Victor Cook

Why Airline Mergers Don't Work: Scale Is Not a Blessing

Tack,

Your comment that airline management should try “… to figure out how to be more customer friendly and attract more air travelers and revenue” cuts right to the core of the problem. If mergers don't work, what's an airline CEO to do?

While my article defines the problem, it doesn't offer a solution. For a road map on how to find a way out of this dilemma I recommend airline CEOs read J.C. Larreche's book "The Momentum Effect: How to Ignite Exceptional Growth." Here's what Sir Richard Branson, who knows a thing or two about the airline business, says on the cover:

"This book shows you how to build momentum and leave your competitors trailing in your wake."

What might airline CEOs learn from it? One example of the insight that jumps from the pages of Larreche's book is that the relationship most air carriers have with their passengers never develops beyond their online booking, ticket purchases, onboard experiences and baggage handling. As JC says on page 154:

"There is no emotional connection. To generate the momentum effect requires a much deeper and more committed relationship than that offered by passive customers who just don't complain. Companies should measure their success by the number of delighted customers they have--people so thrilled with a product or service that they can't help but tell others about it."

We often hear the idea that "less is more." But that concept always is expressed in terms of money. The following comment in JC's book (page 27) explains when less is more from the airline passenger's point of view:

"... less should mean that they get exactly what they need and nothing more, with no superfluous elements that create complexity and could destroy value."

Reading this sentence started me thinking: are there any airline services that create complexity and destroy value? Yes. Baggage handling. This conclusion led me to write a series of articles exploring ways to “… be more customer friendly and attract more air travelers and revenue.” In the last article in that series I proposed a radical solution to the baggage handling problem: remove baggage from the passenger air transport system and shift it to the cargo air transport system. If you’re interested in the pros and cons of this idea start with seekingalpha.com/artic....

Thanks for the opportunity to put this idea back on the table.

~V


On Sep 28 06:32 AM Tack wrote:

> The fundamental problem with almost all airlines (here again, Southwest
> "gets it" the most) is that they so utterly misunderstand their own
> businesses and have developed near-suicidal marketing and pricing
> approaches that unless they wake up to new realities, most will fail,
> whether merged or unmerged.
>
> As an executive (now retired) in capitally-intensive, fixed-cost
> industries during my career, one thing I learned very quickly is
> that volume is everything. When fixed costs comprise a huge segment
> of a business, it's never possible to achieve a positive result by
> adopting any program that reduces volume and gross revenues. Whatever
> savings may be attached to associated variable costs will be outweighed
> by the fixed costs, now allocated over a smaller base.
>
> So, on the surface, a merger would seem to make sense, i.e., expand
> volume faster than the expansion of fixed costs. The problem remains,
> however, that the airlines have totally forgotten how they generate
> revenue and how to grow that revenue. Consequently, they are seeing
> fewer and fewer passengers who wish or need to partake of their "services"
> (I use that term euphemistically).
>
> Think about it for a minute. Is anybody attracted to being humiliated
> at airport check-ins? to being financially punished for not "planning"
> a trip in advance? to getting penalized for changing or canceling
> a trip? or how about paying absurd fees to bring along your luggage?
> or paying 2-3 times as much to go 500 miles as 5000 miles?
>
> This is a mentality associated with arrogance and would work more
> "perfectly" in mandated-as-compulsory products, like health or auto
> insurance, but, it's insanity in a business where people make discretionary
> decisions. And, that's what the airline business has increasingly
> become, a business where the need and/or desire to use the product
> has become optional.
>
> Now, businesses have access to worldwide, instantaneous Internet
> communications and teleconferencing. The absolute need to send somebody
> at exorbitant cost to a meeting is greatly reduced. The greater competition
> in almost all world business segments also dictates that companies
> manage their finances, not just pay whatever the airlines wish to
> charge, as if there were no alternatives.
>
> And, consumers are finding that they can enjoy life just fine without
> flying around the world, or even around the country. It used to be
> that a trip was something exciting to look forward to, a special
> event. Now, the very thought of getting one's pockets picked and
> treated like some sucker to be exploited makes travel unappealing,
> and that's before we even get to the hassle, disrespect and humiliation
> that passes for "airport security." (I think the shoe bomber did
> more to damage the American economy that any other terrorist act,
> but that's another thread.)
>
> Airline executives seem utterly oblivious to the changed rules of
> the game of air travel and its increasingly optional nature. At a
> time when they should be turning themselves into pretzels trying
> to figure out how to be more customer friendly and attract more air
> travelers and revenue (not by nickle-and-dime fees, either), they
> are engaged in a nihilist race with each other to see who can drive
> passengers away the fastest. It's insanity, no less.
>
> For a very long time, I've thought there would be a huge opportunity
> for an airline to come into being, whose operating plan included
> no fees or penalties of any kind and had a simple revenue plan: all
> seats would be priced on a base fee to cover fixed business costs,
> plus a mileage add-on to cover the distance traveled. Ergo, the price
> all of travel would be proportional to the distance one goes. <br/>
>
> Such a plan is too simple, of course, for the convoluted thinking
> of the airline executives, although Southwest probably comes the
> closest. But, for the others --merged or not-- who keep seeing travelers
> as cattle marching inexorably up the chutes of the slaughterhouse,
> their days are increasing numbered.

