Boeing Versus Airbus

by John Newhouse

  Failed efforts by British Airways (BA) to acquire an American base offer a vivid example of the kind of mischief that these restrictions can cause and have. In July 1992, BA and USAir (as it was called then) announced their intention to join forces. BA intended to invest $750 million in a major American carrier on the verge of financial collapse. Shortly thereafter, the big three—American, United, and Delta—banded together to block the bailout of USAir. They were joined by Federal Express, with the group then becoming known as the “fat four.”6

  Their case, a politically potent one as it turned out, was that allowing BA to absorb USAir would lead to the creation of a preeminent domestic carrier, one whose global reach would give it heavy and unique advantages. The issue for the administration of President George H. W. Bush was whether USAir might have to join the lengthening list of airline fatalities or be allowed to merge with BA and thereby threaten the well-being of the big three, the backbone of America’s airline industry. Where did the consumer’s interest lie? Where did the national interest lie?

  U.S. carriers were losing big money at the time and selling off airplanes at very low prices so as to generate enough cash to avoid bankruptcy. Their bonds were no longer investment grade. They were shunned by banks, insurance companies, and pension funds, and were having to pay heavily for what they could borrow. Foreign carriers, most of them government-owned, were becoming lenders of last resort, although not, of course, disinterested lenders. For example, they wanted permission to fly between U.S. cities, picking up and unloading passengers. And in an increasingly globalized economy, it was hard to see why they should be denied this right, which is called cabotage.

  But what every big foreign airline really craved was the freedom to buy a major U.S. carrier. This right of “inward investment,” as foreign control is euphemistically known, would provide far greater and more reliable access to the lush American market than cabotage. But the law provides that three-fourths of a carrier’s voting stock must be U.S.-owned and three-fourths of its senior officers and directors must be U.S. citizens. Non-Americans can own up to 40 percent of the equity.

  However, dropping the protectionist rules would require changes in domestic law, and Congress, if asked, was certain to refuse amending existing law unless other countries—notably Britain, France, Germany, and Japan—extended reciprocal benefits to the United States.7

  To no one’s surprise, BA’s proposed merger with USAir churned up political turmoil. Two strong multistate lobbies formed up. One, belonging to BA-USAir, fought hard and resourcefully to maneuver approval of the deal. The other fought just as hard on behalf of the big three/fat four, and it held better cards.

  The man in the middle was Andrew Card, then secretary of transportation and until recently President George W. Bush’s chief of staff. Given the prohibition on foreign ownership, Card would have had to veto the deal if it appeared to transfer control of USAir to BA. However, BA was proposing to acquire 21 percent of the voting stock and one-fourth of the board membership. That degree of control would have provided a blocking minority, one that could have enabled BA to approve or disapprove major aircraft purchases and capital outlays.

  BA’s proposal didn’t stray beyond the letter of the statute, but did present Card and his department with a politically loaded question of how to interpret the statute and its intent. The decision went against BA—unfortunately. The deal, had it gone through, would have produced concessions on the British side and, in turn, promoted competition on domestic and international routes. It would have brightened prospects for a more liberalized air travel environment.8

  The reality is that America’s airline industry remains more strongly protected than most. BA, for example, had wanted the right to fly passengers nonstop from continental Europe, notably Paris, to New York without touching down at any of its British terminals. This would have allowed BA to become a multihub carrier in Europe, just as its American competitors were at home.

  But here again BA would lose the argument. Paris was the biggest European gateway for TWA, at the time one of America’s major carriers. TWA did not want to compete against BA in Paris—and, as it turned out, would not have to. Then as now, neither the freedom nor inward investment nor cabotage nor any of the other liberalizations that fall under the deceptive rubric “open skies” would be allowed to unbind air services agreements.

  CARRIERS in the United States and around the world are having an easier time leasing airplanes than buying them. Leasing is a financial tool, one that Airbus and Boeing use as a distribution channel, especially for airlines that lack access to capital.

