(originally published 04/13/1998)
Alter Ego Airlines: A Look at What Lies Ahead
by R.W. Mann, Jr.
Alter ego (n): a second self, proxy, surrogate, stand-in, pinch hitter [coll.]
Alter ego airline (n): a proxy carrier utilizing a recognized brand airline code, per DOT requirements accompanied in schedule displays and ticketing notes by a "star" device and the disclaimer "Operated by ...[proxy carrier name]"
Full-service Major airlines respond to the cost-side challenges of new-entrant and low-cost competition through rigorous cost controls, by simplifying product and process and, foremost, through the use of strategies which "average-down" labor costs. Despite what are at present robust industry profits, new demands by airline managers are expected to include changes to labor contracts that would permit the implementation of alter ego, mainline "star"-branded, domestic code-share alliance services, responsive to the proposed Northwest/Continental alliance. The alter ego concept is the latest in a series of post-deregulation labor strategies, and avoids the disadvantages of outright merger/acquisition.
How did alter ego evolve? We can thank DOT for creating the loophole, when they blessed non-owned commuter/regional code-sharing with the "star" device and "Operated by.." disclaimer. DOT then blew the loophole up to B747-size with approval of Northwest/KLM international code-sharing with anti-trust immunity to schedule and price as a single carrier. No matter that a noted airline CEO told Congress just recently that code-sharing is in effect a consumer fraud, and many question the consumer benefit in antitrust immunity. The trend is your friend; go with the "star", as in "Star Alliance". There's no looking back.
Why the sharp labor focus in these arrangements? First off, airlines are labor-intensive (and capital-intensive and energy-intensive; ego-intensive too, but that is the subject of another story). Of all expense components, Majors' labor costs represent upwards of 30% of overall operating expenses. This is in some cases twice the labor cost fraction of new-entrants. Labor costs are an easy target, providing the greatest competitive exposure. Moreover, labor costs have proven manageable, not so capital costs and fuel prices.
Major management accords a high priority to reducing labor costs because
of its exposure on the one-hand, but chiefly because of past successes
at achieving substantial savings this way. Witness the B-Scale.
By the time it is extinguished, just past the turn of the millennium, it
will have enjoyed at the Majors nearly a twenty-year, multi-billion dollar
Alter Ego Airlines and Other People's Money: the "mainline jet solution"
Alter ego airline economics can reduce average labor costs by substituting low cost, "star"-branded jet service for Major airline service, in both existing and "growth" markets. Expanded networks of Major and Major-branded alter ego service produce incremental revenue. Larger potential revenue pools increase the sales thresholds for travel agency overrides, thereby reducing travel agency override commissions and reduce revenue-related costs at the mainline and the alter ego affiliate alike. Alter ego alliance "transactions" do so without the balance sheet trauma and labor-integration down-side of a full merger. Alter ego alliances leverage the 1980's mantra "other people's money" in a late-1990's "virtual merger" format.
For the Majors, alter ego represents the ability to outsource fleet, personnel and related costs, and to reduce or avoid market development costs entirely. Majors then "buy back" the service only when and where needed, on a "net jet" or "fractional-ownership" basis. You've heard of "Business Jet Solutions (c)". Alter ego forms the "mainline jet solution".
From the perspective of the proxy carrier, alter ego represents a potential cost-plus gold mine with a ready-made customer base that reduces market development risk. Expect hot competition for the most desirable code-share alliance partnership nominations. Squabbles over desirable candidates may even break out into full scale acquisitions, to keep a target firm out of the clutches of a competitor.
Many regionals now possess or are willing to acquire jets, small or
larger -- a must. The most forward-thinking of prospective proxy
operators are already structuring multi-carrier deals, providing lift when
and where needed, to whichever Majors pay their distribution fees, often
on the same flights.
Innovative Labor Cost Reduction Strategies: a brief history
The early 1980's saw the introduction of a lower wage scale for new-hires, the reviled and divisive "B-Scale". This device was heavily leveraged, produced literally billions of dollars cumulative savings and was only recently extinguished. Also in the 1980's, management began to affiliate with commuter/regional airline partners, permitted the use of the Majors' airline code and frequent flyer program, to control and reinforce hub traffic and revenue feed.
