Thursday, May 26, 2005

US Air - America West: Synergies between Two Sinking Ships

We need to get this out of the way early: airlines are a terrible business, oil prices are sky high, and companies have no pricing power. Whew! OK, now that we have that out of the way we can dissect the recent announcement that US Airways and America West will be merging into one low-cost carrier that competes with Southwest. To sum the conclusion early, round pegs do not fit into square holes.

The motivation behind this merger is based on the dire prospects that both firms face as stand alones. In fact, US Air has been in bankruptcy twice this century already. It is important to dissect first why both firms cannot stand on their own: intense competition (that was easy). Sure, pension costs, volatile demand, and high fuel costs play major roles, but firms like Southwest and Jet Blue have been able to compete effectively in this environment with a lower cost structure and, therefore, with lower prices. The cost disparity between firms, and therefore the genesis of the intense competition, is the main reason why neither US Air nor America West could survive alone; the only method of staving their inevitable charge to bankruptcy was to merge with each other and claim massive synergy savings as the savior.

To put it simply, the only business model that will function in this dire dynamic is simple: low-cost fares combined with a low-cost business structure. Doug Parker, the new CEO, claims to have a business model that produces enough synergies to compete with Southwest (we’ve heard it before, I know) as discussed in the Wall Street Journal this week. The string of synergies also sounds familiar: $200 million from cutting aircraft and $250-300 million from cutting overhead. Where to begin? Sure, firing a lot of people will save money, but we question the new firm’s ability to accomplish this task. Merging two powerful pilot unions will be difficult; remember they are the ones who land the planes and provide the majority of the value to the consumer. The flight attendants and mechanics will also be difficult. Unionized workforces do not always lead to exorbitant costs, but each union will have to accept lower salaries. As if negotiating with three unions wasn’t hard enough, the new firm must now deal with six. We sincerely question Mr. Parker’s ability to cut compensation costs enough to become Southwest, and there is no middle ground as others have proven.

By far, the most powerful synergy apparent in this merger is that another firm is gone and they may finally take some of the excess capacity with them! When Mr. Parker says they will save $200 million in plane costs, we interpret this to mean that the firms have overlapping routes. This provides a partial solution to the main problem already described in this industry: intense competition (i.e. from overcapacity). Unfortunately, losing a competitor helps everyone equally, not just the merged companies. The overcapacity that has plagued this industry has led to intense price wars. Every time one company attempts to raise prices, the allure of higher utilization becomes too great and one firm ruins the party for everybody by lowering prices again. If the government had not bailed out many airlines with loans after 9/11, then maybe we wouldn’t be in this mess in the first place, but this is no excuse. As it stands, too many competitors are fighting it out and this merger is actually a part of the solution to this problem. Unfortunately, this does not mean that the combined firms will survive since less capacity helps Southwest as well.

It is our opinion that America West, the lower cost of the two, would have been better off if US Air had gone the way of Chapter 7 (third time is a charm). The industry would have still benefited and America West would not be stuck with a firm that cannot seem to keep itself out of bankruptcy. The argument could be made that the combined firms offer better service levels to consumers through wider flight coverage, but this sounds eerily familiar to the argument for the inefficient hub-and-spoke systems seen at Delta and American. Southwest flies point-to-point on profitable routes, coverage is nice only if it is profitable. Adding lines is only beneficial if it is profitable, but the new firm does not want to discuss these issues.

We do not feel that an old firm can change its stripes and become Southwest (remember United Light?). Only a new firm with an obsessive control of costs can create the service-friendly, happy union environment of Southwest or Jet Blue. Combining two sinking ships and hoping they can magically synergize into Southwest is not viable because employees, passengers, or investors do not easily forget the past. It’s an easy prediction, but, in the end, we think these two sinking ships will continue to sink and Southwest will continue to prosper.

Shane Hart, JP Millsap & Tyler Partridge

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