  The bankruptcies of some airlines at the start of the 1990s and the flirtation with bankruptcy of others had a lot to do with the rapid growth of leasing companies. They have been the fastest growing segment in the trade.

  The purchase of a new airplane typically means paying a third of the cost in the two years prior to delivery. The plane may cost $45 million, meaning a progress payment of $15 million. That is a lot of cash for many airlines. But with a lease, the pressure is greatly reduced. A cash payment covering the first three months of the lease may be all that is required. And that might be no more than, say, $900,000, or about $300,000 per month.

  Airlines lease equipment for the same reason that people lease cars. The off-balance-sheet financing is very attractive. A carrier records the rental expense, whereas an aircraft purchase is recorded as a liability on the balance sheet. Leasing is probably the key component of aircraft acquisition, partly because it offers considerable flexibility. A lease may run for three or four years, and then be extended. Or the aircraft may be returned and replaced with one that is more immediately useful. Leasing allows carriers to mix their fleets more productively by taking aircraft in and out of leasing. It allows a lessor to hold an airplane for three to five years, then to flip it at the depreciated price and take a tax advantage.

  In December 2004, a piece in the New York Times by Micheline Maynard showed the extent to which U.S. carriers are “flying on borrowed wings.” The fleets of the two biggest—American and United—were shown to be about 45 percent and 41 percent leased, respectively. US Airways stood at 76 percent, Continental at 65 percent. Among the low-cost carriers, Southwest leases about 23 percent of its airplanes, JetBlue 37 percent. Altogether, nearly half the aircraft used by U.S. airlines are leased.9

  The leasing business has its roots in the 1970s. It began with a Hungarian immigrant named Steven Udvar-Hazy, an airplane buff since childhood. Upon graduating from UCLA in 1972, Udvar-Hazy solved a problem for Alaska Airlines by arranging to lease to another airline a Boeing 727 on which the carrier couldn’t make payments. A year later, Udvar-Hazy and two fellow Hungarian immigrants, a father-and-son team named Gondas, started a company designed to lease airplanes. With just $50,000 in capital, this company set in motion the process that rearranged the airline industry’s pattern of acquiring planes.

  A decade or so later, Udvar-Hazy and his partners discovered that thanks to deregulation, a new airline market was emerging; the start-up carriers it begot needed just the sort of help that an alert and resourceful lessor could provide. Lenders were avoiding the start-ups and also avoiding the carriers in Chapter 11. The self-destructive tendencies of other large airlines also created opportunities for the lessors.

  Udvar-Hazy’s company, known by then as the International Lease Finance Corporation (ILFC), prospered and grew rapidly. Udvar-Hazy himself has since been described as the aviation industry’s megastar, even though he is little known beyond that world. He became somewhat less anonymous when his donation of $66 million to the Smithsonian Institution created a second facility for the Air and Space Museum; the Udvar-Hazy Center, located at Dulles International Airport near Washington, opened in 2003.

  A few years after ILFC began spreading its wings in the 1980s, a small Irish company began buying airplanes, especially Airbus products, and leasing them. The company had blended two Irish symbols by calling itself Guinness Pea
t Aviation. It was a good name, but the company’s reach exceeded its grasp. After buying more airplanes than it could dispose of, Guinness Peat collapsed. General Electric collected the pieces, which became GE Commercial Aviation Services, known for short as GECAS.

  GECAS became the largest leasing company. Next is Udvar-Hazy’s ILFC. And they operate very differently. GECAS deploys a bigger fleet, but ILFC buys the most new airplanes. GECAS purchases very few wide-bodies. ILFC is the largest buyer of the wide-bodied aircraft produced by both Boeing and Airbus. ILFC is not a lender, GECAS is. ILFC does the larger part of its business outside the United States, while GECAS does more of its business within. GECAS is a major piece of the GE toolbox. GE, for example, can guarantee a purchase by GECAS of, say, several new Boeing airplanes, provided Boeing is mating them with a GE engine.

