Delta and Northwest: a mistake from the start.

Why Airline Mergers Don't Work
by Victor Cook

Ever wonder why over the last 30 years Southwest Airlines managers (LUV) spent only $0.03 on mergers and acquisitions for every $1.00 of shareholder value they created? By comparison, Delta management (DAL) spent $2.35 for every $1.00 of value they created. And Northwest (NWA) spent $1.61 on M&A for every value dollar they created. In Louisiana we have a name for this kind of strategy. It's called jumping over a dollar to get to a nickel.

Does Herb Kelleher, former CEO of Southwest Airlines, know something about creating shareholder value that other CEOs don’t know? Perhaps he understands that in the domestic airline market earnings don’t necessarily increase with market share. Or in economics speak, changes in earnings with respect to a changes in market share may be very inelastic. Because the demand for air travel is very price elastic.

BELIEVE IT OR NOT

Believe it or not, elasticity is one of the most powerful metrics in business. In a single number, elasticity pins to the wall the relationship between percent changes in price and quantity. In theory, if the percent change in quantity purchased by customers is greater than the percent change in price paid, demand is elastic. Alternatively, if the percent change in quantity is less than the percent change in price, demand is inelastic.

Then why does one rarely see price elasticity numbers used in industry analyses? In the real world, price and quantity data are notoriously ill behaved. That’s why your Econ 101 professor couldn’t use real numbers in his or her hand-drawn demand schedules.

It is, however, possible to get at the relationship between price and quantity in the real world if you have access to a large base of precise data, an in-depth knowledge of econometric methods and lots of time on your hands. About the only people I know with these resources are doctoral students in economics. Therefore, I was not surprised to find exactly what I was looking for in Jong-Ho Kim’s 2006 dissertation on “Price Dispersion in the Airline Industry: The Effect of Industry Elasticity on Cross-Price Elasticity.”

Dr. Kim based his research on data from the Department of Transportation’s Origin and Destination Survey from the 1st quarter 1989 through the 4th quarter 1997. This is a 10% random sample of all tickets issued in the U.S. In his dissertation Dr. Kim hypothesized that:
Southwest’s entry provides a natural setting for investigating how travelers respond to the changes in air fares.

More specifically, we can make full use of variations in relative prices among airlines and the revenue shares of airlines by focusing on Southwest entry routes. Consequently, we can focus on coach class travel in those markets where Southwest entered and has been serving since then. … [R]ival airlines adjust their average fares upon Southwest’s entry and remain relatively constant in ensuing quartersIn that study, when Southwest entered a new market (city-pair), estimated price elasticity ranged from a high of -2.6 (with only one other competitor), to -1.63 (with four other competitors), to a low of -1.1 (with 7 other competitors). All of these estimates were statistically significant.

WHAT HERB KNOWS

I think Herb Kelleher understands – as no sitting airline CEOs seems to – a fundamental principle about competition.
Given:
a capital intensive industry,
with few meaningful scale efficiencies,
delivering a highly perishable product,
within a partly regulated infrastructure,
operated by talented professionals,
in a very price sensitive market, with
free entry and court protected exit,

shareholder value can best be created organically. How? By maximizing the satisfaction of employees, passengers, suppliers, partners, and shareholders. Here is the corollary to that fundamental principle:

In airlines, building market share through mergers short circuits the creation of satisfied stakeholders.

The purpose of this article is to examine why mergers don’t work today in domestic airlines, using the DAL/NWA merger as an example.

EARNINGS ELASTICITY

Elasticity can be expressed for any pair of variables. Take earnings elasticity for example. It’s the percent change in earnings divided by the percent change in market share. Here’s what happens. Cutting price leads to an increase in market share. But it also leads to a decrease in earnings. Theoretically, in a price elastic market with few scale efficiencies and a perishable product, earnings and market share are not happy partners.

Suppose the management of a hypothetical airline with 20% of all domestic revenues decides it would be good for earnings if they increased share of revenues to 30%. The quickest way to do that is to merge with a company that has 10% of the market. In a matter of months its market share increases by 50%. Bingo!

