Yves here. Hubert lays out why the airlines need a deep restructuring, including a much greater focus on operational efficiency, to have any prospect of being self-supporting. Yet he deems the industry to be dead set against these changes and the US both unwilling to and incapable of imposing them. So we’ll have the worst of all possible worlds: permanent corporate welfare queens that get to keep private sector executive pay and perks.
By Hubert Horan, who has 40 years of experience in the management and regulation of transportation companies (primarily airlines). Horan currently has no financial links with any airlines or other industry participants
Coronavirus has created the greatest challenge the airline industry has ever faced. For the large legacy carriers serving intercontinental markets, the threat is comparable to the meteor that caused massive climate change and drove dinosaurs into extinction. While the industry was clearly viable prior to coronavirus, it faced a number of serious competitive and financial issues that will impede efforts to deal with the impact of the coronavirus meteor.
The industry requires major, painful restructuring. Baring staggering increases in taxpayer subsidies (beyond the $60 billion already pledged in the US), it is unclear how most (perhaps any) of these carriers survive under current ownership in anything like their current form. None of the changes needed to ensure the long-term efficiency and competitiveness of the airline industry are even being discussed at this point, and the processes needed to manage the needed restructuring do not currently exist.
The Financial Devastation Directly Caused by Coronavirus
Airline economics depend critically on extremely high capacity utilization. Small changes have huge profit leverage. US airlines filled 85% of their seats in 2019 (up from 58% when the industry was deregulated and 70% 20 years ago). Once an airline has committed to the costs of operating a given schedule, almost all of the lost revenue from a shortfall of passengers directly reduces the bottom line.
Coronavirus-driven traffic losses have been vastly larger than anyone could have ever imagined. Traffic through TSA checkpoints in US airports was down 96% versus the year before in mid April and 88% in mid-May. While the industry had faced demand shocks in the past (9/11 in the US, various wars, the original SARS outbreak in Asia), none were global in scope, and none were seen as driving permanent declines in demand. Never before has flying on an airplane required accepting serious medical risk. In a recent poll only 23% of US travelers thought flying on an airplane was safe. [FN1]
While no one knows what will happen, this analysis assumes that there is no widely available vaccine and no reliable way to prove individual immunity during 2020. Perhaps infection rates decline gradually and economic activity gradually increases. Perhaps there are new outbreaks and efforts to reopen the economy are put on hold. Perhaps economic activity declines seriously as companies realize that recent losses are unsustainable, and major new waves of layoffs and bankruptcies occur. But the idea of a rapid, “V-shaped” recovery to the January status quo seems wildly improbable.
The revenue losses have been even worse than the drop in passenger counts. Airline profits depend heavily on business travelers paying higher fares. But the gradual increase in domestic traffic appears to be almost exclusively leisure demand, such as pent up desire to visit family members. Corporate travel remains close to zero, [FN2] and the massive short-term substitution of videoconferencing may reduce business travel for years to come.
The profitability of the large US legacy carriers (Delta, United, American) also depends heavily on intercontinental traffic, which has fallen even further than domestic traffic. Cross-border travel bans have been key to slowing the spread of the virus, and the point where the mass market is no longer concerned with the health risks is somewhere in the distant future.
Profitability requires very tightly aligning an airlines’ cost structure with its revenue base. Airlines lock-in to most of their costs (e.g. fleet, airport facilities, IT infrastructure, corporate debt) on lower-cost long-term arrangements because historically they have had very high certainty about future demand. Contracts with labor and suppliers are similarly inflexible, with major penalties if they are suddenly terminated.
In the short-term (3-9 months) airlines might be able to readily shed 10-20% of their costs. Over two years, cost reductions of 30-40% might be possible, depending on the timing of contracts. But revenue can vanish overnight, while cost efficiency plummets and cost per passenger skyrockets. The much smaller demand shocks of the past (the post-dotcom and 2008 financial collapses, fuel prices suddenly exceeding $100/bbl) were highly traumatic, leading to years of major losses. The cost per passenger impact of the coronavirus “meteor striking Earth” magnitude shock is far worse, and (unlike previous crises) there is major risk that it may be many years before demand fully recovers.
