Wednesday, April 27, 2005

Fasten Your Seatbelts: Turbulence Ahead for US Air & America West

Recently confirmed rumors that US Airways and America West Airlines are involved in merger talks has sparked some discussion about how wise a move that would create the nation’s 6th largest airline will prove to be. With the industry just now showing signs of life after nearly 4 years mired in turmoil, this is the first sign of M&A activity in the U.S. market since UAL Corp’s United Airlines flirted with US Airways back in 2000. This potential deal wouldn’t face quite the uphill battle United saw; the resulting airline would barely beat out Southwest for that 6th spot (a combined United/USAir venture would have handled 27% of all domestic air travel).

This chatter is clearly a result of the record fuel costs, empty seats, and ticket-price wars that have virtually eliminated margins for most major airlines. The level of competition and excess capacity makes survival difficult; the thought of a deal that could remove capacity and lead to increased fares is obviously a pleasant one for analysts and investors watching the situation. A merger could allow the two airlines to eliminate redundant equipment, gates and (possibly) personnel across their networks. Those in favor of the merger further cite the little route overlap between the two airlines and the availability of exit funding for the bankrupt US Air should they find a partner. They could right-size their fleet through a little-known codicil of the bankruptcy code that would allow US Air to ditch some of their current airplane leases. Though it is possible to read the initial press and come away with a fairly positive impression, the picture isn’t necessarily so rosy.

As recently as early 2001, pundits were warning against potential over-consolidation in the U.S. air travel industry. Idle for some time, these naysayers are suddenly back in fashion. Airlines are hugely complex entities, with shareholders, employees (whose pension plans tend to own large chunks of stock and whose unions can often dictate company policy), and other “investors” able to exert significant power on management. Then there are the fleets. US Airways (including US Airways Express) sports 13 different planes across its fleet, America West has 6 (with only some overlap in airframe and engine types). These figures don’t compare favorably to the airline everyone seems to have in their sights, Southwest, who operates 417 planes that are all variations of the venerable Boeing 737. Increasing fleet complexity leads to increased maintenance and pilot costs, and has a subtle but significant logistical effect – when flight crews have to be matched to the planes they are rated to fly, the airline loses flexibility.

The market doesn’t seem to like the idea either; America West (NYSE: AWA) lost 6.4% on the day the rumors started. US Airways’ bulletin board issue (OTC BB: UAIRQ.OB) isn’t even worth talking about. Given that US Airways is banking on this deal as a guarantee for the last USD 100 million in exit financing, some wonder how they would fund the huge integration program that would follow any agreement. There is also the hidden cost of frequent flyer programs. The 4 million or so America West frequent flyers would gain access to the entire Star Alliance network; the pent-up demand for free flights could choke profits as flyers exploit the newfound range of their program.

Southwest, thought by many to be the primary target of the new airline, doesn’t think much of the idea. With no discernable braggadocio, SWA CEO Gary Kelly mentioned that the merger “doesn’t really change the competitive landscape as we see it.” This, coming from the incumbent 800-lb gorilla of the growing discount air market, may turn out to be quite prophetic. Taking two struggling airlines (struggling, in spite of AWA’s recent quarterly profit) and mashing them into what would ultimately be the nation’s largest discount carrier might not be what the doctor ordered.

The 9/11 attacks on the World Trade Center and the Pentagon obviously changed the way airlines operate; United Airlines and AMR’s American (both lost planes and crew in the attacks) have flagged, and the subsequent decline in passenger traffic has sent shockwaves through the industry. But players have largely ignored M&A activity as a potential road to profitability, more than likely because the Air Travel Stabilization Board (ATSB) has kept these languishing airlines afloat with loans and subsidies (between them, US Airways and America West took out USD 1.5 billion in loans). GE Capital Aviation Services is equally at fault. They’re currently US Airway’s largest creditor and have “gracefully” extended terms that at the same time keep the airline flying and paying more over longer periods of time. Unlike other industries, where market forces dictate the size and number of players, the U.S. has a number of airlines that just shouldn’t be.

Even the counter-argument has flaws; proponents of the ATSB (and even GE’s “benevolent” actions) say that if they hadn’t acted, the consumer would bear the brunt in the form of service degradation. The fact of the matter, however, is that if US Airways were to exit the market, other players would fill the void in service they left behind. Efficient markets don’t tend to stand idly by and watch players’ failures without presenting new opportunities for profit to those who are most fit to claim it.

A combined airline flying under the US Airways livery would certainly present some opportunity to take capacity out of the skies in the short term. However, someone will have to figure out how they’ll jump the huge hurdles that currently look pretty steep (in the form of approvals from two unions, the ATSB, GE Capital, and the bankruptcy court overseeing US Airways reorganization) and come up with new solutions for fleet management and route optimization. If they succeed, however, and fuel prices pull back from their current, absolutely insane levels, airlines might return to service differentiation – rather than pricing – as a source of competitive advantage. And we might see pillows on our next flight.


J. C. Groon
Kevin Hardy
Amrit Sahasranamam

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