If You Won't Deal With Economic Reality, Then It Will Deal With You

The overall economic cost structure of the American airline industry is pathetically unsustainable. This is not news; the elephant has been sitting in the room for years now but most everyone has refused to acknowledge its presence.

United Airlines is in bankruptcy because of its unsustainably high cost structure. In an effort to become cost-competitive, it has just proposed turning its pension obligations of nearly $10 billion over to the Pension Benefit Guaranty Corporation of the United States government. I.e., all taxpayers will now be paying some portion of the overly generous pension commitments made by the company. This proposed action has now led to threats of strikes by the union.

US Airways is in bankruptcy for the second time in several years, re-entering because they failed to make themselves cost-competitive earlier - which was the whole reason for going into bankruptcy the first time. They still are not anywhere near being cost-competitive and their future is uncertain. As one commentator notes, that uncertainty may be a good thing and finally cause real change.

Delta Airlines is in weak financial shape and, periodically, there is talk of them filing for bankruptcy as well. American Airlines flirted with bankrupcty in the last few years, too.

Everyone acknowledges that the events of September 11, 2001 threw the industry for a loop. High oil prices certainly have not helped. But the cost structure problems within the industry existed before then. And all the government has done is give more of our taxpayer dollars to the industry and sustain the unsustainable status quo. Only a free marketplace can move the industry toward the structure necessary to create an economically viable business model for the industry.

The best thing that could happen is for some of these airlines to fail. There is an economically sustainable industry business model out there - it will likely look similar to the model pursued by Southwest and some of the other younger airlines. It will not have the unsustainable cost burdens from legacy union contracts and it will be savvy about things like hedging against higher fuel costs. But change will not occur in a timely manner until the government stops propping up a failed business model.

The same issues apply to the American auto industry, as highlighted in the General Motors case study in the latest edition of Business Week.

GM is in a horrible bind. That $1.1 billion loss in the first quarter doesn't begin to tell the whole story. The carmaker is saddled with a $1,600-per-vehicle handicap in so-called legacy costs, mostly retiree health and pension benefits. Any day now, GM is likely to get slapped with a junk-bond rating. GM has lost a breathtaking 74% of its market value -- some $43 billion -- since spring of 2000, giving it a valuation of $15 billion. What really scares investors is that GM keeps losing ground in its core business of selling cars. Underinvestment has left it struggling to catch up in technology and design. Sales fell 5.2% on GM's home turf last quarter as Toyota Motor Corp., Nissan Motor Co., and other more nimble competitors ate GM's lunch. Last month, CEO G. Richard "Rick" Wagoner Jr. and his team gave up even guessing where they'll stand financially at the end of this year.

Worst of all, GM reached a watershed in its four-decade decline in market share. After losing two percentage points of share over the past year to log in at 25.6%, GM has reached the point at which it actually consumes more cash than it brings in making cars, for the first time since the early '90s. GM, once the world's premier auto maker, is now cash-flow-negative. That's a game changer. Without growth, GM's strategy of simply trying to keep its factories humming and squeaking by until its legacy costs start to diminish is no longer tenable. If market share continues to slip, its losses will rapidly balloon.

Normally a company in such straits contracts until it reaches equilibrium. But for GM, shrinkage is not much of an option. Because of its union agreements, the auto maker can't close plants or lay off workers without paying a stiff penalty, no matter how far its sales or profits fall. It must run plants at 80% capacity, minimum, whether they make money or not. Even if it halts its assembly lines, GM must pay laid-off workers and foot their extraordinarily generous health-care and pension costs. Unless GM scores major givebacks from the union, those costs are fixed, at least until the next round of contract talks in two years. The plan has been to run out the clock until actuarial tables tilt in GM's favor (a nice way of saying that older retirees eventually will die off). But with decreasing sales and a smaller slice of the market, that plan backfires -- leaving GM open to an array of highly unattractive possibilities.

