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Southwest, AirTran plan merger, Atlanta and revenue the story

28-Sep-2010

As most were speculating about the consolidation of the mainline industry in the US late last year and earlier this year, some were saying it was the low-cost carrier sector in need of consolidation.

Thus, yesterday’s announcement that Southwest would acquire AirTran was to be expected, especially given the hot mergers and acquisitions activity in many industries and the overwhelming power represented by Delta and the about-to-be merged United/Continental. But it also has the potential to prompt a new paradigm in the US industry.

“The acquisition of AirTran fits in beautifully with the strategy we’ve laid out for the next 10 years,” said Southwest Chair and CEO Gary Kelly, noting the carrier is now in its fifth decade. “That strategy reflects our thinking about the business and network opportunities and our progress on the evolution of our fleet. The economy is still very challenging but like all good companies, Southwest is looking for growth opportunities. I’m happy to say we found a way to grow Southwest profitably and not just with the acquisition of AirTran. However, it sets the stage beautifully for us so that we can resume our growth with the necessary profits in place.”

The USD1.4 billion transaction, which will require both regulatory and shareholder approvals, is expected to close by the first half of 2011. The pacing item will be how long the Department of Justice takes to review and decide the case. The recent United/Continental combination received approval ahead of schedule, but both Southwest and AirTran are expecting it to take months.

Estimated transaction timeline

Even so, commercial and operating integration is slated to culminate in 2012, with both carriers operating under Southwest Airlines' Federal Aviation Administration operating certificate in Dallas by 2013. After closing, AirTran CEO and President Bob Fornaro will continue to be involved in the integration of the two companies. Plans for existing AirTran facilities will be developed by integration teams and decisions will be announced at appropriate times.  The carriers' frequent flyer programmes will be combined over time, as well.

Consolidation

LCCs account for just over 29% of total domestic capacity share in the US – up from just under 18% in 2001.

Domestic US LCC capacity (seats): Jan-Aug 2001 to Jan-Aug 2010

The combined Southwest-AirTran will control 22.2% of the domestic market, 0.2 ppts more than Delta, according to OAG schedules.

USA domestic carrier capacity share: Top10 airlines

Carrier

Capacity share

Delta

22.0%

Southwest

18.7%

American Airlines

12.9%

US Airways

11.8%

United Airlines

11.2%

Continental

7.0%

AirTran Airways

3.5%

Alaska Airlines

3.4%

JetBlue Airways

2.9%

Frontier Airlines

1.8%

Four low-cost carriers remain in the market besides Southwest/AirTran, including Virgin America, Spirit, Frontier and JetBlue control around 6% of the market.

Spirit is embarking on an IPO to raise much needed funding in the face of the changing market dynamics. Virgin is still comparatively small and JetBlue continues to grow strategically both domestically and internationally. However, the millions invested in the Boston market in the wake of US Airways base shutdown, will now face the full bore of a strengthened Southwest. It is also facing new Southwest competition in the Caribbean, its other high-growth market.

Five low-cost carriers and five mainline operators should afford approval by the Department of Justice. However, the merger of the two largest low-cost carriers constitutes concentration when compared to the strength of the rest of the pack who now have their competitive work cut out for them. However, including all 10 carriers should assuage any competition fears the government may have.

There are 37 communities that AirTran serves that Southwest does not and another 37 that Southwest serves that AirTran does not, affording much more opportunity for new city pairs, especially in the smaller markets served by the Atlanta-based carrier. This increases Southwest’s penetration into small- and medium-sized cities which will be served with AirTran’s 717s.

Top 10 cities

“With AirTran we get a lot, small overlap in route network, new destinations and all this creates new fleet and route opportunities in the future,” said Kelly. “The opportunity is three fold -- Atlanta, small cities and near international. We clearly have more opportunity post AirTran as opposed to without it. What AirTran provides us is profits, places and planes. If the profits are there we have the opportunity to grow and provide more competition.

“It is a high quality operation, a solid low-fare brand with a compatible fleet of Boeings even though it does bring in a different fleet type in the 86 717s,” Kelly continued. “We’ve looked carefully at these aircraft as have our pilots and we think we can manage well with adding them to our fleet of 737s. AirTran also brings a profitable business at an affordable price.”

