Why Airline Mergers Don't Work 16 comments
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Ever wonder why over the last 30 years Southwest Airlines managers (LUV) spent only $0.03 on mergers and acquisitions for every $1.00 of shareholder value they created? By comparison, Delta management (DAL) spent $2.35 for every $1.00 of value they created. And Northwest (NWA) spent $1.61 on M&A for every value dollar they created. In Louisiana we have a name for this kind of strategy. It's called jumping over a dollar to get to a nickel.
Does Herb Kelleher, former CEO of Southwest Airlines, know something about creating shareholder value that other CEOs don’t know? Perhaps he understands that in the domestic airline market earnings don’t necessarily increase with market share. Or in economics speak, changes in earnings with respect to a changes in market share may be very inelastic. Because the demand for air travel is very price elastic.
BELIEVE IT OR NOT
Believe it or not, elasticity is one of the most powerful metrics in business. In a single number, elasticity pins to the wall the relationship between percent changes in price and quantity. In theory, if the percent change in quantity purchased by customers is greater than the percent change in price paid, demand is elastic. Alternatively, if the percent change in quantity is less than the percent change in price, demand is inelastic.
Then why does one rarely see price elasticity numbers used in industry analyses? In the real world, price and quantity data are notoriously ill behaved. That’s why your Econ 101 professor couldn’t use real numbers in his or her hand-drawn demand schedules. The axes on the graphs were always labeled p1, p2 and q1, q2. Remember?
It is, however, possible to get at the relationship between price and quantity in the real world if you have access to a large base of precise data, an in-depth knowledge of econometric methods and lots of time on your hands. About the only people I know with these resources are doctoral students in economics. Therefore, I was not surprised to find exactly what I was looking for in Jong-Ho Kim’s 2006 dissertation on “Price Dispersion in the Airline Industry: The Effect of Industry Elasticity on Cross-Price Elasticity.” You can buy and download a copy of it from University Microfilms.
Dr. Kim based his research on data from the Department of Transportation’s Origin and Destination Survey from the 1st quarter 1989 through the 4th quarter 1997. This is a 10% random sample of all tickets issued in the U.S. In his dissertation Dr. Kim hypothesized that:
Southwest’s entry provides a natural setting for investigating how travelers respond to the changes in air fares. More specifically, we can make full use of variations in relative prices among airlines and the revenue shares of airlines by focusing on Southwest entry routes. Consequently, we can focus on coach class travel in those markets where Southwest entered and has been serving since then. … [R]ival airlines adjust their average fares upon Southwest’s entry and remain relatively constant in ensuing quarters (page 12).
In that study, when Southwest entered a new market (city-pair), estimated price elasticity ranged from a high of -2.6 (with only one other competitor), to -1.63 (with four other competitors), to a low of -1.1 (with 7 other competitors). All of these estimates were statistically significant.
WHAT HERB KNOWS
I think Herb Kelleher understands – as no sitting airline CEOs seems to – a fundamental principle about competition. Given:
- a capital intensive industry,
- with few meaningful scale efficiencies,
- delivering a highly perishable product,
- within a partly regulated infrastructure,
- operated by talented professionals,
- in a very price sensitive market, with
- free entry and court protected exit,
shareholder value can best be created organically. How? By maximizing the satisfaction of employees, passengers, suppliers, partners, and shareholders. Here is the corollary to that fundamental principle:
In airlines, building market share through mergers short circuits the creation of satisfied stakeholders.
The purpose of this article is to examine why mergers don’t work today in domestic airlines, using the DAL/NWA merger as an example.
EARNINGS ELASTICITY
Elasticity can be expressed for any pair of variables. Take earnings elasticity for example. It’s the percent change in earnings divided by the percent change in market share. Here’s what happens. Cutting price leads to an increase in market share. But it also leads to a decrease in earnings. Theoretically, in a price elastic market with few scale efficiencies and a perishable product, earnings and market share are not happy partners.
