Why Airline Mergers Never Add Up
Airline stocks rallied last week on news that Delta Air Lines was mulling a takeover of either
United Airlines or Northwest Airlines, suggesting that many investors think airline mergers are a brilliant idea.
The rally was an especially strong endorsement of mergers because it was broad — all the big carriers’ shares rose, on the assumption that one merger would lead to another.
But close scrutiny of the business rationale for airline mergers suggests that any improved profits from consolidation will likely be short-lived, at best.
Any cost reductions, for example, could easily be eaten up by higher wages required to win labor’s support for a deal. And because one big merger could prompt a second — Continental Airlines is expected by many analysts to snap up United, Northwest or another carrier as a defensive gesture against Delta — any advantage provided by a bigger route system might be quickly neutralized.
They are unlikely to win over travelers, too. Big mergers could mean less service to some markets, as a newly combined airline might wipe out thousands of jobs by scaling back at smaller hubs. Fliers could expect a surge in delays as combining operations and computer systems would most likely create service meltdowns.
“A merger almost inevitably is going to cause some service problems,” said Philip A. Baggaley, an analyst at Standard & Poor’s who is dubious on the business benefits of combinations.
There would be a few winners, to be sure. Investment bankers and lawyers would reap huge fees for advice on the transactions. Top executives losing their jobs would get tidy severance packages. And executives sticking around would no doubt get raises. Below that level, however, the benefits seem far less certain.
Of course, countless corporate mergers — in manufacturing, media and financial services, among other fields — have made the leap of faith that the sum would be worth more than the parts. But studies generally show that more than half of such combinations fail to create value.
What special magic, then, might occur to make two big airlines worth so much more together?Essentially two theories are at work, each a chestnut of the merger-and-acquisition game, and neither of them a sure thing.
The first is simply to cut costs of the combined companies and hope to hang on to all the customers and revenue. Banks have employed this with some success, since many consumers do not seem to mind when their checking account is sent across the street and their former branch is shuttered.
With airlines, this might be called the Asheville Approach. A year ago, US Airways produced a similar run-up in airline shares by offering to buy Delta for $8 billion — later increased to $10.2 billion and then abandoned after Delta rejected the bid. At the time, US Airways said it planned to reduce combined costs by $1.65 billion a year.
Nearly $1 billion of that cost-cutting was to come from combining route systems and, quite simply, lopping off about 10 percent of the fleet and other flight operations. US Airways used Asheville, N.C., in some presentations to investors to illustrate the approach.
US Airways and Delta each operated about 10 flights daily from that city, and a merger would have meant canceling 2 of those flights and packing passengers onto the remaining 18.
The Asheville passengers were viewed in this equation as captives. More than 80 percent of them were connecting before reaching their final destination, so there was no difference whether they were routed through US Airways’ hub in Charlotte, N.C., or Delta’s Atlanta hub to get to their destination, according to US Airways’ logic.
In trying to fend off US Airways’ offer, Delta attacked the Asheville Approach. “I don’t believe, in this industry, customers are truly trapped,” Edward H. Bastian, president of Delta, said in a December 2006 interview. “They may be trapped short term. You will get short-term gain smashing two companies together and pulling costs out. But that will not be sustainable.”
Betsy Talton, a Delta spokeswoman, said Mr. Bastian’s remarks were specific to the US Airways proposal. She declined to comment on current negotiations with United and Northwest .
Making flights scarcer has the additional benefit — unless you are a customer — of helping to push up fares, “which they’ve done anyway,” said David N. Edwards Jr., airport director at Asheville.
Indeed, in the year since US Airways did not buy Delta, the two carriers independently cut about two flights a day from their combined schedule, “creating a supply-demand factor that allows them to raise fares,” Mr. Edwards said.
There are two problems with that approach in a merger. One, it is a lot easier to ditch planes and leases on gates at airports when an airline is in bankruptcy and can essentially renege on a host of obligations. That is why US Airways made its bid while Delta was still in bankruptcy.
Now, Delta and any partner would have a harder time unloading planes and other assets.
Also, low-cost carriers — Southwest Airlines , AirTran Airways , JetBlue Airways — all want to keep growing. And few things make them happier than seeing network airlines reduce serviceand increase fares, giving the discounters a big and profitable opening to expand. Hubs in Cincinnati, Memphis and Salt Lake City seem especially vulnerable to being scaled back.
The second theory used to justify airline mergers is that combining would increase revenue because a bigger route system would help take market share from competitors. That makes sense, until other carriers also combine. “It certainly scales back the benefits,” said Mr. Baggaley, the Standard & Poor’s analyst.
That leaves raising prices by reducing the number of flights to create some scarcity, a tactic well under way already as big airlines generally plan to cut domestic capacity this year.
“It’s going to be difficult to raise prices in a soft economy,” Mr. Baggaley warned. “If they can avoid cutting them, that would be better than past downturns.”
Despite the questionable economics, United and Northwest appear anxious to make a deal.
“We’ve said for at least a year — we’re standing by the phone,” said an adviser to United’s chief executive, Glenn F. Tilton.
And Northwest’s chief executive, Douglas M. Steenland, told workers Friday: “Doing nothing could be our worst alternative.”