Doug Parker had a vision. His successful America West had completed a merger agreement with bankrupt US Airways Group on May 19, 2005. With this deal he planned to become the dominant low cost carrier in the country as the new US Airways (NYSE: LCC). And he would be its CEO. The next day CNN reported that "Parker thinks he can buck history and make a success out of merging his more successful airline with one in bankruptcy." The company's press release said:
Building upon two complementary networks with similar fleets, closely- aligned labor contracts and two outstanding teams of people, this merger creates the first nationwide full service low-cost airline.
On September 29, 2005 trading began for Mr. Parker's new carrier. On that day its stock closed a little above $20. Then in a remarkable run-up to November 24, 2006 it was trading at around $63. Doug Parker seemed close to realizing his vision. Close, but no cigar. The run-up was followed by a steady erosion in shareholder value that on Friday March 7, 2008 saw his stock close at just under $11. That represented an 82% loss in value from its peak and a 46% loss from its initial price. What went wrong?
In a story US Airways Highlights Drawbacks of Consolidation published in USA TODAY on March 6, 2008 Dan Reed said:
The merged carrier ... led by America West's management, had the second-best operating profit margin among all U.S. carriers last year and the best margin over the last two-year period. But widespread flight delays, a botched integration of the two airlines' reservations systems, a steep decline in service quality and plunging worker morale combined to alienate customers and employees alike.
A DYSFUNCTIONAL INDUSTRY
Over the period from 1990 through 2006 the Air Transportation Association of America reports that domestic airlines posted a cumulative loss of $22 billion on cumulative revenues $1,866 billion. Into Thin Air recounts the extraordinary history of this dysfunctional industry from its deregulation in 1978 to the present. In the New York Times story Roger Lowenstein explained the problem:
One reason the major airlines find themselves in this predicament is that they use huge amounts of fixed capital -- wide-body jets go for $100 million each and can't be readily liquidated. They also depend on a skilled labor force. The two problems exacerbate each other. Since airlines cannot afford to let planes sit idle, they can ill suffer strikes. That makes their unions unusually powerful. Consider some other businesses for a moment: Microsoft has highly skilled programmers but little invested capital. Merrill Lynch has both, but its assets -- stocks and bonds mostly -- could be liquidated overnight. Steel has high fixed capital, but it can replace its workers more easily.
Delta Air Lines (NYSE: DAL) filed for Chapter 11 bankruptcy-court protection on September 14, 2005. About a half-hour later Northwest (NYSE: NWA) also filed for bankruptcy. Then about a year later on November 15, 2006 US Airways made an $8 billion hostile bid to take over Delta. The court rejected this bid in favor of Delta's plan to emerge from bankruptcy. Delta's financial adviser, the Blackstone Group, " ... estimated the value of a reorganized Delta at $9.4 billion to $12 billion in consolidated equity." On Friday DAL was worth $3.8 billion.
How can one possibly evaluate company performance in such a dysfunctional industry? If you really want to know, take 18 minutes to review this audio slide-show Y'all Buckle That Seat Belt from Chapter 3 of my book Competing for Customers and Capital.
THE SEXY BANANA
Possibly the funniest and, at the same time, most revealing account of Why Air Travel Doesn't Work appeared in a story by Timothy Smith in the April 3, 1995 issue of Fortune magazine:
The airline business, like the movie business and professional baseball, is so fundamentally sexy that many people can't resist it. Ever since Eddie Rickenbacker bought Eastern Airlines and Howard Hughes bought TWA, investors have been drawn to airlines for reasons going far beyond money. ... Passengers aren't immune to the industry's sex appeal, either: Flying often involves an implicit (if tiny) risk of death, the close proximity of strangers, and liquor. For all its ineffable allure, though, the airline industry is like the banana business. ... "We sell a perishable product, and it's like the last banana in the store: You can either get a penny for it or you can get nothing for it, so you sell it for a penny," says John Dasburg, chief executive of Northwest Airlines.
Since my articles also are published on Seeking Alpha they get pretty wide exposure. Reactions to my last post on the Unintended Consequences of a Delta/Northwest Merger were mixed. In that article I averaged the closing prices and shares outstanding in coming up with a back-of-the-envelope valuation of the combined DAL and NWA. Which means I assumed that after all the dust settled, the combined airlines would be worth no more than one of them standing alone. A reader of that post on SA, identified as Bill @ Sabre, commented:
This is a very good way to look at the likely consequences of an airline merger. Typically in this industry, the financial press tries to make the case that a merger represents 2+2=5. The truth is that airline mergers more often look like 2+2=3. The after effects of mergers leave a drain on customer care, labor relations and ultimately the bottom line for many years.
Another reader, identified as a frm airline exec disagreed with that assessment:
Two companies of roughly comparable market caps merge, and the combined market cap is the average!!! How about the combined mkt cap is roughly double? ... If every NWA and DAL shareholder got one share of the combined company, there would be roughly twice as many shares outstanding. Thus, even if the share price didn't rise, as it would be expected to do in light of the presumed synergies of the combined company, the market cap would be double that of each stand alone company.
There are the magic words of mergers -- presumed synergies! Sounds like this former airline executive is a DAL shareholder. Or, perhaps, the CFO of a previously merged airline. In any event, this digression from the analysis of risk-adjusted differentials in the case of a DAL-NWA merger is needed to support my assumption that 2+2=2.
THE DOWNSIDE OF AIRLINE MERGERS
A good history of airline mergers from 1979 to date is available online in the Thomson Financial SDC M&A database. The results are surprising: when it comes to airlines, forget what you think about the expected downside of mergers.
The following table reports the M&A totals (excluding stock buy-backs) for the five airlines in my analysis with cumulative transaction costs from 1979 through 2007 that exceeded their year-end market cap.
The cumulative (nominal) M&A transaction costs of the five airlines were $29.6 billion. The market cap of these five companies at the end of 207 was $15.5 billion. The ratio of market cap to nominal transaction costs was 52%.
Delta led the pack with total M&A transaction costs of $10.5 billion. Compared with a year-end market cap of $4.0 billion, this leads to the group's lowest MC/TC ratio: 38%. Over the years Delta management spent about $10 on M&A for every $4 worth of value they created. The most "successful" carrier among this list of M&A failures was US Airways -- with a ratio of 76%.
Little Southwest Airlines (NYSE: LUV) didn't make this list. Over the years Southwest management acquired stock in only three companies for a total of $309 million. Their company's market cap in December 2007 was $9.9 billion. So its MC/TC ratio was 32.04.
Y'ALL BUCKLE THAT SEAT BELT
And now Delta wants to merge with Northwest. Over the 30 years since deregulation these two companies spent $16.50 to create $7.50 worth of shareholder value. From this perspective it looks like $1.00+$1.00=$0.45. What do you think?
Thank you for visiting. As always, I welcome your comments.