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By Paul Mifsud / Carlos Bonilla / Vaughn Cordle, CFA

The counter to Crandall and Oberstar

A number of themes keep surfacing from different participants in this discussion.

The first theme (see Bob Crandall) is that excess capacity doesn't exist. We want to be clear that we are not using this term in a subjective manner, but rather that we are working from a quantifiable definition. In the airline industry excess capacity is capacity over-and-above the level compatible with the industry earning its cost of capital over a full business cycle.

To earn its cost of capital over the most recent business cycle (2000-2009), the industry would have had to raise fares for the average seat by 11%. Calculating consumer demand response over this decade (as prices rise, consumer demand falls, known as the price elasticity) we see that this price level is consistent with 7% lower capacity (holding load factors constant). Hence, the definition of excess capacity.

The second theme (see both Congressman Oberstar’s and Bob Crandall’s comments) is that more mergers cannot be counted on to remedy the industry’s ills. For reasons we laid out in our white paper we believe that absent mergers the only alternative is the slow liquidation we are already witnessing.

Allowing one or more large network airlines to fail – the implicit alternative if mergers are taken off the table -- is not a practical solution for the stakeholders of those airlines and it doesn't solve the industry’s problem of inadequate profitability and severely damaged balance sheets.

This opposition to mergers is based on three premises

  • The first is the mergers don't always work. We agree, but would argue that it is not government’s job to second guess commercial thinking. We would, however, note that the likelihood of success is reduced if the merger is delayed or if the approval requires the shedding of too many assets.

  • The second is that mergers don’t create value in and of themselves but only cannibalize market share. In fact, mergers which better align carriers with both national and global markets do create value, particularly in an era of global alliances.

  • The third is that mergers result in "fewer customer alternatives" and are harmful for consumers. This is proved wrong by the large numbers of domestic and international competitors that will remain. Bob makes the point that low cost carriers (LCCs) will continue to "aggressively" compete against the networks. While this is true, we would add that given the LCC market penetration we anticipate over the next several years, network pricing power will be reduced even further. This supports the need for additional [network] mergers, so as to increase industry pricing power. The system can only profitably support three large networks, not four or five.

Bob Crandall did talk of the need to "Negotiate a level playing field internationally." This was the AA (UAUA) mantra in Crandall's day. That argument is obsolete. Now there is Open Skies with Europe, Japan, India and much of the rest of the world. This administration, like the three before, has embraced this policy. Is he suggesting this policy be rescinded, ATI be removed and alliances disbanded? We will argue that the US network carriers have neither the capital nor clout to unilaterally provide for this nation's need for global access.

Congressman Oberstar is concerned about small communities that will lose air service. We argue that this will particularly be the case if industry consolidation is precluded. It takes viable and healthy large network airlines to serve small markets. LCCs have shown little interest in providing this service.

Finally Congressman Oberstar believes that the Delta (DAL) /Northwest merger created an impetus for additional mergers in the industry. We believe that additional mergers are the result of the same pressures that led to the Delta/Northwest merger.

While the consumer has benefited from the fall in airfares, the industry has suffered. In today's dollars, the industry lost $70 billion over the last decade. Other stakeholders, however, must also be considered, including those small communities and the capital providers. We have grown so used to this industry losing billions of dollars year after year that we have become inured to the threat those losses pose to the service we want. If something cannot continue forever, it won't.

There are areas we agree on. For example, we agree that updating our infrastructure is a valid goal, but we'll note that it is far in the future before it can be achieved.

Mergers are not the ideal solution, but are better than the alternative, which is a continuation of the downward spiral in product quality and viability and the loss of even more small market services.

Paul Mifsud, an airline political strategist and government affairs expert in private practice, focuses on aviation alliances and metal neutral joint ventures. Formerly vice president, Government & Legal Affairs, USA, for KLM Royal Dutch Airlines. He was named 2008 Transportation Lawyer of the Year by the Federal Bar Association and received the Order of Oranj-Nassau (Officer) on behalf of the Queen of the Netherlands. mailto:pmifsud@earthlink.net

Carlos E. Bonilla is managing partner and chief economist at AirlineForecasts, LLC. A former senior vice president with Washington Group, Bonilla has represented clients before the U.S. Congress and other parts of the Federal government. From 2001 to 2003 he served on the White House's National Economic Council as Special Assistant to the President for Economic Policy, where he held the aviation and labor portfolios and was part of the tax policy team. Prior to that he served as senior economist for the U.S. Congress House Budget Committee and as tax policy adviser for the chairman. Bonilla is on the board of directors of Mesa Air Group serves on its Audit Committee. mailto:carlos@airlineforecasts.com.

Disclosure: No positions held in any of the airline stocks

Source: Opposition to Airline Mergers Is Based on Three Premises