By Vaughn Cordle, CFA
The Department of Justice (DOJ) has a shot at blocking the American Airlines (AAMRQ.PK) and US Airways (LCC) merger, but only if their argument is supported by solid evidence that properly values pricing power in addition to quantifying concentration in city pairs that could be adversely impacted by having one less network airline. The DOJ will have to prove that any potential anti-competitive cost will exceed potential benefits produced by the merged airline. Potential benefits include lower average pricing throughout the entire network, especially in the U.S. domestic market.
The 1,000 city pairs that DOJ claims will result in higher prices and less service must be considered and related to the industry's and American's consumer cost and benefits that would result from the removal of one of the four remaining network airlines. This requires an analysis of every operating airline and city-pair in the industry. This includes the domestic, express, and the entire system-wide markets, which includes international city-pairs. Hence, the Department of Transportation's (DOT) views on joint ventures and relevant markets are required if the DOJ and U.S. District Judge Colleen Kollar-Kotelly are to fully understand what will likely happen to pricing/seat capacity in the American and US Airways domestic city-pairs that were examined by the DOJ. The DOJ, of course, will not want to present evidence that weakens their case.
The DOJ's case will depend upon defining the relevant market(s) and potential for market power; however, market power must be quantified in terms of concentration and pricing power - two linked but distinctly different concepts that will produce different consumer benefit and cost values. Benefits include scope economies that are associated with economies of density, which are essentially economies of scale along a given route. Stated differently, economies of density result in reductions in average costs as traffic volume on the given route is increased. This is the key benefit of the merger, and it cannot be excluded from the analysis of pricing power and concentration. Costs must be measured in revenue passenger mile terms, and when costs go down as a result of new economies of density, fares can be reduced on individual city-pairs even when there is less competition on that specific route.
Mergers allow for a larger number of aircraft with different seat sizes that can be better mixed and matched to different markets and changes in demand. This fleet flexibility in turn results in higher load factors and the ability to spread costs over more passengers per aircraft. Moreover, a high percentage of the network airline departures and passengers are carried on contracted express partners that have significantly lower block hour labor costs. This arrangement allows the networks to lower average system labor costs per revenue passenger enplaned and it provides the higher frequency and capacity that passengers demand.
We ran sustainable growth models and found that American and US Airways would not grow as independent airlines, and more likely would shrink [at least in relative terms] over time. Why? Too much leverage, poor capital productivity, and inadequate profitability relative to the lower- cost foreign and US domestic low-fare airlines they must compete. Yes, US Airways is profitable now, but only because their labor costs are too low to be sustained. Recall that their labor costs were beaten down in two bankruptcies. Once these costs increase toward market rates… there go the profits and the ability to grow. American can emerge from bankruptcy as an independent airline and be profitable again. However, it will be burdened with too much debt and because of this high financial leverage, it cannot grow. The airline would be able to produce adequate profits, but only up to the point when labor costs snap back to the much higher market rates, after the current (bankruptcy) labor agreements end.
No serious analyst believed American's former executives when they said they would aggressively grow their key hubs after they emerged from bankruptcy as an independent airline. It was a narrative designed to help the American CEO and core team remain in control and also placate various stakeholders, especially labor. If the airline did expand as planned, it would have destroyed shareholder value... which in turn would have forced management to pull down the growth. Hence this growth story was pure fantasy; a fantasy that the DOJ now ironically uses as their own evidence that the airline could remain viable and strong as an independent airline. Moreover, in my view US Airways is not a viable airline, over the long term, if it remains an independent airline, once labor costs increase to sustainable and significantly higher levels.
As a merged entity, American and US Airways can materially improve all three levers - profitability, capital productivity, and financial leverage - required for sustainable growth. And because of improved efficiency - i.e., lower costs - the merged airline will require less revenue per passenger - all else remaining constant and relative to what would be required if the two airlines stay independent.
The DOJ's analysis of Herfindahl-Hirschman Index (HHI) concentration is materially misleading because the DOJ looks at [management] control concentration and not units of capacity concentration which include the low labor cost express contractors, an analysis that results in a much lower HHI number. The following chart (Exhibit 1) includes the mergers between Southwest (LUV) and AirTran (AAI) (1,334 HHI) and American and US Airways (1,462) and includes the express airlines' capacity as independent managed capacity.
Regardless, after the consolidation and mergers - including American and US Airways - the industry's unit of capacity concentration will be about 1,000 points lower than the 2,500 that the agency considers a key threshold.
However, the DOJ will look at "control" concentration in the domestic market. When the express capacity is included with the network airlines' capacity the HHI increases to 2,447. The DOJ considers this a "highly concentrated" level, but is only a moderate level of concentration when considering the airlines' strong desire to keep fares as low as possible to increase passenger volumes through the networks.
Yes, there is a smaller percentage of city-pairs with one competitor (10,000 HHI), and the fares on these routes will be higher, but these one-airline city-pairs must be considered within the context of the industry as a whole, and related to what is necessary for the airline to earn an adequate profit over its system-wide network. Here the DOJ fails to do its job and even provides a flawed analysis with wrong-headed conclusions. In my view, this flawed analysis may be the reason why the DOJ will fail to block the merger.
