Thursday, April 28, 2005

Project Barbell or Project Dumbbell?

Floundering east coast-based airline US Airways is in serious talks with west coast carrier America West Airlines about a prospective merger. This is not the first time the twice-bankrupt carrier has looked to merge: talks with United stalled in July of 2001 when blocked by the U.S. Department of Justice. Now US Airways is shopping again: according to the New York Times, “…the chairman of US Airways, David G. Bronner told The Associated Press…that the airline had approached several carriers about a merger, but discussions with America West had progressed the farthest.”
Although the merger faces many hurdles, “it could prove the first step in a long-awaited new wave of consolidation of the embattled airline industry,” according to the Wall Street Journal. The deal would create the sixth-largest airline in the United States, just ahead of rival Southwest. Indeed, if US Airways and America West merge, they will do so in an attempt to create a beefed-up discount airline, one that offers amenities like first class and airline clubs, but that would compete head on with Southwest. This raises the old question about Southwest, one of very few profitable U.S. airlines: is it possible to copy its model, and thus its success? If US Airways and America West succeed in emulating Southwest, they will be the first in a long line of aborted efforts to do so. But it is unclear whether the merger would create an entity with all of the synergies and reinforcing capabilities that make Southwest thrive.
There are many potential benefits that could be realized through this merger. According to the Wall Street Journal article on April 21st, many feel that these mergers are inevitable and “could trigger a long-awaited industry shakeout.” Larry Kellner, chief executive of Continental Airlines, Houston states that these talks are “another sign that the industry's going to continue to evolve over the next two years,” and that Continental also intends to "keep our eyes on the marketplace."
One of the most obvious benefits to the US Airways and America West merger is the opportunity to combine two airlines that have hubs in very different areas of the country. They would be able to offer many more choices of routings and flight paths. Especially for US Airways, who has felt the crunch from competitor Southwest Airlines in its major hubs of Philadelphia and Charlotte, the Wall Street Journal states “A merger would allow it (US Airways) to expand its stunted route network and grow to the West, where it offers very few flights.” America West is also facing similar problems on the opposite coast, “For its part, America West is hemmed in by Southwest at its hubs in Phoenix and Las Vegas, and needs places outside its Western U.S. territory to grow and use new airplanes it has on order.” With America West’s reputation for low costs among the carriers, and the combined hubs of the two airlines, “Together they would be a full-service but low-cost operator with a credible national network.”
This touches upon another area that will be helped by the potential merger. Also, according to US Airways bankruptcy proceedings, “bankrupt airlines are allowed to get out of unprofitable aircraft leases, reducing costs and capacity”, Business Week, “Takeoff for Airline Mergers?” This would allow US Airways to cancel certain leases of their own, with the knowledge that they could make up the difference with the new planes on order to America West mentioned in the paragraph above.
Another main area of concern to the airline industry is of course the severe overcapacity that is currently plaguing the skies. This leads to too many filled seats at a cost that most airlines simply can’t afford. The overcapacity problem could also be controlled to a certain extent through the merger. According to the article on April 21st, “if the airlines end up cutting some routes or service in the deal, that could be an answer to the overcapacity problem that has kept fares in the U.S. airline industry too low for most carriers to make money.”
There are three main risks to a potential merger between America West and US Airways. Mergers between airlines involve negotiating with rival unions which tends to be costly, as well as integrating incompatible fleets of planes, complex routes, employees and systems. According to UBS analyst, Robert Ashcroft, “We believe airline mergers work best when buyer is big and powerful (as AWA is not) and target is small and puny (US Airways is weak but over twice the size of AWA).” The two airlines have very few overlapping routes, as US Airways is concentrated on the East coast and America West is concentrated on the West coast, with neither of them offering many transcontinental flights, hence the project is referred to internally as “Project Barbell”. This would be favorable to antitrust regulators, however, it provides few opportunities to consolidate operations. If anything, this deal creates duplicate costs rather than cost savings.
Another concern for investors is that neither America West nor US Airways has sufficient financial resources to take US Airways out of bankruptcy without outside capital. According to the Wall Street Journal, outside investors would have to contribute $500 million to complete the deal. General Electric, the biggest creditor of both airlines, would have to approve the deal as well, which could potentially increase its exposure to credit risk. The federal government, which granted loan guarantees to both airlines after Sept. 11, 2001, would also need to approve the merger, as well as other creditors, the bankruptcy court and America West shareholders. According to Business Week, the fear among industry followers and potentially shareholders is that America West will be weighed down by US Airways problems, such as high costs, complaints about poor customer service and a fiercely competitive market on the East coast.
The third risk of the merger is the threat of competing against Southwest. According to CreditSights analysts, Southwest has a dominant presence on the East coast, namely Philadelphia, and they have made their latest move to start flights in Pittsburg. Southwest also has a bigger presence in Las Vegas and a dominant position in California, as well as more transcontinental flights when compared to America West. CreditSights says Southwest never stands still in the face of a threat, as seen in its fight to bid for the assets of bankrupt ATA Airlines over AirTan. Lastly, UBS analyst Robert Ashcroft also said “We’d expect Southwest to apply maximum pressure to a merged entity, perhaps even before a merger.”
Given the many risks of this merger mentioned above, a successful outcome seems improbable. US Airways is a sinking ship desperately seeking a partner; it has approached many other airlines about a potential merger. Why should America West, who showed profitable results in the fourth quarter of 2004, be brought down with this ship? US Airways has been in bankruptcy twice in the past two years, and this deal will only increase costs and distract management of both airlines from the issues at hand. America West should reconsider this risky proposition and instead capitalize on its recent progress. Perhaps as an airline consultant for R.W. Mann & Co. states, a better name for this deal would be “Project Dumbbell”.

By: Tara Duhan, Michelle Fedunyszyn, Katherine Palmer

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