Thursday, May 26, 2005

Everybody Needs a Friend, Even Airlines

When things get tough, it tends to bring friends close and enemies closer. The air transportation industry has experienced just the type of situations that make friends and enemies come closer. After struggling through the rampant bankruptcy of the 1980’s, many airline companies rebounded during the strong economy of the 1990’s. However, dual economic shocks of the bursting internet bubble (fewer business trips and deep-pocketed customers) and the terrorist attacks of 9-11 (overall reduction in travel) nearly crippled the industry in early 2000’s. Fast forward to 2005, with oil prices above $50/barrel and consumers demanding lower fares, and it is easy to see why many of the 15 airline competitors are scratching and clawing for mere survival, much less a piece of the airline industry profit pie. How much can one industry take? The time has come for a combining of wills, resources, and routes. That brings us to the merger of America West & US Airways. They attempt to succeed where history shows evidence of failed mergers; they will battle politics along with conflicting reports of cost and revenue synergies. Will this merger be redemption for US Airways and provide needed growth for America West? Does this merger make any sense strategically?

Analysts are, on the whole, upbeat on the potential partnering. S&P notes that a combined America West-US Airways merger may have better odds than other airline mergers at succeeding because of little geographic overlap. Businessweek notes that this merger is similar to the last successful airline merger (Delta-Western Air) through the combination of geographical routes to divert traffic away from competitors. One prominent consultant notes that the merger should be very appealing to consumers in the mid-west, where neither America West nor US Airways have a presence. Customers, particularly business customers, may now consider America West as a viable option for national travel. By pricing and scheduling as one company instead of two, further revenue synergies are possible. However, a Goldman Sachs analyst notes that America West’s revenues may suffer from culture issues and from adding the more-competitive and over-capacity Eastern routes, much different than the mildly over-capacity Western routes America West currently flies.

When evaluating the proposed merger, the first thing we analyzed was the alignment between the merger and America West’s competitive advantage and strategy. America West seeks to be a low-cost and low-fare airline carrier and achieves its competitive advantage through improved customer service and efficient operations. However, as the airline industry moves toward lower fares, and larger rivals move aggressively to cut costs, America West’s advantage has been eroded. After the merger, America West’s larger size and national market presence (formerly just West coast) will provide improved negotiations with suppliers (such as Boeing and Airbus), improved incentives for buyers (national flights instead of just regional), and will bring America West closer to the same economy-of-scale levels as its larger rivals (boosting it to the 6th largest airline). This merger does not appear to be just an attempt at “empire building” by America West’s CEO Parker but instead should help America West compete in an ever-changing and difficult industry.

Next, after verifying a true strategic fit, we questioned if the potential synergies of the merger are significant enough to justify the efforts and costs involved in the merger. The synergies of the merger can be thought of as two types: cost synergies and revenue synergies—with cost synergies having a much higher probability of actual achievement than proposed revenue synergies. The cost synergies available to a merged America West appear to be significant: $200 million annually from cutting unprofitable routes and matching aircraft size to route demand; savings from improving US Airways operational efficiencies (more flights per gate per day); and $200 million from direct fixed cost reductions such as redundant work staff, redundant gates, and returning 59 leased airplanes no longer needed by US Airways. The total annual synergies are expected to reach $600 million annually, once the $200 million in revenue synergies are added—mainly from the improved connections between the formerly separated route networks (East coast and West coast) of the two airlines. While the revenue synergies are somewhat dubious, the cost synergies appear to be sound and significant; therefore, we feel that there is attainable value within this merger.

Finally, we questioned if the proposed merger is executable—the strategic fit is there, the value is there, but does America West have the experience/ability to successfully implement the merger as planned? We feel that the biggest challenge of this merger will be the ability to merge the human capital of the two airlines, specifically the unionized workforces which are very different in average tenure. In fact, we believe that the most resistant group to the merger will be the unionized employees of America West. They will undoubtedly be forced into some concessions as they merge with the more experienced union of US Airways. Yet, America West’s Parker has a track record of successful union negotiations and is known for his humility and tact, providing evidence that the difficult union negotiations may be obtainable. While not without risk, we feel that a successful merger is possible as long as Mr. Parker recognizes that communication with, and buy-in from, his own employees will be just as important as the millions of dollars in synergies from the merger.

Rich Foley,Jamie Hood, & Bryant Mitchell

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