Make It Up in Volume!

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GUEST COMMENTARY. "Merger mania" is one of the new buzz phrases in the airline industry these days, along with "runway incursions" and "air traffic control delays," of course. Soon after the proposed acquisition of US Airways by United Airlines was announced, mergers of American with Northwest Airlines and Continental into Delta Air Lines were also floated. These proposals don't exist in the "we never met a merger we didn't like" environment of the 1980s-era Department of Transportation, yet they are accompanied by better-prepared spin doctors and much slicker public-relations efforts. How to make sense of all the hype and "blowing snow"? Airline captain and industry analyst R. Michael Baiada takes on the UAL/US Airways proposal and cuts through the haze.

The recently proposed purchase of US Airways by United Airlines (UAL) opens many interesting questions for the airlines' consumers, shareholders and employees.

First and foremost, United and US Airways management will tell the world and the financial community how much synergistic benefit this merger will bring to the combined company. You will hear how revenues will skyrocket as UAL flows all of the US Airways passengers into United's long-haul system. United will explain to the regulatory authorities the route systems as being very balanced, with little overlap, and this deal will improve service for the flying public. They will tout the purchasing power of the combined company. In fact, they will claim many things, many of which may be true. Sadly, you won't hear about the problems that will increase fares, decrease competition and scuttle shareholder value.

Beyond all of the problems facing United management's successful acquisition of US Airways, the real key to the success is United's ability to manage a $0.12/ASM (available seat mile) route system going into the next economic downturn, while paying down a reported $28 billion in debt. As they always say, the devil is in the details and unfortunately for shareholders, United's performance in managing the details over the last ten years leaves much to be desired.

Further, no one has been able to consistently profit in the northeast U.S. Weather and air traffic control (ATC) inefficiencies continue to drive operating costs far beyond those in other areas of the United States. While all the airlines covet access to the concentration of people in the northeast U.S., consistently flying profitably in this area of the country has been beyond the scope of current airline managers. For years, US Airways has been one of the highest cost carriers in the United States and — even with the industry's highest yields — has ended up a perennial loser in the profit column. Why does United management think that they will be different?

The bottom line is that:

  • United's acquisition of US Airways is bad for consumers. Competition will decrease and fares will increase. While direct flight-by-flight overlap is small, the departure-to-destination overlap through the airlines' respective hubs is considerable. Additionally, to manage such a high-cost structure, United must eventually abandon US Airways' smaller airports, while increasing fares at those cities lucky enough to retain service. The overall effect? Fewer choices, less service and shrinking revenues.
  • United's acquisition of US Airways is bad for shareholders. United will become the highest-cost carrier in the U.S. United's ability to manage such an astronomic cost structure, while servicing upwards of $28 billion of debt, is questionable at best. This represents significant shareholder risk, with little if any potential upside benefit.
  • United's acquisition of US Airways is bad for employees. The seniority and cultural issues will ensure everyone is unhappy for years to come. Also the downside risk of this acquisition will directly threaten their jobs.
  • Finally, it seems that Mr. Goodwin and Mr. Dutta, United's chairman and president, respectively, are willing to gamble shareholder equity that they can do something no one else in the airline industry has been able to do — consistently make money in the northeast U.S.

As I wrote above, the devil is in the details. Here they are.


Costs

Obviously, this deal is a pure revenue play. It is reminiscent of many of the business plans of many new airlines since deregulation. They predict profits based on a few passengers above their break-even load factor. While the airline managers salivate over the increased revenue, they completely ignore what happens to an airline when its load factor is a few passengers below break even. Purely and simply, the costs will kill the success of this deal, and possibly United.

For 1999, as reported on Form 41, United's cost per available seat mile (cost/ASM) was 9.41 cents, while US Airways' was 13.97 cents per ASM, fully 48% higher (see the chart). While revenues for the combined company will certainly increase, the cost/ASM of the new company will skyrocket, probably settling into the 12-cents-per-ASM range.


Click on image for larger version.

To clarify, since United produces about twice the amount of ASMs as US Airways, using a weighted cost/ASM average (two-for-one) puts the combined company's costs at $0.11 per ASM, and that would have been for 1999, i.e., before the most recent fuel increases and United's introduction of its Economy Plus service. Add in the upward slope of US Airways' cost/ASM (from 4Q 1995 to 4Q 1999 US Airways' cost/ASM rose almost four times faster than United's — 20% versus 6%), and the implementation of Economy Plus in the US Airway's fleet, and a reasonable cost/ASM for the combined companies will easily be in the $0.12 range.

While the combined revenue stream may — repeat may — cover these costs today, United's inability to shed costs into the future (i.e., the next downturn) will lead to a financial catastrophe. This reminds me of joke about a company selling their product at a loss, but proudly telling everyone that they will make it up in volume.