In their first quarter investor conference calls Delta, United and American all said that by the end of the second quarter they hoped to reduce their daily cash drain to roughly $50 from the $70-100 million a day they had been hemmoraging at the outset of the crisis. Southwest, a purely shorthaul, narrowbody operator with smaller hubs and less overhead and debt, predicted a cash drain of $30-35 million day by the end of June. Whether this is explained by a staggering level of cognitive dissonance, or by Wall Street’s expectation that Washington will do whatever it takes to protect these equity values, it suggests that capital markets will be a major obstacle to the major restructuring the industry desperately needs.
Thus the big 4 US carriers (DL, UA, AA, WN) are hoping that their daily cash flow can improve to negative $180 million per day, which would annualize to negative $66 billion. Those estimates appear to include $32 billion in payroll protection bailout money provided by Congress under the CARES act.[FN3] In 2019, those four carriers generated positive cash flow of $23 billion from operating activities.
The day-to-day dynamics of cash flows in a crisis is obviously more complicated than can be discussed here. Carriers have been less than totally transparent as to how cash flow and other key metrics are being calculated during the crisis. But as a crude first approximation, the direct impact of coronavirus was to reduce the annual cash generated from the operations of the big 4 by $121 billion, an impact reduced to $89 billion by the one-time receipt of the first tranche of federal bailout money. A financial impact that can be reasonably characterized along “meteor strikes Earth and drives dinosaurs extinct” lines, and that will require radically greater restructuring than the industry had ever contemplated before.
Detailed financial information about major carriers outside the US is less readily available. However, several airlines have already filed for bankruptcy protection (LATAM, Avianca, Virgin, Thai, South African) and many are negotiating with governments for major bailouts and even nationalization (Alitalia).
This industry financial crisis extends across the entire airline ecosystem. Airports, distribution providers (Expedia, Booking.com, Sabre, etc) and service contractors have all had revenues largely disappear, without having comparable access to multi-billion dollar taxpayer subsidies. Those contractors employ staff paid much less than airline employees. Since most have no access to payroll protection subsidies. they have implemented major layoffs. Current obligations to aircraft/engine manufacturers and lessors remain in place but are not sustainable.
What Would an Ideal Plan To Save the Commercial Airlines Include?
By facilitating commerce and tourism, an efficient airline industry creates huge benefits for the economy as a whole. If one is primarily concerned with overall economic welfare, and the public’s interest in maximizing those benefits, the required major restructuring of the airline industry should focus on three objectives:
Providing the greatest level of service and employment possible at each stage of demand recovery that can be justified by actual revenue (and subsidies)
Maximizing the competitiveness and productivity of the restructured industry that eventually emerges and
Ensuring that the (very significant) pain of the restructuring process is fairly distributed.
If the industry revenue base in the second half of 2020 is only 25-50% of what was expected before cononavirus, and 2021 revenue is likely to still be well below previous levels, then a huge chunk of total industry costs need to be permanently eliminated, and half (or more) of planned costs need to be deferred, cut or subsidized by taxpayers this year.
Operations and costs maintained because of unrealistic expectations that the pre-virus status quo can be magically restored will simply serve as a deadweight that will make the efficiency improvements that longer-term recovery requires much more difficult to achieve.
Those efficiency improvements will also require that the restructuring address problems that predate coronavirus, including the systematic reduction in industry competitiveness over the last 15 years. Domestically, this led to mergers of 6 Legacy carriers into just 3, and allowed Southwest to acquire Airtran, its most important competitor. [FN4]
Because the demand collapse will drive huge increases in cost per passenger, industry recovery will require major new offsetting efficiency/productivity gains. Robust competition is needed to maximize the pressure to find the new innovations and service improvements to drive those gains. An industry based on open collusion and protected by huge entry barriers will not produce those improvements.
The virus creates major risks that competition in many markets could quickly become horribly distorted, or vanish altogether. Approval of the domestic mergers and intercontinental alliances had been justified by the false claim that the current existence of three competitors is all that is required to indefinitely provide consumers will the full benefits of competition. The coronavirus crisis provides a painful demonstration why that was never true.
The three collusive intercontinental alliances need to be broken up immediately, as they cannot serve as the basis for competitive international markets in the future. [FN5] They had been justified by the false claim that the current existence of three competitors is all that was required to y provide consumers will the full benefits of competition.
In fact, the collusive alliances never provided sustainably balanced 3-way competition. Instead each enjoyed major pockets of domination (as with the AA/BA alliance in the UK, and the UA/LH alliance in Germany, Switzerland, Austria, Belgium and Scandinavia) where the other alliances played a very secondary role.
