Threats And Opportunities Of Airline Restructuring

The Threats and Opportunities of Airline Restructuring

September 1999

Presentation to the Parliamentary Hearings
on Airline Restructuring
by the CAW Auto Workers
Delegation members:
Anne Davidson, President, Local 1990
Tom Freeman, President, Local 2213
Peggy Nash, Assistant to CAW
President Buzz Hargrove
Jim Stanford, CAW Economist

Canada's Airlines: The Moment of Truth

How Did We Get Here?

A War With No Winners

Strange Competition

1999: Deja Vu All Over Again

Dissecting the Onex Bid

To the Rescue: A "White Knight" for Air Canada?

Insiders Looking After Their Own

Airline Travelers: Still Waiting for Nirvana

Waiting for Nirvana (Part II)

Employee Buy-out = An Unnecessary Pay-Cut

Employee Buy-outs (II): Adding up the Cost

No Lay-offs: A Reasonable Demand

Two Airlines: The Best Way to Fly

The CAW's Position on Airline Restructuring

The Way Forward

Canada's Airlines: The Moment of Truth

There's nothing new about financial chaos in Canada's airline industry: we've been through it several times since the industry was deregulated in 1987.

  • 1988: privatization and debt write off for Air Canada
  • 1992: financial crisis and wage concessions at Canadian
  • 1992: financial crisis and wage concessions at Air Canada
  • 1994: AMR bail out of Canadian
  • 1995: lucrative work rule concessions at Canadian
  • 1996: another bail out and wage concessions at Canadian

You can only bang your head against the wall for so long. This time, there's finally a widespread recognition that the current structure of the industry cannot continue and must be changed.

The time is long past for one time bail-outs, stop-gap measures, and other band-aid solutions. BOTH MAJOR AIRLINES are in financial trouble, mostly because of their irrational and inefficient competition for the domestic market. Yet capacity continues to expand, as the airlines throw more money down the drain in a fruitless effort to dominate money-losing domestic routes.

Something has to give.

Financial Indicators, Major Airlines
Air Cda. Cdn. Airlines
Debt (Dec. 31 1998) $2.9 billion $1.0 billion
Decline in Share Price
(July 1998 to July 1999)
655 percent 660 percent
Decline in Profits (1998) 6$443 million 6$143 million
Capacity Growth (1993-98) 555 percent 520 percent

How Did We Get Here?

Three major factors contributed to the emergence of the current crisis in the industry:

  1. Looming bankruptcy at Canadian Airlines. The 1996 bail-out of this company, based on wage concessions, did not work -just as the CAW predicted at the time. By spring 1999, the company had just $70 million left in the bank, not enough to survive the coming winter. Air Canada management would prefer to just let Canadian die (allowing them to pick up international routes and other assets for cheap). But the federal government will not permit Canadian to go bankrupt: the cost to the national economy would simply be too huge.
  2. Continued financial weakness of Air Canada. It's not as if Air Canada is in great financial shape, either. The company had a disastrous 1998-largely but not solely because of the pilots' strike. As of this August, its share price was still lower than at the time of initial privatization a decade ago. Shareholder unhappiness led to the departure of former CEO Lamar Durrett. Management blames unions for Air Canada's poor performance (the same argument that was made at Canadian Airlines), but the real problem is more deeply rooted. Air Canada, too, loses big money on deregulated domestic routes.
  3. Recognition of irrationality in competitive structure. Suddenly, analysts in both business and government have started to recognize what the CAW has been arguing for years: so called "free competition" on domestic routes is wasteful and destructive and must be reformed.

All of these developments opened the door to a fundamental change in the country's airline policies. At last the federal government took action on August 13, when it allowed the two major airlines to enter into confidential marketing talks (for 90 days) without fear of breaking Canada's competition laws.

The CAW views a fundamental restructuring of Canada's airline industry as inevitable, and long overdue. There is a positive potential for this restructuring process to lay the groundwork for a stronger, more efficient, and more financial stable industry, which would be of benefit to consumers, workers, and shareholders alike. It is essential, however, that this restructuring process be managed with an eye to minimizing the economic hardship experienced by airline workers, and while preserving an integral role for the federal government to oversee (and where necessary exert direct influence on) the performance of the restructured industry.