How bad could it get? BusinessWeek's analysis is that within five years GM must become a much smaller company, with fewer brands, fewer models, and reduced legacy costs. It's undeniable that getting to that point will require a drastically different course from the one Wagoner has laid out so far. He is going to have to force a radical restructuring on his workers and the rest of the entrenched GM system, or have it forced on him by outsiders or a bankruptcy court. The only question is whether that reckoning comes in the next year, if models developed by Vice-Chairman Robert A. Lutz fall flat; in 2007, when the union contract comes up for negotiation; or perhaps in five years, when GM may have burned through its substantial cash cushion...

Remember the old ad slogan, "This is not your father's Oldsmobile"? Well, this is no longer your father's auto industry -- but GM is still run as if it were. Fifteen years ago management struck a deal with unions that made it all but impossible to close auto plants or lay off workers without incurring massive costs. GM also agreed to cushy retiree benefits that put it at a severe disadvantage. Much of what ails GM today flows from that accounting reality and its inability to increase the business at home. The need to keep those plants running, to generate cash, and to feed a sprawling web of aging auto brands compromises car design and results in too many models that sit for years without an update...

But Wagoner will be hard-pressed to get enough relief on medical costs, at least before the scheduled contract negotiations in 2007. The Center for Automotive Research (CAR) in Ann Arbor, Mich., estimates that GM could save at least $1.2 billion a year just by closing the gap in co-payments and deductibles between different kinds of employees. A single, salaried worker pays at least $100 a month toward health costs, while hourly union workers pay no premiums and only a $5 co-pay on drugs. But so far, the United Auto Workers leadership has shown no sign that it's willing to reopen a contract that still has two more years to run. When GM's Group Vice-President for labor relations Gary L. Cowger suggested synching up the union and nonunion plans, UAW Vice-President Richard Shoemaker quipped: "If GM wants to give the salaried workers the same health-care plan we have, we're happy to share."...

Private-equity investors seem to believe that the company's global cost handicap will eventually force it into bankruptcy court to shed union and dealer obligations. Wall Street bankers already are salivating over the opportunity to pick off GM's profitable mortgage operations. But the auto business is a whole other animal. For now, the legacy costs are too onerous and the politics of chopping so many jobs just too dicey for it to be worth the trouble of a takeover. Says one senior banker: "The joke used to be that all of the airlines would have to go through a car wash...now the car companies are going to have to go through the car wash. That's the challenge for anyone looking at these businesses and saying, Look, how do you deal with starting at a $2,000-a-car disadvantage vs. the rest of the world?"...

GM's cash hoard makes a court filing unlikely -- at least for now. If it happened, though, a GM bankruptcy would boggle the mind. The auto maker would bring to a judge four times the assets of the largest case filed so far, by WorldCom Inc. in 2002. Its 324,000 worldwide employees are about 70,000 more than Kmart Corp. (SHLD ) had before it filed that same year. GM could almost certainly find a judge who would allow it to dump many of its most burdensome obligations, says Lynn M. LoPucki, a law professor at UCLA. GM's pension plans are fully funded for now, but if GM's finances worsen or its pension investments sink in the coming years they might still be dumped on the federal Pension Benefit Guaranty Corp. GM also could shed its union contracts, firing anyone who didn't want to take lower wages or benefits. Ending health-care obligations to retirees alone could save $4 billion to $5 billion a year.

Imagine the uproar, though, if that happened. Even if GM could demonstrate to a judge that it had negotiated for the cuts in good faith, the UAW would certainly respond with a strike. That would burn up in a few months much of the cash that any raider coveted. And pensioners could still sue for their benefits. "If there was value, you wouldn't get away scot-free," notes Wilbur L. Ross Jr., who has taken interests in bankrupt steel, textile, and coal companies.