The early 1990's saw the ubiquitous and initially benign commuter/regional airline partnership device used for different purposes. Management used regional partners' across-the-board lower labor costs to replace some mainline jet flying with regionals' turboprops, typically on routes of less than 600 miles. Management then pitted different regional operating units against each other to hold down already low regional labor costs. It is a fact, however, that travelers avoid turboprops when alternative jet service is available, even when the turboprop operation shared the Major's airline code.
The early 1990's saw carriers abandon markets and entire hubs in which
they did not achieve desired financial returns, in some cases replacing
their own service by making supportive deals with operators of 100-plus
seat regional airline jets, operating at below-mainline, regional-scale
labor costs. Jets drew the market better than turboprops, but domestic
code-sharing utilizing jet equipment was prohibited by mainline pilot Scope
clauses. Code-sharing was reluctantly eliminated, in favor of frequent
flyer alliances, which were used as the "glue" to see that customers would
"stick with" replacement carriers.
No jet, no code-share, no market...
Unfortunately, alter ego turboprops with frequent flyer alliances, and interline jets with frequent flyer alliances individually have proven insufficient to guarantee loyalty or competitive parity. The inability to form jet-served, domestic code-shares with full frequent flyer participation has important and adverse revenue and expense implications. Pressure to enter full domestic alliances mounted, as pressure for industry consolidation continued and as the true costs of merger transactions were better understood
Prohibition on regionals' small jet flying eroded in recent rounds of pilot contract bargaining, in one case it was confirmed lost at a Presidential Emergency Board. Still, the inability of most carriers to use 70-plus seat jets in domestic code-sharing continues to keep management from using this device as labor replacement/labor cost control leverage.
This is an important threshold. The 70-plus seat jet domestic
code-share barrier adversely impacts revenue drivers, such as travel agency
CRS screen display (interline connections display poorly vis a vis Major/alter
ego carrier "online" connections), travel agency buy-in (a single alliance
code-share partner revenue pool results in higher threshold revenue requirements
and lower commission rates than do separate carrier sales programs) and
to some extent consumer choice (nationally, almost any Major brand is more
recognizable than any Regional or alter ego carrier brand).
Alter Ego Genesis: 20:20 Hindsight
The B-Scale was on its way out by 1993, but mutated to a new and insidious form. After a series of failed takeover attempts, United Airlines employees (except flight attendants) offered significant, termed wage and benefit concessions in exchange for UAL ownership. The UAL Employee Ownership Transaction featured permanent lower wages and benefits for new hires and leveraged the lowest wage rates with a new form of domestic code-sharing between the major carrier and its "alter ego" airline, U-2. Termed the "airline within an airline" initiative or "U-2", the low-cost airline was later renamed "Shuttle by United".
While U-2 never had a prayer of achieving its target costs, once in place and running, its mission changed in response to customer comments and market requirements. The Shuttle product differentiated itself from Southwest, provided MileagePlus upgrade payoffs, and retained modest revenue-enhancement opportunities associated with a First Class cabin. The one-class approach was shelved and U-2 reverted to the traditional United full-service product. Nonetheless, U-2 has and will continue to generate substantial labor cost savings, both at U-2 and at the "big airline".
As other east-west network carriers found to their competitive disadvantage, U-2 (UA*) is a strong "place keeper" for United's brand as well as for Apollo (CRS) and MileagePlus (frequent flyer program) in the important Los Angles and San Francisco basins and in California/Northwest and Denver/Midwest markets. The combination of these factors mean new and retained revenue in U-2 local and UA long-haul east-west markets, at the expense of American, Delta and others.
United's ESOP-bred initiative and its results were followed closely by other airline management teams, who in a display of the airline industry's tendency towards "pattern bargaining", demanded comparable "airline within an airline" options in their open labor agreements, employee ownership or not.
