Hubert Horan: The Airline Industry Collapse Part 4 – Total Paralysis Continues
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
Readers who had not seen the previous posts outlining the aviation crisis, or would find a summation of the critical issues useful, should take a look at my video interview with Izabella Kaminska of the Financial Times on Friday the 11th.
Here is the FT Link—there’s no paywall but it may ask you to register (and registering for access to FT Alphaville is very worthwhile)
Here is an alternative Youtube link to the video interview (about 40 minutes)
https://www.youtube.com/watch?v=Hzig-gnKWTI
Towards the end of the interview, Izabella noted that my main arguments were “depressing” and asked me to provide a bit of optimism by outlining potential solutions to the industry crisis. This might be a good place to clarify which parts of the crisis will be difficult and painful and which parts are legitimately “depressing.”
This series has laid out data showing that the current crisis is staggering worse than any previous crisis in aviation history. A previous downturn that reduced traffic 6% put 75% of US industry capacity into bankruptcy. The current crisis has cut traffic by 75% and revenue by 85%. The critical corporate and international markets have completely collapsed, every carrier is hemorrhaging cash, and almost none of the major carriers can be considered viable going concerns.
Since the collapse is greater and more widespread than anything the industry has ever faced, it logically follows that the actions needed to halt the collapse and restore sustainable operations will be more difficult and painful than anything the industry has ever required in the past.
More importantly, of collapse of this magnitude fundamentally changes the nature of the problem, and changes how any solution would need to be structured. Past airline crisis were limited to fairly narrow industry segments (a couple carriers had foolishly overexpanded, supply and demand had gotten out of whack in a specific country or market), were known to be temporary and had not disrupted basic industry economics (recessions pass, and don’t structurally change the demand for travel) and there was still a large set of competitors and investors that could help restructure (or replace) the companies that could no longer meet their financial obligations.
The current airline crisis is global, supply and demand are wildly out of balance everywhere, and the pandemic is likely to permanently reduce industry demand (due to videoconference, reduced global trade, and structurally higher fares). Competitors cannot step in to fix local problems; nobody wants to buy anyone’s excess aircraft and the number of competing airlines had already been radically reduced.
The current collapse is a crisis for overall economic welfare. The industry’s ability to sustainably produce benefits for society as a whole (facilitating huge amounts of economic activity, employment, trade, etc.) is fundamentally broken. As the past months have demonstrated, multi-billion dollar cash drains will not magically go away by themselves. Allowing desperate airline investors to pursue their short-term self interest will not maximize long-run welfare benefits for other stakeholders or the rest of society.
“Solving” the industry crisis requires an organization fully empowered to manage an industry-wide restructuring focused on restoring the value airlines provide for society as a whole. It would need to have clear legal authority to terminate prior economic interests (jobs, financial obligations, supplier contracts, local service levels, ownership and control positions) inconsistent with the requirements of a dramatically downsized industry. They would need to have clear legal authority to maximize long-term industry-wide competitiveness and efficiency, even when this conflicted with the short-term interests of specific companies or investors. They would need transparent legal guidelines that ensured the many parties (employees, suppliers, lessors) received compensation on an equitable basis.
The details of such a restructuring process would be difficult and painful, but a variety of plausible approaches could be laid out. What’s “depressing” is that the political obstacles to any type of industry-wide approach focused on restoring the overall economic benefits of airlines seem insurmountable.
As this series has pointed out, the industry, capital markets and the business press have willfully ignored the actual magnitude of the collapse and remain wedded to absurd narratives that falsely assumed rapid, robust demand recovery. The industry and government officials who are actually dealing with the crisis have been myopically focused on narrow objectives (e.g. protecting the financial interests of select investors, minimizing direct government payments to workers). These parties have no interest in restoring and protecting society’s interest in efficient and competitive airline service, and do not appear to consider broader economic interests as legitimate or relevant. In the US, it is not clear that the competence to oversee an industry-wide restructuring focused on overall economic welfare exists anywhere in the Federal government.
After five months absolutely no one from the industry, capital markets or government has put forward any proposals suggesting they understand the crisis or have any idea how it might be solved. Their favored approach seems to consist of nothing more than a determination to protect the industry’s pre-pandemic competitive and ownership status quo. The “rapid demand recovery/industry fundamentals haven’t been affected” narrative was designed to protect the status quo, and the need to protect the status quo explains why the narrative remains strong even though it was completely, totally wrong.[1]
If the current process was serving purposes other than status quo preservation, the narrative would have been abandoned in April, when the evidence that it was wrong became overwhelming. As will be discussed below, the conflict between this evidence and status quo preservation has continued to paralyze efforts to minimize cash drains, pursue temporary governmental relief, and begin a badly needed public discussion about the ugly future of the industry.
This approach is designed to give current airline owners control over any restructuring that might occur, even though they would be totally wiped out under any legally administered reorganization process. It would allow them to impose most of the cost and pain of restructuring onto workers and suppliers. It would allow restructuring to emphasize mergers and collusive pricing arrangements that would shift significant burdens onto consumers. This approach is designed to ensure that long-term industry-wide competitiveness and efficiency cannot be maximized, and to ensure that the burdens of needed changes are not distributed on a transparent and equitable basis.
Thus, to finally answer Izabella’s question, yes, it would be entirely possible to lay out “solutions” for the industry crisis, but that would serve little purpose given the huge obstacles to getting any such solutions implemented. The critical problem isn’t figuring how to restructure an industry where supply and demand are totally out of whack, or how to prevent airlines from collapsing during that restructuring process. The critical problem is how to overcome the political power that gives incumbent airline owners and senior management nearly totally control of the current process, has totally delegitimized society’s broader interest in competitive and efficient airline service, and has paralyzed efforts to keep the industry from falling into the abyss.
