Over the 30 years since airline "de-regulation" Delta (NYSE: DAL) management spent $2.35 on M&A for every $1 worth of value they created. Northwest (NYSE: NWA) spent $1.61 for every $1 worth of value created. Southwest (NYSE: LUV) spent just $0.03 on M&A for every $1 worth of value it created. For the details behind these numbers see my last post: Delta/Northwest: Evaluating Company Performance in a Dysfunctional Industry.VALUE MIGRATION
The preface to Adrian Slywotzky's 1996 book Value Migration begins with this declaration:
Value Migration describes an outside-in approach to strategy. It begins with the customer and works its way back. It requires thinking from the environment back into the company's capabilities and direction.
No surprise Mr. Slywotsky devotes an entire chapter to domestic airlines. In "Migration to a No-Profit Industry" he points to a "hidden competitive advantage" that has become the standard of the day:
Ironically, these highly leveraged carriers had a hidden source of competitive advantage - bankruptcy court. While some carriers … failed completely, the courts often allowed bankrupt carriers to continue operating while they restructured. In 1983, Continental Airlines sought protection and temporarily shut down. A few days later, when it reopened, Lorenzo had voided union contracts, fired more than half the workforce, and dropped more than half his routes, lowering costs significantly (p. 125).
Also, no surprise Mr. Slywotsky had no idea "What if anything, will break the pattern toward zero profits" in the airline industry. I have a few ideas on how to do just that. But, first I offer a new perspective on Competing for Customers and Capital in this dysfunctional industry that gives some support to those ideas.TWO MARKETS, TWO METRICS
Airline companies, like those in every other industry, compete in two separate but equally important markets. As result of the profound differences in how they operate, the markets for capital and customers are described with entirely different theories. Their performance is based on entirely different metrics. And the gap between the two is big enough to drive an 18-wheeler through.
If there is one take-away from this story it's this:
To understand how the markets
for customers & capital interact
you must measure that interaction.
A company's stock market performance is measured by its market cap. Its performance in consumer markets is measured by its sales revenues. Table 1 compares the performance of DAL with NWA and LUV over the period from the close of the 2nd quarter 1994 through the close of the 4th quarter 2007. The starting quarter in this series is the first one in which data were available for all eight domestic airlines included in this analysis.
The first row in this table reports the market value of the three companies and the group for the first and last quarter in the series, followed by the percentage changes in each. The second row reports the sales revenues in the same way.
What can one conclude from the market value data in Table 1? For one thing, all three carriers, as well as the group, appear to have performed quite well. In particular, NWA appears to be a standout with a 237% appreciation in its market cap. Almost double LUV's value creation over the period. Of course, the picture isn't as rosy when you think back to the opening comment in this article: NWA spent $1.61 on M&A for every $1 of value it created.
What can one conclude from the sales revenue data in this table? Again, all three airlines appear to have done well. Especially noteworthy here is LUV's 277% increase in sales revenue. But then again, if these revenues were adjusted for inflation, the result would be far less rosy.
The corrections needed to present an "adjusted" picture of performance are easy to make. But we didn't know till now is how to capture the performance in these two markets with a single metric.TWO MARKETS, ONE METRIC
Everyone is accustomed to measuring a company's market share of sales revenue. Before now, few have ever considered measuring a company's share of market value. Measuring both share of value and share of revenue simultaneously leads to the creation of a single metric that captures the interaction between the market for capital and customers.
Consider Table 2 where market shares of value and revenue are presented for the 2nd quarter of 1994 and the 4th quarter of 2007.
In June 1994 DAL created 17.1% of the group's $16.0 billion market value [from Table 1]. In the same quarter DAL generated 17.8% of the group's $16.6 billion in sales revenues [from Table 1]. The difference between DAL's share of value and its share of revenues was -0.7 points. By the close of the 4th quarter 2007 this difference had grown to -1.9 points. NWA's value-revenue differences went from -5.6 to +1.6 points over the period. While LUV's differences went from +19.5 to +24.3 points.
