Time to Merge in the US Airline Industry
Vaughn Cordle, CFA / August 12, 2005
High jet fuel costs and excess competition will force a major restructuring in the airline industry, which
will accelerate a restructuring that has been underway since the stock market bubble popped and the
events of September 11, 2001. While airlines are paying over $2 per gallon for jet fuel on the West
Coast, the average price paid during the period of 1986 through 2000 was a mere 60 cents.
Fuel costs for the industry will be $9 billion more in 2005 then they were in 2003.
Yields—passenger revenue divided by revenue passenger miles (REV/RPMs) —were 28 percent lower
in the first 6 months of 2005 than they were during the same period in 2000. This has driven traffic back
to 2000 levels, while load factors have increased to historic levels—83 percent in June and July, the
peak demand period in the airline industry. The plunge down in yields has resulted in 22 percent lower
unit revenues (RASMs) for the industry than in 2000.
There are two things occurring in the industry: a structural shift down in yields and a spike in fuel costs.
Both are putting a death squeeze on the industry. We recently completed an analysis on every
passenger-carrying airline reporting to the Department of Transportation—103 in total—and found that
no airline US airline can earn its cost of capital in this environment.
The bottom line is that 85 percent of the airline industry accounts for 99 percent of the losses and
represents the top 13 airlines. These airlines are coming up $11 billion short in terms of earning a risk-
adjusted normal return, meaning that fares have to go up or costs come down—on average across the
board in real terms—before the industry can be considered worthy of investment.
Recent fare hikes are not enough to cover the spike in fuel costs. There is approximately 10 percent too
much capacity in the system, given the cost of that capacity and the revenue generated. If fares were to
increase to the level required to cover true costs (return on capital minus the cost of capital), load
factors and traffic would plunge and the level of excess capacity would become apparent.
The weakest airlines - legacies’ costs are still 33 to 50 percent higher than the low-cost carriers-
would be forced to pull down domestic capacity to stem the gushing red ink. If they do not, they will run
out of cash and file bankruptcy or liquidate.
Given the NYMEX forward curve, the contango condition, and the high crack spreads, we are predicting
that Independence Air, Delta, and NWAC will file bankruptcy and that the new USAir (America West
merger) will be forced into bankruptcy within a few short years, if the America West shareholders vote
for the merger.
The industry is approaching the endgame of a long drawn out restructuring that will be required before
it can be considered a viable industry, at least in terms of earning its cost of capital. Since 2000, the
industry has destroyed $34 billion in shareholder wealth (2004 revenue was $107 Billion on $147
billion in assets) and is on tract to lose another $6 billion or so in 2005.
For many of the old-line major airlines, their survival and viability will be a function of industry
rationalization. This rationalization is best achieved through consolidation. Without consolidation, the
industry could lose several additional big brand airlines. In the war of attrition, the least efficient airline
slowly loses market share and becomes less competitive over time.
Certain combinations make the most strategic and financial sense. The economic logic is sound, and
it is easy to make the economic case. The political case is a different issue, but we believe it can also
be made given the severity of the financial distress and the exceptionally high potential for liquidations
and bankruptcies.
We believe that the best matches are as follows and represent the most likely combinations
• NWAC/Delta
• United/Continental or United/Amercia West/USAir
• American/Alaska Airlines
• America West/USAir
It should be noted that NWAC/American makes a very powerful combination. The
United/AmericaWest/USAir combination would also make sense considering the Star Alliance
partnership. NWAC and Delta are in bankruptcy and this would suggest that they have the most
momentum given their partnership with Air France/KLM and the SkyTeam Alliance. NWAC has a golden
share in Continental and that could prevent another airline from merging with Continental.
In our view, the large branded Alliances make the most sense in terms of expanding the global network
(i.e., portfolio) of national, regional, and feeder airlines in the most efficient manner. The large networks
have enhanced scope economies and provide benefits for the consumer. The US needs healthy and
viable airlines that can compete on a global playing field and provide the quality of service that
consumers want and need.
Large networks are the most efficient means to transport large numbers of passengers around the
world. Numerous point-to-point airlines and hub-and-spoke airlines provide the intensity of rivalry that
will continue to result in low cost air transportation in the US. However, too many airlines results in
destructive competition that ultimately results in less service and lower quality service for the
consumer. Hence the case for consolidation.