With the collapse of international traffic, the alliance carriers will shrink (or abandon) secondary positions, and focus on increasing market power in the markets they dominate. Several key alliance members are especially vulnerable at the moment, and those problems could rapidly destabilize the entire alliance structure.
Within the US, the industry consolidation process distorted competition by giving Delta an artificial advantage among the legacy carriers, and American an artificial disadvantage. This is because in both the creation of the collusive intercontinental alliances and the domestic US mergers that followed, Delta went first, United went second, and American went last. This gave Delta years where it had a huge scale and network advantage, which it used to create a profit/cash flow advantage that was still strong in 2019.
American, with weaker cash flow and greater debt, is widely considered the airline most at risk of bankruptcy while Delta is widely considered to be the least at risk. But if the crisis is not dealt with on an industry-wide basis, but on isolated company-by-company basis, this would likely destroy any semblance of competitive balance between the three big legacy carriers, and could eventually collapse the legacy sector into a Delta-United duopoly.
Outside the US, many markets that were never large enough to support two reasonably sized airlines may collapse into an effective monopoly. Qantas has been aggressively fighting subsidy requests from Virgin Australia in the hope that it could emerge from the crisis with a permanent stranglehold on Australian aviation. Consumers in numerous other countries (Canada, Korea, Russia, much of South America) face similar competitive risks.
The airline bailout requests that led to the CARES Act clearly indicate that when the crisis began both the industry and Congress expected a fairly rapid “V-shaped” demand recovery that would protect the current owners of the major carriers. [FN6] The current revenue (and medical) reality demands an immediate move to bankruptcy protection for most carriers and an industry-wide restructuring program. The industry’s 2019 status quo cannot survive.
Bankruptcy is needed to protect assets that will be critical to the (much smaller) reorganized industry from short-term creditor claims, and to ensure that current owners and insiders cannot divert scarce cash into their own pockets. It will also help maximize the future viability of the reorganized operations, which will be critical to maximizing creditor recovery.
Given the critical importance of robust competition, and the major risks of competitive reductions and distortions, restructuring needs to be addressed on an industry-wide basis. One model for an industry-wide restructuring program is the U.S. Railway Association, a temporary Federal agency that successfully reorganized the bankrupt freight railroads in the Eastern US in the late 1970s. [FN7] At the time the Penn Central was the biggest bankruptcy in world history. Congress created USRA because it recognized that the railroad industry’s deep-rooted problems far exceeded what the Bankruptcy Courts could possibly handle.
However organized, a bankruptcy restructuring of this magnitude and complexity cannot possibly succeed if it is dominated by one set of stakeholders determined to avoid costs and pain by pushing them onto the other stakeholders. Passengers will clearly pay higher fares in a downsized world, but cannot be gouged by airlines exploiting market power after competition has been eliminated. Huge numbers of staff will lose their jobs through no fault of their own, but should not face draconian wage cuts designed to save airlines the bother of better managing operational efficiency and customer service. The recovery of the overall economy depends on maximizing airline service, but capacity must be tailored to actual revenue demand, and not to arbitrary political or bureaucratic preferences.
An Economically Sensible Industry Restructuring Program Appears Impossible in Today’s Political Environment
While it is easy to lay out the basic requirements and objective a successful airline industry restructuring program would require, it is even easier to point out the many political obstacles that will likely prevent the needed restructuring from happening.
All efforts by airlines and Washington to deal with the crisis appear to have been entirely focused on protecting the owners and the future equity value of the incumbent companies, which totally precludes any consideration of the major downsizing and industry-wide restructuring that is actually needed. This is consistent with Washington’s overall emphasis on helping the owners of politically organized large corporations while providing only token support for suppliers, small business and workers. Airline employees did not receive payroll protection support because of the critical work they were doing but to ensure that the airline did not file for the bankruptcy that would wipe out equity.
Even if one argues that programs designed to protect the 2019 status quo for a couple months until a powerful “V-shaped” demand recovery occurred was a plausible position in March, it is now a delusional fantasy. Subsidies for the status quo will waste billions that could be used to allow the future industry to reorganize with more capacity and jobs. But the only people at the table discussing the future of the industry are executives totally dedicated to protecting their shareholders and Washington officials who see the interests of capital accumulators as superior to all other economic interests.