Suppose the management of a hypothetical airline with 20% of all domestic revenues decides it would be good for earnings if they increased share of revenues to 30%. The quickest way to do that is to merge with a company that has 10% of the market. In a matter of months its market share increases by 50%. Bingo!
But in a highly price sensitive market for a perishable product, earnings may increase only a little, say about 6%. The ratio of the percent change in earnings to the percent change in market share (0.06/0.50) is just 0.12. In this hypothetical case, earnings are highly inelastic with respect to market share. Is this is a bad thing? Yes. It’s a classic case of jumping over a dollar to get to a nickel.
MAXIMUM EARNINGS MARKET SHARE
To test the hypothesis that the DAL/NWA merger won’t be good for shareholders I ran a maximum earnings market share analysis on the combined companies in a strategic group with seven other domestic airlines for the calendar year 2007.
In a nutshell, maximum earnings occur when EBITDA generated by the last share point exactly equals the cost of acquiring it. I worked out the details of how to calculate maximum earnings share in my book Competing for Customers and Capital. I applied the results to eight domestic airlines in the 1st quarter of 2003 when only two of them weren’t losing money. If you want to get an overview of that analysis see my audio slide show The Rule of Maximum Earnings. It’s short and no walk in the park.
Table 1 sets the stage for this analysis with each carrier’s share of the combined $114.7 billion revenues in calendar 2007. American Airlines (AMR) captured 20.0% of total revenue. UAL Corp (UAUA) walked away with 17.6%; Delta and NWA got 16.7% and 10.9% respectively.
Continental (CAL) generated 12.4%; US Airways (LCC) had 10.2%; followed by Southwest with 8.6%; Jet Blue (JBLU) at 2.5%; and Frontier (FRNT) with 1.2% of group revenues.
Combined, DAL and NWA actually captured 27.6% of total revenues. Since both carriers were financially cleansed by bankruptcy court, what is your guess about their potential to maximize earnings? The answer appears in Chart 1.
Combining DAL & NWA revenue and costs as they appeared on their individual income statements produced an actual 2007 market share of 27.6% of group revenues. The vertical axis on this chart is the marginal cost (the red schedule) as well as marginal earnings (the green schedule) per share point.
Marginal costs continuously increase reflecting the underlying reality of competition. The marginal earnings schedule is constant, reflecting the assumption that there would be no major changes in the scale of combined operations. Under this assumption, maximum earnings market share is 26.7% of group revenues. If synergies were to be found after merging, the effect would be to push actual and maximum earnings market share even closer together. In either event, the combined companies come within no more than 90 basis points of realizing maximum earnings. That’s the good news.
TOTAL EARNINGS ALMOST AS FLAT
The bad news is the total earnings schedule is almost as flat at the marginal earnings schedule. Chart 2 tells the story.
In Chart 2 market share appears on the horizontal axis ranging from 20% through 35% of group revenue. In this chart, total earnings appear on the vertical axis ranging from zero to $8 billion. There is just a $10 million difference between actual and maximum earnings.
A DOUBLE WHAMMY
I began this article by pointing to the painful price elasticity that exists in this capital intensive market for perishable products. For carriers competing with Southwest in the same city-pair, reported price elasticities range from -1.1 upwards to -2.6 depending on the number of competitors in the market. If you’re the only other carrier in a market with a 10% price premium in a city-pair boarding 1,000 passengers a day, 260 of them likely will switch to Southwest. So you have to match LUV’s price. If you’re competing for 10,000 passengers a day in a market with four other carriers, including Southwest, and you don’t match LUV’s price, 1,630 of them likely will switch to Southwest. So, you’ve still got to match its price.
