JAL's High-Stakes Game with American and Delta

by: Vaughn Cordle, CFA
Regarding the proposed joint venture between Japan Airlines (OTC:JALSY) and Delta (NYSE:DAL), American's reply to Virgin highlights WHY they are so desperate to hang onto JAL. If JAL goes with Delta/Air France, the new grouping, when combine with United/ANA/Continental, will control 60% of the US-Japan market, which leaves oneworld with just 6%.
Given the change in seat market share – based on American's (AMR) numbers and our own work – this suggests that JAL benefits more with a DAL/AF matchup. Of course, the benefits must be weighed against switching costs, which include management in addition to financial costs.
Reuters reported today that Japan Airlines President Haruka Nishimatsu said that it looks more natural to stay with the Oneworld airline alliance at the moment rather than defect to a rival group. Of course, Nishimatsu's statement makes perfect sense; however, it also helps in negotiating with DAL/AF, which could make a hefty equity investment.
AMR is smart to partner with [private equity firm] TPG, but I'm not convinced that TPG will choose to risk too much equity given what Japan-US open skies will likely do to fares and earnings. The only way to save JAL is to reduce underfunded pension plans (over USD $3 billion) and the cost of debt. Without a labor cost reduction, the company is a big, black sinkhole that will destroy any equity investment.
Reports suggest that the retirees are willing to accept some level of cuts. Therefore, the government will either have to force the issue and make changes to current funding requirements or subsidize payments to ease the JAL's financial burden.
It's an open question whether or not the government will go far enough with the restructuring of JAL, and it's tough to value an equity stake without knowing the details of the restructuring, especially as it relates to pension funding. For this reason, TPG will likely not make a commitment until the restructuring is complete, which should occur within 60 days, or so the press reports say.
In terms of a Delta (DAL) or AMR equity stake in JAL, it must first make financial sense, and the financial case cannot be made without knowing what the labor and debt costs will be in the future. Hence, the need to know how deep the restructuring goes before a proper valuation of JAL can be made. Air France/KLM and other SkyTeam members also have a strong incentive in bringing JAL into the Skyteam network. The financial and network benefits cannot not be ignored, especially if JAL equity can be bought at an attractive price.
If I were in the shoes of JAL executives and government officials, I would pit AMR against DAL to get the highest EQUITY investment. Why? Because this reduces the amount of government subsidies and increases the riskiest component of capital to non-Japanese entities, entities that have a significant incentive to control feed into Japan and throughout Asia from gates at Narita and Haneda.
It's a high stakes poker game for United (UAUA), All Nippon (OTCPK:ALNPY), JAL, AF/KLM (OTCPK:AFLYY), AMR, and DAL. Each has a different hand to play and the stake is a function of JAL's restructuring and whether or not it decides to jump to Skyteam.