  GECAS has had exceptional growth since 9/11, becoming virtually the only major lender to most American carriers. Some of them resent GECAS, however, arguing that its financial support of strapped legacy airlines gives some of them a second life under Chapter 11 that they don’t deserve. Allowing nature to take its course would strengthen the industry, the critics of GECAS contend. Southwest Airlines is being harmed “by the capital coming into the market to keep some of the weaker players afloat,” according to Laura Wright, chief financial officer of Southwest.10 But GECAS has a lot to lose if carriers it is propping up go under. It would be left with a great many distressed assets—homeless airplanes.

  BY 1994, the financial crisis afflicting U.S. airlines had begun to subside and was followed by a benign period of five or so years in which they got well. The rising tide created by a strong bond market and resurgent economic growth lifted all boats, even the airline industry. Between 1995 and 1999 it generated a net profit of more than $20 billion. The profit margins of legacy carriers were ranging between 7 percent and 10 percent.

  But cautionary sounds began to be heard. In 1996, Michael Levine, executive vice president of Northwest Airlines, said: “I think historically, the airline business has not been run as a real business. That is, a business designed to achieve a return on capital that is then passed on to the shareholders. It has…been run as an extremely elaborate version of a model railroad, that is, one in which you try to make enough money to buy more equipment.”11

  Predictably, the better times of the late 1990s led U.S. carriers back toward their old ways and the start of another cycle of misery. With a patched-up resource base and credit becoming available, they yet again began acquiring too many new airplanes. They also negotiated labor contracts that might not have cramped their style in good times but in hard times would be barely sustainable, if at all. And they started steadily hiking the fares of the business-class trade, their largest source of revenue. Business-class travelers were seen then by most airlines as “price insensitive” customers who wanted to get there fast and be on time for a meeting. Their tickets were a tax write-off, and what they cost didn’t seem to matter much.

  But then, as the dot-com bubble vented, the economy’s hyper-growth phase shut down. For the legacy carriers, the timing could not have been worse. Raising business-class and other fares coincided with the growth of low-cost airlines and the greater transparency that became available via the Internet; in steadily greater numbers, air travelers were surfing the net for the best prices. Internet travel sites, such as Expedia, Travelocity, and Orbitz, took hold.

  Also acquiring greater transparency were the encrusted problems of the airlines. The financial pressure got heavy. Lenders who had helped the industry by softening loans after the events of 9/11 restored the stiffer terms. Over the next four years U.S. airlines cut capital spending by 62 percent while taking on $16 billion of new debt to cover losses.12 Since 2000, the legacy carriers have eliminated more than one hundred cities from their schedules, although regional airlines now operate many of the routes.

  The ripple effect of serious and concurrent adversity cut a wide swath. According to Louis Miller, executive director of the Tampa International Airport (which is probably as well organized and designed as any airport anywhere), “The financial instability of the six legacy carriers represents the single biggest problem for airports. The airports get no public money and are fully self-supporting. Tampa Airport takes in $170 million per year in revenue. Thirty percent of that comes from airlines, the rest is from parking, car rentals, food, and beverages.” (A rule of thumb is that any commercial airport that handles 2 million or so passengers won’t need public assistance.) Troubled airlines, Miller said, “are using airport assets, or pending assets, to shed debt.” US Airways, he noted, rejected a new hangar worth $27 million to the airport and its bondholders.13

  Indianapolis International Airport has had a similar problem with United Airlines. As part of its bankruptcy deal, the carrier was allowed to cancel the lease with the airport on what was to be its second major maintenance center. The airport was then obliged to begin leasing out the facility to other users.

  The price of fuel, which management can’t control, is a major part of the punitive cost structure that airlines wrestle with. Another large component, of course, is labor, notably the costs of keeping pilots in the air.