Cost Factors: Economy Plus ...

A cost factor that requires clarification is United's Economy Plus seating. As many know, United removed a few rows of seats in its aircraft to increase legroom. While this enhances revenue, it also increases costs by almost 5%. How you ask? Good question.

Since the airlines measure costs in cost/ASM, obviously the number of ASMs produced per aircraft has a direct impact on the airline's cost/ASM. Removing approximately 5% of the seats will increase costs/ASM by 5% because less ASMs are produced while total costs remain constant.

For example, using United's 1999 numbers (the latest DOT form 41 data readily available), the recent seat removal program would have increased United's cost/ASM from $.094 to $.099. This cost increase will actually show up fully in the 2Q 2000 numbers since all of United's aircraft are now configured for Economy Plus. Assuming United expands Economy Plus to its US Airways aircraft (mostly narrow-body aircraft), US Airways' 1999 costs would have jumped from $.139 to $.147 per ASM. Sadly, just one more nail in the coffin United is building for its shareholders.

... Productivity

Additionally and contrary to many management experts, the current financial problem facing US Airways is not high labor costs. The real issue is US Airways' inability to use their capital assets and labor productively, a problem at most airlines, including United. Most of the ongoing analyses of US Airways focuses on its unit cost of labor, but ignores the inefficient use of that labor within the confines of the current process.

To illustrate the difference between unit labor rates and total labor costs, the following example is taken from our 1994 study on airline production, which led to a Congressional hearing on the inefficiencies of the ATC system (Free Flight):

A single B737 aircraft on Southwest's route between Lubbock and Albuquerque has a productive utilization rate of 42,562 available seat miles (ASM) per hour. Conversely, a single US Airways B737 aircraft flying from Boston to Philadelphia only has a productive utilization rate of 24,331 ASMs/hour. In this example, since both airlines use the same aircraft type and the mileage is almost identical on these two routes, from a production standpoint, the Southwest B737 (and crew) is 75% more productive than the US Airways B737.

Stated in labor cost terms, the US Airways crew's hourly rate would have to be 58% less to have pay parity with the Southwest crew based on their production capability, yet their respective hourly rates are similar.

As many industries have learned, more important to profits than the hourly labor rate is the efficient use of labor and capital assets within the production process. And although every airline is well aware of the pilot's hourly rate, no airline even measures the rate of production of its aircraft. Improve the production process and labor costs would drop dramatically.

Reduced Competition and Increased Fares

Rather than speak to this issue, below is the opinion of an expert on airline/airport competition, finance and routes, Michael Boyd of the Boyd Group. He makes the point better than I ever could that the United-US Airways merger will reduce competition. The full text of Mr. Boyd's comments can be found on his web site.

The "Vegas lounge act" press conference held by United and US Airways was orchestrated to dangle those shiny trinkets to the public, making lots of promises and grand statements. P.T. Barnum would have been proud.

They did a great job. They took a clearly anti-consumer merger and in minutes had the alleged aviation cognoscenti jumping through hoops like trained seals. From the usual-suspect crowd of Wall Street analysts and ivory-tower university professors, the accolades began to flow.

They're easily fooled. Let's put it straight. This merger will do a lot of things, not many of which are good:

  • It will reduce competition.
  • It does reduce consumer options in hundreds of markets.
  • It will have a materially detrimental effect on small community air service.
  • It unnecessarily further consolidates the airline industry.

Let's start with some of the amateur nonsense that United has successfully been foisting on the public:

It Won't Reduce Competition

Get real. These university professors who are touting this merger might want to re-take Math 101. Whenever an entire airline system is merged into another, the consumer loses an option, and competition — current and future — is reduced.

There's Little Route Overlap, So Competition Won't Suffer


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That is a pure crock. It's amazing how many aviation analysts have bought into this. It is a hard fact that this merger will reduce competition in hundreds of markets. Remember, this is a hub and spoke system, and it is geared to carry passenger flows, not point-to-point traffic. United's ORD hub serves many of the same flows served by US Airways' PIT hub. Sure, United and US Airways don't compete in the SYR-PIT market. And they don't compete in the PIT-LAX market. But they do compete in the SYR-LAX market. And the ALB-STL market. And in the ROC-SEA market. In fact, a cursory look indicates hundreds of connecting markets — not all of them small by any means — where this deal reduces competition.

It'll Give CLT and PIT More International Service

Another trinket that's not all it's cracked up to be. Sure, there would be some additional on-line international connectivity. But some of the promises made by United are spurious. Both PIT and CLT already have United international access over ORD and IAD. But worse is some of the terminology used by United.