An eventual industry recovery will require dealing with both major problems that existed prior to March and the virus-driven revenue collapse. Washington’s current programs appear heavily focused on bailing out company owners for failed pre-coronavirus investments, since those industries are the ones most aggressively lobbying for taxpayer money. Many other industries (retail, oil and gas, commercial real estate, tech bubble unicorns) made far more irresponsible investments than the airlines, but the airlines still need to deal with the tens of billions wasted on stock repurchases that could only be justified by the assumption that profits would rise indefinitely and the industry would never again face a recessionary-type downturn.
Between 2014 and 2019, the big 4 airlines used $42.4 billion of the cash they had generated to repurchase stock. The combination of stock buybacks and increased leverage (between 2016 and 2019 debt increased from $47 to $75 billion) was designed to inflate short term stock prices. This was done at the direction of these four boards, who had incentivized the four CEOs with $431 million in stock based compensation. Stock buybacks exceeded the free cash flow these airlines were generating, and increased even as key financial metrics began declining. [FN8] Because of the artificial problems created by the industry consolidation process mentioned earlier, American has had to do more to boost its stock price (and thus now has the weakest balance sheet) but all four carriers have pursued buybacks and debt aggressively.
By replacing this cash, the taxpayer bailout money allows the owners of these companies to avoid taking any responsibility for the extractive self-dealing that left them vulnerable to downturns far less serious than coronavirus.
It is not clear whether the current owners and senior executives would be capable of reorganizing these companies into the smaller but more competitive and efficient industry that the larger economy needs. Some of this myopia is understandable. Doug Parker’ job is to do everything possible to avoid the bankruptcy that would wipe out American’s shareholders, and it is Ed Bastian’s job to exploit every possible way to increase Delta’s competitive power on behalf of his shareholders. But this narrow shareholder focus will not serve the public’s interest in eventually achieving a sustainably efficient and competitive industry.
More importantly, these people have focused almost exclusively on petitioning governments to eliminate competition, using increased artificial market power to raise prices and extract more favorable terms from unions and suppliers, and then enriching themselves. They are likely to fight tooth and nail to preserve the collusive alliances that drove consolidation and major increases in market power.
It is also not clear whether any Federal Government entity has the administrative competence or industry expertise to manage a major restructuring program, and it is even less likely that anyone in Washington would ensure that such efforts focused on maximizing long-run industry efficiency and competitiveness and overall economic welfare. The industry expertise and greater public interest perspective that allowed the USRA to successfully reorganize the railroad industry vanished long ago.
Similarly, while the US bankruptcy courts may have been able to reasonably address these issues 30 years ago, their dismal performance handling the airline bankruptcies after 2004 (when over two-thirds of US airline capacity was under Chapter 11 protection) demonstrates that they would probably make today’s problems worse. By contrast, the numerous 20th century cases forced the bankrupt airlines to replace management, make painful capacity cuts, and restructure fleets and networks, changes needed to maximize future viability and creditor payments.
As with Federal agencies such as DOT nominally responsible for industry oversight and protecting broader interests, the biggest airlines have successfully captured the bankruptcy process. Instead of protecting creditors and broader economic welfare it now focuses on serving the interests of incumbent managers and capital accumulators. In the United case, CEO Glen Tilton maintained exclusive control of the reorganization process for four years until he finally produced a minimally acceptable plan. Even though that plan left the company competitive crippled for several more years, the court allowed Tilton to pocket $30 million.
In each recent case, the courts dumped pension obligations onto taxpayers and rubber stamped draconian labor cuts without the legally required evidence that the company could not have reorganized without cuts that extreme. The recent American case was the only time creditors were allowed to challenge management’s reorganization plan, but the Court delayed American’s emergence from bankruptcy by 18 months until creditors agreed to pay the American CEO who had written the rejected plan $10 million. [FN9]
The ability to deal with major industry crises always depended on government agencies tasked with representing broader public interests and judicial processes tasked with upholding evidentiary standards. But they also depended on the ability of capital markets to allocate resources based on objective information about corporate efficiency. The economy’s ability to deal with the airline industry crisis has not only been compromised by the capture of oversight and bankruptcy processes but by the conversion of capital markets into a political utility disconnected from the real economy. The staggering cognitive dissonance between airline equity values and the actual evidence about airline economics suggests a level of “market failure” that may make the desperately needed industry recovery impossible.
