Mergers are the best solution for network airlines - Cordle

The six network airlines reported $70.4 billion in net losses over the last decade that can be attributed to excess seat capacity and a desire to maintain market share. Excess capacity must be viewed within the context of managers' strong desire to maintain market share, which results when network airlines attempt to maintain the scale and scope economies required to compete in both international and domestic markets. Moreover, relative costs increase when airlines shrink as fixed costs are spread over fewer seats.

Based on our analysis of mergers and industry profitability post-merger, we conclude that network airline mergers will not allow the larger airlines to maintain prices profitably above competitive levels for a significant period of time. This is the "market power" definition that the DOJ uses when assessing whether or not to approve a merger - it's not the only criteria, but it's an important one.

In the final analysis, the industry tends to produce seat capacity beyond the level that would allow the industry to earn a rate of return that attracts and maintains shareholder support. I term this phenomenon the "destructive growth prerogative". Without capacity discipline - and this requires an elimination of excess capacity in the system - the industry will continue to destroy economic and shareholder value and, as a result, the quality of the product will only get worse.

Excess capacity can be defined two ways: within the context of required profitability and in terms of passenger load factors. I make the case for profitability that excess capacity is best defined as that capacity that exists above a level that would allow the industry to break even on capital costs over a full business cycle. The last business cycle, from GDP peak to trough, was a 10-year economic cycle that ended in 2009. During this cycle, the industry produced, on average, 6.4% capacity above that which would have allowed it to earn a normal profit (figure 1).

Stated differently, the industry undercharged the product by 10.5%, which in turn resulted in $68.7 billion (in 2009$) in reported net losses. These losses represented 5.5% of total revenue, and the average load factor for the decade was 76%. Based on the actual price elasticity of demand and the revenue level required to earn a normal profit, the average passenger load factor would have increased to 82%, which would have resulted in 18% of the industry's seats unoccupied. This level of excess seat capacity would have provided sufficient unused capacity to accommodate all demand related to factors other than abnormal or emergency peaks.

It's likely that passenger load factors in the low 80s are the natural limit for the network airline. Unfortunately, network airlines are forced to offset higher costs with higher load factors. Higher load factors naturally result in more uncomfortable flights and lower service quality, because the ratio of flight attendants to passengers is reduced. The network airlines lost $70.4 billion over the last decade and undercharged for the product by 12.6% on average. The network (mainline ex-regionals) airlines captured 76% of the total revenue out of the 54 passenger-carrying airlines that existed in the decade ending with 2009.

The reality is that the airlines have been unable - collectively - to raise fares sufficiently to earn their cost of capital or even to earn a normal profit. Why? Because the industry has produced a seat capacity above that level required to earn a profit, and it's almost impossible for a network airline to compete against the low-cost model that doesn't have legacy debt and costs and a productivity advantage relative to the network's hub-and-spoke model. Higher cost network airlines must compete on price to stop the downward spiral in market share loss and viability. To cede market share, to the degree required to earn a normal profit, results in a downward spiral in size that ultimately results in the loss of shareholder support and failure.

Bankruptcy (and the threat of bankruptcy for AA) has forced the suppliers (e.g., labor) and creditors to renegotiate agreements so as to allow the network airlines to emerge as businesses with only the chance to survive and compete. If bankruptcy laws are changed in a way that forces failed businesses to liquidate, it would force suppliers and creditors to accept terms that could keep the business alive - outside of a bankruptcy court.

Big-network airlines are much smaller today than they were ten years ago, as they have ceded market share to faster-growing and lower-cost airlines. As an example, and including the TWA and Reno acquisitions, AA represents 16% of the total systemwide available seat miles today versus 26.3% in 1992. This represents a 38% loss in relative market share over the 16 years. If UA and CO merge, the combined airline will have 22% of the total systemwide capacity (17.7% of the domestic), which is not much more than UA's 20% in 1998 (17% domestic). Mergers work best for all of the network's stakeholders, because failure results in the loss of jobs and investments.

