Air Canada: A Slow Descent

Air Canada: A Slow Descent

The AIR CANADA back-to-work legislation, passed March 14, was meant to spare Canadians from the nightmare, both personal and economic, of a crippling strike by ground workers and a lockout of pilots at the country's biggest airline. So far, however, it's only made a bad situation worse, fuelling more labour hostilities and chaos for passengers.

As they returned from March break, sun-seekers still faced long delays after an unusually large number of pilots called in sick. A few days later, dozens of flights were delayed or cancelled after angry baggage handlers in Toronto launched another wildcat strike--this time in apparent retaliation for Air Canada's decision to discipline three workers who gave federal Labour Minister Lisa Raitt a mocking "slow clap" as she strolled through Pearson's airy concourse.

More recently, television viewers were treated to the spectacle of pilots' union president Paul Strachan on the CBC issuing veiled warnings about the potential for deteriorating safety standards at his employer. Wearing full uniform, he suggested the bankruptcy of Aveos Fleet Performance Inc., the airline's former maintenance arm and major maintenance provider, could lead to future aircraft repairs being done at low-cost facilities in El Salvador, where employees can be paid as little as $16,000 a year. "My question to you is: Is this the man you want maintaining the aircraft that you fly on so frequently?" said Strachan. "I suspect not."

Air Canada threatened to fire Strachan, calling him "irresponsible" and stressing it had no plans to service its jets in Central America (although it didn't rule it out either). In response, a small group of pilots staged an illegal "sick-out" last week, causing the cancellation of more than 40 flights across the country and throwing the travel plans of thousands into disarray. "As a result of trying to legislate away uncertainty, they've done exactly the opposite," George Smith, an adjunct professor in the school of policy studies at Queen's University, says of Ottawa's actions. "I'm sure that people looking at travelling for their summer vacations are now looking at the situation and saying, 'ABAC--Anything But Air Canada.' "

That's the last thing the money-losing airline needs as it grapples with lower-cost rivals while being dragged down by $3.9 billion in long-term debt. As the labour disputes mount, shares of the beleaguered airline have fallen nearly 20 per cent since February and now trade at just 87 cents, compared to an IPO price of $21 just six years ago.

Nor is it likely Air Canada will climb out of the storm clouds anytime soon. While many big U.S. carriers have managed to slash employee pension plans and other labour expenses in a bid to modernize their outdated business models, Air Canada has so far been unwilling or unable to contemplate similar radical changes. And the federal government is partly to blame for the mess as it desperately tries to maintain the status quo.

It all raises the question of whether Air Canada can actually be fixed, or if it's time for Ottawa to open the skies to newer, more competitive--and perhaps even foreign--upstarts. Even if it means clipping Air Canada's wings in the process.

The core of Air Canada's current problems is simple: the cost of flying passengers in its planes is greater than the prices it's able to charge them. Despite a major restructuring in 2003 and 2004, the airline's operating costs remain roughly 30 per cent higher than those of rival WestJet, which built its business on the successful model pioneered by Texas-based Southwest Airlines. That winning formula includes a single type of aircraft (to save on training and maintenance costs), no connecting flights (which cause expensive delays when planes have to wait for passengers) and an all-economy-class configuration (which maximizes passenger numbers).

By contrast, Air Canada flies 204 aircraft, ranging from small regional jets to Boeing 777s, and books customers on the regional carrier Jazz (now a separate company). Its own route network stretches from Goose Bay to Geneva, although passengers can effectively travel to any corner of the globe via a complex--and expensive--network of code-sharing agreements with its Star Alliance partners. With 37 brand-new Boeing 787 planes scheduled to join Air Canada's fleet starting in 2014, it's an impressive-looking business that generates nearly $12 billion a year in sales. Even so, Air Canada ended up with a net loss of $249 million last year. In 2010 it ended up $24 million in the red. And this was during a period when North American airlines collectively earned US$4.1 billion, according to data from the International Air Transport Association.

Air Canada's once-dominant position is being attacked from all sides. When it emerged from bankruptcy protection in 2004, the strategy pitched to investors was to price-match WestJet in the domestic market while leaning on business-class travellers and higher-margin international flights to boost profitability. It worked for a few years. Then fuel prices soared and the economy tanked. At the same time, Porter Airlines launched in 2006 and began to steal Air Canada's deep-pocketed business and government passengers on key routes like Toronto-Ottawa and Toronto-New York, while a new breed of aggressive, lower-cost international players like Dubai-based Emirates threaten to do the same overseas. Fred Lazar, an associate professor of economics at York University, estimates that Air Canada's costs are as much as 50 to 60 per cent higher than some Asian and Persian Gulf carriers' when Canada's uncompetitive tax and airport rent policies are factored into the equation.