For example, announcing that PIT will have "one-stop" service to Beijing, Tokyo, Seoul, Singapore, and various Latin points should raise eyebrows. What does "one-stop" mean? Through flights — wide bodies — to all these points from PIT? Or do they mean change-of-gauge service? Or just connecting service, much of which PIT already has from United? Not clear. In the airline business, "one-stop" is generally meant to be same-plane, not connecting. Is United being fully candid here?

Ditto with promises for CLT. Indeed, same-plane, one-stop CLT - Taipei service? And Auckland? And Seoul? It is really going to be one-stop? Or, is United, a sophisticated carrier, playing semantics between "one-stop" and "connecting" service? As for South America, United could simply add flights to MIA, as AA has done from many cities, to feed its Latin flights. A merger that eliminates a entire airline system is not necessary for this to happen. The net result is still reduced competition for dozens of communities.

No Fare Increases in Point-to-Point Markets for Two Years

What does that mean? The very fact that United used the term "point-to-point" should send some danger signs. Are they really talking about all fares? Some fares? No increases except for certain circumstances? Again, note it says no increases in "point-to-point" fares. Hey, to the flying public, all air travel is "point-to-point". But within airline semantics, "point-to-point" usually means nonstop segments. Okay, does that mean that SYR - PIT stays the same, but SYR - LAX which, in internal airline parlance, is connecting, not "point-to-point," could go up? Maybe. Somebody better ask.

Integration

Fleet Integration ...

US Airways' fleet of 458 aircraft has about 25% compatibility with United's fleet. US Airways' 737-400 (54), 737-200 (59), and 727-200 (4) aircraft (total 117) are compatible with United's current fleet.

US Airways' B767s (12, different engines from UAL), 757 (34 - different engines), 737-300 (85 - different cockpit configurations), A320 (15 - different engines), A319 (31 - different engines) aircraft (total 177) are partially compatible with United's fleet. And finally, US Airways' MD-80 (31), DC9-30 (33) and F-100 (40) aircraft (total 104) are not at all compatible with United's fleet.

... Employee Integration

This will be a disaster. There has never been an airline merger that has left the employees happy. The problem is seniority. At an airline, employees live and die by seniority. Schedules, vacations, and even jobs are all decided by seniority. For example, United has a large wide-body fleet flying to many international destinations (upwards of 150). US Airways has very few wide-body aircraft (approximately 14). And since the larger the aircraft, the higher the pay for pilots, the wide-body aircraft are the most desirable. Depending on how the seniority lists are merged and given US Airways' relatively high pilot longevity, many United pilots' expectations of flying these aircraft could be lowered considerably.

The integration of the pilots' seniority list will be a difficult task that will please neither pilot group. Lawsuits and years of legal maneuvering leading to bitter and disgruntled employees will be the result. In fact, I have heard United pilots already considering filing a lawsuit to protect their seniority. They don't know the facts; they don't know what relief they are seeking. This acquisition will generate so many lawsuits that filing now would put them at the head of the list.

And while the pilots will be a difficult seniority integration task, the problem does not stop there. Mechanics, ramp workers, customer service agents, et. al., all use seniority to bid jobs, work locations, vacations, etc. No one will be happy. And, unfortunately for the shareholders, the surviving management team will need a happy employee group to make this deal work.

The bottom line is that this integration of these two workforces will please no one. And while this may be the sign of a fair integration, a disgruntled workforce is not the best thing in a service industry. Especially a service industry already staggering from record passenger complaints caused by so many delays and cancellations.

Contract Roadblocks

The current United Pilot's Contract states that:

  • The Company recognizes the right of pilots on the Pilots' System Seniority List and/or Second Officer Eligibility Seniority List to perform the Company's flying and operate the Company's aircraft. ... As used in this section, the phrase the "Company's flying" includes without limitation all commercial flight operations of any sort whatsoever, whether revenue, nonrevenue, scheduled or unscheduled, conducted (1) by the Company or an Affiliate, or (2) by an entity managed by or under the Control of the Company or an Affiliate, or (3) by an entity in which the Company or an Affiliate owns any equity interest.
  • Neither the Company nor any Affiliate shall perform any flying for other carriers unless such flying is conducted by pilots on the Pilots' System Seniority List and/or Second Officer Eligibility Seniority List in accordance with the terms and conditions of the Agreement.
  • The Company is authorized to establish the U2 Operation (Shuttle), and it may, at the Company's option, operate U2 as a distinct corporate division of United Airlines provided that the Company, including both the U2 Operation and the Company's other ("Mainline") operations, remains a single carrier for all purposes of both the Federal Aviation Act and the Railway Labor Act. ... All pilots who perform services in the U2 Operation will be United pilot employees pursuant to Sections 2-a or 2-x of the Agreement and will be represented by the Association as part of a single craft or class of United flight crew members that includes all United pilots.

