US’ proposed acquisition of DL
has attracted a lot of attention among the usual crowd of people arguing for consolidation – even if the business fundamentals do not make any sense. Part of the reason for all the excitement is obvious: more money is made in the airline industry by doing a deal than by operating an airline. Yet as the US deal sputters and the progosticators begin to admit that it might not happen after all, it’s time to look at the role mergers have and likely will play in the industry.
First, let’s break airline mergers into three categories. There are mergers of distressed or failing airlines, although most often those become asset acquisitions. The industry has had several of these and generally the best assets have been picked out and the rest of the former airline thrown away. Though not kind to much of anyone, these types of mergers will continue because there is always the hope that a white knight will save even a little bit of a failing airline even though history shows that very little of the distressed carrier actually survives. Secondly, we have had friendly mergers of two viable airlines. These became widespread in the late 80s when a number of mainline airlines without nationwide networks combined to form a couple of nationwide carriers. Although these are the best case for when mergers should work, few have. Delta’s acquisition of Western has been called one of the best mergers in the industry and NW
’s acquisition of Republic allowed two airlines with limited regional presence to become a significant force in the marketplace. Third, there have been a few attempts at hostile takeovers. However, there isn’t one case in the US airline industry of a successful hostile takeover. Perhaps that’s why Doug Parker is starting to backpedal… financiers aren’t willing to risk billions of dollars when it can easily evaporate at the hands of disgruntled employees – who have been responsible for destroying millions of dollars in the global airline industry.
Second, let’s look at what it takes to combine two airlines. Traditionally, one of the two airlines has had to have above average financial performance in order to get the financing necessary to make a merger work. As credit quality in the US overall has deteriorated, banks are willing to engage in riskier and riskier loans. History shows that loans to the airline industry have been some of the riskiest. Any attempt to combine carriers has to come with pretty compelling plans to safeguard the airline and payback the loans. Historically, airlines have justified mergers by reducing overhead and simplifying operations. Nearly all successful, lasting mergers in the industry have been end-on-end type mergers or those between airlines where the sum of the two previous airlines creates a new airline that is stronger than either of the two airlines were alone. Reducing capacity has usually not been a compelling force for combining airlines.
Because US Airways didn’t want to say it was laying off people and can’t simplify operations much because of the vastly differently fleets, it went to the newest justification for mergers which is to reduce capacity even though saying that sets off all kinds of red flags at governments and consumer groups. The red flags are accompanied by fireworks when that kind of talk is made about two carriers that have heavy overlap as US and DL
do. The fallacy of reducing capacity to improve profitability is that what one carrier gives up will be taken over by another carrier. The slobber running down the face of Southwest, AirTran, and JetBlue execs at the prospect of picking up access to key Northeast assets shows that capacity will not go away – except to small cities where there will not be any LFCs ever - and therefore the merger benefit from reducing capacity won’t work in the largest markets and the political backlash will prevent it in the smallest markets. In fact, while network carriers have been very careful about reducing capacity and limiting capital expenditures, low fare carriers today have made huge commitments to new aircraft that can only be used to replace capacity network carriers will get remove. Where it can work is in small and medium sized markets where LFCs won’t go but if there is any significant overlap in those small cities between the merger candidates, regulators will nix the deal as consumers cry out to stop any attempts at raising fares solely for the purpose of fattening profits. If the combined carrier gains excessive market dominance – which is certain to happen in small cities surrounding the hubs of two carriers in the same region - the merger has a very little chance of occurring. It’s easy and perfectly legal for an airline to remove capacity from its own system but it’s very difficult to remove capacity from a combined carrier and get it past regulators and consumers unless there is a compelling case to be made that the industry cannot survive with existing capacity levels.
So what is the state of the industry today? Let’s go back to United’s rejected ATSB loan application in 2003. It was then that the Government Accounting Office told the airline industry that bankruptcy should be the primary tool used by the struggling airline industry to turn itself around. Government subsidies would not be given out. It is against that backdrop that 4 out of the 6 network carriers that existed in 2003 have now been through bankruptcy. Something strange happened in bankruptcy during this business cycle. While bankruptcy historically has translated into a high mortality rate for airlines, United emerged successfully and Delta and Northwest are on track to emerge successfully as well. Only the old USAirways was unable to successfully restructure despite two trips through bankruptcy, leading to its acquisition by America West. Most airlines have learned that it is indeed possible to survive bankruptcy but there are very different strategies of how to get there. Some actually restructure their operations and networks and become viable – such as CO
did during the 90s – and others just keep reducing capacity and slashing costs, a strategy that produces great short-term results but leaves the airlines that use that strategy highly vulnerable since capacity doesn’t leave the industry but is instead just transferred to other carriers. Successful airlines know that you have to maintain a strong presence in key markets or expect to see major competitors move into its markets. Is it any wonder that US Airways under Doug Parker has seen more new service and more new carriers added to US hubs by competitors than at any other airline since 2001?
