Image Source: Boeing
The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.
— Warren Buffett, annual letter to Berkshire Hathaway shareholders, 2008.
The airline industry has just turned in its second consecutive year of record profits, but the harmony may soon be over for the industry as it could be on the verge of its next big problem. If major airlines are not able to develop an efficient pilot pipeline, it could begin to see intense competition for qualified commercial pilots, and tight-fisted labor unions may only make things worse for airlines looking to put their troubled pasts behind them. According to a study by Oliver Wyman, the current regulatory environment in the industry can only yield about two thirds of the pilots that will be needed in the US in the next 20 years, potentially leading to cost pressures across the industry in coming decades as pilots’ salaries and benefits are inevitably hiked northward. Airlines are already starting to feel some turbulence despite operating in a benign environment of ultra-low jet-fuel costs.
Republic Airways (RJET), for one, had been negotiating a deal with its pilots’ union since 2007, but recurring efforts by the company to pay its pilots more–even greater than those at peers Air Wisconsin and SkyWest (SKYW)–just weren’t enough. Incredibly, in a deal submitted August 2015, new first officers would receive a massive 74% pay increase and more-senior officers a bump too, but the pilots’ union still rejected the deal on account of “language…preventing it from encouraging members from taking positions at other regional airlines.” Though the pilots’ union finally agreed to a deal September 2015, the damage to Republic Airways over 8 long years of negotiations (resulting in unrest and attrition) had already been done. In late February, the troubled airline filed for relief under Chapter 11 of the US Bankruptcy Code in the US Bankruptcy Court for the Southern District of New York.
The reorganization process is expected to allow Republic to restructure its finances and contractual relationships with labor (again) while continuing normal business operations. The pilot turmoil at Republic led to the grounding of a material number of the firm’s airplanes over the past several months, as it struggled to renegotiate agreements with the larger carriers it serves, such as American Airlines (AAL), Delta (DAL), and United (UAL), to rework aircraft leases. The union contract ratified in September 2015 initially stabilized Republic Airways’ situation, but drastically higher pay for its pilots means it needs higher compensation from the carriers it serves. Republic will almost certainly be using the bankruptcy courts to force the hand of the larger carriers, though this was clearly not the firm’s preferred option. News that Republic’s VP, Finance and Treasurer, will resign and join AAR Corp (AIR) hasn’t been a reassuring development either.
If you recall, similar union strife had taken place at AMR Corp earlier this decade, and given the airline’s bloated cost structure, which at the time was simply untenable compared to its lower-cost rivals, American was forced to file for bankruptcy protection in November 2011. However, what happened to AMR Corp’s equity during the bankruptcy process was rather unusual and may provide some hope for shareholders of Republic, whose filing like AMR’s could also be viewed as a protective, preemptive move. Unlike those of most defunct equities, shares of AMR Corp were not wiped out, and as the airline merged with US Airways, shareholders of legacy AMR “were guaranteed 3.5% of the equity in the new combined airline.” The merger with US Airways, while largely expected given CEO Doug Parker’s well-documented willingness to take advantage of the bankruptcy process, was quite the turn of events at AMR Corp, which when it filed for bankruptcy listed $29.6 billion in debt and only $24.7 billion in assets. Shareholders of Republic may not be so lucky, however, even if there is a chance at some residual value, but playing the outcome of bankruptcy proceedings will never be our cup of tea.
The plight of other airlines with respect to labor negotiations has been mixed as of late. Spirit Airlines (SAVE), which has witnessed a pilots’ strike earlier this decade, has pilots and flight attendants with amendable contracts, but has yet to enter negotiations with either union. Small portions of both American Airlines’ and Alaska Air’s (ALK) work forces have amendable contracts at the moment as well, but both have their pilots under contract through 2019 and 2018, respectively. JetBlue (JBLU) has been in negotiations with its pilots since April 2015, and the two sides have tentative agreements on parts of a new contract. On the less favorable side, United is currently in negotiations with its flight attendants, many of which have been demonstrating their displeasure at airports across the nation. Delta’s pilots are reportedly seeking a nearly-40% compounded pay raise over a three year period as it recently restarted contract negotiations at the beginning of 2016. The Delta pilot union rejected a pay raise in July 2015 that would have made them the highest paid in the industry at that time.
Perhaps in the worst shape with respect to contract negotiations is Southwest (LUV). The company is currently in negotiations with over half of its unionized labor force, including its pilots who have been in negotiations since September 2012. In November 2015, the pilots’ union rejected a contract that would have made them the highest paid in the industry at that time due to a variety of reasons, including retro-pay and a variety of work rules. In February 2016, pilots began picketing for the first time in the company’s history, and the two sides do not appear to be pleased with one another. With more than 80% of Southwest’s employees unionized, this could be the beginning of the end of its once-enviable labor relations. Management says it believes “Southwest Employees have the best contracts in the industry.” Obviously, their workers don’t care if this is true and want more.
A large portion of the labor unrest in the industry has been caused by the recent strong financial performance of the airlines. Low fuel prices and a solid US economy led to tremendous profits across the industry in 2015, and the workers want a comparable slice of those profits. However, the airlines know these levels of profitability are not sustainable over the long term; if crude rebounds even modestly, profits will feel the heat, as will revenues as the average US consumer’s disposable income shrinks. Wages tend to be very sticky once they are raised, so executive teams have exercised tremendous caution to avoid raising the bar of fixed costs too high just in time for the next recession.
As you’ve heard from us time and time again, the airline industry is notoriously cyclical and historically has been tremendously difficult to navigate for even the best operators. Airlines continue to struggle to properly coordinate capacity increases and demand, despite prior reassurances from executives in the industry, though the latter disconnect may merely be an effort to disprove “implicit collusion.” We’ve had doubts for some time the group won’t revert back to its old ways, “No Fly Zone: Airlines’ Economic Profitability Still Unproven,” and we believe the group should tread lightly with ongoing labor negotiations as financial performance is almost certain to normalize from the current “peak” in coming years. Those unable to prudently manage labor issues may likely see profits “grounded” when the cyclical industry reaches its next downturn, the timing of which is the only uncertainty.
We’ve never been fans of the business models and investment prospects of airlines and likely never will. That doesn’t mean we’re not enamored by the people and airplanes, as anybody else – it just means airline stocks are mere speculative trading vehicles, not long-term investments, as Mr. Buffett puts it.