A War With No Winners

Neither Air Canada nor Canadian Airlines has yet to "break even" under deregulation. Air Canada's profits in recent years (mainly in 1997) still do not offset losses earlier in the decade. Canadian, meanwhile, is $2 billion in the hole.

Air Canada's performance on all indicators (profitability, profit margins, unit costs) has lagged far behind U.S. airlines in the 1990s.

The continuing financial weakness of Air Canada has come home to roost in its vulnerability to takeover. If Air Canada was truly a strong, robust airline, Onex would have had zero chance of succeeding with its relatively low-priced offer.

The whole industry has been weakened by years of wasteful duplication and losses on domestic flights. Like a punch-drunk heavyweight boxer at the end of the 15th round, the supposed "winner" of this irrational battle Air Canada is left staggering and financially wobbly.

Strange Competition

The battle between airlines that has ensued since the industry was deregulated in 1987 is not the "free competition" imagined in the economics textbooks.

Given the size and geography of Canada's market, any airline that gains an advantage over its competitors can convert its initial advantage into a growing dominance. In technical terms, airlines in Canada enjoy strong "economies of scale" and strong "network savings".

Economies of Scale: The bigger you are, the more efficient you are
Network Savings: The more "connected" you are (in terms of routes and hubs), the more efficient you are

Given the powerful benefits that result from being the biggest (and best connected) kid on the block, the dominant airline in any sector of the market can reap huge potential profits. But other airlines will challenge for those profits, by adding capacity (even when there is no demand for it) and tolerating losses as the battle over market share continues. The potential profits of market dominance are transformed into the chronic losses that result from perpetual excess capacity.

This strange competition between airlines is motivated mostly by a desire to hurt the other company. This type of competition does not produce more efficiency or higher quality.

Both airlines match each other's posted fares, dollar for dollar. Both airlines match each other's departures, minute for minute. Both airlines fly half-empty planes to the same des-tinations, or must offer deep discounts to fill their excess seats.

Is this "competition"? If it is, it certainly isn't rational.

1999: Deja Vu All Over Again

Following the 1996 financial crisis and bail-out at Canadian Airlines, the federal government established-at the CAW's insistence-a special committee to examine the ongoing prob-lems in the airline industry. We knew that concessions would not solve the underlying instability of the industry.

The CAW argued the fundamental weakness of the industry stemmed from the inefficient nature of domestic competition under deregulation. We did not argue for a return to full-fledged pre-1987 regulation (in which all routes and fares had to win government approval). But we did argue for a policy which limited the expansion of total capacity in the industry, so that a better balance could be attained between supply and demand. This would reduce the wasteful duplica-tion and losses of the industry, without harming consumers.

Under the umbrella of the Canadian Labour Congress, four of the unions participating in that committee (the CAW, CUPE flight attendants, the Machinists, and the Teamsters) submitted a joint report titled Heads in the Sand. It warn-ed of future finan-cial crisis if the government did not back away from its policy of full deregulation.

By 1998, the two major airlines had increased their total capacity by almost 40 percent in just five years. In contrast, Canada's economy grew by just 17 percent over the same time; Canada's population grew by less than 6 percent. With capacity growing so much faster than the underlying market, financial distress is inevitable.

Canadian Airlines lost another $275 million between October 1998 and June 1999. Except for one good year in 1997, Air Cana-da's profitability has been mediocre at best, and the company's financial reputation is now poor.

In May of 1999 the CAW organized a meeting of airline leadership to address the looming crisis in the indus-try-most immediately the potential bankruptcy of Canadian Airlines.

At that meeting the CAW presented a multi-point program to stabilize and revitalize the industry:

  1. Canada's air transport system should continue to be based upon two major airlines. But this is only viable if competition in the domestic market is eased.
  2. The government should make a minority equity investment (totaling $300 million over three years) in Canadian Airlines or any successor company.
  3. New private investment should also be solicited for Canadian Airlines.
  4. Canadian content requirements should be imple-mented to protect a proportionate share of Canadian jobs at all airlines operat-ing in Canada.
  5. Any corporate downsizing associated with airline restructuring must be accomplished solely through attrition and voluntary buy-outs, not lay-offs.

Dissecting the Onex Bid

The federal government announced on August 13 that it would allow confidential talks between the two airlines. This was viewed as an opportunity to facilitate needed changes in the relationship between the two companies. But now -this broader process has degenerated into a bidding and public relations war between competing proposals to take over and merge the two airlines.

