Delta/Northwest: Evaluating Company Performance in a Dysfunctional Industry

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 his 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 that 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.

... its financial adviser, the Blackstone Group (BX), that 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.

DOES 2+2=2?

My articles published on Seeking Alpha 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 a 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 firm 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 airlines is needed to support my assumption that 2+2=2 in the case of a DAL-NWA merger.

THE DOWNSIDE OF AIRLINE MERGERS

One 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 cost

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?

Comments

[airbusdriver]

I think the root of the problems surrounding airlines is that the Government cannot decide if the industry is an infrastructure or if its a free-market business system. The business communities of many cities depend on regular, reliable air service. When hub status is threatened or the local hometown airline faces possible liquidation watch the politicians come out of the woodwork to protect "their" airline (as if it were a government entity) Of course politician want their constituencies to have cheap airfares so they offer bribes in the form of tax incentives, etc to discount carriers to keep fares (and airline profits) low. In addition, its hard to think of an industry that is so dependent on the Federal Government for its infrastructure. Airports and air traffic controllers are all employees of the government and not controlled by the industry that depends on them. We all want cheap fares, hourly flights to our destination, and onboard meals (not to mention a level of safety unequalled in any other form of transportation)- we just dont want to pay for it. So what is our air transportation system - infrastructure or a free market system?

[Waves]

Great article! I wish our CEO understood these concepts. As a pilot for Delta Air Lines Airlines for nearly 20 years, and my wife a 20 year DAL FA, we were unfortunate victims of (more) mismanagement during the Pam Am debacle. My 4 year degree in airline management doesn't make me an expert, but it certainly gives me a better understanding of how the industry could be run differently.

Back in the early 90's, under the control of Ron Allen, Delta purchased parts of a dying carrier for hundreds of millions of dollars more than it was worth. It was a total disaster in every way, especially from the Delta employee's standpoint. Short term, we ended up with about 6000 Pam Am employees, a handful of their trashed airplanes, and some of their route structure. Long term, we ended up with about 6000 employees and their multiple class action law suits, NO airplanes, and we abandoned much of their route structure. What a deal! Pam Am employees were integrated into our senority list, but some felt that they didn't get enough from the deal. So the law suits flew. It literally took my wife and I about 3 years just to get back to our original date of hire senority numbers. Shortly after this wonderful merger (called an acquistion), Delta started furloughing pilots for the first time in it's history (some will say second time). As it turned out, we had Pam Am pilots flying Delta airplanes, while many Delta pilots got furloughed. In more recent times, due mostly to mismanagement, the company was dragged into a bankruptcy. All of the employees ended up with huge compensation cuts and work rule changes, all the while the previous management walked away with wheel barrels full of money (Mullin & Associates). As a result of this, it has been estimated by some that the pilot work force took nearly 56% in compensation hits including the loss of our pensions. Our pensions were something we had previously bargained for in lieu of more pay. Sooooo, many news articles seem to indicate that the Delta pilots are in favor of a merger with NorthWest. I can't imagine where they come up with such nonsense.

By the way, don't be fooled by the misnomer "de-regulation.&q... The airline industry is one of the most highly regulated and taxed industries in the US. I've been told that it is taxed more heavily than the alcohol, tobacco, & firearm industries combined. Also, the airline industry dosen't make a move without many government entities approval. In reality, "de-regulation&qu... meant the subsidy money stopped (or slowed down to almost nothing), but the regulation continued.

The last merger disaster, the employees ended up with a t-shirt that said, "Above & Beyond." If we merge with NW and lose our shirts again, I sure hope we get another one of those great t-shirts for a replacement!

[Victor J. Cook, Jr.]

Airbusdriver,

“So what is our air transportation system - infrastructure or a free market system?” Both. That’s the problem.

On the demand side, in the competition for customers, it’s a free market system. But as you say, on the supply side it’s a quasi-regulated utility. It’s the “quasi” part that’s the biggest disconnect between the demand and supply sides of this market.

What’s the solution? I don’t know. I’m just trying to understand the consequences of the deal by looking at it through the lens of enterprise marketing.

Thank you for your comments.

~V

[Victor J. Cook, Jr.]

Waves,

Your inside view on the personal impact of Delta’s past deals and your insight on the industry are really valuable.