Three equally sized network airlines will continue to compete vigorously to maintain high passenger volumes throughout the entire network, and this is why price increases can be lower than many might believe even on routes dominated by only three, two, or one dominant airline. This is something the DOJ fails to consider or acknowledge in their 56-page document; however, there will be "soft" competition when only two or three equally sized airlines are competing on the same route. Hence, average fares will increase when there is one less mid-sized competitor due to its merger with another larger competitor. This change in the competitive dynamic is in contrast to the "hard" competition that exists when there is one or more smaller [less flexible] airlines competing with one or more large airlines that have greater and equal flexibility. Flexibility is the ability to mix and match different seat-sized aircraft to account for changes in demand. Hence, a merged airline can produce density economies [i.e., higher load factors] that would not exist without the merger, and this is why pricing will not increase to the level assumed by the DOJ and their rather weak case to block the American and US Airways merger.
The DOT's record on the nature of competition and various markets could (and should) carry considerable weight. After all, the DOJ makes an anti-trust case in the domestic market but must consult with DOT experts and lawyers to understand how the international city-pairs are linked to domestic markets. Why? Because optimal pricing strategies require a full network analysis to understand how executives maximize scope/scale/density economies throughout the entire network. Hence, it could be difficult for the DOJ to make their case if American and US Airways executives provide evidence that individual domestic city-pairs cannot be viewed in isolation from the larger network which includes international city-pairs as they are fed by domestic hubs, which in turn are fed by the express carrier feed.
The airlines earned their cost of capital during the most recent June quarter - their peak earnings for the year - and will likely cover capital costs for 2014 and 2015, given the current assumptions of GDP growth, fuel costs, and industry capacity growth. However, this level of earnings must be put into the proper context. After too many years of inadequate investment, the average age of network airline assets are too old [read inefficient], and the balance sheets must be de-leveraged. Southwest, JetBlue (JBLU) and Spirit (SAVE) are the exceptions and have more optimal levels of leverage. Also, because capital expenditures have been a fraction of depreciation over too many years, the airlines have been in a de facto slow liquidation, which explains why the US networks have the oldest fleets in the world. These airlines will require many years of profits, which means many years of no or very slow growth. Why? Because it takes retained earnings to reduce financial leverage and build up equity.
Paying down debt must be the priority before investing in growth. If the network airlines attempt to grow with high financial leverage, then the market will punish them with a lower stock price and market value, which in turn will drive up the cost of debt and equity capital. Higher capital costs equal less capital to invest in new aircraft and more growth, and it results in low price-to-earnings ratios.
It's an open-ended question whether or not the big networks can earn their cost of capital over the next full business cycle, even if American and US Airways do merge, which I assume they will. It is clear that a combined American and US Airways will generate higher cash flows and have a lower cost structure with lower capital costs, which in turn will require less revenue per passenger - all else being held constant and relative to remaining non-merged airlines. Moreover, merger synergies can be shared with the consumer in the form of lower fares and a better product. Growth is required to keep unit costs competitive and growth requires competitive fares.
Our analysis concludes that the US airline industry works best - for all stakeholders including the consumer - with three large network airlines. Concentration has increased over 40% (in HHI terms) since 2007 and will increase another 10% if American and US Airways merge. However, this increase must be put into proper context. The 2007 HHI low was an historic low and had to increase for the industry to remain viable. Viable in this sense means the industry covers its cost of capital over a full business cycle.
Industry concentration has been inadequate to cover higher fuel costs and this is why the airlines have been unable to pass along the higher fuel costs that have spiked since 2002 (Exhibit 2). This becomes painfully apparent when real yields - average fare paid per mile - are examined (Exhibit 3).
Even Southwest has been destroying economic value (ROIC-WACC) since 2001. Thus, they acquired AirTran and are buying back stock in an attempt to increase earnings per share and share price.
The airline industry structure (i.e., concentration) dominates much of what airline management can do to maximize firm value. Profits must be high enough to pay down excessive debt, properly invest in competitive assets, and deliver the required rate of return to the owners of the assets. There are exceptions of course, such as Allegiant Air and Spirit Airlines, which are highly profitable because they are young airlines with young and low cost employees.
The Bottom Line: The DOJ's case to block the American and US Airways merger is flawed and represents an incomplete understanding of the economic and financial nature of the airline industry.
In my estimation, the merger works best for the industry and the traveling public, and the merged airline will not raise fares to the level that DOJ predicts. The DOJ's challenge is to properly define the relevant market and make the case that an American and US Airways merger would harm not only American's passengers but also lead to higher average fares in the more broadly defined market which includes the entire domestic market (in city-pair terms) or parts of the domestic market where the big networks compete with each other and the one big low-cost and low-fare airline Southwest. Yes, Southwest is still a low-cost and low-fare airline, at least relative to the network airlines. I'm betting that the DOJ will fail to block the merger, but it likely will force American and US Airways to give up some slots at Reagan National Airport (DCA). There is no doubt that pricing power increases in the industry with this additional merger as domestic concentration (HHI terms) increases to a level that is consistent with moderate concentration, but not the "highly concentrated" level that the DOJ claims.
For these reasons I am advising our clients to buy the airlines on any dips in prices that result from temporary increases in fuel costs related to potential air strikes in Syria.
I recently had an opportunity to debate Joseph M. Alioto, the attorney that filed the first lawsuit to block the American and US Airways merger, on the Larry Kudlow (CNBC) show. This is the same lead attorney that deposed me for 8 hours as an expert witness in his previous attempt to block one of the other big airline mergers.