Japan Airlines Likely to Join Skyteam: A Big Win for Stakeholders

by: Vaughn Cordle, CFA

Reports from various sources are that JAL (OTC:JALSF) will officially sign the deal after it is finally endorsed by new JAL top management that will be inaugurated after the JAL group applies for the application of the Corporate Rehabilitation Law. This could happen perhaps as early as this week. It's interesting to note that the Enterprise Turnaround Inititive Corp of Japan (ETIC) is estimating the annual benefits of joining Delta (NYSE:DAL) and Skyteam to be 17.2 billion yen, or $189 million U.S.

I initially roughed out a $300 million opportunity-cost for JAL if they did not join DAL and included the analysis in a research note to clients in late October last year. Delta's later estimate, if I recall, was in the $400 million range.

The lower number estimated by ETIC takes into account that the airline will be 30% smaller by 2012 and after the restructuring. Interestingly, our initial "first cut" estimate of $210 million, when size adjusted [$300 X .70], is fairly close to the ETIC’s $189 million.

Delta's $280 ($400 x .70) appears to be on the high side but I suspect that the ETIC number underestimates the value of the fully developed alliance benefits. We estimated a 2% net benefit as a percent of revenue, while the ETIC is estimating a 1.3% benefit.

The numbers are based on a top-down estimate based on the different sizes of the alliance networks and can be reasonably supported - qualitatively and quantitatively - when presented to JAL stakeholders. The initial estimates were close enough to make the business case that JAL would likely switch to Delta and Skyteam. Interestingly, very few believed that JAL would leave AMR (AMR) and the OneWorld alliance.

The open-ended question is whether or not the DOT (with DOJ input) will grant anti-trust immunity (ATI) to a joint venture between JAL/DAL/AF. We assume that the DOT will grant ATI for the UAL/CAL/ANA joint venture.

The JAL/AMR/BA joint venture ATI is easier granted because it retains a higher level of competition between the three alliances in the Japanese and U.S. markets. However, I don't buy the AMR argument that JAL will not get anti-trust immunity (ATI) for a joint venture because Skyteam ends up with nearly 60% of the market between the U.S. and Japan.

AMR's core argument is that the DOT will not grant ATI for a JAL/DAL/AF joint venture and that the JAL risks losing a $2 billion package from AMR and OneWorld members. The threat of losing $2 billion in economic benefits is not that important, and may not be required, given a proper restructuring and adequate capital from the ETIC.

The risk to the U.S. and Japanese consumer is that the Japanese government will not agree to Open Skies if the U.S. government does not grant ATI to JAL/DAL/AF.

Clearly having three roughly equal alliances competing in the U.S., the Japanese markets is preferable to two large ones and a small one. However, if the choice is between not having an Open Skies agreement and a lop-sided competitive market, where Star and SkyTeam dominate a much smaller OneWorld, I suspect that the U.S. government will go with the choice that provides the greatest consumer benefit. In other words, an Open Skies agreement is a more important objective than maintaining an optimal balance of competition between three competing alliances that are roughly equal.

Given the importance of Open Skies with Japan, I'm of the opinion that the U.S. will eventually grant ATI immunity to a JAL/DAL/AF joint venture, even if the final result is not an optimal balance of competition between the three alliances in the Pacific.

The DOT is, in theory at least, a non-political entity that focuses exclusively on competitive issues and what's best for the consumer. However, DOT Secretary LaHood works for Obama; therefore, politics is always part of the equation to some degree or another. I suspect this is more so the case with the current Congress and White House.

The bottom line: The U.S. will not want to lose an opportunity to open up one of the most restrictive and largest markets in the world.

The approval process may be contentious and drawn out, but if the Japanese government insists that U.S. ATI approval for a joint venture between JAL/DAL/AF is a condition of Open Skies, the U.S. clearly will be forced to choose which option works best for the consumer. AMR is clearly the loser in this scenario and will end up with only a 6-8% market share in the Japan-U.S. market.

If the DOT/DOJ refuses to grant ATI to JAL/DAL/AF, Delta and JAL still win because important gates and slots in Japan will remain closed to competition. The incumbents are better off without enhanced competition that results in a more open, competitive market between the two countries.

The following is from the Joint Application of All Nippon Airways, Continental Airlines and United Airlines that was filed before the DOT on December 2009:

Open Skies, which is linked to the granting of antitrust immunity to the Joint Applicants will bring substantial benefits to U.S. - Japan air travelers and shippers, includes:

    • the freedom for airlines of both countries to operate more flights;
    • a wider range of service options at a lower price;
    • the freedom for airlines to price services in response to consumer demand without government interference;
    • more intense competition among airlines and alliances operating U.S.-Japan/Asia service;
    • expansion of the number of U.S. carrier slots at Tokyo's Narita Airport and new access to Tokyo's Haneda Airport for U.S. carriers; and
    • the opportunity for airlines to form metal-neutral joint ventures that can be immunized from U.S. antitrust laws.
In recent antitrust-immunity cases, the DOT has approved applications where joint applicants held a larger share of service in the affected regions than ANA / Continental (NYSE:CAL) / United's (UAUA) combined share of U.S.-Asia service.

Disclosure: No postions held in any of the airlines metioned in the article