The Case to Reduce Foreign Ownership Restrictions – 270,000 Jobs at Risk
By Vaughn Cordle, CFA / February 24, 2009
Capital productivity significantly increases when two or more airlines eliminate overlapping
functions and reduce capital -both human and physical. In other words, more revenue is
produced per unit of capital. This improvement in efficiency is part of the cost synergies that can
be shared with consumers, capital providers, and labor and is a key reason why airlines worldwide
want to move toward greater coordination and emulate the success of AF/KLM.
The more successful airlines like Lufthansa and AF/KLM hold portfolios of different businesses
[revenue streams] and partner with airlines. Why? It’s more profitable, even when different units
of capacity are separate, stand-alone business entities. The airlines work together to increase
both scope and scale economies, reducing risk and increasing returns for the total corporate
portfolio of assets and airlines. U.S. legacy airlines have been selling assets for years, however,
and are running out of ways to raise capital.
Government policies that exclusively increase industry competition results in increased industry
efficiency, but results in destructive competition. Reducing foreign ownership restrictions could
allow big U.S. airlines to emulate the practical and strategic benefits of what AF/KLM has achieved
for its stakeholders. Many were adamantly opposed to the DAL/NW merger because they did not
believe that positive synergies would materialize and that the merger was a bad deal for both the
shareholders and for the consumer. They wrongly assumed that costs would increase and that
value would be destroyed. Well, those merger synergies are real and should be in the $500m
range this year and $2b annually by 2012. The shareholders will benefit significantly as will
labor. The real value created in this instance must be measured against a status quo scenario,
and the status quo was not sustainable for Delta or Northwest as stand-alone airlines. In other
words, the opportunity costs of not merging became too high to ignore. Delta is now a much
stronger airline because of the merger, and its passengers enjoy and benefit from an enlarged
route system. Delta will likely pass along part of the cost synergies in the form of lower fares and
labor will receive a nice pay raise.
Many rightly argue that the airline industry becomes much more efficient when there are fewer
restrictions, less coordination, and greater competition, but conveniently ignore the need for that
business to earn an adequate level of profitability. The industry is not viable in its current form
because it cannot produce adequate earnings from the current levels of capital needed to
operate. The chronic propensity of the industry to engage in destructive competition gets to the
heart of the industry’s bad fundamentals and over leveraged balance sheet. Hence, there is a
need for new models, models that work within the context of a highly competitive global market
and particularly models that require less [and lower costs of] capital.
The U.S. airline industry cannot afford the new fuel-efficient aircraft that will be required as
additional environmental costs are introduced to lower CO2 emissions. Most airlines are currently
in slow liquidation, as their capital expenditures are inadequate to maintain their current asset
base. The upshot is that the U.S. fleet in terms of legacies is 15 years old on average, and that
age is a key reason why our airlines are not competitive in global markets. Without profitable and
competitive long-haul capacity in international markets, it will be hard for U.S. airlines to maintain
the domestic capacity that produces the more profitable and longer haul international feed.
U.S. airlines have already significantly reduced non-fuel costs and are about as competitive on
costs and capital productivity as they can be. Yet they are still unable to close the cost gap with
younger airlines that don't have the burden of legacy debt and obligations. The problem of
course is that older network airlines have too much leverage as well as higher maintenance and
fuel costs, a functions of an old and worn- out asset base that these airlines cannot afford to
replace. Moreover, as they shrink, the cost of capital is spread out over fewer seats and the
company is left with its highest cost senior employees, which in turn increases relative unit costs.
As lower-cost airlines gain even greater market share, pricing power is further reduced along with
yields and profitability. It becomes a downward death spiral that negatively impacts employee
morale and service quality, in addition to reducing the benefits of scale and scope economies.
The 6 big network airlines employ 61% of the domestic jobs in the industry and 87% of the system-
wide jobs. Jobs and market share will continue to be lost as the big six shrink another 8-9% in
2009 - double the rate of the low-cost airlines. This means 25,000 more high- paying network
airline jobs are lost, in addition to the more than 150,000 (35%) that have already been lost since
2000.
Cross-border equity investments can provide the “strategic” incentive to reduce and improve
capital productivity, productivity that will not exist without such an arrangement. It's true that some
competitors will be at a disadvantage, but adequate competition in most markets will still remain
[or new competition will emerge], and thus, many airlines may have no choice but to enter into a
cross-border arrangement to survive. In other words, the alternative to mergers and closer
coordination is for airlines to continue to shrink, shed jobs, and destroy even more shareholder
wealth. Selling assets and returning cash to shareholders may in fact be the better course of
action. By restricting capital flows and limiting foreign ownership levels, congress and
government officials are preventing the airlines from evolving into models that can allow them to
compete both internationally and domestically.