Not to be outdone, UA and DL now propose an alliance (see below) that
creates a near-40% share player.
ALPA at Delta succumbed to management pressure in 1995, in the last days of the failed (and soon thereafter abandoned) "Leadership 7.5" (7.5 cents per seat-mile cost reduction plan). ALPA offered to reduce pilot wages and benefits for the promised establishment and expansion of "D-2", later named Delta Express.
Hardly a "short-haul" operation, D-2 now flies in Northeast-Florida markets such as Providence-Orlando, leapfrogging the main line by flying nonstop and in parallel to traditional Delta Atlanta hub connection service, while showing the "DL* - Operated by Delta Express" code. Still operating solely in Florida leisure markets, this is a one-class product that reportedly creates marketplace confusion with Delta's "On Top of the World" main line service.
Reportedly talking to UA about a wide-ranging code-share/frequent flyer
alliance. Probably just finished tallying the opportunity costs of
losing Singapore and All Nippon in Asia, plus the entry costs for their
recent Latin American bravado and conclude feeding and "renting" space
on United's Pacific/Latin American networks may be a better option; likewise
United gets access to DL's Atlantic if the EC puts the screws to UA's Star
Alliance. But how does a 40% player get a green light from DOJ?
Only if others pair up, too?
USAirways management, as part of its recently ratified pilot labor agreement, received the option to create its own alter ego "US-2" unit, MetroJet. This one-class, BWI-based operation is not a "short-haul" operation, either. MetroJet (US*) will fly head-to-head with Southwest, in markets such as Providence-Baltimore-Fort Lauderdale. In the process, it will also parallel Delta Express flying, and Southwest.
US pilots rejected proposed US* codesharing on new AA and UA Pacific routes, filed as "done deals" by all three US/UA/AA. Management now reportedly talking to United and American about "hosting" each carrier on its domestic route network. Why sell when you can rent?
A "best of all worlds" proposition in the short term. Keeps the
bidding war going for "real" buyers, who get a whiff of the USAirways network's
value, without a full merger's (presumed) bad aftertaste.
Northwest and Continental propose a worldwide network alliance, but more important, an extensive domestic code-share (NW/NW* and CO/CO*). While the alliance may eventually result in an operational integration or merger, it offers both carriers potential network code-share revenue benefits of a $20 billion carrier combination, rivaling the largest of the present "Big Four" carriers. Wall Street analysts agree that extensive network alliances can increase earnings by as much as 10%, even in the early years, and a multiple of that improvement later on. Major investment houses have thus upgraded both Continental and USAirways (in the later case reportedly, on the mere prospect of a deal with either American or United). Of course, these valuations were before UA/DL and AA/US were announced...
Both management teams state their intent to accomplish the alliance
without reduction in employment. NWA pilots are presently negotiating
a new labor agreement, fear loss of existing flying to what is presently
a lower-cost Continental. Continental pilots, in their tentatively
agreed contract, have crafted a bullet-proof scope clause. While
scope protects existing CO flying, the allocation of new flying is solely
at the discretion of "independent" NW and CO management groups, not controlled
by one or the other carrier's pilot agreement.
Late in the negotiating game, Northwest has reportedly approached its
pilots with a helpful "N-2" proposal: up 40% of the membership accepts
a pay-cut. Allows Northwest to compete with the likes of Pro Air,
Spirit Air, Southwest, U-2, D-2, US-2. While this is "helpful" in
diluting the threat of pilot jobs migrating to "low cost Continental",
it was rejected out of hand by Northwest's pilots. Call this Round
One of the "Short Haul Battle". Round Two plays at NMB Stadium, perhaps
Gained confirmation of small jet "ownership" in last year's Presidential Emergency Board, but at the cost of a drum-tight scope clause and network-cramping small jet limit. Jury's out on what to expect, but all indications suggest a fusillade of early openers along the lines of "short haul", "A-2", "me too", "flex jets", domestic code-sharing, with a threat of merger(s) if need be.
Recent NW/CO, UA/DL, US/AA/UA, N-2 proposals play into management's
hands. Ought to be an E-Ticket ride.