First Air Canada repeated its long-standing offer to buy Cana-dian's international routes. Then came Onex Corp., with a cleverly-crafted (and well-connected) takeover bid, structured as follows:

Step 1: Buy Air Canada (cash & share: $8.25 cash and/or 1 new share per Air Canada share)

Step 2: Merge with Canadian Airlines (cash & share: $2 cash and/or .24 new shares per CAI share)

Step 2: does not proceed without Step 1.

The total deal is worth $5.7 billion:

  • $1.8 billion to Air Canada shareholders
  • $200 million to CAI shareholders
  • $3.7 billion in assumed debt

Note that the "bankers" get 70 percent of the total value of the deal. Clearly the banks have been (and will continue to be) the only real winners from airline deregulation.

In return for 31 percent of the new merged airline, Onex supplies only $250 million equity directly, plus $475 million more borrowed from AMR and the TD Bank. Onex brings more nerve and ambition to the deal, than hard money. AMR has a huge stake in the Onex deal, going far beyond its 15 percent ownership stake: it would win lucrative cross-border connections traffic and an inside track on various service contracts. Some 54 percent of the new company would be owned by public shareholders.

To the Rescue: A "White Knight" for Air Canada?

Air Canada's executives were caught flat-footed by the Onex bid. It appeared they were hoping that Canadian Airlines would simply die, allowing Air Canada to achieve its long sought market dominance at no extra cost. Air Canada's token "offer" to purchase Canadian's international routes (made public in August) would only have hastened Canadian's demise.

Air Canada's executives underestimated the political and economic unaccept-ability of simply allowing Canadian (and 16,000 jobs) to perish. And they underestimated their own vulnerability to a reverse takeover attempt, particularly in light of Air Canada's recent poor performance and depressed stock price. Now the company's leaders are scrambling to oppose the Onex bid:

  1. Air Canada is criticizing the large foreign role in the Onex bid-namely, the participation of AMR. This is from a company which has had three straight American CEOs, is already 25-percent U.S.-owned, and is working behind-the-scenes with other foreign airlines to arrange a competing bid!
  2. Air Canada is trying to delay a shareholder vote on the Onex bid until January or later, perhaps hoping Canadian's worsening financial situation will make the bid seem less viable.
  3. Air Canada is rumoured to be soliciting a competing bid to buy itself, financed by United Airlines, Lufthansa, institu-tional investors (such as Quebec's Caisse de dépôt), and perhaps some Air Canada employees (such as the pilots).

Even if Air Canada's executives find someone else to buy the company (hence preserving their own jobs), this will hardly address the fundamental problem facing the whole industry. Now is the time to fix the financial damage done to both airlines by years of wasteful and unproductive competition in the domestic market.

Insiders Looking After Their Own

Onex and American Airlines have a huge vested interest in their takeover bid. If it works, and if (as expected) the new company's profits improve substantially, Onex could make a huge profit on the deal: tripling or quadrupling its $250 million direct stake.

Air Canada's management is working to defeat the Onex deal. But Air Canada's executives and shareholders have their own set of vested interests, their own hidden agendas:

  • Air Canada executives want to keep their top jobs
  • Air Canada's shareholders want to elicit higher buy-out offers, to help force up the Onex bid; they are happy to sell the company, as long as they get a higher price for it
  • Air Canada's foreign partners (United and Lufthansa) want to capture the lucrative cross-border connec-tions for themselves (rather than for AMR)

We should be highly suspicious of the efforts of these competing bids to position themselves as "champions" or "saviours" of the airline industry and its employees.

If the whole restructuring process is reduced to a battle between competing hostile takeover bids launched by competing self-interested financiers, then we know for sure that the interests of workers and the traveling public will take a distant back seat.

That's why we are demanding that the federal government take an active role in the restructuring process. The future of our members' jobs, as well as of the whole -airline industry, is too important to be left solely up to the takeover wizards alone.

Airline Travelers: Still Waiting for Nirvana

It is often argued that air travelers in Canada have benefitted from lower ticket prices under deregulation, and hence that consumers will be harmed by the restructuring of the industry (whether a merger of the two airlines, or else a moderation of competition between them).

To be sure, some bargains can be found, on certain routes at certain times, as the airlines struggle to fill the abundant seats they have added to their total capacity.

But even including discount seats, average ticket prices have increased under deregulation. Average fares (including discounts) have risen 15 percent since 1992-almost twice as fast as other consumer prices in Canada.