Seat distribution by region

Powerful marketing tool

However, Kelly said Southwest was open minded on studying what may be best for the future. “We still have to confirm whether we keep current customer policies or modify them,” he said. “At this point we are not assuming we will be open to assigning seats, charging for bags, dual class service. But we reserve the right to change our minds. We are using this integration as an opportunity to learn from AirTran. We are very admiring of them and they may be doing things that may work for us. So, we want to be open to that.”

Kelly also said that Southwest would update the investment community later this fall on its strategy over the next five years. “It is no secret we are contemplating going international but we have to prepare ourselves. One of our gating factors in our reservations technology but we’ve narrowed the choice for new technology to two. We do plan to keep AirTran’s international service and expect to learn from it and build our capability over the next several years.”  

Indeed, Southwest, too, has its work cut out for it just in transitioning from Navitaire and deciding whether the next generation system will be Sabre, used by AirTran, or another system.

The two carriers said they have been so focused on reaching an agreement, considerations about fleet, facilities and labor had taken a back seat. However, now that a deal was done, they will be in touch with Boeing concerning gaining a financially better deal on AAI’s fleet, leased from Boeing. CFO Laura Wright noted that. “Southwest’s balance sheet provides a lot of power and we fully anticipate vigorous discussions on how to achieve our cost synergies,” said Wright.

Growth by acquisition

It is the third acquisition by Southwest which acquired Morris Air and Muse Air during the 1980s. In addition, it acquired ATA Airlines’ operating certificate and remaining assets in 2008, which gave it its LaGuardia berth.

Southwest will acquire AirTran Holdings at a 69% premium on the USD4.55 closing price AirTran’s stock was trading at on Friday, 24-Sept. At Southwest’s closing price USD12.28 the value represented a USD7.69 price per share of common AirTran stock, on the higher end of the USD7.25-7.75 price per share the deal envisions. The cash value comes to USD670 million to be paid with available cash plus the assumption of USD2 billion in AAI debt. 

Airline Forecasts’ Vaughn Cordle liked the deal saying that the merger increased Southwest earnings per share by 22 cents and USD2.64 per share in present value terms.

“In other words, Southwest’s stock could/should move to USD15 per share from the pre-announcement value of USD12.28,” he said. “If Southwest attempted to grow organically the share price would likely fall in my estimation. This is why growing by acquisition makes more sense. The 69% control premium to acquire AirTran is more than offset by the merger benefits.”

AirTran revenues and operating income, excluding special items, for the 12 months ending 30-June-2010, were USD2.5 billion and USD128 million, respectively.  Southwest Airlines revenues and operating income, excluding special items, for the same period, were USD11.2 billion and USD843 million, respectively. The proposed transaction, including the anticipated benefit of net synergies, but excluding the impact of one-time acquisition and integration costs, is expected to be accretive to Southwest Airlines pro forma fully-diluted earnings per share in the first year after the close of the transaction and strongly accretive thereafter.  Net annual synergies are expected to exceed USD400 million by 2013. One-time costs related to the acquisition and integration of AirTran are expected to be in the range of USD300 million to USD500 million.

Financial comparison

Dynamic market changes

In addition to the new competitive landscape, the acquisition, which strikes at the heart of Delta’s Atlanta market, is valued at more than USD1.37 billion, but rises to USD3.42 billion including existing AAI debt and capitalized aircraft leases.

More importantly, however, the transaction fills a huge hole in Southwest’s system – Atlanta – where it is expected to generate more than 2 million new passengers and USD200 million in consumer savings annually, according to an economic analysis by Campbell-Hill Aviation Group, LLP, hired by Southwest to evaluate the impact of a Southwest/AirTran deal.

 “These savings would be created from the new low-fare competition that Southwest Airlines would be able to provide as a result of the acquisition, expanding the well-known ‘Southwest Effect' of reducing fares and stimulating new passenger traffic wherever it flies,” said the company.