There were 53 quarters of data between the beginning and end of the series reported in the Tables above. Almost 14 years. How do you capture the effects of the value-revenue differences between these two points?
One way is to calculate the standard deviation of the value-revenue differences over the entire series. This is a measure of volatility commonly used in finance to create discounted rates of return. The standard deviation in DAL's value-revenue differences over the 55 quarters was 6.9 points. The standard deviation in NWA's value-revenue differences was 5.2. LUV's standard deviation was 21.2. Call these a measure of the risk associated with each company's relative performance in both capital and customer markets.
Dividing the value-revenue differences in each period by their risk yields the "risk-adjusted" differences. DAL's risk-adjusted differences went from -0.1 to -0.3; NWA's went from -1.1 to +0.3; LUV's went from +0.9 to +1.1 over the 55 quarters. What do these numbers mean?
The risk-adjusted differential [RAD] is a measure of the interactions between capital and customer markets. In technical terms, within a strategic group, RAD is a standard normal variable with mean zero and standard deviation one. If you are interested in the theory and analytical details behind this metric you can find out in the audio slide show Y'all Buckle That Seat Belt. It runs about 18 minutes.
Think of RAD as a control variable. Companies with risk-adjusted differentials greater than zero are value creators. Those with RADs less than zero experience value migration. Since the standard deviation is one, a company that posts RADs greater that +2.0 is creating significantly more value than its peers. A company that posts RADs less than -2.0 is experiencing significant value migration.DELTA'S ERRATIC GLIDE
Chart 1 reports the value creation & migration pattern for Delta Air Lines over the same 55 quarters.
Through the first 29 quarters ending in June 2001 Delta's pattern of value creation and migration was erratic, reaching a high point of +1.6 in September 1999. Delta clearly was tipped into decline by the attacks on the World Trade Center and the Pentagon. And the company continued to shed value right through December 2007.NORTHWEST'S LONG SLIDE
Chart 2 is a plot of Northwest's value creation and migration in each quarter. The series opens with three negative RADs beginning with the 2nd quarter of 1994. Then the company moves through a run of nine quarters of value creation peaking at +1.7 in December 1995.
In June 1997 NWA entered into a period of continuous value migration that lasted through the 4th quarter of 2006. This value migration had nothing to do with the attacks on the World Trade Center and the Pentagon. Investors continued to shift progressively more value away from NWA for years, finally culminating in bankruptcy.SOUTHWEST'S HIGH RIDE
As Chart 3 shows, the value that migrated from its competitors went largely to Southwest. The company posted positive risk-adjusted differentials in every one of the 55 quarters in this study.
Beginning in March 2000, Southwest posted value creation numbers greater than 1.0 in every quarter but March 2007. This performance is extraordinary. Chart 4 shows why.
This is a plot of the distribution of risk-adjusted differentials for a large sample of companies in the study of Marketing's Impact on Firm Value published by the Marketing Science Institute in 2003. Only 12 of the 337 companies in this study posted risk-adjusted differentials greater than +2.0 in all ten years between 1991 and 2000. Southwest Airlines did that for 18 quarters during, arguably the most turbulent period in domestic airline history.RECONFIGURE OR RE-REGULATE
Given this history, and the failure of virtually all large scale mergers, there are two ways to fix the airlines.
One is to break them up and reconfigure the parts. For example, spin off Northwest's Asian routes along with Delta's European routes and combine them in a public company that would offer formidable competition to Air France KLM, British Airways, and Lufthansa. Since all the air craft in this new international airline would be big, this reconfiguration might go a long way to solving the union's seniority problem. Then the domestic routes of both companies not required for international operations could be merged in a point-to-point/multiple-hub network. Then the aircraft, routes, landing rights, and gates that don't fit the reconfigured domestic network could be auctioned off to the highest bidders. No doubt Southwest would buy more than a few of these and hire most of their employees too.
What's the other way to fix the airlines? Reregulate the supply side of the industry. What do you think of these options?
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.