But, just as bad, you’re likely to be facing a highly inelastic earnings/share schedule. In the DAL/NWA example presented in this analysis, there is just a $30 million difference between total earnings at a 20% share of revenues ($3.56 billion) and a 35% share of revenues ($3.59 billion). That represents just a 0.8% increase in EBITDA across a spread from 20 to 32.5 revenue share points, a 63% increase. Without extraordinary synergies, a merged DAL/NWA might be facing an earnings/share elasticity of just a little over 0.01. Looks just like a double whammy.
What’s an airline CEO to do in this situation? Reconfigure the business model. Is there a road-map on how to do that? Yes, it’s called The Momentum Effect by Professor J.C. Larreche of INSEAD. It’s going to be published in hard copy by Wharton next month.
Full disclosure: I recommend this book as a co-author with a long history of collaboration.
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This article has 16 comments:
1) They only fly 737's. They keep these 737's low tech. They disable autothrottles, autobrakes, and they don't use "glass cockpit" instruments - instead they project old-style round instruments on the modern glass displays. This saves on pilot training costs. It you don't use something, you don't break it, right? Having only one aircraft cuts down on parts inventory and saves on mechanic training as well.
2) Southwest runs the airline like a vulture - circle overhead, and look for easy prey. When a profitable route (that another carrier has built up) swoop in and cherry-pick the low-hanging fruit. Therefore, they only operate on profitable routes.
3) Southwest does NOT operate using a hub and spoke system - this saves cost by eliminating inefficiencies where aircraft have to sit on the ground to wait for connecting flights.
4) Southwest religiously hedges more fuel than any other carrier.
5) Southwest has avoided complex and costly international market expansion other than Mexico, whose flight rules are similar to the USA.
It is not rocket science how they turn a profit. It doesn't require a complex business analysis. They even manage to have the highest pilot pay (by relative comparison based on aircraft size) in the industry while still turning a profit.
If Southwest did not have their fuel hedged, you would see them posting losses and slashing and burning labor contracts just like every other carrier.
I agree with most of what you say in this comment. Though I don’t understand why you add such a negative twist to the way you say it.
For example, saying that “Southwest runs the airline like a vulture” seems to be condemning management for “only operating on profitable routes.” If the another airline did build up the route, why did they sell it? You make it sound like being successful is a shame.
And when you say “If Southwest did not have their fuel hedged, you would see them posting loss …” you speak without full knowledge of the facts. For example, here are the results of their fuel hedging program in the last two years. The gains from hedging totaled $1,260 million. The Before Tax net totaled $1,848 million.
LUV Gains BT Net Difference
2007 $ 585 $1,058 $473
2006 $ 675 $ 790 $115
Totals $1,260 $1,848 $588
The difference of $588 million would have been realized without the hedging gains. Though this would have been a real drag on their earnings.
Even if it were true that fuel hedging was the only reason for their profitability, you're taking a pretty narrow view of their overall operations. For example, if they didn’t have a strong balance sheet they couldn’t run the hedging program. Isn’t that why the other carriers fail to hedge?
Finally, my analysis isn’t about why Southwest turns a profit. It’s about why a Delta/Northwest merger won’t work. And it seems to me that question does require a complex business analysis.
Thanks for you comments,
~V
not creating any new revenue. So what they need to do is find ways to make money and stop cutting back to bare bones, making less people do more work for less money while they get bonuses for wrecking the airline, unless they're going to take less money and do more (PHYSICAL work). Now we know that's not gonna happen. Bottom line is, even if you cut back to bare bones, you're not making money. You're saving what you already have. Create new ways to make more money. This is how your profit margin goes up.
Took all of 1 minute to verify that on Wikipedia.
Makes me wonder what other parts of your article are so thoroughly researched.
Exactly. Creating new ways to make more money so your profit margin goes up is what Professor Larreche's book on "The Momentum Effect" is all about.
Thanks for your comment.
~V
Thanks for reminding me Herb Kelleher no longer is the sitting CEO. I expect he always will be their CEO in spirit, even as he continues to serve as Board Chairman.