Vaughn Cordle, CFA / August 12, 2005
High jet fuel costs and excess competition will force a major restructuring in the airline industry, which
will accelerate a restructuring that has been underway since the stock market bubble popped and the
events of September 11, 2001. While airlines are paying over $2 per gallon for jet fuel on the West
Coast, the average price paid during the period of 1986 through 2000 was a mere 60 cents.
Fuel costs for the industry will be $9 billion more in 2005 then they were in 2003.
Yields—passenger revenue divided by revenue passenger miles (REV/RPMs) —were 28 percent lower
in the first 6 months of 2005 than they were during the same period in 2000. This has driven traffic back
to 2000 levels, while load factors have increased to historic levels—83 percent in June and July, the
peak demand period in the airline industry. The plunge down in yields has resulted in 22 percent lower
unit revenues (RASMs) for the industry than in 2000.
There are two things occurring in the industry: a structural shift down in yields and a spike in fuel costs.
Both are putting a death squeeze on the industry. We recently completed an analysis on every
passenger-carrying airline reporting to the Department of Transportation—103 in total—and found that
no airline US airline can earn its cost of capital in this environment.
The bottom line is that 85 percent of the airline industry accounts for 99 percent of the losses and
represents the top 13 airlines. These airlines are coming up $11 billion short in terms of earning a risk-
adjusted normal return, meaning that fares have to go up or costs come down—on average across the
board in real terms—before the industry can be considered worthy of investment.
Recent fare hikes are not enough to cover the spike in fuel costs. There is approximately 10 percent too
much capacity in the system, given the cost of that capacity and the revenue generated. If fares were to
increase to the level required to cover true costs (return on capital minus the cost of capital), load
factors and traffic would plunge and the level of excess capacity would become apparent.
The weakest airlines - legacies’ costs are still 33 to 50 percent higher than the low-cost carriers-
would be forced to pull down domestic capacity to stem the gushing red ink. If they do not, they will run
out of cash and file bankruptcy or liquidate.
Given the NYMEX forward curve, the contango condition, and the high crack spreads, we are predicting
that Independence Air, Delta, and NWAC will file bankruptcy and that the new USAir (America West
merger) will be forced into bankruptcy within a few short years, if the America West shareholders vote
for the merger.
The industry is approaching the endgame of a long drawn out restructuring that will be required before
it can be considered a viable industry, at least in terms of earning its cost of capital. Since 2000, the
industry has destroyed $34 billion in shareholder wealth (2004 revenue was $107 Billion on $147
billion in assets) and is on tract to lose another $6 billion or so in 2005.
For many of the old-line major airlines, their survival and viability will be a function of industry
rationalization. This rationalization is best achieved through consolidation. Without consolidation, the
industry could lose several additional big brand airlines. In the war of attrition, the least efficient airline
slowly loses market share and becomes less competitive over time.
Certain combinations make the most strategic and financial sense. The economic logic is sound, and
it is easy to make the economic case. The political case is a different issue, but we believe it can also
be made given the severity of the financial distress and the exceptionally high potential for liquidations
and bankruptcies.
We believe that the best matches are as follows and represent the most likely combinations
• NWAC/Delta
• United/Continental or United/Amercia West/USAir
• American/Alaska Airlines
• America West/USAir
It should be noted that NWAC/American makes a very powerful combination. The
United/AmericaWest/USAir combination would also make sense considering the Star Alliance
partnership. NWAC and Delta are in bankruptcy and this would suggest that they have the most
momentum given their partnership with Air France/KLM and the SkyTeam Alliance. NWAC has a golden
share in Continental and that could prevent another airline from merging with Continental.
In our view, the large branded Alliances make the most sense in terms of expanding the global network
(i.e., portfolio) of national, regional, and feeder airlines in the most efficient manner. The large networks
have enhanced scope economies and provide benefits for the consumer. The US needs healthy and
viable airlines that can compete on a global playing field and provide the quality of service that
consumers want and need.
Large networks are the most efficient means to transport large numbers of passengers around the
world. Numerous point-to-point airlines and hub-and-spoke airlines provide the intensity of rivalry that
will continue to result in low cost air transportation in the US. However, too many airlines results in
destructive competition that ultimately results in less service and lower quality service for the
consumer. Hence the case for consolidation.
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