It is strange that we use the term “de-regulation” as if it were a fact. When it works only on the demand side of the market.

I share your wish that Mr. Anderson paid more attention to the concept of value-sales differentials in assessing long-run performance.

Maybe this will get his attention:

6/30/94

DAL’s value share = 16.8%. Revenue = 17.7%: -0.9 points.

2/29/08

DAL’s value share = 13.9%. Revenue = 16.5%: -2.9 points.

6/30/94

LUV’s value share = 23.0%. Revenue = 4.0%: +19.0 points.

2/29/08

LUV’s value share = 34.3%. Rrevenue = 8.8%: +25.5 points.

Conclusion: over the long-run, large scale mergers have not created more relative shareholder value in the domestic airline market.

Thank you for your comments.

~V

[hubogart1]

Things are no better in the Canadian airline market. In 1987 the Canadian market was opened to what was termed “free competition.” Since then, the industry has been beset with what one commentator describes as financial crisis, dislocation, and potential safety hazards. Yet Ottawa has proposed further liberalization in markets, including enhanced deregulation and greater privatization.

One new airline, Roots Air, was in business for just six weeks. Another, Jetsgo, lasted two-and-one-half years. From 1987 to 2005, In the same period, Canadian Airlines, Wardair, Greyhound Air, Royal Air, Canada 3000, Vistajet, Intair, Quebec Air, City Express all flew and landed forever. Canadian airlines have now lost more money than they have made since the first powered flight in Canada in 1909. Consumers have seen benefits in the form of some low fares. Overall, however, the cost of flying, which includes new taxes and user fees, has grown since 1992 by 100 percent. This is four times as fast as average consumer prices have risen.

Increased competition has proved to be at best a mixed blessing for Canadian airlines. The interaction of easy entry for new start-ups and the hunger for large profits for those firms able to achieve a critical mass of destinations and passengers has rendered the Canadian airline industry into a scrap yard

These CEO quotes add spice to the mix:

"I've maintained for a long time that Canada is only large enough to sustain two significant carriers." Clive Beddoe, CEO of WestJet, March 12, 2005. When WestJet started operations in 1996, there were at least 5 airlines larger than itself servicing the Canadian domestic market. Now that he runs the second-largest airline in Canada, Beddoe figures it's time to close the doors to the party.

"You can't produce something for a buck and sell it for 75 cents, day in and day out." Michel Leblanc, CEO of 4 defunct airlines (Intair, Royal, Canada3000, and most recently Jetsgo), commenting on Air Canada's financial difficulties, April 2003.

"We have a cost structure to be effective, profitable competition." Michel Leblanc, launch of Jetsgo, June 2002.

"I do not have the same command of the U.S. market as I did of the Canadian market." Angus Kinnear, who piloted Canada3000 into bankruptcy in November 2001, then moved to Pennsylvania to start a new airline ingeniously called USA3000. Amazingly, USA3000 is still in business, so perhaps it's a good thing Kinnear's U.S. experience was so limited.

"The industry is always in the grip of its dumbest competitors." Robert Crandall, former CEO of American Airlines, 1992.

"How do you become a millionaire? Become a billionaire, then buy an airline." Richard Branson, CEO of Virgin Airlines.

"Recession is when you tighten your belt. Depression is when you have no belt to tighten. When you have no trousers, you are in the airline business." Adam Thompson, former CEO of British Caledonian Airways. (Stanford, 2005).


Stanford, J. In the Ditch Again. No.97. (2005, March 14). Facts from the fringe. Retrieved March 12, 2008, from www.caw.ca/news/factsf...

[Independent E.G.]

Wave, Lisa and everybody else on this wagon(because the fuel cost is going up maybe you should get more people invest in railroads like those big investors):
Cheering such comments will only help the airlines' stock price down. Who benefit from a low stock price of your airlines? Not airline employees, not airlines shareholders, certainly not consumers. You got it? When oil goes up, airlines stock goes down, so does auto and many other industries related to them. High oil price will eventually drive down the wholl economy if you don't put a brake or find alternatives. 911 did not kill airlines and the whole economy they serve. Are you going let oil do the job? No way! Not for some "smart" investors and oil manipulators who believe they are so "smart" or so "powerful"! When and how can we find a solution to solve the "OIL" problem? How are we contributing to do the right thing?