Since many of Air Canada's costs are beyond its control--the airline paid roughly $3.4 billion last year for fuel and another $1 billion in airport and navigation fees--CEO Calin Rovinescu is now focused on cutting its $2 billion in annual labour expenses. His plan? Create one or more new low-cost carriers, complete with lower wages and benefits for employees, to handle Air Canada's less profitable routes. The model is similar to the one now employed by Australia's Qantas Airways, which uses its Jetstar subsidiary to fly a host of domestic and international routes. Qantas also has stakes in a constellation of other Jetstar-branded joint ventures, including ones in Singapore and Vietnam and soon in Japan and Hong Kong. "We remain of the view that participation in that market segment is important to the airline," Rovinescu told analysts during a February conference call. (He declined to speak to Maclean's.)

Not surprisingly, Rovinescu's plan hasn't been a big hit with Air Canada's unionized workforce--particularly pilots. Last May, the 3,000-member Air Canada Pilots' Association voted against a tentative agreement reached by union negotiators that included plans for the low-cost carrier. They later voted 97 per cent in favour of going on strike and turned down another "final" offer by Air Canada in March, even though it didn't include the discount carrier plan. Strachan says many pilots remain deeply skeptical that Rovinescu's discount carrier strategy will actually work in practice, arguing that in the case of Jetstar, "the net effect so far has been a massive offshoring of Australian jobs."

It's difficult to overstate the level of animosity and distrust that Air Canada workers now have for their bosses. Many feel betrayed after agreeing to over $1 billion in labour concessions during Air Canada's 2003 restructuring, only to be asked for further cuts once those agreements expired in 2009.

Union leaders have also accused the management of ACE Aviation, Air Canada's holding company, of stripping the airline of profitable sub-businesses in a bid to generate big returns for its private equity investors--namely New York's Cerberus Capital Management. That includes the 2005 spinoff of loyalty program Aeroplan as an income trust, which generated $250 million in exchange for a 12.5 per cent stake. By contrast, Air Canada's current market cap is just $241 million. It turns out that Air Canada was in large part an airline loyalty program with an airline tacked onto it.

In an attempt to repeat the magic, ACE spun off regional carrier Jazz in 2006 and Air Canada Technical Services (now Aveos) in 2007. But Aveos went bankrupt last month and left 2,600 people out of work, with CEO Joseph Kolshak blaming Air Canada for pushing it over the edge after it deferred and cancelled aircraft maintenance work. Rovinescu, meanwhile, blamed Aveos for "productivity issues" while Strachan claims Air Canada was likely paying too much for Aveos's services because investment bankers thought that would make it appear more attractive to investors.

The unions are also furious with how well Air Canada's top management has fared despite the airline's dismal financial performance. Robert Milton, the CEO of holding company ACE Aviation, which still holds 11 per cent of Air Canada's shares, has earned more than $82 million for his role in completing the various "value-enhancing transactions" for ACE's shareholders, according to some reports. Rovinescu, who was brought aboard in 2009 after acting as Air Canada's chief restructuring officer in 2003 and 2004, earned $4.5 million in 2010 (the most recent year for which compensation figures are available), up from $2.6 million (for nine months' service) a year earlier. He also took home a $5-million retention bonus last month. "If compensation is an issue at Air Canada, it is in the executive suite," stated a recent report distributed by the pilots' union.

Though big salaries aren't unusual for executives charged with turning around troubled companies, York's Lazar says it sends the wrong message to employees who are asked to make sacrifices. "Senior executives could take a hit on their salaries of about 30 to 40 per cent," he says. Lazar also accuses Air Canada's board of sitting on its hands. "If I were advising the unions, I would demand that Air Canada get rid of its entire board and select a new one that's going to be a little more aggressive in curbing executive compensation, and more involved in determining the strategy of the company."

Ottawa also needs to get off the fence. Raitt's constant meddling in Air Canada's labour negotiations may have prevented unpopular and potentially crippling strikes that could have stranded thousands and cut off access to remote communities, but it has also reduced the pressure on the two sides to make the changes Air Canada needs to make to survive. "It just delays the inevitability of having to face the real issues and work with the unions to come up with some kind of agreement," says Marc-David Seidel, an associate professor at the University of British Columbia's Sauder School of Business.

One way out of this trap is to allow more competition in Canada's airline sector, now effectively a comfortable duopoly between Air Canada and WestJet. That's the approach the federal government has taken with the telecom industry by lowering the barriers to entry for new players and raising foreign ownership limits. Seidel argues that big U.S. carriers have been more effective at restructuring because they face a real threat from more nimble rivals like JetBlue Airways, Southwest and Virgin America. "They never really get exposed to true market forces so they're never able to get the full ship in order," Seidel says of Air Canada. Besides, he adds, nowhere is it written that "Air Canada has to be the airline of the future for the country. It could be several new start-up carriers that grow and that are designed for today's competitive environment." That could be accomplished by raising foreign ownership limits on Canadian airlines, now capped at 25 per cent voting control, or relaxing rules so that foreign carriers could fly passengers between Canadian cities, as is the case in Europe.

As refreshing as that sounds, Canadians shouldn't get their hopes up. For the foreseeable future, we appear stuck with the prospect of watching Air Canada struggle to survive, with Ottawa standing at the bedside ready to administer life support as needed.

See alsoAIR TRANSPORT INDUSTRY.

Maclean's April 30, 2012