“I think the story here is about Atlanta and about us bringing more competition and more low fares to that market,” said Kelly. “We see a number of city-pair opportunities to go in with lower fares and stimulate traffic in classic Southwest fashion. The Campbell-Hill study numbers were a lot more ambitous than ours. But we see lower fares, healthy passenger growth in and out of Atlanta. That’s a big opportunity. Clearly there is additional opportunity for us to connect our networks together and grow traffic. So this is not just about Atlanta but Atlanta is where the big numbrs are. There is very little overlap between Southwest and AirTran and if you ranked our competitors on overlap, they are the smallest. We are four to five times their size and we see a lot of places we can add nonstops to their system. I liken it to the ‘90s with California presenting a great growth opportunity and in the last decade at Chicago and Denver. This is a strategic opportunity to fill that gap.” 

Kelly said that Southwest, a point-to-point carrier, is anxious to study AirTran’s hub-and-spoke network. “We want to learn about their schedule and network profitability as well as their flows,” he said. “They are clearly different and describe themselves as a hybrid, not a hub-and-spoke carrier. All airlines have connections. Roughly 15% of our passengers make connections, but we don’t see Atlanta developing much differently than our operation at Chicago Midway.”

As for competition, Kelly added that while most think of Southwest competing against a given airline in a market, Southwest actually competes against everyone. “We are looking for opportunities to lower fares and add flights so we look for markets that are over priced and under served,” he said.

AirTran just finished a new lease with Atlanta providing ample facilities to both current and future levels of service, according to Wright.

While AirTran had been retrenching at Atlanta, Southwest sees a reversal of that. “We see the need for more, not less,” said Kelly, adding there were plenty of gates to accommodate growth there and at Milwaukee. Its greatest overlap is at Baltimore and Orlando. I don’t know that we have to shrink there but I don’t know there is tremendous growth opportunities there either. But we have not premeditation on route changes. AirTran expands our network by 25% and does its profitably. It is also a unique opportunity to grow Southwest with a potential to add 20% or USD2 billion in revenues per year.” 

The combination gives it access to the lucrative Washington National market, where it will, no doubt, have a similar Southwest Effect, especially given JetBlue’s launch of service there in November. But it also grows its LaGuardia service and strengthens its competitiveness in some of its strongest markets, especially Chicago where business travelers have been driving its expansion to such points as Minneapolis, Boston and New York to name just three, according to Kelly. It also allows Southwest a solid growth pattern for the future, including the near international markets of the Caribbean and Mexico.

It may compound the changing market brought on by the Continental/Southwest Newark slot deal that emerged from the United/Continental merger. That could mean, Delta and US Airways should renew their LaGuardia/Washington National slot swap deal that was denied by the Federal Aviation Administration.

The transaction also has the potential to change the US domestic landscape. It would make the nation’s largest domestic carrier even larger and attack Delta not only at Atlanta but with more service at LaGuardia where the giant carrier is trying to grow, along with new service and terminal at JFK, to become New York’s number one carrier. American, too, must compete against a more formidable Southwest as it refocuses its domestic services to feed its international operations.

Frontier is not only battling Southwest at Denver but will now be competing against it at Milwaukee where it is in a pitched battle with AirTran. Republic, which acquired Frontier in bankruptcy in a bid to diversify beyond the diminishing regional airline feeder business, now faces a greater risk but has noted at Denver, at least, it has a cost advantage over both United and Southwest. Southwest’s now has 10 flights at Milwaukee to AirTran’s 47.

“We’ve been through the bankruptcy auction process three times before with Midway, ATA and Frontier last year,” said Kelly explaining the differences between Frontier and AirTran. “Its a very messy process and offers very little control. Frontier required downsizing and a messy restructuring. The acquisition of AirTran is a completely different scenario because we are acquiring a healthy company who was not for sale and it allows us to grow, not shrink.”

Kelly added that Frontier prompted more soul searching at Southwest on adding a fleet type despite the fact that, had it gone through, the Airbus aircraft would have been phased out. “It also allowed us to work very closely with labor making us better prepared to work together with a business combination like AirTran,” he concluded.

The two airlines currently serve 106 communities from coast-to-coast, Mexico and the Caribbean, with 685 all-Boeing aircraft and nearly 43,000 employees. Overlap, they said was negligible but provided plenty of opportunities for new nonstop service across the two networks. AirTran’s Dallas/Forth Worth International Airport service would go away at closing.

“Nothing changes for either company until the regulatory approvals come through,” said Southwest Executive Vice President Strategy and Planning Bob Jordan, who led the negotiating team for the Dallas-based carrier. “That could take months.”