And now, even though two network airlines are still operating in bankruptcy, every one of the six network carriers has reported profits of some kind during the past year. Since the airline industry has never been consistently profitable, few would argue that the airlines are in trouble at this point. No one in Washington even expects airlines to be as profitable as other industries – they just want them to provide reliable, cheap service. Intracity mass transit is heavily subsidized in the US; airlines are just viewed as intercity mass transit that is privately subsidized. Nonetheless, US characterized DL
as a failing carrier in an attempt to provide justification for the transaction. In reality, only the original US was failing and had to be combined with America West if thousands of jobs were to be saved and in order to keep a huge vacuum from developing in the eastern US. DL
’s reorganization has been so successful that it has reached its targets and restructured its airline faster and more dramatically than any airline, all while rebuilding DL
to be a viable long-term competitor, all the while hitting financial targets and having the cost of its DIP financing reduced three times in less than a year. DL
has benefited from a strong environment and today airlines across the board are reporting higher fares and load factor increases, hardly the kind of environment to use when trying to convince regulators and consumer groups that capacity needs to be removed in order airlines to survive.
So when can mergers survive, you ask? Distressed mergers will always be given priority even though there is little evidence they succeed since asset sales usually are used to transfer the best assets and to gain the best return for the distressed carrier. Since no airline is currently anywhere near the point of being distressed, these types of mergers are not likely to be seen for at least several years. Friendly mergers can happen but the ones that are most likely to succeed are those that combine airlines with little overlap – not just at hubs but throughout regions and in small and medium sized cities. The case for workable friendly mergers has to be built on increased operational efficiency and reasonable capacity reductions that will not substantially increase the combined carrier’s market presence. On this metric, the LFCs have a better chance of putting together a workable merger proposal than the network carriers but they happen to know how complicated and expensive mergers are and how unlikely they are of succeeding. Remember that every network carrier has a nationwide network. Only Northwest and Continental are significantly weak in one area of the country from an O&D perspective and also have no large operations in that region. Hostile mergers will rarely succeed in the airline or any service industry and there is no indication that is going to change.
So why do so many people in the industry continue to argue FOR
consolidation? Look at the money. The only people that continue to push for consolidation are those that can make quick profits based on the deal rather than the long-term viability of the industry. No analyst that supports long-term investors has said the US-DL merger is good for the long-term viability of either company or the industry. And Doug Parker and Glen Tilton can hardly be said to be piloting airlines with strong long-term prospects; US continues to watch its market share and competitive position shrink while UA
still has above average costs and debt – with no prospect of getting anything else out of the company in a downturn. The lowest costs alone won’t save an airline but when a carrier balances low costs and strong revenue production, they will succeed. And in the downturns when revenue falls off while costs rise as capacity is removed, being the lowest cost producer is far more valuable, esp. as low fare carriers expand into an airline’s key markets. UA
and US are not positioned for long-term success in the industry which is why their owners want them to do a deal that keeps the money churning by reducing competition and putting off the day when those airlines have to admit their business strategies will fail.
So what kinds of airlines will succeed and become the acquirers when the time IS
right for consolidation – and it will happen. One need only look at AA
as examples. AA
has a war chest at its disposal – and despite its labor costs and relative lethargy regarding growth – still is a very viable long-term airline. CO
in many ways is the poster child for how to successfully restructure an airline and DL
mgmt – some of whom are former CO
execs – are copying CO
’s playbook as well as those of other bankruptcy success stories like Air Canada. Despite the current strategic challenges that CO
faces now with nearly saturated hubs and a limited presence outside of its hubs, CO
is still a very viable airline – and could survive for quite some time as a niche player. Is it any wonder that AA
are the most vocal opponents of mergers and would only participate in consolidation if they were forced to, preferring instead to acquire assets? Only NW
has said little on the topic of consolidation, perhaps because it is one of the few airlines where a friendly merger could happen with CO
if management can overcome the fleet and labor issues.
Consolidation will occur in the airline industry but it will be among carriers that can produce a merger proposal that is beneficial to all parties, including the public who still view airlines as a public asset. The airlines that will be the acquirers are the ones that manage their business year in and year out for long-term viability and success. And the time has to be right. Airlines most often consolidate during down times because it is a lot easier to convince regulators of the need when service is on the verge of being lost and because assets are a lot cheaper then. Merging in the downturns requires that one airline in the pair be managed for long-term profitability and success for stakeholders. Now that most of the industry is owned by creditors who are not interested in getting burned by short term strategies and second bankruptcies, the only deals that fly will be those that make solid financial sense and can be successfully and efficiently executed.