Mergers must be related to the alternative scenarios, which, in the case of the networks, would have been failure or even a greater loss of economic value and jobs. When mergers fail to produce an adequate financial return, this does not indicate a level of performance that is any worse than the alternative or status quo scenario, which in most cases would have been an outright failure, or even much worse, returns on capital.

AA's acquisitions of TWA and Reno could be considered financial failures, but the losses would have likely been higher for AA if it had continued its destructive fare competition with these two airlines. We have argued that shareholders, employees, and consumers benefit when DL/NW and UA/CO merge because the longer-run alternative is failure. The air transportation product quality has followed financial performance down, and adequate investment is not possible without adequate profitability. If the merger does not work, the employees and shareholders suffer, but less than they would without the merger. Given the smaller size of the network airlines today, a merger between CO/UA will not increase market concentration to a level that allows above-competitive returns, only an improvement in returns. Robust competition will continue to result in below-capital cost (and broader market) returns for the airlines collectively, especially in the domestic market and especially for the network airlines over a full business cycle.

While it is difficult to make the merger valuation case based on hypothetical alternative scenarios, we can make reasonable estimations of revenue and earnings based on a reasonable set of assumptions. Higher market caps do provide value in the form of purchasing power that acts as a currency to reward labor and shareholders. Moreover, the cost of debt is reduced as the market value of equity is increased, which in turn reduces the average cost of capital and improves economic returns.

The merged airlines' market cap increases due to cost and revenue synergies, not from raising fares or reducing service. Cost synergies of $1 billion or more can be shared with all stakeholders and revenue synergies of approximately $1 billion are from enhanced scope economies (i.e., enlarging the network and traffic flows) - not from raising fares. $2 billion in cost and revenue synergies can be divided among all stakeholders. Benefits to the consumer come in the form of one-stop shopping for the business traveler from a newly merged company that can afford to improve the product. For example, load factors could be lower if an airline is more profitable, and this improves service quality.

Public policy should be about helping the U.S. airlines compete on a global basis, and it should not be exclusively focused on increasing competition so that a single stakeholder, the consumer, benefits. Other stakeholders, including small communities, labor, and capital providers should be considered, because all stakeholders must be satisfied if the airline is to be viable and worthy of longer-term investment. Without the returns required to increase the market cap, the airline is not worthy of investment. Hence there is a required rate of return that must satisfy the shareholder.

We do not dispute the contention that mergers result in fewer customer alternatives. We do, however, contend that customer benefits and service quality increase when mergers [and alliances] occur at the end of the worst decade in history for the industry. Our market concentration work (HHI) leads us to conclude that the U.S. airline industry has too many airlines and that the system can profitably support only three network airlines, not five or even four. The logic behind this conclusion comes from an examination of the market concentration since 1977 and industry profitability and the correlation between the levels of earnings required to earn the cost of capital over a full business cycle.

There is an optimal level of airlines at any given point in the business cycle, and ebb and flow will naturally occur in the number of competitors as the economy expands and contracts over time. We can state with the benefit of 20/20 hindsight what the number of competitors and market concentration should be in order for the industry to break even on capital costs. As an example, the equivalent of four equally sized [large] airlines was added during the long business cycle ending with 2007. This was a natural byproduct of a strong and expanding economy. However, approximately 4% of that GDP growth and 5% of air travel demand during the period of 2002-2008 was a function of a credit bubble built on a house of (derivatives and debt) cards (pun intended). The upshot is that the recovery will not include that credit-bubble component of growth, and this means the industry needs fewer airlines during the upcoming decade.

We fully agree that U.S. carriers - and thus U.S. jobs - are being sacrificed in the name of ideology, an ideology that has yet to fully develop into a set of coherent policies as it relates to U.S. competitiveness in foreign markets. U.S. carriers are disadvantaged internationally because a level playing field does not exist in terms of labor laws and gate/slot restrictions and even in terms of balance sheet debt, seat costs, and service quality. The U.S. network airlines have the worst service quality, the most overleveraged balance sheets, the lowest returns on assets, and the oldest aircraft and workforce. Moreover, they are not cost competitive in the U.S. domestic market.