But in a highly price sensitive market for a perishable product, earnings may increase only a little, say about 6%. The ratio of the percent change in earnings to the percent change in market share (0.06/0.50) is just 0.12. In this hypothetical case, earnings are highly inelastic with respect to market share. Is this is a bad thing? Yes. It’s a classic case of jumping over a dollar to get to a nickel.

MAXIMUM EARNINGS MARKET SHARE

To test the hypothesis that the DAL/NWA merger won’t be good for shareholders I ran a maximum earnings market share analysis on the combined companies in a strategic group with seven other domestic airlines for the calendar year 2007.

In a nutshell, maximum earnings occur when EBITDA generated by the last share point exactly equals the cost of acquiring it. I worked out the details of how to calculate maximum earnings share in my book Competing for Customers and Capital. I applied the results to eight domestic airlines in the 1st quarter of 2003 when only two of them weren’t losing money. If you want to get an overview of that analysis see my audio slide show The Rule of Maximum Earnings. It’s short and no walk in the park.

Table 1 sets the stage for this analysis with each carrier’s share of the combined $114.7 billion revenues in calendar 2007. American Airlines (AMR) captured 20.0% of total revenue. UAL Corp (UAUA) walked away with 17.6%; Delta and NWA got 16.7% and 10.9% respectively.
Continental (CAL) generated 12.4%; US Airways (LCC) had 10.2%; followed by Southwest with 8.6%; Jet Blue (JBLU) at 2.5%; and Frontier (FRNT) with 1.2% of group revenues.
Combined, DAL and NWA actually captured 27.6% of total revenues. Since both carriers were financially cleansed by bankruptcy court, what is your guess about their potential to maximize earnings?

Combining DAL & NWA revenue and costs as they appeared on their individual income statements produced an actual 2007 market share of 27.6% of group revenues. The vertical axis on this chart is the marginal cost as well as marginal earnings per share point.

Marginal costs continuously increase reflecting the underlying reality of competition. The marginal earnings schedule is constant, reflecting the assumption that there would be no major changes in the scale of combined operations. Under this assumption, maximum earnings market share is 26.7% of group revenues. If synergies were to be found after merging, the effect would be to push actual and maximum earnings market share even closer together. In either event, the combined companies come within no more than 90 basis points of realizing maximum earnings. That’s the good news.

TOTAL EARNINGS ALMOST AS FLAT

The bad news is the total earnings schedule is almost as flat at the marginal earnings schedule.

Market share appears on the horizontal axis ranging from 20% through 35% of group revenue. In this chart, total earnings appear on the vertical axis ranging from zero to $8 billion. There is just a $10 million difference between actual and maximum earnings.

A DOUBLE WHAMMY

I began this article by pointing to the painful price elasticity that exists in this capital intensive market for perishable products. For carriers competing with Southwest in the same city-pair, reported price elasticities range from -1.1 upwards to -2.6 depending on the number of competitors in the market. If you’re the only other carrier in a market with a 10% price premium in a city-pair boarding 1,000 passengers a day, 260 of them likely will switch to Southwest.

So you have to match LUV’s price. If you’re competing for 10,000 passengers a day in a market with four other carriers, including Southwest, and you don’t match LUV’s price, 1,630 of them likely will switch to Southwest. So, you’ve still got to match its price.

But, just as bad, you’re likely to be facing a highly inelastic earnings/share schedule. In the DAL/NWA example presented in this analysis, there is just a $30 million difference between total earnings at a 20% share of revenues ($3.56 billion) and a 35% share of revenues ($3.59 billion). That represents just a 0.8% increase in EBITDA across a spread from 20 to 32.5 revenue share points, a 63% increase. Without extraordinary synergies, a merged DAL/NWA might be facing an earnings/share elasticity of just a little over 0.01. Looks just like a double whammy.

What’s an airline CEO to do in this situation? Reconfigure the business model. Is there a road-map on how to do that? Yes, it’s called The Momentum Effect by Professor J.C. Larreche of INSEAD. It’s going to be published in hard copy by Wharton next month.
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