Airlines must cover the huge and wasteful cost of supporting excess capacity and flying empty seats. They do it by maintaining high prices (especially on full-fare seats). As long as excess capacity is maintained, ticket prices cannot fall.

Waiting for Nirvana (Part II)

Ironically, domestic airfares (including discounts) have increased faster under deregulation than inter-national airfares. International flights are still largely regulated, in contrast to the free-for-all of domestic competition. Regula-tion has attained a better match between supply and demand, allowing the international business to generate better airline profits without gouging the traveling consumer.

The total cost of flying in Canada has increased even faster than the rise in ticket prices alone. Thanks again to deregula-tion and privatization, taxes on airline travel have increased dramatically in recent years. New charges for airport user fees, NavCanada fees, airport improvement fees, and other taxes have all added steeply to the cost of air travel.

Including these taxes, the total cost of flying in Canada has in-creased an incredible 76 percent since 1992, and 16 percent in the last year alone.

Each month, Statistics Canada tracks the prices of 175 different commodities to calculate its monthly Consumer Price Index. Of those 175 commodities, none has experi-enced a greater increase in prices in the last year (and, indeed, during the 1990s as a whole) than the cost of flying.

The notion that consumers have benefitted from deregulation and privatization is clearly false. The traveling public has been gouged by rising average ticket prices and by skyrocket-ing taxes. Despite this, the airlines are wallowing in red ink, and airline workers have had their belts tightened repeatedly.

A moderation of domestic competition could actually benefit consumers, by reducing industry costs on a sustained basis. The government should also step in with measures to monitor (and where necessary roll back) excessive prices.

Employee Buy-out = An Unnecessary Pay-Cut

Air Canada executives have hinted they may help to facili-tate an employee buyout of the company, as a defense against the hostile Onex takeover bid. The Air Canada pilots would support such an initiative.

Employee buy-outs are invariably tied to big wage conces-sions by the workforce. No-one argues that wages are to blame for the current crisis in the industry. Why should workers accept pay cuts, when wages haven't caused the problem-and pay cuts won't solve the problem?

The best way to protect our jobs and our seniority rights is to fight for and win a no-lay-off commitment in restructuring (see below), and other worker protections, from the govern-ment and from the companies. A phony bid to "buy" our own company will not protect us.

Even if workers could afford to buy one or both airlines (and we can't), we would still be faced with pay cuts, job losses, and possibly even merged seniority lists.

In reality, Air Canada's employees could never afford to buy the company, even with big concessions. Unlike previous buy-out candidates, Air Canada is not bankrupt. A buy-out of Air Canada would need $2 billion of real money. That equals over $80,000 per employee.

At best, Air Canada executives would use a minority worker investment to put a "human," Canadian, face on a competing takeover bid from United Airlines and Lufthan-sa. Workers' hard-earned money thus becomes a bargaining chip in a battle between private investors who don't care about real job security. Naturally, the investors who would really control Air Canada love the idea: if workers are willing to cut their own wages, investors certainly won't stand in the way!

Employee Buy-outs (II): Adding up the Cost

Any employee buy-out would require wage concessions from Air Canada workers of at least 15 percent. Labour productivity at the major airlines (measured by ASMs per worker) has grown 30 percent since 1992. Yet despite recent gains, wages in the industry are still 6 percent lower (after inflation) than they were in 1992. Why should workers give back even more to buy a symbolic piece of an airline?

The 1994 employee buy-out of United Airlines is often touted as a model for this industry. But was it really such a success?

  • Only the pilots and Machinists participated
  • They bought 55 percent of the company, but appoint just three of the twelve directors
  • á Wages were cut by 15 percent, or $5.4 billion (U.S.)
  • The concessions are still in place (even though United is now profit-able); concessions must continue or else the unions will lose their majority share
  • United is recognized as having among the worst labour relations in the U.S. airline industry, with features such as two-tier wages10-year contracts

No Lay-offs: A Reasonable Demand

It is widely recognized that total capacity and employment in the industry must be reduced, if the airline industry is to be restructured on a more sustainable and efficient basis.

Onex predicts that 5000 jobs will be lost in its merger proposal: about 10 percent of the combined workforce of the two companies. Some analysts view that estimate as conser-vative: even more jobs may be cut. On the other hand, the past experience of U.S. airline mergers suggests that job losses are usually smaller than initial projections.

