Vaughn
Cordle
submits:
The following is a white paper by three industry experts
making the case that the network airlines that provide essential
access to global markets are in danger of slowly liquidating if
they are not allowed to merge. Mergers provide a market-driven
restructuring solution that effectively allows the network
airlines to compete with the emerging low-cost carrier business
model.
By Vaughn Cordle, CFA, Paul Mifsud and Carlos Bonilla
The US airline industry can only support three large network
airlines.
The announcement of a United (
UAUA
) -Continental Airlines (
CAL
) merger renews interest in the legal, financial and political
issues surrounding consolidation in the US airline industry.
Perspectives on these issues among the many industry stakeholders -
consumers, communities, investors, suppliers, labor, competitors
and politicians - vary, but it is clear that the corporate and
governmental policies applied to these subjects affect not only
these stakeholders, but also the national economy and the
trillion-dollar travel and tourism industry that relies so heavily
on a healthy, reliable air transportation network.
The purpose of this white paper, and those to follow, is to make
the case for market restructuring of the US legacy airlines and the
industry in general through consolidation and network
restructuring. In the US, such consolidation provides an important
network foundation that - with the right corporate, labor and
political leadership - sets the path to sustained growth and US
leadership in the development of the emerging 21st-century global
air transport networks. Without this leadership and without further
consolidation, we expect there will be at least one, and perhaps
two, more failures among the network airlines, as well as several
low-cost-airline failures.
It is important to recognize that the airline industry is
composed of a variety of business models that satisfy distinctly
different, though often overlapping, transportation needs. For
simplicity's sake we distinguish among network, low-cost and
regional carriers.
AA (
AMR
), UA, DL (
DAL
), CO and US (
LCC
) are the major US network airlines. Using a broad mix of aircraft
types, they gather passengers from small and large airports,
domestic and international, and distribute passengers through hubs
strategically located around the country. This model enables
network airlines to accept passenger flows from other carriers'
networks, so commercial relationships with regional carriers and
international network carriers efficiently extend the network
carriers' reach.
The network airline model provides a vast number of communities,
their business travelers, and visitors with global access to the
world's markets. However, these network efficiencies come at the
price: Complexity, legacy labor policies, outdated infrastructures,
and poorly considered government policies (domestic and foreign)
have resulted in lost efficiencies and higher costs for the network
carriers.
Southwest (
LUV
), JetBlue (
JBLU
), AirTran (
AAI
), Frontier and Spirit (
SPR
) are examples of low-cost carriers (LCCs). The low-cost model also
operates from hubs (called "focus cities" by some), but LCCs tend
to operate limited types of aircraft, to feature point-to-point
services, and to operate only between high-density domestic and
cross-border airport markets.
Simplicity, newer fleets, and a younger labor force that began
work in a low-cost environment, as well as quick turnaround times
for their aircraft, provide efficiencies that result in low fares.
However, this model does not lend itself to serving low-density or
small communities.
Moreover, the extension of this model internationally, beyond a
few cross-border routes with Canada, Mexico, and a few Latin
American destinations, has yet to be proven, although Southwest's
large domestic market share makes it the most likely candidate to
initiate long-haul international operations. We expect it to do so
within the next five years.
Regional airlines such as SkyWest (
SKYW
), Expresset (
XJT
), Pinnacle (
PNCL
), and Republic (
RJET
) (the last a hybrid airline that also operates Frontier as a
branded business) are "fixed-fee for departure" airlines that use a
modified LCC model and operate smaller aircraft suitable for
low-density airports. They connect at the hubs of network partner
airlines pursuant to contract conditions that are subject to the
often strict limitations of the scope clauses in the collective
bargaining agreements of the network carriers. These carriers are
specifically structured to link the smallest communities that
receive air service with the network hubs.
All that said, in any discussion involving airline
consolidation, there are a number of issues that should be put into
perspective:
· DOJ policies related to their analysis of market
concentration, product definition and potential market power in the
air transport industry were first developed in the years just after
deregulation in 1978 and have not been modified since. Simply
stated, the policies are dated and stuck in the past.
· The years immediately following deregulation saw the
proliferation of U.S. network carriers, most of which derived over
80% of their revenues from domestic air transportation. Combined,
they provided a similar proportion of all U.S. domestic available
seat miles (ASMs).
· Today, there are only five major U.S. network carriers and 28
LCC and regional airlines in the U.S., so there has been a
considerable alteration in the composition of domestic competition.
This has resulted in destructive price competition.
· The U.S. network carriers' share of the domestic market
(excluding regional ASMs) has been shrinking annually In 2009,
Southwest, the largest LCC, continuing its faster relative growth
trends, provided 14.6% of total U.S. ASMs, while DL provided 16.1%
after the NW merger in late 2008 [Figure 1].
· UA and CO together provided 17.7% of the domestic ASMs in
2009. However, we ultimately expect to see a 5-10% reduction in
combined capacity post-merger, which will reduce their market share
and improve efficiencies. This outcome results because one of the
major purposes of airline mergers is making routes more rational.
For example, the pre-merger domestic shares of DL and NW, were
10.1% and 6.3%, respectively in 2008, but combined they had a 16.1%
share in 2009.