  Among the ills blamed on deregulation is the surfeit of airline pilots. Besides being overabundant, they are widely regarded as the world’s most overpaid high-end technicians. During the worst downturn in the U.S. airline industry’s history, legacy carriers were pressed hard by pilots to award or sustain contracts that were probably not sustainable. These contracts could hasten the collapse of some carriers, and the jobs from which so many of their pilots have prospered.

  Relations between the senior management of legacy carriers and the pilots’ union—the Air Line Pilots Association (known as ALPA)—have worsened since deregulation. Some industry analysts argue that the pilots are largely to blame. Oddly, the salaries of those who fly for the legacy carriers, besides being too high, are based on the size—actually, the weight—of the aircraft they fly. Hence, a pilot who normally flies a four-engine wide-bodied airplane nonstop between two cities set far apart is better paid than one who has the more demanding responsibility of taking off and landing a smaller airplane at sundry airports on a given day or evening.

  Of course, the pilots do have plenty of leverage. For the airline, a strike means watching its revenue stream dry up as heavily mortgaged aircraft sit idly on the ground. And pilots have other weapons. They can burn high-cost fuel by letting engines idle overlong. They can slow down operations. For example, United Airlines pilots staged a slowdown in the summer of 2000, when weather and air traffic congestion already had put the carrier under heavy pressure. The slowdown enabled these pilots to win one of their richest contracts ever.14 That contract is held up as having badly injured the industry’s second-largest carrier, which two years later entered Chapter 11.

  A long article in the Financial Times portrayed the widening scope of the union-management row in detail, with blunt examples and quotes. Rick Dubinski, a former head of ALPA, apparently told United management in the palmy late 1990s, “We don’t want to kill the golden goose. We just want to choke it by the neck until it gives us every last egg.”15

  And Robert Crandall, the irreverent former chief of American Airlines, scolded both sides, saying, “Airline employees were compensated at a level nearly twice the average for all U.S. industries. The two highest paid professions were doctors and airline pilots. However, doctors averaged 41 hours of work per week, while pilots averaged 22 hours per week.”16 He is probably right, but it’s equally true that among airline chiefs Crandall led the way in buying too many airplanes during cyclical upturns.

  Entering Chapter 11 bankruptcy proceedings does offer enfeebled legacy carriers a weapon of sorts with which they can even the playing field. Section 113 of the bankruptcy code gives executives the power to tear up labor contracts and abridge the unions’ leverage. Delta and American have secured concessions from the unions after invoking the threat of bankru
ptcy. US Airways has been steadily cutting costs with this tactic. The salaries of some of its pilots have fallen from $150,000 in 2002 to $70,000.17 Their pension plans, along with those of flight attendants and other groups, are at some risk.

  United Airlines warned that it might terminate some of its pension plans, adding that unless various contracts with unions could be renegotiated some aircraft would probably be repossessed. That warning got some attention; most travelers are not reluctant to fly a bankrupt airline, but one that has airplanes being repossessed is a different matter.

  In November 2004, United announced that it would no longer support its pension scheme. It had a gap of $6.3 billion between the cost of retirement benefits and the assets available to pay for them. The costs are insured by a government-sponsored safety net, the Pension Benefit Guaranty Corporation (PBGC). However, the PBGC was and is also running a serious deficit. It reported a deficit for the year ending September 30, 2004, of $23.3 billion, more than twice that of the year before.18

  A few weeks later, United announced a tentative deal with its pilots’ union. The members agreed to forgo their pensions in return for more than half a billion dollars in convertible notes, which would compensate them for a significant part of their pension loss. However, the deal was contingent on every other union at United giving up its pension plan, willingly or unwillingly. But the other groups, starting with the flight attendants, refused to give way. And United continued to tread water, as did the other legacies.

  In early February 2005, the Financial Times began a long article on the airline industry by noting, “After a year in which airlines cut jobs, trumpeted cost-cutting initiatives and reported record traffic, fourth quarter earning should have marked a turn-round. Instead, net losses for the six biggest U.S. airlines were seven times higher than a year ago, at $4.1 billion.”19