If the industry was restructured while preserving two distinct airlines (as proposed by the CAW), then the total job loss would definitely be smaller than under the Onex proposal.

In any case, it is quite reasonable to require that the neces-sary downsizing be attained through attrition and voluntary buy-outs, with no forced lay-offs.

Attrition currently averages about 1000 per year at each company. Flight attendants at Air Canada recently negoti-ated an early retirement incentive (with a "window" that closes next October); this could increase attrition. Other bargaining units at Air Canada (including CAW members) will bargain for the same program. Many senior employees at both companies would gladly accept buy-outs. Finally, the training and reorganizational tasks associated with restruc-turing will require extra staffing levels for an interim period.

If phased-in over three or more years, and supported by investor and government payments for buy-out packages, several thousand positions could be eliminated in the industry without a single lay-off. The government must make this a central condition before it approves any private restructuring proposal.

Two Airlines: The Best Way to Fly

The current structure of Canada's airline industry is unsus-tainable. Both major airlines are staggering under the weight of excess capacity and losses on domestic routes. The plight of Canadian Airlines is most precarious, of course. But Air Canada is financially unsound, as well.

The weakness of the domestic industry means that Canada misses out on new growth opportunities in other areas. For example, our share of international air travel to and from Canada has fallen to just 37 percent. Yet our airlines keep tying up scarce financial resources and equipment in a money-losing battle for domestic market share.

The losses in the domestic industry can be stopped, however, without the difficult step of merging the two airlines.

A merger would create huge costs and even bigger operational problems. The one-time costs associated with a merger would exceed $1 billion. And merging the workforces, fleets, and facilities of the two airlines would be extremely difficult, especially for workers.

Canada's two-airline policy could be maintained, but only if the money-losing competition for domestic routes is stopped.

How could this occur? Government would facilitate an agreement by both companies to limit capacity in those domestic markets where they are relatively weak. Overall capacity would be reduced and reallocated, in proportion to each airline's existing services. Consumers would still enjoy some choice on most routes. Government would maintain a presence to monitor airfares.

Both airlines could then devote freed-up resources to developing new international opportunities.

The CAW's Position on Airline Restructuring

CAW leaders have stressed the following major points in their response to recent developments:

  1. We support the continuation of a two-airline policy for Canada (including the existing regional affiliates).
  2. We welcome the government's intention to restructure the industry to put it on a sounder economic footing. In particular, we welcome the recognition that perverse competition in the domestic market has had a negative impact on the efficiency and viability of the industry.
  3. As a condition of approving any restructuring, the govern-ment must demand that any downsizing be accomplished through attrition and voluntary buy-outs, with no lay-offs.
  4. The government and the companies involved must also imple-ment measures to protect airline workers against forced relocation and a loss of seniority rights.
  5. The federal government must take a minority equity position in Canadian Airlines or any successor company. We propose an investment of $300 million over three years, which would give the government a roughly one-third share of the recapital-ized company.
  6. In recognition of the long-term dangers posed by the resumption of destructive competition on domestic routes, the federal government must consider regulatory measures to moderate the future growth of domestic capacity.

The Way Forward

The federal government's official position is to sit back and watch the battle unfold between the private deal-makers. As Transport Minister David Collenette said, "We are a by-stander at this stage."

This is an unfortunate disregard of the government's respon-sibility to oversee an airline industry that functions in the interests of all Canadians, not just the financiers.

A key goal of the CAW is to bring the government explicitly and publicly to the bargaining table, with mon-ey and power, to protect workers, consumers, and communities as restruc-turing unfolds.

Everybody recognizes that the nature of domestic airline competition is going to fundamentally change. By stepping back from all-out competition, the industry in essence will experience some form of regulation. The question is, who will control this regulation? Two private airlines through a back-room deal? One dominant airline through its monopoly powers? Or, more appropriately, government itself, through its broader regulatory and consultative authority, and through a minority equity investment in one of the companies?

Airline workers can fight for a better outcome to this difficult and uncertain process by demanding:

  • Pro-active government involvement in restructuring.
  • The continuation of a two-airline policy for Canada (including the existing regional affiliates).
  • A no lay-off pledge in any restructuring (backed up with government restructuring assistance).
  • No forced relocation for airline workers.
  • A minority government equity investment (in Canadian Airlines or any successor company).

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