative modes of travel more competitive, and all those funny things that free markets do.

Monopolies are a mirage. The only true monopolies are government monopolies.

Airlines, are just a supercharged version of what happens when governments intervene. Almost all the troubles they face can be traced back to government interventions producing dislocations. And no I don't mean stuff you must adjust to like fuel.

It's all politics in the end. Because it is certain that fares would rise as a result of complete and true laissez-fairs, politicians prefer to keep this sick system in place because they've used the airlines so much to subsidize peoples' travel, that by now they're totally spoiled.

Having private ownership of airlines is a good start because you can't have markets operate without private property. But markets can only function and allocate resources effectively when there is an healthy price system in place.

A healthy price system is a free price system.