Commercial aviation is critical to the economy, and no one wants major parts of the industry to collapse as a result of coronavirus or other problems. To save as much of the industry as possible in the near and medium terms will require a difficult, painful restructuring process focused on maximizing future efficiency and competitiveness.
But if “saving the industry” is redefined as “saving investors from the consequence of incurring excessive debt while extracting massive value in order to enrich themselves” then the effort cannot succeed. If efforts to “save the industry” are arbitrarily limited to those that can be financed by private investors seeking quick, outsized returns based on artificial market power derived from even more drastic reductions in competition, then the value of airlines to the rest of the economy will be dramatically reduced, and the risk of a major industry collapse increases.
Since commercial aviation is critical to the economy, and traditional restructuring approaches may be totally inadequate, the best interim solution may be to convert the industry to a regulated public utility for several years. Under normal conditions, the industry is obviously able to function on a lightly regulated basis, but it may take 2-5 years for normal conditions to return. At the moment there is no evidence that capital markets and current political and judicial systems could drive a the restructuring that the American economy needs. But the obstacles to that approach appear totally insurmountable at the moment, and there is no evidence that approaches reliant on capital markets and current political and judicial systems could possibly drive the restructuring that the American economy needs.
[FN1] 74% said flying on an airplane was unsafe. Quinnipiac University Poll released 20 May 2020 https://poll.qu.edu/national/release-detail?ReleaseID=3661
[FN2] Comments from the 13th Annual Wolfe Research Global Transportation and Industrials Conference quoted in Holly Hegeman, Plane Business, 28 May 2020, p.7
[FN3] It does not appear that these cash drain estimates include any of the separate $29 billion in loans available until September under the CARES act. Those loans will require collateral and giving the government stock warrants, although the value of most airline assets has collapsed, and the terms of the stock warrants have not yet been defined.
[FN4] The three collusive alliances are led by Lufthansa and United, by Delta and Air France-KLM and by American and British Airways(IAG). For a detailed explanation of how these alliance carriers and the US Department of Transportation succeeded in converting highly competitive intercontinental markets into an oligopoly/cartel see my four part series on airline industry consolidation at ProMarket including “The Airline Industry’s Post-2004 Consolidation Reversed 30 Years of Successful Pro-Consumer Policies” https://promarket.org/category/reading-list/aviation/
[FN5] Current alliance partners could retain codesharing links and frequent flyer reciprocity; the serious competitive issues arise when arms-length marketing links are converted to full economic joint ventures with full revenue and profit sharing. For a more detailed discussion of alliance competitive issues see “Double Marginalization and the Counter-Revolution Against Liberal Airline Competition”, Transportation Law Journal, v.37 n.1, Fall 2010.
[FN6]. The CARES Act required that every carrier maintain service to every airport it had previously served, and banned any effort to temporarily ration capacity to where it was most needed and could be most economically operated. This might have made some sense had traffic initially declined 40% and quickly began recovering to pre-virus levels, but created significant waste given the actual, ongoing 85-95% traffic loss. This not only reflects Washington’s reluctance to recognize the actual magnitude of the demand collapse, but their disinterest in considering industry-wide solutions.
[FN7] The author worked for USRA. The two best books about the magnitude of the Eastern railroad crisis and how it was addressed are Loving, Rush, The Men Who Loved Trains, The Men Who Battled Greed to Save an Ailing Industry, Indiana University Press 2006, and chapters 6-9 of Gallamore, Robert and Meyer, John, American Railroads, Decline and Renaissance in the Twentieth Century, Harvard University Press, 2014.
[FN8] The details of the airline stock buyback and the executive compensation tied to them are laid out at Hunt, Ben, Do The Right Thing, Epsilon Theory, March 19, 2020. “Free Cash Flow” is less than the numbers quoted earlier for cash generated by operating activities as it includes the debt incurred to boost stock prices and to help pay for the buybacks. Again, many companies are guilty of more extreme extractive self-dealing than these 4 airlines (Boeing for example) but any restructuring effort that ignores these issues will likely fail.
[FN9] The author worked on five US airline bankruptcy cases. See “How Alliances Carriers Established a Permanent Cartel” https://promarket.org/2020/05/05/how-alliances-carriers-established-a-permanent-cartel/