Friday, April 29, 2005

Unbuckle Your Seat Belts, You Are Now Free To Take On Southwest.

When we look at the airline industry, no longer the first things to mind are the famous tag lines, “Fly the friendly skies” (United) or “Something Special in the Air” (American). Instead, we think about the rising fuel costs, the excess capacity, and of course, the predominance of bankruptcy as the modus operandi. If we do think of a tagline, it is much more likely to be Southwest’s “You are now free to move about the country.” The industry has transformed; the low cost carriers are capturing an increasing share of the market, and consolidation seems inevitable. On April 22nd, America West, the nation’s second largest low cost carrier, confirmed that it is in preliminary conversations with US Airways for a potential merger. America West, with hubs in Phoenix and Las Vegas, focuses on the western region of the United States. US Airways, with hubs in Philadelphia and Charlotte, has a stronghold on the major airports in the eastern part of the United States. A combination of the two airlines would create the nation’s sixth largest airline based on passenger traffic.

Analysts reveal that there are many troubling issues associated with this possible merger. UBS airline analyst Robert N. Ashford offers that although the idea has some merit, the airlines’ abilities to gain the support of their shareholders, their disparate labor unions, and their potential financiers could prove extremely challenging, not to mention the inevitable struggle with federal regulators and GE Capital for deal approval. Furthermore, with fuel prices continuing to skyrocket for the foreseeable future, absorbing much of the available cash, and with both airlines already being extremely leveraged, a required investment of approximately $500 million to consummate the merger may be insurmountable. Other analysts question the rationale behind the deal from America West’s perspective. They doubt the merit of the profitable, well-managed America West, burdening itself with US Airways’ troubles: a second bankruptcy proceeding, an excessively high cost structure, a very poor customer service record, and a fiercely competitive market in the East.

However on a positive note, industry consultant Mo Garfinkle acknowledges that America West has been “boxed in by Southwest, and sees this as a chance to quickly gain a large, national footprint.” He continues by explaining that Southwest is already serving many of the cities in the East, but targets the outlying airports, whereas US Airways is focused on the major airports.

The big question is this – is there room for a low cost regional player in an industry of declining (and mostly negative) profit margins and excess capacity? The answer is “no.” America West needs to branch out from the Western US, and find a home east of the Mississippi. Landing rights are finite assets and are not acquired easily, especially in the restricted airports like La Guardia (New York) and Reagan National (Washington D.C.). US Airways is facing an uphill battle in bankruptcy court, has recently exacerbated its union strife, and is in desperate need of a white knight on a commercial jet. America West needs to compete effectively against the only true national contender in its market niche – Southwest – but must find a more prominent brand name to market. A match made in heaven? Not quite, but this deal is not about finding synergies between the two completely different business models. Instead, it is an opportune moment for America West to buy some cheap “complementary” assets in precisely the landscape it is looking for, with the strong US Airways brand name to boot.

The possible merger may in fact give America West an advantage amongst the low cost carriers, because not only will America West be able to compete on a national scale in major airports, but it will likely be able to extend its services to business customers. Southwest caters to the leisure traveler and the very price sensitive small business traveler, and has in many respects, alienated the “deep pocketed” business traveler by its out-of-the-way airport locations and multiple-stop travel philosophy.

Clearly, there will be significant integration costs and asset rationalization, especially considering the labor union issues and unproductive US Airways management. But again, this is not a story of synergies but is one of assets, and this merger is the only way America West can go head to head with Southwest. The challenge for the America West management team will be to maintain its position as a low cost carrier after combining forces. It needs to stay lean, and will therefore only preserve those tangible and intangible assets which are strategically aligned with its vision. There will be a transition period for America West to successfully convert the fleet and human capital from its original high cost structure. But, America West has a strong, proven management team that has operated its network efficiently, and does the proper due diligence before securing a deal. It walked away from a potential merger with another low cost carrier, ATA Holdings, last year, when it became evident that America West would not be able to obtain the appropriate fleet mix to service its market. US Airways is different, however, in that it has the essential aircraft (Airbuses and 737’s) for the longer, more comfortable non-stop trips.

The airline industry needs a break. America West and US Airways may spark industry consolidation, effectively creating a positive externality on the remaining airlines by decreasing capacity. This capacity reduction will help thwart the perennial ticket price wars, and ultimately lead to increased revenue for each of the airlines. The proposed deal between America West and US Airways can therefore be lucrative both for the industry as a whole and for the two individual airlines. It will be beneficial for America West by allowing it to attack Southwest head on with a national footprint and stronger brand name. US Airways is remunerated by offering shareholders a valuable stake in the “new” America West rather than a potentially worthless stake through liquidation. Although the question of how to finance the deal and gain federal government and creditor approval is essential, if the business plan is aligned, the money will come.

Rob Rosenfeld

Susie Greener

Savyon Amit


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