The large U.S. network airlines have 270,000 high paying jobs at risk, and this one stakeholder
has the most to lose. Moreover, cross- equity arrangements can come undone, so a flexible
industry with different models can create a stronger industry. There will be a natural churning of
airlines in the larger [alliance-type] portfolios over time and the competitive dynamic will continue
to exist, but in a quite different and more rational form that better manages supply and demand.
The risk and return profile of the industry improves as the alliances provide a vehicle that can
stabilize the industry and move it along a path of becoming worthy of longer term investment.
The free market can work if capital is allowed to flow to the most productive use of that capital,
and the Government will continue to provide the oversight required to maintain safety and make
sure that too much concentration in market share does not occur. The status-quo path for most,
if not all, of our big legacy airlines is a path that ultimately leads to failure. Therefore, change is
inevitable, and any formulation of new strategies must be based on industry fundamentals and
competitor actions and take place within the context of global competition. It’s an ongoing
struggle for survival, and those airlines that don't move fast enough and adapt will not be around
in 5 or 10 years or will simply provide domestic feed into large hub airports that are served by
larger and stronger foreign airlines. This the base-case scenario and outcome that labor and
politicians need to understand.
Research suggests that governments retain foreign ownership restrictions on their airlines
because politicians and officials believe that domestic ownership promotes economic
development, job preservation, trade and tourism, and capital retention. Some union leaders and
their political allies promote national security as the main reason for ownership restriction, even as
the Pentagon and DOD have indicated that security is really not an issue because there are many
layers of protection to prevent airline ownership by those who are hostile to U.S. interests. The
implicit assumption behind such restriction is the questionable notion that U.S. owners are more
likely than foreign owners to consider national, local, and labor stakeholder interests. It’s in the
best interests of foreign airlines to treat U.S. stakeholders well if the partnership is to be
successful in terms of creating value for its own shareholders.
Corporate governance and strategy is a function of who owns the equity, and institutions hold
85% to 105% of the outstanding shares of UAUA, LCC, AMR, CAL, and DAL. These airlines
represent 87% of the industry's jobs. Management serves as agents of these large blocks of
shareholders, whose primary and exclusive goal is to maximize share value. Consequently,
management tends to emphasize shareholder value maximization as a core strategic goal instead
of building a business that can create value in the longer term. Given the wealth-destroying
history and nature of the airline industry, these large investors do not consider the airlines as
long-term investments, nor do they care about strategies that could benefit labor or consumers in
the longer term. Stated differently, management, if they are to retain their jobs, is pressured by
Wall Street to produce short-term returns at the expense of longer term investment. In contrast,
foreign airlines have the strategic incentive to work closely with U.S. airline partners to build a
stronger and more viable airline network. Hence the focus needs to shift to longer-term value
creation and cross-border investments with foreign airlines can provide the collaboration and
incentive required to do so.
Moving toward a more competitive industry that will only help the consumer, as many suggest will
only accelerate the decline and eventual failure of the large U.S. network airlines. Over 270,000
high paying union jobs are at stake, and the exclusive focus is on helping only one of the three
key stakeholders (i.e., shareholders, labor, and consumer) – all three must be addressed and
satisfied for the business to be viable – is a rather naïve perspective in terms of offering practical
solutions that can actually help the U.S. airline industry, its employees, capital providers and
consumers in the longer term.
Foreign airlines may not want to invest in the big U.S. network airlines because of the radical anti-
capital and management-bashing behavior of the unions, especially the pilots' unions. Ironically,
these unions and their political allies oppose lifting ownership restrictions because they believe
that foreign airlines will displace U.S. capacity on longer haul routes. Big European airlines have
higher labor costs and it’s in their best interest to create value for all partners and shareholders. I
believe that more U.S. jobs can be saved with cross-border investment than would be the case
otherwise, and it may be the best way to defend and maintain market share in the Pacific and
Asian markets that have state-sponsored airlines and labor laws that result in super-competitive
cost structures. The status quo path currently in place will result in more job loses and lower
standards of living for those that are lucky enough to maintain a job that lasts until retirement. If
big labor does attempt to take more than its fair share of the revenue produced, the foreign
airlines can easily withdraw support by selling their equity stake.
The bottom line is that U.S. network airlines are not currently competitive with the stronger Asian
and European airlines and younger and lower-cost domestic airlines. They cannot catch up
because they are simply too far behind already in terms of capital expenditure and debt reduction.
Thus, their survival requires a closer relationship with alliance partners [or a merger in some
cases] so some level of sustainable market share can be carved out and maintained. Relaxing
foreign ownership rules will allow for positive cross- border investment that can produce higher
capital productivity and increase profitability. Risk and capital costs can be reduced, and these
positives in turn will result in more capital available for investment and job retention.
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