What this means is that according to the United pilot's contract, on day one of the merger, the US Airways' pilots must be on the United pilot's seniority list and working under the United pilots' contract. Conversely, the US Airways pilots' contract requires that their contract be kept in place for two years after any merger and/or buyout of US Air. Obviously these two contracts are mutually exclusive and must be resolved prior to the acquisition to meet all contract obligations.

In addition to the above contractual restrictions, the United pilot's contract has provisions that limit RJ flying, code share, Shuttle (MetroJet?), etc., that would be breached with the purchase of US Airways. United management has two choices here: Either come to an agreement with the United pilots prior to the sale or ignore their legal obligations. And as we have seen with the recent Reno Airlines fiasco at AMR, ignoring the pilots' contract, especially the scope clauses, could turn out to be very expensive for everyone.

Adding to the confusion is the fact that United and its pilots and mechanics are in Section 6 contract negotiations as defined by the Railway Labor Act. What this means is that neither United nor its labor groups can change the "status quo" until new labor agreements are in place, further complicating this deal.

Airline Quality?

As can be seen by the recent rash of flight cancellations and bad press the airline industry has received over the last few years, airline quality is an oxymoron.

In Search of Excellence?

Having spent years studying the airline process from curb-to-curb, I can reliably state that one of the critical problems within the airline industry is quality control, or more accurately, the lack thereof. While other industries strive towards Six Sigma Quality (approximately 3 defects per million), the airlines are happy with 1-to-2 Sigma quality. Simply look at the mediocre targets with which airlines task themselves. For example, an 80% on-time record is erroneously considered a great accomplishment and is a goal rarely achieved by United or US Airways.

A big problem is that there is simply no one responsible for the quality (there's that troublesome word again) of how airlines accomplish their collective tasks of delivering their passengers to the destination curb. No one is responsible for the cross-departmental task of making sure passengers are well cared for in all aspects from departure curb to destination curb.

This issue is reminiscent of the management philosophies of US industrial leaders after World War II. When confronted by W. Edwards Demming with enlightened Quality Control concepts, they ignored him. Their companies were making money hand over fist. Why should they listen to anyone? They knew what they were doing. Mr. Demming's rebuke led him to Japan where his concepts were the central force in Japan's industrial rebirth in the 1970s. Sound familiar?

What these 1950s managers missed was the fact that the United States had the only surviving industrial base in the world. No matter what they built, or how badly they built it, there was a customer somewhere that would buy it. These managers made the same mistake being made today by airline management — confusing a good economy and expanding markets with good management. History is a wonderful teacher, but first you have to know the history.

Mr. Demming's philosophy is simple. Find the end point of your system, i.e., your product, and build a process that gives you the right answer: A defect-free product each and every time. He correctly identified that fact that it is much more costly to repair a defect at the end of a process than it is to build a process that prevents the defect from occurring. Relate this to how many defects airlines produce each and every flight and you can see why their costs are astronomical and product quality is so poor. For example, an 80% on-time factor means that 20% of the flights are defective. Try and find a profitable manufacturing facility with a 20% defect rate. And in the case of on-time departure performance — United's current mantra — United's goal is in the 55% to 65% range. Again, United sees a defect rate of 40% as acceptable.

Maybe someone can explain how either United or US Airways meets any of the quality parameters and processes used in many other industries. I cannot, and any merger between these two airlines will only lead to less quality, and more, many more unhappy customers.

Operational Excellence

Another oxymoron when applied to the airline industry. One need only look at the dismal on-time performance of both United and US Airways. From September 1987 through March 2000, United's on-time arrival performance was 76.5%, placing them 10th out of the 10 major airlines. Conversely, for the same period US Airways' on-time arrival performance was 78.5%. Looked at differently, United and US Airways averaged almost 23% of their flights late to the gate by at least 15 minutes. In any other industry, these levels of operational incompetence would be met with a swift escort out the door.

Miscellaneous

Along with the problems discussed above, there are numerous other issues that will make the integration of US Airways difficult for United. These include integrating the reservations computers, operational computers, management structures, maintenance programs and computers, cultures, etc.

Egos and Golden Parachutes

Finally, we get to what this merger is all about — money and power. Would United still be interested in buying US Airways if the combined airline was not the world's largest by a wide margin? Would Steven Wolf be willing to sell US Airways if he had been required to operate a profitable airline and would receive no Golden Parachute?

For a more graphic view of how this merger will progress, imagine two aircraft on a collision course. As they collide, passengers, shareholders, crews, employees and bags are strewn all over the place, except for four golden parachutes floating gently to earth. You can fill in the blanks as the four lucky individuals using the parachutes.

Editor's Note:

Although this article is written by a current captain for United Airlines, it in no way expresses the opinions of pilots at United nor of United's management.