Continuing Paralysis Over Crippling Cash Flow Drains
There has not only been no meaningful signs of demand recovery in the last six weeks, but previous hopes that schedules could be expanded in the fall seem to have been dashed. But none of the large carriers announced any major new actions to reduce the ongoing cash drains. Gary Kelly, CEO of Southwest, told a reporter that business would need to double in order to reach cash breakeven.[2]
Observers should keep in mind that while LCCs like Southwest (and Easyjet and Ryanair in Europe) are suffering enormous losses, they are in a much better position than the Legacy international carriers, who would need an even bigger traffic increase to reach cash breakeven. These LCCs focus on short-haul and leisure markets that have declined the least, and their network and cost structures allow them to adopt more readily to sudden demand reductions. These short term advantages are purely fortuitous, but they explain why they are the only airlines that capital markets perceive to have legitimate going-concern value.[3]
Led by United, the US carriers announced last month that they were eliminating the change fees widely despised by their passengers. This should be seen as a short-term PR move, and not a permanent shift to a more customer-friendly approach. It only applied to domestic tickets, and almost all of the domestic tickets currently being sold had already been exempted from change fees. [4]
Continuing Paralysis Over Job Cuts and Federal Subsidies
There has been ongoing media coverage of the possibility of extending the airline payroll protection subsidies that will expire at the end of this month. But none of this coverage offers any coherent explanation of how this could be achieved.
It is not clear how the partisan divide over new coronavirus economic relief efforts could be overcome this year. The “skinny” Republican proposal that was defeated in the Senate last week included very little direct support to any workers and no assistance to airlines whatsoever, despite vaguely supportive statements from President Trump. The House Democratic proposal is much larger, but there has been no public explanation of what new airline subsidies would involve.
The unions representing staff at the big 4 carriers have been fighting for more taxpayer money. Despite seemingly supportive statements it isn’t clear whether the airlines actually want new subsidies. The original March CARES Act subsidies prohibited layoffs and required airlines to continue to serve every US city previously served, on the (obviously incorrect) assumption that a major revenue recovery would be well underway when the subsidies expired in October. As a result, the CARES subsidy worsened the airline cash drain by forcing them to fly lots of nearly empty planes, and to pay staff who could not be properly utilized.
Airline executives appear caught between the proverbial rock and hard place. Openly stating the need for layoffs large enough to match vastly reduced operations would cause their pilots and mechanics to openly rebel and would signal Wall Street that they were on the edge of bankruptcy. Warnings to date about October layoffs cited smaller numbers that appeared designed to limit near-term industrial unrest (and Wall Street concerns) while pushing needed costs cuts into next year. Management needs to publicly support the union demands but new subsidies would certainly mandate a lot more employment and service than the airlines think they can afford, and make it more difficult to reduce negative cash flow. If subsidies aren’t extended, management may be able to tell staff that they tried but couldn’t overcome the mess in Washington. But election uncertainty may make it difficult to pursue the October layoffs initially planned.
Continuing Paralysis Over Unpleasant Realities About the Future of the Industry
Public discussion of the airline crisis has totally ignored the inevitable reality that future airfares will be much higher than consumers (and politicians) have contemplated.
The historic airline economic equation combined large and growing overall demand, the ability to optimize total revenue by managing the mix of high and low fare passengers (including the ability to shift low fare demand to times when there was little high fare demand and the ability to achieve 80% load factors year round) and the ability to carefully tailor costs and capacity to readily predictable demand.
The pandemic obliterated most high-fare (corporate/international) demand; the cost of a specific flight hasn’t fallen but it earns much less revenue, and airlines can’t reduce fixed and corporate costs in line with reduced revenue. All of the data and models historically used to manage revenue, capacity and costs are now largely useless. Higher unit costs require higher fares. Greater uncertainty about costs and revenues requires even higher fares.
In the very short-term fares will remain low because filling the abundant excess seat capacity will (very marginally) improve cash flow, but the losses and aggregate cash drains that result are obviously unsustainable. The major restructuring needed to pull the industry back from the abyss will require huge capacity cuts and much higher fares. The capacity cuts will not only reduce costs but will recreate some of the scarcity (via high load factors) needed to support higher business fares.
These higher fares and schedule cuts (and the massive layoffs and supplier cutbacks that will accompany them) will (needless to say) be incredibly unpopular, and will lead to further demand declines, and then to further price hikes and capacity cuts.
These problems will get worse if (as is likely) capacity cuts take the form of reduced competition and increased price collusion. Under a managed, industry-wide restructuring process balanced competition can be preserved but (given the political issues discussed above) no one is working to protect consumers or industry efficiency. If one large airline collapses, thousands of markets will be reduced to duopolies and monopolies, and a carrier may try to exploit the chaos in order to achieve a permanent market share dominance.
All of this is just airline economics 101. But absolutely no one in the industry, government, capital markets or media is willing to face up to this inevitable reality.
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[1] Hubert Horan: The Airline Industry Collapse Part 3 – Recovery Expectations Were Always Dreadfully Wrong, Naked Capitalism August 4, 2020
[2] Kyle Arnold, “Southwest Airlines needs ‘business to double in order to break even,’ CEO says” Dallas Morning News, August 28, 2020
[3] Ben Goldstein, “S&P Global Sees Just Three Investment-Grade Airlines Left” Aviation Week, August 12, 2020
[4] Brett Snyder, “United Ditches Domestic Change Fees” Cranky Flyer, August 31, 2020.