Alter Ego End Game - management's view
Seeing themselves potentially out-flanked by the proposed NW/CO alliance, "Big Three" carrier management see a rapidly developing end-game. They understand and have started to posture that they face an impossible dilemma: competition from perennial low-cost-leader Southwest, low-cost new entrants, alter ego versions of brand name carriers (including some of their own invention, thanks to the demonstrated portability of certain CEOs' careers), the specter of large scale domestic code-share alliances and the prospect of all-out merger/acquisition battles over airlines holding key regional franchises.
Management hints that, in addition to relief from scope clauses, any real solution requires relaxed small jet limitations, and ahh, while we're at it, the flexibility to introduce yet-undefined, new forms of "synthetic" service as may materialize in the crystal ball. After all, things might change. For sure, the stakes have never been bigger.
As a practical matter, the Big Three do face these competitive developments.
The airline industry evidences strong "patterning", in that everything
from marketing strategies to labor bargaining evolves from one carrier's
deal to the next (often from the same managers!) and with innovative improvements.
The carriers are at present motivated by the real potential of substantial
share loss and up-tick in costs associated with the proposed, domestic
Network expansion rules
The appearance of online jet service is a competitive necessity to expand the network, meet consumer demands and thereby maintain essential hub feed and point market presence. If network expansion is a critical success factor, "virtual" network expansion using a partner's assets must be considered the penultimate home run.
Domestic code-sharing offers the prospect of instantaneous, large-scale network expansion without the brick-and-mortar costs of acquiring aircraft, facilities, training and market development. Domestic code-sharing as envisioned by Northwest/Continental features mutual use of "Other People's Money" and assets.
There are strong returns to network scale in the airline business, particularly
in the area of network revenue benefits and distribution (travel agency
commission) cost reduction. This is where the few cost reduction
opportunities exist for NW/CO, who have sworn off the low-hanging fruit
of labor force rationalization and reductions in force. Whatever
Northwest/Continental save through network distribution economies, comes
at the expense of the then comparatively smaller American, United and Delta
networks, in a form of "zero sum" outcome.
Management understands the competitive and negotiating dilemmas. Management also understands and has long practiced the use of "F.U.D."-factor (Fear, Uncertainty and Doubt) communications in achieving its negotiating objectives. It argues on a cost-competition basis that it must introduce low-cost airline devices, while minimizing the revenue effects, thereby achieving a "double-dip" benefit. At the same time, it understands that many of the cost and revenue advantages created by these devices "bleed through" to create savings and new revenue at the mainline as well. Thus, total benefits for the main line far exceed those at the alter ego airline. Make that a pair of double-dips.
Management also poisons the well with talk of forced merger as the alternative to permissive code sharing, inflaming the sense or experience that merger-related seniority integration (controlled by one carrier and its organized employees) inflicts more harm than a no-holds-barred domestic code-share.
Issues that are unclear and may become the most critical (from a control
perspective) and contentious (from a negotiation perspective) are hard,
fast, final and enforceable definitions of the roles of "alter ego", "short
haul", "small jets" and regional carriers vis a vis Majors' mainline
operations. These are purposely left unclear, with wiggle room to
suit management's requirements, and to enable innovative new forms of synthetic,
Alter ego opportunities and threats
While generally targeting deeper-pocket cockpit crew expenses, work rules and scope restrictions in their attempts to introduce alter ego labor cost reduction devices, management fully understands that it incurs a minority of incremental costs in the cockpit. Only half are incurred on the aircraft at all, the rest being on the ground, where hourly pay rates do not scale with the aircraft being utilized and where the costs are relatively fixed and "chunky". On the other hand, concessions gained from pilots are understood to have a bow-wave effect on other labor groups.
Alter ego revenue opportunities are equally relevant. While any given customer will not pay significantly more to fly a brand name mainline carrier versus an alter ego brand, the mix of customers who will make this choice in favor of the mainline (or its endorsed brand) is a higher yielding group. This is what results in the Majors' "revenue premium". The end-consumer and travel agency markets, voting their preferences, still favor national brand carriers over others, if the flight is a jet and carries the major brand/alter ego "star" codes.