Why Airline Mergers Don't Work: Scale Is Not a Blessing

Fat Panda,

You're right. I am comparing apples and oranges; and different markets; and different levels of competition; and different fleets; and different fuel hedging bets; and different cultures; and so on. That’s the whole point.

I designed the risk-adjusted differential to standardize the outcomes of these and many other strategic choices in order to inform investors about managements’ overall value-revenue orientation. If these differences didn’t exist the risk-adjusted differential would be zero for all companies all the time!

Thanks for giving me the opportunity to clarify this important issue.

~V

Why Airline Mergers Don't Work: Scale Is Not a Blessing

Indeolie,

Your conclusion would hold water except for one thing: Southwest has held the same lofty position on the value creation scale since Q1 ’93. That makes it 37 years of value leadership, most of the time without the need for fuel hedges.

You can verify this result in the 18 minute audio slide show “Y’all Buckle That Seat Belt” based on Chapter 2 of my book “Competing for Customers and Capital. Here’s a link to that presentation: breeze.tulane.edu/chap.../.

Thanks for the opportunity to clear up this commonly held misconception.

~V

Why Airline Mergers Don't Work: Scale Is Not a Blessing

Change is the Only Constant,
Better strategic alternatives do exist.

For example, see my Seeking Alpha article “General Motors’ Natural Share Level: Can GM Be Like IBM?” (December 15, 2008).

A company’s “natural share level” occurs when the incremental cost of the next revenue share point equals the incremental earnings from acquiring that share point. In my book -- “Competing for Customers and Capital” -- I ran these numbers for Southwest Airlines in a similar peer group for Q1’03 on page 126. LUV’s actual share level was 7.6%. That share level produced an actual EBITDA of $139 million. At that time LUV’s “natural share level” was 13.6% with a theoretical maximum EBITDA of $176 million.

By Q2’09 LUV’s actual share level had increased to 10.0%. I haven’t had reason to run the company’s natural share level or maximum EBITDA for the most recent quarter. I guess you’ve given me one!

If you’re interested in how “natural” or “maximum earnings” market share is determined check out my 14 minute audio slide show on “The Rule of Maximum Earnings” from chapter 5 of my book. Here’s a direct link: breeze.tulane.edu/chap.../.

Thanks for your thoughtful comment.

~V

Why Airline Mergers Don't Work: Scale Is Not a Blessing

User 457816,
You overlooked the last sentence of my article:

“If you want to understand the details behind this analysis, review my 18 minute audio slide show Y’all Buckle That Seat Belt.”

Clicking on the hyperlink at the end of this sentence you will find these results are based on a set of objective rules using audited financial data. You also will find the results are basically unchanged since Q1’93 for a comparable peer group of U.S. airlines.

Thanks for the heads-up.

~V

U.S. Airline Stocks: Bargain-Hunters' Dream or Falling Knife?

Interesting article, Mark. The price/revenue ratio is a great metric -- simple to compute with powerful implications.

To place this metric in perspective you might what to see my paper "The Value/Revenue Ratio." In it I track that ratio over 56 years for all public companies. The long run expectation is about 1.0, but the semi-long run swings are even more interesting. See papers.ssrn.com/sol3/p...

Vic

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