Breakup or bankruptcy are the ghosts of GM's future. They become much more substantial threats if current management can't deliver on its promised turnaround over the next couple of years -- or if the board doesn't find someone who has a better idea of how to deploy GM's $468 billion in assets....

Maybe Wagoner will decide to bite the bullet and spend the billions needed to launch such a dramatic overhaul now, rather than waiting. And maybe the UAW leadership will get religion and offer more than token help. Where they decide to take GM will matter a great deal to the army of auto workers toiling away in its factories, the vast web of businesses that feed off of them, and legions of investors. As we learned a long time ago from outfits like AT&T, no company is too big to fail, or at least shrink dramatically. Not even mighty GM.

I have spent a majority of my career leading numerous successful turnarounds in the healthcare industry. By the time I am brought in by the investors, it is usually the case that management has ignored economic reality for too long. Sometimes, external factors beyond the control of management change the nature of an industry. However, it is my experience that a lack of disciplined management behavior contributes substantially to the problems in most cases.

There is simply no excuse for indecisive management behavior or lax oversight by the Board, including tolerating union contracts that put the company at a competitive disadvantage in this global economy. In the end, it is the working people in the company who are at the most risk and management has an ethical obligation to make the right decisions sooner rather than later.

Tinkering with problems in only minor ways and moving slowly over extended periods of time - as the airline and auto industries have both done - will likely lead to failure with a greater cost to employees and the society than if decisive action had been taken earlier. It is an immutable law of nature that if you won't deal with economic reality, then it will deal with you - on its terms.

For those of us living in Rhode Island, this immutable law of nature is equally as relevant to our salary, healthcare benefits, and pension problems in the public sector. The misguided incentives of the public sector mean that it is possible to ignore the problems longer than the private sector marketplace would tolerate but there should be no question - the state's residents will pay a price at some time. The analogy with the private sector is real: The longer our politicians and bureaucrats fail to address our unsustainable public sector costs, the more likely we are to face severe consequences which will be borne most heavily by the working people and retirees least able to afford it. It is a matter of justice, therefore, that Rhode Island adjust its rich and unaffordable public sector salaries, healthcare benefits and pension offerings in order to make them competitive with the non-union private sector marketplace.

ADDENDUM I:

The first sign that change may be looming at General Motors comes with the news that Kirk Kerkorian is buying a substantial equity stake in the company.

Now if someone could just find a way to introduce similar market forces into the public sector....

ADDENDUM II:

As I said, if you won't deal with economic reality, it will deal with you as Standard & Poors has downgraded both GM and Ford credit ratings to "junk" status. For GM, the rating agency said:

The credit agency said its downgrade of GM to non-investment-grade status reflects its conclusion that management's current strategies may not be effective in dealing with the automaker's competitive disadvantages, which include rising health care costs and billions of dollars in post-retirement liabilities.

ADDENDUM III:

The May 11 edition of the WSJ reports:

A bankruptcy judge approved a proposal from United Airlines parent UAL Corp. to transfer four underfunded employee pension plans to the federal government, paving the way for the largest pension default in U.S. corporate history.

The plans, which have a shortfall of $9.8 billion, cover more than 120,000 United workers and retirees. United, the nation's second-largest carrier in terms of traffic, wants to transfer them to the federal Pension Benefit Guaranty Corp., or PBGC, which would add to the already heavy strain on the agency from a spate of pension defaults in recent years. Since accounting for United's obligations last year, in anticipation it would assume them, the agency has taken on obligations exceeding its assets by $23.3 billion.

The PBGC and UAL joined together in the settlement agreement approved by U.S. Bankruptcy Court Judge Eugene Wedoff in a Chicago court. The judge said the agreement didn't amount to a breach of the carrier's union contracts. But with many workers facing big cuts in their benefits, United's unions are preparing to fight the decision...

