Victor Cook

Why Airline Mergers Don't Work

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

Why Airline Mergers Don't Work

Roman,

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

Why Airline Mergers Don't Work

johnk,

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!"

Why Airline Mergers Don't Work

Airline Guy,

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

Why Airline Mergers Don't Work

cmj862,

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

Why Airline Mergers Don't Work

Analysis Guy,

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