The deal

Under the terms of the agreement, shareholders of AirTran Holdings, Inc, will receive a combination of Southwest common stock and cash valued between USD7.25 and USD7.75, depending upon the average trading price of Southwest stock for a 20-trading-day period to and including three trading days prior to the closing of the merger.  

Each share of AirTran common stock will be exchanged for USD3.75 in cash and 0.321 shares of Southwest Airlines' common stock, subject to certain adjustments, based on Southwest Airlines' share price prior to closing.  Including the existing AirTran net indebtedness and capitalized aircraft operating leases, the transaction value is approximately USD3.4 billion.

Assuming an exchange ratio of 0.321 and the conversion of AirTran's outstanding convertible notes, AirTran stockholders would receive approximately 57 million shares of Southwest Airlines common stock, which represents approximately 7% of the pro forma Southwest Airlines common shares outstanding, as well as approximately USD670 million in cash.

Should the deal not go through there is a USD39 billion break-up fee owed to Southwest by AirTran. The deal leaves an opening for a higher bid but AirTran cannot solicit such a bid, according to Jordan.

Targeting 15% pre-tax ROIC

CFO Laura Wright said the acquisition ensures Southwest will meet its overall return of invested capital and profitability targets sooner.

“Upon full realisation of the synergies, our pre-tax return on invested capital should exceed 15%,” she said. “The combination will also deliver a healthy return on equity of over 20%.”

Wright said net synergies will come from the expanded and diversified network in the creation of a substantially larger low-fare airline, greatly expanded customer service offerings.

“Together we will serve 100 million passengers with the potential of 100s of new itineraries for both carriers’ existing customers,” she said. “The combination will also have a more powerful frequent flyer programme, allowing our new frequent flyer programme, scheduled to be launched next year, to just get stronger.”

She also noted that AirTran has no cargo offering as Southwest does. “As we build one network we can capitalize on joint marketing, schedule optimisation capabilities, revenue management improvements, business select, Early Bird and bags fly free campaign which has allowed Southwest to increase top line revenues by USD1 billion in the first half of 2010 versus the first six months of 2007 with slightly less capacity.”

Southwest sees many opportunities to reduce costs in such areas as advertising and distribution, facilities consolidation, corporate overhead, IT, improved efficiencies, economies of scale and financing rates on aircraft. “These cost synergies provide an opportunity to offsets costs in categories we expect to increase such a labor,” said Wright. “With that in mind, the net synergy opportunities are driven by network and improved revenue potential. Combined, the revenue of the two companies for the 12 months ended 30-June-2010 was USD3.7 billion. Some USD400 million of net synergies equates to about 3% of the combined company’s 12 months revenue ended 30-June-2010.”

She outlined the USD300-500 million of costs include the cost of the deal, facilities transition, aircraft integration, labor integration including training, technology and system integration along with marketing integration and miscellaneous costs for contingencies. The USD670 million of the cash portion will be funded by cash on hand with current cash balance of USD3.3 billion and another USD500 million coming from AirTran. The company also has a USD600 million line of credit and over USD700 million in unencumbered aircraft value.  

The two airlines would be consolidated using Southwest’s headquarters, logo and livery.

At a Glance:

Southwest Airlines

AirTran Airways

Employees (FTE as of 2Q 2010)

34,636

8,083

Number of Aircraft

544

138

Type of Aircraft

Boeing 737-700: 345

Boeing 737-500: 25

Boeing 737-300: 173

Boeing 737-700: 52

Boeing 717-200: 86

Number of Enplaned Passengers

(in millions, 2009)

101,338

23,998

Nonstop Routes

461

177

Number of Cities Served

69

69

Morgan Stanley acted as lead financial advisor to AirTran Holdings, Inc., with both Sullivan & Cromwell, LLP, and Smith, Gambrell & Russell, LLP, acting jointly as legal advisors. Citigroup Global Markets Inc. and Dahlman Rose & Company acted as financial advisors to Southwest Airlines while Vinson & Elkins LLP acted as legal counsel to airline.

The back story

The deal began when, during his first quarter conference call, Fornaro signaled his interest in consolidation. Next came a call from Kelly.