The court's decision could have wide repercussions in the airline industry, which is struggling with high fuel costs, intense fare competition and overcapacity. Sidestepping its pension liabilities will help UAL attract additional funding, while giving it a huge cost advantage over many of its rivals, which are saddled with underfunded defined-benefit retirement plans of their own. That will put further pressure on those airlines to slash their costs or in some cases seek bankruptcy protection in hopes of terminating their own pension plans...

The United move likely will provide impetus for pension-insurance overhaul legislation that will be introduced in Congress. The bills are expected to include many provisions sought by the White House, including raising company premiums to put the PBGC on firmer financial footing, imposing a seven-year deadline on companies to fully fund their pension plans and imposing a new method for more precisely measuring assets and liabilities.

The PBGC was created in 1974 to guarantee corporate pension plans and pay benefits to workers whose employee-sponsored plans fail. To finance its activities, the PBGC collects premiums -- currently about $1 billion a year -- from employers with defined-benefit plans. It also receives funds from pension plans that it takes over and earns returns on its investments. So far, the agency hasn't had to use any taxpayer funds, but some analysts warn a bailout funded by taxpayers could be on the horizon if the agency's deficit keeps growing.

Delta and Northwest Airlines are backing a bill introduced recently in Congress that would allow them to stretch out payments on their pension shortfalls for 25 years -- if they freeze the plans in question and ensure that the deficit wouldn't grow any larger. The bill has run into resistance from lawmakers reluctant to give airlines a special break.

Lawmakers fear other companies in distressed industries, like the auto-parts makers, could seek to shed their pension plans while under bankruptcy-court protection. Some companies, like US Airways Group Inc., have done so already.

The court's approval will help UAL sidestep more than $3 billion in pension contributions over the next five years, while leading to retirement benefit cuts for many of its workers and retirees. The agreement requires the PBGC to make a final determination soon that the plans meet the requirements to be taken over. It also requires UAL to give the pension insurer as much as $1.5 billion in notes and convertible stock in the reorganized carrier to settle its claims. The size of the PBGC's potential stake in UAL isn't known because the airline hasn't finalized its plan of reorganization, but the PBGC has said that the settlement agreement leaves it in a better financial position than other creditors...

In a statement, United said the settlement agreement "is a crucial step forward for the future of United, as it strengthens the financial platform this company needs to attract exit financing and compete effectively."...

Judge Wedoff said that because the PBGC initiated the pension termination, the union's labor contracts with UAL wouldn't be breached. Under retirement law, if the PBGC initiates termination, that takes precedence over contractual obligations, the judge said...

[Richard Turk, a spokesman for the Aircraft Mechanics Fraternal Association local in San Francisco] said the union still has contractual rights to the retirement benefits in its current contract, but UAL hopes today to persuade Judge Wedoff to void that contract so the airline can impose lower pay and benefit terms on the workers...

The PBGC, according to terms of the settlement, would guarantee payments to plan participants totaling $6.6 billion, meaning workers and retirees would be shorted by $3.2 billion in the form of benefit reductions. The agency's maximum guaranteed benefit is set by law and adjusted yearly; generally, lower-paid workers have a greater chance of receiving all of their pension. This year the maximum paid to most retirees is $45,614 for a 65-year-old person, meaning many United workers -- particularly pilots, who must by law retire at age 60 -- would receive less than they expected.

The likely jettisoning of the costly defined-benefit pension plans is central to UAL's business strategy as it works to attract $2 billion to $2.5 billion in debt financing to step out of court protection this fall. Prospective lenders have told the airline in no uncertain terms that they aren't interested in raising money if the airline is going to pay it all out in pension contributions in the next few years...

UAL has been suggesting since last summer that it couldn't come out of Chapter 11 with the big pension liabilities. In a second round of employee concessions, its pilots agreed to let their pension plan be shifted to the government in exchange for $550 million in convertible notes in the reorganized UAL. But retired pilots, who stand to take a huge hit between what they were getting from the airline and what they will receive in payments from the PBGC, continued to object yesterday in court...

A related story is here.