Open Skies results in more competition and an even greater market share loss, over time, for the U.S. airlines, hence the need for larger, stronger, and more fit U.S. network airlines that can compete with regard to service and price. This is not possible, given the current market structure of the U.S. airline industry.

Mergers will allow UA, DL, CO, NW, and even US and AA to compete more effectively on a global playing field that is not level. Without the mergers, we make the case that the network airlines continue down a slow liquidation path that weakens the industry's ability to produce a product that can satisfy all stakeholders, including the small communities and capital providers that require healthy network airlines.

We make the case that, without mergers or industry consolidation, network airlines will have even less financial incentive to serve small markets. With mergers, the larger networks produce cost and revenue synergies that enhance profitability; e.g., Delta projects $2 billion in synergies annually by 2012, which in turn enhances the network airline's ability to support small-community service. Each network will have greater [scope economy] incentive to maintain and even develop the small community feed that can connect with a larger global and domestic network that is better rationalized via mergers and alliances with foreign partners. In our view, the less profitable and the smaller the network, the less incentive to serve the least profitable routes, which are the thinly populated shorter haul markets to small communities.

In a higher fuel cost world, a 50-seat regional jet is not the best aircraft, and more 70-100 seat regional aircraft are needed. Continental, as an example, has a scope clause with its pilots that do not allow its commuter partners to fly anything larger than a 50-seat aircraft. Clearly this agreement cannot hold once the airline merges with United, which does allow its commuters to fly aircraft with more than 50 seats.

We can agree that public policies have, at least to some degree, resulted in destructive fare competition and alarming wealth destruction in the airline industry. The larger problem for the network airlines has been a loss of market share, especially in the domestic market, to younger, lower-cost, and point-to-point airlines. How can AA pass along the $700-$900 million a year in required pension/healthcare contributions required to close a $5 billion [defined benefit] pension funding deficit? Massive losses and inadequate profitability when times are good has resulted in a need to shift American jobs offshore to facilitate lower labor costs.

When the network airlines had 94% of the market share of systemwide seats in 1992, the network airlines were more profitable and could serve the consumer with a higher quality product (e.g., lower load factors with happier, higher paid employees). Today, the network airlines produce 67% of the systemwide seats and only 57% of the domestic seats. With a weaker dollar, it becomes more expensive to move jobs offshore, and a more profitable industry should result in more jobs retained within the U.S. Consolidation, improved profitability, and mergers that work best for those airlines too weak to survive on their own is the best solution for a weak and feeble industry that is currently unfit for long term investment.

Mergers reduce the number of competitors in basically the same way as consolidation via failure. The industry simply has too many airlines after a decade-long economic expansion that was insufficient for an industry that reported almost $70 billion in losses as a result of excess seat capacity. Travel prices will have to increase to offset higher government fees, security costs, airport passenger facility charges, labor and fuel costs, and the need to repair badly damaged balance sheets. Without consolidation, the airlines will continue to destroy economic wealth and outsource jobs that continue the downward pressure on wages and benefits and loss of high paying union jobs.

The modification of bankruptcy and labor laws could force the airlines to manage the business for profits, not market share. And we agree that international agreements should be based on leveling the playing field. However, this will not solve the core competitive problem the network airlines have domestically, which is a legacy cost structure that was borne in an era that no longer exists. It was an era in which only a handful of large airlines competed within the tight regulatory (pricing) control of the government - one without low-cost competition. Bankruptcy and mergers may be the only way the network airlines can survive against younger and lower-cost airlines in the international and domestic markets. The risk, after a merger, is that labor will overreach in its attempt to recoup wages and work rule concessions that were sacrificed in previous restructurings.

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Vaughn Cordle, CFA AirlineForecasts, LLC
www.airlineforecasts.com/
Washington, DC 703 830-1701 (office)
703 946-5474 (mobile)
vaughn@airlineforecasts.com
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