“I called Bob in the Spring and asked him ‘are you interested in exploring an acquisition?’,” said Kelly. “I outlined the way I was thinking about it so I didn’t set expectations he wasn’t open to. He was open to at least hearing what I had to say. He made clear that AirTran was not for sale but open to discussions which took place over a number of months.”

Fornaro continued. “When Gary called I wasn’t sure what the subject would be because two or three years ago we talked about codesharing in Chicago,” he said. “I didn’t know whether it would be an acquisition or some other type of partnership. I was really unsure. After the conversation I thought about Southwest relative to AirTran having vast resources. Then I thought you put yourself in a position to win and with that, I realized that we’d be in a much better position and our 8,000 people would be better off for it.

“There was a sense of sadness,” he continued. “When I started we had a 20-year-old fleet and now it is 6.5 years old. We didn’t run a very good airline and now we do. A lot of people didn’t think we could do it but we did and grew to be the second largest carrier in the world’s busiest airport. But still, Southwest has huge financial resources that we don’t have. If we want to be a success; if we want to win, we have to create opportunities where our people are better off and have brighter futures. We have struggled as a company but we are flexible and innovative and, with what Southwest’s resources brings our people, I ended up being very excited. By joining forces we could do more together than what we would be able to accomplish on our own.

“This was also an easy win for our shareholders,” he said. “If your share price is USD4.50 and the potential offer is between USD7.25 and USD7.75, it’s a great deal for shareholders. AirTran could probably get back there on its own but the industry is fraught with risk. So you look at a sure thing with a strong premium, you feel the shareholders will favor it.”

The deal was kept very close to the vest, with few discussions outside of the inner circle negotiators between the two airlines. Kelly said that labor, which was also under a non-disclosure agreement as were the negotiating execs, had to be told as part of negotiations on open contracts.

It was also the right time for Southwest. “I think this has been a good idea for a long time,” said Kelly. “I’ve been asked many times over many years about this idea. But I don’t think we were ready before. We have made tremendous progress over the last five years not the least of which is in our leadership team which we reorganized to really strengthen and take advantage of the talent. They are phenomenal. Now, we are ready. We are financially ready and financially healthy. We are not growing our route system organically so we don’t have to manage those dual challenges. The economy presents a challenge for all business. And you can’t just be a buyer. Someone has to be willing to sell. It is happening now because we feel comfortable with our capability. I think this is a revenue story and that cost is going to be a wash. We don’t know and it all depends on whether we can make the networks work but we have already proven we know how to optimize networks and ring revenue out so we see an opportunity to generate strong revenues. I don’t think we had these capabilities five years ago.”

“Our conservative fiscal management and strong balance sheet were big factors in enabling us to consider us this transaction,” added Wright. “Our cash balance and profits have been growing and we have significantly reduced capital expenditures. Cash flow from operations exceed USD900 million on capital expenditures of USD300 million. We expect cash to continue to grow as cap ex continues to decline. This put us in a position to structure the transaction while preserving a strong balance sheet and providing a superior return to shareholders.”

Much work to be done on labour

On labour, Kelly said there is much work to be done including such near-term issues as addressing open contracts. He also said it was up to employee units to hammer out their seniority agreements. In addition, pay gaps between the two airlines must be identified, along with the creation of pay rates for the 717.

“Southwest is famous for taking care of its people and, as we work through this integration, I think employees will be ecstatic about the opportunity to grow,” he said. “We’ve contemplated the change in labor costs but revenue synergies dwarf these costs. Every single work group at Southwest has a better pay and benefits package so we believe this acquisition can benefit all stakeholders.”

Based on current operations, the combined organization would have nearly 43,000 Employees and serve more than 100 million customers annually from more than 100 different airports in the US and near-international destinations. In addition, the combined carriers' all-Boeing fleet consisting of 685 active aircraft would include 401 Boeing 737-700s, 173 Boeing 737-300s, 25 Boeing 737-500s, and 86 Boeing 717s, with an average age of approximately 10 years, one of the youngest fleets in the industry.  Southwest Airlines also announced, previously, that it is evaluating the opportunity to introduce the Boeing 737-800 into its domestic network to complement its current fleet, providing opportunities for longer-haul flying and service to high-demand, slot-controlled, or gate-restricted markets.  This acquisition supports Southwest Airlines' evaluation of the Boeing 737-800.

Low-Fare Network


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