· Given what we consider an appropriate amount of domestic ASMs
produced post-merger, a AA/US combination would be approximately
19.6%, which is somewhat larger than UA (+CO), DL(+NW), and
Southwest.
Figure 1:
Our analysis of the trends over the last decade suggests that,
without a new strategic direction and significant changes in the
industry's structure, AA and US will continue on the slow
liquidation path to failure. Corporate, labor and government
policies that ignore these trends risk reshaping the competitive
landscape and America's access to the global air transport network
far more adversely for stakeholders than the current consolidation
trend that naturally led to mergers between UA, CO, DL, and NW.
Bad industry fundamentals: The prisoner's
dilemma
In game theory terms, the industry's problem represents the
classic "prisoner's dilemma" because firm value, airline economics
and passenger preferences provide strong incentives to cheat (by
over producing to gain disproportionate market share and lower
relative costs). These incentives are so great that the ability of
the individual airline to profitably maintain seat production
levels that optimally balance supply/demand is severely limited.
The result is, collectively, the entire industry is laden with
excess capacity. Excess capacity is at the heart of the industry's
inability to earn its cost of capital.
This is a confusing issue because, when one looks at
uncomfortably high passenger load factors, the concept of excess
capacity doesn't ring true. However, when both price and supply
elasticity are thoroughly examined, the airlines' excess capacity
can be measured and defined in economic, finance, and even
strategic terms to show its role in the industry's financial
struggles in cold, hard numbers. We have developed models that
produce such numbers.
We ran the numbers for every airline from 1977 through 2009 and
calculated how much excess capacity was in the system and each
region. Then we calculated the economic spread (in Economic Value
Added terms) returns for the industry during each business cycle
and for each airline. What we found was that, for the decade ending
in 2009, the industry produced an average of 7% excess capacity,
and this factor alone led to $70 billion in net losses (in 2009 $),
or negative 5.7% in revenue. The elasticity of demand analysis
concluded that the industry underpriced the product by 11% over the
10 years ending 2009.
The only way the industry could have priced the product above
its true economic cost would have been to reduce the 7% excess
capacity by raising revenue to the required level. Of course, this
was not possible because every airline had to grow market share in
order to lower relative unit costs and expand valuation multiples.
Growth results in lower relative costs because new employees are
brought in at first-year pay and maintenance costs are lower when
equipment is new. "Grow in order to lower relative costs" is a
rational strategy for management at the individual-airline level
but results in destructive price competition at the industry
level.
So the fundamental industry problem is that what appears to be
perfectly rational for the individual airline is irrational at the
industry level because it negatively impacts industry structure and
market concentration in such a way that the individual airline
cannot earn its cost of capital. Hence, bad industry fundamentals
result in an industry unable to attract and maintain shareholder
support.
These bad industry fundamentals will not change without
consolidation one way or another. For CO and UA, the best option is
to merge because the alternative is to fail, and the same holds
true for US and AA. Failure is not a good option for labor and
other stakeholders, especially for the shareholders and for small
communities, which can only be served if there are profitable and
large network airlines. Network airlines must be able to afford to
fly the thinly populated short haul flights utilizing small
regional jets if small communities are to continue to receive air
transportation service. The low-cost airline model is not designed
to service these small communities.
Our analysis suggests that the US market can support a maximum
of only three major network carriers.
Although we are forecasting profits for the U.S. majors in 2010
and 2011, these profits are inadequate to address the airline
industry's continuing problem of excess capacity and destructive
price competition that leads to inadequate earnings, especially in
the domestic market. The projected levels of earnings do not
address poor balance-sheet and earnings fundamentals such as
equity, capital investment, and growth. Without improvement in the
industry fundamentals, the airlines will remain unable to satisfy
consumer expectations and investor and labor requirements, all of
which must be defined in sufficient and certain value terms.
Our financial models indicate that industry revenue must
increase by 15-20% to offset over $20 billion in higher costs that
are estimated to be in the pipeline. Although charging higher fares
and ancillary fees would reduce demand and result in 10-12% of
excess capacity that should be removed, this is not likely to
happen without additional mergers. If the industry is not allowed
to consolidate in the most rational manner, the result will be a
continuation of the slow liquidation and the inevitable failure of
US and AA, the two remaining network airlines in need of
restructuring. The most likely outcome would be an AA bankruptcy
and outright liquidation of US.
While aviation is traditionally a cyclical industry, the current
business cycle is different because the large network airlines have
never been so weak or so over-leveraged. Capital expenditures have
been inadequate for too long. Even if consolidation proceeds, the
remaining legacy airlines must retain many years of earnings before
they have a healthy capital structure.
We estimate that network airlines have a $50 billion [book]
equity deficit on the balance sheet. Growth and proper investment
in equipment and human capital is not possible until this deficit
has been addressed via retained earnings. And adequate retained
earnings are not possible unless the market structure changes to
increase market concentration. Succinctly stated, the industry has
too many airlines and this does not allow the profitability
required to properly invest in the business and satisfy key
stakeholders.
Disclosure:
No positions
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The Myth of One Bad Trade
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