~V
hedges. the stock has no upside potential. because of the number of shares outstanding. they also have no intl routeswhere future growth is.
cal is the best bet for airlines and book huge profits if the price of oil goes down a little
Fuel hedging is not the only reason makes money. See my response to the comments of "analysisguy" at the beginning of this series. I also would note the comment directly above by User 167840: "... Southwest employees are valued and respected!"
I find your merger analysis interesting but while it represents a very technical approach, I think it doesn't fully reflect the advantages of larger share of market capacity/price controls and some flexibility that comes with it. After all, if I remember correctly, one of the most-touted advantages for the merger is to take some of the domestic capacity out and move it to international markets (while benefiting the international routes through an even larger domestic network). I agree with you that this merger is not about achieving economies of scale on the cost side as much as it is about the revenue potential but I disagree with your logic to the extent that it doesn't account for the network re-alignment and capacity management. Your examples are very helpful but maybe they only take us half-way there.
You’re right, my analysis “doesn't account for the network re-alignment and capacity management.” Even if I had access to the necessary data, I’m not qualified to do that analysis without the help of airline specialists. But, there’s another way in which my analysis may not “fully reflect the advantages of larger share of market capacity.” It is a static, single period analysis. If the air travel market were growing at a fast clip, the results could be quite different.
Thanks for your comments.
~V
Thanks for your article. It definitely discussed airline mergers in a way that I hadn't thought of previously. I have a couple of issues to raise to you with your article.
First, use Southwest to compare if growing by merger is the best way. However it is apparent that much of their "profitability" is accounting shenanigans. LUV depreciates their aircraft over nearly twice as long of a period than the industry standard (28.5 years vs. 15 years). So they can report less depreciation expenses right now, but as they start retiring aircraft they are going to take large losses that they will probably write off as one-time expenses... shenanigans!
Also, since they are still in growth mode, their deferred expenses have grown to become much larger than the industry average. Hiding expenses through new capital expenses is earnings manipulation.
While legal, the time will come when LUV's growth will slow and they will have to pay for their "play." LUV recently announced that they are scaling back on their growth plans, I think we will start to see the effect of their mounting deferred expenses in the next couple of years.
In short, I think your analysis of airline mergers is very insightful, I just don’t think that you should compare their success/failure with a Southwest model that is not reporting the full picture.
I welcome your comments.
Tim
Chart 3 in my previous post “Fixing the Airlines: Reconfigure or Regulate” shows a 55 quarter time series of Southwest’s risk-adjusted differentials. Its RADs peaked at +3.5 in March, 2003 and closed at +1.2 in December, 2007. Or, the company’s risk-adjusted share of value fell from 3.5 to 1.2 standard deviations above the expectation. Over the same period Southwest’s enterprise marketing risk was 21.2 compared with a large-sample, cross-industry mean of 6.6.
In short, LUV’s risk-adjusted value shares dropped by nearly two-thirds in a period when its risk was three times greater than expectations. LUV’s share price peaked at $19.40 on October 27, 2003 and closed at $12.75 on March 31, 2008.
If Southwest’s management applied accounting "shenanigans" to its financial statements over the years, investors seem already to have factored them into its share price. It appears you have identified two of them. Of course, there were other powerful forces at work in their competition for customers and capital that had a huge effect on their stock price. Among them was the “financial cleansing” of competitors’ balance sheets by the bankruptcy courts.
Taking all this into consideration don’t you think it’s okay to compare Southwest’s success/failure with that of competitors who have used their own accounting ”shenanigans” to distort the full picture? While markets are far from perfectly efficient, investors like you clearly know who to find the peas under the mattress.
Thanks for your comments.
~V
LUV's fuel hedging is slowly dissipating. LUV is also planning to add service to international destinations as soon as next year. Frankly, LUV does an excellent job in the domestic market--the legacy carriers do not. LUV's success is due to the fact that it is disciplined and focused with a simple business model.