The availability of a low-cost, mainline-endorsed alter ego brand in the marketplace results in higher overall sales on the mainline and alter ego brand combined, more direct sales, higher travel agency sales hurdles and lower commission rates and overrides, a classic "win-win" deal. Alter ego network expansion and revenue opportunities create increasing returns and margins on what is essentially zero incremental capital investment and at no increased risk . It is significant that incremental revenue generated through an alter ego alliance causes revenue-related costs to decline, not only on the incremental revenue portion but back to the first dollar.
If the "up-side" of gaining access to alter ego domestic code sharing is attractive, the "down-side" of being locked out is clearly worthy of avoidance. Management's concern is that the emergence of larger, competing networks of code-share service causes more service-seeking, "top tier", elite frequent flyer customers to gravitate to the largest networks. This would deprive the Big Three carriers of some of their revenue premium, because they cannot within present scope limitations offer the larger, competitive network hoped-for by Northwest/Continental.
Therefore, for both revenue retention and cost reduction reasons, management
hints they need an alter ego operation, domestic code-sharing and other
composite labor cost reduction and revenue enhancement devices.
With clear evidence of pattern bargaining, parallel thinking, and innovators
that they are, management may devise an even more creative definition or
concept for "synthetic" service. Failing elegant solutions,
the finite number of ideal partners and the end game that results may eventually
drive carriers back to outright acquisitions.
An alter ego look ahead: management, employees and consumers
The B-scale is dead; what will follow is yet to be determined. From the labor perspective, a multi-billion dollar, bad after-taste remains, made worse by record industry profits. From mainline management's perspective, the cost reduction void is masked in the short term by strong air travel demand, clear pricing power in business markets, moderate fuel prices and the prospect of further medium term earnings growth.
What goes up, must come down. Eventual maturation of this star-struck economic cycle, a down-turn in demand accompanied by large-scale domestic code-sharing, revenue loss and distribution cost increase has Big Three carrier management focus fixed at 18 months and 18,000 yards ahead: on the next big method of tapping into labor savings while at the same time expanding their networks.
Acquisitions and mergers can't be ruled out, but the alter ego concept now looks to be the strongest contender, in addition to which it fits management's cash flow return-oriented incentive plans to a "T". Prospective alter ego carrier management, now is the time to sharpen those pencils and think "multi-carrier agreement". Being free of a long-term, exclusive contract may not turn out to be a disadvantage right now. Jonathan Ornstein, are you listening?
Major carrier employees should understand what relaxing scope and thereby permitting alter ego service is worth to management. (Hint: check the executive incentive compensation scheme, see how it benefits from capital- and risk-free returns). Understand that management will go to great lengths to avoid the 'no code-share' alternative -- this is a survival (and a personal rice-bowl) issue.
Advice to employees: Prioritize your interests, establish your personal bottom line, enjoy the ride, but maintain situational awareness. Employees at alter ego or "nominee" carriers, congratulations, you get to fly for the Majors (star-variety). Just don't expect an increase in payscale. There are lots of wannabe "star" carriers out there. As usual, the low cost producer wins.
Consumer alert: get ready to put up with even more complex and far-from-seamless forms of "partnership" programs, accompanied by smooth-sounding,anxiety-reducing P.R. campaigns -- and yet higher prices. Maybe the British are right, terming them "schemes". There is a reason that even airline CEOs bash code-sharing alliances as frauds. But in fairness, what kind of Hobson's choice do they have if DOT sanctions the fraud and as a result, "everyone is doing it".
Regulators: just remember that this evolving version of the fraud
results in an unprecedented level of domestic market concentration, further
cements airline control over facilities and access to markets, reinforces
already usurious pricing through joint inventory management (with antitrust
immunity) and may even (heaven forbid!) reduce access to already vested
frequent flyer benefits. Is Joel Klein monitoring this frequency?